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 

What role is played by a financial manager in matter of dividend policy. Discuss the alternatives that he might consider and the factors which he should take into consideration before finalizing his views on dividend policy?

What  role  is  played  by  a  financial  manager  in  matter  of  dividend  policy. Discuss the alternatives that he might consider and the factors which he should take into consideration before finalizing his views on dividend policy?

A financial manager is a person who is responsible in a significant way to carry out the finance functions. In a modern organization a financial manager occupies a key position. He or she is one of the members of the top management team, and his or her role, day-by- day  is  becoming  more  pervasive,  intensive  and  significant  in  solving  complex management problems. The finance manager is responsible to shaping the fortunes of the organization and is involved in the most vital decisions of the allocation of capital. He ensures that the funds of the enterprise are utilized in the most efficient manner.

Financial managers plan, organize, direct, control and evaluate the operation of financial and accounting departments. They develop and implement the financial policies and systems of establishments. Financial managers establish performance standards and prepare various financial reports for senior management. They play a significant role in dividend decision. They are employed in financial and accounting departments in companies throughout the private sector and in government.

Example Titles

•      controller

•      director - financial services

•      director of accounting

•      finance director

•      manager, financial control

•      manager, financial planning and analysis

•      manager, internal audit services

•      treasurer

Main duties

•      Plan, organize, direct, control and evaluate the operation of an accounting, audit or other financial department

•      Develop  and  implement  the  financial  policies,  systems  and  procedures  of  an establishment

•      Prepare or co-ordinate the preparation of financial statements, summaries, and other cost-benefit analyses and financial management reports

•      Co-ordinate  the  financial  planning  and  budget  process,  and  analyze  and  correct estimates

•      Supervise the development and implementation of financial simulation models

•      Evaluate financial reporting systems, accounting procedures and investment activities and make recommendations for changes to procedures, operating systems, budgets and other financial control functions to senior managers and other department or regional managers

•      Recruit, organize, train and manage staff

•      Act as liaison between the organization and its shareholders, the investing public and external financial analysts

•      Establish profitability standards for investment activities and handle mergers and/or acquisitions

•      Notify and report to senior management concerning any trends that are critical to the organization's financial performance.

Dividend Decisions

The size and frequency of dividend payments are critical issues in company policy. Dividend policy affects the financial structure, the flow of funds, corporate liquidity, stock prices, and the morale of stockholders. The finance manager plays an important role in the dividend policy.

The objective of dividend policy is to maximize shareholder’s return so that the value of his investment is maximized. Shareholders’ return consists of two components: dividends and capital gains. Dividend policy has a direct impact on these components.

A Low payout ratio may produce higher share price because it accelerates earnings growth. Investors of growth companies will realize their return mostly in the form of capital gains. Dividend yield- dividend per share divided by the market price per share- will be low for such companies. The impact of dividend policy on future capital gains is, however, complex. Capital gains occur in distant future, and therefore, are considered uncertain. It is not certain that low payout ratio policy will necessary lead to higher prices in reality. It is quite difficult to clearly identify the effect of payout on share price.

A high payout ratio means more current dividends and less retained earnings, which may consequently result in slower growth and perhaps lower market price per share.

Paying dividends involve outflow of cash. The cash availability for the payment of dividends is affected by firm’s investment and financing decisions. Thus, investment decisions affect dividend decisions.

There are three main factors that may influence a firm's dividend decision:

•      Free-cash flow

•      Dividend clienteles

•      Information signaling

The free cash flow theory of dividends

Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects.

A key criticism of this theory is that it does not explain the observed dividend policies of real-world companies. Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision

.

Dividend clienteles

A particular pattern of dividend payments may suit one type of stockholder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular

patterns of dividend payments, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

A key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to provide the pattern of cash flows that they desire. An investor who would like to receive some cash from their investment always has the option of selling a portion of their holding. This argument is even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that there are taxation- based clienteles for certain types of dividend policies.

Information signaling

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm's future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller  and  Rock  pointed  out  that  this  is  likely  due  to  the  information  content  of dividends.

When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information that may provide a clue as to the firm's future prospects. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm's ability to generate cash flows in the future they may keep dividends  constant,  or  possibly  even  reduce  the  amount  of  dividends  paid  out. Conversely, managers that have access to information that indicates very good future prospects for the firm (eg. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers' behaviour to inform their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.

Example: Dividend Policy at ONGC

Dividends are declared at the Annual General Meeting of the shareholders based on the recommendation by the Board. The Board may recommend dividends, at its discretion, to be paid to our members. The Board may also declare interim dividends. Generally, the factors that may be considered by the Board before making any recommendations for the dividend include, but are not limited to, future capital expenditure plans, profits earned during the financial year, cost of raising funds from alternate sources, cash flow position and applicable taxes including tax on dividend, subject to the Government guidelines described below:

As per the guideline dated February 11, 1998 from the Government of India, all profit- making PSUs which are essentially commercial enterprises should declare the higher of a minimum dividend of 20 percent on equity or a minimum dividend payout of 20 percent of post-tax profit. The minimum dividend pay-out in respect of enterprises in the oil, petroleum, chemical and other infrastructure sectors such as us should be 30 percent of post-tax profits