THE IMPACT OF DIVIDEND POLICY AND EARNINGS ON STOCK PRICES OF NIGERIA BANKS

Transcription

1 THE IMPACT OF DIVIDEND POLICY AND EARNINGS ON STOCK PRICES OF NIGERIA BANKS BY ANIKE, ESTHER AMUCHE PG/M.SC/09/53718 DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION UNIVERSITY OF NIGERIA NSUKKA FEBUARY,

2 THE IMPACT OF DIVIDEND POLICY AND EARNINGS ON STOCK PRICES OF NIGERIA BANKS BY ANIKE, ESTHER AMUCHE PG/M.Sc/09/53718 A DISSERTATION SUBMITTED TO THE DEPARTMENT OF BANKING & FINANCE, FACULTY OF BUSINESS ADMINISTRATION IN PARTIAL FULLFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF MASTER OF SCIENCE(M.Sc) DEGREE IN BANKING AND FINANCE SUPERVISOR: PROF. C. UCHE FEBUARY, DECLARATION 2

3 I, Anike Esther Amuche, with registration number PG/M.Sc/09/53718, a postgraduate student in the Department of Banking and Finance do hereby declare that this work embodied in this Dissertation is original and has not been submitted in part or in full for any other diploma or degree of this or any other University. STUDENT Anike, Esther Amuche APPROVAL 3

4 This dissertation has been approved for the Department of Banking and Finance By SUPERVISOR Prof. C. Uche HEAD OF DEPARTMENT Dr. J.U.J. Onwumere DEDICATION 4

5 I dedicate this work to my father in heaven, the Almighty God who makes all things possible and does things at His appointed time.to you, oh Lord, be all the glory and adoration for your Love and Sufficiency. ACKNOWLEDGEMENTS It s a thing of joy to know that someone cares for me. To this, I wish to express my overwhelming joy to all those whose advice, encouragement, prayer, care and love have 5

6 made me a success. First, I want to acknowledge my amiable supervisor Prof.C.Uche, for his assistance throughout the course of this research work, particularly his patience, tolerance and his invaluable devotion to this work. My profound gratitude also must go to Dr. Austin Ujunwa, who created time out of his tight schedule to assess my work properly. To my H.O.D Dr. J.U.J Onwumere and all my lecturers, Dr.Mrs O.P.Egbo, Dr.Chikeleze, Dr. Mrs N.J Modebe, Dr. C. Nwude, who groomed me towards attaining this height, I say thank you. I must say thanks to all the staff in the department of Banking and Finance, among who are Mrs.Aneke, Mrs. Anakwenze, and Aunty Chika. My big nephew, Mr. Alum Martins (Igbudu 1 na-nike), who has been a true brother indeed, whose anchor by the grace of God has made the sky my starting point. I will not fail to thank the couple who God used to encouraged me, Engr and Mrs Beloved-Dan Obi-Anike, Dr. Ekette Maurice. My family has been wonderful, for their timeless love prayers especially my lovely Mum, Mrs Anikeokwor Josephine, my brother, Hon. Anike Eugene, my aunts Ozo, Appolo and my sisters, Iyke-Ikpa Caroline, Anike Virginia and Okolo Nwanneka. My typist, Blessing, who faithfully reproduced this work from mostly hand-written manuscript as a service of love. My thanks as well go to all the Staff and Management of Nigeria Stock Exchange Onitsha, Anambra State., whose assistance provided the data for my analysis and findings. Worthy of acknowledging are my friends whose encouragement gave my world a meaning. Notable among them are: Ujunwa Angela (Mrs),Ubagwu Charles, Ageme Tony, Anyaoku Emeka P, Nsofor Ebere, Ihuoma Ajuonuma, Mrs. Onuseluogu Oddi, Mrs.Nkwonta Uzomaka, Imo G. Ibe, Offor Nneka, Mrs Okolo Alice to mention but a few. I love you all. Above all, I appreciate the giver of wisdom,the Excellency, the Ever Present help in time of need, the merciful and gracious Father. Thank YOU LORD. ANIKE ESTHER AMUCHE DEPARTMENT OF BANKING AND FINANCE UNEC. TABLE OF CONTENTS Title Page i Declaration ii Approval Page iii Dedication iv 6

7 Acknowledgement v List of Tables ix Abstract x CHAPTER ONE INTRODUCTION 1.1 Background of the Study Statement of Problem Objectives of the Study Research Questions Research Hypotheses Scope of the Study Significance of the Study References CHAPTER TWO REVIEW OF RELATED LITERATURE 2.1 Dividend Policies And Earnings Types of Dividends Methods of Dividend Payment Dividend Announcements and Stock Returns Dividend Policy and Asymmetric Information Stock Prices and Dividend Announcements Stock Prices, Dividends And Semi-Strong Market Efficiency Stock Splits on Price And Liquidity Corporate Dividend Policy Determinants Shareholders Earnings (EPS) and the Firm References CHAPTER THREE RESEARCH METHODOLOGY 3.1 Research Design Nature and Sources of Data Population and Sample Size

