Everything you need to know about the types of dividend policy. Dividend policy is one the essential components of financial management, the profits earned by business organizations are either distributed to shareholders are retained by the business or in some cases it is partly retained and partly distributed. Dividend policy is concerned with a firm’s decision on pay out earnings or retaining and reinvesting them and also deciding how much it will pay out to shareholders in dividends.
Read this article to learn about: 1. Regular Dividend Policy 2. Irregular Dividend Policy 3. Stable Dividend Policy 4. No Dividend Policy 5. Residual Dividend Policy 6. Policy of No Immediate Dividend 7. Policy of Regular and Extra Dividends 8. Policy of Regular Stock Dividend 9. Low Regular Dividends plus Extra Dividends Policy 10. Dividends Fluctuating with Earnings Policy 11. Constant Dividend Payout Policy 12. Constant Dividend Rate Policy 13. Optimum Dividend Policy 14. Constant Percentage of Earnings.
Additionally, there may be another approach whereby two more policies may be adopted by the management of a company, viz.,: 1. Conservative Dividend Policy 2. Liberal Dividend Policy.
Types of Dividend Policies Adopted by Firms, Companies and Business Organizations
Types of Dividend Policy – Regular, Irregular, Stable and No Dividend Policy
The various types of dividend policies are classified as under:
1. Regular Dividend Policy:
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Payment of dividend at the usual rates is termed as regular dividend policy. The investors such as the middle class families, retired persons and institutional investors prefer this type of dividend policy. However it should be remembered that regular dividend can be maintained only by companies of long standing and stable earnings.
2. Irregular Dividend Policy:
Some companies follow irregular dividend policy due to reasons such as lack of liquid funds, uncertainty of future earnings, unsuccessful business operations etc.
When a company does not have a long standing and stable earnings it will not be able to commit itself to paying dividends regularly. When there is no certainty as to whether dividend will be paid in a year or not and how much of dividend will be paid, the company is said to follow an irregular dividend policy. Investors who expect a company to pay a certain amount as dividend every year may not want to invest in such a company.
3. Stable Dividend Policy:
The term stability of dividend means consistency or lack of variability in the stream of dividend payments, even though the amount of dividend may fluctuate from year to year. The company decides to pay a certain amount of dividend every year, consistently, whether more or less. Some investors may be more interested in a source of income for today rather than capital appreciation. This serves as an assurance to those investors who depend on dividend as a .source of income.
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Significance of Stable Dividend Policy:
The stability of dividend policy is helpful to the shareholders and the company in the following ways:
i. Confidence among shareholders- Payment of regular and stable dividend may help in building confidence in the minds of investors regarding regularity of dividends.
ii. Investors’ desire for current income- There are many investors like retired persons, salaried people, and other fixed income group may prefer to receive income regularly to meet their living expenses. Such investors prefer a company with stable dividend policy.
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iii. Institutional investors- Investments are made not only by individuals but also by institutions. Normally the institutional investors prefer to invest in shares of those companies, which pay dividends regularly.
iv. Stability in market price of shares- Stable dividend policy may also help a company in maintaining stability in the market price of its shares.
v. Rising additional finance- A stable dividend policy is also advantageous to company in rising external finance.
vi. Spreading of ownership of outstanding share- Stable dividend policy may also help in spreading the ownership of shares more widely among small investors.
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vii. Reduces the chances of Loss of control- Because of the spreading of ownership for outstanding shares among the large number of small investors the chances of Loss of control by the present management over the company are reduced.
viii. Market for debentures and preferences shares- A stable dividend policy also helps the company in marketing of outstanding shares and debentures.
4. No Dividend Policy:
The company may follow a policy of paying no dividend presently because of requirement of funds for the future growth and expansion or unfavourable working capital position. Company may decide not to pay any dividend at all. If the profits of a company are reinvested in the business, it may result in growth and better profits in future.
