Determinants of dividend policy
The effect of the global financial crisis on Swedish firms
by
Henrik Svensson & Victor Thorén
May 2015
Master’s Programme in Corporate and Financial Management
Abstract
Dividend is a much-debated subject and has been compared to a puzzle with no sole solution to explain why firms pay dividend. Many academics have tried to determine what company variables determines a firm’s dividend policy. These studies have provided different explanatory variables to explain why firms pay dividends. Therefore, the main purpose of this study was to fill in a piece of the dividend puzzle by investigating the determinants of dividend policy for Swedish firms.
The global financial crisis in 2008 caused the Swedish economy experienced the fastest deceleration in demand and production since World War II. This challenging event forced many firms to take considerable action to avoid the negative effect that followed. The lack of studies regarding the impact of the financial crisis made us want to test whether Swedish firms experienced any significant changes in the determinants of dividend policy.
Using a quantitative and deductive approach, this study used the Irrelevance, Bird-in-hand, Signalling, Agency, Catering, Life Cycle andPecking Order theory to examine the determinants. The sample was drawn from the NASDAQ OMX Stockholm Large cap list. There were three time periods employed, pre & post the financial crisis as well as one whole period. By using a random effects model we tested the relationship between the selected company determinants and the dividend payout ratio for the three time periods.
The study found that profitability, size, risk, retained earnings, and firm value can be seen as determinants of dividend policy for Swedish firms since they are significant. This implies that Life cycle, Agency, Bird-in-hand, Catering and Pecking order theory is applicable to the Swedish firms. The study does not find any supporting evidence for Signallingor the Irrelevance theory. The results showed that there were no statistically significant changes in the determinants between the pre & post period, except for a minimal difference in firm value. This implies that the financial crisis didnot affect Swedish firms dividend policy.
Acknowledgements
We would like to thank out supervisor Naciye Seckerci for her support throughout the research process and Lund School of Economics and Management for providing the necessary means for conducting the research.
