TABLE OF CONTENTS

INTRODUCTION .................................................................................................... 2

Importance of dividends from an investors perspective .......................................... 2

Importance of dividends from companys perspective ............................................ 3

Dividend policy helps to reduce agency theory ........................................................ 4

Challenges and problems associated with dividends policy. Why many companies
listed in exchange failed to declare them as dividend Policy Company while they
are generating big profit on annual basis. ................................................................ 6

REFERENCES ......................................................................................................... 9

INTRODUCTION
Dividends are profits of the company that are distributed to the shareholders as return on their
investments, dividends are paid in proportion to the nominal value of the shares unless the
articles restrict them to the amount of paid up on the shares. The most common form of divided
payment is cash dividend. Dividends can also be declared and paid on form of shares, that is
bonus shares, or in kind, in specie. ( (Megginson, Smart and Graham, 2010)

Importance of dividends from an investors perspective

As Dividend has been an important part of the markets total return. When its looked into a
normal market environment, investors would well served to turn their attention back to the
importance of dividends and their potentially larger role in an investors total return in a more
normal return environment, rather than seeking yield just for yields sake, dividends should be
viewed instead within the context of an investments historically provided a significant portion
of total return and can be an indicator of financial strength strong corporate governance and a
companys commitment to shareholder value.
With the dividend the investor is able to reinvest the dividend over a long period of time on the
aspect of compounding, which is very important for an individual investor, this is where the
investor takes the plan to buy other investments or buy more shares of the share the investor
already own.
Dividend is also important for the investors for future benefits, like when they retire, they have
enough money to meet their spending, or for the betterment of their children. The investors will
be in a position to plan for the betterment of their family.

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Investors have choices. If he wants to sell the stock it will much easier to sell a stock which
dividends are being paid fairly. But if a stock which no dividends are paid, there will be no
investor who is ready to buy that stock

Importance of dividends from companys perspective

A company's dividend is often compared to fixed income investments. This means that when a
company increases its dividend the company's attractiveness increases in the eyes of the investor.
As a result the companys is able to finance through equity easily. This will help in boosting the
morale of the shareholders and will also encourage them to stay invested longer to benefit from
the company's growth. (Emery, Finnerty and Stowe, 2007)
Dividends help the company to stabilize the stock price in the situation where the stock price
falls. Many investors consider these dividends as a sign of safety and financial conservatism
(which they are in many cases). Dividends in and of themselves, however, do not necessarily
make the company a better investment. It enables the investor to think that the company is doing
well and encourages them to invest in that company, which creates a demand in that specific
stock and the leads to higher stock price.
Behind the current surge in dividends is a desire by many companies to make their stocks more
attractive, thus allowing them to raise money by issuing new stock instead of by bonds or other
debt securities. Debt financing swelled considerably during the past five years as stock prices fell
to levels so low as to make new issues virtually impossible to market. Many stocks are still
selling far below their record high prices, and a dividend sweetener is seen by many corporate
finance officers as a way to increase demand (Time 1976)
The tax consequences are tremendously important. If the company is earning7%, and the
individual investor can only hope to earn around 7%, there is no need to keep the proceeds for
the just to pay the tax instead the company can pay dividend without just paying the tax instead
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the company can pay dividend without paying a tax and get back the money from the investors
as they would reinvest in the company.
For example, a small company which has a constant earning of 7% on equity made a profit of
$100,000 last year. If the business reinvests that money back into itself, the shareholders could
reasonably expect the company to earn $7,000 on the reinvested earnings. If the $100,000 had
been paid out in the form of dividends, it would have been subject to the investors individual tax
rates. For simplicitys sake, lets say all of the shareholders are in the 25% tax bracket. When the
$100,000 was paid out as dividends, $25,000 would have gone to the Inland Revenue, leaving
only $75,000 available to the investor to reinvest at 7%. At the end of the year, the investors
could only expect a return of $5,250 ($75,000 reinvested at 7% = $5,250). Over time, the
discrepancy can add up to very significant numbers.

Dividend policy helps to reduce agency theory

The relationship between shareholders and management is called an agency relationship. Such a
relationship exist whenever someone (the principal) hires another (the agent) to represent his/her
interests (Ross et al., 2009). Within the context of the firm, agency theory is primarily concerned
with owner-manager relationship and with the need for shareholders to monitor management
behaviour. Basically agency theory involves the costs of resolving conflicts between the
principals and agents and aligning interests of the two groups.
The main issue in agency theory is how to minimize the costs of having someone else make
decisions that affect you. This really refers to the cost of managing through other people a
situation which you have a stake. The answer lies in whether creating incentives, constraints and
punishments or having reasonable monitoring procedure and developing contracts that minimize
the possibility of conflicts of interest from outset. Costs associated with financial contracts occur
throughout the business decision making process and can be very significant. Therefore, these
costs play an important role throughout all aspects of corporate financial management.

