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The Effect Of Government Ownership On Dividends Finance Essay

This chapter consists of the collection of the research that had been done in relation to the topic of interest. Most of the collected literatures are about the dividend payout and the factors that are eligible for this research.

2.2 Dividend Payout

Li and Lie (2006) found that the decision to change the dividend and the magnitude of the change depend on the premium that the capital market places on dividends. They also formed that the stock market reaction to dividend changes depends on the dividend premium. Thus, the capital market rewards managers for considering investor demand for dividends when making decisions about the level of dividends. Therefore, a high sensitivity of the stock price to dividend changes should result in a full-dividend-payment solution, while a low sensitivity might lead to dividend cuts or abolishment of the dividend payout. The sensitivity factor can be derived from prior dividends the company and the industry have experienced, or through the process of learning about the investor’s expectations.

Dimitrios Vasiliou et al. (2005) in their study stated that dividend policy of firms could be analyzed by considering the amount of money that firms paid to their shareholders. Dividends could be seen from a shareholders’ side, which emphasizes on the realized dividend yield and another widely used, element that were used to investigate the dividend policy of firms was the firms’ dividend payout ratios. The payout ratio is the portion of earnings that firms distribute to their shareholders, thus it was a variable which captures the policy of firms by comparing their earnings with their total distributed dividends. They also indicated that many researchers used this ratio as the dependent variable and explained the dividend policy of firms by finding corporate variables which significantly affected the level of the distributed dividend.

Grinstein and Michaely (2004), Allen and Michaely (2002), Grullon and Michaely (2002) and Blouin and Nondorf (2004) pointed out that such measures provide an incomplete picture. If a firm increases dividend payment and share repurchase expenditures proportionally, it is difficult to conclude that the dividend policy is more (or less) tilted towards dividends. Rather, such increase is a demonstration of overall increase in payout. Accordingly, we will be focusing on the dividend payout ratio as defined below to better capture the relative importance of dividends as a form of payout rather than changes in the overall amount of firm payout.

Jayesh Kumar (2003), had examined empirically the relationship between the ownership structure, corporate governance and dividend payout using a large panel of Indian corporate firms over 1994-2000. They found unobserved firm heterogeneity which explains a large fraction of cross-sectional variation in dividend payout growth that exists among Indian corporate firms, as found in several studies. They also documented that ownership is one of the important variables which influence the dividend payout policies; though the relationship is different for different class of owners and at different levels. This suggests that the ownership structure does not ifluence dividend pay out policy uniformally. The impact changes over the change in size of the holdings as well as their identity. They expect that firms, for which the interest alignment between different class of owners, is more likely to be severe, less payout of their earnings as dividends. They tested this proposition by estimating the partial adjustment model.

Baker and Wurgler (2003) documented a close link between fluctuations in the propensity to pay dividends and catering incentives. Ramcharran (2001) provided an empirical model of dividend policy in emerging equity markets. Feldstein (1970) examined the corporate taxation and dividend behavior, and found that the policy of different profits taxation had a substantial effect on corporate saving. Baumol et al. (1970) examined the relation between earnings retention, new capital and growth of the firm. Jensen et al. (1992) examined the determinant of crosssectional differences in insider ownership, debt, and dividend policies.

According to Jayesh Kumar (2003), the empirical evidence concerning the possible association of owners and payout policy is extremely limited, none in case of emerging economies. Most of studies had tried to explain these phenomena of dividends and institutional shareholders in developed countries. In a recent study Short et al. (2002) examined the link between dividend policy and institutional ownership for UK firms. They found a positive association between dividends and institutional share-holders and negative association with managerial ownership. In emerging markets like India, Korea, Taiwan, China, etc. the institutional setup is quite different than those of the developed countries.

Nikolaos Eriotis (2002), had stated that given the firm’s investment and financing decisions, a small dividend payment corresponded to high earnings retention with less need for externally generated equity funds. Most firms had a long-term target dividend payout ratio, and that many firms smooth dividends by moving only partway towards the target payout in each year. The dividend decision was associated with the investment decision and the financial mix decision. If the firm paid high dividend, then less money would be available for reinvestment, and consequently might not have enough money to go ahead with their expenditure program. This, in turn, results in a greater reliance on external financing.

