IMPACT OF RETAINED EARNINGS ON THE MAXIMIZATION

OF FIRM VALUE AND SHAREHOLDERS WEALTH

BY

MUHAMMAD ALI TIRMIZI

INSTITUTE OF ENGINEERING AND MANAGEMENT SCIENCES

FOUNDATION UNIVERSITY ISLAMABAD

2012

IMPACT OF RETAINED EARNINGS ON THE MAXIMIZATION

OF FIRM VALUE AND SHAREHOLDERS WEALTH

By

Muhammad Ali Tirmizi

130/FUIMCS/Ph.D (MS)-2006

Ph.D Scholar & HEC Awardee

A Dissertation submitted to the

Faculty of Management Sciences

Institute of Engineering and Management Sciences

Foundation University Islamabad

In Partial Fulfillment of the Requirements For the

DEGREE OF DOCTOR OF PHILOSOPHY

IN

MANAGEMENT SCIENCES

2012

ii

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TEAM OF SUPERVISOR, EVALUATORS & EXAMINERS

Supervisor Prof. Dr. Mehboob Ahmad mmehboobahmad@gmail.com Supervisor

Bahria University Islamabad.

Evaluators Prof. Dr. Amin Sarkar aminsarkar@aamu.edu Foreign Evaluator

Alabama A & M University, Alabama, United States of America.

Prof. Dr. Sajid Anwar sanwar@usc.edu.au

Foreign Evaluator

University of the Sunshine Coast, Queensland, Australia.

Examiners Prof. Dr. Khair-uz-Zaman drkzaman2001@yahoo.com External Examiner

COMSATS Institute of Information Technology, Vehari.

Dr. Syed Hassan Raza hassan_raza@aiou.edu.pk

External Examiner

Allama Iqbal Open University, Islamabad.

Dr. Hummayoun Naeem hummayoun@yahoo.com

Internal Examiner

Foundation University Institute of Engineering & Management Sciences, Rawalpindi.

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DEDICATION

I dedicate my research work to my dearest parents, wife and son, with whose support and

encouragement I have been able to complete my doctorate with pride.

vi

ACKNOWLEDGEMENTS I humbly bow to Almighty Allah for giving me strength and faculties to complete my

doctorate with diligence, dedication and commitment.

I would like to pay my gratitude to my research supervisor and teacher, Prof. Dr. Mehboob

Ahmad, and grateful that he supported and guided me all through the process of my doctoral

research work. His valuable suggestions helped me to complete this dissertation free of

technical and theoretical flaws.

I am also grateful to Prof. Dr. M. Iqbal Saif, Head of the Department of Management

Sciences of Foundation University, Islamabad, who supported and encouraged me to

complete my doctorate under tough university schedules.

I am grateful to the respondents from corporate sector of Pakistan who completed and

returned research instruments to facilitate me in the testing, analyzing and reporting the

collected financial data in the prescribed time limits.

In addition, I am grateful to Higher Education Commission (HEC), Government of Pakistan,

for granting me scholarship under the scheme Indigenous Ph.D 5000 Fellowship Program

which included my university tuition fee and monthly stipend during the period 2006 to 2011.

Finally, I am highly grateful to my father, mother, wife and son with whose moral support,

encouragement and facilitation I have been able to finish my Ph.D dissertation with pride.

vii

TABLE OF CONTENTS Page

APPROVAL SHEET... ii

TEAM OF SUPERVISOR, EVALUATORS & EXAMINERS... iii

DECLARATION...... iv

DEDICATION.. v

ACKNOWLEDGEMENTS..... vi

TABLE OF CONTENTS. vii

LIST OF TABLES.... xiii

LIST OF GRAPHS....... xvi

LIST OF FIGURES...... xvii

ACRONYMS......... xviii

ABSTRACT............... xxi

Chapter # Page

CHAPTER -1: INTRODUCTION...... 1

CHAPTER -2: REVIEW OF THE LITERATURE...... 6

REVIE OF RELEVANT THEORATICAL DEVELOPMENT.. 6

2.1 Early Developments regarding Dividends and Retained Earnings (1950-60). 6

2.2 Dividend Policy and MM Theory (1960-80s).. 7

2.3 Pecking Order Theory and extended work on Dividend Policy (1980s-2000s).........

10 2.4 Critical Analysis... 12

REVIEW OF THE EMPIRICAL WORK DONE... 14

SECTION - I: TREATING INDEPENDENT VARIABLES. 14

2.5 Studies conducted in United States of America... 14 2.6 Studies conducted in Canada 31

viii

2.7 Studies Conducted in United Kingdom 35

2.8 Studies conducted in European Union Countries. 38

2.9 Studies conducted in Australia. 42

2.10 Studies conducted in Korea and Japan. 43

2.11 Studies conducted in China, Taiwan and India 44

2.12 Studies conducted in African Countries... 46

2.13 Studies conducted in Turkey and Malaysia.. 48

2.14 Studies conducted by considering multiple countries.. 50

2.15 Critical Analysis... 55

SECTION - II: TREATING DEPENDENT VARIABLES 56

2.16 Studies conducted in USA and Canada 56

2.17 Studies Conducted in United Kingdom 62

2.18 Studies conducted in European Union Countries. 64

2.19 Studies conducted in Australia and India. 66

2.20 Studies conducted by considering multiple countries.. 68

2.21 Critical Analysis... 69

SECTION - III: TREATING MODERATING VARIABLE. 70

2.22 Studies conducted in USA, UK and Canada 70

2.23 Studies conducted in Australia and European Union Countries.. 76

2.24 Studies conducted in China, Taiwan and Uzbekistan.. 79

2.25 Studies conducted in African Countries... 80

2.26 Critical analysis 82

SECTION - IV: STUDIES CONDUCTED IN PAKISTAN... 84

SECTION - V: RETENTION POLICY AND REINVESTMENT 87

AFTER REVIEW OF LITERATURE THE PROPOSED PLAN OF ACTION.. 91

CHAPTER-3: THEORETICAL FRAMEWORK....

......

94

3.1 Overview of Theoretical Framework of the study... 94

3.2 Modified Research Model 98

3.3 Definition of the Variables... 104

ix

3.3.1 Firm Value. 104

3.3.2 Shareholders Wealth

105

3.3.3 Retained Earnings (Retention Policy of the firm). 105

3.3.4 Dividend Payout (Dividend Policy of the firm) 105

3.3.5 Capital Budgeting Process and Decisions. 106

3.4 Operationalization of the Variables.. 106

3.4.1 Operationalized form of Dividend Payout, Firm Value and

Shareholders Wealth variables under Condition 1 representing

Model 1 of the study... 106

3.4.2 Operationalized form of Retained Earnings, Firm Value and

Shareholders Wealth variables under Condition 2 representing

Model 2 of the study... 108

3.4.3 Operationalized form of Capital Budgeting Process and

Decisions under Condition 2 representing Model 2 of the

study.. 111

3.5 Interactions of the Variables 114

3.6 Hypotheses of the Study... 114

3.6.1 Hypotheses concerning retained earnings impact on Firm

Value 115

3.6.2 Hypotheses concerning retained earnings impact on

shareholders wealth... 115

3.6.3 Hypotheses concerning dividend payout impact on Firm Value. 116

3.6.4 Hypotheses concerning dividend payout impact on

shareholders wealth... 116

3.6.5 Hypotheses concerning interaction of firm value and

shareholders wealth... 117

3.6.6 Hypotheses concerning moderating affect of capital budgeting

process and decisions on the interactions of variables of model 1

& 2. 117

CHAPTER - 4: RESEARCH DESIGN.......

......

118

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4.1 Research Design of the Study.. 118

4.1.1 Purpose of the study.. 118

4.1.2 Type of investigation. 120

4.1.3 Extent of researcher interference... 120

4.1.4 Study setting.. 120

4.1.5 Unit of analysis.. 121

4.1.6 Sampling design 121

4.1.7 Sample size (n).. 121

4.1.8 Time horizon. 121

4.1.9 Data collection Method. 122

4.2 Universe and the Sampling.. 122

4.3 Rationale of the Selection of the Universe... 123

CHAPTER - 5: DATA COLLECTION...... 125

5.1 Rationale and Selection of Tool... 125

5.2 Tool Development.... 125

5.3 Details of the Tool 126

5.4 Validity and Reliability of the Tool. 128

CHAPTER - 6: DATA ANALYSIS AND INTERPRETATION......

