Dividend policy: meaning, types, importance

Dividend policy: meaning, types, importance

The word "dividend" means "things to be divided". Dividend policy refers to a company’s decision outlining the way it distributes its earnings among the shareholders. In the article, we will discuss the definition, main types, and importance of the dividend policy.

Dividend policy: meaning, types, importance

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A dividend is a distribution of reward as a part of a company’s earnings to the shareholder. If the organisation earns money and surpluses, it can pay them off or retain in the enterprise to make more earnings. There are two ways of how a corporation can pay dividends to the shareholders: in cash (via bank transfer) or offer to purchase additional shares. Dividends are divided into such categories as cash, composite, special or extra, stock (bonus), property, interim, bond, optional and other.

Dividends are paid per share at a constant price. As a rule, the shareholders receive as many dividends as they buy in the corporation, that is, according to their stock share. The company should not regard dividend payments as expenses; however, the payments should be conducted after the company’s taxes are paid in full. Otherwise, the company is risking to fall into a debt loop. If the organisation retains earnings, such information should be revealed to the shareholders. When talking about the payment dates, most corporations set a stable schedule determining the exact days when shareholders receive their dividends. However, the corporations often pay additional dividends on the out-of-schedule dates. They are called special dividends. Another way how the company can pay dividends is with regard to the shareholder’s activity.

What is the meaning of dividend policy?

When speaking about the meaning of dividend policy in general, it consists in undertaking a specific financial decision by the company on sharing its earnings with the shareholders. Such a decision creates a basis for the company’s policy in the field of dividends.

Dividend policy is dealing with the nuances of paying dividends in cash or other forms. The exact sum of dividends is established by the company and depends on the number of excess earnings. When a corporation makes a lot of cash, it is obliged to pay it off to the shareholders.

The size of the shareholders’ investments plays a crucial role in determining the precise amount of cash paid. Shareholders are interested in investing money in successful enterprises, so they expect to get as high revenues as possible.

All investors can be divided into various categories depending on the size of their investment. On the other side, a company they are investing in is obliged to pay a return on investment back to the shareholders in the form of dividends. As you can see, this system works if you were opening a deposit account in the bank.

The truth is every corporation has to choose whether to pay dividends or retain earning to make new profits. If the business earns enough money, it has means for further expansion. If it doesn't make enough money, it has to ask for financial help from outside resources or cut the payments of dividends to the investors. So, the way how a corporation manages its earnings has a direct influence on the level of wealth of investors. It also influences the future development of the corporation.

All about dividend policy: meaning, types, importance

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As you can see, the corporation is the only institution responsible for making payments to the investors who would like to have their expectations come true. However, the company possesses a right of retaining the earnings that can help to survive or make more profits. It means that a dividend is considered a right of shareholders to get a part of the revenues and surplus of the corporation. The truth is the shareholders cannot expect the same amounts of the earnings, but the dividends have to be fair. You might ask why and what is the problem? The thing is the corporation should distribute a reasonable amount of dividends according to the risks the shareholders undertake when making investments. Plus, every corporation needs to retain the rest of the profits for its further growth and survival.

There is no guidance on what amounts of profits should be held back by the corporation. If you are a little familiar with the main principles of finance and accounting, you understand that every financial situation is unique, and company’s value is estimated due to its ability to pay dividends directly or in the future in the form of a backdoor return.

There is a direct connection between the amount of taxes a company pays and its value. For example, let’s imagine that government taxes 100% from the business. Then, investors have no reason to put their savings into an unprofitable business that doesn't live off the money.

If the corporation needs to estimate whether the investment opportunity is efficient or not, it has to calculate a ratio between the rate of return on investment and the cost of shares. The return on investment should always exceed the cost of a share. Otherwise, the company will bankrupt. A successful is one that cannot stand still but moves forward investment in various projects. That is why, the shareholders get only residual dividends, and the rest of the money is used to take advantage of the investment opportunities.

The corporation must always choose the form of the dividend distribution. The dividends can be distributed either in cash or via a share buyback. When building an efficient dividend policy, the company’s management has to take into account various factors. The truth is most of the corporations prefer paying dividends in the form of a backdoor return than in cash. This way money remains inside the company which is more beneficial to the company’s development. The company leaders determine how to use their assets to make earnings. The truth is, the investors of successful corporations prefer to participate in the buyback program as it is a more promising opportunity. They don’t have to look for a new successful company to invest in and spend their precious time.

The main types of dividend policy

meaning of dividend policy

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There exist two opposite opinions about the influence of the company’s dividend policy on investors’ earnings. It is believed that the corporation’s dividend policy does not influence the investors' revenues as they can make money by selling their market shares if needed. On the other hand, the amount of dividends depends on the market share price.

The corporation needs to allocate resources on achieving their long-term goals. A company usually is not able to pay off a significant percentage of its revenues to every shareholder immediately. The business needs to retain some earnings to expand its development and avoid relying upon the outside resources. It created a basis for the following types of dividend policies.

