The financial manager must take careful decisions on how the profit should be distributed among shareholders. It is very important and crucial part of the business concern, because these decisions are directly related with the value of the business concern and shareholder’s wealth. Like financing decision and investment decision, dividend decision is also a major part of the financial manager. When the business concerns decide dividend policy, they have to consider certain factors such as retained earnings and the nature of shareholder of the business concern.
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as the part of the profit of a business concern, which is distributed among its shareholders.According to the Institute of Chartered Accountant of India, dividend is defined as “a distribution to shareholders out of profits or reserves available for this purpose”.
Types of Dividend/Form of Dividend
Dividend may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are classified into:Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed by majority of the business concerns.Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing shareholders of the business concern.Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond or notes.Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional circumstance. This type of dividend is not published in India.Dividend Decision
Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for financing its long term growth. Hence, dividend decision plays very important part in the financial management.Dividend decision consists of two important concepts which are based on the relationship between dividend decision and value of the firm.
Irrelevance of Dividend
According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the company. There is no relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the value of the firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.Modigliani and Miller’s Approach
According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affect the value of the firm. “Under conditions of perfect market, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of shares”.Assumptions
MM approach is based on the following important assumptions:1. Perfect capital market.
2. Investors are rational.
3. There are no tax.
4. The firm has fixed investment policy.
5. No risk or uncertainty.
Criticism of MM approach
MM approach consists of certain criticisms also. The following are the major criticisms of MM approach.- MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm.
- MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present day business life.
- MM approach does not consider floatation cost and transaction cost. It leads to affect the value of the firm.
- MM approach considers only single decrement rate, it does not exist in real practice.
- MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors will behave rationally.
Relevance of Dividend
According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between dividend policy and value of the firm. Relevance of dividend concept is supported by two eminent persons like Walter and Gordon.Walter’s Model
Prof. James E. Walter argues that the dividend policy almost always affects the value of the firm. Walter model is based in the relationship between the following important factors:- Rate of return I
- Cost of capital (k)
If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.
Assumptions
Walters model is based on the following important assumptions:1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
Criticism of Walter’s Model
The following are some of the important criticisms against Walter model:Walter model assumes that there is no extracted finance used by the firm. It is not practically applicable.
- There is no possibility of constant return. Return may increase or decrease, depending upon the business situation. Hence, it is applicable.
- According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the business.
Gordon’s Model
Myron Gorden suggest one of the popular model which assume that dividend policy of a firm affects its value, and it is based on the following important assumptions:1. The firm is an all equity firm.
2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has perpectual life.
5. There are no taxes.
6. Constant relation ratio (g=br).
7. Cost of capital is greater than growth rate (Ke>br).
Criticism of Gordon’s Model
Gordon’s model consists of the following important criticisms:- Gordon model assumes that there is no debt and equity finance used by the firm. It is not applicable to present day business.
- Ke and r cannot be constant in the real practice.
- According to Gordon’s model, there are no tax paid by the firm. It is not practically applicable.
Factors Determining Dividend Policy
Profitable Position of the Firm
Dividend decision depends on the profitable position of the business concern. When the firm earns more profit, they can distribute more dividends to the shareholders.Uncertainty of Future Income
Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular income, the firm should maintain regular dividend policy.Legal Constrains
The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.Liquidity Position
Liquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.Sources of Finance
If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for retained earnings.Growth Rate of the Firm
High growth rate implies that the firm can distribute more dividend to its shareholders.Tax Policy
Tax policy of the government also affects the dividend policy of the firm. When the government gives tax incentives, the company pays more dividend.Capital Market Conditions
Due to the capital market conditions, dividend policy may be affected. If the capital market is prefect, it leads to improve the higher dividend.Types of Dividend Policy
Dividend policy depends upon the nature of the firm, type of shareholder and profitable position. On the basis of the dividend declaration by the firm, the dividend policy may be classified under the following types:- Regular dividend policy
- Stable dividend policy
- Irregular dividend policy
- No dividend policy.
Regular Dividend Policy
Dividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to the small investors, retired persons and others.Stable Dividend Policy
Stable dividend policy means payment of certain minimum amount of dividend regularly. This dividend policy consists of the following three important forms:- Constant dividend per share
- Constant payout ratio
- Stable rupee dividend plus extra dividend.
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