Internal Finance and Dividend Policy

Every year a profitable company faces the same choice: pay the profit out to the shareholders as dividends, or keep it in the business. The choice is more important than it looks.

Retained profit is the largest source of new equity for most companies, cheaper than a share issue and needing nobody’s approval; but every naira kept is a naira that the shareholders do not receive, and they expect the company to earn a good return on it.

This topic explains internal sources of finance (retained profit and the cash released by tighter working capital), the limits on retention, and dividend policy: the residual, stable and progressive policies, the theories of dividend irrelevance, clientele, signalling and the bird in the hand, the measures of dividends (payout, cover and yield), scrip dividends and special dividends, the legal and tax rules in Nigeria, and how to judge a company’s capacity to pay, with worked examples.

The next topic starts the study of the cost of capital with the cost of equity.

The syllabus lists the effect of dividend policy on shareholders and on the retention of profit as a source of finance. Read Islamic finance: riba, murabaha, ijarah, mudaraba, sukuk and musharaka first.

Internal sources of finance

When a company retains profit, reserves rise, and the money is reinvested in the business to produce further profit. The benefits are that there are no issue costs (no new shares are issued), the finance is readily available without a case to a bank or new shareholders. Shareholder approval is not needed for the retention of earnings. The limits are:

• Profitability: profit can be retained only if it is earned; a loss-making company has nothing to retain.
• Efficient use: retained profit must earn a suitable return. If it does not contribute to future growth in earnings and dividends, shareholders will demand higher dividends and less retention.
• Dividend policy: profit is either retained or paid out, so retention withholds dividends, and shareholders have expectations of the dividend.

Another internal source is working capital efficiency: tighter control of inventory, receivables and payables reduces the working capital needed and releases cash once, which can be used for investment (an earlier topic explained how). Selling surplus assets is a further internal source.

Dividend policy

A company’s dividend policy is its approach to deciding how much of its profit to pay out. The main policies are:

• Residual policy: fund every project with a positive NPV first, using the target mix of equity and debt, and pay out what is left. Dividends vary with investment opportunities.
• Stable or progressive policy: pay a steady dividend, raised gradually as earnings rise, and cut only if there is no alternative. Shareholders can plan around it and a change signals the directors’ view of the future.
• Constant payout ratio: pay a fixed percentage of earnings, so the dividend moves with profit.
• Other forms: an interim and a final dividend; a special dividend paying out surplus cash once; a scrip dividend giving shares instead of cash; and share buy-backs as an alternative way to return cash.

Example of a residual policy: a company earns ₦6,000m after tax with 1,000m shares (earnings per share ₦6). It plans investment of ₦7,000m, to be financed 60% from equity (retained profit) and 40% by debt. Equity needed is 7,000 × 0.6 = ₦4,200m, so the dividend is 6,000 − 4,200 = ₦1,800m, or ₦1.80 a share, a payout ratio of 30%.

If investment were ₦2,000m lower the dividend would be higher; if the equity needed exceeded profit, there would be no dividend and new shares would have to be issued.

Does dividend policy matter?

• Irrelevance (Modigliani and Miller): in a perfect market the value of a company depends on the earnings from its investments, not on how they are split between dividends and retention. A shareholder who wants cash from a company that pays nothing can sell a few shares (a “homemade dividend”): a holder of 1,000 shares at ₦40 who wants ₦2,000 sells 50 shares; a holder who does not want cash can reinvest the dividend.
• Bird in the hand: some argue that investors prefer a certain dividend now to an uncertain capital gain later, so a higher payout raises the value and lowers the cost of equity. Others reply that the risk of a firm’s cash flows is not changed by the payout.
• Clientele effect: shareholders choose companies whose payout suits their needs and tax position (pensioners may want high income, others growth), so a change in policy upsets some of them and attracts others.
• Signalling: managers know more than the market, so a rise in the dividend is read as confidence about future profit and a cut as bad news, which is why companies avoid cutting.
• Market imperfections: issue costs and taxes make retention cheaper than paying dividends and then raising new equity; but if the company has no good projects, the cash should be returned.

