Theories for Dividend Policy and Factors Affecting Dividend Payout

A Review of the Literature

Prepared for,
11038 Corporate Finance 307
School of Economics and Finance
Curtin Business School
Curtin University
Miri Sarawak Campus

Abstract
The main objective of this literature review is to highlight the major theories for dividend policy that have been discussed and argued by many researchers over the years. It is aim to helping firms’ management to set their dividend policy and provide additional knowledge to investors. The theoretical aspect is agency theory which has negative relationship between percentages of insiders and ratio of dividend payout. The signaling theory is applicable in the real world but there is no evidence to support changes in dividend payout signaling the current and future performance of the firm. Bird-in-the-hand theory which risk adverse investors prefer receive dividend now instead of sell their shares in future for capital gain and this theory was not agreed by MM. Next is tax preference theory to study whether the level of firm leverage ratio will affect the dividend payout but it is not applicable for Indian firms. Lastly will discuss about how firm size and financial leverage can affect the firms’ dividend payout. In conclusion, since firms are free to choose whether to distribute dividend or retained their earnings, so there are not right or wrong theories and factors for dividend policy. Government regulations on firms and corporate governance implement by the firms make the difficulties for researchers to conclude a standard dividend policy can implement by different firms across different country.

1.0 Introduction Dividend policy is a policy follows by management to decide size and pattern of dividend they should pay and in what circumstances they should declare dividend to shareholders (Robinson, 2005). Normally a firm can either use internal sources such as retained earnings and depreciation or external source such as borrowings or raise fund from public by issuing new stock. These two financing decision arise two choices for a firm either choose to declare dividend by using plowback ratio for retained earnings and the proportion of dividend payout is one subtract retention rate. Otherwise, the firm can goes for capital structure choice. The firm has the freedom to decide level of dividend they want pay to their shareholders based on some factors as limitation and regulations required (Moradi, Salehi and Honarmand, 2010). To determine how much portion they should distribute, there are some factors can use as standard to help them determine on distribute more or less dividends. Rafique (2012) conclude that factors that affecting the size of dividend payout include earnings of the firm, firm size, corporate tax, financial leverage, growth and profitability. On the other hand, Malik et al. (2013) found that growth and profitability are insignificant in determining dividend policy.
There are lots of unsolved and controversial issues regarding dividend policy although lots of reviewed and researched had been done by financial economists over the years but still can’t conclude a standard outcome for dividend policy that agreed and followed by every country. The controversial of the dividend policy was described by Black (1976) as “The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that don’t fit together”. Since there are no standard for firm’s management to determine the factors of dividend payout, in different countries have different leading factors to determine the dividend payout decision. According to Okpara (2009), Nigeria pay-out policy’s factors is based last year’s dividends, current ratio and earnings that have significant impact on the dividend payout for future year. There are some sample listed companies chosen from Malaysia to study which are food industries and the result was most of the food industries decided the ratio of dividend declare based on debt equity ratio and it has positive correlated outcome between these two variables (Appannan and Wei Sim, 2011). Thus, it will be a continuous study and arguments will done by researchers in future regarding factors affecting dividend policy until there is a standard outcome that agreed by financial economist and academic scholars and follows by all the firm across different countries.
As mentioned above, firms have freedom to pay dividend to their shareholders or not. It is because without paying the dividend, firm’s income can either being invest by management for acquiring securities, investing in operating assets, distribute as cash dividend or retire firm’s debt (Boanyah, Ayentimi and Frank, 2013). Dividend payment becomes a subject matter to shareholders because normally increase in share prices was leaded by the increased in the dividend payout after announcement from the firms (Norhayati, et al. 2006). Besides, theoretical model of dividend policy is also a debatable and controversial topic. Those theories are used to explain the reason why firm should distribute dividend and the behavior of dividend policy. In Rafique’s (2012) article mentioned seven theories that is applicable to explain the dividend policy which include bird-in-hand theory, agency theory, signaling theory, transaction cost and residual theory, life cycle theory and catering theory.
The aim of this literature review will discuss about the theoretical aspect of dividend policy such as agency theory, signaling theory, bird-in-the-hand theory and tax preference theory. Besides, there will be some discussion bring out from the review work done by of different researchers’ article regarding the theories and highlight some issue about the disagreement of those theories. Of course, in order to prove that these theories are correlated with decision to influence the dividend policy, there will be some empirical studies of real world situation discuss below to support the argument of each theory. Lastly, few factors that may affect the dividend payout such as the size of the firm and financial leverage also will discuss below.
Thus, the main objective of this literature review is to review and conclude some researched done by the economist. This paper might helpful for firms’ management to determine which theories and factors should be used and follows by them in order to set their company’s dividend policy.