......

129

6.1 Data Analysis Plan... 129

6.2 Descriptive Analysis of Collected Data... 129

6.2.1 Respondents data... 130

6.2.2 Firm demographic data.. 132

6.3 Regression Analysis of Model 1 136

6.3.1 Impact of Dividend Payout on Firm Value.. 136

6.3.2 Impact of Dividend Payout on Shareholders Wealth. 138

6.3.3 Impact of Firm Value on Shareholders Wealth.. 139

6.3.4 Impact of Dividend Payout and Capital Budgeting Process and

Decisions on Firm Value... 140

6.3.5 Impact of Dividend Payout and Capital Budgeting Process and

Decisions on Shareholders Wealth.. 141

xi

6.4 Regression Analysis of Model 2 143

6.4.1 Impact of Retained Earnings on Firm Value... 143

6.4.2 Impact of Retained Earnings on Shareholders Wealth... 144

6.4.3 Impact of Firm Value on Shareholders Wealth.. 145

6.4.4 Impact of Retained Earnings and Capital Budgeting Process and

Decisions on Firm Value... 147

6.4.5 Impact of Retained Earnings and Capital Budgeting Process and

Decisions on Shareholders Wealth.. 149

6.5 Comparison of Model 1 and 2 151

6.6 Analysis at Industrial Level.. 157

6.6.1 Performance of the sample 157

6.7 Sources of Financing 159

6.8 Profitability.. 161

6.9 Reinvestment Activities... 164

6.10 Outcome of Recent Projects. 167

6.11 Managerial Ownership. 168

6.12 Capital Budgeting Techniques. 170

6.13 Discount Rate for Investment Projects. 173

6.14 Adjustment of Risk Factors.. 174

6.15 Average Growth... 176

6.16 Expected Growth.. 177

6.17 Financing Condition. 179

6.18 INTERPRETATION OF DATA. 180

CHAPTER - 7: FINDINGS AND DISCUSSION.......

......

183

7.1 SECTION-1: Discussion and Findings Relating Research Models... 184

7.2 SECTION-2: Discussion and Findings Relating Supporting Data..... 186

CHAPTER - 8: CONCLUSION AND RECOMMENDATIONS..... 190

8.1 Conclusion 190

8.2 Recommendations 192

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REFERENCES.. 193

LIST OF PUBLICATIONS OF THE CANDIDATE. 214

APPENDIX A: RESEARCH INSTRUMENT 215

APPENDIX B: STUDY POPULATION. 234

APPENDIX C: RESEARCH SAMPLE.. 239

APPENDIX D: EMPIRICAL EVIDENCE OF INTERACTION OF

VARIABLES OF THE STUDY... 245

APPENDIX E: FIRMS LEFT AFTER DATA COLLECTION PROCESS... 249

APPENDIX F: FIRMS DEFAULTED DURING DATA COLLECTION.. 253

APPENDIX G: DISTRIBUTION OF RESEARCH QUESTIONNAIRES. 254

APPENDIX H: FIRMS REPLIED WITH COMPLETELY FILLED

QUESTIONNAIRES. 258

APPENDIX I: FACTOR ANALYSIS. 259

APPENDIX J: EXTENTION OF EQUATIONS... 265

xiii

LIST OF TABLES

Table Title Page

Table 4.1 Randomly selected firms industry-wise distribution.. 123

Table 5.1 Detail of the distribution of questionnaires in the sample... 126

Table 5.2 Industrial sector wise distribution of responded sample firms 127

Table 5.3 Empirical evidence regarding response rate of research studies. 127

Table 5.4 Cronbachs Alpha score of the variables of Model 1 and 2... 128

Table 6.1 Dividend payer and non-payer categories of the sample. 129

Table 6.2 Frequency of respondents designation 130

Table 6.3 Frequency of respondents gender... 130

Table 6.4 Frequency of gender of the respondents.. 131

Table 6.5 Frequency of education level of the respondents. 131

Table 6.6 Frequency of ownership of the sample firms... 132

Table 6.7 Frequency of employees of the sample firms.. 133

Table 6.8 Frequency of age of the sample firm... 133

Table 6.9 Frequency of the industrial classification of the sample firm.. 134

Table 6.10 Frequency of the total sales revenue of the sample firms 134

Table 6.11 Frequency of the type of dividend payment by the sample firms 135

Table 6.12 Frequency of retention of earnings by the sample firms.. 135

Table 6.13 Frequency of maintaining dividend policy by the sample firms.. 136

Table 6.14 Impact of dividend payout on firm value 137

Table 6.15 Impact of dividend payout on shareholders wealth... 138

Table 6.16 Impact of firm value on shareholders wealth.. 139

xiv

Table 6.17 Impact of dividend payout and moderating variable on firm value. 140

Table 6.18 Impact of dividend payout and moderating variable on shareholders wealth. 142

Table 6.19 Impact of retained earnings on firm value... 143

Table 6.20 Impact of retained earnings on shareholders wealth... 144

Table 6.21 Impact of firm value on shareholders wealth.. 146

Table 6.22 Impact of retained earnings and moderating variable on firm value 147

Table 6.23 Impact of retained earnings and moderating variable on shareholders wealth. 149

Table 6.24 Regression results of model 1...... 151

Table 6.25 Regression results of model 2..... 151

Table 6.26 Regression results of model 1 without moderator affect.. 153

Table 6.27 Regression results of model 2 without moderator affect.. 153

Table 6.28 Regression results of model 1 with moderator affect.... 154

Table 6.29 Regression results of model 2 with moderator affect.... 155

Table 6.30 Change in the values of R and R square for model 1 and 2.. 156

Table 6.31 Indicators of sample performance at industrial level... 157

Table 6.32 Analysis results of the sources of financing of the sample.. 159

Table 6.33 Analysis results of the sources of financing of the sample.. 159

Table 6.34 Analysis results of the profitability of the sample... 161

Table 6.35 Analysis results of the profitability of the sample... 162

Table 6.36 Analysis results of the reinvestment activities of the sample.. 164

Table 6.37 Analysis results of the reinvestment activities of the sample.. 165

Table 6.38 Analysis results of the outcome of recent projects of the sample 167

xv

Table 6.39 Analysis results of the managerial ownership in the sample firms.. 168

Table 6.40 Analysis results of the use of capital budgeting techniques by the sample... 170

Table 6.41 Analysis results of the use of capital budgeting techniques by the sample... 171

Table 6.42 Analysis results of use of discount rate for investment projects by sample... 173

Table 6.43 Analysis results of the adjustment of risk factors by the sample. 174

Table 6.44 Analysis results of the adjustment of risk factors by the sample. 175

Table 6.45 Analysis results of the average growth of the sample during (2000 - 2009) 176

Table 6.46 Analysis results of the expected growth of the sample in 2 to 3 years 177

Table 6.47 Analysis results of the expected growth of the sample in 2 to 3 years 179

xvi

LIST OF GRAPHS

Graph Title Page

Graph 6.1 Net profit as percentage of sales of the sample firms at industrial level.. 163

Graph 6.2 Reinvestment activities of the sample firms at industrial level... 166

xvii

LIST OF FIGURES

Figure Title Page

Figure 3.1 Thesis Research Model 97

Figure 3.2 Modified Research Model... 102

Figure 3.3 Simplified Interaction of variables in Modified Research Model... 103

xviii

ACRONYMS

APT Arbitrage Pricing Theory

APV Adjusted Present Value

ARR Accounting Rate of Return

BHCs Bank Holding Companies

CAPM Capital Asset Pricing Model

CARs Cumulative Abnormal Returns

CEO Chief Executive Officer

CF Cash Flow

CFO Cash Flow from Operations

CFO Chief Financial Officer

CRE Corporate Real Estate

CREM Corporate Real Estate Management

COR Cost Over Run

ERC Earnings Response Coefficient

EU European Union

EVA Economic Value Added

FCF Free Cash Flows

FDI Foreign Direct Investment

GMM Generalized Method of Moments

IRR Internal Rate of Return

ITC International Trade Centre

IVS Intrinsic Valuation System

xix

KSE Karachi Stock Exchange

MARA Market Adjusted Return Approach

M&A Merger and Acquisition

MM Theory Miller and Modigliani Theory

MVA Market value Added

NI Net Income

NPV Net Present Value

OLS Ordinary Least Square regression

PBP Payback Period

PI Profitability Index

PO Pecking Order

POR Payout Ratio

RE Retained Earnings

REIT Real Estate Investment Trust

R&D Research and Development

RIM Residual Income Model

ROA Return On Assets

ROE Return On Equity

ROI Return On Investment

ROIC Return On Invested Capital

SECP Securities and Exchange Commission of Pakistan

SMEs Small and Medium Enterprises

SMEDA Small and Medium Enterprise Development Authority, Government of Pakistan

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SPSS Statistical Package for Social Sciences

UK United Kingdom

USA United States of America

V Value of the Firm

VCM Value Creating Management

VECM Vector Error Correction Model

WACC Weighted Average Cost of Capital

xxi

ABSTRACT

In this research study a mathematical model has been adopted and extended into two

conditions representing two research models that have; dividend payout, retained earnings,

firm value, shareholders wealth and capital budgeting process and decisions as variables.

