DIVIDEND POLICY INTRODUCTION The term dividend usually refers to cash payments made by companies to its shareholders. If the payment is made from sources other than current or accumulated retained earnings, the term distribution rather than dividend is used. However it has become acceptable to refer to distribution from earnings as a dividend and a distribution from capital as liquidating dividend. Preferred stock dividends are usually fixed by the terms of the issue and are therefore not subject to policy decisions of company managers. Payment of dividend to common stockholders is, however, a matter of company policy to be decided by the board of directors. As a result, the proportion of earnings paid out a dividend may vary considerably from one company to another and from one year to the next for the same company. The most common type of dividend is in the form of cash. Public limited companies usually pay regular cash dividends semiannually in Kenya. Occasionally, however, firms will pay the regular cash dividend and an extra or special cash dividend payment that is not likely to be repeated in the future. Another type of dividend is paid out in shares of stock and is referred to as stock dividend or bonus shares. In this case, new shares of common stock are issued and distributed to existing stockholders; this has the effect of increasing the number of shares outstanding thereby reducing the value of each share. A bonus share issue is commonly expressed as a ratio. For instance, with a five percent stock dividend, a shareholder receives five new shares for every one hundred shares currently owned. Thus, shareholders maintain their proportionate ownership of the company. Dividends may also be paid in the form of stock (or share) splits. This is a method of increasing the number of shares outstanding through a proportional reduction in the par value of the share. Thus, a three-for-one stock split implies that three new shares are issued in place of one existing share and the par value of the existing share is divided equally among the three new shares created. Stock split decisions are typically made when managers believe that the firm’s stock is trading in the secondary markets at a price that is so high that trading in the stock is hampered. Stock splits do not have any effect on the firm’s capital structure. A reverse split occurs if several existing shares are merged into one new share and the par value of the new share becomes a multiple of the number of shares merged and the par value of the existing share. Cash Dividend Payment Procedures The payment of cash dividends to shareholders is decided by the company’s Board of Directors. Such a decision is made after a careful evaluation of the past period’s financial performance and future outlook of the firm. Once a dividend has been declared, it becomes a liability of the firm and cannot be easily rescinded. Following is an outline of the typical payment sequence:  Declaration Date. The directors meet, say on January 15, and pass a resolution to pay a cash dividend of, say KShs. 2.00 per share to all holders of record on February

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





15. The first date, January 15, in this simplified example, is referred to as the declaration date. Date of Record. This is the date on which the company closes its share transfer books and makes up a list of shareholders ‘as of that date.’ In the above example, if the company is notified of the sale and transfer of some shares before February 16, the new owner receives the declared dividend. If the notification is received on or after February 16, the old shareholder receives the dividend. Ex-dividend date. Due to the time needed to make bookkeeping entries when a share is traded, some transfers made before the date of record may not reach the firm in time to enable the new owner’s name be entered into the firm’s shareholders’ register. To avoid conflict, stock brokers have established a convention of declaring that the right to participate in dividends remains with the stock until four business days prior to the date of record; on the fourth day before the date of record, the right to receive dividends no longer goes with the shares. The date when the right to dividends leaves the stock is known as the ex-dividend date. Prior to this date, the stock is said to trade cum-dividend. Ceteris paribus, it is expected that the share price will decline by the amount of dividend on the ex-dividend date. Date of Payment. This is the actual date on which the firm will mail dividend cheques to holders on record and is usually set a few weeks after the date of record.

DIVIDEND THEORIES The central issue of dividend policy is whether it is possible to affect shareholders’ wealth by changing the company’s dividend payout ratio. There is controversy as to whether a high payout ratio is better than a low payout ratio and vice versa. Using the dividend discount valuation models, the value of a share is the present value of the expected future dividend stream. This implies that a high dividend payout would, other things constant, result in a high share value. Consequently, a high dividend payout ratio should increase the wealth of shareholders and is therefore welcome. However, it is also common knowledge that payments of dividends reduce the resources of the company, and unless replaced by new capital issues, could affect the firm’s investment prospects and compromise its earnings ability and future dividend payments. The following theories have been advanced by Finance researchers on the effects of dividend policy on shareholders’ wealth:

DIVIDEND IRRELEVANCE ARGUMENT Professors Merton H. Miller and Franco Modigliani (MM) have advanced the Dividend Irrelevance theory, which posits that in perfect capital markets, the dividend payout ratio is irrelevant.1 They argue that a firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which the firm splits its earnings stream between dividends and internally retained, and reinvested, funds does not 1

Miller, M. H. and F. Modigliani (1961). “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business, 34, October, 411 – 433.

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affect this value. They assert that, given the investment decision of the firm, the dividend decision does not in any way affect the wealth of shareholders. MM hypothesis of irrelevance is based on the following critical assumptions: 1. There exists perfect capital markets in which all investors are rational, information is available to all at no cost, securities are infinitely divisible and no investor is large enough to affect the market price of a security. 2. Taxes do not exist, or there are no differences in a tax rates applicable to capital gains and dividend. Thus, investors are indifferent between dividend and capital gains. 3. A firm has a fixed or given investment policy that is not subject to change. 4. Transactions can take place instantanconsly and at no cost. Similarly, securities can be issued by a firm without the incurrence of issue costs. 5. Investors are perfectly certain as to the future investments and profits of the firm. Because of this assurance, there is, among other things, no need to distinguish between stocks and bonds as sources of funds. The analysis, therefore, assumes an all equity firm. According to MM, the effect of dividend payment on shareholder wealth is exactly offset by other means of financing. If the firm’s investment decision is already made, the firm must decide whether to retain its earnings or to pay dividends and, say, sell new stock in the amount of these dividends in order to finance its investments. MM suggest that the market value of the firm’s stock before the financing and dividend payment remains unaffected regardless of the decision taken. The shareholder is, therefore, indifferent between dividends and retention of earnings and subsequent capital gains. Now, the oneperiod rate of return, ku, for an unlevered firm’s stock can be defined as: D1  P1  P0  P0 Where D1 is the dividend per share paid at the end of period t. P1 is the price per share at the end of period t. P0 is the price per share at the beginning of period t. ku 

(1)

Solving equation (1) for P0, the market price (or value) at the beginning of the period can be expressed as:

Po 

D1  P1 1  ku

(2)

Using the stated assumption that the firm is all-equity financed, we can determine the firm’s total market value by multiplying equation (2) by the total number of shares of common stock outstanding, n, at the beginning of the period:

V0  nP0 

nD1  nP1 nD1  P1   1  ku 1  ku

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(3)

