Dividend Irrevance Theory

CHAPTER ONE

INTRODUCTION

The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth. If a company pays out as dividend most of what it earns, then for business requirements and further expansion it will have to depend upon outside resources such as issue of debt or new shares.

The term ‘dividend policy’ refers to “the practice that management follows in making dividend payout decisions or, in other words, the size and pattern of cash distributions over time to shareholders” (Lease et al. , 2000, p. 29). Dividend policy of a firm affects both the long-term financing and the wealth of shareholders. This issue of dividend policy is one that has engaged managers since the birth of the modern commercial corporation. Surprisingly then dividend policy remains one of the most contested issues in finance. The study of dividend policy has captured the attention of finance scholars since the middle of the last century.

They have attempted to solve several issues pertaining to dividends and formulate theories and models to explain corporate dividend behaviour.

BACKGROUND OF DIVIDEND POLICY

The issue of corporate dividends has a long history and, as Frankfurter and Wood (1997) observed, is bound up with the development of the corporate form itself. Corporate dividends date back at least to the early sixteenth century in Holland and Great Britain when the captains of sixteenth century sailing ships started selling financial claims to investors, which entitled them to share in the proceeds, if any, of the voyages.

At the end of each voyage, the profits and the capital were distributed to investors, liquidating and ending the venture’s life. By the end of the sixteenth century, these financial claims began to be traded on open markets in Amsterdam and were gradually replaced by shares of ownership. It is worth mentioning that even then many investors would buy shares from more than one captain to diversify the risk associated with this type of business.

At the end of each voyage, the enterprise liquidation of the venture ensured a distribution of the profits to owners and helped to reduce the possibilities of fraudulent practice by captains (Baskin,1988). However, as the profitability of these ventures was established and became more regular, the process of liquidation of the assets at the conclusion of each voyage became increasingly inconvenient and costly. The successes of the ventures increased their credibility and shareholders became more confident in their management (captains), and this was accomplished by, among other things, the payment of “generous dividends” (Baskin, 1988).

As a result, these companies began trading as going concern entities, and distributing only the profits rather than the entire invested capital. The emergence of firms as a “going concern” initiated the fundamental practice of firms to decide what proportion of the firms’ income (rather than assets) to return to investors and produced the first dividend payment regulations (Frankfurter and Wood, 1997). Gradually, corporate charters began to restrict the payments of dividends to the profits only. The ownership structure of shipping firms gradually evolved into a joint stock company form of business.

But it was chartered trading firms more generally that adopted the joint stock form. In 1613, the British East India Company issued its first joint stock shares with a nominal value. “No distinction was made, however, between capital and profit” (Walker, 1931, p. 102). In the seventeenth century, the success of this type of trading company seemed poised to allow the spread of this form of business organization to include other activities such as mining, banking, clothing, and utilities. Indeed, in the early 1700’s, excitement about the possibilities of expanded rade and the corporate form saw a speculative bubble form, which collapsed spectacularly when the South Sea Company went into bankruptcy. The Bubble Act of 1711 effectively slowed, but did not stop, the development of the corporate form in Britain for almost a century (Walker, 1931). In the early stages of corporate history, managers realized the importance of high and stable dividend payments. In some ways, this was due to the analogy investors made with the other form of financial security then traded, namely government bonds.

Bonds paid a regular and stable interest payment, and corporate managers found that investors preferred shares that performed like bonds (i. e. paid a regular and stable dividend). For example, Bank of North America in 1781 paid dividends after only six months of operation, and the bank charter entitled the board of directors to distribute dividends regularly out of profits. “Paying consistent dividends remained of paramount importance to managers during the first half of the 19th century” (Frankfurter and Wood, 1997, p. 24)

In addition to the importance placed by investors on dividend stability, another issue of modern corporate dividend policy to emerge early in the nineteenth century was that dividends came to be seen as an important form of information. The scarcity and unreliability of financial data often resulted in investors making their assessments of corporations through their dividend payments rather than reported earnings. In short, investors were often faced with inaccurate information about the performance of a firm, and used dividend policy as a way of gauging what management’s views about future performance might be.

