Project Report on:

DI VI DEND POLI CY AND

RETENTI ON
Submitted to: Prof Naveen Rego By: Pradnya Desai---- Roll 7 Pranita Juvatkar--- Roll 16 S ati !ar a:--- Roll 1" D#anan$ay S#ettigar:--- Roll %& S#radd#a Surve:--- Roll %6 'ks#ay (aidya:--- Roll %" )*B+S

+odels of Dividend Poli,y

To distribute dividend or not is a debatable issue. A person investing in shares for fixed income will always want dividend while a person investing in the shares for capital gains will deem it indifferent. There have been many theories/arguments as to whether distribution of dividend is really important or not. ome of them are as follows: -alter.s +odel: 'rgument: A firm!s dividend policy will be determined by the relationship between the return on investment "R#$% and the expected rate of return. 'ssum/tions: &. All financing through the retained earnings' no external source. (. )ith additional business underta*en+ firm!s business ris* wont change. Thus+ R#$ "r% and re,uired rate of return on capital "*% are constant. -. There!s no change in *ey variables+ which are . and /. 0. Perpetual life of the firm. Justifi,ation: The firm would have an optimum relation of r and * i.e. if r 1 *+ then the firm will retain earnings. 2ut if r 3 * then the firm would distribute dividend so that shareholders can earn some R#$ from elsewhere. $f r 4 *+ it becomes matter of indifference. 0ordon.s model: 'rgument: 2eing ris* averse+ an investor will always prefer present income to future income. 'ssum/tions: &.5irm is an all e,uity firm. (. R#$ "r% and expected rate of return on capital "*% are constant. -. 5irm has perpetual life. 0. The retention ratio is constant. 6. 7rowth rate is constant and is less than expected rate of return on capital "*%.

8. $nvestors are ris* averse. 9. They put premium on certain investments and discount on uncertain. Justifi,ation: :2ird in the hand is worth two in the bush.! ;;; is the bottom line of this argument. $f investors are ris* averse+ the rational investors in general would prefer dividend ; they!ll avoid ris*. The payment of current dividend removes any chance of ris*. $f firm retains earnings+ dividends obviously will be received in future. 5uture dividend is uncertain. Thus the rational investors will prefer current dividends+ and discount future dividends. The argument that deems dividends to be irrelevant is the famous << <odel. ++ +odel 1+odigliani and +iller +odel2: 'rgument: /ividend policy has no effects on share price of a firm and is therefore of no conse,uence. )hat matters is the investment policy through which the firm can increase its earnings and therefore t8he value of the firm. 'ssum/tions: &. Perfect capital mar*ets i.e. all investors are rational+ information is available to all+ free of cost+ there are no transactional costs+ securities are infinitely divisible+ no floatation costs+ etc. (.=o taxes or no difference in tax rates applicable to dividends and capital gains. -. 5irm has a given investment policy which does not change i.e. ris* extent will be constant. Justifi,ation: $f a company retains earnings instead of giving it out as dividends+ the shareholder enjoys capital appreciation+ which is e,ual to the amount of earnings retained. $f it distributes dividends+ the shareholder will enjoy dividend in amount by which capital would have appreciated had the company retained its earnings. Thus it!s ,uite irrelevant whether dividend is given or not.

