DETERMINANTS OF DIVIDENDS POLICY: EVIDENCE FROM NON-FINANCIAL COMPANIES LISTED ON ABU DHABI SECURITIES EXCHANGE (ADX) MARWAN BUTROS ABU MANNEH

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1 DETERMINANTS OF DIVIDENDS POLICY: EVIDENCE FROM NON-FINANCIAL COMPANIES LISTED ON ABU DHABI SECURITIES EXCHANGE (ADX) MARWAN BUTROS ABU MANNEH Thesis submitted to the Cardiff School of Management in partial fulfillment of the requirements for the degree of Master of Philosophy Cardiff School of Management Cardiff Metropolitan University Western Avenue Cardiff, UK, CF5 2YB

2 Declaration I declare that this work has not previously been accepted in substance for any degree and is not being concurrently submitted for any other degree. I further declare that this thesis is the result of my own independent work and investigation, except where otherwise stated (a bibliography is appended). Finally, I hereby give consent for my thesis, if accepted, to be available for photocopying and for inter-library loan, and for the title and abstract to be made available to outside organizations. Marwan Abu Manneh (Candidate) Prof. Kamal Naser (Director of Studies) Prof. David Brooksbank (Supervisor) ii

3 Dedication I dedicate this work to both my mother (HELEN EISSA) and my father (BUTROS ABU MANNEH), for all their support, all the guidance they have given me, and all the time they have spent in assisting me, I can never express the amount of gratitude but I hope this can be as a small token of appreciation to them. iii

4 Acknowledgement I am very lucky to have a helpful, supportive, and patient supervisory team, I am very grateful for both Professor Eleri Jones and Professor David Brooksbank for all the support and patience I have received from them, I am also extremely grateful for Professor Kamal Nasser for his unlimited guidance and support which he offered happily. iv

5 Abstract In this study, an attempt is made to establish the relationship between dividend policy and a number of attributes of non-financial companies listed on ADX. Dividend policy was represented by the dividend pay-out ratio calculated by dividing annual dividends paid over the annual income plus annual depreciation expense. Nine explanatory variables were used to represent corporate attributes: size, profitability, growth, ownership, leverage, free cash flows, risk, industry, and issuing or otherwise of governance report. To identify companies attributes that impact their dividend policies, the 2011 annual reports together with profiles for all non-financial companies listed on ADX were used. At the end of 2011, 31 non-financial companies were listed on ADX. The non-financial companies comprise telecommunications, energy, property and real estate, consumer staples, services and manufacturing. Single and multi-regression analyses were undertaken to identify attributes that influence dividend policy. The single regression showed that all variables estimated in the regression model separately were positively associated with dividend pay-out except growth and risk. Yet, only three variables including size, leverage and industry appeared to be significant determinants of dividend. The multiple regression pointed to four out of the nine company s attributes to be the most important factors that influence dividend policy (leverage, free cash flows, ownership and industry), two variables appeared to be positively and significantly associated with dividend policy (leverage and free cash flows). This implies that availability of free cash flows and levels of leverage are the most important factors that shape dividend policies of non-financial companies listed on ADX. The result lends support to agency theory. v

6 Table of Contents Page Declaration ii Dedication iii Acknowledgement iv Abstract v CHAPTER 1: INTRODUCTION INTRODUCTION THE PROBLEM STUDY AGENDA DATA COLLECTION AND STUDY METHODOLOGY OVERVIEW OF THE STUDY LIMITATION OF THE STUDY 8 CHAPTER 2: OVERVIEW OF CORPORATE DIVIDENDS POLICY INTRODUCTION DIVIDENDS POLICY THEORIES Dividend Relevance Theory a Bird-In-Hand Theory b Tax-Preference Theory c Dividend Signaling Theory d Agency Theory e Clientele Effect Dividends Irrelevance Theory DIVIDEND POLICY IN PRACTICE Residual Dividend Policy Stable Dividend Policy a Constant Dividend Per Share b Constant Pay-out Ratio Policy c Low Regular Dividend Plus Extras (Hybrid Dividend Policy) FACTORS INFLUENCING DIVIDEND POLICY External Factors Influencing Dividend Policy a The State of Economy b State of Capital Market c Legal Restrictions d Government Policies e Taxation Policy f Contractual Restrictions Internal Factors Influencing Dividend Policy a Desire of the Shareholders b Investment Opportunities c Stability of Earnings d Desire to Retain the Control of Management e Liquidity position 25 vi

