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DIVIDEND PAYOUT POLICY IN THE CHINESE EQUITY MARKET

By

JIANAN GUO

MWM (DEAKIN), BE (FUDAN)

Submitted in fulfilment of the requirements for the degree of

Doctor of Philosophy

Deakin University

November, 2013

sfolRetracted Stamp

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ACKNOWLEDGEMENTS

To my beloved family and friends, who have provided me with continuing support

throughout my PHD candidature, I owe my sincere appreciation. Specifically, I owe the

greatest debt to my parents who have encouraged me to pursue the higher education

degree. I am also fortunate to receive the love and support of my wife, Huan Sun, who has

shared the sweet and bitter with me, particularly in the final stages of this thesis. This work

is dedicated to them.

It has also been a challenging task to stay motivated and innovative within a balanced

research dissertation. I greatly appreciate my supervisors, Professor Gerald Gannon, Dr

Hong Feng Zhang and Dr Hoa Nyugen, for their enthusiasm and continuous guidance

throughout my PHD candidature. To me, they have set the best examples of a better

academic as well as a self motivated researcher.

Special thanks are owed to Professor Edward Lin and Professor Nava Subramaniam, for their

efforts to sort out the administrative issues during the final stage of this thesis.

The research has also benefited from the comments of attendees at the 18th SFM

Conference, National Sun Yat Sen University (Kaohsiung, Republic of China), 2011 PhD

Conference in Economics and Business (University of Queensland), 6th International

Accounting and Finance Doctoral Symposium (Bologna, Italy) and the 21st Annual

Conference on Pacific Basin Finance, Economics, Accounting and Management.

And, finally, the Higher Degree Research Scholarship and the financial support from the

School of Accounting, Economics and Finance, Deakin University, are gratefully

acknowledged.

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ABSTRACT

Dividend payout policy is a critical component of corporate financial management, as

well as being important to investors. Empirical studies, however, that focus on the cash

dividend policy in emerging markets, especially the Chinese equity market, are limited. This

thesis attempts to substantiate empirical evidence on the topic of dividend payout policy

with a particular focus on its interaction with ownership structure, stock market abnormal

return and subsequent earnings growth in the Chinese market.

This thesis supplies an empirical analysis of the influence of the ultimate controlling

shareholders, including their types and control rights, on the cash dividend payout

announcement, using a sample of 1,200 Chinese listed firms. The results of this analysis

provide sound support for the viewpoint that the cash dividend policy is related to

ownership structure in the Chinese market. Specifically, the level of the ultimate controlling

shareholders’ control rights, defined as the aggregate direct and indirect shareholdings, is

positively correlated with the likelihood and magnitude of the cash dividend payout.

Further, the outcomes also demonstrate that firms with various types of ultimate

controlling shareholders exhibit divergence in the likelihood and magnitude of cash

dividend payouts. The cash payout policy is also sensitive to firm characteristics such as size,

profitability and financial leverage.

This thesis also investigates the investors’ reactions towards the dividend

announcements with a sample from 1,203 Chinese listed firms. The results indicate that

Chinese minority shareholders respond positively to the stock dividend announcement,

especially in the case of a stock dividend from capital reserves. Unexpected cash dividends

are also positively associated with stock abnormal returns, while unexpected earnings have

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little, or even negative, influence on announcement effects. Further, investors respond

discriminatively towards the unexpected cash dividends from the listed firms with various

types of ultimate controlling shareholders. In addition, dividend announcement effect is

also sensitive to idiosyncratic risk and firm size.

This thesis also extends the investigation into how cash dividend announcements

influence the subsequent earnings growth in the Chinese market. Consistent with some

contemporary studies, the results suggest that a higher cash payout is associated with

better future earnings growth, but the positive association diminishes as the payout ratio

increases. The stock dividend decision is negatively correlated with future earnings growth,

which is contrary to the investors’ positive response towards these announcements.

Further, future earnings’ growth is also closely correlated with profitability, dividend yield

and growth opportunity.

Together, the results of this thesis suggest that the cash dividend policy of Chinese

listed firms is worthy of continuous investigation as the Chinese market grows and evolves.

A major contribution of this thesis is that it illustrates that both Chinese investors and listed

firms have acknowledged the crucial role of the cash dividend policy in corporate

governance infrastructure. Correspondingly, this indicates several policy implications. First,

the privatization of Chinese state owned enterprises enhances the diversity of shareholders

and improvesminority shareholders’ positions in the capital market. Second, by establishing

a robust cash dividend payout, Chinese listed firms are able to cope with the agency cost

due to the separation of ownership and control, and consequently improving the efficiency

and the firm valuation.

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TABLE OF CONTENTSChapter 1 Introduction ........................................................................................................................1

1.1. Introduction ..............................................................................................................................1

1.2. Research Scope .........................................................................................................................7

Chapter 2 Literature on dividend payout policy ............................................................................... 13

2.1. Introduction ........................................................................................................................... 13

2.2. Lintner model and dividend irrelevance theorem................................................................. 13

2.3. Dividend payout policy, agency cost and corporate governance .......................................... 16

2.3.1. Agency cost and dividend policy..................................................................................... 16

2.3.2. Corporate governance and dividend policy .................................................................... 22

2.4. Dividend policy and stock abnormal return........................................................................... 31

2.4.1. Dividend announcement effect: US and other developed markets ............................... 31

2.4.2. Dividend announcement effect: emerging markets....................................................... 39

2.5. Dividend Policy and Future Earnings Growth ........................................................................ 41

2.5.1. Signalling hypothesis of dividend policy ......................................................................... 41

2.5.2. Relationship between dividend policy and future earnings growth............................... 48

2.6. Summary ............................................................................................................................... . 53

Chapter 3 Review of Chinese Stock Market and Payout Policy ........................................................ 56

3.1. The Evolution of the Chinese Stock Market........................................................................... 56

3.2. Legal Environment of the Chinese Stock Market................................................................... 62

3.2.1. Corporation Law.............................................................................................................. 62

3.2.2. Securities Law ................................................................................................................. 63

3.2.3. Income Tax Code............................................................................................................. 65

3.3. Payout Practice in the Chinese Stock Market ........................................................................ 67

3.3.1. Evolution of regulatory requirement on cash payout .................................................... 68

3.3.2. Snapshot of payout practice in the Chinese stock market ............................................. 70

3.4. Summary ............................................................................................................................... . 73

Chapter 4 Ultimate Controlling Shareholders and Dividend Payout Policy in the Chinese StockMarket............................................................................................................................... ................ 74

4.1. Introduction ........................................................................................................................... 74

4.2. Hypotheses development ...................................................................................................... 79

4.3. Data and descriptive statistics ............................................................................................... 83

4.3.1. Proxies for cash dividend policy, control rights and type of UCSs.................................. 84

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4.3.2. Control variables ............................................................................................................. 87

4.3.3. Descriptive statistics ....................................................................................................... 89

4.4. Empirical Analysis................................................................................................................... 92

4.4.1. Cash dividend policy, control rights and cash rights....................................................... 92

4.4.2. Cash dividend policy and types of UCSs.......................................................................... 97

4.4.3. Robustness check.......................................................................................................... 102

4.5. Summary .............................................................................................................................. 106

Chapter 5 Dividend Announcement Effect and Ultimate Controlling Shareholders in the ChineseStock Market............................................................................................................................... .... 108

5.1. Introduction ......................................................................................................................... 108

5.2. Hypotheses development .................................................................................................... 113

5.3. Data and descriptive statistics ............................................................................................. 118

5.3.1. Sample construction ..................................................................................................... 118

5.3.2. Dependent variable....................................................................................................... 119

5.3.3. Independent variables .................................................................................................. 120

5.3.4. Descriptive statistics ..................................................................................................... 123

5.4. Empirical results................................................................................................................... 127