3

Here, the value of the firm is seen to be equal to the discounted sum of two cash flows: dividends paid out, nD1, and the end of period value of the firm, nP1 (or V1). If the firm sells m new shares at the end of the period, the firm’s value at the beginning of the period would be:

Thus

nP0 

nD1  P1   mP1  mP1 1  ku

nP0 

nD1  n  mP1  mP1 1  ku

(4)

It must be noted, however, that since dividend policy affects the amount of new financing required, P1, the price per share at the end of the period, depends on D1, the dividend paid per share. This implies that the dividend policy affects the firm’s value, V0. The key to understanding why dividend payout does not affect the firm’s value, given the set of assumptions earlier outlined, is the firm’s sources and uses of funds. The major sources are external funds provided through the issue of new shares, mP1, and the net operating income, X1. The net operating income is defined as earnings from operations before interest and taxes. If there are no non-recurring items on the income statement, then operating income equals EBIT, the earnings before interest and taxes. If we assume that spontaneous sources and uses of funds (for instance, changes in accounts payable, inventories, and other short-term liabilities and current assets) are negligible, then the major uses of funds are investment expenditures, I1, and dividends, nD1,. By definition, the sources and uses of funds in a period must be equal, so that:

mP1  X 1  I1  nD1

(5)

Alternatively, this equation can be stated as follows:

mP1  I1  nD1  X 1

(5)

Substituting equation (5) into equation (4), we obtain:

nP0 





nD1  n  mP1  I 1  nD1  X 1  1  ku nD1  n  mP1  I 1  nD1  X 1 1  ku

n  mP1  I1  X 1 1  ku

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(6)

4

Notice that dividends do not appear in equation (6), implying that the firm can choose any dividend policy, whatsoever, without affecting the stream of cash flows available to shareholders. The firm could elect to pay dividends in excess of cash flows generated from operations and still be able to undertake any planned expenditures on investments. This is made possible by the firm’s ability to raise new equity capital without incurring any floatation costs. Since all planned investments can be undertaken regardless of the extent of dividend payout, the firm’s value is independent of its dividend policy. This conclusion implies that the gains realized by shareholders when the firm pays dividends is exactly offset by the capital loss incurred on the share’s value arising from external financing i.e. the share’s end-of-period, or terminal value declines when dividends are paid. Thus, the wealth of shareholders – dividend plus terminal price – remains unchanged and shareholders must be indifferent between dividends and earnings retention. It must be emphasized that this conclusion does not negate the position that dividends are the foundation for share valuation. The irrelevance position simply argues that the present value of future dividends remains unchanged even though dividend policy changes their timing (Van Horne, 1998). It does not argue that dividends are never paid, only that their postponement is a matter of indifference when it comes to the market price per share. Solved Illustration Brooke Bond Ltd has five million shares selling at KShs. 120 per share. The company is thinking of paying a dividend of KShs. 10 per share at the end of the current year. The discount rate for an all-equity firm in the same risk class as Brooke Bond is 10 percent. Using MM’s model, you are required to: i) Calculate the price of the share at the end of the current year if dividends are paid and if they are not paid. ii) Determine the number of shares to be issued if the company earns KShs. 90 million pays dividends and makes new investments of KShs. 66 million. Solution i)

From equation (1), Po 

D1  P1 1  ku

 P1  P0 1  ku   D1

When dividend is not paid: P1 = 120(1 + 10%) – 0 = KShs. 132 When dividend is paid: P1 = 120(1 + 10%) – 10 = KShs. 122 ii)

From equation (5),

Thus, m 

m

I 1  nD1  X 1 P1

66000000  5000000  10  90000000 ≈ 213145 shares 122

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Homemade Dividends Under the set of assumptions made to prove dividend irrelevance, investors are able to replicate any dividend stream that the company might pay. If dividends are less than desired, investors can sell part of their stockholdings in the market, at no cost, to generate the desired cash flow for the period. If dividends are more than desired, investors can use the extra amount to purchase additional stock of the company. Thus, investors are able to make homemade dividends and the company cannot do anything for the investors which they cannot do on their own. The firm’s decision with respect to dividends is, therefore, not a thing of value to investors. Also, since homemade dividend is a perfect substitute for company dividend, the dividend policy adopted by the firm is not relevant to investors.

DIVIDEND RELEVANCE ARGUMENTS Under the simplifying assumptions on which MM’s dividend irrelevance proposition is based, their conclusion is logically consistent and intuitively appealing. However, their model is likely to be deficient in the real world, where markets are not efficient, capital gains and dividends are taxed at different rates, the issue of securities is associated with floatation costs, and investors may not only have difficulties trading in securities but must also incur transaction costs. The existence of these imperfections in the market may mean that the dividend policy adopted by a firm could affect investor’ perceptions and they may no longer be indifferent between capital gains and dividends. Some of these imperfections are examined next. Personal taxes The assumption made by MM that taxes do not exist is unrealistic. In practice, investors pay taxes, both on any dividends received and on any capital gains realized. In most countries, the rate of taxation on dividends is usually higher than the rate at which capital gains are taxed. Even when the rate of taxation on dividends is similar to the capital gains taxation rate, the payment of taxes on capital gains may be deferred until the stock is sold and the gains realized. This effectively gives the shareholder a valuable timing option when earnings are retained as opposed to when dividends are paid so that the effective tax rate on dividends is higher. The tax advantage of capital gains over dividends, therefore favors a low dividend payout. Floatation Costs MM’s dividend irrelevance proposition is based on the assumption that, given a firm’s investment policy, funds paid out by the firm in the form of dividends can be replaced by funds acquired through external financing. The argument here is that, whether retained earnings or external financing is used, the value of the firm remains unaffected – this implies that the two forms of financing are equivalent. This argument cannot hold if floatation costs exist on issue of securities as is the case in the real world. Floatation costs include legal charges, underwriting commission and brokerage fees incurred by security issuers. Since no floatation costs are incurred when earnings are retained, the firm ends up netting less than a Shilling in external financing for every Shilling paid out in