7 2.4.2f Corporate Age g Extent of Shares Distribution h Flotation Costs i Business Cycle j Past and Rivals Dividend Rates k Regularity and Stability in Dividend Payment l Corporate Size and Borrowing Ability m Loan Repayments n Timing of Dividend Payment SUMMARY AND CONCLUSION 28 CHAPTER 3: REVIEW OF STUDIES RELATED TO DIVIDENDS POLICY INTRODUCTION PREVIOUS STUDIES RELATED TO CORPORATE DIVIDEND POLICY SUMMARY AND CONCLUSION 64 CHAPTER 4: DATA COLLECTION AND STUDY METHODOLOGY INTRODUCTION DATA COLLECTION STUDY HYPOTHESES Corporate Size Corporate Profitability Growth Opportunities Ownership Structure Leverage Free Cash Flows Corporate Risk Industry Corporate Governance MODEL DEVELOPMENT STATISTICAL TESTS Univariate Analysis Bivariate Analysis Variance Inflation Factor Multivariate Analysis SUMMARY AND CONCLUSION 82 CHAPTER 5: DATA ANALYSIS AND FINDINGS INTRODUCTION DISTRIBUTION OF THE NONFINANCIAL COMPANIES COVERED IN THE CURRENT STUDY ON DIFFERENT INDUSTRIES MAIN FEATURES OF THE DEPENDENT AND INDEPENDENT 85 VARIABLES EMPLOYED IN THE CURRENT STUDY Dividend pay-out Size Profitability Growth Ownership Leverage Free Cash Flows Risk 97 vii

8 5.3.9 Industry Governance RELATIONSHIP BETWEEN DIVIDEND PAY-OUT AND EACH OF THE 102 EXPLANATORY VARIABLES- SINGLE REGRESSION Size Profitability Growth Ownership Leverage Free Cash Flows Risk Industry Governance Summary of the results of the single regressions RELATIONSHIP BETWEEN DIVIDEND PAY-OUT AND THE 111 EXPLANATORY VARIABLES- MULTIPLE REGRESSION Correlation among the independent variables Relationship between dividend pay-out and all explanatory 112 variables- Full regression Relationship between dividend pay-out and all explanatory 114 variables- Stepwise regression Relationship between dividend pay-out and all explanatory variables- Backward regression DISCUSSION OF THE CORRELATION REGRESSION RESULTS SUMMARY AND CONCLUSION 120 CHAPTER 6: DATA ANALYSIS AND FINDINGS INTRODUCTION DIVIDEND POLICY THEORIES Relevant irrelevant theory Bird- in- Hand Theory Tax- Preference Theory Dividend Signaling Theory Agency Theory DIVIDEND POLICY IN PRACTICE Residual Dividend Policy Stable Dividend Policy FACTORS INFLUENCING DIVIDEND POLICY EMPIRICAL EVIDENCE ON DIVIDEND POLICY OF NON-FINANCIAL 132 COMPANIES LISTED ON ADX The choice of the sample company and the variables used in the study Characteristics of the sample companies covered in the current study Results of the regression analysis 138 Bibliography 140 viii

9 List of Tables Page Table 4.1 Distribution of non-financial companies listed on ADX among 67 various sectors Table 4.2 Distribution of non-financial companies listed on ADX among 78 various sectors Table 5.1 Names of the non-financial companies covered in the study 83 according to industry Table 5.2 Descriptive statistics about corporate dividend pay-out 86 Table 5.3 Descriptive statistics about the growth variable according to 87 industry Table 5.4 Descriptive statistics about the profitability variable according to 89 industry Table 5.5 Descriptive statistics about the growth variable according to industry 91 Table 5.6 Descriptive statistics about the majority shareholders variable 92 according to industry Table 5.7 Descriptive Statistics about the leverage variable according to 94 industry Table 5.8 Descriptive Statistics about free cash flows variable according to 96 industry Table 5.9 Descriptive statistics about the risk variable according to industry 98 Table 5.10 Descriptive statistics about classification of companies used in this 99 study according to industry Table 5.11 Descriptive statistics about companies issued/ not issued 100 governance report Table 5.12 Descriptive statistics about companies have/ do not have influential 101 personality on their board of directors Table 5.13 Relationship between dividend pay-out and corporate size 103 Table 5.14 Relationship between dividend pay-out and corporate profitability 103 Table 5.15 Relationship between dividend pay-out and corporate growth 104 Table 5.16 Relationship between dividend pay-out and corporate ownership 105 Table 5.17 Relationship between dividend pay-out and corporate leverage 106 Table 5.18 Relationship between dividend pay-out and corporate free cash 107 flows Table 5.19 Relationship between dividend pay-out and corporate risk 107 Table 5.20 Relationship between dividend pay-out and corporate industry 108 Table 5.21 Relationship between dividend pay-out and corporate governance 109 Table 5.22 Relationship between dividend pay-out and existence of one 109 influential personality or more on the board of directors Table 5.23 Summary of the single regression results 110 Table 5.24 Correlations among the Independent Variables 111 Table 5.25 Relationship between dividend pay-out and all explanatory 113 variables Table 5.26 Relationship between dividend pay-out and all explanatory 114 variables- Stepwise regression Table 5.27 Relationship between dividend pay-out and all explanatory 116 variables- backward regression ix

