Nottingham University Business School

MSc Finance and Investment

CORPORATE FINANCE N14129

Determinants of dividend policy -Empirical investigation of the Media and Personal goods industries in the UK

Roua Ioana DOBRE

Student ID: 4171076

Word count: 2180

COPY 11. Introduction

Dividend policy has been talked about for many years in financial literature. Views have

been changed very often, starting with Miller and Modigliani’s (M&M, 1961) model, in which

firm’s dividend policy is deemed irrelevant given the assumption of perfect capital markets.

However, many have proved this model is flawed as this assumption is relaxed, and as we move

through time, the factors considered important when making dividend decisions increase

dramatically. Ang (in Baker, Powell and Veit, 2002, pp. 267) highlighted that “… we have moved

from a position of not enough good reasons to explain why dividends are paid to one of too

many”.

This study focuses on several factors that influence the dividend policy of 3 firms from the

Media industry and 3 firms from the Personal goods industry in the UK. It is structured as

follows: in section 2 I illustrate the theoretical background of the determinants of dividend

policy; Section 3 presents the data collected and the methodology followed in performing the

analysis; Section 4 explores the results reached by the study and explains their meaning, to

draw a conclusion in Section 5.

2. Literature Review

There are five major theories that have been developed to convey the determinants of

dividend setting. They have been discussed by Baker and Powell (1999), Frankfurter et al.

(2002) and Brav et al. (2004) among others.

Tax effect

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As Baker, Powell and Veit (2002) explain, stocks that pay dividends must offer higher pre-

tax returns than stocks not paying dividends, and the favourable tax treatment on capital gains

could cause the share price to drop less than the dividend payout, thus motivating investors’

preference for non-dividend paying stocks. Studies have proved that some, but not all

investors, like dividends.

Clientele effect

This effect implies that investors choose firms that suit their investment preferences over

time, influenced by the tax differentials among them. The implication of this effect is that

dividend policy attracts to the company only those investors who like it. Secondly, difficulties

arise when dividend policies are changed, because shareholders become used to their payout

patterns (Stern, 2005). Pettit (1977) reveales that the safest companies, with older and poorer

investors tended to pay higher dividends than companies with younger and richer investors.

Agency theory

Jensen and Meckling (1976) introduce the Agency Theory, which comes from the conflict

of interests that arises between managers and shareholders, and Rozeff (1982) and Crutchley

and Hansen (1989) expand it. This theory states that the payment of dividends reduces the cash

flow remaining to the management and forces those who control the firm to seek finance

externally. This is costly and exposes the firm to market’s inspection for the new funds, hence

ensuring that management acts in the best interest of shareholders.

Signalling model

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When the markets are less than efficient, information asymmetry between managers and

shareholders arises, at which point dividend payments can communicate information about the

company’s future. This behaviour would result in positive stock price changes (Baker and

Powell, 1999). Woolridge and Chinmoy (in Stern and Chow, 1992) explore the implications of

dividend cuts from this perspective and conclude that it can be both a positive and a negative

signal.

Bird-In-The-Hand

This theory states that investors prefer cash dividends to capital gains due to the

uncertainty of the price appreciation. Hence, managers should pay a high percentage of

earnings out to increase the share price. However, Brealey (in Stern and Chew, 1992) claims

that dividend policy has no effect on the total cash flows of the firm if it has no influence on the

investment and capital structure decisions. MM (1961) and Battacharya (1979) agree that this

theory was flawed.

Other factors

Among other factors affecting payout decisions Nickell and Nicolitas (1999, in Benito,

2003) and Benito (2003) add the company’s financial pressure, this argument being supported

by the empirical findings of Benito and Young (2003). They further highlight that investment

decisions and dividend omissions are positively correlated. However, given investment

opportunities, “high actual levels of investments are inversely related to the propensity to omit

a dividend” (p. 545). Finally, McCabe (1979) argues that there is a negative relationship

between long-term debt and dividend payout of the firm.

