DIVIDEND POLICY

What is a Dividend?
 A dividend represents a portion of a company's profits that is distributed to its shareholders,
typically on a periodic basis, such as quarterly or annually.
 When a company generates profits, it can choose to distribute a part of these earnings to its
shareholders as a reward for their investment in the company.
 Dividends are an essential way for companies to share their success with shareholders,
providing them with a return on their investment and demonstrating financial health and
stability.
What is an Internal Source of Finance?
 An internal source of finance refers to funds generated within the company, typically through
retained earnings that are reinvested back into the business.
 Retained earnings, when kept within the company instead of being paid out as dividends, act
as a form of self-funding or internal finance. This money can be utilized for various
purposes, such as expansion, research, or debt reduction.

INVERSE RELATIONSHIP BETWEEN DIVIDEND PAYOUT AND RETAINED

EARNINGS
 The dividend payout ratio represents the proportion of earnings a company pays out to
shareholders as dividends, while retained earnings are the portion of profits kept within the
company for reinvestment.
Explanation of Inverse Relationship
a. Higher Dividend Payout, Lower Retained Earnings:
 When a company decides to distribute a higher portion of its profits as dividends, it leaves
fewer earnings internally for reinvestment. This reduction in retained earnings limits the
funds available for future growth opportunities, R&D, expansion, or capital investment.
b. Lower Dividend Payout, Higher Retained Earnings:
 Conversely, if a company opts for a lower dividend payout ratio, it retains more earnings
within the company. This larger pool of retained earnings provides greater financial
flexibility for investments in growth projects, innovation, or to withstand economic
downturns.
A company's retained earnings form a critical part of its internal financing for future ventures.
When dividends take a significant share of profits, the available funds for investment in growth
initiatives are reduced.
 What is Dividend Policy?
 Dividend policy refers to the strategy used by a company to distribute earnings between
dividend payouts to shareholders and retained earnings for future investment or financing
needs.
 Dividend policy involves the allocation of profits between paying dividends to shareholders
and retaining earnings within the company for future growth or investments. It's a crucial
decision influenced by various factors, impacting shareholders' returns and the company's
financial health.
The overall dividend policy is influenced by:
a. Financing Decision:
 Dividend policy involves the decision-making process on how earnings should be allocated
between dividend payouts and retained earnings.
 Retained earnings are an essential source of internal finance for a company. The decision on
how much to distribute as dividends versus retain for investment purposes is part of the
financing decision-making process.
 If a company has significant growth opportunities requiring capital, it might prefer to retain
earnings for investment. This choice would limit the surplus available for external financing
through dividend payouts. Conversely, when investment prospects are limited, a higher
dividend payout might be preferred.
b. Creating Value for Shareholders:
 Shareholders often seek early returns through regular dividends, especially in uncertain
market conditions. Dividend policies play a crucial role in shaping shareholder value.
 A higher dividend payout could enhance the perceived value of a company's shares in the
market. However, it might reduce surplus funds available for investment, potentially
impacting future growth.
 Management must strike a balance between meeting current shareholder expectations by
paying dividends and securing future value by retaining earnings for future investments.

The following are the main alternative policies regarding dividends.

a. Fixed Percentage Payout Ratio:
 The fixed percentage payout ratio is a dividend policy where a company distributes a set
percentage of its earnings as dividends to shareholders. This ratio remains constant regardless
of fluctuations in profits.
 While this policy offers predictability, it might not be suitable for companies with volatile
earnings. Additionally, it restricts management's flexibility in retaining higher profits for
potential investments. The fixed payout ratio might not align with shareholder expectations
for stable dividends if profits fluctuate significantly.
EXAMPLE 1.

