Dividend Theories and Policies: The Relevance of the Policy on the Value of the Firm

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DIVIDEND THEORIES AND POLICIES
THE RELEVANCE OF THE POLICY ON THE
VALUE OF THE FIRM
COURSE TITLE: CORPORATE FINANCE
COURSE CODE: FIN 801
A PRESENTATION SUBMITTED TO THE DEPARTMENT OF ACCOUNTING AND
FINANCE, FACULTY OF MANAGEMENT SCIENCES, UNIVERSITY OF ILORIIN, KWARA
STATE, NIGERIA.
BY
NASIRUDEEN ABDULLAHI
UIL/PG2020/1432
LECTURER IN CHARGE: DR. I.B ABDULLAHI
OCTOBER, 2021

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DIVIDEND THEORIES AND POLICIES
THE RELEVANCE OF THE POLICY ON THE VALUE OF THE FIRM
Introduction
The dividend policy decision involves the choice between distributing the profits belonging to
the shareholders and their retention by the firm. A major decision area of Financial
management is the dividend policy decision in the sense that the firm has to choose between
distributing the profits to the shareholders and ploughing them back into the business. The
selection would be influenced by the effect on the objective of Financial Management of
maximizing shareholder’s wealth. The firm should pay dividend if the payment will lead to the
maximisation of the wealth of the owners and if not then the firm should retain profits to
finance investment programmes.The relationship between dividends and value of the firm
should, therefore, be the decision criterion.There are conflicting opinions regarding the impact
of dividends on the valuation of a firm. Retained earnings are the most significant internal
sources of financing the growth of the firm. On the other hand, dividends may be considered
desirable from the shareholders’ point of view as they tend to increase their current return.
Dividends, however, constitute the use of the firm’s funds. Dividend policy involves the
balancing of the shareholders’ desire for current dividends and the firms’ needs for funds for
growth.
Objective of dividend policy
A firms’ dividend policy has the effect of dividing its net earnings into two parts:
retained earnings and dividends. The retained earnings provide funds to finance the firm’s long
– term growth. It is the most significant source of financing a firm’s investment in practice.
Dividends are paid in cash. Thus, the distribution of earnings uses the available cash of the
firm. A firm which intends to pay dividends and also needs funds to finance its investment
opportunities will have to use external sources of financing, such as the issue of debt or equity.
Dividends - Classification
The term dividend usually refers to cash paid out of earnings. If a payment is made
from sources other than current or accumulated retained earnings, the term distribution, rather
than dividend, is used. However, it is acceptable to refer to a distribution of earnings as a
dividend and a distribution from capital as a liquidating dividend. More generally, any direct
payment by the corporation to the shareholders may be considered a dividend or a part of
dividend policy.

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Dividends come in several different forms. The basic types of cash dividends are:
Regular cash dividends
Extra dividends
Special dividends
Liquidating dividends
Cash Dividends
The most common type of dividend is a cash dividend. Commonly, public companies
pay regular cash dividends four times a year. As the name suggests, these are cash payments
made directly to shareholders, and they are made in the regular course of business. In other
words, management sees nothing unusual about the dividend and no reason why it won’t be
continued.
Sometimes firms will pay a regular cash dividend and an extra cash dividend. By
calling part of the payment “extra” management is indicating that the “extra” part may or may
not be repeated in the future. A special dividend is similar, but the name usually indicates that
this dividend is viewed as a truly unusual or one-time event and won’t be repeated. Finally, the
payment of a liquidating dividend usually means that some or all of the business has been
liquidated, that is, sold off. However it is labeled, a cash dividend payment reduces corporate
cash and retained earnings, except in the case of a liquidating dividend.
Bonus Shares (Stock dividend)
An issue of bonus shares is the distribution of shares free of cost to existing
shareholders. Bonus shares are issued in addition to the cash dividend and not in lieu of cash
dividends. Hence, companies may supplement cash dividend by bonus issues. Issuing bonus
shares increase the number of outstanding shares of the company. The bonus shares are
distributed proportionately to the existing shareholder. Hence there is no dilution of ownership.
For example, if a shareholder owns 100 shares at the time when a 10 per cent (ie., 1:10) bonus
issue made, he will receive 10 additional shares. The declaration of the bonus shares will
increase the paid-up share capital and reduce the reserve and surplus earnings of the company.
The total net worth is not affected by the bonus issue.
Stock Split
A stock split is essentially the same thing as a stock dividend, except that a split is
expressed as a ratio instead of a percentage. When a split is declared, each share is split up to
create additional shares. For example, in a three-for-one stock split, each old share is split into
three new shares.

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Standard Method of Cash Dividend Payment
The decision to pay a dividend rests in the hands of the board of directors of the
corporation. When a dividend has been declared, it becomes a debt of the firm and cannot be
rescinded easily. Sometime after it has been declared, a dividend is distributed to all
shareholders as of some specific date. Commonly, the amount of the cash dividend is
expressed in terms of dollars per share (dividends per share). As we have seen in other
chapters, it is also expressed as a percentage of the market price (the dividend yield) or as a
percentage of net income or earnings per share (the dividend payout).
Example of procedure for dividend payment
January 15 January 28 January 30 February 16
(Declaration date) (Ex-Dividend date) (Record date) (Payment date)
Establishing Dividend policies and Decisions
How do firms actually determine the level of dividends they will pay at a particular
time? As we have seen, there are good reasons for firms to pay high dividends and there are
good reasons to pay low dividends. There are three approaches for establishing dividend
policy. These are three types of the dividend policy, such as residual dividend approach,
dividend stability and a compromise dividend policy.
Residual Dividend Approach
Firms with higher dividend payouts will have to sell stock more often. Such sales are not
very common and they can be very expensive.
Consistent with this, we will assume that the firm wishes to minimize the need to sell new
equity. We will also assume that the firm wishes to maintain its current capital structure.
If a firm wishes to avoid new equity sales, then it will have to rely on internally generated
equity to finance new positive NPV projects. Dividends can only be paid out of what is
left over. This leftover is called the residual, and such a dividend policy is called a
residual dividend approach.
With a residual dividend policy, the firm’s objective is to meet its investment needs and
maintain its desired debt-equity ratio before paying dividends.
Illustrate, imagine that a firm has N1,000 in earnings and a debt-equity ratio of 0.50. Notice
that, because the debt-equity ratio is 0.50, the firm has 50 cents in debt for every N1.50 in total
value. The firm’s capital structure is thus debt and equity.
The first step in implementing a residual dividend policy is to determine the amount of
funds that can be generated without selling new equity. If the firm reinvests the entire N1,000
and pays no dividend, then equity will increase by N1,000. To keep the debt-equity ratio of