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3. Literature Review

In this section, the literature on the dividend policy will be explored to broaden our understanding about dividend policy. The attempt is made to find the answers to the questions that have been addressed by the researcher community in previous years, for example, why dividend policy is so important for the management of the companies and also for the investors who have a stake in them by holding their stocks? And can a company increase its value by just changing its dividend policy?

3.1 Why pay dividends?

There are many factors that provoke controversy among finance scholars in order to issue dividends to shareholders and investors. These factors normally include the role of dividends in stock valuation, impact of dividend on stockholder’s wealth and expectation of future cash flows from dividend. Kania and Bacon (2005) referred the statement of Robert Park, emphasizing the need to issue dividends;

“The maximum growth of earnings occurs, other things being equal, when (a) all revenues covering depreciation are reinvested to replace depreciating capital and (b) all earnings are invested, or plowed back, into new and expanded assets. In that extreme case, assuming perfect market and no change in perceived risk or required return, the moneys plowed back into assets would show up dollar-for-dollar in a raise in the price of the stock. Assuming also no tax differences, the investor could look upon dividend receipts at the end of the year as being… an equivalent rise in the market price of the stock by the end of the year. He could treat market appreciation the same as the receipt of dividend income (228-229)”

The Dividend Irrelevancy Theorem of Miller & Modigliani indicates that there is no financial effect on investors by the decision of the firm to distribute dividends or to reinvest earnings. In perfect market the dividends would be equivalent to capital gains without transaction costs or tax considerations. Shapiro (1990) also states by referring MM Theory that there will be no change in shareholder’s wealth due to change in dividend policy without tax consideration, investors will received equal returns as capital gains or dividends as long as company’s investment policy not effected by dividend policy.

There are also some negative aspects linked with payout profits such as agency costs, lost opportunity and potential tax costs. Organizations also face restrictions and limitations imposed by legal constraints, in order to frame their dividend policies, such as capital impairment rule and insolvency rule. If firm decided to pay the dividend and earnings are not enough to cover investment opportunities and dividends, it means the firm has to use expensive external financing methods which results high opportunity cost for the firm. (Shapiro, 1990)

Now the question is why firms offer dividends if they suppose irrelevance in perfect market and negative characteristics? According to Shapiro (1990), investors could be different mathematically to dividend policy but for the behavioural reason dividends are very important and relevant for investors. The transaction costs, taxes and agency costs also make dividend policy so relevant in case of shareholder’s wealth. Basically, the increase in dividend is a positive sign for investors because it decreases the amount of free cash flow for unauthorized use of management. Dickens, Casey, and Newman (2002) also states the importance of factors explaining dividends because of intrinsic model holds that a stock price is a present value of its future dividends.

3.2 Dividend signal future success or not?

One of the most important predictions of dividend signalling hypothesis is that dividend changes are positively correlated with future changes in profitability and earnings. The choice of management to either increase or decrease current dividend may not effect on the present value of the firm but these changes could cause to change the opinions of shareholders and investors. Stability of dividend policy of the firm is always important in terms of eliminating uncertainty as well as potential poor market valuation by investors, and fall in the dividend means negative market responses and causes reduction in stock prices. According to Shapiro (1990), stock prices depend on firm’s dividend policy and the core reason of decline in stock prices occur due to dividend cut. In the same way, dividend payout percentages depend on permanent increase in firm’s earnings.

Another fundamental idea of stable dividend might include the amount of expensive external financing needed by the firm. According to Shapiro, “stable dividend policy further limits the transaction costs paid buy the investor when a variable dividend may result in selling or buying of shares to compensate for the deviation from needed current income”. He also suggests that as first resort external financing methods high dividends provide benefits to investors.

Practitioners believe that management should be able to work in favour of shareholders and the dividend policy of the firm should work to accomplish this goal. For this companies are not entitled to issue dividends where NPV is positive with the rejection of investment projects, by altering the investment policy. Droms (1990) states in his paper, ‘Finance and accounting for non-financial managers’ that earning growth and corporation’s prosperity lead to an increase in dividends, and then increase stock’s value and capital gains.

