Abstract- Finding a balance between a company’s financial objectives and its shareholders’ expectations depends on its dividend policy. This process includes deciding whether to keep profits for future investments or pay them out as dividends to shareholders. The several kinds of dividend policies—stable, constant, residual, and hybrid approaches—are examined in this study along with their effects on shareholder value and legal ramifications. With an emphasis on the Indian business setting, it also looks at ideas regarding the applicability and inapplicability of dividend policy, taking into account elements like profitability, growth, and taxation. The purpose of this study is to shed light on how businesses manage dividend policy in order to stay in line with legal obligations, preserve investor confidence, and fit with strategic objectives.
Keywords- Dividend Policy, Shareholder Value, Corporate Law, Profit Allocation, Reinvestment, Taxation, Indian Corporate Sector
“Navigating the Legal Implications of Corporate Dividend Policy in India”
1. INTRODUCTION
The percentage of a company’s profits that are paid to shareholders is known as the dividend rate; it is normally set by the board based on recent results and is paid out on a quarterly basis. Dividends can be paid out to shareholders on a specified date and can take the form of cash or more shares.
A dividend policy outlines how and when dividends are paid, covering factors like frequency, timing, and amount. Common types include stable, constant, and residual policies, each shaping how a company manages profit distribution as part of its broader business strategy..
Although investors are aware that corporations are not obligated to pay dividends, many still view it as a sign of the financial strength of that particular company.
2. UNDERSTANDING THE CONCEPT OF DIVIDEND POLICY
It is important to first define dividends before delving into a discussion of dividend policies. In essence, dividends are a percentage of profits given to shareholders by a business. Companies can choose to share these profits with their equity holders or reinvest them to support future expansion. The board of directors usually announces dividends, which are distributed to all stockholders on a per-share basis.[1]
Profitability, cash flow, stability, and growth possibilities all influence a company’s decision to pay dividends. In general, investors want dividends that are steady and predictable, however some can be enticed by larger but unpredictable payouts. The size, growth stage, and industry all affect dividend policies. While growth-oriented businesses, such as those in IT or biotech, frequently reinvest revenues for expansion, established corporations in stable industries are more likely to pay dividends. Whatever strategy is used, a well-defined dividend policy is necessary to direct financial choices.
3. MECHANISM OF A DIVIDEND POLICY
Dividends, which are usually a regular distribution of a company’s profits, are one way that some businesses choose to honor their common stockholders.[2] Because of this approach, which provides shareholders with a steady income stream, some investors find dividend-paying equities especially alluring.
For these businesses, having a clear dividend policy is essential. It highlights important elements like: The monthly, quarterly, or yearly dividend payment schedule, dates of payout, sum given to shareholders
The management of the business is in charge of making these choices, and they also need to take into account any other elements that can affect dividend distributions. Giving shareholders the choice to reinvest their dividends through a Dividend Reinvestment Plan (DRIP), which enables them to buy more shares, or to receive their dividends in cash is one such option.
4. DIFFERENT TYPES OF DIVIDEND POLICIES
I. Consistent Dividend Policy- The simplest and most popular strategy is a stable dividend policy, which aims to provide shareholders with yearly dividends that are steady and predictable. Most investors find this certainty desirable because they get dividends regardless of changes in the company’s earnings. In order to give investors more assurance regarding the dividend amount and timing, this policy focuses on matching payments with the company’s long-term growth rather than short-term earnings volatility.
II. Policy of Constant Dividends- The possible absence of higher payouts in years of profitability is one drawback of a consistent dividend policy. A consistent dividend policy, on the other hand, reflects the entire range of the company’s profitability by allocating a set percentage of its earnings as dividends annually. Dividends grow in response to increases in earnings; they may be lowered or withdrawn in response to declines in earnings. Financial planning can be difficult due to the unpredictable nature of dividend payments, even though this strategy enables investors to directly profit from the company’s financial performance.
III. No Dividend Policy- Some businesses choose not to pay dividends at all, particularly those in early-stage startups or high-growth industries. Rather, they put their profits back into expansion prospects like debt reduction, acquisitions, or R&D. This approach places more emphasis on growth and seeks to increase shareholder value by raising the stock price as opposed to distributing profits right away. Even though some companies might not pay dividends, reinvestment is frequently viewed as a means of achieving larger long-term returns.
