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Study On The Impact Of Residual Dividend Policy Finance Essay

There are many studies in the financial literature regarding dividend policy and its impact on market value, as discussed in chapter three. Some researchers (Gordon 1959; Litzenberger and Ramaswamy 1979; Blume 1980; Litzenberger and Ramaswamy 1982; Ang and Peterson 1985; Dyl and Weigand 1998; Koch and Shenoy 1999) have indicated such a relationship, while others denied its existence (Miller and Modigliani 1961; Black and Scholes 1974; Merton and Rock 1985; Peter 1996). They argue, however, that the investment policy and the investment decision should affect the company market value but not the dividend policy.

With the emergence of a new variable, i.e. the investment policy, and the researchers’ reference that the company’s market value does determine the investment policy due to the belief that current and future earnings realized result from the company investment policy, the companies value depends mainly on their ability to achieve continued earnings even if they do not distribute dividends now and in the future and the dividend policy is only a tool for the distribution of earnings achieved through the investment policy to shareholders (Miller and Modigliani 1961; Horne and McDonald 1971; Fama 1974; Titman 1984; Cornell and Shapiro 1987; Holder, Langrehr et al. 1998). They added that such a policy has one main importance as it represents one kind of signal sent by the management to shareholders about the company's ability to continuously achieve future earnings under the non-symmetry of information available to management and shareholders, known as the "signal hypothesis".

Because of this view of the investment and dividends decisions, the investment decision has acquired greater importance as it is responsible for the company’s continuous earnings. The dividend decision is arguably complementary to the investment decision; therefore, the funds available should be directed primarily towards investment, while the surplus funds (after the exhaustion of all investment opportunities) should be directed to dividends. This is known as the "Residual Dividends Policy".(see: Van Horne 1983; Brigham, L. et al. 1999; Lumby and Jones 1999; Brealey and Myers 2003; Watson and Head 2004; Arnold 2008)

The Residual Dividends Policy concept means that the company tends to direct all available funds to the investment opportunities available to it, and distribute the remaining funds as cash dividends for shareholders (Van Horne 1983; Brigham, L. et al. 1999; Lumby and Jones 1999; Watson and Head 2004; Arnold 2008). If there remains a surplus of funds after exhausting all opportunities there may be a chance for dividends, but if there are no extra funds, there will be no dividends for distribution.

A number of questions come to the fore in this respect: Is there a "pure" residual dividend policy? (Baker and Smith 2006) What happens if there are no funds on hand after exhausting investment opportunities for a long period? Will a company stop distributing dividends? Will the management seek to issue new equities if it is found that the cash available is not sufficient for investment opportunities? To what extent? What impact will this then have on the finance decision?

Following a pure residual dividends policy, the company would create a situation of concern inflicting the company and its position. In this respect, the company's announcement of such cash dividends, taking into account that it follows the residual dividend policy, will lead shareholders to think that the company management had exhausted all investment opportunities available and there would be no further investment opportunity. This would create a kind of suspicion and mistrust on the development and continuity of the company earnings achieved, especially in the current asymmetry of information between the management and shareholders.

Another disadvantage emanates from the pure residual dividends policy without any cash dividends. Accordingly, shareholders fear that the management would enter into non profitable projects, in order to exhaust all available funds, which increases the agency costs (Jensen 1986).

The company’s adoption of the residual dividends policy does not necessarily mean that there are no cash dividends because the pure residual dividends policy is quite difficult to implement in practice (Baker and Smith 2006). Therefore, the management always sets a target for the dividends ratio, on condition that the shortage in funds is covered by external financing, where a target is also set for the leverage ratio.

This chapter will focus on exploring if UK companies follow the residual dividends policy or not for the period from 1998 up to 2007 by using Baker and Smith methodology in their study (2006) by calculating the standardized free cash flow as per the Lehn and Poulsen (1989) definition, as the mean and standard deviation for standardized free cash flow for the companies that follow a residual dividends policy close to zero.

Our sample was the equity companies in UK pound which have been available for ten years from 1998 till 2007 from the DataStream. The total number of available sample companies amounted to 590 out of 691 companies (85.38%) divided into 14 sectors.

The standardized free cash flow (SFCF) has been calculated by using excel sheets for all companies in our sample and for each sector. Then, the means and standard deviation for the market in general and for each individual sector were calculated. This has been followed by running one-sample t test by using SPSS.

We find that UK companies in general will not follow residual dividend as a cash dividend and all other individual sectors except bank and insurance which do follow residual dividend policy.

This chapter is organized as follows: Section 4-2 is a review of previous studies, followed by Section 4-3 will be dedicated to methodology and variables. The details of the statistical sample will be included in Section 4-4. The results and discussion of these results would be in Section 4-5 and 4-6, while the last section will be devoted to conclusions together with a summary section (4-6).

