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DIVIDEND POLICY; IRRELEVANCE TO THE VALUE OF FIRM

BEING THE ASSIGNMENT ON CORPORATE FINANCE ACC802/FIN801

SUBMITTED TO:
DR. I. B. ABDULLAHI

DEPARTMENT OF ACCOUNTING AND FINANCE

SCHOOL BUSINESS AND GOVERNANCE
KWARA STATE UNIVERSITY, MALETE.

By

NAME MATRIC NO PROGRAMMME

SHEHU ISSA 16/27/MAC017 M.Sc. Accounting

OMOTOSHO IFEDOLAPO O. 16/27/MFI009 M.Sc. Finance
ADEBIYI OLUWASEGUN 16/27/MAC/004 M.Sc. Accounting
BELLO LUKMAN A. 16/27/MFI003 M.Sc. Finance
SOLIU FATIMAH O. 16/27/MFI013 M.Sc. Finance
APAOKAGI BADIRU A. 16/27/MFI002 M.Sc.
Finance
ABIDOYE MOBOLAJI KAFAYAT 16/27/MAC002 M.Sc. Accounting
JAWONDO KHADIJAT O. 16/27/MACO18 M.Sc. Accounting
DADA SUNDAY 14\27\mac005 M.Sc.Accounting

GROUP 3
APRIL, 2017

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INTRODUCTION

At the end of each financial year, each company ascertains its performance by establishing

whether a profit has been made or not. When a company makes a profit, the company’s board

of directors will need to determine the level of profit that has to be paid as dividend to equity

holders and the form the dividend use to take. The basic issue is whether dividend should be

paid now or ploughed back for business value.

The role of financial manager, therefore, is to strike a balance between dividend payout and

retention of earnings. This is a very difficult task because shareholders have different and

conflicting objectives – heterogeneous expectation – some may prefer steady flow of income

while others may prefer capital gains arising from increase share price.

Dividend policy is extremely important because of its announcement effect on share values. A

stable dividend policy is expected to lead to higher share prices because of the greater

confidence of investors about future prospect of the company. The objective of a dividend

policy should be to maximize a shareholder returns so that the value of his investment is

maximized.

Returns consist of two components: dividends and capital gains. Dividend policy has a direct

influence on this component despite the fact that the higher the dividend paid, the lower the

retention, the two serves the same purpose of maximizing the shareholders wealth while retain

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earnings are used to finance expansion, dividend payment increase a purchasing power of a

shareholder.

Dividend may be distributed among the shareholders in the form of the following:

A. Cash dividend

B. Stock dividend

C. Bond dividend

Cash Dividend

Most companies paid dividend cash. Cash dividend is a product of cash availability and cash

plan. The cash account and the reserve account of a company will be reduced when a cash

dividend is paid. Thus, both the total asset and the net-worth of the company are reduced

when cash dividend are distributed.

Stock Dividend/ Scrip Dividend

Stock dividend/ Scrip dividend involves the payment of a dividend in the form of extra shares

rather than cash.

As an alternative to paying out cash dividends during a year, a company may choose to pay a

stock dividend (scrip dividend).

Stock dividend is essentially a transfer to the shareholder of a number of additional equity

shares without the payment of cash as dividend to shareholders i.e. preservation of company’s

liquidity.

Scrip Issue/ Bonus issue/ Capitalization issue

This is the capitalization of the reserves of a company by the issues of additional shares to

existing shareholders in proportion to their holdings usually at no cost.

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A scrip issue is also called bonus issue or capitalization issue.

The declaration of bonus shares will increase the paid up share capital and reduce the reserves

and surplus of the company. The total net-worth is not affected by the bonus issue.

DIFFERENCE BETWEEN SCRIP DIVIDEND AND SCRIP ISSUE

1. With scrip dividend new shares are issued at full market price. This will lead to the

creation of share premium.

Whereas in a scrip issue the shares are issued at nominal value.

2. Scrip dividend attracts withholding tax while scrip issue does not attract withholding tax.

3. Scrip dividend is not necessarily issued to all shareholders. It may be optional. While

scrip issue is issued to all the shareholders.

TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable

position. On the basis of the dividend declaration by the firm, the dividend policy may

be classified under the following types:

• Regular dividend policy

• Stable dividend policy

• Irregular dividend policy

• No dividend policy.

Regular Dividend Policy

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Dividend payable at the usual rate is called as regular dividend policy. This type of policy

is suitable to the small investors, retired persons and others.

Stable Dividend Policy Stable dividend policy means payment of certain minimum

amount of dividend regularly. This dividend policy consists of the following three

important forms:

 Constant dividend per share

 Constant payout ratio

 Stable rupee dividend plus extra dividend.

