To install StudyMoose App tap and then “Add to Home Screen”
Save to my list
Remove from my list
THE IMPACT OF PROFITABILITY, LIQUIDITY AND FIRM SIZE ON THE DIVIDEND PAYOUT RATIO OF FIRMS LISTED ON SEM.2.0 LITERATURE REVIEWDividend is considered as an important aspect for firms financing decision that has encouraged many finance scholars worldwide to determine its underlying secrets. Lease et al. (2000, p.29) have once defined dividend policy as the practice that management follows in making dividend payout decisions or, in other words, the size and pattern of cash distributions overtime to shareholders. The financial manager is often faced with two decisions that is, the capital budgeting and financing decision.
The capital budgeting concerns the assets the firm must acquire while financing decision concerns the financing of those assets acquired.When firms start earning profits another concern is whether the profit should be distributed as cash dividend or plough back for future investments. There are numerous reasons why a firm should pay dividend like, dividend payments signal a better financial standing and future success of a firm; it makes the shares issued to appear more attractive and increases its demand, pushing up its price and it fulfills the fiduciary responsibility that managers have towards its shareholders.
Verified writer
Proficient in: Free Essays
4.7 (348)
“ Amazing as always, gave her a week to finish a big assignment and came through way ahead of time. ”
Furthermore, firms having a stable dividend payout will be negatively affected if dividend is lowered or cut down while firms which do not pay dividend may appear attractive if new dividend payment is declared.2.1 Theoretical ReviewDividend policy is seen to be a debatable issue in the financial literature. For more than half a century, many academicians and researchers have developed numerous models which tried to explain the behavior and determinants of dividend policy, but it remains unresolved.
As once Black (1976, p.5) said, The harder we look at the dividends picture, the more it seems like a puzzle, with pieces that just do not fit together. Since then, the amount of theoretical and empirical research on dividend policy has increased considerably.There are three main contradicting theories that have been developed. Some theories argued that increase in dividend increases the firm`s value (bird in the hand theory) while other state that dividend payment reduces a firm`s value (tax preference theory). Another school of thought came up with the dividend irrelevance theory that is, dividend payment does not impact on a firm`s value. To complicate things further, other dividend policy theories have been found. To begin with, the dividend irrelevance theory is explained below.2.1.1 Theories about dividend policyModigliani and Miller dividend irrelevance theoryMiller and Modigliani (1961, M&M theory) suggest that, in an efficient market, dividend payment does not affect the firms' value. This theory is based upon some unrealistic assumptions such as, tax on dividend and capital gain are the same; no transaction involved during trade; no information asymmetry; no agency problem and finally participants are price takers in the market. Shareholders are not concerned in receiving cash dividend or capital gain and the firm`s value get affected only by the firm investment decision. That is, the earning power and the riskiness of the firm determined the firm`s value and not by the way the firm chooses to finance its projects or pay dividends. The M&M theory further states that investors can create their own homemade dividend by adjusting their portfolio according to their preference and that dividend policy does not affect them. To better understand the M&M theory, the proof of irrelevancy is provided below:M&M proof of irrelevancyThe M&M have proved their theory by using the dividend discounted model (DDM). The DDM states that the value of a stock is the present value of all the future cash flow (dividend) discounted using an appropriate discount factor. This equation is shown below: po = €‘€ћ Dt t=1 (1+ r) t (1)Where, Po = current share price t = time of dividend Dt = dividends paid at time t rt = required rate of return at time t.According to DDM, the future discounted dividends (Dt) determine the current value of share price and not its future value. In an efficient market the required rate of return (r) demanded by investors is the dividend and the capital gain. Assuming a one period world, r = D1+ (P1-Po) Po (2)Where, Po = current market price P1 = expected market price at period 1 D1 = dividend paid at the end.Rearranging equation (2), we obtain: Po = D1+ P1 (1+ r) (3)As many economists believe that the value of a firm (Vo) is determine by its share price, we let n be the number of share outstanding at time zero, to obtain the value of the firm. nPo = Vo = nD1+ nP1 (1+ r) (4)As stated by M&M that dividend is irrelevant, the funds equation is used to