Measuring dividends

For the company above, suppose the dividend is ₦2.00 a share and the share price ₦40:

• dividend cover.
  earnings per share (EPS) ÷ dividend per share (DPS) = 6 ÷ 2 = 3.0 times
• payout ratio.
  2 ÷ 6 = 33%
• dividend yield.
  2 ÷ 40 = 5.0%
• the price/earnings ratio is 40 ÷ 6 = 6.7

The growth in dividends that retention can support is the retention ratio × the return on retained funds: with 70% retained and a return of 15%, g = 0.7 × 0.15 = 10.5%, an estimate used in the dividend growth model for the cost of equity in the next topic.

Capacity to pay: dividends are paid in cash, so a company needs cash and not only profit. A guide is the cash left after meeting operating needs, capital expenditure and debt repayments: operating cash flow ₦9,000m less capital expenditure ₦5,000m less net debt repayment ₦1,000m leaves ₦3,000m available.

A policy that pays out more than the free cash flow in the long run has to be funded by borrowing or share issues.

Legal and tax rules in Nigeria

• Company law: under the Companies and Allied Matters Act 2020 (sections 426 to 428), a company may declare dividends in general meeting on the recommendation of the directors, and the meeting may reduce but not increase the amount recommended; dividends are paid out of distributable profits, not out of capital, and directors may set aside reserves (section 430) before recommending a dividend. Directors may also pay interim dividends.
• Tax: dividends are subject to withholding tax of 10%, deducted at source; for an individual resident shareholder this is a final tax, and a reduced rate may apply under a double taxation agreement. The company’s own profit is taxed before the dividend is paid, so the dividend is paid from after-tax profit.
• Loan covenants and regulators: lenders may limit dividends, and regulators of banks and insurers set their own limits on payouts to protect capital.

The ideas in more depth

Why the investment decision comes first

If a company has projects that earn more than the shareholders’ required return, retaining profit to fund them creates value; paying the money out and then raising new equity would cost issue fees. If it has no such projects, retaining the cash and investing it at lower returns destroys value, and paying it out or buying back shares is better.

This is the logic of the residual policy and of irrelevance: the real question is the investment, not the dividend.

Why companies smooth dividends

Directors know that shareholders and the market read dividend changes as news. A cut is feared more than a rise is welcomed, so dividends are set at a level the directors are confident they can maintain. Are changed only when earnings have moved lastingly. This is why dividends are smoother than earnings.

Sources and references

• The Companies and Allied Matters Act 2020 (sections 426 to 430) on dividends and reserves; the withholding tax rules on dividends; the Securities and Exchange Commission and Nigerian Exchange rules on timely payment of declared dividends.

These points are stated as at 5 November 2026.

Worked examples

1. Equity needed.
   7,000 × 0.6 = ₦4,200m.
2. Dividend.
   6,000 − 4,200 = ₦1,800m.

1. Cover.
   6 ÷ 2 = 3.0 times.
2. Yield.
   2 ÷ 40 = 5.0%.

1. Growth.
   0.7 × 15% = 10.5%.

How to answer in the exam

• Link dividends to the investment plan: state the policy and the amounts retained and paid.
• Use the ratios: cover, payout, yield and growth, with the formula shown.
• Give both sides of the theory: irrelevance and the arguments for relevance, applied to the case.
• Mention the legal and cash constraints on paying dividends.

Common mistakes in the exam

• Treating dividend policy as unrelated to investment and financing.
• Calculating the yield on earnings instead of on the price.
• Forgetting that dividends need cash as well as profit.
• Saying that a dividend cut has no effect on the share price.
• Using the payout ratio instead of the retention ratio for growth.
• Omitting the withholding tax and the legal limits.

Quick revision

• Retained profit: cheap and easy, but limited by profit, returns and dividend expectations.
• Policies: residual, stable or progressive, constant payout.
• Cover = EPS ÷ DPS; yield = DPS ÷ price; g = retention × return.
• Nigeria: dividends from distributable profit; 10% withholding tax.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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