What is a '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. 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.

A dividend is a distribution of a portion of a company's earnings, decided by the board

of directors, to a class of its shareholders. Dividends can be issued as cash payments, as
shares of stock, or other property.

The dividend rate may be quoted in terms of the dollar amount each share receives
(dividends per share, or DPS), or It can also be quoted in terms of a percent of the current
market price, which is referred to as the dividend yield.

A company's net profits can be allocated to shareholders via a dividend, or kept within the
company as retained earnings. A company may also choose to use net profits to repurchase their
own shares in the open markets in a share buyback. Dividends and share buy-backs do not
change the fundamental value of a company's shares.

What is a 'Dividend Policy'

A dividend policy is the policy a company uses to decide how much it will pay out to
shareholders in the form of dividends.

Dividend policy is the set of guidelines a company uses to decide how much of its earnings it
will pay out to shareholders. Some evidence suggests that investors are not concerned with a
company's dividend policy since they can sell a portion of their portfolio of equities if they want
cash

There are three main approaches to dividends:

Residual Dividend Policy

Companies using the residual dividend policy choose to rely on internally generated equity to
finance any new projects. As a result, dividend payments can come out of the residual or leftover
equity only after all project capital requirements are met. These companies usually attempt to
maintain balance in their debt/equity ratios before making any dividend distributions, deciding
on dividends only if there is enough money left over after all operating and expansion expenses
are met.

For example, let's suppose that a company named CBC has recently earned $1,000 and has a
strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity).
Now, suppose this company has a project with a capital requirement of $900. In order to
maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this project by
using debt ($300) and two-thirds ($600) by using equity. In other words, the company would
have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual
amount of $400 ($1,000 - $600) for dividends. On the other hand, if the project had a capital
requirement of $1,500, the debt requirement would be $500 and the equity requirement would be
$1,000, leaving zero ($1,000 - $1,000) for dividends. If any project required an equity portion
that was greater than the company's available levels, the company would issue new stock.

Typically, this method of dividend payment creates volatility in the dividend payments that some
investors find undesirable.

1. The first step in the residual dividend model to set a target dividend payout ratio to
determine the optimal capital budget.

2. Then, management must determine the equity amount needed to finance the optimal
capital budget. This should be done primarily through retained earnings.

3. The dividends are then paid out with the leftover, or residual, earnings. Given the use of
residual earnings, the model is known as the "residual-dividend model."

A primary advantage of the dividend-residual model is that with capital-projects budgeting,

the residual-dividend model is useful in setting longer-term dividend policy. A significant
disadvantage is that dividends may be unstable. Earnings from year to year can vary
depending on business situations. As such, it is difficult to maintain stable earnings and thus
a stable dividend. While the residual-dividend model is useful for longer-term planning,
many firms do not use the model in calculating dividends each quarter.

Dividend Stability Policy

The fluctuation of dividends created by the residual policy significantly contrasts with the
certainty of the dividend stability policy. With the stability policy, quarterly dividends are set
at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides
them with income.

Suppose our imaginary company, CBC, earned $1,000 for the year (with quarterly earnings
of $300, $200, $100 and $400). If CBC decided on a stable policy of 10% of yearly earnings
($1,000 x 10%), it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if
CBC decided on a cyclical policy, the dividend payments would adjust every quarter to be
$30, $20, $10 and $40, respectively. In either instance, companies following this policy are
always attempting to share earnings with shareholders rather than searching for projects in
which to invest excess cash.

Hybrid Dividend Policy

The final approach is a combination between the residual and stable dividend policy. Using
this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-
term goal. In today's markets, this approach is commonly used by companies that pay
dividends. As these companies will generally experience business cycle fluctuations, they
will generally have one set dividend, which is set as a relatively small portion of yearly
income and can be easily maintained. On top of this set dividend, these companies will offer
another extra dividend paid only when income exceeds general levels.