As stated by Kent and David (2002), conventional wisdom suggested that a properly managed dividend policy is important to shareholders because it can affect share prices and shareholder’s wealth. It means that by dividend policy, management follows in making dividend payout decisions, which determines the size and pattern of cash distributions over time to shareholders. These distributions may be through dividends and share repurchases. They also indicated that managers could accomplish of having stable dependable dividends by taking estimated firm’s earnings and investment opportunities, and then forecasted that information to find average residual model payout ratio and dollars of dividends finally set a target payout ratio based on the average projected data.

Fama and French (2002) tested the trade-off and pecking order models. Bagwell and Shoven (1989) analyzed the cash distribution to shareholders. Miller and Scholes (1982) re-examined whether shareholders with high dividend yield recieve a higher risk of adjusted rate of return. Gugler (2003) investigated the relationship between dividends and ownership and control structure of the firm for Astrian firms. Black (1976) tried to answer the dividend puzzle. Faccio et al. (2001) provided a quantitative evidence on the expropriation that takes place within business group and on the differences in expropriation between Europe and Asia. Gugler and Yurtoglu (2003) provided a new explanation of why dividends may be informative.

Fama and French (2001), found evidence suggesting that three fundamentals- profitability, investment opportunities, and size, are the factors in the decision making paying dividends. Dividend payers tend to be large, profitable firms with earnings under the order of investment outlays. Firms that have never paid dividends are smaller and they seem to be less profitable than dividend payers, but they have more investment opportunities, and their investment outlays are much larger than their earnings. They indicated larger firms and more profitable firms are more likely to pay dividends while dividends are less likely for firms with more investments.

Fenn and Liang (2001) analyzed how corporate payout policy is affected by managerial stock incentives. Fama and French (2002) analyzed the cause of disappearing dividends. Marsh and Merton (1987) developed a model of the dividends process for the aggregate stock market. Howe and Pin Shen (1998) examined how the intra-industry information effects of dividend initiations announcement. Brook et al. (1998) examined how do firms use dividends to signal large future cash flow increases. DeAngelo et al. (1996) studied the signaling content of managers dividend decisions. Dewenter and Warther (1998) compared dividend policy of US and Japanese firms. Healy and Palepu (1988) found that investors interpret announcements of dividend initiations and omissions as managers forcast of future earning changes.

Reddy (2002) examined the dividend behavior and attempts to explain the observed behavior with the help of trade-off theory, and signaling hypothesis. They supported the earlier finding that dividend omissions have information content about future earnings, but they did not find any evidence in support of the tax-preference theory. Porta et al. (2000) did not find any conclusive evidence on the effect of taxes on dividend policies. Kevin (1992) shows that dividend stability is a primary determinant of payout while profitability is only of secondary importance. Mahapatra and Sahu (1993) did not find evidence in support of Linter's model.

Bhattacharyya (2000) developed a model of dividend payout that is based on the principal-agent paradigm. In his model, uninformed principals (shareholders) set up a menu of contracts to screen agents according to productivity type (which is known to the agent). Higher quality agents are those who have access to more positive net present value (NPV) projects. These agents are induced to invest the firm’s cash rather than pay out dividends. Lower quality agents do not have the same access to positive NPV projects and the compensation contract they choose induces them to pay out higher dividends. In equilibrium, high quality managers receive higher compensation than do low quality managers and pay out lower dividends. Empirically, Bhattacharyya’s model predicts that dividend payout and managerial compensation are negatively correlated.

