Financial Management and Strategic Management · Dividend Decision

Dividend Decision and Forms of Dividend

Updated 4 October 2026 · Fact-checked

The dividend decision is the choice of how much of a company's profit to pay shareholders and how much to retain for reinvestment. Solve questions by splitting profit into dividend and retained earnings, naming the form of dividend, and showing its effect on cash, reserves and share capital.

Understand Dividend Decision and Forms of Dividend

A company earns profit for its shareholders. It then faces a choice: pay part of the profit out as dividend, or keep it in the business as retained earnings. This choice is the dividend decision. It is one of the three core decisions of financial management, along with the investment decision and the financing decision.

The dividend decision is linked to financing. Retained earnings are an internal source of finance with no issue cost. If you pay more dividend, you keep less for projects, so you may need to raise new equity or debt. If you retain more, you need less outside money, but shareholders get less cash now. So the real question is: does the company earn a better return on the money than shareholders could earn elsewhere?

The payout ratio shows how much of profit goes out as dividend. The retention ratio is the rest. They always add up to 100%.

Dividends come in different forms:

Cash dividend: paid in cash. Cash and reserves fall. Total net worth falls.
Stock dividend / bonus shares: the company issues extra shares to existing holders free, in proportion to their holding. Reserves are capitalised into share capital. No cash leaves. Net worth stays the same.
Scrip dividend: the company issues scrips (promissory notes) promising to pay the dividend at a future date. The scrips may be transferable and may carry interest. It is used when the company is short of cash now. On declaration, reserves fall and a liability (notes payable) is created, so net worth falls just as in a cash dividend. Only the cash outflow is deferred.

In the exam, treat bonus shares as a capitalisation of reserves, not as income to the shareholder. Each holder owns more shares, but the percentage holding and the total value of the holding stay unchanged, other things equal. The market price per share usually falls in proportion.

Know who declares the dividend. An interim dividend is declared by the Board. A final dividend is recommended by the Board and declared by the shareholders at the AGM.

The dividend payout process then follows this order of dates: the declaration date, then the ex-dividend date and the record date (under T+1 settlement in India these are the same day; the record date fixes who is entitled), and then the payment date. A buyer must buy before the ex-date to be entitled to the dividend. Keep this order clear for theory questions.

Key rules to remember

Dividend per share (DPS): DPS = Total equity dividend ÷ Number of equity shares; Use the number of shares outstanding at the time the dividend is declared.
Earnings per share (EPS): EPS = (Net profit after tax − Preference dividend) ÷ Number of equity shares; Deduct preference dividend before finding EPS.
Dividend payout ratio: Payout ratio = DPS ÷ EPS × 100 = Total equity dividend ÷ Earnings available to equity × 100; Shows the share of earnings paid out.
Retention ratio: Retention ratio (%) = 100% − Payout ratio (%); Retained earnings ÷ Earnings available to equity × 100. If you take the payout ratio as a fraction, use 1 − payout ratio instead.
Bonus shares issued: Bonus shares = Existing shares × Bonus ratio; For a 1:4 bonus, holders get 1 new share for every 4 held, so multiply by 1/4.
Theoretical ex-bonus price: Ex-bonus price = Cum-bonus market value of holding ÷ Total shares after bonus; Value of the holding stays the same under the usual assumption of no change in total market value.

How to solve Dividend Decision and Forms of Dividend questions

Use this method for any numerical or theory question on dividend forms.

1Read the question and note the form of dividend: cash, bonus, stock or scrip.
2Write down the given data: profit, preference dividend, number of shares, face value, reserves.
3Compute earnings available to equity, then EPS, DPS, payout ratio and retention ratio as needed.
4For a cash dividend, reduce cash and reserves by the amount. For a bonus issue, move the amount from reserves to share capital at face value.
5Recompute shares outstanding after the issue and adjust per-share values.
6Check that net worth is unchanged in a bonus issue and falls by the dividend in a cash dividend.
7State the conclusion in one line: effect on cash, retained earnings and shareholder wealth.

Quickest way: Quick route for MCQs and written answers

When to use it: Use when time is short, for 1-2 mark MCQs and 5-mark short notes.

For MCQs, ask first: does cash leave the company now? Cash dividend yes; bonus no; scrip not now, but reserves still fall and a liability is created at declaration.
If the option says bonus shares change net worth or give cash to holders, eliminate it.
For ratio MCQs, find EPS first, then DPS, then payout. Retention is 100% minus payout.
For bonus-price MCQs, divide the total holding value by the new share count.
In written answers, use a small layout: Given, Working, Result, Comment. Marks are given for each working line, so show them.
For short notes, write the meaning, features, accounting effect and one advantage and one limitation.

