Dividend Policy Meaning, Types and Nature

What is dividend policy?

The Dividend Policy of a company outlines its approach to designating profits for dividend payouts after retaining earnings. The development and implementation of this policy fall under the purview of the company’s Board of Directors. It outlines the framework for the long-term dividend declaration pattern.

According to Weston and Brigham, “Dividend policy determines the division of earnings between payments to shareholders and retained earnings”.

The company’s management must structure the ‘Dividend Policy’ in a way that appropriately splits net earnings into ‘Retained Earnings’ and ‘Dividends.’

This stated policy should also meet both the objectives of:

  1. Maximisation of wealth for its shareholders, and
  2. Business Growth

The decision to break the ‘Net Profit’ (post-tax) into two parts, viz:

  1. Distributing to shareholders as a ‘Dividend’, and
  2. Ensuring business continuity and fostering company growth.

It is a crucial one, having a long-term impact on the company’s prospects. This decision is of paramount importance. It is taken, keeping in view specific parameters as follows:

  1. The trend of profitability,
  2. The market value of the company’s shares,
  3. Use of funds in a profitable way.
  4. Taxation angle, and

Below are the two observations that relate to dividend policy decisions:

  1. Should the company prioritize maintaining a consistent and stable growth rate for its dividends?
  2. What percentage of the company’s ‘Net Profit’ must go toward dividends?

Nature of Dividend Policy

The Dividend Policy of a company entails the following characteristics:

1) Optimal Dividend Policy

Considering the impact of a company’s dividend policy, it is essential for the company to carefully formulate a rational premium policy. This should involve thorough consideration of all relevant factors and aim to minimize fluctuations in dividend payments over an extended period. Maximisation of shareholders’ wealth needs to be the prime objective.

2) Close Relationship with Retained Earnings

There is a close relationship between the Dividend Policy of a company and its policy on Retained Earnings. These two end products represent a company’s net profits for a given year.

3) Influence of Dividend Policy on Subsequent Financial Decisions

The dividend policy of the company can impact the company’s future financial planning. Dividend distribution to the shareholders results in the reduction of the liquidity strength of a company. It may have to seek funds from additional external sources to that extent, the cost of which may be more when compared with the cost of retained earnings. At times, the management of a company decides to distribute dividends, when better investment avenues are lacking.

4) Impact on Shares

The premium policy of a company holds immense significance as it has wide-ranging effects; it directly impacts the following:

  1. Liquidity position,
  2. Financing decisions,
  3. The growth rate of the business,
  4. Maximisation of shareholders’ wealth, etc.
  5. The market price of the shares,

From the shareholders’ perspective, current dividends get precedence over future dividends or capital gains due to a lack of maturity and instability in the market. The effect of the current rate of dividends on the share price is visible in the market immediately in the form of an increase or decrease in the share price (a high rate of dividends leads to an increase, whereas a low rate of dividends leads to a decrease). Better share price and a high rate of dividends result in the ‘maximisation of shareholders’ wealth.

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Types of Dividend Policy

A company may choose to adopt one of the following types of dividend policies, based on its suitability:

Types of Dividend Policy

1) Stable Dividend Policy

This category of policy guarantees the consistent payment of a predetermined percentage of a company’s annual income to its shareholders. It has three sub-categories:

i) Constant Payout Ratio

In this sub-category, a fixed percentage of a company’s annual earnings is paid to the shareholders as dividends.

ii) Stable Plus Extra Dividend

A low rate of dividend per share is paid to the shareholders regularly. However, in the year of higher profits, an additional dividend is paid.

iii) Constant Dividend per Share

Under this sub-category, a ‘Reserve Fund’ is created to pay fixed dividends to the shareholders even during a year when the company cannot generate revenue. This policy is primarily suitable for those companies that have a stable annual income.

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Advantages of Stable Dividend Policy

The advantages of a stable policy are as follows:

i) Shareholders of the company get a regular stream of income.

ii) It facilitates the building up of confidence amongst the investors.

iii) The market value of a company’s shares is stabilised.

iv) The strong positive sentiment towards the company’s shares continues to enhance its reputation.

2) No Dividend Policy

At times, a company may choose to retain its entire net profit as Retained Earnings, to utilize it for business growth or to meet working capital requirements. 

3) Regular Dividend Policy

Companies with a consistent and reliable income stream often opt for this particular category of Dividend Policy. It means payment of dividends regularly, even if the rate of dividends is low. In other words, the emphasis lies on the consistency of dividend payouts rather than their specific rates. It suits the investors, who are:

  1. Retired persons, and
  2. Persons belonging to low-income groups.

Advantages of Regular Dividend Policy

The advantages of a regular dividend policy are as follows:

i) It sends a positive signal in the market, resulting in the stabilisation of the market value of the company’s shares,

ii) As it ensures regularity of dividend payments, the confidence level of the shareholders and faith of investors is high.

iii) The company’s shareholders are recipients of the regular flow of income.

iv) The goodwill of the company in the market is maintained.

4) Irregular Dividend Policy

As the name itself suggests this type of policy refers to a company’s decision not to distribute dividends to its shareholders regularly due to specific reasons, some of which are as follows:

i) A company may be facing a liquidity crisis.

ii) The business carried out by a company may not be a success or profitable.

iii) Annual revenue generation by a company may be unpredictable.

iv) A company may be scared of giving regular payouts, due to certain reasons of the company.

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