Financial Management - Divident Policies - Notes - Finance, Study notes of Business Administration

Download Financial Management - Divident Policies - Notes - Finance and more Study notes Business Administration in PDF only on Docsity! DIVIDENT POLICIES INTRODUCTION Dividend policy and decision are critical and crucial areas of management. Dividends are earnings which are distributed to the shareholders. The percentage of earnings paid or dividends declared is called payout ratio. A high pay out means more dividends and this will lead to less funds internally generated and available for expansion and growth. A low pay out therefore should result in higher growth as retained earnings are significant internal sources of financing the growth of the firm. Such dividend policies affect the market value of the firm. Whether such dividend will result in increased value or not will be directly dependent on the profitable investment opportunities available and exploited by the firm. On the other hand, there is a predominant view that dividends are bad as they lead to the payment of higher taxes and they reduce the shareholders’ wealth. Dividends when declared are taxed by the governments. Despite this there is a strong investor expectation that dividends are a form of rewards to them. Given these different perceptions, what is the ideal position in the dividend declarations? How do companies construct their dividend policies? What are the factors reckoned in constructing such policies? The following detailed discussion will aim at providing valuable inputs in arriving at the right answer. Dividend I. What is dividend? A dividend is a bonus, an extra, a payment, a share or a surplus or periodical return on any original investments. Suppose we have invested in a company 189 Rs.100,000 as a share holder and the company declares a return of say Rs.10,000 on this investment in a particular year, then the return is called the dividend on the investment made and the dividend pay out is 10%. II. How do we define dividends? Thus dividend is the distribution of value to shareholders, normally out of the profits made by the firm in a particular year. Of course, unlike interest payable on a deposit or a loan which is compulsory payment, dividend is not a compulsory yearly payment. Only if the company makes a profit decides to distribute such profits, declare dividends, the share holders will get a return. III. Factors which influence dividend decisions 1. Legal constraints : Normally all countries prohibit companies from paying out as cash dividends any portion of the firm’s legal capital, which is measured by the par value of equity shares (common stock) Other countries define legal capital to include not only the par value of the equity shares (common stock), but also premium paid if any (any-paid in – capital in excess of par). These capital impairment restrictions are generally established to provide a sufficient equity base to protect creditor’s claims. We shall examine an example to clarify the differing definitions of capital: Company XYZ Limited’s financial highlights as revealed from its latest balance sheet are as follows: Equity share at par 1,00,000 Premium paid over par value (Paid-in capital in excess of par) 2,00,000 190 5. Owner considerations: In establishing a dividend policy, the firm’s primary concern normally would be to maximise shareholder’s wealth. One such consideration is then tax status of a firm’s owners. Suppose that if a firm has a large percentage of wealthy shareholders who are in a high tax bracket, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payments of taxes until they sell the stock. Of course, when the equity share is sold, the proceeds are in excess of the original purchase price, the capital gain will be taxed, possible at a more favorable rate than the one applied to ordinary income. Lower-income shareholders, however who need dividend income will prefer a higher payout of earnings. As of now, the dividend income is not taxed in the hands of the share holders in India. Instead, for paying out such dividends to its share holders, the company bears the dividend distribution tax. 6. Market Considerations: The risk-return concept also applies to the firm’s dividend policy. A firm where the dividends fluctuate from period to period will be viewed as risky, and investors will require a high rate of return, which will increase the firm’s cost of capital. So, the firm’s dividend policy also depends on the market’s probable response to certain types of policies. Shareholders are believed to value a fixed or increasing level of dividends as opposed to a fluctuating pattern of dividends. In other words, the market consideration is a kind of information content of the dividends. It’s a kind of signal for the firm to decide its final policy. A stable and continuous dividend is a positive signal that conveys to the owners 193 that the firm is in good in health. On the other side, if the firm skips in paying dividend due to any reason, the shareholders are likely to interpret this as a negative signal. 7. Taxation The firm’s earnings are taxable in many countries. This taxation is applied differently in different countries. One can group these different taxation practices as under: Single taxation The firm’s earnings are taxed only once at the corporate level. Share holders whether they are individuals or other firms do not pay taxes on the dividend income. They are exempt from tax. However the shareholders both individuals and other firms are liable for capital gains tax. India currently follows this single taxation. Under this, the firms in India pay 35% tax on their earnings and they will have to pay additional tax at 12.5% on the after tax profits distributed as dividends to the shareholders. The experience shows that after the implementation of this single taxation, Indian firms have started sharing a sizeable portion of their earnings with their shareholders as dividends Double taxation Under this, the shareholders’ earnings are taxed two times: first the firms’ profit earnings are taxed as corporate tax and then the shareholders’ dividend earnings out of the after tax profits are taxed as dividend tax. 194 Split rate taxation Under this, the firm’s profits are divided into retained earnings and dividends for the purpose of taxation. A higher tax rate is applied to retained earnings and a lower one to earnings distributed as dividends. As share holders pay tax on dividends and tax on capital gains, this lower tax rate can be justified. But for a lower tax rate on the dividend income, the system works on the same lines as that of double taxation. Imputation taxation The advantage of this system is that the shareholders are not subjected to double taxation. A firm pays corporate tax on its earnings. Shareholders pay personal taxes on their dividends but they will get full or partial tax credit for the tax paid by the firm on its original earnings. In countries like Australia, the shareholders will get full tax relief or tax credit while in Canada, only partial relief is provided. IV. What is the form in which dividends are paid? 1.Cash dividend: 1. Regular cash dividend – cash payments made directly to shareholders, usually every year. If more than one dividend payment is made during a year, it will be normally referred to as interim dividends. The total dividend therefore would be the sum of such interim dividends and final dividend if any. 2. Extra cash dividend – indication that the “extra” amount may not be repeated in the future. For example, the firm may earn a bumper profit in a particular year 195 different. A three-for-two stock split, for example, corresponds to a 50% stock dividend. A 10% stock dividend is then equivalent to a eleven-for-ten stock split. If the initial balance sheet was Common stock (100,000 shares) 1000,000 Retained Earnings 800,000 Total Equity 1,800,000 With an 11-for-10 stock split, the new balance sheet would be Common stock (110,000 shares) 1000,000 Retained Earnings 800,000 Total Equity 1,800,000 Share dividend Vs Share split Share dividend Share split The balance in paid up capital and share premium accounts go up. The balance in paid up capital and share premium accounts does not change The balance in reserves and surplus account decreases due to transfer to the paid up capital and share premium account1111 The balance in reserves and surplus account does not under go any change. The par value per share remains unaffected The par value per share changes – it goes down. However, in both cases – share dividend and share split – the total value of the shareholders’ funds remains unaffected. 4. Share repurchase Share repurchase is also otherwise known as repurchase of its own shares by a firm. Only recently the share repurchase by firms in India was permitted under 198 Section 77 of the Indian Companies Act. The following conditions are to be adhered by Indian firms in case they decide to pursue share repurchase option - a firm buying back its own shares will not issue fresh capital, except bonus issue, for the next one year - the firm will state the amount to be used for the buyback of shares and seek prior approval of the shareholders - the buyback of the shares can be effected only by utilizing the free reserves, i.e. reserves not specifically earmarked for some other purpose or provision - the firm will not borrow funds to buyback shares - the shares bought under the buyback schemes will have to be extinguished and they cannot be reissued