Impact of dividend policy on a firm performance

DPO it = Dividend Payout ratio is ROE it = Return on Equity for firm i at

measured as the dividend per equity share time t (in years). Used as a proxy for performance
divided by earnings per share and is measured as net profit after tax
divided by shareholders equity.
FSIZE it = Firms size is measured by the
natural logarithm of the book value of the
firms Total Assets
FLit = Financial leverage is proxied as
the debt to equity ratio. It measures the percentage
of debt over equity
BI it = Board independence relates to
the total non-executive directors over total
number of directors

ROA; net profit divided by total assets), Leverage: Leverage is calculated as the ratio of total
debt to total equity of the company.
Leverage = Total Debt / Total Equity
Size of The Firm: For the purpose of calculating the
variable i-e size of the company, the research used
natural log of total assets of the company.
Size = In (total assets)
DPR = Dividend per share / Earning per share

ROA; net profit divided by total assets),

return on equity (ROE; net profit divided by
shareholders’ equity),
and market-to-book ratio (market value of equity
divided by book value of the equity)

DPO it = Dividend Payout ratio is measured as the ROE it = Return on Equity for firm i at time t (in
dividend per equity share years). Used as a proxy for
divided by earnings per share performance and is measured as net profit after tax
divided by
shareholders equity.
OS it = Ownership structure has been calculated by
the percentage of
shares held by board of directors divided by total
numbers of shares
FSIZE it = Firms size is proxied as total number of
directors present in the
Board of Directors.
Return on Assets (ROA) and Dividend paid out ratio=Dividend per share/Earning per
Return on Equity (ROE) share
Firm size=Total assets
Firms Leverage=Total debt /Total Assets
Growth in sales
 DYit is dividend
yield is calculated as dividend NEit is net earnings defined as earning per share
per share divided by price per share after tax
OWNit is ownership structure defined as numbers
of majority shareholders holding more then 5%
of stocks
MBVit is market to book value of equity
LIQit is turnover defined as the value of stock
traded/stock market capitalization
INVit is slack defined as accumulated retained
earnings/ total assets
SIZEit is size defined as natural logarithm of total assets.
SGit is sales growth defined as percentage change in
sales
LEVit is leverage defined as total debts/ current
year value of equity
Dividend payout ratio ROA : is the ratio of earnings before interest and
(DIVE) taxes to total assets
Dividends/earnings ratio, where earnings are SIZE : is the natural log of total assets
measured after INV : is the ratio of market capitalization to total
taxes and interest but before extraordinary items assets
DEBT : is the ratio of the book value of total debt to
total assets
RISK : is the standard deviation of monthly share
returns
Year-effects : years dummies that,
Industry-effects : industry dummies that take a value
of 1 for companies

DIVIDEND POLICY THEORIES

Over the time various theories of dividend policy have emerged; some of the main theories are as
follows:
3.6.1 The Residual Theory of Dividend Policy
The residual theory of dividend policy holds that the firm will only pay dividend from residual
earnings, that is dividends should be paid only if funds remain after the optimum level of capital
expenditures is incurred i.e. all suitable investment opportunities have been financed.
With a residual dividend policy, the primary focus of the firm is on investments and hence
dividend policy is a passive decision variable. The value of a firm is a direct function of its
investment decisions thus making dividend policy irrelevant.
3.6.2 Dividend Irrelevancy Theory, (Miller & Modigliani, 1961)17
The dividend irrelevancy theory asserts that dividend policy has no effect on either the price of
the firm or its cost of capital.
Dividend Irrelevance Arguments
Dividend policy does not affect share price because the value of the firm is a function of its
earning power and the risk of its assets. If dividends do affect value, it is only due to:
a) Information effect : The informational content of dividends relative to management's earnings
expectations
b) Clientele effect: A clientele effect exists which allows firms to attract shareholders whose
dividend preferences match the firm's historical dividend payout patterns.

A study conducted by Aswath Damodaran18 found that

*(a) Older investors were more likely to hold high dividend stocks and
*(b) Poorer investors tended to hold high dividend stocks
Hence, firms with older investors pay higher dividends and firms with wealthier investors pay
lower dividends.