8 3.4 Model Specification Model Justification Description of Research Variables Dependent Variable Independent Variables Control Variables Techniques of Analysis References CHAPTER FOUR PRESENTATION AND ANALYSIS OF DATA 4.1 Presentation of Data Test of Hypotheses Test of Hypothesis One Test of Hypothesis Two Test of Hypothesis Three Comparaism Of Results with Objectives Objective One: To determine the impact of dividend yield on stock prices of Nigerian banks Objective Two: To determine the impact of earnings yield on stock prices of Nigerian banks Objective Three: To determine the impact of dividend payout ratio on stock prices of Nigeria banks Reference 8

9 CHAPTER FIVE SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS 5.1 Summary of Findings Conclusion Recommendations Contributions to Knowledge Bibliography 9

10 LIST OF TABLES Table 4.1 Panel Data of Model Proxies Table 4.2 Descriptive Statistic Table 4.3 Regression Result of Hypothesis One Table 4.4 Regression Result of Hypothesis Two

11 ABSTRACT This study examined the impact of dividend yield on stock prices of Nigerian banks; the impact of earnings yield on stock prices of Nigeria banks and the impact of payout ratio on stock prices of Nigeria banks. The study adopted the ex-post-facto research design and panel data covering 5-year period were collated from annual reports of banks and the Nigeria Stock Exchange daily official list. The Ordinary Least Square Regression Model was used to estimate the relationship between dividend yield, earnings yield, payout ratio and stock prices. Average of daily stock prices was adopted as the dependent variable, while the independent variables included dividend yield (DY), earnings yield (EY) and payout ratio (POR). The result emanating from this study revealed that dividend yield had negative and significant impact on commercial banks stock prices in Nigeria (coefficient of Dyield = ; p-value = 0.035). Earnings yield had negative and significant impact on commercial banks stock prices in Nigeria (coefficient of Eyield = ; p-value = 0.048) and dividend payout ratio had negative and non-significant impact on commercial banks stock prices in Nigeria (coefficient of Por = ; p-value = 0.269). The study thus, revealed that the dividend yield, earnings yield and payout ratio are not factors that influences stock prices rather the bank size was found to have positive and significant impact on stock prices. The study therefore recommends among others that managers should act in the best interest of investor as to reduce the agency problem, thus complete information about the dividend polices of the firm should be provided. 11

12 CHAPTER ONE INTRODUCTION 1.1 BACKGROUND OF THE STUDY The subject matter of dividend policy remains one of the most controversial issues in corporate finance. For a very long time now, financial economists have engaged in modeling and examining corporate dividend policy and earnings as they affect banks stock prices in Nigeria (Amidu, 2007). Black (1976) hinted that, The harder we look at the dividend picture, it seems like a puzzle with pieces that don t fit together. In over thirty years since then a vast amount of literature has been produced examining dividend policy. Recently, however, Frankfurterc and Wood (2002) concluded in the same vein as Black and Scholes (1974) that the dividend puzzle, both as a share value-enhancing feature and as a matter of policy, is one of the most challenging topics of modern financial economics. Forty years of research have not been able to resolve it. Research no dividend policy and earnings have shown not only that a general theory of dividend policy remains elusive, but also that corporate dividend practice varies over time, among firms and across countries. The patterns of corporate dividend policies not only vary over time but also across countries, especially between developed and emerging financial institutions. Glen, et al (1995) suggested that dividend policies in emerging markets differed from those in developed markets. They reported that dividend payout ratios in developing countries were only about two thirds of that of developed countries. Different scholars have defined the term dividend policy differently. Hamid, et al (2012) defined dividend policy as the exchange between retained earning and paying out cash or issuing new shares to shareholders. Booth and Cleary (2010) defined dividend policy as an exclusive decision by the management to decide what parentage of profit is distributed among the shareholders or what percentage of it retains to fulfill its internal needs. Nwude (2003:112) defined the term as the guiding principle for determining the portion of a company s net profit after taxes to be paid out to the residual shareholders as dividend during a particular financial year. Emekekwue (2005:393) defined dividend policy as the portion of firm earnings that will be paid out as dividend or held back as retained earnings. Huda and Farah (2011) pointed out 12

13 that dividend policy has been an issue of interest in financial literature; academics and researchers has developed many theoretical models describing the factors that managers should consider when making dividend policy decisions. Key factors behind the dividend decision have been studied by numerous researchers. Lintner (1956) suggested that dividend payment pattern of a firm is influenced by the current year earnings and previous year dividends. In this case, dividend may be seen as the free cash flows which comprises of cash remaining after all business expenses have been met (Damodaran, 2002). The dividend decision in corporate finance is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company s stockholders. The decision as stated by Pandey (2005), is an important one for the firm as it may influence the financial structure and stock price of the firm. In addition, the decision may determine the amount of taxations that stockholders pay. The dividend payment ratio is a major aspect of the dividend policy of the firm, which affects the value of the firm to the share holders (Litzenberger and Ramaswany, 1982). The classical school of thought holds this view and they believe that dividends are paid to influence their share prices. They also believe that market price of an equity is a representation of the present value of estimated cash dividends that can be generated by the equity (Gordon, 1959). Another classical school of thought, on the other hand, believes that the price of equity is a function of the earnings of the company. They believe that dividend payout is irrelevant to evaluating the worth of equity. What matters, they say is earnings (Miller and Modigliani, 1961). Mayo (2008: ) observed that retained earnings provide funds to finance the firms on long term growth. It is the most significant source of financing a firm s investment. Dividends are paid in cash, thus the distribution of earnings utilizes the available cash of the company. When the firm increases the retained portion on net earnings, shareholders current income in the form of dividends decreases, but the use of retained earnings to finance profitable investments is expected to increase future earnings. On the other hand, when dividends increase, shareholders current income will increase but the firm may be unable to retain earnings and, thus, relinquish possible investment opportunities and future earnings. 13

