DIVIDEND POLICY

18.0 LEARNING OBJECTIVES

After studying this chapter, the reader should be able to:

♦ Understand the meaning of a company's dividend policy;

♦ Explain the differences between passive and active dividend policies;

♦ Advance theoretical reasoning for the relevance or irrelevance of dividend payment to

the value of the firm;

♦ Discuss the practical factors that influence a company's dividend policy

♦ Explain the impact of stability of dividends on the value of a share;

♦ Mention the disadvantages of stable naira dividend payment and those of stable
dividend pay-out ratio; and
♦ Explain other aspects of dividend decisions such as cash dividends, scrip dividends, scrip
issues, share split, share consolidation and share re-purchase.

18.1 INTRODUCTION

Dividends are payments by the company to those who provide it with equity finance
- the shareholders. From the viewpoint of these shareholders, dividends represent
compensation for postponing consumption. The dividend policy of the firm relates
to various decisions on payments of dividend. The firm regards dividend decision as
a major aspect of the financing decision of the firm. The critical question then is
whether profits should be distributed as dividends or retained within the firm to
finance future expansion and growth. What will be the effect of either decision on
the value of the firm? If the company decides to pay dividends, how much should be
paid and how much should be retained? If there are investment opportunities,
should the firm use the monies available for dividend to finance these investments
or should it pay dividends and borrow later to finance the investment opportunities?
Should the company follow a policy of fixed Naira amount per share per annum or a
fixed percent of earnings per annum. All these questions require answers. The
solutions and other aspects of dividends decisions including factors influencing
payment of dividends will form the subject matter of this chapter.

18.2 PASSIVE AND ACTIVE DIVIDEND POLICIES

When a company follows a passive dividend policy it means it is treating dividend

payment as residual. This means that the determining factor as regards payment of
dividend and how much to pay is the availability of profitable investment projects.
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These are projects with positive NPV. The idea is that as long as the company has
projects whose returns are in excess of (or at least equal to) the required returns, it
should continue to finance these projects and pay out nothing as cash dividends.

If, however, the company has no single profitable investment, it can pay 100 percent
of the profits available for distribution as cash dividends. This implies that in
between zero percent and 100 percent there will be various dividend payout ratios
whose values will depend on availability of profitable projects.

On the other hand, the active dividend policy regards dividend payment as a critical
factor in the determination of the value of the firm and hence, the wealth of its
shareholders. This policy treats dividend payment not just as a way of sharing profits,
it also looks at retentions as residue. The question that readily comes to mind when
examining these two policies, is: are dividend payments really relevant to the wealth
of the shareholders or are they irrelevant? The discussion below will focus on the
theoretical arguments put forward by Modigliani & Miller (M & M) showing the
irrelevance of dividends to the wealth of the shareholders.

18.3 IRRELEVANCE OF DIVIDENDS

Modigliani and Miller (M & M) strongly argued on how the value of the firm (and
therefore the wealth of its shareholders) is unaffected by the way available profits
are shared between retentions and dividend payout. They believe that the value of
the firm is determined by the stream of its earnings or its pattern of investment
rather than the pattern of distribution of its profits. Their contention is that as long
as the firm has capital projects with positive NPV, it should continue to invest in
them as this action will increase the value of the firm.

This M & M assertion was based on the assumptions of perfect capital market where
there are:
(a) No transaction costs;
(b) No floatation costs;
(c) No taxes on earnings; and
(d) Certainty about the future earnings of the firm.
The following points appear to form the bases of M and M's argument:
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(i) If profits were distributed (instead of being retained) and external equivalent
equity finance had to be raised to finance investment, the possibly reduced
value of the share after financing plus the dividends paid will be exactly equal
to the value of the share before financing. Dividend payments, according to
M & M, thus have no effect on share value. The value of the share would
have reduced because more shares were issued.

(ii) If shareholders were expecting dividends and they did receive the dividends,
they could replace exactly these dividends by selling shares and receiving
cash. Thus, by this action, they could manufacture "home made" dividends. If
on the other hand, the company paid them dividends, when in fact they did
not need such cash, they could use the "free" cash to buy shares of the
company on the stock market.