Fukuda (2000) tested the dividend signaling hypothesis using a Japanese-based data. Benartzi et al. (1997) investigated the information content of dividend changes. Fama (1974) provided empirical relationship between the dividend and investment decision of firms. Porta et al. (2000) outlined and tested two agency models namely, “outcome model” and “substitute model”. Aivazian et al. (2003) found that emerging market firms exhibit dividend behavior similar to those of US. Amihud and Murgia (1997) investigated the relation between dividends, taxes and signaling using a Germany-based data. Kato et al. (1997) analyzed voluntary dividend announcements in Japan.

Mohanty (1999) attempted to examine the behavior of payout after the bonus issue, they found that bonus issuing firms yielded greater returns to their shareholders than those that did not make any bonus issue but maintained a steadily increasing dividend rate. In a survey of manager's perception about dividend decision, Bhat and Pandey (1994) found that payment of dividends depend on current and expected earnings as well as the pattern of past dividends, dividends are used in signaling the future prospects, and dividends are paid even if there is profitable investments opportunity. In an analysis of state-owned enterprises (SOEs), Mishra and Narender (1996) found support for the Linter's model.

In another study, Bradley, Capozza and Seguin (1998) examined the link between cash-flow volatility and dividend payout. Using the asymmetric and signaling theories, they developed a single-period model that predicts a negative relationship between dividend payouts and cash-flow volatility. They argued that firms with cash flow volatility would seek to minimize the penalty associated with dividend cuts by announcing a lower current dividend. Using a sample of seventy-five equity REITs over the 1985 – 1992 periods, the authors found evidence of a negative relationship between cash-flow volatility and dividend levels. In addition, REITs with low debt to total assets ratio and large, well diversified property portfolios pay out more dividends.

Hurley and Johnson (1998) proposed a generalised Makov dividend discount model. Feldstein and Green (1983) provide a model of market equilibrium to explain why firms that maximise the value of their shares pay dividends. Miller and Modigliani (1961) in their seminal work, analyzed the effect of dividend policy on the current price of its shares Miller and Rock (1985) extended the standard finance model of the firms dividend by allowing the firms manager `insider' to know more about the firm's financial health than `outside' investors. Barclay et al. (1995) analyzed the relationship between leverage and dividends choice. Kumar (1988) showed that there is an existence of coarse dividend-signaling equilibria.

Brennan and Thakor (1990) developed a theory of choice for distribution of cash from firm to shareholders. Black and Scholes (1974) tested the effect of dividend yield on the stock returns, after dividend announcements. Gorden (1959), in his seminal work, proposed that even in the presence of perfect capital markets, the existence of uncertainty about the future cash flow, will suffice to make the price of shares dependent upon the dividend policy. Lang and Litzenberger (1989) tested the cash flow signaling and free cash flow in order to explain of the impact of dividend announcements on stock prices.

Easterbrook (1984) presented two agency cost explanations for changes in dividend payouts. Lalay (1982) investigated a large sample of bond indentures focusing on connection between shareholders and bondholders on the dividend decision. Bhattacharya (1979: 1980) derived the existence conditions for a non dissipative signaling model and showed that dividends are signals for future cash flows.

Aharony and Swary (1980) argue that dividend payments can serve as market signals, conveying asymmetric information regarding the firm’s future earnings. Kallberg et al (2003) reported that the current dividend payout of REITs is a credible signal of the future prospects of the firm. The dividend pricing model is also reported to be a better model that fit REITs than other equities.

2.3 Government Ownership and Dividend Payout

2.4 Size of firm and Dividend Payout

Khamis Al-Yahyaee, Toan Pham and Walter (2007), in their study stated that variables such as size had the potential to influence a firm’s dividend policy. Larger firms have an advantageous position in the capital markets to raise external funds and are therefore less dependent on internal funds. Furthermore, larger firms have lower bankruptcy probabilities and therefore should be more likely to pay dividends. This implies an inverse relationship between the size of the firm and its dependence on internal financing. Hence, larger firms are expected to pay more dividends. The coefficient on size is significant at all reasonable levels with a positive sign indicating that larger firms are more likely to pay dividends.