Consequently, an increase in divided payments tended to be reflected in rising stock prices. As corporations became aware of this phenomenon, it raised the possibility that managers of companies could use dividends to signal strong earnings prospects and/or to support a company’s share price because investors may read dividend announcements as a proxy for earnings growth. Subsequent works in the 20thcentury identified three main contradictory theories of dividends. Some argue that increasing dividend payments increases a firm’s value.

Another view claims that high dividend payouts have the opposite effect on the firms value ; i. e. it reduces the firms value. The third theoretical approach asserts that dividends should be irrelevant and all efforts spent on the dividend decision is wasted. In 1961 a proposition that the value of the firm was independent of its dividend policy was made by professors Franco Modigliani and Merton Miller (M&M). Their view was that the market value of a public company is determined only by the investment and operating decisions that generate cash flows.

Capital structure and dividend policy are just ‘financial’ decisions, or ways of dividing up operating cash flows among investors. Both Franco Modigliani and Merton Miller won Nobel Prizes for this contribution. The M&M proposition was the inception of so much academic thinking and financial economists have been producing studies of dividend policy ever since. As often happens, however, different researchers have come to different conclusions that attempt to explain investors’ demand for dividends.

DEFINITIONS

• Dividends Dividend is the distribution of value to shareholders.

It is the payment made by a company to a shareholder usually after a company earns a profit, since dividends are money divided to shareholders after a profit, it is not considered a business expense but a sharing of recognized assets among shareholders. Dividends are either paid regularly or can be called out anytime.

• Dividend Policy

A dividend policy is a set of company rules and guidelines used to decide how much the company will pay out to its shareholder. Part of the profit is kept in the company as retained earnings and the other part is distributed dividends as to shareholders.

• Types of Dividends Cash Dividend

A cash dividend is a payment made by a company out of its earnings to investors in the form of cash (cheque or electronic transfer).

• Stock Dividend/Bonus Shares

A stock dividend is the distribution of shares free of costs to the existing shareholders, the shares are distributed proportionately to the existing shareholders hence, there is no dilution of shareholding (Pandey,2005). The payment of stock dividends neither affects cash and earnings position of the firm nor is ownership of stockholders changed. Stocks Repurchase/Buy Back

This is a program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This is usually an indication that the company’s management thinks the shares are undervalued. Because a share repurchase reduces the number of shares outstanding (i. e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares. When a company does repurchase shares, it is essentially saying that “ it cannot find a better investment than our own company. “(investopedia). Stock Splits

Similar to a stock dividend and is commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder. A stock split is a change in the number of outstanding shares of stock achieved through a proportional reduction of increase in the par value of the stock. The management employs this device to make a major adjustment in the market price of the firm’s stock and consequently in its earnings and dividends per share.

• Scrip Dividend

Scrip dividend means payment of dividend in scrip of promissory notes.

Sometimes company needs cash generated by business earnings to meet business requirements because of temporary shortage of cash. In such cases the company may issue scrip or notes promising to pay dividend at a future date.

• Bond Dividend

As in scrip dividends, dividends are not paid immediately in bond dividends. Instead the company promises to pay dividends at a future date and to that effect bonds are issued to stock holders in place of cash. The purpose of both the bond and scrip dividends is alike, i. e. , postponement of dividend payments.

Difference between the two is in respect of the date of payment and their effect is the same.

• Property Dividends

In property dividend the company pays dividends in the form of assets other than cash. Generally, assets which are superfluous for the company are distributed as dividends to the stockholders.

DIVIDEND POLICIES

The primary purpose of the firm is not payment of dividend. Rather, it is to maximize shareholders’ wealth. Paying dividend in certain situations, may harm, rather than enhance, the shareholders wealth.