Given this scenario, the company is not doing for the shareholders anything
they cannot do themselves. It is therefore not creating value. Based on the
above, the fact that a company pays dividend or does not pay dividend,
according to M & M is therefore immaterial to the investors.

18.4 RELEVANCE OF DIVIDENDS

The following are points put forward in favour of dividend payments.
18.4.1 “Bird in Hand” Argument

The traditional view of the theory of dividends is that dividends are the
singular determinant of value of a share and that the receipt of the share of
profits now, in form of income rather than in future, in form of capital
appreciation, enhances the value of the share. This second position is in line
with bird in hand is worth more than two in the bush argument as N1 paid
now in cash is worth more than N1 supposedly retained as further
investment. Aside from this, the payment of dividends help to resolve the
uncertainty in the minds of investors about the future earnings potential of
the company. Investors place greater reliance on the ability of the firm to
earn profits in future and pay dividends, reduce the risk perception of the
company and this increases the value of the company's shares, all things
being equal.

18.4.2 Group Preferences

There are certain categories of investors who, because of their employment

status or their tax position, would prefer less of current income and more of
capital appreciation. On the other hand, there will be some groups who
because of their economic activities would favour less of capital appreciation
and more of current income. The

first group might consist of highly paid workers and high marginal income tax
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payers who would prefer to buy shares of companies that retain much of
their profits. A company should identify such group and ensure that its
dividend policy is geared toward their desire. On the other hand, there exists
certain institutional investors such as pension funds administrators who may
be tax exempt but require constant cash inflows to meet payments to
pensioners. A company that has these groups of investors should emphasise
dividend payments so as to keep their loyalty. Any dividend policy that is not
in line with the group's desire will only encourage shift in investors' loyalty.
Similarly, inconsistency of dividend policy will attract the same action. The
effect is that investors who are not happy with a particular company's
dividend policy would want to sell their shares of that company (and buy
those of the company that meets their desire). The action of these investors
would probably create a depressing effect on the share price and jerk up its
cost of capital.

Although, another group of investors might be buying these shares, the

process itself may have a psychological effect on the shareholders. The above
argument typifies the clientele'or preferred habitat concept.

18.4.3 Information and Cumulative Device

Payment of dividends can be used by a company to convey positive

information to shareholders about the company's future profitability while a
statement could also be issued. However, in order to make this statement
about management's intention real, the current dividend-payout ratio might
be increased. The belief of management here is that action speaks louder
than words.

The payment of cash dividends is therefore meant to signal to investors that

management actually knows and believes that the company's financial
situation is better than what the share price is showing. If this view is correct,
then, the increase in dividend-payout would be expected to create a positive
impact on share price in the stock market.

18.5 FACTORS AFFECTING DIVIDEND POLICY

The theoretical aspects of dividend policy have, so far, been considered. The
following will discuss the practical factors that should be taken into account when a
firm is formulating a dividend policy.
(a) Legal Constraints:
The management of a company must recognise the existence of laws guiding
payment of dividends. For example, a company should not

pay dividend out of capital and may only pay dividends, according to
Companies and Allied Matters Act (CAMA1990, as amended) out of:
(i) Profits arising from the use of company's property;
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(ii) Revenue reserves; and

(iii) Realised profit on a fixed asset sold

CAMA also specifies that dividends can only be declared on the

recommendation of the directors, and any amount so recommended cannot
be increased by the general meeting; although, it can be reduced.

(b) Future Financial Requirement

Once the legal constraints have been cleared, management should focus on
its future financial needs including future investment opportunities. This
should be done via budgeted sources and application of funds statements,
budgeted cash flow statements and cash budget.

(c) Liquidity

Dividends are usually paid out of cash. Therefore, the amount of dividend
paid by the company is largely influenced by the available cash resources.
Cash has alternative uses within the firm; management may, therefore, want
to give recognition to this, perhaps more important alternatives (and also be
protected against the future) and may, therefore, decide not to have high
target dividend-payout.