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One way of solving the agency problem is by increasing the payout ratio .The payout ratio shows
how well earnings carry the dividend payments: the lower the ratio, the more secure the dividend
because smaller dividends are easier to pay out than larger dividends. When the firm increases its
dividend payment, assuming it wishes to proceed with planned investment, it is forced to go to
the capital market to raise additional finance. This encourage monitoring by potential investors
of the firm and its management, thus reducing agency problems. Rozeff (1982) develops a
model that underpins this theory, called the cost minimisation model. The model combines the
transaction costs that may be controlled by limiting the payout ratio, with the agency costs that
may be controlled by raising the payout ratio. The central idea on which the model rests is that
the optimal payout ratio is at the level where the sum of these two types of costs is minimised.
Hence, it is assumed that rational stockholders realize that the firm is financing the dividend by
new funds and that this is costly, nevertheless they find this process desirable because they
observe the terms on which new funds are raised and perhaps the identity of the new funds
suppliers, furthermore, since it is likely that new equity suppliers will not supply funds unless
they receive the new information about the uses intended for the funds, the shareholders also
may gain new information about management intentions.
in corporate world, if there is a clear written dividend policy, it will reduce the agency problem
as agency theory is the nature of the agency relationship deriving from the separation between
ownership and control if no dividend policy the directors may pass a resolution for an
inappropriate dividends even though there are no profit, or even there is profit they will hold any
pay out. So minority investors will get affected. If there is no dividend policy, the shareholders
will not have full confidence and their investment will be in uncertainty

Implementing, dividend policies may increase managers agency behavior. Also when domestic
firms enjoy subsidies or a policy of protectionism, the demands on managers to become more
efficient is relaxed (Joshi and Little 1996). Second, high state involvement means creating more
of agency problems to shareholder-administrator conflicts. It said that the degree of industry
regulation enters the dividend policy decision. One of the issues is the degree that management
of the economy is based on social philosophies of protecting the weaker sectors such as
employees or poorer customers; this may influence managers to consider the interests of nonPage 5 of 9

equity stakeholders. This implies that stakeholder theory should be particularly relevant to the
Indian case, and, as shown by Holder,( Langrehr and Hexter 1998 ) this may lead to a diminish
the pressure on dividend levels. However, the relevance of stakeholder theory also implies
extension of agency problems to conflicts of interests between equity holders and other
stakeholders, increasing the need for shareholders to monitor management behavior.

Challenges and problems associated with dividends policy. Why many

companies listed in exchange failed to declare them as dividend Policy
Company while they are generating big profit on annual basis.
Dividend payouts tend to be low and fairly smoothed, and are unrelated to reported earnings.
Dutch firms formulate their dividend decisions based on operating cash flows instead,
presumably to avoid unnecessary liquidity constraints. Also, dividend dynamics show no
statistical relationship with the severity of agency problems, to the extent that these are reflected
in firm size, leverage, and investment opportunities (Fama and French, 2001). Thus, it appears
that Dutch firms interpret dividend policy fairly flexibly and do not use it to mitigate free cash
flow concerns. In principle, it could be that most firms are already tightly monitored by their
concentrated shareholders. However, it is equally likely that shareholders are often too weak to
enforce optimal payout policies.
The idea considered by Miller and Modigliani which states that firms should never give up a
positive NPV project to increase a dividend is strongly agreed by the companies (Ross et al.,
2009).
Some companies use the cash to repurchase shares of its own stock instead of paying dividends.
Share repurchases have taken on increased importance in recent years. Companies engage in this
type of repurchase for a variety of reasons. In some rare cases, a single large stockholder can be
bought out at a price lower than that in a tender offer. The legal fees in a targeted repurchases
may also be lower than those in a more typical buyback. More frequently certain stockholders
become nuisance to the repurchasing firm. Though targeted repurchases executed for these
reasons are in the interest of the remaining shareholders, the shares of large stockholders are
often repurchased to avoid a takeover unfavourable to management.
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One of the reasons why companies have limitations on dividend payments is because of legal
restriction on dividend payments. Like bond indentures, loan agreements, and preferred stock
agreement usually contain restrictions on the amount of common dividends a firm can pay.
These limitations are designed to minimize the firms agency costs. State law also impose
restrictions. They are designed to prevent excessive cash distributions. Most states prohibit a
firm from paying dividends if doing so would render it insolvent. Many also prohibit firms from
making dividend payments out of accounts that fall outside a legally defined surplus. In some
states, firm cash distribute current earnings, in others it also includes paid-in capital, in some
states, and a firm can distribute current earnings, even though prior losses had eliminated its
surplus.

