Types of Dividend Policy

11/10/2021 0 By indiafreenotes

A company’s dividend policy dictates the amount of dividends paid out by the company to its shareholders and the frequency with which the dividends are paid out. When a company makes a profit, they need to make a decision on what to do with it. They can either retain the profits in the company (retained earnings on the balance sheet), or they can distribute the money to shareholders in the form of dividends.

The regular dividend policy is used by companies with a steady cash flow and stable earnings. Companies that pay out dividends this way are considered low-risk investments because while the dividend payments are regular, they may not be very high.

Dividend policy is a very important and integral part of the corporate strategy of any company as it influences investor’s confidence and indicates the company’s financial health. The management of the company must factor in the business environment, the company’s growth strategy, liquidity position, etc. before determining the amount and frequency of dividend payments.

Stable Dividend policy

Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. For example, if a company sets the payout rate at 6%, it is the percentage of profits that will be paid out regardless of the amount of profits earned for the financial year.

Whether a company makes $1 million or $100,000, a fixed dividend will be paid out. Investing in a company that follows such a policy is risky for investors as the amount of dividends fluctuates with the level of profits. Shareholders face a lot of uncertainty as they are not sure of the exact dividend they will receive.

Residual Dividend Policy: In this type of dividend distribution, the company pays dividend based on the amount of left over earnings. In residual dividend policy, a company pays dividends only after ensuring that all the planned investments have been done. In most cases, the dividend payment happens when the part of profit earmarked for funding the capital expenditure proposals is put aside. This policy reduces the need for raising external funds to a large extent.

  • Constant Dividend Per Share: In this policy, a company pays a fixed amount of dividend per share every year irrespective of the profit generated by it. Such companies create a reserve fund which ensures that it is able to pay the same dividend in those years too when it fails to achieve an adequate level of earnings. Please note that the amount of dividend is largely constant year after year, but the rate of the dividend may vary depending on the level of earning during each year.
  • Constant Payout Ratio: In this policy, the dividend paid every period is a fixed proportion of the earnings during that period. In other words, the percentage of profit distributed to the shareholders in the form of dividends remains constant. So, the dividends paid in such a company will vary as the earnings fluctuate from one period to another.
  • Constant Dollar Dividend: In this policy, a company pays a relatively lower rate of dividend per share to avoid instances of no dividend payment in case of weak financial performance. In other words, dividends paid in dollar terms largely remain constant irrespective of the profit level during the period.

Regular Dividend policy

Under the regular dividend policy, the company pays out dividends to its shareholders every year. If the company makes abnormal profits (very high profits), the excess profits will not be distributed to the shareholders but are withheld by the company as retained earnings. If the company makes a loss, the shareholders will still be paid a dividend under the policy.

Irregular Dividend policy

Under the irregular dividend policy, the company is under no obligation to pay its shareholders and the board of directors can decide what to do with the profits. If they a make an abnormal profit in a certain year, they can decide to distribute it to the shareholders or not pay out any dividends at all and instead keep the profits for business expansion and future projects.

The irregular dividend policy is used by companies that do not enjoy a steady cash flow or lack liquidity. Investors who invest in a company that follows the policy face very high risks as there is a possibility of not receiving any dividends during the financial year.

No Dividend policy

Under the no dividend policy, the company doesn’t distribute dividends to shareholders. It is because any profits earned is retained and reinvested into the business for future growth. Companies that don’t give out dividends are constantly growing and expanding, and shareholders invest in them because the value of the company stock appreciates. For the investor, the share price appreciation is more valuable than a dividend payout.