CAPITAL STRUCTURE AND DIVIDEND

POLICY; TWO SIDES OF A COIN

Bello A. Sulaimon

July, 2014
 Capital Structure and Dividend Policy; Two Sides of a Coin

Bello A. Sulaimon
sulbellven01@yahoo.com; +(234) 8160442283

Department of Accounting, Bayero University, Kano

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 diverg ent 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 proposes a 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.

Capital Structure and Dividend Policy; Two Sides of a Coin

Key words: Capital, Dividend, Finance, Capital Structure, dividend Policy and profit.

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.

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It should be noted that there are multiple
financing sources, where the firms can depend on
it to finance their investments. Financing sources
categorize into two sources, the internal financing
which includes common stock issuance, preferred
stocks, reserves and retained earnings. Another
source called external financing which consists
short and long term loans and bonds issuance. At
this case ,firms must choose the best financing
sources to reach the optimal capital structure to
be in harmony with firms requirements to take
suitable financing decision and then reflect
positively on their performance.
An issue that is strictly connected with the choice
of financing sources is dividend policy, which also
constitutes a broad research area. The issue of the
optimal capital structure (target capital
structure), as well as the choice of dividend
policy, remains unsolved. Both those areas of
research are interconnected and dependent on
each other. In addition, the choice of capital
structure and dividend policy is dictated by
different factors that are difficult to identify and
not easy to consider in research. Theoretically
most models discussing capital structure of firms
identify tax savings, bankruptcy costs, transaction
costs, adverse selection and agency cost etc as the
dominant factors influencing a firm’s choice of
debt and also its impact on firm performance
(Modigliani and Miller, 1963).
In practice different firms may pursue different
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goals but the core objective of any firm is to
minimize its cost. So far as the creditors and
investors in the stock market are concerned, of
the total cost they are specifically interested in
the financing cost of capital. This may be so
because debt to equity ratio enables the creditors
in knowing the likelihood of default of the
excessively leveraged firms. Similarly, to know
the expected returns on their risk bearing
activities, investors and traders in the stock
market are interested to know the relative
impact of debt on a firm’s performance. Both
Capital Structure and Dividend Policy; Two Sides of a Coin
investors and traders examine the daily
performance of firms listed on stock exchanges
and rank firms accordingly. It is on the basis of
this ranking and historical prices of stocks that
they decide to invest their funds in relatively high
performing firms.
The payment of dividends conveys to
shareholders that the company is profitable and
financially strong. An increase in payment ratio
signals to shareholders a permanent or long-term
increase in firms expected earnings. Accordingly,
the price of share may be affected by changes in
dividend policy. Dividend may offer tangible
evidence of the firm’s ability to generate cash,
and as a result, the dividend policy of the firm
affects the share price (Solomon, 1963). The
market value of share is affected not because of
the change in dividend but because of the
information about changes in the future expected
earnings conveyed through the payment (Pandey,
2000 pp.765).
It is contended that dividends are relevant
because they have informational value. It is also
believed that information content of dividend can
go a long way to affect companies share market
price by sending signals to prospective investors.
Some of the pertinent problems are: why do
companies pay dividend? What actually informs
the dividend policy? What is the form of
dividend? Do dividend matters? Of all the theories
of dividend policy, which of one them best predict
dividend policy behaviour in a specific case e.g.
quoted firms in Nigeria? Can the magnitude of the
factors that influence dividend policy be used in
predicting market share prices of the firms under
review?
Statement of the Problem
The main objective of a business organization is
the maximization of profit which will lead to
maximization of shareholders wealth. However,
there may be conflict between a firm’s competing
objectives. For instance, the sales manager may
want to have the highest growth possible, while
the finance manager may want to maintain a
certain credit rating to boost sales. As a result of
growth in sales, production plan will be altered
leading to procurement of more equipment to
meet increase in sales. Higher sales growth could
mean a wide variety of products is needed, which
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in turn calls for higher inventory. Higher
inventory levels may mean less efficient use of
assets (lower asset turnover).Hence, high growth
may mean borrowing if this growth cannot be
financed through fund generated from operation.
More borrowing may mean a lower crediting
rating. This competing interest must be balanced
to improve corporate efficiency through asset
utilization.
Objective of the Study
The objective of this study is to propose a new
and integrated theory of dividend policy and
Capital Structure and Dividend Policy; Two Sides of a Coin
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 are driven by the
same underlying factors.
Significance of the Study
The endogenously-determined allocation of
control between the manager and investors is
important 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  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
remains an issue of discuss, both areas are