5.4.1. Univariate analysis ........................................................................................................ 127

5.4.2. Multivariate analysis ..................................................................................................... 130

5.4.3. Robustness Check ......................................................................................................... 137

5.5. Summary .............................................................................................................................. 138

Chapter 6 Dividend Payout Policy and Future Earnings Growth in the Chinese Stock Market ...... 139

6.1. Introduction ......................................................................................................................... 139

6.2. Hypotheses development .................................................................................................... 143

6.3. Data and descriptive statistics ............................................................................................. 146

6.3.1. Sample construction ..................................................................................................... 146

6.3.2. Dependent variables – proxies for earnings growth..................................................... 147

6.3.3. Independent variables .................................................................................................. 147

6.3.4. Descriptive statistics ..................................................................................................... 150

6.4. Empirical Analysis................................................................................................................. 154

6.4.1. Univariate analysis ........................................................................................................ 154

6.4.2. Multivariate analysis ..................................................................................................... 157

6.4.3. Robustness test............................................................................................................. 165

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6.5. Summary .............................................................................................................................. 167

Chapter 7 Conclusion ...................................................................................................................... 170

7.1. Introduction ......................................................................................................................... 170

7.2. Key findings .......................................................................................................................... 172

7.2.1. Dividend policy, corporate control rights and subsequent equity financing................ 172

7.2.2. Dividend policy, corporate control rights and announcement effect .......................... 174

7.2.3. Dividend policy and future earnings growth ................................................................ 176

7.3. Summary .............................................................................................................................. 177

7.4. Concluding remarks ............................................................................................................. 181

Bibliography ............................................................................................................................... ..... 183

Appendices............................................................................................................................... ....... 196

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LIST OF APPENDICES

Appendix 4.1 Robustness check: Comparison of various econometric models ………………….. 196Appendix 4.2 Robustness check: Multicollinearilty…………………………………………………………….. 197Appendix 4.3 Robustness check: Selection bias………………………………………………………………….. 198Appendix 5.1 Robustness check: Samples before winsorization…………………………………………. 199Appendix 5.2 Robustness check: Multicollinearility……………………………………………………………. 200Appendix 5.3 Robustness check: Fama Macbeth two step procedure……………………………….. 200Appendix 6.1 Robustness check: Omitting EXPECTED_ROA and/or DIVYIELD……………………… 201Appendix 6.2 Robustness check: Comparison of various econometric models…………………… 202Appendix 6.3 Robustness check: High/Medium/Low CASH_PAYOUT ( CASH_PAYOUT)…….. 204Appendix 6.4 Robustness check: Cash payers with simultaneous stock dividend……………….. 206Appendix 6.5 Robustness check: EPS growth over 2 year window……………………………………… 207Appendix 6.6 Robustness check: Selection bias – Heckman selection model……………………… 208Appendix 6.7 Robustness check: Multicollinearity……………………………………………………………… 208

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LIST OF FIGURES

Figure 3 1 Number of listed firms (1990 2011) ................................................................................ 58Figure 3 2 Annual trading turnover (1990 2011), in billion CNY ...................................................... 58Figure 3 3 Total market capitalization (1990 2011), in billion CNY .................................................. 58Figure 3 4 Negotiable/Total market capitalization ratio (1990 2011), in %..................................... 60Figure 3 5 Number of listed firms and percentage of cash dividend payers (1992 2010) ............... 71Figure 3 6 Average cash dividend payout ratio of cash payers (1992 2010).................................... 72Figure 5 1 CAAR trends of cash only payers grouped by the sign of UCEXPECTED_DPS andUNEXPECTED_EPS ........................................................................................................................... 129Figure 5 2 CAAR trends of cash only payers grouped by the types of UCSs .................................. 130

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LIST OF TABLES

Table 3 1 Distribution of listed firms with continuous cash dividend payout (1992 2009) ............. 70Table 4 1 Sample distribution by types of UCSs ............................................................................... 86Table 4 2 Variable definition............................................................................................................. 88Table 4 3 Descriptive statistics ......................................................................................................... 90Table 4 4 Pearson's correlation matrix ............................................................................................. 92Table 4 5 Control rights and the likelihood of cash dividends.......................................................... 94Table 4 6 Control rights and the magnitude of cash dividends........................................................ 95Table 4 7 Types of UCSs and the likelihood of cash dividends ......................................................... 99Table 4 8 Types of UCSs and the magnitude of cash dividends...................................................... 101Table 4 9 Difference between control rights and cash rights......................................................... 103Table 4 10 Robustness check: dividend policy and the gap between control rights and cash rights............................................................................................................................... ......................... 104Table 4 11 Robustness check: dividend policy, types of UCSs and the gap between control rightsand cash rights ............................................................................................................................... . 105Table 5 1 Distribution of observations by the combination of stock and cash dividends.............. 119Table 5 2 Variable definition........................................................................................................... 123Table 5 3 Descriptive statistics ....................................................................................................... 124Table 5 4 Pearson's correlation matrix ........................................................................................... 126Table 5 5 Average CARs of different combinations based on earnings shock, dividend shock andsimultaneous stock dividend .......................................................................................................... 128Table 5 6 Stock dividend announcement and stock abnormal returns.......................................... 131Table 5 7 Unexpected earnings, unexpected dividend and stock abnormal returns..................... 133Table 5 8 Control rights and stock abnormal returns..................................................................... 135Table 6 1 Sample distribution number of firms (% of total)......................................................... 146Table 6 2 Variable definitions ......................................................................................................... 149Table 6 3 Summary statistics of FUTURE_EPSG and FUTURE_EBITG by payout decision.............. 150Table 6 4 Descriptive statistics ....................................................................................................... 152Table 6 5 Pearson's correlation matrix ........................................................................................... 153Table 6 6 Mean FUTURE_EPSG (FUTURE_EBITG) comparison ....................................................... 156Table 6 7 Cash dividend and future earnings growth cash only payer sample ........................... 158Table 6 8 Future earnings growth and over investment problem ................................................. 162Table 6 9 Future earnings growth and stock dividend decision ..................................................... 164

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Chapter 1 Introduction

1.1. Introduction

Dividend policy is important to the corporation and the design of dividend policy is an

essential component of corporate finance infrastructure. The literature on the dividend

policy and practice in developed markets is relatively comprehensive, but the coverage of

the dividend policy in emerging markets is yet to be complete. This thesis supplies recent

empirical research in the area of dividend policy with particular focuses on its interaction

with agency cost of free cash flow and ownership structure in the Chinese equity market.

In the United States and the United Kingdom, the conflict of interest between

shareholders and entrepreneurs, known as the agency cost,1 has raised concerns because

dispersed shareholders cannotmonitor the daily operations of the firm, while themanagers

have the discretion to use the firm’s resources to pursue personal interests (Jensen and

Meckling, 1976). Specifically, the managers are likely to abuse the firm’s free cash flow and

conduct empire building activities, such as take over sprees and investing in projects with

non positive net present value (Jensen, 1986). Consequently, a corporate governance

mechanism is necessary to monitor and restrict managers’ self dealing activities (Barnea et

al., 1981, Fama and Jensen, 1983, Agrawal and Knoeber, 1996, Gillan, 2006, Shleifer and

Vishny, 1997), among which cash dividends become an important measure of internal

corporate governance mechanisms to cope with the agency cost of free cash flow.2 By

1 Agency cost has a broad and multiple aspect definition which includes the stewardship betweenshareholders andmanagement, the asymmetric information between large (inside) shareholders andminority(external) shareholders, and the conflicts of interest between debt holders and shareholders.2 Other internal corporate governance measures include board composition, managerial remuneration andcorporate financial policies (Jensen, 1986, Jensen et al., 1992, Hermalin and Weisbach, 1991).