EXAMPLE 2

b. Constant or Increasing Dividend

a. Constant Dividend Policy:
 In this policy, dividends remain fixed regardless of fluctuations in earnings. The company
maintains the same dividend payout year after year. Any increase in dividends is contingent
upon achieving higher earnings per share (EPS), and the company forecasts maintaining that
increased level.
 Example: Let's say a company consistently pays a dividend of $1 per share annually,
irrespective of its profitability. Even if its earnings rise substantially, the dividend remains
fixed at $1 per share.
b. Increasing Dividend Policy:
 Here, companies aim for sustainable long-term growth in earnings, leading to incremental
dividend increases. However, the focus remains on stability to avoid negatively impacting
shareholder expectations. Any dividend increase is cautiously planned to avoid volatility in
share prices.
 Example: A company gradually raises its dividend payouts in line with its growing
profitability, such as increasing dividends from $1 to $1.10 per share annually to reflect
rising earnings.
EXAMPLE 3.

c. Zero Dividend Policy:

 Zero dividend policy refers to a company's decision not to distribute dividends to its
shareholders for a certain period.
 Companies may choose this policy initially to reinvest profits into business operations for
growth or expansion, rather than distributing them as dividends. This reinvestment helps the
company solidify its position in the market, invest in new projects, or expand its operations.
 While zero dividends can be a short-term strategy for growth, it's usually not a sustainable
long-term policy. Most companies aim to strike a balance between reinvestment and
shareholder returns.
 Over time, shareholders typically expect some return on their investment in the form of
dividends. Prolonged absence of dividends might lead to dissatisfaction among shareholders,
impacting the company's stock value.
 Although a small minority of shareholders may accept it as a policy for reasons such as tax
benefits for capital gains, the majority of shareholders would like to get some dividends. In
fact, the large institutional investors who control the bulk of shareholdings these days rely on
dividend income. They are unlikely to be happy with a zero-dividend policy.
 A. DIVIDEND IRRELEVANCE
 Dividend irrelevance theory suggests that the dividend policy of a company does not affect
its value in a perfect capital market. Investors are indifferent between receiving dividends
and capital gains, assuming certain conditions.
 This theory is based on the idea that investors consider both dividends and capital gains as
equivalent in their investment decisions. It's rooted in the understanding that investors'
preferences for current income via dividends versus future returns through capital gains are
neutral.
 Example: Consider an investor holding $1,000 worth of stock. The company issues a
dividend of $50, reducing the stock price by the same amount to $950. Alternatively, if the
company reinvests those funds into growth opportunities, the stock price might increase to
$1,050. In both scenarios, the investor's total wealth remains the same, whether through
dividends or capital gains.
MODIGLIANI AND MILLER (MM) HYPOTHESIS
 MM Hypothesis, proposed by Franco Modigliani and Merton Miller, asserts that in a perfect
market without taxes, transaction costs, or asymmetric information, the dividend policy of a
company is irrelevant to its stock price and its overall value.
 In a perfect and efficient market, investors are assumed to be rational and have access to all
relevant information. They make investment decisions based on the company's future
earnings potential and risk associated with those earnings rather than the dividend policy.
What are the Assumptions?
a. Perfect Capital Markets:
 Assumption of perfectly efficient markets with no transaction costs, no influence on prices by
individual investors, and free flow of information.
 Example: In an ideal market, if an investor sells shares, it won't impact the share price due to
the market's perfect efficiency.
b. Absence of Taxes:
 MM assumes no corporate or personal taxes exist.
 Example: Under the assumption of no taxes, investors are indifferent between dividends and
capital gains.
What are the Criticisms of MM Hypothesis?
 Imperfection of Market:
a. Flotation Costs:
 In the real world, costs incurred while raising new capital through share issues reduce the
actual funds available for investment.
 Example: A company intending to raise $100 million may end up with only $95 million after
accounting for 5% floatation costs.
b. Transaction Costs:
 Existence of transaction costs when investors sell securities contradicts MM's assumption of
cost-free trading.
 Example: Investors facing high brokerage fees might prefer receiving dividends instead of
selling shares for liquidity.
c. Tax Incidence:
 In practice, taxes affect investor decisions; dividend taxation timing and capital gains tax
differences are critical.
 Example: Dividends taxed immediately while capital gains taxed only when shares are sold,
affecting investor preferences.

I. According to MM, the prevailing market price Po is determined as follows:

 This formula illustrates how the expected future cash flows in the form of dividends and
future share price expectations are discounted back to their present value using the cost of
equity capital, giving the current market price of a share based on these future expectations.

