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Dividend vs Profit Retention Decision

Prerequisites

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1. The Fundamental Question

Every company faces: What to do with earned profit?

  • Pay as Dividend → Satisfy shareholders → Immediate return
  • Retain in Business → Finance growth → Future returns

This is called the Dividend Decision or Dividend Policy.

2. Arguments FOR Dividend Distribution

2.1 "Bird-in-Hand" Theory

Principle: "A bird in hand is worth two in the bush."

  • Current dividend = Certain (guaranteed cash now)
  • Future gains = Uncertain (may or may not materialize)
  • Investors prefer certain dividends over uncertain future capital gains

Example: ₹10 dividend today is better than promise of ₹15 capital gain next year (which may not happen).

2.2 Shareholder Preference

Income-seeking Investors:

  • Retired persons need regular income
  • Depend on dividends for living expenses
  • Don't want to sell shares for cash needs

Tax Considerations (varies by jurisdiction):

  • In some cases, dividend tax may be lower than capital gains tax

2.3 Resolution of Uncertainty

  • Regular dividends reduce uncertainty about firm's profitability
  • Markets react positively to dividend announcements
  • "Dividends don't lie" - Actual cash paid proves real earnings

2.4 Signaling Effect

Dividend Announcement = Positive Signal:

  • Management is confident about future
  • Company has strong cash flows
  • Financial health is good

Dividend Cut = Negative Signal:

  • Possible financial trouble
  • Cash flow problems
  • Stock price usually falls

3. Arguments FOR Profit Retention

3.1 Growth Opportunities

  • Retained earnings = Cheapest source of finance
  • No flotation costs (unlike new shares/debt)
  • Fund expansion, R&D, new projects without borrowing

Example: A tech startup with high growth potential should retain profits to invest in innovation rather than pay dividends.

3.2 Tax Advantage (Capital Gains)

  • In many jurisdictions, capital gains tax < dividend tax
  • Retention increases share value → Capital appreciation
  • Shareholders can realize gains when they choose (by selling shares)
  • Tax deferral benefit: Pay tax only when shares sold

3.3 Financial Flexibility

High Retention → Strong reserves →

  • Better credit rating
  • Easy to raise debt in future
  • Can weather economic downturns
  • No pressure for external financing

3.4 Avoids Ownership Dilution

If dividends paid → Less retained earnings → May need to issue new shares for growth → Ownership dilution for existing shareholders

If profits retained → Finance growth internally → No new shares needed → Control maintained

4. The Trade-off

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5. Optimal Dividend Policy

Walter's View: Pay dividend only if firm's return < Investors' required return

Graham & Dodd: Balance between current income and future growth

Practical Approach:

  1. Identify profitable investment opportunities
  2. Finance them with retained earnings (cheapest source)
  3. Distribute remaining profit as dividend

Formula (Residual Dividend Policy):

Dividend = Net Profit - (Target Equity Ratio × Capital Budget)

6. Impact on Share Price

6.1 Dividend Announcement Effect

Positive Dividend News → Stock price ↑

  • Increased dividend = Confidence signal
  • Market interprets as good earnings

Dividend Cut News → Stock price ↓

  • Seen as financial trouble
  • Investors lose confidence

6.2 Long-term Impact

Depends on what company does with retained earnings:

  • High ROI projects → Justified retention → Share value increases
  • Low ROI or idle cash → Wasteful retention → Should have paid dividend

Exam Pattern Questions and Answers

Question 1: "Should a company pay high dividends or retain profits? Discuss." (8 Marks)

Answer:

Introduction (1 mark): The dividend vs retention decision is a critical financial policy choice. There's no universal answer - it depends on the company's lifecycle, growth opportunities, and shareholder preferences.

Arguments for Dividend Payment (3 marks):

  1. Bird-in-Hand Theory: Shareholders prefer certain current dividends over uncertain future capital gains, reducing investment risk.
  2. Shareholder Satisfaction: Income-seeking investors (retirees, pension funds) depend on regular dividends for cash needs.
  3. Signaling Effect: Dividend payments signal management confidence and strong cash flows, positively impacting stock price.

Arguments for Retention (3 marks):

  1. Growth Financing: Retained earnings are the cheapest source of finance with no flotation costs, ideal for funding expansion and R&D projects.
  2. Tax Efficiency: Capital gains from increased share value (due to retention) may be taxed lower than dividend income.
  3. Financial Flexibility: Building reserves strengthens the balance sheet, improves credit rating, and provides a cushion for uncertain times.

Conclusion (1 mark): Optimal policy balances both - finance profitable projects through retention (if ROI exceeds shareholder expectations) and distribute surplus as dividends. Mature firms with limited growth should pay more dividends; growth firms should retain more.

Question 2: "Explain the signaling effect of dividends." (4 Marks)

Answer:

Dividend announcements convey information (signals) to the market about management's view of the company's future prospects.

Positive Signal - Dividend Increase: When a company increases dividends, it signals that management is confident about sustainable future earnings and strong cash flows. Markets interpret this positively, often leading to stock price appreciation.

Negative Signal - Dividend Cut/Omission: Reducing or skipping dividends signals potential financial difficulties, weak earnings, or liquidity problems. This creates uncertainty and typically causes stock price to fall as investors lose confidence.

Implication: Companies are reluctant to cut dividends even in tough times because of the severe negative market reaction, making dividend policy "sticky" and resistant to downward changes.

Summary

The Dilemma: Distribute profits (immediate return) vs Retain (future growth)

Factors Favoring Dividend:

  • Bird-in-hand certainty
  • Income needs
  • Signaling confidence

Factors Favoring Retention:

  • Growth opportunities
  • Cheapest finance
  • Tax advantages
  • Financial strength

Solution: Residual Dividend - Finance all profitable projects first, then pay dividend from remainder.

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Quiz Time! 🎯

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