Page 195 - DMGT409Basic Financial Management

Basic Financial Management

Notes 4. Providing funds for research, and development of new and improved products to replace
the existing products before they decline.

12.1 Meaning of Dividend Policy

The term ‘dividend’ refers to that portion of company’s net earnings that is paid out to the equity

shareholders (not for preference shareholders, since they are entitled to have a fixed rate of

dividend). Dividend policy of a firm decides the portion of earnings is to be paid as dividends to
ordinary shareholders and the portion that is ploughed back in the firm for investment purpose.

The total net earnings of equity may be paid as dividends (100% dividend payout ratio), which
may consequently result in slower growth and lower market price or a part of net earnings may
be paid as dividends, higher capital gains and higher market price. When a company uses a part
of its net earnings for dividend payments then, the remaining earnings are retained.
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Did u know? Net earnings = Operating Profit - (Interest + Tax + Preference Dividend)

Hence, the alternative use of net earnings or net profit dividends and retained earnings are

competitive and confl icting.

12.2 Types of Dividend Policies

Dividend decision of a firm is taken after taking into consideration, its operating and fi nancial
condition. When there are variations in these conditions the fi rm may require to adopt the one
that is suitable for the present conditions. What are the different types of dividend policies
available to the financial manager? The types of dividend policies are as follows:

12.2.1 Stable Dividend Policy

The term “stability” refers to the consistency or lack of variability in the stream of dividend
payments. In more precise terms, stable dividend means payment of a certain minimum amount
of dividend regularly. There are three distinct forms of stability, they are:

1. Constant Dividend Per Share: A company that follows this policy will pay a fi xed amount
per share as dividend. For example ` 2 as a dividend on the face value of share of ` 10 each.
The level of earnings would not affect this policy or the dividend payments. This type of
dividend policy is more suitable for the company whose earnings are stable over a number
of years. Stability of dividend does not mean stagnation in dividend payout. In fact, the
prime feature of this policy is to study positive change.
2. Constant Payout Ratio: The ratio of dividend to earnings is known as payout ratio. In other
words, dividend per share is divided by earnings per share to get dividend payout ratio.

It is also known as constant percentage of net earnings. In this policy a fixed percentage of

earnings are paid as dividends each year. Here the ratio is fixed or constant, but dividend

per share varies according to the fluctuations in the earnings.
Example: It a company follows a 30 per cent payout ratio it means for every one rupee
of net earnings, ` 0.30 ,paid as dividends. Assume if a company earned ` 10 last year and `
15 in the current year. Then the dividend amount for last year is ` 3 (10 x 30/100) and ` 4.5
(15 x 30/100) for the current year. The relationship between EPS and DPS is shown in
fi gure 12.1.

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