Professional Documents
Culture Documents
Bello A. Sulaimon
July, 2014
Capital Structure and Dividend Policy; Two Sides of a Coin
Bello A. Sulaimon
sulbellven01@yahoo.com; +(234) 8160442283
AbstrAct
The endogenously-determined distribution of control amid the manager and investors is imperative not
because of agency or private information problems but because of potentially divergent beliefs that can
lead to disagreement about the value of the project available to the firm. The key underlying factor is past
corporate performance. Better past performance leads to less disagreement and thus affects the costs and
benefits of different control allocations. Dividend policy and capital structure thus constitute an implicit
governance mechanism that determines how much control over the firm’s real (investment) decisions is
exercised by the manager vis a vis the shareholders, and the firm’s past performance impinges on this
governance mechanism. This study proposesa new and integrated theory of dividend policy and capital
structure that treats these financial policy variables as two sides of the same coin. A key aspect of this
theory is that capital structure and dividend policy are jointly determined as part of a continuum of
control allocations between managers and investors, and hence cross-sectional variations in both.
INTRODUCTION
Background of the Study
there is reason to believe that there are common
The capital structure and dividend policy of
factors affecting both.
limited liability companies is considering being an
Modigliani and Miller (1961) show that in perfect
argumentative topic in the literature of corporate
capital market with no information asymmetry
finance in recent years. The literature on
and predetermined investment decision, the
corporate financial policy, namely dividend policy
value of the firm’s is independent of the financing
and capital structure is voluminous and has a
decisions. Hence, a firm’s financing decision
hoary tradition, dating back to the seminal
including dividends, have no effect on the value
Modigliani and Miller (1958) contributions. Two
of the firm, or the distribution of wealth between
aspects of this literature are noteworthy. First, for
classes of security holders. However, in an
the most part, theories of dividend policy differ
imperfect setting, dividend can influence
from theories of capital structure, since, the
shareholders wealth by providing information to
literature has treated dividend policy and capital
investors or through wealth redistribution
structure as two distinct choices, even though
among claim.
`
It should be noted that there are multiple goals but the core objective of any firm is to
financing sources, where the firms can depend on minimize its cost. So far as the creditors and
it to finance their investments. Financing sources investors in the stock market are concerned, of
categorize into two sources, the internal financing the total cost they are specifically interested in
which includes common stock issuance, preferred the financing cost of capital. This may be so
stocks, reserves and retained earnings. Another because debt to equity ratio enables the creditors
source called external financing which consists in knowing the likelihood of default of the
short and long term loans and bonds issuance. At excessively leveraged firms. Similarly, to know
this case, firms must choose the best financing the expected returns on their risk bearing
sources to reach the optimal capital structure to activities, investors and traders in the stock
be in harmony with firms requirements to take market are interested to know the relative
suitable financing decision and then reflect impact of debt on a firm’s performance. Both
`
information about changes in the future expected in turn calls for higher inventory. Higher
earnings conveyed through the payment (Pandey, inventory levels may mean less efficient use of
2000 pp.765). assets (lower asset turnover).Hence, high growth
It is contended that dividends are relevant may mean borrowing if this growth cannot be
because they have informational value. It is also financed through fund generated from operation.
believed that information content of dividend can More borrowing may mean a lower crediting
go a long way to affect companies share market rating. This competing interest must be balanced
price by sending signals to prospective investors. to improve corporate efficiency through asset
Some of the pertinent problems are: why do utilization.
companies pay dividend? What actually informs Objective of the Study
the dividend policy? What is the form of The objective of this study is to propose a new
dividend? Do dividend matters? Of all the theories and integrated theory of dividend policy and
`
benefits of different control allocations. Dividend Preference share capital: This is a form of
policy and capital structure thus constitute an capital which give the holder the right to a
implicit governance mechanism that determines fixed dividend income.
how much control over the firm’s real WACC: Weighted Average Cost of Capital,
(investment) decisions is exercised by the this is the expected returns on a portfolio
manager vis a vis the shareholders, and the firm’s of all the firm’s securities. Used as hurdle
past performance impinges on this governance rate for capital investment.
mechanism. This study is therefore significant as
it attempt to justify the exiting theories on capital
LITERATURE REVIEW
structure and dividend policy.