2.0 Literature Review
2.1 Theories for Dividend Policy
2.1.1 Agency Theory
Agency relationship is a relationship where managers and shareholders can put trust on each other to achieve their targeted goals. Both shareholders and managers should not violate this agency relationship because the shareholders giving their trust to managers to operate and manage their corporations and the shareholders provide job opportunities to the managers. Most of the researchers believe that one of the reason why firm’s pay dividend to their shareholders is to minimize the agency cost and conflicts between the manager (agency) and the shareholders (principle). Since managers can act on behalf of the shareholders to make decision for the firm, then there is chance for the manager to act based on their own interest rather than shareholders’ interests.
When the firm is making extra earnings, there will be free cash flow exist in the firm and the shareholders wish to decrease the free cash flow to prevent the managers use such surplus cash for retain purposed. Shareholders want the management to increase firm’s wealth instead of shareholders’ wealth. This creates the agency cost and it can be reduced by paying as higher dividend as possible. In shareholders point of view, it is better for firms’ manager to distribute the free cash flow to them in dividend form rather than retained it in the future project which might have chances to create losses when the investment is a negative net present value. In managers’ point of view, firm may bear higher risks to borrow money from the bank institutions in order to distribute dividend to shareholders and for investment purpose if the firm do not made sufficient earnings to cover both dividend and investment opportunities.
The dividend payment can become one of the tools or measurement to monitor firm’s management performance to prevent inappropriate behavior of the managers (Baker and Powell, 1999). Rozeff (1982) agreed with the agency theory explanation for dividend policy and his paper stated that the higher the percentage of outsiders, then there will be a high percentage for such firm to increase their dividend payment in order to minimize agency costs. In contrast, there is a negative relationship between percentages of insiders and ratio of dividend payout.

2.1.2 Signaling Theory Managers act as a legal representative on behalf of shareholders having best knowledge of the firms’ operation and wealth than shareholders. Then there will be asymmetric information created between managers and shareholders, normally the firm’s manager will use dividend as an information delivering tool to reflect the private information and current performance of the firm to outsiders. Thus, investors believe that changes in price of dividend become a signal to the market about current performance and prediction of the companies’ future growth. Besides, dividend announcements also become a signal represents the information regarding the firms’ shares price. Signaling are usually used by managers to deliver information as an actions to notice the investor and public about prevent being take over, indicating future profits, getting external finance or simply want to signal certain information that complied with the parent company’s policy. There are large amount of researchers and respondent supported and agreed with signaling effect model. The studies shows that when there is an announcement of decrease in dividend price, the price of the share will drops due to the announcement and conversely, share prices increase often driven by the announcement of increase in dividend. In real world situation, when there is a cut in dividend will be indicated by investors as a bad news about the firm might perform badly in future. Of course the managers would not simply increase the dividend unless they are certain about the firm going to perform well in future and making expected earnings so that can increase the distribution of dividend in future.
In fact, there was an empirical study did by Li and Zhao (2008) and they conclude that there is no evidence to support the signaling theory of dividend policy. It is because they found out there is a negative coefficient in measuring the asymmetry information regarding factors affecting firms’ to pay dividend. They also suggest that firms will pay lesser dividend when they are in the poor information environment. Although in studies there is no evidence to prove that signaling theory is applicable for dividend policy, but this theory still practice in the real world situation and get supported by many researchers and even agreed by the respondents (investors).

