Developing an Optimal Dividends Policy to Maximize Wealth for Shareholders

Published: 2021-06-26 22:55:05
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It is a known fact that a lot has been said and published on this subject by renowned author, experts, professional in the operation/regulation or capital market. It will be inexpedient to study issue of this magnitude without making reference to existing works and writes ups; this will also give credibility to the study.
In his view, Omogoriola (1999) defined dividend as the return to the shareholder hence the shareholders will try to relate dividend record to their expectation and the state of the economy, this is to say that shareholders are interested in dividend changes in the value of their share (capital gain).
An optimal dividend policy is that which maximize the wealth of the shareholders; it can be expressed as the responsibility of the company’s management, which also entails, declaring and paying dividends that meet the aspirations of the shareholders.
Dividend decision is affected by investment opportunities and if the cost of obtaining external finance outweighs the benefit (return) for each investment, the company may utilize the retained earnings; for such profitable investment opportunities.
In Nigeria, the companies and Allied Matters Decree (CAMD 1990) part XII section 370 – 385 treats dividend policy. The decree provides that dividend cannot be paid out of capital, since this will lead to depletion of companies’ capital, which is against the legal principle that the capital of the company must be maintained. It also provides that dividend should not be paid by company if it will make it unable to pay its debt as at when due. Likewise losses of the previous year need not be made good in the current years before dividend is paid. The decree further stipulates that profit of previous years may be distributed as dividend from the 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 assets may be treated as profit available for distribution.
The law further states that the directors may set aside as reserve a proportion of the company’s profit, before recommending any dividend payment; which shall be applicable for any purpose to which the profit of the company may be properly applied, at the discretion of the directors and pending such application, the reserve may be employed either in the business of the company or be invested in such investment (other than shares of the company) as the directors may from time to time think fit; the directors many carry
forward any profit which they may think prudent not to distribute.
The fact is that, the view dividend is not relevant to the value of share is not correct, if all the assumptions upon which the view lies are relaxed to meet realities of the market.
The factors, which affect dividend policies of a company, are shareholder’s preference; legal constraints, financial needs of the company’s affairs among others.
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 are always in conflict. At time point dividend declared should not jeopardize the financial needs of the company. According to Pandey (1989), liquidity of the company needs to be given adequate consideration when dividend is about to be declared. This is more important when the cost of raising funds is considered and this should not be clouded by the longer term benefits of the company.
Dividends represent the benefit investors get on the stock of investment for the risk they undertake and for the time value of their investment.
The forms of dividend include:
(i) Cash
(ii) Stock or Script or bonus issue
(iii) Property (Omogoriola 1999)
This is the dividend paid in liquid form (i.e. cash) out of earnings of the company. Dividends paid in this form are highly preferred by most shareholders. It represents major form of dividend payment. The cash dividend payment depends on the internal sales and reputations of the company governing dividend payments, while at the same time considering the liquidity or solvency of a company. (Osaze1985). Therefore, the financial manager should ensure that the dividend does not impair the day to day operating obligations of the company
This form of dividend is given to owner of common stock and is mostly adopted when a company is short of cash. In this form of dividend, payment date and payment period is very short and it would be classified as short form liability. This has the effect of increasing the number of outstanding shares of the company.
This form of dividends is very common and is situational. These be likened to a time when Breweries were declared illegal through the application of the Volstead account, the stock of liquor on hand could not be disposed off through normal channels. Hence, these were distributed to the stockholders thereby increasing the trading activities for the products. (Omogoriola 1999)
(i) Tax Benefit: When shareholder receive cash dividend. This is an addition to his ordinary income and attracts tax at an ordinary income tax rate; but when he receives bonus shares, it is not subject to tax.
The shareholders can sell the new shares received by way of the bonus issue to satisfy his desires for income and pay capital gain tax which are usually less than the income taxes on the cash dividends.(
(ii) Future Dividend May Increase: For a company, if all the policy of dividend payouts are strictly adhered to, the total cash received by the shareholder will increase in the future.
These may have a favorable effect on the value of the shares; however the bonus per share has no considerable effect on the price of the share. (
(iii) Indication of Higher Future Profits: Issuing bonus shares to all shareholders seldom signifies profitability in business and confidence in the board of directors.