Over the years, the issue of the optimal capital
Scope of the Study
structure as well as the choice of dividend policy,
Scope of this research work will be to contribute
`
Debt capital 1997, Marsh, 1982; Jaliv and Harris, 1984; Titman
and Wessels, 1988 and Okafor and Harmon,
If a company maintains the proportion of these
sources of finance, the weighted average cost of 2005). The latter authors made a significant
capital (WACC) will remain unchanged. contribution in formulating and testing the
determinants of capital structure as identified by
Capital Structure Theories
theory. Two outstanding theories emerge and
Capital structure, refers to the various financing present a clear direction and firm behaviour
options of the asset by a firm. A business concern about debt and capital structure. These are trade-
can go for different levels of the mixture of equity, off theory and pecking order theory.
debt and other financial facilities with equity
According to trade off theory propounded by
having the emphasis on maximizing the firm’s
Modigliani and Miller (1958), if firms are more
market value. Capital structure affects the
profitable they prefer debt financing as
liquidity and profitability of a firm (Raheman,
compared to equity for the sake of profit. This
Zulfiquar and Mustafa, 2007).However, not all
posture is driven by three forces (Raheman et al,
business firms use a standardized capital
2007):
structure hence they differ in their financial
decisions under various terms and conditions. It (1) More debt in a firm’s capital structure allows
is therefore a difficult situation for these firms to for more tax benefits as their tax liabilities
determine the capital structure in which risk and become lower and even in some cases it is waved
costs are minimum and that can raise the value of off. Some firms having more profits go for more
shareholder wealth and or maximize profits debts rather than equity.
(Raheman, et al, 2007).This difference of choices
(2) If a firm has a low profit than there exists
about the financing decisions gives rise to various
greater chances of bankruptcy. So if the firm
capital structure theories.
takes more debts there are chances that it is
These theories try to justify and explain the bankrupt and as a result of this, investors cannot
differences of the capital structure across regions have trust on it. On the other hand, if a firm has
and times. Most empirical studies dealing with more profits than exists less chances of
capital structure theories are not recent (Taggart, bankruptcy so that investors’ trust rises and the
firm tends to earn more profits.
`
investors is a cost in form of interest rate because
creditors always check the position of the use to finance investments, that is used as a
company and monitor the management. So, if a
firm has a good image that it can get loan at a
lower cost because creditors are not worried
about bankruptcy and their agency cost is very
low, it can acquire more debts.
`
benchmark when raising funds for investing in troubling. The two dominant capital structure
new capital budgeting projects. Generally if a theories are the (static) tradeoff theory and the
firm uses more debt, the risk associated with its pecking order theory. The tradeoff theory states
future earnings is increased. At the same time, that a firm’s capital structure balances the costs
however, because debt has a fixed cost (that is, and benefits of debt financing, where the costs
interest), more debt allows the firm to earn a include bankruptcy and agency costs, and the
higher expected rate of return. Thus, there is a benefits include the debt tax shield and reduction
risk/return tradeoff associated with increasing of free-cash-flow problems (e.g. Jensen (1986),
(decreasing) debt. The firm should use the Jensen and Meckling (1976) and Stulz (1990)). A
amount of debt that maximizes the value of the prediction of the theory is that an increase in the
firm. Stated differently, at the best, or optimal, stock price, because it lowers the firm’s leverage
capital structure, the value of the firm is ratio, should lead to a debt issuance by the firm
information that investors don’t have, and goes existing theories, Baker and Wurgler (2002) find
on to show that firms will finance new that the level of a firm’s stock price is a major
investments first from retained earnings, then determinant of which security to issue, and Welch
from riskless debt, then from risky debt, and (2004) finds that firms let their capital structures
finally, only in extreme circumstances like change with their stock prices rather than issuing
financial distress, from equity. This implies that securities to counter the mechanical effect of stock
equity issues should be quite rare, particularly returns on capital structure. While Baker and
when the firm is doing well and its stock price is Wurgler (2002) attribute their finding to
high. managers attempting to time the market, Dittmar
The empirical evidence is, however, perplexing in and Thakor (2005) show theoretically and
light of these theories. As reinforced by Graham empirically that firms may issue equity when their
and Harvey’s (2001) survey evidence, firms issue stock prices are high even when managers are not
equity rather than debt when their stock prices attempting to exploit market mispricing (see also
are high (e.g. Asquith and Mullins (1986), Jung, Schultz (2003) for empirical evidence).
