Dividend Decision

Meaning of dividend
Dividend is the term derived from the ‘dividendum’ which means total divisible sum.

Dividend refers to the periodic payments to shareholders of the firm out of the divisible profits.
It is a share in total profits of the company distributed to equity shareholders.

In other words, dividend is that amount of profits used to distribute to shareholders on their
shareholding. It is a periodic return to shareholders on their investment in the company’s
shares.

Meaning of dividend decision:

Dividend decision refers to deciding the amount of profit used to pay as dividend to
shareholders and the amount of profit to keep as retained earnings in the firm for future
financing.

Meaning of dividend policy

policy refers to establishing the guidelines for decisions and actions, Dividend policy is
concerned with guidelines to decide the amount of profits be used for distribution of dividend
to shareholders and the amount of profits be retained as retained earnings in the business.

It is company’s rules and regulations to decide amount of profits used for dividend payment
and amount of profits retained as retained earnings.

Legal rules regarding declaration of dividend

The Companies Act provides various rules regarding the declaration and payment of dividend.
They are summarized below:

1. Right to Recommend the Dividend

The right to recommend a dividend lies with the Board of directors. Only when the Board
recommends a dividend, the shareholders can declare a dividend in the general meeting.
However, the shareholders cannot insist the directors to recommend. Even if there are sufficient
profits, but the directors feel that a distribution of dividend is undesirable in the interests of the
financial stability of the company, they can refuse to recommend a dividend.

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2. Right to Declare a Dividend

Only the shareholders in the Annual General Meeting can declare the dividend. The Board of
Directors determines the rate of dividend to be declared and recommends it to the
shareholders. The shareholders, by passing a resolution in general meeting, can declare the
dividend.

The shareholders can either accept the same rate of dividend or they can even reduce the rate.
However, they cannot enhance the rate of dividend recommended by the directors.

3. Payable out of Profits Only

The company can declare and pay a dividend only where there is a profit. In other words,
dividend is payable only out of profits. If there is no profit, there can be no distribution of
dividend. The Companies Act provides that a dividend can be paid only:

1. Out of the profits of the Current financial year, or

2. Out of the profits of the previous years, or

3. Out of moneys provided by the Central or State Governments for the purpose of paying a
dividend.

Therefore, if a dividend is paid out of capital, it amounts to a breach of trust. It amounts to an

unauthorized reduction of capital and is ultra vires. Hence, void. The directors shall become
jointly and severally liable.

4. Provision for Depreciation

It is already stated that a dividend can be declared only out of profits. The profits should be
arrived only after providing for depreciation for the current year and also for all the arrears of
depreciation or loss in any previous year [Sec. 205 of Companies Act]. However, the Central
Government can exempt any company from this obligation in the interest of the public.

5. Setting off the Previous Losses

If any loss is incurred in any previous year after 1960, such loss should be set off against the
profits of the current year before declaring a dividend [Sec. 205(1)(b)].

6. Payable Only in Cash

The dividend is payable only in cash. However, a company is not prohibited from capitalizing
its profits or reserves by the issue of bonus shares or by making partly paid up shares into fully
paid up shares.

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7. Transfer to Reserves

It is also provided in the Companies Act that every company before declaring any dividend
should transfer a certain percentage not exceeding 10% of the profit, to the reserves of the
company. The percentage shall be prescribed by the Central Government.

Separate rates are prescribed if the company declares the dividend out of the current year’s
profits. The Table below shows the percentages of profits to be transferred compulsorily to
reserves before declaration of any dividend as per the provision of the Companies (Transfer of
Profits to Reserves) Rules, 1975.

Proposed Rate of Dividend Percentage of Profit to be transferred to

reserves

1. Above 10% but below 12.5% of the paid up Not less than 2.5% of the current profits
capital

2. Above 12.5% but below 15% Not less than 5% of the current profits

3. Above 15% but below 20% Not less than 7.5% of the current profits

4. Above 20% Not less than 10% of the current profits

TABLE: Percentage of Profits transferred to Reserves before declaring Dividend

However, the companies are at liberty to transfer a higher percentage of profit to the reserves.
The Companies Amendment Act introduced this provision only in the year 1974 by
incorporating Sec. 205 A in it.

8. Time Limit for Payment

When a dividend is declared, it should be paid within 42 days from the date of declaration. The
dividend when declared shall become a debt due from the company. If the company does not
pay the dividend within the period, every person who is a party to the default is punishable
with simple imprisonment up to seven days and also with a fine.

9. Unpaid Dividend Account

If a dividend is declared but not paid within 7 days from the date of expiry of the 42 days,
should transfer the amount of unpaid dividend to a separate account with any Scheduled Bank
opened under the style “Unpaid Dividend Account of………Company Ltd“.

