DIVIDEND DECISIONS (UNIT:IV)

Q1. What is Dividend? Explain Cash and Stock Dividend.

Ans: A dividend is a distribution of a portion of a company's earnings to its

shareholders. It's essentially a way for a company to share its profits with its investors.
Dividends are typically paid out regularly, usually quarterly, semi-annually, or annually,
although some companies might not pay dividends at all, opting to reinvest earnings
back into the business for growth.

There are two primary types of dividends:

1. Cash Dividend:
 A cash dividend is paid out in the form of cash to shareholders.
 It's a direct payment from the company's earnings and is usually expressed as a
certain amount per share (e.g., $0.50 per share).
 Shareholders receive this cash payment either through checks mailed to them or
through direct deposit into their brokerage accounts.
2. Stock Dividend (or Bonus Shares):
 Instead of paying cash, a company can issue additional shares of its stock to
existing shareholders as a dividend.
 This means that shareholders receive more shares in the company without any
cash changing hands.
 The number of additional shares received is typically proportional to the number
of shares already owned. For example, a 5% stock dividend would mean receiving
5 additional shares for every 100 shares held.

Both cash and stock dividends are ways for a company to reward its shareholders. The
decision of whether to pay cash or stock dividends depends on various factors,
including the company's financial situation, its growth plans, cash flow, and the
preferences of its shareholders.

Cash dividends provide shareholders with immediate income, while stock dividends
increase the number of shares held by investors without changing the total value of
their investment (assuming the stock price remains constant). Companies might opt for
stock dividends to preserve cash for other uses or to signal confidence in future
prospects by reinvesting earnings back into the business.
 Q2. Explain Dividend Policy along with its theories.

Ans: Dividend policy refers to the strategy or approach a company uses to decide how much of
its earnings to distribute to shareholders as dividends and how frequently these dividends are
paid. There are several theories and factors that influence dividend policy:

1. Dividend Relevance Theory:

The relevance theory of dividend policy suggests that dividends have a significant impact on a
firm's value and investor behavior. It emphasizes that dividend decisions can influence investors'
perceptions, choices, and the overall value of the company. There are two types:

Walter's Model:

1. Relationship between Return on Investment (r) and Cost of Capital (k):

 Walter's model posits that the relationship between a company's internal rate of return (r) on
investments and its cost of capital (k) determines the optimal dividend policy.

2. Impact of Dividend Policy on Firm's Value:

 If the rate of return on investment (r) is greater than the cost of capital (k) i.e., (r > k):
 Retaining earnings to finance new investments is more beneficial for the firm. This is
because the returns generated from reinvested earnings are higher than the cost of
obtaining capital from shareholders. In this scenario, the firm's value increases by
retaining earnings rather than paying dividends.
 If the rate of return on investment (r) is less than the cost of capital (k) i.e., (r < k):
 Distributing earnings as dividends becomes more favorable for the firm. This is because
the returns from reinvestment are lower than the cost of obtaining capital from
shareholders. Paying dividends becomes an efficient way to distribute earnings and
increase the firm's value.

Key Assumptions of Walter's Model:

1. Eternal Existence: The model assumes that the firm operates perpetually without an
end.
2. No External Financing: The company does not rely on external sources for financing its
investments; it only uses retained earnings for investment purposes.
3. Investment Opportunities: There are enough investment opportunities available to the
company to reinvest its earnings profitably.

Gordon Growth Model:

 Gordon's model, also known as the Gordon Growth Model or the Dividend Discount
Model (DDM), is a valuation approach used to determine the intrinsic value of a stock
based on its dividends. It emphasizes the relationship between a company's dividends,
its growth rate, and the required rate of return by investors.

Key Assumptions of Gordon’s Model:

1. Constant Growth Assumption:

 The model assumes that dividends will grow at a constant rate (g) indefinitely.
This is often referred to as the perpetuity assumption.
2. Impact of Dividend Growth and Required Rate of Return:
 Gordon's model suggests that the value of a stock is directly related to its
expected future dividends.
 An increase in expected dividends or a decrease in the required rate of return (r)
will increase the stock's present value. Conversely, a decrease in expected
dividends or an increase in the required rate of return will decrease the stock's
present value.
3. Influence of Dividend Yield and Growth Rate:
 The model highlights the significance of both the current dividend yield and the
expected growth rate of dividends in determining the stock's present value.
 A higher dividend yield or a higher expected growth rate results in a higher
present value of the stock.

2. Dividend Irrelevance Theory:

a. In a perfect market, where there are no taxes, transaction costs, or information
asymmetries, the dividend policy of a company is believed to be irrelevant for its
valuation.
b. Investors are assumed to be rational, having access to the same information, and
able to create their desired income stream (via dividends or selling shares)
without any cost or preference.
c. According to Modigliani and Miller, if a company retains earnings instead of
paying dividends, shareholders can still create their own income by selling a
portion of their shares. The value of the company remains the same because the
retained earnings are reinvested in projects that increase the company's value.
d. Essentially, the theory argues that investors are indifferent between dividends
and capital gains as long as the company reinvests its earnings effectively.

Q3. Explain Dividend policies in practice.