Kim, and Stulz (1996), Marsh (1982), and Mikke Recently, Fama and French (2004) have provided
and Partch (1986)). More ominously for the
`
direct evidence against the pecking order capital structure of a firm:
hypothesis and concluded that this hypothesis 1. Business risk—firms with greater business
cannot explain capital structure choices. They risk generally cannot take on as much debt as
find that equity issues are not as infrequent as firms with less business risk. A more detailed
the pecking order hypothesis predicts, and that discussion of business risk is given below.
between 1973 and 2002 the annual equity 2. Tax position—remember interest on debt is
decisions of more than half the firms in their tax deductible, which makes debt attractive as a
sample violated the pecking order. These source of financing. Also remember that more
empirical studies on dividend policy and capital debt generally implies a greater chance of
structure raise the obvious question: why do bankruptcy, which is extremely expensive.
firms work with lower leverage and dividend 3. Financial flexibility—to strengthen its balance
payout ratios when their stock prices are high? sheet, a firm might raise funds by issuing more
raise funds in the capital markets in a slumping that is, what portion of the financing is debt
economy. and what portion is equity—is termed its
4. Managerial attitude—some financial financial risk.
managers are more conservative than others Dividend Policy
when it comes to using debt, thus they are Dividends are cash payments made to
inclined to use less debt, all else equal. stockholders. Decisions about when and how
5. Business and Financial Risk—the much of earnings should be paid as dividends are
risk associated with a firm can be divided part of the firm’s dividend policy. Earnings that
into two components: the risk associated are paid out as dividends cannot be used by the
with the type of business the firm operates firm to invest in projects with positive net present
—that is, competitive conditions, whether values—that is, to increase the value of the firm.
the industry is capital- intensive or labor- The dividend policy that maximizes the value of
intensive, dangers associated with the the firm is said to be the optimal dividend policy.
manufacturing process, and so forth—is Financing decision requires an appropriate
termed its business risk; and the risk selection and combination of capital from
associated with how the firm is financed— available sources, investment decisions are
`
concerned with the efficient deployment of capital funds while, dividend decision involves
the periodic determination of proportion of a
firms total distributable earnings that is payable
to its shareholders. The larger the dividend paid,
the less funds are retained for investment and the
more the company will have to rely on other
sources of long term funds (such as additional
issues of equity and or debt capital) to finance
projects.
In developed countries, the decision between
paying dividend and retaining earnings has been
taking seriously by both investors and
`
a belief that managers change dividends values. In other words, a firm should pay
(increase or decrease) only when it is dividends only when it has funds that are
necessary i.e, decreases occur only when not needed to invest in positive NPV
the firm is facing financial difficulty, while projects—that is, only free cash flows
increases occur only when it is expected should be paid as dividends. If this theory
that the firm can continue to pay higher is correct, then we might expect a firm’s
dividends long into the future. If this is true, stock price to increase when it decreases
then changes in a firm’s dividend policy dividends to invest in positive NPV
provide information to investors, who will projects, and we might expect the stock
react accordingly. For example, investors price to decrease when the firm increases
would consider an increase (decrease) in dividends because it no longer has as
dividends to be good (bad) news, and thus many positive NPV projects as it did in
increase (decrease) the price of the firm’s prior years.
stock. Factors Influencing Dividend Policy
Clientele effect—investors might choose a Constraints on dividend payments—the
particular stock due to the firm’s dividend amount of dividends a firm pays might be
policy—that is, some investors prefer limited by:
dividends and others do not. If such a restrictions in debt agreements that state
clientele effect does exist, then we would the maximum amount of dividends that
expect that a firm’s stock price will change can be paid in any year;
when its dividend policy is changed. the amount of retained earnings, which
Free cash flow hypothesis—if investors represents the maximum amount of
truly want managers to maximize the value dividends that can be paid at any time;
of the firm, then dividends should be paid the liquidity position of the firm—if cash
only when the firm has no investments is not available, dividends cannot be paid;
with positive net present and
limits of the IRS on the amount of earnings
a firm can retain for non-specific reasons.