3. Data and Methodology

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I chose the following companies to perform the analysis on: British Sky Broadcasting

Group, WPP and Aegis Media from the Media industry and Burberry, Abbeycrest and C.A.

Sperati from the Personal goods industry. These companies are listed on the London Stock

Exchange. I collected data for 10 years (2001-2010) from Datastream and performed an OLS

regression focusing on the effect of size of the firm, slack, risk and cash flow per share on

dividend payout. Variables are defined by the following formulae:

Dividend Payout Ratioi=DividendsiNet Income i

¿¿ i=logTotal Assetsi ¿;

Slacki=Retained EarningsiTotal Assetsi

;

Riski=Total assetsiNet Income i

;

Cash Flow per Sh arei=OperatingCash Flowi−Preferred Dividendsi

CommonSharesOutstanding i

Pruitt and Gitman (1991) refer to risk as year to year variability and include it among the

factors that affect the firm’s dividend policy. They argue that a firm that knows what its future

earnings will be is more likely to pay a higher percentage of its earnings than a firm with

fluctuating earnings. Jensen et al. (1992) also portrays the fact that as the uncertainty of

earnings increases, firms avoid committing to paying high dividends.

As shown by Alli et al. (1993), a poor liquidity of cash flows position traduces into

shortage of cash, which leads to less generous dividends. They argue that dividend payments

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actually depend more on cash flows than on current earnings, as the former reflect the

company’s ability to pay dividends.

Lloyd et al. (1985) were among the first to modify Rozeff's model by adding “firm size” as

an additional variable. Eddy and Seifert (1988), Jensen et al. (1992), Redding (1997), and Fama

and French (2001) showed that there is a positive relationship between the size of the firm and

the amount of their net profits that paid as cash dividends. Furthermore, size is often

associated with agency costs, as shown by Jensen and Meckling’s (1976) and Sawicki (2005).

Another explanation for this positive relationship is large firms’ easier access to capital markets

and their increased ease in raising funds for external financing (Holder et al, 1998). Thus,

instead of reducing dividends to finance future profitable projects, they use this ability. In

contrast, small firms have limited access to external market, which means they increase their

retention ratio, using internal funds for financing future projects, which is detrimental to

dividend payout.

Slack is referred to as investment opportunities available to the firm and it reduces the

external financing requirements, becoming an important factor in solving the problem of under

investment. According to Myers & Majluf (1984) and John & Williams (1985), slack reduces the

signalling need of the firms and incentives to smooth the dividend behaviour.

Table 3.1 Study hypotheses

Factor RelationshipSlack Negative

Company-specific risk NegativeCash flow per share Positive

Firm size (proxied by log of assets) Positive

These hypotheses will be illustrated in the next section, as the factors are put into context

and dealt with from a realistic point of view, based on previous findings and theories.

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4. Results and AnalysisTo analyse the impact of the named factors upon dividend policy, I have used the

following model:

Dividend Payouti=β0+ β1 ¿¿ i+β2Slack i+β3Cash Flow per Sharei+β4 Riski ¿

This model was applied to the two sectors separately and then to the combination of the

two.

Table 4.1 Regression results

SIZE: The results of Table 4.1 reveal that the size of the company is significantly and

positively related to dividend payout in all 3 models, making it the most important determinant

of dividend policy on the sample. This is in line with Eddy and Seifert (1988), Jensen et al.

(1992), Redding (1997), and Fama and French (2001), whom pointed out larger firms pay higher

cash dividends. This is partly explained by the fact that large firms face higher agency cost due

to ownership dispersion, increased complexity and shareholder’s lack of monitoring (Jensen

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and Meckling, 1976; Lloyd et al, 1985). The size of the firms I chose, proxied by log of total

assets, vary across sectors. The media sector has larger firms, with assets generally following an

ascending trend over the period analysed and correlated with the growth of dividends per

share experienced by both BSkyB and WPP Group. Aegis Group had a slight drop in total asset

value in 2009, but has quickly recovered. In the personal goods sector, there are massive

differences both in size and in dividend policy. Burberry was the only company, out of the three