3egal and Pro,edural 's/e,ts of Dividend

Dividend can be defined as: A cash payment using profits thats announced by a companys Board of Directors to be distributed among the stockholders. >onceptually+ dividends may be in the form of ,as#4 sto,k or /ro/erty. )#e Board of Dire,tors must de,lare all dividends5 Through the stoc*s+ an investor can ma*e income either through the capital gains or through the periodic dividends. A company announces dividend either ,uarterly+ semi; annually or yearly. Thus it is a steady /eriodi, source of income. $t is in the proportion to the share of capital+ which the investor actually holds in the company. Though dividend is usually offered+ it is necessary to note that a ,om/any is under no obligation to /ay t#e dividends. $t may or may not pay the dividends. .ven if it pays' t#ere is no set level as to t#e /ayment of dividend. That is there is no minimum or maximum limit on the amount of dividend that can be paid. <ost often+ the dividend comes in the form of cash: a company will pay a small percentage of its profits to the owner of each share of stoc*. ?owever+ it is not unheard of for companies to pay dividends in the form of stoc*. /ividends can be determined by a fixed rate *nown as /referred dividends+ or a variable rate based on the company@s latest profits *nown as ,ommon dividends. Asually+ amount of profit made is announced in the A7<s or ,uarterly/semi;annual result. The company declares amount of dividend on each share "Asually as percentage of face value%. At this point of time+ the 2o/ announces that : The dividend of the set amount will be paid to shareholders of record as of the record date and will be paid or distributed on distribution date!. Re,ord date is a concept to enable proper distribution of dividend. A company issues shares+ and once it starts operating+ the shares begin to be traded in the stoc* mar*et. Thus ownership of a single share might pass even &BBB hands within a year. Thus at the time of distributing dividends it would have been very difficult to determine the exact owner of a share+ if concept of :Record /ate! wouldn!t have existed. A company usually maintains record of its shareholders. $t declares a date called :Record /ate!+ prior to which all the transferred names have to be entered into the company!s records. The company will give dividends only to those investors whose names are found in company!s records on the record date. Thus even if share is sold on the day after record date+ the concerned seller; investor will receive the dividend. This is done because a dividend payout automatically reduces the value of the company "it comes from the company@s cash reserves%+ and the investor would have to absorb that reduction in value. /ividend is ,uite unpredictable' but a trend might be deciphered studying past pattern+ future expectations+ industry trends etc.

#n the distribution date+ which as the name suggests is the date when dividends are distributed+ the shareholders on record as on record date will be mailed che,ues. The legal aspects of dividend distribution in the $ndian >ontext "As per company law% are as follows: &. >ompanies can pay only cash dividends "with the exception of bonus shares%. (. /ividends can be paid only out of the profits earned during the financial year after providing for depreciation and after transferring to reserves such percentage of profits as prescribed by the law. The companies "Transfer to reserves% Rules+ &C96+ provide that before dividend declaration a percentage of profit as specified below should be transferred to the reserves of the company. )here the dividend proposed exceeds &BD but not &(.6D of the paid up capital+ the amount to be transferred to the reserves shall not be less than (.6 D of the current profits. )here the dividend proposed exceeds &(.6D but not &6D+ the amount to be transferred to reserves shall not be less than 6D of the current profits. )here dividend proposed exceeds &6D but not (BD+ the amount to be transferred to the reserves shall not be less than 9.6D of the current profits. )here the dividend proposed exceeds (BD + the amount to be transferred to reserves shall not be less than &BD. -. /ue to inade,uacy or absence of profits in any year+ dividend may be paid out of the accumulated profits of previous years. $n this context+ the following conditions as stipulated by the companies "/eclaration of /ividends out of reserves% Rules+ &C96+ have to be satisfied: The rate of the dividend declared shall not exceed the average of the rates of which dividend was declared by it in 6 years immediately preceding that year or &BD of its paid up capital+ whichever is less. The total amount to be drawn from the accumulated profits earned in the previous years and transferred to the reserves shall not exceed an amount e,ual to one;tenth of the sum of its paid up capital and free reserves and the amount so drawn shall first be utiliEed to set off the losses incurred in the financial year before any dividend in respect of preference or e,uity shares is declared. The balance of reserves after such drawal shall not fall below &6D of its paid up capital.

0. /ividends cannot be declared for past years for which the accounts have been closed.

Retained 6arnings 's ' Prudent 7nvestment Poli,y:

DR7Ps: These days+ because of lac* of investment initiatives+ industries are encouraging the investors to reinvest their dividends. The concept is called DR7P or t#e Dividend Re-7nvestment Plan . As per this plan+ the shareholder will be given choice of accepting dividend or reinvesting it. $f he/she opts for the latter+ his dividend is credited to his /her individual /R$P A/c and the e,uivalent shares will be allotted to him. )o /ay or not to /ay: ince the company is under no obligation as to payment of dividend+ 8S#ould a ,om/any /ay dividend. is an important issue of discussion. $n general it can be said that the younger companies in growth mar*ets are far more li*ely to pay a small or no dividend so that they can find further expansion. $n contrast+ more mature companies in slower growing mar*ets are li*ely to pay higher dividends because they do not have opportunity to invest in the expansion. Thus regular dividends are paid out to ma*e holding the stoc* more appealing to investors+ a move the company hopes will increase demand for the stoc* and therefore increase the stoc*@s price.