Ferris, Nilanjan Sen and Ho Pei Yui (2006), in their study examined whether the decline in the number of dividend payers is purely a U.S phenomenon or is part of a global trend. They examined the characteristic of dividend payers on the basis of profitability, size, and investment opportunities. They used total assets in measuring size of firm. They found that firm size and profitability have significant positive influences on the decision to pay dividends.

Sawicki (2004) provided results that firm size was positively related to dividend payout. She indicated that as the size of a firm increases, shareholders are not able to monitor the firm effectively and this results in weak control of management. Thus, shareholders will demand higher dividend payout, which acts as an indirect monitoring tool. High dividend payout leads to the increased need of external financing which in turn leads to increased monitoring of these firms by both existing and potential creditors. Besides, she also found that large firms will choose to distribute a larger proportion of their earnings to shareholders through dividends rather than pumping more financial resources into expansion plans as to ensure the safety of investors’ funds. In addition, she also provided results that dividend payout and firm size for government-linked companies are negatively related. As many of the larger firms are government- linked companies, there are already disclosure regulations in place to prevent misuse of funds. Moreover, larger firms that focused on research and development require large amount of financial resources. Thus, dividend payout ratio may be smaller for these large firms.

Aivazian, Booth, and Cleary (2003) hypothesized that larger firms with better market access should be able to pay higher dividends. They have concluded that both return on equity and profitability positively correlate with the size of the dividend payout ratio. Their study also concluded that firm size also positively correlated with dividend payout. Barclay et al. (2003) studied to see if corporations change their dividend policy following trades of blockholders who have opposite preferences for dividends. Their results indicated that firms seldom change their dividends even after the substitution of a new blockholder. Perez-Gonzalez (2003) investigated a similar issue but finds that firms with large shareholders tend to have lower dividends in years when dividends were more tax disadvantaged.

Mohammed Omran and Pointon (2003) provided results that firm size has also been the subject of attention in dividend policy. It may be expected that smaller firms grow faster through retentions and so there would be a negative relationship between the retention ratio and firm size, and hence a positive relationship between the dividend payout ratio and firm size. The size effect demonstrates that larger firms pay out a higher proportion in dividends. This can be re-expressed in terms of smaller firms, in the whole sample, retaining proportionate more.

Ooi (2001) agreed that firm size plays a significant role in determining the dividend policy of firms. Larger firms tend to have higher payout ratios. Compared to small firms, larger firms have easier access to the capital markets and therefore less dependent on internal funds. He also hypothesized a positive relationship between firm size and dividend payout. His results showed that payout ratio was positively related to firm size and profitability but negatively to total debt ratio. As larger firms less dependent on internal funds, they could afford to pay out higher dividends. Compared to smaller- sized firms, it may be more difficult and expensive to raise external funds. Therefore, they needed to rely more on retained earnings and hence pay lower dividends.

As stated by Gompers and Metrick (2001), institutional investors prefer large and more liquid firms which are also more likely to be dividend paying firms. Thus the results here do not necessarily indicate a significant relation between dividend payout and institutional ownership. Institutional ownership is taken as a control variable in this multivariate analysis. Overall, it appears that dividend-paying firms are different from repurchase-only firms. Dividend-paying firms are comparable in characteristics even though many firms also use additional funds for share repurchases.

Redding (1997) indicated that firm size and market liquidity were important determinants in a company’s decision whether to pay dividends. Large firms are more likely to pay dividends. This is because large firms are more liquid, and the institutional investors that prefer dividend-paying stocks for fiduciary reasons also are large in size and need liquid stocks. In addition, the number of shareholders is included as size is linked to dividend payout. Large companies have more shareholders, and more people are interested in trading the stock, and are therefore more liquid. The findings result showed that large companies and liquid companies were likely to pay a large amount of dividends.

In a study by Moh’d (1995), firm size and industry representation function as control variables. Firm size is employed as a control variable for both the transaction cost and agency cost proxies. Industry representation was also used as a control variable as it is an important factor in the payout decision. It was found that dividend payout is positively related to firm size, the amount of institutional holdings, and number of shareholders. It is negatively related to past and future growth, operating and financial leverage risk, intrinsic business risk, and insider shareholdings.

