Dividend Policies of Companies

 Dividend Policies of Companies

Dividend Policies of Companies- The dividend policy evolved with the prescribed legal framework within an enrolment.  In Nigeria the companies and allied mater act (CAMA) or act 1990 part xiii section 379-385 treats dividend policy.  The decree provided that dividend cannot be paid out of capital since this will lead or amount to depletions of company’s capital which is against the legal principle that the capital the company must be maintained.

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  Also the company should not pay dividend if it make it unable to pay its debt as and when fall due.  Likewise losses of previous year need not be make good in the current year before dividend is paid.

The decree further analyses that profit of previous year may be distributed as dividend form the reserve fund because they are still regarded as the company’s profit  unless and until they are capitalized’ while realized profit in the sale of fixed asset may be treated on profit available for distribution.

Dividend decision is affected by investment opportunities and legal environment within the company operates when a company has profitable and viable investment opportunities and the cost of obtaining external finance outweighs the benefit from each investment the company may utilize the retained earnings.

The law also empowered that “the directors may before recommending any dividend set aside out of profit of the company such as they think proper as a reserve (s) which shall at the discretion of the directors be applicable for any purpose to which the profit of the company may be properly applied and pending such may at the discretion either’s be employed in the business of the business of the company or be invested in such investment (other then shores of the company as the director may from time to time think fit).  The directors may also without placing the some to reserve carry forward any profit, which they may think prudent not to divide.

The fact is that the view that the dividend is not relevant to value of shares is incorrect of all the assumption upon which it lies is relaxed to meet realities of the market.

It is not an easy task to determine the desire of shareholders who are spread over the country in fact in case of a company whose shares are widely held the interest of the various shareholder groups are always in conflict.  Good as this point is dividend declared should not jeopardize the financial needs of he company.  Liquidity of the company needs to be given adequate consideration when dividend is about to be declared.

This is more important when cost of raising fund is considered and this should not be clouded be the longer-term benefits for company.


Dividend represents the benefits investors get on the stock of investment from the companies to compensate them for the risk they are undertaking and for the time of their investment.

Alternatively dividend is the expected value on the market shares i.e. capital market. The from of dividend include cash stock scrip bond and property.

CASH DIVIDEND:   Is the dividend paid in liquid from (cash) out of the earning of the company? Dividends paid in this from are highly preferred by most shareholders.  It represents major forms of dividend payment.  This cash dividend payment depends on the internal rules and roughhouse of  the company governing manages should ensure that the payment of cash divided does not impair the day-to day operating obligations of the company.

BOUND DIVIDEND:           These are very similar to scrip except that the data of payment motility of bound is longer hence it can classified as a long-term liability.

SCRIP DIVIDEND:   This form of dividend are given to owners of common stock and is mostly adopted when a company is short of cash.  In this form of dividend payment data and period is very short and it would be classified as short-term liability.

PROPERTY DIVIDEND:     These from of dividend is very and is situational. These could be likened to when breweries were declared valgal through the application of the visited   account the stock of liguor on hand could not be disposed off through normal channel.  Hence these were distributed to the stockholders.


  1. Dividend as a residual: The residual theory suggests that firms should taken on all investment which increase shareholder’s wealth and pay the residue as dividends companies hardly pursue this policy. Retention (EPS- DPS) are the residual.
  2. A stable dividend policy:        Linters (1964) shows that companies do in effect have target payout ratios and that dividend payment related to long term earnings managers emphasis stability of dividend according to Osaze (1985) directors appear to dividends as a relating to long term expectation
  3. Dividend as information policy:       Rational investors pay attention to the information content of dividend. Indeed charges in dividends policy convey information to the stock market. An increase in the dividend is interpreted as food news a cut in the dividend a bad news.  All these tend to affect the shore price eventually.  Petite (1972) suggested that it is possible to fool shareholder for a shore period of time by increasing the dividend.
  4. 100% payout ration:   Rubnor (1960)suggest that companies should be legally required to adopt a policy of 100% payout. One of the major reason is that shareholder prefer dividends and that directors would need to convince investors for any proposed investment which offers increase in wealth whatever these merits in practice companies do not generally pursued a target ration of 100% shareholders and government do not encourage this.
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A model is an initiation of the real thing and hence, it gives an idea about the operation of the actual phenomenon. These assumptions are necessary in order to see the extent to which the object under study can generate the anticipated result. Show validation in the stock market is said to be determined by interaction of forces of supply and demand. There exist models that can be used to cost of capital and retain earnings. There are numerous models with numerous validations, but this study will only concern itself with the following:

  1. Modipilani and Miller Model
  2. Gordon’s Model
  3. Walter’s Model

As a result of time lag that might exist in the market (i.e. for shares to reflect the might exists in the market (ie. For shares to reflect the decoration of divided).  Efficient market hypothesis will also be given some considerations


The most comprehensive argument for the irrelevances of dividend is found in Modigilein and Miller theory (1961) they posited that investment decision of the firm the dividend payout is a mere details.  It does not affect the wealth of shareholders.  They argued that shareholders are indifferent to whether they receive either dividend or capital gains and that the value of a company is determined solely by the “earning power” of its assets and investment.  They claimed that if the firms investment decision is given the spilt of dividend between retained earnings and dividend is not relevant for decision-making.  The current price of a company’s share is independent of the percentage of carryings that the firm distributes as dividend and that dividend policy is therefore irrelevant to share price of a profit-maximizing firm.

The assumption upon which they based their model are:

  1. The firm operates in a perfect capital market.
  2. Taxes do not exist or that since tax rate rule for capital gains and withholding tax.
  3. Fixed investment policy for the firm and there is risk of uncertainly.

The implication of this is that rate of return (or discount rate) will be equal to all shares. If it is not so the low return yielding shares will be sold by investors who will purchase the high return yielding shares.

Shares valuation model is than give as:

Po       =          D1 + p1



R          =          discount rate or rate of return

P1       =          prince ruling in year one

Po       =          dividend ruling.

What can be reassembly conduced    form these assumption is that the value of shares depends on discount rate and capital gain (ie p1-po). The discount rate (internal rate of return to an investor) for holding a shares for a period is defined as the discount rate at the equates the present value of dividends received during the period plus the and of period selling prices. The question can be asked what world be the effect of a situation when the discount rate arrived at above is less then the average discount rate ruling in the capital and money markets?

With these assumptions the financial manger should consider his responsibility to be that of determining the optional investment policy of his firm.  Once this policy is formulated dividend policy becomes irrelevant

The irrelevant states that the effect of dividend payment on shareholder wealth is offset exactly by other means of financing it argues that id a firm decide of payout dividend and finances its requirement by issuing stock the wealth of the shareholder will be unaffected. The market price of the share will reduce by exactly the amount of the dividend paid having the shareholder exactly as well as of dividends had not been paid.

Modlgilani and Miller argue also that if the reused new funds in the firm of loan stock the irrelevance of dividend policy remains unattached also.  This theory has been criticized on the basis of assumption upon which the model was based.

The risk question attitude of shareholders make them to value present dividend more then future dividend and even capital gain thus the equity holder will apply a high discount rote to later dividends then to earlier dividends.

Perfect capital market assumption was nullified on the understanding that if the shareholder decided on borrowing and lending rather then buying and selling he will face a high borrowing rate and probably a lower rate then that obtainable by companies.

Dividend payout by companies carries with it some information contents and this usually reflects on shares price. It is unrealistic to support that invests are in agreement about the risk and return characteristic of the company.  Some investors may have access to information which are we are not available to other investors.

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Then to the criticism that contain shareholders will exhibit a performance for either high dividend or capital pains; Modigilani and Miller argue that if a company pursue a consistent dividend policy each corporation would tend to attract itself a client consisting of those preferring it particular payout ratio but one client would be entirely as good as another in terms of the valuation would imply for the firm.  In other words the suggested that market value is unaffected by the choice between dividends and capital gain although individual shareholders with particular payout preference are likely to flock together by investing in the same companies which debt to meet those preference.

The infatuate things are that these theory has not been authenticated with known empirical studies


The Gordon’s model rest his argument on the theory of relevancy argument resolution of uncertainty that he payout of current dividends resolves uncertainty in the mind of investors.   With argument that an investor is not indifferent between dividends is a not capital gain he prefer dividends.

Gordon contents that uncertainly on the part of investors increases at an increasing rate with the distance in the future of prospective cash payment.  As a result the discount rate is said to risk with the distance in the future when a company cuts its dividend to finance investments.  It’s near divided its reduced while distance dividends are increased.

As the investors are not indifferent between current dividends and the retention of earning with the prospect of future dividends capital gains or both. They prefer the early resolutions of uncertainly are willing to pay a higher price for all the stock that offers the greater current dividends all other things held constant.  This is not to say that the basic business risk of a firm’s investment is affected by its dividend payout.  Rather it is contended that investor’s perception of such risk ness may be affected.

