CHAPTER 18 DIVIDEND POLICY Q.1. A.1.

Explain the nature of the factors which influence the dividend policy of a firm. The following factors generally influence the dividend policy of the firm. 1. Shareholders expectations: Shareholders expectation relating to dividends or capital gains depends on their economic status, effect of differential tax system, need for regular income, etc. 2. Firms financial needs: Financial needs of the company to finance the profitable investment opportunities. 3. Legal restrictions: Legal restrictions like dividend to be paid out of current or past profits do influence dividend policy of a firm. 4. Liquidity: The overall liquidity of a company has an effect on the dividend decision of a firm. In the absence of sufficient cash, a firm may be unable to pay dividends even if it has profits. 5. Firms financial condition: The financial condition or capability of a firm depends on its use of borrowings and interest charges payable. A high levered firm is expected to retain more profits and distribute lesser dividends in order to strengthen its equity base. 6. Capital market accessibility: Accessibility by firm to the capital market becomes an important factor to declare dividends. For example, a fast growing company which has a tight liquidity position will not face any difficulty in paying dividends if it has access to the capital markets. 7. Institutional lenders: Lenders of funds like financial institutions and banks may generally put restrictions on dividend payments to protect their interests when the firm is experiencing low liquidity or low profitability, etc. The primary purpose for which a firm exists is the payment of dividend. Therefore, irrespective of the firms needs and the desires of shareholders, a firm should follow a policy of very high dividend payout. Do you agree? Why or why not? This statement is not true. The primary purpose of the firm is not payment of dividend. Rather, it is to maximize shareholders wealth. Paying dividend in certain situations, may harm, rather than enhance, the shareholders wealth. The MM view is that dividends are irrelevant. If we consider taxes and assume that dividend incomes are taxed and capital gains are tax exempt, then paying dividends will be harmful. On the contrary if capital gains are taxed and dividends are tax exempt, then it may be in the interest of shareholders if dividends are paid. A company having profitable growth opportunities will like to retain more and create shareholder wealth. What are the factors which influence managements decision to pay dividend of a certain amount?

Q.2.

A.2.

Q.3.

A.3.

Dividends are paid in cash. A firms dividend policy has the effect of dividing its net earnings into two parts, i.e., retained earnings and dividends. The retained earnings provide funds to finance the long term growth. Thus, the distribution of earnings uses the available cash of the firm. The firm which needs funds to finance its investment opportunities will have to use external source of financing. To safeguard the firm from approaching the capital market for external financing, a firm may not like to distribute cash dividend. Firms with a lot of investment opportunities do distribute some dividend because paying dividend has information value. It provides a positive signal to investors about the future profitability of the firm. What is a stable dividend policy? Why should it be followed? What can be the consequences of changing a stable dividend policy? Stable dividend policy means regularity in paying some dividend annually, even though the amount of dividend may fluctuate over years, and may not be related with earnings. Precisely, stability of dividends refers to the amount paid out regularly. This policy should be followed, because by and large, shareholders favour this policy and value stable dividends higher than the fluctuating ones. The stable dividend may have a positive impact as the market price of the share. This policy resolves uncertainty in the minds of investors about future earnings, and satisfies the desire of many investors, such as old, retired persons, etc. If the companies change from the stable dividend policy to an irregular or fluctuating dividend policy, it gives an unfavourable signal to shareholders about the stability of the firms operations. How is the corporate dividend behaviour determined? Explain Linters model in this regard. The firms dividend policy may be expressed either in terms of dividend per share or dividend rate. According to empirical findings in India, USA and other countries, corporate managers feel that current dividends depends on current earnings, the future earnings potential as well as dividends paid in the previous year. Further, dividends must be paid even when a company needs funds for undertaking profitable investment projects since dividends have information value. Linters model is based on the assumptions that firms generally think in terms of proportion of earnings to be paid out as dividend. Firms generally have target payout ratios in view while determining change in dividends. Shareholders like a steadily growing dividends. Thus, firms change their dividends slowly and gradually even when there are large increases in earnings. This implies that firms have standards regarding the speed with which they attempt to move towards the full adjustment of payout to earnings. Linter has suggested the following formula for change in dividends of firms in practice: DIV1 = DIV0 + b (pEPS1 DIV0) where DIV1 is the expected dividend per share; DIV0 is the dividend per share of the previous year; p is the target payment ratio; b is the speed of adjustment; and EPS1 is the expected earnings per share in the current year.

Q.4. A.4.

Q.5. A.5.

Q.6. A.6.