When the profit of a company does not rise and it declares bonus issue, the company will experience a dilution of earnings this is not desirable, bonus shares are usually declared by directors only when they expect rise in earning to affect the additional outstanding shares. (
(iv) Psychological Value: The receipt of bonus shares gives them a chance to sell the shares to make capital gains without impairing their principal investment. They also associated it with property of the company. (
The bonus issue is also an advantage to the company in the following ways:
(a) Conservations of cash: The declaration of a bonus issue allows the company to declare a divided without using up cash that may be needed to finance a profitable investment opportunities within the company.
The company is, thus able to retain earning and at the same time satisfy the desires of shareholders to receive divided. The use of bonus issue represents a compromise which enables directors to derive both the objectives of a dividend policy. The receipt of bonus shares satisfies shareholders psychologically.
(b) More Attractive Share Price: Sometimes, the intention of a company is issuing bonus shares to reduce the market price of the share and make it more attractive to investors. It the price could be brought down to a desired rang, the drawing will increase, some investor can legally meet the requirement of certain institutional investor to invest in shares.
Thus some companies follow a policy of target dividend pay out ration over the long run.
When earning increase to a new level, a company increase dividends only when its feels it can maintain the increase in earning. This will ensure stability of dividend policy in the long run.
(c) A mean of pay dividend under financial difficulty and contractual restrictions: When a company is facing a stringent cash situation the only way to replace the cash dividend is the issue of bonus shares.
The declaration of the bonus issue is necessitated when the restriction to pay cash dividend are put under loan agreement. This under loan agreement. This under the situation of financial stringency or contractual constrain in paying cash dividend, the bonus issue is meant to maintain the confidence of shareholders in the company.
A company’s decision regarded the amount of earnings to be distributed as dividend on the following factors:
(1) Financial needs of the firm
A dividend policy should consider the financial needs of a company since the company would continue in existence, projected cash flow statement should be prepared taking into Account expected future capital expenditure increase in debtors build up of stock, debt servicing and any other thing likely to have impact on the cash position of the company.
The risk of future cash flows should be considered to avoid possible mis-interpretation of non-payment of dividend by the stock market, a company can also build up a target dividend payout in its cash flow statement. Thus, the company will be able to know its overall financial needs. If it projected future negative cash flows, arrangement can be made to raise extra funds, if it projected future positive cash flow, possibly extra dividends can be made.
Therefore, depending on the needs to finance their investment opportunities, companies may follow different dividend policies.
(2) Liquidity
This is an important consideration in a dividend decision since payment of dividend represent the use of cash. A company may be profitable but may not be liquid. The greater the cash position or liquidity of a company the greater its ability to pay dividends. The liquidity of a company is influenced by the company’s investment and financial decisions.
(3) Access to borrowing
A company may not be liquid, it can still pay dividend. It may have access to borrowing from financial institutions. A bank can extend various forms of credit facilities to the company.
The greater the ability of a firm to borrow, the greater is its ability to pay cash dividends even if it not liquid.
(4) Access to the capital market
A company could raise new debt or equity from the capital market if it is not liquid enough to pay cash dividends. The greater the access of a company to the capital market, the greater it’s ability to pay cash dividends.
(5) Control
A company that pays a large dividend may need to raise capital through issuance of additional shares later to finance profitability investment opportunities.
When new shares are issued the controlling interest of the company may be diluted especially if the controlling shareholders do not or cannot subscribe to the shares issued. Thus, controlling shareholders prefer a low dividend pay out so that the company can finance its investment programme with retained earning.
(6) Restrictions in loan agreement or bond indentures
To ensure that a lender could service it s debts, the protective covenant in a loan agreement or bond indenture often include a restriction in the payment of dividends. It usually specifies the maximum percentage of cumulating earnings that can be paid out as dividend. Thus, with such restriction in force the ability of a company to pay dividends is reduced.
(7) Nature of shareholders and their desire for individuals
If it is possible for a company to ascertain the nature of its shareholders, their desire for dividend income can be known. If for instance, most shareholder are high income tax broker, there would be more preferences for capital gains to dividend payout, the low dividend payout would depend on whether the company has profitable investment opportunities. If most shareholders are in the low income tax broker, there would be preference of or dividends. While it might be easier to ascertain the desire of shareholders in a closely held company, it might not be easy with a company with a large number of shareholders.