A company having profitable growth opportunities will like to retain more and create shareholder wealth. Factors influencing Dividend Policy External factors Following are the external factors which affect the dividend policy of a firm: i)

General state of economy – In cases of uncertainty, depression in the economy, the management may like to retain the earnings and build up reserves to absorb shocks in the future. ii)

Capital Markets – if a firm has easy access to capital markets to raise funds, it may follow liberal dividend policy and vice versa. ii)

Legal Restrictions – the management must comply to all legal restrictions such as transfer to reserves etc. Legal constraints such as the capital impairment rule which prohibits payment of dividends if such payment will result in impairment of capital. iv)

Contractual Restrictions – lending financial institutions may put restrictions on dividend payments to protect their interests. v)

Taxation Policy – consideration of corporate taxes and dividend distribution tax to be paid by the companies. Internal Factors The following are the internal factors which affect the dividend policy of a firm: )

Desire of shareholder – the shareholders, being the owners of the company influence the dividend payout. Their expectation for dividend depicts companies strength, certainty and liquidity. Shareholders’ preference for dividends or capital gains may depend on their economic status and the effect of tax differential on dividends and capital gains. Wealthier shareholders may prefer capital gains as they are taxed at a lower rate while those with small means may be counting on regular dividends. The composition of the shareholders may result in a policy targeted towards serving that clientele. i)

Financial needs of Company – financial needs of the company may directly conflict with shareholders’ desire. Company’s vision for future growth and profitability may bypass the dividend expectation. Firms should tailor their dividend policies to their long term investment opportunities and to have maximum financial flexibility and avoid frictions and costs arising from external financing. This may also depend on the lifecycle stage e. g growth firms having a large number of investment opportunities will opt to retain most of their profits. ii)

Nature of Earnings – a firm with a stable income can afford to have higher dividend payout and vice versa iv)

Desire of Control – the objective of maintaining control over the company by an existing management group or the body of shareholders can also influence dividend policy. Large dividends may affect the firm’s cash position thus necessitating the need to raise new capital to fund investment projects; this in turn may dilute the shareholders control. v)

Liquidity Position – prime importance for dividend payments Common dividend policies are stable dividend policy, constant payout ratio and residual dividend policy. Recently we have also seen hybrid dividend policies emerging. Stable Dividend Policy In the stable dividend policy, management maintains a fixed dividend per share each year. Under this policy a company will pay a fixed amount per annum per share regardless of the fluctuations in its profits. Dividends are increased only after an increase in earnings appears sustainable. The aim of the dividend stability policy is to reduce uncertainty for investors and to provide them with income.

Constant Payout Ratio

In the constant payout ratio situation, management seeks to pay a constant percentage of net earnings as dividend to shareholders in each dividend period e. g 20% of earnings. Dividends fluctuate proportionately with earnings and are likely to be highly volatile in the wake of wide fluctuations in the earnings of a company. This provides clear direction to investors.

Residual Dividend Policy

In a residual dividend policy, profits are used to fund new projects with the residual or remaining profit distributed as dividends. Dividend will only be paid if there are no profitable investment opportunities available.

This policy is consistent with shareholders wealth maximization objective. Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects.

Constant Dividend Plus Extras/ Hybrid

This policy is a hybrid of the residual and stable dividend policy. It is meant to keep expectations low for dividends, and supplement those dividends with bonuses in good years. It is a policy based on paying a fixed dividend to shareholders supplemented by an additional or extra dividend in years of marked prosperity.

Irregular Dividend Policy

Some companies follow irregular dividend payments on account of the following:

1. Uncertainty of earnings.
2. Unsuccessful business operations.
3. Lack of liquid resources.
4. Fear of adverse effects of regular dividends on the financial standing of the company.

No Dividend Policy

A company may follow a policy of paying no dividends presently because of its unfavourable working capital position or on account of requirements of funds for future expansion and growth.

THEORIES OF DIVIDEND POLICY

DIVIDEND IRRELEVANCE THEORY

Prior to the publication of Miller and Modigliani’s (1961) paper on dividend policy, the common belief was that higher dividends increase a firm’s value. However in 1961 M&M demonstrated that under certain assumptions about perfect capital markets, dividend policy would be irrelevant. They stated that in a perfect market dividend policy has no effect on either the price of a firm’s stock or its cost of capital, and shareholders wealth is not affected by the dividend decision and therefore they would be indifferent between dividends and capital gains.

The reason for their indifference is that shareholders wealth is affected by the income generated by the investment decisions a firm makes, not by how it distributes that income. According to M&M dividends are irrelevant regardless of how the firm distributes its income; its value is determined by its basic earning power and its investment decisions. M&M further argue that, to an investor, all dividend policies are effectively the same since investors can create their own dividends by adjusting their portfolios based on their preferences.

