LESSON EIGHT

DIVIDEND DECISION

1.1 Introduction

Dividend policy determines the division of earnings between payment to stock holder’s and
re-investment in the firm. It therefore looks at the following aspects:

i). How much to pay – this encompassed in the four major alternative dividend policies.
 Constant Amount of Dividend Per Share
 Constant Payout Ratio
 Fixed Dividend Plus Extra
 Residual Dividend Policy
ii) When to pay – paying interim or final dividends
iii) Why dividends are paid – this is explained by the various theories which has to
determine the relevance of dividend payment i.e.:
 Residual dividend theory
 Dividend irrelevance theory (MM)
 Signalling theory
 Bird in hand theory
 Clientele theory
 Agency theory
iv) How to pay: cash or stock dividends.
Importance of Dividend Decisions
Dividend’s decisions are integral part of a firm’s strategic financing decision. It is therefore a
plan of action adopted by management e.g payment of high dividends means less retained
earnings and the firm may have to go to the market to borrow for investment purposes. This
will increase its gearing level.

Solution to the Dividend Puzzle

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A firms dividend decision may have some relevance to the firm’s share value. The managers
therefore require to formulate an optimal dividend policy which will maximize the wealth of
the shareholders (value of shares).

The lesson covers:

 Lesson Objectives
 Dividend Policy and Decisions
 Alternative Dividend Policies
 Dividend Theories
 Mode of paying Dividends
 Factors influencing dividend policies
 Learning Activities
 Summary
 Further reading.

1.2 Lesson Objectives

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

1. Discuss the Divided policy and decisions

2. Discuss dividend theories
3. Discuss factors affecting dividend payment

1.3 HOW MUCH TO PAY: ALTERNATIVE DIVIDENDS POLICIES

a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. The DPS would
therefore fluctuate as the earnings per share changes.
Dividends are directly dependent on the firm’s earnings ability and if no profits are made no
dividend is paid.

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This policy creates uncertainty to ordinary shareholders especially who rely on dividend
income and they might demand a higher required rate of return.

b) Constant amount per share (fixed D.P.S.)

The DPS is fixed in amount irrespective of the earnings level. This creates certainty and is
therefore preferred by shareholders who have a high reliance on dividend income.
It protects the firm from periods of low earnings by fixing, DPS at a low level.
This policy treats all shareholders like preferred shareholders by giving a fixed return. The
DPS could be increased to a higher level if earnings appear relatively permanent and
sustainable.

c) Constant DPS plus Extra/Surplus

Under this policy a constant DPS is paid every year. However extra dividends are paid in
years of supernormal earnings.
It gives the firm flexibility to increase dividends when earnings are high and the shareholders
are given a chance to participate in super normal earnings
The extra dividends is given in such a way that it is not perceived as a commitments by the
firm to continue the extra dividend in the future. It is applied by the firms whose earnings are
highly volatile e.g agricultural sector.

d) Residual dividend policy

Under this policy dividend is paid out of earnings left over after investment decisions have
been financed. Dividend will only be paid if there are no profitable investment opportunities
available. The policy is consistent with shareholders wealth maximization.

ii) WHEN TO PAY

Firms pay interim or final dividends. Interim dividends are paid at the middle of the year and
are paid in cash. Final dividends are paid at year end and can be in cash or bonus issue.

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1.4 DIVIDENDS THEORIES (WHY PAY DIVIDENDS)

1. Residual dividend theory

Under this theory, a firm will pay dividends from residual earnings i.e. earnings remaining
after all suitable projects with positive NPV has been financed.
It assumes that retained earnings is the best source of long term capital since it is readily
available and cheap. This is because no floatation cash are involved in use of retained
earnings to finance new investments.
Therefore, the first claim on earnings after tax and preference dividends will be a reserve for
financing investments.
Dividend policy is irrelevant and treated as passive variable. It will not affect the value of the
firm. However, investment decisions will.
Advantages of Residual Theory
1. Saving on floatation costs
No need to raise debt or equity capital since there is high retention of earnings which requires
no floatation costs.
2. Avoidance of dilution of ownership
New equity issue would dilute ownership and control. This will be avoided if retention is
high. A high retention policy may enable financing of firms with rapid and high rate of
growth.

