Friday, June 17, 2011

“Dividend can be paid only out of profits” Explain this statement and also discuss your role as a Finance Manager in the matters of dividend policy.


“Dividend can be paid only out of profits” Explain this statement and also discuss your role as a Finance Manager in the matters of dividend policy.

Ans.   Dividend decision is highly important for a firm.  It is required to plan to maximize the owner’s wealth.  It is the responsibility of the management to make the owner aware of the objectives and the implications of the dividend policy so that the market reaction is favourable.  It is a continuous activity spread over a period of several years.  Following are the options that are required to be considered for the dividend policy formulation and implementation:
1.                  It is important for a firm to decide that the dividend should be paid right from the first year of operations so as to give regular dividend to its shareholders.
2.                  It can decide whether it should give equal amount or a fixed percentage of dividends every year irrespective of the amount of earnings as in case of preference shares.
3.                  It can decide whether the dividend is a fixed percentage of total earnings so as to give variable amount of dividend every year depending upon the earnings and the number of ordinary shares.  It is known as fixed payout ratio option.
4.                  Property dividend or bonus share dividend may be given if it is paid in cash or in the form of shares of other companies held by it or by converting retained earnings into bonus shares.

Factors Affecting Dividend Decision:
Dividend decision determines the division of earning between payments to shareholders and retained earnings.  It has the strong influence on the financial decision of the business.  Distribution of dividends reduces the cash funds of the business and then it may have to depend on external sources of finance on higher interest rate.  The factors that affect the dividend decision of a company are discussed below:
1.                 Legislation:  Certain legislation may be instrumental in defining the dividend decision of the company.  As per companies Act, 1956.  the dividend can be paid only out of profits and not out of capital.  If the profits are inadequate or absent then the company may declare dividends out of the accumulated profits.  It also ensures that a certain percentage of profits less than 10 percent are transferred to the reserves of the company.  According to Income Act, a closely held company is required to pay a minimum percentage of its net profits as dividends to its members.  The Restrictions Act, 1978 has exempted manufacturing private limited companies from the compulsory distribution of profits.  The legislation pertaining to dividend should be followed otherwise the dividend decision would be ultra-virus.
2.                 Amount of Earning:  The amount of earnings plays an important role in dividend decision-making.  A rational approach should be adopted wherein amount and the nature of earnings should be considered.
3.                  Liquidity Status:  The dividend decision should also consider the liquidity status of the firm since the dividend will outflow the capital.  Almost every business needs funds for its activities continuously.  In that situation, paying cash dividend is avoided.
4.                  Investment opportunities and shareholder’s preferences:  From the earnings a company has to decide how much it can share.  Whether it should share a major amount or it should not share any money and keep the entire amount for its future activities, is important to decide.  Retention of earnings is being carried out to finance the future activities of the company.  If certain important projects are in hand, a company should give preference to the retention of earnings over the payment of dividend.  Investors have to pay taxes on two components i.e. tax on dividends and tax on capital gains.  While the former tax is payable by the investor when he gets the dividend, the latter tax is paid due to retention of earnings.  Capital gains tax is lower than the tax on dividend and it is payable only when the share are actually sold i.e. deferred payment of taxes.  If a company has paid dividend to its shareholders, but it wants finances to finance its investment programmes through right shares.  The shareholders will pay income tax on the dividend as per their income slab and if they purchase the right shares, they have to give full money.  Otherwise if the company instead of giving dividend, issues the right shares to its existing shareholders, tax on dividend could be saved.  Thus the investor could prefer the retention of earnings.  It has been observed that the persons who are in the top tax-slab would like to have capital gains whereas those in lower tax-slab like to have dividend.
5.                  Capital Market:  A company can follow liberal attitude if the capital market is comfortable and the company has easy access to it.  If it does not have access due to high cost of capital then it would like to follow conservative policy on dividend.
6.                  Profit rate and stability of earnings:  If a company is getting high rate of return on its investment, it will have good profit and hence it can give dividend.  Similarly if the amount of earnings is uniform, it can predict the future earnings and can afford to give dividend.  But if it has fluctuating earnings or normal or lesser rate of return than the interest rate, it cannot afford to distribute dividend.  In that case, it would like to retain the earnings for future requirements.
7.                  Inflation:  Inflation is responsible for the depreciation of assets and hence the replacement cost of such assets would be high.  To compensate, earnings may be required to be retained to maintain the earning power of the firm.
8.                  Control:  A company may like to keep its control to the existing management and shareholders.  If it goes for more share, control may be diluted or may go to the new shareholders.  If it issues debentures, financial risk of the company would increase.  Thus it may like to retain the earnings or goes for lesser dividend to payout ratio.
9.                  Contractual Obligations:  Certain contracts related to loans may provide the restriction to go for cash dividends.  Generally while taking credits, creditors used to have a clause in the agreement to protect themselves from possible insolvency of the firm.

1 comments:

Unknown said...

Thanx for solve this question and publish on website

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updated till june 2011