Capital Structure and Dividend Policy; Two Sides of a Coin

to provide further evidence to test the impact of
deemed to be interconnected and dependent on
capital structure and firm dividend policy will be
each other. In addition, the choice of capital
seen as two side of the same coin.
structure and dividend policy is dictated by
Definition of terms
different factors that are difficult to identify and
 Capital: A stock of money, possessed by a
not easy to consider in research. The importance
person or firm which may be invested
of the issue is underlined by the recognition
from time to time in order to earn income
granted to Modigliani and Miller regarding the
but which is intended not to be diminished
issues of forming capital structure and, indirectly,
 Debt capital: Capital attributable to
dividend policies. In the theory of economics, and
creditors i.e outside interest. These are
specifically finances, we can observe different
loans of a long-term nature, it could be
attitudes to the issue of shaping the most
secured or unsecured.
favorable sources of activity financing, described
 Dividend: The amount of a firm’s profits
in the theory of substitution and in the theory of
paid to the proprietors of the firm i.e.
hierarchy (Van Auken2005).
shareholders of a company.
Capital structure
 Ordinary share capital: The holders of this
Capital structure refers to how a company
capital are the owners of the business.
finances its operations and it is usually by:

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  Ordinary share capital
 Preference share capital
 Debt capital
If a company maintains the proportion of these
sources of finance, the weighted average cost of
capital (WACC) will remain unchanged.
Capital Structure Theories
Capital structure, refers to the various financing
options of the asset by a firm. A business concern
can go for different levels of the mixture of equity,
debt and other financial facilities with equity
having the emphasis on maximizing the firm’s
market value. Capital structure affects the
liquidity and profitability of a firm (Raheman,
Zulfiquar and Mustafa, 2007).However, not all
business firms use a standardized capital
structure hence they differ in their financial
decisions under various terms and conditions. It
is therefore a difficult situation for these firms to
determine the capital structure in which risk and
costs are minimum and that can raise the value of
shareholder wealth and or maximize profits
(Raheman, et al, 2007).This difference of choices
about the financing decisions gives rise to various
capital structure theories.
These theories try to justify and explain the
differences of the capital structure across regions
and times. Most empirical studies dealing with
capital structure theories are not recent (Taggart,
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1997, Marsh, 1982; Jaliv and Harris, 1984; Titman
and Wessels, 1988 and Okafor and Harmon,
2005). The latter authors made a significant
contribution in formulating and testing the
determinants of capital structure as identified by
theory. Two outstanding theories emerge and
present a clear direction and firm behaviour
about debt and capital structure. These are trade-
off theory and pecking order theory.
According to trade off theory propounded by
Modigliani and Miller (1958), if firms are more
profitable they prefer debt financing as compared
Capital Structure and Dividend Policy; Two Sides of a Coin
to equity for the sake of profit. This posture is
driven by three forces (Raheman et al, 2007):
(1) More debt in a firm’s capital structure allows
for more tax benefits as their tax liabilities
become lower and even in some cases it is waved
off. Some firms having more profits go for more
debts rather than equity.
(2) If a firm has a low profit than there exists
greater chances of bankruptcy. So if the firm
takes more debts there are chances that it is
bankrupt and as a result of this, investors cannot
have trust on it. On the other hand, if a firm has
more profits than exists less chances of
bankruptcy so that investors’ trust rises and the
firm tends to earn more profits.
(3) The agency cost which has to be borne by
investors is a cost in form of interest rate because
creditors always check the position of the
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.
Capital structure has been a major issue in
financial economics ever since Modigliani and
Miller showed in 1958 that given frictionless
markets, homogeneous expectations, etc., the
capital structure decision of the firm is irrelevant.
This conclusion depends entirely on
benchmark when raising funds for investing in
new capital budgeting projects. Generally if a firm
uses more debt, the risk associated with its future
earnings is increased. At the same time, however,
because debt has a fixed cost (that is, interest),
more debt allows the firm to earn a higher
expected rate of return. Thus, there is a
risk/return tradeoff associated with increasing
(decreasing) debt. The firm should use the
amount of debt that maximizes the value of the
firm. Stated differently, at the best, or optimal,
capital structure, the value of the firm is
the

