2. Literature Review
I study the dividend policy based on several reasons. First, dividends can reflect the primary determinant of equity value. Second, a firm can do two things with its earnings: pay them out to equity holders or reinvest in positive NPV projects. Third, as a firm matures, growth opportunities want to reduce the free cash flow, and then dividend will be the better choice. Finally, the price of a stock is strong signal of expected future dividend payments.
Dividend policy is that firms’ managers decide to pay out earnings versus retaining and reinvesting them. I summarize three theories of dividend policy as follows. First, in the Modigliani-Miller (1961) world has shown, investors may be indifferent about the amount of dividend as it has no influence on the value of a firm. The MM theorem implies any payout is OK, but it bases on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Similarly, managers may be indifferent as funds would be available or could be raised with out any flotation costs for all positive net present value projects. Second, Bird-in-the-hand theory (Gordon and Lintner) says that investors prefer a high payout. Dividends (a bird in hand) are better than retained earnings (a bird in the bush) because the latter might never materialize as future dividends (can fly away). Third, tax preference theory states investors prefer a low payout. Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends. Hence, firms should set a low payout dividend policy based on the tax preference. Truth is one. However, three theories all derive different dividend payout policy. This is why dividend payout policy is still discussed extensively until now.
Jensen and Meckling (1976) first addressed the agency problem. They examined the relationship between principal and agent within the theory of the firm. Agency theory has identified the existence of two agency relationships. First, in the manager-shareholder relationship, the manager acts as an agent for the shareholders who are considered to be the owners. Shareholders are not in control of the company, since the managers make all pertinent decisions. If managers hold less than 100% of the shares, then they may invest less effort in managing firm resources and may transfer the resources to their own benefits. Second, in the shareholder-debtholder relationship, the manager is assumed to act on behalf of the shareholders. If an investment yields large returns, then equity holders capture most of the gain. If it fails, debt holders bear the consequence. In both of these relationships, the interests of the agent and principal are separated, imposing agency costs. According to Jensen and Meckling (1976), the optimal capital structure is to minimum the agency costs.
Jensen (1986) argues that there are important divergences of interest between managers and shareholders that might induce managers to issue equity and waste funds by taking up negative NPV projects. On the other side, Jensen thinks that debts may reduce agency costs. The firms may have free cash flows under management's discretion. Therefore, raising the leverage ratio would reduce the free cash flows problem because the management has to pay out cash regularly. The benefits and drawbacks of debts constitute the trade-off theory of capital structure. Although debts can increase the value of the firm when the firms have less debt, debts also reduces the value of the firm when the debts are too many. Hence, the firm has to find an optimal capital structure to maximize the value of the debts. In addition, Jensen (1986) also suggests increasing dividend payout ratio in order to mitigate the free cash flow problem when firms have a lot of free cash flows. According to Jensen’s paper, I think the relationship between the agency problem and dividend payouts is very stronger. In this proposal, I study the relationship between the agency problem and dividend payouts. I use insider ownership and corporate governance index to proxy the agency problem.
LLSV (1998) discuss a set of key legal rules protecting shareholders and creditors and document the prevalence of these rules in 49 countries around the world. They also aggregate these rules into shareholder (anti-director) and creditor rights indices for each country, and consider several measures of enforcement quality, such as the efficiency of the judicial system and a measure of the quality of accounting standards. LLSV (1998) use these variables as proxies for the stance of the law toward investor protection to examine the variation of legal rules and enforcement quality across countries and across legal families. LLSV (2000a) further find that a common element explaining these differences is how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms. They show that common law counties assign higher valuations to publicly-traded stock. In the other word, law would impact the valuation of firms. LLSV (2000b) show that minority shareholders press corporate insiders to pay dividends, since they cannot be sure to get a fair return particularly in countries where shareholder rights are not well developed. My proposal mainly wants to extend LLSV’s work and clarify what factors indeed influence the dividend payouts.