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forcing the managers to distribute the excessive cash balance, the shareholders are able to

limit the opportunity of any imprudent investment decisions by the management (Jensen,

1986, Lang and Litzenberger, 1989, Yoon and Starks, 1995, Fuller and Blau, 2010).

Different from the traditional ownership structure in Anglo American markets where

the shareholdings are widely spread and the management is highly independent from the

owners, concentrated ownership is more popular among the civil law countries, including

Europe and most emerging markets, as well as some common law countries (La Porta et al.,

1999, Claessens et al., 2000, Claessens et al., 2002, Faccio and Lang, 2002). Strictly speaking,

the existence of large shareholders is a double edged sword. On the one hand, the largest

shareholders become part of the corporate governancemechanism and positively influence

the cash dividend payout as they make the managers distribute excessive cash and alleviate

the agency cost of free cash flow (Shleifer and Vishny, 1986, Dyck and Zingales, 2004, Truong

and Heaney, 2007, Holderness, 2003). On the other hand, the objective of large

shareholders is to maximize their private benefits, which may well drive them to pursue

unorthodox strategies to expropriate the wealth of the minority shareholders (Grossman

and Hart, 1980, Harris and Raviv, 1988). Empirical evidence suggests that large shareholders

have both motivation and capability to manipulate the dividend policy and benefit

themselves more than minority shareholders (Shleifer and Vishny, 1997).

The dividend policy, including both cash dividends and stock dividends, in the Chinese

equity market has become an interesting topic. Although past empirical studies suggest

Chinese listed firms pay less cash dividends to shareholders than firms in other countries

(La Porta et al., 2000a, Allen et al., 2005), this phenomenon has changed in recent years.

From the investors’ standpoint, cash dividends have become an important form of

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investment return. On the other hand, listed firms are under continuous pressure from the

authorities to make more cash dividend payouts to external minority investors.3 Further,

listed firms are gradually adopting dividend payout policy as an instrument to deal with the

relationship between investors and managers, as well as between large and small

shareholders. Therefore, this thesis concentrates on dividend payout policy and its

interaction with ownership structure, abnormal stock return and future earnings growth, as

China’s equity market was established to support its transformation towards a market

oriented economy after significant economic reforms were enacted.

Most studies on dividend policy in the Chinese market4 are associated with its unique

features, especially the highly concentrated ownership and the non negotiable shares

under the split share structure.5 For the non negotiable shareholders, cash dividends are

the only justified means to realize their investment returns.6 Some empirical studies, such

as Gul (1999), Cheng et al. (2009) and Huang et al. (2011), take the state owned non

negotiable shares as the proxy of the influence of large shareholders, and report non

negotiable shareholders’ preference for cash dividends. Unlike the aforementioned studies,

the first research question of this thesis will focus on the relationship between cash

3 Because the Chinese equity market was designed to support the entrenched state owned enterprises, mostChinese listed firms adopted a residual dividend policy, that is, investment opportunity overrides the cashdividend payout. In other words, cash dividend policy took second place.4 Dissimilar to United States and other developed markets, the Chinese stock market does not treat sharebuyback (repurchase) as a type of profit distribution. Therefore, in this thesis, dividend policy and payoutpolicy in the Chinese market are interchangeable.5 Split share structure refers to the separation of negotiable and non negotiable shares, which is a legacy ofpartial share issuance privatization. State owned shares and legal person shares stemmed from state ownedshares, which used to be non negotiable until the split share structure reform (SSSR) in 2005.6 Non negotiable shares were forbidden to be traded in the secondary market because the liquidation of thelarge block shareholdings would crush the newly established Chinese stock market. Founding state ownedshareholdersmade this promise to justify the high initial public offering price. Otherwise, no external investorswould have taken part in the partial SIP because they would certainly have been disadvantaged in everyaspect, including corporate control and wealth effect, without this promise.

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dividend payout and control rights, defined as the direct and indirect shareholdings, of the

ultimate controlling shareholders (UCSs). Compared with cash rights which only include the

direct shareholdings, control rights are better measurements of ultimate controlling

shareholders’ influence on the listed firm. Moreover, after the split share structure reform

(SSSR) was completed and all common shares became negotiable, the negotiability of

common shares was no longer a special feature of the Chinese equity market.

Besides the level of control rights, this thesis also lays emphasis on the types of

ultimate controlling shareholders, as the diversity of Chinese investors has improved

significantly in recent years and the traditional partition of state owned/private investors

can be extended as different types of state owned investors exhibit significant divergence

in their background and operating style (Chen et al., 2009c). For example, a large proportion

of state owned investors still maintain the status of government agencies with

responsibilities beyond economic profits. Intuitively, listed firms with this type of ultimate

controlling shareholder are exposed to lower agency costs as the managers are bonded

politically. However, the minority shareholders in these firms are subject to more

expropriation risk, because the managers are more likely to collaborate with controlling

shareholders. In the meantime, divergence also exists among incorporated state owned

investors as they are affiliated with different levels of government. As per Sun and Tong

(2003), the share issuance privatization in China adopted the policy of ‘‘taking a firm grip on

the large, letting go of the small’’, which meant medium and small state owned enterprises

were floated on the stock market while the government maintained tight control of the

large state owned enterprises. Some of these large state owned enterprises have gradually

become shareholding companies and have received the state owned shares of those

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floated enterprises from multiple levels of government. In general, the qualities of state

owned enterprises are positively correlated with the level of government, and the state

owned shareholding companies affiliated with central government are deemed to be most

powerful. Not only are they entitled to great support from the central government, but they

are also more likely to own shares in the listed firms with better quality and stronger

operating performance. In addition, they are preferred by financial institutions as their

affiliation with central government enhances their credibility. In comparison, state owned

shareholding companies affiliated with local government usually have less autonomy and

the firms under their control are of inferior quality. The above mentioned differences are

not fully reflected in the previous studies about dividend payout policy and ownership

structures in the Chinese equity market. Therefore, this thesis attempts to fill in this gap

and explore whether the type of ultimate controlling shareholders influences the dividend

payout policy of underlying firms.

The second research question of this thesis is to investigatewhether Chinese investors

respond resiliently to dividend announcements, including stock dividends and changes in

cash dividends. In developed markets, the unexpected cash dividend announcement is

deemed to contain private information from the managers and/or insider shareholders

(Bhattacharya, 1979, Miller and Rock, 1985, John and Williams, 1985, Denis et al., 1994,

Ghosh and Woolridge, 1988, Divecha and Morse, 1983, Lonie et al., 1996, Yoon and Starks,

1995, Amihud and Li, 2006, Graham et al., 2006). Similar studies have been conducted on

the Chinese market, which document that stock dividends7 are more welcomed by

7 In the United States, stock dividends are regarded as a tool to convey managers’ private information, as perthe retained earnings hypothesis (Crawford et al., 2005, Bechmann and Raaballe, 2007), but it relies on theunique accounting principles of the US market.

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negotiable shareholders8 than cash dividends (Zou et al., 2008, Chen et al., 2009a, Chen et

al., 2002, Yi et al., 2007, Anderson et al., 2011, Cheng et al., 2009). This second research

question follows the methodology adopted in Cheng et al. (2009) and connects it with the

ownership classification in Chen et al. (2009c). The market reaction towards unexpected

dividend announcements from firms with various types of ultimate controlling shareholders

may show divergence if investors are aware of the different backgrounds and features of

these UCSs and incorporate these factors into firm valuation. Further, an unexpected

change in cash dividend announcement from listed firms with different types of ultimate

controlling shareholders may also convey different information due to the fundamental

divergence among these ultimate controlling shareholders. The scrutiny of this research

question will shed more light on whether the Chinese investors regard the cash dividend

not only as a distribution of net profit but also as a method to force the managers to pay

out excessive cash balances and reduce the agency cost.

