4. Dividend decisions Flashcards
What are the determinants of Dividend Policy?
Determinants of dividend policy
Many factors determine the dividend policy of a company. Some of the factors determining the
dividend policy are:
(i) Dividend Payout ratio: A certain share of earnings to be distributed as dividend has to
be worked out. This involves the decision to pay out or to retain. The payment of
dividends results in the reduction of cash and, therefore, depletion of assets. In order to
maintain the desired level of assets as well as to finance the investment opportunities,
the company has to decide upon the payout ratio. D/P ratio should be determined with
two bold objectives – maximising the wealth of the firms’ owners and providing sufficient
funds to finance growth.
(ii) Stability of Dividends: Generally investors favour a stable dividend policy. The policy
should be consistent and there should be a certain minimum dividend that should be paid
regularly. The liability can take any form, namely, constant dividend per share; stable D/P
ratio and constant dividend per share plus something extra. Because this entails – the
investor’s desire for current income, it contains the information content about the
profitability or efficient working of the company; creating interest for institutional
investor’s etc.
(iii) Legal, Contractual and Internal Constraints and Restriction: Legal and Contractual
requirements have to be followed. All requirements of Companies Act, SEBI guidelines,
capital impairment guidelines, net profit and insolvency etc., have to be kept in mind
while declaring dividend. For example, insolvent firm is prohibited from paying dividends;
before paying dividend accumulated losses have to be set off, however, the dividends
can be paid out of current or previous years’ profit. Also there may be some contractual
requirements which are to be honoured. Maintenance of certain debt equity ratio may be
such requirements. In addition, there may be certain internal constraints which are
unique to the firm concerned. There may be growth prospects, financial requirements,
availability of funds, earning stability and control etc.
(iv) Owner’s Considerations: This may include the tax status of shareholders, their
opportunities for investment dilution of ownership etc.
(v) Capital Market Conditions and Inflation: Capital market conditions and rate of inflation
also play a dominant role in determining the dividend policy. The extent to which a firm
has access to capital market, also affects the dividend policy. A firm having easy access
to capital market will follow a liberal dividend policy as compared to the firm having
limited access. Sometime dividends are paid to keep the firms ‘eligible’ for certain things
in the capital market. In inflation, rising prices eat into the value of money of investors
which they are receiving as dividends. Good companies will try to compensate for rate of
inflation by paying higher dividends. Replacement decision of the companies also affects
the dividend policy.
How tax considerations are relevant in the context of a dividend decision of a company?
Dividend Decision and Tax Considerations
Traditional theories might have said that distribution of dividend being from after-tax profits,
tax considerations do not matter in the hands of the payer-company. However, with the arrival
of Corporate Dividend Tax on the scene in India, the position has changed. Since there is a
clear levy of such tax with related surcharges, companies have a consequential cash outflow
due to their dividend decisions which has to be dealt with as and when the decision is taken.
In the hands of the investors too, the position has changed with total exemption from tax being
made available to the receiving-investors. In fact, it can be said that such exemption from tax
has made the equity investment and the investment in Mutual Fund Schemes very attractive in
the market.
Broadly speaking Tax consideration has the following impacts on the dividend decision of a
company:
Before Introduction of Dividend Tax: Earlier, the dividend was taxable in the hands of
investor. In this case the shareholders of the company are corporates or individuals who are in higher tax slab; it is preferable to distribute lower dividend or no dividend. Because dividend
will be taxable in the hands of the shareholder @ 30% plus surcharges while long term capital
gain is taxable @ 10%. On the other hand, if most of the shareholders are the people who are
in no tax zone, then it is preferable to distribute more dividends.
We can conclude that before distributing dividend, company should look at the shareholding
pattern.
After Introduction of Dividend Tax: Dividend tax is payable @ 12.5% - surcharge +
education cess, which is effectively near to 14%. Now if the company were to distribute
dividend, shareholder will indirectly bear a tax burden of 14% on their income. On the other
hand, if the company were to provide return to shareholder in the form of appreciation in
market price – by way of Bonus shares – then shareholder will have a reduced tax burden. For
securities on which STT is payable, short term capital gain is taxable @ 10% while long term
capital gain is totally exempt from tax.
Therefore, we can conclude that if the company pays more and more dividend (while it still
have reinvestment opportunities) then to get same after tax return shareholders will expect
more before tax return and this will result in lower market price per share.
According to the position taken by Miller and Modigliani, dividend decision does not influence value.
Please state briefly any two reasons, why companies should declare dividend and not ignore it.
The position taken by M & M regarding dividend does not take into account certain practical
realities is the market place. Companies are compelled to declare annual cash dividends for
reasons cited below:-
(i) Shareholders expect annual reward for their investment as they require cash for meeting
needs of personal consumption.
(ii) Tax considerations sometimes may be relevant. For example, dividend might be tax free
receipt, whereas some part of capital gains may be taxable.
(iii) Other forms of investment such as bank deposits, bonds etc, fetch cash returns
periodically, investors will shun companies which do not pay appropriate dividend.