10 CHAPTER 1 INTRODUCTION 1.1 INTRODUCTION Numerous studies have been undertaken to explain dividend policy (Naceur et al., 2006; Pal, and Goyal, 2007; Gill et al. (2010); Naser et al. 2013). Most of these studies, however, have covered developed countries (USA and UK). Limited number of studies has been conducted in developing countries (China, India). Despite these studies, the issue of what determines corporate dividend policy is still unresolved. Dividend policy is important for any company since it is used as a mechanism to signal to the outside world information about a company s prospect of stability and growth (Naser et al, 2013). Shareholders and potential investors formulate investment impressions about companies by looking into the management s ability to initiate dividends. In addition, dividend policy affects the capital structure and investment decision of the company. This in turn can be used by management as well as shareholders to minimize agency costs 1. Managers success is measured by their ability to maximize shareholders wealth. To achieve this objective, managers need to fully understand the dividend policy mechanism. The importance of a dividend policy can be explained by the residual theory. The theory makes the point that companies 1 Some managers tend to increase the dividend payout and force themselves to borrow. This move subjects management to the scrutiny of a third party (lender) to assure shareholders and minimize agency costs. 1

11 choose to pay dividends when they have residual income but cannot find profitable investment opportunities. It can further be argued that the importance of the dividend policy is derived from the fact that it affects corporate share price (See for example: Litzenberger and Ramaswamy, 1982; Yilmaz and Gulay, 2006). Hence, companies prefer not to reduce or eliminate dividend payments as this signals poor performance. Although dividend policy is important to all companies, so far no research has been undertaken to examine determinants of dividend by companies operating in the United Arab Emirates (UAE). In this study, an attempt is made to investigate the dividend policies of non-financial companies listed on Abu Dhabi Securities Exchange (ADX). 1.2 THE PROBLEM As mentioned earlier, shareholders and potential investors look into a company's capability to initiate a dividend. A sound dividend policy is important for investors who value the profit stability of the company. A high and regular corporate dividend policy indicates that the company is doing well. Therefore, enhanced dividends may give an indication about the overall health of the company. Although previous research has attempted to solve the dividend policy puzzle, the issue as to why companies tend to pay dividends is still unresolved (Fischer, 1976; Frankfurter, 1999). However, different reasons have been advanced in the literature to explain corporate dividend policy. Yet, consensus about these reasons has not yet been achieved among researchers. However, all researchers agree that dividend policy is important, as dividend payment is one of the most commonly-observed phenomena in 2

12 corporations worldwide. The broad objective of the current research is, therefore, to identify factors affecting the dividend policies of all non-financial companies listed on ADX. 1.3 STUDY AGENDA The importance of dividend policy can be assessed on the basis of its effects on companies and shareholders. Companies tend to maintain the balance between debt and equity in their capital structure. Hence, they pay dividends from the residual earnings (what is leftover) after meeting all operating and capital expenditures. By doing so, they demonstrate that they have enough money to pay dividends after they have paid for all operating and expansion expenses. Otherwise, the company may be forced to borrow or to issue additional shares to generate funds. This move will influence the debt: equity ratio (capital structure). Hence, a company's management tends to maintain stability in its dividend pay-out in order to reduce uncertainty for investors and to provide them with income. The company can also use dividend pay-out for tax purposes. Dividend payout can be also used by a company's management to signal information about its performance. Companies with high agency costs pay high dividends in order to force managers to go often to the capital markets for needed funds, thus subjecting management to frequent scrutiny and monitoring by market participants. There is no consensus, however, on the effect of a dividends policy on the shareholders or potential investors. Dividends are important to shareholders and potential investors since they indicate the company's 3

13 financial health. Dividends are also attractive for shareholders and potential investors who are looking to secure current income. In addition, changes in dividend pay-out may affect the price of a security. Companies that have a long-standing history of stable dividend pay-outs would be positively/ negatively affected by any changes in their policy. In addition, companies without a dividend history may be viewed favorably when they declare dividends. Contrary to those who make the point that dividends has no effect on shareholders and potential investors, it could be argued that dividend policy is irrelevant since shareholders and potential investors have the ability to create dividends. This might be achieved by them through adjusting their investment portfolios to reflect their own preferences. For example, it is expected that investors who need a steady stream of income would invest in bonds, rather than in shares. Another argument that supports the opinion that dividend payout has no effect on shareholders and potential investors, contends that taxation on a dividend is higher than taxation on capital gains. This reality may deter investors from investing in shares. At the end of 2008 and early 2009, the global financial crisis struck most of the companies in different parts of the world. The main problem facing these companies was securing loans to ensure growth. Banks are currently adopting a conservative lending policy since they do not have enough liquidity and they are trying to avoid the repeat of the credit crisis. Hence, companies should rely on internal sources of finance to fund their activities. This means 4

14 more attention needs to be paid to dividend policy than ever before. It is, therefore, critically important to investigate the determinants of dividend policy of companies listed on ADX. This research is set out to examine the specific factors that have been used in the literature to explain dividend policy. These include: 1. Dividend policy can be used as a mechanism to signal financial information to the outsiders regarding the stability and growth prospects of the firm. 2. Dividends policy can play an important role in a firm's capital structure. 3. Dividend policy can be affected by the firm's investment decisions. 4. According to the "residual dividend" theory, a firm pays dividends only if it does not have profitable investment opportunities. 5. A firm's stock price is affected, among other things, by the dividend pattern. Firms prefer not to reduce or eliminate dividend payments because they are confident of keeping up with their good performance. 6. Because the success of a financial manager is tied to the maximization of shareholder wealth (and firm value), s/he must understand the dynamics of dividend policy. 1.4 DATA COLLECTION AND STUDY METHODOLOGY As mentioned earlier, secondary data will be mainly extracted from the latest annual reports of companies listed on ADX. The annual 2013 report will be used to identify factors that impact dividend policy. Secondary data extracted 5