 Ans: In practice, dividend policies adopted by companies are shaped by various factors,
strategies, and considerations, and they can vary significantly based on the company's
financial health, industry, growth prospects, and shareholder preferences. Here are some
key aspects of dividend policies in practice:

1. Stability and Consistency:

 Regular Dividend Payments: Many companies aim for stability and consistency in their
dividend payments. They set a pattern of regular payouts (quarterly, semi-annually, or
annually) to provide predictability for investors who rely on dividends for income.

2. Dividend Yield and Payout Ratio:

 Dividend Yield: Companies often consider maintaining an attractive dividend yield

relative to their stock price to attract income-seeking investors. A higher dividend yield
might make the stock more appealing.
 Payout Ratio: The payout ratio (dividends paid out as a percentage of earnings)
influences how much of the earnings the company distributes as dividends. Companies
may have different target payout ratios based on their growth strategies and financial
health.

3. Dividend Stability and Growth:

 Dividend Growth: Some companies aim for a consistent growth rate in dividends over
time. This approach signals confidence in the company's financial health and long-term
prospects. Companies with a history of dividend growth often attract long-term
investors seeking reliable income and growth.
 Dividend Stability: Other companies prioritize maintaining a stable dividend amount,
even if it means slower or no dividend growth. They emphasize consistency in payouts
regardless of short-term earnings fluctuations.

4. Dividend Reinvestment and Share Buybacks:

 Dividend Reinvestment Plans (DRIPs): Some companies offer DRIPs, allowing

shareholders to automatically reinvest dividends into buying more shares, promoting
long-term investment.
 Share Buybacks: Companies may opt for share buyback programs instead of dividends,
repurchasing their own shares from the market. This reduces the number of outstanding
shares, potentially increasing the value of remaining shares.
 5. Financial Health and Profitability:

 Earnings and Cash Flow: Companies consider their earnings stability, cash flow
position, and profitability when deciding on dividend payouts. Consistent profitability
and sufficient cash reserves enable companies to sustain dividends during economic
downturns or challenging periods.

6. Future Growth Opportunities:

 Investment Opportunities: Companies with promising growth opportunities might

retain more earnings to invest in new projects, acquisitions, or research and
development instead of distributing them as dividends. This choice could lead to
potential future growth but might result in lower current dividends.

7. Shareholder Preferences and Tax Considerations:

 Shareholder Preferences: Understanding the preferences of different investor groups

(income-seeking vs. growth-oriented investors) can influence a company's dividend
policy.
 Tax Considerations: Tax laws and rates on dividends affect how companies structure
their dividend policies and impact shareholder decisions.

Q4. What are the factors affecting Dividend Decision?

Ans: he decision on dividends involves multiple considerations and is influenced by

various factors:

Company Performance:

1. Earnings: The company’s profitability and earnings influence its ability to pay dividends.
Higher earnings often allow for larger dividends.
2. Cash Flow: The availability of cash flow affects the company’s capacity to distribute
dividends.

Investor Expectations:

1. Desire for Income: Investors seeking regular income prefer higher dividend payments.
2. Growth Expectations: Growth-oriented investors might prefer companies reinvest
profits rather than distributing dividends.
 Financial Considerations:

1. Debt Obligations: Existing debt commitments and the need for cash to service debt
can impact dividend decisions.
2. Capital Requirements: If the company needs funds for expansion, R&D, or acquisitions,
it might limit dividend payouts to retain cash.

Legal and Regulatory Constraints:

1. Legal Restrictions: Some jurisdictions impose legal restrictions or guidelines on

dividend payments.
2. Tax Implications: Dividend policies might be influenced by tax considerations for both
the company and shareholders.

Market Conditions and Industry Trends:

1. Competitive Pressures: In competitive industries, companies may opt for higher

dividends to attract investors.
2. Industry Norms: Dividend policies often align with industry norms or standards.

Shareholder Relations:

1. Shareholder Preferences: Understanding shareholder preferences (income vs. growth)

can shape dividend decisions.
2. Shareholder Base: A diverse shareholder base with varied preferences might
necessitate a balanced dividend strategy.

Future Outlook and Uncertainty:

1. Future Prospects: If the company foresees uncertain economic conditions or

investment opportunities, it might alter dividend policies.
2. Stability and Consistency: Some companies prefer to maintain a consistent dividend
policy to signal stability and reliability to investors.

Management Philosophy and Strategy:

1. Company’s Objectives: Management’s vision, strategy, and priorities influence dividend

choices.
2. Long-term Plans: Companies with long-term growth plans might retain earnings for
future investments.
 Investor Relations and Communication:

1. Communication Strategy: Clear communication about dividend policies helps manage

investor expectations and perceptions.
2. Corporate Governance: Strong governance frameworks often impact dividend
decisions positively.

Economic Factors:

1. Interest Rates: Changes in interest rates can influence dividend policy decisions.
2. Inflation: High inflation may prompt companies to adjust dividends to maintain real
returns for investors.

Decisions about dividends are complex and require a balance between rewarding
shareholders, reinvesting in the company, and ensuring financial stability. Companies
assess these factors to determine the optimal dividend policy aligned with their goals
and circumstances.