Dividends and Dividend policy
The intricacies of Dividends and Dividend policy can leave even the most seasoned financial professional feeling a little uneasy. While conventional wisdom suggests that paying dividends affects both firm's value and shareholder wealth to retain earnings to explore growth opportunities, much debate still surrounds this dynamic discipline; especially when it comes to how dividend decisions can lead to value maximization Kent (2003). Dividend policy is an important component of the corporate financial management policy. It is a policy used by the firm to decide as to how much cash it should reinvest in its business through expansion or share repurchases and how much to pay out to its shareholders in dividends. Dividend is a payment or return made by the firm to the shareholders, (owners of the company) out of its earnings in the form of cash. For a long time, the subject of corporate dividend policy has captivated the interests of many academicians and researchers, resulting in the emergence of a number of theoretical explanations for dividend policy. For the investors, dividend serve as an important indicator of the strength and future prosperity of the business, thereby companies try to maintain a stable dividend because if they reduce their dividend payments, investors may suspect that the company is facing a cash flow problem. Investors prefer steady growth of dividends every year and are reluctant to investment to companies with fluctuating dividend policy. Over time, there has been a substantial increase in the number of factors identified in the literature as being important to be considered in making dividend decisions. Thus, extensive studies have been done to find out various factors affecting dividend payout ratio of a firm. However, there is no single explanation that can capture the puzzling reality of corporate dividend behavior. Ocean deep judgment is involved by decision makers to resolve this issue of dividend behavior. The decision of companies to retain or pay out the earnings in form of dividends is important for the maximization of the value of the firm (Oyejide, 1976). Therefore, companies should set a constructive target dividend payout ratio, where it pays dividends to its shareholders and at the same time maintains sufficient retained earnings as to avoid having raise funds by borrowing money.
A tough challenge was faced by financial practitioners and many academics, when Miller and Modigliani (M&M) (1961) came with a proposition that, given perfect capital markets, the dividend decision does not affect the firm value and is, therefore, irrelevant. This proposition was greeted with surprise because at that time it was universally acknowledged by both theorists and corporate managers that the firm can enhance its business value by providing for a more generous dividend policy and that a properly managed dividend policy had an impact on share prices and shareholder wealth. Since the M& M study, many researchers have relaxed the assumption of perfect capital markets and stated theories about how managers should formulate dividend policy decisions.
Dividend policy has attracted a substantial amount of research by many researchers and theorists, who have provided theoretical as well as empirical observations, into the dividend puzzle (Black, 1976). Even though researchers and theorists have extended their studies in context to dividend decisions, the issue as to why corporations distribute a portion of their earnings as dividends is not yet resolved. The issue of dividend policy has stimulated much debate among financial analysts since Lintner's (1956) seminal work. He measured major changes in earnings as the key determinant of the companies' dividend decisions. There are many factors that affect dividend decisions of a firm as it is very difficult to lay down an optimum dividend policy which would maximize the long-run wealth of the shareholders resulting into increase or decrease of the firm's value, but the primary indicator of the firm's capacity to pay dividends has been Profits.
Miller and Modigliani (1961), DeAngelo and DeAngelo (2006) gave their proposition on the dividend irrelevance, but the argument made by them was on assumptions that weren't practical and in fact, the dividend payout decision does affect the shareholders value.
The study focuses on identifying various determinants of dividend payout and whether these factors influence the dividend payout decision.
There are many theories in the corporate finance literature addressing the dividend issue. The purpose of study is to understand the factors influencing the dividend decision of companies. The specific objectives of this study are:
To analyze the financials of the company to draw a framework of factors such as Retained earnings, Age of the company, Debt to Equity, Cash, Net income, Earnings per share etc. responsible for dividend declaration.
To understand the criticality of a company's profitability (in terms of Earnings per share) component in declaration of dividends.
To measure each factor individually on how it affects the dividend decision.
Q1. What is the relation between dividend payout and firm's debt?
Q2. What is the relation between dividend payout and Profitability?
Q3. What is the relation between dividend payout and liquidity?
Q4. What is the relation between dividend payout and Retained Earnings?
Q5. What is the relation between dividend payout and Net Income?
Scope of the Study:
This study investigates areas of concern that are extensive thereby due to limitation of time; the scope of research will be limited as the period of study is only three years 2006-2008. The study is focused only on firms trading on NYSE and has considered only those firms who pay dividends.
