Constant Payout

The ratio of dividend to earnings is known as payout ratio. Some companies may follow a policy of constant payout ratio, i.e., paying a fixed percentage of net earnings every year. With this policy the amount of dividend will fluctuate in direct proportion to earnings. If a company adopts a 40 per cent payout ratio, then 40 per cent of every rupee of net earnings will be paid out. For example, if the company earns Rs. 2 per share, the dividend per share will be Re 0.80 and if it earns Rs. 1.50 per share the dividend per share will be Re 0.60.

This policy is related to a company’s ability to pay dividends. If the company incur losses no dividends shall be paid regardless of the desires of shareholders. Internal financing with retained earnings is automatic when this policy is followed. At any given payout ratio, the amount of dividends and the additions to retained earnings increase with increasing earnings and decrease with decreasing earnings. This policy simplifies the dividend decision, and has the advantage of protecting a company against over or under payment of dividend. It ensures that dividends are paid when profits are earned, and avoided when it incurs losses.

Small Constant Dividend per Share Plus Extra Dividend

Under the constant dividend per share policy; the amount of dividend is set at a high level, and the companies with stable earnings usually adopt this policy. For companies with fluctuating earnings, the policy to pay a minimum dividend per share with a step-up feature is desirable. The small amount of dividend is fixed to reduce the possibility of ever missing a dividend payment. By paying extra dividend (a number of companies pay an interim dividend followed by a regular final dividend) in periods of prosperity, an attempt is made to prevent investors from expecting that the dividend represents an increase in the established dividend amount This type of a policy enables a company to pay constant amount of dividend regularly without a default and allows a great deal of flexibility for supplementing the income of shareholders only when the company’s earnings are higher than the usual, without commit-ting itself to make larger payments as a part of the future fixed dividend. Certain shareholders like this policy because of the certain cash flow in the form of regular dividend and the option of earning extra dividend occasionally.

When have discussed three forms of stability of dividends.

Generally when we refer to a stable dividend policy, we refer to the first form of paying constant dividend per share. A firm pursuing a policy of stable dividend may command a higher price for its shares than a firm, which varies dividend amount with cyclical fluctuations in the earnings.

Significance of Stability of Dividends

The stability of dividends has various advantages from the point of view of shareholders as well as company. They are:

Resolution of Investors’ Uncertainty

We have argued in me previous chapter that dividend has informational value and resolves uncertainty of the minds of investors. When a company follows a policy of stable dividends, it will not change the amount of dividend if there are temporary changes in its earnings. Thus, when the earnings of a company fall and it continues to pay same amount of dividend as in the past, it conveys to investors that the future of the company is brighter than suggested by the drop in earnings, Similarly, the amount of dividend is increased with increased earnings level only when it is possible to maintain it in future. On the other hand, if a company follows a policy of changing dividend with cyclical changes in the earnings, shareholders would not be certain about the amount of dividend. This may lead them to require a higher discount factor to be applied to the company than if a stable dividend policy were followed.

Investors’ Desire for Currents Income

There are many investors, such as old and retired persons, women, children etc., who desire to receive regular periodic income. They invest their savings in the shares with a view to use dividends as a source of income to meet their living expenses. These investors, who desire to receive regular dividend income, will prefer a company with stable dividends to one with fluctuating dividends.

Institutional Investors’ Requirements

Shares of the companies are not only purchased by individuals but also by financial, educational and social institutions and unit trusts. In India financial institutions, such as IFCI, lDBI, LICI, and UTI are some of the largest investors in corporate securities. Every company is interested to have these financial institutions in the list of their investors. These institutions generally invest in the shares of those companies, which have a record of paying regular dividends. These institutional investors may not prefer a company, which has a history of adopting an erratic dividend policy. Thus, to cater to the requirement of institutional investors, a company prefers to follow a stable dividend policy.

Raising Additional Finances

A stable dividend policy is also advantageous to the company in its efforts to raise external finances. Stable and regular dividend policy tends to make the share of a company as quality investment with increase in the loyalty and goodwill of shareholders. Investors purchasing these shares intend to hold them for long periods of time. They would be more receptive to an offer by the company for further issues of shares. A history of stable dividends serves to spread ownership of outstanding shares more widely among small investors, and thereby reduces the chance of loss of control. The persons with small means, in the hope of supplementing their income, usually, purchase shares of the companies with a history of paying regular dividends. A stable dividend policy also helps the sale of debentures and preference shares. The fact that the company has been paying dividend regularly in the past is sufficient assurance to the purchasers of these securities that no default will be made by the company in paying their interest or preference dividend returning the principal sum. The financial institutions are the largest purchasers of these securities. They purchase debentures and preference shares of companies, with history of paying stable dividends.