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dividends. Thus, if floatation costs are considered, external financing becomes dearer and retention of earnings would be favored. Transaction Costs and Security Divisibility The assumption that investors can make homemade dividends as a substitute for company dividends is also untenable. In practice, selling of shares is not a convenient exercise and, in addition, investors must pay brokerage fees for all transactions entered into. For small sales, the transaction costs may be quite significant as a proportion of the amount netted. Because of these reasons, shareholders with current consumption desires that are in excess of current dividends paid out will prefer that the company pays additional dividends. The sale of shares in lieu of dividends by shareholders dissatisfied with the current dividend may also be hampered by the fact that shares are, in reality, non-divisible and must be transacted in multiples of one. Thus, the assumption under perfect markets that securities are infinitely divisible is not realistic and shareholders are likely to prefer dividends to capital gains. The ‘lumpiness’ associated with the non-divisibility characteristic may affect in the reverse direction shareholders who perceive the current dividends as being more than adequate and are desirous of investing the excess amount in shares. Information Asymmetry and Agency Costs Managers generally have more information than the owners on whose behalf the managerial functions are being performed. Because of differences in information and skills between owners and managers, the owners can never be certain about how managerial effort and skill contributed to actual performance outcomes. This difference in the command of information is known as information asymmetry. Information asymmetry creates problems in contracting between owners and managers and creates additional problems arising from the fact that the best information for planning is in the hands of the controlled (the managers) and not in the hands of the controller (the owners). Further, managers are not motivated and are reluctant to disclose this information for fear that it may be used against them (Kaplan and Atkinson, 1998). Thus, a conflict exists between managers and owners referred to as the agency problem. Shareholders are forced to incur agency costs as a way of managing this problem. Dividend policy may be seen as one way of reducing agency costs. The argument is that companies which pay dividends will frequently be raising investment funds from the capital markets. Since participants in these markets, such as financial institutions, will be forced to monitor such companies using their professional expertise, shareholders need not incur agency costs. This is especially so given that dividends transfer resources to shareholders to the detriment of lenders who have a priority claim on the firm’s assets in the event of liquidation. It follows that shareholders will prefer dividends to earnings retention and subsequent capital gains.

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BIRD-IN-THE-HAND ARGUMENT This argument, largely attributed to Gordon (1963), suggests that the payment of dividends has an effect on the value of a firm. Proponents of this view assert that investors operating under conditions of uncertainty perceive current dividends as representing a more certain form of income than future dividends arising from retention of current earnings. It is assumed that investors are rational risk averters who attach more risk to income occurring in the distant future than current income. Accordingly, investors would not use a constant discount rate to evaluate all income – they would use a lower rate to evaluate the expected dividend receipts and apply a higher rate to the more distant capital gains, all else being equal. If dividends are reduced, therefore, investor uncertainty will increase, raising the required rate of return, and in turn, lowering the firm’s value: Let kt; t = 1, 2, 3, …, be the required rate of return on investments at time t, such that kt-1 < kt Dt be the dividend per share payment expected at time t. The price (or value) per share, P0 at time t = 0 can be obtained as:

P0 

D3 D1 D2    ... 2 1  k1 1  k 2  1  k 3 3

(7)

If the firm is assumed to retain a fraction, b, of its earnings, the dividend per share at time t, Dt, will be (1 – b)EPSt, where EPSt are the earnings per share at time t. Now, if the firm’s earnings grow at a constant rate, g = br, such that r is the rate of return at which retained earnings are reinvested per year, we would have: D1 = D0 1  g   1  bEPS 0 1  g  D2 = 1  bEPS 0 1  g 

2

D3 = 1  bEPS 0 1  g  And so on

3

Using these relationships, equation (7) can be rewritten as follows:

1  bEPS 0 1  g  1  bEPS 0 1  g 2 1  bEPS 0 1  g 3 P0     ... 1  k1 1  k 2 2 1  k 3 3

(8)

For analytical simplicity, it may be assumed that k1 = k2 = … = k, the weighted average cost of capital of the firm. Then, if k > g, it can be shown using the properties of geometric series that:

P0 

1  bEPS 0 1  g  1  bEPS 1 kg



kg

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(9)

8

Notice that the numerator of the right hand side of the above equation will be smaller the higher the retention ratio, b. The value of the share, P0, will accordingly be lower. We can therefore conclude that a higher retention ratio, or more appropriately, a lower dividend payout, reduces the firm’s value. Shareholders will therefore prefer dividends to capital gains. TAXATION AND DIVIDEND POLICY Assuming, as before, that a firm’s dividend policy is given and that external financing can be raised at no cost to the firm, dividend policy analysis can take the following form, if both the firm and individual investors pay taxes: Suppose three different tax rates exist: a proportional corporation tax rate, Tc; a personal tax rate on income from dividends, interest and wages, Tp; and a capital gains tax rate, Tg. Further, the analysis will assume that neither companies nor individuals can make use of loopholes in the tax laws to enable them avoid a part of or the totality of their tax liability. In most countries, the capital gains tax rate Tg, would be lower than the ordinary personal income tax rate, Tp. Even when the two tax rates are the same, the option to defer payment of the capital gains tax until the gain is realized means that the effective rate of taxation on capital gains would be lower than that on ordinary income. 2 Thus, the analysis assumes that Tg is less than Tp. So long as this assumption holds, rational wealth maximizing shareholders will prefer capital gains (or stock repurchases) to dividends and the stock prices would be higher when earnings are retained or stock repurchased than when dividends are repaid. A formal analysis follows (for a more detailed discussion, see Weston and Copeland, 1992): Case 1 If a firm pays out all of its cash flows as dividends, the ith shareholder will receive an after-tax income, Ydi , equal to: Ydi  [( NOI  rDc )(1  Tc )  RD pi ](1  T pi ) (10) where NOI is the net operating income or cash flow from operations; r is the borrowing rate assumed identical for both individuals and firms; Dc is the corporate debt, Tc is the corporation tax rate; Tp is the personal tax rate on income received by the ith individual, say, in the form of dividends, or interest; Dpi is the personal debt held by the ith individual – it is assumed that individuals can choose to own shares in an all-equity firm and borrow to provide personal leverage, or they can own shares in a levered firm to maintain the same level of risk.

The first term within the brackets in equation (10) is the firm’s after-tax cash flow and all of this is assumed to be paid out in the form of dividends. The before-tax income received by the individual shareholder is the dividend received less the interest on debt used to buy shares. The individual’s after-tax income is the before-tax income minus personal income taxes. 2

Capital gains taxation was abolished in Kenya in 1985 on the grounds that its continued existence was violating the Canon of Efficiency.

