Regression with P-VOL, D-Yield and P-OUT

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Theoretical Framework

This chapter will introduce theories about dividend policy, risk, and market efficiency hypothesis in order to help the reader understand the empirical results and the analysis.

Theories of Dividend

Dividend Policy

The dividend policy is highly individual for every firm, depending on the growth opportunities and capital requirements for the company. Depending on what situation the company faces, the mangers of the firm have to find the optimal payout ratio for their business and work for the investors’ best interest. Kania and Bacon (2005) separate dividend policy into four different strategies; these are the pure residual dividend policy, the smoothed residual dividend policy, the constant dividend residual policy, and the small quarterly dividend with annual bonus.
The pure residual dividend policy is a strategy where the firm sets it budget for investment opportunities and other capital requirements, then they determine the optimal capital structure and lastly the remaining earnings will be paid out as a dividend to the investors (Droms & Wright, 2010). This strategy will give a different dividend from year to year and it is not sure the company will generate any dividends after proceeding these steps (Kania Bacon, 2005). The smoothed residual dividend policy strategy is simply to ignore temporary changes in earnings, only the long-term changes are important when changing the dividend. The main goal of this strategy is to have a low as possible fluctuating dividend between the years, but with an increasing dividend per share over time (Shapiro, 1990). The constant payout residual dividend policy states that the company should maintain a specific payout ratio so that the dividend fluctuates with the earnings of the company (Kania & Bacon, 2005). The last strategy is the quarterly dividend strategy where the company delivers a quarterly dividend and possibly an extra bonus at the end of the year. The managers in a company that has fluctuating earnings and investments, benefits by a strategy of this sort since they have some flexibility within the cash management.

Dividend Irrelevance Theory

Modigliani and Miller (1961) claim in their irrelevance theory that the dividend should be irrelevant for investors. They argue that the dividend should not have any effect on the share price, except that the share price should decrease with the same amount as the dividend. The investor’s wealth should not be affected because of the choice of which dividend policy the company uses. The general idea of the theory states that this is true in a world with no transaction costs or any taxation on capital gain or dividend. The theory also assume that all earnings is paid out and that the management always acts in the investor’s best interest. A perfect market has free information and where no seller or buyer can affect the price by themselves (Modigliani & Miller, 1961). Håkansson (1982) also supports this view where he reports that the dividend should be irrelevant to a firm’s value when the market is efficient and the investors have the same homogeneous beliefs and time additive utilities. Miller and Scholes (1978) state that a dividend should either be irrelevant or that capital gain should be better for the investor since the tax were higher on dividends than on capital gain.
Shapiro (1990) argues that this theory will only hold if the investment strategy is independent of the firm’s dividend policy. This means that if the firm’s investment strategy is influenced by whether they do or do not pay out a dividend, the theory will not hold. That would be the case when the investments strongly influence the firm’s future cash flows.

Relevance of Dividend Policy

Baker and Powell (1999) argue in their study that managers believe that paying out a dividend is an effective tool to maximize the value to the investors and that the best dividend policy should be a balance between the dividend payout and future growth. These findings are also consistent with the findings of Lintner (1956). He states that dividends are an important factor of the firm value. Gordon (1962) uses the dividend in his valuation method for corporations, which means that the dividend has a vital role, in his point of view.
Although investors may be in theory mathematically indifferent to dividend policy, empirically, dividends themselves have proven very relevant in the eyes of investors for behavioral reasons (Shapiro, 1990). There are no perfect capital markets and they are not frictionless. Therefore, the dividend policy can affect the investors through market imperfections and behavioral considerations. These market imperfections are the bird-in-hand theory, the signaling effect, the agency theory and the clientele effect (Baker & Weigand, 2015). They describe four different and relevant aspects of why dividend policy is important for the investors and the dilemma the managers faces in a firm when to choose dividend strategy.