Organization of the paper:
The remaining chapters will be organized as follows:
Chapter Two: literature review
This chapter discusses the Determinants of Dividend payout and the theories behind the research questions in context to the Dividend policy.
Chapter Three: Research Methodology
The chosen research design, data collection and statistical tests for analysis are described in the chapter.
Chapter four: Data Analysis and Findings:
To address the research questions, results obtained from the regression analysis will be presented and discussed.
Chapter five: Recommendations and Conclusion.
This chapter provides recommendations for the future research and a conclusion for all this research.
Dividend remains one of the greatest enigmas of modern finance. Corporate dividend policy is an important decision area in the field of financial management hence there is an extensive literature devoted to the subject. Dividends are defined as the distribution of earnings (present or past) in real assets among the shareholders of the firm in proportion to their ownership. Dividend policy refers to management's long-term decision on how to utilize cash flows from business activities-that is, how much to plow back into the business, and how much to return to shareholders (Khan and Jain, 2005).
Lintner (1956) conducted a notable study on dividend distributions, his was the first empirical study of dividend policy through his interview with managers of 28 selected companies, he stated that most companies have clear cut target payout ratios and that managers concern themselves with change in the existing dividend payout rather than the amount of the newly established payout. He also states that, Dividend policy is set first and other policies are then adjusted and the market reacts positively to dividend increase announcements and negatively to announcements of dividend decreases. He measured major changes in earnings as the key determinant of the companies' dividend decisions. Lintner's study was expanded by Farrelly et al. (1988), who, mailed a questionnaire to 562 firms listed on the New York Stock Exchange and concluded that managers accept dividend policy to be relevant and important. Lintner's view was also supported by the study results of Fama and Babiak (1968) and Fama (1974) who suggested that managers prefer a stable dividend policy, and are hesitant to increase dividends to a level that cannot be supported. Fama and Babiak's (1968) study also concludes that Net income appears to explain the dividend change decision better than a cash flow measure.
The study by Adaoglu (2000), Amidu and Abor (2006) and Belans et al (2007) stated that net income shows positive and significant association with the dividend payout, therefore indicating that, the firms with the positive earnings pay more dividends.
Merton Miller and Franco Modigliani (1961) made a proposition that the value of a firm is not affected by its dividend policy. Dividend policy is a way of dividing up operating cash flows among investors or just a financial decision. Financial theorists Martin, Petty, Keown, and Scott, 1991 supported this theory of irrelevance. Miller and Modigliani's conclusion on the irrelevance of dividend policy presented a tough challenge to the conventional wisdom of time up to that point, it was universally acknowledged by both theorists and corporate managers that the firm can enhance its business value by providing for a more generous dividend policy as investors seem to prefer dividends over capital gains (JM Samuels, FM.Wilkes and R.E Brayshaw).
Benartzi et al. (1997) conducted an extensive study and concluded that Lintner's model of dividends remains the finest description of the dividend setting process available. Baker et al. (2001) conducted a survey on 630 NASDAQ-listed firms and analyzed the responses from 188 CFO's about the importance of 22 different factors that influence their dividend policy, they found that the dividend decisions made by managers were consistent with Lintner's (1956) survey results and model. Their results also suggest that managers pay particular attention to the dividend policy of the firm because the dividend decision can affect firm value and, in turn, the wealth of stockholders, thus dividend policy requires serious attention by the management.
E.F Fama and K.R French (2001) investigated the characteristics of companies paying dividends and concluded that the top most characteristics that affect the decision to pay dividends are Firm size, Profitability, and Investment opportunities. They studied dividend payment in the United States and found that the proportion of dividend payers declined sharply from 66% in 1978 to 20.8% in 1999, and that only about a fifth of public companies paid dividends. Growth companies such as Microsoft, Cisco and Sun Microsystems were found to be non-dividend payers. They also explained that the probability that a firm would pay dividends was positively related to profitability and size and negatively related to growth. Their research concluded that larger firms are more profitable and are more likely to pay dividends, than firms with more investment opportunities. The relationship between firm size and dividend policy was studied by Jennifer J. Gaver and Kenneth M. Gaver (1993). They suggested that 'A firm's dividend yield is inversely related to the extent of its growth opportunities'. The inference here is that as cash flow increases, the coefficient of dividend decreases, indicating that smaller firms that have greater investment opportunities thus they tend not to make dividend payment while larger firms tend to have proactive dividends policy.
