A dividend is a percentage of a company’s profits that is paid out to shareholders. Dividends are more common with established companies and they’re often used as a means of rewarding current investors for their loyalty and/or attracting new investors. Growth companies are less likely to pay dividends, as they tend to reinvest profits.
To receive a dividend from a company, you must own shares before its ex-dividend date. This is the date the company uses to establish ownership of shares in order to determine who receives an upcoming dividend payment. The company’s dividend policy determines how profits are divided up among shareholders.
Imperfections in the capital market make it rare for a company to follow a pure residual dividend policy. Most businesses instead follow smooth dividend policies that call for regular dividends that show some correlation with the business’ past and present earnings.
Passive Dividend policy
Regular Dividend Policy
Under this type of dividend policy, the company follows the procedure of paying out a dividend to its shareholders every year. If the company earns abnormal profits, then it retains the extra profit. Whereas, if it remains in loss any year, it also pays its shareholders a dividend. This type of policy is adopted by the company with stable earnings and steady cash flow. In the eyes of investors, a company paying regular dividends is low risk despite the fact the quantum of regular dividend might be small. Under this policy, the investors get dividends at a standard rate.
The class of investors putting their investments into these companies is generally risk-averse. They mainly belong to the retired or weaker section of the society and aim at regular income. The company can only adopt this policy if it has a regular income. The main demerit of this policy is that investors cannot expect an increase in dividends, even if the market is relatively booming. This type of policy helps in creating confidence among the shareholders. It also helps stabilize the market value of shares, which increases the company’s goodwill.
Stable Dividend Policy
Under this type of dividend policy, the company pays out a fixed percentage of profits as dividends yearly. For example, suppose a company sets the payout rate at 10%. Then this profit percentage will be paid out as dividends every year regardless of the quantum of profit. Whether a company makes a profit of $1 million or $200000, a fixed dividend rate will be paid out to the shareholders. In the eyes of investors, a company adopting this policy is risky. The reason being the amount of dividend fluctuates with the level of profit.
In it, the company makes three components for their dividends. One part is a constant dividend per share, and the other is a constant payout ratio. Last is a stable rupee dividend plus extra dividends. The reserve fund created for this purpose pays a constant dividend per share. The actual company volatility is not verifiable through the dividend payout. The target payout ratio defines a stable dividend policy. It also helps stabilize the market value of shares in the same line as the regular dividend policy.
Irregular Dividend Policy
Under this type of dividend policy, the company states that it has no obligation to pay a dividend to the shareholders. The board of directors will decide the quantum and rate of dividend. They will decide in respect of action taken with the earned profit. Their action concerning paying a dividend has nothing to do with the company’s scenario of earning a profit or coming into a loss. It depends on the decision of the board of directors. The board might decide to distribute profit despite having low or no profit. It gains investors’ confidence, and they will invest more in the company, and the company’s liquidity will increase.
In the eyes of Investors Company, paying periodic dividends is considered risky. On the other hand, the company might retain all or significant amounts of profit and distribute no or fewer dividends. The company may do this to increase the growth by using retained earnings. Moreover, companies with irregular cash flow and a lack of liquidity adopt this policy. The class of investors who are risk lovers prefers investing in this type of company.
No Dividend Policy
Requirements for a Residual Dividend
When a business generates earnings, the firm can either retain the earnings for use in the company or pay the earnings as a dividend to stockholders. Retained earnings are used to fund current business operations or to buy assets. Every company needs assets to operate, and those assets may need to be upgraded over time and eventually replaced. Business managers must consider the assets required to operate the business and the need to reward shareholders by paying dividends.
For the residual dividend policy to work, it assumes the dividend irrelevance theory is true. The theory suggests that investors are indifferent to which form of return they receive from a company whether it be dividends or capital gains. Under this theory, the residual dividend policy does not affect the company’s market value since investors value dividends and capital gains equally.
The calculation for residual dividends is done passively. Companies using retained earnings to finance CapEx tend to use the residual policy. The dividends for investors are generally inconsistent and unpredictable.