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FINANCIAL MANAGEMENT & CORPORATE FINANCE-KMB204

UNIT IV - SET 1
DIVIDEND

Definition of 'Dividend'
A share of the after-tax profit of a company, distributed to its shareholders according to the
number and class of shares held by them. Dividend refers to a reward, cash or otherwise, that a
company gives to its shareholders. Dividends can be issued in various forms, such as cash
payment, stocks or any other form. A company’s dividend is decided by its board of directors
and it requires the shareholders’ approval. However, it is not obligatory for a company to pay
dividend. Dividend is usually a part of the profit that the company shares with its shareholders.
A share of the after-tax profit of a company, distributed to its shareholders according to the
number and class of shares held by them.
Smaller companies typically distribute dividends at the end of an accounting year, whereas
larger, publicly held companies usually distribute it every quarter. The amount and timing of the
dividend is decided by the board of directors, who also determine whether it is paid out of
current earnings or the past earnings kept as reserve. Holders of preferred stock receive dividend
at a fixed rate and are paid first. Holders of ordinary shares are entitled to receive any amount of
dividend, based on the level of profit and the company's need for cash for expansion or other
purposes.

Dividend Types
 Cash Dividends: Cash dividends are, by far, the most popular form of dividend. In cash
dividends, stockholders receive checks for the amounts due to them. Cash generated by
business earnings is used to pay cash dividends. Sometimes, the firm may issue
additional stock to use proceeds so derived to pay cash dividends or bank may be
approached for the purpose. Generally, stockholders have strong preference for cash
dividends.
 Stock Dividends: Stock dividends rank next to cash dividends in respect of their
popularity. In this form of dividends, the firm issues additional shares of its own stock to
the stockholders in proportion to the number of shares held in lieu of cash dividends. The
payment of stock dividends does not affect cash and earning position of the firm nor is
ownership of stockholders changed. Indeed there will be transfer of the amount of
dividend from the surplus account to the capital stock account which tantamount to
capitalization of retained earnings. The net effect of this would be an increase in number
of shares of the current stockholders but there will be no change in their total equity.
With payment of stock dividends the stock-holders have simply more shares of stock to represent
the same interest as it was before issuing stock dividends. Thus, there will be merely an
adjustment in the firm’s capital structure in terms of both the book value and the market price of
the common stock.
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Illustration
The Style Construction Company had the following capital structure before issuing a stock
dividend:

The management issues additional stock of 10,000 shares to pay dividends @ 5 percent. Market
price of the stock is Rs. 20 a share. For each 20 shares of stock owned, the stockholder receives
one additional share.
The capital structure after the issue of stock dividends will stand as under:

With issue of additional stock of 10,000 shares amount worth Rs. 2,00,000 Rs. 20 x 10,000
shares) is transferred from retained earnings account to Common Stock and Capital Surplus
accounts. Since the par value of additional shares remains the same, Common Stock Capital
would increase by Rs. 50,000 to Rs. 10,50,000.
The residual of Rs. 1,50,000 goes into Capital Surplus account. Thus net worth of the Company
remains what it was before the issue of stock dividends.
As a result of the adjustment in capital structure of the Company due to issue of stock dividends,
earnings per share will tend to decline exactly in the proportions by which total number of shares
increased. Assume, for example, the company had earnings of Rs. 50,00,000.
The earnings per share before issue of stock dividends would be then Rs. 250. Issue of stock
dividends will result in drop in earnings per share. Thus, with issue of additional stocks of
10,000 shares earnings per share will fall to Rs. 2.38 (Rs. 5,00,000/2,10,000).
However, total earnings available to a stockholder would remain unaffected because earnings per
share decreased exactly in proportion to increase in number of shares of the stockholder.
Guidelines on Stock Dividends:
While announcing stock dividends, the management must keep in mind legal provisions
regarding the distribution of such dividends and also guidelines prescribed by the controller of
capital issues in respect thereof Section 205 (i) of the Companies Act, 1956, as amended from
time to time, lays down certain guidelines which must be complied with while distributing stock
dividends.
These are:
(1) Articles of association must permit issue of bonus shares.
(2) Sufficient undistributed profits must be present.
(3) A resolution capitalizing profits must have been passed by the Board of Directors.
(4) The resolution of the Board of Directors must be approved by the stockholders in a general
meeting.
(5) The bonus issue is permitted to be made out of free reserves built out of genuine profits or
share premium collected in cash only.
(6) Reserves created by revaluation of fixed assets are not permitted to be capitalized.
(7) Development rebate reserve is considered as free reserve for the purpose of calculation of
residual reserves and is also allowed to be capitalized.
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(8) The residual reserves after the proposed capitalisation should be at least 40% of the increased
paid-up capital.
(9) Thirty percent of the average profits before tax of the company for the previous three years
should yield a rate of dividend on the expanded capital base of the company at 10%.
(10) Declaration of bonus issues in lieu of dividend is not allowed.
(11) The company should make a further application for an issue of bonus shares only after 24
months have elapsed from the date of sanction by the Government of an earlier bonus issue by
the Company.
(12) Bonus issues are not permitted unless the partly paid shares, if any, are made fully paid-up.
(13) Companies defaulting in payment to any public financial institution will have to produce a
no objection letter from it before issuing bonus shares.
(14) The amount of reserves to be capitalized by issuing bonus shares should not exceed the total
amount of the paid-up capital of the company.
SEBI Guidelines:
(i) Issue of bonus shares after any public/rights issue is subject to the conditions that no bonus
issue shall be made which will dilute the value or rights of the holders of debenture, convertible
fully or partly.
In other words, no company shall, pending conversation of FCDs/PCDs, issue any shares by way
of bonus unless similar benefit is extended to the holders of such FCDs/PCDs, through
reservation of shares in proportion to such convertible part of FCDs or PCsD. The shares so
reserved may be issued at the time of conversion of such debentures on the same terms on which
the bonus shares were made.
(ii) Bonus share is made out of free reserves built out of the genuine profits or share premium
collected in cash only.
(iii) Reserves created by revolution are not capitalized.
(iv) The declaration of bonus issue in lien of dividend is not made.
(v) The bonus issue is not made unless the partly paid up shares, if any, are made fully paid-up.
(vi) The Company:
(a) Has not defaulted in payment of interest or principal in respect of fixed deposits and interest
on existing debentures or principal on redemption thereof, and
(b) Has sufficient reason to believe that it has not defaulted in respect of the payment of statutory
dues of the employees such as contribution to provident fund, gratuity, bonus, etc.
(vii) A company which announces its bonus issue after the approval of the Board of Directors
must implement the proposals within a period of six months from the date of such approval and
shall not have the option of changing the decision.
(viii) There should be a provision in the Articles of Association of the company for capitalisation
of reserves, etc and if not, the company shall pass a resolution at its General Body Meeting
making provisions in the Articles of Association for capitalisation.
(ix) Consequent to the issue of bonus shares if the subscribed and paid-up capital exceeds the
authorised share capital, a resolution shall be passed by the company at its General Body
Meeting for increasing the authorised capital.

 Scrip Dividend:
Scrip dividend means payment of dividend in scrip or promissory notes. Sometimes companies
need cash generated by business earnings to meet business requirements or withhold the payment
of cash dividend because of temporary shortage of cash.
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In such cases the company may issue scrip or notes promising to pay dividend at a future date.
The scrip usually bears a definite date of maturity. Sometimes maturity date is not stipulated and
its payment is left to the discretion of Board of Directors. Scrip may be interest bearing or non-
interest bearing. Such dividends are relatively scarce.
Issue of scrip dividends is justified in the following circumstances:
(i) When a company has sufficiently large earnings to distribute dividends but cash position is
temporarily tight because bulk of the sale proceeds tied in receivables for time being will be
released very shortly, the management may issue certificates to stockholders promising them to
pay dividend in near future.
(ii) When a company wants to maintain an established dividend record without paying out cash
immediately, the management may take recourse to scrip dividend.
(iii) When the management believes that stock dividend will not be useful because future
earnings of the company will not increase sufficiently to maintain dividend rate on increased
shareholding, issue of promissory notes to pay dividends in future would be a wise step.
(iv) When the company does not wish to borrow to cover its dividend. The danger lies in their
use as a sop to stockholders when business earnings are inadequate to cover dividend payments.
Such kind of dividend is not in existence in India.

