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Thompson Rayner
2009602212, EMBA (Uitm, Sabah)

Dr. Gurdeep Chawla, National University, California (The Journal of American Academy of
Business, Cambridge). 2Abdulrahman Ali Al-Twaijry, Qassim University, Saudi Arabia (The Journal
of Risk Finance)


Some financial analysts feel that the consideration of a dividend policy is irrelevant because
investors have the ability to create "homemade" dividends. These analysts claimed that this
income is achieved by individuals adjusting their personal portfolios to reflect their own
preferences (http://www.investopedia.com/articles/03/011703). For example, investors
looking for a steady stream of income are more likely to invest in bonds (in which interest
payments don't change), rather than a dividend-paying stock (in which value can fluctuate).
Because their interest payments won't change, those who own bonds don't care about a
particular company's dividend policy but again what about those investors who interested in
dividend-paying stock.

Determining dividend policy has been one of the most difficult challenges facing by financial
economist. Somehow, we have not yet completely understand the factors that influence
dividend policy and the manner in which these factors interact. This journal summary will
review two journals on the issues of dividend policy decision and also dividend policy and
payout ratio.


The study on dividend policy decision according to Dr. Gurdep Chawala of National
University, California highlighted that dividend theories such as MM proposition, tax
preference, and bird-in-the-hand theories have presented wide ranging arguments from
dividend irrelevance to low dividends to high dividends. The argument is elaborate further on
the dividend theory as stated below.

MM Proposition Theory

MM proposition theory emphasized that a company’s value depends on

the types of investments it makes, the associated business risk and the
earnings which the company’s generated. The argument from Merton
Miller and Franco Modiglaini (MM) is that investors can generate their own

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dividends by selling their stock and their arguments are valid under
restrictive assumptions which include : no personal or corporate income
taxes, no flotation or transactions costs, investors are indifferent between
dividends and capital gains, companies’ dividend policies and capital
budgeting decisions are independent and availability of symmetric (or
same) information to investors and managers. Somehow, MM proposition
has been challenged because of its unrealistic assumptions.

Tax Preference Theory

On tax preference theory, Litzenberger and Ramasamy highlighted that

there are taxes in real world and tax rates on capital gains have
historically been lower than tax rates on ordinary income . Taxes on
capital gains can be postponed until realized (securities are sold) in future
years but ordinary income is taxed in current year. Therefore, investors
prefer companies that pay low or no dividends and postpone the
distribution of earnings.

Bird-in-The-Hand Theory

In contrast to MM proposition and Litzenberger and Ramaswamy favoring

low dividends, Gordon and Lintner have advocated high dividends. They
have developed “bird-in-the-hand’ theory and argued that dividends paid
during current period are more certain than promises for capital gains and
higher returns in future. They have further argued that investors are risk
averse and require higher returns for taking higher risk. This mean, a
company paying low or no dividends would experience higher cost of
capital which would result in increased overall costs in running their
business and this will decreased their earnings thus lower stock prices.

Contradiction in Dividend Theory

According to Dr. Gurdeep Chawla, MM have called Gordon and Lintner’s theory
“bird-in-the-hand” fallacy and acknowledged that stock prices increase as
a result of more than expected increase in dividends. They have claimed
that, companies are usually reluctant to cut dividends and, therefore, an
increase in dividends indicates managers’ expectations about increased
earnings, increased cash flows, and better company performance in

MM have further stated that a company sends positive signal to market

about its future performance by increasing dividends and it leads to
increase in stock prices. Changes in dividend policy would make the

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company more or less appealing to different types of investors, impact
demand for its securities, and lead to change in stock prices.

Overall, these theories contradict each other and advocate different

approaches to formulating dividend policies. Somehow, according to
Dr.Gurdep Chawla, empirical studies have been conducted to evaluate the
dividends theories but the results are inconclusive because the difficulty in
explaining the changes in stock prices which can be attributed to a
number of variables.

Companies’ Dividend Policy

On deciding the amount of dividend payment, a company determines the amount of

payment based on the residual dividend policy where a company uses internal equity
(retained earnings) to finance its projects first and then any leftover
(residual) earnings are distributed to shareholders in form of dividends.

However, dividends tend to fluctuate under this policy because dividends

depend upon the capital budget and retained earnings of a particular year
which might change from year to year and this situation create more
uncertainty for investors and they demand higher returns for increased
risk which raises companies’ cost of capital. In addition, a decrease in
dividends might send a negative signal to the market and adversely
impact stock prices. Therefore, the policy can be used for long-term
planning but can not be strictly implemented every year.