So the company may decide not to pay any dividend and reinvest it in its business. But the company has to convince the shareholders about its policy. It does not benefit the present shareholders in any way other than capital appreciation. It may benefit the future shareholders by way of more profits in the future.
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Types of Dividend Policies – With Advantages and Disadvantages
Dividend policy is one the essential components of financial management, the profits earned by business organizations are either distributed to shareholders are retained by the business or in some cases it is partly retained and partly distributed. The ratio of the actual distribution or dividend, and the total distributable profits, is called dividend payout ratio. On the other hand dividend policy is concerned with a firm’s decision on pay out earnings or retaining and reinvesting them and also deciding how much it will pay out to shareholders in dividends.
Business organizations have to frame and work on a definitive policy constructively because paying high dividends may lead to fewer funds internally available for expansion and growth. On the other hand paying lower dividends results in higher retained earnings that are significant internal sources of financing for the growth of the firm. Therefore management has to broadly decide its policy on its broad attitude towards distribution of dividends. There are basically 5 types of dividend policy.
Let us discuss them one by one:
Type # 1. Residual Dividend Policy:
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The term residual indicates the quantity of profits left over. In residual dividend policy a business organization will only pay dividends after all acceptable investment opportunities have been undertaken. Thus, residual dividend policy is used by companies to finance its capital expenditure proposals through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the capital expenditure proposal needs are met.
Advantages:
(a) This policy is good for business because it reduces the occurrence of raising external funds.
(b) Residual dividend policy reduces the issues of new stocks and flotation costs.
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Disadvantages:
(a) Creates volatility in the dividend payments that may be undesirable for some investors.
(b) It’s risky venture, however as the companies dividends are at risk.
(c) The amount payable as dividend fluctuates heavily if this policy is practiced.
Type # 2. Regular Dividend Policy:
In regular dividend policy companies pay dividend to shareholders in a definite manner at a usual rate. Regular dividend policy aims to provide for a regular and sizeable dividend flow, whilst allowing the company to maintain the financial flexibility to take advantage of attractive investment opportunities in the future.
The company typically pays annual dividends on the basis of its results for the previous year, and special dividends following disposals or asset. The investors who expect regularity of income prefer to get regular dividend.
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Advantages:
(a) This policy enhances prestige and credit standing of the company.
(b) Shareholders prefer this policy, as it leads to stability in market prices of shares.
(c) Regular dividend policy eliminates uncertainty in investors’ mind about dividend payment.
(d) Helps a company in meeting its financial requirements from retained earnings.
(e) Provides a source of regular source of income to investors.
Disadvantages:
(a) A company paying regular dividends may have less money to grow the business.
Type # 3. Stable Dividend Policy:
As the name of the policy suggests, stable dividend policy focuses on regularity in paying some dividend even though the amount of dividend may vary every year and may not be associated with earnings of the company. In other words Stable dividend means that a certain minimum amount of dividend is paid regularly. It may also mean that dividend is paid regularly by the company, but the amount or rate of dividend is not fixed.
The stable dividend may take the following forms:
i. Constant Dividend per Share:
Under this policy the management of the company pays a fixed amount of dividend on every share irrespective of level of earning year after year. In order to ensure consistency in payment of dividends reserve fund is created to pay fixed amount of dividend in the year when the earning of the company is not enough. It is suitable for the firms having stable earning. It is important to note that even though dividend is constant every year however this does not mean that the rate of dividend will never be increased, depending on the level of earning of the company the rate may change.
ii. Constant Payout Ratio:
Payout ratio means is dividend as a percentage of earnings. It is an important concept in the dividend policy. According to this policy, the percentage of earnings paid out as dividends remain constant irrespective of the level of earnings. Thus, as earnings of a company fluctuate, dividends paid by it also fluctuate accordingly in proportionate to the earning of the company.
iii. Constant Rupee Dividend, plus Extra Dividend:
According to this policy a company pays a low rate of dividend per share to reduce the chances of not paying dividend. In other words dividends in rupee terms mostly remain constant irrespective of the level of earnings and in the period when company performs exceptionally well the management pays extra dividend.
