B.

Com 2nd Semester Module: 5

Financial Management Dividend Decision

Module: 5
Dividend Decision
1 Mark Questions
1. What is dividend
The term dividend relates to the portion of profit, which is distributed to shareholders of
the company. It is a reward or compensation to them for their investment made in the firm.
The dividend can be declared from the current profits or accumulated profits.
2. What is dividend decision?
Dividend decision is the firms decision concerned with the amount of profits to be distributed
and retained in the firm. Dividend decision is the type of decision taken by a firm which
depends on the preference of the equity shareholders and investment opportunities, available
within the firm.

3. What is dividend policy?

Dividend policy means policy or guideline followed by the management in declaring of
dividend. It is the decision about how much of earnings to pay out as dividends versus
retaining and reinvesting earnings in the firm.

2-Mark Questions
1. Mention the different types of dividends
Classifications of dividends are based on the form in which they are paid. Following given
below are the different types of dividends:
Cash dividend
Bonus Shares referred to as stock dividend in USA
Property dividend interim dividend, annual dividend.
Special- dividend, extra dividend etc.
Regular Cash dividend
Scrip or bond dividend
Liquidating dividend
Property dividend
2. What are the different types of dividend policies
Firms may pursue any one of the following dividend policies:
Stable Dividend Policy
Generous or liberal dividend policy
Low regular dividend plus extra dividend policy
Residual dividend policy
Multiple dividend increase policy
Erratic Dividend policy
Uniform cash dividend plus bonus policy
4-Marks Questions
1. Elucidate the term ploughing back of profits
'Ploughing back of profits' is an important source of internal or self financing by a company.
It refers to the process of retaining a part of the company's net profits for the purpose of
reinvesting in the business itself. In other words, the savings generated internally by a
company in the form of 'retained earnings' are ploughed back into the company for
diversification of its business. It is actually the amount held back by the entrepreneur after
paying a reasonable dividend to the shareholders of the company and these undistributed
profits are used by the company to meet its present and future financial requirements. This
reduces their dependence on funds from external sources in order to finance their regular
business needs. Such a source of finance may be used by the company for the following
purposes:-

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Financial Management Dividend Decision

For expansion and growth of the business

For strengthening the financial position of the company
For meeting various working capital requirements of the company
For redemption of old debts
For replacement of obsolete assets and modernisation.

2. Briefly explain the factors determining dividend policy

The following are the factors determining dividend policy:
a) Profitable Position of the Firm- Dividend decision depends on the profitable position
of the business concern. When the firm earns more profit, they can distribute more
dividends to the shareholders.
b) Uncertainty of Future Income- Future income is a very important factor, which affects
the dividend policy. When the shareholder needs regular income, the firm should
maintain regular dividend policy.
c) Legal Constraints- The Companies Act 1956 has put several restrictions regarding
payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down
certain restrictions on payment of dividends.
d) Liquidity Position- Liquidity position of the firms leads to easy payments of dividend.
If the firms have high liquidity, the firms can provide cash dividend otherwise, they
have to pay stock dividend.
e) Sources of Finance- If the firm has finance sources, it will be easy to mobilise large
finance. The firm shall not go for retained earnings.
f) Growth Rate of the Firm- High growth rate implies that the firm can distribute more
dividend to its shareholders.
g) Tax Policy- Tax policy of the government also affects the dividend policy of the firm.
When the government gives tax incentives, the company pays more dividend.
h) Capital Market Conditions- Due to the capital market conditions, dividend policy may
be affected. If the capital market is prefect, it leads to improve the higher dividend.
3. Explain the different types of dividend policies
On the basis of the dividend declaration by the firm, the dividend policy may be classified
under the following types:
I. Regular Dividend Policy- Dividend payable at the usual rate is called as regular
dividend policy. This type of policy is suitable to the small investors, retired persons
and others.
II. Stable Dividend Policy- Stable dividend policy means payment of certain minimum
amount of dividend regularly.
This dividend policy consists of the following three important forms:
a) Constant dividend per share
b) Constant payout ratio
c) Stable rupee dividend plus extra dividend.
III. Irregular Dividend Policy- When the companies are facing constraints of earnings
and unsuccessful business operation, they may follow irregular dividend policy. It is
one of the temporary arrangements to meet the financial problems. These types are
having adequate profit. For others no dividend is distributed.
IV. No Dividend Policy- Sometimes the company may follow no dividend policy because
of its unfavourable working capital position of the amount required for future growth
of the concerns.