Table of content
1.0 Introduction
1.1 Purpose and research question
1.1.1 Hypothesis
1.2 Research limitations
1.3 Thesis outline
2.0 Literature review
2.1 Dividends
2.2 Irrelevance theory
2.3 Bird-in-hand theory
2.4 Signalling theory
2.5 Agency theory
2.6 Catering theory
2.7 Life cycle theory
2.8 Measures of dividend
2.9 Previous studies of determinants
2.10 Selected dividend policy determinants
2.10.1 Growth opportunities
2.10.2 Profitability
2.10.3 Cash flow
2.10.4 Size
2.10.5 Risk
2.10.6 Retained earnings
2.10.7 Firm value
3.0 Methodology
3.1 Research method choices
3.2 The data
3.2.1 Sample and sample size
3.2.2 Data collection & time period
3.2.3 Variables definition
3.3 Regression model
3.3.1 Average values of the errors is zero
3.3.2 Variance of the errors is constant
3.3.3 Covariance between the error terms is zero
3.3.4 Independent variables are non-stochastic
3.3.5 Disturbances are normally distributed
3.3.6 No multicollinearity
3.3.7 Fixed & Random effects
3.3.8 T-test
3.3.9 Z-score
3.3.10 R-squared
3.4 Validity & Reliability
3.4.1 Validity of the independent variables
3.4.2 Reliability
4.0 Empirical findings
4.1 Regressions
4.1.1 Whole period regression (2003-2013)
4.1.2 Pre-crisis period regression (2003-2007)
4.1.3 Post-crisis period regression (2009-2013)
4.1.4 Z-score
5.0 Analysis and discussion
5.1 Determinants of the dividend policy
5.1.1 Growth
5.1.2 Profitability
5.1.3 Cash flow
5.1.4 Size
5.1.5 Risk
5.1.6 Retained earnings
5.1.7 Firm value
5.1.8 What are the determinants of the dividend policy in Swedish firms?
5.2 Were the determinants of dividend policy amongst Swedish firms affected by the financial crises?
6.0 Conclusion
6.1 Summary
6.2 Contribution
6.3 Further research
7.0 References
List of tables
Table 2.1 List of previous studies
Table 3.1 Sample selection
Table 4.1 Regression results for whole period (2003-2013)
Table 4.2 Regression results for pre-crisis period (2003-2007)
Table 4.3 Regression results for post-crisis period (2009-2013)
Table 4.4 Z-scores for the independent variables
Table 5.1 Determinants of dividend policy
Table 5.2 Difference in coefficients (pre and post crisis period)
1.0 Introduction
“The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don't fit together.”
- Fischer Black, 1976
Dividend is and has been a debated subject among academics for many years. Does it create value or is it totally irrelevant? And why do firms pay dividend? The Irrelevance theory, a groundbreaking theory first introduced in 1961 by Miller & Modigliani (M&M) states that dividend has no affect on the value of shares. This has since then been much debated. Opposing M&M, Lintner in 1956 mentions the Bird-in-hand theory, which is contradictive to the Irrelevance theory and indicates that investors are inclined to pay a premium on dividend paying shares. It states that investors would rather have one bird in the hand, than two in the bush (Lintner, 1956).
Jensen (1986) joined the debate by introducing theAgency theory, which tries to explain why firms pay dividend. Jensen looked at dividend from the agency cost perspective and examined the possibility of using dividend payments as a means of decreasing agency costs (Jensen, 1986). Dividend also has the benefit of conveying information of future earnings and financial stability, which brings us to Signalling theory. In 1956 Lintner first introduced this theory, connecting managers dividend payout ratio to the share price. It was further mentioned by M&M (1961). The theory was then discussed by Akerlof (1970) where he stated that information asymmetry (lemons problem) makes the firm want to signal they are not a lemon. Fischer Black (1976) further argued that dividend policy says something the managers don’t say explicitly. It signals that a raise in dividend is only feasible if the firm can continue paying dividend in the future and managers will only lower the dividend if the outlooks for a quick recovery seem dismal.
A contemporary contribution to the dividend discussion is the Life cycle theory presented by DeAngelo & DeAngelo (2006), which states that the need to distribute free cash flow is the driver for the optimal dividend policy. The theory states that firms pay out different amounts depending on if they are a young firm with the need for internal financing or a more mature one where they can shift out a larger portion of retained earnings. This associates to the financial crisis, were firms were put under a lot of stress, mainly from the difficulty of financing themselves during the crisis. Therefore,the need for internal financing increased andin turnaffected dividend.
The global financial crisis has had a significant impact on the global business environment in recent years. The event is of high relevance as it impacted many firms financially and as a result firms had to take action in order to limit the negative effects. Few attempts have been made to investigate the impact that this significant event has had on the determinants of the firm’s dividend policy. The origins of the global financial crisis can be traced back to the US housing and mortgage market. The fall in prices combined with highly leveraged consumers, thanks to subprime loans, resulted in a dramatic increase in credit losses. This together with the difficulty in assessing the risk due to securitization of these loans lead to an interbank lending failure. When Lehman Brothers filed for bankruptcy, it showed clear evidence of the severity of the impact that these subprime loans and structure credit products had on banks. The financial unease therefore turned into an acute global financial crisis (Riksbanken, 2009, translated).
The rapid spread of the financial crisis as a result, lead to sharp declines in the global economy, which resulted in many countries having to revise their GDP forecasts by 4 to 5 percentage points (Braunerhjelm, Djerf, Frisén, Ohlsson, 2009, translated). Sweden, which is a small open economy country with extensive foreign trade and a financial market that is well integrated with the rest of the world, was directly impacted by the global economic downturn (Riksbank, 2009, translated). The global economic downturn caused a large decline in the demand for Swedish exports goods, causing significant effects on employment and production in the country, as the portion of exports accounted for 40 percent of GDP in 2007 (Riksbank, 2009, translated). This caused Sweden to experience the fastest deceleration in demand and production since World War II (Braunerhjelm, Djerf, Frisén, Ohlsson, 2009, translated). In addition to the sharp drop in demand for Swedish exports, many firms had to reassess their investment policies as they found it increasingly difficult to finance these investments from banks. Since this had such a large effect, we feel it is relevant to investigate how an event of this magnitude can affect firm’s dividend policy. Furthermore, we can clearly state that despite all of the theories mentioned there is no sole solution to the dividend puzzle that was first discussed by Fisher Black (1976). The questions he asked; “why do firms pay dividends” and “why do investors pay attention to dividends” are still relevant today.
