divident policy
TRANSCRIPT
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Introduction
Net earning has two parts- Retained earning and Dividends
Retained earning used for further investment
Dividends are paid in cash to shareholders
Dividend increases the value of share
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Practical Consideration in Paying Dividends
Depend upon firms financial needs, growth plans and investment opportunity
Signaling information about prospects of the company
Investor preference for dividend than capital receipts for his own investments
Control over the company may be lost Resolution of investors uncertainty Ability to raise additional financeClosely / Widely Held Company
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Firm’s need for fund
Growing firm generally keep major proportion of net earning. Growth firms have large number of investment opportunity
hence they should give precedence to retention of earning. Matured firms have infrequent investment opportunity hence
they should distribute most of their earning. It is argued that when IRR (return on investment) is greater
than cost of capital, it is profitable to reinvest the net earning or most of it.
Retained earnings are preferred than external equity as they does not involve floatation costs.
Some companies prefer to raise external equity for financing investment decision.
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Investor preference for dividend than capital receipts
Some shareholder’s may prefer near dividends than future dividend or capital gain.
Depends upon economic status, the effect of tax differential on dividends and capital gains.
In closely held companies, director knows shareholder’s expectations well and frame dividend policy accordingly.
Institutional investors avoid speculation
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Control over the firm
If dividends are paid, cash may affectedFor further expansion company may
have to issue new shareThe control of existing shareholders will
be diluted if they do not want or cannot buy new shares
Hence payment of dividend may withheld and earning may be retained
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Investor preference for dividend than capital receipts
Widely held companies : Small investors, Retired or old person and Wealthy investors.
Shareholder’s income may go against company’s investment and long term growth
Management should properly trade off between dividend and retained earning
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Resolution of investors uncertainty
Dividends have informational value.It resolves uncertainty in the mind of
investor.Companies generally have to pay small
amount of income even when earnings fall.It conveys that future of the company is
bright.
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Other Practical Consideration in Paying Dividends
Risk taking capability of firmFirm’s constraints- financial and legal.Policy of the company: whether stable
dividend per share or payout ratioLiquidity requirementTaxation treatment
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Other Practical Consideration in Paying Dividends
Temporary excess cash on account of windfall gains and not the better investment option available to firm
Capital Budgeting decision-- If policy is independent (No impact)- If Dependent (Higher payout means
lower capital budgeting)
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Stability of dividends
It has the positive effect on market price of the share.
It also mean regularity in paying some dividend annually.
Three forms of dividend stability Constant dividend per share (dividend rate) Constant payout Constant dividend per share plus extra dividend.
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Constant dividend per share
In India, companies announces dividend as a percent of the paid-up capital per share.
Dividend rate may increase.
EPS
DPS
Time
EPS&DPS
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Constant Dividend per Share plus Extra Dividend
Generally adopted by companies with fluctuating earnings.
Policy to pay a minimum dividend per share with a step up feature.
Paying extra in period of prosperity. Known as interim dividend with final dividend. It helps in paying dividend without a default.
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Merits of stability of dividends
It has several advantages.Resolution of investors uncertainty.Investors’ desire for current income.Institutional investors requirements.Raising additional finances.
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Danger of stability of dividends
Once established, difficult to change.It creates a clientele that depends on it.Have to maintain the stability even
during lean years.Hence dividend rate should be fixed at
conservative figures.
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Constant Payout
The rate of dividend to earning is known as payout ratio.
Some company may follow a policy of constant payout ratio.
Paying a fixed percentage of earning per year. Amount of dividend fluctuates in direct proportion
to earning. In losses, no dividend shall be paid.
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Constant Payout
EPS
DPS
Time
EPSandDPS
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Constraints on paying dividends A high leveraged firm expected to retain more to
strengthen its position. Raising much external equity will adversely
affect the firm’s financial flexibility. Financial flexibility includes the firm’s ability to
access external funds at later date. Access to capital market. Restriction in loan agreements. Lenders may put restrictions on dividend
payment until some conditions met.
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Issues in dividend policy
Low policy payout may produce higher share price but not always
Dividend is a current earning while capital gain is a future earning
Dividend yield = dividend per share/ market price per share
Dividend are generally taxed more than capital gain
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Legal and procedural aspects to be considered in dividend policy
Companies can only pay cash dividend (with the exception of bonus shares)
Dividend can not be declared for past years
Dividend can be declared out of the profit of the same financial year and after providing for the government dues and depreciation under companies act
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Conclusion
Don’t pay dividend on the expense of new project can give better returns than cost of equity
Try to avoid the new equity raising Frame dividend policy based on - Targeted debt-equity ratio- Investment needs of the company- Capital market norms and tax code- Avoid dividend cuts
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