Unit 3: Dividend Policy

Dividend Policy

Dividend Policy refers to the decision regarding how much profit should be distributed to shareholders as dividends and how much should be retained in the business for growth.

A good dividend policy balances:

• Shareholder expectations for income
• Company’s need for future investment

Factors Affecting Dividend Decisions

Factor	Explanation
1. Earnings / Profitability	Higher profits → higher dividend paying capacity.
2. Cash Flow Position	Dividend is paid in cash; even profitable firms may not pay if cash is low.
3. Stability of Earnings	Firms with stable earnings prefer stable or regular dividends.
4. Growth Opportunities	Fast-growing companies retain profits for expansion → lower dividends.
5. Shareholder Preferences	Some shareholders prefer regular income; others prefer capital gains.
6. Taxation Policies	Dividend distribution tax, personal tax, and corporate tax influence decisions.
7. Legal Restrictions	Companies must follow laws related to dividends (e.g., can’t pay out of capital).
8. Contractual Restrictions	Loan agreements often restrict dividend payments.
9. Access to Capital Market	Companies with easy access to finance can pay higher dividends.
10. Business Cycles	During recession, firms retain earnings; during boom, dividends are higher.
11. Control Considerations	Promoters may retain profits to avoid issuing new shares and losing control.
12. Internal Policies	Conservative firms maintain low dividends; aggressive firms pay higher dividends.

Theories of Dividend Policies

A. Walter’s Model

• Dividend policy affects the value of the firm.
• Decision depends on the relation between:
• r = return on investment 
• k = cost of equity

Condition	Dividend Policy	Effect
r > k	Growth firms	Retain earnings, low/no dividend
r < k	Declining firms	Pay high dividend
r = k	Normal firms	Dividend policy irrelevant

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B. Gordon’s Model (Bird-in-Hand Theory)

• Investors prefer certain dividends over uncertain future capital gains.
• Higher dividend → lower risk → higher share price.

• Formula:

$$P_0=\frac{D_1}{k-\mathrm{g}}$$

• Implies dividend is relevant and affects firm value.

C. Modigliani–Miller (MM) Theory of Irrelevance

• Dividend policy has no impact on the value of the firm.
• Assumptions: perfect capital markets, no taxes, rational investors.
• Value depends on investment decisions, not dividend.

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D. Residual Dividend Theory

• Dividend = Profit after financing all investment needs.
• If investment needs are high → low dividends.
• If investment needs are low → higher dividends.

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E. Traditional Theory

• Balance between dividends and retained earnings leads to optimal valuation.

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Corporate Dividend Behaviour of Companies

Companies generally follow certain patterns:

1. Stable Dividend Policy (Most Common)

• Company pays consistent dividend every year.
• Provides confidence & stability to shareholders.

2. Constant Dividend Payout Ratio

• Company pays a fixed % of earnings as dividend.

3. Hybrid Dividend Policy

• Small regular dividend + extra dividend in good years.

4. Zero Dividend Policy

• Fast-growing companies retain all profits (e.g., tech startups).

5. Bonus Shares / Stock Dividend

• Instead of cash, company issues extra shares to shareholders.

6. Stock Buybacks (Share Repurchase)

• Alternative to dividends.
• Sign of confidence and improves EPS.

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Legal Aspects of Dividend

In India, legal aspects come mainly from:

A. Companies Act, 2013

Key rules:

1. Dividends must be declared out of:

• Current year profits
• Past year’s accumulated profits
• Government-provided funds for guaranteed dividends (for govt companies)

2. Depreciation must be provided before declaring dividends.
3. Dividends cannot be paid out of capital.
4. Unpaid dividends for 30 days must be transferred to Unpaid Dividend Account.
5. After 7 years, unpaid dividend goes to the Investor Education and Protection Fund (IEPF).

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B. SEBI (for listed companies)

• Must declare dividends along with book closure dates.
• Timely disclosure to stock exchanges is mandatory.

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Procedural Aspects of Dividend Declaration

1. Board Meeting

• Board of Directors recommends the dividend amount.

2. Approval in AGM

• Dividend is approved by shareholders in the Annual General Meeting.

3. Fixing Record Date

• Determines which shareholders are eligible.

4. Transfer of Dividend Amount

• Amount is transferred to a separate Dividend Account within 5 days of declaration.

5. Payment of Dividend

Must be paid within 30 days through:

• NEFT
• Cheque
• Electronic transfers

6. Transfer of Unpaid Dividend

• After 30 days → Unpaid Dividend Account
• After 7 years → IEPF

Summary Notes 

• Dividend policy = choice between current dividends vs future growth.
• Factors: profits, cash flow, tax, legal, shareholder preference, growth prospects.
• Theories: Walter, Gordon (relevance), MM (irrelevance), Residual.
• Corporate behavior: stable dividends, constant payout, bonus shares, buybacks.
• Legal aspects: follow Companies Act, provide depreciation, no dividend out of capital.
• Procedure: board recommendation → AGM approval → payment → transfer unpaid dividends.