9a,tors 6ffe,ting Dividend Poli,y:

5ollowing reasons result into payment of dividends. 7nvestor Preferen,e for dividends: $f taxes and transaction costs are ignored+ dividends and capital receipts could be perfect substitutes. Fet+ according to ?ersh hefrin and <eir tatman principles of self;control and aversion for regret lead to investor preference for dividends. o elf >ontrol and dividends: $ndividuals often lac* self;control. o they rely on rules and programmes+ which chec* their temptations. $n the realm of personal financial management+ individuals li*e to protect their principal from their spending tendencies. A simple way to do this is to limit their spending to the dividend income so that the capital amount is maintained intact. o Aversion to regret and dividends: Although the dividend and the capital receipts are perfectly substitutable+ when taxes and transaction costs are abstracted away+ empirical evidence suggests that most people feel more regret when they sell the stoc* because they can readily imagine the conse,uences of that action. 7nformation Signaling: <anagement often has significant information about the prospects of the firm that it cannot "or prefers not to% disclose to the investors. The information gap between management and shareholders generally causes stoc* prices to be less than what they would be under conditions of information symmetry. According to signaling theory+ these firms need to ta*e actions that cannot be easily imitated by firms that do not have such promising projects. #ne such action is to pay more dividends. $ncreasing dividends suggest to the mar*et that the firm is confident of its earning prospects that will enable it to maintain higher dividends in future as well. 2y the same to*en+ a decrease in

dividends is perceived as a negative signal+ because firms are reluctant to cut dividends. This leads to conse,uent drop in stoc* prices. :lientele 6ffe,t: $nvestors have diverse preferences. ome want more dividend income' others want more capital gains' still others want a balanced mix of both. #ver a period of time+ investors naturally migrate to the firms+ which have a dividend policy that matches their preferences. The concentration of investors in companies with dividend policies that are matched to their preferences is called clientele effect. The existence of clientele effect implies that: A% 5irms get the investors they deserve and 2% $t will be difficult for firm to change an established dividend policy.

Payment of dividends vs5 issue of bonus s#ares -#y do investors #ave strong /referen,e for dividend rat#er t#an bonus s#are; 7n a ,losely #eld ,o5 is it /referred to issue bonus s#ares or dividends;
A dividend is a portion of a company@s earnings that is returned to shareholders. /ividends provide an added incentive "in the form of a return on the investment% to own stoc* in stable companies even if they are not experiencing much growth. <any companies ;; mature and young+ large and small ;; pay a regular dividend to their stoc*holders. >ompanies use dividends to pass on their profits directly to their shareholders. /ividend can be defined as follows. A cash payment using profits thats announced by a companys Board of Directors to be distributed among the stockholders. $n other words+ dividends refer to a /art of t#e firm.s net earnings+ which is paid to the shareholders. =et earnings mean the profit remaining after the payment of interest and taxes "PAT%+ some part of this may be transferred to the reserves and surpluses+ while the remaining part is usually distributed as dividend. The shareholders are the actual owners of the company and should therefore get a return on the investment made by them. Through the stoc*s+ an investor can ma*e income either through the capital gains or through the periodic dividends. A company announces dividend either ,uarterly+ semi; annually or yearly. Thus it is a steady /eriodi, source of income. $t is in the proportion to the share of capital+ which the investor actually holds in the company. Though dividend is usually offered+ it is necessary to note that a ,om/any is under no obligation to /ay t#e dividends. $t may or may not pay the dividends. .ven if it pays' t#ere is no set level as to t#e /ayment of dividend. That is there is no minimum or maximum limit on the amount of dividend that can be paid.

