Practical aspects of dividend policy


Two important dimensions of a firm’s dividend policy are:

* Quantum of the average payout ratio

* Stability of dividends over a time period

These two dimensions are conceptually distinct from one another.

The considerations which are relevant for determining the average payout ratio are:

1. Funds requirements.
2. Liquidity.
3. Access to external sources of financing.
4. Shareholders’ preferences.
5. Differences in the cost of external equity and retained earnings.
6. Control
7. Taxes.

Irrespective of the long-run payout ratio followed, the fluctuations in the year-to-year dividend may be determined mainly by one of the two guidelines.

(i) Stable dividend payout ratio
(ii) Stable dividends or steadily changing dividends. Firms generally follow a policy of stable dividends or gradually rising dividends.

Since internal equity (in the form of retained earnings) is cheaper than external equity an important dividend prescription advocates a residual policy to dividends. According to this policy the equity earnings of the firm are first applied to provide equity finance required for supporting investments. The surplus, if any, is distributed as dividends.

Firms subscribing to the residual dividend policy may adopt one of the following approaches: (i) Pure residual dividend policy approach (ii) Fixed dividend payout approach and (iii) smoothed residual dividend approach. The smoothed residual dividend approach, which produces a table and steadily growing stream of dividend, often appears to be the most sensible approach in practice.

Not withstanding the normative prescription of the smoothed residual dividend approach, Lintner’s classic study of corporate dividend behavior showed that: (i) Most of the firms think primarily in terms of the proportion of earnings that should be paid out as dividends rather than in terms of the proportion of earnings that should be ploughed back in the firm. (ii) Firms try to reach the target payout ratio gradually over a period of time because shareholders prefer a steady progression in dividends.

The amount of dividend that can be legally distributed is governed by company law, judicial pronouncements in leading cases, and contractual restrictions. The important events and dates in the dividend payment procedure are:

* board resolution
* shareholder approval
* record date
* dividend payment

Bonus shares are shares issued to existing shareholders as a result of capitalization of reserves. In the wake of a bonus issue (i) Shareholders’ proportional ownership remains unchanged. (ii) The book value per share, the earnings per share, and the market price per share decrease, but the number of shares increases.

In a stock split the par value per share is reduced and the number of shares is increased proportionately. In a nutshell, a stock split is similar to a bonus issue from the economic point of view, though there re some difference from the accounting point of view.

The issue of bonus shares is governed by certain guidelines, the important ones being the residual reserve requirement and the profitability requirement.