Bird-in-Hand Theory

The Bird-in-Hand Theory is a theory presented by Lintner (1962) and later supported and named by Bhattacharyya (1979). The general idea of the theory is that investors would rather receive a dividend today then wait for the capital gain tomorrow. The strongest argument for this is the level of uncertainty in an investment; therefore, investors wants to secure some of the invested money (Hussainey, Mgbame, & Chijoke-Mgbame, 2011).
Even more, Gordon (1962) state that investors wants to receive a dividend rather than wait for a capital gain, even if the internal rate of return is the same. This is because there is a risk with waiting for capital gains and that risk exist even in perfect capital markets, according to Lintner (1956).
Bhattacharyya (1979) has the idea that outside investors has imperfect information about the expected earnings of a firm. Therefore, the uncertainty makes the investor to prefer a secure dividend before a capital gain. The theory has received quite a lot of criticism and there has not been any supportive research about this, even though some academically prominent people support the theory (Hussainey et al. 2011).

Agency Cost

The Agency cost theory argues that managers do not always work in the shareholders’ best interest, namely that they are more interested in their own gain. For example, when the management team decide to payout a smaller amount and instead use the retained earnings to overinvest and spend it on perquisites for the management team (Al-Malkawi, 2007).
This theory contradicts to the irrelevance theory by Modigliani and Miller (1961), where they assume that the management always work in the shareholders’ best interest.
Jensen and Meckling (1976) argue that the agency cost arises when delegating the decision making to agents, from the owners. They say that this cost will be higher if both the owner and the agent/manager are utility maximizers, since managers will not act in the shareholders’ best interest. The insider is better off if they do not have a high payout ratio since there will be more retained earnings that could be spent on self-interest (Jensen & Meckling, 1976).

Signaling Hypothesis

The dividend signaling hypothesis states that if managers suggest an increased dividend in a firm, the managers believe that the outlook of the company is positive, and this could imply that the firm can maintain a high dividend in the future. This implies that when a firm increases its dividend and is able to maintain it, it is a positive signal to the investors and an incentive to buy the stock. The managers indicate that the company is doing well. Studies have shown that firms which increased their dividend with 10% or more saw their stock price increase by 1.34%. In contrast, it was the opposite for firms that lowered their dividend, their stock prices decreased by 3.71% (Berk & DeMarzo, 2014).
The studies by Lintner (1956) and Baker and Powell (1999), state that managers believe that changes in dividend should be triggered by permanent changes in profits, rather than temporarily. Baker and Weigand (2015) also argue that the managers choose the dividend payout policy based on private information about the company’s future profits. They state that insiders get this incentive when the current market value is lower than the intrinsic value.

Clientele Effects of Dividends Theories

Modigliani and Miller (1961) argue that investors prefer stocks in cases where the company fulfill a specific need. This is because investors face different tax treatments but also transactions costs in different markets. Investors in the high tax brackets will tend to prefer stocks with no or a low dividend. Berk and DeMarzo (2014) state that in a market where individual investors held 54% of market value but only received 35% of the dividends.
There are two different types of clientele effect, taxation and transaction costs. These effects are different for all investors, depending on the size of your portfolio, what type of investor you are, and where the securities are traded (Hussainey et al. 2011).
The tax-preference theory states that firms with low payout ratios increases the value of the stock. This is because the required rate of return gets lower, since high payout stocks has a negative tax implication against capital gain. (Al-Malkawi, 2007) However, this is not the case in Sweden since the taxation level is the same for both capital gains and dividends (Skatteverket, 2016).