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Case 2 The firm may decide to pay no dividends, in which case, we assume that all capital gains are realized immediately by investors and taxed at the capital gains tax rate. In this case, the after-tax income of the ith shareholder Ygi, would be obtained as: Ygi  ( NOI  rDc )(1  Tc )(1  Tgi )  rDpi (1  T pi )

(11)

Now, the individual pays a capital gains tax rate on the firm’s income and deducts aftertax interest expenses on personal debt. The following example will be used to illustrate that equation (11) yields a higher income to the individual than equation (10): The cash flows from operations of a firm in a certain year were KShs. 50000. The firm is in the 40 percent tax bracket with KShs. 300000 debt outstanding. Interest on debt both for companies and individual investors is 10 percent. The ith individual, who happens to be the sole shareholder of the company has persona; debt totaling KShs. 100000. Personal tax rate is 30 percent while capital gains tax is 15 percent. The individual’s income under the two cases would be: Case 1:

Ydi  [( NOI  rDc )(1  Tc )  RD pi ](1  T pi )

 [50000  0.1  300000)(0.6)  0.1  100000](1  0.3)  KShs.1400

Case 2:

Ygi  ( NOI  rDc )(1  Tc )(1  Tgi )  rDpi (1  T pi )

 (500000  0.1  300000)(0.6)(0.85)  (0.1  100000)(0.7)  KShs.3200

Clearly, the individual is better off when the firm pays no dividends (Case 2). These results will be true as long as the capital gains tax rate is less than personal tax rate on dividend income. Thus under these assumptions, dividend policy is relevant, and dividend payments reduce the firm’s value. On the other hand, if the two rates of personal taxation are the same, the results under case 1 and case 2 would be similar and dividend policy is irrelevant. DIVIDEND SIGNALING Cash dividend may be viewed by investors as signals. Managers, as insiders who have monopolistic access to information about the firm’s cash flows, will choose to establish unambiguous signals about the firm’s future if they have the proper incentive to do so. Thus, firms with good news about their future profitability will want to relay this information to market participants. Management may, for instance, announce an increment in dividend payout as a way of telling investors of their belief that future cash flows will be large enough to support the higher dividend level. The signal sent to investors is that management truly believes that the firm’s financial position and future profitability is better than is reflected in the current price of stock.

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Accordingly, to the extent that dividends provide information on economic earnings not provided by reported accounting earnings and other publicly available information, the price of stock may react to change in dividends. Indeed, empirical investigation has established that the price of a firm’s stock will generally rise when its current dividend is increased and reduce when its current dividend has been reduced or omitted (see for example, Michaely et al., 1995; Asquith and Mullins, 1983 and Healy and Palepu, 1988). The fact that firms do not like reducing their dividend is further testimony to this empirical fact.Thus, firms will not raise their dividends unless they expect future cash flows not to reduce to a level that will warrant a reduction of dividend to its original level. Any increase in dividend is, therefore, the management’s signal that the firm is expected to do well. The change in stock price following the dividend signal is called the information-content effect of the dividend.

STOCK DIVIDENDS AND STOCK SPLITS A stock dividend simply is the payment of additional shares in lieu of cash to existing shareholders. Also referred to as a scrip dividend or bonus shares, a stock dividend capitalizes distributable profits in the form of extra shares, leaving it to the shareholder to decide on whether to keep it in the form of extra shares or sell on the market for cash. Thus, the greatest advantage to a company of a dividend is that no cash leaves company and liquidity position is enhanced. A stock dividend, essentially, is a book keeping transfer from retained earnings to the capital stock account. In a stock split, there is no change in the capital accounts; instead, a large number of shares of common stock is issued. No cash is paid out and the proportion of the entire firm that each shareholder owns is unaffected. When a stock is split, a specified number of new shares are exchanged for a given number of outstanding shares. In a two-for-one split, for instance, two new shares are exchanged for each old share. The par value of the old share is split between the total number of shares existing in its place after the stock split. Sometimes a reverse stock split can be done by a firm. This is the situation in which a specified number of shares are combined to form one new share. In a one-for-three reverse split, each investor exchanges three old shares for one new share. The par value is tripled in the process. Given real world imperfections, three related reasons are usually cited for reverse stocks splits (Ross, Westerfield and Jaffe, 2002, p. 531). First, transaction costs to shareholders are often less after the reverse split. This is because the brokerage commission per monetary unit traded rises as the price of the stock falls. Second, the liquidity and marketability of a company’s stock are improved when its price is raised to the popular trading range. Third, stocks selling below a certain level are not considered respectable and may not be easily marketable especially among unsophisticated investors who may misconstrue cheapness to mean low quality. Financial analysts argue that reverse stock splits may achieve instant respectability and result in a slight increment in the market value of stock. The change in market value can

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be attributed to information content of stock splits and the fact that total dividend paid commonly increase slightly after a stock split (Gitman, 1991, p. 595). Value of Stock Dividends and Stock Splits. In the idealized world of a perfect capital market, it can be argued that a stock dividend or split is not a thing of value and does not change the wealth either of the shareholders or the firm as a whole. Although shareholders receive additional shares, their proportional ownership remains unchanged. The market price of stock should decline proportionately, after a stock split or stock dividend so that the total value of their holdings stays the same. Suppose a firm has KShs. 10000 of earnings and 1000 shares outstanding, implying earnings per share of KShs10.00 with a price earnings ratio of 8, the price per share is KShs. 80.00, and the total market value of the firm is 80000. Now assume the firm pays a 10 percent stock dividend. The total number of shares outstanding would go up to 1100 (i.e.110 percent of 1000). If the total earnings remain constant, the EPS would be KShs. 9.0909. Given the price earnings ratio of 8, the market value of the firm’s stock would be KShs. 72.7273 and the value of the firm in total still remains at KShs. 80000 (72.7273  1100 shares).And the wealth of each shareholder remains unchanged since their proportional ownership of the firm is unaltered. Stock dividends and split may, however, be accompanied by an increased cash dividend. Stock dividends and splits result in an increase in the number of shares held by each investor. If the cash dividend per share remains unchanged, the total cash received by each investor will go up. Whether this increase results in shareholder wealth increase will depend on the valuation of dividends.

STOCK REPURCHASE Rather than pay cash dividends, a firm can rid itself of excess cash by repurchasing shares of its own stock from its shareholders. These shares are normally kept in the company’s treasury and may later be resold when the company needs money. This is the reason repurchased shares are also called treasury shares. Companies may repurchase their own shares in two ways: on the open market or via a tender offer. Open market repurchases, usually, but not always, involve gradual programs to buy back shares over a period of time. In a tender offer, the company usually specifies the number of shares it is offering to repurchase, the tender price and the period during which the tender is in effect. A pro rata basis of repurchase is used in the event that the number of shares tendered by the shareholders exceeds the minimum number specified by the company. If the offer is undersubscribed, the company may either extend the tender period or cancel it altogether. The practical motives for share repurchases include obtaining shares to be used in acquisitions or having shares available for employee stock options. It has also been hypothesized that reasons to do with shareholder wealth maximization may be responsible for the recent surge in importance and frequency of stock repurchases in the developed world, particularly the U. S. A.