A study by Few, Abdul Mutalip, Shahrin, and Othman (2007) on the dividend policy of Malaysian public listed companies also shows that dividend paying companies are more likely to be larger firms and higher profitability. Their result is consisten with the other studies discussed earlier.

2.4 Dividend Payout and Taxes

Tambah pasal tax kat malaysia

According to (Al-Yahyaee, Pham, and Walter (2005), tax differentials are a major part of the dividend puzzle. One explanation for paying dividends is to minimize agency problems. However, Omani firms are highly levered through bank loans, which reduce the role of dividends in alleviating agency problem.

Chetty and Saez (2005), proposed that the dividend tax cut represented a large increase in the after-tax value of dividends to individual investors This tax change moved from initial proposal to signed law in under five months, and was thus largely unanticipated prior to 2003. Because this tax cut is an exogenous increase in the after-tax value of dividends to individual investors, it represents a unique laboratory for using actual firm behavior to determine the role of taxes and other factors that affect dividend policy.

Julio and Ikenberry (2004) argued that the recent increase in dividend payments cannot be entirely explained by reduced taxation because the recent increase in dividends by firms that already paid dividends began before the tax rate decrease, and many recent dividend initiations have occurred in stocks held predominantly by institutions, where tax motivations are less obvious.

As stated by Chetty and Saez (2004), the finding that taxes are of ‘‘second-order’’ importance is consistent with the research investigating the recent dividend tax cut. It was found that taxes are not of first-order importance for most firms but they are important for the margin of some firms (e.g., 13% of nonpayers). Present numbers are consistent with the survey evidence: As early as 2004, about six percent of nonpayers had initiated dividends since the 2003 dividend tax cut.

Blouin, Raedy and Shackelford (2004), Brown, Liang and Weisbrenner (2004) and Chetty and Saez (2004) – all examined on how firms responded to the 2003 dividend tax cuts. These studies typically employed managerial shareholdings and institutional shareholdings to sharpen their hypothesis tests of the effects of the recent dividend tax cut.

Perez-Gonzales (2003) stated that some studies focus on the impact of changes in dividend policies on the firms’ ownership structure with mixed empirical results. This investigates the predicted linkage between tax rates and payout levels. He found that in a U.S. dataset that firms with large individual shareholders adjust their payouts according to the personal income tax rate, supportive of the static tax clientele model.

Allen and Michaely (2003) pointed out that the major challenge in studying corporate payout policy is to build a framework on the premise that firms maximize shareholders’ wealth while shareholders maximize their own utilities. This challenge is particularly evident in the context of taxes because even if a firm intends to set its payout policy to maximize shareholders’ wealth, the heterogeneous tax status among shareholders would make such an attempt ineffective. In fact, the tax irrelevance view of Miller and Scholes (1978) posited that investors’ diverse tax status should not affect corporate payout decisions since the dividend tax can be effectively laundered.

In equilibrium, as stated by Allen and Michael (2003), firms supply stocks that minimize taxes for each of those clienteles. The empirical support for such a static tax clientele model is mixed. Surprisingly, high tax-bracket individuals in the US hold a large percentage of dividend-paying stocks in their portfolios. Moreover, Richardson et al. (1986) and Michaely et al. (1995) argued that the changes in payout policies do not necessarily lead to adjustments of ownership concentration and structures.

Perez-Gonzalez (2002) documented that tax reforms in the US are followed by the changes of firms’ payout policy that are consistent with tax-induced preferences of the largest shareholders. Thus, it seems that firms do adjust their payout policy as a result of changes in the tax law while shareholders do not seem to rebalance their portfolios significantly by changing the proportions invested in paying and in nonpaying firms.

As proposed by Short et al. (2002), taxation policy is supposedly a key determinant of payout in developed countries in case of India tax policy is different than those of developed countries. In India, dividends have been taxed at a at rate of 10% for quite some time, which has been removed totally recently. Dividend payout may be beneficial, if used to offset tax liability against the capital loss, as after dividend payments the prices of stocks fall.

