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Effects of Dividend Policy

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This chapter discusses the theoretical and empirical literature on dividend policy. Section 2.2 reviews the theoretical literature of dividend policy beginning with the irrelevance proposition by Miller and Modigliani, followed by agency cost argument. Then, Section 2.3 discusses the empirical literature which is arranged in chronological order while Section 2.4 concludes the chapter.


Theoretical literature on corporate dividend policy centered around two classic works; the first is the Lintner Dividend Stability Model by Linter (1956) and second is that by M&M Dividend Irrelevant Theory by Miller and Modigliani (1961).

2.2.1 M&M Irrelevant Dividend Theory and Other Related Theories/Models

The seminal work on dividend policy was initiated in 1961 by Miller and Modigliani (M&M), proposed that dividend policy was irrelevant. Therefore, any changes made in dividend policy make no different to firm value since a stockholder can replicate any desired stream of payments by purchasing and selling equity. However, several assumptions were made, including: no personal or corporate taxes; no stock flotation or transaction costs; financial leverage has no effect on the cost of capital; investors and managers have asymmetry information about the firm's future prospect; and distribution of income between dividends and retained earnings has no effect on the firm's cost of equity (Foong, Zakaria and Tan, 2007). The main conclusion of this paper is that firm's capital budgeting policy is independent of its dividend policy. M&M's proposition was strongly supported by Friend and Phuket (1964) and Black and Scholes (1974).

Nevertheless, subsequent literature advances several theoretical justifications for firms' payout choices. One branch of this literature has focused on an agency-related rationale for paying dividend policy. The agency models of payout relax the original M&M's assumption about the independence of dividend and investment policies of the firm. According to Jensen and Meckling (1976), the origin of agency theory lies on the separation of ownership and control. The discrepancy between the value of the 100 percent owner-managed and less than 100 percent owner-managed firm is a measure of the agency cost. Jensen and Meckling defined agency relationship as a contract under which one or more persons (principal) engage another person (agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationships are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal.

Meanwhile, Mahadwartha (2002) draws on Fama (1980) and Eisenhardt (1989) had augmented that agency theory concerned with resolving two problems that occur in agency relationship. The first is the agency problem that arises when the interest or goals of the principal and agent conflicted and it is difficult for the principle to verify what the agent is actually doing. The second is the problem of risk sharing that arises when the principle and agent have different attitudes towards risk. Different in risk preferences leads to different policy decisions and disregard the value maximizing activity as the economics pursued.

According to Moh'd, Perry and Rimbey (1995), agency theory relates to dividend policy stems from the works of Rozeff (1982) and Easterbrook (1984). Rozeff adapt the agency theory argument of Jensen and Meckling by constructing a model in which dividends serve as a mechanism for reducing agency costs, thus offering a rationale for the distribution of cash resources to shareholders. According to Rozeff, if a firm is forced to raise external capital to replenish funds paid out in dividends, then managers must reduce agency costs and reveal new information in order to secure the new funding. Moreover, a dividend payment may act as one form of bonding mechanism to lessen agency costs because it reduces the opportunity for managers to use firm cash flow for perquisites activities.

Besides that, Easterbrook (1984) develop an argument that outside shareholders are active in seeking to draw funds from the firm to force managers to subjects themselves to the scrutiny of capital markets. Easterbrook lists some of the mechanism by which dividends and capital raising exercises can control agency costs. Agency costs are less serious if the firm is constantly in the market for new capital since it continuously put the management under scrutiny by investment banks, security exchange and capital suppliers. Therefore, the payment of dividends causes the firm to undergo a third-party audit, which serves to motivate managers to both reveal new information and reduce agency costs in order to secure needed funds. Shareholders are willing to bear the costs of new funding to realize the greater benefits associated with the reduction in both agency costs and information asymmetries.

Additionally, Jensen (1986) free cash flow hypothesis asserts that funds remaining after financing all positive net present value projects have a tendency to have high agency costs. Thus, a commitment to pay out funds to shareholders as dividends might decrease the agency costs since it reduces the amount of free cash flows that managers could otherwise be wasted through over-investment and/or projects that provide personal benefits to managers.