IV. Policy for Residual Dividends- Although it is another erratic strategy, some people believe that the residual dividend policy is a sensible one. In this case, dividends are paid out only when the business has satisfied its working capital and capital expenditure (CAPEX) requirements. Even while this leads to erratic dividend payments, it is consistent with good business practices and guarantees that the company does not jeopardize its financial health or incur undue debt in order to pay dividends.
V. Hybrid Dividend Policy- By combining aspects of different strategies, a hybrid dividend policy provides flexibility. A business might, for example, ensure a consistent base dividend while simultaneously disbursing extra payments from one-time gains or during very prosperous times. Predictability and the possibility of larger returns are balanced by this method, which guarantees a minimum payout level while also offering the possibility of bigger dividends during periods of exceptional performance.
5. APPROACHES TO DIVIDEND POLICIES
A company’s dividend policy outlines how management determines the amount and schedule of shareholder dividends. Its main goal is to decide what percentage of profits ought to be paid out as dividends. One important indicator is the dividend payout ratio, which shows what proportion of profits are distributed to shareholders in cash[3]. There are two primary schools of thought about dividend policy: (i) those who believe it is unimportant, and (ii) those who believe it is essential.[4]
I. Irrelevance of Dividend Policy-
1. Residual Approach: According to this approach, dividend decisions are irrelevant to the firm’s valuation because they have no effect on shareholder wealth or share price. It sees dividend distribution as a component of the larger financing plan; profits are only distributed as dividends or reinvested in the company when there are no other feasible investment options. Every period, the company chooses whether to pay dividends or keep earnings for future investments.
2. Modigliani and Miller (MM) Model: According to Modigliani and Miller, a company’s worth is determined by its investment strategy and the earning potential of its assets, not by dividends. The MM model states that the distribution of retained earnings and dividends has no effect on share prices in a perfect capital market with logical investors and no tax bias. According to the model, shareholder wealth is unaffected by dividends because the necessity for additional stock issuance offsets any potential increase in share price.
The main tenet of the MM Model is that any rise in market value brought about by dividend payments is precisely counterbalanced by a fall in retained earnings, which calls for the issue of further shares. As a result, the market value as a whole stays constant, and shareholders are unconcerned about keeping profits or getting dividends.
II. Relevance of Dividend Policy-
On the other hand, proponents of the relevance approach think that a company’s value is impacted by its dividend policy. They contend that current dividends raise the value of the company’s stock by lowering investor uncertainty. Investors face more uncertainty in the absence of dividends, which raises the needed returns and lowers the stock’s valuation.
1. Walter’s Approach: According to Professor Walter, a company’s value and dividend policy are directly related. In order to maximize shareholder wealth, his model highlights the significance of the relationship between the rate of return (r) and the cost of capital (k). Based on this r and k relationship, the model illustrates several payout percentages while taking the firm’s size, business type, and risk into consideration.
2. Gordon’s Approach: According to Professor Gordon’s approach, which is well-known for the “bird-in-the-hand” argument, investors would rather receive present dividends than risky capital gains in the future. According to his theory, the market value of the company is strongly correlated with the dividend policy since risk-averse investors prefer quick payouts. According to this strategy, a steady and reliable dividend policy can boost investor confidence and aid in wealth maximization.
6. DIVIDEND POLICIES IN INDIA
Several studies have analyzed the dividend behavior of Indian companies. Mahapatra and Sahu (1993) found that cash flow is the primary factor influencing dividends, followed by net earnings. Bhat and Pandey (1994) noted that managers prioritize current earnings in dividend decisions. Narasimhan and Asha (1997) highlighted that investor demand for higher payouts increased after the uniform 10% dividend tax introduced in the 1997–98 budget. Mohanty (1999) observed that companies issuing bonus shares largely maintained or slightly reduced their pre-bonus dividend levels.
Narasimhan and Vijayalakshmi (2002) found that insider ownership does not significantly impact dividend policy. However, the broader patterns of dividend payments, including their initiation, omission, or modification, remain unclear, warranting further examination.[5]
Building on Fama and French (2001),[6] the study explores how company size, growth, and profitability influence dividends. It also examines the signaling hypothesis (Healy & Palepu, 1988), analyzing how dividend changes convey earnings information. Following DeAngelo et al. (1992), the study also assesses the implications of dividend increases and decreases.