In this section, I introduce the relationship between dividend payouts and insider holding. Schooley and Barney (1994) indicate that negative relationship between dividend payouts and ownership exists before a turning point; once managerial ownership exceeds the critical point, it switches to a positive one. However, as La Porta et al. (2000b) point out, legal protection causes that widely-held firms dominate in a protected environment and closely-held firms in an unprotected one. Some research addresses a negative relationship between dividend payouts and ownership. I think it is because their samples are usually composed of firms in a specific environment without including a lot of countries. Therefore, I try to locate the relationship by considering totally four surfaces in my proposal. Jensen and Meckling (1976) and Morck et al. (1988) have provided important contributions to the research on ownership structures and corporate valuation. Jensen and Meckling concluded that concentrated ownership is beneficial for corporate valuation, because large investors are better at monitoring managers. Morck et al. distinguish between the negative control effects and the positive incentive effects of higher shares of ownership. They suggest that the absence of separation between ownership and control reduces conflicts of interest and thus increases shareholder value. Shleifer and Vishny (1997), La Porta et al. (1998,1999), Morck et al. (1988) and Claesens et al. (2000a, 2000b) studied the conflicts of interest between large and small shareholders. Their policies may result in the expropriation of minority shareholders when large investors control a corporation. Such companies are unattractive to small shareholders and their shares have lower valuation. According to these literatures, the ownership structure is an important factor in studying the dividend payouts.
Jensen et al (1992) and Chen and Steiner (1999) examine the relation between corporate governance issues and the dividend payout policy. Gompers and Metrick (2003) find that firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions.
3. Data and Methodology
A. Data
This proposal follows the measure method from La Porta et al. (2000b). La Porta et al. cover the data between totally 33 different countries. The basic sample includes 4,103 firms from 33 countries. This data allow me to compute dividend payout ratios in 1994 and sales growth rates from 1989 to 1994.
Table One. Religion Countries
Table Two. Civil law countries & Common law countries
B. Methodology
I separate the 33 countries into two groups. The first group belongs to the common law countries. The other group belongs to the civil law countries.
Dependent Variables
Dividend payout ratio is used as the dependent variable in my proposal. The measure of dividend payout ratio is regular cash dividends divided by annual earning per share. Dividends are defined as total cash dividends paid to common and preferred shareholders. Earnings are measured after taxes and interest.
Dividend Payout Ratio =Dividend per Share / Earnings per Share
Independent Variables
- Insider Holdings
To extent to which ownership and control is coupled is measured by the percentage of insider holdings. It is defined as closely held shares divided by common stock outstanding. As Insider ownership increases, agency cost declines, since the insiders bear more of the wealth effects of their decisions. The percentage of insider holdings is defined below:
The Percentage of Insider Holdings = Closely Held Shares / Common Stock Outstanding.
The closely held Shares are defined by Worldscope Disclosure database. It includes: A. Shares held by officers, directors and their immediate families B. Shares held in trust C. Shares of the company held by any other corporation (except shares held in a fiduciary capacity by banks or other financial institutions) D. Shares held by pension/benefit plans E. Shares held by individuals who hold 5% or more of the outstanding shares
It excludes: A. Shares under option exercisable within sixty days B. Shares held in a fiduciary capacity C. Shares held by insurance companies D. Preferred stock or debentures that are convertible into common shares”
b. Corporate Governance Index (Gompers, 2003)
I briefly summarize the construction of corporate governance index. To see Gompers et al. (2003) would obtain more details on the construction of the corporate governance index. If every provision that restricts shareholder rights then we add one point for every firms.
Multiple Regressions
With the multiple regressions, I use additional control variables.
Controlling Variables
Because dividend policy is not affected only by ownership structure, several controlling variables are added to the regression. All of these variables represent the needs for external finance.