While disbursing excess cash may reduce the agency problem between managers and shareholders, there may be alternative means of controlling this problem. Schooled and Barney (1994) draw on Jensen and Meckling (1976) argument that the agency problem is less severe when managers hold a large fraction of the outstanding shares in the company. If managers hold a small fraction, they work less vigorously or consume excessive perquisites because they bear a relatively small portion of the resulting costs. Therefore, agency theory argues that managerial ownership is a self monitoring mechanism and also bonding mechanism. Managerial stock ownership can reduce agency costs by aligning the interests of a firm's management with its shareholders. Managerial ownership bonded management personal wealth to firm value (shareholders wealth) (Jensen and Meckling, 1976; Rozeff, 1982; and Easterbrook, 1984).

Furthermore, institutional stock ownership can also decrease agency costs by monitoring firm. According to Shleifer and Vishny (1986), ownership concentration creates the incentives for large shareholders to monitor the firm's management, which overcomes the free-rider problem associated with dispersed ownership whereby small shareholders have not enough incentives to incur monitoring costs for the benefits of other shareholders. Due to active monitoring from shareholders, managers are better aligned towards the objective of delivering shareholder value. In addition, institutional investors also finding it increasingly difficult to sell large portions of stock without depressing stock prices. Therefore, many institutional investors choose to monitor the actions of firm managers more effectively to increase stock performance rather than selling their holding at a loss. Consequently, institutional investors are actively working to effect corporate policy decisions.

2.2.2 Lintner Dividend Stability Theory and other Related Theories/Models

Lintner (1956) is among the pioneers to theorise on corporate dividend behavior through Lintner stability dividend theory. Lintner had conducted a classic series of interviews with 28 corporate managers about their dividend policy. He then proceeded to formulate a seemingly logical model of how companies decide on dividend payments. Dorsman, Montfort and Vink (1999) summarized Lintner's survey in four “stylised facts”. First, firms have long-term target dividend payout ratios. Second, managers focus more on dividend changes than on absolute levels. Third, dividend changes follow shifts in long-term, sustainable earnings. This trend implies that managers tend to “smooth” dividends so that changes in transitory earnings are unlikely to affect dividend payments over the short term, and lastly, managers are reluctant to make changes to dividends that might have to be reversed. They are particularly concerned about having to rescind a dividend increase.

Based on these conclusions Linter developed a model, which has become known as the Lintner model, to explain the change in dividends each year. One assumption in this model is that managers will try to pay an amount of dividends that is an optimal percentage of the profit made. This is explains for the equation:

D*ti = rEti (1)


D*ti = the target level dividend of dividend for fund i year t.

r = the optimal amount of dividend as a percentage of the profit, for fund i.

Eti = the profit company i made in year t.

The value of r will be between 0 and 1 since companies usually won't pay more dividends then that there was profit.

When the profit changes the actual amount of dividend paid differs from the optimal amount that follows out of (1). To compensate for this difference the company will gradually adjust the dividends. This is what can be seen in the next equation:

Dti –D(t-1)i= c(D*ti - D(t-1)i) (2)


c = Velocity at which a company adjusts the dividend

The velocity (C) will be between 0 and 1. Higher values of C correspond to higher velocity in adjusting the dividends. Lintner also introduced a constant term. Because it is assumed that corporations are reluctant to decrease dividends, this constant term would have to be positive. This constant term together with equations (1) and (2) form the Lintner partial adjustment model:

Dti –D(t-1)i= a + βi1 D(t-1)i + βi2 Eti + μti (3)


βi1 = -Ci

βi2 = Ci ri

μti = The random disturbance

Besides the Lintner partial adjustment model, Waud (1966) proposes a second order rational distributed lag function for detailed derivation of the model. According this model, dividends are the results of a `the partial adjustment' and `the adaptive expectations'. It assumes that the target dividends are proportional to the long-run expected earnings (E*). Thus, the equation:

D*ti = rE*ti (4)

On one hand, the actual dividend change will follow a partial adjustment model:

Dti - D(t-1)i = a +c(D*ti – D(t-1)i) + μti (5)