1.1 Purpose and research question
The aim of our empirical research is to investigate the determinants of dividend payout policy and contribute to the on going debate why firms pay dividend. This will be accomplished by looking at a 11 year period, 2003-2013. In addition to this, we will try to clarify the effects made by the financial crisis on the determinants of dividend, which is an event that has received little attention. We contribute to the research surrounding the financial crisis by measuring the dividend policy determinants pre & post the global financial crisis of 2008. These years will be split in two 2 separate five year periods between 2003-2007 and 2009-2013.
Our research contributes to the dividend policy research in three distinct ways. Firstly,we will seek to address the reasons why Swedish firms pay dividends, which to our understanding hasn’t been extensively researched. Furthermore, we will try to determine whether previous studies on dividend determinates can be applicable to the Swedish market.
RQ1: What are the determinants of the dividend policy in Swedish firms?
Secondly, we will try to answer whether these companies’ dividend policy was or wasn’t affected by the macroeconomic environment. This is achieved by examining how one of the most challenging crises in recent years affected the determinants of dividend policy.
RQ2: Were the determinants of dividend policy amongst Swedish firms affected by the financial crises?
Thirdly, we will introduce a new variable in the form of price to earnings to the regression and test it’s affect on dividend policy.
1.1.1 Hypothesis
Based on our research questions and theoretical framework, we have composed the following hypotheses and sub-hypotheses against the outcome of the data analysis.
H1: The determinants of dividend policy
H1a: Growth will have a positive effect on dividend policy
We believe that growth will have a positive affect on dividend policy following the Signalling theory were firms use dividend to signal growth opportunities to investors. This would imply that a firm with high growth opportunities would increase their dividend payout ratio.
H1b: Profitability will have a negative effect on dividend policy
This hypothesis is based on the assumption that firms with low profitability are in most need of signalling to the markets that future profits lie ahead.
H1c: Cash flow will have a positive effect on dividend policy
We assume that higher cash flows lead to an increase in dividend payout ratio as a tool to prevent agency conflicts.
H1d: Size will have a positive effect on dividend policy
The Life cycle theory suggests that mature firms are more likely to pay dividend due to their access to external financing.
H1e: Risk will have a negative effect on dividend policy
Based on the Pecking order theory, firms with higher risk will chose internal financing before external financing. This will lead to firms reducing the amount of dividend paid to investors.
H1f: Retained Earnings will have a positive effect on dividend policy
A mature firm that has been historically profitable should be able to distribute larger proportions of retained earnings.
H1g: Firm value will have a positive effect on dividend policy
According to Catering theory and Bird-in-hand theory investors are willing to pay a premium on shares that pay dividend.
H2: There will be a change in determinants between the two periods
Based on the significant impact that the financial crisis had on the Swedish economy we assume that firms will take action that will affect the dividend policy, due to the considerable macroeconomic effects experienced.
1.2 Research limitations
A closer look at the dependent variable shows that there are two ways of measuring dividend and thus the results may differ between the different measurements. This is something we are aware of and have therefore chosen the most appropriate formula based on previous research. Furthermore,investor preference is an aspect that this research cannot account for and will always be a factor that could contradict all relevant theory. Looking at the Swedish NASDAQ OMX Stockholm Large Cap list, there are a lot of financial firms, which we have chosen to remove from the sample. Thus, removing financial firms excludes an important industry for the Swedish market.The reasons for removing them isthat the nature of the firms aren’t comparable to the same extent, however we are aware that the number of observations was affected negatively. Stock repurchase is a aspect that could have a explanatory factor, however in this study we have chosen to discard it as we focus on dividends as a means of distributing wealth.Furthermore we have excluded taxes both on a corporate and personal level, due to its complex nature. Thesecould be seen as explanatory factors of a firm’s dividend policy.