Profitability
Dividends have traditionally considered the primary approach for publicly traded firms to share profits to their shareholders. The premise for share profits to shareholders is that the firms earn excess cash. The more profitable firms are, the more dividends they are capable of paying, others being equal. Although earnings are commonly viewed as the proxy for profitability, free cash flow is used in our study. Because dividends are paid in cash, and the accounting earnings are often inconsistent with the cash flow, we use free cash flow rather than accounting earnings to represent the capability for firms to return cash to their shareholders. Therefore a positive relationship between dividend payouts and free cash flow is expected. Free cash flow is deflated by total assets, to eliminate the effect of firm size:
Free Cash Flow = Total Assets / Funds from Operations
, where Funds from Operation is estimated based on net profits, and includes A. Depreciation B. Amortization of Intangibles C. Deferred Taxes.
It excludes: A. Extraordinary items B. Changes in working capital.
Risk
Rozeff (1982) pointed that riskier firms have harder access to capital markets, which increase the dependence on internal funds and make them reluctant to pay out dividends. Therefore, the hypothesized relationship between risks and dividend payouts is negative. We use beta as a risk proxy. Beta is a measure of market risk which shows the relationship between the volatility of the stock and the volatility of the market. The data is collected from the Worldscope database directly. It is based on between 23 and 35 consecutive month end price percent changes and their relativity to a local market index.
Growth
Relative to large, mature companies, the timing of investment opportunities for high-growth firms is less predictable. When such opportunities present themselves, management typically needs to react very quickly. In such cases, large cash reserves on hand provides the most flexibility. Thus, high-growth firms tend to increase retained earnings for contingent use and have a lower dividend payout ratio. We anticipate a negative relationship between growth and dividend payouts. The proxy for growth is the ratio of the market value of equity to the book value of equity.
The Development of Stock Market
Unlike other controlling variables that present the characteristics of individual firms, the development of stock market can be regarded as one of the characteristics of each country and also affect dividend policies of firms. In a better developed stock market, firms can raise external funds more easily. Thus the firms in better developed market tend to less rely on internal funds and are more willing to increase dividend payouts. The relationship between development of capital market and dividend payouts can be expected to be positive. The development of capital market is measured by stock market capitalization to GDP ratio (CAP/GDP).
Taxes
According to La Porta et al. (2000b), they find no conclusive evidence on the effect of taxes on dividend policies, so that we do not contain taxes as our controlling variable.
The equation is written as follows.
Table Three. Commom law countries
Table Four. Civil law countries
4. Predict Results and Conclusions
LLSV (1998) examine laws differ around the world give investors limited bundle of rights. Countries of the common-law traditions tend to protect investors more than the civil-law, and especially the French-civil-law. And German-civil-law and Scandinavian countries have the best quality of law enforcement and in common-law countries as well. Besides, the French-civil-law countries have strongly concentrated ownership, which is consistent with the substitute mechanism for poor investor protection. LLSV (1998) remind us the importance of law to investor protection around different countries. After LLSV (1998), LLSV (2000a) find that a common element explaining these differences is how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms. Moreover, they show that common law counties assign higher valuations to publicly-traded stock.
Figure One. LLSV(2000b)
I think legal power and corporate governance would reduce the agency problem. Manages may have more investment opportunities to raise the valuation when insider holdings ratio increases. Therefore, firms would pay more dividend payouts under higher insider holdings environment. In my proposal, my hypothesis is that a positive relationship between dividend payouts and ownership in a protected and better corporate governance environment, and a negative relationship in an unprotected and worse corporate governance firms.
My hypothesis may find no evidences to support it. Because in countries with poor shareholder protection and most of their ownership is coupled with control. Dividends thus become a tool for controlling shareholders to signal the moderation of expropriation and to reduce agency costs. Firms with more concentrated ownership have less cost to pay dividends and have to allay the concerns about expropriation, and it implies that more dividends are paid as the insider holdings increase. In this situation, I may obtain a positive relationship between ownership and payouts in an unprotected and worse corporate governance environment.
Table
Figure Two.
Table
Reference
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Insider Ownership
Dividend Payout Ratio
Common Law Countries
Civil Law Countries
[1]Ph.D. student, Department of Finance, National Central University, Taiwan.