As a result, the formation of expectations follows an adaptive expectation model:

E*ti –E(t-1)i = d(Eti – E*(t-1)i) (6)


Miller and Modigliani's (1961) hypothesis on the irrelevance of dividend policy is not compatible with empirical evidence. This fact implies there must be additional factors that compel firms to pursue a consistent policy of paying dividend. Rozeff (1982) had initiated the adoption of agency cost in dividend determinant. He develop a model of optimal dividend payout in which increased dividends lower agency costs but raise the transaction costs. The optimal dividend payout minimizes the sum of these two costs. Rozeff use two independent variables as proxies for agency cost which are percent of stock held by insiders and the natural logarithm of the number of shareholders. Based on 1000 sample of companies from 1974 until 1980, he shows that dividend payout is negatively related to the percentage of stock held by insiders. Besides that, he also found that outside shareholders demand a higher dividend payout if they own a higher fraction of the common equity and if their ownership is more disperse.

Llyod, Jahera and Page (1985) try to confirm and expand the work of Rozeff in introducing agency theory as an explanatory factor in dividend payout ratios. The researchers had replicate Rozeff's study using more recent data. An OLSQ cross sectional regression is applied to 1984 data on 957 US firms, and the conclusions reached support and strengthen the results of Rozeff. They provide a strong support for their hypothesis of dividends as a partial solution to agency problems.

Jensen, Solberg and Zorn (1992) examine the determinants of cross-sectional differences in insider ownership and dividend policies in the U.S. They analyzed firm data at two points in time, 1982 and 1987on 565 and 632 firms respectively. These policies are found related directly and indirectly through their relationship with operating characteristics of firms. Their empirical results support the hypothesis that levels of insider ownership differ systematically across firms. The results of the analysis support the proposition that financial decisions and insider ownership are interdependent. Specifically, insider ownership has a negative influence on firm's dividend levels. Therefore, this observation supports Rozeff's proposition that the benefits of dividends in reducing agency costs are smaller for firms with higher insider ownership.

Alli et.al (1993) re-examine the dividend policy issues by conducting a simultaneous test of the alternative explanations of corporate payout policy using a two-step procedure that involves factor analysis and multiple regression. The sample of 150 firms came from 34 industries, with the largest share from the chemical and allied products industry (13.9 percent). The average firm size and capitalization of the final sample was representative of New York Stock Exchange (NYSE) listed firms. The results reveal that six significant factors can be used to explain corporate payout policies which include agency cost factor. Although the results shows that ownership dispersion does not affect dividend but the significant positive coefficient of institutional and insider ownership indicates that dividends are used to mitigate agency problem which is consistent with the findings of Rozeff (1982).

Agrawal and Jayaraman (1994) use the sample of all-equity and levered firms which consist of 71 matched pairs. All equity firms are defined as those that use no long term debt throughout a continuous five year period. Their results indicate that dividend yields and payout ratios of all-equity firms are significantly higher than those of levered firms. These results are robust to the choice of the time period used for measuring these variables. They also found that within the group of all-equity firms, firms with higher managerial holdings have lower dividend payout ratios because they are substitute mechanisms for controlling the agency costs of free cash flow. This relationship is more pronounced in all-equity firms since they lack one mechanism for controlling these agency costs. Therefore, their findings support the Jensen's (1986) hypothesis that dividends can be viewed as a substitute mechanism in mitigating the agency costs of free cash flow.

Hansen et.al (1994) tests the relevance of monitoring theory for explaining the dividend policies of regulated electric utilities. They focus on this industry partly because relative to industrial firms, utilities are arguably somewhat more insulated from the discipline of other monitoring mechanism for controlling agency costs. Their tests are conducted in each of two recent five year periods, the first five year period ending in 1985, which is characterized by high but declining industry wide investment growth and financing and the more recent five year period ending in 1990, which is characterized by secular asset growth yet low industry-wide growth. Their findings show that utilities faced with higher regulatory and managerial conflict, lower flotation costs and lower asset growth pay proportionally greater dividends. Their findings are consistent with the monitoring hypothesis that these utilities firms use dividend induced equity financing to control equity agency costs that arise out of the stockholder-regulator and stockholder-manger conflicts.

