Dividend Policies and Patterns
Prerequisites
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1. What is Dividend Policy?
Dividend Policy is the framework/guideline used by a company to decide:
- How much profit to distribute as dividend
- How much to retain
- Pattern of dividend payment over time
2. Major Types of Dividend Policies
2.1 Stable Dividend Policy
Principle: Pay constant/increasing dividend regardless of profit fluctuations.
Features:
- Dividend remains same or gradually increases each year
- Not reduced even if profit falls temporarily
- Most popular and investor-friendly
Example:
Year 1: Profit ₹10L, Dividend ₹2 per share
Year 2: Profit ₹8L, Dividend ₹2 per share (maintained despite lower profit)
Year 3: Profit ₹12L, Dividend ₹2.50 per share (increased)
Advantages:
- Provides certainty to shareholders
- Attracts income-seeking investors
- Positive signal of management confidence
- Reduces stock price volatility
Disadvantages:
- May strain cash in bad years
- Less flexibility for retention
- Pressure to maintain even if cash scarce
2.2 Constant Payout Ratio Policy
Principle: Pay a fixed percentage of profit as dividend every year.
Formula:
Dividend = Profit × Payout Ratio
If Payout Ratio = 40%, then 40% of profit paid as dividend
Example:
Year 1: Profit ₹10L, Dividend = 40% × ₹10L = ₹4L
Year 2: Profit ₹8L, Dividend = 40% × ₹8L = ₹3.2L
Year 3: Profit ₹12L, Dividend = 40% × ₹12L = ₹4.8L
Advantages:
- Directly tied to profitability
- Automatic adjustment with earnings
- Fair distribution based on performance
Disadvantages:
- Dividend fluctuates (uncertainty for shareholders)
- May create anxiety if dividend falls
- Not preferred by income-dependent investors
2.3 Residual Dividend Policy
Principle: First finance all profitable projects, then pay dividend from leftover (residual) profit.
Process:
- Identify capital budget (profitable projects)
- Finance using retained earnings (cheapest)
- Remaining profit = Dividend
Formula:
Dividend = Net Profit - (Target Equity Ratio × Capital Budget)
Example:
Net Profit: ₹20 lakhs
Capital Budget (projects): ₹30 lakhs
Target Debt:Equity = 50:50
Equity needed = 50% × ₹30L = ₹15L
Residual = ₹20L - ₹15L = ₹5L → Dividend
Advantages:
- Maximizes firm value by funding all good projects
- No need for costly external financing
- Theoretically optimal
Disadvantages:
- Highly fluctuating dividends (depends on investment opportunities)
- Creates uncertainty
- May signal instability to market
2.4 Irregular Dividend Policy
Principle: No fixed pattern. Dividend declared based on circumstances.
When Used:
- Startups/growth companies
- Unstable earnings
- Seasonal businesses
Example: Pay dividend only in profitable years, skip in loss years.
Disadvantages:
- High uncertainty
- Not preferred by investors
- Difficult to plan for shareholders
3. Hybrid Policy (Most Common in Practice)
Stable Dividend + Extra:
- Pay regular stable dividend (₹2 per share always)
- Plus extra dividend in exceptionally good years (₹1 bonus)
Example:
Normal year: ₹2 per share (regular)
Exceptional year: ₹2 regular + ₹1 extra = ₹3 total
Advantage: Combines stability with flexibility.
4. Comparison of Policies
| Policy | Dividend Pattern | Shareholder Certainty | Best For |
|---|---|---|---|
| Stable | Constant/Increasing | High | Mature firms, income investors |
| Constant Payout | Fluctuating | Low | Variable earnings firms |
| Residual | Highly Variable | Very Low | Growth firms, optimal use of funds |
| Irregular | Unpredictable | None | Startups, unstable firms |
Exam Pattern Questions and Answers
Question 1: "Explain Stable Dividend Policy with its merits and demerits." (6 Marks)
Answer:
Definition (1 mark): Stable dividend policy involves paying a constant or gradually increasing dividend per share every year, regardless of fluctuations in the company's profits.
Features (1 mark): The dividend amount remains fixed (e.g., ₹5 per share) or increases in small increments over time. It is not reduced even when profits temporarily decline, ensuring predictability for shareholders.
Merits (2 marks):
- Investor Confidence: Provides certainty and stability, attracting income-seeking investors like retirees who depend on regular dividend income.
- Positive Signaling: Consistent dividends signal management's confidence in sustained earnings, reducing stock price volatility and maintaining investor trust.
Demerits (2 marks):
- Cash Flow Strain: During low-profit years, maintaining stable dividends may drain cash reserves and create liquidity problems.
- Reduced Flexibility: Commits funds to dividends, leaving less retained earnings available for profitable investment opportunities or unforeseen contingencies.
Question 2: "Distinguish between Stable Dividend Policy and Constant Payout Ratio Policy." (6 Marks)
Answer:
| Aspect | Stable Dividend Policy | Constant Payout Ratio Policy |
|---|---|---|
| Dividend Amount | Fixed amount (e.g., ₹5/share) maintained | Varies with profit; fixed % of profit |
| Formula | DPS = Constant (say ₹5) | Dividend = Profit × Payout % |
| Fluctuation | Stable, no fluctuation | Fluctuates with earnings |
| Certainty | High certainty for shareholders | Low certainty, depends on profit |
| Example | Always ₹5/share regardless of profit | If profit ₹10L, 40% = ₹4L; if profit ₹8L, 40% = ₹3.2L |
| Suitable For | Mature firms with stable earnings | Firms with variable but positive earnings |
Summary
Four Main Policies:
- Stable: Constant DPS (most popular) ✓
- Constant Payout: Fixed % of profit (fluctuating DPS)
- Residual: After financing projects (optimal but variable)
- Irregular: No pattern (least preferred)
Most Common in Practice: Stable + Extra (hybrid)
Choice Depends On:
- Company lifecycle stage
- Earnings stability
- Investment opportunities
- Shareholder base
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Quiz Time! 🎯
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