M&M based their argument on the following assumptions;

• No corporate and personal taxes
• no transaction and flotation costs incurred when securities are traded
• all market participants have free and equal access to the same information
• no conflicts of interests between managers and security holders (i. e. no agency problem)
• all participants in the market are price takers

DIVIDEND RELEVANCE THEORIES

‘The Bird in hand’ Theory This theory was developed by John Lintner (1962) and Myron Gordon (1963) as a response to Modigliani and Miller’s dividend irrelevance theory.

Gordon and Lintner claimed that M&M made a mistake by assuming lack of the impact of dividend policy on firm’s cost of capital. They argued that lower payouts result in higher costs of capital. They suggested that investors prefer the “bird in the hand” of cash dividends rather than the “two in the bush” of future capital gains.

Dividend policy is relevant to the value of the firm for the following reasons:

As the value of a shilling received now is always higher than the value of a shilling received later, shareholders prefer current dividend payments to retention of earnings. Since dividend received now is certain income whereas RE reinvested in corporate assets may be uncertain income, the income likely from retained earnings will be discounted by investors to reflect the uncertainty as to whether and when it will be received in cash in the future as either a capital gain or dividend. Bird-in-the-hand theory was criticized by M&M who claimed that dividend policy does not affect the firm’s cost of capital and that investors are totally indifferent if they receive more dividend or capital gains.

They called Gordon and Lintner’s theory a bird-in-the-hand fallacy indicating that most investors will reinvest the dividend in other firms or even the same firm and that a firm’s riskiness is only affected by its cash-flows from operating assets. ii)

Tax Preference Theory

Tax preference theory was first developed by Litzenberger and Ramaswamy. This theory claims that investors prefer lower payout companies for tax reasons. It is argued that dividends are taxed in year received while capital gains taxed only when the stock is sold and usually at a lower rate than that for dividends.

Unlike dividend, long-term capital gains allow the investor to defer tax payment until they decide to sell the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future. The tax advantage of capital gains over dividend income may make shareholders prefer earnings retention to payout. Thus the stock price per share of the firm would be higher if dividends are not paid than if they were paid out. MM assumption that taxes do not exist is far from reality as investors have to pay taxes on dividend received or capital gains realized. ii)

Clientele Theory of Dividends

The theory that a company’s stock price will move according to the demands and goals of investors in reaction to a tax, dividend or other policy change affecting the company. The clientele effect assumes that investors are attracted to different company policies, and that when a company’s policy changes, investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will move. Clientele theory deals with the relationship of types of investors to stock prices and dividends.

The basic thesis is that since dividends are personal income, and thus involve higher taxes than capital gains, the types of clientele that are attracted to firms might be related to whether dividends are considered high or low. This thesis remains highly controversial. iv)

Agency Theory of Dividends

Agency theory suggests that by distributing resources in the form of cash dividends, internally generated cash flows are no longer sufficient to satisfy the needs of the firm, thereby forcing managers to subject themselves to the scrutiny of third parties to attract needed capital.

In effect, the payment of dividends provides the incentive for managers to reduce the costs associated with the principal agent relationship. The agency argument has some unique characteristics that make it a promising approach for explaining other aspects of dividend policy as well. Not only can agency theory offer an explanation for why firms pay dividends, but it may also define how much each firm should pay. Agency theory offers a rationale for dividend policies that are observed to vary from industry to industry and between otherwise similar firms.

Signalling Theory

This is the theory that investors regard dividend changes as signals of management earnings forecasts. Ross Steven (1977). Ross did an empirical study on the impact of dividends on share prices, he observed that increases in dividends is often accompanied by increases in share prices while a dividend cut or reduction generally leads to stock price decline. According to Ross this suggested that investors preferred dividends to capital gains. Signaling theory states that changes in dividend policy convey information bout changes in future cash flows (e. g. , Bhattacharya, 1979, Miller and Rock, 1985).

