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Theories of dividend decision , determinants , companies act 2013

V. Theories of Dividend Decisions

A. Irrelevance Theory (Modigliani and Miller - MM):

  • Core Idea: Dividend policy is irrelevant under perfect market conditions (no taxes, transaction costs, perfect information). Investors can create "homemade dividends."
  • Assumptions: Perfect markets, rational investors, no taxes, no transaction costs, fixed investment policy.
  • Criticisms: Real world is not perfect; taxes, transaction costs, and information asymmetry exist.

B. Relevance Theories: Dividend policy matters.

  • Walter's Model:
    • Core Idea: Optimal dividend policy depends on the relationship between the firm's internal rate of return (r) and the cost of capital (k).
    • If r > k: Growth firm; retain earnings (0% payout).
    • If r = k: Indifference; dividend policy doesn't matter.
    • If r < k: Declining firm; pay out all earnings (100% payout).
    • Formula: P = (D + (E-D) * (r/ke)) / ke
      • P = Market Price per share
      • D = Dividend per share
      • E = Earnings per share
      • r = firm's rate of return
      • ke = Cost of Equity Capital
  • Gordon's Model (Dividend Discount Model - DDM):
    • Core Idea: Value of stock is the present value of expected future dividends.
    • Formula: P0 = D1 / (ke - g)
      • P0 = Current price
      • D1 = Expected dividend next year
      • ke = Required rate of return
      • g = Constant growth rate of dividends
    • Implication: Higher dividends and growth = higher stock price.
    • Criticisms: Assumes constant growth rate, sensitive to inputs (ke and g).
  • Bird-in-the-Hand Theory (Myron Gordon and John Lintner):
    • Core Idea: Investors prefer current dividends ("bird in the hand") over uncertain future capital gains.
    • Rationale: Dividends reduce uncertainty.
    • Implication: Higher dividends = higher stock price.
    • Criticisms: Contradicts MM irrelevance theory.

C. Tax Preference Theory:

  • Core Idea: Dividend policy influenced by tax implications for investors.
  • Rationale: If dividends taxed higher than capital gains, investors prefer retained earnings.
  • Empirical Evidence: Mixed, tax laws vary.

D. Signaling Theory (Dividend Signaling):

  • Core Idea: Dividends convey information about future prospects.
  • Rationale: Management has inside information.
  • Implication: Dividend increase is a credible signal of higher future earnings. Dividend decrease is negative.

V. Determinants of Dividend Policy Decisions

  • Profitability: Sufficient profits to pay dividends.
  • Liquidity: Sufficient cash for distribution.
  • Investment Opportunities: Attractive projects may lead to retaining earnings.
  • Financial Leverage (Debt): High debt may restrict dividend payments.
  • Growth Rate: High-growth companies often retain earnings.
  • Shareholder Preferences: Consider preferences for dividends vs. capital gains.
  • Legal Restrictions: Companies Act and other regulations.
  • Contractual Restrictions: Loan agreements may restrict payments.
  • Inflation: High inflation reduces real value of dividends, restricting policy.
  • Stability of Earnings: Stable earnings lead to higher payouts.
  • Access to Capital Markets: Easy access encourages distribution.
  • Control Objective: Stock dividends maintain control.
  • Taxation: Significant effect on dividend policy.

VI. Companies Act, 2013 and SEBI Guidelines on Dividend Distribution (Theory Only)

A. Companies Act, 2013 (Key Provisions):

  • Section 123: Declaration of dividends.
    • Out of current profits, past accumulated profits, or money from government.
    • Depreciation must be provided for.
    • Board can transfer profits to reserves.
    • Inadequacy of profits: dividends can be declared from accumulated profits subject to rules.
  • Section 124: Unpaid Dividend Account.
    • Unpaid/unclaimed dividends within 30 days go to Unpaid Dividend Account.
    • Unclaimed for 7 years, transferred to Investor Education and Protection Fund (IEPF).
  • Interim Dividend: Board can declare interim dividends.

B. SEBI (Securities and Exchange Board of India) Guidelines on Dividend Distribution (Listed Companies):

  • Listing Agreement/Regulations: Mandates disclosures and procedures.
  • Disclosure Requirements:
    • Dividend amount, record date, payment date.
    • Reasons for changes in policy.
  • Record Date: Announce record date for eligibility.
  • Payment Timeline: Adhere to timeline after declaration.
  • Dividend Warrants/Electronic Transfer: Payment methods.
  • Compliance with Accounting Standards: Dividend distribution must comply.
  • Regulations for Bonus Issues: Specific regulations.

Important Considerations:

  • Practical Application: Complex area; consider financial situation, opportunities, and shareholder preferences.
  • Dynamic Nature: Review and adjust periodically.
  • Consultation: Consult with advisors and legal counsel.
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