Risk and Dividend

There are two types of risks associated with investing in assets; these are the systemic risk and the unsystematic risk, which are undiversifiable and diversifiable respectively. The risk of owning a specific asset is the unsystematic risk, in the case of stock, the firms-specific risk. The systematic risk is the risk of the market and this risk affect all stocks on the market. When investing in several stocks in a portfolio, the unsystematic risk is diversifiable, as the specific risk do not affect the whole portfolio as much (Berk & DeMarzo, 2014). Since investors are risk averse, the volatility of a stock in their portfolio is important, because it is a measure of exposed risk (Hussainey et al. 2011).
The dividend policy affects a stock in several ways; most research illustrates how the dividend affect the return of the stock, but the risk of the stock is also an important issue. The most common risk measurements are variance and standard deviation, which is the volatility of a stock (Berk & DeMarzo, 2014). Ben-Zion and Shalit (1975) conducted a research on the 1000 largest American industrial companies, where they showed a negative relationship between the dividend yield and the companies risk, meaning that a lower risk is related to a high dividend and the other way around. They also reported that risk is positively related to leverage and has a negative relation with size of the firm. The positive relation with leverage means that companies with high leverage have a greater risk than companies with lower leverage. Firm size has a negative relation to the risk of the firm, which indicates that larger firms usually have a higher level of diversification than smaller firms do (Ben-Zion & Shalit, 1975).
There are four theoretical mechanisms that could explain the relationship between dividend yield and the stock price volatility, but also the relationship between payout ratio and stock price volatility. These four mechanisms are:

  • Duration Effect
  • Rate of Return Effect
  • Arbitrage Realization Effect Informational Effect

The first two represent the mechanisms of the cash flows and the latter two imply that managers could affect the volatility of a stock and by that lower the risk of the company (Baskin, 1989).
Duration is a common expression for demonstrating the sensitivity of a bond to changes in the interest rate. However, the duration can be used when looking into how sensitive stocks are to changes in the equity discount rate (Berk & DeMarzo, 2014).
Firms with high dividend yield and a stable payout policy will have a shorter duration. Short-term debt is not as volatile as long-term debt in the case of changes in the interest rate. Similarly, the price of high yielding firms will not fluctuate as much as low-yielding firms does when the discount rate changes (Baskin, 1989). Baskin’s (1989) research shows that this is true with all other factors equal. The Gordon growth model (Gordon, 1962) have been used to illustrate this. However, the model assumes that there is a constant growth in dividend, so the effect could be more general than this (Allen & Rachim, 1996).
According to Baskin (1989), firms with low dividend yield will be valued more for the future earnings than the assets in the firm. Gordon (1962) argues that the firm with low dividend will be more sensitive to changes in rate of return estimates. When estimates about the rate of return are less reliable, the volatility of the stock in firms with low dividend will be higher. This effect could be partly of systematic risk (Baskin, 1989).
Allen and Rachim (1996) argues that both dividend yield and the payout ratio has an important role in showing the growth opportunities of the company, this because of the cost of capital can be high. They state that it is rational by firms with large investment requirements to have low dividend payout and retain the earnings for investments.
The arbitrage realization effect is a theory that assumes that the financial markets could be materially inefficient. The hypothesis states that stocks that are undervalued can stay undervalued for a long time since forces of equilibrium can be slow. For example, an investor should not buy a stock that is worth more if the undervaluation will remain under the holding period. A firm that pays no dividend and where the undervaluation will not disappear has no chance of delivering any excess return (Baskin, 1989).

1 Introduction 
Background .
Problem Discussion
2 Theoretical Framework 
Theories of Dividend .
Risk and Dividend
Market Efficiency Hypothesis
3 Method
Methodological Approach
Research Strategy
Data Collection
Research Method
Critical Assessment
4 Empirical Results 
Descriptive Statistics
Regression with P-VOL, D-Yield and P-OUT
Regression with Control Variables
Regression with D-YIELD excluded
Regression with P-OUT excluded
5 Analysis
Correlation and Multicollinearity Issues
Regression Outputs
Theoretical Implications of the Empirical Results
6 Conclusion 
7 Discussion and Suggestion for Further Studies .
8 Bibliography 
9 Appendices
The Dividend Policy Issue and its Impact on the Risk in a Stock A study of the relationship between the dividend policy and the volatility of the stock price on the Swedish market

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