Apart from the determination of and investors’ reaction towards cash dividends, the

third research question of this thesis is to investigate how the cash dividend payout

influences future earnings growth. As per the traditional ‘pecking order’ theory, a higher

payout ratio leads to lower retention and increases the future cost of funds, which

undermines the future operating performance (Gordon, 1962, Myers, 1984, Rozeff, 1982,

Fama and French, 2002, Ibbotson and Chen, 2003). Some contemporary opinions, however,

indicate there might be a positive correlation between the payout ratio and future earnings

8 The sample window of most studies on the dividend announcement effect in the Chinese market, includingthis thesis, covers the period before SSSR, and the share trading in the secondary market is dominated byindividual investors and private institutional investors, while non negotiable shareholders are not allowed tobe involved.

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growth as the dividend payout reduces free cash flow and restricts managers’

overinvestment activities. In other words, the underlying firm’s operating performance will

benefit from reduced agency costs of free cash flow (Arnott and Asness, 2003, Zhou and

Ruland, 2006, Gwilym et al., 2006, Huang et al., 2009, Vermeulen and Smit, 2011). With

regard to the Chinese market, there is not yet any literature covering this issue. Therefore,

this third research question will supply some empirical evidence on the relationship

between cash dividend payout and future earnings growth in a transitional economy. The

results may well suggest the significance of agency costs in the Chinese market and provide

a methodology for forecasting the earnings growth based on the dividend level.

1.2. Research Scope

As discussed in the preceding subsection, the main objective of this thesis is to

perform empirical research on how dividend policy interacts with corporate control rights,

announcement effect and future earnings growth in the Chinese stock market. This thesis

is scheduled as follows.

Chapter 2 supplies a review of the existing literature in order to establish three

themes of research that have dominated the dividend policy literature. The first part of this

chapter outlines the first focus of research pertaining to the relationship between corporate

control rights and dividend policy. The second part includes the literature on the

relationship between dividend payout, corporate control rights and stock abnormal return,

while the last part presents the relationship between dividend payout policy and

subsequent equity financing. Based on the traditional dividend theory and agency theory,

the relationship between dividend policy and controlling shareholders is relatively

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persistent in a developed market (Truong and Heaney, 2007). The literature on dividend

announcement effect is also quite consistent, that is, the dividend announcement carries

private information from corporate insiders (Grinblatt et al., 1984, Bechmann and Raaballe,

2007, Cheng and Leung, 2008). It is arguable, though, whether the cash payout has positive

or negative impacts on the future earnings growth (Fama and French, 2002, Zhou and

Ruland, 2006, Huang et al., 2009). With all three focuses of research, the literature review

in the following chapter highlights the importance of dividend payout policy as a solution

to the agency cost in the corporate governance area. Specifically, the potential connection

between dividend payout policy and ownership structure, as well as the impact of dividend

payout on stock abnormal return and future profitability, form the main themes of this

chapter, which instructs the design of empirical research in the following chapters.

Chapter 3 provides a brief review of the history and legal framework of the Chinese

stock market, as well as the dividend payout practices of Chinese listed firms. The capital

market in the Chinese economy was designed to support the state owned enterprises to

convert from the subsidiaries of multiple level governments to independent entities via

partial share issuance privatization (SIP). Meanwhile, the Chinese civil law legal system is

influenced by its unique political infrastructure and generally regarded as weak in terms of

investor protection (La Porta et al., 1998). Consequently, the pyramid structure has become

a popular format to facilitate controlling shareholders to redirect the listed firms’ financial

resources to other controlled entities. Recently, the securities regulatory authority, China

Securities Regulatory Commission (CSRC), promulgated some regulations which are tough

on the listed firms and relevant controlling shareholders, such as restricting controlling

shareholders from occupying listed firms’ financial resources.

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Chapter 4 conducts an empirical study of how the level of control rights and the types

of UCSs affect cash dividend policy among Chinese listed firms, based on a sample between

2003 and 2010. Specifically, this chapter connects and extends the works of Chen et al.

(2009c) and Cheng et al. (2009), which investigate the relationship between ownership and

operating performance, and the connection between negotiable/non negotiable shares

and dividend preference, respectively. The likelihood and the magnitude of cash dividend

policy are examined in both univariate and multivariate analysis. The propensity of cash

dividend policy is proxied by a dummy variable and the magnitude of cash dividend policy

is measured by the cash payout ratio. UCSs’ control rights are introduced as the proxy of

ownership. In addition, four dummy variables, which indicate the types of UCSs, are

included along with the level of control rights. The analysis suggests that both the

propensity and the magnitude of cash dividend payout are positively associated with the

control rights, consistent with the findings in Cheng et al. (2009) that non negotiable

shareholders prefer cash dividends. Similar to Chen et al. (2009c), different types of UCSs

are found to have divergent impacts on the propensity and magnitude of cash dividend

payouts. Among the listed firms with state owned ultimate controlling shareholders, listed

firms controlled by state owned enterprises affiliated with central governments (SOECG)

have a higher probability of announcing a cash dividend, while listed firms controlled by

state owned enterprises affiliated with local governments (SOELG) have a lower probability

of announcing a cash dividend. In terms of cash dividend magnitude, listed firms with state

owned UCSs do not exhibit outstanding cash dividend payout ratio, while listed firms

controlled by the State Asset Management Bureau (SAMB) report a lower cash dividend

payout ratio than other firms in the sample. Contrary to the traditional thinking, listed firms

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under the control of private investors show a significantly higher cash dividend payout ratio

and a marginally larger probability of making a cash dividend payout than firms with state

owned ultimate controlling shareholders. This empirical chapter contributes to propose

control rights, rather than non negotiable shareholdings, to be used as the measurement

of influence from large shareholder, as well as improve the traditional state private

segregation of shareholders in the Chinese market with a scrutiny into the various types of

state owned large shareholders.

Chapter 5 undertakes an event study on the stock and cash dividend announcement

effect, as well as the divergence in announcement effect among the firmswith various types

of UCSs. As the past literature finds that Chinese investors react more positively towards

stock dividend announcements than cash dividend announcements, this chapter explores

whether this pattern has continued since the Securities Law was enforced in 1999. The

announcement effect is measured by the cumulative abnormal return across different

event windows. The stock dividend is proxied by a dummy variable, while the cash dividend

shock is measured as the unexpected cash dividend adjusted by industry average growth. It

is found that the cumulative abnormal return responds positively to the stock dividend

announcement, especially in the case of stock dividends from capital reserves. This finding

contributes to the literature in Chinesemarket, which, for the first time, separates the stock

dividend from retained earnings from the stock dividend from capital reserve.

Meanwhile, unexpected cash dividends have a marginally positive contribution to

cumulative stock abnormal returns. The results are consistent with past literature that

minority shareholders prefer stock dividends while non negotiable shareholders prefer

cash dividends (Cheng et al., 2009). Meanwhile, UCSs’ control rights have little influence on

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the cumulative abnormal return, but the unexpected cash dividends from firms with

different types of UCSs lead to divergent cumulative stock abnormal return. Specifically,

market reaction to unexpected cash dividends from firms with private or SAMB UCSs is

generally positive in the short and medium event windows. Dissimilar to previous studies,

the earnings shock has no significant impact on the cumulative abnormal return. The above

finding makes contribution to the dividend announcement effect literature in the Chinese

market and examines the effectiveness of CSRC’s regulations on cash dividend payout.

Chapter 6 conducts an empirical analysis of the relationship between current cash

dividend payouts and future earnings growth in the Chinese market, based on a sample

taken between 2001 and 2010. This chapter extends the works of Arnott and Asness (2003),

Zhou and Ruland (2006) and Vermeulen and Smit (2011) to the Chinese market with the

purpose of investigating whether cash dividend policies of Chinese public firms follow the

pecking order theory or the free cash flow hypothesis. Further, this chapter explores a

potential quadratic relationship between cash dividend payouts and future earnings

growth, which can be regarded as a combination of pecking order theory and free cash

hypothesis. Additionally, the influence of stock dividend announcements on the future

earnings growth is also examined.

