Dividends Payment

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CHAPTER 1
INTRODUCTION
1.1 INRODUCTION TO DIVIDENDS
Dividends are commonly defined as the distribution of earnings (past or present) in
real assets among the shareholders of the firm in proportion to their ownership. [1],[2]
Dividends are commonly defined as distribution of earnings (past or present) in real
assets among the shareholders of the firm in proportion to their ownership. There are
three parts of this definition, all equally important.1
The first is that dividends can be distributed only from earnings and not from any
other source of equity, like, paid –in – surplus etc.
The second is that dividends must be in form of a real asset. It is common practice to
pay dividends in cash (in form of dividend cheque) because of the convenience of the
matter. It is hard to imagine that Boeing, would send the right wing of a 747 as a
dividend to one of its major stockholders. Regardless, evidence shows (from other
countries) that some firms during high levels of inflation have paid dividends in the
form of product they were producing.
The third part of the definition states that all stockholders’ share in dividends relative
to their holding in the corporation.
Dividend policy has been an issue of interest in financial literature since Joint Stock
Companies came into existence. The question of the ratio of retained earnings to
distributed earnings is referred to as dividend decision or policy. The guiding
philosophy of dividend decision is naturally to adopt a policy that maximizes the
shareholders’wealth.Therefore, from the view point of financial management, the
objective is to find out the dividend policy that will maximize or enhance the value of
the firm.

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This section draws heavily from the thorough review provided by Frankfurter and Wood.

1

Dividends are paid from the firm’s after tax income. For the recipient, dividends are
considered regular income and are therefore fully taxable. This tax treatment results
de facto in double taxation of dividends in America (but not in several other countries,
e.g. Canada and Germany), the only source of income that is subject to such
treatment. In India the company declaring the dividend has to pay dividend
distribution tax and dividend income is exempt from tax for the recipients or the
shareholders.2
However in most of the countries the economic consequence of dividends is an
involuntary tax liability to the owners (country like India being an exception).
There is an incongruity which becomes evident at this juncture. The incongruity is
that dividend announcements and payment are considered good news, held and hailed
as such by investors and most analyst, whereas dividend cuts and reductions are
considered bad news suggesting impending financial doom. This incongruity is
commonly referred to as “Dividend puzzle”. Three decades ago, Black (1976) wrote:
“The harder we look at dividend picture, the more it seems like a puzzle, with pieces
that just don’t fit together” [3] Brealey and Myers (2002) have enlisted dividend
policy as one of the top ten puzzles in finance.[4],[5]
The questions of "Why do corporations pay dividends?" and "Why do investors pay
attention to dividends?" have puzzled both academicians and corporate managers for
many years.
Perhaps the answers to these questions are obvious. Perhaps dividends represent the
return to the investor who puts his money at risk in the corporation. Perhaps
corporations pay dividends to reward existing shareholders, and to encourage others
to buy new issues of common stock at high prices. Perhaps investors pay attention to
dividends because it is only through dividends or the prospect of dividends investors
receive a return on their investment or the chance to sell their shares at a higher price
in the future.

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There have been several changes in the tax regime in the last few years. The Union budget 1997-98
made dividend taxable in the hands of the company paying them and not in the hands of the investors
receiving them.Simlarly, there have been changes in the capital gains tax and exemption of dividend
income under Section 80 L of the Income Tax Act 1961.All these changes have implications for
dividend policy of the corporate firms.

2

Or perhaps the answers are not so obvious. Perhaps a corporation that pays no
dividends is demonstrating confidence that it has attractive investment opportunities
that might be missed if it paid dividends. If it makes these investments, it may
increase the value of the shares by more than the amount of the lost dividends. If that
happens, its shareholders may be even more better off. They end up with capital
appreciation greater than the dividends they missed out on, and they find they are
taxed at lower effective rates on capital appreciation than on dividends.
In fact, the answers to these questions are not obvious at all. Although Professor
Black's observations were made two decades ago, financial economists still are
wrestling with the "dividend puzzle."
There is yet another dimension to academe’s failure to solve the puzzle. Academic
thinking about dividends – and whatever this thinking produced- has completely
ignored the evolution of dividend payments in modern corporations. Dividend
payment behavior, known as “dividend policy”, did not simply appear out of
nowhere. It evolved with modern Corporation over a period of four centuries. The
details of this evolution are chronicled in a number of publications; among them is an
article by Franfurter and Wood (1997). The evolution of dividends by these eminent
professors has been discussed in the succeeding section. Putting corporate dividend
policy in a historical perspective makes one wonder how and why scholarly model of
dividend policy could disregard such evolution.
In 20th century, emphasis on the importance of dividends emanated from the
publication of a major investment text, which, in a short time, turned out to be the
bible of financial analysts. The text, written by Graham and Dodd (1934), was later
updated (Graham et.al., 1962). In this text, the authors proclaim dividends to be the
only purpose of firm’s existence. They also contend that if two firms are operating in
the same environment and are identical in every respect, the one that pays regular
dividends would sell for a higher P/E multiple than the one that does not meaning that
former is less risky than the latter.[6],[7]
Serious academic thinking and concomitant research into the dividend decisions and
practice began in the early 1950s. Consistently with Graham Dodd thesis, early

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models (often referred to as bird-in the- hand models3) intended to show that
dividends are valued for the discounted cash stream they provide to the shareholder.
These models advocated a dividend policy that amounted to a 100%, 0, and anythingin-between payout ratio of earnings; that is, not much of a policy at all, even if one
accepted the value creating logic of the bird-in-the-hand models. Thus, it can be stated
till the mid of 20th century dividend payment primacy existed.
The debate over the importance of dividend policy first appeared in Miller and
Modigliani (1961), who concluded that in a world of perfect capital markets, the
payment of dividends does not affect the value of the firm and is therefore irrelevant.
In such a world, firm value depends only on the distribution of future cash flows that
result from the investments undertaken [8],[9]. For example, Bernstein (1996)
contends “dividends, in and of themselves, do not matter, provided managers avoid
driving down the spread between ROE and the cost of capital.”[10] To accommodate
the world in which market imperfections exist, academicians have developed many
theories to explain reasons for a firm to pay dividends. For example, for mature
companies with highly stable cash flows, paying too little in dividends could lead
managers to investing excess cash flow in projects or acquisitions with insufficient net
present value. Yet, for high growth firms, paying out too much in cash dividends may
reduce the firm's financial flexibility and force it to pass up valuable investment
opportunities. Either of these situations could negatively affect a firm's value over
time. Despite much research intended to resolve the dividend puzzle, dividend policy
remains one of the most judgemental decisions that a manager must make. As Ang
(1987) notes, "Thus, we have moved from a position of not enough good reasons to
explain why dividends are paid to one of too many. Unfortunately, some of these may
not be very good reasons, i.e., not consistent with rational behaviour."
During the last several decades, the debate over the importance of dividend policy has
continued leading the best academic minds to grapple with dividend puzzle. Financial
economists posited -and still so a variety of theories that tried, almost exclusively, to
justify the payment of dividends using the principles of wealth maximisation.

3

The allegory is that cash today is preferred to cash in the futures, as one bird in hand is preferred to
two in the bush .Of course, it would depend on what the two birds are doing in the bush and on whether
we are one of the birds.

4

Some researchers have surveyed corporate managers and institutional investors to
determine their views about dividends. Despite extensive debate and research, the
actual motivation for paying dividends remains a puzzle. Therefore this study is an
endeavour to add to the existing body of knowledge and contribute towards solving
the dividend puzzle prevalent in Corporate Finance.
Those who are proponents of the Dividend Relevance hypothesis emphasize that
firm’s should design an appropriate dividend payout policy. However, while framing
an appropriate dividend policy several questions may be posed in front of a Finance
manager. To enumerate a few: How much cash should firms give back to their
shareholders? And what form should payment take? Should corporations pay their
shareholders through dividends or by repurchasing their shares, which is the least
costly form of payout from tax perspective? Firms must take these important
decisions over and over again (some must be repeated and some need to be revaluated
each period on regular basis).
Because these decisions are dynamic they are labeled as payout policy .The word
“policy” implies some consistency over time, and that payouts, and dividends in
particular, do not simply evolve in an arbitrary and random manner.
Payout policy is important not only because of the amount of money involved and
repeated nature of the decisions, but also because payout policy is closely related to,
and interacts with, most of the financial and investments decisions firms make.
Management and board of directors must decide the level of dividends, what
repurchases to make (and the mirror image decision of equity issuance), the amount of
financial slack the firm carries (which may not be a trivial amount); investment in real
assets, mergers and acquisitions , and debt issuance. Since capital markets are neither
perfect nor complete, all of these decisions interact with one another.
Understanding the payout policy may also help one to better understand the other
pieces in this puzzle. The most common observations that play an important role in
the discussion of payout policies:
a) Large and established firms typically pay out a significant percentage of their
earnings in the form of dividends and repurchases.

