Dividend Decision – Introduction

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”.

Dividend refers to that portion of profits after tax which is distributed among the owners/shareholders of the firm. It is the return that shareholders get on their investment. It may be in form of cash or stock.

Types of dividend –

On the basis of Type of shares:

1. Equity Dividend – Dividend paid to the equity shareholders of a firm. The rate of dividend is decided by the board of directors of the firm on the basis of current year profits and future fund requirements of the firm.

2. Preference Dividend – Dividend paid to the preference shareholders of a firm. It is paid at a fixed rate of interest to the preference shareholders before any profit is distributed to equity shareholders.

On the basis of Time of Payment:

1. Interim Dividend – Dividend paid by the company to its shareholders after the balance sheet has been finalized and before the Annual General Meeting of the company. It is a dividend paid in advance.

2. Regular Dividend – Dividend declared by the company in the Annual General Meeting in the regular course of the business.

3. Special Dividend – It is a special, “one time” dividend paid to the shareholders of a firm if the firm earns a huge profit in a particular year.

On the basis of Mode of payment:

1. Cash Dividend – Dividend paid in form of cash. It is paid out of the Earnings after interest and taxes of a firm.

2. Stock Dividend – Dividend paid in form of stock. It is given to the existing shareholders when a firm wants to raise more funds or as a bonus issue.

3. Bond Dividend – Dividend paid in form of bonds or debentures. A firm pays dividend in bonds due to liquidity problems.

4. Scrip Dividend – Dividend paid in form of Promissory Note instead of cash due to liquidity problems faced by the firm.

5. Property Dividend – Dividend paid in form non-monetary asset instead of cash due to liquidity problems faced by the firm.

6. Composite Dividend – When dividend is paid in more than one form or through multiple modes. A company may choose to pay dividend partly in cash and partly in form of a bond, stock or property.

Factors affecting dividend decision

Financial Position of the Firm – When a firm earns stable and adequate profits, it can distribute more dividends to its shareholders.

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.

Investment opportunities available – If a company has ample investment opportunities available at its disposal, promising high returns it may choose to retain its profit.

Shareholders Preference and expectations – Dividend policy of a company depends upon the preferences of the shareholders and their expectations regarding the rate of dividend.

Sources of Finance – If the firm has external financial sources available at its disposal, it may not use funds from its retained earnings.

Growth Rate of the Firm – High growth rate implies that the firm can distribute more dividend to its shareholders.

Tax Policy – If the government provides tax incentives, the firm can pay more dividend to its shareholders.

Capital Market Condition – If the capital market is prefect, it will result in higher earnings of the company and lead to increase in dividend of shareholders.

Liquidity position of the firm – A company facing liquidity constraints may not be able to distribute its profit in form of cash and may opt to pay in form of stocks or not pay dividend at all for that period.

Dividend Decision Models

A firm must decide whether to distribute all profits, retain them, or distribute a portion and retain the balance. Dividend decision is essentially a trade-off between retained earnings and issue of new shares.

Dividend decision consists of two important theories which are based on the relationship between dividend decision and value of the firm.

• Relevance Theory of Dividend – Walter`s model, Gordon`s Model
• Irrelevance Theory of Dividend – Modigliani and Miller`s Approach

Also read: Full article on Dividend decision Models