1.3 Thesis outline
The first chapter introduces the reader to the subject and relevant background setting, as well as stating the purpose and research questions. In chapter 2 the relevant theories and previous empirical findings are presented, finishing off with the definition and description of our selected determinants of dividend payout ratio. Chapter 3 presents the data and methodology as well as the regression model used. In chapter 4 the empirical findings are presented and in chapter 5 the analysis and discussion connects the empirical findings back to the theoretical framework. Lastly, chapter 6 summarizes and concludes our research.
2.0 Literature review
2.1 Dividends
Dividends can be defined as payments made to a firm’s shareholders out of past and current earnings (Pyles, 2014). The amount of earnings that a firm decides to distribute to its shareholders is set at a specific date by the board of directors, known as the dividend declaration date (Damodaran, 2010). The declaration date is important in the sense that the announcement to increase, decrease, or to maintain dividend puts across information upon which the market reacts to the changes that is most likely to occur (Damodaran, 2010).
From the perspective of an investor the degree of reward they receive for investing in a firms shares is of high importance. Dividend can be categorized as the source of secured return that an investor receives (Pyles, 2014). Consequently, this leads to investors paying considerable attention whether a stock is purchased with or without dividends. For an investor to have the right to receive dividends, from the invested firm, there is a need to own the stock before the ex-dividend date. Purchase of shares post the ex-dividend date will result in forgoing the dividend received for the period, and as a result the market will reflect this loss with a fall in the stock price (Pyles, 2014).
2.2 Irrelevance theory
Miller Modigliani’s theory on dividend uses the perfect market assumption as a starting point under which the Irrelevance theory is developed. The Irrelevance theory states that a firm’s dividend policy is irrelevant since it doesn’t affect the value of the company under perfect market conditions (Miller & Modigliani, 1961). Thereby stating that whether the firm pays dividend or how much doesn’t have an effect on the value of the firm. M&M further states that investors can construct their own dividend by simply selling stocks to receive the preferred amount. If the firm pays to much dividend the investor just buys back shares and should therefore be indifferent between dividend and capital gains. As a result, shareholders are then unwilling to pay a premium for dividend paying firms hence the Irrelevance theory (M&M). However, DeAngelo, DeAngelo & Skinner(2009)argue that in a rational market the current market value equals the discounted future expected dividend. Thus the only way for an investor to get full value today is if the market expects the firm to fully distribute the value generated by the investment policy (DeAngelo et al, 2009).
One might now consider the issue with the different taxation on capital gains but Black & Scholes (1974) and Miller & Scholes (1978) found that even this doesn’t affect the results. As well as developing the irrelevance theory in the groundbreaking article,M&M also acknowledge the information content of dividend, contributingfurther to Signalling theory first mentioned by Lintner (1956).
2.3 Bird-in-hand theory
“Better a bird in the hand than two in the bush”
– John Lintner, 1956
The Bird-in-hand theory first mentioned by Lintner (1956) states why a firm should pay dividend. It contradicts Miller & Modigliani’s Irrelevance theory since it states that investors are inclined to pay a premium for dividend stocks. Gordon in 1959 & 1962 elaborated on this theory by stating that investors have a likeness to shares that pay dividend today since there is higher uncertainty to future dividends and investors therefore use a higher discount rate for companies who don’t pay dividend. Paying dividend has other benefits such as a higher credit rating and this is useful since the firm will improve their ability to raise capital(Purmessur & Boodhoo, 2009). The theory is an equally controversial as M&M and has many opposes.