II. If there is no external financing, the value of firm is equal to the number of times the
Price of the share given by
 The formula states that the market value of the entire firm (nPo) is determined by the total
worth of dividends (nD1) and the total worth of shares (nP1), both discounted by the cost of
equity capital (ke).

Where;
 nPo represents the total market value of the firm.
 ke is the cost of equity capital.
 nD1 is the total dividends paid by the firm over a certain period.
 nP1 is the total price of shares held by the investors.
III. If the firm were to finance all investment proposals, then the amount to be raised
through new shares is given by
 The Formula addresses the scenario where a firm intends to finance all its investment
opportunities through new shares. It calculates the amount that needs to be raised through the
sale of new shares to cover the total investment requirement after considering the firm's
current earnings and dividend policy.

i. Total Investment Requirement (I):

 This represents the total amount the firm needs for its investment projects or opportunities.
ii. Earnings of the Firm (E):
 This signifies the total earnings generated by the firm. In the context of financing investment
proposals, it's important to assess whether the current earnings are sufficient to cover the
investment needs.
iii. Total Dividend Paid.
 This represents the sum of dividends paid out to shareholders over a certain period. For a
firm to raise funds through new shares without external financing, the dividend paid from
earnings might limit the retained earnings available for investment.
iv. Retained Earnings.
 This represents the portion of earnings retained by the firm after paying dividends. It's the
amount available for reinvestment in the absence of external financing.

EXAMPLE 4.
A risk class to which the company belongs has an approximate capitalisation of 13%. The
company has a capital of Tshs 100 million shares of Tshs 100 each. The dividend proposed at the
end of year 1 is Tshs 10 per share. The shares are currently quoted at par. Let’s calculate market
price at the end of the year under each of following scenarios:
a. Dividend is declared
b. Dividend is not paid
c. Dividend is paid, earnings are Tshs 50 million and the company wishes to make new
investments of Tshs 100m
 B. DIVIDEND RELEVANCE
I. WALTER’S MODEL
 It's a financial theory that focuses on the relationship between a firm's internal rate of return
(r) or return on investments and its cost of capital (k).
 If a firm's return on investments (r) exceeds its cost of capital (k), the firm will reinvest its
earnings. Conversely, if r < k, shareholders might benefit more from receiving dividends and
investing elsewhere.
Let us understand on internal rate of return and cost of capital.
a. Internal Rate of Return (r):
 Represents the rate at which the firm's investments generate profits. If the firm's projects
yield returns higher than its cost of capital, it signals profitability.
b. Cost of Capital (k):
 The rate that represents the firm's cost of financing its operations and projects. It includes the
cost of debt, equity, and other sources of capital.
What is the decision-Making Process under Walter’s model?
a. r > k (r is greater than k):
 In this scenario, when the firm's internal rate of return is higher than the cost of capital,
retaining earnings for reinvestment would be beneficial. Reinvesting profits in projects
yielding returns higher than the cost of capital creates value for shareholders.
 Example: If a firm has an internal rate of return of 15% and a cost of capital of 10%,
retaining earnings for reinvestment in projects earning 15% would enhance shareholder
value.
b. r < k (r is less than k):
 When the return on investments falls below the cost of capital, shareholders might benefit
more from receiving dividends and investing elsewhere.
 Example: If a firm's internal rate of return is 8%, but the cost of capital is 10%, shareholders
might prefer receiving dividends and investing in other opportunities yielding returns above
10%.

What are the Walter's Model Assumptions?

i. No Change in Business Risk:
 The model assumes that the business risk remains constant even when new investments are
made. It implies that the risk associated with the firm's projects is identical to the existing
risk level.
 This assumption simplifies the model by assuming that the risk profile of the firm does not
alter with new investments, allowing a straightforward analysis of the relationship between
returns and cost of capital.
 Example: If a company expands its operations in a similar industry or sector, the risk profile
might remain relatively stable.
ii. Key Variables Remain Unchanged:
 It assumes that crucial factors like the firm's rate of return and cost of capital remain constant
over time.
 This assumption simplifies calculations by holding these variables steady, but in reality, they
often fluctuate due to market conditions and company performance.
 Example: Assuming the rate of return on investments stays consistent without considering
market changes or economic shifts.
iii. No Use of Outside Capital:
 The model assumes that all financing for investments is done internally, without considering
external sources like debt or equity.
 By excluding external financing, Walter focuses solely on the relationship between the firm's
earnings, dividends, and investments.
 Example: If a company solely relies on retained earnings to fund growth without issuing new
shares or taking on debt.
iv. Firm as a Going Concern:
 It assumes that the firm operates continuously without facing financial distress or potential
closure.
 This assumption allows the model to focus on long-term investment decisions without
considering potential disruptions.
 Example: Companies that have a stable market presence and robust operations can fit this
assumption.