Following the aforementioned literature, the future earnings growth is measured by

growth in earnings per share and earnings before interest and tax per share over a one year

window. The results indicate that the cash payout ratio and a change in cash payout ratio

has a positive influence on the future earnings growth, which is generally consistent with

Arnott and Asness (2003), Zhou and Ruland (2006) and Vermeulen and Smit (2011). The

future earnings growth of firms with higher over investment potential, proxied by Tobin’s

12

Q, benefits more from higher cash dividend payout. The proposed non linear relationship

between cash dividend payout and future earnings growth is not significant, although the

contribution from cash payout to future earnings growth diminishes marginally as the cash

payout increases. Finally, a stock dividend announcement does exert a negative impact on

the future earnings growth, which is in line with the free cash flow hypothesis. This chapter

makes contribution to interpret the cash dividend as a tool to deal with the agency principal

problem, as well as supply an explanation to the widely discussed ‘stock dividend puzzle’ in

the Chinese market.

Chapter 7 provides a summary and conclusion. In the traditional corporate finance

research, dividend policy is associated with firm valuation and corporate governance

mechanisms. The results suggest that dividend policy manifests itself as a mechanism to

mitigate the free cash flow problem and improve the efficiency of operations in the Chinese

market. Importantly, dividend policy is affected by the ownership structure and

consequently exerts an influence on the operating performance and firm valuation. These

findings suggest some further research into the agency cost and relevant tunnelling

behaviour of ultimate controllers is necessary.

13

Chapter 2 Literature on dividend payout policy

2.1. Introduction

This chapter provides a literature review of the previous studies on the three main

research themes covered in this thesis. Section 2.2 briefly outlines Lintner’s model and

Miller and Modigliani’s dividend irrelevance theorem. Section 2.3 outlines the first theme

pertaining to the relationship between cash dividend, agency cost and corporate control

rights. The first part of Section 2.3 addresses the studies on the theoretical views about the

relationship between cash dividend, agency cost and corporate control rights, while the

second part of Section 2.3 elaborates on the signalling hypothesis of cash dividends,

whereas the last part of Section 2.3 discusses the relationship between dividend policy and

ultimate controlling shareholders. Section 2.4 reviews the literature on the dividend

announcement effect, which is comprised of two parts the theoretical viewpoints and the

empirical evidence. Section 2.5 deals with the second theme, the research on the

relationship between dividend policy and future earnings growth, which consists of two

parts. The first part of Section 2.5 focuses on the free cash flow hypothesis of dividend

policy, whereas the second part covers the empirical research on how dividend policy is

correlated with future earnings growth. Finally, Section 2.6 summarizes the literature on

which the following chapters are based.

2.2. Lintner model and dividend irrelevance theorem

Lintner (1956) proposed that managers designed the dividend policy deliberately

rather than simply distribute the residual of net profit after reserving sufficient funds for

14

future investment plans. Managers would maintain a steady dividend payout unless they

could confirm that the change in the updated earnings level was sustainable. Furthermore,

Lintner (1956) posited that managers are concerned more about the target payout ratio

than the absolute changes in earnings amount. Fama and Babiak (1968) confirm the

robustness of net profit as an earnings parameter and supply empirical evidence to support

the Lintner model with little serial dependence on the disturbances, based on a sample of

United States industrial firms. Ang (1975) suggests the coherence between dividends and

earnings is faster than normally expected in the long run and short run components. Kalay

(1981) document a negative relation between earnings uncertainty and payout ratio in

cross sectional tests, but a similar correlation is not observed in the time series analysis.

Moreover, based on a worldwide firm level sample, Chay and Suh (2009) conduct cross

sectional analysis and report a significant negative association between cash flow

uncertainty, proxied by the volatility in stock returns, and cash payout policy, including both

the magnitude and propensity of the cash dividend.

Besides the traditional cash dividend payout, share repurchase has become more

popular in recent years. Brav et al. (2005) conducted a survey among 384 financial

executives and found share repurchase was preferred, not only because of its flexibility in

distributing residual cash flows, but also its function of adjusting the capital structure

instantaneously. Skinner (2008) reports only a small portion of public firms contribute to

the aggregate cash dividend payout and argues that the traditional version of the Lintner

model is unable to capture the evolution in payout practice because the sticky dividend

policy results in a weakening correlation between dividends and earnings. Instead, the

speed of adjustment improves over time and becomes more significant when the payout is

15

measured by total cash distribution, including share repurchase. Some empirical evidence

suggests that newly listed firms arewary of initiating cash dividends and the amount of cash

dividend payouts is concentrated within a relatively small number of large firms (Fama and

French, 2001, DeAngelo et al., 2004, Skinner, 2008).

Another cornerstone in dividend literature is the Miller Modigliani (MM) dividend

irrelevance theorem. Miller and Modigliani (1961) put forward the theory that

shareholders’ wealth level is only determined by the firm’s investment policy but is not

affected by the dividend policy, given a frictionless market. Similar to Lintner’s suggestion

of a target dividend payout ratio, Miller and Modigliani (1961) theorize that the change in

current dividend will convey some information about future target payout ratios. It is the

shareholders’ speculation on this information, rather than the dividend policy, that drives

the share price. Miller and Modigliani (1961) also discuss various types of market

imperfections, such as income tax and transaction costs, and shed light on the directions of

subsequent payout policy research, such as tax clientele effect and agency cost theory.9

TheMM dividend irrelevance theorem has been continuously debated, especially its

assertion that only investment policy contributes to firm value in a frictionless market.

DeAngelo and DeAngelo (2006) posit that dividend policy is as important as investment

decisions in firm valuation, and the optimal payout ratio is within a range rather than at a

certain level when the retention of free cash flow is allowed. In the framework of MM’s

dividend irrelevance theorem, managers have to pay out the present value of future free

cash flow if the decision is in the best interests of shareholders. DeAngelo and DeAngelo

9 The agency cost theory can be subdivided into an incomplete contract (free cash flow problem) and anasymmetric signalling hypothesis (asymmetric information).

16

(2007) argue MM’s dividend irrelevance theorem may well produce some side effects

because the above assumption can be easily challenged by agency principal problems and

stock bubbles.10

2.3. Dividend payout policy, agency cost and corporate governance

2.3.1. Agency cost and dividend policy

The separation between ownership and control is the source of the agency cost

theory and modern corporation theory in financial economics (Ross, 1973). Entrepreneurs

with intelligence capital and investors with financial capital form a collaborative relationship

in which the investors are the principal and the entrepreneurs work as the stewards.

Shareholders delegate the firm resources to entrepreneurs (directors) with expertise and

professional judgement, whichmakes directors the actual controller of the firm’s assets and

they are assumed to work in the best interests of the principal. However, as the assumption

of homo economicus11 holds, the entrepreneurs’ interest is not always aligned with that of

the shareholders’, which results in the potential conflict of interest in which the directors

will maximize their own benefits at the cost of shareholders (Jensen and Meckling, 1976).

Because it is unrealistic to develop a perfect contract in detail to define the rights and

responsibilities of both principal and agent, shareholders have to utilise other methods to

10 Agency principal problem caused by separation of ownership and control results in managers’ preferencefor retaining more free cash flow and conducting self dealing activities at the expense of shareholders.Irrational exuberance in the stock market tempts managers to issue new shares at overvalued prices, evenwhen there is no ideal investment opportunity.11Homo economicus refers to rational decision making purely based on the principle tomaximise self interest.

