JOMO KENYATTA UNIVERSITY

OF
AGRICULTURE & TECHNOLOGY
JKUAT SODeL

SCHOOL OF OPEN, DISTANCE AND eLEARNING

P.O. Box 62000, 00200
2017

Nairobi, Kenya
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E-mail: elearning@jkuat.ac.ke

HCBA 3108: FINANCIAL MANAGEMENT

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 HCBA 3108:FINANCIAL MANAGEMENT
This presentation is intended to be covered within one
week. The notes, examples and exercises should be sup-
plemented with a good textbook. Most of the exercises
have solutions/answers appearing elsewhere and accessi-
ble by clicking the green Exercise tag. To move back to
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the same page click the same tag appearing at the end of
the solution/answer.
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Errors and omissions in these notes are entirely the re-

sponsibility of the author who should only be contacted
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through the Department of Curricula & Delivery

(SODeL) and suggested corrections may be e-mailed to
elearning@jkuat.ac.ke.
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 HCBA 3108:FINANCIAL MANAGEMENT
LESSON 5
Dividend decisions

5.1. Learning Objectives:

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By the end of this lesson, you should be able to:

1. Evaluate the dividend theories
2. Formulate appropriate dividend policies.
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5.2. Introduction
Dividend policy determines the division of earnings between pay-
ments to shareholders and re- investment in the firm. It is con-
cerned with:
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1. How to pay dividend
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2. When to pay dividend
3. How much dividend to pay
4. Why dividend is paid
Dividend is one of the ways equity investors benefit from the
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organizations. In essence an investor can gain through.

1. Cash dividend
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2. Stock dividend
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3. Capital gains
4. Treasury stocks of favorable prices
A cash divided involves cash distribution of profits among share-
holders
JJ II A stock dividend is paid in additional shares of stock in lieu
J I of or in addition to cash dividend. It is a book-keeping transfer
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 HCBA 3108:FINANCIAL MANAGEMENT
of equity from retained earnings to ordinary share capital.
Treasury stocks are the shares bought back by the company
from amongst the outstanding shares. This could be done in
lieu of paying cash dividend.
The immediate impact of stock repurchase is to increase the
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earnings per share, holding all other factors constant. This may
result in higher market prices. Hence capital gains will be sub-
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stituted for dividends.

Stock repurchases present the following advantages.
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• It helps guard against hostile takeovers by reducing out-

standing shares and making them expensive.
• It can be used for signaling purposes – Treasury stock
JJ II could be seen as a positive signal since it could be mo-
J I tivated by the management beliefs that the firms shares
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are undervalued.
• Could be used is a means of undertaking capital re-organization
of the company’s capital structure
• They present shareholders with a choice to sell or not,
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unlike dividend which must be accepted at a cost of paying

taxes.
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• Reduces outstanding shares and help increase market price

per share.
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5.3. Alternative dividend policies

Dividend policies answer the question relating to how much
JJ II dividend should be paid. Accordingly the amount of dividend
J I payable can follow any of the following six methods.
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• Constant dividend per share
• Constant dividend payout ratio
• Constant dividend per share plus extras
• Constant dividend payout ratio plus extras
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• Residual dividend policy

• 100% re-investement.
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5.3.1. Contant Dividend Per Share.

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The company undertakes to pay fixed amount of dividend per

annum per share regardless of the fluctuations in profits.An in-
crease if any, only takes place if the firm believes that an increase
JJ II in profit levels is sustainable. This policy can be illustrated as:
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This policy is advantages in that it allows shareholders con-

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stant cash flows. They in such a circumstance perceive less risk

and will demand a lower cost for their finance. It can hence
reduce a firm’s WACC.
However, its disadvantages include:
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• It is unsustainable during long spells of loss making
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• May crowd out investment projects when profit levels are
low since most of them will finance dividends.
• May force transfers to revenue reserve to help in paying
future dividends when earnings are low.
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5.3.2. Constant Payout Ratio

A firm pays a fixed dividend rate as a percentage of earnings.
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The DPs would hence fluctuate as the earnings per share change.
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The policy can be shown as

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The policy is advantageous by not straining finances during

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loss making periods. However it is perceived as more risky by

investors who may demand a higher cost of capital.

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5.3.3. Constant Dividend Per Share Plus Extras
This is a compromise between the constant payout ratio and the
constant DPS. An extra dividend is given to sit in such a way
that they don’t perceive it as commitment by the firm towards
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this higher dividend. This is illustrated as:

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5.3.4. Residual Dividend Policy
Dividend is paid out of earnings left over after capital budgets
have been fully financed. Dividend is only paid if there are
no profitable opportunities available. Whereas the policy helps
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maximize shareholders wealth, it may scare away income ori-

ented potential shareholders.
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5.3.5. 100% re investment

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No dividend is paid. This could be a beneficial policy for small

under capitalised firms pursuing corporate wealth maximization
(CWM) as the primary objective.

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5.4. The Relevance of Dividend Policy (Dividend The-
ories)
Dividend theories address the questions as to why dividends
should be paid. They rationalize the relevance or otherwise of
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distributing profits to shareholders in form of dividends. There

are basically two schools of thought arguing for the relevance or
otherwise of dividend policy.
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These are:
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• The dividend irrelevance school of thought

• The dividend relevance school of thought

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5.5. The Irrelevance School of Thought
The argument here is that dividend policy has no effect on a
firm’s stock price or its cost of capital. The principal proponents
of the dividend irrelevance school of thought are:
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• MM dividend irrelevance theory – Franco Modigliani and

Merton Miller ( 1961)
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• The clientele effect theory of Richardson Pettit, 1977.