More support and further contribution to the agency theory of dividend debate, is provided by Moh'd, Perry and Rimbey (1995). These authors introduce a number of modifications to the cost minimization model including industry dummies, institutional holdings and a lagged dependent variable to the RHS of the equation to address possible dynamics. The results of a Weighted Least Squares regression, employing panel data on 341 US firms over 18 years from 1972 to 1989 support the view that the dividend process is of a dynamic nature. Higher dividend payouts are observed when managers hold a low percentage of firm shares, and as the outside ownership becomes more dispersed. This adds support for both Rozeff's and Easterbrook's hypotheses that stockholders seek greater dividend payout as they perceive their level of control to diminish.

The first study that examines the determination of financial policy variables in light of agency concerns in the banking industry is by Mendez and Willey (1995). Their study examines agency theory arguments in the banking industry by analyzing the effect of four variables that proxy for agency costs namely earnings volatility, managers' portfolio diversification losses, bank size and standard deviation of bank equity returns on the three financial policy variables of managerial stock ownership, leverage and dividend yield. The study examines the largest 104 US banks during the period 1985-1989. Evidence support the view that bank managers consider agency costs while trying to determine the most appropriate financial policies (managerial stock ownership, dividends and leverage).

Noronha, Shome and Morgan (1996) develop an agency-cost framework for the simultaneous determination of a firm's capital structure and dividend decisions. In the model, simultaneity is contingent on the applicability of Easterbrook's (1984) monitoring rationale for paying dividends, which, in turn is hypothesized to depend on the existence of alternative sources of monitoring. Estimations of the Rozeff (1982) specification for dividend payout for subsamples stratified according to the prevalence of non-dividend monitoring mechanisms and growth-induced capital market monitoring, confirm the sample-specific validity of the monitoring rationale. A simultaneous system of equations is then estimated and the results reveal that only for the subsample with lower availability of alternative mechanisms the payout rate is related to agency variables. For the subsample with alternative mechanisms in place the payout rates of firms are not related to proxies for agency cost variables.

D' Sauza and Saxene (1999) examine the effects of agency costs on an international firm's dividend policy. He used sample of 349 firms worldwide to determine the relationship between dividend payout and agency cost. The dividend policy of a firm is defined as its dividend payout ratio (the ratio of dividends per share and earnings per share) while the percentage of institutional holdings of a firm's common stock is used as a proxy for controlling agency costs. The dividend payout variable used in the study is a three year average for the period 1995 to 1997, while the institutional holdings pertain to the year 1997. Multiple regression analysis was performed and the result reveals the statistically significant and negative relationship of dividend payout with the explanatory variable institutional holdings. Therefore, these findings are consistent with those of prior studies using United States' data.

Han, Lee and Suk (1999) also empirically examine the effect of institutional on corporate dividend policy. They utilize a sample of 303 firms during the 1988 to 1992 period. They had control seven factors believed to influence dividend policy namely insider ownership, revenue growth, capital expenditures on plant and equipment, ratio of debt to assets, standard deviation of return on assets, operating income to assets and target dividend yield. Nevertheless, using the Tobit analysis, they found a contradict results with agency cost hypothesis but supporting tax based hypothesis. According to tax based hypotheses, dividend payout is positively related to institutional ownership because institutions prefer dividends prefer dividends over capital gains under the differential tax treatment.

Ang, Cole and Lin (2000) measure absolute agency costs by observing a zero agency-cost base case as a reference point of comparison for all other cases of ownership and management structures. Based on the Jensen and Meckling agency theory, the zero agency cost base is the firm owned solely by a single owner-manager. When management owns less than 100 percent of the firm's equity, shareholders incur agency costs resulting from management's shirking and perquisite consumption. They employ a sample of 1708 small corporations and provide a direct confirmation of the predictions made by Jensen and Meckling (1976). Agency costs are indeed higher among firms that are not 100 percent owned by their managers, and these costs increase as the equity share of the owner-manager declines. Hence, agency costs increase with a reduction in managerial ownership, as predicted by Jensen and Meckling.

