Effect of Dividend Payment on Stock Prices Case Study of Nairobi Stock Exchange 20 Share Index

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Submitted to the Department of Finance in partial fulfillment of the Financial Seminar Course; University Of Nairobi.

October, 2010.





1.1 Background of the study In finance, there are some areas, which have puzzled researchers. One of them is the dividend behaviour of firms. Along with capital structure, dividend policy has been one of the first areas of corporate finance to be analyzed with a rigorous model, and it has since been one of the most thoroughly researched issues in modern finance. In spite of this, much remains unexplained concerning the role of dividends. Black (1976) epitomizes the lack of consensus by stating ”The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don‟t fit together.”

Dividend policy determines the division of earnings between payments to stockholders and reinvestments in the firm. Managers‟ task is to allocate the earnings to dividends or retained earnings. Dividend policies are the regulations and guidelines that firms develop and implement as means of splitting their earnings between distributing to their shareholders and the retained earnings. The main aim of dividend policy is shareholder‟s wealth maximization. Dividend is the distribution of firms‟ value to shareholders (Tajirian 1997). A firm uses dividends as a mechanism for financial signaling to the outsiders regarding the stability and growth prospects of the firm. By law dividends must be paid from profits and not from a corporation‟s capital. The law stipulates that dividend payment may not exceed the corporation‟s retained earnings as shown on its balance sheet.

A more plausible explanation is that dividends are required because of the separation of ownership and management (Hansen et al 1994). According to one form of this argument, dividends are a signal of the sustainable income of the corporation: management selects a dividend policy to communicate the level and growth of real income because conventional accounting reports are inadequate guides to current income and future prospects. While this 2

theory remains to be fully elaborated, it does suggest that the steadiness (or safety) of the dividend, as well as its average level, might be used in a dynamic setting.

Other corporate distribution distributions include Extra Dividends which refers to an extra dividend to shareholders on a one time or infrequent basis. This could be as a result of a company having a good financial year. Spin-offs are distribution of shares of a subsidiary company to shareholders. Companies spin off unrelated or underperforming business to shareholders so that they can concentrate on the core business. Split-Offs also can be used as corporate distribution which refers to exchange of a parent company‟s stock for a pro-rata share of the stock of a sub-sidearm company. Also the Dividend reinvestment plan (DRIP) allows shareholders to reinvest their dividends in additional stock rather than receiving them in cash.

There are four main dividend policies as follows: a) Constant payout ratio. This is where the firm pays a fixed dividend rate. The dividend per share would therefore fluctuate as the earnings per share changes. Dividends are directly dependent on the firm‟s earnings ability and if no profits are made, no dividends are paid. b) Constant amount per share (fixed dividend per share). The dividend per share is fixed in amount irrespective of the earnings levels. This creates certainty and is therefore preferred by shareholders who have a high reliance on dividend income. It protects the firm from periods of low earnings by fixing dividend per share at a low level. c) Constant dividend per share plus extra /surplus. A constant dividend per share is paid every year. However, extra...
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