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5.5.1. The MM Dividend Irrelevance Theory

Their primary argument is that a firm’s value is determined
by its basic earning power and its business risk. The value ul-
timately depends on the income generated by a firm’s assets
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and not how this income is divided between shareholders and
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retention.Consequently, a firm’s value depends of the investing
decisions as opposed to the dividend decisions.
MM arguments was based on the following assumptions
• Absence of corporate and personal taxes
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• A perfect and frictionless capital market implying absence

of floatation transaction costs.
• Efficient markets indicating that investors and managers
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have homogenous information regarding future investment

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opportunities.
• Investment policy is independent of the dividend policy.

5.5.2. The Clientele Effect Theory

JJ II According to Pettit, different group of shareholders have differ-
J I ent preference for dividend. Whereas low income earners prefer
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higher dividend for consumption needs, high income groups pre-
fer less dividend to avoid taxes. When a firm sets a dividend
policy, different clientele groups shift into and out of it until
equilibrium is attained.
At this equilibrium, the dividend policy set by the firm will
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be consistent with its clientele. Hence at equilibrium, dividend

decision is irrelevant. This is because at this level, management
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would be hesitant to change its dividend policy since it might

force current shareholders to sell their stock, forcing prices down.
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5.6. The Dividend Relevance School of Thought

The argument here is that the dividend decision has either a
JJ II negative or positive effect on the firms stock values or cost of
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Hence dividend policy could be relevant with an upward ef-
fect on cost or vice versa. The most common proponents of the
relevance of dividend policy include:
1. Gordon Myron and John Lintner – Bird in Hand Theory
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2. Litzenberger and Ramaswamy – Tax differential theory

3. Stephen Ross – Signalling effect theory
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5.6.1. The Bird in Hand Theory

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According to the proponents of this theory, a bird in hand (i.e.

dividends) is worth more than those in the bush (i.e. capital
gains). Accordingly, a shareholder receiving dividend is better
of than the one receiving capital gains.Accordingly, a firm’s value
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will be maximized by setting a high dividend payout ratio.
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Myron Gordon argues that Ks decreases as the dividend pay-
out is increased because investors are less certain of capital gains,
which are supposed to result from retaining earnings, than they
are of receiving dividend payments.
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5.6.2. The Signaling Effect Theory

Stephen Ross in 1977 argued that in an inefficient market, man-
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agement can use dividend payment to signal important infor-

mation to the market which is only known to them. This the-
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ory is also called the information content hypothesis. Managers

use dividends to signal future prospects. If management in-
creases dividend, it signals expected high profit and therefore
JJ II share prices will increase. Hence dividend decisions are relevant
J I and a firm that pays higher dividend will have a higher value,
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especially in an inefficient market.

5.6.3. Tax Differential Theory

According to the proponents of this theory, tax rate on divi-
dend is usually higher than the tax rate of capital gains.A firm
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that pays dividend will therefore have a lower value since the
shareholders will pay taxes on this dividend. Hence dividend
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decisions are relevant and a firm that pays no dividend has the
highest value.
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NB: Graphically, the relevance and irrelevance perspectives.

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Example . XYZ has never paid dividend and new consider-

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ing three alternatives i.e. 100% retention, 50% payout and 100%
payout. The company ROE is 15% and the book value of the
stock are Sh.30 per share. Illustrate the dividend irrelevance
JJ II theory using cost of equity as your guiding rule.
J I Solution:
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5.7. Setting Dividend Policy in Practice

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A given firm, the optimal payout ratio depends on

1. Investor preference for dividends or capital gains.
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2. The firms investment opportunities

3. The target capital structure
4. The availability and cost of capital
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5. Cash availability
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If the residual dividend policy is implemented, then a firm would
need to follow the following steps when determining the dividend
policy.
• Determine the optimal capital budget
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• Determine the amount of equity needed to finance that

budget, given the target capital structure
• Use retained earnings to meet equity requirements if the
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extent possible
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• Use to excess to pay dividends

One can make use of MCCS and IOS to show optimal debt level.

5.7.1. Factors influencing dividend policy

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J I The factors can be categorized to 3 groups
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• Constraints
• Investment opportunities
• Alternative capital sources
1. The constraints to dividend payment include:
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(a) Restrictive bond covenants: bond indentures limit

dividend payments to those after certain minimum
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safety levels of current ratio, interests coverage ratio

etc are attained.
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(b) Availability of cash: shortage of cash limits the amounts

payable for dividend.
(c) Preferred stock restrictions: preferred dividends must
be paid first before ordinary dividends are paid.
JJ II (d) Impairment of capital rule: dividend payments can-
J I not exceed retained earnings
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(e) Penalty tax on improperly accumulated earning: to
prevent wealthy individuals from using companies to
avoid personal taxes, a surtax may be imposed on
improperly accumulated income. This mainly applies
to private companies
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2. Investment opportunities also influence dividend policy.

The more the investments, the less the payout and vice
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versa. The ability to accelerate or postpone projects will

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permit a firm to adhere more closely to a stable dividend

policy
3. Alternative sources of capital have an influence on:
If cost of floatation of new stock is exorbitant, a firm would prefer
JJ II a lower payout to instead use retention since internal equity is
J I cheaper. If management is concerned about maintaining control,
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it may be reluctant to sell new stock, hence may retain more
earnings.

Revision Questions
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Exercise 1.  ABC Ltd has a target capital structure which

consists of 70% debt and 30% equity. The company anticipates
that its capital budget for the upcoming year will be Sh. 3m.
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If net income of Sh. 2 m is reported and the company fellows a

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residual dividend policy, what will be the dividend payout ratio.

Exercise 2.  Explain the MM dividend irrelevant theory.
Exercise 3.  Explain the Clientele Effect Theory.
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