What are the Criticisms of Walter's Model?

i. Simplified Reality:
 The assumptions oversimplify real-world scenarios, ignoring factors like changing risk
profiles, market dynamics, and the impact of external financing on investment decisions.
ii. Static Variables:
 Assuming constant rates of return and cost of capital might not reflect the dynamic nature of
financial markets where these factors can change due to various economic and industry-
specific reasons.
iii. No Consideration for External Financing:
 The model disregards the impact of leveraging or external financing on investment decisions,
which is a significant factor in practical corporate finance.

iv. Limited Applicability:

 Due to its rigid assumptions, the model might not be suitable for companies operating in
highly volatile industries or those heavily reliant on external financing for growth.
The formula:

The formula essentially illustrates the relationship between the company's dividend policy,
market price of shares, earnings, rate of return on investments, and the cost of capital. It
highlights how investors perceive companies based on their dividend distribution, growth
prospects, and the returns they offer compared to the cost of capital. Companies with higher
growth prospects and lower dividends may have higher market prices due to expected future
returns, while those with higher dividends might also maintain high share prices due to stable
returns to shareholders.

EXAMPLE 5:

II. SHARE PRICE UNDER GORDON’S GROWTH MODEL

Under Gordon’s model, the market price of a share is expressed as the present value of future
streams of dividends.

NOTE:
E(1-b) = E(a) = D1 = Do(1+g)
EXAMPLE 6.
Saturn Ltd has shared the following details:
Earnings per share Tshs 2000, IRR = 15%. Let’s calculate the value of a share when:
a. when dividend payout ratio is 10 and cost cost capital is 18%.
b. when dividend payout ratio is 40 and cost of capital is 15%.