Van Horal (1987)
(8) Legal Consideration
Companies should usually look at any of the government lows restricting its ability to play dividend. The companies and Allied Matters Decree of 1990 in Nigeria, for instance restrict payment of dividend to only cumulative distributable earnings so that a company will pay dividend out of capital.
However, the company is not under any legal obligation to pay dividends. The payment of dividends is at the discretion of the board of directors Olowe (1998).
(9) Assessing any information that affect market price
The company should consider any dividend information that can affect the market price of its shares. It should consider the following:
The dividend pay out ratios of other companies in the industry especially those having about the same growth rate.
Information effects of a charge in dividends.
The expectations of investors and security report.
(10) Stability of dividends
The stability of dividends means maintaining dividend position in relation to trend line or upward stopping. A policy of a constant dividend per share or constant dividend plus extra dividend is a stable dividend is a stable dividend policy. However, a policy of paying our a fixed percentage earnings as dividends will result in fluctuating dividend being paid out to shareholders. When earning are cyclical, such a policy will result in instability of dividend payment.
A company pursuing a stable dividend policy will commend a higher fixed percentage of earnings. The stability of dividends resolve uncertainly in the mind of investors. Satisfies currents income desires of some investors and legally meet the requirement of certain institutional investor to invest in shares. Thus some companies follow a policy of target dividend payout ration over the long run. When earnings increase to a new level, a company increase dividends only when it feels it can maintain the increase in earnings. This ensure stability of dividend policy in the long run.
There are two types of companies these are as follows:
(i) Closely – held company
(ii) Widely – held company
The body of shareholders of the closely held company is small and homogenous and the expectations of shareholders are usually known to management, while that of the widely – held company shareholders is very large and the small shareholders regarding dividends and capital gain. Hence, these shareholders may be divided into four groups as follows:
(a) Small shareholders
(b) Retired and old persons
(c) Wealthy shareholders
(d) Institutional shareholders. Pandy (2000).
These categories of shareholders are not the frequent
They hold a small number of shares in a few companies with the purpose of receiving dividend income, or making capital gains. Thus they do not have a definite investment policy.
They purchase shares only when their savings permit. This group rarely proves to be dominating in the body of shareholders in a company and they are much, concerned with the dividend policy of the company.
These group of shareholders invest in shares to get regular income. They use their savings or provident or pension funds to purchase shares. These group usually select shares of companies who have good history of paying regular and liberal dividends. Although, a retired person who has some of source of income and is in a high tax bracket may be interested in capital gains.
This class has a definite investment policy of increasing their wealth and maximizing taxes.
They are concerned with the dividend policy followed by a company. They are in high tax bracket and the dividend received in cash by them would be tax at high rate.
Because of this they prefer a dividend policy of retaining earnings and distributing bonus shares.
The wealthy shareholders class is quite dominating in many companies; and are able to influence the composition of the board of directors, by their majority voting rights.
This group have a consideration influence on the dividend policy of the company.
They are the group that purchase, large blocks of share to hold them for relatively long periods of time. Unlike wealthy shareholders, institutional investors and not concerned with the personal income taxes but are concerned with profitable investments. They avoid speculative issues, but seek diversification in their investment portfolios and favour a policy of regular cash dividend payments.
It is obvious from the above that in most companies (most especially quoted companies), the interest of various shareholders groups are in conflict. Reconciling these conflicting interests of different types of shareholders is not an easy task.
However, the board of directors always considers the following points.
Firstly, the board should adopt a dividend policy, when gives consideration to the interest of each of the groups comprising a substantial proportion of shareholders.
Secondly, the dividend policy, once established should be continued as long as it does not interfere with the financing needs of the company. A definite dividend policy, followed for a long period in the past, tends to create the clientele effect, (i.e. it attract those investors who consider the dividend policy in accord with their investment needs. Thus, an established dividend policy should be changed slowly and only after having analysed its probable effects on the existing shareholders, Pandy (2000).
The types of dividend policy which are available to the management of companies are listed as follows:
Regularity of dividends is considered a desirable policy by the management of most companies. Shareholders also generally favours this policy and value regular dividends higher than the fluctuating ones.
Residual dividends sometimes means stability in paying some dividend annually, even though the amount of dividend may fluctuate over years, and many not be related with earnings. There are number of companies which have records of paying dividend for a long continues periods. To be precise, stability of dividends refers to the amount paid out regularly. We can distinguish three forms of such stability.