14 The theoretical rationale for corporate dividend policy has been an important topic in corporate finance for a very long time. After the dividend policy-irrelevance proposition by Miller and Modigliani (1961), several theories have attempted to explain why and how companies pay out the cash generated by their business operations as dividend. Three main factors may influence a firm s dividend decision. These are: - Free cash flows, Dividend clientele and Information signaling (Pandey, 2005). Under the free-cash flow theory of dividends, the payment of dividends is very simple: the firm simply pays out, as dividend, any surplus cash after it invests in all available positive net present value projects. Criticism of the theory is that it does not explain the observed dividend policies of real world companies. Most companies pay relatively consistent dividend from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision (Brigham, 1995). Under the dividend clientele, a particular pattern of dividend payments may suit one type of stockholders more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas, a person with a huge income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If Clientele exists for a particular pattern of dividend payment, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies (Okafor, 1983). According to the clientele effect theory of dividend policy, investors who would like to receive some cash from their investment always have the option of selling a portion of their holding. This argument is even more cogent in recent times with the advent of very low-cost discount stockholders. Thus, it remains possible that there are taxation based clientele for certain types of dividend policies (Pandey, 2005). Information content or signaling says that investors regard dividend changes as signals of management earning potentials. The model was developed by Ezra (1983). It suggests that dividend announcements convey information to investors regarding the firm s value prospects (Ezra, 1983). He said many earlier studies had shown that stock prices tend to 14

15 increase when an increase in dividend is announced but tend to decrease when a decrease or omission is announced. Therefore, Ezra pointed out that, this is likely due to when investors have complete information about the firm, they will look for other information that may provide a clue as to the firm s future prospects and also managers have more information than investors about the firm and such information may inform their dividend decision. It could be seen, therefore, that when mangers lack confidence in the firm s ability to generate cash flows in the future, they may keep dividends constant or possibly even reduce the amount of dividends payout. Conversely, managers that have access to information that indicates very good future prospects for the firm are more likely to increase dividends (Ezra, 1963). Hence, the purpose of this study is to perform a cross-sectional study to find the situations in Nigeria which these hypotheses apply and also determine how stock prices react to such dividend and earnings report as indicated by investors ratio values with bias to bank stocks. 1.2 STATEMENT OF PROBLEM The goal of corporate entities is to maximize the value of shareholders investment in the firm. Managers pursue this goal through their investment, financing and dividend decisions. Investment decisions involve the selection of positive net present value projects. Financing decisions involve the selection of a capital structure that would minimize the cost of capital of the firm while dividend decisions of the firm determine the reward which investors and potential investors of the firm receive from their investment in the firm. Apart from the investment and financing decisions, managers need to decide, on regular basis, whether to pay out of the earning to shareholders, reducing the agency problem (Jensen and Meckling, 1976). However, the question remains whether paying out of earnings would essentially create value for the shareholders or not. A dividend payment provides cash flow to the shareholders but reduces firm s recourses for investment; this dilemma is a myth in the finance literature. A great deal of theoretical and empirical research on dividend policy effects has been done over the last several decades. Theoretically, cash dividend from earnings means giving reward to the shareholders, that is, something they already own in the company; but this will 15

16 be offset by the decline in stock value. In an ideal world (without tax and any restrictions) therefore dividend payments would have no impact on the shareholders value. In the real world, however a change in the dividend policy is often followed by a change in the market value of stocks. The economic argument for investor s preference for dividend income was offered by Graham and Dodd (1934). Subsequently, Walter (1963) and Gordon (1959 and 1962) forwarded the dividend relevancy idea, which has been formalized into a theory, postulating that current stock price would reflect the present value of all expected dividend payments in the future. Another researcher made efforts to further understand the dividend controversy. Average investors, subject to their personal tax rates, would prefer to have less cash dividend if it is taxable: size of optimal dividend inversely related to personal income tax rates (Pye, 1972). The theoretical literature on dividend effects has been well developed. Researchers largely accepted that dividend per-se has no impact on the shareholders value in an ideal economy. However, in a real world, dividend announcement is important to the shareholders because of its tax effect and information content. Given the above problems and the controversies surrounding the impact of dividend policy and earnings on stock prices of Nigeria banks, the lacuna which this study seeks to fill is to provide empirical evidence on the impact of dividend policy and earnings on stock prices of Nigeria banks using investment ratios such as dividend yield, earnings yield, payout ratio with the introduction of some control variables in an emerging market like Nigeria. Hence, the contribution of this study is in terms of geography. 1.3 OBJECTIVES OF THE STUDY The general objective of this study is to determine the impact of dividend policy and earnings on bank stock prices. However, the specific objectives are: 1. To determine the impact of dividend yield on stock prices of Nigerian banks. 2. To determine the impact of earnings yield on stock prices of Nigerian banks 3. To determine the impact of dividend payout ratio on stock prices of Nigeria banks. 16

