A STUDY ON DIVIDEND POLICY AND VALUE OF THE FIRM:MANAGERIAL PERSPECTIVES IN MALAYSIA

BY:

OSWALD TIMOTHY EDWARDCHU HONG HENGLAU GEE CHOON

DECEMBBR 2OO5

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: A Study On Dividend policy and Value of the Firm:Managerial perspectives in Malaysia

: En Oswald Timothy Edward

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s.k: 1. Prof Madya Ruhana ZainuddinKoordinator URDCUiTM Cawangan Johor

2 En Oswald Timothy EdwardKetua projekUiTM Cawangan Johor

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APPROVED RESEA.RCH BUDGET

projeci iifie: A Study On Diviciend Policy anci Value of the Firm: Managerial Perspectives in Malaysia

Project leader: En Oswald Timothy Edward

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Tarikh : 20 DISEMBER 2005No. Fail Projek : 600-IRDC/SSP/ 513/1395

Penolong Naib Canselor (Penyelidikan)Institut Penyelidikan, Pembangunan dan PengkomersilanUniversiti Teknologi MARA40450 Shah Alam

Yang berbahagia Prof.,

LAPORAN AKHIR PENYELIDIKAN "A STUDY ON DIVIDEND POLICYAND VALUE OF THE FIRM: MANAGERIAL PERSPECTIVES INMALAYSIA''

Merujuk kepada perkara di atas, bersama-sama ini disertakan 3 (tiga) naskahLaporan Akhir Penyelidikan bertajuk "A STUDY ON DIVIDEND POLICYAND VALUE OF THE FIRM: MANAGERIAL PERSPECTIVES INMALAYSIA".

Sekian, terima kasih.

Yang benar,

OSWALD TIMOTHY EDWARDKetuaProiek Penvelidikan

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KUMPULAN PENYELIDIKAN

OSWALD TIMOTHY EDWARD

Ketua Penyelidikan

CHU HONG HENG

Ahti

Tandatangan

LAU GEE CHOON

Ahti

G7

Tandatangan

Tandatangan

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Acknowledgement

I wish to acknowledge the assistance of many persons within the industry who

responded to the questionnaires and numerous requests for timely information not

available in regularly published sources. To them I am ever so grateful. I would like

to express my gratitude to my mentor for his suggestions and challenges in

completing this project. I am extremely grateful to URDC members for their support.

Finally, I dedicate this study to my beloved ones for their understanding and support.

Any remaining errors are my own.

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CONTENTS

AcknowledgementAbstractList of Tables

Chapter

1.0 INTRODUCTION1.1 Background of the Study1.2 Problem Statement1.3 Research Questions|.4 Objectives of Studiesl.5 Importance of Study1.6 Organizing of Study

2.0 THEORETICALFRAMEWORK2.1 Introduction2.2 Behavioral Model of Dividend Policy2.3 Traditional View of the Significance of Dividend2.4 Dividend and Taxes2.5 The Irrelevance of Dividend Policy2.6 The Signaling Theory

3.0 LITERATURE REVIBW3.1 Dividend Irrelevance Theory3.2 Dividend Relevance Theory

3.2.1 Bird-in-the-Hand Theory3.2.2 The Signaling Explanation3.2.3 The Tax Preference Explanation3.2.4 The Agency Explanation

4.0 RESEARCHMETHODOLOGY4.1 Introduction4.2 Sources of Data

4.2.1 Primary Data4.2.2 Secondary Data

4.3 Data Collection Method4.4 Sampling Process

4.4.1 Relevant Population4.4.2 Sampling Frame4.4.3 Sampling Method4.4.4 Sample Size

4,5 QuestionnaireDesign4.5.1 Data measurement Scale

4.6 Data Analysis

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4.6.1 Statistical Package4.6.2 Statistical Technique

FINDINGS AND ANALYSIS5. I Characteristics of Respondents

5. I .l Position of Respondents In The Company5.1.2 Duration of Years Involved in Determining Dividend

Policy5.1.3 Type of Industries and Response RateReliability AnalysisRelationship Between Responding and Nonresponding FirmsAnalysis on Relationship between Dividend Policy andValueDividend Relevance TheorySetting Dividend Policy

CONCLUSION AND DISCUSSION6.1 Conclusion6.2 Limitations of Study6.3 Recommendations for Further Research

A1

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6.0

BibliographyAppendix A. Questionnaire

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Table 2.1

Table 2.2

Table 4.1

Table 5.1

Table 5.2

Table 5.3

Table 5.4

Table 5.5

Table 5.6

Table 5.7

Table 5.8

Table 5.9

Table 5.10

LIST OF TABLES

Example of difference in share prices as a result of low andhigh dividend payout policies under Brennan's proposition.