4. State and explain the different types of dividends

The following are the major types of dividends:
a) Cash dividend: A cash dividend is a usual method of paying dividends. Payment of
dividend is cash results in the reduction out flow of funds and reduces the net worth of
the company. The shareholders get an opportunity to invest the cash in any manner,
they desire. Hence, the ordinary shareholders prefer to receive dividends in cash. In

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Financial Management Dividend Decision

case of companies having cash dividends, the firm must have adequate liquid
resources, so that its liquidity position is not adversely affected on account of cash
dividend.
b) Scrip (or) Bond dividend: A scrip dividend promises to pay the shareholders at a
future specific date. In case a company does not have sufficient funds to pay dividends
in cash, it may issue notes or bonds for amounts due to the shareholders. The objective
of scrip dividends is to postpone the immediate payment of cash. A scrip dividend
bears interest and is accepted as collateral security.
c) Property Dividend: Property dividends are paid in the form of some assets other
than cash. They are distributed under exceptional circumstances and are not popular
in India.
d) Stock Dividend: Stocks dividend means the issue and the bonus shares to the
existing shareholders. If a company does not have liquid resources, it is better to
declare stock dividends. Stock dividend amounts to capitalization of earnings and
distribution of profits among the existing shareholders without affecting the cash
position of the firm.

15-Marks Questions
1. What is dividend and what are its different types? Explain the different
types of dividend policies and the different factors influencing dividend
policies.
According to the Institute of Chartered Accountants of India, dividend is "a distribution to
shareholders out of profits or reserves available for this purpose." The term dividend refers to
that portion of profit (after tax) which is distributed among the owners / shareholders of the
firm. The different types of dividend are as follows:
a) Cash dividend: Companies mostly pay dividends in cash. A Company should have
enough cash in its bank account when cash dividends are declared. If it does not have
enough bank balance, arrangement should be made to borrow funds. When the
Company follows a stable dividend policy, it should prepare a cash budget for the
coming period to indicate the necessary funds, which would be needed to meet the
regular dividend payments of the company. It is relatively difficult to make cash
planning in anticipation of dividend needs when an unstable policy is followed.
b) Bonus dividend or Stock dividend: An issue of bonus share is the distribution of shares
free of cost to the existing shareholders, In India, bonus shares are issued in addition
to the cash dividend and not in lieu of cash dividend. Hence, Companies in India may
supplement cash dividend by bonus issues. Issuing bonus shares increases the number
of outstanding shares of the company. The bonus shares are distributed
proportionately to the existing shareholder. Hence there is no dilution of ownership.
c) Special dividend: In special circumstances Company declares Special dividends.
Generally company declares special dividend in case of abnormal profits.
d) Extra- dividend: An extra dividend is an additional non-recurring dividend paid over
and above the regular dividends by the company. Companies with fluctuating earnings
pay-out additional dividends when their earnings warrant it, rather than fighting to
keep a higher quantity of regular dividends.
e) Annual dividend: When annually company declares and pay dividend is defined as
annual dividend.
f) Interim dividend: During the year any time company declares a dividend, it is defined
as Interim dividend.
g) Regular cash dividends: Regular cash dividends are those the company exacts to
maintain every year. They may be paid quarterly, monthly, semi-annually or annually.
h) Scrip dividends: These are promises to make the payment of dividend at a future date:
Instead of paying the dividend now, the firm elects to pay it at some later date. The
scrip issued to stockholders is merely a special form of promissory note or notes
payable

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Financial Management Dividend Decision

