The Determinants of Corporate Dividend Policy

Abstract

ABSTRACT What factors determine a corporation's dividend policy? This study empirically examined the data for a sample of 483 firms taken from the Multex Investor Database to assess the impact of selected financial variables on the dividend decision using OLS Regression. Results of this study suggest that the higher the firm's PE, the lower its risk, and the higher the payout ratio. The greater the degree of insider ownership the lower the dividend payout. These findings suggest that management in the firms examined have an incentive to reduce dividends in order to increase the expected value of their stock options received as executive compensation. The firms in the sample also seek to insure access to equity capital to fund growth by establishing a good reputation with stockholders through higher dividends. The importance of dividend cash flow as a signaling device to stockholders also evident in the sample since even with high growth, the firm willing to increase debt to fund increasing dividends. The firms in the sample desire to put their money where their mouth is by sending a strong positive signal to institutional owners to enhance reputation and maintain access to capital. INTRODUCTION Dividend policy one of the most controversial subjects in finance. Finance scholars have engaged in extensive research to explain why companies should pay or not pay dividends. Many researchers (Baker & Powell, 1999) have developed and empirically tested various models to explain dividend behavior. Some researchers (Baker, Veit & Powell, 2001) have surveyed corporate managers and institutional investors to determine their views about dividends. Despite extensive debate, the actual motivation for paying dividends remains a puzzle (Baker & Powell, 1999). A better understanding of the motivation for the dividend decision could shed significant light on stock valuation, since dividends play a central role in traditional stock valuation models. In such models, stocks have value because they hold the promise of future cash payouts. Dividends constitute the primary cash payment to stockholders or the greater the expected future stream of dividends, the greater the value of the stockholder's share (Carlson, 2001). Some researchers believe that dividends increase shareholder wealth (Gordon, 1959), others believe that dividends are irrelevant (Miller & Scholes, 1978), and still others believe that dividends decrease shareholder wealth (Litzenberger & Ramaswamy, 1979). More recent research (Cornell & Shapiro, 1987; Peterson & Benesh, 1983; Prezas, 1988; Ravid, 1988) suggests that there are interactions between investment and financing decisions. Cornell and Shapiro (1987) suggest that non-investor stakeholders (customers, employees, suppliers, distributors, and other firms providing complementary goods and services) influence this interaction of investment and financing decisions. The purpose of this study to investigate the factors that motivate the dividend decision. Payout ratio the dependent variable in the regression. The independent variables selected from the literature include: price to earnings ratio, profit margin, debt to equity ratio, current ratio, float, insider ownership, institutional ownership, and the estimated five-year growth rates for earnings per share and sales growth. Analysis of these variables should shed some light on how a firm determines the amount of dividends to pay stockholders. LITERATURE REVIEW Lintner (1956) hypothesized that dividends are based primarily on net income levels and are adjusted slowly in response to income changes. Lintner provides evidence that a rise in individual tax rates encourages stockholders to prefer corporate savings over a dividend payment as a tax shelter since retained earnings are not taxed immediately as dividends are. The shareholder only pays capital gains taxes at the time of the sale of the stock. …