Accordingly the current author has formulated a new theory named as Hybrid Theory of

Firm Valuation. This study statistically tests the theory by empirically evaluating the models

and the supporting variables. The hypotheses which are tested in the study have been deduced

based on extensive financial literature review that includes a vast array of financial models.

The size of the sample consists of 102 randomly selected listed Pakistani manufacturing firms

that belong to eight industrial sectors and are located in twelve cities of Pakistan. The data is

collected by means of an extensive but strategically developed research instrument. Linear

Ordinary Least Squares regression analysis is applied on the collected data. It suggests that

second model has greater predictability and strength as compared to the first model. The

inference of the tests of the models is also endorsed by the analysis of the supporting

variables of the study. The major findings of the study have revealed that retention policy

model is much congenial for the sample firms operating in Pakistan and application of the

payout of dividends model can be postponed until high growth and reinvestment period is

over. It is established that retained earnings has created higher impact on the firm value and

the wealth of the shareholders in the business environment of Pakistan. The investment and

reinvestment activities undertook by the sample firms during the study period (2000 to 2009)

supports the higher association of the variables of the second model. The empirical tests of

the models have supported the Hybrid Theory of Firm Valuation.

Key words: Theory, Retained earnings, dividend payout, firm value, shareholders wealth,

capital budgeting process and decisions, reinvestment and investment of

internal funds, growth, listed manufacturing firms, Pakistan.

1

CHAPTER 1: INTRODUCTION

The topic impact of retained earnings on the maximization of firm value and shareholders

wealth has not been explored extensively in the past. Greater emphasis has been placed on

dividend payout behavior of the firms by finance researchers who explored and measured

dividend policy issues in international arena. The current author has seen a very limited

number of studies written on the topic of this thesis. Recent decade has produced some

valuable studies that have set the course of future studies in this area. A comprehensive

approach is required to explore a bigger canvas that may explain both sides of the story

relating to distribution of capital earned by a business firm.

The earliest study that initiated debate on distribution of capital in the form of dividends as

well as retention of capital for investment purposes was published by Lintner (1956). The

classic work of Lintner is still considered as foundation of corporate finance. Multiple finance

models have been developed based on his work. Graham and Dodd in (1951) discussed the

securities analysis techniques and concentrated on dividends affects. But, the work of Lintner

was more explanatory and comprehensive. In this area well-known theories have been

developed by corporate finance researchers by taking into account the dividend policy of the

firm. MM theory presented by Miller and Modigliani (1961) was also considered a valuable

asset of corporate finance until the time this theory was refuted by researchers in the last

decade. The current author has discussed in detail these and related theories in the subject of

corporate finance in chapter 2.

Despite the fact that a large number of studies, over a period of more than forty years, have

explored the issues concerning dividend policy in an international context, no one has yet

solved the dividend puzzle (Bhattacharyya, 2007). The current author has considered dividend

policy as one side of the coin. The other side of the coin is retention of earnings by firms

2

which are used by the firm in operating, financing and investing activities. In real world, if a

coin has only one side and other side is removed, it becomes worthless with no value. So,

both the sides of the coin make it valuable. We identify this fact as knowledge gap in

corporate finance literature. It can be understood by the help of the following formula:

1 = dividend payout ratio + plowback (retention) ratio

The current author has formulated Hybrid Theory of Firm Valuation based on above

mentioned formula and also based on the review of corporate finance literature. The current

author evaluated both sides of the coin and explored related issues in the business

environment of Pakistan to test the formulated theory. In Pakistan the research in the subject

of corporate finance is evolving and is at the embryonic stage of development. Recent decade

has produced some quality research in the subject of financial economics. But, there are

multiple uncharted areas in the subjects of corporate finance which need to be addressed in

Pakistan.

A study published by Mehar (2007) gained the attention of current author towards the issue

of lower dividend payout by the firms operating in Pakistan. In Pakistan retention rate is

much higher as compared to the payment of dividend of 23% of the incremental profits of the

company. The current author has studied multiple concepts that explained the retention and

use of earnings by a firm and came up with different point of views on this issue until the

time he read a study in the subject of mathematical finance by Sethi and Taksar (2002) that

addressed the issue concerning optimal financing problem of infinite horizon corporation.

This study is based on the work of Sethi and Taksar, accordingly adopted firm valuation

equation, derived by them, to evaluate impacts of retained earnings as well as dividend

payout on the value of the firm in the business environment of Pakistan. According to

Pecking Order Theory (Brealey and Myers, 2003, chap. 18, p. 511) retained earnings are the

primary source of financing used for the reinvestment activities by a firm and the

3

reinvestment procedure includes selection of viable projects by means of capital budgeting

process. This statement shows the importance of capital budgeting for a firm. This study

introduces capital budgeting process and decisions as moderating variable and shareholders

wealth as another dependent variable. So, the statement of the problem developed by the

current researcher is as follows:

What is the level of significance and application of reinvestment models of corporate

retained earnings in Pakistan and how these models effect the value maximization of the firm

and enhancement of shareholders wealth?

The main objective of this study is to test the mathematical models devised by the current

author based on the work of Sethi and Taksar and extends the scope of this research by

incorporating other related variables that can potentially alter the interactions of variables in

the research models. In this study two mathematical models have been devised through

modification of Sethi and Taksar (2002) model. The first model tests the interactions of

dividend payout with and without the influence of capital budgeting process and decisions

included as moderating variable on the firm value and shareholders wealth. And the second

model tests the interactions of retained earnings with and without the influence of capital

budgeting process and decisions included as moderating variable on the firm value and

shareholders wealth. This study further compares the strengths of the two models by

applying linear regression on the collected data. The current author has pooled manufacturing

firms that are listed at Karachi Stock Exchange (KSE) of Pakistan as population and

randomly selected firms to test the Hybrid Theory of Firm Valuation. A comprehensive

research instrument has been developed that incorporates operationalized form of variables

from multiple past research studies and publications to tap the responses of the respondents of

the sample. The sample firms were approached through postal and electronic mail. The firms

approached that belonged to eight industrial sectors, located in twelve cities of Pakistan. The

4

sample firms that responded with completely filled research questionnaires belonged to four

industrial sectors of Pakistan. A number of hypotheses were formed on the bases of review of

existing corporate finance literature and then tested the same using Ordinary Least Squares

linear regression analysis. Statistical Package of Social Sciences (SPSS) is used for statistical

analyses.

The major findings of the tests of the research models supported The Hybrid Theory of Firm

Valuation and revealed that investment and reinvestment of retained earnings model is

significant and suitable for the listed manufacturing firms operating in the business

environment of Pakistan. The dividend payout model is currently not feasible to be applied in

the case of listed firms operating in Pakistan. The basic reason behind this argument is the

higher growth experienced by the listed sample firms during the study period that ranges

from 2000 to 2009. In this period sample firms that responded have also reinvested greater

portion of their net income in value enhancing activities that include; business expansion

activities within the firm, new investments in long-lived assets and investment in real estate.

This study can benefit the policy makers in the Government of Pakistan as well as the listed

Pakistani manufacturing firms, local and foreign research organizations, finance and

economics research scholars who want to understand a wider picture of the flow and

distribution of capital earned by the listed manufacturing firms in Pakistan. The formulation

of a new corporate finance theory and modified version of the models used in this study, are a

small contribution from the current scholar. Therefore, it is hoped that this study will

contribute towards the existing knowledge base of the corporate finance. This study will also

facilitate interested parties to understand financial systems and models in the context of

Pakistan. The results of this research can also be used by academicians to develop case

studies that raise issues in this field and also researchers can explore financial models in

diversified forms of business environments. The models based on Hybrid Theory of Firm

5

Valuation tested in this research thesis can also be tested in other parts of the world to check

the robustness and generalizability of the results and inferences.