As mentioned earlier+ the dividend can be paid out either ,uarterly+ semiannually or even annually. ometimes+ the companies may also declare an extra or special dividend+ usually to share profits made due to some temporary changes in the mar*et+ or on special occasions in the company;genesis "..g.: ?/5> completing (6 years%. <ost often+ the dividend comes in the form of cash: a company will pay a small percentage of its profits to the owner of each share of stoc*. ?owever+ it is not unheard of for companies to pay dividends in the form of stoc*. /ividends can be determined by a fixed rate *nown as /referred dividends+ or a variable rate based on the company@s latest profits *nown as ,ommon dividends. Bonus S#ares are the shares issued top existing shareholders as a result of capitaliEation of reserves. $n the wa*e of a bonus issue: The shareholders! proportional ownership remains unchanged. The boo* value per share+ the earnings per share+ the mar*et price per share decrease+ but the number of shares increase. 5ollowing are the reasons for issue of bonus shares. The bonus issue tends to bring the mar*et price per share within a more popular range. $t increases the number of outstanding shares. This promotes more active trading. The nominal rate of dividend tends to decline. This may dispel the impression of profiteering. The share capital base increases and the company may achieve a more respectable siEe in the eyes of investing community. hareholders regard a bonus issue as a firm indication that the prospects of the company have brightened and they can reasonably loo* for increase in total dividends. $t improves the prospects of raising additional funds. $n recent years many firms have issued bonus shares prior to issue of convertible debentures or other financing instruments. Thus the motives differ as regards to the issue of bonus shares and payment of dividends. ince compared to receipt of dividends+ receipt of additional stoc* is a ris*. ?ence investors do not prefer it. imilarly+ in case of a closely held company+ since no active trading occurs+ there is no point in increasing the investor li,uidity. Thus practice of issuing bonus shares is rarely follo ed in a closely held company.

)y/es of dividend /oli,ies

7enerous /ividend and 2onus Policy: uch firms reward shareholders generously by stepping up total dividend payment overtime. Typically+ these firms maintain the dividend rate at a certain level "&6;(6D%

and issue bonus shares when reserves position and earnings potential permit. uch firms naturally have a strong shareholder orientation. <ore or less fixed dividend policy: ome firms have a target dividend rate which is usually in the range &BD to (BD which they consider as a reasonable compensation to e,uity shareholders. uch firms normally do not issue bonus shares. $nfre,uently+ may be once in a few years+ the dividend rate may be slightly raised to provide somewhat higher compensation to e,uity shareholders to match the higher returns from other forms of investment. .rratic dividend policy: 5irms which follow this dividend policy seem to be indifferent to the welfare of e,uity shareholders. /ividends are paid erratically whenever management believes that it will not strain its resources.

>oncept testing : #AR>. #5 $=T.R=AT$#=AG 5$=A=>. H The integration and associated globalisation of capital mar*ets has opened up a vast of array of new sources and forms of financing. The corporate treasurers in the prsent day can access foreign capital mar*ets as easily as the domestic ones. .,uity financing H .,uity refers to a share in the ownership of the company. The firm might issue e,uity shares simultaneously in two or more countries. uch issues are *nown as euroe,uity shares. .,uity can be raised in the form of A/R! and 7/R!s. A/R!s H A significant portion of public offerings by non;A companies in the A is in the form of A/R!s or American /epositary Receipts. A/R!s are negotiable instruments issued to investors by an authorised depositary+ normally a A ban* or depositary+ in lieu of the shares of the foreign company+ which are actually held by the depositary. A/R!s can be listed and traded in a A Hbased stoc* exchange. .,uity can be raised from the non A mar*et by way of 7/R!s. 7/R!s or 7lobal depositary receipts are listed in a stoc* exchange other than American toc* exchange. 2ond financing H A corporate bond is a debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. 5oreign bond H A foreign bond is a bond sold in a foreign country in the currency of the country of issue.5or example+ A canadian company selling a foreign bond in =ew For*+ denominated in dollars. .urobond H A eurobond is a bond issued that is denominated in a currency that is not that of the country in which it is issued. 5or example+ a A denominated band sold outside A .

Bank finan,ing and Dire,t loans

A major part of financing of foreign subsidiaries is also done by its parent company. )hen a subsidiary borrows from its parent+ there is transfer of funds within the <=> and thus there is no increase in the cost of ban*rupcy.The subsidiary is able to deduct its interest payments from income "debt being tax;deductible%+ while the parent treats the interest as income.

0overnment and develo/ment bank lending

5inancing is also done by government or development ban*s. 2ecause 7overnment and development ban* financing is generally at favourable terms many corporations consider these official sources of capital before considering the issue of stoc*s+ bonds+ etc. ?ost 7overnment of foreign investments provide financing when the projects are li*ely to generate jobs+ earn foreign exchange or provide training to their wor*ers.

