in this article, we will study the dividend and dividend decisions which are important to know by shareholders and useful for commerce and management students.
What is a Dividend?
A dividend is the share of profits that is distributed to shareholders in the company and the return that shareholders receive for their investment in the company. The company’s management must use the profits to satisfy its various stakeholders, but equity shareholders are given first preference as they face the highest amount of risk in the company. A few examples of dividends include:
1. Cash dividend
A dividend that is paid out in cash and will reduce the cash reserves of a company.
2. Bonus shares
Bonus shares refer to shares in the company are distributed to shareholders at no cost. It is usually done in addition to a cash dividend, not in place of it.
Types of Dividend
Definition: The Dividends are the proportion of revenues paid to the shareholders. The amount to be distributed among the shareholders depends on the earnings of the firm and is decided by the board of directors.
Types of Dividend
- Cash Dividend:It is one of the most common types of dividend paid in cash. The shareholders announce the amount to be disbursed among the shareholder on the “date of declaration.” Then on the “date of record”, the amount is assigned to the shareholders and finally, the payments are made on the “date of payment”. The companies should have an adequate retained earnings and enough cash balance to pay the shareholders in cash.
- Scrip Dividend: Under this form, a company issues the transferable promissory note to the shareholders, wherein it confirms the payment of dividend on the future date.A scrip dividend has shorter maturity periods and may or may not bear any interest. These types of dividend are issued when a company does not have enough liquidity and require some time to convert its current assets into cash.
- Bond Dividend:The Bond Dividends are similar to the scrip dividends, but the only difference is that they carry longer maturity period and bears interest.
- Stock Dividend/ Bonus Shares:These types of dividend are issued when a company lacks operating cash, but still issues, the common stock to the shareholders to keep them happy.The shareholders get the additional shares in proportion to the shares already held by them and don’t have to pay extra for these bonus shares. Despite an increase in the number of outstanding shares of the firm, the issue of bonus shares has a favorable psychological effect on the investors.
- Property Dividend: These dividends are paid in the form of a property rather than in cash. In case, a company lacks the operating cash; then non-monetary dividends are paid to the investors.The property dividends can be in any form: inventory, asset, vehicle, real estate, etc. The companies record the property given as a dividend at a fair market value, as it may vary from the book value and then record the difference as a gain or loss.
- Liquidating Dividend:When the board of directors decides to pay back the original capital contributed by the equity shareholders as dividends, is called as a liquidating dividend. These are usually paid at the time of winding up of the operations of the firm or at the time of final closure.
Thus, it is found out that usually the dividends are paid in cash, but however in certain situations, there could be the other forms of dividend .
Definition: The Retained Earnings represent that portion of the equity earnings (left after deducting the tax and preference dividends), which is sacrificed by the equity shareholders and is ploughed back into the firm to reinvest these in the core business operations, such as paying off the debt obligations or purchasing a capital asset.
In a balance sheet, you often come across the term reserves and surplus, which essentially represents the accumulated retained earnings, i.e. the total profits of the firm and is considered as the crucial source of long-term finance.
Advantages of Retained Earnings
These earnings are viewed favorably due to the following reasons:
- These earnings are readily available, and the firm is not required to seek help from the shareholders or lenders in case of urgency of funds.
- The use of retained earnings reduces the cost of issuing the external equity and also eliminates the losses incurred on under-pricing.
- There will be no dilution of control and ownership, in case the firm relies on the retained earnings.
- Generally, the stock market views the equity issue as doubtful and therefore, these earnings do not carry a negative connotation.
Disadvantages of Retained Earnings
Despite several advantages of the accrual earnings, it is not free from certain bottlenecks which are as follows:
- The amount raised through the accrual earnings could be limited and also it tends to be highly variable because certain firms follow a stable dividend policy.
- The opportunity cost of these earnings is relatively high because it shows that amount of earnings, which have been foregone by the equity shareholders.
- Some companies do not give much importance to the opportunity cost of these earnings and invest these into sub-marginal projects that have negative NPV.
The retained earnings are also known by different names, such as accumulated income, accumulated profit, accumulated earnings, earned surplus, undistributed earnings, etc.
The dividend policy used by a company can affect the value of the enterprise. The policy chosen must align with the company’s goals and maximize its value for its shareholders. While the shareholders are the owners of the company, it is the board of directors who make the call on whether profits will be distributed or retained.
The directors need to take a lot of factors into consideration when making this decision, such as the growth prospects of the company and future projects. There are various dividend policies a company can follow such as:
1. Regular dividend policy
Under the regular dividend policy, the company pays out dividends to its shareholders every year. If the company makes abnormal profits (very high profits), the excess profits will not be distributed to the shareholders but are withheld by the company as retained earnings. If the company makes a loss, the shareholders will still be paid a dividend under the policy.
The regular dividend policy is used by companies with a steady cash flow and stable earnings. Companies that pay out dividends this way are considered low-risk investments because while the dividend payments are regular, they may not be very high.
2. Stable dividend policy
Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. For example, if a company sets the payout rate at 6%, it is the percentage of profits that will be paid out regardless of the amount of profits earned for the financial year.
Whether a company makes $1 million or $100,000, a fixed dividend will be paid out. Investing in a company that follows such a policy is risky for investors as the amount of dividends fluctuates with the level of profits. Shareholders face a lot of uncertainty as they are not sure of the exact dividend they will receive.
3. Irregular dividend policy
Under the irregular dividend policy, the company is under no obligation to pay its shareholders and the board of directors can decide what to do with the profits. If they a make an abnormal profit in a certain year, they can decide to distribute it to the shareholders or not pay out any dividends at all and instead keep the profits for business expansion and future projects.
The irregular dividend policy is used by companies that do not enjoy a steady cash flow or lack liquidity. Investors who invest in a company that follows the policy face very high risks as there is a possibility of not receiving any dividends during the financial year
4. No dividend policy
Under the no dividend policy, the company doesn’t distribute dividends to shareholders. It is because any profits earned is retained and reinvested into the business for future growth. Companies that don’t give out dividends are constantly growing and expanding, and shareholders invest in them because the value of the company stock appreciates. For the investor, the share price appreciation is more valuable than a dividend payout.