The layout of this research thesis incorporates the following chapters which are briefly stated

below.

Chapter 2 explains literature review of books and articles relating to variables of the study.

The proposed plan of action and formulation of the Hybrid Theory of Firm Valuation are

explained at the end. Chapter 3 explains theoretical framework of the study including

deductions of hypotheses, definition, operationalization and interaction of variables. Chapter

4 explains research design of the study. Also, Universe and sampling methodologies are

explained. Chapter 5 explains data collection process including tool development and

description. Chapter 6 presents data analysis plan, regression results of models. Also, analysis

of support data is presented in tabular form. Chapter 7 presents interpretation of the models

analysis in section one and supporting data analysis in section two. Also, salient findings are

presented by the current scholar. Chapter 8 concludes the study and some recommendations

are suggested at the end. References and appendices follow this chapter.

6

CHAPTER 2: REVIEW OF THE LITERATURE

This chapter presents review of the corporate finance literature.

REVIEW OF THE RELEVANT THEORETICAL DEVELOPMENT

The current author has reviewed and documented the relevant theoretical development in the

corporate finance literature relating variables of the study from the books of the following

authors: Brigham and Ehrhardt, 2001; Brealey and Myers, 2003; Mahapatra and Mahapatra,

2004; Copeland, Weston and Shastri, 2007.

2.1. Early Developments regarding Dividends and Retained Earnings (1950-60)

Dobrovolsky (1951) considered corporate retention decision as an active and primary

decision variable for a firm when savings are preferred over payout of dividends to the

shareholders. According to the author dividend and retention decisions are by-products of

each other when ownership and control functions are separated due to agency conflicts.

Retention decision is primary to a firm because growth oriented firms prefer to reinvest

earnings instead of paying dividends to the shareholders.

Lintner (1956) described distribution of income by corporations regarding dividends, retained

earnings and taxes by constructing a corporate dividend behavioral model. He conducted 28

interviews to determine factors affecting dividend policy. The stylized factors presented by

him describe dividend decisions of a firms as; (i) Firms that are at their maturity stage payout

larger portion of their earnings as dividends whereas, growth oriented companies payout

small part of their earnings, incase they have such funds available, (ii) The main focus of

managers in a company is on relative change in dividend per year rather than on absolute

levels of dividends payout per year, (iii) Sustainable earnings of the company determine

7

smooth dividends payout whereas, changes in earnings of the company has no effect on this

payout process, (iv) Managers always remain very critical of decisions regarding dividend

payout policy and have mindset to increase dividend payout per year.

2.2. Dividend Policy and MM Theory (1960-80s)

Miller and Modigliani (1961) extensively worked on the dividend policy variable in idealized

conditions. They presented MM Theory of dividend policy. According to MM theory the

value of the firm is unaffected by the dividend policy in a world without taxes, transaction

costs or other market imperfections. Also, this theory suggests that the value of the firm

depends only on the income produced by its assets and division of income in terms of

dividend and retained earnings is not useful for the firm. Authors developed MM Theory on

the basis of the following assumptions; capital markets are frictionless, individuals can

borrow and lend at the risk-free rate, there are no bankruptcy costs and business disruptions,

firms can only issue risk-free debt and risky equity claims, all firms are in same risk class,

only corporate taxes are enforced, all cash flow streams are non-growth, same information is

available to the principal and agent and change in capital structure has no effect on the

operating cash flows of the firm.

Friend and Puckett (1964) tested the effect of dividend payout on the share value by using

cross-sectional data and criticized the approach that linked higher dividend payout with

higher price to earnings ratio by the firm. The earlier work reported that dividend multiplier

was several times the retained earnings multiplier. Empirical work established that riskier

firms had lower dividend payout and price to earnings ratio. It was also reported that retained

earnings had measurement error and dividends had not. But, authors eliminated the

measurement error of retained earnings by using net income of the firm normalized by the

8

price ratio for the firm and at industrial level it was normalized by price ratio for the industry.

But, in-spite of these developments no test was performed to analyze the difference between

the impacts of retained earnings and dividends significance. And, no theory was formulated

in this area.

Farrar and Selwyn (1967) assumed a world with personal taxes in-addition to corporate taxes

and developed a model to represent maximization of after tax income by the individual. They

applied partial equilibrium analysis and assumed that shareholders have two choices;

shareholders can own shares in an all-equity firm and borrow to provide personal leverage or

buy shares in a levered firm. So, shareholders can demand for dividends or defer dividends in

an anticipation of future higher capital gains.

Brennan (1970) extended the work of Farrar and Selwyn (1967) into a general equilibrium

framework. They assumed that shareholders demand higher dividend yield on the firms

security investment at a given level of risk because dividends were taxed higher than the

capital gains.

Black and Scholes (1974) endorsed the assumptions of the MM theory and further added that

high payout to clienteles satisfies their demand and under this condition high or low

dividends have no effect on price or returns. So, value of the firm is not affected by its

dividend policy.

Ross (1977) worked on the irrelevance proposition of MM Theory which stated that market

knows the random stream of return of the firm and valuing this stream sets the value of the

9

firm. He developed a theory that stated that an increase in the use of debt by the firm will

represent unambiguous signal to the marketplace that firm has improved its prospects.

Miller and Scholes (1978) explained the case of a firm value that was facing disparity in

corporate and personal taxes regarding dividend income and capital gains. They added that if

the tax on ordinary personal income is greater than the capital gain tax, individuals will be

indifferent between the payments in the form of dividends or capital gains, when firm decides

to repurchase shares from the individuals. So, under this case value of the firm will be

unrelated to its dividend policy even in a world with personal and corporate taxes.

Bhattacharya (1979) developed a dividend-signaling model to explain the dividend payout

behavior of firms under tax disadvantage conditions. He indicated that dividend payout

signals to the market about the value of the firm. Author assumed that if investors believe that

firms that pay higher dividends per share have higher values, then an unexpected increase in

dividend payout will be considered as positive value enhancing signal. In-order to achieve

optimal dividend payout under signalling nature of dividends, tax disadvantage was traded-

off by higher dividend payout by the firm.

Rozeff (1982) suggested that even if we ignore tax considerations, optimal dividend policy

does exist. Author traded-off flotation cost of raising external equity with the increase in

dividend payouts that benefits firm by reducing agency costs. The author indicated that fast

growing firms could reduce their dependence on external equity financing by paying lower

dividends to the shareholders. So, growth was reported negatively related to the dividend

payout by the author.

10

Asquith and Mullins (1983) analyzed the affect of dividend initiation announcement on the

wealth of the shareholders. Authors considered firms that had mostly never paid dividends in

their life spans and when dividend initiation announcement was aired, the first two days

abnormal returns of the shareholders were maximized significantly.

2.3. Pecking Order Theory and extended work on Dividend Policy (1980s-2000s)

Myers (1984) suggested a Pecking Order Theory for capital structure. This theory categorized

the sources of financing used by the firm. According to author firms prefer retained earnings

(available liquid assets) as their main source of funds for investment. The second preference

was given to debt and third was external equity financing by the firm. Author added that firm

avoids issuing common stock or other risky securities in-order to save it-self from becoming

higher leverage firm because higher leverage may led to bankruptcy.

Miller and Rock (1985) constructed a signaling model based on the concept of net

dividends. They included and combined dividends and external financing variables to show

that they are merely two sides of the same coin which explains that every firm at certain point

in time faces financing sources and utilization constraints. Authors also linked announcement

effect on shareholders wealth with the firms earnings surplus. So, these authors explained

firms earnings surprises, unexpected dividend changes and unexpected external financing as

signals to the market about the value of the firm.

Masulis and Trueman (1988) constructed a model by considering investment and dividend

decision variables under fairly realistic assumptions which included; payment under same

effective marginal tax rate by all the firms, different tax rates on dividend income for

diversified group of individuals, zero effective capital gains taxes, regular taxation of

11

corporate equity purchase similar to dividend payment taxation and 80% dividend exclusion

from taxes on all dividends paid between two corporations. So, larger cost of deferring

dividends induces firms to optimally payout cash dividends to its shareholders.