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The following hypotheses have been used to explain shareholder wealth enhancement through stock repurchases: 1. Information (or Signaling) Hypothesis: A positive signal may be sent to the market if management believed the stock were undervalued and they were constrained not to tender shares they owned individually. In this context, the premium in repurchase price over the existing market price would reflect management’s belief about the extent of undervaluation (Van Horne, 1998). However, repurchase may send the signal of bad news if it is interpreted to mean that management has exhausted profitable investment opportunities. 2. Tax Avoidance Hypothesis: Where dividends and capital gains are taxed at different rates, repurchase of shares may offer a tax advantage over payment of dividends to the taxable investor. The tender for stock repurchase will be taxed as a capital gain rather than dividend so long as the distribution is essentially not equivalent to paying a dividend. The timing option available to investors on capital gains ensures that any gains arising from the repurchase are not taxed on the remainder of the investor’s holdings until the remaining stock is sold. In essence, the bulk of the capital gains is postponed. This presents a present value advantage to investors, who, therefore, are better off if excess funds are channeled to them through stock repurchase than through dividends. 3. Leverage Hypothesis: If the repurchase is finance by issuing debt rather than paying out cash, the firm’s leverage increases, and if any gain arises out of such leverage, shareholders would be the ultimate beneficiaries.

FACTORS INFLUENCING DIVIDEND POLICY Contractual Constraints Often, the firm’s ability to pay dividends may be constrained by certain restrictive covenants in loan agreements or preference share agreements. These covenants generally protect creditors from losses due to insolvency on the part of the firm. They may prohibit the firm from paying cash dividends from earnings generated before signing the loan agreement; or until a certain profit level is achieved. Alternatively, they may limit the dividends paid to a certain amount or percentage of earnings. Similarly, preference dividends must be paid before cash dividends are paid to ordinary shareholders. Firm’s Financial Requirements Financial requirements of a firm are directly related to the level of asset expansion envisaged in the coming period. Over the life cycle of a firm, the growth stage is characterized by rapid expansion and therefore greater need to finance capital expenditures. Similarly, high growth firms are typically in need of funds to maintain and improve their assets. Such firms typically require funds for expansion and are likely to depend heavily on internal financing through retained earnings to take advantage of emerging profitable opportunities; they are likely to pay only a small proportion of their profits as dividends. On the other hand, firms in the maturity stage that have been around for long normally have access to new capital from external sources and may not need to rely to a large extent on retained earnings for survival.

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Liquidity Position Dividends are paid out in the form of cash and, hence, the greater the firm’s cash position and overall liquidity, the greater its dividend payment capacity. A firm may be very profitable but not liquid enough because retained profits will have been invested in assets required for the conduct of business such as plant and equipment and inventories. At the same time, firms may be desirous of maintaining some liquidity cushion and, as such, reluctant to jeopardize this position by paying a large dividend. Legal Constraints Legal rules governing cash dividend payment may be very complicated. They vary from one country to another. Generally speaking, the essential nature of these rules may be captured under three related provisions: 1) Capital Investment Restrictions: These prohibit firms from paying cash dividends from any portion of their ‘legal capital,’ which may at times be defined to include both the par value of stock and any capital paid in excess of par (also called share premium). Such rules are designed to protect creditors’ claims by ensuring that a sufficient equity base is maintained. 2) Insolvency Rules: These generally provide that firms cannot pay cash dividends while insolvent. Insolvency is usually defined in the financial distress sense to mean excess of liabilities over assets. 3) Net Profits Rule: This states that cash dividends can be paid only from past and present earnings. Legal rules are important in that they provide a framework within which dividend policies may be formulated. Control A company may make it a policy that all expansion projects are financed using retained earnings only. Such a policy may be defended on the grounds that the firm fears the dilution of control that may result in the event that existing shareholders are unable to subscribe for additional shares if new shares are floated to raise capital for expansion. Firms with such a policy in place will be forced to adopt a low dividend payout. Managers of companies in danger of acquisitions from an external group may, however, go for a high payout as a way of convincing the shareholders that they are doing their best to maximize their (shareholders’) wealth. Market Considerations Managers should formulate a suitable dividend policy after a careful evaluation of probable market responses. For instance, if shareholders prefer a stable dividend payout and the company adopts a fluctuating payout policy, they (shareholders) may use a higher rate of return to discount the firm’s earnings. Shareholders are likely to use a lower discounting rate if the frequency and magnitude of dividends can be easily predicted. This should result in an increase in the market value of stock and therefore, shareholders’ wealth. The information content of a dividend is another aspect that must be judged carefully by a company. If a firm skips dividend payment in a given period, say due to a loss or very

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low earnings, investors are likely to interpret this as a negative signal. This creates uncertainty about the firm’s future and may drive down the value of its stock. Owner Considerations The firm must give consideration to investment opportunities available to owners (Gitman, 1991, p. 595). Firms should not retain funds for investment in projects yielding lower returns than the owners could obtain from external investment of equal risk. The firm should evaluate the returns expected on it’s own investment opportunities and determine whether greater returns are obtainable from external investments such as government securities or other corporate stocks. If it appears that shareholders would have better opportunities externally, the firm should pay out a higher percentage of its earnings. A lower payout would be justifiable if the firm’s investment opportunities are at least as good as external investments of a similar risk. The tax position of shareholders is another important consideration. The primary objective of financial management is shareholder wealth maximization. The dividend policy adopted by a firm should therefore be the one that can help in attaining this objective. Where a firm is closely-held, the body of shareholders is small and homogeneous and their expectations can be easily known to management. The dividend policy adopted in this case will be the one that meets those expectations. Where a firm is widely-held however, it is a formidable task to ascertain the shareholders’ preferences and the policy adopted should be the one that has a favorable effect on the wealth of the majority of them. Shareholders of a widely-held firm may be divided into four distinct groups (Pandey, 2001, p.774): 1) Small Shareholders: These hold a small number of shares in a few companies without a definite investment policy. However, they are likely to belong in the low income tax bracket and as such might prefer a high dividend payout. This preference may not influence the company’s dividend policy because small shareholders rarely prove to be the dominating group in the shareholders’ body. 2) Retirees: These use their pension funds or savings to invest in shares with the main aim of getting a regular income. As such, they will, generally, be interested in a high dividend payout. 3) Wealthy Investors: These are people in high income tax brackets who are concerned about maximizing their wealth as they minimize the amount of taxes they pay. If they happen to be the dominating group of shareholders, the firm may be forced to adopt a low dividend payout policy. 4) Institutional Investors: Unlike wealthy investors, these are concerned not with personal income taxes but with profitable investments. Most institutional investors seek diversification in their investment portfolios and favor a policy of regular dividend payout. The interests of shareholders in a widely-held company may, therefore, be in conflict and it is important that management strikes a balance when determining the dividend policy. If one group comes to dominate the company and sets, say, a low payout policy, those shareholders who seek income are likely to sell their shares over time and shift into high