 Bond Dividend: As in scrip dividends, dividends are not paid immediately in bond-
dividends; instead company promises to pay dividends at future date and to that effect
issues bonds to stockholders in place of cash. The purpose of both bond and scrip
dividends is alike, i.e. postponement of dividend payment.
Difference between the two is in respect of date of payment and their effect is the same. Both
result in lessening of surplus and in addition to the liability of the firm. The only difference
between bond and scrip dividends is that the former carries longer maturity date than the latter.
Thus, while issue of bond-dividend increases long-term obligation of the Company, current
liability increases as consequence of issue of scrip dividends. In bond dividends stockholders
have stronger claim against the company as compared to scrip dividends.
Bonds used to pay dividends always carry interest. This means that company assumes fixed
obligation of interest payments annually on principal amount of bond at the maturity date. It
should be remembered that the company is assuming this obligation in return of nothing except
credit for declaring the dividend.
How far the company will be able to meet this obligation in future is also difficult to predict at
the time of issue of bonds.
Management should, therefore, balance cost of issuing bond dividends against benefits resulting
from them (benefit of the bond dividend lies in postponement of dividend for a distant date)
before deciding about distribution of dividends in the form of bonds. Bond dividends are not
vogue in India.

 Property Dividends:
In property dividends, Company pays dividends in the form of assets other than cash. Generally,
assets that are superfluous for the Company are distributed as dividends to stock-holders.
Sometime, a Company may use its products to pay dividends. Securities of subsidiaries owned
by the Company may also take the form of property dividends. This form of dividend is not
vogue in India.
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Types of Dividend Policies

1. Stable Dividend Policy: When a firm constantly pays a fixed amount of dividends and
maintains it for all the times to come regardless of fluctuations in the level of its earnings,
it is said to have pursued a relatively stable dividend policy. In such a policy,
stockholders are assured of fixed dividends per share. During periods of prosperity the
firm withholds all extra-ordinary income of the business to use it to maintain dividend
amount during lean years. Stability of dividend policy does not mean stagnation in
dividend pay-out ratio. In fact, slow but steady change is the prime feature of stable
dividend policy.
When the firm’s earnings tend to rise regularly and the management feels satisfied that increased
earnings are sustainable and permanent, amount of dividend per share is increased. Likewise,
dividend will not be allowed to decline in correspondence with a fall in business earnings until it
is felt that the firm will not be able to recover from the setback.
In actual practice, most of the companies follow stable dividend policy because of the following
reasons:
 Finns regularly paying dividends at a fixed rate have always high credit standing in the
market. They can raise as much funds as they like from the market because of widespread
demand of their shares.
 Stable dividend policy fosters a rise in share values. Investors generally pay higher
premium to shares promising a certainty of dividend income than to those with
fluctuating dividends because of risks inherent in the latter. Those who derive their
regular income from dividend would always prefer to hold such shares as assure certainty
of dividend.
 Since dividends communicate information to investors about a firm’s profitability and
managerial efficiency, naturally firm pursuing stable dividend policy enjoys a great
confidence of shareholders. This may be immensely useful in fund raising activity of the
firm and will also give boost to the morale of the management.
 Firm with stable policy can very easily formulate long-term financial planning because
the finance manager can in that case correctly estimate future supply and demand of
capital in the firm.
However, in designing stable dividend policy finance manager should see that dividend pay-out
ratio is not fixed at a level that the firm may subsequently find it difficult to sustain. It would be
worthwhile to keep in mind future earning power of the firm while determining dividend rate.
Stability in level of earnings indeed is a basic condition for pursuing this policy. Firms with
erratic fluctuations in level of earnings may find it extremely difficult to follow stable dividend
policy. Public utility concerns and others manufacturing staple products of daily consumption
generally follow this policy because of relatively less variations in their earnings.

2. Policy of no Immediate Dividend: Very often management may decide to declare no

dividend despite large earnings of the firm.
This policy is generally pursued in the following circumstances:
 A new and rapidly growing concern which needs tidy amount of funds to finance the
expansion programmes.
 When the firm’s access to capital market is difficult or when availability of funds is
costlier.
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 Where shareholders have agreed to accept higher return in future or they have strong
preference for long-term capital gains as opposed to short-term dividend income.
Policy of no immediate dividends should be followed by issue of bonus shares so that the firm’s
capital increases and amount of reserves and surplus is reduced or the firm’s stock should be split
into small lots so as to keep dividend per share low while providing large dividend amounts to
stockholders. This course of action would be necessary to keep share prices within limits.
Detailed account of significance of stock dividends has been given under the heading stock
dividends.