Helwege and Liang (1996) tested the pecking order theory and found that firms with surplus

funds avoided to generated capital from the capital market and internal cash deficit showed

no predictability for the decision to obtain external funds by the firm. Authors found

consistency in results with the pecking order hypothesis.

Allen, Bernardo and Welch (2000) developed theory of dividends based on tax clienteles

which suggested that higher payout of dividends to the shareholders signal the market the

worth of the firm. Authors indicated that under higher tax on dividend payouts, an inclination

towards shares repurchase as a means of distribution of income by the firm was observed in

the developed part of the world.

Baker and Wurgler (2002) developed a theory in which the decision of dividend payout was

driven by the demand of the investor. Authors indicated that catering is the best explanation

of dividend initiation by the managers of the firm because managers initiate dividend payout

when investors put a relatively high stock price on dividend payer and when non-payer are

priced as compared to dividend payers, dividends are omitted.

Fama and French (2002) analyzed firms dividend and debt policies under the effect of trade-

off and pecking order models. Authors reported that firms that were highly profitable and had

fewer investments paid higher dividends to their shareholders. They also reported that firms

that had higher profitability and investments had lower leverage ratios and this fact

12

established consistency of finding with the trade-off and pecking order theories. Also, higher

leveraged firms have higher cost of capital and it makes firms riskier for investment.

2.4. Critical Analysis

The debate on firm valuation was stated in 1950s, which in result signified dividends and

retained earnings as active and primary decision variables. Early Research scholars identified

dividends and retained earnings as by-products that affect firm value. During 1960s after the

development of MM theory dividend policy became the center of attention and researchers

from around the world started working on dividend payout as predictor of firm value. In early

studies, firm valuation was examined in terms of change in per share value in idealized

conditions. During 1970s and 80s, multiple models of dividend policy like; dividend-

signaling model, dividend initiation affect model, etc, were developed and tested by

considering real market data. Moreover, tax effect of dividends were extended to include debt

policy of the firm and effects of tax shield in case of corporate and personal taxes were

examined by international researchers.

The introduction of Pecking Order Theory in 1980s enhanced the concept of firm valuation

and in-addition to dividend payments investment sources were included as important

variables affecting firm value. Extensive research was done in respect of pecking order

around the world and corporate finance researches examined firm value by constructing

models that varied in scope and application.

During 1980s, 90s and2000s, further work on dividend policy was carried out and new

models like; dividends based tax clienteles, catering model of dividend initiation, trade-off

model, etc, were developed and affect of leverage was tested in respect to firm valuation.

Evidence cited above shows that an extensive research work was carried out by considering

dividend policy as an important decision variable for a firm. But, research on dividend policy

13

was carried out in isolation and the significance of retained earnings variable which is a part

of retention policy of a firm was altogether neglected. Minimal amount of studies regarding

retained earnings done in recent times are available on payment on online research databases.

So, retained earnings beside dividend policy, has not been extensively researched in the past.

This fact indentified a gap in the corporate finance literature. Moreover, dividend payout and

retained earnings are two important decision variables and during firm valuation process

impact of these variables should be examined in-order to access the affect of distribution of

net income of a firm in terms of dividend payout and retained earnings.

Review of existing available empirical studies has been carried out to support and check the

significance of the identified knowledge gap.

14

REVIEW OF THE EMPIRICAL WORK DONE

The empirical work reviewed in the context of the title of this research study covering the

variables of the devised models is comprehensively explained below:

SECTION - I: TREATING INDEPENDENT VARIABLES

The independent variables from the two devised models of this research study are; dividend

payout variable (dividend policy) and retained earnings (retention policy). The empirical

work done related to these variables covered a vast number of issues directly or indirectly

involving two variables. The studies reviewed and reported here mainly include testing,

analyzing or evaluation of formulated models by the authors concerned with respect to

geographical regions of the world.

2.5. Studies conducted in United States of America

Ghosh and Woolridge (1989) investigated the reaction of firms shareholders when common

stock dividends were cut to generate funds for investment. They also examined growth

oriented dividend cuts in the context of stock market reaction and performance of the sample

firms. They associated dividend cut with the principle of value maximization of the

shareholders. They selected US firms that exercised dividend cuts or omitted dividends

payout, and collected 49 dividend cut observations during 1962 to 1984. They also compared

two samples of firms that had cut dividends based on growth and earnings. The authors used

Market Adjusted Return Approach (MARA) and found that dividend cut announcements in

the growth oriented as well as earnings oriented cases affected negatively the stock price of

the firm and also reduced the capital of the shareholders. The authors concluded that a sample

firm that followed shareholders value maximization policy occasionally cut dividends to

15

accumulate funds for investments. The dividend cut announcements negatively affected stock

price of the sample firms and it resulted into decreased firm value and shareholders wealth.

Agrawal and Jayaraman (1994) evaluated dividend policies of all-equity US firms. They

defined all-equity firms as, those that use no long-term debt throughout a continuous five-

year period. They finalized 71 matched pairs of all-equity US firms and collected data

during 1979 to 1983. They tested dividend payout model and applied multivariate regression

analysis on the collected data. They found that dividend payout and managerial ownership

were inversely related. The authors reported that all-equity sample firms paid-out higher

dividends as compared to levered firms. They concluded that all-equity sample firms were

smaller in size but paid higher dividends to their shareholders due to lower level of

managerial ownership structure in these firms.

Barclay, Smith and Watts (1995) analyzed leverage and dividend policy choices of multiple

USA based business entities. They assessed more than 6,700 US industrial firms and

collected 71384, 6780 and 70695 firm year observations during 1963 to 1993 for the analysis

of pooled, cross-sectional and fixed effects. They considered broad spectrum of financial

theories to understand the relative importance of each and every aspect of these theories that

create impact on the financial behavior of US industrial firms. The authors applied OLS

regression analysis and found stable value of the leverage and dividend policy. They

identified taxes at personal and corporate level as well as leverage as the determinants that

affected the firm value. They identified direct and indirect bankruptcy costs as factors that

decreased firm value. The higher asset in place firms with higher market to book value had

significant lower levels of leverage ratios. However, regulated firms had higher leverage and

dividend payout as compared to unregulated firms. Under signaling effect of dividend policy

16

under-valued high quality sample firms showed higher leverage and dividend payouts. The

tax effect of dividend policy was not supported by the findings of the study. But, results of

pooled regression analysis showed that large sample firms had lower leverage ratios and

higher dividend yields. The authors identified leverage and dividend policy as signaling tools.

Elston (1996) investigated the importance of dividend policy by considering sensitivity of

liquidity of firms investment policys considered as constraint under the framework of Q

Theory of investment. He defined cost of capital and creation of liquidity constraints as two

major ways through which dividend policy affect the investment mechanism of the firm. He

developed and modified dividend payout model to represent firm investment at a particular

time. The size of the sample was 220 large US stock issuing firms and financial data of 770

firm year observations was collected during 1975 to 1988. He applied GMM method to test

the model. He found that cash flow was significant for all groups of firms. The author

explained that increase in firm size showed greater dependence on the cash flow used to fuel

the investment demand. The author concluded that dividend policies of sample firms were

independent of the issues concerning investment decisions and liquidity constraints.

Sloan (1996) investigated the role of earnings and free cash flows in performance evaluation

of the firm. He discussed realization and matching principles of accounting and elaborated

their impact on the measurement process of firms earnings. He discussed two types of

dividend discount models. He used earnings and cash based models to forecast prospective

dividends of the firms. He identified earnings based model of discount cash flow as the best

available mechanism that can predict future direction of the firm. He considered the return

strategy of listed US firms for the period 1963 to 1993 and found that the hedged portfolios

of the sample firms generated abnormal return of 11%. The author concluded that the finding

17

of his study supported the manipulation mechanism of earnings. Sample firms used this

mechanism to raise the level of stock prices which in result temporarily raised the market

values of the sample firms.

Chung and Wright (1998) analyzed Tobins Q ratio to estimate the impact of corporate

investment behavior on market value of the firm. The major objective of the study was to

examine how Tobins Q contributes towards the valuation of corporate policy decisions?

The authors also examined cross-sectional association among the variables by considering

five years data of publicly traded large manufacturing firms collected during 1983 to 1987.

