What is dividend and why is dividend decision important?

What is dividend and why is dividend decision important?

Definition:

Distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

A taxable payment declared by a company's board of directors and given to its shareholders out of the company's current or retained earnings, usually quarterly. Dividends are usually given as cash (cash dividend), but they can also take the form of stock (stock dividend) or other property. Dividends provide an incentive to own stock in stable companies even if they are not experiencing much growth. Companies are not required to pay dividends. The companies that offer dividends are most often companies that have progressed beyond the growth phase, and no longer benefit sufficiently by reinvesting their profits, so they usually choose to pay them out to their shareholders also called payout

Dividend Decision

A  Dividend decisions are an important aspect of corporate financial policy since they can have an effect on the availability as well as the cost of capital. The Lintner proposition which asserts that the corporate management maintains a constant target payout ratio has  been the most influential. However, the concept of primary of dividend decisions as well as the reasons for it are not unambiguously defined. There is a variety of theories which attempt to rationalize the observed secular constancy of the dividend payout ratio. These studies examine the factors underlying the structure of the management, the nature of the product and financial markets, as well as the influence of the shareholders in their attempt to explain the Lintner proposition. However, in the case of any one firm, the following two pertinent questions need to be examined on an empirical basis to provide substance to the notion of primary of dividend decisions. (a) What are dividend decisions primary for?, and (b) for whom are they primary? An attempt has been made to develop a theoretical framework to approach these questions and identify the appropriate concept of primary and determine empirically the relationship of the primary notion with the objectives of the share holders and the management. The modeling framework postulates that (a) the dividend decisions may be primary to the management of the firm and /or the shareholder, and (b) each of the decision makers can have a short run and /or long run objective when they evaluate dividend decisions. Share price increases have been postulated as the basic short run objective of both the groups of decision makers. Similarly, both the share holders and the management are viewed as net worth maximizes over the long run. The fundamental hypothesis for the short run models is that the management increases the dividend per share whenever the share price down, and that the share holder responds, to these in such a way as to increase the share price. This result is expected if dividend decisions are primary for both the groups. In the long run context, it was felt that a progressive management would increase the net worth the firm by investments in fixed assets or through building the reserve base.

            Dividends would be a primary decision if the internal financing of investment is constrained by the necessity to pay dividends at a constant rate. These are two extreme forms in which dividend decisions can be considered to be primary. A variety of intermediate positions are possible in any specific case of a firm. The models were designed to accommodate a rich variety of such behavioral patterns.

            Dividend decision determines the division of earnings between payments to shareholders and retained earnings.

            The Dividend Decision, in Corporate finance, is a decision made by the directors of a company about the amount and timing of any cash payments made to the company's stockholders. The Dividend Decision is an important part of the present day corporate world. The Dividend decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the Dividend decision may determine the amount of taxation that stockholders pay.

Factors influencing Dividend Decisions:

            There are certain issues that are taken into account by the directors while making the dividend decisions:

·         Free Cash Flow

·         Signaling of Information

·         Clients of Dividends

Free Cash Flow Theory:

            The free cash flow theory is one of the prime factors of consideration when a dividend decision is taken. As per this theory the companies provide the shareholders with the money that is left after investing in all the projects that have a positive net present value.                   

Signaling of Information:

            It has been observed that the increase of the worth of stocks in the share market is directly proportional to the dividend information that is available in the market about the company. Whenever a company announces that it would provide more dividends to its shareholders, the price of the shares increases.          

Clients of Dividends:

            While taking dividend decisions the directors have to be aware of the needs of the various types of shareholders as a particular type of distribution of shares may not be suitable for a certain group of shareholders.

            It has been seen that the companies have been making decent profits and also reduced their expenditure by providing dividends to only a particular group of shareholders. For more information please refer to the following links:

Forms of Dividend

·         Scrip Dividend- An unusual type of dividend involving the distribution of promissory notes that calls for some type of payment at a future date.

·         Bond Dividend- A type of liability dividend paid in the dividend payer's bonds.

·         Property Dividend- A stockholder dividend paid in a form other than cash, scrip, or the firm's own stock.

·         Cash Dividend- A dividend paid in cash to a company's shareholders , normally out of the its current earnings or accumulated profits

·         Debenture Dividend

·         Optional Dividend- Dividend which the shareholder can choose to take as either cash or stock.

Significance of dividend decision

·         The firm has to balance between the growth of the company and the distribution to the shareholders

·         It has a critical influence on the value of the firm

·         It has to also to strike a balance between the long term financing decision( company distributing dividend in the absence of any investment opportunity) and the wealth maximization

·         The market price gets affected if dividends paid are less.

·         Retained earnings helps the firm to concentrate on the growth, expansion and modernization of the firm

·         To sum up, it to a large extent affects the financial structure, flow of funds, corporate liquidity, stock prices, and growth of the company and investor's satisfaction.

Factors influencing the dividend decision

·         Liquidity of funds

·         Stability of earnings

·         Financing policy of the firm

·         Dividend policy of competitive firms

·         Past dividend rates

·         Debt obligation

·         Ability to borrow

·         Growth needs of the company

·         Profit rates

·         Legal requirements

·         Policy of control

·         Corporate taxation policy

·         Tax position of shareholders

·         Effect of trade policy

·         Attitude of the investor group