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yielding stock (Weston and Copeland, op cit.). Thus, to some extent, a firm’s payout policy determines the types of shareholders it has, and vice versa .This is called the clientele effect. THE CLIENTELE EFFECT In the words of Modigliani and Miller (1961), “if the frequency distribution of corporate payout ratios happened to correspond exactly with the distribution of investor preferences for payout ratios, then the existence of these preferences would clearly lead ultimately to a situation in which each corporation would tend to attract itself a clientele consisting of those preferring its particular payout ratio.” Thus, the clientele effect hypothesizes that investors in high income tax brackets who prefer capital gains to dividends would invest only in firms paying low or no dividends. Those in the low income tax brackets, conversely, would buy shares in firms that pay high dividends especially if they desire current income or favor resolution of uncertainty. To illustrate, suppose that 30 percent of all investors prefer high dividends and 70 percent prefer low dividends whereas 50 percent of firms pay high dividends while 50 percent pay low dividends. The low-dividend firms will be in short supply and their stock price is likely to rise due to the high demand; the stock of high-dividend firms will be bid low. This arbitrage situation will be corrected in the long-run as more firms lower their payout ratios in a bid to improve their stock prices so that eventually, 70 percent of all firms will be paying low dividends. At this point, arbitrage opportunities will have been eliminated and no single firm will be able to affect its market value by shifting from one dividend strategy to another. The clientele effect is a possible explanation for management’s reluctance to alter established payout ratios because such changes might cause current shareholders to incur unwanted transaction costs. Empirical investigations of the clientele effect have been performed with mixed results.

ALTERNATIVE DIVIDEND POLICIES A firm’s dividend policy represents a plan of action to be followed whenever the dividend decision must be made. The management of most companies consider it desirable to have to have some element of stability and regularity of dividend payment. Shareholders, too, seem to prefer stable to fluctuating dividends. Whatever the policy adopted by the firm, maximization of shareholders wealth and provision of sufficient financing must be overriding concerns in any decisions taken regarding dividend payments. Three major types of dividend payment schemes may be distinguished: Constant Payout-Ratio Policy The dividend payout ratio, calculated by dividing the cash dividend paid by the firm’s earnings in a particular period, indicates the percentage of each Shilling earned that is distributed to owners in the form of cash. When a company follows the policy of paying a certain percentage of earnings each period to its owners, it is said to have adopted a constant dividend payout ratio policy. With this policy the amount of dividend will

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fluctuate as earnings change and retained or internal financing is automatic as long as the firm is profitable. The advantage of this policy is that it does not put any pressure on the firm’s liquidity since dividends are paid only when the firm has made profits. However, the policy is not likely to maximize the value of the firms stock because it results in unreliable signals to the market about the future prospects of the firm and because it may interfere with investment policy. Stable Dividend per Share Policy This policy is based on the payment of a fixed amount per share, or fixed rate on paid up capital, as dividend every year, irrespective of the fluctuation in earnings. Often, firms using this policy will increase the regular dividend or dividend rate once a proven increase in earnings has occurred. This policy may be difficult to implement if earnings show a pattern of wide fluctuations over time. However, firms may reserve excess earnings in times when earnings are high to enable them meet their dividend obligations in times of low earnings. The reserve may be invested in marketable securities which can be easily converted into cash to enable the firm pay dividends in bad years. The stable dividend per share policy provides owners with generally positive information or signaling effect, which may help stabilize the firm’s value. Low Regular Dividend plus Extras This is a compromise between the first two policies. Under this policy, the firm pays a low regular dividend, supplemented by an additional (or extra) dividend whenever earnings warrant it. The low amount of dividend is fixed to reduce the possibility of ever missing the dividend payment and to avoid giving shareholders false hopes. The extra dividend should not be a regular event, otherwise it becomes meaningless. This policy is common among companies that experience cyclical fluctuations in earnings. It (the policy) enables such firms to share earnings with shareholders when results are good while at the same time ensuring that the firm’s stock price remains stable even when results are not encouraging. Class Illustration I The Doch Company belongs to a risk class for which the appropriate required equity return is 15 percent. It currently has 100,000 outstanding shares selling at KShs. 100 each. Doch is contemplating the declaration of a KShs.5.00 dividend at the end of the current financial year, which just began. Using MM hypothesis and the assumption of no taxes, answer the following questions: a) (i) What will be the price of the stock at the end of the year if a dividend is not declared? (ii) What will it be if a dividend is declared? b) Assuming that the firm pays a dividend, has net income of KShs.1 million and makes new investments of KShs. 2 million during the period, how many new shares must be issued?

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Class Illustration II The net income of Metropol Ltd, which has 10,000 outstanding shares and a 100-percent payout policy, is KShs.32,000. The expected value of the firm one year hence is KShs.1,545,600. The appropriate discount rate is 12 percent for Metropol Ltd. a) What is the firm’s current market value? b) What is the ex-dividend price of Metropol stock if the board follows its current policy? c) At the dividend declaration meeting, several board members claimed that the dividend is too meager and is probably depressing Metropol’s share price. They propose that Metropol sells enough new shares to finance a KShs.4.25 dividend. (i) Comment on the claim that the low dividend is depressing the stock price. Support your argument with appropriate calculations. (ii) If the proposal is adopted, at what price will the new shares sell and how many will be sold? Class Illustration III Artline Ltd has recently obtained a listing on the Nairobi Stock Exchange. 90 percent of the company’s shares were previously owned by members of one family but since the listing, approximately 60 percent of the issued shares have been owned by other investors. Artline’s earnings and dividends for the five years prior to the listing are detailed below: Years Prior to Listing Profit After Tax (K£) Dividends Per Share (KShs.) 5 1,800,000 7.20 4 2,400,000 9.60 3 3,850,000 12.35 2 4,100,000 13.12 1 4,450,000 14.24 Current Year (estimate) 5,500,000 The number of issued ordinary shares was increased by 25 percent three years prior to the listing and by 50 percent at the time of listing. The company’s authorized capital is currently K£ 25 million in KShs.5.00 ordinary shares, of which 4 million shares have been issued. The market value of the company’s equity is K£ 78 million. The board of directors is discussing future dividend policy. An interim dividend of KShs.6.32 per share was paid immediately prior to the listing and the finance director has suggested a final dividend of KShs.4.68 per share. The company’s declared objective is to maximize shareholder wealth. Required: a) Comment upon the nature of Artline’s dividend policy prior to the listing and discuss whether such a policy is likely to be suitable for a company listed on the stock exchange. b) Discuss whether the proposed final dividend of KShs.4.68 is likely to be an appropriate dividend: (i) if the majority of shares are owned by wealthy private individuals; (ii) if the majority of shares are owned by institutional investors.