Irregular Dividend Policy

When the companies are facing constraints of earnings and unsuccessful business

operation, they may follow irregular dividend policy. It is one of the temporary

arrangements to meet the financial problems. These types are having adequate profit.

For others no dividend is distributed.

No Dividend Policy

Sometimes the company may follow no dividend policy because of its unfavourable

working capital position of the amount required for future growth of the concerns.

DIVIDEND PAYOUT RATIO

This is the ratio of ordinary dividends to retained earnings. Dividend policy is concerned the

problem, WHICH IS BETTER “the payment of dividends now or the retention of earnings for

capital gain” or is there an optimum dividend payout ratio that maximize the combined value of

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dividend paid plus capital gain?. Therefore, it is quite possible that some investor will prefer

high payout companies while others may prefer low payout companies.

Thus, the relationship between dividend and the value of share is not clear cut. the financial

manager must understand the various conflicting factors, which influence the dividend policy

before deciding on the earnings.

Factors Affecting Dividend Policy

There are numbers of constraint affecting decision regarding dividend payout

(1) Legal

Company law allows a payment to dividend only out of distributable profit i.e.

(a) Profit arising from the use of company’s property although it is a wasting asset

(b) Revenue reserves

(c) Realized profit on a noncurrent asset (fixed asset) sold, but where more than one

asset is sold, the net realized profit on the assets sold; calculated on conventional

accounting principles. it is forbidden to distribute dividend out of capital (SECTIONS

379-382 OF CAMA).

(2) Government regulation

Government, through some guidelines restricts the amount of dividend payable to

shareholders by restricting dividend payment to a certain percentage of profits after

taxation. However, from 1988, dividend payment has been deregulated.

(3) Statutory requirements

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Some company are required to transfer a given percentage of their profit before and

after tax to statutory reserve, e.g.

Insurance companies

LIFE -10% of PBT or 1% of total premium whichever is higher

NON LIFE -20%of PBT or 3% of total premium whichever is higher

Banks

30% of PAT if statutory reserve is less than minimum paid up capital

15% of PAT if statutory reserve is more than minimum paid up capital

10% of PBT to SME reserve (ceased from March 11, 2008)

5% of PBT to microfinance credit reserve ( from March 11, 2008)

(4) Liquidity

Regardless of other consideration, a company will be unable to pay a dividend if cash is

not available to do so. It may however sometimes borrow e.g. by bank overdraft for this

purpose

(5) Share valuation

It has become part of stock market that investors favor a company if its dividends are

basically stable over time. A gentle upward movement is to be desired but violent

frustrations in either direction are not. This factor often leads many companies to adopt

a very cautious dividend policy.

(6) Internal re-investment Opportunities

If external finance is not available or available only by incurring significant transaction

costs, then the payment the payment of dividends may mean foregoing worthwhile

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investment opportunities. Dividend may have to be restricted to provide financing for

such investments.

(7) Loan Redemption

If loans \ preference share capital are due for redemption, this will require funds and

might cause a reduction in the level of dividend payout.

(8) The Risk Factor

Where a company wishing to obtain capitalization is not a blue chip. It may have to offer

higher dividend rates in order to encourage investors to undertake the risk involved.

Wide variations in dividends, however, should be avoided.

(9) Taxation

When the majority of shareholders are in the high income bracket, they will prefer to

receive returns in the form of capital profit such as bonus as they have to pay a high rate

of tax on dividend income; but when shareholders mainly consist of small investors in

low tax income bracket they are pleased to receive annual returns as high as can be

justifiably expected since the taxation angle does not concern them to such an extent.

(10) Level of Inflation

Investors sometimes expect dividends to increase at least in line with the level of

inflation. Also, in a world of increasing inflation, current flow is better than future when

the purchasing power of flow will be low.

THEORIES OF DIVDEND POLICY

There are two theories of dividend policy

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(1) The Dividend Irrelevancy Theory and

(2) The Dividend Supremacy / Relevancy Theory

For this purpose of this study, we are to focus on Dividend Irrelevancy Theory

The irrelevancy theory was first suggested by Modigliani and Miller (M&M) in 1961 and says

that the payments of dividend are irrelevant and the amounts paid do not affect the value of

the company in the long run.

THE DIVIDEND IRRELEVANCE THEORY (M&M)

In 1961 Franco Modigliani and Melton H Miller (M&M) argued against the claim that an active

dividend policy should be pursued as a means of maximizing shareholder wealth. They argued

that in a tax free world, shareholders are indifferent between dividends and capital gain, and

the value of a company is determined solely by the any power of its asset and investments.