4-2 Prior studies

The development of management and finance sciences and intellectual schools of thought led to a mismatch in visions about adopting some financial decisions and policies. Today, researchers cannot seem to agree unequivocally on a particular topic, or more accurately the impact of those financial decisions and policies on the market value of the company, despite some researchers have suggested that dividend policy has affected the market value (as was discussed in the previous chapter). However, others deny this effect and confirm that dividend policy has no effect on the market value; the real impact, according to them, is attributed to the investment policy.

In this respect, Miller and Modigliani (1961) in their seminal study in 1961 confirm that the dividends policy has no effect on the market value under the conditions and assumptions of the efficient market in terms of providing information to all shareholders at the same time, no taxes and no transaction costs. This is called the Irrelevance theory which means that there is no link between dividend policy and market value. The study reported that the value of the company is not affected by dividends; the real influence comes instead from the investment policy being the company’s earnings generator.

Fama study (1974) sought to test the presence of the mutual relationship between the dividends decision and the investment decision. The results arrived at was consistent with M&M study, as the investment decision taken, from time to time, by the efficient market is separate from the dividends decision and the two decision are independent.

However, in spite of that, some researchers (see: Kalay and Loewenstein 1986; Impson 1997; Doron and Ziv 2001) say that the dividends decision assumes a special importance as it is used by the management to send information to shareholders about their company status and the future expected earnings within the concept of signal theory (referred to in the second chapter), regardless of investment decision. The two decisions are separated.

In his study, therefore, Partington (1985) pointed to three types of dividends policy: first, the residual dividends policy meaning that cash dividends should be resorted to only after exhausting all the investment opportunities available to the company. In other words, priority must be given to the investment decision in allocating available funds. The second is the independence of the dividend policy, regardless of the investment and finance policies. The third type follows neither the residuals nor the independent dividend policy.

Partington found that there is a separation between the dividends decision and the investment decision, as companies finance their investments and projects from the surplus of cash distributions and cover the shortage funds requirements from loans or the issuance of new shares. In other words, the dividend decision is of the second type (independent decision). Companies, on their part, do not follow the residual dividends policy as a dividend policy.

Loderer’s study (1989) dealt with investment, finance and dividend decisions, where he discussed the idea of paying dividends in the case of corporate debts. The study aimed to verify this phenomenon regarding U.S. companies through two scenarios: first, do these companies seek to pay dividends and finance the required funds for investment and dividends; second, the companies seek to raise the leverage target and pay for dividends the funds which are not required for investment.

The study discussed which decision comes first, the dividend decision or the finance decision. In other words, does the dividend decision precede the finance decision or does it follow to be as a residual? The study asked if there is a "pure" residual dividends policy or not to implement it strictly.

The study tested the above scenarios and found that there is no target for corporate dividends for the first scenario. For the second scenario about the leverage target, the study indicated that the finance decision and the investment decision could not be separated, as the managers undertake such decisions at the same time. The dividends decision, therefore, will be the residual decision, where the results proved to be better than those achieved by the first scenario, but not to the extent that it can be circular, for the companies seek leverage targeting even if they have a dividends target.

The study results stress that the investment decisions are simultaneously made with the dividends and financial decisions. This means that payout considerations do affect investment decisions, which means that the managers are not only willing to incur the transaction costs of raising outside funds to maintain a certain payout, but they are also willing to forego otherwise beneficial investment projects in order to pay dividends.

Alli, Khan and Ramires study (1993) tested the dividends policy through many factors. The study tested the dividends payout ratio in connection with eight factors: issuance costs, pecking order, ownership dispersion, dividends stability, tax and agency cost effects, financial slack, and cash flow quality and capital structure flexibility. The final sample for the study was about 105 companies in the United States for the period 1985-1987.

The study diagnosed a significant negative relationship between dividends payout ratio and both issuance costs and pecking order. This indicates that the companies which suffer from high issuance costs and has growth, risk and expected high level of capital expenditure will pay low dividends. This supports the residual dividend theory in that the funds priority for growth and capital expenditure and company will not lead to issue new equities to reduce the issuance costs.

The study also found a significant positive relationship between the dividends payout ratio and capital structure flexibility (easier access to capital markets). This result means that the companies having more flexibility in capital structure will be able to pay high dividends, which is consistent with the residual dividends theory because of the availability of surplus funds investment resulting from the flexibility of the financial structure.

Olson and McCann in their study (1994) sought to investigate the link between the dividends and earnings for quarterly time series of dividends and earnings in the United States for the period from 1978 to 1989 (48 quarters), by determining whether earnings can be used as a predictor of dividends and whether dividend can be used as a predictor of earnings.