3.3. Determinants of Dividend Policy

3.3.1 Leverage

The leverage of any firms is very important in way of explaining its dividend policy. Leverage has negative relationship with dividends because the firms with low debt ratios will pay more dividends. “Firms with relatively less debt and more tangible assets have greater financial slack and more able to pay and maintain their dividends” (Aivazian et al. and Cleary, 2003). The agency cost theory of dividend policy supports this argument. However, another argument is turning our attention to the positive relationship of leverage with dividend policy, and this argument is supported by signalling theory. “Firms with high payout ratios tend to be debt financed, while firms with low payout ratios tend to be equity financed” (Chang and Rhee, 1990).

3.3.2 Institutional Ownership

Al-Najjar (2009) states in his paper by referring Short et al. (2002) argument that firms are forced by dividend payments to go to capital markets and will be monitored for additional funds. Here Institutional ownership could be used as monitoring device and will reduce the external monitoring systems. It shows the positive relationship between dividends payments and degree of institutional ownership. Al-Najjar (2009) copied the statement of Short et al. (2002) that “From the tax perspective, there are clear incentives for (tax-exempt) institutions to demand high levels of dividends as a result of the bias in the UK tax system in favour of dividends for tax-exempt shareholders”. This also shows the existence of positive relationship between degree of institutional ownership and dividends.

Few other experts argued that institutional ownership and dividends are alternative signalling devices. To signal good performance, the presence of institutional ownership eases the need of dividends (Al-Najjar, 2009). Therefore, the signalling theory supposes reverse association between institutional ownership and dividends. So, by summarising the whole scenario, it can be said that agency theory and tax preference theory described the positive association between institutional ownership and dividends but on the other hand signalling theory states a negative relationship.

3.3.3 Profitability

The profitability aspect always regard as an important factor that affects the firm’s dividend policy. There is a positive relationship between dividend and profitability of the firm because firms are always willing to pay high dividends if they are gaining high profits. Signalling theory of dividend also support this reality. Profitable firms pay dividends to convey their good financial performance. (Aivazian et al. and Cleary, 2003)

3.3.4 Business Risk

It is also believed that business risk is one of the determinants having negative relation supported by agency theory of dividend policy. “A firm with stable earnings can predict its future earnings with a greater accuracy. Thus, such a firm can commit to pay larger proportion of its earnings as dividends with less risk of cutting its dividends in the future” (Al-Najjar, 2009)

3.3.5 Asset Structure

It is also assumed that there a relationship between firm’s dividend policy and firm’s asset structure. As mentioned by Koch (1999), “Firms with more tangible assets have greater tax benefits without relying on debt, and therefore might be more inclined to use dividend policy to influence information asymmetry and agency costs”. On the other hand it is also argued that there is an inverse relationship between dividend policy and asset tangibility specifically in developing markets. Aivazian et al. and Cleary (2003) states “when the assets are more tangible, fewer short-term assets are available for banks to lend against. This imposes financial constrains on firms operating in more primitive financial systems, where, the main source of bank in short-term bank financing is more primitive financial system, where the main source of debt is short-term bank financing”.

3.3.6 Liquidity

A positive relationship between liquidity and dividend is supported by signalling theory by considering that the firms with high availability of cash will pay high cash dividends as compare to the firms with insufficient cash. Falahati (2010) identify in his paper that liquidity is attached with any particular good, when at least one immediate transaction for cash in exchange the good is made without the risk of settlement delay or default.

The liquidity of the good depends on time and the volume of transactions. For example if the volume is of such transaction is greater at time, the liquidity of that good will be more as well. Falahati (2010) also mentioned the importance of immediate settlement of debts as the requirement of liquidity definition because delay of paying debts in normal circumstances causes insolvency and bankruptcy.

3.3.7 Growth Opportunities

The higher growth opportunities show the expansion of finance by retaining the earnings rather then paying as dividends. Al-Najjar (2009) referred Myers and Majluf’s findings. They stated that firms with high growth opportunities will have low payout ratios and this result supported by agency theory of dividend policy (Aivazian et al. and Cleary, 2003)

3.3.8 Firm Size

It is also understandable that larger firms have easy access to capital market because of their maturity and as compare to small firms they should be able to pay more dividends. Transaction cost explanation of dividend policy support this argument (Aivazian et al. and Cleary, 2003)

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