Managers’ Views in Developing Dividend Policies

Although dividend theories can provide helpful tools for making dividend
policy decisions and dividend policies can be useful guidelines, they do not
explain managers’ views in developing dividend policies. Listed below are
the summary of survey finding which conducted by researcher from
various listed company related to dividend policy.

a) Survey No. 1

Researcher Baker, Powell and Veit

Respondent Company Listed in National Association of Securitys
: Dealer Quotation (NASDAQ)
Survey Focus a) To determine their views about dividend policy, the
: relationship between dividend policy and value and
four common explanation for paying dividends
(Signalling, tax preference, agency cost and bird-in-

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hand argument)
b) Important factors in making decision about
dividend policy
a) Highlighted that, respondent gave the strongest
support for signalling explanation for paying
dividends but expressed little or no support for tax
preference and agency cost explanation. Most
respondent disagreed with statements supporting
the bird-in-hand explanation for paying dividends.
b) Past dividends was the most important factor followed by
stability of earning, the level of current earning and the fourth
most important factors is the expected future earning.

b) Survey No.2

Researcher Frankfurter, Kosedag, Schmidt and Topalov

Respondent Public Listed German Firm (Chief financial officer)
Survey Focus Payment of dividend
Consensus among respondent that stockholders like to receive regular
Findings dividends and paying a cash dividend is necessary because stockholder
: except it. The practice must continue to avoid bad signal to the
stockholder on the company performance.

c) Survey No.3

Researcher Baker and Powell

Respondent Companies listed on New York Stock Exchange (NYSE)
Survey Focus Factors influencing dividend policy
Level of current and future earnings, pattern or continuity of past
Findings 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 highly ranked factors.

d) Survey No. 4

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Researcher Pruitt and Gitman
Respondent Highest ranking financial officer of 1000 largest
: companies in the USA
Survey Focus Factors influencing dividend policy
Findings Current and last year’s profit, variability of earnings and growth rate in
: earning strongly influence companies’ dividend policy.

e) Survey No.5

Researcher Baker, farrelly and Edelman

Respondent Companies listed on New York Stock Exchange (NYSE)
Survey Focus Views about dividend policy
Anticipated level of the firm’s future earnings, the pattern of past
Findings dividends, the availability of cash and concerns about maintaining or
: increasing stock price were the major determinants of their dividend


According to Abdulrahman Ali Al-Twaijry of Qassim Universiti, Saudi Arabia

on his research finding related to identification of variables with an
expected influence on dividend policy and on payout ratio highlighted
that, Pearson correlation results confirmed what was suggested in the
literature that current dividends are affected by its past and future and
also dividends were associated with net earnings but less strongly. Other
finding by abdulrahman Ali Al-Twaijry from his research such as :

• Size has a significant effect on the DPS.

• The payout ratios (POR) have no significant association with either
the current, past or future net earnings.
• The correlation between POR and the company’s future earning
growth, in general, is negative but insignificant.

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• The company’s level of leverage has a negative (sometimes
significantly) relationship with the POR.
• The strongest determiner of the POR is its past ratios.
• Comparison analysis revealed that cash per share has a significant
positive impact not only on DPS but also on POR.
• Dividend policy and payout ratio 361 of mean comparisons suggests
that shares with higher book values receive significantly more
dividends, and that the POR is significantly higher for those shares.


Finding from both of the journal which discussing on dividend policy decision and dividend
policy payout ration stated clearly that empirical research has been inconclusively and does
not validate dividend theory but somehow it is important for managers to understand the
argument and factors that can help the managers in formulating dividend policy. As stated in
the research finding by Dr.Gurdeep Chawla, the pattern of past dividends, the stability of
earnings, current and expected future earning, concern about impact on stock prices and the
stability of cash flows actually some of the factor that determining the companies’ policy.

On the payout ratio, Abdulrahman Ali Al-Twaijry findings emphasis that payout ratios (POR)
were not found to have strong effect on the company’s future earning growth but significantly
have negative correlation with company’s leverage. It is also noted that cash per share and
share book value significantly positively affecting DPS and POR.


Abdulrahman Ali Al-Twaijry, Qassim University, Saudi Arabia (The Journal of Risk Finance)

Dr. Gurdeep Chawla, National University, California (The Journal of American Academy of
Business, Cambridge


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