17 1.4 RESEARCH QUESTIONS As a result of the objectives stated above the following research questions will be asked. These are: 1. To what extent does the dividend yield of banks listed on the Nigerian Stock Exchange have positive significant impact on their stock prices? 2. To what extent does the earnings yield of banks listed on the Nigerian Stock Exchange have positive significant impact on their stock prices? 3. To what extent does the payout ratio of banks listed on the Nigerian Stock Exchange have positive significant impact on their stock prices? 1.5 RESEARCH HYPOTHESES The research questions raised above therefore led to the formulation of the following hypothetical statements. These are: 1. Dividend yield does not have positive and significant impact on stock prices of Nigerian banks. 2. Earnings yield does not have positive and significant impact on stock prices of Nigerian banks. 3. Dividend payout ratio does not have positive and significant impact on stock prices of Nigeria banks. 1.6 SCOPE OF THE STUDY The banking sector represents the lending spectrum of any economy, thus responsible for the supply of funds to the productive sub-sectors of the Nigerian economy, hence its importance to the growth of the Nigerian Economy. The study covers a five years period ( ), and is based on reports of twenty (20) banks (Data on Spring Bank Plc was not available). The choice becomes appropriate within the period culminated in the reduction of banks in the country to 21 banks. However, also, the post consolidated financial statements and accounts of these banks were published in As also observed since 2005, the Banking sector of the Nigerian Stock Exchange has been the most active till date. Panel data series was collated from the Annual Statements and Accounts as well as stock prices of these banks from the Nigeria Stock Exchange at the end of the year 17

18 1.7 SIGNIFICANCE OF THE STUDY This research will be particularly significant to the following groups: 1) INVESTORS AND POTENTIAL INVESTORS The major beneficiaries of an enhanced value created firm as indicated by the share prices are investors and potential investors. Their contribution, in monetary terms in the promotion, incorporation, continual existence to the growth of the firm must be rewarded with a premium above their risk free rate, thus, acting as a compensation for time and risk inherent in these firms. Therefore, this research will contribute, along with other similar literatures available in this area of finance, to enhancing the maximization of investors and potential investors objectives as concern capital gains from their investment. 2) ACADEMIC Essentially, this research intends to contribute significantly to the volume of literature available in this area of finance. In academics, the unknown is never exhausted, as the list of what we do not know could go on forever. Therefore, as a contribution to this area, hints, recommendations about dividends, earnings and stock prices will be examined. 3) MANAGEMENT In large firms, there is a divorce between management and ownership. The decision taking authority in a company lies in the hands of managers. Shareholders as owners of the company are the principals and managers are their agents. Thus, there is principal-agent relationship between shareholders and managers therefore managers should and must act in the best interest of shareholders as consistent with shareholders wealth maximization objectives of the firm. Therefore, this research will enable management to understand what must be done in order to act in the best interest of shareholders in choosing dividend policies that will maximize shareholders value. 18

19 REFERENCES Amidu, M. (2007), How Does Dividend Policy Affect Performance of the Firm on Ghana Stock Exchange?, Investment Management And Financial Innovations, Vol. 4, Issue 2, Pp Black, F. (1976), The Dividend Puzzle, Journal of Portfolio Management, Vol. 2, pp 5-8. Black, F., and Scholes M. (1974), The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns, Journal of Financial Economics, Vol. 1, pp Booth, L. and Cleary, W. S. (2010), Dividend Policy. An Introduction to Corporate Finance, Canadian: 2 nd edition, John Wiley and Sons. Brigham, E. F. (1995), Fundamentals of Financial Management, New York: McGraw Hill. Damodaran, A. (2002), Corporate Finance, Theory and Practice International Edition, New York: John Wiley and Son. DeAngelo, H. and DeAngelo, L. (2006), The Irrelevance of the M & M Dividend Irrelevance Theory, Journal of Financial Economics, Vol.79, pp Emekekekwue, P. E. (2005), Corporate Financial Management, 5 th edition, African Bureau of Educational Sciences. Ezra, S. (1963), The Theory of Financial Management, New York: Columbia University Press. Ezra, S. (1983), The Theory of Financial Management, New York: Columbia University Press. Frankfurter, G. M. and Wood, B. J. (2002), Dividend Policy Theories and their Empirical Tests, International Review of Financial Analysis, Vol. 11 No. 2 pp Glen, J. D., Karmokolias Y., Miller R. R, and Shah S. (1995), Dividend Policy and in Emerging Markets, International Financial Corporation. Discussion Paper No 26. Gordon, M. J. (1962), The Savings Investment and Valuation of a Corporation, The Review of Economics and Statistics, Vol. 44 pp Gordon, M. J. (1959), Dividend, Earnings and Stock Prices, The Review of Economics and Statistics, Vol. 41 No 2 May, pp