I chose, displaying a steady growth of total assets. Jewellery manufacturer and distributor

Abbeycrest faced a real crisis in 2005, its full-year losses widened sharply after being hit by the

costs of restructuring, a soaring gold price, and a sharp downturn in the UK fine jewellery

market. As a result, the firm has been implementing a recovery program called the Disposal,

which involves assets sale and leaseback, making 2005 the last year its shareholders received

dividends. Sperati has maintained its dividend level constant from 2007, while experiencing a

slow decline in total assets over the years. This firm is relatively small compared to the others,

having a total assets value of only £750,000 (2010), as opposed to Burberry’s £1,39 billion.

These facts reiterate the strong positive relationship between the size of the firm proxied by log

of total assets and its dividend payout.

SLACK: According to Alli et al (1993), financial slack and dividend payout are negatively

correlated. The results I have obtained illustrate the point that in order for firms to retain their

ability to undertake profitable projects that involve investments, they may prefer to increase

their financial slack rather than resorting to external financing, thus diminishing the funds

available for dividends. This is proven by the negative relationship between slack and dividend

payout present across the sample. This variable is strongly correlated with the size of the

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company, as according to the theory, larger companies have easier access to external financing

than do smaller companies, which is why a strong variation across industries is observed. In the

media sector, represented by larger firms, slack is not so important, whereas in the personal

goods industry, its impact on dividend payout is greater.

RISK: It has been argued that the higher the risk of the firms, the higher will be their cash

flows volatility. Thus, such increase will bring forward an increased need for external financing,

driving these firms to the reduction of dividend payout (Higgins, 1972; McCabe, 1979; Rozeff,

1982; Chang and Rhee, 1990; Chen and Steiner, 1999). My findings are mostly in line with these

arguments, with the exception of the personal goods sector, represented by the clothing and

accessories sub-sector, which displays a significant positive relationship between risk and

dividend payout. This can be explained by the uncommon pattern of companies I have chosen

to represent the industry, each from different sub-sectors. Furthermore, the nature of the

products sold, with Burberry and Abbeycrest having luxury goods, affects the results because of

the special consuming patterns displayed.

CASH FLOW PER SHARE: High profitable firms with more stable earnings can manage the

larger cash flows, leading to their payment of larger dividends. This has been illustrated by

Naceur et al. (2006) and Baker et al (2007). Afza & Mirza (2010) portray the point of view of the

companies, portraying the importance of the amount of payout cash generated from

operations. As such, companies with positive operating cash flows are expected to pay higher

dividends than those with the opposite sign. These arguments are supported by my findings, as

the three models reveal positive but insignificant relationships between cash flows per share

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and dividend payout. In the media industry, fluctuations in this indicator are observed to occur

in the same periods, namely drops in 2004, 2006 and 2008, the latter of which was the only

year with negative cash flows for BSkyB. This situation is explained by the massive acquisitions

this industry has undertaken, referring to both the purchasing of companies and developing

technology, especially in the case of BSkyB, a true pioneer in the telecommunications

subsector. Again, in the personal goods industry, there is great variation across companies, but

the relationship still holds.

5. Conclusion

Generally, my findings coincide with the theory, namely the hypotheses set were mostly

respected, with the exception of risk in the personal goods industry. As such, the size of the

company and its cash flow per share are positively related to dividend payout, while risk and

slack show the opposite relationship. No model will ever explain 100% the reality, as they are

simplifications of it. The variables I have used explain a part of the dividend policy, but this

depends on the industry to which the companies belong too, as specificities appear across

industries. In such a small sample, the companies chosen could be outliers of the population,

defying the normal statistical pattern. In conclusion, for a result to be statistically significant,

the analysis should be done on hundreds of companies, so that the bigger picture is fully drawn.

The STATA results for the 3 regressions as following:1- Personal Goods2- Media3- Total

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