(i) Constant dividend per share or dividend rate.
(ii) Constant payout
(iii) Constant dividend per share plus extra dividend.
Irrespective of the fluctuation in earnings, a number of companies follow the policy of a fixed amount per share or fixed rate on paid up capital as dividend every year.
This policy does not imply that the dividend per share or dividend rate will never be increased. The earnings per share and the dividend per share relationship under this policy is shown per share policy.
Note: Figure 2.1. Constant Dividend per share policy
ESP: Means Earnings Per Share
DPS: Means Dividend Per Share.
If the earnings pattern of a company shows wide fluctuations, it will be difficult to maintain this policy.
In practice, when a company retains earnings in good years for this purposes, it ear marks this surplus as reserve for dividend equalization. These funds are invested in current asset like marketable securities, so that they may easily be converted into cash at the time of paying dividends in bad years.
According to Pandey (2002). A constant per share policy puts ordinary shareholders at per with preference shareholders irrespective of the firms investment opportunities or the preference of shareholders. Those investors who dividends as the only source of their income may prefer the constant policy. They do not accord much importance to the changes in a share prices.
Some companies pay a fixed dividend of net earnings every year. (i.e. a policy of constant payout ratio).
With this policy, the amount of dividend with fluctuates in direct proportion to earnings. For instance, if a company adopts 40% pay out, then 40% of every naira of net earnings will be paid out. Therefore, if a company earns =N= 4.00per share, the dividend per share will be =N=2.00per share, the dividend per will be =N=0.60. the relationship between the earning s per share and dividend per share under this policy is illustrate in figure. 2.2
Figure 2.2. Dividends policy of constant payout ratio
This policy is related to a company’s ability to pay dividend. If the company incurs losses dividends shall not be paid regardless of the desires of shareholders.
Internal financing with retained earning is automatic when this policy is followed:
At any given payout ratio, the amount of dividend and addition to retained earnings increased with increasing earning and decrease with decreasing earnings.
This policy does not put any pressure on a company’s liquidity since dividend are distributed only when the company has profits.
According to Rubner (1996), he suggested that companies should be legally required to adopt a policy of 100% payout. On of the major reasons is that share holders prefer dividends and that directors would need to convince investors for nay proposed investment which offers increase in wealth.
Weather they merits, but is practice, companies do not generally pursue a target ratio at 100%. Shareholders and management do not encourage this
Clarkson and Elliot (1969) however, argued that given taxation and transaction cost dividends are luxury that neither shareholders nor companies can afford this. Only few firm pursue this policy of a 100% retention ratio.
(iii) Constant dividend per share plus extra dividend
It is desirable, for a company with fluctuating earnings, to adopt the policy to pay a minimum dividend per share with a step-up feature. The small amount of dividend is fixed to reduce the possibility of ever missing a dividend payout. By extra dividend in periods of prosperity an attempt is made to prevent investors from expecting that the dividend represent an increase in the established dividend amount. According to Pandy (2000). Certain shareholders like this policy because of certain cash flow in the form of regular dividend and the option of earning extra dividend occasionally.
The regular payments of dividends has several advantages such as:
(a) Resolution of investors’ uncertainly
(b) Investors’ desire for current income
(c) Institutional investors’ requirements
(d) Raising additional finances etc.
(a) Resolution of investors’ uncertainty
When a company follows a policy to stable dividends, it will not change the amount of dividend if there are temporary changes in its earnings. Thus, when the earning of a company fall and it continues topay dividends as in the past (the same amount), it conveys to investors that the future of the company is brighter than suggested by the drop in earning.
(b) Investors’ Desire for Current Income
There are many investors who desire to receive regular periodic income. They invest their savings in the shares with a view to use dividends as a source of income to meet their living expenses. These investors will prefer a company with stable dividends to the one with fluctuating dividends.
(c) Institutional Investors Requirements
The shares of companies are not only purchased by individuals but also by corporate bodies such as financial, education and social institutions and unit trusts. Therefore, every company is institutions generally invest in the shares of those company which have a record of company prefers to follow a stable dividend policy.
(d) Raising Additional Finances
A stable dividend policy is also advantageous to the company in its efforts to raise external finance. Stable and regular dividend policy tends to make the share of the company as quality investment rather than a speculation.
