CHAPTER SIX

DIVIDEND POLICY

nividend - is the earnings distributed to shareholders. It constitutes the use of the firm cash to

shareholders current return.

increase the
Dividend decision - 1s the split of earnings between dividends and retained earnings

Dividend policy - refers to the process by which a company lays down its policy on payment

of dividend i.e. the nature of the dividend to be paid either cash or stock dividend and the
frequency for payment of these dividends i.e. interim or final dividend.

The objective of a dividend policy is to maximize a shareholders return so the value of his
investment is maximized. Shareholders return consists of two components:

) Dividend gain

(ii) Capital gain

Dividend policy has a direct influence on these two components of return.

Dividend Relevance
Prof James E. Walter and Myron Gordon Hypothesis
Walter and Gordon argue that the choice of dividend policies will always affect the value of

the firm. The higher the divided the grater the current value of the share. Higher retention

wIll ensure greater capital gain and thus future value is increased.

Their models show the importance of the relationship between the firm's rate of return and

its cost of capital in determining the dividend policy that will maximize the shareholder

wealth.

Basic assumptions of Walter & Gordon theories

1. All equity firms- the firms has no debt

2. Internal financing or no external financing. The firm finances all investments through
Tetained earnings, i.e. no debt or new equity is issued.

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3. 100% pay out or retention - all earnings are either distributed as dividends or reinvested

internally immediately.
4, Constant returns constant EPS and DPS. That EPS and DPS are assumed to remain

constant forever in determining a given value.

5, Infinite time - the firm has a very long time or infinite life.

6. Perpetual earnings. The firm and its stream of earnings are perpetual.

7. No taxes corporation tax do not exist

NB: Gordon's model is similar to that of Walters's model. This similarity is due to the

similarities of assumptions thai,under both the models.

Dividend Irrelevance

Franco Modigliani and Merton Miller (MM) proposition.

market situation, the dividend policy of a firm is
According to MM, under a perfect
They argue that the value of
the firm
irrelevant, as it does not affect the value of the firm.
when investment
depends on the firms earnings that result from its investment policy. Thus,
decision of the firm is given, dividend decision is of no significance in determining the value

of the firm.

market condition may experience one of the following

A firm operating in perfect capital
dividends.
three situations regarding the payment of

dividends therefore, a shareholder will receive

i) The firm has sufficient cash to pay
assets reduce as a result of decline in cash balance.
cash but his claim on the firm's
cash to pay dividends and therefore, it issue new
ii) The firm does not have sufficient
dividends.
share to finance the payment of
but a shareholder needs cash. Shareholders will sale
iil) The firm does not pay dividends,
a part of their claim to the new
their shares party to get cash. He exchanges
shareholder in exchange for cash.
MM hypothesis of irrelevance is based on the following assumptions.

.Perfect capital markets -The firm operates in perfect capital markets where investors
to all and transactions and flotation
behave rationally, information is freely available

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 costs do not exist. It also implies that no one investor is large enough to affect the market

share.
price of a
N o taxes- taxes do not exist or there is no difference in the tax rates applicable to capital

gains and dividends. This means that the investor values a shilling of dividend as much as

a shilling of capital gain.

3. Investment policy is fixed thus ensuring a consistent return.

4. No risk- risk ofuncertainty does not exist. Investors are able to forecast future prices

and dividends with certainly, and one discount rate is appropriate for all securities and all
time periods.

Dividends and Uncertainty

The Bird-in-the-hand Argument

Of two stocks with identical earnings record and prospects but the one paying a larger

dividend than the other, the former will undoubtedly command higher price merely because
a

future values. Stockholder often act upon the principle that a

stockholder prefer present to
bird in the hand is worth vo in the bush and for this reason are willing to pay a premium

discount the with the lower rate.

for the stock with the higher dividend rate, just as they one

of uncertainly, investors tend to

This view is based on the assumption that under conditions
dividend.
discount distant dividends (capitalgains) at a higher rate than they discount near
risk averse and therefore, have a preference for near
Investors behaving rationally are
dividend to future dividend.

The investor would most certainly prefer to have his dividend today and let tomorrow
typical
in the same general position and with the
take careof itself. However, given two companies
Same earning power, the one paying the larger divVidend will always sell at a higher price.

the further one lookS into the future, the more

Uncertainly increases with futurity that is,
uncertain dividends become. Thus investors prefer to avoid uncertainty and would be willing
O pay higher price for the share that pays the greater current dividend, all other things held

Constant.

Compiled by: Kemboi Olger 79

 Dividend Policy
Aspect of
ation model states that the value of a security equals the future ex)
[he dividend valuat expected

uns from that security discounted at the security holders required rate of return. The
iIn:
ret

ividend mod nodel is based on the assumption that the current market value of a share equals the

value placed by investors on future expected cash returns on the shares. In otherwords the
chare prices equal the present value of all expected future dividends.

Share price (ex div) Annual dividend in percentage

Cost of equity

Share price (cum div) = Annual dividend in percentage + current dividends

Cost of equity

Factors Affecting Company's Dividend Policy

If the company has a number of viable
i) The company's long-term financing decision
-

most of the earnings to finance these investments. Under these

ventures, it will retain
stock dividends.
conditions will pay less cash dividends but instead
A company must give good returns to its
ii) Return to shareholders (Wealth Maximization)
-

for current income, i.e. the company will have to pay good
shareholders to satisfy their desire
keep them happy as investors. This will have an impact on
dividends to its shareholders to
will increase at the NSE.
the company's share prices which
of raw materials, machinery and
i) Economic conditions prevailing During inflation prices
-

and companies may not be able to

Thus, the operating cost
increase
other overheads go up.

pay dividends.
A company which has paid dividends may
v) Access to capital and money markets
-

result of cash drain. Thus if a company has

Cxperience liquidity problems (finance gap) as a
it will not hesitate to pay dividends as the gap
easy access to capital and money markets,
Created can be finance immediately.
V)The company's control - The control of the company is in the hands of ordinary share

either issued shares raised

nolders. This control may be diluted if the company has
more or

g n level of debt finance. If the company pays large

sums of dividends in cash, this may call

Compiled by: Kemboi Olger 80

for immediate financing. If this financing will dilute the company's control, then such a

company may not pay dividends as shareholders may forego their dividends for the sake of

retaining their control.

Stable Dividends

A company should endeavor to maintain a policy of paying stable dividends, and avoid

fluctuation in amounts of dividends paid. This is because:

i) Stable dividends have positive impact on the company's share prices because if a company

pays stable dividends shareholders can plan for such and this will induce demand for the
company' s shares on the stock exchange which will result in an increase in share prices

ii) They are seen by lenders as a positive indication of the company's good performance.

This will enable the company to raise further capital by way of share capital and debt finance

at relatively good terms.

il) Stable dividends are usually attractive to institutional investors/shareholders which any
company should attract because:
they contribute valuable ideas to the company,
-

they can contribute finance under situations of financial crisis,

- they lower the company's issuing expenses of its shares and cost of paying

dividends as these are paid to fewer investors.

Types of Stable Dividends

1) Constant amount of dividends per share-With this policy a company will pay a fixed
amount per annum per share regardless of the fluctuation in its profits.
11)Constant percentage o f net profit per share - This policy i f followed in such a way that the

company will pay a fixed percentage, e.g. 10% ofits earnings per annum.With this method
the dividends per share will increase with the increase in profit and decrease with the

decrease in profits.
1v) Fixed dividend per share plus extra amount of dividend as and when situations

warrant it-with this method the amount payable in dividends is fixed at slightly
Small amounts and if the company make extra profits then extra dividends are

declared in addition to the fixed amount.

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