The following points strengthen the M-M argument:

1. If earnings were distributed as dividends, each existing shareholder would gain, but would

suffer a proportionate loss in the form of reduction in this relative share of the company. This is

also because the absence of retained earnings implied that new shares \ loan stocks would

have to be issued to finance an internal investment program.

Earning retention, on the other hand would lead to appreciation in the value of existing shares,

since new investment would be financed without resorting to supplementary issues. This leads

one to conclude that shareholders should be indifferent between payment of dividend (and

obtaining new outside fund) and retained earnings.

2. A stockholders’ consumption preference need not be jeopardized by the dividend policy

adopted by his firm. If a firm pays more cash dividends than an investor needed for immediate

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consumption, he would return the surplus by buying extra shares with the fund. If fewer

dividends are declared, he would attain his consumption level by selling a proportionate

fraction of his total shares in the market. For this reason, again, shareholders should be

indifferent between payment of dividend and retained earnings.

3. Proponents of this theory point to apparent empirical contradictions, such as stocks with low or

more dividend payouts enjoying high market prices or high payout stock with depressed market

prices. They conclude, therefore, that dividend is not the critical factor determining share

values.

The implication of the dividend irrelevancy theory is that the investment programme of a

company is specified, it does not matter if projects are financed by the retained earning (i.e a

cut in dividend) or new external equity. The impact upon shareholders ’wealth will be the same.

4. MM argued that if a company with investment opportunities decide to pay a dividend, so the

retained earnings are insufficient to finance all the investments, earning additional funds from

outside sources would make up the short fall in funds. The consequent loss of value in the

existing shares, as a result of obtaining outside finance instead of using retained earnings is

exactly equal to the amount of the dividend paid. A company should therefore be in different

between paying a dividend ( and obtaining new outside funds) and retaining earnings.

MM also argued that if a company raised new funds not in form of shares, but as an issue of

loan stock the irrelevance of dividend policy ( i.e. in difference between dividend and capital

gain) remains unaffected. Although, the cost of loan may be lower than the cost of equity, an

increase in the company’s level of gearing would cause the cost of equity to rise so that the

effective marginal cost of the new funds would be the equivalent.

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MM theory is anchored on the following assumptions:

1. Perfect capital markets, where investors act rationally, and have access to perfect and

costless information.

2. No floatation costs on securities issued by a company, and so transaction cost on securities

sold by a shareholders.

3. A world of no taxation, or if there is taxation, the same tax rate is applicable to capital gain

and dividend income.

4. Perfect certainty by every investor as to future investments and profits of the company.

5. Risks of uncertainty do not exist.

6. The company will maintain a fixed investment policy.

Proof for MM approach

MM approach can be proved with the help of the following formula:

Po = D1 + P1
(1 + Ke)
Where ,

Po = prevailing market price of a share.

Ke = Cost of equity capital.

D1 = Dividend to be received at the end of period one.

P1 = Market price of the share at the end of period one.

P1 can be calculated with the help of the following formula.

P1 = P 0 ( 1 + K e ) – D 1

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The number of new shares to be issued can be determined by the following formula:

M * P1 = I - (X - nD1)

Where,

M = Number of new share to be issued.

P1 = Price at which new issue is to be made.

I = Amount of investment required.

X = Total net profit of the firm during the period.

nD1 = Total dividend paid during the period.

Illustration 1

Ayeole Company Ltd., has 100000 shares outstanding, the current market price of the

shares N15 each. The company expects the net profit of N200,000 during the year and it

belongs to a rich class for which the appropriate capitalisation rate has been estimated to

be 20%. The company is considering dividend of N2.50 per share for the current year. What

will be the price of the share at the end of the year (i) if the dividend is paid and (ii) if the

dividend is not paid.

Solution

Po = D1 + P1
(1 + Ke)
(i) If the dividend is paid

P0 = N15

Ke = 20%

D1 = 2.50

P1 = ?

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15 = 2.50 + P1
1 + 20%

15 = 2.50 + P1
1.2

2.50 + P1 = 15 * 1.2

P1 = 18 - 2.50

P1 = N15.50

(ii) If the dividend is not paid

P0 = N15

Ke = 20%

D1 = 0

P1 = ?

15 = 0 + P1
1.20

0 + P1 = 15 * 1.20

P1 = N18

Illustration 2

Kingkong company belongs to a risk class for which the appropriate capitalization rate is 12%. It

currently has outstanding 30,000 shares selling at N100 each. The firm is contemplating the

declaration if dividend of N6 per share at the end of current financial year. The company

expects to have a net income of N300,000 and a proposal for making new investments of

600,000. Show that under the MM assumptions, the payment of dividend does not affect the

value of the firm. How many new shares issued and what is the market value at the end of the

year?.

