Financial Management: Chapter 5- Working Capital

Management

Chapter 4: Dividend Decisions

MEANING AND CONCEPT
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 shareholders 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:
1.
2.
3.
4.

Cash dividend
Stock dividend
Bond dividend
Property dividend

1. 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.
2. 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.
3. 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.
4. 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.

FACTORS DETERMINING DIVIDEND POLICY

Mohammed Umair: Dept of
Commerce, KJC

Financial Management: Chapter 5- Working Capital

Management

A discussion on internal financing ultimately turns to practical considerations which determine the
dividend policy of a company. The formulation of dividend policy depends upon answers to the
questions:

1. Financial Needs of The Company: Retained earnings can be a source of

finance for creating profitable investment opportunities. When internal rate of
return of a company is greater than return required by shareholders, it would be
advantageous for the shareholders to re-invest their earnings.
2. Legal implications: Under Section 205(1) of the Companies Act 1956, dividend
is to be paid out of current profits or past profits after depreciation. The Central
Government can allow a company to pay dividend for any financial year out of
profits of the company without providing for depreciation if it is in the public
interest.
3. Liquidity position: Payment of dividends means outflow of cash. Ability to pay
dividends depends on cash and liquidity position of the firm. A mature company
does not have much investment opportunities, nor are funds tied up in
permanent working capital and, therefore has a sound cash position. For a
growth oriented company in spite of good profits, it will need funds for
expanding activities and permanent working capital and therefore it is not in a
position to declare dividends.
4. Access to the Capital Market: By paying large dividends, cash position is
affected. If new shares have to be issued to raise funds for financing investment
programmes and if the existing shareholders cannot buy additional shares,
control is diluted. Payment of dividends may be withheld and earnings are
utilised for financing firms investment opportunities.
5. Investment Opportunities: If investment opportunities are inadequate, it is
better to pay dividends and raise external funds whenever necessary for such
opportunities.
6. Desire of Shareholders: The desire of shareholders (whether they prefer
regular income by way of dividend or maximize their wealth by way of gaining
on sale of the shares). In this connection it is to be noted that as per the current
provisions of the Income Tax Act, 1961, tax on dividend is borne by the
corporate as (Dividend Distribution Tax) and shareholders need not pay any tax
on income received by way of dividend from domestic companies.
7. 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.
8. 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.

Mohammed Umair: Dept of

Commerce, KJC

Financial Management: Chapter 5- Working Capital

Management

9. Policy of Control: Policy of control is another determining factor is so far as

dividends are concerned. If the directors want to have control on company, they
would not like to add new shareholders and therefore, declare a dividend at low
rate. Because by adding new shareholders they fear dilution of control and
diversion of policies and programmes of the existing management. So they
prefer to meet the needs through retained earing. If the directors do not bother
about the control of affairs they will follow a liberal dividend policy. Thus control
is an influencing factor in framing the dividend policy.
10.
Regularity and stability in Dividend Payment: Dividends should be
paid regularly because each investor is interested in the regular payment of
dividend. The management should, in spite of regular payment of dividend,
consider that the rate of dividend should be all the most constant. For this
purpose sometimes companies maintain dividend equalization Fund.
11.
Time for Payment of Dividend: When should the dividend be paid is
another consideration. Payment of dividend means outflow of cash. It is,
therefore, desirable to distribute dividend at a time when is least needed by the
company because there are peak times as well as lean periods of expenditure.
Wise management should plan the payment of dividend in such a manner that
there is no cash outflow at a time when the undertaking is already in need of
urgent finances.
12.
Trade Cycles: Business cycles also exercise influence upon dividend
Policy. Dividend policy is adjusted according to the business oscillations. During
the boom, prudent management creates food reserves for contingencies which
follow the inflationary period. Higher rates of dividend can be used as a tool for
marketing the securities in an otherwise depressed market. The financial
solvency can be proved and maintained by the companies in dull years if the
adequate reserves have been built up.
13.
Needs for Additional Capital: Companies retain a part of their profits
for strengthening their financial position. The income may be conserved for
meeting the increased requirements of working capital or of future expansion.
Small companies usually find difficulties in raising finance for their needs of
increased working capital for expansion programmes. They having no other
alternative, use their ploughed back profits. Thus, such Companies distribute
dividend at low rates and retain a big part of profits.