(d) Capacity for borrowing

A firm may not be liquid, but may be in a strong position to borrow at short
notice. This ability can be by arranging a line of credit. The ability of a firm to
borrow, often largely influences its ability to meet its shortterm obligations as
and when due, including payment of cash dividends.

(e) Access to The Capital Market

If the company is large enough and has good access to the corporate bond
market, it needs not bother much about its liquidity situation for the purpose
of paying cash dividends.

(f) Existence of Restrictive Covenants

Restrictions on payment of cash dividends may be entrenched in a loan

agreement.

(7) Dilution of control

Payment of cash dividends, supported by subsequent raising of external

finance may dilute the controlling interest of the existing shareholders, if
they do not partake in the provision of such finance. These shareholders
may, therefore, favour financing of investment opportunities from relatives.

18.6 STABLE DIVIDEND PAYMENT PER SHARE VERSUS STABLE PAYMENT RATIO

Another area of dividend policy which is of concern to management is which

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dividend payment policy to follow: stable dividend per share or stable payout ratio.

18.6.1 Stable Dividend Per Share Policy

The management of a company that follows this policy wants to be paying and
maintaining an absolute naira amount of dividend per share. For example, 80kobo
per share might be paid annually on regular basis notwithstanding that earnings are
fluctuating or that the cash position is changing over time.

The share of a company that follows this policy usually attracts a premium because
of preference for current regular income of certain investors, positive signaling
effects and directives given to certain institutions. However, the following
constraints limit the desire of firms to follow this policy.

(a) It creates a financial commitment on the part of the company to maintain

that fixed figure even in the face of profitable investment opportunities.

(b) If the firm becomes illiquid, it still has to pay this fixed Naira dividend.

(c) In a period when the level of earnings is low, the dividend payment must still
be met.

(d) Where the company is compelled to pay an amount below the usual fixed
amount, it may cause a psychological problem with a possible negative effect
on share price.

(e) The company may be exposed to take-over bid, if it pays dividend below the
usual fixed amount.

18.6.2 Stable Pay-Out Ratio

Under this policy, the company pays a fixed percentage of earnings as

dividend every year. This implies a variable Naira amount every year,
depending on each year's level of earnings.
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The only advantage to the company which follows this policy is flexibility
and convenience. The company only pays an amount of dividend that is
supported by earnings. The company is not likely to have any problem
paying dividends provided the earnings are substantially realised. However,
the following disadvantages might occur to a company that follows this
policy.

(a) When dividends vary in line with earnings level, investors naturally
look at the company as inconsistent. This may create a negative
effect on share price.

(b) A fall in earnings followed by a drop in dividend is a pointer to

investors, of management's thinking about the future profitability of
the company. If earnings drop but the dividend level is still
maintained, investors might still have some confidence in the ability
of management to weather through the storm.

(c) Certain investors that require specific periodic income might rank the
company very low and consequently try to dispose their shares with
the attendant negative effect on share price.

(d) Certain institutional investors, for example, the Pension Fund

Administrators (PFAs) might need to abide with specific directives
from the regulatory authority.

18.7 CASH DIVIDENDS

These are dividends recommended by the directors and approved and declared at
the annual general meeting (AGM). They are subject to withholding tax and are
normally paid out of cash. Declaration and payment might sometimes put pressure
on the company's liquidity.

18.8 SCRIP DIVIDENDS

These are dividends also recommended by the directors and approved and declared
at the annual general meeting (AGM). However, they are paid through issue of
ordinary shares of the company as against being paid by cash. They essentially
constitute a transfer to the shareholders' additional shares with no further cash
coming from them. The following should be noted about scrip dividends:

(a) The dividends have been declared, only they do not involve payment ofcash.

(b) Acceptance of scrip dividends by the shareholders is optional.

(c) Scrip dividends are, like cash dividends, taxed.

(d) The company would be able to conserve cash and use it for other worthwhile
investment opportunities.
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(e) The issuance of scrip dividend is a way out of a company's liquidity problems.

(f) The company might make some savings in finance charge and thus increase
profitability by not borrowing to pay dividends.