Manos (2002) had investigated the agency theory of dividend policy in the context of an emerging economy, India. He had modified the Rozeff's cost minimization model by introducing a business group affiliation namely foreign ownership, institutional ownership, insider ownership and ownership dispersion as a proxy for agency cost theory. The model is estimated and tested on a cross-section of 661 non-financial companies listed on the Bombay Stock Exchange. The results reveal a positive impact of all business group affiliation to payout decisions. The positive relationship between foreign and payout indicates that the greater the percentage held by foreign institutions, the greater the need to induce capital market monitoring. Besides that, capital market monitoring is also important when the dispersion of ownership increases since the more widely the ownership spread, the more acute the free rider problem, hence, the greater need for outside monitoring. Further, the evidence of a positive relationship between institutional and the payout ratio is consistent with the preference for dividends related prediction.

Study by Short, Zhang and Keasey (2002) is the first example of using well-established dividend payout models to examine the potential association between ownership structures and dividend policy. They had modified the Full Adjustment Model, the Partial Adjustment Model (Lintner, 1956), the Waud Model (Waud, 1966) and the Earnings Trend Model. Moreover, the paper presents the first results for the UK, where the institutional framework and ownership structures are different from the US. This study is conducted on a sample of 211 firms listed on the London Stock Exchange Official List for the period 1988 to 1992. The result from the four dividends models consistently shows positive and statistically significant associations between institutional ownership and dividend payout ratios and thus suggests a link between institutional ownership and dividend policy.

The study by Khan (2006) investigates how the ownership structure of firms affects their dividends policies. His sample period covers the period of 1985-1997 and the sample size reaches a maximum of 281 firms in 1989 and a minimum of 126 firms in 1985. A key contribution of this article is that it exploits extremely rich ownership data on all beneficial owners (individuals, insurance companies, pension funds and other financial institutions) holding more than 0.25% of any given firm's equity. A significantly negative relation between dividends and ownership concentration result appear to corroborate Rozeff's model, dividends fall when the degree of ownership of ownership concentration increase, which is generally associated with better incentives to monitor. However, the positive relationship between dividends and insurance companies would suggest that they are relatively poor at monitoring compared to individual investors. These results imply particularly acute agency problems when insurance company shareholdings is high and provide some support for the views expressed in the various governance reports.

Harada and Nguyen (2006) analyze the effect of ownership concentration on the dividend policy of Japanese firms from April 1995 to March 2002. Consistent with Khan (2006), they find that firms with high ownership concentration pay lower dividends. Their analysis uncovers a number of agency conflicts. First, tightly controlled firms are less likely to increase dividends when profitability increases and when operating profits are negative. This pattern is consistent with their lower payout and the assumption that dominant shareholder extract private benefits from resources under their control. Second, they also find that tightly controlled firms are more likely to omit dividends when investment opportunities improve which protect the interest of current shareholders. Clearly, this decision reduces the likelihood of requiring further funding that would benefit outside investors.

Mancinelli and Ozkan (2006) reports on empirical investigations into the relationship between the ownership structure of firms and the firm's dividend policy using a sample of 139 listed Italian companies. Ownership structure in Italy is highly concentrated; hence the relevant agency problem of concern seems to be the one that arises from the conflicting interests of large shareholders and minority shareholders. The Tobit regression results support the prediction that higher level of ownership concentration is associated with a higher probability of expropriation of outside shareholders. There are private benefits to the larger shareholders of holding larger amounts of cash; lower dividend payouts will increase the ability of the large shareholders to expropriate the outside minority shareholders. Furthermore, their findings also provide some support for the prediction that managers prefer to hold resources under their control rather than distributing returns to shareholders.

Cook and Jeon (2006) investigate the determinants of foreign and domestic ownership and a firm's payout policy. Their empirical study based on a sample of 507 firms out of the 683 firms listed on Korea Exchange (KRX) for the period 1999 to 2004. The results support the agency model, higher foreign ownership is associated with a greater dividend payout. Domestic intuitional investors, however, do not play a prominent role in a firm's payout policy. Thus, they conclude that foreign investors are more active monitors of corporate by reducing agency problems and leading firms to increase the level of payouts.