Elton and Gruber's evidence for dividend vield statisticranked by deciles

Likert's scale

Characteristics of the Respondents

Type of Industry and Response Rate

Reliability Coefficient (Alpha Values)

Characteristics of Responding and Nonresponding Firm

Relationship Between Dividend Policy and Value of TheFirm (Panel A)

The Bird-in-the-Hand Explanation (Panel Bl)

The Signaling Explanation (Panel 82)

The Tax Preference Explanation (Panel B3)

The Agency Explanation (Panel 84)

Setting Dividend Policy (Panel C)

19

24

46

51

52

53

55

57

58

60

6l

62

64

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Abstract

This study investigates the views of corporate managers about the relationship between

dividend policy and value; explanations of dividend relevance including the bird-in-the-

hand, signaling, tax-preference, and agency explanations; and how firms determine the

amount of dividends to pay. We obtain data from 2004 mail survey sent to 207 chief

financial officers/financial controller/corporate managers of firms listed on the Bursa

Malaysia. Based on 64 usable responses, the empirical result show that most survey

respondents believe that dividend policy affects firm value. Of the four explanations for

dividend relevance, the respondents generally express the highest level of agreement with

statements about signaling. The results also show that managers are concerned about the

continuity of dividends when setting dividend payments

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CHAPTER ONE

INTRODUCTION

1.1 Background ofthe Study

Many companies pay dividend to their shareholders as yield or return for the money they

invest in the company. Dividend can be regarded as any direct payment by the

corporation to the shareholders. Cash dividend is popular and very desirable from the

view of investors.

In addition to the declaration of cash dividend, the firm has other options for distributing

profits to the shareholders. These options are the stock dividend, stock split and stock

repurchase. A share dividend represents a distribution of additional shares to the existing

shareholders. It involves nothing more than a bookkeeping transfer from retained earning

to capital stock accounts (common stock plus capital surplus); a shareholder's percentage

ownership remains constant. Stocks dividends are frequently used to conserve cash and

still appease investors' desire for dividends.

A stock split is a change in the number of outstanding shares of stock achieved through a

proportional reduction or increase in the par value of the stock. Only the par value and

number of outstanding shares are affected. The amounts in the common stock, premium

and retained earning accounts do not change. Stock dividends and stock split can be used

to keep the market price of the stock within a popular trading range. Many companies

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believe in the existence of such a trading range for their stocks, and they attempt to keep

their stock process within the range. If there is such a popular trading range, a large

volume of low-priced stocks should provide a broader and more stable market for the

stock.

However, both stock dividends and stock splits are more costly to administer than cash

dividend. Cash dividends represent a transfer of assets to stockholder and thus increase

stockholder wealth; they represent income to the recipient. But both stock dividends and

stock splits do not involve a transfer of corporate assets to stockholders; consequently,

they did not represent incoming increase the number of shares outstanding. If the

company maintains the same amount of cash dividends per share after the stock dividend,

the total payment is increased proportionally.

A repurchase of share occurs when a firm buys back outstanding shares of its common

share. Firms repurchase share for three major reasons, which are for stock option

purpose, acquisition reason and to increase earning per share by retiring the share. The

third motive is the reason why repurchase decision can be treated as dividend decision.

The firm chooses to reduce the number of shares outstanding so that future dividend

could be increased. Stock repurchases have distinct advantages such as an increase in

earnings per share, certain tax benefits, and a significant shift in capital structure within a

short period of time.

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Dividend policy can be categorized as guiding principle chosen by the firm to pay

dividend to its shareholders. There are various types of dividend policy such as stable

dividend policy, constant dividend payout policy and residual dividend policy. Stable

dividend policy refers to two situations; constant dividend policy and stable growth

dividend. Stable growth dividend upholds a constant growth rate of dividend eventually.