Capital Structure and Dividend Policy; Two Sides of a Coin

assumptions made. By relaxing the assumptions
and analysing their effects, theory seeks to
determine whether an optimal capital structure
exists or not, and if so what could possibly be its
determinants.
All thing being equal, the more debt a firm uses,
the higher its cost of debt. In any event, if the
overall WACC is affected by how the firm finances
itself—that is, how much debt and equity it
uses—then we want the be able to determine the
proportion of each type of funds the firm should
use to maximize its value.
The Target Capital Structure—capital structure
refers to the combination of funds, in the form of
debt and equity, a firm uses to finance its assets. A
firm usually sets a target capital structure, which
is the proportion of debt and equity it wants to
use to finance investments, that is used as a
maximized because the overall WACC is
minimized.
The evidence on capital structure is even more
troubling. The two dominant capital structure
theories are the (static) tradeoff theory and the
pecking order theory. The tradeoff theory states
that a firm’s capital structure balances the costs
and benefits of debt financing, where the costs
include bankruptcy and agency costs, and the
benefits include the debt tax shield and reduction
of free-cash-flow problems (e.g. Jensen (1986),
Jensen and Meckling (1976) and Stulz (1990)). A
prediction of the theory is that an increase in the
stock price, because it lowers the firm’s leverage
ratio, should lead to a debt issuance by the firm
to bring its capital structure back to its optimum.
The pecking order theory (see Myers and Majluf
(1984)) assumes that managers have private

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information that investors don’t have, and goes
on to show that firms will finance new
investments first from retained earnings, then
from riskless debt, then from risky debt, and
finally, only in extreme circumstances like
financial distress, from equity. This implies that
equity issues should be quite rare, particularly
when the firm is doing well and its stock price is
high.
The empirical evidence is, however, perplexing in
light of these theories. As reinforced by Graham
and Harvey’s (2001) survey evidence, firms issue
equity rather than debt when their stock prices
are high (e.g. Asquith and Mullins (1986), Jung,
Kim, and Stulz (1996), Marsh (1982), and Mikke
and Partch (1986)). More ominously for the
existing theories, Baker and Wurgler (2002) find
that the level of a firm’s stock price is a major
determinant of which security to issue, and Welch
(2004) finds that firms let their capital structures
change with their stock prices rather than issuing
securities to counter the mechanical effect of
stock returns on capital structure. While Baker
and Wurgler (2002) attribute their finding to
managers attempting to time the market, Dittmar
and Thakor (2005) show theoretically and
empirically that firms may issue equity when
their stock prices are high even when managers
are not attempting to exploit market mispricing
(see also Schultz (2003) for empirical evidence).
Recently, Fama and French (2004) have provided
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direct evidence against the pecking order
hypothesis and concluded that this hypothesis
cannot explain capital structure choices. They
find that equity issues are not as infrequent as the
pecking order hypothesis predicts, and that
between 1973 and 2002 the annual equity
decisions of more than half the firms in their
sample violated the pecking order. These
empirical studies on dividend policy and capital
structure raise the obvious question: why do
firms work with lower leverage and dividend
payout ratios when their stock prices are high?
Capital Structure and Dividend Policy; Two Sides of a Coin
Factors Influencing Capital Structure Decision