What are the different payout methods? How do shareholders react to these methods? Three distinct forms of dividend payout methods are (1) constant dividend per share; (2) constant dividend payout ratio; and (3) constant dividend per share plus extra dividend. Constant dividend per share: The policy of a company to pay fixed amount per share or fixed rate on paid-up capital as dividend every year, irrespective of fluctuations in the earnings. Those investors who have dividends as the only source of their income may prefer this method. They do not accord much importance to the changes in the share price. Constant payout: The ratio of dividend to earnings is known as payout ratio. With this policy, the amount of dividend will fluctuate in direct proportion to earnings. Internal financing with retained earnings is automatic when this policy is followed. Constant dividend per share plus extra dividend: The policy to pay a minimum dividend per share with step-up feature is desirable. The small amount of dividend is fixed to reduce the possibility of ever missing a dividend payment. The extra dividend may be paid as an interim dividend in periods of prosperity. Certain shareholders like this policy because of the certain cash flow in the form of the regular dividend and the option of earning extra dividend occasionally. What is a bonus issue or stock dividend? What are its advantages and disadvantages? Bonus share means distribution of free shares to the existing shareholders. This is known as stock dividend in the USA. This has the effect of increasing the number of ordinary shares of the company by capitalisation of retained earnings. In India, bonus shares cannot be issued in lieu of cash dividend. The earnings per share and market price per share will fall proportionately to the bonus issue, but the total net worth of the firm is not affected by the bonus issues. Advantages The shareholders are benefited as bonus shares are not taxable as income. They interpret it as an indication of higher profitability of the firm. If the company is following the constant dividend policy, then total cash dividend of the shareholders will increase in future. Some of the shareholders can sell bonus shares to make capital recovery. The company is able to retain the earnings and at the same time satisfy the desires of shareholders to receive dividend. It is the only way for firm to pay dividend under financial difficulty and contractual restrictions, and maintain the impression of firm in shareholders mind intact. Disadvantages Bonus share have no effect on share value. From the companys point of view, they are more costly to administer than cash dividend. Explain a stock split? Why is it used? How does it differ from a bonus shares?

Q.7. A.7.

Q.8.

A.8.

A stock (share) split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares, the shareholders total fund remains unaltered. For example, a firms total share capital of Rs 10 crore being represented by 1 crore shares, each having par value of Rs 10. The firm can split their shares two-for-one. Then after split off the number of shares will be 2 crore each having par value of Rs 5 and total share capital will remain at Rs 10 crore. Stock split is done with the main purpose to reduce the market price of the share and place it in a more popular trading range. This helps in marketability and liquidity of the companys shares. Generally, when the share is split, the company seldom reduces dividend per share proportionately, so total dividends of a shareholder increase after a stock split. The reduction of the number of outstanding shares by increasing per share par value is known as reverse split. This may be done, when company wants to prop up the market price per share. In case of both bonus share and stock split, the total net worth of firm does not change, but number of outstanding shares increases substantially. In case of bonus shares, the balance of the reserves and surpluses account decreases due to a transfer to the equity capital and share premium accounts. The par value per share remains unaffected. With a stock split, the balance of the equity accounts does not change, but the par value per share changes. Bonus shares represent simply a division of corporate pie into a large number of pieces. Explain. The declaration of bonus shares is a method of capitalizing the past earnings of the shareholders. It is a formal way of recognizing earnings of the shareholders which they already own. It merely divides the ownership of the company into a large number of share certificates. The ownership of shareholder does not change by receipt of bonus share. In short, it represents simply a division of corporate pie into a large number of pieces.

Q.9. A.9.

Q.10. What are the effects of bonus issue and share split on the earnings per share and the market price of the share? A.10. Bonus shares and stock split reduce the market price of the share reduces and it becomes more attractive to the shareholders. The reduced market price per share, place the companys share in a more popular trading range. This helps in increasing marketability and liquidity of the companys share. The earnings per share also reduce on account of bonus shares issue and stock split. Q.11. What is meant by the buyback of shares? What are its effects? Is it really beneficial to the company and shareholders? A.11. The buyback of shares is the repurchase of its own shares by a company. In India companies are authorized to buy back their shares. But they can not do so by raising debt. They will use their surplus cash for doing so. Also after the buyback,

company can not issue new shares for next 12 months. There are two methods of the share buyback in India. 1. A company can buy its shares through authorized brokers on the open market. 2. The company can make a tender offer, which will specify the purchase price, the total amount, and the period within which shares will be brought back. The purpose of the buyback is to provide companies the flexibility of improving their EPS and share price, to defend themselves from hostile takeovers and adjust their capital structure. In practice, share prices may fall if the buyback results into slow growth. It may not be effective in countering the takeover if it does not have enough surplus cash.