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SOLVED NUMERICAL EXAMPLES Example One As the Chairman of Kasuku Garments Ltd, a large clothing chain based in Kisumu, you have just received a letter from a major shareholder. The shareholder asks about your company’s dividend policy. Indeed, the shareholder asks you to estimate the amount of the dividend you are likely to pay next year. You have not collected all the information about the expected dividend payment, but you do know the following: 1. The company will follow a residual dividend policy; 2. The total capital budget for the year is likely to be one of three amounts, depending on the results of capital budgeting studies currently underway. The capital amounts are KShs.2 million, KShs.3 million, and KShs.4 million. 3. The forecasted level of potential retained earnings next year is KShs.2 million. 4. The target or optimal capital structure is a debt ratio of 40 percent. You have decided to respond by sending to the shareholder the best information available to you. Required a) Describe a residual dividend policy. b) Compute the amount of the dividend (or the amount of new equity required) and the dividend payout ratio for each of the three capital expenditure amounts. Solution: a) The residual dividend theory treats dividend policy strictly as a financing decision and views the payment of cash dividend as a residual – the amount left over after all acceptable investment opportunities have been undertaken. Thus, as long as there are investment opportunities with returns exceeding those that are required, the firm will use retained earnings, and the amount of senior securities that the increase in equity base will support, to finance these investments. If the firm has any earnings left over after financing all acceptable investment opportunities, these earnings will then be distributed to shareholders in the form of cash dividends. If not, there will be no cash dividends. Thus, firms that adopt a residual dividend policy would treat the dividend decision in three steps as follows (Gitman, 1991, pp. 588 – 9): 1. Determine the optimum level of capital expenditures, which would be the level generated by the point of intersection of the investment opportunities schedule and the weighted marginal cost of capital. 2. Using the optimal capital structure proportions, estimate the total amount of equity financing needed to support the expenditures generated in step (1). 3. Because the cost of retained earnings is less than the cost of new issues of common stock, use retained earnings to meet equity requirements in step (2). If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount as cash dividends.

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The treatment of dividend policy as a passive residual tends to suggest that the investors’ required return is not influenced by the firm’s dividend policy - a premise suggesting, in turn, that dividend policy is irrelevant. The residual policy does not necessarily mean, however, that cash dividends will fluctuate from one period to the next depending on fluctuations in investment opportunities. Firms may smooth out actual payments by saving some funds in surplus years in anticipation of deficit years, enabling them to establish dividend payments at a level at which the cumulative distribution over time corresponds to cumulative residual funds over the same period. b) A tabular approach is used in the analysis as follows: New Financing Required (Capital Expenditure Amounts) Retained Earnings Available (given) Equity Required (60% of new financing required) Dividends (Retained Earnings less Equity Required) Dividend Payout Ratio (Dividends  Retained Earnings)

KShs.2,000,000

KShs.3,000,000 KShs.4,000,000

2,000,000

2,000,000

2,000,000

1,200,000

1,800,000

2,400,000

KShs.800,000

KShs.200,000

KShs.0*

40%

10%

0%

* Since the retained earnings available, KShs.2.0 million is less than the equity requirement of KShs. 2.4 million, no dividends would be paid and new common stock would have to be issued amounting to KShs.400,000 (i.e. 2.4 million less 2.0 million). Example Two Bica Industries has earnings this year of KShs. 16.5 million, 50% of which is required to take advantage of the firm’s excellent investment opportunities. The firm has 206,250 shares outstanding, each currently selling at KShs.320. Julie Atieno, a major shareholder (18,750 shares), has expressed displeasure with a great deal of managerial policy. Management has approached her with the prospect of selling her holdings back to the firm, and she has expressed a willingness to do this at a price of KShs.320 per share. Assuming that the market uses a constant P/E ratio of 4 in valuing the stock, answer the following questions: a) Should the firm buy back Julie’s shares? Assume that dividends will not be paid on them if they are purchased. b) How large a cash dividend should be declared? c) What is the final value of Bica Industries stock after all cash payments to shareholders? Solution: a) The discussion in the text concerned firms that make non-selective stock repurchases, usually executed through tender offers or open market purchases. Firms also

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occasionally engage in the repurchase of shares from specific individual shareholders as is the case in this problem. This is called ‘targeted repurchase’. A number of reasons may be responsible for this practice: In some rare cases, a single large shareholder can be bought out at a price lower than that in a tender offer; plus, the legal fees in a targeted repurchase may also be lower than those in a more typical share repurchase. Secondly, the repurchasing firm may argue that certain shareholders may have been a nuisance. These two reasons seem to be applicable in this problem. The third reason could be to avoid a takeover from the large shareholder if management is not in its (the large shareholder’s) favor. If Julie’s shares are repurchased, the firm’s assets (represented by cash) and, therefore, value declines by: 18,750 shares  KShs. 320 per share = KShs.6 million The firm’s new market value is KShs.60 million, determined as follows: Market Value before Repurchase (206,250 shares  KShs.320) Reduction in value occasioned by Repurchase New Market Value

KShs.66,000,000 6,000,000 KShs.60,000,000

Number of shares outstanding after repurchase = 206,250 – 18,750 = 187,500. New market value per share  60,000,000  187,500  KShs. 320 Thus, the firm’s shareholders are as better off after the repurchase as they were before. If the firm’s total earnings remain at the same level as this year, the remaining shareholders gain because their earnings increase from the current KShs. 80 per share (i.e. KShs.16.5 million  206,250) to KShs. 88 (i.e. KShs.16.5 million  187,500). And the market value per share increases to KShs.352 (i.e. KShs.88  4) from the previous level of KShs.320. Thus, Bica Industries should repurchase the shares from Julie. b) The amount of earnings available for distribution is 50% of current earnings, or KShs.8.25 million. Since KShs. 6 million has already been used to buy back Julie, the amount remaining to be distributed in the form of cash dividends must be KShs.2.25 million (i.e. KShs.8.25 million less KShs.6 million). This translates to a dividend per share of KShs.12 (i.e. KShs.2.25 million  187,500 shares).