illustrate this. As capital structure does not matter in this theory debt financing is excluded. On the left-hand side is the sources of funds (cash flow from operation (CF1) and new issue of shares (mP1), where m is number of shares in issue at time 1) and on the right-hand side is the uses of funds (dividend payments (nD1) and investment (I1) at time 1). As sources of funds must equal to uses of funds, the following fund equation is obtained, CF1+ mP1 = nD1+ I1; (5)Rearranging equation (5), we get nD1 = CF1+ mP1 - I1; (6)By substituting equation (6) into equation (4) and simplifying it we get, Vo = CF1 - I1+ (n+m) P1 (1+ r) (7)As dividend do not appear in the equation (7), it can be said that cash flow, investments and required rate of return does not get affected by the current dividend policy. While there are many studies in favour of the dividend irrelevance theory, other theories challenge the M&M theory like the bird in the hand hypothesis.Bird in the hand Hypothesis (BIHH)The BIHH opposed the M&M theory stating that in a world of uncertainty and imperfect information, dividend policy does matter. This theory suggested that investors prefer bird in the hand of cash dividends rather than two in the bush of future capital gains. This is so as a higher dividend payment decreases uncertainty about future cash flows, leading to a lower cost of capital, thus increasing firm`s value. However, M&M (1961) contradicted this theory stating that the riskiness of a firm relies on the riskiness of its operating cash flow and not by the way its earnings are distributed. M&M have named this as the bird in hand fallacy as the firm`s risk is determined by its investments and financing decisions not by its dividend policy. This was further supported by Bhattacharya (1979).Tax- Effect HypothesisUnder the M&M theory, it is assumed that there is no difference on tax charge on capital gains and dividends. However, in real life it is not the case as taxes have huge impact on the dividend payments and on value of the firm. This is where the tax preference theory comes into play, where it take into consideration that capital gains are taxed at a lower rate than dividends and investors prefer firms to retain their earnings rather than distributing it as dividend. Firm will then use these earnings for investments, whereby increasing the stock price in order to be able to benefit from capital gain in the future.This theory was further supported by the dividend clientele hypothesis (DCH) developed by M&M (1961), whereby they found out that the portfolio choices of investors may be influence by transaction costs and tax differences between dividend payments and capital gains. Therefore, investors will tend to choose a portfolio whereby theses cost are reduced, influencing dividend policies and firm`s value. Despite that, M&M still stated that in perfect markets all dividend policies are the same and that dividend remained irrelevant.Factors influencing dividend decisionsThere are various factors affecting the dividend policy of a firm. Many studies have been carried out to determine which factor affects dividend payment the most. However, for our study, among the various factors that exist, three main factors that is, profitability, liquidity and firm`s size have been chosen to show their impact on dividend payments. There are numerous studies that have been carried out to test their relationship with the dividend payment.2.1.2 Theory about profitability and dividend policyKeeping in mind that firms pay dividend from its earnings, it is not possible for unprofitable firm to continue paying dividend forever. Therefore, taking profitability as a prime factor of dividend payment is logical. Firms having less retained earnings will be less likely to be able to pay dividend while, other firms use dividend as a signal for the firm`s better prospects due to the presence of asymmetric information which is known as the signaling theory.The information content of dividends (signaling) hypothesisOne of the unrealistic assumptions of the M&M theory is that managers and outsiders have the same amount of information regarding the firm`s prospects. However, it can be noted that managers who look after the company posses more information about the firm`s current and future position than the shareholders. This leads to an informational gap between them causes the true value of the firm to be inaccurate causing mispricing of share price. As a result, shareholders use changes in dividend payment as a signal in determining a firm`s future earnings and prospects. A rise in dividend payment conveyed a positive signal about firm`s future earning causing the share price to rise while a reduction in the dividend payment resulted in a negative signal about the firm, causing share price to fall. (Asan, 2009). As such, firms will opt for a smooth dividend payment known as the dividend- smoothing hypothesis and will increase dividend only when they can sustain it in the