State reasons for using internal funds as a sour,e of finan,e5

<any companies use retained profit as a source of finance. $nstead of paying dividends to shareholders I borrowing funds from outside+ Profit After Tax can be used as capital or a source of finance #R a part of Profit After Tax can be used for payment of dividends I remaining can be used as internal funding. Terms li*e+ retained profits+ retained earnings I internal funding indicate same thing. 5ollowing are the reasons for using internal funds as a source of finance: Non-e</ensive H Retained earnings are self;evidently the cheapest form of finance. =o interest is charged on retained earnings I at the same time+ no shares are issued. As a result+ there are no professional fees to be paid. No ,#ange of o ners#i/ H =ormally+ existing owners of the business are reluctant to transfer )ime H Reputed companies can get loans ,uite easily. 2ut it ta*es several months to attract a the ownership in the new hands. /ue to internal funding+ ownership remains with existing managers. suitable e,uity partner. A detail study of capabilities of e,uity partner is re,uired. $t should also be *ept in the mind that chosen e,uity partner has to show interest in the company. 6<it strategies H =ormally+ private e,uity investors re,uire an exist within three to five years. =istory H ?istory shows that companies which are loo*ing to build a substantial siEe over a &B This means after every three to five years+ company is bound to choose a new e,uity partner. to &6 years period I want to retain control I ownership of the original shareholders I management team+ retained earnings is the best source of finance.

6valuate internal funds as a sour,e of finan,e5

$nstead of paying dividends to shareholders I borrowing funds from outside+ Profit After Tax can be used as capital or a source of finance #R a part of Profit After Tax can be used for payment of dividends I remaining can be used as internal funding. Terms li*e+ retained profits+ retained earnings I internal funding indicate same thing. According to history+ internal funding is used for a steady growth over a period over &B to &6 years. #n internal funding+ no professional fees have to be paid. >ompany need not go for the search of the private e,uity partner I at the same time+ control I ownership are retained by existing partners I shareholders.

#n opposite side+ as outsiders are not allowed to interfere in the business of the company due to fear of losing control+ company does get talented I experienced people on the board. >ompanies+ which are growth oriented+ have to depend on private e,uity partner for wor*ing capital re,uirements. #ne more aspect to be considered while evaluating internal funds as a source of finance is that the ban*s+ while giving loans or overdraft facilities+ follow :one to one! gearing rule which means that ban* may be reluctant to lend more than the sum of the share capital plus retained profits. $f the share capital is to remain unchanged+ the only way a company can increase the amount a ban* will be prepared to lend is through increasing retained profit. =ow+ it must be clear that it is up to individual company to decide whether to go for internal funding or private e,uity. As long as the management team understands the urgency of maximiEing retained profits+ company can be made fully self;sufficient in funding+ with help from the ban*. $t can also be said that internal e,uity is not just about providing the comfort of full control to owner managers who might otherwise have to see* external e,uity investors+ it is also about necessity of survival I success.

Dis,uss retained earnings as a /rudent investment /oli,y5

/epreciation charges and retained earnings represent the internal sources of finance available to the company. $f depreciation charges are used for replacing worn;out e,uipment+ retained earnings represent the only internal source for financing expansion and growth. >ompanies normally retain -B D to JB D of profit after tax for financing growth. ?ence+ these are an important source of long;term financing.

Retained earnings can be reviewed for their advantages and disadvantages from H
15 9irm.s Point of (ie : &. They are readily available internally. They do not re,uire tal*ing to outsiders. (. They effectively represent infusion of additional e,uity in the firm. Ase of retained earnings+ in lieu of external e,uity+ eliminates issue costs and losses on account of underpricing. -. There is no dilution of control when a firm relies on retained earnings. Disadvantages H &. The amount that can be raised by way of retained earnings may be limited. 5urther+ the ,uantum of retained earnings tends to be highly variable. (. The opportunity cost of retained earnings is ,uite high+ since it is nothing but the dividends foregone by the e,uity shareholders. >5 S#are#older.s Point of (ie : &. >ompared to dividend income+ the capital appreciation that arises as a se,uel to retained earnings is subject to a lower rate of tax. (. Reinvestment of profits may be convenient for many shareholders as it relieves them to some extent of the problem of investing on their own. Disadvantages H &. hareholders who want a current income higher than the dividend income may be highly averse to converting a portion of capital appreciation into current income+ as it calls for selling some shares. (. <any firms do not fully appreciate the opportunity cost of retained earnings. 'dvantages H 'dvantages H