15 from the annual reports will be used to estimate the following regression model: Div. (pay-out) = β 0 +β 1 SIZ + β 2 PROF + β 3 GRW+ β 4 OWN+ β 5 LEV+ β 6 FCF+ β 7 RISK+ β 8 DPER+ β 9 GOV+ ε Where: Div. (pay-out) = Dividend Pay-out measured by Cash dividends paid/ Annual net income + Annual depreciation expense β 0 = Intercept β 0 β 9 = Parameters of the model SIZ = Size measured by total Assets PROF = Profitability measured by Net Income/ Equity GRW = Growth measured by changes in fixed assets OWN = Ownership measured by percentage of shares owned by majority shareholders LEV = Leverage measured by long-term liabilities/ total assets FCF = Free Cash Flows measured by annual net income minus changes in current assets and changes in fixed assets RISK = Risk is measured by the variance of the company s return to the market return DPER = Dominant Personality- Existence or otherwise of one or more of influential persons on the board of directors of the company GOV = Issuing or otherwise of governance report ε = Standard Error 1.5 OVERVIEW OF THE STUDY 6

16 In addition to the introductory (current) chapter, the study will contain five chapters. A brief summary of each chapter is given below. Chapter 2 Overview of Dividend Policy: This chapter provides insight into relevance and irrelevance of dividend theories. Dividend policies employed in practice are discussed in this chapter. In addition, factors that influence dividend policy are explained in this chapter. Chapter 3 Review of Studies Related to Dividend Policy: All relevant studies published in international journals in English language will be reviewed in this chapter. Since the focus of the current study will be on dividend policy of non-financial companies listed on ADX, the review will be restricted to studies that have focused on non-financial companies. Chapter 4 Data Collection and Study Methodology: In this chapter, data collection and study methodology will be covered in detail. Methods used to collect data will be described together with model development and justifications for all variable that will be used to estimate the model. Statistical instruments and the rationale behind using such instruments will be also included in this chapter. 7

17 Chapter 5 Data Analysis and Findings: In this chapter, the results of the analyses of the collected data will be provided. Explanations of the results will also be given in this chapter. Chapter 6 Summary and Conclusions: This chapter provides a summary and conclusions for the study. 1.6 LIMITATIONS OF THE STUDY The current study is acknowledged to have the following limitations due to time and resource constraints: 1. The current study will focus on companies listed on ADX. To obtain a full picture about the determinants of dividend policy of companies operating in the UAE, companies listed on Dubai Stock Exchange may be included in future research. This may even facilitate comparison between companies listed on the two markets. 2. The focus of the current study is on non-financial companies listed on ADX. An additional study that examines dividend policy of the financial companies listed on ADX may provide a good basis for comparison. 3. Primary data can be used to provide evidence on how company managers in Abu Dhabi formulate their dividend policy which will also be useful. 8

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19 CHAPTER 2 OVERVIEW OF CORPORATE DIVIDENDS POLICY 2.1 INTRODUCTION Corporate dividends policy refers to a decision on whether to retain part of the earnings to reinvest them or distribute them among shareholders. Dividend policy involves elements such as the average fraction of earnings to be paid out over time and whether the firm should maintain a constant dividend growth rate over time. In other words, dividend policy involves decisions on how much and when earnings should be paid as dividends. In theory, dividend policy is determined by factors such as 2 : Availability of profits, availability of profitable investment opportunities, availability of liquidity, level of inflation, share prices, composition of shareholders, company's policy toward dividends stability, contractual restrictions imposed by lenders, access to external sources of funds, and management's attitude and objective. Different theories have been advanced in the literature to explain corporate dividend policy. The main purpose of this chapter is to explore these theories. 2.2 DIVIDENDS POLICY THEORIES In general, two schools of thought exist: relevance and irrelevance theory. While the relevance dividend theory points to a relationship between dividend policy and share price and firm value, irrelevance theory indicates that such a

20 relation does not exist. The succeeding sections provide detailed explanations of these theories Dividend Relevance Theory Financial decisions made by a firm are mainly classified into two broad categories: investment and financing decisions (Baker and Powell, 2005). While investment decisions are concerned with type and amount of assets that the firm wants to maintain, financing decisions are concerned with securing necessary funds to finance these assets. Financing assets take the form of equity or debt. Dividend decisions, however, are considered to be a type of financing decision since they impact the amount of earnings that a firm distributes to shareholders and the amount of earnings retained for reinvestment. Corporate dividend policy refers to a decision on whether to distribute part of earnings among shareholders or retain them for future reinvestment. Dividends policy involves elements, such as the average fraction of earnings to be paid out over time and whether the firm should maintain constant dividend growth rate. In other words, dividend policy involves decisions on how much and when earnings should be paid as dividends. Determining divided pay-out is not straight forward since it is likely to influence shareholders' wealth and the firm's ability to retain profit to invest in profitable investment opportunities. Hence, Pruitt and Gitman, (1991) strongly believe that dividend and financing decisions are interrelated and cannot be separated. For example, if a company decides to pay dividends, this means that less earnings are available to invest in profitable projects. This move might force the company to raise funds externally. Consequently, it is 11