3. Tax position of shareholders

High-income shareholders prefer low dividends to reduce their tax burden on dividends
income.
They prefer high retention of earnings which are reinvested, increase share value and they can
gain capital gains which are not taxable in Kenya.

ii) MM Dividend Irrelevance Theory

Was advanced by Modiglian and Miller in 1961. The theory asserts that a firm’s dividend
policy has no effect on its market value and cost of capital.

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They argued that the firm’s value is primarily determined by:
Ability to generate earnings from investments
Level of business and financial risk
According to MM dividend policy is a passive residue determined by the firm’s need for
investment funds.
It does not matter how the earnings are divided between dividend payment to shareholders
and retention. Therefore, optimal dividend policy does not exist. Since when investment
decisions of the firms are given, dividend decision is a mere detail without any effect on the
value of the firm.
They base on their arguments on the following assumptions:
1. No corporate or personal kites
2. No transaction cost associated with share floatation
3. A firm has an investment policy which is independent of its dividend policy (a fixed
investment policy)
4. Efficient market – all investors have same set of information regarding the future of the
firm
5. No uncertainty – all investors make decisions using the same discounting rate at all time
i.e required rate of return (r) = cost of capital (k).

iii) Bird-in-hand theory

Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty. Dividends payments are more
certain than capital gains which rely on demand and supply forces to determine share prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the bush
(uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value since shareholders
will require to use lower discounting rate.
MM argued against the above proposition. They argued that the required rate of return is
independent of dividend policy. They maintained that an investor can realize capital gains
generated by reinvestment of retained earning, if they sell shares.
If this is possible, investors would be indifferent between cash dividends and capital gains.

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iv) Information signaling effect theory
Advanced by Stephen Ross in 1977. He argued that in an inefficient market, management can
use dividend policy to signal important information to the market which is only known to
them.
Example – If the management pays high dividends, it signals high expected profits in future
to maintain the high dividend level. This would increase the share price/value and vice versa.
MM attacked this position and suggested that the change in share price following the change
in dividend amount is due to informational content of dividend policy rather than dividend
policy itself. Therefore, dividends are irrelevant if information can be given to the market to
all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the
higher the value of the firm. The theory is based on the following four assumptions:
1. The sending of signals by the management should be cost effective.
2. The signals should be correlated to observable events (common trend in the market).
3. No company can imitate its competitors in sending the signals.
4. The managers can only send true signals even if they are bad signals. Sending untrue
signals is financially disastrous to the survival of the firm.

v) Tax differential theory

Advanced by Litzenberger and Ramaswamy in 1979
They argued that tax rate on dividends is higher than tax rate on capital gains. Therefore, a
firm that pays high dividends have lower value since shareholders pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the value of the firm
and vice versa.
Note
In Kenya, dividends attract a withholding tax of 5% which is final and capital gains are tax
exempt.

vi) Clientele effect theory

Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different preferences for
dividends depending on their level of income from other sources.

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Low-income earners prefer high dividends to meet their daily consumption while high
income earners prefer low dividends to avoid payment of more tax. Therefore, when a firm
sets a dividend policy, there’ll be shifting of investors into and out of the firm until an
equilibrium is achieved. Low, income shareholders will shift to firms paying high dividends
and high-income shareholders to firms paying low dividends.
At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has.
Dividend decision at equilibrium are irrelevant since they cannot cause any shifting of
investors.

vii) Agency theory

The agency problem between shareholders and managers can be resolved by paying high
dividends. If retention is low, managers are required to raise additional equity capital to
finance investment. Each fresh equity issue will expose the managers financing decision to
providers of capital e.g bankers, investors, suppliers etc. Managers will thus engage in
activities that are consistent with maximization of shareholders wealth by making full
disclosure of their activities.
This is because they know the firm will be exposed to external parties through external
borrowing. Consequently, Agency costs will be reduced since the firm becomes self-
regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is because dividend
policy can be used to reduce agency problem by reducing agency costs. The theory implies
that firms adopting high dividend payout ratio will have a higher due to reduced agency
costs.

