Page 300 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes are higher than normal in a given period. By terming the additional dividend as extra dividend,
the firms avoid giving shareholders false hopes. This policy is especially common among
companies that experience cyclical shifts in earnings.
14.2.2 Factors affecting Dividend Decisions

Most investors have two forms of return from the purchase of common shares. These are:
1. Capital gains: The investor expects an increase in the market value of the common shares
over a period of time.

Example: If the stock is purchased at 40 and sold for 60, the investor will realize a
capital gain of 20. Capital gain may be defined as the profit resulting from the sale
of capital investments, in this case common shares.
2. Dividends: The investor expects at some point, a distribution of the firm’s earnings. From
mature and stable organizations, most investors expect regular dividends to be declared
and paid on the common shares. This expectation takes priority over the desire to retain
earnings to finance expansion and growth.
The three major factors explain the investor’s priority of dividends over capital gains:
1. Reduction of uncertainty: The promise of future capital gains or a future distribution of
earnings, involves more uncertainty than a distribution of current earnings.
2. Indication of strength: The declaration and payment of cash dividend carries some sort of
confidence that the firm is reasonably strong and healthy.
3. Need for current income: Many shareholders require a regular flow of income through
their investments, for their day-to-day expenses.

Constraints on paying dividends from the firm’s point of view: Though most firms recognize
the investors demand for dividends, several factors may restrict the firm’s ability to declare and
pay dividends. These are:
1. Insufficient cash: Although a firm may have earned enough income to declare dividends
but may not have sufficient cash to pay the dividends. The firm’s liquid funds may have
been tied up in receivables or inventory or may be short on liquid funds because of
commitment to fixed assets.

2. Contractual restriction: Like a bond indenture that restricts the dividend pay out to 20%
of earnings during the tenure of the bond or the firm, agreeing as a part of a contract with
a creditor to restrict dividend payments.
3. Legal restrictions: Occasionally, a firm will be legally restricted from declaring and paying
dividends unless a certain portion of current profits is ploughed back into business by way of
retained earnings. Companies (Declaration of Dividend out of Reserves) Rules 1975 provides
for such restrictions. Further dividends can be paid only out of the profits earned during the
financial year after providing for depreciation (Sec. 205 of the Companies Act, 1956).

Importance of Stability of Dividends

A number of arguments can be given to underline the importance of steady dividend payments
including:

1. Perception of stability: When a firm pays regular dividend it is considered as a sign of
continued normal operations. On the other hand, a reduction in dividend payment will be

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