21 not surprising to see some managers viewing dividend policy as a factor that would influence shareholders' wealth and corporate value (Baker et al, 1985; Baker and Powell, 1999a). Thus, dividend policy is relevant to the value of the company. Dividend Relevance Theory Dividend relevance theory is not a new issue. It goes back to the early part of the twentieth century when Williams (1938) claimed that share value is determined by the present value of future dividend and the selling price of the share. This claim has been supported by Graham and Dodd (1951) who emphasized that a share price is influenced by dividend and earnings. The claim was also supported by Gordon (1959) who developed a model that relied on dividends distribution to corporate share value. Accordingly, dividend policy is an important factor in determining the value of the firm. Market price would increase with high dividend pay-out and decline with low dividend payout. Hence, an optimal dividend policy that maximizes the value of the firm can be achieved, although how value maximization can be achieved is still debatable. Dividend relevance theory claims that investors view dividend payout as a sign of management capabilities. Investors look at dividend policy as an important factor in assessing the certainty of a company's profit. Hence, frequent and high corporate dividend policy indicates that the company is very likely to perform well. Therefore, high dividend pay-out is a sign of overall financial health of the company. 12

22 The following models have been developed under dividend relevance theory. Traditional Model This model has been founded by Graham and Dodd (1951). According to this model, the market price of the share increases when a company declares dividend and decreases when it does not. Hence, the market price of shares is positively related to higher dividends. The model can be expressed quantitatively as follows. MP s = M (D+E/3) Where: MP s : Market price per share M : D : Multiplier Dividend per share E: Earning per share Walter s Model 13

23 WALTER S MODEL Walter developed his model on the assumptions that (1) all corporate investments are financed internally through retained earnings; (2) rate of return and cost of capital are constant; (3) the firm either distributes dividends or reinvested internally; Walter s model can be expressed quantitatively as follows. hares MP s = D + (E D) r/k D + (E k k MP s = Market price per share D = Dividend per share E = Earnings per share r = Firm s average rate of return k = Firm s cost o capital The effect of dividend payment on the share price is identified by comparing the rate of return (r) and the cost of capital (k). When r > k, the price per share increases as the pay-out ratio decreases (optimal pay-out ratio is nil); When r = k, the price per share does not vary with the changes in the pay-out ratio (optimal pay-out ratio does not exist); When r < k, the price per share increases as the pay-out ratio increases (optimal pay-out ratio is 100%). Gordon s Dividend Capitalization Model 14

24 Gordon (1959) assumes that (1) the firm financed all its investment through equity; (2) retained earnings are used to finance projects; (3) corporate rate of return (r) and cost of capital (k), are constant; (4) no taxes exist; fraction of earnings retained for reinvestment (b) is constant. The model can be expressed quantitatively as follows: MP s = Y (1-b)/(k-br) Where: MP s Y b br r k = the price per share = Earnings per share = fractions of earnings retained for reinvestment = Growth rate = Return on investment = Rate of return required by shareholders When comparing r with k, the relationship between market price and the payout ratio will be identical to that resulted from W alter model a Bird-In-Hand Theory This theory was developed by Lintner (1956) and Gordon (1959). The theory contends that investors are risk-averse and prefer to receive dividend payments rather than future capital gains. Hence, dividend pay-out is relevant and affects the share's market value. Investors value dividends more than capital gains when making investment decisions. Current dividends are relatively certain compared to future capital gains. Therefore, a bird in the hand (dividends) is better than a bird in the bush (capital gains). Gordon (1959) believes that current dividends resolve part of the investors' 15

25 uncertainty. Investors prefer to receive a certain amount of income now rather than waiting for uncertain higher amount of income in the future. According to Litner (1956) and Gordon (1959), since investors believe that dividends are less risky, they discount the firm s dividend stream at a low rate of return, thus increasing the value of the firm s share. In this respect, Gordon (1959) developed the following growth model. SV 0 = D 1 /(r-g) Where: SV 0 = Share Value at the beginning of a period D 1 r g = Dividends paid during the period = Investor s required rate of return = Constant dividend growth rate Linter (1956) and Gordon (1959) think that investors view the rate of return (r) as being less risky than the future growth rate g b Tax-Preference Theory In the long run, retained earnings results in capital gains, Capital gains are taxed at a lower rate than dividends. Hence, taxation is an important consideration for investors. So investors may prefer capital gains to dividends. This is referred to as the "Tax-Preference theory" (Litzenberger, and Ramaswamy, 1979). Needless to say taxes on capital gains are not paid unless the investment is sold. Investors have full control on when tax on 16

