How Do Companies Decide Their Dividend Payment Practices?

Introduction

Dividend policy is a firm’s policy with regards to paying out earnings as dividends versus retaining them reinvestment in the firm. And the terminology of dividend puzzle has motivated many researchers and scholars in finance to study and examine the extent to which dividend policy is influence by firms’ financial decisions or market decisions. Firm’s dividend policy is one of the most puzzling and interesting topics of research. In fact, dividend policy has been described as puzzle with pieces that just do not fit together (Fischer Black, 1976). Traditionally, finance researchers and scholars focus on explanations for dividends which are based on the desire to communication information to shareholders or to satisfy the demand for pay outs from various dividend clienteles (Allen and Michaely, 2003). An alternative view of dividend policy proposed that an optimal pay out policy is driven by the need to distribute the firm’s free cash (DeAngelo and DeAngelo, 2006). An alternative viewpoint of the dividend policy, other researchers believe that the dividend policy is irrelevant to shareholders’ wealth at the absence of imperfections (Modigliani and Miller, 1961). The objectives of this article are to perform literature reviews on the dividend policy and discuss the determinants of dividend policy and then adopt the determinants of dividend policy to scenarios.

Literature Review

The literature review presented in this article discusses both the theoretical background and empirical evidence with regards to dividend policy theories as well as a review of the major dividend policy determinants. Since the advert of influential research on dividend policy, a great number of theoretical models evolved in attempt to solve the debate as to the role of dividends of firms. The main theories of interest are the agency theory, free cash flow hypothesis, the life-cycle theory of dividends. The study also covers the signalling theory, transaction cost theory and the residual theory of dividends. As determinants of dividend policy are concerned, previous studies did not reach a consensus as to the dividend policy that still remain the part of the dividend puzzle. Amongst the determinants of dividend policy, firm risk is a controversial problem. The relationship between firm risk and dividend policy has been discussed in signalling theory (Pettit, 1977) and life-cycle theory (DeAngelo, DeAngelo and Stulz, 2006). It is also questionable whether or not changes in firm risk (unsystematic risk) cause changes in dividend policy. In fact, researchers pay more attention to the role of market risk (systematic risk) in determining dividend policy because they argued that investors diversify their investments in a suitably wide portfolio and the investments which perform well and those which perform badly should tend to cancel each other out, and finally much risks can be diversified away.

Miller and Modigliani Irrelevance Theory

Modigliani and Miller (1961) propose that shares are traded in a perfect capital market, meaning no taxes and transaction costs exist, the share price cannot be influenced by sellers or buyers, investors can access to information for free, securities are valued based on discounted value of cash flows, having a complete knowledge of discounted cash flows and certainty about investment policy of companies, and managers act as good agent of shareholders. According to this irrelevance proposition, Miller and Modigliani suggested that dividends and capital gains are equal when investors consider returns on investment. The only thing impacts the valuation of a firm is its earnings, which is a direct result of the firm’s investment policy and the future prospects. Once investors know about the investment policy, they will not need any additional sources on the dividend of the firm. Thus, the investment decision depends on the investment policy of the firm, not the dividend policy. Again, the irrelevant theory goes a step further to explain that regardless of whether or not a firm pays out dividends, investors have ability to make their own cash flows from the shares depending on their need for cash. If investors need more money than the dividends which the firm distributes to them, they can sell out part of their investment to compensate the difference. Likewise, if investors have no present cash requirement, they can reinvest the dividends they received in the stock market.

Dividend Signalling Theory

This is another hypothesis for the reason why Miller and Modigliani’s irrelevant theory is inadequate as an interpretation of financial market practice is the existence of asymmetric information between managers and outside investors. In M & M’s theory, it assumes that managers and outside investors have the equal information about firm’s current performance and prospects and have access to the firm’s information for free. In fact, managers who run the firm usually possess information about its current performance and future prospects which are not available to outside investors. This informational gap between managers and outside investors may cause the true inherent value of the firm that would be not available to the market. Accordingly, share price may not always be an appropriate tool to accurately measure the firm’s value. In order to bridge the gap, managers may need to share their knowledge with outside investors so that they can more accurately understand the truth of value of the firm. However, look back the history of dividend payout policy, due to the imperfections of information available to investors, dividends become a useful tool from managers to convey private information to the market because investors used visible cash flows to evaluate the firm. On the other hand, dividends may contain implicit information about the firm’s prospects.

High Dividends Increase Share Price (Bird-in-hand Hypothesis)

One traditional view about the effects of dividend policy on firm’s value is that dividends increase firm value. With uncertainty and imperfect information, dividends are valued differently to retained earnings or capital gains. Investors prefer to receive cash dividends rather than future capital gains of shares. Increasing dividend payments may be associated with increases in firm value. As higher dividend payments reduce uncertainty about future cash flows, a high dividend payout ratio will reduce cost of capital and increase share value. But Miller and Modigliani (1961) have criticized this hypothesis and argued that the firm risk is determined by its risky operating cash flows, not by the way it distributes firm’s earnings. That means the riskiness of the firm’s cash flow influences the dividend payments, increases in dividends will not reduce the risk of the firm.