India’s tax policies have evolved, notably with the 1997–98 budget shifting dividend taxation to corporations rather than investors. Changes in capital gains tax and Section 80L exemptions have further shaped corporate dividend policies. The tax-preference hypothesis suggests that favorable tax regimes encourage higher payouts, making the impact of taxation on dividend practices a key area for study.
7. WHO IS ELIGIBLE FOR DIVIDEND POLICY
Stockholders who held company stock prior to the ex-dividend date are entitled to dividend payments. Common and preferred shareholders are included in this, as are occasionally staff members who own business equity. The company’s dividend policy specifies the dates on which eligibility is determined.[7] Those who qualify for dividends include:
a) Common Stockholders: Declared dividends are payable to common stockholders who owned shares prior to the ex-dividend date. The quantity of shares they possess determines how much they get paid.
b) Preferred Stockholders: Usually, preferred stockholders receive dividend guarantees ahead of common stockholders. According to corporate agreements, they get fixed dividend payments that are frequently more than those given to common shareholders,
c) Employees with Stock Ownership: A few businesses allow their staff members to own stock. Employee stock ownership plans (ESOPs) allow shareholders to earn dividends depending on their holdings, providing them with supplemental income in addition to their job.
8. SIGNIFICANCE OF DIVIDEND POLICIES
A dividend policy clarifies a company’s profit distribution to shareholders, which is especially important for investors that prioritize income. Investor trust is increased and people who value steady income over capital gains are drawn to a steady dividend stream. A consistent dividend policy shows sound financial management and a dedication to shareholders, even though corporations are free to discontinue them at any time.
A well-designed dividend policy can increase shareholder value, reduce capital expenses, and increase the attractiveness of a company by providing steady payments. It also shows a company’s overall approach; mature companies tend to focus on stability through dividends, whereas growth-oriented companies reinvest profits to expand.
9. CONCLUSION
A company’s dividend policy shapes its financial strategy and shareholder value, making it a crucial component of corporate finance. It displays the harmony between allocating profits and holding onto money for future expansion. Although theoretical models provide valuable insights, their practical implementation is contingent upon various aspects, including financial conditions, industrial dynamics, and regulatory frameworks.
Dividend decisions in India are made more difficult by ownership structure, taxation, and market conditions. A well-crafted policy communicates management’s dedication to financial stability while also bolstering investor trust. In the end, a successful dividend strategy complies with the long-term objectives of the business, regulatory standards, and shareholder expectations.
Notes:-
[1] Chen, J. “What is a dividend policy?” ,June 18,2024, available at: <https://www.investopedia.com/terms/d/dividendpolicy.asp#:~:text=A%20 dividend%20policy%20 outlines%20how,%2C%20constant%2C%20and%20residual%20policies>(Last visited on January 10,2025)
[2] Hayes, A. “Dividends: Definition in stocks and How Payments work.”, July 8,2024, available at: <https://www.investopedia.com/terms/d/dividend.asp > (Last Visted on January 12,2025)
[3] ‘Dividend policy- BMS.’ < https://dducollegedu.ac.in/Datafiles/cms/ecourse content/Dividend Policy- BMS.pdf > accessed 01 November 2024
[4] Silva, L.C., Goergen, M. and Renneboog, L., ‘Dividend policy, earnings, and cash flow: A Dynamic Panel Data Analysis’, Dividend Policy and Corporate Governance, (2004) pp. 85–106, doi:10.1093/0199259305.003.0006.
[5] Dr. Y. Subba Reddy, “Dividend Policy of Indian Corporate Firms: An Analysis of Trends and Determinants” <https://nsearchives.nseindia.com/content/research/Paper71.pdf > accessed 02 January 2025
[6] Eugene F. Fama, Kenneth R French, ‘Disappearing dividends: changing firm characteristics or lower propensity to pay?’ Journal of Financial Economics, Volume 60, Issue 1, (2001) p. 3-43, <https://doi.org/10.1016/S0304-405X(01)00038-1> (Last visited on 06 January 2025)
[7]Hagargi, V., ‘Dividend policy – meaning, types, importance and objectives, Alice Blue Online’ <https://aliceblueonline.com/what-is-dividend policy/#:~:text=Dividend%20policy%20refers%20to%20a,supports%20long%2Dterm%20business%20goals.> (2024) (Last visited on 05 January 2025)
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Author: Adhiraj Chowdhury | 2nd Year Law Student | UPES, Dehradun.
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