Dividend signaling suggests a positive relation between information asymmetry and dividend policy. In other words, the higher the asymmetric information level, the higher is the sensitivity of the dividend to future prospects of the firm. Several empirical studies attempt to test the informational content of dividend changes. Stephen Ross argues that in inefficient markets, management can use the dividend policy to signal important information only known to the market.

When management pays high dividend they signal high expected dividend in future hence maintaining high dividend level. This decreases share price. In response, MM argued differently noting the fact that companies are reluctant to reduce dividends and hence do not raise them unless they anticipate higher earnings. They argued that a higher than expected dividend increase is a ‘signal’ to investors that the firm’s management forecasts good future earnings. Conversely, a dividend reduction or a smaller than expected increase is a signal that the firm’s management is forecasting poor earnings in the future.

According to MM, therefore investor’s reactions to changes in dividend policy do not necessarily mean that investors prefer dividend to retained earnings. Rather, they argued the price changes following dividend actions simply indicate that there is important information or signaling content in dividend announcements. They argue that change in share price is because of information only of the dividend policy and dividends are irrelevant when information is available to all market players. Signaling theory is based on the following assumptions;

1. The sending of the signal by management should be cost effective
2. The signal should be correlated for survival effects which are common trend
3. No company can imitate its competitor in sending the signal
4. The management can only send true signal even if they are bad signal. Sending of untrue signal would be financially disastrous for the survival of the firm

CHAPTER TWO

KEY EMPIRICAL EVIDENCE RELATING TO THE MAIN THEORIES ON DIVIDEND POLICY

Dividend Irrelevance Theory Relationship between Dividend Yield and Stock Returns

Black and Scholes (1974) examined the relationship between dividend yield and stock returns in order to identify the effect of dividend policy on stock prices. They constructed 25 portfolios of common stocks listed on the New York Stock Exchange (NYSE), extending the capital asset pricing model (CAPM) to test the long run estimate of dividend yield effects. Black and Scholes’s study tested the tax-effect hypothesis, however its conclusion strongly supported M&M’s irrelevance proposition. Black and Scholes used a long-term definition of dividend yield (previous year’s dividends divided by the year-end share price).

Their results showed that the dividend yield coefficient is not significantly different from zero either for the entire period (1936-1966) or for any of shorter sub-periods. That is to say, the expected return either on high or low yield stocks is the same. Black and Scholes, therefore, concluded that neither high-yield nor low-yield payout policy of firms seemed to influence stock prices. Black and Scholes’s conclusion provided important empirical support to M&M’s dividend irrelevance argument.

Dividend Policy and Stock Price Volatility: Evidence from Bangladesh Afzalur Rashid (Abu Dhabi University) & A. Z. M. Anisur Rahman (University of Dhaka) This study considered the data for the period of 1999-2006. The sample consisted of 104 non-financial firms listed in Dhaka Stock Exchange. Depending on the availability of company annual reports a total of 554 observations was made.

The dividend, earnings and related accounting data was collected from company annual reports.

The study tested the following Null hypothesis: There is no significant difference in stock price during the ex and post announcement of earnings in the form of dividend and that inter-industry variation will have no impact on stock prices.

The company share price was collected from the ‘Monthly Review’ of Dhaka Stock Exchange. The sample consisted of varieties of industries, such as, Cement, Ceramic, Engineering, Food and Allied Fuel and Power, Jute, Paper and Printing, Pharmaceuticals and Chemicals, Service and Real Estate, Tannery, Textile and Miscellaneous industries, these were classified into five broad categories; Engineering, Food and Allied, Pharmaceuticals and Chemicals, Textile and Miscellaneous industries.

Findings

The regression coefficients of the industry classification suggested that, some of the industries have significant influence on dividend policy and stock price volatility in Bangladesh.

Based on this analysis the null hypothesis was accepted with little modification: There is no material impact on stock price during the ex and post announcement of earnings in the form of dividend and that inter-industry variation will have little impact on stock prices.

Conclusion

From the study there was evidence of relationship between the stock price volatility and dividend policy in Bangladesh, by using the cross-sectional regression analysis after controlling earning volatility, payout ratio, debt, firm size and growth in assets Comments The study above established that investors are not concerned with a company’s dividend policy since they can sell a portion of their portfolio of equities if they want cash. The dividend irrelevance theory basically indicates that an issuance of dividends have little to no impact on stock price.