Low Dividends Increase Share Price (Tax-Effect Hypothesis)

In the Miller and Modigliani’s irrelevance theory, it assumes that a perfect market exclude any possible tax effects and also assumes that there is no difference in tax treatment between dividends and capital gains. In real world, taxes exist and may have influenced on dividend policy and the firm value. Generally, there is a difference in tax treatment between dividends and capital gains. Indeed, because the effects of tax may affect the demand for dividends, most investors prefer to receive post-tax returns. When managers seek to maximise shareholders’ wealth by increasing earnings ratio in response to tax preference, taxes may also affect the supply of dividends. This hypothesis suggests that low dividend payout ratio contributes to low cost of capital and then increase the share price. In other words, low dividend payout ratio maximises the firm’s value.

Dividend Policy Determinants

Dividend Policy is subject to debate by researchers for a long time. They have studied the factors that managers should take into consideration when setting the dividend policy. And those factors refer to various accounting variables which are identified to affect the decision of whether pay out dividends or not, the amount of the dividends paid out and whether increase or decrease the dividends.

Liquidity

Liquidity usually measures the ability of the firm to meet its payment obligation. A firm’s liquidity is an essential factor that affects the decision of cash dividends pay out. If the firm has high level of liquidity, high dividends are paid out. Moreover, liquidity could signal the ability of a firm to pay dividends without outside sources of financing.

Next PLC

Barclays PLC

Free Cash Flow/Operating Cash flow ratio measures the relationship between free cash flow and operating cash flow. Free cash flow is most often defined as operating cash flow subtract capital expenditures. In terms of analysis, capital expenditures are considered to be an essential outflow of funds to maintain a firm’s competitiveness and efficiency. Normally, the higher the percentage of free cash flow embedded in a firm’s operating cash flow, the greater the financial strength of the firm.

From the worked Free Cash Flow/Operating Cash Flow ratio of Next PLC and Barclays PLC, it indicated that both companies have higher level of free cash flow and then healthy financial performance. That is, Next and Barclays have the ability to meet the need for cash dividends pay out. However, we captured that Barclays PLC ‘s operating cash flow of £60,711m. This may be due to the uncertainties involved in legal, competition and regulatory matters. The outcome of legal, competition and regulatory matters, both those to which the Group is currently exposed and any others which may arise in the future, is difficult to predict. However, in connection with such matters the Group may incur significant expenses. (Barclays PLC Annual Report, 2016).

Dividend Policy and Firm Risk (Systematic and Unsystematic Risk)

According to the Capital Asset Pricing Model of William Sharpe (1964) and John Lintner (1965), the rate of return on portfolio is affected by two components of risks. These two components of risks are the systematic (diversifiable) and unsystematic (non-diversifiable) risk. Systematic risk is defined as the co-variation of portfolio rate of return with market rate of return. Unsystematic risk represents the share’s variance that is not attributable to the volatility of market as a whole. As the number of the shares increase, unsystematic risk becomes less important because the effects of unsystematic risk of various shares in the portfolio will diversify away.

Barclays PLC

The frequency of cyber attacks continues to grow on an annual basis and is a global threat which is inherent across all industries, including financial sector. As the financial sector remains a primary target for cyber criminals, In 2017, a number of highly published attacks involving ransomware, theft of customer data and service unavailability across a wide range of organisations. The cyber threat increases the inherent risk to the availability of the Group’s data, to the integrity of financial transactions of the Group (Barclays PLC Annual Report, 2017). Due to cyber attacks, resulting in inadequate financial data and even being sued, outside investor may doubt on the financial data of the Group and consider to sell out their shares because they worry about the operational risks would significantly influence the future prospects of the Group.

Next PLC

Next has a longstanding policy of returning surplus cash to shareholders through share buybacks and special dividends, whilst maintaining an appropriate level of debt. Adequate financing facilities are therefore required to support the operational needs of the business.

(Next PLC Annual Report, 2017). In order to mitigate uncertainty in liquidity risks, the Group provide medium and long term financing to support the business. In addition to provision of special dividends and share buybacks, the Group may release surplus cash in form of investment other profitable companies.

References

• Khaled Hussainey, Chijoke Oscar Mgbame, Aruoiwo M. Chijoke-Mgbame, (2011) “Dividend policy and share price volatility: UK evidence”, The Journal of Risk Finance, Vol. 12 (1) pp.57-68
• Mark E. Holder, Frederick W. Langrehr & J. Lawrence Hexter, (1998) “Dividend Policy Determinants: An Investigation of the Influences of Stakeholder Theory”, Financial Management, Vol. 27(3), Special Issue: Dividends, pp. 73-82
• Merton H. Miller & Kevin Rock, (1985) “Dividend Policy under Asymmetric Information”, The Journal of Finance, Vol.4
• Harry DeAngelo, Linda DeAngelo, (2006) “The irrelevance of the MM dividend irrelevance theorem”, The Journal of Financial Economic Vol.79 pp.293-315
• Harry DeAngelo, Linda DeAngelo, Rene M. Stulz, (2006) “Dividend policy and the earned/contributed capital mix: a test of the life-cycle theory”, The Journal of Financial Economics Vol. 81 pp. 227-254
• Paul K. Chaney, Craig M. Lewis, (1995) “Earnings management and firm valuation under asymmetric information”, The Journal of Corporate Finance Vol. 1 pp. 319-345