Investment opportunities—firms that need
great amounts of funds for positive NPV
`
investments usually pay relatively lower relatively small. Also, in countries that have few
amounts of dividends than firms with few regulations to protect small stockholders,
positive NPV investments. companies tend to pay greater amounts of
Alternative sources of capital—the higher earnings as dividends.
the costs of issuing new common stock, Furthermore, Oyejide (1976) empirically tested
generally the lower the relative amount of for company dividend policy in Nigeria using
dividends paid by a firm; firms that are Lintner’s model as modified by Brittain. He
concerned about diluting current disagreed with previous studies and concluded
ownership through new issues of common that “the available evidence provides a strong
stock are likely to pay relatively low and unequivocal support for the conventional
dividends. devices for explaining the dividend behaviour of
Effects of dividend policy on cost of equity— Nigerian limited liability business
`
to the partial liberation of the indigenization dividend-paying stocks and don’t pay dividends
decree in 1989 and the subsequent simultaneous when investors prefer non-dividend paying
abolition of the indigenization decree of 1995), stocks. This suggests that managers are
firm growth potentials and long term debts. conditioning dividend decisions on their firms’
However, Adesola (2004) in his study of dividend stock prices. And we know that firms consider
policy behaviour in Nigeria using Lintner’s model their stock price to be an important determinant
as modified by Brittan between 1996 – of whether to issue debt or equity (see Graham
2000appears to agree with Oyejide and Nyong’s and Harvey (2001)), which suggests that capital
view that there is substantial and unequivocal structure and dividend policy choices may be
support for the Lintner’s model. correlated via dependence on common factors.
More troubling is the fact that existing theories CONCLUSION
also do not explain why some firms never pay
Sighting the work of Michael F., Todd M. and
`
corporate performance, and consequently higher REFERENCES
agreement between the manager and investors, Adelegan, O., 2001. The Impact of Growth Prospect,
results in lower debt-equity ratios. Second, better leverage and firm size on dividend behaviour of
Corporate firms in Nigeria Manuscript,
corporate performance leads to lower dividend Department of Economics, University of Ibadan
Adesola, W. A., 2004. ”An Empirical study of dividend
payout ratios. policy of quoted firms in Nigeria”, An
Recommendation unpublished M.Sc Thesis, University of Calabar.
Allen, F., and R. Michaely, 2002, “Payout Policy,”
Based on the findings of this research, we Working Paper, forthcoming in North-Holland
Handbook of Economics (eds. G. Constantinides,
therefore present the following recommendations M. Harris and R. Stulz), 2002.
which will be useful to stakeholders. Asquith, P., and D. Mullins, 1986, “Equity Issues and
Offering Dilution,” Journal of Financial
Economics 15, 61-89.
Baker, M., and J. Wurgler, 2002, “Market Timing and
- Financial structure and dividend policy
Capital Structure,” Journal of Finance 57, 1-32.
should be thought of as co-determined Baker, M., and J. Wurgler, 2004, "A Catering Theory of
Dividends" Journal of Finance 59, 1125-1165.
`
Information That Investors Do Not Have",
Journal of Financial Economics 13, 187-221.
Nyong, M. O., 1990. “Dividend Policy of Quoted
Companies: A behavioural Approach using
recent data”, Manuscript. Department of
Economics, Lagos State University.
Oyejide, A., 1976. “Company dividend policy in
Nigeria: An empirical Analysis”, Journal of
Economics and Social Studies.
Petit, R. R., 1972. “The impact of Dividend and
Earnings Announcements: The International
Entrepreneurship and Management Journal 1(3):
335–52.
Schultz, P., 2003, “Pseudo Market Timing and the
Long-Run Underperformance of IPOs,” Journal of
Finance 58, 483-517.
Stulz, R., “Managerial Discretion and Optimal Financial
Policies,” Journal of Financial Economics 26, 3-
27.
Van Auken, H. E. 2005. A model of small firm capital