3. Policy of Regular Extra Dividends: Firms following regular dividend policy pay out
dividends constantly to stockholders at constant rate and do not change the pay-out ratio unless it
is believed that changes in earnings are permanent. When profits of the firm swell, management
may decide to distribute a part of the increased earnings as extra dividend instead of increasing
regular dividend pay-out ratio.
Extra dividends are declared only in the year when the earnings exceed the annual dividend
requirement by some given amount. Whether or not the extra dividends will be declared depends
on a number of factors, among which the important ones are expected funds requirements, the
desired level of liquidity, and expectations about future earning levels.
Such a policy gives impression to the stockholders that extra dividends have been paid because
the firm has made extra ordinary earnings which will be skipped subsequently when business
earnings will drop to normal level. With this policy, the firm’s credit standing and so its share
values are not likely to be adversely affected with omission of extra dividends in future.

However, a firm following the policy of regular and extra dividends year after year may give a
wrong impression among the stockholders who may treat extra dividends as part of regular
dividends with the result that they may react very strongly to omission of extra dividends in
future when earnings of the firm do not warrant distribution of such dividends and firm may lose
confidence of stockholders and its credit standing in the market.
It is, therefore, pertinent for the management to make it crystal clear in policy announcement that
a regular dividend rate will be paid under normal circumstances with the possibility of extra
dividends only when earnings power and other conditions warrant.
Further, to distinguish between regular and extra dividends, they should be clearly labelled to
that effect. Bigger companies have been found assigning different numbers to regular and extra
dividends.
It is only when extraordinary earnings become a permanent feature and management feels that
increased earnings will support an increase in dividend rate permanently that extra dividends
become a part of regular dividend and dividend rate is raised accordingly.

4. Policy of Regular Stock Dividends: Firm pursuing this policy pays dividends in stock instead
of cash. Stocks to pay dividends are designated as ‘bonus shares’ which are very frequently used
to capitalize reinvested earnings of the firm. Issue of bonus shares does not at all affect liquidity
position of the firm; it increases, indeed, the share holding of residual owners but not their equity
in the firm.
Such a policy is generally followed under the following circumstances:
 When the firm needs cash generated by earnings to cover its modernisation and
expansion programmes.
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 When the firm is deficient of cash despite high earnings. This is particularly true if the
firm’s sales were affected through credit and entire sale proceeds are tied in receivables.
It may be noted that it may be dangerous to pursue the policy of stock dividend regularly for a
long period of time because in that case earnings per share will decline sharply, value of shares
tends to plumb and credit standing of the firm receives big jolt.
Besides, stockholders cannot remain satisfied with receiving dividends in stocks. They may cry
for cash dividends after some time and may even force the management to change.

5. Policy to Pay Irregular Dividends: Firm following this policy does not pay out fixed amount
of dividend per share. Instead, dividend per share is varied in correspondence with change in
earning level; larger the earnings means higher the dividend and the vice-versa. This policy is
based on management’s belief that shareholders are entitled to dividend only when earning and
liquidity position of the firm warrant.
Generally, this policy is adopted by firms with unstable earnings. Firms with fluctuating
investment opportunities may find this policy useful. A large part of profits may be ploughed
back in the year when a firm has number of highly profitable investment opportunities.
In the subsequent year, when the firm will have no or limited investment opportunities to seize,
the management may distribute larger portion of earnings which would otherwise have remained
unutilized.

Factors Affecting the Dividend Policy of a Company

 Profitability: The profitability of a firm is reflected in net profit ratio and ratio of profit
to total assets. A highly profitable company have a capacity to pays higher dividends and a
company with less profits will adopt a conservative dividend policy.
 Trends of profits: Even if the company has been profitable over the years, the trend
should be properly analyzed to find the average earnings of the company. This average
number should be then studied in relation to the general economic conditions. This will
help in opting for a conservative policy if a depression is approaching.