Constant dividend policy maintains a relatively stable dollar dividend over time. An

increase in the dollar dividend usually does not occur until management is convinced that

the higher dividend level can be maintained in the future. Management also will not

reduce the dollar dividend until the evidence clearly indicates that a continuation of the

present dividend cannot be supported. As a consequence, firms are generally to set

dividend at a sustainable level and to raise it only when the new level can be sustained.

In the constant dividend payout policy, the percentage of earning paid out in dividend is

held constant. It means that some firms would pay dividend equaling a constant

percentage of their earning. For example, a firm having a 40Vo constant payout ratio and

earning RM2.00 per share would pay a dividend of RMO.80 per share. In general, earning

is quite volatile, fluctuating with changes in the economy and each firm's own special

circumstances. If a firm follows a constant payout dividend policy, the volatility of

dividends will match the volatility of earnings. A constant payout dividend policy is

likely to be a disaster for most firms. It would result in wildly fluctuating dividends,

which would scare away all investors seeking a particular level of dividend, as they could

not plan on a steady income. By the same token, investors interested primarily in capital

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gains would never know when they might receive a large dividends and the large tax

liability that goes with it. As such, very few firms follow such a policy.

The residual dividend policy is widely known. The theory hypnotizes that the amount of

dividends should not be the focus of the company. Instead, the primary issue should be to

determine the amount of earning retained within the firm for investment. The amount of

earnings retained, according to this view, depends on the number and size of acceptable

capital budgeting projects and the amount of earning available to finance the equity

portion ofthe funds needed to pay for these projects. Any earning left after these projects

have been funded is paid out in dividends. Because the dividends arise from residual, or

leftover earnings, this is known as Residual Dividend Policy.

From these three dividend policies, stable dividend policy is much more appreciated by

both shareholders and firms. This is because the shareholders look upon a stable dividend

as a sign of firm stability. It will also reduce a lengthy quarterly discussion on dividend

levels by board of directors. Unless circumstances warrant a possible change, the regular

dividend can be declared. This policy avoids wasting the time of the board and allows its

members to concentrate on more important matters facing the firm.

Corporate dividend policy is an important issue for at least two reasons. First, there may

be conditions where a change in dividend policy can alter the value of the firm. Second, if

dividend policy can alter the market value of the firm or its asset, it might also affect the

value of its new capital projects. If dividend policy does affect the value of capital

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projects, the net present value of a given capital project will be different for a company

with different dividend policy.

Dividend policy might affect the value of the firm for two reasons. First, tax rates on

capital gain are usually different from tax rates on dividend. If the company could reduce

taxes by transforming dividend into capital gains, shareholders might value the firm at a

correspondingly higher level. A second reason why dividend policy might affect the

value of the firm is that it could provide valuable information to shareholders. For

example, suppose that a firm has important information about the profitability of new

investment opportunities that it wishes to convey to shareholders without disclosing

details that might be useful to competitors. Changing the level of dividends might be an

effective method of signalling favourable developments, helping to ensure that the market

value of the firm reflects fullv all the information that is available to manasement.

The board's decision to pay a dividend is called declaring a dividend. This occurs on the

declaration date. At that date a liability, called dividend payable, is created on the firm's

balance sheet. Because the common stock of public corporations typically is traded every

day in the marketplace, the board of director must select a cutoff date, or date of record,

to determine who will receive the dividend. At the end of business on this date. the

company stockholder records are checked. All owners of the common stock at that time

receive the forthcomins dividend.

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When stock is traded on an exchange or in the over-the-counter market, it would take

several days to process the paperwork necessary to record the change of ownership that

occurs when the stock changes hand. On the date of record, the company's transfer agent

will have not yet known of stock trading that occurred in the days immediately preceding

the date of record. The transfer agent is the party, usually a commercial bank that keeps

the records of stockholder ownership for a corporation. The transfer agent pays dividends

to the appropriate stockholders of record after the company has deposited the required

money with the transfer agent.