Foley and Hines (2001) argued that dividend payments from an incorporated subsidiary abroad to its American parent may give rise to tax liabilities within the United States. Accordingly, these potential tax liabilities may figure importantly in the determination of dividend policy for American multinationals. In order to understand these concerns, a description of some of the relevant features of the U.S. tax treatment of American multinational firms follows. Several other concerns, such as the ability to monitor managers overseas and internal capital budgeting, also might influence dividend policy within firms, and are considered separately in Desai.

On the other hand, Grubert and Mutti (2001) said that the complexity of the existing system of taxing American multinationals has prompted renewed interest in the adoption of a system of territorial taxation characterized by the exemption from taxation of dividends received from foreign affiliates. Evaluation of a potential transition to dividend exemption, as envisioned. For example, it requires estimating the revenue consequences of such a change, evaluating the responses of multinational firms to changed investment incentives, as well as the efficiency costs of the existing system.

Grubert and Mutti (2001), along with Grubert (2001a), suggested that the U.S. government revenue would actually increase under a territorial tax regime, as current revenues are minimal and the revenue consequences of changed expense allocation under dividend exemption would be more than any offset losses. Regarding investment incentives, Grubert and Mutti (2001) and Altshulter and Grubert (2001) projected a limited change in the investment patterns of multinationals under dividend exemption given the low repatriation taxes currently paid by U.S. multinationals investing in low-tax countries. The analysis that follows complements these efforts by employing a Lintner framework to estimate the efficiency consequences of the current system of repatriation taxation and the likely response of dividend policies to moving to a territorial tax regime.

Murphy (1999) proposed that executives compensated with options have a personal financial incentive to limit dividends because they face a 100 percent implicit “tax” rate on dividends, both before and after the dividend tax cut. That is, executive options fall in value with the decline in the share price that results from a cash dividend which is not offset by the receipt of the dividend to option holders. Thus, while an executive who holds a large share of their wealth in options would have a personal financial incentive to keep dividend payments low, this is true both before and after the dividend tax cut.

Frank and Jagannathan (1998) investigated the dynamic trading models and it was found that investors of different tax brackets trade around the ex-dividend days to transfer the tax liability of the distribution to investors in low tax brackets. When there are no transactions costs and all risks can be fully hedged, tax can be entirely avoided. The investor’s portfolio choice thus becomes independent of the dividend policy. Empirical studies have shown that large abnormal trading volume exists in almost all stock markets around the world, consistent with the suggestions of the dynamic trading models. However, the price drop over the ex-dividend days is on average less than the dividend, which implies that tax is not entirely avoided by dynamic trading.

Grubert (1998) reported that dividends are sensitive to tax costs in their analyses of cross-sections of tax returns for 1990 and 1992, respectively. Hines and Grubert, offered evidence that the use of alternatives to dividends, such as interest and royalty payments, likewise respond to the tax costs associated with repatriation. Gruber presented somewhat anomalous results suggesting that levels of retained earnings are insensitive to tax costs. This evidence is consistent with the sensitivity of dividends to repatriation taxes under Grubert’s interpretation that repatriation taxes do not affect net investment by subsidiaries, since firms can substitute alternatives to dividends in order to repatriate income to parents.

As proposed by Glen et al (1995), the table revealed an apparent relationship between the tax rates and dividend pay out with the reduction in capital gains tax with effect from 1st January, 1996, dividend pay out as a percentage of after tax earnings rose to approximately 69 per cent while pay out as a percentage of total distributable earnings rose to 14 per cent. The table indicates that on average, about 46 per cent of after tax earnings and 15 per cent of the total distributable earnings are paid out as cash and stock dividend respectively.

