CHAPTER 2

2.1 Introduction

Dividend policy has been the subject of investigation and debate for almost 50 years, most of it conducted in the United Kingdom. Before regression analysis was applied by John Lintner in 1956 to the behaviour of a small group of industrial companies, dividends were good and should be maximised by firms wherever possible. Lintner, who showed that firms adopted and tended to adhere to optimal long-term dividend pay-out ratios which were relatively stable, suggested that managers would only raise a firm’s dividend if they were confident that the firm’s future earnings could be maintained at a consistently higher level in the future. An implication of this was that the announcement of a dividend increase might convey useful information about future earnings. Lintner’s work (and the work of Darling (1957) who confirmed the relationship between dividends and past and current earnings) opened a Pandora’s Box of dividend-related phenomena, the validity of which, other researchers have spent years and decades debating closely1. In a series of researches at the beginning of the 1960s, Miller and Modigliani (in particular, Miller and Modigliani, 1961) provided a mathematically consistent theory of capital structure in which dividends were shown to be irrelevant to a firm’s value. But this did not appear to coincide with the observed behaviour of dividend policy-setters in a sufficiently watertight fashion. A competing theory, which stated that dividends directly contributed to the value of a firm, was produced by Gordon (1962).Gordon’s model2 for the valuation of a firm’s share price. Hence, the current dilemma concerning the role of dividends in the stock market was laid bare almost forty years ago. It is best summed up in the words of Black (1976):“The harder one looks at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together“. But the debate was, however, broadened by Miller and Modigliani (1961), who added several adjuncts to their assertion of dividend irrelevance to the firm’s value. One of these was the existence of tax clienteles. Investors would choose the kind of firm they wanted to invest in with respect to the firm’s dividend policy and thereby sort themselves into clientele groups. Investors who wished to accumulate long-term wealth would choose firms with low or zero dividend pay-outs, while those who wished to have a steady dividend income to meet short-term consumption needs would invest in firms with a tradition of high dividend pay-out ratios.3The existence and effects of tax clienteles have been analysed by a large number of scholars. Brennan (1971), for instance, argued that the existence of a clientele effect would logically have no impact on the value of the firm, while Long (1978) and Litenberger and Ramaswamy (1982) presented evidence that it did. No clear, irrefutable resolution to this debate has yet emerged. A further kind of clientele has also been discussed by Black and Scholes (1974) and Pettit (1977. The other important adjunct Miller and Modigliani posited was that a firm’s choice of dividend might be seen as a signal to investors (actual and potential), which contained hitherto unavailable information concerning the firm’s future earnings prospects. This conclusion was to be the starting point of a forty-year record of research into the existence and nature of signals putatively broadcasted in dividend announcements. But dividend research did not develop in isolation from other major developments. The 1950s and 1960s were fertile times in the development of financial economics. It was in this period that Sharpe (1964) and Lintner (1965) developed the Capital Asset Pricing Model (CAPM). This development in particular, provided stimulus for investigation of dividend policy behaviour associated with volatility.

1 Lintner’s findings have been reconfirmed by a large number of studies over the decades. Early confirmations with respect to United Kingdom data were made by Brittain (1964), Brittain (1966), and Fama and Babiak (1968). McDonald, Jacquillat and Nussenbaum (1975) observed dividend policies in France; Chateau (1979) published results with respect to Canadian companies; Shevlin (1982) observed the stability of dividend policies in India. More recently Leithner and Zimmermann (1993) tested the dividend stability of West German (prior to Unification), British, French and Swiss companies; and

Dividend stability in the United Kingdom was further assessed by Lasfer (1996). Dividend policies in Japan were found to be stable by Kato and Loewenstein (1995), and also by Dewenter and Warther (1998), who compared the Japanese market with the market in India. Adaoglu himself however, observing firms on the Indian Stock Exchange, confirmed Glen, Karmokolias, Miller and Shah (1995), who found relatively unstable dividend policies in emerging markets.

2 This has been shown to be based on at least one flawed assumption (Brennan, 1971), but has not been disproved to the satisfaction of all scholars.

In fact, it was not until the tail end of the 1970s that a proper basis for a theory of dividend policy was formulated. During the last fifty years the several theoretical and empirical studies are done leading to the mainly three outcomes: the increase (decrease) in dividend pay-out affect the market value of the firm or the dividend policy of the firm does not affect the firm value. Furthermore there are numerous theories on why and when the firms pay dividends. Miller and Modigliani (1961) suggest that in perfect markets, dividend do not affect firms’ value. Shareholders are not concerned to receiving their cash flows as dividend or in shape of capital gain, as far as firm’s doesn’t change the investment policies. In this type of situation firm’s dividend pay-out share effect their residual free cash flows and the result is when the free cash flow is positive firms decide to pay dividend and if negative firm’s decide to issue shares. It is concluded that change in dividend may be conveying the information to the market about firm’s future earnings. Gordon and Walter (1963) present the bird in the hand theory which says that investors always prefer cash in hand rather then a future promise of capital gain due to minimising risk. The agency theory of Jensen and Meckling (1976) is based on the conflict between managers and shareholder and the percentage of equity controlled by insider ownership should influence the dividend policy. Easterbrook (1984) gives further explanation regarding agency cost problem and says that there are two forms of agency costs; one is the cost monitoring and other is cost of risk aversion on the part of directors or managers. The explanation regarding the signalling theory given by Bhattacharya (1980) and John Williams (1985) dividends allay information asymmetric between managers and shareholders by delivering inside information of firm future prospects. Miller and Scholes (1978) find that the effect of tax preferences on clientele and conclude different tax rates on dividends and capital gain lead to different clientele

3 The pay-out ratio measures the dividend paid out as a percentage of net profit after tax available for potential distribution to shareholders.

Life Cycle Theory explanation given by the Lease (2000) and Fama and French (2001) is that the firms should follow a life cycle and reflect management’s assessment of the importance of market imperfection and factors including taxes to equity holders, agency cost asymmetric information, floating cost and transaction costs Catering theory given by Baker and Wurgler (2004) suggest that the managers in order to give incentives to the investor according to their needs and wants and in this way cater the investors by paying smooth dividends when the investors put stock price premium on payers and by not paying when investors prefer non payers. As regards the empirical literature the roots of the literature on dividend policy is related to Lintner (1956) seminal work after this work the model is extended by the Fam