What is Dividend Policy?

A dividend is a part of the profit paid to the shareholder in an organization. The management of the organization has the right to decide the policy for giving a dividend from the earnings to the shareholder. However, an organization is not in the obligation to declare a dividend for the investor. Dividend policy differs from organization to organization. As the management has the only authority to decide dividend rate, dividend amount, and time of dividend payout by considering all other elements that create an impact on the payment of a dividend.

Types of Dividend Policy

The organization has to choose the dividend policy to pay a dividend for the investor. An investor's main focus is maximizing their wealth by preferring more dividends. The organization’s main focus is that they try to retain the earnings instead of giving a high dividend to the investor. If an organization pays a high dividend to the investor, it may reduce the cash in hand and retain earnings maintained by the organization. A proper dividend policy must be chosen by the organization to satisfy both the interest of the investor and the organization. The different policies of dividends are discussed here:

• Regular
• Irregular
• Residual
• Stable
• No dividend

Regular policy

When the dividend is given on a regular basis at the usual rate is called a regular dividend policy. The main goal of the policy is to provide regular dividends for the shareholder and also maintain a liquidity position so the organization can be benefited from opportunities for new investment in the future. This dividend policy is preferred by the investors who need a regular payment for financial income stability. Investors like widows, retired people, financially unstable weaker persons, middle-class families would select this policy. A regular policy adds some advantages for the organization by creating a profitable history, gaining shareholder confidence, stabilizing the value of shares in the market, etc. A regular dividend policy is perfect for an organization that has a long-standing and stable return from the investment.

Irregular policy

The residual policy is when an organization pays the investor’s dividend from the leftover earnings. Here the organization uses the maximum earnings for investment and ensures that entire capital expenditures are fulfilled. After using, the remaining amount is distributed to the shareholder as a dividend payout. In this kind of dividend policy, the organization t­­ries to avoid raising funds from externals for investment by using most of the amount for investment.

Stable policy

Under a stable policy, the investor receives a certain quantity of the profit on a regular period as a dividend. The organization which follows this dividend policy should have a constant cash flow. An investor can be at ease because the organization gives a dividend regularly. The stable dividend policy can be categorized into constant dividend per share & constant dividend payout ratio.

Constant dividend per share

Some organizations pay a dividend per share on a fixed basis even if the profit earnings differ from one year to another year. That organization creates a separate reserve fund for dividend payment. Even if they do not earn profits during the current financial year, they pay a dividend to every investor using the reserve fund generated for paying the dividend. This dividend policy per share will be suitable for organizations that earn stable profits for several years.

Constant dividend payout ratio

The constant dividend payout ratio is that the dividend payment is at a fixed rate from profits. Here, the amount of dividend changes every year on the basis of the profits earned by the organization. This policy is likely to be preferred by those organizations that are able to give a constant dividend payout to the investor.

No dividend policy

In no dividend, the shareholder won’t be paid a dividend. In case of adverse positioning of working capital, finance requirement for extension, and finance requirement of capital funding for new investment then an organization can choose no dividend policy. The management has to take such a decision by convincing the investor about the policy. Although the no dividend policy can benefit the investor in the long run, it will be a great struggle for the organization to adopt the particular policy. As the whole profit earned during the financial year will be reinvested, the organization will be benefited from capital appreciation and business growth.

Determinants of dividend policy

The dividend payment involves legal and financial considerations. It’s difficult for different organizations to follow a common dividend policy at different periods because dividend decisions have to be fixed only after considering other special circumstances. The factors that determine the dividend policy of an organization are as follows:

Tax policy

The dividend policy is affected by tax policy either directly or indirectly. It reduces the earnings after tax that remain for the shareholder.

Ownership structure

An organization with more promoters would prefer low-dividend because paying dividends reduces the stock value. An organization with more institutional ownership would prefer a high dividend payout as it helps to increase management control.

Age of organization

A start-up company would hold major profits to develop its business operation for growth in the future. Whereas an older organization that has established reserves would pay a more dividend.

Liquid resources

If an organization with lower liquid resources but has a sufficient profit to distribute a dividend yet decides not to give the dividend for the investor considering the liquid position.

Nature of industry

A certain industry with stable and steady earnings would have to give a high dividend ratio. But the industry that has uncertain and uneven earnings would have to give a low-dividend ratio.

Inflation

Inflation allows the organization to hold the major portion of the revenue and provide a lower dividend. When prices rise the organization increases the capital reserves as the amount gained by depreciation would not be sufficient to switch the fixed asset. Hence to maintain the assets earnings have to be retained.

Profitability

An organization with high profitable performance will pay a higher dividend compared to the organization with lower profitability which pays a lower dividend.

Context and Applications

This topic is significant in the professional exams for undergraduate postgraduate courses for bachelor of accounting and finance, bachelors in banking and insurance, bachelor of business administration, bachelor of commerce, masters of accounting and finance, master in banking and insurance, masters of commerce, and masters of business administration.

Practice Problems

Question 1: The word dividend means___________ to investors.

1. The portion of profit distributed
2. Part of share distributed
3. Bonus share

Answer: Option 1 is correct.

Explanation: Form the profit generated by the organization a portion of profits is distributed to the shareholders as a dividend.

Question 2: Who decides dividend policy in an organization?

1. Labors
2. Shareholder
3. Management

Answer: Option 3 is correct.

Explanation: Management has the only authority to decide the dividend policy. Even though shareholders are owners of an organization they don’t have the right to decide dividend policy.

Question 3: An organization which pays dividends from the leftover earning is called__________ dividend policy.

1. Regular 
2. Residual
3. Irregular

Answer: Option 2 is correct.

Explanation: A residual dividend policy has the only feature that pays out dividends from the earnings that are leftover. After meeting all the capital expenditure dividend is paid at the end.

Question 4: A organization that has a steady profit-earning capacity for a number of years can follow __________ dividend policy.

1. Irregular
2. No dividend
3. Stable

Answer: Option 3 is correct.

Explanation: A stable dividend policy fits an organization that earns a steady profit for many years. The organization is able to provide a dividend for a shareholder stably if it has a steady profit.

Question 5: The investors that prefer regular dividend policy are/is _______.

1. Financially unstable person, widows, retired person
2. Financially stable person
3. Students

Answer: Option 1 is correct.

Explanation: A regular dividend policy suits an investor who seeks a regular income to fulfill their financial expenses. Investors like financially unstable people, widows, retired persons, and middle-class families would prefer a regular dividend policy.