The study arrived at many results but for our study about residual dividend policy, an autoregressive model for dividends was estimated and contrasted with a model that included the earnings information set as well as an autoregressive earnings series.

The results indicate that the inclusion of earnings data improves the predictability of the autoregressive dividends model using both the level of variables and deviations from expected values measures. This result is consistent with the residual dividends policy.

In addition, the study uncovered some financial characteristics for the firms adopting the residual dividends policy. These firms have higher growth in asset turnover, lower growth in sales and use less debt than firms that do not follow residual dividend policy.

Brav, Graham, Harvey and Michaely study (2005) made a survey to identify factors that monitor dividends and repurchases decisions in the United State. The survey covered 384 financial executives in 256 public companies and 128 private companies. The public companies have been divided as follows: 166 companies that paid dividends, 167 companies that have bought back their shares, and 77 companies that didn't pay dividends. The results of the study adopted as the results depended mainly on the responses of the public companies.

The researchers also conducted separate interviews with 23 financial executives for the sake of raising questions and inquiring about any matters that lack clarity. The answers resulting from personal interviews have been taken into account in terms of their support of the study.

The study finds many important results; of special importance for the current research are two main points. First, the companies try as much as possible to avoid reducing dividends and seek instead to make them stable. Those companies, however, do not tend to increase dividends only after covering all investment and liquidity requirements. This is consistent with the residual dividends concept.

In addition, the study has found that companies do not repurchase their shares before crystallizing the investment decision, i.e. what remains from free cash flow. This result is also consistent with the residual dividends concept.

The researcher think that the most important weaknesses of the above studies that they were not addressed mainly to investigate and discuss if the companies follow up residual dividend policy or not, but their results come to support the residual dividend policy concepts.

The study of Baker and Smith (2006) consisted of two sections. The first is a survey of 309 companies to ascertain whether their behavior is consistent with the residual dividends policy or not. The study has shown that the companies choose one of three methods for their dividends. The first one being the pure residual dividend policy, the second is the managed dividends policy; and the third is the modified residual dividends policy which enjoys characteristics of the above two methods.

The second part is dedicated to know the companies' managers’ visions on how they set their dividends policies.

Moreover, the first part of the study sought to explore whether the companies follow the residual dividends approach or not during the nineties, despite the availability of the necessary data for twenty years in order to obtain a balance between the necessary information required on the one hand, and the fact that the management will be responsible for such data on dividends on the other.

The study has based its findings on the fact that the companies that follow the residual dividends policy are those where the mean and standard deviation of the standardized free cash flow is zero or close to zero. It has adopted the operational definition of standardized free cash flow in Lehn and Poulsen’s study (1989).

The study also found that during the nineties, most companies follow the modified residual dividends policy.

4-3 Model and hypotheses

4-3-1 Study Model

This study depends in its methodology on the same procedures taken up by both Baker and Smith in their study (2006) to identify firms that are pursuing a residual dividends policy in the UK for a period of ten years. The standardized free cash flow will be calculated for all companies and sectors then we test the hypotheses by t – test on 95% confidence level to find if the market or any sector in the hypotheses accepted aria to accept or refuse the hypotheses.

Why Standardized Free Cash Flow (SFCF)?

Free Cash Flow is a measure of the after-tax operational funds produced by company, without taking in consideration the source of debt and equity financing that are available for distribution to the stakeholders. It is important to stress that the free cash flow must be available for distribution to the stakeholders (Tham and Velez Pareja 2004).

Jensen in 1986 defines the Free Cash Flow as “cash flow in excess of that required to fund all projects that have positive net present value when discounted at the relevant cost of capital" (Jensen 1986).

The Residual Dividends Policy concept means that the company tends to direct all available funds to the investment opportunities available to it, and if there remains a surplus of funds after exhausting all opportunities there may be a chance for dividends, but if there are no extra funds, there will be no dividends for distribution (Van Horne 1983; Brigham, L. et al. 1999; Lumby and Jones 1999; Watson and Head 2004; Arnold 2008).

Based on the above concepts, the researcher agree with Baker and Smith (2006) opinion that low standardized free cash flow will be manifestation of Residual Dividend Policy

4-3-2 Operational Definition

The operational definition used by Lehn and Poulsen (1989) in their study will be adopted to determine the operational definition of the concept of standardized free cash flow. It will be calculated according to the following steps for each one of the ten years:

The Undistributed cash flow = The operating profits before depreciation – income taxes – gross interests – preferred stock cash dividends – stock cash dividends.

The Free cash flow = The undistributed cash flow - capital expenditure.