26 capital gains is realized, but, they can't control tax on dividends. Consequently, some investors may prefer a low dividend pay-out c Dividend Signaling Theory Dividend signaling theory is based on the asymmetric information where managers have better access, than outsiders, to inside information about the company (Bhattacharya, 1979; Miller and Rock, 1985). They may signal such information with the shareholders and potential investors through their dividend policy in order to reduce asymmetries. Managers may use changes in dividend policy to communicate information to the market about the future prospect of the firm. Constant or increase in dividends pay-out signals positive messages about the future prospects of the company. This would result in an increase in share price. Whereas, not paying or decrease in dividends pay-out might be received negatively by shareholders and potential investors and this would result in a decline in share price d Agency Theory Agency theory assumes that the relationship between shareholders and management is an agency one (Jensen and Meckling, 1976; Easterbrook, 1984; La Porta et al., 2000). There is always a conflict of interest between shareholders and management. While the former tries to maximize their wealth, the latter try to maximize their compensation. To minimize the conflict between them, management tends to take steps to assure shareholders. In this respect, dividend mechanism can be employed by management to reduce agency cost resulting from the conflict of interest with shareholders. 17

27 Increasing dividend pay-out may force management to look for external sources of funds and subject itself to the scrutiny of a third party. Accordingly, an optimum level of dividend pay-out is achieved when minimizing the agency cost e Clientele Effect According to the relevant theory, a firm's share price reacts to changes in dividends policies. The clientele effect assumes that investors are influenced by different company policies, and when a company's policy changes, investors will adjust their shareholdings accordingly (Miller and Modigliani, 1961; Elton and Gruber, 1970; Black and Scholes, 1974). Investors tend to keep the shares that their dividend policy matches their needs. In other words, investors who prefer certain dividends over uncertain future capital gains, will hold shares with a high dividend pay-out, and vice versa. In this case, the dividend policy is not really relevant, but its stability is. As a consequence, investors adjust their investment strategy to suit their needs and this would affect share price. Hence, the clientele effect is the tendency of a firm to attract the type of investor who likes its dividend policy Dividends Irrelevance Theory The above discussion about dividends relevance theory showed that dividends affect the firm's share value and hence the value of the firm. Dividends irrelevant theory, however, indicates that dividend policy is irrelevant in determining the value of the firm. The theory is advocated by a group of financial theorists (Miller and Modigliani, 1961; Miller, 1986; Martin et 18

28 al., 1991) and is based the theory on a number of assumptions: (1) perfect capital market where no taxes and transaction costs exist, a single buyer or seller cannot influence the market price, and there is free access to information; (2) participants behave rationally in the market, they value their securities by discounting future cash flows associated with such investments; (3) certainty about the firm's investment policy and complete knowledge of cash flows; and (4) managers act as perfect agents of the shareholders. Miller and Modigliani (1961) explained that investors can affect the return on their shares regardless of the share's dividend. For example, if an investor expects high dividend pay-out, he/ she could buy more shares from the dividends received above his/ her expectation. In the same fashion, if the investor expects the company to have a small dividend pay-out, the investor could sell some of the company's shares to compensate for the shortage in cash he/ she expects to receive. Consequently, dividend is irrelevant to investors, since they can formulate their own. On the other hand, one of the main weaknesses of the irrelevance theory is the assumption that investors are certain about investment policy of the firm. In this respect, Titman (1984) referred to a link between investment and financing decisions. He believes that shareholders have an incentive to maximize the wealth of other stakeholders of the firm since they incur the cost of liquidating the firm. For example, employees have to look for other job opportunities, and liquidation may increase the maintenance costs of the customers. Hence, the stakeholder s theory developed by Cornell and Shapiro (1987) draws from Titman (1984) and refers to the link between 19

29 investment and financing decisions of the firm. According to them, financing decisions, such as corporate dividend policy, affect the level of operating income. Dividend policy is, therefore, relevant to the share value of the firm. 2.3 DIVIDEND POLICY IN PRACTICE As mentioned earlier, dividend policy determines the allocation of earnings between payments to shareholders and retained earnings. The significance of the dividend policy lies in the firm's management ability to maintain a balance between growth and dividends distribution to the shareholders. Dividend policy is, therefore, an important element in the value of the firm. Firms may adopt residual or stable dividend policies Residual Dividend Policy Companies which rely on internally-generated equity to finance new projects employ residual dividend policy (Aduda and Kimathi, 2011). Residual dividend policy is a method of distribution where dividends are paid after all the requirements for capital are met. Thus, dividends are computed from the residual cash after spending on new capital goods. The aim of this dividend policy is to decide if there is enough money left after all costs are met. In general, residual dividend policy goes through the following steps: 1. Determine the value of operating and expansion expenses (capital budget) required for the year. 2. Determine the total amount of earnings that can be used to finance the expansion. 20

