Determinants of Dividends Policy
Theories of Dividend Policy
Several theories have been used to explain dividends policy and how dividends are paid. According to the life-cycle theory, dividends are paid by mature firms because they have more profits and fewer attractive investment opportunities. Mature firms have high retained earnings as a proportion of total equity and total assets (Grullon, Michaely & Swaminathan, 2002, p.387). Firms with low retained earnings as a proportion of total equity (RE/TE) tend to be in a capital mix stage, but those firms with high retained earnings as a proportion of total equity (RE/TE) tend to be more mature with more profitability growth. The life-cycle theory provides an explanation for the massive payout of firm dividends in that large firms pay dividends when the cost of retaining free cash flow is more than the flotation cost and profit retention (Denis & Osobov, 2008, p.62).
The tax preference theory suggests that dividends are subject to a higher tax cut other than capital gains (Haesner & Schanz, 2013, p.527). Investors prefer to retain profits in a firm other than the distribution of cash dividends. For tax related reasons investors favour low dividend payout other than the high dividend payout because of the advantage of capital gain from retained profits. This implies that tax is a core determinant of the dividends policy in those large firms with more capital gain than small firms because dividends are subject to higher tax (Frankfurter & Wood Jr, 2002, p.112).
The signalling theory is another dividend policy theory. The theory asserts that information asymmetry between outside shareholders and inside managers allows the firm managers to use dividends to signal information on the firm’s performance to outside shareholders. This implies that inside managers in a company can signal private information on the performance of a firm to outside shareholders hence affecting the dividends policy (Frankfurter & Wood Jr, 2002, p.117). Information asymmetry between inside traders and outsiders are the foundation of the agency costs hence the need to pay dividends in order to reduce the agency costs. Again, dividend payment signal to shareholders that they are not being exploited hence narrow the information asymmetry (Frankfurter & Wood Jr, 2002, p.117).
The other theory is the agency-cost theory. This theory explains that managers in a company are monitored by shareholders in order to prevent them from exploiting the shareholders investments. The monitoring expense is incurred by the shareholder as an agency cost. The shareholder monitors the managers in order to close the information asymmetry gap (Easterbrook, 1984, p.650). The shareholders, therefore, make a decision to pay high dividends in order to turn to external financing to fund new projects. This is important to firms because they maximize the shareholders wealth in order to remain competitive in the market. An alternative to this is share repurchasing whereby shareholders decide to repurchase shares in order to reduce free cash flow. When firms buy back shares, the dividends payout ratio also decreases. So firms pay dividends in order to reduce their agency costs (DeAngeloa, DeAngeloa & Stulzb, 2006, p.227).
Determinants influencing Dividends Policies
Free cash flow influences the dividends policy. Free cash flow is the cash flow in excess of funds or finances required to finance all company projects. According to the agency-cost theory, when free cash flow increases, the agency conflict between managers and outside shareholders increases, and this might decrease the performance of the firm. The agency problem occurs when managers fail to maximize the value of shareholders shares, but rather derive benefits for themselves from the shares (Al-Kuwari, 2009, p.38). Free cash flow influences the dividends payout ratio in that the more the free cash flow, the more the dividend payout to shareholders in order to reduce the possibility of the funds being wasted by the managers on non-profitable projects. This gives the hypothesis that the dividend payout is positively associated with the free cash flow (Kania & Cacon, 2005, p.109).
The size of a firm influences the dividend payout ratio according to the life-cycle theory. Firms with high retained earnings as a proportion of total equity tend to be more mature with more profitability growth. According to Kania and Bacon the firm size correlates with the dividend payout ratio. Fama and French concurs that dividend payers are larger than non-payers. Dividend payers have more assets. The dividend payers are also more profitable than non-payers and much of their market value is derived from their expected growth in the future. They have more aggregate earnings hence pay more dividends. Firms that have never paid dividends are smaller and are less profitable although they have more investment opportunities. The argument here is that large firms have more profits hence more likely to increase their dividend payout. An increase in dividend payout also reduces the agency costs hence increasing the performance of the company. Most of the agency costs tend to be associated with the firms size in that, large firms have higher agency costs than small firms hence the need to pay more dividends in order to reduce the agency costs (Baker, Veit & Powell, 2001, p.19). According to the agency theory, firms pay more dividends in order to indirectly monitor the performance of the company managers. This implies that in large companies, information asymmetry increases, and this tends to decrease the shareholders ability to monitor the management of the company. (Baker, Shantanu & Samir, 2008, p.171).
The growth opportunities of a firm influence the dividend policy ratio. The argument is that large firms use internal funding sources in order to finance investment projects because of their current growth opportunities in the future. The firm, therefore, cut dividend payment so as to reduce its dependence on external financing (Kania & Cacon, 2005, p.111). Fama and French argue that firms that have never paid dividends have best growth opportunities in the future. They have more asset growth rates than firms that pay dividends. You also find that R&D in firms that do not pay dividends is high hence increasing the competitiveness of these firms. They have better growth opportunities in the future while payers of dividends have low profitability and poor investment opportunities.
Another hypothesis is that the dividend payout is negatively associated with business risk. Business risk influences dividends payout ratio in that firms with high levels of business risk have lower dividend payout, while firms with low levels of business risks have higher dividends payout. The argument here is that high risk companies have higher external financing and low dividend payout so as to reduce the costly financing. The firms with greater systemic risks have uncertain future profits, and this tend to reduce their dividend payout because the future profitability of the company is unknown (Muhammad, 2012, p.28). So, as the uncertainty of the company profit increases, the dividends payout declines. This implies that the companies with unstable earnings have low dividend payout and this is important for the company because it reduces external financing which is always costly for most of the companies (David & Igor, 2008, p.62).
The profitability of a firm influences the dividends payout ratio according to the life-cycle theory. Kania and Bacon, 2005, p.111, argues that profitability and return on equity of a firm correlate with the dividend payout ratio. Fama and French concur that dividend payers have higher measured profitability than firms that do not pay dividends. Large firms have higher dividends payments based on the profitability of the firm. The argument here is that any variability in the company earnings has an impact on the dividend payment ratio. So, the dividend payout ratio of a company is the percentage of profits given to the shareholders (Henk Von & Megginson, 2008, p.347).
Tax is another factor that determines the dividend policy. According to the tax preference theory dividends are subject to a higher tax cut. Dividends are taxed directly and most of the investors tend to prefer to retain profits in a firm other than the distribution of cash dividends so that they can reduce the cost of the tax (Allen, Bernardo & Welch, 2000, p.2499). Tax, therefore, influences the dividends policy in that investors pursue dividend payout policies in order to minimize tax obligations. The argument here is that firms prefer retained earnings than paying dividends because dividends are taxed directly but retained earnings are only taxed after the company has been sold (Eugene & Kenneth, 2000, p.43).
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