Effect of Dividend Policies

The optimal dividend policy of a firm depends on investor’s desire for capital gains as opposed to income, their willingness to forgo dividend now for future returns, and their perception of the risk associated with postponement of returns. However any normative approach to dividend policy intended to be operative under real world conditions should consider the firms investment opportunities, any preferences that investors have for dividends as opposed to capital gains and vice versa, and difference in “cost” between retained earnings and new equity issues.

Various firms adopt dividend policies depending on the company’s articles of association and the prevailing economic situation. Some make high pay out, while others make low pay out and yet others pay stock dividends (bonus issue) in lieu of or in addition to cash dividend while others pay cash only. All in a bid to maximize shareholders wealth which, in this case, is the market value of the firm’s common stock. Modigliani and Miller (1961) demonstrated the irrelevance of dividend policy under a set of assumption, that is, dividend policy has no effect on stock prices. But when these assumptions are relaxed, the theory begins to collapse. This raises the question does dividend policy have any effect on the value of firms in Nigeria? If yes, to what extent? 2

Objective of Study
The objective of this study is to critically examine the possible effects that a firm’s dividend policy might have on the market price of its common stock and also, those factors that influence firm’s dividend policy in general.

It further attempts at identifying other factors that influence share price behaviour of quoted companies in Nigeria, and finally identifies the most commonly practiced dividend policy in Nigeria.

Theoretical Framework
Pandy (1979) defines dividend as that portion of a company’s net earnings which the directors recommend to be distributed to shareholders in proportion to their share holdings in the company. It is usually expressed as a percentage of nominal value of the company’s ordinary share capital or as a fixed amount per share.

Dividends are usually paid out of the current year’s profit and sometimes out of general reserves. They are normally paid in cash, and this form of dividend payment is known as cash dividend. Another option available to a company for the distribution of earnings is by stock dividend (bonus issue) which is supplementary to cash dividend. When cash dividend is paid to shareholders, it has an adverse effect on the liquidity position and the reserves of the firm as it tends to reduce both of them (cash and reserves). Unlike cash lend, stock dividend does not affect the total net work of the firm, as it is a capitalization of owners’ equity portion.

Furthermore, according to section 370 sub-section (1) of CAMA, a company may in the annual general meeting, declare dividend only on the recommendation of the Directors. The Company may from time to time pay to the members such interim dividends as appear to the directors to be justified by the profits of the company. According to sub-section (3), the general meetings shall have power to decrease the amount of dividend recommended by the directors, but shall have no power to increase the amount recommended. While sub-section (5) stated that, subject to the provisions of these act, dividend shall be payable only out of the distributable profit of the company.

Furthermore, section 381 of CAMA states that a company shall not declare or pay dividends if there are reasonable grounds for believing the company is or would be, after the payment, unable to meet up with or pay its liabilities as they become due. According to Van Home (1971) dividend policy entails the division of earnings between shareholders and reinvestment in the firm. Retained earnings are a significant source of funds for financing corporate growth, but dividend constitutes the cash flows that accrue to shareholders. There exist two divergent schools of thought with regards to these, the dividend policy and the retained earning policy.

Dividend policy suggests a positive attitude for, it is a deliberate policy to maintain or increase dividend at a certain level with the ultimate aim of sustaining the price of the ordinary shares on the stock exchange. This is because capital markets are not perfect, although shareholders are indifferent between dividend and retained earnings due to market imperfections and uncertainty, but they give a higher value to the current year dividend than the future dividend and capital gains. Thus the payment of dividend has a strong influence on the market price of the shares. Management might maintain a dividend level even at the expense of liquidity or forced into borrowing to do so. With this approach it holds that dividends, on the other hand, are desirable from the shareholders point of view, as increasing their current wealth and consequently dividend level determines share price as well as indicates the prospect of profitability of the firm.

On the other hand, profit retention policy tends to suggest a more passive residual attitude towards dividend, that is, a passive attitude towards retention. Dividend pay out reduces the amount of earnings to be retained in the firm and affect the total amount of internal financing. When dividends are treated as a financing decision, the net earning of the firm may be viewed as a significant source of financing the growth of the firm. Dividends paid to shareholders represent a distribution of earnings that cannot be profitably reinvested by the firm. The approach to dividend is viewed merely as a residual decision. This theory is known as the residual theory of dividend and was first proposed by Miller and Modiliani in 1961. Investor prefer to have the firm retain and reinvest earnings rather than pay them out in dividend if the return on the investment earnings exceeds the rate of return the investors could themselves obtain on other comparative investment. Otherwise, the investors prefer dividend. Relevance of Dividend

