There is a continuous debate about what drives companies to pay dividends. The first theory for dividends was initiated by Miller and Modigliani (1961) who emphasized that dividend policy was irrelevant. Since then, controversial judgment has been raised to determine the factors which affect dividend policy in companies (Al-Malkawi, 2007). He added that the economists have presented great efforts for more than fifty years to test the determinants of dividend policy.
Most studies in this area have reported certain factors which have an impact on dividend policy decisions. It is known that the agency problem is considered to be one of the main problems between management and shareholders International Research Journal of Finance and Economics – Issue 80 (2011) 106 (Douglas, 2009). Dividend is used by managers as a tool to reduce this problem (Jirapon, 2004). It has been noticed that dividend payout is highly associated with the type of the governance in the company (Mehar, 2005). It is cited by Jiraporn et al. 2008) that one of the essential theories explaining the dividend policy is the agency cost theory.
Agency cost emphasizes reducing the agency cost between two parties, namely the investors (owners) and the managers (the control) (Jiraporn, 2004). It has been argued that the company might use dividends to alleviate the agency problem between managers and shareholders (Jensen, 1986). Researchers have examined many factors which have an impact on reducing agency cost problems. These factors include outside directorship, insider ownership and asymmetric information (see Al-Najjar & Hussainey, 2009a; Mitton, 2004).
Further, there are many studies of firm characteristics which have an impact on the dividend policy. These include profitability, liquidity, firm size, debt level, risk, industry type, tangibility (see Danis et al. , 2008; Al-Najjar & Hussainey, 2009a). This study is designed to examine corporate governance’s influence on dividend policy. Objectives of the Study The aim of this research is to find out the effect of corporate governance and firm characteristics factors on dividend policy in the UK firms.
The research is aimed to know whether corporate governance and firm characteristics factors are taken into consideration when dividend decisions are made by the UK firms. The UK was chosen for the study as the researchers felt that it would give accurate results since most of the UK firms pay dividends to their shareholders (Hussainey & Walker, 2009). Generally board independence alone has been taken as the independent variable for measuring corporate governance and dividend policy (for example Al-Najjar and Hussainey, 2009a).
But this paper explores corporate governance by three factors, i. e. , board size, board independence and audit type. Dividend Theories and Literature Review Large numbers of studies have discussed various theories which are relevant to dividend policy. Dividend theories, prior research related to the association between dividend policy and corporate governance mechanisms and the association between dividend policy and firm characteristics variables are reviewed in this study. Dividend Theories Agency Theory This is one of the most important theories in dividend policy.
In addition, they added that if the company has a quality corporate governance team, it will pay more and higher dividends. This is consistent with Jenson (1986) where he argued that the company which owns a weak governance team is less likely to distribute dividend to outside shareholders. This is because managers would like to have cash and spend it in projects which will return benefits for their own purposes. Furthermore, Michaely and Roberts (2006) noted that shareholders will expect more dividends if the company has strong governance.
One of the main agency conflicts between managers and shareholders is the debt level (Al-Najjar and Hussainey, 2009a). They argued that investors want to maintain the debt level at the lowest level. As a result, more dividends are expected by shareholders if the firm has a low debt ratio. Furthermore, Jiraporn (2004) 107 International Research Journal of Finance and Economics – Issue 80 (2011) tested the agency cost as an explanation factor for the dividend policy. He found that the firm which gives its shareholders limited rights is more likely to face the agency problem.
That is because the managers exploit the weakness of shareholders and make decisions which serve their own ends. On the other hand, as cited by La Porta et al. (2000), firms which are located in countries which protect shareholders’ rights are forced to pay higher dividends to their minority shareholders. He also pointed out that a country which has a common law system has more protection for the investor from those which have a civil system. This is consistent with Kowalewski et al. (2007) who tested the strength of corporate governance as a determinant of dividend payout.
He found a positive relationship between corporate governance practices and dividend payouts. Furthermore, he noted that companies pay more dividends if the shareholders’ rights are well protected by commercial law in a country. Most importantly Al-Najjar and Hussainey (2009a) argued that the agency cost can be eliminated by paying dividends to the shareholders. They noted that if the company paid dividends, the free cash flow would be less in the hand of the insiders (the managers).
Therefore, managers do not have more cash to spend on projects which benefit their own interests. They added that paying dividends makes the firm subject to capital market inspection as the possibility of issuing new shares increases. This study is designed to explore how the agency cost between managers and shareholders can be resolved. This can be achieved by exploring the association between dividends and three corporate governance variables which are: board size, board independence and audit type.
Signaling Theory The next essential theory is ‘Dividend Signaling’ which was developed to deal with asymmetric information between managers and investors, (Miller & Rock 1985). It is stated by Al-Najjar and Hussainey (2009b) that managers have more information about the company than investors and so they can make changes to the capital structure based on this information. Consequently, investors consider any change in dividend policy as a reflection of the company’s future performance. They added that, based on this assumptions, managers are not supposed to send wrong signals to the market.
Koch and Shenoy (1999) argued that firms which anticipate more future earning want to spread information to the outsiders about this earning, whereas the firms expecting a reduced cash flow would not be able to signal this situation to the shareholders. As a result, investors rely on these signals to decide on their investment among firms. It is noted that a positive relationship was found between the announcement of a dividend payout change and the price of the stock (Aharony and Swary, 1980). In addition, they examined how the governance quality affects the decision of whether to pay a dividend or repurchase the stock.
