Abstract

Dividend policy decision is one of the three decisions of financial management because it affects the financial structure, the flow of funds, corporate liquidating and investors attitudes. The main aspect of dividend policy is to determine the amount of earning to be distributed the shareholder and the amount to be retained in the firm. Divined policy involves the decision to pay out earning versus retaining them for reinvestment in the firm. The relationship between dividend and the value of the share is not clear cut. The financial manager must understand the various conflicting factors which influence the dividend policy before deciding the allocation of its companys earnings into dividends and retain earnings. This study focuses on the dividend practice and theory that influence the shareholders. Introduction Dividend policy is the policy used by a company to decide how much it will pay out to shareholders in dividends. In financial accounting course, it is said that after deducting expense from the revenue, a company generates profit. Part of the profit is kept in the company as retained earnings and the other part is distributed as dividends to shareholders. From the share valuation model, the value of a share depends very much on the amount of dividend distributed to shareholders. Deciding on the amount of earnings to pay out as dividends is one of the major financial decisions that a firms managers face. The dividend decision is not obvious. In practice, dividend policy is not well understood. Corporations view the dividend decision as quite important. Dividend A dividend is a portion of a company's profit that is paid out to the shareholders, commonly in cash or stock. For investors, dividends present a great way to get periodic payouts on a highyield investment. However, like all types of investments, there are drawbacks to any plan that routinely pulls out money rather than continues increasing revenue. Dividend Policy Dividend policies are the regulations and guidelines that companies develop and implement as the means of arranging to make dividend payments to shareholders. Establishing a specific dividend policy is to the advantage of both the company and the shareholder. In order to make sure the policy is workable, a company should develop a viable policy and then run this policy through a number of test scenarios in order to determine what impact the dividend policy would have on the operation of the business.

Types of Dividend Cash dividends: Cash dividends represent actual money paid to investors from a companys retained earnings. This dividend policy theory simply states how much money a company pays out per shareholder and class of stock, such as preferred and common. The frequency of payouts and the type of growth associated with cash dividends are also part of this theory. Most companies engage in cash dividends that remain the same for each quarter or year, with slight increases over time. Other times, a company may initiate special, one-time cash dividends through its dividend policy. Stock dividends: Stock dividends work in mostly the same manner as cash dividends, though investors receive additional stock shares rather than money. The frequency and amount of shares each investor receives follows a similar pattern to cash dividends as well. In some cases, however, stock dividends may be less popular as issuing new stock in large numbers can dilute the worth of current shares outstanding. While investors may enjoy the idea of stock dividends, the overall value of all stocks held by the investors may go down in price or worth. The benefit of stock dividends to a company, however, is that the company retains cash from retained earnings. Stock repurchases: Stock repurchases in terms of dividend policy theory do not actually mean a company gives investors anything. In reality, repurchasing stock from investors reduces the supply of stock in a given market. Under the basic economic principle of supply and demand, when supply goes down for a given item, the price of the item increases. With stock investments, price increases result in higher stock value to current shareholders, who can then sell the stock at a large profit in some cases. Additionally, a company who repurchases stock is often seen as a good investment, which increases demand and again increases the stock price under this dividend policy theory. Advantages and Disadvantages Advantages Dividends certainly do have a place within the financial world. They provide a way for investors to place a large amount of capital that can then be used as a source of income, since it regularly brings in money. Profit while retaining a stake in the company - Normally, a stockholder would have to sell his or her stock in order to profit from his or her investment in a company. Dividends allow investors to profit from their investment in the company without selling their stock. This means you can look forward to regular returns. Short-term results and long-term opportunities - An investor can continue to receive dividend payments from the company as long as the investor continues to hold stock.

This can lead to significant dividend payments for a long-term investment, even though you're seeing results over a short-term time frame. Visible indications of your investment's security - A continued, increased dividend payout is considered to be a good indicator of a company's continued success. This allows you to quantify your gains easily.

Disadvantages Dividends are not universally available - The Board of Directors is responsible for deciding whether or not a dividend is to be paid out to its investors. However, even if a company makes a significant profit, it is under no obligation to pay a dividend. Tax repercussions - Dividends are often criticized as being subject to double-taxation, as the company is taxed on its income and the individual shareholder is also subject to paying taxes on the dividend payout. In the United States, dividends are subject to a 15 percent dividend tax rate. This is higher than what you can expect to pay on other types of investment windfalls. Dividends are not universally available - The Board of Directors is responsible for deciding whether or not a dividend is to be paid out to its investors.