30 3. Use the earnings to finance part or all of the expansion expenses. 4. Any earnings left can then be distributed as dividends Stable Dividend Policy Dividend stability means consistency in the dividend pay-out each year. It refers to regular payments of a certain amount of dividend year after year even if the earnings of the company witnessed fluctuations (Ap Gwilym et al., 2000). This is because shareholders generally value stable dividends better than companies with fluctuating dividend policy. This policy satisfies the demand of some individual and institutional investors in securing regular income. Under a stable dividend pay-out policy, dividends payments can be fairly predicted. This can be viewed as a sign of the firm's financial stability and restores confidence in the firm. The main difference between the residual dividends policy and the stable predictable dividends policy is that while the former is uncertain and fluctuating, the latter is almost certain and stable. Although a stable dividend policy may have a positive impact on the firm, the policy could prove to be dangerous. Once a firm adopts a stable dividend policy, changes in such a policy might be received negatively by the market. On the other hand, stable dividend pay-out can be in the form of a constant amount of dividend per share, constant pay-out ratio, low regular dividend plus extra dividend a Constant Dividend Per Share 21

31 Under this policy, the firm pays an exact amount per share year in year out (Brigham and Ehrhardt 2012). The policy may follow the following steps: 1. Pay the same amount of dividends every year. 2. Base your capital budgeting decisions on what is left from the earnings after paying dividends (residual earnings) b Constant Pay-out Ratio Policy Under the constant pay-out ratio policy, the company sets out a policy to pay the same percentage of earnings every year (Dividend Pay-out Ratio = Dividends Per Share/ Earnings Per Share). Unlike the stable and predictable dividend policy where the amount of dividends is certain, under the constant pay-out ratio policy the percentage of dividends to retained earnings is constant, while the amount of dividends is uncertain and dependent on the value of retained earnings (Brigham and Ehrhardt, 2012). The constant payout ratio policy takes the following steps: 1. Pay a determined percentage of the reported earnings (if achieved). 2. Base your capital budgeting decisions on what is left (residual) of the retained earnings c Low Regular Dividend Plus Extras (Hybrid Dividend Policy) 22

32 Under the regular dividend plus extra policy, the firm is expected to pay a regular minimum amount of dividends each year and to pay extra dividends if it performs better than expected (Marsh, 2012). Under this policy, investors are certain about a minimum amount of income every year. Although this policy provides investors with minimum certain income, it might send negative signals to the market if it continued to pay the minimum amount of dividends. This could be viewed by the market as the company is not making good progress. In all cases, the policy goes through the following steps: 1. Pay a certain amount of dividends every year. 2. In case you performed better than you expected pay bonus dividends. 3. Base your capital budgeting decisions on the residual earnings after paying regular dividends and any bonus dividends. 2.4 FACTORS INFLUENCING DIVIDEND POLICY 3 Dividend policy might be affected by different external and internal factors External Factors Influencing Dividend Policy The following external factors influence corporate dividend policy a The State of Economy: In case that the economy is passing through uncertain economic conditions or recession, management may decide to retain most or all earnings to preserve its liquidity position and absorb future shocks. On the other hand, in case of 3 The following factors are mainly taken from 23

33 economic prosperity, corporate management may decide to maintain a balance between distributing dividends and keeping significant part of the earnings in order to use them in future profitable investment opportunities b State of Capital Market Companies operating in a favorable capital market tend to employ a liberal dividend policy. Whereas, companies operating in unfavorable capital markets are expected to adopt a conservative dividend policy c Legal Restrictions In general, Company Law imposes restrictions on dividends policies in order to protect investors and creditors. Companies Law requires companies to pay dividends from the past or current profits only. Companies are not allowed to pay dividends out of their capital. In addition, companies are not allowed to declare dividends before taking part of the earnings as reserves to cover all current and arrears depreciation d Government Policies Corporate earnings are widely affected by change in government fiscal, industrial, labour, and other government policies. A government may ask companies operating within specific industry not to pay dividends beyond a certain percentage. Thus, corporate dividend policy has to be formulated in line with government policies e Taxation Policy 24

34 Taxation policy is another factor that may impact corporate dividend policy. High corporate taxation reduces earnings and this would affect dividend payout f Contractual Restrictions Lenders tend to put restrictions on the dividend payments to protect their interests, especially when the firm is passing through liquidity problems. For example, the lender might set a clause in the loan agreement forcing the firm not to pay any dividends unless its liquidity ratio is more than 1:1. Or the firm is not allowed to pay any dividends before paying the due amount of the loan Internal Factors Influencing Dividend Policy a Desire of the Shareholders Investors look at two types of return out of their investment in shares: capital gains (increase in the share price) and dividends as a source of regular income that covers part of their running expenses. Many investors look for regular dividends to reduce uncertainty about the company and insure the strength of its financial position b Investment Opportunities If the firm has profitable investment projects and found it difficult and costly to raise funds externally, it may decide to retain the earnings. Normally, firms tend to have low pay-out if they have profitable investment opportunities. 25