20 Graham, B. and Dodd, D. L. (1934), Security Analysis, lst edition, New York: McGraw-Hill. Hamid, Z., Hanif, C.A., Ul-Malook, S. S. and Wasimullah (2012), The Effect of Taxes on Dividend Policy of Banking Sector in Pakistan, African Journal of Business Management, Vol. 6 No. 8, February, pp Huda, F. and Farah, T. (2011), Determinants of Dividend Decision: A Focus on Banking Sector in Bangladesh, International Research Journal of Finance and Economics ISSN Issue 77, pp Jensen, M. C. and Meckling, W. H. (1976), Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, Vol. 3 No 4, pp Lease, R.C., John, K., Kalay, A., Loewenstein, U. and Sarig, O.H. (2000), Dividend Policy: It s Impact on Firm Value. Boston: Harvard Business School Press. Lintner, J. (1956), Distribution of Incomes of Corporations among Dividends, Retained Earnings and Taxes, American Economic Review, Vol. 46 No. 2, pp Litzenberger, R. H. and Ramaswamy, K. (1982), The Effects Dividends on Common Stock Prices Tax Effects or Information Effects, The Journal of Finance, Vol. 37 No. 2 May, pp Mayo, H. B. (2008), Investments, Introduction International Studies: 9 th edition, Canada: Thomson Higher Education. Miller, M. H. and Modigliani, F. (1961), Dividend Policy, Growth and the Valuation of Shares, The Journal of Business, Vol. 43 No. 4 Oct., pp Nwude, C. E. (2003), Basic Principles of Financial Management. A Second Course: 1st edition Enugu: Chuke Nwude Nigeria. Okafor, F O. (1983), Investment Decision Evaluation of Projects and Securities, Enugu: Gostak Publishing Company Ltd. Pandey, I. M. (2005), Financial Management, 9 th edition, New Delhi: Vikas Publishers. Pye, G. (1972), Preferential Tax Treatment of Capital Gains, Optimal Dividend Policy and Capital Budgeting, The Quarterly Journal of Economics, Vol. 86, pp Walter, J. E. (1963), Dividend Policy; It Influence on the Value of the Enterprise, The Journal of Finance, Vol. 18 No 2 May, pp

21 CHAPTER TWO REVIEW OF RELATED LITERATURE 2.1 DIVIDEND POLICIES AND EARNINGS Nwude (2003:112) defines dividend policy as the guiding principle for determining the portion of a company s net profit after taxes to be paid out to the residual shareholders as dividend during a particular financial year; the purpose of a dividend policy being to maximize shareholders wealth, by which is dependent on both current dividend and capital gains. Mishra and Narender (1996) found that not all profit-making state owned enterprises have adhered to the dividend policy guidelines. Emekekwue (2005:393), the essence of the dividend policy is to determine what portion of firms earnings that will be paid out as dividend or held back as retained earnings. Retained earnings are one of the important sources of financing of firms projects. Dividend, on the other hand, is that portion of a firm s after tax profit that is shared out to shareholders as reward for investment while dividend, puts disposable income in the hands of shareholders. Juma h and Pacheco (2008) assert that, on average, profitability, liquidity and the size of companies are important determinant of cash dividend decision. Arif, et al (2011), opines that discretionary accruals do not significantly influence dividend policy. It means that the practices of earnings management are not only for the sake of dividend avoidance, but there can be several other reasons for this manipulation. The investor while making investment decision with a hope to have dividend, should not focus on the earnings management as a signal for the dividend policy formulation. Emekekwue (2005:393) found that dividend policies vary among firms. Some vary with the business cycle while others do not. The so called growth firms usually pay out paltry amounts to shareholders and use what is left to address the financial needs of the firm. However, the objective of providing funds to build up reserves in order to finance expansion projects, service and retire existing obligations and, consequently, enhance the earnings power of the firm is at variance with putting disposable income in the hands of shareholders. A high rate of retained earnings translates to a lesser amount of disposable income to 21

22 shareholders. Similarly, if a large portion of corporate earnings is paid out as dividend, the firm will not have enough to service and retire existing obligations, and of course, for reinvestment. Since retained earnings act as a buffer to the future earnings capacity of the firm, it is generally argued that a drop in retained earnings will precipitate a drop in the market value of stocks. Basse (2009) is of the view that firms seem to increase their dividend payments when facing an environment of a rising price level in order to stabilize the real value of dividend income. Therefore, higher inflation is a major driver of dividend increases. Brennan and Thakor (1990) found that despite the preferential tax treatment of capital gains for individual investors, majority of a firm s shareholders may support dividend payment for small distributions. The directions in making dividend decisions should therefore give some consideration to the preference of the various categories of shareholders, and the problem is usually to identify the consensus preference of shareholders, especially in the case of widely held companies. The incidence of taxation on the firm and the shareholders has a bearing on dividend policy. Tax is a strong fiscal disincentive on dividend distribution. Miller and Scholes (1978) observed that dividend taxes do not influence share prices. Harris, et al (1999) found that if share prices absorb the effect of dividend taxation, then corporations could distribute dividends without imposing a penalty on shareholders at the margin, that is, dividend policy would be unaffected by dividend taxes. The Dividend Signaling Hypothesis argues that dividends are used by companies to signal higher than expected future free cash flow, if managers have private information about the future or current cash flow, then investors will interpret a current dividend increase (decrease) as a signal that managers expect permanently higher (lower) future free cash flow levels (Bhattacharya, 1979). The Free Cash Flow Hypothesis, first explained by Jensen and Meckling (1976), argues that agency problems arise in companies where ownership and control are separated, such as in public companies with disperse shareholding. Managers have an incentive to over invest relative to their first best optimal level in companies with sizable free cash flows or cash reserves. The overinvestment stems from the empire building or perks-prone attributes 22