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10. Transfer to General Revenue Account

Any amount transferred to the Unpaid Dividend Account, which remains unpaid or unclaimed
for a period of three years, should be transferred by the company to the General Reserve
Account of the Central Government. However, the person to whom the dividend is payable can
claim the money from the Central Government. The company which transfers any amount to
the General Reserve Account should furnish a statement furnishing the nature of amount,
names of the persons entitled to receive the amount, their addresses, amount due to them, etc.

Determinants of dividend policy/ factors influencing

Dividend policy aims to provide for a regular and sizeable dividend flow, while allowing the
company to maintain the financial flexibility to take advantage of attractive investment
opportunities in the future.

Determinants of dividend policy

1 Legal constraints
2 Requirement of the shareholders
3 Availability of liquid funds
4 Financial needs of the firm
5 Investment opportunities
6 Economic conditions
7 Nature and size of business
8 Stability of earnings
9 Desire of control over management
10 Access to the capital market
11 Tax implications
12 Business cycle
13 Contractual obligations
14 Competitors dividend policy

1. Legal constraints:
While designing a dividend policy the companies have to consider provisions of
company’s act, Income tax act, SEBI Guidelines. Under companies act , dividend canbe
paid out of current profit or past profits after providing for depreciation. Again , under
the act companies have to transfer a prescribed percentage of profit o general reserve, if
the rate of dividend exceeds certain percentage of paid up capital.
For ex: if the rate of dividend is below 10% of paid up capital, then the company has to
transfer 2.5%to general reserve, if the rate of dividend is more than 20% at least 10% of
net profits be transferred to general reserve. Dividend cannot be paid out of capital.

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2. Requirement of shareholders:
Shareholders expectations should be considered while planning the dividend policy. Not
all investors are alike. Some investors prefer constant regular return on their investment
and some investors prefer capital appreciation. So while designing dividend policy the
management has to consider the nature of investors.
If the shareholders expect constant regular return then regular cash dividend policy is
preferable. On the other hand, if the shareholders prefer capital appreciation in that case
regular stock dividend policy is suitable.

3. Availability of liquid fund:

When company pays dividend its results in outflow of cash and thus payment of
dividend is highly influenced by cash and liquidity position of the firm. Companies with
good financial performance and exceptional earnings always maintain a good amount of
liquid funds on the other hand growth based company spends a lot of funds on
expanding activities and permanent working capital and therefore most of the growth
oriented companies are not in a position to declare dividends.
Further some companies invest surplus cash in short term investments in order to earn
quick profits from idle cash, thus irrespective of sufficient retained earnings, the firm
may not be able to pay cash dividend if the earnings are not held in cash.

4. Financial needs of the firm:

Company’s ability or inability to raise funds from external source also determines nature
of dividend policy. Well established and big companies have better access to the capital
market than the small, financially weak & new companies. They can borrow funds from
the external sources on easy terms. These companies may follow liberal dividend policy.
Whereas small, financially weak & new companies have to depend on their internal
sources and therefore they will have to build up good reserves by following conservative
dividend policy.

5. Investment opportunities:
Investment made in buying financial instruments such as new shares, bonds, securities,
etc. is considered as a financial investment. Investment made in plant and equipment,
land & Building and other infrastructure facilities is considered as real investment.
A company should identify appropriate invest opportunities and invest in them so that
it provides the basis for the firm’s earning power and value. Therefore a company can
utilize present and past profits to invest in profitable ventures, however if investment
opportunities are inadequate it is better to pay dividends and raise external funds
whenever necessary for such opportunities.

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6. Economic conditions:
Economic conditions are considered to be sound or positive when an economy is
expanding and are considered to be adverse or negative when an economy is
contracting. Therefore if the economy is going through period of recession most the
firms face problem of low sales and declining profits and therefore as a precautionary
measure may not declare dividends to protect themselves from cash crunch.

7. Nature and size of business:

The dividend policy is also influenced by the nature and size of its business. Big business
organizations require more funds than the small business organization. Therefore
depending of business and size dividend policy is framed accordingly.

8. Stability of earnings:
The size and nature of earnings of a company determine the type of dividend policy.
If the company earns stable & regular earnings then the company can follow stable &
regular dividend policy. On the other hand, if the earnings are not stable & more
irregular then the company cannot follow stable & regular dividend policy. The size of
the earnings also decides the nature of dividend policy.