(g) There would be increase in ordinary share capital base and therefore
reduced gearing level.

(h) They are suitable for ordinary shareholders who are interested in capital
gain.

18.9 SCRIP ISSUES

Scrip issues, also known as bonus issue, involve a mere book-keeping entry,
capitalizing the existing reserves of the company and simultaneously issuing ordinary
shares to the shareholders to the tune of the amount capitalised. Scrip issues are the
result of a financial process, the details of which have been discussed earlier in this
pack. It should be noted, however, that some authors also refer to scrip issues as
stock dividends.

18.10 SHARE SPLIT

This is a reduction in the nominal or par value of a unit of share, the result of which
proportionally increases the number of ordinary shares in issue. A company may, for
example, make a share split of 2 for 1 by which the original nominal value of a share
say N1 is reduced to NO.50 and the number of shares increases twofold. It should be
noted that, unlike bonus issue, share split does not change the total shareholders
capital. Management makes share split where it intends to achieve an appreciable
decrease in the market value of a company's share. The ultimate purpose was to
make the shares more marketable thereby possibly attracting more investors.

18.11 SHARE CONSOLIDATION

Share consolidation, also known as reverse share split, is a process whereby the
nominal value of a share is increased; the result of which reduces the number of
shares in issue. A 1 for 4 share consolidation implies that each shareholder would
receive 1 new share for 4 old shares already held by him.

A nominal value of say 25k per share might be increased to N1 per share. An
ordinary shareholder who currently has 2000 shares of 25k per share will now own
500 shares of N1 per share. Share consolidation is used where
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management believes that the share is selling at a very low price and this
process would probably jerk up the price on the stock market.

The announcement of share consolidation, like share split and bonus issue, is
likely to create some signaling effects as this is usually taken by investors as a
company in financial problems. In the case of share consolidation, management
might just want to move the share price to a higher price range within which
trading can be taking place at lower transaction costs.

Notwithstanding, management should critically assess the worthiness of share

consolidation operation to avoid possible fall in the company's share price.

18.12SHARE REPURCHASE

Share repurchase, also known as share buy-back or treasury shares, is the

repurchase of the shares of a company from its shareholders by the company
itself, either in the open market (stock exchange) or by tender offer.

A company may want to re-acquire its own shares for the purpose of achieving
its share-option plans for its top managers. It may also want to buy back its own
shares for use in a share-for-share exchange scheme in acquisition. Some
companies may want all their shares to, now, be privately owned; hence
management might repurchase those shares owned by external shareholders.
In other cases, management might just want to redeem the shares. It should be
noted that share re-purchase negates the view of the traditionalists on the
theory of dividends that cash dividends are the sole determinant of the value of
a share.

It should be noted that share re-purchase has just been recently legalised on the
Nigerian stock market.

It is only in United States that share repurchases are popular; in other countries,
they are illegal and yet in some they are uncommon because of their attendant
tax consequence.

18.13 SUMMARY AND CONCLUSIONS

The dividend policy decision of a company is a critical factor in the financial

management of that company. Some schools of thought believe there is a
strong relationship between dividend payments and the value of the firm. These
are the traditionalists. However, M & M believe that the patterns of dividend
payments do not affect the value of the firm. Theoretical reasons were
advanced in support of each position. Notwithstanding the theoretical
propositions on theory of dividends, there are practical factors to be considered
in determining the dividend policy of a firm. These include legal constraints,
future financial requirements, liquidity, capacity for borrowing and so on.
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Another aspect of the dividend policy of the firm is whether a firm should pay a fixed naira dividend-payout ratio, applied to annual
profits. Although the latter policy might have its own virtue, the stable fixed naira payment per share is recommended because it
generates investors' confidence in the ability of the management to profitably manage the company for an indefinite future period.

There are other considerations in dividend decisions that are worth mentioning. These are the scrip dividends, scrip issues, share split,
share consolidation and share repurchase. Decisions regarding all these financial operations are normally made by management
against the backdrop of the need to maximize shareholders wealth which is the principal financial objective of strategic financial
management.