The loyalty and Goodwill of shareholders towards a company increases with stable dividend policy hence they would be more than ready to receive an offer by the company for further issues of shares. The financial institutions are the larger purchasers of these securities who purchase debenture and preference shares of those companies which have a history of paying stable dividends.
This is policy of paying out the remaining profit after all the profitable investment have been undertaken.
The outcome of this policy is an erratic dividend pattern, which will lead to a fall in the market price of the share, companies hardly pursue this policy.
The earnings of a company could be used to pay dividend to shareholders or used for other purposes such as retirement of debts, financing new investment, increase the welfare of the workers and meeting of other social responsibilities.
This means that there are a lot of interested parties in the earnings of a firm. Therefore, a balance should be stuck between this two conflicting interest (i.e. pay dividend or retain earnings) – at least before a desirable, sable and meaningful dividend policy is formulated. The major question about whether dividend policy is a means of actively influencing shareholders’ wealth will now be discussed according to the various schools of thought.
"If dividend do matter, there will be an optional dividend policy that will maximize shareholders’ wealth. If not, dividend policy is a mere detail" Van Horne (1989).
There are two opposing schools of thought. The irrelevance school of thoughts accept the argument that dividend policy is irrelevant to shareholders’ wealth, (that is the market value of shares). While the traditional school of though claims that an active dividend policy should be pursued as mean of maximizing shareholders wealth.
Modigliani and Miller (1961) is the most well-known supporters of the irrelevancy argument. They assert that, given the investment decision of the firm, the dividend payout ratio is a mere detail.
It does not affect of shareholders. M&M argued that that the value of the firm is determined by the "earning power" of the firm’s assets or its investment policy and that the manner in which the earnings stream is split between dividends and retained earnings does not affect this value. The critical assumptions are as follows. Van Horne, (1989).
(i) There is a prefect capital markets in which all investors are rational being: information are available to all at no cost, instantaneous transactions are without cost, infinitely divisible securities and no investors are large enough to affect the market price of a security.
(ii) There is absence of floatation costs in securities issued by the firms.
(iii) A world of no taxes.
(iv) A given investment policy of the firm, is not subjective to change
(v) Perfect certainty by every investor as to future investments and profits of the firms is known. (Although,
M & M dropped this assumptions later). M & M argued that if a company with investment opportunities decides to pay a dividend, so that retained earnings insufficient by obtaining additional funds from outside sources. The consequent loss of value in the existing shares, as a result of obtaining outside amount of the dividend paid.
A company should therefore be indifferent between paying a dividend (and obtaining new funds outside), and the form of shares, but as an issue of loan stock, the irrelevance of dividend policy (i.e. in difference between dividends and capital gain) remains unaffected. Although the cost of loan stock may be lower than the cost of equity, an increase in the company’s level of gearing would causes the cost of equity to rises.
The correctness of this argument therefore, depends on the correctness of the M&M position on gearing and the cost of capital and of course it ignores the effect of tax relief on debt interest as well as personal income taxes on dividends and capital gains.
To answer the criticism that certain shareholders will show a preference for either high dividends or capital gains, M & M argued that if a company pursues a consistent dividend policy. Each corporation would tend to itself a "clientele" consisting of those preferring its particular payout, preferences are likely to "flock" together by investing in the same companies elect to satisfy these preferences and thus reduce wealth if investors.
M & M argued that internal financial and external financing are equivalent. This cannot be true, if the costs of floatation new issues exist. No floatation costs are involved if the earnings are retained. The presence of floatation costs makes the external financial via retained earnings.
Thus, if floating cost are considered, the equivalence between refrained earnings and new share capital is disturbed and the retention of earnings would be favoured over the payment of dividends.
M & M argued that the wealth of a shareholder will be the same whether the firm pays dividends or not. If a shareholder is not paid dividends and he desires to have current income. He can sell the shares, he has to pay a brokerage fee which is more for small sales; and it is also inconvenient to sell the shares. Because of the transaction costs and inconvenience associated with the sale of shares to realize capital gains, shareholders may prefer capital gains. Payment of dividend allocates resources to shareholders and thus, alleviate the need for incurring agency costs.
It may not be correct under whatever condition, to assume that the discount rate "K" should be the same whether the firm uses the internal or external financing.
