Dividend Policy: Types, Theories, Factors & Decisions

What is Dividend Policy?

Dividend policy refers to the long-term plan a company adopts to decide:

• How much profit to distribute as dividends to shareholders.
• How much to retain for reinvestment or debt repayment.

It is a key financial decision because it affects:

• Shareholder wealth.
• Company growth.
• Market perception.

Why Does Dividend Policy Matter?

mindmap
  root((Dividend Policy))
    Types["Cash Dividends\nStock Dividends\nLiquidating Dividends"]
    Theories["Residual Theory\nBird-in-Hand\nTax Preference\nInformation Content"]
    Factors["Legal Constraints\nEarnings Stability\nCash Flow\nGrowth Opportunities\nShareholder Preferences"]
    Objectives["Maximize Shareholder Wealth\nMaintain Investor Confidence\nBalance Growth & Returns"]
    Real-World["Nepal: NEPSE-listed firms\nGlobal: Apple (stock splits)\nNepalese banks (cash dividends)"]

Types of Dividends

Dividends can be classified into three main types, each with different implications for shareholders and the company.

1. Cash Dividends

• Paid in cash (most common).
• Recorded in the Dividend Payable account.
• Example: Nabil Bank declares a NPR 10 per share dividend.

How Cash Dividends Work (Journal Entry)

2. Stock Dividends (Bonus Shares)

• Paid in additional shares (not cash).
• No cash outflow, but increases outstanding shares.
• Example: NEPSE-listed Global IME Bank issues 1 bonus share for every 5 held.

Journal Entry for Stock Dividend

3. Liquidating Dividends

• Paid from company assets (not retained earnings).
• Reduces shareholder equity (not a normal dividend).
• Example: A Nepali retail shop sells land and distributes proceeds to shareholders.

Theories of Dividend Policy

Four major theories explain why companies pay dividends and how it affects shareholder value.

1. Residual Theory (Modigliani-Miller Approach)

• Dividends are a residual after funding all profitable projects.
• Assumption: Investors prefer capital gains over dividends.
• Implication: Companies should pay dividends only if no better use for funds exists.

Example:

• Nepal Investment Bank has NPR 100M profit.
• It needs NPR 80M for expansion.
• Dividend = NPR 20M (residual after funding projects).

2. Bird-in-Hand Theory (Walter’s Model)

• Dividends are valuable because they provide certainty.
• Investors prefer current dividends over uncertain future capital gains.
• Higher dividends → Higher stock price.

Example:

• Nepal Rastra Bank (NRB) pays stable dividends to attract conservative investors.

3. Tax Preference Theory (Gordon-Lingo Model)

• Investors prefer capital gains (taxed at lower rates) over dividends (taxed immediately).
• Low-tax-bracket investors prefer dividends.
• High-tax-bracket investors prefer capital gains.

Example:

• In Nepal, dividends are taxed at 10% (for individuals).
• Capital gains tax is lower (5% for long-term).

4. Information Content Theory (Signaling Theory)

• Dividend changes signal management’s confidence.
• Increase in dividends → Good news (company is profitable).
• Decrease in dividends → Bad news (financial distress).

Example:

• Nepal Bank Limited announces a 50% dividend hike → Stock price rises.
• Global IME Bank cuts dividend → Investors sell shares.

Factors Affecting Dividend Policy

Companies consider multiple factors before declaring dividends.

Dividend Policies: A Comparison

Companies follow different dividend policies based on their stage and strategy.