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b) Historically, cash dividends have been the predominant form of payout.
Though nowadays stock repurchases, stock splits are also gaining importance.
c) Corporations smooth dividends relative to earnings.
d) Markets react positively to announcements of repurchases and dividend
increases, and negatively to announcements of dividend decreases.
As it is known and well accepted that the objective of an organization is shareholders’
wealth maximization. The challenge to financial economists is to develop a payout
policy framework where firms maximize shareholders’ wealth and investors
maximize utility. Clear guidelines for an “optimal payout policy” have not yet
emerged despite voluminous literature. An acceptable explanation for observed
dividend behavior of companies has still not been obtained. The factors that drive
dividend decisions and manner in which these factors interact need to be understood
completely by the financial economist
In nutshell, it can be stated Dividend decisions are recognised as centrally important
because of increasingly significant role of the finances in the firm’s overall growth
strategy.Dividend policy connotes to the payout policy, which managers pursue in
deciding the size and pattern of cash distribution to shareholders over time.
Managements’ primary goal is shareholders’ wealth maximization, which translates
into maximizing the value of the company as measured by the price of the company’s
common stock. This goal can be achieved by giving the shareholders a “fair” payment
on their investments. However, the impact of firm’s dividend policy on shareholders’
wealth is still unresolved.

1.2 A SHORT HISTORY OF DIVIDEND POLICY
Corporate dividend payments to shareholders began more than 300 years ago and
have continued as an acceptable, if not, required, activity of corporate mangers,
despite the apparent contradictory economic nature of these payments.
It seems that the corporation progressed from original liquidating dividend, to
distribution of all profits (retaining some capital), to a token dividend payment, the
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size and frequency of which are left to the discretion of management. At the same
time, alternative schemes of distribution (such as repurchase of stock, green mail, etc.)
and quasi- distribution (such as stock dividends and splits) have been devised and
accepted.
Clearly, this evolution could not have occurred in vacuum .It has been paralleled, if
not participated, by systematic removal of the owners from management, i.e., the
separation of control from ownership.
Frankfurter and Wood (1997) provide an excellent comprehensive survey of the
history of corporate dividend policy since the inception of shareholder-held
corporations.4It was noted early in the sixteenth century captains of sailing ships in
Great Britain and Holland began selling to investors’ claims to the financial payoffs
of the voyages. At the conclusion of the voyages, proceeds from the sale of the cargo
and shipping assets, if any, were divided among the participants proportionate to
ownership in the enterprise. These distributions were, in fact, payments that
effectively liquidated the venture, or liquidating dividends. By this practice,
claimholders avoided complex accounting practices, such as accrual accounting
procedures. In addition, the liquidation of ventures minimized potentially fraudulent
bookkeeping practices. By the end of the century, these claims on voyage outcomes
began trading in the open market. These claims to outcomes were later replaced by
share ownership.
Even before the development of modern capital market theory, along with the
statistical measurement of the impact of diversification on portfolio risk, investors in
these sailing ventures regularly purchased shares from more than one captain to
diversify the inherent risk in these endeavors. Also, as in the modern corporation,
investors provided capital for these ventures, while the captains offered their
specialized skills—for instance, seafaring and management skills.
However, as time passed owners began to realize that the complete liquidation of
assets at the end of each voyage was inefficient; start-up and liquidation costs for new
ventures were significant. A track record of success for a captain, and increasing
confidence by shareholders in the accountability of the management of the firm, gave
4

This section draws heavily from the thorough review provided by Frankfurter and Wood.

7

way to a system of partial liquidation at the termination of specific ventures—
dividends in the range of 20 percent of the profits but not liquidating dividends.
The concept of firms as "going concerns" without a finite life corresponding to the
length of a "voyage" persisted and produced the first dividend payment regulation.
Corporate charters included limitations of dividends to payments from profits only.
By 1700, the British Parliament had passed two standards that regulated dividend
payments: the profit rule and the capital impairment rule. The profit rule was
intended to protect creditors from de facto liquidations of the firm to the benefit of
shareholders. The capital impairment rule, which restricted transfers from retained
earnings to dividends, was adopted to provide for the firm's continuing existence.
The success of the stock ownership structure of shipping companies spread to
numerous new industries in the latter part of the seventeenth century—for example,
mining, banking, retailing, and utilities.
The first dividend statute in the United States was enacted in New York in 1825 and
was quickly emulated by other states. Following the Civil War, the majority of
northern manufacturing firms paid regular dividends in the range of 8 percent of
profits. The general lack of financial information resulted in investors trying to
establish firm value by analyzing the firm's dividend track record. The general
increases in dividend payments were reflected in rising share prices. After 1920, U.S.
firms for the first time began to "smooth" dividend payments, that is, create a
relatively stable dividend payment stream less volatile than earnings. During the
1920s, average payout ratios grew to about 70 percent of profits.
In the years following World War II, corporate dividend policy remained relatively
unchanged, and payout levels have stayed fairly constant. By 1960, the payout level
for all corporations was slightly in excess of 60 percent. Management continued to
smooth dividends and, indeed, does so to this day.
Thus, the history of dividends began with the payout of liquidating dividends when
sailing ventures were terminated upon completion and the profits and proceeds from
asset sales were distributed to claimholders. However, due to inefficiencies induced
by total liquidation, dividends began being paid from profits. Earnings were retained

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to finance new investments, and dividend payments became only small partial, or
symbolic, liquidations.5
Frankfurter and Wood (1997) concluded their study on the evolution of dividends
with the following observation:
Dividend-payment patterns (or what is often referred to as "dividend policy") of firms
are a cultural phenomenon, influenced by customs, beliefs, regulations, public
opinion, perceptions and hysteria, general economic conditions and several other
factors, all in perpetual change, impacting different firms differently. Accordingly, it
cannot be modeled mathematically and uniformly for all firms at all times

1.3 DIVIDEND POLICY
A dividend policy of a corporation may range from a mere decision regarding
dividend action to rather complex formal statements approved by board of directors
and reviewed on regular basis. Dividend policy may be reviewed at the annual
shareholders’ meeting or may be published in the annual report.
Not all the firms require a formal dividend policy. Closely held businesses in which
the equity participants hold a position on the board of directors or maintain a working
knowledge of the business probably do not require a formal policy. Formal dividend
policies are normally associated with firms that have achieved significant size in
revenue and variety of shareholders. The complexity of financial management and
planning play an important part in determining when a formal dividend policy is
required. Industrial organizations that are capital intensive and must engage in long
range planning to assure adequate supplies of capital in future may require a specific
dividend policy to assure that sufficient amount of funds are available when asset
acquisition is undertaken. At the same time, it is important to achieve a balance
between retained earnings and dividends to assure a market for new equity shares in
event additional equity capital is required.

5

Anytime a firm pays out cash as a dividend, or repurchases common stock, the firm has been reduced
in size, or in a real sense partially liquidated.

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In view of the multi-dimensional nature of dividend policy decision, a deliberate
policy needs to be framed and pursued in this regard. It should not be allowed to
become a series of ad hoc decisions taken on the spur of the moment considering only
the immediate availability of cash for dividend payment (Chakrabarty et.al.1981).
Thus, the objective of choosing a dividend policy should be to maximize the value of
the firm.
Dividend policy can be of two types: managed and residual. In residual dividend policy
the amount of dividend is simply the cash left after the firm makes desirable
investments using NPV rule. In this case the amount of dividend is going to be highly
variable and often zero. If the manager believes dividend policy is important to their
investors and it positively influences share price valuation, they will adopt managed
dividend policy. The optimal dividend policy is the one that maximizes the company’s
stock price, which leads to maximization of shareholders’ wealth. Whether or not
dividend decisions can contribute to the value of firm is a debatable issue.
As an outcome of limitations present in the real world, most factors favour retention of
earnings rather than cash dividend. The tax advantage from capital gains is substantial,
and favours retention. Other factors include the presence of floatation costs, the
phenomenon of underpricing and legal hassles that are also in favour of retention of
earnings, rather than its distribution .The presence of transaction costs is the only factor
that favours cash dividend payment.
Due to the factors overwhelmingly supporting retention, firms ought to follow the
following dividend policy:
1) Identify all possible positive NPV projects.
2) Retain the required cash to accept all such projects, so as to increase the value of the
firm.
3) Maximise returns to shareholders through increase in the prices of shares
4) Distribute the remaining cash balance only when all positive NPV projects are
funded.