The study by Mollah, Rafiq and Sharp (2007) investigates the influence of agency cost variables on dividend policy during the pre and post of the 1998 financial crisis. Using cross-sectional and pooled regression, the paper measures the effect of the percentage of insider ownership, dispersion of stockholders, free cash flow and degree of collateralizable assets on the dividend payout ratio. The pre-crisis sample includes 153 companies for ten years from 1988 through 1997 while the post-crisis sample includes 153 companies for five years from 1999 through 2003. The crisis year of 1998 is omitted. The study finds agency cost variables to have only a modest explanatory power during the pre-crisis period and none in the post-crisis period on the Dhaka Stock Exchange. This result might be due Bangladesh firms having highly concentrated ownership structure, thus an agency cost is insignificant in influencing the dividend policy. The failure of agency cost variables to influence dividends may indicate an impediment to efficient capital information. This failure captures an aspect of an emerging market such as Dhaka that differs fundamentally from more evolved markets.

Mat Nor and Sulong (2007) investigate the relationship between types of ownership structure and dividends on the main board of Bursa Malaysia for the years 2002 and 2005. This data from a sample of 406 firms employs a multiple regression analysis since the data are cross sectional. The results reveal that concentration ownership has a significant positive effect on dividends for both years, but with minimum impact. Results of foreign and managerial ownership on dividends show insignificant relationship in the year 2002, but the results are significant effect on dividends in 2005. The significant positive relationship of managerial ownership with dividends implies that insider shareholdings provide greater incentives for the alignment of management and shareholders' interest resulting in higher dividends. The results also suggest that managerial ownership does play an active monitoring role in Malaysia, one of the emerging economies to mitigate potential managerial discretionary behavior and free cash flow problems. Nevertheless, the negative significant effect of foreign ownership on dividends fails to support the agency argument.

Obema, El-Masry and Elsegini (2008), examine the effect of ownership structure on corporate dividend policies of a sample of top Egyptian listed companies. Ownership structure is measured by four variables namely managerial ownership ratio, blockholder ownership ratio, institutional ownership ratio and free float ratio. The results show that only institutional ownership has a significant relationship with dividend policy. One explanation could be that the institutional blockholders voted for higher payout ratios to enhance managerial monitoring by external capital markets.

The study by Kouki and Guizani (2009) analyze the influence of shareholder ownership identity on dividend policy for a panel of Tunisian firms from 1995 to 2001. This study uses dividend per share as a dependent variable and ownership classes as an independent variables. The results indicate that there is a significantly negative correlation between institutional ownership with the level of dividend distributed to shareholders. This is due to most of cases, institutional investors are banks, and they are either shareholders or debt holders. They prefer paying interests to themselves than distribute dividend to all shareholders. Further, the results also show that the higher ownership of the five largest shareholders leads to the higher of dividend payment. They conclude that dividend rates are higher in Europe when there are multiple large shareholders suggesting that these large shareholders dampen expropriation in Europe. This evidence in Tunisian context strengthens the argument of the positive role of multiple large shareholders in corporate control.

Harjito (2009) examine the influences of agency factors to dividend payout ratio. This research tries to define an appropriate mechanism to decreasing agency cost which represent by dividend payout ratios policy. This study takes data from companies listed in JSX from year 2001 to 2005. The results reveal a significant negative effect of insider ownership on dividend policy. This implies that dividend payment is rise in order to decrease agency problem when there is separation function between corporate ownership and corporate control. Nevertheless, institutional ownership influence dividend payout negatively which is contradict with the agency argument. This might be due to institutional ownership tend to do other investment or expand their business that to pay shareholders. This condition is supported by the better economic atmosphere of Indonesia, which offers good opportunities to invest.


Miller and Modgliani (M&M) claim that under assumption of perfect capital market, dividends are irrelevant and they have no influence on the share price. Nevertheless, when capital markets are imperfect and when the assumptions made by M&M are relaxed, some researchers have argued that dividends do matter; hence firms should pursue an appropriate dividend policy. A difference set of explanatory variables has been hypothesized to distinguish the companies' specific characteristic that influence on the dividend distribution.

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