Dividend policy

01/July/2025 01:06 Share:

Dividend Policy

Definition

Dividend policy refers to the guidelines a company follows to decide how much profit will be distributed to shareholders as dividends and how much will be retained in the business. It affects the company's capital structure, investor relations, and market value.

Basic Issues in Dividend Policy

Whether to pay dividends or retain profits for reinvestment
How much dividend to pay (payout ratio)
Timing and frequency of dividend payments
Form of dividend – cash or stock (bonus shares)

Factors Affecting Dividend Policy

Factor	Explanation
Earnings Stability	Companies with stable earnings can pay regular dividends.
Liquidity Position	Cash availability affects the ability to pay dividends.
Investment Opportunities	Firms may retain profits to invest in new projects.
Shareholder Preferences	Some investors prefer regular dividends over capital gains.
Tax Policies	Dividend taxation influences investor preference.
Access to Capital Market	Easy access encourages higher dividend payouts.
Legal Restrictions	Laws may limit dividend payments in certain situations.
Inflation & Economic Trends	Inflation reduces purchasing power, affecting dividend value.

Types of Dividend Policy

Stable Dividend Policy: Fixed dividends are paid regardless of profits.
Constant Payout Ratio: A fixed percentage of earnings is paid as dividend.
Residual Dividend Policy: Dividends are paid after all investment needs are met.
No Dividend Policy: Entire profits are retained for expansion or restructuring.

Models of Dividend Policy

1. Walter’s Model

Assumes dividend policy affects firm value based on return on investment and cost of capital.

P = (D + [(r/k) × (E - D)]) / k

If r > k → Retain earnings
If r < k → Pay higher dividends
If r = k → Dividend policy is irrelevant

Example: EPS = ₹10, DPS = ₹6, r = 20%, k = 10%
P = [6 + (20/10 × (10 - 6))]/0.10 = ₹140

2. Gordon’s Model (Bird-in-Hand)

Investors prefer certain dividends now over uncertain capital gains in the future.

P = E(1 - b) / (k - br)

b = Retention ratio, r = Return on investment, k = Cost of capital

Example: EPS = ₹10, b = 0.4, r = 15%, k = 10%
P = 10(1 - 0.4) / (0.10 - 0.4×0.15) = ₹150

3. Modigliani and Miller (MM) Hypothesis

Suggests dividend policy is irrelevant in a perfect market — investor wealth depends on firm’s investment decisions, not dividend payments.

Assumes no taxes, no transaction costs, and rational investors.
Dividend payment has no effect on firm’s value.

Example from Industry

Infosys Limited follows a balanced dividend policy, distributing consistent dividends while retaining enough earnings for expansion. Its stable dividend payout has helped maintain investor confidence and stock value.

Conclusion

Dividend policy is a strategic decision that impacts both the firm’s internal financing and shareholder satisfaction. Models like Walter’s and Gordon’s support the relevance of dividends in determining firm value, while MM theory considers it irrelevant under ideal market conditions. In real practice, a balanced dividend policy — maintaining regular returns while supporting growth — is most effective.

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