Advantages:
a) This policy Creates confidence amongst share holders.
b) Attracts income conscious investors.
c) Promotes stability in the market prices of shares.
d) Encourages institutional investors.
e) Enhances creditworthiness and goodwill of the company.
f) It helps in giving regular income to the shareholders.
Disadvantages:
a) Difficult to change stable dividend policy as it may have a negative impact on shareholders and market price of the shares.
Type # 4. Irregular Dividend Policy:
Company, upon making profit must decide on application of profits. It could continue to retain the profits within the company, or it can pay out the profits to the owners of the firm in the form of dividends.
Therefore in irregular dividend policy a company does not pay regular dividend to the shareholders for various reasons such as to generate funds for expansion and growth, if a company expects uncertainty in its future business operations and non-availability of liquid cash resources.
Type # 5. No Dividend Policy:
Even though dividends play an important role in rewarding shareholders, but some companies view in broader context of the varying liquidity needs of the company and their vision of the company’s future. A company implements no dividend policy due to lack of liquidity because of its unfavorable working capital position.
Further management wants the business to grow and the stock to appreciate and in order to do this they prefer reinvesting excess cash in the business, rather than giving away on dividends.
Types of Dividend Policy – Residual, Stable and Flexible (With Examples)
The dividend policies of the firms can be broadly categories in three categories:
1. Residual dividend policy,
2. Stable dividend policy and
3. Flexible dividend policy.
1. Residual Dividend Policy:
In this policy, if the firm has earnings left after financing all acceptable opportunities, these earnings would then be distributed to shareholders in the form of cash dividends. If not, then there would be no dividends. If the number of acceptable investment opportunities involves more amount than the retained earnings, then the firm would finance the excess needs with a combination of new equity capital and debt.
The payout ratio will fluctuate from year to year in consonance with fluctuations in the amount of acceptable investment opportunities available to the firm. The percentage of earnings to be paid out as dividends will fluctuate from period to period depending on fluctuations in the amount of acceptable investment opportunities available to the firm.
If the firm has no profitable investment opportunities available, then dividend payout ratio will be 100%. The residual dividend policy implies that dividends are irrelevant. Financing the investment opportunity through the retained earnings is given priority over dividend payouts.
For example, a company has equity capital of Rs. 100,00,000 comprising 10,00,000 shares. If earnings of the company after payment of interest and tax are Rs. 28,00,000 and the company has investment opportunity of Rs. 20,00,000, then the company would pay Rs. 0.80 per share as dividend.
2. Stable Dividend Policy:
In stable dividend policy, the payment of dividend remains constant for a long period. The payment of dividend can be constant on two bases. First, the amount of dividend will remain constant from year to year.
For example, a firm decides to pay dividends at rate of Rs. 2 per share for the coming 5 years, it is a stable dividend in amount policy. Second, the company may fix percentage of profit to be distributed as dividend for a number of years. For example, if a company decides that 50% of profit after interest and tax would be paid to equity shareholders as dividend, it is a stable percentage dividend policy.
Stable dividend policy is possible if the earnings of the company do not fluctuate much.
3. Flexible Dividend Policy:
This policy is the combination of above-mentioned two policies. In flexible dividend policy, some extra dividend is paid in years of super normal profits in addition to a constant dividend payment.
For example, a company has a dividend policy of paying dividend of Rs. 2 per share per year plus 50% of super normal profits. The company has 1,00,000 shares of Rs. 10 each and its normal profits are Rs. 30,00,000.
Now, if the company earns after tax profits of Rs. 40,00,000 in a year, it will pay Rs. 3 per share as dividend. In this amount, Rs. 2 are from constant dividend and Rs. 1 per share from super normal profits (Rs. 40,00,000 – Rs. 30,00,000 divided by 10,00,000 shares).