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5) Raise fresh capital only when internally generated earnings are not enough to
accept all positive NPV projects.
Such a policy of dividend is referred to as passive residual dividend policy. This policy
dictates returning only excess cash. Following such a policy must lead to optimal
results.
The passive residual dividend policy would imply fluctuating dividend from period to
period, because the flow of earnings and the availability of positive NPV projects can
hardly be said to be steady. Both earnings and available opportunities are volatile by
nature. Therefore, following a passive residual dividend policy essentially implies
volatile dividends over time.
However, the empirical evidence is contrary. Several studies have revealed that
dividends are sticky and follow a smoother pattern than earnings, a phenomenon that
is sustained by general observation. Firms generally do not raise dividends unless they
are absolutely sure of sustaining this trend in future. Similarly, they do not reduce
dividends unless they feel that the drop in earnings is due to bad economic conditions,
or to other reasons that are likely to prevail for an extended time. Therefore dividends
are likely to be more stable than earnings.
On occasion, the firm may have to maintain a stable dividend payout ratio simply
because the shareholders expect it and reveal a preference for it. Shareholders may
want a stable rate of dividend payment for a variety of reasons. Risk averse
shareholders would be willing to invest only in those companies which pay high
current returns on shares.
Some of them are partly or fully dependent on dividend to meet their day-to-day
needs. This class of investors generally include pensioners and other small savers.
Similarly, educational institutions and charity firms prefer stable dividends, because
they will not be able to carry on their current operations otherwise. Such investors
would, therefore prefer companies which pay a regular dividend every year. Some
may like more dividends, while some other. Investors who favour dividend may chose
high- dividend paying companies for their portfolios, while the group that does not
need dividend would pick stocks that offer more capital appreciation may prefer
capital gains; yet another group may like to have both. Thus the investors can be
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grouped according to their preference for dividend or capital gains. These groups are
refereed to as clienteles. The clientele effect refers to investors’ selection of firms that
match their preference for dividends. A change in dividend policy would cause the
clienteles to shift their investments. The argument that firms should not change their
dividend policies for the sake of retaining the same clientele is a debatable one.

1.4 ECONOMIC RATIONALE TO DIVIDENDS
The dividend literature has primarily relied on two lines of reasoning to generate
predictions about dividend behaviour: information asymmetry and agency conflicts.
The information asymmetry models argue that managers know more than investors
about firm’s prospects and the dividends reveal some of that information to the
market. This implies that dividends change announcements should be positively
related to stock returns because a higher dividend level signals higher current or
future earnings. A number of studies report significant excess returns around the
announcement of dividend changes: positive (negative) returns are associated with
positive (negative) changes in dividends. Information asymmetry also helps to explain
the observed reluctance of managers to change dividends.
The collective wisdom of the literature suggests that, when a firm is underpriced

relative to the private information held by managers, managers may be able to use
dividends to establish a market value for the stock that is more in line with their
private information. Since the payment of dividends has costs to management,
managers have to evaluate the importance and urgency of establishing an appropriate
market value. For example, if the firm or its shareholders are planning to sell
securities, or if the firm is a potential takeover target, establishing the proper value of
the firm—a value that incorporates favorable private information—is important. The
extent of undervaluation by the market and the size of the required equity sale may be
determinants of the dividend payout.
Lenders generally prefer to entrust their money to stable firms rather than ones that
are erratic, as this reduces risk. Therefore it could be speculated that a consistent
dividend flow helps to raise the credit standing of the firm and lowers the interest rate

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payable. Creditors suffer from information asymmetry as much as shareholders and
may therefore look to this dividend decision for an indication of managerial
confidence about firm’s prospects.
Firms should adopt a dividend policy that allows implementation of an investment
policy that maximizes market value. In general, firms should not underpay dividends.
Retained funds should be invested in projects that pass the NPV Rule. Having too
much cash lying around is an ill-advised investment. Consistent with this observation
is research that illustrates that the market responds positively to the announcement of
increases in capital expenditures.
In short, excessive cash balances increase managers' degree of investment flexibility,
which may be to the detrimental for the shareholders. After all, managers experience a
normal set of human temptations. On the one hand, if management compensation
and/or prestige is based on firm size or sales, the temptation exists to overinvest in
projects or to acquire other firms that may not be strategically advisable nor value
enhancing.
On the other hand, overpayment of dividends and underinvestment in positive NPV
projects also are potential problems. These problems can be overcome by bond
covenants that restrict dividend payouts.
In general, high-growth firms can afford to write strict or tight dividend constraints
that severely limit their ability to pay future dividends. This is because these firms are
not plagued by overinvestment concerns given the abundance of good investment
projects. These firms are likely to need outside financing regularly and therefore are
subject to the discipline of frequent capital market scrutiny. Further, these firms have
less need for future dividend flexibility because of their need to finance investment.
Moreover, dividends are less important to investors in high-growth firms who seek
out these firms in the expectation of receiving little, if any, dividend income.
For the opposite reasons, low-growth firms should negotiate looser dividend
constraints. With a scarcity of future positive NPV investments, these firms are likely
to generate large free cash flows that should be paid to shareholders. Without the
dividend payout commitment, overinvestment may be a temptation. [11]

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Highly leveraged firms can write strict dividend policy constraints. Heavy debt
service obligations limit these firms' ability to overinvest, and frequent refinancing
provides capital market discipline. Indeed, empirical research indicates that growth
firms and firms with higher leverage, all else being equal, choose tighter dividend
constraints and pay fewer dividends (Kalay 1979). [12], [13], [14]
Low-leveraged firms also should negotiate looser dividend constraints relative to
firms with high debt levels to provide future flexibility. Low debt service obligations
mean less debt refinancing and discipline imposed by capital markets. Accordingly,
dividends and dividend slack are relatively more important.
For high-growth firms with low leverage and broad ownership, dividends are
relatively more important in controlling potential agency conflicts between managers
and shareholders. All else being equal, dividend payments force a firm especially a
high-growth firm to the capital markets more regularly. The scrutiny provided by the
capital markets limits the extent of managements' self-serving behavior.

But, if managers own a significant percentage of outstanding shares, their interests are
more closely aligned with shareholders than if they own few shares. Accordingly, one
can expect the optimal dividend payout to be a function of the level of management
ownership. From an agency perspective, high management ownership suggests that a
lower dividend payout may be appropriate, and vice versa.
Thus it is evident that Dividend policy6 of a firm has implication for investors,
managers and lenders and other stakeholders (more specifically the claimholders)[4],
[5]. For investors, dividends – whether declared today or accumulated and provided at
a later date are not only a means of regular income7, but also an important input in
valuation of a firm8.[10] Similarly, managers’ flexibility to invest in projects is also
dependent on the amount of dividend that they can offer to shareholders as more
dividends may mean fewer funds available for investment. Lenders may also have
6

Brealey (1992) poses that dividend policy decisions as “what is the effect of a change in cash
dividends, given the firm’s capital budgeting and borrowing decisions?” In other words, he looks at the
dividend policy in isolation and not as by products of other corporate financial decisions.
7
Linter (1956) finds that firms pay regular and predictable dividends to investors where as the earnings
of corporate firms could be erratic. This implies that shareholders prefer smoothened dividend income.
8
Bernstein (1976) observes that given the ‘concocted’ earnings estimate provides by firms, the low
dividend payout induces reinvestment risk and earnings risk for the investors.

14

interest in the amount of dividend a firm declares, as more the dividend paid less
would be the amount available for servicing and redemption of their claims. The
dividend payments present an example of the classic agency situation as its impact is
borne by various claimholders. Accordingly dividend policy can be used as a
mechanism to reduce agency costs. The payment of dividends reduce the
discretionary funds available to managers for perquisite consumption and investment
opportunities and require managers to seek financing in capital markets. This
monitoring by the external capital markets may encourage the managers to be more
disciplined and act in owners’ best interest.
The agency relationship between a corporation’s owners and its management creates
opportunities for management to pursue goals other than shareholder wealth
maximisation. The payment of cash dividends and managerial stock ownership may
reduce agency conflicts.

1.5 DIVIDEND POLICY AND ITS LINKAGES WITH OTHER
FINANCIAL POLICIES
Dividend Policy for a company is a pivotal policy around which other financial
policies rotate. The dividend decision is an integral part of a company’s financial
decision making, as it is explicitly related to the other two major decisions in
Corporate Finance- investment decision and the financing decision. The board of
directors must make inter-alia the decisions pertaining to investment, financing and
dividends simultaneously as these three decisions are interrelated. Dividend policy
decisions influences the financing decision of the firm through retained earnings.
Financing decisions would relate to the amount of funds to be raised from external
sources as investment needs of a firm can be fulfilled by a combination of retained
earnings and external financing. Therefore, it is important to understand how profits
are divided between dividend payments and retained earnings.
Given the firm’s investment and financing decisions, a small dividend payment
corresponds to high earnings retention with less need for externally generated equity
funds. A number of studies suggest that most firms have a long term target payout

15

ratio, and that many firms smooth dividends by moving only part way towards the
target payout ratio every year. The management of the firms also takes into
consideration the expected future income and current income in setting the long run
target. Put differently, they think that if they pay high dividends, then less money will
be available for reinvestment, and consequently may not have enough money to go
ahead with their expenditure program. This in turn results in greater reliance on
external financing. In these cases, the dividend decision feeds back on investment
decision, and has an immediate impact upon firm’s capital structure.
Thus if the dividend policy is purely viewed as function of investment policy then it
becomes the residual left after the firm has retained funds for investment in all
available projects with positive NPV. Dividends will vary from year to year, larger in
years of high cash flow and few investment opportunities, and will be reduced when
the need for reinvestment is high relative to internally generated cash flow. Therefore,
a CFO should establish a low maintainable regular dividend with steady increases
every year.