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Solution

P0 = D 1 + P 1
(1 + Ke)
P0 = 100

D1 = N6

P1 = ?

Ke = 12%

100 = 6 + P1
1 + 0.12
100 = 6 + P1
1.12

6 + P1 = 112

P1 = 112 - 6

P1 = N106

Dividend is not declared

Ke = 12%, P0 = 100, D1 = 0, P1 = ?

100 = 0 + P1
1 + 12%

100 = 0 + P1
1.12

P1 = N112

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Calculation of number of new shares to be issued

Dividends Paid Dividends not Paid

Net Income 300,000 300,000
Total Dividends 180,000 -
Retained Earnings 120,000 300,000
Investment Budget 600,000 600,000

Amount to be raised as new shares 480,000 300,000

(Investment - Retained Earnings)

Relevant - Market Price Per Share N106 N112

No. of new shares to be issued 4528.3 2678.6

Total number of shares at the end of year 30,000 30,000

Existing Shares 4528.3 2678.6
New shares issued 34528.3 32678.6

Market price per share N 106 112

Market value for shares N3,660,000 3,660,000

There is no change in the total market value of shares whether dividends are distributed or not

distributed.

Illustration 3

ABC Ltd. has a capital of N1,000,000 in equity shares of N100 each. The shares are currently

quoted at par. The company proposes to declare a dividend of N10 per share at the end of the

current financial year. The capitalization rate for the risk class to which the company belongs is

12%.

What will be the MP of the share at the end of the year, if

(i) A dividend is not declared.

(ii) A dividend is declared.

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(iii) Assuming that the company pays the dividend and has net profits of N500,000 and

makes new investments of N1,000,000 during the period, how many new shares must be

issued? Use the MM Model.

Solution

As per MM Model, the current MP of the share is

P0 = D 1 + P 1
1 + Ke

(i) If the dividend is not declared

100 = 0 + P1
(1 + 0.12)

100 = P1
1.12

P1 = N112

(ii) If the dividend is declared

100 = 10 + P1
1 + 0.12

100 = 10 + P1

1.12

112 = 10 + P1

P1 = 112 – 10

P1 = N102

(iii) In case the firm which pays dividend of N10 per share, then the number of new

shares to be issued is M.

M * P1 = I – (X –nD1)

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M * 102 = 1,000,000 - (500,000 - 10,000 * 10)

102m = 1,000,000 - 400,000

M = 600,000
102
= 5882.35 or 5883
The firm should issue 5883 new shares @ N102 per share to finance its investment

proposals.

Illustration 4

Z Ltd., has risk allying firm for which capitalization rate is 12%. It currently has outstanding

8,000 shares selling at N100 each. The dividend for the current financial year is N7 per share.

The company expects to have a net income of N69,000 and has a proposal formatting new

investments of N160,000. Show that under the MM hypothesis the payment of dividend does

not affect the value of the firm.

(a) Value of the firm when dividends are paid. Price of the shares at the end of the current

financial year.

P1 = P0 (1 + Ke) - D1

= 100 (1 + 0.12) - 7

= 100 * 1.12 – 7

P1 = N105

(b) Number of shares to be issued

S = I – (TE – nD)
P1
= 160,000 - (69000 – (8000 * 7))
105
= 160,000 - (13000)

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105
147,000
105 =1400 shares
The MM hypothesis explained in another firm also assumes that investment required by
the firm on account of payment of dividends is finance out of the new issue of equity shares.
S = I – (TE - nD)
M1
S = value of the firm can be calculated as follows.
nPo = (N + S) M1 - (1 - TE)
1 + Ke
nPo = Value of the firm
TE = Total Earnings
M1 = Market Price at the end of the period
Ke = Cost of capital
D = Dividend paid at the end of the year (or) period
N = Number of shares outstanding at the beginning of the period.

nPo = (N + S) M1 - (1 - TE)
1 + Ke

= 8000 + 1400 * 105 - (160,000 - 69,000)

1 + 12%

= 9400 * 105 - 91000

1.12
= 800,000
REFERENCE

Akinsulire, O. (2014). Financial management (8th Edition). Lagos: El-Toda Ventures Limited

C. Paramasivan and T. Subramanian, Financial Management, New Age International (P)

Limited, Publishers

Pandey, I.M. (2005). Financial Management. New Delhi: Vikas Publishing House

Aremu I.B, (2016) Investment decision

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Jack, C. B. & James, F. N. (2001).Financial Management and Policy.Prentice Hall. 11thed

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