The data of the study comprised of 4,430 time-series and cross-sectional observations. They

considered the model of market value of the firm and further modified it to test the

associations of variables. They used regression analysis and found that low Q firms with

debt burden were positively associated with their market values and dividend payout of over-

investing firms with higher Q value had no association with their market values. Also,

negative association between financial slack and market value was reported. The authors

reported positive associations between debt ratios, higher payouts, financial slack (retained

earnings) and R & D investments with the market values of over-investing firms.

Fama and French (1998) investigated the association of earnings, investment and financing

with the firm value. They selected all the US based firms that had financial information

available relating the variables of the study. They collected data during 1965 to 1992. The

authors developed a regression model representing total market value of the firm that had

spread of value over cost. They found positive change in firm value linked with the increased

past, present and expected future growth in earnings. Firms payout of dividends and debt

also positively affected the firm value. So, the authors rejected the idea that taxes have effect

18

on the pricing of dividends. Similarly, the test of debt with the tax effect showed that they

were not related and taxes did not create variations in the association of value of the firm and

financing decisions. Leverage created negative affect on the firm value. The authors

concluded that sample firms earnings had information conveying characteristics.

Baker and Powell (1999) compared valuable views of 170 senior level managers from 113

regulated (termed as utilities) and 392 unregulated (termed as manufacturing) listed US

Corporations regarding four issues related to dividend payout behavior. They also

investigated the correlation between various determinants of corporate dividend policy. They

extended their study based on; the signalling, bird in the hand, tax preference and agency

costs explanation of dividend policy. They used survey instrument of Baker (1985). The

response rate of the survey was 33.7%. The authors applied chi-square test and analyzed the

views of the senior level managers of regulated and unregulated US sample firms. They

found that results supported the signaling explanation of the dividend policy. The authors

reported that the level of current and expected future earnings, pattern or continuity of past

dividends, concern about maintaining or increasing stock price, concern that a dividend

change may provide a false signal to investors and stability of cash flows were the most

important determinants of the dividend policy.

Chen and Steiner (1999) investigated the association between managerial ownership with

firms risk taking capacity, debt policy and dividend policy behaviors by employing non-

linear simultaneous equation estimation method. They also examined the interaction of

external shareholders with the firm management and the interaction of shareholders with the

bondholders under the influence of agency theory. They selected sample of 785 listed firms

and applied OLS regression analysis on the collected data. They found risk positively

19

associated with managerial ownership. The debt and dividend policies showed negative and

significant association with the managerial ownership. This association showed that under

enhanced monitoring and control of managers of sample firms, debt and dividends payout

levels reduced significantly. As a consequence, conflict between firms shareholders and

bondholders increased. The authors concluded that managerial ownership facilitated sample

firms to mitigate agency conflicts but conflict between firms shareholders and bondholders

aroused. Thus, low propensity to payout dividends by the sample firms indicated a trend of

stockpiling of earnings.

Dutta (1999) examined the relationship between managerial ownership known as inside

ownership of equity in US based Bank Holding Companies (BHCs) and also analyzed the

dividend and debt policy decision choices of these corporations. The size of the sample was

136 BHCs and the financial data was collected during 1994 to 1997. The author applied

simultaneous equations regression analysis also known as two-stage least squares

procedure on the three models representing inside holdings, dividends and debt linkages and

found negative association between insider holdings and dividends. He reported positive

association in the case of debt and dividends. The author concluded that banks in USA had

higher managerial ownership concentration and involvement in the form of equity

ownership. This phenomenon indicated higher level of capital retention by the banks in

USA.

Riahi-Belkaoui (1999) defined earnings determination as, the process of finding acceptable

level of reported earnings of the firm. He associated earnings determination as response to

wealth generation or net value added. The objective of his study was to test net value added-

earnings policy model. This model was based on net value added of the earnings and it was

20

basically used to measure wealth generated by the firm. He further modified the initial

permanent net value added model. The size of sample financial data was 4,410 firm year

observations collected during 1976 to 1995. The author used descriptive and correlation

analysis and found that current earnings of the firm were significantly predicted by the net

value added and last year level of firm earnings.

Arnott and Asness (2001) discussed the role of dividend policy in forecasting the earnings

growth of the firm. The main focus of this study was to investigate the factors related to

dividend policies of a wide quantity of market-based firms. They had considered the model of

expected returns known as constant growth valuation model and further modified this

model in-order to represent dividend yield in terms of multiple of payout ratio and earnings

yield. Authors acquired data from multiple sources during the years 1950 to 2000 in the USA.

They used regression analysis and found that the yield curve had a weaker forecasting power

as compared to the payout ratio in the prediction of the earnings growth. The authors reported

that in an efficient market where constant expected returns on equity investment prevailed,

lower earnings yield directly linked with futures higher real earnings growth. They

concluded that low payout ratios and high retention rates of the firms led to lower earnings

growth. Thus, payout ratios were not the positive predictors of the future earnings growth for

the sample firms.

Kholdy and Sohrabian (2001) revisited pecking order and free cash flow hypotheses by

considering firms of different sizes. They used Vector Error Correction Model (VECM) to

estimate the causal relationship between cash flow and investment behavior of sample firms

and explained the long-term trends and short-term dynamics of the variables. They selected

aggregate firm level data from different USA published sources and collected 64 time series

21

observations during 1980 to 1996. The authors also segregated firms as, small, medium and

large based on their asset values. They applied co-integration tests to estimate the VECM

for each sized group of firms in the time series data and found that small sample firms used

more debt and borrowed twice as compared to the amount invested by the firms. Medium

sample firms were found busy in the maximization of shareholders value. Large sample

firms used retained earnings and debt extensively to fuel investments. The authors concluded

that results of their study conformed to the assumptions of pecking order and free cash flow

hypotheses.

Park and Morton (2001) studied Earnings Response Coefficient (ERC) which was used to

capture the sensitivity of returns generated from security investments to the unexpected

earnings. Park and Morton hypothesized the determinant of ERC different from persistent

earnings, opportunities for growth, risk associated with earnings, quality of the auditor and

the size of the firm. They named ERC as the mix of internally and externally generated

common equity capital. Park and Morton developed two hypotheses and tested the same

using regression analysis. They used cross-sectional data of about 15,000 firms collected over

eleven years. They concluded by saying that firms usually preferred internal equity for

financing investments. They further added that the choice of selection of sources of common

equity affected the cost of equity capital and it was evident from their results that internal

equity capital brought low cost of capital and had higher ERC. Firms having high growth

rate also had greater informational asymmetries during the period of greater positive

investment opportunities.

Opler, Pinkowitz, Stulz and Williamson (2001) analyzed the determinants of corporate cash

holdings and marketable securities. The size of the sample was 24 industrial listed US firms

22

and the data of 87,117 firm year observations was collected during 1952 to 1994. The authors

found that, on average, sample firms held 6% of cash to net assets. They reported that more

growth oriented and riskier small sized sample firms held excess cash and had lower market

to book values. Managers of the sample firms had ownership greater than 5% and this factor

reduced firms cash holdings level and higher amounts of cash was diverted to investment

related activities. The authors concluded that cash holdings were used as a tool by the sample

firms to counter as well as manage risk.

Upneja and Dalbor (2001) evaluated that; whether the financial growth cycle in the restaurant

industry of USA along with the affect of pecking order theory could explicate the capital

structure decisions of the managers. They also investigated the association of debt and value

maximization of the firm. The size of the sample consisted of all the USA restaurant firms

operational during 1991 to 1998. The authors formulated a total debt of the firm model and

tested it. They used Ordinary Least Square (OLS) regression and found positive association

of bankruptcy with the total debt and cash flows with the total debt of the sample firms. The

authors concluded that the requirement of short-term debt by the USA restaurant sample

firms made them risky investments. Thus, debt borrowings by the sample firms supplemented

their internally available funds and fueled the expansion activities.

Sethi and Taksar (2002) tried to solve the optimal financing problem of an infinite horizon

corporation. The basic aim behind this approach was to find a financing mix that contained

retained earnings and external finance as the sources of financing and contributed towards the

value maximization of the firm. The authors considered an earlier work done by Sethi (1978)

as foundation. The work of Sethi addressed the horizon problem of the firm by categorizing

the firms earnings level. The authors constructed optimal financing problem of a firm in the

23

form of a model and elaborated the investment mechanism of the firm by ranking the

available projects based on their expected rates of return and funds. They used Hamilton

Jacobi-Bellman equation and further derived it to generate firm valuation equation that

represented state of a firm where assets of the firm were kept at threshold level of funds and

if this level exceeded beyond this level, excess was paid out as dividends and if this level did

not increase from the threshold level then firm retained all of the earnings for the

reinvestment in the best available projects. So, the value of the firm was dependent on the

value threshold level of funds that varied with the stream of earnings of the firm over time.