Regular Dividend Policy

If dividends are paid at the usual rate, they are regarded as consistent. Some shareholders can get regular dividends. When talking about the advantages of the regular dividend policy, they include:

  • Creating confidence among the investors;
  • Long-term financing;
  • Establishing a successful record of the corporation;
  • Stabilisation of the value of the company’s shares.

Some investors, mostly those of the smaller enterprises, consider regular dividends as a reliable source of financial aid that can help to cover everyday expenses.

If you are wondering about the intervals between payments, dividend distributions are usually paid every year or month. Many European firms prefer semi-annual schedule conducting dividend payments twice a year.

It is worth saying that regular dividend policy suits only those corporations that can boast of having stable revenues. The truth is that the rate of regular dividends is usually quite low.

Stable Dividend Policy

The concept of stable dividend policy is related to the consistency of the sum of paid dividends. According to this type of dividend policy, investors are paid not only regularly but at a set amount of cash dividends. In a nutshell, stable dividend policy is a long-term plan that cannot depend on the changes in the company’s progress during certain periods. The company can accept this type of policy in a few forms. They include:

  • Constant dividends per share;
  • Constant payout ratio;
  • Constant dividend per share plus extra dividends.

The stable dividend policy is perhaps most often implemented by the companies. It has both advantages and disadvantages. This type of policy can encourage investors to buy the company’s shares and keep them for a longer time. It can also encourage wealthy investors to invest in reliable companies with stable payments.

When talking about the disadvantages of this policy, they show that investing in other companies may be tricky. For example, sometimes financial managers avoid declaring the revenues even if they are substantial. Another disadvantage is concerned with the form of payments. It is not always easy to get dividends in cash as shareholders are suggested to reinvest to support the further development of the corporation.

Irregular Dividend Policy

Some companies implement this policy because they do not have enough confidence in their business plans and economic potential, the success of the business operations, are afraid of possible negative effects of regular dividends.

No Dividend Policy

Some companies choose not to follow any policies. They do not pay dividends at a particular period of the year because of its unfavourable financial position. They can also make agreements with the investors about conducting payments of the dividends in the case of expansion.

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Importance of dividend policy

Dividend policy: importance

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A lot of confusion arises when we think about the importance of the dividend policy. No less complicated is a question of the influence of paid dividends on the share price. The thing is dividend policy is a controversial topic. It is tricky to be developed such a dividend policy that would suit both investors and company leaders. That is why this question is often called a dividend puzzle.

A dividend theory implies various models that are expected to help companies analyse and choose the perfect dividend policy. Some of the most popular dividend models include the Miller and Modigliani Hypothesis (dividend irrelevance theory), Walter’s Model, Gordon’s Model (dividend relevance theories).

Financial theories suggest that the corporation’s dividend policy should be built depending on the type of the firm.

These schools of thought that developed the dividend relevance theories and dividend irrelevance theories are opposite. The dividend relevance theories are represented by people like James E. Walter and Myron J. Gordon. In their opinion, current dividends paid in cash are much more attractive to the investors, especially, of the small companies, and less risky to the company. That is why the shareholders choose the companies that can pay a regular percentage of the company’s earnings. It consequently affects the cost of market share.

The dividend irrelevance theory is represented by Modigliani and Miller who claimed that shareholders don't choose between dividends paid in cash and future gains. However, this theory has not gained success among financial managers and shareholders.

Walter’s model of the relevance of dividend policy is, as of today, one of the most popular models of dividend policy. Let's take a closer look at the crucial ideas of the model. There is a common misunderstanding that dividends paid by the company are viewed negatively by it. However, there exists a strong connection between the number of dividends and the market share price. Every company takes some place on the ranking of the enterprises without regard to the industry it is engaged in. If the company does not pay some percentage of its revenues to the investors, it is perceived negatively by them. It leads to a decrease in the market share price. The supporters of Walter’s model claim that the investors’ certainty of the company’s reliability can be reduced if they are paid well and regularly in the form of high return on investment. However, the investors may start to worry about the money invested in case of non-payment of dividends. It can be concluded that investors prefer the current dividends instead of the dividends that will possibly be paid in the future.

According to Walter’s model, the company is allowed to use only retained earnings to finance new investment projects. The external finance is not considered a reliable source of investment. The cost of capital and the rate of return on investment always remain the same. Even when a new investment decision is undertaken, the risks of the business don’t change. There is a direct connection between making investments and obtaining dividends. One cannot ignore the fact that a corporation is the only entity that can pay dividends or retain earnings. For the company, it is more beneficial to retain earning to get higher profits. It is also beneficial to the investors under the condition that the organisation uses these profits to multiply them.

Importance of Dividend Policy

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Dividend policy is a company’s policy on the amounts of cash to be paid to the shareholders (investors) and the revenues to be retained in the corporation. There many types of dividend policies most famous of which are regular, stable and irregular policies. They help to divide the profits into two groups: dividends and retained earnings. Every company makes its own choice on the best policy with consideration of its main principles, level, and stability of revenues and attitude of the company leaders.

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Source: Legit.ng

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