future.2.1.3 Theory about liquidity and dividend policyLiquidity can be referred to the ability to meet short term obligations by using the firm`s readily convertible assets (Bangkok Bank, 2008) that is, the ability to convert an asset to cash quickly. Investors may demand a higher return on assets which are sensitive to liquidity of the firm. According to Scott (2003) cash flow is a key component for a business sustainability and growth. Moreover, a strong negative relationship between liquidity and leverage has been noted as the firm will have to hold greater liquid asset to absorb its debt. It can be noted that firms do face the problem of liquidity even though they are profitable. Thus, the greater the liquidity, the higher will be the cash flow available to pay dividend. This was supported by Alli et al (1993) indicating that dividend payment is more dependent on cash flow rather than profitability as it is less affected by accounting practices. Thus, earnings do not really show the ability to pay cash dividend. It can also be noted that firms with a high cash flow are more likely to pay more dividend in order to reduce the agency cost present between managers and shareholders. This is explained through the agency costs and free cash flow hypothesis.Agency costs theory (Jensen & Meckling, 1976) and free cash flow hypothesis (Jensen, 1986)One of the idealistic assumptions of the M&M dividend irrelevance hypothesis is that there is no conflict of interest between management and shareholders. The managers (agents) of the firm are hired by the shareholders (principals) to work for their interest that is, increasing the shareholders` value. However, it can be noted that the interests of managers are far different from that of shareholders, like benefiting from excessive perquisites and over- investments in rewardable but unprofitable projects. In such a way, shareholders have to borne certain agency costs to monitor the activities of their agents to make them work for their interest instead of fulfilling their own interest. Another agency problem is the conflict of interest between the shareholders and the bondholders where the shareholders are the agent of the bondholders` funds. An excess dividend paid to shareholders is seemed as shareholders usurping wealth from bondholders (Jensen and Meckling, 1976). Shareholders having limited liability can access the firm`s cash prior to bondholders; as a result, bondholders prefer a low dividend payment to secure their claims.As per the free cash flow theory, firms will not pay dividend until it generates cash needed to enhance firm value and any excess cash are return to shareholders as dividend as managers can carelessly use excess cash (Thanatawee, 2011). Sometimes, managers are also obliged to raise fund from the capital market where investment professionals like bankers and financial analyst would monitor the activities of managers decreasing the agency costs for shareholders.Besides that, the M&M stated that dividend policy is independent from investment policy. In contrast, this theory found a direct linked between dividend policy and investments decision, stating that dividend payments reduce over- investments problems by managers, increasing the firm`s value ( Lang and Litzenberger, 1989).2.1.4 Theory about firm`s size and dividend policyA direct link can be established between a firm`s size and its dividend payout as big companies prefer to pursue the interest of management instead of the interest of the company. Moreover, large companies have easier access to capital market, making them less dependent on their internal fund whereby they can increase their dividend payout ratio. This can be illustrated through the life- cycle theory.The life-cycle TheoryThe life cycle theory states that as a firm matures its ability to generate cash increases. As a result, the firm is in a better position to distribute its cash flow to its shareholders in the form of cash dividend. Moreover, the firm is in a better position to raise finance through external sources to finance its investments whereby, it can use its retained earnings for distribution. On the other hand, a small and newly- established firm will have many growth opportunities. Furthermore, it faces substantial problems in raising capital to finance its projects through external sources due to a higher risk of default. Thus, the firm has no other way than using its retained earnings to finance its projects rather than using it for distribution. However, as the firm reaches maturity, its growth rate flattens, profitability increases, its systematic risk decreases, and the firm starts generating cash flow. Eventually, the firms start paying dividend.
DISSERTATION- CONTENT. (2019, Aug 20). Retrieved from https://studymoose.com/dissertation-content-essay
👋 Hi! I’m your smart assistant Amy!
Don’t know where to start? Type your requirements and I’ll connect you to an academic expert within 3 minutes.
get help with your assignment