This model (Gordon’s) tries to relate the market value of a company (shares value) to the dividend policy of the company. The assumption upon which be based this theory are:

  1. There is no opportunity to obtain external financing
  2. The firm ahs not debt in its capital structures
  3. The firm is a going concern and its stream of earning are perceptively
  4. Internal rate or return ® and cost of capital are content.
  5. The cost of capital is greater then the growth rate otherwise there is no reasonable values for the shores


He was of the opinion that present value of shores is the present value of stream of dividend when discounted of the company’s cost of capital.  Based on this assumption his first shares valuation model (1962) was given as

Po       =          E1(1-b)

K          -br


Po       =          presents value of shores

B          =          retention rate

K          =          the company

R          =          internal rate of return of the company.

Another model a new development

Gordon (1962) based on econometrics principles. Eh attempted to corrected shores price with some variables ie. Current dividend yield retained earning etc. the model was given by the following definition.

Po       =          ao+ai D+a2RE+C


Po       =          current shares price

D         =          dividend

Re       =          addition to retained earnings

Ao +a and a2           =          parameters that are being used to define the relationship one important aspect of he model is that of employs statistical method that can be adjusted to numerous tests of reliability if the forecast given by the models fails to reflect the true market value.  It is due to random of residual factor.

Good as this model might seem, it was criticized   on the basis of not including all the variables risk being the most important. The data will also be used for analysis that is the accounting record is invested with measurements errors or what can be termed different accountant with different accounting policies and basis different profits”


Professor James E. Walter (1976) also strongly argued that dividend policy is relevant in he sense that its chose almost always affect the value of the firm. If his view is correct in lines with Gordon’s model then dividend policy will affect shareholders wealth?

The assumption upon which he rest his model are:

  1. All investment are done with retained earnings ie. No debt in the capital structure
  2. 2.                 All firms internal rate of return, r and its cost of capital k are constant.
  3. 3.                 All earning are either distributed as dividend or re-invested internally.
  4. 4.                 Earning and dividend are constant
  5. 5.                 The firm is a going concern in view of these assumptions his model is given as


P          =          D+ (r/k) (E-D)



P          =          market price per shares

D         =          dividend per shares

E          =          earning per shares

R          =          internal ratio of return

K          =          cost of capital

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His proceeds by classifying firms into growth firm which is a firm with internal rate of return greater then it’s cost of capital. The best policy for this firm is to pay not dividend. Normal firm internal rate of return is the some as its cost of capital and this firm can be indifferent to the amount of dividend paid out.

The model had been criticized on the pounds that it confuses dividend policy with investment policy of he firm and it fails to recognize the effect of risk on valuation of shares.


The determination of shares value through model was challenged by some scholars that claimed that the stocks price behaves randomly. This theory which is known as “Random walk theory” is the off shoot of efficient market hypotheses (EMH) This scholars successfully established the randomness and having done this they were faced with the problem of what censed the randomness.  They needed to discover what it was in the working of some “secondary market hypotheses” then was found to be information.

Efficient market hypotheses (EMH) was examined in its “weak” semi-strong and is “strong” firm.

The “weak” firm was of the opinion that preceding pattern of prices has been taken into consideration before the current market value materialize.  This is the some thing as saying that all previous information has been taken into accounts in determination of shares value.

The “semi-strong” holder that current market value does not only reflect the past information but any other information that is publicity available.  Ti holds that if investors assimilate the information instantaneously nobody can gain at the deficient of other investor.  The semi-strong firm explains this randomness in terms of current prices reflecting fully all publicity available information about shares.

The strong firm believes that the current prices of a security impound not only all relevant published information but also information, which are not publicity available. Some people may have privilege information about shares.  He question is whether or not possession of such information lead these people to perform consistently betters then the market as a whole.

Due to legality involve in the inside dealings the efficient market hypotheses may be valid in its semi-strong firm at least it should be valid in its weak firm this is more so since information that affect share prices usually reflect with lay


This chapter has tried to highlight some of the theoretical model used in shares valuation as it relates to dividend.

Modigilani and Miller theory of dividend irrelevance was briefly considered with its underlined assumption and criticism. This was of the view that what determines share’s value is the discount rate and that discount rate differential in companies will lead to asset switching

Gordon’s model which rest on retention ratio and internal rate of return (IRR) was also considered his econometrics model of share valuation was briefly explained and this was found inadequate since it may be tedious to incorporate besides the fact that the function itself may not be liner.

Also Gordon’s theory of relevance theory resolution of uncertainty was considered.  This argument that investor is not indifferent between dividends and capital gain ie. Investor prefers dividends. They prefer early resolution of uncertainty and are willing to pay higher price for all the stock the offer the greater current dividends.

Walter’s model given on insight to the fact the companies can be classified into the growth neutral and declining firms. He growth firms should retain all its earnings declining firms paying all it earning as dividend while the neutral firm can choose to be indifferent.

Efficient market hypotheses (EMH) tries to highlight one of the reasons why models of shares valuation fail to conform to realities of market.  Essentially however it is theory on its own


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