This dividend policy is more practical as compared to the first two dividend policies. It ensures more dividend payouts to shareholders in periods of super normal profits.
Types of Dividend Policies – With Usefulness and Limitations
The dividend decision in a firm is taken in the light of the firm’s operating and financial conditions. In this total framework, the firm will find that there may be different dividend policies and it has to choose the one amongst them which suits its existing conditions and the top management approves of it.
Each of these dividend policies and their usefulness and limitations are discussed below:
Type # 1. Stable Dividend Policy:
When a firm constantly pays a fixed amount of dividends and maintains it for all times to come regardless of fluctuations in the level of its earnings, it is said to have pursued a relatively stable dividend policy. In such a policy stockholders are assured of a fixed dividend per share.
During periods of prosperity the firm withholds all extraordinary income of the business to use them to maintain dividend amount during lean years. Stability of dividend policy does not mean stagnation in dividend payout ratio. In fact, slow but steady change is the prime feature of a stable dividend policy.
When the company’s earnings tend to rise regularly and management feels satisfied that increased earnings are sustainable, permanent dividend per share is increased. Likewise, dividend will not be allowed to decline in correspondence with a fall in business earnings until it is felt that the firm will not be able to recover from the setback.
The behavioural relationship between dividends and earnings is exhibited in Figure 45.1.
It may be noted from the above figure that while earnings fluctuate from year to year, dividends will rise only after yearly rise in earnings takes a long-run tendency.
In real world, most of the companies follow stable dividend policy because of the following reasons:
(a) Companies regularly paying dividends at a fixed rate have always high credit standing in the market. They can raise as much funds they like from the market because of widespread demand of their shares.
(b) Stable dividend policy fosters a rise in share values. Investors generally pay higher premium to shares promising a certainty of dividend income than to those with fluctuating dividends because of risks inherent in the latter. Those who derive their regular income from dividends would always prefer to hold such shares as assure safety of dividends.
(c) Since dividends communicate information to investors about the company’s profitability and managerial efficiency, a company pursuing stable dividend policy enjoys a great confidence of shareholders. This may be immensely useful in fund-raising activity of the firm and will also give boost to the morale of the management.
(d) A company with stable dividend policy can very easily formulate long-term financial planning because the finance manager can in that case estimate correctly future supply and demand of capital in the company.
However, in designing stable dividend policy a finance manager should see that the dividend payout ratio is not fixed at a level that the company may subsequently find it difficult to sustain. It would be worthwhile to keep in mind future earning power of the company while determining the dividend rate.
Stability in the level of earnings is indeed a basic condition for pursuing this policy. A company with fluctuations in the level of earnings may find it extremely difficult to follow a stable dividend policy.
Public utility concerns and other manufacturing stable dividend policy. Public utility concerns and other manufacturing stable products of daily consumption generally follow this policy because of relatively lesser variations in their earnings.
Type # 2. Policy of No Immediate Dividend:
Very often the management may decide to declare no dividend despite large earnings of the company.
This policy is usually pursued in the following circumstances:
(i) When the firm is a new and rapidly growing and it needs tidy amount of funds to finance its expansion programmes.
(ii) When the firm’s access to capital market is difficult or when availability of fund is costlier.
(iii) Where shareholders have agreed to accept higher return in future or they have strong preference for long- term capital gains as opposed to short-term dividend income.
Policy of no immediate dividends should be followed by issue of bonus shares so that the company’s capital increases and amount of reserves and surplus is reduced or the company’s stock should be split into small lots so as to keep dividend per share low while providing larger amounts to shareholders.
This course of action would be necessary to keep share prices within limits. Detailed account of significance of stock dividends and stock splits has been given under the heading stock dividends and stock splits.
Type # 3. Policy of Regular and Extra Dividends:
Companies following regular dividend policy pay dividends constantly to stockholders at constant rate and do not change the payout ratio unless it is believed that changes in earnings are permanent.