i) Liquidating dividends: These dividends are those which reduce paid-in capital: It is a
pro-rata distribution of cash or property to stockholders as part of the dissolution of a
business
j) Property dividends: These dividends are payable in assets of the corporation other than
cash. For example, a firm may distribute samples of its own product or shares in
another company it owns to its stockholders.
Dividend policy means the practice that management follows in making dividend pay-out
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders. Firms may pursue any one of the following dividend policies:
a) Generous or liberal dividend policy- Firms that follow this policy reward shareholders
generously by stepping up dividend over the time.
b) Stable dividend policy-Firms may follow the policy of:
i. Stable dividend pay-out ratio-According to this policy, the percentage of
earnings paid out of dividends remains constant. The dividends will fluctuate
with the earnings of the company.
ii. Stable rupee (inflation adjusted) dividend policy: As per this policy the rupee
level of dividends remains stable.
c) Low regular dividend plus extra dividend policy- As per this policy, a low, regular
dividend is maintained and when times are good an extra dividend is paid. Extra
dividend is the additional dividend optionally paid by the firm if earnings are higher
than normal in a given period. Although the regular portion will be predictable, the
total dividend will be unpredictable.
d) Residual dividend policy-Under this policy, dividends are paid out of earnings not
needed to finance new acceptable capital projects. The dividends will fluctuate
depending on investment opportunities available to the company.
e) Multiple dividend increase policy- Some firms follow the policy of very frequent and
small dividend increases. The objective is to give shareholders an illusion of movement
and growth.
f) Erratic dividend policy- Dividends are paid erratically when the management feels it
will not strain the resources of the firm. Interests of the shareholders are not taken care
of while making the dividend decisions. It has been observed by various researchers
that firms generally prefer to follow a stable or a gradually rising dividend policy.
g) Uniform cash dividend plus bonus policy- Under this policy, the minimum rate of
dividend per share is paid in cash plus bonus shares are issued out of accumulated
reserves. However bonus shares are not given compulsorily on an annual basis. They
may be given over a period of a certain number of years, for example 3-5 years
depending on the accumulated reserves of the company that can be utilized for the
purpose of issuing bonus.
The factors determining dividend policies are as follows:
a) Profitable Position of the Firm- Dividend decision depends on the profitable position
of the business concern. When the firm earns more profit, they can distribute more
dividends to the shareholders.
b) Uncertainty of Future Income- Future income is a very important factor, which affects
the dividend policy. When the shareholder needs regular income, the firm should
maintain regular dividend policy.
c) Contractual constraints- Often, the firms ability to pay cash dividends is constrained
by restrictive provisions in a loan agreement. Generally, these constraints prohibit the
payment of cash dividends until a certain level of earnings have been achieved, or they
may limit dividends to a certain amount or a percentage of earnings. Constraints on
dividends help to protect creditors from losses due to the firms insolvency. The
violation of a contractual constraint is generally grounds for a demand of immediate
payment by the funds supplier.
d) Internal constraints- The firms ability to pay cash dividends is generally constrained
by the amount of excess cash available rather than the level of retained earnings against
which to charge them. Although it is possible for a firm to borrow funds to pay

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Financial Management Dividend Decision

dividends, lenders are generally reluctant to make such loans because they produce no
tangible or operating benefits that will help the firm repay the loan.
e) Growth prospects- The firms financial requirements are directly related to the
anticipated degree of asset expansion. If the firm is in a growth stage, it may need all
its funds to finance capital expenditures. Firms exhibiting little or no growth may never
need replace or renew assets. A growth firm is likely to have to depend heavily on
internal financing through retained earnings instead of distributing current income as
dividends
f) Owner considerations- In establishing a dividend policy, the firms primary concern
normally would be to maximize shareholders wealth. One such consideration is then
tax status of a firms owners. Suppose that if a firm has a large percentage of wealthy
shareholders who are in a high tax bracket, it may decide to pay out a lower percentage
of its earnings to allow the owners to delay the payments of taxes until they sell the
stock. Of course, when the equity share is sold, the proceeds are in excess of the original
purchase price, the capital gain will be taxed, possible at a more favourable rate than
the one applied to ordinary income. Lower-income shareholders, however who need
dividend income will prefer a higher pay-out of earnings. As of now, the dividend
income is not taxed in the hands of the shareholders in India. Instead, for paying out
such dividends to its shareholders, the company bears the dividend distribution tax.
g) Market Considerations- The risk-return concept also applies to the firms dividend
policy. A firm where the dividends fluctuate from period to period will be viewed as
risky, and investors will require a high rate of return, which will increase the firms cost
of capital. So, the firms dividend policy also depends on the markets probable
response to certain types of policies. Shareholders are believed to value a fixed or
increasing level of dividends as opposed to a fluctuating pattern of dividends.
h) Legal Constrains- The Companies Act 1956 has put several restrictions regarding
payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down
certain restrictions on payment of dividends.
i) Liquidity Position- Liquidity position of the firms leads to easy payments of dividend.
If the firms have high liquidity, the firms can provide cash dividend otherwise, they
have to pay stock dividend.
j) Sources of Finance- If the firm has finance sources, it will be easy to mobilize large
finance. The firm shall not go for retained earnings.
k) Growth Rate of the Firm- High growth rate implies that the firm can distribute more
dividends to its shareholders.
l) Tax Policy- Tax policy of the government also affects the dividend policy of the firm.
When the government gives tax incentives, the company pays more dividends.
m) Capital Market Conditions- Due to the capital market conditions, dividend policy may
be affected. If the capital market is prefect, it leads to improve the higher dividend.
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