Dividend Policy Theories

Dividend policy theories attempt to establish the relationship between a firm's payout policy and its value. In essence, they attempt to determine whether investors prefer dividends or capital gains. Dividend Relevance Theories These are theories whose propagators argue that the dividend policy of a firm affects the value of the firm. There are two main theorists from this school of thought: James E. Walter (Walters model): It shows the relationship between the firms rate of return r, and its cost of capital k in determining the dividend policy that will maximize the wealth of shareholders. P = (DPS/k) + [r (EPS DPS)/k]/k Where: P = market price per share DPS = dividend per share EPS = earnings per share r = firms average rate of return k = firms cost of capital Myron Gordon (Gordons model): According to Gordons dividend model the market value of the share is equal to the summation of the present value of the infinite stream of dividend. However, dividend per share is expected to grow when earnings are retained.

Dividend Irrelevancy Theory: Dividend irrelevancy theory asserts that a firm's dividend policy has no effect on its market value or its cost of capital. Modigliani and Miller (MM) argue that a firm's value is determined solely by its basic earnings power and its risk class. Here, the value of the firm is dependent on the firms earnings which result from its investment policy, such that when the policy is given the dividend policy is of no consequence.
MM prove their proposition, but only under a set of restrictive assumptions, including

Zero taxes, Zero flotation and transaction costs, Independence between dividend policy and equity costs Symmetric information. Bird-In-The-Hand Theory Myron Gordon and John Lintner have proposed another theory, the bird-in-the-hand theory. Gordon and Lintner argue those rS increases as the dividend payout is reduced because investors view dividend payments as more certain than the capital gains that presumably result from retained earnings. MM call the Gordon-Lintner argument the "bird-in-the-hand fallacy" because, in MM's view, most investors are going to reinvest their dividends in the same or similar firms, and the riskiness of the firm's cash flows to investors in the long run is solely a function of the riskiness of the firm's assets. Investors behave rationally, are risk-averse and therefore have a preference for near dividends to future dividends. Residual Theory This theory states that only when a company can no longer identify any investment opportunities with a positive net present value should it pay a dividend. In other words, a company should not pay dividends if it can positively identify investments in new projects with a positive NPV. A residual approach to the dividend policy, as the first claim on retained earnings will be the financing of the investment projects. With the residual dividend policy, the primary focus of the firm's management is indeed on investment, not dividends. Dividend policy becomes irrelevant, it is treated as a passive rather than an active, decision variables. Suppose, the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000 - $600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000 - $1,000) for dividends. Dividend Signaling Theory In practice, change in a firms dividend policy can be observed to have an effect on its share price an increase in dividend producing an increasing in share price and a reduction in dividends producing a decrease in share price. The change in dividend payment is to be

interpreted as a signal to shareholders and investors about the future earnings prospects of the firm. Generally a rise in dividend payment is viewed as a positive signal, conveying positive information about a firm's future earnings prospects resulting in an increase in share price. Conversely a reduction in dividend payment is viewed as negative signal about future earnings prospects, resulting in a decrease in share price.

Conclusion Dividend Policy is an important determinant of market performance. It has evolved and adjusted in response to changing business conditions, market parameters and regulations. This policy is important for both company and investor. Dividend policy affects the financial structure, the flow of funds, corporate liquidity, stock prices, and the morale of stockholders. A companys dividend policy provides tremendous insight into its relationship with shareholders, and can help us better understand managements strategy for enhancing shareholder value. Dividend payments can also change the overall riskiness of the companys asset base. Both of these can be detrimental to creditor wealth, and creditors will doubtless take pricing or contractual actions to offset these potential uses of dividends. Dividends can be used to shift assets out of the company and therefore from the potential claim of creditors. If a company has a loose dividend policy, lacks a track record of paying dividends, and has consistently bought back shares at high prices, it might be best to look elsewhere for dividend income. If the company and investor follow the dividend policy carefully, then it will be better for both of them. Dividend payment should be avoided as they would lead to decrease in shareholders wealth for the reason of tax consequences, cost of policy formulation, transaction cost, and cost of capital, default risk, and tax free. On the contrary, avoidance of dividend payment would lead to decrease in shareholders wealth for the reason of bad signal and withdrawal of investment. Here, the financial manager can take a good contribution to provide dividend among the shareholders. They have to think about the relevance of their practical work with theories. The financial manager must understand the various conflicting factors which influence the dividend policy before deciding the allocation of its companys earnings into dividends and retain earnings. Both cash and stock dividend should be paid consistently. The board of directors should consider some crucial factors to determine the level of dividend payment, namely liquidity, availability of worthwhile projects, availability of alternative funds, profitability, growth, leverage, reaction of market to dividend reduction, ownership structure nature of the industry, tax clientele effect and so on. Companies do not normally increase dividends unless they are confident that the increase is sustainable. This means that increasing the dividend is a way in which the management of a company can signal investors that they are confident. Financial managers must give concentrations on how much the companys earnings are required for investment in projects with positive NPV and the possible effects of their decision on shares prices.