Factors affecting Dividend Policy

Dividend policy of a company sets the guidelines to be followed while deciding the amount
of dividend to be paid out to the shareholders. The company needs to adhere to the dividend
policy while deciding the proportion of earnings to be distributed and the frequency of the
distribution. There are various types of dividend policies regular, stable, constant and
irregular. In this post, we will discuss various factors affecting dividend policy.
A company needs to analyze certain factors before framing their dividend policy.
TYPE OF INDUSTRY
The nature of the industry to which the company belongs has an important effect on the
dividend policy. Industries, where earnings are stable, may adopt a consistent dividend policy
as opposed to the industries where earnings are uncertain and uneven. They are better off in
having a conservative approach to dividend payout.

OWNERSHIP STRUCTURE
The ownership structure of a company also impacts the policy. A company with a higher
promoter holdings will prefer a low dividend payout as paying out dividends may cause a
decline in the value of the stock Whereas, a high institutional ownership will favor high
dividend payout as it helps them to increase the control over the management.

AGE OF CORPORATION
Newly formed companies will have to retain major part of their earnings for further growth
and expansion. Thus, they have to follow a conservative policy unlike established companies,
which can pay higher dividends from their reserves.

THE EXTENT OF SHARE DISTRIBUTION

A company with a large number of shareholders will have a difficult time in getting them to
agree to a conservative policy. On the other hand, a closely held company has more chances
of succeeding to finalize conservative dividend payouts.

DIFFERENT SHAREHOLDERS EXPECTATIONS

Another factor that impacts the policy is the diversity in the type of shareholders a company
has. A different group of shareholders will have different expectations. A retired shareholder
will have a different requirement vis-a-vis a wealthy investor. The company needs to clearly
understand the different expectations and formulate a successful dividend policy.

LEVERAGE
A company having more leverage in their financial structure and consequently, frequent
interest payments will have to decide for a low dividend payout. Whereas a company
utilizing their retained earnings will prefer high dividends.

FUTURE FINANCIAL REQUIREMENTS

Dividend payout will also depend on the future requirements for the additional capital. A
company having profitable investment opportunities is justified in retaining the earnings.
However, a company with no internal or external capital requirements should opt for a higher
dividend.

BUSINESS CYCLES
When the company experiences a boom, it is prudent to save up and make reserves for dips.
Such reserves will help a company declare high dividends even in depressing markets to
retain and attract more shareholders.

GROWTH
Companies with a higher rate of growths, as reflected in their annual sales growth, a ratio of
retained earnings to equity and return on net worth, prefer high dividend payouts to keep
their investors happy.
CHANGES IN GOVERNMENT POLICIES
There could be the change in the dividend policy of a company due to the imposed changes
by the government. The Indian government had put temporary restrictions on companies to
pay dividends during 1974-75.
PROFITABILITY
The profitability of a firm is reflected in net profit ratio, current ratio, and ratio of profit to
total assets. A highly profitable company generally pays higher dividends and a company
with less or no profits will adopt a conservative dividend policy.

TAXATION POLICY
The corporate taxes will affect dividend policy, either directly or indirectly. The taxes directly
reduce the residual earnings after tax available for the shareholders. Indirectly, the dividend
distribution is taxable after a certain limit.

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.

LIQUIDITY
Liquidity has a direct relation with the dividend policy. If a firm has a strong liquidity and
enough cash for its working capital, it can afford to pay higher dividends. However, a firm
with less liquidity will choose a conservative dividend policy.

LEGAL RULES
There are certain legal restrictions on the companies for dividend payments. It is legal to pay
a dividend only if the capital is not reduced post payment. These rules are in place to protect
creditors interest.

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 and other expenses.

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 a nutshell, the management of a company is completely free to frame the required
dividend policy. There are no obligations to be adhered to. So, the company needs to
judiciously weigh all the above-mentioned factors and formulate a balanced dividend policy.
A dividend policy can also be revised in the wake of changes in any of the factors