Bird in the hand’ Hypothesis Gordon (1959) suggested that there were three possible hypotheses for why investors would buy a certain stock;

• To obtain both dividends and earnings,
• To obtain dividends, and
• To get the earnings.

Gordon examined these hypotheses by estimating different regression models using cross-section sample data of four industries (chemicals, foods, steels, and machine tools) for two years 1951 and 1954. The dividend hypothesis was tested using a linear regression

Gordon found that dividends have greater influence on share price than retained earnings. In addition, he argued that the required rate of return on a share increases with the fraction of retained earnings because of the uncertainty associated with future earnings. Similarly, Gordon (1963) argued that higher dividend payouts decrease the cost of equity or the required rate of return on equity. Baker, Powell and Veit (2002) surveyed managers of NASDAQ firms to assess their view about dividend policy issues including the BIHH.

Their questionnaire contains one statement about the BIHH, stating “investors generally prefer cash dividends today to uncertain future price appreciation”. Based on 186 responses, only 17. 2 percent agree with the statement, 28 percent no opinion, and 54. 9 percent disagree. Therefore, they concluded that the findings does not provide support for the bird-in-the-hand justification for why companies pay dividends Empirical support for the BIHH as an explanation for paying dividends is enerally very limited, and the argument has been challenged especially by M&M (1961) who argued that the required rate of return (or the cost of capital) is independent of dividend policy, suggesting that investors are indifferent between dividends and capital gains.

Comments

From the bird in hand Theory, investors prefer dividend as it is more certain than capital gains that might or might not appear if they let the firm retain its earnings. The higher capital gains/dividend ratio is, the larger total return is required by investors due to increased risk.

SIGNALLING THEORY

Signaling with dividends? New evidence from Europe: Elizabeth Fatima Simones Vieira (October 2005) Introduction In this study the author investigated the impact of dividend change announcements in the firm value and future performance in three European countries – France, Portugal and United Kingdom (UK). Ahead of the analysis of market reaction to dividend announcements and of the firm’s future profitability, we wish to test the maturity hypothesis and the ‘window dressing’ phenomenon.

Objectives of the Study

The relevance of dividend policy in corporate finance, the different results obtained on empirical research conducted by now (namely in what concerns the relationship between dividend changes and future profitability) and the relative frequency with which we may observe an opposite relation between share prices reaction and dividend changes, are the main reasons for research in this domain, with the purpose of trying to fit another piece of the dividend “puzzle”.

The study tries to correct some limitations of previous work in the dividend policy field and to provide additional relevant evidence to the “information content of dividends” hypothesis, which may be interesting to academics. The importance of this study, and its distinction from others conducted in this domain, is based on the following reasons:

• The study examines market behaviour in the face of the dividend change announcements, so as to provide relevant additional evidence to the “information content of dividend” hypothesis.
• It analyses a vast group of performance measures, both economic and financial, before and after dividend change announcements, as well as in a short and long term perspective.
• This allows verifying to what extent the future performance is in consonance with dividend changes, and it allows making some considerations about the “window dressing” effect and the maturity hypothesis.
• It gives special emphasis on the cases where the market reacts differently than would be expected under signalling theory i. e. the enigmatic cases when the market reacts negatively to dividend increases and positively to dividend decreases.
• Examining the possible reasons that lead to an opposite relation between market reaction and dividend change announcements has not been previously done in the finance literature.
• This research analyses three European markets with different characteristics: the Portuguese, the French and UK markets.

Literature Review Lintner’s Model

The first empirical study accomplished in the dividend policy domain was performed by Lintner (1956). In its classic study, carried out in the United States (US), Lintner showed that managers tend to smooth dividends, because they are afraid to sending negative information to the market.