17

minimise this problem and incur agency cost, such as a competitive remuneration package,

monitoring of costs and residual losses.12

The existence of the agency principal relationship installs managers as the actual

controller of the firm’s assets who are likely to abuse the free cash flow, which is ‘the cash

flow in excess of that required to fund all projects that have positive net present value’

(Jensen, 1986). External investors may tackle this free cash flow problem by demanding

more cash dividends.13 Rozeff (1982) posits an optimal dividend payout ratio to minimize

the aggregation of agency costs and floatation costs of external equity funding. To reduce

the cash holding by paying cash dividends will mitigate the agency cost, as the managers’

inclination to have a spending spree (e.g., over invest) is suppressed, but the side effect is

that the firm has to raise external capital when projects with positive net present values

emerge. There is a trade off between them though as the benefit from decreased agency

costs may well be overridden by the higher floatation costs of subsequent equity financing.

Crutchley and Hansen (1989) outline three methods to deal with agency cost,

including managerial shareholdings, cash dividend and debt financing. Managers would

adopt the least costly financial policy to reduce the agency cost and increase firm value for

both shareholders and themselves. It is found that managers are not inclined to use cash

dividends when the floating cost is high, but are likely to distribute more cash when firm

size is larger, which is in line with the agency cost hypothesis. Denis et al. (1997) conclude

12 Monitoring cost refers to the dissipated resources spent on supervising the directors, such as auditing fees.Residual loss is the economic consequence of managers’ decisions which fail to maximize shareholders’wealth. Large shareholders may face agency cost stemming from ‘free rider problems’, that is, minorityshareholders will take advantage of the conflict between large shareholders and directors. Entrepreneurs alsoincur ‘bonding cost’ to affirm their commitment to the company. Jensen andMeckling (1976) also explore theagency cost of debt.13 Debt cost is another solution with similar purpose to decrease the cash balance. But it may lead to theagency cost between shareholders and debt holders.

18

that the firm value is undermined by the size of managerial equity ownership and the

presence of external block shareholders, because these factors are inversely related to the

level of diversification.

Simultaneously, Easterbrook (1984) suggests the divergence in the level of risk

aversion between shareholders and managers leads to another type of agency cost. As

entrepreneurs’ human capital and interest in the firm is less diversified, they are more risk

averse than investors who prefer taking more financial risks to exploit the tax shield from

debts. Similar to Rozeff (1982), the primary market will discipline managers’ behaviour

when they pursue additional external equity funds. Even if no additional external equity

capital is needed, a cash distribution will alleviate the divergence in the risk appetite

between shareholders and entrepreneurs. By contrast, Blau and Fuller (2008) posit that

corporate management incorporates the operating flexibility into the design of dividend

policy. Fundamentally, the agency principal relationship assumes managers have more

expertise than shareholders. By decreasing dividend payments and storing liquidity,

managers obtain flexibility which enables them to be engaged in profitable investment

projects, but shareholders may not agree with the managers’ decision because fewer

dividends are unappealing. Further, shareholders will supply further equity funds when the

stored liquidity is insufficient, therefore, managers face a trade off between investment

flexibility and the current dividend.

Some recent studies argue that it would be hard for managers to redirect financial

resources as the variability of future cash flow makes it unverifiable. In other words, the

managers’ control on the firm assets may be very expensive. Therefore, the focus of

research on agency cost and dividend policy turns to the relationship between insiders and

19

outside equity. Fluck (1998) investigates the function of outside equity and argues that

agency cost can be alleviated by debt and outside equity, because investors will evaluate

the probability of whether their future cash rights can be realized, and their decision to

purchase the outside equity indicates they are satisfied with the expected outcome. Not

only does debt impose fixed financial charges on management as a discipline, but also puts

the managers’ fate in the debt holders’ hands when the put option on the firm assets held

by outside equity investors is exercised in the case of bankruptcy. Entrepreneurs pay cash

dividends to outside equity holders in order to convince them, to some extent, that their

future cash rights are honoured.

Unlike Jensen and Meckling (1976), Myers (2000) argues that managers pay cash

dividends to external shareholders in order to extend the agency principal contract,

because the future return on investment is subject to market uncertainty, and managers

are attempting to mitigate a negative response from shareholders. In other words, cash

dividends are introduced as a mechanism to sort out the agency cost as it ensures the

investors will hold the investment longer; and outside equity becomes a supplementary

solution when shareholders receive sufficient cash dividends.

The empirical evidence on the agency cost of free cash flow has been widely

documented in both developed and emerging markets. Born and Rimbey (1993) review the

hypothesis in Easterbrook (1984), that the signal embedded in the cash dividend change is

ambiguous because it relies on investors’ capability to distinguish growing firms from

disinvesting firms (i.e., mature firms). Their outcomes indicate that firms with subsequent

financing are more likely to pay fewer cash dividends, but the market reaction to these

20

firms’ announcements is much larger compared with the latter, which provides supportive

evidence to underpin the agency cost model developed by Easterbrook (1984).

In a sample of Canadian firms with a large percentage of internal shareholders, Eckbo

and Verma (1994) report significant agency costs exist when owner managers hold the

dominant voting power in the firm, because such firms always pay low cash dividends or

even omit the cash distribution altogether. They conclude the cash dividend is the result of

consensus among various shareholder groups with heterogeneous backgrounds.14

Mercado Mendez and Willey (1995) observe that the cash dividend policy of the

banking industry is positively influenced by bank size, but negatively associated with poor

diversification, which means the management of banks partially takes the agency cost into

account when they design the financial policy. Similar to the banking industry, utility

companies are also strictly regulated and different from other firms in many features, such

as their capital structure and the appointment of senior management (Hansen et al., 1994).

The utility industry always faces political pressure as any change in ratemay cause rebounds

from the authority and the public. Besides the traditional agency shareholder problem, the

shareholder regulator conflicts also influence the firm’s financial policies. Hansen et al.

(1994) argue that equity finance following a large dividend distribution puts the firm under

the microscope of the underwriter, whose due diligence report will work as an effective

check on the details of the firm. Consistent with the agency cost hypothesis, their empirical

results suggest the floating cost of new equity and ownership concentration has negative

impacts on the dividend payout ratio of utility firms.

14 Eckbo and Verma (1994) also indicate some evidence on the tax clientele effect because the magnitude ofthe cash dividend will increase when the firm is controlled by institutional shareholders with a lower marginaltax rate.

21

Lie (2000) investigates firms’ decisions to deal with excess cash balances by three

types of announcements, special dividend, regular dividend increase and self tender offer.15

Special dividend and self tender offers are generally used to deal with the excess cash from

non recurring events, while a regular increase in cash dividends follows the increase in cash

due to recurring events. Empirical results suggest investors react actively to self tender

offers and special dividends, but sluggishly to regular dividend increases and small special

dividends, which supplies evidence to the free cash flow hypothesis that a large cash

distribution is to alleviate the agency problem.

Brockman and Unlu (2009) look into the substitution between debt and cash dividend

policy by investigating how the credit rights across various markets influence the cash

dividend decision. They argue that managers would make compromises with creditors in

the issue of dividend policy because creditors are concerned about the potential wealth

transfer from them to shareholders. Therefore, a more conservative dividend policy would

satisfy both creditors and shareholders. Their empirical results suggest that the quality of

protection on credit rights is positively correlated with the probability and magnitude of

cash payouts. In other words, the agency cost of debt carries substantial weight when

managers decide on the cash distribution to shareholders, which underpins the reality that

creditors are more involved in corporate financial policy.

Further, Brockman and Unlu (2011) explore agency cost in the frame of the lifecycle

theory of dividend payouts. The lifecycle theory of cash dividend advocates that firms in the

growth stage are less likely to distribute cash to shareholders, while firms in the mature

15 Self tender offers are a type of share buyback, but only target a certain group of shareholders. It is a methodused to avoid hostile takeover.

22

stage are more likely to do so, because the investment return of the former’s financial

resources is much higher than that of the latter.