1.6 PURE vs SMOOTHED RESIDUAL DIVDEND POLICY
As discussed in the earlier sections dividend policy can be broadly of two types:
Managed vs Residual. Residual dividend policy implies distribution of leftover
cashflows.
The amount of dividend as residual can be worked as below:
Dividend = Net income – Capital outlay for new projects- debt to be raised as per
target capital structure
Paying dividend strictly as per above equation is referred to as pure residual dividend
policy It is likely to result in dividends that fluctuate from period to period. Paying
dividend as residual; of earnings and investment requirements is against the tenets of
value creation and would make returns on equity volatile. The pure residual dividend
policy has following disadvantages:

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1) It takes away the argument of the information content of dividends, because
persistent variability in dividend provides ambiguous signals to investors. At best, it
can lead to confusion in the mind of the investors.
2) It is not consistent with idea of clientele effect. Clientele effect is too based on the
fact of fixed dividend rather than varying dividend.
To overcome the shortcomings of the pure residual dividend policy, the firm can
adopt a policy of dividend distribution that reduces the element of uncertainty,
provides useful signals, and does not disturb clienteles. Continuing to follow the
residual policy, the amount of dividend needs to be smoothed over time. The firm
may decide the level of initial dividend and then raise it gradually, even if this leaves
the firm with some extra liquidity. This extra liquidity provides a cushion to maintain
fixed dividend payouts in case there are temporary aberrations in projected cash flows
and growth plans.
Besides providing such a cushion, the smoothed residual dividend policy remains
consistent with arguments of (i) information content of dividends, (ii) investors’
preference for current income, to render stability to current income to meet current
liabilities, and (iii) clientele effect
Most firms tend to follow the stable dividend policy with slow steady growth to
indicate steady cash flows. The general principle is to increase or decrease dividend
only if it becomes necessary. Drastic changes in dividend are generally avoided and
serve no useful purpose.

1.7 DIVIDEND DECLARATION PROCESS
Most firms in the India pay dividends quarterly. After making the dividend decision
during a board meeting, a firm's board of directors releases information on the size of
the dividend on the announcement date. Further, the announcement states that the
cash payment will be made to "shareholders of record" as of a specific record date.
However, because of delays in the share transfer process, the stock goes "exdividend" two business days before the record date, or the ex-dividend date. After the

17

stock goes ex-dividend, the shares trade without the rights to the forthcoming
quarterly dividend. The dividend cheques are mailed to shareholders of record on the
payment date, which is about two weeks after the record date. Figure 1 shows the time
line of the period from the board meeting through the mailing of the dividend checks.
Board of Directors
Meeting

Min 7 days

Ex-Dividend Date (Two
Business Days before
Record Date)
2 days

Payment Date (About Two
weeks after Record Date)

Time line for
dividend
Notice to
the
Exchange

Shareholder Record Date
Dividend
Announcement Date

Max. 30 days

Min. 14 days
Figure 1.1: Dividend Time line

1.8 ALTERNATIVE FORMS OF DIVIDENDS
Firms normally reward shareholders with regular cash dividends .Firms follow stable
dividend policy and refrain from increasing dividend, even when earnings continue to
grow. These earnings get accumulated over a period of time, enhancing the
shareholders’ wealth and causing share prices to rise consistently
Besides cash payment, firms also have alternative methods to provide rewards to
shareholders that directly or indirectly are in the interest of shareholders. These
special types of dividend avoid any possibilities of miscommunication arising from
the increased dividend, because such actions are taken as one - off measures
There are ways other than regular or periodic cash dividends to reward
shareholders.Three other ways of rewarding shareholders are very popular. They are
as follows:

18

1.8.1 STOCK REPURCHASES OR SHARE BUY BACKS
Following a stable dividend policy, firms normally do not increase dividend payout,
despite increased earnings, for the sake of reducing chances of misinterpretation of
information content of dividend, and also as in pursuit of a policy to retain a good
proportion for future requirements, should good opportunities come by. Firms may be
uncertain of future capital expenditure requirements with several projects under study.
These may relate to acquisitions that require huge outlays. When flush with sufficient
funds, with no relevant growth opportunities in sight, firms may decide to return the
excess cash back to shareholders.
Hence, the firm faces two choices for returning the excess cash- either give bumper
dividends or buyback shares. An increasingly popular method of rewarding
shareholders in a form other than regular cash is the share buyback. Under stock
repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing
the number of shares. This, in turn, increases both EPS and stock price. It is a
substitute for dividend payment when it is large. It provides an option to shareholders
to continue or exit their investment in any desired ratio. Till 1998, share buyback was
not allowed in India. After it was allowed, several firms in India have offered share
buyback. A share buyback has several advantages. It communicates the worth of the
firm in the opinion of management, is capable of increasing promoters’ shareholding,
provides protection against hostile takeovers, and alters shareholding pattern and
capital structure.
1.8.2 BONUS SHARES
Issue of bonus shares is a way of capitalizing reserves into shares. It only changes the
form and not the content or wealth of shareholders.
Adhering to a stable dividend policy despite continuous excess earnings implies an
accumulation of reserves. Shareholders are owners of the capital subscribed and
residual profit that is retained in the business. These retained profits appear as
‘Reserves and the Surplus’.The sum of the Capital subscribed and the reserves is
referred to as shareholders’ fund. These retained profits keep enhancing the value of
the reserves and surplus, period after period. This increase in book value is reflected
in share prices.
19

When proportion of reserves and surplus becomes relatively high in relation to
subscribed capital, firms normally issue bonus shares, to get back an appropriate
proportion of subscribed capital to reserves and surplus. The issue of bonus share is
mere reorganization of shareholders’ funds, keeping the overall value same as before.
1.8.3 STOCK SPLITS
The stock split too is a reward to shareholders that works in the same way as bonus
shares. It is an action taken by a firm to increase the number of shares outstanding.
Normally, splits reduce the price per share in proportion to the increase in shares
because splits merely “divide the pie into smaller slices”. A stock dividend is a
dividend paid in additional shares of stock rather than in cash. Both stock dividends
and splits are used to keep stock prices with in an "optimal” range.
Stock splits are identical to bonus issues in respect of the effects on valuation,
liquidity, price, book value, and EPS. The only difference between two lies in the
books of accounts. In case of bonus share issue ‘reserves and surplus’ is capitalized
and transferred to paid up capital, while in case of split ‘reserves and surplus’ as well
as ‘capital’ remain unaffected. The number of shares simply gets multiplied.

1.9 DECLARATION AND DISTRIBUTION OF DIVIDENDS BY A
COMPANY UNDER INDIAN LAW
A range of firm and market characteristics have been proposed as potentially
important in determining dividend policy. Dividend policy decisions are affected by
legal, tax and accounting factors of a country. These factors of legal, tax and
accounting may substantially vary from country to country. Taxation policy is
assumed as a major determinant of dividend payout in the developed countries. In the
case of India, the tax policy is different from those of developed countries. In India
Companies Act 1956 has imposed statutory restrictions. The Companies Act 1956,
governs the declaration and payment of dividends. A company paying dividends
should adhere and comply with these norms, which are discussed as follows.

20

1.9.1 LEGAL REGIME
Section 205 of the Act regulates the declaration and distribution of dividend. All the
companies which have share capital other than section 25 of Companies Act and
make profit are bound by law to declare and distribute dividends. As per Section 205
of the Companies Act, 1956, a dividend (including interim dividend) can be paid out
of current profits or profits accumulated of earlier years. However, depreciation for
the entire year has to be provided before a dividend is declared or paid. For this
purpose, the Board needs to approve the provisional financial results (unaudited) and
a working of the profits available for distribution as dividend, post providing for
depreciation for the full year and amount required to be transferred to reserves as per
the Companies. 9Sections 205 A, B and C deal with some other aspects of distribution
of dividend such as establishment of Investor Education and Protection Fund,
Payment of unpaid and unclaimed dividend etc.
Separate bank account needs to be opened and the amount of dividend will have to be
transferred to that account. Dividend will have to be remitted within 30 days of
declaration. The other procedure of record date/book closure, payment of tax on
dividend within 7 days of declaration, etc. will have to be complied with. Dividend is
also payable out of divisible profits or out of the money provided by the Central or
any State Government for the payment of dividend in pursuance of a guarantee given
by that Government.
1.9.2 MODE OF DECLARATION
Dividend can be declared out of four sources. Firstly It can be declared out of the
profits of the company for that year arrived at after providing for depreciation in
accordance with the provisions of the Act. Secondly, out of the profit of the company
for any previous financial year or years arrived at after providing for depreciation in
accordance with those provisions and remaining undistributed. Thirdly, out of both
the sources above or lastly, out of the money provided by the Central Government or
State Government for the payment of dividend in pursuance of a guarantee given by
that Government.