Another school of thought holds that without Modigiani and Miller’s restrictive assumptions, their argument collapses. They asserted that since, in reality investors operate in a world of brokerage fees, taxes, and uncertainty, it is better to view the firm in the light of these factors.
The leading proponent of the relevance of dividend theory, Gordon (1962) suggests that shareholders do have a preference for current dividends, that, in fact theme is direct relationship between the dividend policy of a firm and its market value. Gordon argues that investors are generally risk-averters and attach less risk to current as opposed to future dividends or capital gains. This ‘birds r’ hand” argument suggest that a firm’ dividend policy is relevant since investors prefer some dividend now in order to reduce their uncertainty. When investors are uncertain about their returns they discount the firm’s future earnings at a lower rate therefore placing a higher value on the firm.

Another writer, Walter (1963) was of the opinion that dividend policies in most cases do affect the value of the firm. The effect of the optimum dividend policy on the relationship between the firm’s internal rate of return (r) and its cost of capital (k) according to him, is a growth function of the firm where r>k, all earnings can be reinvested, hence, the firm is assumed to have sample profitable opportunities so as to maximize the value per share over and above the rate expected by shareholders. In a normal firm where r=k, dividend policy have no effect on the market value per hare since the rate of return is equal to the cost of capital. In a declining firm where the optimum payout ratio should be 100% to enable increase in the market value per share, Walter expressed this as thus: k-dr

Where P Market value of the share
E = Earnings per share
K = Cost of capital
r = Internal rate of return
d = Current dividend
This Walter theory has been criticized because r and k are not constant in real life situation. Moreover, the non-existence of external financing makes it weak. The firm’s r decreases as more investment occurs and k changes directly with the firm’s risk. It should be understood here that Walter’s model though weak, recognizes the fact that dividend policy is relevant, according to Samuels and Wilkes (1975).

The owners of a company share are entitled to a revenue stream of dividends. The value of the share corresponds to the present value of this steam of dividends payments. Obviously, there is considerable uncertainty surrounding the size of the future dividends, indeed it is as a result of change expectations about future dividends that share prices fluctuate. The owner considers his returns as accruing not just from dividend payments but from the additional gains resulting from any capital appreciation on the share. Normally he does not intend to hold the share in perpetuity, he wishes to sell the share and obtain capital gains, but when he sells the share, the buyer is also simply purchasing a stream of future dividend expectations. The reason the capital gain expectation arises is because of expectation about future dividend stream rise between the time when the investor purchases the shares and when he sells them.

This theory can be demonstrated. Suppose an investor buys a share expecting to hold it for two years: The value of the share to him is the present value of the two years dividend payment, plus the discounted value of the price he expect to receive on selling the share. If P0 = Price of share today

P2 = Price of share at the end of the 2nd year
D1 = Dividend per share to be received at the end of 1st year 1 = Discount rate, and
D2 = Dividend at the end of the 2nd year, then
Po = D1 + D2 + P2
(1+i) (1+i)2 (1+i)2
The investor who buys the share at the end of the 2nd year pays P2 for it and expects to hold it for two further years, so, looked at from time 0 will give
P2 D3 D4 P4
(1+i)2 (1+i)3 (1+i)4 (1+i)4
Rewritten as
P0 =  Dt / (1 +i)t
The theory demonstrated above is in line with Graham, Dodd and Cottle’s statement that “the predominant rate dividend has found full reflection is a generally accepted theory of investment value which states that a common stock is worth the sum of the entire dividend to be paid on it in the future, each discounted to its present worth”. Methodology

This study fundamentally falls under the ex post factor design type because there is no experiment involved, but rather is designed to test an event that has already taken place. Therefore it deals with historical facts about dividend policy and its effects on the value of Nigerian firms.

The primary data were collected through personal interviews with a stockbroker, bankers and the members of staff of the Nigerian stock exchange, Kaduna branch. This was to enable a thorough complementary presentation with the secondary data since; the data used in this study is mainly secondary data being document analysis and reappraisal. The data machinery adopted for this study is the published accounts of selected firm for the relevant years sampled for analysis. This enabled the collection of the common stock price list of the selected firms, obtained from the Nigerian stock exchange Kaduna branch. Samples of fifteen quoted companies were selected. The basis of selecting these companies was to ensure that all industries are covered but as the study progressed, it became obvious that the data to cover the ten year period was not available in the required quantity so, what could be got was used. The study covers a period of 10 (ten) years spanning 1990 to 1999.