This process altered the functionality of the inflow and outflow of firms capital. The authors

concluded that they comprehensively addressed the value function of the firm by taking into

account retained earnings and external equity as sources of financing and thus solved the

optimal financing problem.

Brien (2003) investigated the impact of industrial innovative competitive strategy of the firm

on its capital structure decisions. He considered R&D investment as the basis of lower

leverage. He associated financial slack, also known as corporate retained earnings, with

lower level of corporate leverage because financial slack provided financial cushion to the

firm in the time of cash flow volatility and also helped the firm in the continuous flow of

funds for innovative investment projects. The author selected 16,358 US listed firms and

collected 91,000 firm year observations during 1980 to 1999. He applied OLS regression

analysis to evaluate three models of leverage and found innovation based strategical approach

as drives of leverage at lower points and this outlook drove sample firms to achieve greater

value. The results of the study also supported pecking order theory. The author concluded

that sample firms strategic orientation was closely associated with its competitive position in

the market place. Financial slack and best strategic approach facilitated sample firms.

24

Deshmukh (2003) investigated the affect of asymmetric information on dividend changes. He

examined firms that changed their status from non-dividend paying to dividend paying by

going public. Also, implications of the pecking order theory were examined by the author. He

defined initiation of dividend by a non-dividend paying firm as, a function of asymmetric

information problems which makes a firm to initiate dividend payout if its optimum dividend

level is positive which is determined by changes in firm-specific attributes. The size of

sample was 1,371 financial and utilities firms that went public during 1990 to 1997 and

financial data of 6,171 firm year observations was collected to test the hazard model of

dividend initiation. The author found that firm size and cash flow were positively associated

with dividend initiation of the sample firms and this fact supported pecking order theory.

De Angelo, De Angelo and Stulz (2004) discussed the accumulation of retained earnings of

25 largest long-standing dividend paying US industrial firms and explained the factors that

compelled them to stop paying dividends to their shareholders. These largest industrial firms

had US dollars 1.8 trillion in excess cash holdings which was equal to 51 % of the total assets

of these firms. It showed conservative payout policies and higher level of agency problems

between principal and agent. So, the objective of this study was to test the association of

increase of dividends payout with the higher levels of earned equity of the sample firms. The

size of the sample was 25 large industrial firms and financial data was collected during 1973

to 2002. The authors applied univariate, multivariate and sensitivity analysis plus logit

regression analysis and found positive association between propensity to payout dividends

with the profitability level and size. The authors also found that firms level of earned equity

was the best predictor of firms probability to pay dividends. They concluded that the capital

and asset structures of the sample firms portrayed a clear picture of firms capacity to payout

25

dividend or to retain earnings and the change in dividend policy was directly linked with the

level of equity earned by them.

Aivazian, Ge and Qiu (2005) investigated the association of debt maturity with firm

investment. They selected all US based non-financial firms and collected financial data

during 1982 to 2002. They used investment model and applied GMM method to test the

associations of the variables. They found positive association of Tobins Q and cash flow and

negative association of leverage with investment. The authors reported significant negative

association between firms debt maturity and investment. They also found that high growth

sample firms faced under-investment problem. The authors concluded that increase in

investment was linked with the reduction of debt maturity levels for the sample firms.

Hubbard (2005) explained that in the USA the setback to the corporations as well as

shareholders was due to double taxation on corporate earnings and dividend payments. This

was considerably reduced after the Presidential order on January 7th, 2003. The order targeted

three factors namely corporate earnings taxation, dividend taxation and corporate retained

earnings taxation. The order proposed to eliminate investor-level taxes relating to the above

stated factors. The objective of Hubbards study was to analyze the effects of this approach

on the US economy. These tax reforms led to integrated tax system and accordingly separate

treatment of corporate and investor income taxes. The dividend relief model will eliminate

double taxation of retained earnings and also devise a dividend reinvestment plan which

authorizes corporations to declare deemed dividends. He concluded that the hybrid reform

mechanism would streamline the bottlenecks in the tax system and contribute towards the

betterment of the economic system of America.

26

Grinstein and Michaely (2005) investigated the association between institutional ownership

and payout policy. They selected 654 publicly listed US firms and collected end of the year

institutional stock holdings data of 79010 firm year observations during 1980 to 1996. Firms

were grouped based on their market capitalizations and size. The authors developed and

tested models that comprised of dividends, stock repurchase and total payout associations

with the institutional holdings and found no association of dividend payout with institutional

holdings. The authors linked the finding with the shift in cash dividend to share repurchase by

the sample firms. This change made share repurchase less costly and easier to exercise. The

authors concluded that the sample firms that were involved in share repurchase activities had

higher institutional holdings.

Feng, Ghosh and Sirmans (2007) studied the involvement of CEO in direct selection of

dividend payout policies of Real Estate Investment Trust (REIT) firms of USA. They

discussed the optimal entrenchment hypothesis in the study. According to this hypothesis

close coordination of shareholders with their agents ensured that their activities were closely

monitored. They selected 236 REITs firms during 1999 and 2000 and found that they (firms)

had paid 144 % of their net income as dividends in the past five years. The authors used

descriptive, univariate and multivariate analysis and found that high entrenched group of

CEOs paid 60 % more dividends as compared to the low entrenched CEOs. They concluded

that CEO entrenchment badly affected the performance and growth of the sample firms

because entrenched CEO acted in the best interest of the shareholders.

Amihud and Mendelson (2008) identified liquidity and risk as factors that affected firm

value. They mentioned liquidity as the main factor that restricted timely payments of interests

and principal to the investors. They associated costs of less liquid firms securities with

27

informational asymmetries and linked transaction and brokerage costs with this problems.

The authors presented examples to explain positive association between liquidity of the

financial asset and the financial market. They suggested that a firm could increase its market

value by increasing the investor base and introduction of more stock dealers in the market.

They also suggested that initiation of dividends by low liquid firms could be achieved by

increasing trade volumes. They identified liquidity as the main factor that forced a firm to

indulge in share repurchase and stock payout activities. The authors concluded that market

value of the firm was dependent on the liquidity of its financial assets and firm value could be

enhanced by incorporating liquidity increasing financial policies.

Bhattacharyya, Mawani and Morrill (2008) initiated with the reference of an earlier study that

identified dividends among the ten most important unsolved problems of corporate finance.

The authors identified dividend payout as a sign that indicated financial position of the firm

that saved it from agency problems. They indicated that in advanced countries the prime

source of financial capital for new investments is retained earnings. Authors modified the

total compensation model and tested it by collecting data of 14,013 firm year observations of

US based firms during 1992 to 2001. They used descriptive analysis, tobit regression and

sensitivity analysis and the results satisfied the managerial compensation model. The authors

concluded that no formal theoretical model could clearly explain association between

managerial compensation and dividend policy. The model tested predicted the behavior of

two types of managers who were in two different situations regarding the use of available

capital. In these situations one manager invested in productive ventures and other paid

available capital as dividends to the shareholders.

28

Chen (2008) examined the association and affect of corporate governance on the firms cash

holdings policies by comparing the difference between new and old economy USA listed

firms. He defined new economy firms as, those firms that compete in the internet, computer,

software, telecommunications or networking industries, whereas traditional manufacturing

firms were defined by him as old economy firms. The size of the sample was 1500 listed US

firms and the financial data of 1815 firm year observations was collected during 2000 to

2004. He applied Wilcoxon two sample test and OLS regression analysis on the financial data

and found that new economy firms had 33% and old economy firms had 12.5% cash to total

assets ratios. Top executive ownership was higher in new economy firms and these firms also

had higher proportion of inside board of directors. The new economy firms also had lower

profits as compared to the old economy firms. The dividend payout ratio was 61% for old and

19% for the new economy firms. The author concluded that under effective corporate

governance system new US economy firms retained higher levels of cash to fund available

growth opportunities. But, in the case of old economy firms, shareholders demanded

dividends in-order to mitigate the agency problems.