Apart from the empirical evidence in favour of the lifecycle theory, they confirm the

existence of an agency cost inclusive lifecycle theory of cash dividends. Because managers

need to distance themselves from potential suspicion of hoarding financial resources, they

will pay more cash dividends if the environment of transparent disclosure is not available,

which underpins the validity of cash dividends as a solution to agency costs.

2.3.2. Corporate governance and dividend policy

The research on agency cost depends on the reality in the Anglo American markets

that shareholdings are widely dispersed among investors, and managers take advantage of

this situation because it is relatively difficult for scattered shareholders to take collective

action against the management. In other markets, however, the concentration of

ownership and the presence of large shareholders have more impact on corporate

governance issues in those markets.

Shleifer and Vishny (1986) attempt to develop a model and explain how a large

minority shareholder takes the responsibility of monitoring the company’s management,

and deals with the agency principal conflicts when diffused minority shareholders are

actually free riders. Cash dividend becomes a subsidy to large shareholders because they

need to be compensated for the additional monitoring work. Subject to higher marginal tax

rates, minority shareholders are disadvantaged when they receive cash dividends, but

regard it as reasonable because they share the benefit of the improved share price

23

stemming from large shareholders’ extra surveillance of management.16 Large shareholders

can also be the source of an agency problem between large and small shareholders, as large

shareholders may collaborate with managers and expropriate small shareholders’ wealth.

Although Barclay et al. (2009) argue that there is weak evidence to support the connection

between large shareholders and cash dividend payouts, their argument targets the tax

clientele effect and does not rule out the possibility of collaboration between large

shareholders and managers.

Jensen et al. (1992) argue that the contribution of a cash dividend to alleviate agency

cost is less significant when the underlying firm reports a higher percentage of insider

ownership, because firm specific features cause the endogeneity of dividends and

ownership. Their empirical results propose that insider ownership has a significant negative

correlation with dividend payout and debt level. Similar to Jensen et al. (1992), Crutchley

and Jensen (1999) contend that capital structure, including the level of insider ownership

and institutional shareholdings, and dividend policy are designed simultaneously in order

to minimize the agency cost. They observe that institutional shareholdings work as an

alternative monitoring mechanism which is able to substitute the cash dividend. They also

report a statistically significant curvilinear relationship between dividend payout and inside

ownership.

When institutional investors gain significant power in the financial industry, the

function of dividend signalling is not only limited to conveying information on firms’

operation but is also utilized to attract institutional investors. Allen et al. (2000) point out

16 Recent studies, such as Barclay et al. (2009), document weak connections between institutionalshareholders and dividend paying firms.

24

that the presence of institutional shareholders enhances corporate governance and the

information content embedded in the dividend change. As institutional investors have the

expertise to evaluate the performance and quality of listed firms, bad firms will incur

significant costs if they attempt to improve their reputation by mimicking good firms’

payout policy. Institutional shareholders will take action against incompetent managers by

dumping their shareholdings and facilitating potential takeover activities, when they reduce

cash dividend. They conclude that both dividend policy and firm value is positively

influenced by the existence of institutional investors. Meanwhile, Chae et al. (2009) report

that the effectiveness and direction of corporate governance on the cash dividend depends

on firms’ financial constraints. Firms will reduce the payout ratio when they face tougher

external financing constraints even if corporate governance is enhanced.

Based on Lintner (1956) and Fama and Babiak (1968), Short et al. (2002) document a

positive interaction between institutional shareholders and dividend policy based on UK

panel data. The positive relationship is enhanced when the underlying firm’s profitability is

strong. In the meantime, an inverse relationship between managerial shareholdings and

dividend payout is observed, which supplies evidence to the free cash flow hypothesis. Khan

(2006) also uses a panel of 300 UK firms between 1985 and 1997 to investigate the

relationship between dividend policy and ownership structures. The result suggests a

negative and curvilinear relationship between the shareholding of the top five largest

shareholders and dividend payouts. In addition, the individual shareholdings are negatively

related to the dividend payout, while the level of shares held by insurance companies has a

positive relationship with the dividend payout. The author attributes the outcomes to either

25

the fact that cash dividends substitute for the poor corporate governance, or that powerful

shareholders exert influence on the management on the issue of corporate financial policy.

Baba (2009) reports that a larger increase in foreign ownership has a positive

influence on the likelihood of cash dividend announcements and the probability of an

increase in cash payout magnitude among Japanese listed firms. Although foreign investors

only have a relatively small stake in the Japanese market, the results indicate that active

external shareholders will exert considerable influence on the dividend policy. The empirical

results of Grinstein and Michaely (2005) find there is a significant positive relationship

between share repurchase and institutional shareholdings, while the correlation between

institutional shareholdings rendering a higher dividend payout and cash dividend payout is

ambiguous, although dividend paying companies have higher percentages of institutional

shareholdings.

The legal environment is another important issue which affects cash dividend policy.

In general, the quality of legal protection will determine to what extent the shareholders’

property rights can be endorsed, and mitigates the damage to their wealth caused by

agency costs. In other words, besides the conventional corporate governance

infrastructure, an effective legal system becomes a back up solution to the agency problem.

La Porta et al. (2000a) conduct a cross border analysis on how legal systems influence the

dividend policy. Two testable models, ‘outcome model’ and ‘substitute model’, are

developed to explore how firms design their dividend policy. The ‘outcome model’ posits

that the dividend policy is an outcome of an effective legal system on the issue of

shareholders’ property rights. The payment of a cash dividend is the result of minority

shareholders exercising their entitlement to extract cash from the firm, which shows the

26

power of the legal system to improve the self motivated corporate governance system.

Rather than the causal relationship, as proposed in the ‘outcome model’, the ‘substitute

model’ hypothesizes that cash dividends and legal protection are substitutes. The

foundation of this hypothesis is that the subsequent equity finance needs the firm to

establish a remarkable reputation in the capital market in order to receive decent treatment

from the investors, including both active participation in seasoned equity offerings and

lower funding costs. The ‘outcome model’ predicts that dividend payout ratios should be

higher in those countries with stronger corporate governance.

Based on the regression results from a sample of 4,103 dividend paying public firms

from 33 legal regimes, La Porta et al. (2000a) document there are significant differences

between the dividend payout patterns of civil law regimes and that of common law regimes.

The empirical evidence is inclined to support the ‘outcome model’ as providing stronger

legal protection (in common law regimes) and it is associated with higher cash dividend

payouts. Meanwhile, they also report a side effect of this relationship which is the lower

growth rate in common law regimes, as the minority shareholders are more likely to

withdraw cash from the listed firm which may well undermine the long run growth.

Farinha and Lopez de Foronda (2009) compare the relationship between dividend

policy and insider ownership in different legal regimes with civil law and common law legal

systems. In common law regimes, the cash dividend payout is, in general, negatively

correlated with insider ownership in a common law legal system. During this descending

process, payout ratio will rebound when the insider shareholdings are significant but non

dominating, which reflects the insider shareholders’ attempt to compromise outside

investors’ demand for decreasing the cash controlled by insider owners. The pattern is

27

totally opposite in civil law regimes, where cash dividend increases as the internal

shareholding increases, but with a retrace during the ascending process. From the author’s

viewpoint, the divergent pattern suggests dividend policy works as a corporate governance

mechanism in regimes with different legal systems and distinct agency costs.

Adjaoud and Ben Amar (2010) test whether outcome hypothesis or substitution

hypothesis is more suitable to explain the relationship between dividend policy and

corporate governance quality, with a sample of 714 observations listed on the Toronto

Stock Exchange, and find supportive evidence that dividend policy is a kind of corporate

discipline mechanism. They use the Globe & Mail annual corporate governance index, as

well as four sub category scores board composition, shareholding and compensation

issues, shareholder rights issues and corporate governance disclosure policy to assess the

robustness of corporate governance mechanisms. Their regression results indicate that

strong corporate governance is associated with a higher dividend payout ratio, which is

similar to Farinha and Lopez de Foronda’s (2009) findings on the common law regime.