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1.5 Factors to consider in paying dividends (factors influencing dividend)

1. Legal rules
a) Net purchase rule: States that dividend may be paid from company’s profit either past
or present.
b) Capital impairment rule: prohibits payment of dividends from capital i.e. from sale of
ssets. This is liquidating the firm.
c) Insolvency rule: prohibits payment of dividend when company is insolvent. Insolvent
company is one where assets are less than liabilities. Insolvent company is one where
assets are less than liabilities. In such a case all earnings and assets of company belong
to debt holders and no dividends is paid.
2. Profitability and liquidity
A company’s capacity to pay dividend will be determined primarily by its ability to generate
adequate and stable profits and cash flow.
If the company has liquidity problem, it may be unable to pay cash dividend and result to
paying stock dividend.
3. Taxation position of shareholders
Dividend payment is influenced by tax regime of a country e.g in Kenya cash dividend are
taxable at source, while capital is tax exempt.
The effect of tax differential is to discourage shareholders from wanting high dividends.
(This is explained by tax differential theory).
4. Investment opportunity
Lack of appropriate investment opportunities i.e. those with positive returns (N.P.V.), may
encourage a firm to increase its dividend distribution. If a firm has many investment
opportunities, it will pay low dividends and have high retention.
5. Capital Structure

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A company’s management may wish to achieve or restore an optimal capital structure i.e. if
they consider gearing to be too high, they may pay low dividends and allow reserves to
accumulate until a more optimal/appropriate capital structure is restored/achieved.

6. Industrial Practice
Companies will be resistant to deviation from accepted dividend or payment norms within
the industry.
7. Growth Stage
Dividend policy is likely to be influenced by firm’s growth stage e.g a young rapidly growing
firm is likely to have high demand for development finance and therefore may pay low
dividend or a defer dividend payment until company reaches maturity. It will retain high
amount.
8. Ownership Structure
A dividend policy may be driven by Time Ownership Structure e.g in small firms where
owners and managers are same, dividend payout are usually low.
However, in a large quoted public company dividend payout are significant because the
owners are not the managers. However, the values and preferences of small group of owner
managers would exert more direct influence on dividend policy.
9. Shareholder’s expectation
Shareholder clientele that has become accustomed to receiving stable and increasing div. Will
expect a similar pattern to continue in the future.
Any sudden reduction or reversal of such a policy is likely to dissatisfy the shareholders and
may result in a fall in share prices.
10. Access to capital markets
Large, well-established firms have access to capital markets hence can get funds easily
They pay high dividends thus, unlike small firms which pay low dividends (high retention)
due to limited borrowing capacity.
11. Contractual obligations on debt covenants
They limit the flexibility and amount of dividends to pay e.g. no payment of dividends from
retained earnings.

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1.6 Learning Activities

(i) Discuss the importance of dividend and dividend policy

(ii) Defined key divided policies and theories
(iii) Highlight factors to consider before you pay dividends

1.6 Summary

Dividend are the rewards investors get for investing their hand earned cash in a
corporation. Understanding the dividend payment is key for financial students as they
prepare their career in finance. Payment of dividend is correlated with the value of firm
hence understanding the concept is a critical concept in finance.

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1.7 Further Reading

1. Financial Management, 10 edition I M Pandey

2. Fundamentals of Financial Management, Concise Edition, By Eugene F. Brigham, Joel F.

Houston.

3. Stice, E., Stice, J., & Diamond, M. A. (2005). Financial accounting: Reporting & analysis.
Florence, SC:. Cengage Learning.

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