They are also afraid of raising the level of dividends, due to the fear of having to decrease them in future. Dividend policy, which is more often followed by companies, is based on maintenance of a stable level of dividend through the years, increasing the level only when there are perspectives that growth can be maintained in the future. Lintner selected 28 companies, analyzing a period of seven years (1947 to 1953) and surveyed the views of firms’ managers about dividend and dividend policy. Lintner’s study allowed coming to a group of conclusions which include;

1. Company managers consider dividend policy definitions a priority
2. Earnings are the primary factor determining the degree of dividend changes
3. Managers seem to believe that shareholders prefer stable dividends and that the market put a premium on such stability, recognizing that shareholders prefer a steady increase of dividends
4. Managers focus more on dividend changes than on absolute levels
5. Most managers avoid making changes to dividends that have a significant probability of being reversed in the near future
6. Firm seem to have a long term target payout ratio and tend to make periodic partial adjustments to the target payout rather than changing their pay out when a change in earnings occurs.

They are equally reluctant to decrease dividends Empirical tests on the information content of dividends MM (1961) suggested that, if managers’ expectations of firm’s future earning affect dividend policy decisions, then, changes in dividend policy would convey information to the market on the future earnings of their companies, which concept is known as the information content of dividends.

The empirical studies were analyzed in two different ways that is dividend cold be used as a future cash flows sign Bhattacharya (1979) or dividends could provide information concerning earnings as defined by Miller and Rock (1985). The market reacts positively to dividend increase announcements and negatively to their decrease. Effect of dividend announcements on future earnings Dividend changes should be followed by subsequent earnings changes, in same direction, providing evidence that dividend changes convey credible information about the future prospects of dividend paying firms. Effect of dividend announcements on share price

Unexpected dividend changes should be positively associated with share price changes, providing evidence that financial market interprets correctly dividend changes. Empirical tests show that dividend change announcements lead to a change in share price in the same direction. Effect of dividend announcements on market expectation revisions The relation between dividend changes and market prospects revision regarding future earnings is positive.

Sample Selection

The sample is drawn from dividend announcements of firms listed on the Euro next Lisbon (EL), Euro next Paris (EP) and the London Stock Exchange (LSE).

For the French and the UK markets, the study considers the dividend announcements between 1994 and 2002 with data obtained from Bloomberg and DataStream databases. For the Portuguese market the study considers the dividend announcements between 1988 and 2002 where data is obtained from Dhatis, an EL database and financial statements collected directly from companies. Since the study aims at analyzing dividend changes, the sample includes the dividend events (increases, no change, and decreases) from 1995 – 2002 for the French and the UK markets and from 1989 – 2002 for the Portuguese market.

The samples include 84 firms for Portugal and a total of 380 events; 93 firms for France and a total of 356 events; 524 firms for the UK and a total of 3,278 events.

Methodology

The study chose the methodology, which in the author’s point of view, is most appropriate to test the hypothesis formulated, which entails mainly sensitivity analysis, event studies and panel data analyses, which endows regression analysis of both a spatial and temporal dimension, to estimate parameters of interest. The methodology was also presented to test whether firm-specific variables have influence on the market reaction to dividend change announcement

Results

The study found no support in the French market for the dividend information content hypothesis in what concerns the relation between dividend change announcements and the market reaction, and only a weak support in the Portuguese and the UK markets. The study found some evidence of the “window dressing” phenomenon and the maturity hypothesis supported mainly with the UK data, which reinforces the evidence of Grullon, Michael and Swaminthan (2002).

The study examined, in general, the effect of dividend announcements on future earnings conditioned to the relation between dividend change announcements and market reactions.

For the events with positive relation between dividend change announcements and the market reaction, the results provide a weak evidence for the dividend information content hypothesis in what concerns the relationship between dividend changes and future earnings. For the enigmatic events with negative relation between dividend change announcements and the market reaction, in global terms, the study found no evidence of the dividend information content hypothesis in what concerns the relationship between the dividend changes and future earnings.

Overall, the study doesn’t find support for the dividend signaling content hypothesis, which is consistent with some recent studies, such as those of DeAngelo, DeAngelo and Skinner (1996); Benartzi, Michaely and Thaler (1997) and Benartzi et al (2005).

The weak support the study finds for this hypothesis is associated with the UK market, where information asymmetry is higher than in the other two countries, which leads to the belief that market-based systems managers tend to use dividends, in some extent, as a mechanism to mitigate the information asymmetry which is in accordance with Lasfer and Zenonos (2004) evidence.