TYPES OF DIVIDEND POLICY

Firms dividend policy divides net earnings into retained earnings and dividends.
Retained earnings provide necessary funds to finance long term growth while
dividends are paid in cash generally. 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:
1. Regular dividend policy
Mohammed Umair: Dept of
Commerce, KJC

Financial Management: Chapter 5- Working Capital

Management

2. Stable dividend policy

3. Irregular dividend policy
4. No dividend policy.
1. 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.
2. 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:
(a) Constant dividend per share (b) Constant payout ratio (c) Stable rupee dividend plus
extra dividend

3. Irregular Dividend Policy: When the companies are facing constraints of earnings

and unsuccessful business operation, they may follow irregular dividend policy. It is
one of the temporary arrangements to meet the financial problems. These types are
having adequate profit. For others no dividend is distributed.
4. No Dividend Policy: Sometimes the company may follow no dividend policy
because of its unfavourable working capital position of the amount required for future
growth of the concerns.
STOCK DIVIDEND 0R BONUS SHARES
The term bonus means an extra dividend paid to shareholders in a joint stock
company from surplus profits. A bonus share is a free share of stock given to current
shareholders in a company, based upon the number of shares that the shareholder
already owns. While the issue of bonus shares increases the total number of shares
issued and owned, it does not change the value of the company.
Advantages/Objectives of issuing Bonus Shares:
(a) To company
(i) Conservation of Cash. The issue shares allows the company to declare a dividend
without using up the cash that may be used to finance the profitable investment
opportunities within the company and thus company can maintain its liquidity
position.
(ii) Under Financial Difficulty and Contractual Restrictions. When a company faces
stringent cash difficulty and is not in a position to distribute dividend in cash, or where
certain restrictions to pay dividend in cash are put under loan agreement, the only
way to satisfy the shareholders or to maintain the confidence of the shareholders is
the issue of bonus shares.

Mohammed Umair: Dept of

Commerce, KJC

Financial Management: Chapter 5- Working Capital

Management

(iii) Remedy for Under-Capitalisation. In the state of under-capitalisation, the rate of

divided is very much high. In order to lower down the rate of dividend, the company
issued bonus shares instead of paying dividend in cash.
(iv) Widening the Share Market. If the market value of a company's share is very high,
it may not appeal to small investors. By issuing bonus shares, the rate of dividend is
lowered down and consequently share price in the market is also brought down to a
desired range of activity and thus trading activity would increase in the share market.
Now small investors may get an opportunity to invest their funds in low priced shares.
(v) Economical Issue of Securities. The cost of issue of bonus shares is the minimum
because no underwriting commission, brokerage etc. is to be paid on this type of
issue. Existing shareholders are allotted bonus shares in proportion to their present
holdings.
(a) To investors
(i) Tax-Saving. The stock dividend is not taxable as income in the hands of
shareholders while cash dividend is taxable as ordinary income.
(ii) Marketability of Shares. Shareholders who are in dire need of money sell their
stock dividend and pay capital gain taxes which is usually less than the income tax on
cash dividend. Thus, by issuing bonus shares, marketability of shares is increased.

(iii) Higher Future Profits of the Company. The payment of stock dividend is normally
interpreted by shareholders as an indication of higher profitability. Stock dividend is
generally declared by the directors of the company only when they expect rise in
earnings to offset the additional outstanding shares. Thus, it may convey some
information which may have a favourable impact on the value of shares.
(iv) Increased Future Dividend. In a company as been following a policy of paying a
fixed rate of dividend and continues if after issuing bonus shares, the shareholders will
get larger amount of cash dividend in future. Moreover, it may have a favourable
affect on the value of shares.
(v) Psychological Value. The declaration of stock dividend may have a favourable
psychological effect an shareholders. It gives an impression of prosperity of the
company. It helps to increase the capital value of shares in the market.
Disadvantages of Issuing Bonus Shares (company)
1. Issue of bonus shares declines the rate of dividend in the future
2. The companies encourage speculative dealings in shares by issuing bonus
shares
3. Issue of bonus shares is a very lengthy process. It requires the approval of SEBI
which might delay in the issue of shares
Mohammed Umair: Dept of
Commerce, KJC

Financial Management: Chapter 5- Working Capital

Management

Disadvantages to the shareholders:

1. Some shareholders may prefer cash dividend to stock dividend, such shareholders
may feel disappointed (no doubt they can very well sell their bonus shares and get
their money).

Mohammed Umair: Dept of

Commerce, KJC