Study of DIVIDEND POLICY adopted by different FMCG & IT Sectors

INTRODUCTION When a company makes profit, it has to decide what to do with the money it has earned. Companies usually have three options for its cash, To fund working capital To finance investments in the company, where management have identified and developed opportunities that have returns greater than the return on working capital Distribute it to shareholders as dividend

There is, thus, a type of inverse relationship between retained earnings and cash dividends. i.e. Larger retentions-lesser dividends and smaller retentions-larger dividends. The term "dividend" usually refers to a cash distribution of earnings. If it comes from other sources, it is called "liquidating dividend". It mainly has the following types: Regular: Regular dividends are those the company expects to maintain, paid quarterly (sometimes monthly, semiannually or annually) Extra: Those that may not be repeated Special: Those Dividends which are unlikely to be repeated Stock Dividend: Paid in shares of stocks. Similar to stock splits, both increase the number of shares outstanding and reduce the stock price How Do Firms View Dividend Policy? One firm's policy might be to pay out 40% of earnings as dividends whereas another company might have a target of 50%. This suggests

that dividends change with earnings. Empirically, dividends are slow to adjust to changes in earnings. Given the objective of financial management of maximizing present values, the firm should be guided by the consideration as to which alternative use is consistent with the goal of wealth maximization. i.e., the firm would be well advised to use the net profits for paying dividends to the share holders if the payment will lead to the maximization of wealth of the owners. If not the firm should rather retain them to finance investment programs, the relationship between dividends and value of the firm should, therefore, be the decision criterion. There are however conflicting opinions regarding the impact of dividends on the valuations of the firm. According to one school of thought, dividends are irrelevant, so that the amount of the dividends paid has no effect on the valuation of the firm. On the other hand certain theories consider the dividend decision as relevant to the value of the firm measured in terms of the market price of the shares. Before discussing the 2nd school of thoughts, let us first understand why a company pays the dividend and in what form. In other words, what are the factors which help in determining the dividend policy of a company? These Factors can be classified as follows: (1) Dividend Payout (D/P) ratio:

A major aspect of the dividend policy of a firm is its dividend payout (D/P) Ratio i.e., the % share of the net earnings distributed to the shareholders as dividends. The D/P Ratio of a firm should be determined with reference to two basic objectives: Maximizing the wealth of the firms owners and Providing sufficient funds, to finance growth

These objectives are not mutually exclusive, but interrelated. In practice, shareholders have a clear cut preference for dividends because of uncertainty and imperfect capital markets. The payment of dividends can, therefore, be expected to affect the price of a share; a low D/P Ratio may cause a decline in share prices, while a high ratio may lead to a rise in the market price of the share. Making a sufficient provision for financing growth can be considered a secondary objective of dividend policy. The firm must forecast its future needs for funds, and taking in to account the external availability if funds and certain market considerations, determine both the amount of retained earnings needed and the amount of retained earnings available after the minimum dividends have been paid. Thus, dividend payments should not be viewed as a residual, but rather a required outlay after which any remaining funds can be reinvested in the firm. (2) Stability of dividends: The term dividend stability refers to the consistency or to the lack of variability in the stream of dividends. In more precise terms, it means that a certain minimum amount of dividend is paid out regularly. The stability of dividends can take any of the following 3 forms: (i) Constant dividends per share (ii) Constant / stable D/P Ratio (iii) Constant dividends per share plus extra dividend Constant dividend per share:

According to this form of stable dividend policy, a company follows a policy of paying a certain fixed amount per share as dividend. For instance, on a share of face value of Rs. 10, a firm may pay a fixed amount of, say Rs. 2.50 as dividend. This amount will be paid year after year, irrespective of the level of earnings. In other words, fluctuations in earnings would not effect the dividend payments. In fact, when a

company follows such a dividend policy, it will pay dividends to its shareholders even if its suffering losses. A stable dividend policy in terms of fixed amount of dividend per share does not, however, means that the amount of dividend is fixed for all the time to come. The dividend per share is increased over the years when the earnings of the firm increase and it is expected that the new level of earnings can be maintained. Constant payout Ratio:

With constant / payout ratio, a firm pays a constant % of net earnings as dividend to the shareholders. In other words, a stable Dividend payout Ratio implies that the percentage of earnings paid out per year is constant. Accordingly, dividend would fluctuate proportionately with earnings and are likely to be highly volatile in the wake of wide fluctuations in the earnings of the company. As a result, when the earning of a firm decline substantially or there is a loss in given period, the dividends, a cording to the target payout ratio, would be low or nil. (3) Legal, contractual and internal constraints and restrictions The legal factors stem from certain statutory requirements, the contractual restrictions arise from certain loan covenants and the internal constrains are the result of the firms liquidity position. Legal Requirements: Legal stipulations do not require a dividend declaration but they specify the conditions under which dividend must be paid. Such conditions pertain to (i) Capital impairment (ii) Insolvency Capital Impairment Rules:

Legal enactments limit the amount of cash dividends that a firm may pay. A firm can not pay dividends out of its paid up capital, otherwise there would be a reduction in the capital adversely affecting the security of its lenders. The rationale of this rule lies in protecting the claims of the preference shareholders and creditors on the firms assets by providing sufficient equity base since the creditors have originally relied upon such an equity base while extending credit. Any dividends that impair capital are illegal and the directors are personally held reliable for the amount of illegal dividend.

Insolvency:

A firm is said to be insolvent in two situations: first, when the liabilities exceeds the assets and second, when it is unable to pay its bills. If the firm is currently insolvent in either sense, it is prohibited from paying dividends. Similarly a firm would not pay dividends, if such a payment leads to the insolvency of the firm of either type. The important provisions of company law pertaining to

dividends are described below, 1. Companies can pay only cash dividend (with the exception of bonus shares) 2. Dividend can be paid out of the profits earned during the financial year after providing the depreciation and after transferring to reserves such percentage of profits as prescribed by the law. The Companies (transfer to reserve) Rules, 1975, provides that before dividend declaration, a percentage of profits as specified below should be transferred to the reserves of the company. 3. Due to inadequacy or absence of profits in any year, dividend may be paid out of accumulated profits of the previous years. In this

context, the following conditions, as stipulated by the companies (Declaration of Dividend out of Reserves) Rules, 1975, have to be satisfied. a. The rate of declared dividend should not exceed the average of the rates at which the dividend was declared by the company in 5 years immediately preceding that year or 10% of its paid up capital whichever is less. b. The total amount to be drawn from the accumulated profits earned in previous years and transferred to the reserves should not exceed an amount equal to 1/10t h of the sum of the paid up capital and free reserves and the amount so drawn should first be utilized to set off the losses incurred in the financial year before any dividend in respect of preference or equity shares is declared. c. The balance of the reserves after such withdrawal should not fall below 15% of its paid up capital. 4. Dividends can not be declared for the past years for which the accounts have been closed. (4) Capital market considerations: Yet another set of factors that can strongly affect dividend policy is the extent to which the firm has access to the capital markets. In case the firm has an easy access to the capital market, either because it is financially strong or large in size, it can follow a liberal dividend policy. However, if a firm has limited access to the capital market, it is likely to adopt a low dividend payout ratio. Such firms are more likely to rely more heavily on retained earnings as a source of financing their investments.