The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth.
If a company pays out as dividend most of what it earns, then for business requirements and further expansion it will have to depend upon outside resources such as issue of debt or new shares. Dividend policy of a firm, thus affects both the long-term financing and the wealth of shareholders.
As a result, the firm’s decision to pay dividends must be reached in such a manner so as to equitably apportion the distributed profits and retained earnings.
Since dividend is a right of shareholders to participate in the profits and surplus of the company for their investment in the share capital of the company, they should receive fair amount of the profits. The company should, therefore, distribute a reasonable amount as dividends (which should include a normal rate of interest plus a return for the risks assumed) to its members and retain the rest for its growth and survival.
Types of Dividend Policy:
(a) Regular Dividend Policy:
Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons, widows and other economically weaker persons prefer to get regular dividends.
A regular dividend policy offers the following advantages:
(a) It establishes a profitable record of the company.
(b) It creates confidence amongst the shareholders.
(c) It aids in long-term financing and renders financing easier.
(d) It stabilises the market value of shares.
(e) The ordinary shareholders view dividends as a source of funds to meet their day-to-day living expenses.
(f) If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by companies of long standing and stable earnings, A company should establish the regular dividend at a lower rate as compared to the average earnings of the company.
(b) Stable Dividend Policy:
The term ‘stability of dividends’ means consistency or lack of variability in the stream of dividend payments. In more precise terms, it means payment of certain minimum amount of dividend regularly.
A stable dividend policy may be established in any of the following three forms:
(i) Constant dividend per share:
Some companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year after year. Such firms, usually, create a ‘Reserve for Dividend Equalisation’ to enable them pay the fixed dividend even in the year when the earnings are not sufficient or when there are losses.
A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years.
(ii) Constant payout ratio:
Constant pay-out ratio means payment of a fixed percentage of net earnings as dividends every year. The amount of dividend in such a policy fluctuates in direct proportion to the earnings of the company. The policy of constant pay-out is preferred by the firms because it is related to their ability to pay dividends. Figure given below shows the behavior of dividends when such a policy is followed.
(iii) Stable rupee dividend plus extra dividend:
Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profits. Such a policy is most suitable to the firm having fluctuating earnings from year to year.