9

(Transfer of Profits to Reserves) Rules, 1975

21

1.9.3 PROHIBITION
A company, which has failed to redeem the redeemable preference shares within the
stipulated time, cannot declare dividend.
1.9.4 STEPS INVOLVED IN THE PROCESS OF DECLARATION AND
DISTRIBUTION OF DIVIDEND
a) Computation of depreciation
Depreciation shall be provided either at the rate specified in Schedule XIV of the
Companies Act or any other basis approved by the Central Government.
b) Compulsory transfer of profits to reserves
Before declaring the dividend, some part of the profit has to be compulsorily
transferred to the Reserves of the Company. This amount is based on the proposed
rate of dividend.10 However voluntary transfer of higher percentage to reserves is
permitted subject to the conditions stipulated in the Act.
c) Board resolution
The most important step in the process is the Board Resolution for declaration of
dividends. Unless the Board recommends the payment of dividend, the same cannot
be declared at an Annual General Meeting.
d) Annual General Meeting (“AGM”)
The item pertaining to declaration of dividend should be included in the agenda of the
notice for AGM which should be sent to members as well as the creditors. An
ordinary resolution is required for declaration of dividend. However shareholders
cannot increase the amount of dividend recommended by the Board.

10

The Companies (Transfer of Profits to Reserves) Rules, 1975 set out different thresholds/limits for
the percentage of profits to be transferred to reserves depending upon the extent of the dividend
proposed to be paid. Under the said Rules, if the proposed dividend exceeds 20% of the paid-up capital,
the amount to be transferred to reserves should be at least 10% of the current profits. The Company has
informed us that they have applied this threshold in arriving at the amount of INR 20 crores and have
assumed, for such computation, that the profits (net of tax) for the entire year would be approximately
INR 200 crores.

22

e) Time Limit for payment of Dividend
The dividend account should be opened with the company’s bankers and the dividend
amount payable should be transferred to that account. Within 30 days of the AGM the
dividend warrants should be sent to the shareholders.
f) Transfer to unpaid dividend account
Within 7 days from the date of expiry of 30 days from the date of dividend
declaration, the amount remaining unpaid or unclaimed should be transferred to the
‘unpaid dividend account’ to be opened in a scheduled Bank. Dividend which remains
unpaid or unclaimed for a period of 7 years shall be transferred to the Investor
Education and Protection Fund within a period of 30 days of its becoming due for the
transfer.11
g) Circumstances under which dividend need not be paid
i)Where

it

could

not

be

paid

because

of

operation

of

any

law;

ii) Where a shareholder has given direction to the company regarding payment of
dividend and those directions could not be complied with;
iii)Where there is a dispute regarding the right to receive the dividend;
iv) Where the dividend has been lawfully adjusted by the company against any sum
due from the shareholders; and
v) Where the dividend could not be paid but not due to any default on part of the
company.
h) Tax Limit
In addition to the income tax chargeable in respect of the total income of a company
for any assessment year, any amount declared, distributed or paid by such company
by way of dividends (whether interim or otherwise) and also whether paid out of
current or accumulated profits is charged with additional tax at the rate of 15 %.12 The

11

Governed by Investor Education and Protection Fund (Awareness and Protection of Investors) Rules,
2001 and section 205 C of the Act

12

Excluding surcharge and cess (which may vary every financial year)

23

liability of payment of tax is on the principle officer of the company. The tax has to be
paid within 14 days of declaration, distribution or payment of any dividend whichever
is the earliest. The tax on distributed profit paid by the Company would be treated as
the final payment of tax in respect of dividend.
i) Special Provisions relating to Listed Company
In addition to the steps mentioned above the listed companies also need to advance
intimation regarding the venue of the Board Meeting to the stock exchange where the
securities are listed. Within 15 minutes of the closure of the Board meeting,
intimation is also to be sent to the stock exchange containing the particulars of
dividend. Details regarding the general meeting for the declaration of dividend are
also to be given to the Stock Exchange.
It is clear from the above discussions that there are various steps, which are usually
involved in the declaration and distribution of dividend by a company incorporated
under the Act. However depending upon the facts and the memorandum and articles
of the company there might be some variation or addition to these steps.

1.10 DIVIDEND PAYMENT PATTERNS ACROSS THE LIFE
CYCLE OF A FIRM.
There are distinct differences in dividend policy over the life cycle of a firm, resulting
from changes in growth rates, cash flows, and project investments in hand. Firms
generally adopt dividend policies that suit the stage of life cycle they are in. For
instance, high- growth firms with larger cash flows and fewer projects tend to pay
more of their earnings out as dividends. In a promising start-up firm initiated by a
small group of entrepreneurs using their own capital, perhaps supplemented by funds
from family members and/or venture capitalists. At the same time outsiders
understand little about the firm and its prospects. Management believes that growth
prospects are outstanding but, to finance this growth, capital requirements will be
large. However, access to the capital markets on any reasonable terms is not possible.
Accordingly, at this early stage of the firm's life cycle, no dividends are practical.[11]

24

After a period of sales and asset increases, along with favorable earnings growth, the
firm undertakes an initial public offering. At this point the underwriters, as well as the
disclosure mandated by SEBI filing requirements, serve as the signaling device for the
market. However, ownership is still heavily concentrated among insiders and capital
requirements are large. In order to issue debt financing on reasonable terms, the firm
writes tight dividend constraints. Again, through this period of the firm's life cycle, a
zero payout is best.
During a rapid growth phase with favorable earnings increases, the firm begins to tap
the capital markets with debt issues and seasoned equity sales, although most of the
investment is still financed with internally generated funds. Ownership concentration
begins to fall as new equity investors are added. Some institutional investors begin to
take positions in the firm. With frequent tapping of the capital markets, disclosure
increases and the level of asymmetric information begins to fall.
Even though the firm has heavy investment needs, it may begin to pay a modest
dividend to establish a dividend track record and appeal to a broader group of
institutional investors. Competition begins to challenge the firm's dominant market
position. The dividend constraint in the new debt issues is reduced, and the firm starts
to build its capacity for dividend payments, or its reservoir of payable funds, for
periods in which it will face declining investment opportunities.
As the firm matures it attracts growing institutional ownership, and the ownership
level of officers and directors shrinks. Periodic external financing and continuous
following by analysts reduces asymmetric information. However, positive NPV
projects are harder to discover and sales growth slows. Potential agency costs begin to
develop as the classic problem of the separation of ownership and control arise.
Although leverage ratios remain at levels consistent with the firm's basic business
risk, the firm may gradually increase its dividend payout in a sustainable manner
based on forecasts of free cash flows.
Finally, further market erosion and new technology began to supplant the firm's basic
markets. Operating cash flows far exceed investment requirements. Potential agency
problems become increasingly large. The firm can begin to self-liquidate through
extremely high dividend payout levels.

25

The dividend policies of firms may also follow several interesting patterns adding
further to the complexity of such decisions. First, dividends tend to lag behind
earnings, that is, increases in earnings are followed by increases in dividends and
decreases in earnings sometimes by dividend cuts. Second, dividends are “sticky”
because firms are typically reluctant to change dividends; in particular, firms avoid
cutting dividends even when earnings drop. Third, dividends tend to follow a much
smoother path than do earnings. Especially the companies that are vulnerable to
macroeconomic vicissitudes, such as those in cyclical industries, are less likely to be
tempted to set a relatively low maintainable regular dividend so as to avoid the
dreaded consequences of a reduced dividend in a particularly bad year.

1.11 DIVIDEND DISTRIBUTION AND ITS IMPACT ON
SHAREHOLDERS’ VALUE
There are two divergent schools of thought on dividend policy. One school of thought
believes that on dividend policy, while the other school of thought advocates that
dividend decision is irrelevant to the determination of the value of the firm. The set of
people who believe that dividend policy affects the value of the firm link the dividend
policy to investment opportunities available in comparison with the expectations of
shareholders.
Assuming sufficient business opportunities are available to the firm, then the dividend
policy affecting firm’s value will depend upon the returns that are being offered by
these opportunities, compared to the expectations of shareholders. If these business
opportunities offer higher returns than the expectations of shareholders, then a
dividend policy oriented towards retention of earnings for exploiting new business
will be more rewarding to shareholders than a policy that favors distributing the
earnings and forgoing any profitable business opportunities. In such situations, the
dividend policy favoring retention of earnings should lead to a larger increase in value
of the firm than dividend policy favoring distribution of earnings.
On the contrary, if variable business opportunities provide a return that is less than
expected return to the shareholders, then retention of earnings to finance the new

26

business opportunities will diminish the value of the firm rather than adding to it. In
such a situation, distributing earnings to shareholders, rather than retaining them in
the business, will be advisable. A dividend policy favoring greater payout will add
more value to the firm.
Shareholders wealth is represented in the market price of the company’s common
stock, which, in turn, is the function of the company’s investment, financing and
dividend

decisions.