FACTORS DETERMINING DIVIDEND POLICY

1. Company's Financial Requirements:
 Dividend decisions are influenced by the need for funds for investment. Companies evaluate
their future investment needs before deciding on dividend payouts.
 Growing companies requiring substantial funds for expansion or development might opt for
retaining earnings to reinvest in their business rather than distributing dividends. Conversely,
established companies might follow a stable dividend policy.
 Example: Tanzanian companies experiencing rapid growth, such as in the technology or
renewable energy sectors, might prefer retaining earnings for capital-intensive projects to
fuel expansion.
2. Legal Constraints.
 In the determination of a company’s dividend policy, legal restrictions play a crucial role in
shaping dividend distributions. In the Tanzanian market, the Companies Act, 2002 (Section
180(3)), serves as a regulatory framework for dividend payments. This section mandates that
dividends can be paid out of realised profits less realised losses or revenue profits less
revenue losses, provided that directors reasonably believe the company can meet its liabilities
post-payment. This legal provision ensures that companies distribute dividends prudently
without jeopardizing their financial stability.
 Similar legal constraints are prevalent globally, ensuring responsible dividend distributions.
These laws aim to protect stakeholders' interests by preventing reckless dividend payouts that
could endanger a company's financial viability. By mandating payments based on realisable
profits and assets' value, these regulations safeguard against insolvency risks arising from
excessive dividend distributions.
 Therefore, legal constraints serve as a safeguard mechanism, guiding companies to maintain
financial health and uphold the interests of shareholders and stakeholders alike. Compliance
with such regulations ensures prudent dividend decisions, fostering sustainable growth and
stability within the corporate sector.
3. Liquidity
 Liquidity, as a factor influencing dividend policy, refers to a company's ability to pay
dividends from available cash reserves rather than mere profits. Despite earning profits,
companies might lack immediate cash due to ongoing operational cycles, impacting dividend
payouts.
 Liquidity's impact on dividend policy highlights the importance of assessing actual cash
availability before committing to dividend payouts. Failure to manage liquidity adequately
can result in the need for external financing or reduced dividends, affecting investor
perceptions and stock prices.
 Understanding liquidity's role in dividend policy emphasizes the need for companies to
ensure a balance between profit reinvestment for growth and maintaining adequate cash
reserves for dividend payouts, thereby managing shareholder expectations and market
perceptions effectively.
4. Shareholder’s Expectation.
 Shareholder expectations significantly influence a company's dividend policy. These
expectations are shaped by various factors such as taxation laws, investment opportunities,
and concerns regarding ownership dilution.
 Shareholders hold diverse preferences regarding receiving dividends versus capital
appreciation. Their expectations are shaped by taxation laws impacting dividend income
versus capital gains, available investment opportunities, and potential dilution of ownership
due to higher dividend payouts.
i. Taxation Influence:
 For instance, shareholders in higher tax brackets might prefer capital appreciation over
dividends due to the immediate tax implications on dividend income. In contrast, capital
gains tax might be incurred only upon selling shares.
 Example: In Tanzania, shareholders face a 10% dividend withholding tax (if not listed in
the Dar es Salaam stock exchange) or 5% (if listed). Capital gains tax, however, might be
lower or exempt for listed shares, impacting the choice between dividends and capital
appreciation.
ii. Investment Opportunities:
 Shareholders may favor higher dividend payouts if the company lacks lucrative
investment opportunities elsewhere in the market.
 Example: If alternative investments offer low returns, shareholders may expect higher
dividends as they prefer current income over potential future gains.
iii. Ownership Dilution Concerns:
 Increased dividend payouts might force the company to issue more equity shares for
investment, leading to ownership dilution.
 Example: If additional shares are issued without existing shareholders' subscriptions, it
might dilute their ownership and control over the company.
EXAMPLE 7.
TBM Ltd declared an interim dividend of Tshs 50 per share and a final dividend of Tshs 50 per
share. Over the same period, TBM Ltd reported net earnings of Tshs 400 per share.
Required:
Calculate the dividend payout ratio and comment on it.

EXAMPLE 8.
PTC Ltd has 50,000 equity shares at Tshs 100 each outstanding on 1st April 20X0. The firm
plans to declare dividend of Tshs 20 per share. The shares are currently quoted at par. The
approximate capitalisation rate is15%. Under the MM model, calculate the price when:
(i) Dividend is declared
(ii) Dividend is not declared
(iii) How many additional equity shares need to be issued if the company needs Tshs 2,000,000,
of which earnings for the year are estimated at Tshs 1,200,000 and dividend payout will happen.

EXAMPLE 9.
Determine the share price for Prime Retail Ltd using Gordon’s growth model

EXAMPLE 10.
Information relating to James Plc:

Calculate the market price per share. Also, determine the optimum dividend payout ratio for the
firm and the value of a share at that ratio.

EXAMPLE 11.
Brica Ltd has provided the following details:

Calculate the market price per share using (i) Gordon’s model, (ii) Walter’s model.

EXAMPLE 12.
JFK Ltd has 1 million shares outstanding at the beginning of 20X0. The current market price is
Tshs 1200 and the Board has approved a dividend of Tshs 62 per share. The capitalisation rate
suitable for the risk class to which the company belongs is 9.8%.
Calculate the following:
(a) Based on the MM approach, the market price when
(i) dividend is declared
(ii) dividend is not declared
(b) If the company proposes an investment of Tshs 372m and the income for the year is Tshs
150m, how many additional shares will it have to issue to finance the investment?

EXAMPLE 13.
The net income of GGM Corporation, which has 10,000 outstanding shares and a 100% dividend
payout policy, is TSHS.32,000. The expected value of the firm one year hence is
TSHS.1,545,600. The appropriate discount rate for Magita is 12 percent.
REQUIRED:
(i) What is the current value of the firm?
(ii) What is the ex-dividend price of Magita’s stock if the board follows its current policy?

EXAMPLE 14.