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CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The survival of the long run objective of any business organization depends to a large extent on the decision it takes toward its capital structure and dividend policies. The overall objective of any business organization is to maximize the shareholder wealth. The firm has to invest in some of its profitable venture which promise the highest returns with the shareholders fund and other fixed interest debt finance. The decision of the firm to employ debt finance came with certain element of risk toward the shareholders. The proportion of debt to owners equity employed (gearing) will have some effect on their earnings either positively or negatively depending on the shareholder decision towards risk. The impact of capital structure and dividend policy on corporate performance has been unsettled one. M & M argued that the way and manner in which the operation of a firm is financed does not affect the value of the firm while some believe that the use of debt in the financing mix will magnify the value of the firm if the financial manager will be indierent to the source of finance that appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize return to various organizational constituencies but also because of the impact such a decision has on the organization’s ability to survive in its competitive environment. The prevailing argument originally developed by Modigilani and Miller (1989) is that an optimal capital structure exist which balance the risk of bankruptcy with the tax saving of debt. It is important to note that dividend is not a contractual obligation of the firm to its shareholder or debt providers. The amount of the dividend, if any, is rested on management’s best options to use the income. The board of directors who are ultimately responsible for setting dividend policy can chose not to pay any dividend using the firm’s earnings to acquire additional asset instead. Dividend policy is the principle use in determining what portion of earning should be paid out as dividend during the period, the divided policy may be expressed in the follow objectives such as target payout ratio; a divided policy table give the tax earning on the firm available to it legal constraint and the need to satisfy the shareholders must be decided whether or not to pay divided.

If yes, what proportion of its total earning should be paid out and what form of divided payout will be in the best interest of the firm? In every business, capital structure is of primary importance. It is to show how a company finances its operations through some combination of equity; debt etc. A firm’s capital structure is the composition of its liabilities. The capital structure indicates how the company finances its entire operations and expansion by utilizing different financial resources whether it is from equity capital, debt capital, or other forms of capital such as vendor financing. Vendor financing is a process of selling goods or products before paying the bill to the vendor. It doesn’t cost anything to the company; instead it gives more return on investments. It should be noted that capital structure includes equity capital which is the money invested into a company in exchange for an ownership interest in that company. Usually, equity capital has two kinds, first is the contributed capital. This is the money which the shareholder invested in the business. Secondly, are the retained earnings which represent the profit or earning of the company that is being kept by the company to use as additional fund for growth, acquisitions and expansions? Another form of capital in the business is the debt capital through long term debt and specific short term debt. This money which is a part of company’s capital structure is borrowed or lent from the other banks or financial institutions to finance the order requirement of the business. Pandy (1985), entrepreneurs usually start their companies with other stockholders in the business in order to contribute to the increase of the business capital. In this connection, the management of the company is authorized to use the collected money capital to invest in the factories or plant and to purchase equipments and supplies. The stockholders use their money to purchase share stock in the company. In this way, each stockholder owns a share or percentage of the company through investing their money as part of the capital of the company.

Nevertheless, dividend policy refers to the company’s regulation and guidelines on dividend payments to the shareholders of the organization. Having a dividend policy is very essentials for both the company and the shareholders, it is easier to monitor and figure out the impact of the dividend policy in the entire operation of the business. Therefore, dividends are payments made by the corporation to its shareholder when a company earns a profit or surplus and such money can be used as retained earnings. Many corporations retain a portion of the shareholders profit and whatever money le will be paid to the share holders as dividends. Equally important, there are various kinds of dividend payouts. Firstly is the cash dividend, this is product of cash avail ability and cash planning. The cash account and the reserves account of a company will be reduced be when the cash dividend is paid. Second is the stock or scrip dividend it involves the payment of a dividend in

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