Fargher and Weigand (2009) investigated the dividend initiation and the reasons behind the

initiation and continuous payout of dividends to the shareholders by the sample firms. The

authors indicated that firms normally started paying dividends when moved from faster

growth phase to a slower growth phase of their lifecycle. They selected a sample of 594 firms

that initiated dividend payout during 1964 to 2000. They used three-factor market model to

analyze seven years financial data representing pre and post event of dividend initiation. The

authors found increased return on asset before the dividend initiation for the entire sample,

but after dividend initiation, decline in return on asset was observed, which stabilized after

three years of event. The authors reported increased cash and short-term investments from

29

year (-3 to 0) and then declined from year (0 to +3). The authors concluded that lifecycle

stages of the firm could better explain the tendencies of dividend initiation capacity of the

firm. Dividend initiation benefited slower growth oriented firms higher than other firms of

the sample.

Puleo, Smith and Casey (2009) examined the relationship of corporate governance and

dividend policy in the highly regulated insurance industry of USA. They used agency

transaction cost trade-off model that was developed by Rozeff (1982). Rozeff model

elaborated the functional interaction mechanism of dividend policy with agency costs, where

the dividend payments compelled firms to acquire external capital from capital markets and

as a consequence agency costs were minimized. The authors used extended model of

dividend yield to test the association of the variables. They selected a sample of 55 insurance

firms and collected 241 firm year observations during 2002 to 2006. They found no

association between good corporate governance and dividend policy. The authors concluded

that their study had not supported the strong corporate governance theory in the case of

sample extracted from the US insurance industry.

Weigand and Baker (2009) investigated the perspectives of corporate distribution policy

modifications done in the past and reviewed the evolution of share repurchase concept as an

extension of cash dividend payout by the firms. They followed the Works of Lintner (1956)

and Miller and Modigliani (1961). They segregated payout policies based on the effects of

signaling, agency and risk hypotheses. They called appearing and disappearing of dividends

as, catering, which suggested that, stock movement was associated with the flow of

dividends along with their risk factors. They reported decreasing trend of dividends payout in

USA, UK, Germany, France and Japan. In these highly advanced market economies firms

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switched from cash dividend payout to share repurchase. The authors identified two most

important factors that were responsible for the increased trend of firms share repurchase,

these were; adjustment of low stock price to fair price and the confidence of the managers in

the future prospects of the firm. The authors concluded that: Share repurchase is flexible

earnings disbursement activity used as a means to return capital to shareholders at the

appropriate time as compared to dividends payout mechanism.

Wu and Yeung (2009) investigated interactions of the types of firm growth structure with the

leverage ratio under the conditions of market imperfections. They explained market

imperfections as asymmetric information and agency conflicts. They selected three groups of

firms; lower growth type firms, mixed growth type firms and high growth type firms and

checked the consistency of trade-off theory, pecking order theory and market timing theory.

They collected financial data of 1,22,909 firm year observations during 1971 to 2005. The

authors applied pooled OLS regression and found negative association between profitability

and the group of sample firms. High growth sample firms used retained earnings heavily for

financing research and development as well as investments in intangible assets. However,

low growth type sample firms were debt oriented firms. The authors concluded that they

observed decreasing trend of leverage from low to high growth type sample firms which

supported pecking order theory.

Fuller and Blau (2010) explained a new dimension of payout of dividends to the shareholders

by a corporation. They adopted an integrated approach that combined signaling and excess

cash flow (free cash flow) hypothesis of dividend policy to explain the payout phenomenon.

The categories of firms defined by the authors were; higher earning, intermediate earning and

low earning good and bad firms facing informational asymmetry and free cash flow problem.

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The size of the sample was 2,197 dividend paying listed US firms examined during 1980 to

2000. The authors used firm performance as the measuring methodology and applied

univariate and multivariate regression analysis of the non-monotonic argument on the

quarterly dividend per share model. They also tested models of total payout and Cumulative

Abnormal Returns (CARs) and found that the intermediate sample firms had the highest total

payout and low performance sample firms prior to the announcement of the dividends had the

highest Cumulative Abnormal Returns (CARs). Also, significant results for firm size were

reported by the authors. However, results were not significant in the case of growth

opportunities and dividend yield. The authors confirmed non-monotonic level of association

of dividend.

2.6. Studies conducted in Canada

Brav, Graham, Harvey and Michaely (2003) discussed the payout policies of the USA and

Canadian corporations by conducting surveys of 384 Chief Financial Officers and Treasurers.

They explored the key factors responsible for the dividends as well as share repurchase

policies. The objective of this study was to investigate the substitute nature of share

repurchase and change in dividend payout policies of the sample. A sample of 384 financial

executives was selected from 256 public and 128 private firms to answer a survey

questionnaire. The authors also conducted 23 one-to-one un-structured interviews from CFOs

and Treasurer of the sample public firms. They found that the sample firms were larger in

size and had higher sales and credit ratings. CEOs of sample firms took all the decisions

relating dividend policies. They observed that managers had cut dividends only under

extreme conditions and a drastic shift to stock repurchase from cash dividend payout was

reported. They also found that signaling model was not used by the sample firms. They

identified earnings per share, floatation costs, liquidity cost, issuance costs, credit rating,

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capital structure and takeover resistance as contributing factors. The authors concluded that

the contributing factors identified by them set the direction of the payout policies of the

sample firms.

Booth and Cleary (2006) conducted research in Canada and tested a theoretical model

relating evaluation of firms investment decisions under the influence of financial constraints.

They identified financial constraints as the wedge between the cost of internal and external

capital and mentioned that financial constraints made acquisition of external capital more

costly. The authors adopted value of the firm model known as Investment Opportunities

Formula from the work of Miller and Modigliani (1961) and modified this model to

represent optimal investment by the firm in the initial startup phase and tested it empirically.

The size of the sample was 1,133 US firms and data of 20,394 firm year observations was

collected during 1981 to 1998. The test of the model showed positive and significant

association of retained earnings with the investment activities. The authors concluded that the

US sample firms faced higher cash flow volatility and this factor forced them to retain and

maintain an adequate level of financial slack used to fund growth projects.

Bhattacharyya (2007) documented almost all the research evidence (theoretical and

empirical) related to dividend policy. He segregated evidence based on dividend clientele

hypothesis, signalling hypothesis and agency hypothesis. He discussed the work of John

Lintner (1956) and termed dividend policy as an area where a lot more could be done to

understand the complete picture of the unresolved problem of dividend policy. He quoted the

work of Bond and Mougoue (1991) as an extension of Lintner work and explained the classic

work of Modigliani and Miller (1961) which introduced the concept of dividend irrelevance

in the perfect and efficient capital market. He linked dividend problem with the higher level

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of taxation on dividends. The work of Miller and Scholes (1978) presented the concept of

conversion of dividend income to the capital gain income that could be attained by borrowing

an appropriate amount of debt. This process created tax shield in the form of compensation

on the interest payments. The author quoted the study of Peterson, Peterson and Ang (1985)

related to the tax shield used by investors. Author quoted the work of other researchers

relating investigations of the firms dividend payouts and share repurchases as well as

demand mechanism of dividends from the investors (shareholders). The author discussed

informational asymmetry and signalling models relating tax-clientele hypothesis and also

elaborated the work of Bhattacharyya (1979). Heinkel (1978) compared different productivity

levels of the firm under irrelevant dividend and asymmetric information propositions. The

author also discussed studies concerning free cash flow hypothesis and quoted the work of

Jensen (1986) that defined the relationships between free cash flow and interacting variables

based on principal and agent informational flow mechanism. The author concluded that over

the period of forty years corporate finance researchers had identified and reported multiple

stylized factors that explained the dividend policy of corporations but dividend puzzle was

not yet solved.

Bhattacharyya, Mawani and Morrill (2008) investigated the association of dividend payout

and managerial compensation. They adopted the model of dividend payout developed by

Bhattacharyya (2003). This model of dividend policy was based on agent-principal

framework and it linked uninformed principal with the informed agent. The authors

categorized firm managers as high and low quality with respect to the payout or investment

of the availability funds. The authors collected 707 firm year observations of non-financial,

non-professional service and non-government sector firms during 1993 to 1995. The authors

tested total compensation model by further extending it to represent log of firms retained

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earnings model and applied tobit regression analysis on the model. They found negative

association of dividend policy with the managerial compensation of the Canadian sample

firms. The authors also found negative association between dividend payout and earnings

retention and positive association between earnings retention (retained earnings) and capital

expenditure and the beta (risk).

Li and Zhao (2008) studied the impact of informational asymmetries on the dividend