Common mistakes in Dividend Decision and Forms of Dividend

Treating a bonus issue as a payment of cash or as income to shareholders.
The word dividend suggests money received.
Fix: Remember that a bonus issue only converts reserves into share capital. No cash moves and total shareholder wealth is unchanged.
Forgetting to deduct preference dividend before calculating EPS and payout.
Students start directly from profit after tax.
Fix: Always compute earnings available to equity first.
Adding the bonus shares to the existing shares but keeping the old market price.
Students forget that the price adjusts after the issue.
Fix: Divide the total value of the holding by the new number of shares to get the ex-bonus price.
Saying a scrip dividend avoids the dividend liability altogether.
No cash is paid on the declaration date.
Fix: Write that scrip only defers the payment. The liability remains and is paid at the later date.
Confusing bonus shares with a stock split.
Both increase the number of shares.
Fix: A bonus issue capitalises reserves and keeps face value the same. A split reduces face value and leaves reserves and share capital unchanged.
Mixing up the declaration, ex-dividend, record and payment dates, or saying the Board declares every dividend.
The dates look alike, the order is not memorised, and interim and final dividends are treated as the same.
Fix: Learn the order: declaration date, then ex-dividend date and record date (the same day under T+1 settlement), then payment date. Only a buyer who buys before the ex-date is entitled to the dividend. Also remember that the Board declares an interim dividend, while a final dividend is recommended by the Board and declared by shareholders at the AGM.

Worked examples

Example 1

A company has net profit after tax of ₹12,00,000 and 4,00,000 equity shares of ₹10 each. It has no preference shares. It pays a cash dividend of ₹1.50 per share. Calculate EPS, total dividend, payout ratio, retention ratio and retained earnings for the year.

Show the solution

EPS = ₹12,00,000 ÷ 4,00,000 = ₹3.00.
Total dividend = ₹1.50 × 4,00,000 = ₹6,00,000.
Payout ratio = 1.50 ÷ 3.00 × 100 = 50%.
Retention ratio = 100% − 50% = 50%.
Retained earnings = ₹12,00,000 − ₹6,00,000 = ₹6,00,000.

Answer: EPS ₹3.00; total dividend ₹6,00,000; payout ratio 50%; retention ratio 50%; retained earnings ₹6,00,000.

Example 2

A company has 5,00,000 equity shares of ₹10 each, fully paid, and free reserves of ₹40,00,000. The market price is ₹60 per share. It issues bonus shares in the ratio 1:5. Mr. A holds 2,000 shares. Find the bonus shares issued, the amount capitalised, Mr. A's new holding, and the ex-bonus price assuming total market value of the company is unchanged.

Show the solution

Bonus shares issued = 5,00,000 × 1/5 = 1,00,000 shares.
Amount capitalised = 1,00,000 × ₹10 = ₹10,00,000, taken from free reserves. Reserves after issue = ₹40,00,000 − ₹10,00,000 = ₹30,00,000.
Total shares after issue = 5,00,000 + 1,00,000 = 6,00,000.
Mr. A receives 2,000 × 1/5 = 400 shares, so his new holding = 2,400 shares.
Total market value before = 5,00,000 × ₹60 = ₹3,00,00,000.
Ex-bonus price = ₹3,00,00,000 ÷ 6,00,000 = ₹50.
Mr. A's holding value: before 2,000 × ₹60 = ₹1,20,000; after 2,400 × ₹50 = ₹1,20,000. No change.

Answer: 1,00,000 bonus shares; ₹10,00,000 capitalised; Mr. A holds 2,400 shares; ex-bonus price ₹50; his wealth stays at ₹1,20,000.

Exam tips

Short notes on types of dividend are common. Cover cash, stock or bonus, and scrip, with the effect of each on cash and reserves.
In numerical questions, show EPS, DPS and payout as separate lines. Each line can earn a step mark.
Use the words capitalisation of reserves when you explain bonus shares.
Learn the dividend dates in order: declaration, then ex-date and record date (the same day under T+1), then payment. A one-line sequence is enough to answer a 2-mark MCQ.
Always end with a one-line comment on the effect on cash, retention and shareholder wealth.

Practice questions from Dividend Decision

Dividend Decision and Forms of Dividend in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Dividend Decision and Forms of Dividend: frequently asked questions

What is the dividend decision in financial management?

It is the decision on how much of the profit to distribute to shareholders and how much to retain. It is closely tied to the financing decision because retained earnings are an internal source of funds.

What is the difference between bonus shares and a cash dividend?

A cash dividend pays out cash and reduces reserves and net worth. Bonus shares only convert reserves into share capital, so no cash leaves and net worth stays the same.

What is the difference between bonus shares and a stock split?

A bonus issue capitalises reserves and the face value per share stays the same. In a stock split the face value is reduced and the number of shares rises, while share capital and reserves stay unchanged.

What is a scrip dividend?

A scrip dividend is paid by issuing scrips (promissory notes) that promise payment on a later date. The scrips may be transferable and may carry interest. It helps when the company is short of cash now, but the liability remains and is paid later.