Managements’

primary

goal

is

shareholders’

wealth

maximization, which translates into maximizing the value of the company as
measured by the price of the company’s common stock. Shareholders like cash
dividends, but also like the growth in EPS that results from ploughing earnings back
into the business. The objective of the finance manager should be to find out an
optimal dividend policy that will enhance value of the firm. It is often argued that the
share prices of a firm tend to be reduced whenever there is a reduction in the dividend
payments. Announcements of dividend increases generate abnormal positive security
returns, and announcements of dividend decreases generate abnormal negative
security returns. A drop in share prices occur because dividends have a signaling
effect. According to the signaling effect mangers have private and superior
information about future prospects and choose a dividend level to signal that private
information. Such a calculation, on the part of the management of the firm may lead
to a stable dividend payout ratio.
It has been recognized by various research studies that a dividend policy could make
significant impact on corporate future value when established and carefully followed.
The goal of wealth maximisation is widely accepted goal of the business as it
reconciles the varied, often conflicting, interest of the stakeholders.
The interest in shareholders value is gaining momentum as a result of several recent
developments:


The threat of corporate takeovers by those seeking undervalued, under
managed assets.



Impressive endorsements by corporate leaders who have adopted the approach.

27



The growing recognition that traditional accounting measures such as EPS and
ROI are not reliably linked to the value of the company’s shares.



Reporting of returns to shareholders along with other measures of performance
in business press.



A growing recognition that executives’ longterm compensation needs to be
more closely tied to returns to shareholders.

The “shareholders value approach” estimates the economic value of an investment
(e.g. shares of a company, strategies, mergers and acquisitions, capital expenditure) by
discounting forecasted cash flows by the cost of capital. These cash flows, in turn,
serve as the foundation for shareholder returns from dividends and share price
appreciation.
A going concern must strive to enhance its cash generating ability. The ability of a
company to distribute cash to its various constituencies depends on its ability to
generate cash from operating its business and on its ability to obtain any additional
funds needed from external sources. Debt and equity financing are two basic external
sources. Borrowing power and the market value of the shares both depend on a
company’s cash generating ability. The market value of the shares directly impacts the
second source of financing, that is, equity financing. For a given level of funds
required, the higher the share price, the less dilution will be borne by current
shareholders. Therefore, management’s financial power to deal effectively with
corporate claimants also comes from increasing the value of the shares. This increase
in value of shares can be brought about by rewarding shareholder with returns from
dividends and capital gains.
The most famous statement about the relationship between dividend policy and
corporate value claimed that, in the presence of perfect markets, “given a firm's
investment policy, the dividend payout policy it chooses to follow will affect neither
the current price of its shares nor the total return to its shareholders”. However,
"market imperfections as differential tax rates, information asymmetries between
insiders and outsiders, conflicts of interest between managers and shareholders,
transaction costs, flotation costs, and irrational investor behaviour might make the
dividend decision relevant”.
28

The relevance of dividend policy to corporate value is due to market imperfections.
Shareholders can receive the return on their investment either in the form of dividends
or in the form of capital gains. Dividends constitute an almost immediate cash payment
without requiring any selling of shares. On the contrary, capital gains or losses are
defined as the difference between the sell and buy price of shares. Friction costs are
one of the market imperfections and are further distinguished in transaction costs,
floatation costs and taxes. Another market imperfection is that of information
asymmetries between the insiders (e.g. managers) and the outsiders (e.g. investors).
Agency conflicts, stemming from the different objectives of company's stakeholders,
form the third market imperfection. Finally, there are some other issues that are related
to dividend policy and cannot be placed among the previously mentioned
imperfections.
The significance of Modern goal of Shareholders’ Wealth maximization in Corporate
Finance and its linkage with dividend decision has been reflected in the above text.
Therefore, one of the objectives of this research is to study the relationship between
the shareholders’ wealth and the dividend payout and to analyse whether the dividend
announcements has an effect on wealth of the shareholders as reflected by
shareprices.

1.12 DIVIDEND PAYMENTS: AN INDIAN SCENARIO
In this segment a brief outline of the findings of the major studies done in Indian milieu
is given. The dividend payment patterns and trends of various Indian companies are
highlighted.
Reddy Y.Subbba and Rath Subhrendu (2005) examined the dividend behavior of
Indian corporate firms. Dividend trends for large sample of stocks traded on Indian
markets indicated that the percentage of companies paying dividend declined from over
57% in 1991 to 32% in 2001, and that only a few firms paid regular dividends. Even
though regular payers consistently paid higher dividends than did other firms, on
average. Dividend-paying companies were less likely to be larger and more profitable
than non-paying companies, though growth opportunities do not seem to have

29

significantly influenced the dividend policies of Indian firms. Overall for all firms,
investment opportunities faced by Indian firms do not show any distinguishing pattern
or trend over the years. The rise of the number of firms not paying dividends is not
supported by the requirements of cash for investments. [15],[16]
In a study done by Sharma Dhiraj, “Are dividends in vogue in India? An empirical
study of Sensex companies”, the dividend behavior of the Indian firms with the help of
signaling and tax effect theory for 1990-200513 was analyzed. It was found that firms
paying dividend during this period have followed continuous progressive trend. In the
recent years, companies in the growth sector like software firms have paid greater
dividends as compared to other sectors firms. The level of dividend payout has
increased substantially from Rs. 167.97 crores to Rs. 13602.20 crores in 2005. The
level of average dividend has also gone up from Rs. 6.46 crores in 1990 to 523.18 crore
in 2005. Though the dividend behavior has followed a continuous up trend, there have
been variations in each year‘s payout pattern. In 1998, the level of dividend payout fell
down drastically due to tax imposition on payers by Indian government in 1997, but
unlike this, the year 2004 did not show any substantial increase in dividend payout
behavior of companies even after the withdrawal of taxes in the hands of shareholders
in 2003.Similarly, 2000 and 2004 witnessed low dividends in comparison to the
previous years, due to the instable political environment and volatile market conditions.
The following Table1.1 shows the percent increase or decrease in the level of average
dividend from preceding year.

13

The data shown under this section draws heavily from Sharma Dhiraj, “Are dividends in vogue in
India? An empirical study of Sensex companies”, The ICFAI journal of Applied Finance, March 2007

30

Table 1.1: Dividend payout of Sensex 30 companies
Year

Total Payout (Rs.

Average Dividend

Percent change

Crore)
1990

167.97

6.46

1991

356.31

13.71

112.23

1992

429.62

16.52

20.50

1993

546.56

26.02

57.50

1994

890.42

34.25

31.63

1995

1297.21

49.89

45.66

1996

1854.14

71.31

42.94

1997

2244.30

86.32

21.05

1998

244.30

94

8.90

1999

3236.00

124.46

32.40

2000

3885.60

149.45

20.10

2001

5121.05

196.96

31.79

2002

6860.70

263.87

33.97

2003

10684.04

410.93

55.73

2004

11768.33

452.63

10.15

2005

13602.70

523.18

15.59

The dividend yield is a simple measure that tells the shareholders and investors what
would be the return from owning a stock irrespective of any capital gain or loss. It is
worth mentioning here that new companies either do not pay dividend or pay small
one. The underlying notion is that they are investing in future of the business rather
than returning cash to shareholders. Only mature and old companies pay a high yield
.The average dividend yield of the Indian firms have gone up from 5.655% in 1990 to
17.5% in 2005, which is a 210% increase. Thus, it can be inferred that dividend yield
has increased over the years showing that companies have generated more income per
share as one moves from 1990 to 2005.[17]
Table 1.2 given below shows that growth does not follow a consistent pattern. There
are substantial variations in the shareholder’s dividend yield. Since dividend yield is
not only a function of dividend payout but also of market price of the stock. The
fluctuations in the yield can be attributed to the volatility in stock prices.

31

Table 1.2: Dividend yield of Sensex 30 companies
Year

Dividend yield (%)

Total Yield (%) Average

1990

454.95

17.50

1991

274.87

10.57

1992

427.46

16.44

1993

317.34

12.21

1994

311.23

11.97

1995

239.04

9.19

1996

360.25

13.86

1997

274.68

9.68

1998

251.74

10.51

1999

242.48

9.35

2000

223.89

8.61

2001

157.47

6.06

2002

185.60

7.14

2003

88.23

3.40

2004

301.10

11.58

2005

146.99

5.65

From the trends in the payout, it is apparently conspicuous that the Indian firms are
distributing dividend consistently14. The market recognizes and favors the dividend
distribution decisions of a firm. The fact that such a large number of firms in India are
paying dividends and continuous progressive upward trend reveals that “Dividend
decisions are relevant” as far as the Indian firms are concerned. Thus it can be said,
“Dividends are still in vogue in India”. These results are in sharp contrast to the
prediction of the made by Y.Subbba Reddy and Rath Subhrendu (2005) in their study
that there would be decline in dividend payments in the time to come.
Singhania Monica (2005) studied 590 manufacturing, non-government, non-financial,
non-banking companies listed on the Bombay Stock Exchange for a period from 1992
to 2004. The sample companies were categorized into payers and non payers, in the
period understudy. Payers were further classified into regular payers, initiators and

14

The conclusion has been made based on the dividend payout of Sensex 30 companies.