23 embedded in the managers' utility function. An increase in dividend reduces the free cash flow available to managers and, therefore, limits the overinvestment problem, creating value for the company. Conversely, a dividend cut augments the cash on hand to the managers and aggravates the overinvestment problem. The Maturity Hypothesis, advanced by Grullon, et al (2002) and DeAngelo and DeAngelo (2006), argues that, as a company matures, its investment opportunity set shrinks with a consequent decline in systematic risk. A positive price reaction to a dividend increase suggests that the company has entered a mature life cycle stage of lower profitability and lower risk. According to the Maturity Hypothesis, reactions to news about systematic risk reduction dominate reactions about lower future profits and, therefore, the stock price response to a dividend increase announcement is positive. Conversely, the decision to decrease dividends signals the transitioning from a mature to a decline stage with higher systematic risk and even lower profitability. The stock price response to a dividend decrease announcement is, therefore, negative. The Maturity Hypothesis is a conjecture, because Grullon, et al (2002) do not develop a theoretical model and, therefore, do not propose a separating equilibrium in which other companies cannot mimic mature companies. Also the Catering Hypothesis, proposed by Baker and Wurgler (2003), assumes that for either institutional or psychological reasons, some investors have an uninformed and perhaps time-varying demand for dividend-paying stocks. For instance, dividend clientele theories argue that changes in tax code, transaction costs or institutional investment constraint can lead to changes in the demand for dividend paying stocks. Behavioural explanations, such as the bird-in- the-hand or self-control arguments, could also lead to a time-varying demand for dividend paying stocks. The market, therefore, assigns a timevarying premium to dividend paying stocks. Managers cater to this premium by paying out more dividends when the dividend premium is high, and by holding cash inside the company when the dividend premium is low. Although dividend payers and non-payers are consistently different in many characteristics, such as size, life-cycle stage and profitability, Baker and Wurgeler (2003) provide some evidence that managers cater to investor sentiment and their conclusions are robust to a variety of alternative explanations. 23

24 Despite extensive empirical testing of the above dividend hypotheses over the last 30 years, the conclusions are surprisingly varied, and a wide consensus on the corporate payout rationale is still lacking. The empirical evidence on the Dividend Signaling Hypothesis is mixed at best. On one hand, Nissim and Ziv (2001) found that using a particular model of earnings expectations, current dividend changes are positively correlated to future earnings changes hence the stock prices. On the other hand, other studies (among others, Deangelo, et al 2003 and Benartzi, et al 1997) found positive correlation between dividend changes and concurrent or lagged earnings changes, but no correlation with future earnings changes. Even more interesting, they find that companies that cut dividends have higher earnings in the future relative to comparable companies. The Maturity Hypothesis is supported not only by Grullon, et al (2002), but also by DeAngelo, et al (2003). In their paper, they show that the fraction of publicly-traded industrial firms that pay dividends is high when retained earnings are a large portion of total equity and falls to near zero when most equity is contributed rather than earned. The earned/contributed capital mix is therefore a critical parameter to classify the life-cycle stage of a company. Although the Catering Hypothesis has been formulated only recently, Li and Lie (2006) shows that the stock market reaction to dividend changes depends on the dividend premium associated with dividend-paying stocks. In buttressing the signaling effect of dividend decision of the firm, Pandey (2005) says investors can use the knowledge about managers behavior to inform their decision to buy or sell the firm s stock, bidding the price up in the case of positive dividends surprise or scaling it down when dividends do not meet expectations. This view was supported by Miller and Rock (1985). Thus, this, in turn, may influence the dividend decision as managers know that stockholders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firms, this also tends to lead to a dividend policy of a steady, gradually increasing payment (Bhaumik, 2007). 24