Due to the unrealistic nature of the assumptions, M&M’s hypotheses is alleged to lack practical relevance. This suggests that internal financing and external financing are not equivalent. Dividend policy of the firm may affect the perception of shareholders and, therefore, they may not remain indifferent between dividends and capital gains.
The following are the situations where the M&M hypotheses may go wrong.
(a) Tax differential" Cow-payout clientele
(b) Floatation costs
(c) Transaction and Agency costs
(d) Diversification
(e) Uncertainty: High – payout clientele
(f) No or low tax no dividends
M&M assumption that taxes do not exist is far from reality. Investor have to pay taxes on dividends and capital gains, but with different applicable tax rates. Dividend are generally treated as the ordinary income, while capital gains are specially treated for tax purpose.
In most countries (Nigeria inclusive), the capital gains tax rate is lower than the ordinary income tax rate. Thus, the tax advantages of capital gains over dividend strongly favours a low-dividend policy. In reality, most investors may have higher marginal income tax rate. Thus, dividends on an average, are considered to be bad since they will result in higher taxes.
Investors may have the desire to diversify earnings, they may under these circumstances will inclined to use a higher value of "K" if they expect the use of internal financing and lower value of "K" if they expect the use of external financing, hence, the value of the form will be higher, if it first pays dividends rather than retaining it.
M&M contended that the market prices of two firms with identical investment and capital structure policies and risk, cannot be different dividend policies. A number of writers have expressed contrary views. They opined that dividends resolve are relevant under conditions of uncertainly it is suggested that dividend resolve uncertainly in the mind of investor and therefore, they prefer dividends to capital gains.
Future dividends are said to be discounted at a higher rate than near dividends. As a result a firm paying dividends earlier will command a higher value than a firm which follows a policy of retention. This implies that there exists a clientele high-payout shares.
In Nigeria today, there is no tax on dividend income in the hands of shareholders (both individuals and companies), while capital gains are taxed at 10%. This taxation system creates a conflict between shareholders and companies. Companies would like to pay no or low dividends to save additional corporate tax while shareholders would like to have more divided income.
Professor James E. Walter argues that the choice of dividend policies always affect the values of the firm. His model clearly shows the relevance of the relationship between the firm’s rate of return "r" and its costs of capital "k" determing the dividend policy that will maximize the wealth of shareholders. Walter’s model is based on the following assumptions. Pandey (2000).
(i) Internal Financing
(ii) Constant return and cost capital
(iii) 100 percent payout or retention
(iv) Constant EPS and DPS.
(v) Infinite time
(i) Internal Financing
The firm finances all investment through retained earnings; (that is debt or new equity is not used)
(ii) Constant Returns and Cost Capital
The firm’s rate or return ‘r’ and its cost of capital ‘k’ are constant
(iii) 100 percents Payout or Retention
All earnings are either distributed as dividends or reinvented internally immediately.
(iv) Constant EPS and DPS
Beginning earnings and dividend never charge. The values of the earnings per share ‘EPS’ and the dividend per share ‘DPS’ may be changed in the model to determine results, buy any giving values of EPS and DPS are assumed to remain constant forever in determining a given value.
(v) Infinite Time
The firms has a very long or infinite life. In Walter’s view, dividend policy depends on the profitability of investment opportunities available to the firm and the cost of capital if the firm has profitable opportunities, its value will be maximum when 100% of earnings are retained. Therefore, in Walter’ model, the dividend policy in the firm depends on the availability of investment opportunities and the relationship between the firm’s internal rate of return ‘r’ and its cost of capital ‘k’ now Walter is viewing dividend policy as a financing decision and when dividend policy is treated as a financial decision, the payment of cash is passive residual. Therefore the firm should use its earning to finance investment if r >k; should distribute all earnings when r (a) No External financing
(b) Constant Rate or Returns
(c) Constant opportunity cost of capital
(A) No External Financing
Walter’s model assumes that the investment opportunities of the firm are financed by retained earnings only and no external financing – debt or equity – is used for the purpose. When such situation exists, either the firm’s investment or its dividend policy or both will be sub-optimum. Thus is shown graphical in Fig. 2.3.
The horizontal axis represents the amount of earnings, investment and new financing in naira.
The vertical exist shows the rate of return and cost of capital. It is assumed that the cost of capital remains constant regardless of the amount of new capital raised.