32

current payers. Non-payers companies were further categorized as never paid, former
payers and current non-payers.
It was found that the percentage of companies paying dividends declined from 75.93 %
in 1992 to 63.73 % in 2004.Total non-payers steadily increased from 1992 upto 1996
but increased thereafter. Companies, which have never paid continuously declined
throughout the sample period from 86% in 1991-92 to 16% in 2003-04.The number of
companies, which have paid dividend at some point during the period of study,
increased over time and reached almost 80% of non payers in 2004.
It was evident from the findings that companies in payer group have declined. In payer
group, regular payers and initiators have consistently declined whereas current payers
continuously increased. It can be inferred from the study that the never-paid companies
and former payers have consistently declined while current no payers increased
throughout the sample. The total number of companies paying dividend increased upto
1996 and registered a sustained decline therafter, except for the year 2004 where there
is an increase.
Among the sample companies, regular payers are more in number as compared to
initiators and current payers throughout the period of study, ranging from 430
companies in 1993 to 239 companies in 2004 and have paid higher average dividend
compared to that of current payers and initiators. Further, current payers paid higher
dividend compared to initiators except in the year 1995. The number of initiators
declined throughout the sample period from 30 in 1993 to 4 in 2004, whereas current
payers steadily increased in number from 35 in 1994 to 133 in 2004 throughout the
period of study.
An analysis of average percentage dividend payout during 1992-2004 showed a
volatile trend.Percentage increased from 25.47 in 1992 to 46.02 in 1997 and then
showed a declining trend till 2000 before reaching the peak average percentage DPR
of 67.86 in 2004. However, 1% trimmed average percentage DPR showed a more
stable pattern, ranging between 22–40% up to 1997 and then recorded a declining
trend up to 2000 before finally reaching 57.37 percent in 2004.An analysis of
industry-wise DPR showed an increasing trend across all industries during the sample

33

period . Companies in the business of metals and metal products registered a stable
pattern of around 25% in dividend payout throughout the sample period.
Table 1.3 : Average Percentage Payout During 1992-2004
Year

Average % Payout

Std. Deviation

1% Trimmed Average% Payout

1992

25.47

57.85

22.54

1993

29.46

49.63

27.34

1994

29.84

38.97

28.37

1995

30.15

38.01

28.84

1996

38.98

103.94

34.39

1997

46.02

100.07

41.90

1998

38.51

68.80

35.74

1999

47.93

218.67

37.25

2000

37.71

76.62

35.03

2001

43.75

91.99

41.12

2002

49.73

152.90

42.56

2003

48.69

146.52

42.61

2004

67.86

246.75

57.37

The aforementioned trends largely indicated that among the sample companies, the
number of those declaring dividend in any given year has declined over the period of
study from 448 in 1992 to 376 in 2004. However, the average dividend payout ratio
increased significantly over the period of study. This implies that those companies,
which declared dividend, paid high amounts as dividends over the period of study.
Dividend payout ratio showed a volatile trend, ranging from about 25 to 68%
during1992-2004. In addition, wide industry-wise fluctuations are visible over the
period of study. Moreover, a major proportion of the sample companies follow a

34

dividend policy of part retention of profits and part distribution of profits over the
period of study.
It is known that primarily, there are three basic approaches regarding dividend policy:
1. One hundred per cent retention of profits i.e. no dividend: Some managements may
prefer to plough back their entire earnings indefinitely on the consideration of
financial stability of the company.
2. One hundred per cent distribution of profits, i.e., no retention: Some managements
may prefer to distribute all the earnings to the shareholders. This is carried out in
order to give the due share of profits to the shareholders.
3. Part distribution and part retention of profits: Some managements prefer to adopt a
course between the first and second policy. They plough back a part of the earnings
and distribute the remaining part among shareholders.
The study also highlighted that predominantly a major proportion of the sample
companies follow a dividend policy of part retention of profits and part distribution of
profits over the period of study. However, companies following such a dividend
policy have declined from about 75% in 1992 to about 56% in 2004. Conversely,
companies following a policy of 100% retention of profits have increased over the
period of study from 142 in 1992 to 214 in 2004 (i.e., from about 24% in 1992 to
about 36% in 2004).
It may be emphasized that companies following a dividend policy of 100%
distribution of profits have been an insignificant number (i.e., below 1% of sample
companies) throughout the period of study. However, companies following such a
dividend policy have increased in number from 5 in 1992 to 46 in 2004 over the
period of study. [18]
The various studies done in Indian context have several implications but there is no
consensus as to what should be the dividend policy of the firms in India. Therefore it
becomes important to study dividend behavior of Indian companies using the
framework of empirical models.

35

1.13 DIVIDEND POLICY: THE GLOBAL PERSPECTIVE
Dividends are important in other countries where public companies are a common
form of corporate organization. However, economic environments around the world
differ in terms of laws, regulations, and customs. Consequently, dividend policies
systematically vary from country to country. For example, cash dividend payments
are smaller and less relevant for firms in Japan, Switzerland, and Israel but are
relatively more important in Canada and the United Kingdom. The frequency of
dividend payments also varies from country to country. Dividends typically are paid
quarterly in the United States and Canada, but most firms in Finland, Italy, and many
other countries pay dividends annually.
In the following sections the dividend payment patterns and trends in countries in
Europe, the Pacific Rim, and North America has been discussed. These countries have
developed sophisticated economic and capital market systems and their financial
markets are studied frequently by researchers.
1.13.1 DIVIDEND SIZE AND FREQUENCY ACROSS THE WORLD
The average annual dividend yield in the European industrial countries, such as
Germany, France, Switzerland, and Italy, is between 2.5 percent and 3.5 percent. This
yield is less than the 4 percent average annual dividend yield in Canada and the
United States.
Most firms in these European countries pay dividends only once a year. Again, this
practice is in contrast to the United States and Canada, where dividends are typically
declared quarterly and sometimes even monthly. The European country that seems
unique in its firms' dividend policies is the United Kingdom. There, average dividend
yields are higher (6.12 percent, according to one study) and dividends are paid
semiannually. In recent years, most Japanese firms have increased their annual
dividends and now declare dividends more frequently (twice a year rather than once).
Moreover, firms have to pay dividends in order to be listed on the Tokyo Stock
Exchange

36

1.13.2 INSTITUTIONAL FEATURES
The differences in dividend practices throughout the world can be attributed to unique
institutional features in various countries. In most European countries and Japan,
shareholders must typically approve the proposed dividend. In Germany, Switzerland,
Brazil, and several other countries, the law specifies the minimum percentage of
earnings that must be distributed as dividends. However, corporations in these
countries usually are able to exploit loopholes in the tax code to circumvent these
requirements. In Switzerland, firms raise considerable equity and simultaneously pay
dividends. The information provided to the market concerning forthcoming dividend
payments ranges from being available at the beginning of the ex-dividend month in
Switzerland to the absence of any dividend announcement prior to the ex-dividend
day in Japan.
1.13.3 TAX DIFFERENCES
A variety of tax codes, which change frequently as tax reforms are passed in various
countries, also can have an important effect on dividend policies. Dividends and
capital gains are the alternative sources of return for shareholders, but, in many
countries, there are no capital gains taxes or they were introduced for the first time
during the last decade of 20th century. For instance, in Canada capital gains taxes were
introduced in the tax reform of 1971 and in Japan in the tax reform of 1988. In Israel,
the government attempted to introduce capital gains taxes in 1994 but backed down
under public pressure in 1995.
In contrast, capital gains have been taxed in the United States since early in the
twentieth century. Under the U.S. tax code, capital gains received a preferential tax
treatment relative to dividends between 1921 and the Tax Reform Act of 1986, when
the rates were equalized. However, since the Omnibus Reconciliation Act of 1993,
capital gains again have been taxed at a lower rate than dividends in the United States.
In 1997, the capital gains tax rate was lowered again relative to dividends. U.S.A has
removed the dividend tax both from companies and the recipients. Dividends received
by low income individuals were taxed at a 5% until December 31, 2007 and will
become fully untaxed in 2008.These provisions are set to expire on January1,

37

2011.This way the government can keep check on the income of rich and exempt the
small shareholders as well.
In England there are two different Income tax rates on dividends. The rate an
individual pays depends on whether the overall taxable income (after allowances)
falls with in or above the basic rate Income tax limit, varying from 10-32.5%
In India, the dividend distribution tax was first introduced by Finance Act of 1997,
was accepted by the Finance Minister, Yashwant Sinha ,while presenting Finance Bill
for 2002-03.Before that, dividends were taxed in hands of the recipients as any other
income. This tax was again abolished in the year 2002.The budget for the financial
year 2002-2003 proposed the removal of dividend distribution tax bringing back the
regime of dividends being taxed in the hands of the recipients and the Finance Act
2002 implemented the proposal for dividends distributed since 1 April 2002. But
presently, the new dividend distribution tax rate for companies was higher at 12.5%,
and was increased with effect from 1st April 2007 to 15%.This Dividend distribution
tax(DDT) was introduced by Section 115(O).In addition to the company tax, the
Government sought to tax dividends distributed by the companies. However the
introduction of DDT has evoked several controversies and debates in India. It has
been severely criticized by the companies on the pretext of double taxation. Dividend
is paid after paying income tax on the profits earned by the companies. DDT is further
levied on profits distributed to shareholders of a company. The profits of the company
are supposed to be the income of shareholders. This way they as part owners i.e. the
shareholders have already been taxed. DDT thus amounts to double taxation.
Shares or mutual funds become long term assets after one year of holding in Indian
context. Sale of such long-term assets gives rise to long term capital gains. As per
Section 10(38) of Income Tax Act, 1961 long term capital gains on shares or
securities or mutual funds on which Securities Transaction Tax (STT) has been
deducted and paid, no tax is payable. STT has been applied on all stock market
transactions since October 2004 but does not apply to off-market transactions and
company buybacks; therefore, the higher capital gains taxes will apply to such
transactions where STT is not paid. However short term capital gains, on sale of
shares and mutual funds are taxed at the rate of 10% under section 111A where STT