25 In general, as stated by Pandey (2005), the dividend decision is usually taken by considering, at least, the three questions of: How much excess cash is available? What do our investors prefer?, And what will be the effect on our stock prices of announcing the amount of the dividend? Therefore, as confirmed by Patra (2005), the dividend decision is the major decision area of financial management. A firm is to decide what portion of earnings would be distributed to the shareholders by way of dividend and what portion of the same (earnings) would be retained in the firm for its future growth. Therefore, Patra concludes that dividend and retention are desirable but they are conflicting with each other. From the forgoing, a finance manager should be able to formulate a suitable dividend policy that will satisfy the shareholders without hampering the progress of the firm. In finance, there are various theories that attempt to explain the relationship between a firm s dividend policy and common stock. These are: Dividend Relevance Theory, Optimal Dividend Theory (policy) and Dividend Irrelevance Theory. Walter (1963) argue that the choice of dividend policies almost always affect the value of the firm. His model, one of the earliest theoretical works, shows the importance of the relationship between the firm s rate of return and its cost of capital in determining the dividend policy that will maximize the wealth of shareholders. Walter s model was based on the following assumptions, according to Francis (1972): (1) the firm finances all investments through retained earnings, that is, debt or new equity is not issued, (2) The firm s rate of return and its cost of capital are constant (3) all earnings are either distributed as dividends or reinstated internally immediately (4) there is a constant EPS and DPS and (5) the firm has a very long or indefinite life (Pandey, 2005). According to Ezra (1963), in Walter s model, dividend policy is a financial decision and when the dividend policy of a firm is treated as a financing decision, the payment of cash is a passive residual. Another relevance model was developed by Myron Gordon which explicitly relates the market value of the firm to dividend policy (Gordon, 1962). Gordon s model was based on the following assumptions: the firm is an equity firm and it has no debt; no external financing is available; the internal rate of return of the firm is constant; the firm and its streams of earnings are perpetual; the appropriate discount rate for the firm remains 25

26 constant; corporate taxes do not exist; constant retention and the cost of capital is greater than its growth rate. Gordon model s conclusions about the dividend policy are similar to that of Walter s model. This similarity, according to Pandey (2005), is due to the similarities the of assumptions that underline both model, thus, Gordon s model suffers from the same limitations as Walter s model. To underline, the relevance of dividend policy, is the bird-inhand argument of Krishman (1933). This view is based on the assumption that under conditions of uncertainty, investors tend to discount near dividends at a higher rate than they discount future dividends. Investors thus behaving rationally are risk averse and, therefore, have a preference for near dividends to future dividend (Pandey, 2005). The logic underlining these bird-in-hand arguments can be captured in the words of Krishman (1933), when he said if two stocks with identical earnings record and prospects, but the one paying a larger dividend than the other, the former will undoubtedly command a higher price merely because stockholders prefer present to future values. Myopic vision plays a part in the price making process. Stockholders often act upon the principle that a bird-in-hand is worth two in the bush and, for this reason, are willing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the lower rate (Pandey, 2005:284). Gordon, (1962) also expresses the bird-in-hand argument more convincingly and in formal terms. According to him, uncertainty increases with futurity, that is the further one looks into the future, the more uncertain dividend becomes. Accordingly, when dividend policy is considered in the context of uncertainty, the appropriate discount rate cannot be assumed to be constant (Pandey, 2005). In fact, according to him, it increases with uncertainty and investors prefer to avoid uncertainty and would be willing to pay higher price for the share that pays the greater current dividend, all other things held constant. Miller and Modigliani (1961), are the chief advocates of the dividend irrelevance argument. For them under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of the firm. They argue that the value of the firm depends on the firm s earnings that result from the investment policy; when the investment decision of the 26

27 firm is given, dividend decision, which is the split of earnings between dividend and retained earnings, is of no significance in determining the value of the firm. Francis (1972) asserts that the M and M hypothesis of irrelevance is based on the following assumptions: the firm operates in a perfect market where investors behave rationally and information is freely available to all, and transaction and flotation costs do not exist; no taxes exist; the firm has a fixed investment policy and risk of uncertainty does not exist. Thus, the M and M (1961) dividend irrelevance proposition states that changes in dividends are offset one-for-one by changes in proceeds from net new issues of securities, so that investment and earnings are unaffected or does not affect equity valuation. These irrelevance propositions have been questioned by De Angelo and DeAngelo (2006) who assert that dividends payout rules, like investment plans, can be sub optimal. They specifically claimed that the dividend irrelevance proposition is true only in environments that are simplified in a way that is not generally appreciated. They assert that in a more general setting, the dividend policy is relevant in exactly the same sense as investment policy is relevant. In another strand of finance-literature on asset pricing, analysts take the view that paying low level of dividend does not result in under-valuation of the firm; the value of a firm with a given current capital is the same under low or zero future dividends as high future dividend. This view is known as the Neutrality of dividend policy and is held by Black (1976). Black and Scholes (1974) observed that shareholders trade-off the benefits of dividend against the tax losses. Based on this trade off, shareholders are classified into three clienteles: a clientele that considers dividend as always good; clientele that considers dividends as always bad and clientele flat are indifferent to dividend. As explained by Pandey (2005), most shareholders in high tax brackets may belong to high payout clientele since, in their case, the tax advantage may outweigh the benefit of dividends. On the other hand, shareholders in low tax bracket may fit into low payout clientele as they may suffer marginal tax disadvantages of dividend while tax-exempt investors are indifferent between dividends and capital gains, since they pay no taxes on their income. So, the supply of dividends and demand for dividend matched, there will be no gain if a firm changes its dividend policy since the investors have already made their choices 27