The following factors should be considered when
making decisions about the capital structure of a
firm:
1. Business risk—firms with greater business
risk generally cannot take on as much debt as
firms with less business risk. A more detailed
discussion of business risk is given below.
2. Tax position—remember interest on debt is
tax deductible, which makes debt attractive as a
source of financing. Also remember that more
debt generally implies a greater chance of
bankruptcy, which is extremely expensive.
3. Financial flexibility—to strengthen its balance
sheet, a firm might raise funds by issuing more
common stock. On a relative basis, a stronger
financial position—that is, stronger balance
sheet—generally implies the firm is better able to
raise funds in the capital markets in a slumping
economy.
4. Managerial attitude—some financial
managers are more conservative than others
when it comes to using debt, thus they are
inclined to use less debt, all else equal.
5. Business and Financial Risk—the risk
associated with a firm can be divided into two
components: the risk associated with the type of
business the firm operates—that is, competitive
conditions, whether the industry is capital-
intensive or labor-intensive, dangers associated
with the manufacturing process, and so forth—is
termed its business risk; and the risk associated
with how the firm is financed—that is, what
portion of the financing is debt and what portion
is equity—is termed its financial risk.
Dividend Policy
Dividends are cash payments made to
stockholders. Decisions about when and how
much of earnings should be paid as dividends are
part of the firm’s dividend policy. Earnings that
are paid out as dividends cannot be used by the
firm to invest in projects with positive net present
values—that is, to increase the value of the firm.
The dividend policy that maximizes the value of
the firm is said to be the optimal dividend policy.
Financing decision requires an appropriate
selection and combination of capital from
available sources, investment decisions are
concerned with the efficient deployment of
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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
Capital Structure and Dividend Policy; Two Sides of a Coin
management, and has been the subject of
considerable research by economists in the last
four decades (Lintner, 1956; Britain, 1964;
Modigliani and Miller, 1961; Petit, 1976; Black
and Scholes, 1974; Michael, Thaler and Womack
1995; Dhillon and Johnson, 1994; Amibud and
Murgin, 1997; Chariton and Vafeas, 1998) as
cited in Adelegan (2001).
Dividend Policy and Stock Value
Researchers argue whether there exists an
optimal dividend policy. Some academicians
argue that a firm’s dividend policy does not affect
the value of a firm (dividend irrelevance theory),
while other argue that the dividend policy is an
important factor in the determination of a firm’s
value (dividend relevance theory).
Investors and Dividend Policy—investors’
reactions to changes in dividend policies can be
summarized as follows:
 Information content, or signaling—there is
a belief that managers change dividends
(increase or decrease) only when it is
necessary i.e, decreases occur only when
the firm is facing financial difficulty, while
increases occur only when it is expected
that the firm can continue to pay higher
dividends long into the future. If this is
true, then changes in a firm’s dividend
values. In other words, a firm should pay
dividends only when it has funds that are
not needed to invest in positive NPV
projects—that is, only free cash flows
should be paid as dividends. If this theory
is correct, then we might expect a firm’s
stock price to increase when it decreases
dividends to invest in positive NPV
projects, and we might expect the stock
price to decrease when the firm increases
dividends because it no longer has as
many positive NPV projects as it did in