Altshuler, Newlon and Randolph (1995) said the cross-section used by Hines and Hubbard makes it impossible to distinguish the effects of transitory and permanent changes in repatriation taxes. They attempted to identify permanent and transitory tax costs by creating an unbalanced panel of subsidiaries using tax returns from 1980, 1982, 1984 and 1986. Permanent repatriation tax costs for subsidiaries are constructed from a first-stage regression that is used as explanatory variables statutory withholding tax rates and average tax rates of other subsidiaries in the same country.

Hines and Hubbard (1990) analyzed a cross-section of U.S. multinationals using tax return data from 1984 in an effort determine the sensitivity of multinational dividends to tax costs. In their sample, Hines and Hubbard noted that large aggregate payouts are the result of selective and infrequent dividend payments by affiliates. Using this cross-section of data, they concluded that a one percent decrease in the repatriation tax is associated with a four percent increase in dividend payout rates. The evidence provided in Hines and Hubbard suggested that tax considerations are very important determinants of the timing of dividend repatriations.

Poterba and Summers (1985) agreed that a higher dividend tax rate relative to capital gain rate increases the tax benefits of share repurchases and affects insiders’ tax preference. Thus, a greater divergence in these two tax rates, compounded with a higher level of insider ownership, should strengthen the tax impact on payout policy. Our results are consistent with this argument. When the tax treatments between dividends and repurchases are more diverse, firms with higher levels of or greater increases in total payouts to insiders are more likely to choose share repurchases as the form of payout.

Hartman (1985) found that, transitory tax costs influence dividend payments while permanent tax costs do not. The effort to disentangle the permanent and temporary tax costs of dividends is limited, however, by the very small number of annual observations for each firm.

Peterson, Peterson, and Ang (1985) agreed with the fact that individuals pay considerable taxes on dividends has been particularly important in the dividend debate, because there appears to be a substantial tax disadvantage to dividends compared to repurchases. Dividends are taxed as ordinary income. Share repurchases are taxed on a capital gains basis. Since the tax rate on capital gains has usually been lower than the tax rate on ordinary income, investors had an advantage if firms repurchased, rather than paid dividends.

Kalay (1982) and Stiglitz (1983) suggested some additional dynamic tax-avoidance strategies and, consequently, claim that the possibility of dividend ‘laundering’ leads firms to the situation analyzed by Miller and Modigliani, in which dividend policy is irrelevant. Elton and Gruber (1970) stated that the tax-related literature on dividend policy focuses on the role that tax plays in the dividend policy. The extent literature can be sorted into two strands: static tax clientele models and dynamic trading models (e.g. Kalay 1982, Michaely and Vila 1995).

According to Blume, Crockett and Friend (1974) Lewellen, Stanley, Lease and Schlarbaum (1978), in the static tax clientele models, investors employ the buy-and-hold strategy, and according to their tax statuses they choose the stocks that would minimize their tax liabilities. When the tax environment changes, the static models predict that either the firms adjust their dividend policies to fit the tax preference of the clienteles or there will be an ownership shift. Previous empirical studies provide contradicting evidences on the relationship between investor tax status and dividend yield.

2.5 Dividend Payout and Profitability

Amihud and Li (2004) cast doubt on the hypothesized relation between dividend changes and future earnings. By contrast, other recent studies including Garrett and Priestley (2000) as well as Nissim and Ziv (2001) found evidence that dividend changes provide information about the level of profitability in subsequent years. In addition, survey evidence by Baker and Powell (1999) and Baker, Powell, and Veit (2001) showed that managers of U.S. corporations strongly agree with the signaling explanation for paying dividends.

As proposed by DeAngelo et al. (2004) it was expected to be a strong impact of changes in profitability. On the other hand, consistent with Baker and Wurgler (2004), there needs to be a fairly strong component that cannot be explained by changes in the firms’ characteristics across time. Moreover, we must also be reminded that the 1980’s and 1990’s is a period known for strong technology and internet companies that are normally small, less profitable, and therefore less prone to paying dividends.