When profits of the company swell, the management may decide to distribute a part of the increased earnings as extra dividends instead of enhancing the regular dividend payout ratio.
Extra dividends are declared only in the year in which earnings exceed annual dividend requirement by some given amount. Whether or not extra dividends will be declared would depend on a number of factors including expected funds requirements, desired level of liquidity and expectations about future earnings.
Such a dividend policy gives impression to the stockholders that extra dividends have been paid because the company has made extraordinary earnings which will be skipped subsequently when business earnings will drop to normal level.
With this policy, the company’s credit standing and so also its share values are not likely to be adversely affected by the omission of extra dividends in future.
However, the policy of regular and extra dividends year after year may give wrong impression to the stockholders who may treat extra dividends as part of regular dividends with the result that they may react very strongly to omission of extra dividends in future when earnings of the company do not warrant distribution of extra dividends.
In such a situation the company may lose confidence of stockholders and also its credit standing in the market. It is, therefore, pertinent for the management to make it crystal clear in the policy announcement that a regular dividend rate will be paid under normal circumstances with the possibility of extra dividends only when the magnitude of earnings and other conditions warrant. Further, to distinguish between regular and extra dividends, they should be clearly labeled to that effect.
Bigger companies generally assign different numbers to regular and extra dividends. It is only when extraordinary earnings become a permanent feature and the management feels that increased earnings will support an increase in dividend rate permanently that extra dividends becomes a part of regular dividend and dividend rate is raised accordingly.
Type # 4. Policy of Regular Stock Dividend:
The company adopting this policy pays dividends in stock instead of in cash. Stock dividend is also designated ‘bonus shares’ which is very frequently used to capitalize reinvested earnings of the company. Issue of bonus shares does not effect at all the liquidity position of the company. It increases indeed the shareholding of residual owners but not their equity in the company.
Such a policy should be followed under the following circumstances:
(i) When the firm needs cash generated by earnings to cover its modernization and expansion programmes;
(ii) When the firm is deficient in cash despite high earnings. This is particularly true if the firm’s sales are affected through credit and entire sales proceeds are tied in receivables.
It may be dangerous to pursue the policy of stock dividend regularly for a long period of time because in that case the earnings per share would decline sharply, value of shares would tend to plumb and the credit standing of the firm would receive a big a jolt. Besides, stockholders cannot satisfy with receiving dividends in stocks. They may cry for cash dividends after sometime and may even force the management to change.
Type # 5. Policy to Pay Irregular Dividends:
Firm following this policy does not pay out fixed amount of dividend per share. Instead, dividend per share is varied in correspondence with change in level of earnings. Larger earnings mean higher dividends and vice versa. This policy is based on the management belief that stockholders are entitled to dividend only when earning and liquidity position of the firm warrants.
Generally, this policy is adopted by firms with unstable earnings. Under this policy, a large part of profits may be ploughed back in the year in which the firm has host of highly profitable investment opportunities. In the subsequent year when the firm will have no or limited investment opportunities to seize, the management may distribute larger share of earnings which would otherwise have remained unutilized.
Types of Dividend Policy – Top 4 Dividend Policies Available for a Company
There cannot be a single dividend policy which will be suitable to all types of companies. This is because the companies differ from each other in respect of nature of products, behaviour of sales, profits levels, liquidity position and availability of profitable investment opportunities. Hence a dividend policy will have to be designed in the light of the factors affecting a particular company. There are various types of dividend policies, of which, a suitable policy can be selected.
These policies are as follows:
(1) Stable Dividend Policy:
A company can frame a policy of paying a fixed dividend regularly. Under such a policy shareholders are assured of fixed dividend per share.
Stable dividends may be declared:
(i) At the present level or
(ii) At a lower level, or
(iii) At a higher level.