It has been argued that investors prefer certain dividends now rather than uncertain capital gains
in the future (the bird-in-the-hand argument). It has also been argued that real-world capital
markets are not perfect, but semi-strong form efficient. Since perfect information is therefore not
available, it is possible for information asymmetry to exist between shareholders and the
managers of a company. Dividend announcements may give new information to shareholders
and as a result, in a semi-strong form efficient market, share prices may change. The size and
direction of the share price change will depend on the difference between the dividend
announcement and the expectations of shareholders. This is referred to as the signalling
properties of dividends. It has been found that shareholders are attracted to particular companies
as a result of being satisfied by their dividend policies. This is referred to as the clientele effect.
A company with an established dividend policy is therefore likely to have an established
dividend clientele. The existence of this dividend clientele implies that the share price may
change if there is a change in the dividend policy of the company, as shareholders sell their
shares in order to reinvest in another company with a more satisfactory dividend policy. In a
perfect capital market, the existence of dividend clienteles is irrelevant, since substituting one
company for another will not incur any transaction costs.
The dividend decisions are made very conservatively. That is, companies are hesitant to start
paying dividends or to increase the amount of dividends they pay because they know theyll be
reluctant to reduce them in the future. In one of the earliest research studies on dividends, Linter
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(1956) documented several patterns with respect to firms dividend policies, patterns that are
roughly consistent with this conservative view of dividends in particular:
1- Firms have long-run target dividend payout ratios.
2- Dividend changes follow shifts in long-run, sustainable earnings(not short-run changes in
earnings)
3- Managers are reluctant to increase dividends if they might have to be cut later
4- Managers focus on dividend changes rather than on dividend levels.

Taxes: Dividends were traditionally taxed as ordinary personal income for the calendar year
they were received, whereas capital gains are taxed only in the year in which they are realized
The firm can avoid (or delay) this transfer from shareholders to the IRS by omitting dividends
and reinvesting the funds in zero NPV investments. Another and far better option to have
avoided the dividend tax would have been to repurchase stock from shareholders that are willing
to sell their shares (only those that choose to sell will pay the capital gains tax)

Transactions Costs: Individuals who do not want dividends will reinvest them in the firm and
incur an unnecessary brokerage fee.
reinvestment plan (DRIP).

This problem can be reduced through a dividend

Another solution is for investors to own mutual funds, where

dividends are generally reinvested into the fund at very low transaction costs.

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REFERENCES
Emery, D.R., Finnerty, J.D. and Stowe, J.D. (2007) Corporate Financial Management, 3rd
edition, New Jersey: Pearson Education,Inc.
Megginson, W.L., Smart, S.B. and Graham, J.R. (2010) Financial Management, 3rd edition,
China: South-Western.
Ross, S.A., Westerfield, R.W., Jaffe, J.F. and Jordan, B.D. (2009) Corporate Finance, Core
Proinciples and Applications, 2nd edition, New York: McGraw-Hill.
Joshi, V. and. Little. I.M.D, (1996), Indias Economic Reforms 1991-2001, Oxford: Clarendon
Langrehr F.W and Hexter, J.L. (1998), Dividend policy determinants: An investigation of the
influences of stakeholder theory, Financial Management, 27(3),73-82.
Fama, E.F., French, K.R., 2001. Disappearing dividends: changing firm characteristics or lower
propensity to pay? Journal of Financial Economics 60, 3-43
Linter, John.1956,"Distribution of incomes of corporations among dividends, Retained Earnings
and Taxes" American Economic Review 46 (May) pp.97-113
Rozeff, M.S., (1982), Growth, beta and agency costs as determinants of dividend payout
ratios, Journal of Financial Research, 5 (3), 249-259.
TIME 1976, " STOCK MARKET: A Shower of Dividends for Investors, (online) available on
http://www.time.com/time/magazine/article/0,9171,945564,00.html [accessed on 12 April 2011]

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