DeAngelo and DeAngelo (2004) suggested, changes in profitability can explain about 36 percent of the trend in dividend payers. On the other hand, other changes not related to firm characteristics can explain about 44 percent of the trend in dividend payers. A possible explanation to this effect is the catering theory of Baker and Wurgler (2004)

Aivazian, Booth, and Cleary (2003) concluded that both return on equity and profitability positively correlate with the size of the dividend payout ratio. Their study also concluded that corporations with high debt ratios often had lower dividend payments, and firm size also positively correlated with dividend payout. Moh’d, Perry, and Rimbey (1995) also concluded that dividend payout related positively with firm size. Holder, Langrehr, and Hexter (1998) suggested that corporations who placed their business focus on a single business line had lower payout ratios than less focused firms.

Veit, and Powell (2001) found that factors relating to earnings are among the most important factors in determining dividend policy. For example, evidence by Pruitt and Gitman suggested that important influences on the amount of dividends paid are current and past years’ profits, the year-to-year variability of earnings, and the growth of earnings. Thus, it is expected that Norwegian managers to base dividend decisions on those variables found empirically to explain corporate dividend behavior, especially those related to earnings.

Fama and French (2000) found that larger and more profitable firms are likely to pay more dividends. This is due to their ability to sustain the high payout. Mollah et. al. (2000) reported that the number of common stockholders, the level of collateralizable assets, and free cash flow is positively related to dividend payout ratio. Insider ownership on the other hand is positively related to dividend payout ratio.

Benartziet al. (1997) showed that earnings growth rate does not increase subsequent to dividend changes. It had been argued that their results may be attributed to inadequate controls for expected changes in profitability. A procedure that controls for expected change in profitability was utilized and it was shown that profitability declines after dividend increases and the level of dividends does not increase after dividend increases.

Barbee et al (1996) suggested that annual sales may be a more reliable indicator of a firm’ s long-term profitability than earnings. They ascribed this to earnings being more variable due to temporary occurrences, e.g. short-term pricing policies. Senchack and Martin (1987) also made the point that sales are less likely to be affected by accounting discrepancies than earnings. With this in mind, changes in sales are also investigated in terms of dividend policy along with profit margins on sales.

DeAngelo et al (1992) used a US data for 1980-85 to investigate the dividend policy of firms that reported a poor earnings performance after sustained dividend distributions and profitability. They cited a work by Miller and Modigliani (1961), arguing that dividend changes for firms with a track record of profitability can be more reliably viewed as a significant change in dividend policy rather than a continuation of previous policy. DeAngelo et al (1992) discovered that around half of all firms with ten or more year’s prior positive dividends and earnings cut dividends in the initial loss year.

Healy and Palepu (1988) stated that some evidence is found that dividend reductions are a sign that future earnings will be lower than for non-reducers, although the statistical significance of these findings is quite low. However, it was found that an earnings rebound after a loss for dividend reducing firms consistent with amongst others. Finally, the overall debt position of the firm is linked to future profitability, with high debt levels suppressing profitability in future years.

Jensen (1986) argued that excessive free cash flows will lead to management committing moral hazard. A firm with high profitability has the potential to have high free cash flows if high investment opportunities do not exist. Therefore, the agency theory argues that outside shareholders push managers to pay higher dividends in the presence of higher firm profitability. According to Miller and Modigliani’s (1961) information content of dividend (signaling) hypothesis, dividend changes trigger stock returns because they convey new information about the firm’s future profitability. That is, the use of dividends signals management’s confidence in the future. Many others such as Miller and Rock (1985) argued that dividends mitigate information asymmetry between management and shareholders.

In the Malaysia context, the empirical evidence support the results from the other studies conducted outside the country. The studies by Mohamed et al. (2006) showed that firms paid out on average, about 40 percent of their earnings as dividend. A quarter of their operating cash flow was used to pay dividend. The study also confirms the fact that profitability and liquidity were important determinants of dividend payment. Additionally, another study by Few, Abdul Mutalip, Shahrin, and Othman (2007) reported that dividend-paying companies are relatively more profitable, less risky, matured and stable as compared to non dividend paying companies.

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