9. Desire of control over management :

Desire of the company to keep control over management is an important factor
determining the nature of dividend policy of a company. If they have strong desire to
have control on affairs of company, then they should not issue new equity shares to get
additional funds.
Issue of additional equity shares means dilution of voting power to new members,
which results in losing control over the affairs of company. Alternative way is to
building larger reserves through conservative dividend policy and uses the same as
retained earnings to meet their funds requirements.
10. Access to capital market:
If capital market conditions are very favorable, then the companies are able to get the
required funds very easily on easy terms. In that case the companies can use larger
portion of profits to distribute dividend & retain smaller portion of profits for future
financing purpose. On the other hand if capital market condition is not favorable, then
the companies find it very difficult to get the required funds on easy terms. Even if they
get then they have to pay high rates interest. In such cases, the companies can use small
portion of profits to distribute dividend & retain portion for future financing purpose.

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11. Tax implications:

The income tax rates also influences the dividend policy of the company. High taxation
reduces the earnings of the companies and consequently the rate of dividend is lowered.
Even corporate dividend distribution tax levied by the government also reduces the
dividend rates of companies.

12. Business cycle:

Business cycles have strong influence on dividend policy of a company. Dividend policy
has to be adjusted according to change in business conditions. During the boom, prudent
management has to follow a conservative dividend policy an create good reserves to
meet contingencies, which may arise during inflationary period. However during
depression a regular dividend policy is followed as a tool for marketing the securities in
the market and to prove financial solvency of the company provided the company has
adequate reserves.

13. Contractual obligations:

While raising loans from external sources the lenders put some conditions on companies
as to declaration and payment of cash dividend. Lenders to protect their interest impose
some restrictions. Therefore the management while designing a dividend policy has o
keep in mind the various contractual restrictions imposed by the lenders.

14. Competitors dividend policy:

Competitor’s dividend policy is an important determinant of dividend policy of a
company. If competitors are paying high rate of dividend than this company, the
investors going to invest in that company only. Therefore to attract prospective investors
the company under consideration has to pay high rates of dividend or least rates of
dividend paid by competitive companies.

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Types of dividend policy

Residual Regular Stable Irregular No

dividend dividend dividend dividend dividend
policy policy policy policy policy

1. Residual Dividend policy:

The term residual indicates the quantity of profits left over. In residual dividend policy a
business organization will only pay dividends after all acceptable investment opportunities
have been undertaken. Thus, residual dividend policy is used by companies to finance its
capital expenditure proposals through equity that is internally generated. In this policy the
dividend payments are made from the equity that remains after all the capia expenditure
proposal needs are met.

2. Regular dividend policy:

In regular dividend policy companies pay dividend to share holders in a definite manner at
a usual rates. Regular dividend policy aims to provide for a regular and sizable dividend
flow, at the same time as allowing the company to maintain the financial flexibility to take
advantage of attractive investment opportunities in the future. The company typically pays
annual dividends on the basis of its results for the previous year, and special dividends
following disposals or assets. The investors who expect regularity of income prefer to get
regular dividend.

3. Stable dividend policy:

As the name of the policy suggests, stable dividend policy focuses on regularity in paying
some dividend even though the amount of dividend may vary every year and may not be
associated with earnings of the company,

In other words stable dividend means that a certain minimum amount of dividend is paid
regularly. It may also mean that dividend is paid regularly by the company, but the amount
or rate of dividend is not fixed. The stable dividend may take the following forms:

a. Constant dividend per share:

Under this policy the management of the company pays a fixed amount of dividend on
every share irrespective of level of earnings year after year. In order to ensure
consistency in payment of dividends reserve fund is created to pay fixed amount of
dividend in the year when the earning of the company is not enough.
It is suitable for the firms having stable earning. It is important to note that even tough
dividend is constant every year however this doesn’t mean the rate of dividend will
never be increased, depending on the level of earning of the company the rate may
change.

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b. Constant payout ratio:

Payout ratio means dividend as a percentage of earnings. It is a important concept in the
dividend policy. According to this policy the percentage of earnings paid out as
dividends remain constant irrespective of the level of earnings. Thus as earnings of a
company fluctuate, dividends paid by it also fluctuate accordingly in proportionate to
earning of the company.
c. Constant rupee dividend plus extra dividend:
According to this policy a company pays a low rate of dividend per share to reduce the
chances of not paying dividend. In other words dividends in rupee terms mostly remain
constant irrespective of the level of earnings and in the period when company performs
exceptionally well the management pays extra dividend.

4. Irregular dividend policy:

As discussed earlier company upon making profit must decide on application of profits.
It could continue to retain the profits within the company, or it can pay out the profits to
the owners of the firm in the form of dividends. Therefore in irregular dividend policy a
company doesn’t pay regular dividend to the shareholders for various reasons such as to
generate funds for expansion and growth, if a company expects uncertainty in its future
business operations and non availability of liquid cash resources.

5. No dividend policy:
Even though dividends plays an important role in rewarding shareholders, but some
companies view in broader context of the varying liquidity needs of the company and
their vision of the company future. A company implements no dividend policy due to
lack of liquidity because of its unfavorable working capital position. Further
management wants the business to grow and the stock to appreciate and in order to do
these prefer reinvesting excess cash in the business rather than growing away on
dividends.