(iv) In certain situations, there could be penalties for non-declaration of dividend, e.g. tax on
undistributed profits of certain companies.
Write a short note on assumptions of Modigliani & Miller Hypothesis.
The Modigliani & Miller hypothesis is based on the following assumptions:
(i) The firm operates in perfect capital markets in which all investors are rational and
information is freely available to all.
(ii) There are no taxes. Alternatively, there are no differences in the tax rates applicable to
capital gains and dividends.
(iii) The firm has a fixed investment policy.
(iv) There are no floatation or transaction costs.
(v) Risk of uncertainty does not exist. Investors are able to forecast future prices and
dividends with certainty, and
(vi) one discount rate is appropriate for all securities and all time periods. Thus, r = k = kt for
all t.
Write a short note on Traditional & Walter Approach to Dividend Policy
According to the traditional position expounded by Graham and Dodd, the stock market places
considerably more weight on dividends than on retained earnings. For them, the stock market
is overwhelmingly in favour of liberal dividends as against niggardly dividends. Their view is
expressed quantitatively in the following valuation model:
P = m (D + E/3)
Where,
P = Market Price per share
D = Dividend per share
E = Earnings per share
m = a Multiplier.
As per this model, in the valuation of shares the weight attached to dividends is equal to four
times the weight attached to retained earnings. In the model prescribed, E is replaced by
(D+R) so that
P = m {D + (D+R)/3}
= m (4D/3) + m (R/3)
The weights provided by Graham and Dodd are based on their subjective judgments and not
derived from objective empirical analysis. Notwithstanding the subjectivity of these weights,
the major contention of the traditional position is that a liberal payout policy has a favourable
impact on stock prices.
The formula given by Prof. James E. Walter shows how dividend can be used to maximise the
wealth position of equity holders. He argues that in the long run, share prices reflect only the
present value of expected dividends. Retentions influence stock prices only through their
effect on further dividends. It can envisage different possible market prices in different
situations and considers internal rate of return, market capitalisation rate and dividend payout
ratio in the determination of market value of shares.
Walter Model focuses on two factors which influences Market Price
(i) Dividend Per Share.
(ii) Relationship between Internal Rate of Return (IRR) on retained earnings and market
expectations (cost of capital).
If IRR > Cost of Capital, Share price can be even higher in spite of low dividend. The
relationship between dividend and share price on the basis of Walter’s formula is shown
below:
Vc =
a
c
c
R D (E-D) R
R
+
Where,
Vc = Market value of the ordinary shares of the company
Ra = Return on internal retention, i.e., the rate company earns on retained profits
Rc = Cost of Capital
E = Earnings per share
D = Dividend per share.
Write short note on effect of a Government imposed freeze on dividends on stock prices and
the volume of capital investment in the background of Miller-Modigliani (MM) theory on
dividend policy.
Effect of a Government Imposed Freeze on Dividends on Stock Prices and the Volume of
Capital Investment in the Background of (Miller-Modigliani) (MM) Theory on Dividend Policy
According to MM theory, under a perfect market situation, the dividend of a firm is irrelevant as
it does not affect the value of firm. Thus under MM’s theory the government imposed freeze on
dividend should make no difference on stock prices. Firms if do not pay dividends will have
higher retained earnings and will either reduce the volume of new stock issues, repurchase
more stock from market or simply invest extra cash in marketable securities. In all the above
cases, the loss by investors of cash dividends will be made up in the form of capital gains.
Whether the Government imposed freeze on dividends have effect on volume of capital
investment in the background of MM theory on dividend policy have two arguments. One
argument is that if the firms keep their investment decision separate from their dividend and
financing decision then the freeze on dividend by the Government will have no effect on
volume of capital investment. If the freeze restricts dividends the firm can repurchase shares
or invest excess cash in marketable securities e.g. in shares of other companies. Other
argument is that the firms do not separate their investment decision from dividend and
financing decisions. They prefer to make investment from internal funds. In this case, the
freeze of dividend by government could lead to increased real investment.
Write short note on factors determining the dividend policy of a company.
Factors Determining the Dividend Policy of a Company
(i) Liquidity: In order to pay dividends, a company will require access to cash. Even very
profitable companies might sometimes have difficulty in paying dividends if resources are
tied up in other forms of assets.
(ii) Repayment of debt: Dividend payout may be made difficult if debt is scheduled for
repayment.
(iii) Stability of Profits: Other things being equal, a company with stable profits is more likely
to pay out a higher percentage of earnings than a company with fluctuating profits.
(iv) Control: The use of retained earnings to finance new projects preserves the company’s
ownership and control. This can be advantageous in firms where the present disposition
of shareholding is of importance.
(v) Legal consideration: The legal provisions lay down boundaries within which a company
can declare dividends.
(vi) Likely effect of the declaration and quantum of dividend on market prices.
(vii) Tax considerations and
(viii) Others such as dividend policies adopted by units similarly placed in the industry,
management attitude on dilution of existing control over the shares, fear of being
branded as incompetent or inefficient, conservative policy Vs non-aggressive one.
(ix) Inflation: Inflation must be taken into account when a firm establishes its dividend policy