35 Conversely, firms which lack profitable investment opportunities tend to have high dividend pay-out. Generally, firms operating in industries which are in the growth phase of the product life cycle are characterized by high dependence on retained earnings. On the other hand, firms operating in industries which are in the maturity and decline stage normally distribute a larger proportion of their earnings as dividends because there is nothing to invest in. Retaining profits will strengthen corporate financial position and increase the working capital for future expansion. Under these circumstances, the firm would distribute a low rate of dividend or not at all and retain a significant part or all earnings c Stability of Earnings A company that has stable earnings can afford to have high dividend pay-out. However, the nature of the business impacts corporate earnings. For example, companies dealing with basic goods and services are more likely to maintain stable earnings than companies dealing with luxury goods or services d Desire to Retain the Control of Management Dividend in the form of shares may lead to dilution in management control on the firm. Hence dividend policy is employed to identify the level of management control. Thus control can be an influencing factor in formulating corporate dividend policy e Liquidity position 26

36 Reporting retained earnings does not necessarily mean cash. Dividend payout results in cash outflow. Availability of cash and sound financial position are, therefore, important factors that influence dividend policy. It is very likely for a firm that has a surplus of cash and good liquidity position to pay more dividends than a firm with a shortage in cash flow and uncertain liquidity position. The liquidity of the firm is related to its investment and financial decisions. Hence, the liquidity position of the firm affects the rate of expansion and the manner of financing f Corporate Age Corporate age can be a determinant factor of dividend policy. A newlyestablished company is expected to use its earnings for future expansion. It will adopt a restricted and unclear dividend policy. A newly-established company takes some time before formulating its dividend policy. A relatively old and well-established company would, however, have less space for expansion and have formulated a clear dividend policy g Extent of Shares Distribution The nature of corporate ownership influences dividends policy. A closely- held company is very likely to expand through retained earnings and to have a restricted dividend policy. On the other hand, if the ownership of the firm is widely spread in the hands of investors with low or medium income, the company would be expected to employ a flexible dividend policy to ensure regular income to shareholders h Flotation Costs 27

37 A firm can raise funds through issuing securities to the public instead of using earnings. This involves flotation costs. These costs include fees payable to the merchant bankers, underwriting commission, brokerage, listing fees, marketing expenses, etc. In addition, in case the size of the issue was small, this involves high flotation costs as a percentage of funds to be raised. Moreover, indirect flotation costs might incur when the securities are underpriced. Usually, issue of additional shares is made at less than the market price. Hence, floating costs should be taken into account when formulating dividend policy i Business Cycle The business cycle experienced by a firm may affect dividend policy. If the firm is going through a boom, it might retain part of its earnings as reserves for possible contingencies in the future. The firm might go for high dividend pay-out in a depressed market in order to market its securities j Past and Rivals Dividend Rates Management can take into account dividends paid in previous years when formulating the current dividend Policy. The current dividend rate should be around the average past rates. Substantial change in dividends rate (whether increase or decrease) would subject the company to speculation. The company may take into account the dividend policy of rival organizations when formulating its own policy k Regularity and Stability in Dividend Payment 28

38 If a firm is adopting a regular and stable dividend policy, it is expected to continue with the same policy. Changes in dividend policy would send negative signals to the market about the firm s financial position and performance l Corporate Size and Borrowing Ability In general, well established and relatively large firms have better access to external sources of funds than newly established and relatively new and unknown firms. These companies may adopt a flexible dividend policy with high dividend pay-out. Conversely, small firms have to depend on internal sources of funds and they have to build up good reserves. Consequently, they tend to have low dividend pay-out m Loan Repayments A firm with high leverage ratio would be expected to retain a significant proportion of its earnings and declare low dividend pay-out, unless arrangements are made of debt redemption on maturity. As mentioned earlier, section f, in some cases the lenders may restrict dividend distribution as long as their loans are outstanding. Some loan contracts require certain liquidity and solvency rates to be met. Management takes such requirements into account when deciding dividend pay-out n Timing of Dividend Payment Another factor that might impact corporate dividend policy is its timing. Dividend pay-out is a cash outflow. It is, therefore, of paramount importance 29

39 to distribute dividends at a time when cash is not needed by the firm. Management can schedule dividend pay-out at a time when there is less need for other cash outflows. 2.5 SUMMARY AND CONCLUSION This chapter presents an overview of dividends policy. It provides insight into the differences between the relevance and irrelevance theories of dividend. Dividend policies adopted in practice are also discussed in this chapter. This chapter also explored possible factors that might influence employment of specific dividend policy. Empirical evidence on dividend policy will be the subject of the next chapter. Model here? 30

40 CHAPTER 3 REVIEW OF STUDIES RELATED TO DIVIDENDS POLICY 3.1 INTRODUCTION Dividend policy needs to be carefully formulated since it affects the capital structure of the firm and the wealth of shareholders together with the value of the firm. Steady dividend pay out sends a positive signal to the market. However, steady dividend pay out may raise shareholders' expectations and makes them dependant on dividend income. Any fluctuations or decrease in the value of dividend pay out may have a negative impact on investors. In addition, maximizing shareholders' wealth may result in a liquidity problem that forces the firm to look for external funding. Furthermore, an increase in dividend pay-out will reduce cash flows available to the firm and prevents it from expanding and investing in profitable projects. This may even restrict firms from paying dividends in the future. It is, therefore, important to formulate dividend policy that strikes a balance between firm's liquidity needs and shareholders' needs. In the last five decades, several studies were undertaken to explain dividend policy. This chapter provides a summary of these studies. 31