(b) Signaling effect: Rise in dividend payment is viewed as a positive signal whereas a reduction
in dividend payment is viewed as a negative signal about the future earnings prospects of the
company, thus leading to an increase or decreases in share prices of the firm. Managers use
dividends as signals to transmit information to the capital market. Theoretical models by
Bhattacharya (1979)19, Miller and Rock (1985)20 and John and Williams (1985)21 and Williams
(1988)22 tell us that dividend increases convey good news and dividend decreases convey bad
news.
However, this theory is based on the following assumptions:
1. There is an existence of perfect capital markets i.e. No personal or corporate taxes and no
transaction costs.
2. The firm's investment policy is independent of its dividend policy.
3. Investors behave rationally and information is freely available to them
4. Risk or uncertainty does not exist.
The above-mentioned assumptions exclude personal and corporate taxes as well as any linkage to
capital investment policy as well as other factors that limit its application to real world situations

3.6.3 The Bird in the Hand Theory, (John Lintner 1962 and Myron Gordon, 1963)23, 24
23
The essence of this theory is not stockholders are risk averse and prefer current dividends due to
their lower level of risk as compared to future dividends. Dividend payments reduce investor
uncertainty and thereby increase stock value. This theory is based on the logic that ' what is
available at present is preferable to what may be available in the future'. Investors would prefer to
have a sure dividend now rather than a promised dividend in the future (even if the promised
dividend is larger). Hence dividend policy is relevant and does affect the share price of a firm.
3.6.4 The Tax Differential Theory, (B. Graham and D.L. Dodd)
This theory simply concludes that since dividends are taxed at higher rates than capital gains,
investors require higher rates of return as dividend yields increase. This theory suggests that a
low dividend payout ratio will maximize firm value.
3.6.5 Percent Payout Theory (Rubner 1966)25
Rubner (1966) argued that shareholders prefer dividends and directors and managers requiring
additional finance would have to convince the investors that proposed new investments would
increase their wealth. However to increase their job security and status in the eyes of the
shareholders companies can adopt 100 per cent payout. However this policy is not followed in
practice.
3.6.6 Per Cent Retention Theory (Clarkson and Eliot 1969)26
Clarkson and Eliot (1969) argued that given taxation and transaction costs dividends are a luxury
that is not afforded by shareholders as well as by companies and hence a firm can follow a policy
of 100 per cent retention. Firms can thus avail of new investment opportunities that would be
beneficial to shareholders too.
25
Agency Cost Theory (Jenson)27, 28
Since Jenson and Meckling (1976), many studies have provided arguments that link agency costs
with the other financial activities of a firm. It has been argued that firms payout dividends in
order to reduce agency costs. Dividend payout keeps firms in the capital market, where
monitoring of managers is available at lower cost. If a firm has free cash flows (Jensen (1986), it
is better off sharing them with stockholders as dividend payout in order to reduce the possibility
of these funds being wasted on unprofitable (negative net present value) projects. This modern
view of dividend policy emphasizes the valuable role of dividend policy in helping to resolve
agency problem and thus in enhancing shareholder value.

3.6.8 A Summary View of Dividend Policy Theories

The dividend policy theories focus on the issue of the relevancy of dividend policy to the value of
a firm.
Dividend Irrelevance
Dividends do not make any difference (M & M theory)
If there are no taxes disadvantages associated with dividends.

Dividend Relevance
Dividends are relevant and have positive impact on firm value
If stockholders like dividends, or dividends operate as a signal of future prospects. (Lintner &
Gordon)
Dividends help to resolve agency problem and thus enhancing shareholder value. (Jenson)
Dividends are not good (Graham and Dodd)
If dividends have a tax disadvantage and increasing dividends reduce value.

There are therefore, conflicting viewpoints regarding the impact of dividend decision on value of
a firm.

The dividend decision refers to all techniques used to determine the level of dividends that
can be distributed to shareholders. In the latter, there is a question of choosing between the distribution
of dividends and the capitalization of a grater part of the net profit for the company.
We must first state that the particular interest for the dividend issue has been the subject of
numerous theoretical achievements and empirical studies of testing these theories and sentences
without, however reaching a common point of view, and therefore we can not speak of a uniform
dividend decision but rather of the methods and practices underlying the decision distribution of
dividends.
Moreover, the theory in this area is the least developed and most incomplete. The dividend
decision is the most controversial because the "difficult point" for both the investment decision and the
1
financing decision is the dividend itself.
Theories of dividend decision in literature are the support and the modelers of practices for
the decisions in dividend of Western firms. There are, in particular, two theoretical trends well
crystallized, namely:

theories that promote the distribution of dividends;

theories that discourages the distribution of dividends.

