Dividend policy: objectives, factors, types and forms of dividend

1. Meaning

A dividend is the part of the profit distributed to shareholders in proportion to their holding. Dividend policy is the firm’s settled approach to how much of its earnings it pays out (the payout ratio, D/E) and how much it retains (the retention ratio, b = 1 − D/E). Retained earnings are the cheapest and most convenient source of growth finance; dividends give the shareholder a current return and signal the firm’s health. The policy decides the balance.

2. Objectives

• maximising the wealth of shareholders (the value of the share);
• providing a regular, predictable income to shareholders;
• retaining enough funds for growth and for contingencies;
• keeping the share price stable and the firm’s credit standing good;
• keeping control with the present shareholders by avoiding fresh issues.

3. Factors affecting dividend policy

Internal factors

1. Earnings and their stability: steady earnings support a steady dividend.
2. Liquidity: profit is not cash; a profitable but cash-short firm cannot pay much.
3. Growth and investment needs: a growing firm retains more.
4. Age of the firm: established firms pay more; new firms plough back.
5. Access to capital markets: a firm that can borrow easily can afford to pay out more.
6. Control: retaining earnings avoids issuing new shares and diluting control.
7. Past dividend record: shareholders expect at least last year’s rate.

External factors

8. Shareholders’ preferences: retired or institutional investors want income; others want growth (the clientele effect).
9. Taxation: since 1 April 2020 dividends are taxed in the hands of the shareholder (the dividend distribution tax on companies was abolished by the Finance Act, 2020), so the shareholder’s tax rate now matters more.
10. Lenders’ covenants in loan agreements restricting dividends.
11. Inflation and the state of the economy: in inflation, more must be retained to replace assets.
12. Legal restrictions (section 6).

4. Types of dividend policy

• Stable (regular) dividend per share: a fixed amount each year, raised only when the firm is sure higher earnings will last. Favoured by investors who want regular income; it signals confidence. Example: a company paying Rs. 5 a share every year whether EPS is Rs. 8 or Rs. 12.
• Constant payout ratio: a fixed percentage of earnings, so the dividend fluctuates with profit. Example: 40% of EPS — Rs. 4 when EPS is Rs. 10, Rs. 2 when it is Rs. 5.
• Stable dividend plus extra: a low regular dividend with an extra (special) dividend in good years; the extra is not expected to recur.
• Irregular dividend: no fixed pattern; paid when profits and cash allow. Common in firms with uncertain earnings.
• Residual policy: dividends are paid only out of what is left after financing all profitable investments; follows from the MM view that dividends are irrelevant.
• No dividend: a young, fast-growing firm retains everything.

Lintner’s study of American firms (1956) found that managers aim at a long-run target payout ratio and adjust the dividend towards it slowly, avoiding cuts. This is the empirical basis for stable dividend policies.

5. Forms of dividend

1. Cash dividend: the usual form; needs adequate cash.
2. Bonus shares (stock dividend): fully paid shares issued free out of free reserves, securities premium or capital redemption reserve (section 63, Companies Act, 2013). No cash leaves the firm; reserves are capitalised. A bonus issue cannot be made in lieu of a cash dividend.
3. Scrip dividend: promissory notes payable at a future date, used when cash is short.
4. Bond dividend: like scrip but for a longer period, and carrying interest.
5. Property dividend: assets other than cash (rare).
6. Interim dividend: declared by the board between two annual general meetings; final dividend is declared at the AGM on the board’s recommendation.

6. Legal rules (Companies Act, 2013)

• Section 123: dividend only out of the profits of the year (after providing depreciation), undistributed profits of earlier years, or money provided by the Government; transfer to reserves is at the company’s discretion; dividend is payable only in cash (cheque or electronic mode), apart from capitalisation by bonus issue.
• Section 124: dividend unpaid within 30 days of declaration goes to an Unpaid Dividend Account; after seven years, to the Investor Education and Protection Fund.
• Section 127: failure to pay a declared dividend within 30 days is an offence.

How this is examined

The 10-mark essay (“define dividend policy and explain the types with examples”, February 2025; “factors determining dividend policy”, August 2024) is section 1 with either 3 or 4 in full. The 6-mark notes on factors, forms or objectives are single sections. Add the two worked examples in section 4 whenever the question says “with examples”. The theories (Walter, Gordon, MM, traditional) are in the next note.