Standardized calculation of free cash flow = Free cash flow / market value of the company.

4-3-3 Study Hypothesis

The main null hypothesis of this chapter can be summarized as follows:

"UK companies follow the residual dividends policy"

From this main hypothesis, 14 sub hypotheses can be generated for each sector in the London Stock Exchange (LSE).

4-4 Data Collections and descriptive

We have tried to get as many companies as possible to provide a fair reflection of the behavior of companies in UK.

We have collected our sample through the following criteria: an equity company in UK pound whose base date goes back to 1/1/1998 (ten years from 1998 till 2007) of DataStream. We have excluded 2008 from the sample period for two reasons: first, there is incomplete data for a large number of companies; second, the year 2008 has been affected in recent months by the global financial crisis, which may affect the study results.

We have found that the number of companies that met the above criteria was 697 from various sectors. Excluding the companies with incomplete data, the resulting sample consists of 590 companies representing 85.38% of the total number of companies, as is shown in table no. 4-1 below:

The null hypothesis states that the UK companies follow the residual dividends policy, while the alternative hypothesis states that UK companies do not follow the residual dividends policy. The companies tend to follow the residual dividends policy if the mean and standard deviation of Standardized Free Cash Flow (SFCF), calculated according to Lehn and Poulsen model (1989), is equal to zero during the study period. Therefore, we can write this hypothesis in a statistical format as follows:

The SFCF has been calculated by using excel program for the companies in the sample at the level of the market in general and at level of each sector in particular (Appendix 4-2). The SFCF may be summarized in table (4-2).

Table 4-3 provides a descriptive statistical analysis of SFCF mean for the market and sectors, showing that the mean value is not equal to zero. Therefore it may well be concluded that companies in UK do not follow the residual dividends policy in general and for most sectors. Besides that, it has been found that some sectors are very close to zero like banks and insurance sectors which mean that these sectors follow up the residual dividends policy.

The above results indicate that we refuse the null hypotheses which state that UK companies adopt the residual dividends policy in general and economic sectors in particular. Conversely, we accept the alternative hypothesis which states that the UK companies do not follow the residual dividends policy in general and the economic sectors in particular except the banking and insurance sectors which follow the residual dividends policy.

Besides that, when we see the P-value in table 4-4 we confirm the t test results that the market in general does not follow residual dividends policy and that all sectors do not follow residual dividends policy except banking and insurance sectors. This is because P value is less than the level of significance (5%) in the market in general and all other sectors except banking and insurance sectors.

This result gives us evidence that the companies in UK not prefer investment policy than dividend policy which is one of the main results of Irrelevant Theory. On other words, this result provides us further evidence of the non-validity of M&M assumption in 1961 as saying that the companies follow the residual dividends policy where the cash dividends depend absolutely on the remaining funds after meeting all the company's investments available.

The above result indicates that there is a separation between the investment policy and dividends policy. This is supported by Fama’s study (1974) regarding the independence of investment decisions from the cash dividends decisions.

Regarding bank and insurance sectors, the results show that they are follow residual dividend policy which mean that the companies in these sectors prefer investment policy than dividend policy.

The researcher belief that this results is attributed to several reasons, most important of which are the nature of banking and insurance needs in terms of liquidity needed for the continued evolution of the work of banks in the operational aspects. On the other, the investment policy in insurance companies is connected with the nature of the insurance concept of the operation as the investment income is one of the main sources of insurance to cover various expenses.

The banking sector results in this chapter is supported through the analyses in the previous chapter where it has become clear that there is no effect of all kinds of dividends policy (cash dividends, shares dividends and stock buybacks) on the market value of the company. While there is an effect of the earnings and investment policy (retained earnings) on the market value. However there is no same conformation for insurance sector results.

4-7 Conclusions

This chapter has examined and tested to what extent the companies in UK follow the residual dividends policy as a policy for their cash dividends at the market level in general and at each individual sector in particular.

In this respect, the results showed that the companies in general do not follow the residual dividends policy as a policy for cash dividends at the market level in general except for banking and insurance sectors for the period from 1998 up to 2007 by using Baker and Smith methodology in their study (2006) by calculating the standardized free cash flow as per the Lehn and Poulsen (1989) definition, as the mean and standard deviation for standardized free cash flow for the companies that follow a residual dividends policy close to zero.

Our sample was the equity companies in UK pound which have been available for ten years from 1998 till 2007 from the DataStream. The total number of available sample companies amounted to 590 out of 691 companies (85.38%) divided into 14 sectors.

We find that UK companies in general will not follow residual dividend as a cash dividend and all other individual sectors except bank and insurance which do follow residual dividend policy.

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