(i) Stable Dividends at the Present Level:
Under this policy, a fixed rate of dividend as was paid last year is maintained. During periods of prosperity the firm withholds all the surplus income of the business to use them to maintain the rate of dividend during lean years. This policy meets the expectations of the shareholders for current income and does not affect the market price of company’s shares.
(ii) Stable Dividends at a Lower Level:
In case a company has favourable investment opportunities and requires funds for taking advantage of these, it fixes a new lower level of dividends and assures the shareholders that the dividends will be maintained at this level in future. This policy reduces the current earnings of the shareholders and may also cause a reduction in the market price of its shares.
(iii) Stable Dividends at a Higher Level:
Regular dividends may be raised to a higher level through a policy decision of the management. Such a decision is taken when the management feels that the earnings of the company have increased on a permanent basis and the increased earnings will support an increase in dividend rate permanently. The increase in the fixed rate of dividend causes an increase in the market price of the company’s shares.
(2) Low Regular Dividends plus Extra Dividends Policy:
Under this policy, a low rate of dividend is fixed which is paid regularly but in the years of extra-ordinary earnings, it also pays extra dividend. This policy is pursued by those companies whose income considerably fluctuates from year to year.
(3) Dividends Fluctuating with Earnings Policy:
Under this policy, the dividends are changed according to the fluctuations in the earnings of the company and hence the dividends fluctuate from year to year. Shareholders get higher dividends if the company has higher earnings and vice versa. Such a policy allows greater flexibility to management in respect of retaining earnings to finance the profitable opportunities but at the same time, the uncertainty of dividends adversely affects the market price of company’s shares.
(4) Policy of No Dividend at Present:
Such a policy is pursued due to two reasons:
(i) When the company is not in a position to pay dividends due to lower profits,
(ii) When the firm needs tidy amount of funds to finance its expansion programmes and hence it decides to retain all of its profits.
Policy of no dividends affects the market price of the shares adversely and hence the management should assure its shareholders to pay higher dividends in the near future.
Types of Dividend Policy – With Graphs
1. Constant Dividend Payout Policy:
This method is also known as ‘constant payout ratio method’. This concept of stability of dividends means ‘always paying a fixed percentage of the net earnings every year’. Under this method, if earnings vary, the amount of dividends also varies from year to year. The dividends varies from year to year, if earnings vary.
The dividend policy is entirely based on company’s ability to pay under this policy. The company follows a regular practice of retained earnings. For most firms, earnings are quite volatile, fluctuating with changes in the economy and firm’s own special circumstances. Very few firms select this method. The relation between earnings per share and dividend per share under this policy is shown in figure 18.2.
2. Constant Dividend Rate Policy:
It is a most popular kind of dividend policy which advocates the payment of dividend at a constant rate, even when earnings vary from year to year. This may be possible only when the earnings pattern of the company does not show wide fluctuations. This policy is possible only through the maintenance of what is called ‘dividend equalization reserve’.
The company then invest funds equal to such reserves in some current investments so as to manage the liquidity of the necessary funds in times of need. Firms are generally careful to set the dividend at a sustainable level and raise it only when the firm can sustain the higher level. Occasionally firms may cut dividends in adverse situations.
Firms are against cutting dividends, because of the extremely unfavourable news it conveys to the market. The relation of earnings per share and dividend per share under this policy is shown in figure 18.3.
I. Multiple Dividend Increase Policy:
Some firms follow a policy of very frequent and very small dividend increases to give the illusion of movement and growth. The obvious hope behind such a policy is that the market rewards consistent increases.
II. Regular Dividend Plus Extra Dividend Policy:
Some firms consciously divide their announced dividends into two portions a regular dividend and an extra dividend. The regular dividend is the dividend that will continue at the announced level. The extra dividend payment will be made as circumstances permit.
III. Uniform Cash Dividend Plus Bonus Shares Policy:
This policy is usually adopted in case of companies which have fluctuating earnings. Under this method, a minimum rate of dividend per share is paid in cash plus bonus shares are issued out of accumulated reserves. But the issue of bonus shares is not on annual basis. It depends upon the amount kept in reserves over a period.