Ho, H. (2003) undertook a comparative study of dividend policies in Japan and Australia. Their study revealed that dividend policies in Australia and Japan are affected by different financial factors. Dividend policies are affected positively by size in Australia and liquidity in Japan. Naceur et al (2006) examined the dividend policy of 48 firms listed on the Tunisian Stock Exchange during the period 1996-2002. His research indicated that highly profitable firms with more stable earnings could afford larger free cash flows and thus paid larger dividends. Li and Lie (2006) reported that large and profitable firms are more likely to raise their dividends if the past dividend yield, debt ratio, cash ratio are low. A study was conducted by Norhayati Mohamed, Wee Shu Hui, Mormah Hj.Omar, and Rashidah Abdul Rahman on Malaysian companies over a 3 year period from 2003-2005. The sample was taken from the top 200 companies listed on the main board of Bursa Malaysia based on market capitalization as at 31December 2005. Their study concluded that bigger firms pay higher dividends.
or the purpose of finding out how companies arrive at their dividend decisions, many researchers and theorists have proposed several dividend theories. Gordon and Walter (1963) presented the Bird in Hand theory which suggested that to minimize risk the investors always prefer cash in hand rather than future promise of capital gain. This theory asserts that investors value dividends and high payout firms. As said by John D. Rockefeller (an American industrialist) 'The one thing that gives me contentment is to see my dividend coming in'. For companies to communicate financial well-being and shareholder value the easiest way is to say 'the dividend check is in the mail'. The bird-in-hand theory (a pre-Miller-Modigliani theory) asserts that dividends are valued differently to capital gains in a world of information asymmetry where due to uncertainty of future cash flow, investors will often tend to prefer dividends to retained earnings. As a result the value of the firm would be increased as a higher payout ratio will reduce the required rate of return (see, for example Gordon, 1959). This argument has not received any strong empirical support. Dividends, paid by companies to shareholders from earnings, serve as an important indicator of the strength and future prosperity of the business. This explanation is known as signaling hypothesis. Signaling is an example factor for the relevance of dividends to the value of the firm. It is based on the idea of information asymmetry between managers and investors, where managers have private information about the firm that is not available to the outsiders. This theory is supported by models put forward by Miller and Rock (1985), Bhattacharya (1979), John and Williams (1985). They stated that dividends can be used as a signaling device to influence share price. The share price reacts favorably when an announcement of dividend increase is made. Few researchers found limited support for the signaling hypothesis (see Gonedes, 1978, Watts, 1973) and there are other researchers, who supported the hypothesis, for example, in Michaely, Nissim and Ziv (2001), Pettit (1972) and Bali (2003).
The tax-preference theory assumes that the market valuation of a firm's stocks is increased when the dividend payout ratios is low which in turn lowers the required rate of return. Because of the relative tax liability of dividends compared to capital gains, investors need a large amount of before-tax risk adjusted return on stocks with higher dividend yields (Brennan, 1970). On one side studies by Lichtenberger and Ramaswamy (1979), Poterba and Summers, (1984), and Barclay (1987) have presented empirical evidence in support of the tax effect argument and on the other side Black and Scholes (1974), Miller and Scholes (1982), and Morgan and Thomas (1998) have either opposed such findings or provided completely different explanations. The study by Masulis and Trueman (1988) model dividend payments in form of cash as products of deferred dividend costs. Their model predicts that investors with differing tax liabilities will not be uniform in their ideal firm dividend policy. As the tax liability on dividends increases (decreases), the dividend payment decreases (increases) while earnings reinvestment increases (decreases). According to Farrar and Selwyn (1967), in a partial equilibrium framework, individual investors choose the amount of personal and corporate leverage and also whether to receive corporate distributions as dividends or capital gains. Barclay (1987) has presented empirical evidence I support of the tax effect argument. Others, including Black and Scholes (1982), have opposed such findings or provided different explanations.
Farrar and Selwyn's model (1967) made an assumption that investors tend to increase their after tax income to the maximum. According to this model corporate earnings should be distributed by share repurchase rather than the use of dividends.
Brennan (1970) has extended Farrar and Selwyn's model into a general equilibrium framework. Under this, the expected usefulness of wealth as a system of barter is maximized. Despite being more robust both the models are similar as regards to their predictions. According to Auerbach's (1979) discrete-time, infinite-horizon model, the wealth of shareholders is maximized by the shareholders themselves and not by firm market value. If there does, infact, exist a difference between capital gains and dividends tax; firm market value maximization is no longer determined by wealth maximization.