Dividend policy decisions - meaning and significance , kinds of dividends, bonus shares.

Dividend Policy Notes

I. Dividend Policy Decisions: Meaning and Significance

Definition: Dividend policy refers to the decisions madeDecisions by a company's board of directors regardingon the amount, form, and timing of cash distributions to its shareholders out of itsfrom profits. It's about determiningDetermines how much of the company's earnings will beis paid out as dividends versus retained for reinvestment in the business.reinvestment.

Significance:

Significance:

• Shareholder Value: Dividend policy directly impactsImpacts shareholder wealth and investor perceptions of the company.perceptions. Regular and increasing dividends are often seen as a sign ofsignal financial healthhealth.
and
• stability.

  Investment Decisions: Investors use dividend informationUsed to assess the profitability and riskrisk. of a company. Some investors (e.g., retirees) rely on dividends as aIncome source offor income.

  some

  investors.

• Capital Budgeting: Dividend policy is intertwined with capital budgeting. Retained earnings are a primaryfunding source of financing for new projects.

• Signaling: Dividends can signalSignals management's confidence in the company's future earnings. ADividend dividendincreases increase isare usually interpretedpositive.
positively.

• Market Valuation: Dividend policy influencesInfluences the market value of theshares.

company's

shares. There are theories (which we'll cover later) that explore this relationship.

II. Kinds of Dividends

• Cash Dividend:

  TheMost mostcommon, common type. Paidpaid in the form of cash. Requires the company to have sufficient cashcash.

available.

• Stock Dividend (Bonus Shares):

  Paid in the form of additional sharesshares. ofNo thecash company's stock. Does not involve an outflow of cash.outflow. Increases the number of outstanding shares andshares, reduces the per-share priceprice.

(ideally
• proportionally, though market reactions can vary).

  Property Dividend:

  Paid in the form of assets other than cash (e.g., marketable securities, inventory).cash. Rare in practice due to valuation and valuation/tax complications.

• Scrip Dividend (Deferred Dividend):

  A promissoryPromissory note issued to shareholders promising to pay a dividend at a future date.later. Used when acash company lacks sufficient cashis currently lacking but expects to have itexpected in the future.

• Liquidating Dividend:

  A returnReturn of capital to shareholders, typicallyshareholders during aliquidation. company's liquidation or winding-up. Represents a distributionDistribution of theassets, company's assets rather thannot earnings.

• Composite Dividend:

  Some companies declare dividend partly inPartly cash and partly in kind.

III. Bonus Shares (Stock Dividends)

Meaning: A distributionDistribution of a company's accumulated profits in the form ofas free additional shares to existing shareholders, in proportionproportionally to their holdings.

Merits:

• Preserves Cash: Allows the company to conserveConserves cash for reinvestmentreinvestment.
or
• other purposes.

  Signaling Effect: Can signal management'sSignals confidence in the company's long-term prospects.

Issuing
• bonus shares is often seen as a positive signal.

  Increased Marketability: Can reduce theReduces per-share price, making the stock more affordable for smaller investors,affordable, potentially increasing trading volumevolume.

and
• liquidity.

  Enhanced Investor Confidence: Investors who hold a fixed number of sharesShareholders can profit from the price rise of shares after theannouncement.

stock
• dividend announcement.

  May Prevent Hostile Takeovers: Helps to expand theExpands ownership base.

Demerits:

Demerits:

• Dilution of Earnings per Share (EPS): Increases theshares number of outstanding shares,outstanding, potentially reducing EPS.

• Psychological Impact: Investors may perceive a bonus issue negativelyNegative if the underlying performance of the company is not strong.

• Tax Implications: While the receiptSale of bonus shares is generally not taxable at the time of issuance, the subsequent sale of those shares will be subject to capital gains tax.

• No Real Value Creation: Bonus shares don't fundamentally change the company's value; they just divide theDivides existing equity among more shares. The marketMarket price should adjustadjust.
accordingly.

Accounting Treatment: Bonus shares are issuedIssued by capitalizing reserves (e.g., retained earnings, general reserve, security premium).

Legal Requirements (India):

• Fully paid-up shares:shares Canonly.
be
• Authorization issued only on fully paid-up equity shares.

  Authorization:from Articles of AssociationAssociation.

must permit the issue of bonus shares.
• Shareholder Approval: Requires a resolutionapproval in a general meetingmeeting.
of the company.
• No default: Company must not have defaulteddefault in payment of interest or principal in respect ofon fixed deposits or debt securitiessecurities.
issued
• Issued by it.

  Utilizing Reserves: Bonus shares can be issued out offrom free reserves, security premium account, or capital redemption reserve account.