Because it takes time for news of stock trade to reach the transfer agent, the rules of

trading dictate that two days before the date of record, common stock that has an

upcoming dividend payment will begin to trade ex-dividend. Investors who buy the stock

on or after the ex-dividend date will be buying it "without" entitlement to the

forthcoming dividend. The two-day period gives exchange officials enough time to notiff

the transfer agent ofthe last batch trades that occurred before the ex-dividend period. The

extra time ensures that the stockholder records will be correct on the date of record.

1.2 Problem Statement

Dividend policy is the most controversial subject in finance. Why company keep paying

cash dividend to shareholder? Why some companies keeps changing their dividend

policy? Does dividend really affect value of the company? Is there an optimal dividend

policy? Lintner (1956), Baker and Powell (1999), Shelor and Officer (1994) are among

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financial scholars whom found out that dividend policy does affect the value of the firm.

Contradictory, Miller and Modigliani (1961) have theoretically explained that the value

of the firm is unaffected by dividend policy in the world without tax, and support by

other scholars [e.g. Black and Scholes (1974), Miller and Scholes (1978)]. So, why

corporate managers still insist to pay dividend to shareholder if it is irrelevant? Today

many academicians and corporate managers still debate whether the dividend policy

matters. If it is true that dividend does affect value of the company, which relevant

theory of dividend can best explained the dividend phenomenon in Malaysia? So, this

study wants to reveal the puzzle of dividend issues by looking at the view of corporate

managers in Malaysia context.

1.3 Research Questions

This study addresses three-research question:

1. Do corporate managers believe that dividends are relevant?

2. What explanation of relevance dividend theories do managers tend to favor?

3. How do firms set the amount of dividends that they pay?

t.4 Objectives of Study

There are various theories being discussed that are conflicting and controversial in the

case of dividend. Understanding the theories is very important in order to comprehend

better with the reasons why firms give dividend to the shareholders. The contradictory

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issue of whether dividend impinges on the value of the firm is still debatable. Perhaps,

by looking at the practitioners' opinion will help us to reduce the confusion and to

understand more on this subject, as they are the decider of dividend policy in the firm.

Thus, the main objective of this study is to investigate the views of corporate managers

towards the dividend policy in Malaysia. The main objective of this study will be

supported by specific objectives, which are:

l. To find out the relationship of dividend policy and value of the company from

corporate managers view.

2. To explain the dividend relevance theory in Malaysia including the bird-in-the-

hand, signaling, and clientele tax preference and agency explanations.

3. To learn how firms determine the amount of dividends paid to shareholders

1.5 Importance of Study

Some finance scholars have engaged in extensive theorizing to explain why companies

should pay or not pay dividends [e.g. Miller and Modigliani (1961)]. Some researchers

have developed and empirically tested various models to explain dividend behavior [e.g.

Lintner (1956)]. Other researchers have surveyed corporate managers and institutional

investors to determine their views about dividends [e.g. Baker and Powell (1999) and

Baker, Farrelly and Edelman (1985)]. Regardless of extensive research and debate, the

actuaf rationale for paying dividends remains puzzle. It is important to investigate the

dividend policy issues in order to determine to what extent the corporate managers agree

with the various interpretation of dividend policy contained in the academic literature.

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Understanding the beliefs of managers who are involved in setting dividend policy may

contribute to our understanding of why firms pay cash dividend. This study will help to

reveal the issue of dividend policy in Malaysia from the view of corporate managers.

1.6 Organizing of Study

Chapter One defined the meaning of dividend and explained the relationship of dividend

policy with value of the company. In this chapter, the objectives of study and problem

statement on dividend policy are also included. Importance of this study is also enclosed

in this chapter.

Chapter two comprises of theoretical framework of dividend policy, which discuss the

commencing of several theories in dividend policy.

Chapter three consists of literature review regarding dividend irrelevance theory

dividend relevance theories such as bird-in-the-hand, signaling, and clientele effect

agency explanation.

Chapter four describes the methodology of the research. The discussion on the research

design, sampling technique, questionnaire design, data collection and data analysis will

also be included.

and

and

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Chapter five is basically the continuation of Chapter four that explained the analysis of

study, findings, and interpretation of d,ata that will show the real situation of dividend

policy from corporate managers' perspective.