Capital Structure and Dividend Policy; Two Sides of a Coin

policy provide information to investors,
who will react accordingly. For example,
investors would consider an increase
(decrease) in dividends to be good (bad)
news, and thus increase (decrease) the
price of the firm’s stock.
 Clientele effect—investors might choose a
particular stock due to the firm’s dividend
policy—that is, some investors prefer
dividends and others do not. If such a
clientele effect does exist, then we would
expect that a firm’s stock price will change
when its dividend policy is changed.
 Free cash flow hypothesis—if investors
truly want managers to maximize the
value of the firm, then dividends should be
paid only when the firm has
investments with positive net present
prior years.
Factors Influencing Dividend Policy
 Constraints on dividend payments—the
amount of dividends a firm pays might be
limited by:
 restrictions in debt agreements that state
the maximum amount of dividends that
can be paid in any year;
 the amount of retained earnings, which
represents the maximum amount of
dividends that can be paid at any time;
 the liquidity position of the firm—if cash
is not available, dividends cannot be paid;
and
 limits of the IRS on the amount of earnings
a firm can retain for non-specific reasons.
no
 Investment opportunities—firms that need
great amounts of funds for positive NPV

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 investments usually pay relatively lower
amounts of dividends than firms with few
positive NPV investments.
 Alternative sources of capital—the higher
the costs of issuing new common stock,
generally the lower the relative amount of
dividends paid by a firm; firms that are
concerned about diluting current
ownership through new issues of common
stock are likely to pay relatively low
dividends.
 Effects of dividend policy on cost of equity—
in an effort to minimize its WACC through
the cost of equity, a firm will examine the
effect a dividend policy has on its required
rate of return. Factors such as risk
perception, information content
(signaling), and preference for current
returns versus future returns (that is,
dividend yield or capital gains) are
considered when the dividend policy is
established.
Dividend Policies around the World
There is great variation in dividend policies of
firms in different parts of the world. In most parts
of the world, dividend policies are based on local
tax laws. For example, in countries where the tax
on capital gains is less than the tax on dividends,
firms tend to retain greater amounts of earnings
than in countries where the tax on dividends is
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relatively small. Also, in countries that have few
regulations to protect small stockholders,
companies tend to pay greater amounts of
earnings as dividends.
Furthermore, Oyejide (1976) empirically tested
for company dividend policy in Nigeria using
Lintner’s model as modified by Brittain. He
disagreed with previous studies and concluded
that “the available evidence provides a strong
and unequivocal support for the conventional
devices for explaining the dividend behaviour of
Nigerian limited liability business
Capital Structure and Dividend Policy; Two Sides of a Coin
organization.”.Nyong (1990) conducted a study
on dividend policy of quoted companies in
Nigeria dividend policy of cross section of Nigeria
quoted companies and also to assess the
magnitude of these factors in predicting the
observed share prices of the companies, he
observed among others that the conventional
Lintner’s model performs creditably well.
Adelegan (2001) in a more recent study of the
impact of growth prospect, leverage and firm size
on dividend behaviour of corporate firms in
Nigeria between 1984 – 1997; observed that the
conventional Lintner’s model does not perform
quite creditably in explaining the dividend
behaviour of corporate firms for the period under
review. Supports that factors that mainly
influenced the dividend policy quoted firms are
after tax earnings, economic policy changes (due
to the partial liberation of the indigenization
decree in 1989 and the subsequent simultaneous
abolition of the indigenization decree of 1995),
firm growth potentials and long term debts.
However, Adesola (2004) in his study of dividend
policy behaviour in Nigeria using Lintner’s model
as modified by Brittan between 1996 – of whether to issue debt or equity (see Graham
2000appears to agree with Oyejide and Nyong’s
view that there is substantial and unequivocal
support for the Lintner’s model.
More troubling is the fact that existing theories
also do not explain why some firms never pay
dividends whereas others consistently do, why
the payment of dividends seems dependent on
the firm’s stock price, and why there seem to be
correlations between firms’ capital structure and
dividend policy choices. For example, companies
like Cisco and Microsoft until recently have for
years operated with no dividends.
Similarly, firms like General Electric, Anheuser-
Busch, and Coca-Cola have had a long history of
paying dividends while still maintaining relatively
high growth. Why? It seems implausible to argue
that Cisco and Microsoft have nothing to signal
while General Electric, Anheuser-Busch and Coca-
Cola do, or that managers at Anheuser-Busch and
Coca-Cola pay dividends to reduce managerial
excess cash consumption while Cisco and
Microsoft have no such worries. Further, Baker
and Wurgler (2004) find that managers pay
dividends when investors place a premium on
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dividend-paying stocks and don’t pay dividends
when investors prefer non-dividend paying
stocks. This suggests that managers are
conditioning dividend decisions on their firms’
stock prices. And we know that firms consider
their stock price to be an important determinant
and Harvey (2001)), which suggests that capital
structure and dividend policy choices may be
correlated via dependence on common factors.
CONCLUSION
Sighting the work of Michael F., Todd M. and
Capital Structure and Dividend Policy; Two Sides of a Coin
Anjan T. (2006), they presented a model of
potential disagreement between managers and
investors that leads to testable predictions about
both capital structure and dividend policy. The
basic idea is simple. The better a firm performs;
the greater is the confidence that investors have
in the manager’s ability to make future decisions
that will also result in good performance. Hence,
the probability that investors will disagree with
the manager’s project choice declines and this
makes it less expensive for the manager to make
financial policy choices that increase the
manager’s project-choice control and reduce the
investors’ ability to block such project choices.
The analysis implies that the manager’s project-
choice control is decreasing in the firm’s leverage
and in its dividend payout ratios. This leads to
the following two key predictions: First, better
corporate performance, and consequently higher
agreement between the manager and investors,
results in lower debt-equity ratios. Second, better
corporate performance leads to lower dividend
payout ratios.
Recommendation
Based on the findings of this research, we
therefore present the following recommendations
which will be useful to stakeholders.
- Financial structure and dividend policy
should be thought of as co-determined
financial policy variables to implement
endogenously-determined control
allocations
- That the common underlying factor
tying financial structure and dividend
together is the firm’s performance.
- It would be interesting to examine
which other corporate decisions are
driven by corporate performance via
its impact on the optimal sharing of
control between the manager and
investors.
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Capital Structure and Dividend Policy; Two Sides of a Coin
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