3. Optimum Dividend Policy:
Accepting that there is an optimum dividend policy, it is then necessary to find an approach to decide what the payout ratio should be. One approach would be to assess the net preferences for dividends over capital gains, this is illustrated in figure 18.4.
In figure 18.4. Curve A shows how the share price is likely to vary with the size of payout ratio. Curve B shows the effect of higher payout ratios in reducing share values. This reduction of share values is due to the fact that higher payout require that outside funds be obtained to replace the dividends paid. Curve C shows the combined influences of these two factors on share price. If the company does not have sufficient investments to use up all its earnings, the residue should be earmarked for payment as dividends.
Types of Dividend Policies – Most Popular Policies that a Company may Adopt in Practice
In practice, a company may adopt any one of the different dividend policies.
The most popular policies are described here-in-under:
Type # 1. Constant Percentage of Earnings:
A company may follow a dividend policy in terms of a definite percentage of earnings. The merit of this policy is that it keeps into account the current earnings in dividend distribution. As such shareholders are greatly benefitted when earnings are increasing. But the shareholders may not prefer this policy in the case of earnings declining each year. The fluctuations in earnings may cause fluctuation in the amount and rate of dividends. This adversely affects the market value of company’s shares and under such circumstances raising capital/fund from external sources becomes a difficult job.
The problem associated with this policy may be put as under:
“Shareholders start expecting higher dividends due to unstable dividend associated with this policy. They have the desire for increasing dividend in their minds. When the profit of the company remains constant or starts declining, few shareholders think to keep away and start selling their shares which causes downfall in the market prices of the shares.”
Type # 2. Constant Dividend Rate:
A certain percentage of paid up capital may be adopted as dividend policy. The merit of this policy is that the shareholder is fully assured as how much dividend he is going to get from his investments. Few shareholders depend upon the annual income of their holdings and like to receive fixed amount as dividend each year.
It is assumed that the market value of the shares of a company may be higher, when the company pays dividend at a constant dividend rate rather as a constant percentage of earnings. When profit is increasing, there is no difficulty in maintaining constant dividend rate, but in the case of declining trend in profit it becomes difficult to maintain the constant dividend rate.
That is why it is suggested that the dividend rate should be fixed at lowest possible level so that the adverse impact on company’s resources may not take place due to dividend distribution even in worst days of the company and shareholders may be kept happy by paying them extra dividend in the good days.
In addition to above two policies, there may be another approach whereby three more policies to be followed by the management of a company, viz.,:
(A) Conservative Dividend Policy
(B) Liberal Dividend Policy
(C) Sound or Stable Dividend Policy.
(A) Conservative Dividend Policy:
Conservative dividend policy is one where the management distributes only a few portion of profit as dividend in spite of excessive profit earned. Under this policy major part of the whole profit is reinvested in the business and shareholders are paid minimum possible dividend. Thus, the main consideration in adopting this dividend policy is the financial soundness of the business and shareholders’ current expectations are reared in the background.
The pay-out ratio under this policy happens to be very low and sometimes is zero also. This policy is considered to be most appropriate and intelligent for those companies which are progressive and which need extra capital/fund for improvement and development programmes. The shareholders of such companies are benefitted in the long-run. A note of precaution while following this policy is to care the shareholders’ impatience.
(B) Liberal Dividend Policy:
When the management distributes major part of profits as dividend among the shareholders, it is called liberal dividend policy. Only that part of profit is retained which is most urgently required. The pay-out ratio under this policy is very high and retention ratio is very low. Under this policy, more importance is attached to the current/immediate interests of the shareholders rather their long-term interests.
Obviously, there are chances of funds being shortage for the company’s development, expansion and replacement programmes. There is also a chance that company’s shares may be of speculative nature leading to a difficulty m raising funds through new issues as well as adversely affecting the financial position.