Moreover, they pointed out that the company which is managed by weak corporate governance will prefer to pay dividends rather than repurchase the stocks as it will give a signal to the capital market that the management is working for the shareholders’ interests and so the company performs well. Moreover, Benartzi et al. (1997) applied the signaling theory by testing whether dividend changes gave signals about changes in past and future earning. They found that dividend change reflected past growth of the company’s earning whereas it did not give signals about the changes in future profitability.
This is consistent with the study conducted by Watts (1973). In this research, the signaling theory is examined by two variables which are: firm profitability and firm growth. Pecking Order Theory The next area of discussion is the ‘Pecking Order Theory’ which was first initiated by Mayers (1984), and Myers and Majluf (1984). This theory is one of the corporate leverage theories (Murry and Goyal, 2003). It contains two assumptions which are as follows. First, there is asymmetric information between managers and outside shareholders.
The second assumption is that the firm will follow a pecking order to finance its activities (Al-Najjar & Hussainey, 2009b). They indicated that the firm will depend first on the retained earnings in financing and distributing the dividends. They added that if the retained earnings are not enough, the firm will use debt to borrow, rather than issuing new shares. International Research Journal of Finance and Economics – Issue 80 (2011) 108 This is consistent with Mayer (1984) in that the company prefers internal funding, rather than external sources for dividend distribution.
This is also consistent with Necur et al. (2006) who argued that internal sources of finance are given priority to be spent as dividends, but if these are insufficient, the firm can depend on the debt and finally on equity issuance. This theory is examined by the debt level. Transaction Cost Theory ‘Transaction Cost’ is an important theory which was initiated by Rozeff (1982) who assumed that the more dividends which were paid, the lower would be the agency cost incurred. However, he added that if the company paid high dividends, this would lead to an increase in the transaction cost.
Al-Najjar & Hussainey (2009b) argued that smaller companies will have more transaction costs than larger ones, because the small companies would mostly rely on debts to finance their activities and payment of dividends. They concluded that firm size can be a determinant of dividend policy of the company. This theory is tested by the firm size variable. Bankruptcy Theory The final theory in this section is known as the ‘Bankruptcy Theory’. This theory was not considered by Miller and Modigliani (1961). They thought that bankruptcy costs had no influence on the dividend policy in the company.
A general bankruptcy cost occurs when the firm faces great difficulty in meeting its long-term obligations (Al-Najjar & Hussainey, 2009b). As a result, firm ownership has to be transferred and the capital structure is likely to have a new form. Some researchers found that the business risk toward bankruptcy costs is associated with the dividend policy in a particular firm (Ho, 2003; Aivazian et al. 2003). This theory can be examined by the firm risk which is measured by firm beta. Literature Review on Study Variables and Formation of Hypotheses Board Independence This represents the total number of non-executive directors in the board.
As indicated by Belden et al. (2005), it is believed that the outside directors on the company board tend to reduce the agency cost in the firm. They also noted that the outside directors represent the shareholders effectively and ensure their rights in the company. As a result, they concluded that the more outside members there were on the board, the more dividends the company was willing to pay. This is consistent with Kowalewski et al. (2007) who mentioned that shareholders preferred to receive dividends if the insider directors were occupying the board, as they worried about how the management would decide on their earnings.
Furthermore, it was cited by Bathala and Rao (1995) that the firm with a high debt ratio indicated high risk and this led to an agency problem. To avoid this problem, non-executive directors should be included on the board to protect shareholders’ rights. A large number of studies argued that board independence is related positively with the dividend payout ratio (Jiraporn et al. , 2008; Borokhovich et al. , 2005; Bathala & Rao, 1995). However, Al-Najjar and Hussainey (2009a) examined the relationship between dividend policy and outsider directorship for 400 non-financial UK firms.
They reported a negative association between the number of outside directors and the amount of dividend paid. Furthermore, Cotter and Silvester (2003) argued that managers should share the interest with shareholders to solve the interest conflict between them and their shareholders. They suggested that managers should increase their ownership of the equity and that firms should increase the payout ratio and increase the leverage ratio. However, they tested the relationship between the dividend policy and the number of non-executive directors and they found no association.
Therefore, the hypothesis related to the board’s independence can be written as follows: H1. There is a relationship between board independence and dividend policy. 109 International Research Journal of Finance and Economics – Issue 80 (2011) Board Size This represents the total number of the members (executive and non-executive) in the company board (Borokhovich et al. , 2005). It is cited by Belden et al (2005) that the greater the size of board membership, the higher are the dividends paid to shareholders. He argued that this was because more people monitoring the decisions made by the chief executive officer.
The hypothesis related to board size can be written as follows: H2. There is a positive relationship between board size and dividend policy. Audit Type This classifies the type of auditing companies according to whether it is one of the Big Four audit companies or any other audit company. Lang and Lundholm (1996) examined the quality of disclosure by measuring the association between information asymmetry and the number of analyst following (disclosure quality). They found that the greater the number of analysts following, the amount of asymmetric information given to the shareholders by the managers was reduced.
This was because the investors got enough information from the annual reports analyzed by the analyst following. In this study, the quality of the disclosure is measured by the audit type. Glosten and Milgrom (1985) argued that the asymmetry information is an important factor which leads shareholders to request the quality of the disclosure. Furthermore, Minton (2002) measured the quality of the disclosure by indicating whether the firm is audited by one of the big five international audit companies. He found that a company which is audited by one of the big five audit companies pays more dividends.
It is cited by Lee et al (2007) that the shareholders expect higher earnings if the company is audited by big five audit companies. Hussainey and Al-Najjar (2009) found negative relationship between information asymmetry and dividend policy. In other words, the less information asymmetry, the more dividends paid to the investors. Hussainey (2008) argued that the company should consider which firm will audit its financial statement because the type of audit concerns the shareholders and the analysts in terms of their investment decisions.