2.1.3 Bird-In-The-Hand Theory Most of the investors are risk adverse so they will try to minimize their risk and invest their money in investment that can guarantee the highest return. For those investors which mostly stick to the risk aversion behavior, they will consider the future cash flow of the firm is unpredictable and uncertainty, so they are preferable the firm to distribute dividend to them when there is an extra earning in the firm which is once or twice a year depends on the firms’ dividend policy and management decision. The impact of such shareholders’ preferences asking for higher payment of dividend ratio will results the required rate of return in future to decrease and increase the firms’ value. The bird-in-the-hand theory explained that the investors’ preference of dividend (bird-in-the-hand) is higher because it is a sure thing to get the dividend when firms is doing well earning extra cash flow rather than capital gains (bird-in-the-bush) in future which is more risky to suffer losses. Hence, firms should increase their dividend payout ratio in order to increase the value of their share price but this statement was argued by Miller and Modigliani.
The dividend-irrelevance theory suggested by Miller and Modigliani (1961) explain that the investors did not prefer either receiving dividend now or earning capital gains in the future because both will either benefit them in different ways. The only matter for investors is the firms invest in positive net present value investment and making profits which can benefit shareholders’ wealth. Miller and Modigliani statement is arguable because the risk that might bear by the shareholders such as managerial capability and business cycle risk are not fully covered by receiving dividend now and capital appreciation in future. Besides, shareholders’ cash needs from receiving dividend cannot fulfill by selling their stocks. Thus, bird-in-the-hand theory is applicable to represents dividend and it is preferable by the investor who willing to take less risk (Shao, Kwok and Guedhami, 2010).
2.1.4 Tax Preference Theory It is important for firms to consider investors’ preferences in determining the dividend policy they should applied since such policy might influence investors’ decision to invest in a firm. Based on this theory, there are two groups of investors, first group of investor are those who fall into the high tax brackets (earning higher income and need to pay higher income tax) and they prefer to receive lower percentage of firms’ earnings. Another group of investors are fall into low tax brackets (earning lower income and need to pay lower income tax) will wish to receive higher percentage of firms’ earnings. This is because investors who fall in range of high group income will need to pay more for income tax when they receive more dividends. Capital gains will be taxed at lower rate compare to dividend, so the investors who fall in high tax brackets normally will prefer the firms to pay lower dividend or non-dividend form as a return (Dhaliwal, Erickson, and Trezevant, 1999). Investors who tend to prevent paying heavy income tax will prefer firm to retained their earnings rather than distribute dividend to them. For shareholders’ who fall in low tax brackets or subject to zero tax rates will prefer to receive higher dividend in returns. This situation implies the tax clientele effect which investors decided to invest in a firm based on the particular tax circumstances stated in the dividend policies set by the firm that can fulfill their requirement (Baker and Powell, 1999). Tax preference theory support that firms should pay lower dividend in order to maximizes their share prices. When a firm is growing, the company will utilize their internal generated funds in order to provide sufficient financial support to their investment projects. Thus, it will increase the external financing for such company and it will affect the company distribute lower dividend because of less free cash flow in the firm. Conversely, firms are able to distribute higher dividend to their shareholders when they are in the slow growth process. Normally such firms having lesser investment opportunity, the free cash flow in the firm will be more than growing firms, so they are able to distribute higher dividend to shareholders. This shows the negative relationship between firm’s growth and percentage of dividend payout. For Indian firms, tax preference theory is not applicable because firms’ growing does not affect Indian firms from paying high dividends and the changes in the tax regime did not influence their dividend behavior (Reddy, 2002).

2.2 What factors Affecting Dividend Payout?
2.2.1 Firm Size It is rational for the investor to think that the bigger the firm size, the larger the dividend will be distributed by the firm. It is because normally larger firms have higher earnings than small firms which can distribute higher dividend for their shareholders. This statement was proved by Eriotis (2005) reports about the dividend distributed each year in Greek was determined by the Greek’s firm size. This explained the large firms is more easy to get access to capital markets easily by decreasing generated funds internally and raise fund at the lower costs so that they are able to distribute higher dividend. Rafique’s hypothesized that there is a positive relationship between firm size and the dividend payout ratio. Since the firm size is measured based on the total assets owned by the firm, so the hypothesis about larger firm need to pay higher dividend is also relates with the agency theory. Lloyd, Lahera, and Page (1985) conducted an empirical study by using firm size as one of the variable will influence firm’s dividend payout ratio and their outcome was consistent with their hypothesis which the larger the companies, the larger the payment of dividend in order to decrease the agency costs.