Dividend Decisions: A Worked Example

Scenario: Kathmandu Retail Shop (KRS) has:

• Net Profit (2024): NPR 5,00,000
• Authorized Capital: 10,000 shares of NPR 100 each
• Issued & Paid-up Capital: 8,000 shares (fully paid)
• Retained Earnings (2023): NPR 2,00,000
• Projected Growth Investment: NPR 3,00,000

Question: How much dividend should KRS declare if it follows:

1. Residual Theory?
2. Stable Dividend Policy (NPR 5/share)?

Solution (Using Residual Theory)

1. Total Funds Available = Net Profit + Retained Earnings = NPR 5,00,000 + NPR 2,00,000 = NPR 7,00,000

2. Funds Needed for Growth = NPR 3,00,000

3. Residual Dividend = Total Funds - Growth Needs = NPR 7,00,000 - NPR 3,00,000 = NPR 4,00,000

4. Dividend per Share = Residual Dividend / Outstanding Shares = NPR 4,00,000 / 8,000 = NPR 50/share

Journal Entry:

Solution (Using Stable Dividend Policy)

If KRS follows NPR 5/share:

1. Total Dividend = NPR 5 × 8,000 = NPR 40,000
2. Retained Earnings = Net Profit - Dividend = NPR 5,00,000 - NPR 40,000 = NPR 4,60,000

Journal Entry:

In the Real World

Dividend policies shape how Nepali and global companies reward shareholders and fund growth.

1. NEPSE-Listed Companies (Nepal)

• Nabil Bank follows a stable dividend policy (NPR 10-15/share annually) to attract conservative investors.
• Global IME Bank uses a stock dividend (1:5 bonus shares) to avoid cash outflow while rewarding shareholders.
• Nepal Investment Bank declares extra dividends when profits exceed expectations (e.g., NPR 20/share in 2023).

2. Global Tech Giants (Dividend vs. Growth)

• Apple Inc. pays dividends + stock buybacks (NPR ~1.5/share in 2024) while reinvesting heavily in R&D.
• Amazon pays no dividends (reinvests all profits) but offers capital gains via stock appreciation.
• Coca-Cola follows a high dividend policy (~3% yield) to attract income investors.

3. Nepali Startups vs. Mature Firms

Exam Tip

What Examiners Look For

1. Definitions & Theories

   • Know Residual Theory, Bird-in-Hand, Tax Preference, and Signaling Theory.
   • Example: "Explain how the Information Content Theory affects NEPSE stock prices." (Expect a real-world example like Nepal Bank’s dividend hike.)

2. Journal Entries & Ledger Postings

   • Must show T-accounts for:
     • Cash dividend declaration & payment.
     • Stock dividend declaration & issuance.
   • Common mistake: Forgetting to close Dividend Payable after payment.

3. Numerical Problems

   • Always calculate:
     • Dividend per share.
     • Retained earnings after dividend.
     • Residual dividend (if using Residual Theory).
   • Example Question:

     "A company has NPR 10M profit, NPR 5M retained earnings, and needs NPR 8M for expansion. Calculate dividend under Residual Theory."

4. Comparison of Dividend Policies

   • Table format is best for comparing:
     • Stable vs. Variable Dividend Policy.
     • Cash vs. Stock Dividends.
   • Example: "Compare Nabil Bank’s stable policy with F1Soft’s no-dividend policy."

5. Real-World Applications

   • Link theories to Nepali companies:
     • "Why does Nepal Investment Bank pay extra dividends?" → Signaling Theory.
     • "Why does Daraz Nepal not pay dividends?" → Growth Opportunity.

Common Pitfalls to Avoid

❌ Ignoring tax implications (e.g., Nepal’s 10% dividend tax). ❌ Miscounting shares (e.g., using authorized capital instead of issued shares). ❌ Not reconciling retained earnings after dividends. ❌ Assuming all companies follow Residual Theory (many follow stable policies).

Final Advice:

• Memorize journal entries for all dividend types.
• Practice numericals using Nepali rupees (NPR).
• Relate theories to NEPSE companies in exam answers.
• Draw T-accounts for dividend transactions—they fetch extra marks!

flowchart LR
  A["Dividend Declaration\n(Board Meeting)"] --> B["Journal Entry:\nDr Retained Earnings\nCr Dividend Payable"]
  B --> C["Record in Ledger\n(Dividend Payable A/c)"]
  C --> D["Announce to Shareholders\n(Dividend Record Date)"]
  D --> E["Payment Date\nDr Dividend Payable\nCr Bank A/c"]
  E --> F["Shareholders Receive\nCash/Stock"]