Theories that favor the distribution of dividends are inspired from "Bird-in-the Hand Theory"
based on a plastic expression in English "A bird in the hand is worth in the bush" which, in other words,
means: an U.S. dollar received today as dividend is safe, while future profits obtained as a result of the
reinvestment of that U.S. dollar in the firm is uncertain. Its value is updated at a rate that incorporates
the risk of future investment projects and, as such, it is less.
Myrton Gordon and John Lintner have tried to demonstrate with scientific arguments that
shareholders are not indifferent to paying dividends; the share’s value moving in function of the
evolution rate of the distribution. Thus, they have shown that the dividend decision affects the rate of
return required by shareholders (the cost of the capital), R c, meaning that when there is a reduction in
the rate of distribution of dividends, there is a rise of R c, as shareholders are less confident of capital
2
gains to be generated from accumulated profits reinvested, rather than by paid dividends . In fact, they
were those who said that investors give a higher value to a dividend of U.S. dollars, then to expected
capital earnings of U.S. dollars because of the equation for determining the cost of capital

Re =D1/P0+g
The earning component of dividends (yield dividend), 01PD, i.e. the dividend “in hand” has a lower risk
rate than growth, g, of the dividend per share, i.e. capital gains possible ”in the bush”. Therefore,
investors will demand a higher total income if the capital gains’ component is more important in the
overall than the earnings in dividends. From the point of view of the impact of the dividend on the share,
American specialists and Graham and Dodd believe that "one U.S. dollar distributed in dividends has,
3
in the price of shares, an impact, in average four times grater than one capitalized U.S. dollar” .
Among those who fought the view of Gordon and Lintner were Franco Modigliani and Merton Miller.
They claimed that Rc is independent of the dividend decision, i.e., in other words, investors' attitude
towards the two components from the relationship (1) is the same. They called the argument of Gordon
and Lintner the “sparrow in the hand" mistake because, from the view of Modigliani and Miller most
investors plan reinvesting the amounts received from dividends on shares of the same company or
similar, and in any case, the company's cash flow risk on medium and long term is determined only by
the risk of operational cash flow and not by the dividend decision.
At the other pole, there are the theories that discourage the distribution of dividends, "Residual
Theory," in which the dividend is not in a direct relationship with the profit’s level, as it is considered a
residual variable. The basic idea of these theories is the capitalization of profits for self-investment
projects when their expected profitability exceeds the cost of capital, in fact, an essential criterion of
the theory of finance company.
In general, the dividend decision is very much influenced by investment opportunities and funds
available to finance these investments. Residual dividend theory shows that in order for a firm to
rightfully decide how they divide the net profit (for dividends and self), must take the following four steps:

to determine an optimal investment budget;

to determine the appropriate capital for financing these investments;

to use, as much as possible, the profits accrued for financing investments;

the payment of dividends only to the extent that the net available income is greater than the funds
needed to cover the optimal investment budget.

The question whether firms apply this theory into practice is quite delicate, since it, mostly, involves
irregular payments of dividends, so it becomes optimal only if investors are not disturbed by these
fluctuations of dividends. In general, however, investors prefer stable dividends, and that is why
companies try to stabilize the distribution of dividends, and to print a slightly rising.
In what follows, we try to cover the main theories of dividend decision in the chronological order of
their appearance in the economic literature.
2. Lintner’s partial adjustment model
This model is the result of an investigation conducted on 28 American companies judiciously selected
by Lintner in 1956. The conclusion was that "most shareholders prefer a reasonable dividend, stable,
and that the market reacts positively to the stability or a gradual increase of the dividend”. Thus, the
observed dividend decisions are characterized by a stable rate of distribution of profits, in particular
"with a coupon, generally stable and in regular progression, mathematically modeled as follows:
Dt=a0+c (*t- DD )+et (2)
t-1