Theories of dividend decision , determinants , companies act 2013

IV.

V. Theories of Dividend Decisions

These theories attempt to explain the relationship between dividend policy and the value of the firm.

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

• Core Idea: UnderDividend policy is irrelevant under perfect market conditions (no taxes, no transaction costs, perfect information), dividend policy is irrelevant to the value of the firm.. Investors can create their own "homemade dividends"dividends."
by
• selling shares if they need cash, or reinvest dividends if they don't.

  Assumptions: Perfect markets, rational investors, no taxes, no transaction costs, fixed investment policy.

• Criticisms: The realReal world is not perfect.perfect; Taxes,taxes, transaction costs, and information asymmetry exist,exist.
making the theory less applicable.

B. Relevance Theories: These theories argue that dividendDividend policy does matter.matters.

• Walter's Model:

• Core Idea: The optimalOptimal 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% dividendpayout).
payout ratio is optimal).
• If r = k: Indifference; dividend policy doesn't matter.

• If r < k: Declining firm; pay out all earnings as dividends (100% dividendpayout).
payout
• ratio is optimal).

  Formula: P = (D + (E-D) * (r/ke)) / ke

  Where:

  • P = Market Price per share,share
  • D = Dividend per share,share
  • E = Earnings per share,share
  • r = firm's rate of return,return
  • ke = Cost of Equity Capital

Gordon's Model (Dividend Discount Model - DDM):

• Core Idea: The valueValue of a stock is the present value of its expected future dividends.

• Formula: P0 = D1 / (ke - g)

  Where:

  • P0 = Current price,price
  • D1 = Expected dividend next year,year
  • ke = Required rate of return,return
  • g = Constant growth rate of dividends.
    dividends

• Implication: Higher dividends and a higher growth rate of dividends lead to a= higher stock price.

• Criticisms: Assumes a constant growth rate, which is not always realistic. Also very sensitive to the inputs (ke and g).

Bird-in-the-Hand Theory (Myron Gordon and John Lintner):

• Core Idea: Investors prefer current dividends (a "bird in the hand") over uncertain future capital gains.

• Rationale: Dividends reduce uncertaintyuncertainty.
about
• future returns.

  Implication: Higher dividends lead to a= higher stock price,price.

even
• if the total return is the same.

  Criticisms: Contradicts the MM irrelevance theory.

C. Tax Preference Theory:

• Core Idea: Dividend policy is influenced by the tax implications for investors.

• Rationale: If dividends are taxed at a higher rate than capital gains, investors may prefer companiesretained thatearnings.
retain
• earnings and generate capital gains. Conversely, if dividends are taxed at a lower rate, investors may prefer higher dividend payouts.

  Empirical Evidence: Evidence is mixed, asMixed, tax laws varyvary.

across countries and over time.

D. Signaling Theory (Dividend Signaling):

• Core Idea: Dividends convey information about a company's future prospects.

• Rationale: Management has inside informationinformation.
about
• theImplication: company's profitability.

  Implication: A dividendDividend increase is a credible signal that management expectsof higher future earnings. A dividendDividend decrease is anegative.

negative

signal.

V. Determinants of Dividend Policy Decisions

Factors

• thatProfitability: influence a company's dividend policy:

  Profitability: A company needs sufficientSufficient profits to pay dividends.

• Liquidity: Even if profitable, a company must have sufficientSufficient cash tofor distributedistribution.
dividends.

• Investment Opportunities: CompaniesAttractive with attractive investment opportunitiesprojects may chooselead to retainretaining earningsearnings.

to
• fund those projects.

  Financial Leverage (Debt): High debt levels may restrict a company's ability to pay dividends. Creditors may impose restrictions on dividend payments.

• Growth Rate: High-growth companies often retain earningsearnings.
to
• finance growth.

  Shareholder Preferences: Companies need to consider theConsider preferences offor theirdividends shareholders. Some investors prefer dividends, while others prefervs. capital gains.

• Legal Restrictions: Companies Act and other regulationsregulations.
• Contractual Restrictions: Loan agreements may restrict dividendpayments.
payments.

• Contractual Restrictions: Loan agreements or bond indentures may restrict dividend payments.

  Inflation: High inflation will reduce thereduces real value of dividendsdividends, andrestricting hencepolicy.

dividend
• policy becomes restrictive.

  Stability of Earnings: Stable earningearnings companies tendlead to payhigher apayouts.

high
• dividend payout ratio.

  Access to Capital Markets: Companies with readyEasy access toencourages capitaldistribution.

markets
• tend to distribute earnings in the form of dividend.

  Control Objective: IfStock management wants todividends maintain controlcontrol.

of
• theTaxation: company, they may declare stock dividend instead of cash dividends.

  Taxation: Taxation policy has a significantSignificant effect on the dividend policypolicy.

of

the company.

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

A. Companies Act, 2013 (Key Provisions):

• Section 123: Deals with the declarationDeclaration of dividends.

  Dividends

  can
  • Out onlyof becurrent declaredprofits, out of:

    Current profits.

    Pastpast accumulated profits (undistributed profits).

    Money provided by the Centralprofits, or Statemoney Governmentfrom forgovernment.

  the payment of dividends.
  • Depreciation must be provided forfor.
  before declaring dividends.

  Transfer to Reserves: The

  • Board may decide tocan transfer a portion of the profits to reservesreserves.
  before declaring dividends.

  In case

  • Inadequacy of inadequacy of profits,profits: dividends can be declared out offrom accumulated profits subject to certainrules.
  conditions
  and
rules.

• Section 124: Deals with the Unpaid Dividend Account.

  Dividends

  that
  • Unpaid/unclaimed remain unpaid or unclaimeddividends within 30 days must be transferredgo to an Unpaid Dividend Account.

  If the amount remains unclaimed

  • Unclaimed for 7 years, it must be transferred to the Investor Education and Protection Fund (IEPF).

• Interim Dividend: The Board of Directors maycan declare interim dividendsdividends.
during the financial year.

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

• Listing Agreement/Regulations: SEBI regulations mandate certainMandates disclosures and proceduresprocedures.
for
• dividend distribution by listed companies.

  Disclosure Requirements:

  Companies

  must disclose the dividend
  • Dividend amount, record date, payment date,date.
  and other relevant information to the stock exchanges.

  Must disclose the reasons

  • Reasons for any changes in thepolicy.
  dividend
  policy.

• Record Date: The company must announce theAnnounce record date for determiningeligibility.
shareholders
• eligiblePayment Timeline: Adhere to receive dividends.

  Payment Timeline: Companies must adhere to a prescribed timeline for dividend payments after declaration.

• Dividend Warrants/Electronic Transfer: DividendsPayment canmethods.
be
• paid via dividend warrants or electronic transfer to shareholders' bank accounts.

  Compliance with Accounting Standards: Dividend distribution must becomply.

in
• compliance with applicable accounting standards.

  Regulations for Bonus Issues: SEBISpecific hasregulations.

specific regulations governing the issuance of bonus shares, including eligibility criteria, disclosure requirements, and timelines.

Important Considerations:

• Practical Application: DividendComplex policy is a complex area. Companies mustarea; consider a wide range of factors, including their financial situation, investment opportunities, and shareholder preferences.

• Dynamic Nature: Dividend policy is not static. Companies should review their dividend policy periodicallyReview and makeadjust adjustmentsperiodically.
as needed.
• Consultation: Companies should consultConsult with financial advisors and legal counselcounsel.
when

making dividend policy decisions.

This detailed overview should provide a comprehensive understanding of dividend policy decisions. Remember to consult specific legal and regulatory documents for the most up-to-date information. Good luck!