In France and Portugal, characterized by bank-based system, where information asymmetry is lower than in the UK, there is no need to use dividend to convey information to the market, being the signaling effect of dividend is less important. This is validated by studied done by Aivazian, Booth and Cleary (2003); and Goergen, Renneboog and Silva (2005).

Conclusion

The empirical tests carried out to analyze the assumptions of dividend signaling theory, allow us to conclude the following;

1. The relationship between dividend changes and subsequent earnings is sometimes inconsistent with what is predicted by the theory. The information send by firms to the market is not always related to future earnings growth or cash flow
2. Although the empirical evidence supporting the positive relationship between dividend change announcements and the subsequent share price reactions, some recent studies have not supported this idea. The market is not always able to catch signal sent by firms
3. Generally, unexpected dividend changes are associated with market earnings revisions
4. There is evidence of a negative relationship between dividend changes and firms risk This study provides a deeper analysis in the dividend policy field and affords additional insight into the cases where the market reacts differently than is theoretically expected according to the dividend policy signaling hypothesis.

Finally, it contributes to go further in the analysis of the relation between firm-specific variables and the market reaction to dividend change announcements.

CHAPTER THREE

UNRESOLVED ISSUES

From the survey of the empirical evidence testing the DIH, the impact of dividend policy on the value of a firm remains unresolved.

1. Simplicity of the assumptions adopted in crafting the dividend irrelevance theory for instance the existence of efficient markets, no transaction costs and taxes. This is not the position in a real-life situation. More research on all these factors considered constant should be carried out to find out if there is any one theory that achieves an optimal dividend policy.
2. Many research studies on dividend signaling have been done in developed countries hence there is need to further discover on the dividend signaling of listed companies in developing countries. There is need to identify which variable, owner or manager influences the dividend decision more?
3. The arguments of whether dividends are relevant or not still lingers. It is critical that further research be done in various sectors of the economy with different companies
4. There is need to establish which of the following variables is more important in the dividend policy decision; Investment opportunities, refinancing ability, stock price and potential repayment capacity.
5. The argument that dividends portray future prospects of a company requires further research since there are instances where dividends have not signaled future prospects of a company.
6. The studies done by MM consider that capital gains are taxed lower than dividends. In some developing countries including Kenya, capital gains are not taxed at all. There is need for a study on the effect of the tax shield on capital gains in these countries for the effect may result in a greater difference on reaction of share holders as opposed to the above theories proposed from eveloped countries.
7. Financial markets are assumed to be perfect markets, though it is widely known that transaction costs do play a role, other factors unique to the regulatory body of the stock exchange come into play. In Kenya for example, if one buys share today, one has to wait for at least one week before selling those shares because of immobilization process. Also, one is not able to purchase shares below a 100 lot. I. e. one should purchase shares in groups of at least 100 which affects both demand and price of highly priced shares.
8. The herd theory explaining the effect of mob psychology on the recent global crisis is very evident in Kenya. This was noticeable when many companies like Kengen launched an Initial Public Offer (IPO) that latter resulted to sky rocketing prices immediately after trading commenced. This later led to over subscription of subsequent several IPO whose prices didn’t go up afterwards such as Mumias Sugar Company. This in turn led to many people shying away from the stock exchange. Accelerated by the global crisis, this made the stock market have a bear run. Further studies should be done in this area.
9. Information efficiency: – There is uneven information flow on the various companies on the stock exchange. This may be due to internal policy, media influence or both. It is an open secret that some senior corporate directors give media personnel handouts to cover their events and functions. This has been used to reduce information asymmetry in the companies while many others remain undervalued. E. g. many people are aware that Safaricom announced their results, but how many are aware when Carbacid – a listed company announces its results? This area of information flow should be researched
10. In Kenya the announcement of dividends is done before the closure of the shareholders register. This leads to a rush for the shares before the register is closed and a latter sale of the shares once dividends are paid. This leads to an upsurge of shares prices which is short lived in contrast to the signaling theory where the announcement of dividend would imply expected future prospects. This in turn would translate that the value of the firm increased and then reduced within a span of a few months. Is this the actual case?