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Forms of dividend:
Dividends can be paid by the company in any of the following modes; some of them are
common forms and some o f they are optional such as:

1. Cash dividend: As cash dividend is a dividend paid in cash and it is the most
common method of paying the dividend followed by most of the corporations. In order
to pay dividend in the form of cash companies must have not only sufficient profits but
also sufficient liquid cash.

2. Property dividend: A company may sometimes rather than paying cash dividend
may issue a non monetary dividend to investors. Thus, a property dividend is an non
reciprocal transfer of non monetary assets from a company and its shareholders. It is
payable in form of assets from a company and its shareholders. It is payable in form of
assets other than cash. A property dividend can in the form of real estate, investments or
inventories that the company holds or it can either be in form of shares of its subsidiary
company.
3. Scrip dividend: Scrip is a provisional certificate issued by a company to its
shareholders the certificate states a promise made by the company to the shareholders to
pay them dividend at further specific date. Companies usually opt to distribute scrip
dividend due non availability of liquid cash. Since the company postpones dividend
therefore promissory note may or may not include interest to pay shareholders at a later
date.

4. Stock dividend: Stock dividend is in the form of additional shares, rather than cash.
Usually when company pay dividend in the form of additional or bonus shares when it
doesn’t have sufficient money. In some countries dividend paid in the form of cash is
taxable, however in India dividend received from a Indian company by the shareholders
is exempted from tax under section 10(34) of income tax act. On the other hand when a
company issues stock dividend rather than cash there usually not taxed until the shares
are sold.
5. Bond dividend: When a company pays dividend in the form of debentures or bonds
of the company, it is called bond dividend. Company pays bond dividend when their
cash position is very weak and they don’t want to lose control over company by paying
dividend in company’s equity shares. Through bond dividend companies liquidity is
maintained and at the same time, they keep control over company and shareholders
expectations for dividend.
6. Interim dividend: The dividend declared & paid in between two final dividends or
between two annual general meetings is called as interim dividend. In contrast to final
dividend, Board of directors in board meeting declares an interim dividend. The final
dividend is decided and sanction in annual general meeting of shareholders.
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7. Final dividend: The dividend paid at the end of accounting year is called the final
dividend. It is the dividend declared & sanctioned at annual general meeting of
shareholders. It is the dividend declared & paid finally out of divisible profits. At the
end of accounting year, final accounts are prepared to ascertain the final trading results
of company. Out of net profits of the company annual dividend is paid.

Merits & Demerits of stock dividend/ bonus shares

Merit of issuing bonus shares to shareholders:

 Bonus shares entitles shareholders for undistributed
 Increased future dividend
 Issue of bonus shares usually brings sense of satisfaction amongst shareholders
 Stock dividend is not taxable as income in the hands of shareholders
 Increase the capital value of shares in the market and this increases wealth of share
holders
 Quick liquidation: this means investors can sell bonus shares in stock market.

Demerit of issuing bonus shares to shareholders:

 Issuing bonus shares increases volume of shares and this lowers security of investors as
reserves decreases.
 If the performance of the company is bad shareholders may not be able to get value for
bonus share in the market.
 Issue of bonus shares declines the rate of dividend in future.

Merit of issuing bonus shares to company:

 Issuing bonus shares can help a company to reduce the market price of the share and
make it more attractive to investors
 By issuing bonus shares a company can increase trading of shares, thus liquidity
increases
 Issue of bonus shares enables a company to increase the morale and motivational level of
the stakeholders
 Bonus shares increases the marketability of the shares
 Company can issue bonus share and use liquid cash for various purposes.
Demerits of issuing bonus shares to company
 Leads to increase in capital of the company
 Shareholder preferring cash to stock dividend may be disappointed
 Shareholder expect existing rate dividend per share to continue
 Bonus quite often attracts speculative dealings in shares.

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Sources of bonus issues:

The bonus shares can be issued out of profit or reserve which have been earned by the
company profit or reserve should be free for the purpose of dividend and as specified in
company act . The reserves can not be used for issue of bonus which are not earned by
company .

The following is the list of reserves which can be used for issuing bonus shares

 Profit and loss account

 general reserve
 revenue reserve
 free reserves
 dividend equalization fund
 capital reserve
 sinking fund
 debenture redemption reserve only after redemption
 development rebate reserve
 allowance after expiry of 8 years
 capital redemption reserve
 share premium or security premium if received in cash

Meaning of right issues:

A right issue involves selling of ordinary shares to the existing shareholders of the company.
The law in India requires that the new ordinary shares must be first issued to the existing
shareholders on a prorata basis.

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