Chapter Six ends the paper with conclusion, recommendation and limitation of study.

l0

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CHAPTER TWO

THEORETICAL FRAMEWORK

2.1 Introduction

The most crucial issue in the area of dividend policy is whether a company's choice of

dividend policy can affects its share price. As often happens in finance, there are

conflicting points of view.

One school of thought, the traditional one, advocates high payout ratios. According to the

traditional view, shareholders prefer immediate dividends to less certain and more distant

capital gains, which would presumably result if the cash were reinvested in the business

instead of being paid out as dividends. For obvious reasons, finance textbooks have

dubbed this view the "bird-in-the-hand arsument".

A second school of thought takes the opposite stance. According to that view,

shareholders prefer capital gains over dividends, and hence low payout ratios, because

capital gains are taxed at a lower rate than dividends.

A third school of thought, which owes its origin to Merton Miller and Franco

Modigliani's classic article on dividend policy, maintains that a company's stock market

value is relatively insensitive to its choice of dividend policy. Their article demonstrated

that under somewhat idealized conditions and with a company's capital expenditure

il

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program held fixed, changes in the company's payout ratio would not affect its stock

market value. According to this view, dividend policy is a passive rather than an active

decision; each period a company should first determine its capital investment program

and then pays out as dividends whatever cash is Ieft over. However, this so-called

"dividend irrelevance" does depend on Miller and Modigliani's assumptions.

A fourth school of thought, which has attracted growing support in recent years, has

brought the dividend policy debate full circle. According to this view, dividend changes

represent an important signal to investors regarding changes in management's

expectations as to the company's future earnings. In particular, a dividend increase

signals the expectation of higher future earnings. It is widely acknowledged that, at least

in this particular sense, dividend policy is relevant to share valuation.

Most important from a practical standpoint, companies actually behave as though

dividends do matter. For example, it is not uncommon to find rapidly growing companies

with fund needs that are growing more rapidly than earnings but which nevertheless pay

small dividends. Also, there are many companies, such as electric utilities, that have

relatively high payout ratios and that sell new issues of common stock from time to time.

If dividend policy really does not matter, it would be cheaper for these companies to pay

out smaller dividends and finance capital investment with retained earnings rather than

more expensive new issue.

t2

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2.2 Behavioral Model of Dividend Policy

Lintner (1956) conducted interviews with 28 carefully selected companies to investigate

their thinking on the determination of dividend policy. His fieldwork suggested that:

1. Managers focused on the change in the existing rate of dividend payouts, not on

the amount of the newly established payout as such;

2. Most managements sought to avoid making changes in their dividend rates that

might have to be reversed during the year or so;

3. Major changes in earnings "out of line" with existing dividend rates were the

most important determinants of a companyos dividend decisions; and

4. Investment requirements generally had little effect on modifuing the pattern of

dividend behavior.

Taken together, the observations suggest that most companies had somewhat flexible but

nevertheless reasonably well-defined standards regarding the speed with which they

would try to move toward a full adjustment of dividend payout to earnings. Lintner

suggests that corporate dividend behavior can be described on the basis of following

equation.

A Div,t : ai + ci(Divi1* - Divi.1-1) : U;1,

where

A Divrt: the change in dividends

ci - the speed of adjustment to the difference between a target dividend payout and

last year's payout

laIJ

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2.3

Div;1* : the target dividend payout

Divi,t-r: last period's dividend payout

&i,(Jir, : a constant and a normally distributed random error term

The target dividend payout, Divtt* is a fraction, ri, of this period's earnings, NIit. Upon

fitting the equation to annual data from l9l8 through 1941, Lintner finds that the model

explain 85% of the changes in dividends forhis sample of companies. The average speed

of adjustment is approximately 30o/o per year, and the target payout is 50% of earnings.

Traditional View of the Significance of Dividend Policy

(Birds-in-the-Hand)

If the amount of dividends a company pays affects its share price, there exists some

optimum level of dividends that maximizes the company's stock market value. In the

extreme, if one believes that shareholders always prefer more dividends to less, the

company should pay out all its earnings. However, few would take the argument that far.

Several models have been developed to assist in determining the optimal dividend policy.

One of the earliest, which was served as a foundation for later models, was presented in

Graham and Dodd's classic book on securities analysis:

Share price : price-earnings multiple x (dividends per share * 1/3 of earning per share)

IAt-

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