2.2.2 Financial Leverage The topic of financial leverage do have a significant influence on firms’ dividend payout ratio were studied and agreed by most academic scholars. Firms with high leverage are more sticks to bearing higher risk because the debt must be paid off. Rafique (2012) concluded that these two variables have a direct relationship to influence each other. Financial leverage of a firm is measures based on debt equity ratio as a proxy. He explained that a firm with high leverage level firm will try to keep their internal cash flow as required to make sure they fulfill the duties for protecting their creditors purposed. When the moment firm required maintaining their cash flow internally, it leads to decrease the probability for firm to distribute the dividend to shareholders. A high firm with high level of debt burden will lead to increase in transaction costs. The firms with such condition will try to avoid paying high dividend because by do so will also increase their external financing cost. This lead to an assumption which non-dividend paying firms which not paying dividend regularly because of having high level of leverage and dividend paying firms has low level of leverage that enable them to pay dividend every year regularly. The statement of high leverage firms paying lower dividend was supported by Malik et al. 2013. He conducted an empirical test to study about to what extent the debt can have significant influence on dividend payout. The sample of listed companies chosen was from the KSE-100 Index and the relevant data used were taken from the companies’ official website from the range of 2007 to 2009. First empirical test was using regression model and the result showed there is a significant and positive relationship between the leverage ratio and the behavior of dividend payout.
For the empirical test using probit model concluded the same result as regression analysis which dividend policy has a positive relationship with debt to equity ratio. If a firm have a low debt to equity ratio, it shows good sign which the firm will reduce their debts. Both empirical test and analysis conclude that firms with high debt to equity ratio are unable to pay higher dividend. In other way round, firms with low debt to equity ratio have higher probability to distribute higher dividend as a return to benefits their shareholders. Thus, they disagree with the null hypothesis about there is a negative effect of financial leverage on probability for firms to pay dividend. Ahmed and Javid (2008) conduct the empirical study using sample of listed company from KSE and concluded that there is a negative relationship between leverage and the determinant of dividend policy. They explain the dividend payout policy was determined by the whether there is sufficient money left in the firm. Before a firm decides to pay dividend, they will consider the debt and equity ratio balances of the firm. This shows that firms are practicing the dividend payout is declared only when they confirm that there are free cash flow (after deducting all the expenses and operating costs) in the firm. Besides, there is a regulation required firms to follow which is stated in the corporate law limit firms only can pay the dividend out of the return of equity. 3.0 Conclusion This literature review objective is to highlight the major theories for dividend policy that have been discussed and argued by many researchers over the years. The factors affecting the dividend payment ratio also discussed in this paper which focused on the size of the firm and the financial leverage. All the discussion brought with some evidences to support what had found by the previous researchers. Besides, this literature review raise the arguable issue and different perspective between different researchers based on their empirical test and study conducted to support their own hypothesis.
The first theory discussed was agency theory that shows there is a conflict of interest between managers and shareholders lead to agency costs. The managers need to minimize the agency costs by maximize the dividend payout. Both shareholders and managers will act based on their best interest so paying dividend can be a monitoring tool to measure the integrity of the management team that act to maximize the shareholders wealth rather than retained the money in the firm to maximize their own interest. Agency theory was agreed by many researchers and also supported by Rozeff explained that there is a negative relationship between percentages of insiders and ratio of dividend payout.
Since there is asymmetric information created between managers and the investors, signaling theory was used to deliver the companies private information to the outsiders. This theory was agreed and supported by many researchers and respondents. Li and Zhao disagree with asymmetric information theory and suggest that the firm will pay lesser dividend when they are in the poor information environment. Although no evidence to prove signaling theory is applicable for dividend policy, but in real world this theory was applied by investors to guess firms’ current and future performance. There is an opportunity for the researcher to continue their studies and research to find out sufficient evidence to prove this theory.
Third theory was discussed on bird-in-the-hand theory. This theory explained risk adverse investors’ preferences to received dividend because it is a sure thing to get dividend when the firms are earning money now rather than take risk to wait for capital gains in future because firms might invest in negative net present value project. Miller and Modigliani not agreed with by explaining investors are either prefers dividend or capital gains in future as long as firms’ action can increase shareholders value. MM statement is arguable because the desire of investors want to receive the dollar amount dividend cannot be replaced by selling their shares (capital gains).
Last theory discussed is tax preference theory which there is tax clientele effect categorized investor into two groups which is low tax brackets willing to receive higher dividend and high tax brackets willing to receive lower dividend or allowed company to retained the earnings. This theory was not applicable in Indian firms as stated by Reddy, changes in the tax regime did not influence their dividend behavior. Tax preference theory is only applicable in certain country’s listed companies depends on the corporate tax regulations set by the government and the firms’ dividend policy applied.
Next, firm’s size as a variable to influence dividend payout ratio was discussed above. Rafique’s (2012) hypothesized that there is a positive relationship between firm size and the dividend payout ratio and it was supported by the Lloyd. Last factor discussed is the financial leverage. Firm with high leverage ratio will pay less dividend and vice versa. Rafique conclude that there is a direct relationship between these two variables. On the other hand, Ahmed and Attiya conclude there is a negative relationship between leverage ratio and dividend payout. Both suggestion from different researchers not totally wrong but it is depends on the corporate governance and dividend policy implement by the firm to decide their dividend should pay based on leverage factor or not.
This literature review is helping firms’ management and provide knowledge to investors a clear picture of how dividend policy was defined and what factors can influence the dividend payout decision conclude by different researchers. There is no right or wrong theories although they had concluded different result because dividend policy implement in different country and industry was actually driven by different factors and environment to drives its behaviors. The recommendation suggest is conduct research and study on every country across the world to conclude a consistent standard dividend policy can be implemented by firms in different countries. The difficulties will be the difference of government regulation and corporate governance in every firm in different country is different lead to challenging for every country implement consistent dividend policy.

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