Before discussing dividend policy, it’s important to define the term “dividend.”
A dividend is a payment made to shareholders in lieu of their share capital. It is that portion of a company’s profits that is distributable among its shareholders according to the resolution passed in the meeting of the board of directors.
This may be a fixed percentage on the share capital or a fixed rate per share. The economic soundness of a company is judged by the amount of dividends declared and paid by the company. It affects shareholders and the goodwill of the firm.
Dividend Policy: Definition and Explanation
Dividends are part of the profit distributed to a company’s shareholders. The question that the board of directors must answer is how much to distribute and how much to retain in the business as a resource to meet future contingencies and expansion.
Allocation of profit between shareholders and retained earnings is an essential part of the function of management.
Thus, dividend policy involves establishing a suitable dividend pattern to distribute to a company’s shareholders through its board of directors. Dividend policy is a system of decision-making and problem-solving.
Dividend policy has far-reaching consequences in terms of its influence on share price, growth rate, and goodwill. A higher market price of shares and higher current dividends increase shareholder wealth.
Factors Influencing Dividend Policy
Many factors influence a company’s dividend policy, including:
1. Legal Restrictions: The legal restrictions that influence dividend policy are as follows:
- Dividends can only be paid out of profit and not out of capital
- Companies can declare and pay dividends using the previous year’s profit
- At least 10% of profit must be transferred to the company’s reserves
- Dividends are payable in cash, but by following legal formalities, dividends can also be paid in bonus shares or assets
2. Size of Earnings: Dividend policy is dependent on the earnings of the firm. It is not only the amount of dividend but also the nature of the earnings that bears upon dividend policy. A stable dividend policy is preferable.
3. Shareholder Preferences: Management should follow a policy that suits the interests not only of the company but also its shareholders.
4. Liquidity Position: A company’s dividend policy must consider the liquidity position of the company. The payment of dividends reduces the company’s cash reserves of the company.
Growing companies have a pressing need for funds, and so, for these companies, the payment of dividends in cash should be avoided.
5. Management Attitude: Some companies use internal sources to finance expansion programs because issuing new shares would alter the control of the company. When debentures are issued to finance expansion, this runs the risk of causing the earnings of existing members to fluctuate.
6. Condition of Capital Market: When the capital market is comfortable, companies can follow a liberal dividend policy.
7. Stability of Earnings: When a company is making remarkable progress and has stable earnings, a liberal dividend policy can be followed.
8. Trade Cycle: When there is inflation in the country, the company will earn more profit. Therefore, the company can distribute more dividends and, when it needs funds, these can be borrowed externally at a favorable interest rate.
9. Ability to Borrow: A company that can borrow from external sources at a cheap rate can borrow from the outside. In such cases, the cost of borrowed capital and retained earnings can be compared.
10. Past Dividend Rate: While deciding on a dividend policy, managers and the board of directors should pay attention to the dividend rate in previous years.
Different Types of Dividend
1. Cash Dividend
There are two types of cash dividends:
- Regular Dividend: Annually paid, proposed by the board of directors, and approved by shareholders in a general meeting.
- Interim Dividend: If the articles of association permit, directors can decide to pay a dividend any time between two annual general meetings before finalizing the accounts. This generally happens when a company has huge profits.
2. Stock Dividend
When a company does not have sufficient cash, it may pay a dividend in bonus shares, which is referred to as a stock dividend.
3. Scrip Dividend
A scrip dividend is used when earnings justify a dividend but the company’s cash position is temporarily weak. In this case, shareholders are issued shares and debentures of another company, which are held by the company as investments.
4. Bond Dividend
In rare instances, dividends may be paid in the form of debentures/bonds or notes for a long-term period with a fixed rate of interest. The effect is the same as in a scrip dividend, where the shareholders become the company’s secured creditors.
5. Property Dividend
Dividends may be paid in the form of assets instead of earnings. This usually happens when certain assets are no longer required in the business.