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c) Value of the firm after all the cash payments to shareholders: Current Value of Firm (See part [a]) Less: Total Cash Payment New Firm Value Value of one share 

KShs.66,000,000 8,250,000 KShs.57,750,000

57,750,000  KShs. 308 187,500

REFERENCES AND SUGGESTED FURTHER READINGS Asquith, P. and D. Mullins Jr. (1993). “The Impact of Initiating Dividend Payments on Shareholder Wealth,” Journal of Business, January. DeAngelo, H., and L. DeAngelo (2006). The Irrelevance of the MM Dividend Irrelevance Theorem. Journal of Financial Economics 79, 293–315. DeAngelo, H. and L. DeAngelo (2007). Payout Policy Pedagogy: What Matters and Why. European Financial Management 13, 11–27. Gitman, L. J. (1991). Principles of Managerial Finance, 6th edition, (New York: Harper Collins Publishers). Gordon M. J. (1963). “Optimal Investing and Financing Policy,” Journal of Finance, 18, May, 264 – 272. Handley, J.C., 2008. “Dividend Policy: Reconciling DD with MM.” Journal of Financial Economics 87(2), 528 – 531. Healy, P. M. and K. G. Palepu (1988). “Earnings Information Conveyed by Dividend Initiations and Omissions,” Journal of Financial Economics, 21. Michaely, R. H., Thaler and K. Womack (1995). “Price Reactions to dividend Initiations and Omissions: Overreactions or Drift,” Journal of Finance, 50. Miller, M. H. and F. Modigliani (1961). “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business, 34, October, 411 – 433. Pandey, I. M. (2002). Financial Management, 8 th Edition, (New Delhi: Vikas Publishing Company). Ross, S. A. Westerfield, R. W. and J. F. Jaffe. Corporate Finance, (Boston: McGrawHill/Irwin, 2002). Samuels, J. M., Brayshaw, R. E. and F. M. Wilkes, Management of Company Finance, (London: International Thomson Business Press, 1990). © Odongo Kodongo, 2012. All Rights Reserved.

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Weston, F. J. and T. E. Copeland (1988). Financial Theory and Corporate Policy, 3 rd Edition, (Reading, Mass.: Addison Wesley) Weston, F. J. and T. E. Copeland (1992). Managerial Finance, 8 th Edition, (New York: Dryden Press)

QUESTIONS AND PROBLEMS 1. About nine years ago, Doch Associates Ltd, a large and old established firm, ceased paying dividends because of its poor financial performance and mounting losses. Following considerable reorganization and investment, the firm is now an efficient, profitable and soundly managed organization. Consideration is being given to recommencing the payment of dividends, but when initially discussed at board level, there was no agreement on the merits of this step. Three main views were expressed:  A stable dividend policy should be introduced as soon as possible;  Dividends are irrelevant to shareholders;  Dividends should be paid only when the firm has no investment opportunities which promise a return equal to or greater than that required by shareholders – this situation is unlikely to arise for several years. Required: Outline, and explain the importance of, the main points which should be considered when deciding upon corporate dividend policy. Comment on the three main views expressed by the board of Doch Associates. 2. The following is the summarized balance sheet of Kaka Kuona Ltd as at November 30, 2003: Fixed Assets Land and Buildings Furniture and Fittings Current Assets Stock Prepaid Expenses Debtors Cash in Hand Financed By: Capital Ordinary Shares of KShs. 10 each Retained Earnings Long-term Liability Long-term Debt Current Liabilities Creditors Accruals

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KShs. 60,000,000 8,000,000 35,000,000 5,000,000 30,000,000 10,000,000 KShs. 148,000,000

60,000,000 10,000,000 18,000,000 40,000,000 20,000,000

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KShs. 148,000,000 Additional Information: 1. In the past, Kaka Kuona Ltd’s earnings per share (EPS) averaged KShs. 6.00 and the dividend payout ratio was 50 percent or KShs. 3.00 per share. For the year ended November 30, 2003, the EPS declined to KShs. 2.50. Because it was felt that this decline was temporary, the annual dividend of KShs. 3.00 per share was maintained for the financial year ended November 30, 2003, as well as for the first six months of the financial year ending November 30, 2004. 2. Recent projections, however, have caused management to revise downwards the expected EPS. For the financial year ending November 30, 2004, the forecast of EPS has been reduced to KShs. 2.00 per share and for the financial year ending November 30, 2005, adjusted to KShs. 2.20. 3. Kaka Kuona Ltd’s ordinary shares are currently selling in the market at KShs. 15.00 per share. The management of Kaka Kuona Ltd is considering whether or not to retain the cash dividend of KShs.3.00 per share for the next two financial years. Required: a) Calculations to help determine whether it will be feasible to maintain dividends at KShs.3.00 per share for the next two financial years. b) Determine whether the company should replace the cash dividend with a bonus issue of one share for every four ordinary shares. c) Explain the course of action that the management of Kaka Kuona Ltd should take in the light of the declining projections in dividend payouts. (CPA, Business Finance, December 2004) 3. It is proposed that there be a change in taxation to a system which penalizes corporate retained earnings and favors distribution of profits, thereby effectively forcing companies to distribute all earnings. Examine the implications of such a change from the viewpoint of (i) corporate financial management, (ii) shareholders and (iii) the workings of the financial system and financial institutions. 4. a) Explain the factors that finance managers should analyze before making a dividend decision. b) Assume all things are held constant other than the item in question, for each of the companies below: (i) A company with a large proportion of insider ownership all of whom are high income individuals. (ii) A growth company with an abundance of investment opportunities. (iii) A company experiencing ordinary growth that has high liquidity and much unused borrowing capacity. (iv) A dividend paying company that experiences an unexpected drop in earnings from a trend. (v) A company with volatile earnings and high business risk.

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Required: Expect whether or not you would expect each company to have a medium/high or a low dividend payout ratio and the reasons for such categorization. (CPA, Financial Management, June 2000) 5. In the past when governments have enacted income policies, they have invariably also restricted the level of dividend increases that companies can make. The argument has been that it is only fair that the ‘wages of investors’ (dividends) should be under the same restraint as wages paid to workers. Discuss the reasoning behind the dividend restraint policy and comment on its scope for providing equity with an incomes policy. 6. The question on the adequacy or otherwise of dividends paid to shareholders is becoming increasingly an issue in shareholders’ meetings. Some shareholders feel that the dividends paid to them are “less” compared to dividends paid by another similar company (sic). Why should a company pay a different dividend from another even though their issued share capital is the same? (CPA, Financial Management, December 1998)

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