(C) Sound or Stable Dividend Policy:
This policy of dividend payment is of long-term and no important changes are being made in this policy for pretty longer period. This policy attaches equal importance to company’s future requirements and shareholders’ current expectations and tries to balance the both reasonably. Normally, the amount of dividend distribution and amount of retained earnings are more or less of equal magnitude. The dividend paid in good years is more or less the same as paid in normal or adverse years.
When the earnings are too much, adequate reserves/funds are created which are being used for the purpose of dividend distribution in the years when earnings are low, so that dividend rate is kept constant. Thus, it is a kind of middle path policy. Adequate provisions are made both for known and unknown contingencies. Thus, this policy is helpful in maintaining the goodwill and reputation of the company.
In the case of sound dividend policy, the management strives as not to bring changes as far as possible in the dividend rate payable to shareholders. It is to be remembered that management should adopt stable dividend rate policy rather than stable pay-out ratio policies.
Essentials of a Stable Dividend Policy:
(i) Stability:
Stability here signifies the regularity being maintained in the dividend distribution. If a company declares and pays very attractive and rich amount of dividend in one particular year but fails to distribute dividend in the following next year, it cannot be termed as good policy. On the other hand, if a company pays dividend on an average rate each year, the shareholders might be satisfied and shares are immune to speculation.
(ii) Gradual Rise in Dividend Rates:
Management of the company should always make efforts to keep the dividend rates rising gradually. Whenever company’s earnings increase and/or price inflated shareholders desire that their income should also rise. Dividend rate must be kept on rising in accordance with the rise in profit. If in any year profit is very high, then additional dividend should be distributed.
(iii) Moderate Start:
Management of the company should declare the dividend at low rate (minimum rate) in the initial years, so that the financial position of the company can be sounder. Of course, gradual increase in dividend rate should be allowed with the progress of the company.
(iv) Distribution of Dividend in Cash:
Dividend should be distributed normally in cash. However, stock bonus (Bonus shares) may also be declared particularly when reserves of the company become excessive. While distributing stock dividend, care should be taken whether the company is subjected to over-capitalisation.
(v) Other Factors:
Dividend must be paid out of profit earned. It should be paid after setting off the past losses. Normally, dividend is paid only once in a year but interim dividend may be paid just to boost the zeal and morale of the shareholders.
Advantages of a Stable/Sound Dividend Policy:
The main feature of Sound Dividend Policy is the stability and regularity of the dividend. When dividend policy lacks stability, the market value of shares witnesses fluctuations which adversely affect the company and its shareholders both. Speculators often take advantage of such a situation and sometimes the very existence of the company is being challenged by such a situation.
Moreover, the following advantages are expected to accrue due to stable dividend policy:
(i) Shareholders’ Satisfaction:
Some shareholders like middle-class or old persons or pensioners are very aware and alert towards income and they attach more importance to dividends regularly receivable each year without fail. Such shareholders may be kept satisfied through adoption of a sound dividend policy.
(ii) Confidence among the Shareholders:
Due to stable and regular dividend amount being received by the shareholders, a confidence in their mind is created for the shares of the company. The company does not reduce the amount of dividend even if profit is low in any year and specially created reserves/funds are being appropriated for the payment of constant amount of dividend. This keeps the goodwill of shares in capital market intact and even better.
(iii) Relative Stability in Market Price of Shares:
The market values of those shares, on which dividend is received with regularity at stable rate, are subject to less fluctuations and there are least chances of speculation in such shares. Not only this, the goodwill of the company also increases which has favourable impact on market values of shares.
(iv) Helpful in Long-Term Planning:
Correct assessment of financial requirements and sources of fund supply may be made under sound dividend policy, on the basis of which long-term plans can easily be formulated.
(v) Stability in National Income:
If all or most of the companies operating in the country invariably follow stable and sound dividend policy, there will be stability in national income also which will be indicator of stability of whole economy.