28 or there exist opportunities for shareholders to shift from one firm to another (Pandey, 2005). In a bid to satisfy these two objectives, management is put in serious dilemma as they must come up with policies that will address their needs for reserves and disposable income to shareholders. 2.2 TYPES OF DIVIDENDS Nwude (2003: ) points out that there are five types of dividends that payout. These consist of cash dividend, stock dividend or bonus issues, stock or share split, reverse stock split and stock repurchase. Cash Dividend: Cash dividend is payment of dividends in cash. This is customary for any company that declares dividends to pay in cash. When a cash dividend is paid the implication of the balance sheet is that the company s cash account and reserves account will be reduced, thus reducing both the total assets and the net worth of the company. A company that declares cash dividend must ensure that it has sufficient cash to meet it requirements. Stock Dividend or Bonus Issue: Stock dividend is the payment of dividend in the form of issue of additional shares to the residual owners of the firm. It involves capitalizing the company s share premium or reserves and increasing the share capital account by the same amount capitalized from the reserves account Liquidity is preserved as no cash leaves the company. The advantage to the shareholders is that they receive a dividend which they can convert into cash whenever they wish to sell their share while the disadvantage is that as the number of equity shares is increased, if the retained earnings do not yield a satisfactory rate of return, the share price can fall, especially when there is massive off-loading by the shareholders in the capital market. Stock dividend is issued to each shareholder in proportion to his or her existing shareholding in the company. Stock or Share Split: This means the division of the existing share price by two or multiplication of the existing number of shares by two. The effect of stock split is that it reduces the prevailing par or nominal value of shares by half and doubles the existing number of shares. Management uses stock split to lower the price of its shares to attract increased trading activity on the shares on the stock exchange. Stock split does not affect 28

29 either side of the balance sheet in terms of Naira amount, but changes the figure and book entry of the number of shares outstanding as well as the par value. Reverse Stock Split: A reverse stock split is a financial strategy of consolidating the nominal value of an existing share issue and a corresponding decrease in the number of shares in existence. Stock Repurchase: This is the acquisition of a company s outstanding shares by the company itself for warehousing in the stock treasury. The purpose of stock repurchase may be to reduce the number of outstanding shares in order to increase the earnings per share (EPS) of the remaining shares which will consequently increase the market price per share (MPPS), and thus, general capital gains to shareholders. The capital gains substitute the cash dividends. 2.3 METHODS OF DIVIDEND PAYMENT In Nigeria, the payment of dividend is predicated on the existing legislations which could be amended from time to time. Nwude (2003:127) points out that section 379(1) of the Companies and Allied Matters Decree (CAMD) 1990 now Act, states that a company may in general meeting, declare dividends in respect of a year or other period only on the recommendation of the directors. The company shall pay, from time to time to the members such interim dividends as appear to the directors to be justified by the profits of the company. The general meeting shall have the power to declare the amount of dividend recommended by directors, but shall have no power to increase the recommended amount. Where the recommendation of the directors of a company with respect to the declaration of a dividend is varied in accordance with subsection (3) of this section by the company in general meeting, a statement to that effect shall be included in the relevant annual return. Subject to the provisions of this Decree, dividends shall be payable to the shareholders only out of the distributable profits of the company. Section 380 provides that subject to the company being able to pay its debts as they fall due, the company may pay dividends out of the following profits: 29

30 Profit arising from the use of the company s property, although it is a lasting asset. Revenue Reserves. Realized profit on a fixed asset sold, but where more than one asset is sold, the net realized profit on assets sold. In Nigeria, dividends are often paid twice: the first is the interim dividend and the final dividend. Brealey and Myers (1999:418) assert that dividend is set by the firm s board of directors. The announcement states that the payment will be made to all those stockholders who are registered on a particular recorded-date. Two weeks later, dividend cheques are mailed to stockholders. 2.4 DIVIDEND ANNOUNCEMENTS AND STOCK RETURNS One of the earliest studies in this direction was by Petit (1972) who found that the market made use of dividend change announcements in pricing securities. Rozeff and Kinney (1976) explain that since firms release more information to the public in the month of January, above-normal returns in the month of January can be attributed to this increased inflow of information by firms to the market. Gordon (1959, 1962), Foster and Vic -kery (1978) and Lee (1995) confirm positive abnormal returns to dividend payment announcements. Contrary to the above studies, Easton and Sinclair (1989) find negative abnormal returns, that is, a negative reaction by stock prices to dividend announcements; this is normally attributed to the tax effect of dividends for shareholders. Baker and Powell (1999) point out that manager sought to avoid making changes in their dividend rates that might have to be reversed within a year or so. Therefore, they (managers) tended to make partial adjustments towards a target payout ratio rather than dramatic changes. Lonie, et al (1996) investigates the dividend announcements of 620 U.K companies from January to June 1991 using event study and interaction tests. They found that investors responded to increase or decrease in dividends. However, their findings also reveal that, even for companies with no change in dividends, the average abnormal returns one day prior to the announcements were significantly different from zero as indicated by the statistic. Below and Johnson (1996) also fail to support the semi-strong form of market efficiency for 30