38

is paid from Assessment Year 2005-06 as per Finance Act 2004. For Assessment Year
2009-10 the tax rate is 15%.
Dividend tax laws vary greatly among countries. The Canadian tax code calls for a
dividend tax credit, although the details change from time to time (e.g., the tax reform
of 1971). A dividend tax credit is part of the tax code in Japan and also was adopted
in Germany in 1977. In the United Kingdom, a dividend imputation system is used off
and on, depending on whether the Conservative Party or the Labour Party is in
power.15 A complicated dividend imputation system also was in place in Australia
until recently. In New Zealand, until 1985, dividends were taxed or not taxed,
depending on the source of the funds that financed the dividend. In Italy, dividends on
registered stocks and savings stocks are taxed at different rates. The tax code for
individuals in the United States is costly for shareholders. Dividends are subject to
taxation both at the corporate and the individual level. Further, the United States has
no tax credit or imputation system, although from time to time small amounts of
dividend income are exempted from taxation. Tax laws for corporate income from
dividends also are different in various countries, although the general rule in most of
them is that corporate investors enjoy a preferential tax treatment of dividend income.
1.13.4 DIVIDEND PAYOUT PATTERNS AROUND THE WORLD
Despite the statistical differences in the characteristics (size, yield, frequency, etc.) of
the dividend streams of corporations in various countries—and the range of tax laws,
regulations, and institutional features— some similarities can be pointed out in
corporate dividend policies in various countries. Specifically, dividend smoothing
seems to be a management tendency everywhere which is in alignment with findings
of classic study
Lintner's (1956) on corporate dividend decisions in the United States(Refer to the
Literature review section for details). Numerous researchers have replicated Lintner's
methodology and have observed similar corporate payout decisions in different
countries. These researchers, using variations of Lintner's model, have documented
patterns of dividend streams similar to those he found for U.S. companies. The
15

In an imputation system the personal tax liability on dividends is reduced by the amount of taxes the
corporation paid on the income that was used to pay out the dividend. The rationale for this system is
the desire to avoid double taxation of corporate income.

39

evidence suggests that managers tend to maintain smooth dividend payout patterns;
they pay out stable amounts of dividends and avoid sudden changes, especially cuts in
dividends. This practice transcends national boundaries.

1.14 RELEVANCE AND SCOPE OF THE STUDY
Previous empirical studies have focused mainly on developed economies like UK and
US. The study undertaken looks at the issue from emerging markets perspective by
focusing exclusively on Indian Information Technology, FMCG and Service sector
respectively. The major objective of this research is to empirically examine rationale
for stable dividend payments by finding the applicability and validity of Lintner Model
in Indian scenario. Inspite of importance of dividend policy decisions various
theoretical determinants of dividend decision are not well established. Therefore, the
present research work also seeks to examine and identify the relative importance of
some of known determinants of dividend policy in Indian context.
Empirical research on corporate governance and dividend payout policies has mostly
concentrated on developed economies like US and UK and Japan. Some studies in
Indian context before 2000, have provided evidence of ownership as one of the
important variable that influences dividend payout policies. The relationship between
ownership and dividends is different for different classes of owners and at different
levels, which suggests that influence of ownership structure on dividend payout policy
is non linear. The impact on dividend payout changes with the change in holding size
as well as with their identities. However, some recent studies have found that
ownership is not a significant variable affecting dividend payout policy of a firm. The
research work also has made an endeavor to bring to light the influence of ownership
groups of a company on dividend payout behavior of a firm.
This research has also tried to unfold the relationship between the shareholders wealth
and the dividend payout and analyse whether the dividend payout announcements
affects the wealth of the shareholders. The findings would bring to light whether
Dividend relevance or Dividend irrelevance hypothesis holds good in IT,FMCG and
Services sector in India.

40

Given the diversity in corporate objectives and environments, it is conceivable to have
divergent dividend policies that are specific to firms, Industries, markets or regions.
Through the research an attempt has been made to suggest how dividend policy can be
set at micro level. Finance mangers would be able to examine how the various market
frictions such as asymmetric information, agency costs, taxes, and transaction costs
affect their firms, as well as their current claimholders, to arrive at reasonable dividend
policies. Previous research studies have focused on dividend payment pattern and
policies of developed markets, which may not hold true for emerging markets like
India. In Indian Context, few studies have analysed the dividend behavior of corporate
firms and focused on Indian cotton textile Industry, Banking sector and Manufacturing
sector. However, it is still not apparent what the dividend payment pattern of firms in
India is. Very few studies have analyzed the dividend behavior of corporate firms in
the Indian context. To date, most studies have paid attention on influence of cash flows
or earnings on the dividend payment of a firm.
Further, for the dividend policy makers of the Indian IT, FMCG & Service Industry,
the study may prove to be useful for re-sketching their dividend policy keeping in view
the analysis, results and discussions presented. Through the research one can have
better understanding of the factors that should systematically affect firms’ payout
decisions. It also gives insight into what kind of ownership structure is beneficial for
the shareholders.

1.15 CHAPTER PLAN
The research is organized into nine chapters. Chapter One introduces the topic and the
research. This chapter familiarizes the readers with the dividend puzzle. It throws light
on the theoretical background, genesis, concept and meaning of dividends. The
primacy and importance of dividend decision has also been discussed in this chapter.
The chapter also talks about the dividend trends in India and in other countries.
Literature Review has been discussed in details in chapter Two. Both conceptual
models and methodological and empirical studies done till date in India and abroad
related to the research objectives has been incorporated in this chapter. Chapter three
gives an Overview of the industry. This chapter highlights briefly the financial

41

performance, growth prospects, and characteristics of the various sectors chosen for
study. Chapter four is focused on Research Methodology adopted for the
accomplishment of the research objectives. This chapter discusses in detail the various
models developed, tools and techniques used for analyzing the research objectives.
The next four chapters deals with the data analysis. Chapter Five covers the empirical
analysis of the Lintner model proposed by John Lintner (1956) in the three sectors
under study. The chapter highlights the target payout ratios and speed of adjustment
coefficients of each sector respectively using pooled and panel data analysis. Chapter
six highlights the model developed to identify the corporate Dividend Policy
determinants. It contains the analysis and findings of factor analysis and Multiple
Linear Regression analysis in each of the sectors respectively. Chapter seven discusses
in detail the data analysis and findings of quadratic polynomial regression analysis.
This model has been developed to find the impact of various ownership groups on the
dividend payout ratios. Chapter eight unfolds the impact of dividend announcement on
shareholder’s wealth as reflected by the share prices through the use of most
sophisticated technique in Corporate Finance i.e. Event study. The chapter reports
whether the abnormal returns are generated on dividend announcement or not. Chapter
nine summarizes and concludes the research. It also brings to light the future areas of
research.

1.16 CONCLUSIONS
Cash dividends as a payout mechanism are an important method of rewarding
shareholders everywhere in the world where public companies are a common form of
corporate organization. However, economic environments differ from country to
country in terms of laws, regulations, and customs. Consequently, dividend policies
vary among countries in terms of relevance, payment frequency, dividend size, and
the decision-making process.
Corporate dividend policies are similar in certain respects all over the world.
Specifically, the smoothing of dividends appears to be a common management
practice everywhere.

42

Much of the research in the global scenario has examined the different institutional
features in various countries to analyze the impact of market imperfections on
dividend policy. The idea is to shed light on some puzzles associated with dividend
policies by examining how a variety of economic and market settings affect dividend
decisions.
The major purpose the present study is to empirically examine rationale for dividend
existence by finding the applicability and validity of Lintner dividend Model in Indian
scenario. The present research work also seeks to examine and identify determinants
of dividend policy in Indian context with specific focus on Information Technology,
FMCG and Service sector. The ownership pattern of Indian companies is disperse.
Therefore, the study is an endeavor to investigate to what extent ownership structure
can influence dividend payout of the company. As discussed in the chapter two
schools of thought exist, one that are proponents of Dividend relevance hypothesis
and other that refutes dividends linkages with shareholders’ wealth and support
dividend irrelevance hypothesis. The research work also strives to find the impact of
dividend announcements on shareholders’ wealth in IT, FMCG and Service sector. So
far to the best of our knowledge this is the very first attempt to study dividend
behavior in these three sectors respectively. The research findings could be useful for
CFO’s of these sectors in framing an optimal dividend policy and shareholders who
plan to invest in the sectors under study.

43

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