Jiraporn and Ning (2006) posit agency costs play a determinant role when firms design

a dividend policy, by examining the association between dividends and the strength of

shareholder rights. Contrary to La Porta et al. (2000a), their empirical evidence is inclined

to underpin the substitution model, that is, there is an inverse relationship between

dividend payout and shareholder rights. Firms would announce higher dividends when

shareholder rights aremuchweaker, as themanagement needs to convince themarket that

they would not expropriate shareholders’ wealth. The result is that dividends replace

shareholder rights as a corporate governance mechanism.

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Some studies argue the ‘outcomemodel’ proposed by La Porta et al. (2000a) may only

be suitable for markets where the shareholding is widely dispersed. In fact, the

phenomenon of shareholding concentration is widely seen in markets other than UK and

US. Gugler and Yurtoglu (2003) contend that the change in dividend payout reflects the

severity of the conflict between large and small shareholders.With a sample of 266 German

listed companies, they find that the payout will be reduced when the largest shareholder

increases its stake, but is increased when the second largest shareholder acquires more

outstanding shares. The first result indicates the free cash flow problem deteriorates as the

largest shareholder has more voting rights, while the second phenomenon suggests the

second largest shareholder attempts to challenge the largest shareholder’s monopoly on

the firm’s financial resources.

Besides the level of shareholdings, Gugler (2003) contends that the identity of the

largest shareholder influences the underlying firm’s payout policy. Gugler (2003) defines

the four types of largest shareholders as families, banks, foreign investors and state

governments, because they have unique backgrounds and interests. A system of

simultaneous equations is applied to the panel data of 214 non financial Austrian firms

between 1991 and 1999. Significant divergence among the different types of largest

shareholders is documented. The listed firm with a state government as the largest

shareholder smooths the dividend policy, while family controlled firms exhibit more

volatility in the dividend payout and are more likely to cut cash dividends. The dividend

smoothing activity, however, is only marginally important in firms with banks or foreign

investors as the largest shareholder. The investment cash flow, proxied by the research and

29

development expenditure, is inversely related to the dividend policy, which supports the

maturity hypothesis that mature firms will distribute the cash to shareholders.

Faccio et al. (2001) argue that the existence of large shareholders has changed the

payout pattern significantly. Investors in both European and Eastern Asian firms tightly

affiliated with single large shareholders receive more cash dividends, because they are

aware of the potential for expropriation. When the affiliation is loose, though, the cash

dividends of European firms are not affected, whereas similar Asian firms reduce their cash

payout because multiple large shareholders, also known as ‘parties acting in concert’,

collaborate and exacerbate the expropriation.

Renneboog and Trojanowski (2007), using UK panel data, investigate whether

corporate control structure influences the dividend policy. Their results show a significant

negative relationship between the largest shareholders’ voting rights and payout ratios, and

the pattern is irrelevant to the type of largest shareholder. Meanwhile, the traditional

connection between earnings and cash payout, as suggested by Lintner (1956), still holds,

but is undermined by the existence of a large shareholder and/or a coalition among large

shareholders. Large shareholders attempt to optimize the aggregate costs from both free

cash flows and subsequent equity financing. Not only does the result support the gradual

adjustment in dividend payout (i.e., smoothing the dividend), but it also underpins the

pecking order theory where the funding cost is more relevant when management design

the payout policy.

Wei and Zhang (2008) analysed eight East Asian emerging markets before the Asian

financial crisis, and found that the sensitivity of a firm’s capital expenditure to its free cash

flow is negatively correlated with the cash rights held by the largest shareholder, but

30

positively correlated with the magnitude of the divergence between the largest

shareholders’ cash rights and control rights. These results can be explained by the free cash

flow hypothesis, because the largest shareholder would occupy the free cash flow of listed

firms and expropriateminority shareholders’ wealth. As the divergence between cash rights

and control rights enlarges, the controlling shareholder has more incentive to exploit

additional economic benefits from the underlying firm via overinvesting its free cash flow.

With regard to the relationship between dividend policy and ownership structure, Gul

(1999) reports that government ownership is positively associated with Chinese listed firms’

cash dividend payouts, based on a sample of Chinese listed firms between 1991 and 1995.

Similarly, Cheng et al. (2009) document a positive relationship between state owned shares

and cash dividend payouts, as well as a positive relationship between private shareholdings

and stock dividend.17 Further, Huang et al. (2011) also report a positive contribution from

non negotiable shares on both the magnitude and likelihood of cash dividend

announcements with a sample between 1994 and 2006. All these studies attribute the

positive relationship between non negotiable shares and cash dividend to the unique

ownership structure in the Chinese equity market, especially the non negotiability of state

owned shares, because a cash dividend is the only justified form of investment return from

the viewpoint of non negotiable shareholders.

17 Stock dividends in the Chinese market contain two types, stock dividend from retained earnings and stockdividend from capital reserves, which are similar to bonus shares and stock splits in a developed market,respectively.

31

2.4. Dividend policy and stock abnormal return

2.4.1. Dividend announcement effect: US and other developed markets

The relationship between dividend policy and stock abnormal return is a test of the

efficient market hypothesis (EMH), and themainstream research on the stock price reaction

to dividend announcements surrounds the information content embedded in dividend

change, omission and initiation. Large firms are reluctant to change dividends unless the

managers are assured about the sustainability of operating profits (Lintner, 1956). Investors

are likely to take the dividend announcement as an objective indicator of firm performance,

because external stakeholders lack detailed information about the firm apart from that

obtained from financial reports. Assuming the management conveys information via

dividend announcements, investors react vigorously to the change in dividend policy. On

the other hand, this mechanism is also known by managers who then design the dividend

policy carefully in order to avoid any undesired impacts on the firm value.

Pettit (1972) attributes the ‘sticky dividend policy’ to themanagement’s concerns that

the announcement of dividend changes will be used to assess share price. Based on a

sample of 625 dividend change announcements between 1964 and 1968, the author finds

investors react negatively to dividend decreases and positively to moderate dividend

increases (10 to 25%).18 The results of Pettit (1972) are affirmed by Kwan (1981) who applies

the models in Lintner (1956) and Fama and Babiak (1968) on a small sample with better

specification of information content. Higher unexpected changes in dividend (larger than

10%) are associated with higher cumulative abnormal returns around the event window.

18 But investors’ reaction becomes sluggish if the dividend increase is smaller than 10% or larger than 25%.

32

Bhattacharya (1979) proposed that managers use the cash dividend as an opportunity

to signal the expected cash flow because of the different tax rates on dividend income and

capital gain. Intuitively, investors respond differently based on the direction of news. A

positive cash dividend shock or dividend initiation is viewed as a signal of the manager’s

optimism about future cash flow, while a lower than expected cash dividend

announcement shows the managers’ lack of confidence. The argument in Bhattacharya

(1979) is that it treats the dividend, to some extent, as a commitment to shareholders,

although investors should be aware that they are only entitled to the residual value.

Aharony and Swary (1980) use quarterly data from the US capital market, and show

the information content of changes in dividend is more useful in conveying information to

the public than that from the corresponding earnings announcement. The stock abnormal

return around the dividend announcement independent of the earnings announcement is

significantly positive (negative) when there is a dividend increase (decrease). Moreover,

with a sample across the window between 1947 and 1968, Charest (1978a) finds that the

monthly return after the dividend change announcement is consistently large, especially in

the case of a dividend decrease, which suggests a significant market anomaly. The author

attributes the result to the under reaction of investors, but cannot rule out the possibility

of measurement error in the abnormal return. On the other hand, Divecha and Morse

(1983) also document a significant