Page 216 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 9: Dividend Decisions

classic among them being that of Lintner, to support the viewpoint that companies pursue Notes
a stable dividend policy. Most firms are in favor of stable dividend per share but they are
very careful not to raise dividends per share a level that can safely be sustained in, the
future. This cautious creep up of dividends per share results in stable dividend per share
pattern during fluctuating earnings per share periods, and a rising step function pattern of
dividends per share during increasing earnings per share periods.

6. Legal Rules: Legal rules restrictions are significant as they provide framework within
which dividend policy is formulated. In other words, dividend policy of a firm has to be
evolved within the legal framework and rules and regulations. The legal rules have to do
with capital impairment rule, net profits and insolvency rule.
Capital Impairment Rule: First these provisions require that, the dividend can be paid from
earnings either from current year's earnings or from past years earnings and be reflected
in the earned surplus. If firm pays dividend out of capital that adversely affects the security
of its lenders. The purpose of this rule is to protect creditors (preference shareholders and
creditors of the firm) by providing sufficient equity base because they have originally
relied on that base. Therefore, the financial manager should keep in mind the legal rules
while declaring dividends.
Net Profits: This rule is essentially a result of the earlier rule. A firm can pay cash dividends
within the limits of current profits plus accumulate balance of retained earnings. According
to Sec. 205 of the Companies Act, 1956, dividends shall be declared or paid only from
current profits or past profits after recovery of depreciation'. But Central Govt. is
empowered to all (only in public interest) any company to pay dividends for any financial
year out of profits of the company without providing depreciation. A firm can take profits
of past years if the current year's profits are not sufficient to maintain stable dividend
policy. If there are any losses that are to be carried forward, they should be set apart from
current year's earnings before declaration of dividends. So financial manager has to strong
within the boundaries, at the same time has to consider many financial variables and
constraints in deciding the amount that is to be paid as dividends.

Insolvency Rule: A firm is said to be insolvent in two cases. One, in a legal sense, the
recorded value of liabilities exceeding the recorded value of assets, or two, as in a technical
sense, as the firm's inability to pay its creditors as obligations came due. If the firm is
insolvent in either sense, it is prohibited the payment of dividends. The rationale of this
rule is to protect the creditors.
7. Contractual Requirements: Generally lenders may put conditions in a bond indenture or
loan agreement often includes a restriction of the payment of dividend. This is done to
protect their interests when the firm is experiencing low liquidity or profitability. The
restrictions may be in three forms. Firstly, firms may be prohibited from paying dividends
in excess to a certain percentage say 10 per cent. Secondly, a ceiling in terms of net profits
that may be used for dividend payment may be laid down. Say only 50 per cent of net
profits or a given absolute amount of net profits can be paid as dividends. Finally, dividends
may be restricted by insisting upon a minimum of earnings to be retained. Reinvestment
reduces debt equity ratio, which enhances the margin of pillow for the lenders. Therefore,
keeping in mind all the restrictions of lenders dividend declaration should be done.
8. Financial Needs of the Company: This is one of the key factors, which influence the dividend
policy of a firm. Financial needs means funds required for foreseeable future investment.
The required funds may be determined with the help of long-term financial forecasts. A
firm that has sufficient profitable investment opportunity, should follow low dividend
payout ratio. On the other hand, a firm that has no profitable investment opportunities or

LOVELY PROFESSIONAL UNIVERSITY 211