 Maintenance of Reserves: Various reserves for different purposes are needed for
efficient running of a company. Reserves for — depreciation, working capital, bad debts,
dividend equalization, expansion, taxation, debenture redemption, and preference share
redemption are very common for a company to keep apart. The surplus is available for
dividend.
 Existence of Earned Surplus: A company cannot pay dividends out of capital. Dividend
is payable out of current profits or accumulated profits of a company. It can be paid after
providing for depreciations as per Companies Act.
 Cash Needs of a Company: Cash position is a big criterion to pay dividend. For a
company, cash is needed for various contingencies. They cannot be ignored for the
survival of a company. So, dividend policy has to be made after a serious consideration
of the cash position of the company.
 Need for Growth and Expansion: A company, quite likely, is brought into being not to
remain static. It is to grow and expand. For this, cash flow must exist. Every available
amount cannot be spent for payment as dividend to shareholders. That will restrict the
scope for its growth and expansion.
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 Many companies follow orthodox dividend policy and provide for liberal ploughing back
of profits into the business and these retained earnings are utilized for expansion and
growth as a source of internal finance.
 Steady and Stable Dividend Policy: An ideal dividend policy rests on the principle of
stability and steadiness. Attractive dividend rate — after providing for reasonable, regular
and stable income — should be aimed at. Regularity of dividend depends upon stability
of earnings, dividend equalization reserve and adequate free reserves.
 It is not a sound dividend policy, to distribute a good amount as dividend because of huge
profits. Conservation of excess profit for future needs is a prudent step towards a sound,
regular dividend policy.
 A stable and steady dividend policy ensures long term planning and long term financing
easier. The credit — worthiness of the company, too is thus enhanced. Market value of
shares also is stabilized. By encouraging confidence of shareholders, the shares of such a
company are subjected to least speculation.
 Government Taxation Policy: In these days corporate taxation is a very important factor
to take into consideration. Government levies huge amount of taxes on companies to
augment its revenue needs. This means the management is put into difficulty in
maintaining stable or high rate of dividend. So, this has to be considered while
formulating dividend policy.
 Legal Restrictions: There may be ceiling on the rate of dividend imposed by the
Government. Here the management is helpless. Similarly, for closely held companies
there may be restrictions on ploughing back of profits because members are interested in
reducing their income tax on their dividends.
 Dividend Restrictions by Creditors: Lenders to companies, while granting long term
credit, may restrict the rate of dividend payment. This dictation by the lenders restricts
the management in declaring dividend as they intend to do.
 Fixed Asset Replacement Provision: While the price is on rise, i.e., in an inflationary
economy management has to give serious thought on replacement of fixed assets. It
would require huge amount which must be provided to keep the company running.
Hence, a company is compelled to provide for liberal depreciation. Depreciation on
historical cost is absolutely inadequate during inflation.
 Inflation: Inflationary environments compel companies to retain major part of their
earnings and indulge in lower dividends. As the prices rise, the companies need to
increase their capital reserves for their purchases of fixed assets. In case of inflationary
situation, same quantity of closing stock will have more valuation, so payment of tax also
increase.
 Control objectives: The firms aiming for more control in the hands of current
shareholders prefer a conservative dividend payout policy. It is imperative to pay fewer
dividends to retain more control and the earnings in the company.

In recent years, many Indian companies are confronted with such a problem. As discussed above,
dividend policy depends on financial as well as legal considerations. It is not the sweet will of
the Board of Directors that can enable a company to declare dividend as it wishes.
The financial matters like trend of profit, existence of earned surplus, cash position, reaction of
shareholders, economic policy of the nation, need for expansion, and nature of the enterprise
trade cycle, age of the company, government taxation policy are determinants of dividend policy.
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But, exclusively, they cannot be the final guide. Legal consideration, also dominate dividend
policy. Only profits or accumulated surplus can be touched for dividend. It must be out of cash.
There is legal directive as to the proportion between dividend and paid up capital. There are clear
guidelines as to how the dividend pays out could be made. After 42 days from the date of
declaration of dividend, if no claim is lodged or dividend cannot be paid, then within 7 days after
the expiry of 42 days an account as “Unclaimed Dividend Account”has to be opened.
Dividend payable must be paid or dividend warrant should be sent to shareholders within 42
days from the date of declaration of dividend. In case of unclaimed dividend, three years’ time is
allowed, and then the total amount is transferred to General Reserve Account of the Central
Government.