Earning, investment and new financing (N) Fig. 2.3
A firm’s investment opportunities.
Thus, the average cost of capital ‘ka’ is equal to the marginal cost of capital ‘km’ the rates of return of investment opportunities available to the form are assumed to be decreasing.
This implies that the most profitable investment s will be made first and the poorer investment occurs where r = k. I is the optimum investment regardless of weather the capital to finance this investment is raised by selling shares, debentures, retaining earning or obtaining loan. If the firm’s earning are E1 then (I – E1) amount should be raised to financing the investment.
However, external financing is not including in Walter’s simplified model. Thus, for this situation Walter’s simplified model would show that the owner’s wealth is maximized by retaining and investing firm’s total earning of E1 and paying no dividend. In a more comprehensive model allowing for outside financing, the firm should raised new funds to finance I investment the wealth of the owners will be maximized only when this optimum investment is made.
(b) Constant Rate of Returns
‘r’ is infact not constant, but decreases as more and more investment is made. The firm should stop investing at a point where r=k. in fig. 2.3. the optimum point of investment occurs at 1 where r = k; if the firm’s earning are E2 it should pay dividends equal to (E2-1) on the other hands; Walters model indicates that, if the firms earnings are E2, they should be distributed because r < k at E2. This is clearly an erroneous policy and will fail to optimize the wealth of the owners.
(c) Constant Opportunity cost capital
A firm’s cost of capital or discount rate does not remain constant, it changes directly with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost of capital. By assuming that the discount rate is constant, Walter’s model abstracts from effect of risk on the value of the firm.
According to Pandey (2000), another important view expressed on dividend policy of a company is the one expressed by Myron Gordon popularly called the Gordon’s model this model. This based on some assumptions; these are:
(i) The firm is an all – equity firm, and it has no debt
(ii) No external financing is available
(iii) The internal rate of return, ‘r’ of the firm is constant (this ignores the diminishing marginal efficiency of investment)
(iv) The appropriate discount rate ‘k’ of the firm remains constant. (Thus, Gordon model also ignores the effect of change in the firm’s risk – class and its effect on ‘k’).
(v) The firm and its stream for earnings are perpetual
(vi) Corporate taxes do not exist
(vii) The retention ratio ‘b’ once decided upon is constant. (Thus, the growth rate of g = br is constant forever)
(viii) The discount rate is greater than growth rate.
Walter’s model which believed that dividend decision should be seen as financing decision was also not left out. He believes that while some firm’s retain all earnings, some should pay all its earnings as dividend, others can choose to be indifferent.
Gordon’s theory of relevance theory resolution of uncertainly was considered, where he argues that investors prefer early resolution of uncertainly and are willing to pay higher for all the stock that offer the greater current dividends.
Gordon’s Model rest its argument on the theory of relevancy resolution of uncertainly that payout of current dividends resolves certainly in the mind in investors.
It should be expected that the conflicting schools of thought about the relevance of dividend policy to shareholder’s wealth could be resolve by empirical evidence, that is, by looking at the facts in the true world.
Unfortunately, although empirical research has been carried out. It has so far proved inconclusive and neither point of view can yet be said to have won.
The actual practices of companies, may suggest that dividend policy is relevant; however, this view cannot be firmly substantiated. In practices, it would appears that investors are not indifferent to the extend to which
earnings are paid out as dividends are more important than earnings in determining the market values of shares.
The main reasons for this are:
a. The payment of dividends provides evidence that the company has been able to generate cash from its operations. Logically, a stable dividend policy should lead to higher share prices, because of the greater confidence of investors about future prospects.
b. changes in dividend policies are generally considered to be reliable indications of changes in future expectations if earnings.
c. Uncertainly tends to means that investors value current dividends more highly than dividends payable sometimes in the future. in other words. Given two otherwise identical companies, the one which distributed its earnings sooner, would have the higher valuation.
This chapter has highlighted the various terms of dividend, types of dividend policy as well as discuss the factors that may influence the dividend policy of quoted companies. The chapter also made mention of the various groups of investors which could constitute the shareholders of a firm as well as, have an influence in the determination of the dividend policy of the firms.
The chapter does not forget to do justice to the arguments on the relevance or otherwise of dividend policy’ by mentioning and discussing the different shares values is the discount rate and that discount rate differential in companies will lead to assets switching.

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