Determinant of Corporate Dividend Policy

Introduction

For many years, there has been an ongoing debate about dividend policy about the financial academics. They have argued on whether companies should or should not pay dividends. Miller and Modigliani (1961) have argued that dividends were irrelevant in a perfect and frictionless market. However, many academics have questioned this particular view. Why do companies still pay dividends if they are irrelevant? As a result, many academics carry out empirical investigations to determine the factors of corporate dividend policy. Others have surveyed managers of firms to find out their opinions on dividend policy. If, according to these academics, dividend is indeed relevant, we need to identify the determinants of the corporate dividend policy. The purpose of this study is to examine the factors that motivate the dividend decision in United Kingdom companies.

In this paper, an empirical investigation is carried out to determine those factors. A literature review will be done on the determinants of corporate dividend policy, followed by the methodology and then results and analysis. Six companies listed on the London Stock Exchange have been chosen from two industries; the food and drug retailer and the general retailer. The three companies from the food and drug retailer industry include Sainsbury, Tesco and Morrison and the other three companies from the general retailer industry comprises of French Connection, Marks and Spencer and Ted Baker.

Literature Review

Lintner (1956) concluded that the net present value (NPV) of earnings affected dividend payouts. The higher NPV showed higher dividends. In addition to that, Lintner (1956) discovered the other factor is the sustainability of earnings, where a firm may increase its earnings but keep the dividends constant until they are confident that the high earnings can be maintained in the long run. He also provided evidence that stockholders preferred to forgo dividends when the individual tax rates were increased as dividends were taxed immediately whereas capital gains were not taxed immediately. This makes dividends tax disadvantaged compared to capital gains.

Brav, Graham, Harvey and Michaely (2004) conducted a survey on 384 financial executives and conducted in depth interviews to determine the factors that drive dividend and share repurchase decisions. They concluded that the managers think that the dividend policy affects the firm value and is a signal for future prospects. In line with Lintner's findings where dividend policy is very conservative, they found that from a management's perspective, dividend conservatism emanates primarily from the market's asymmetric reaction to dividend increases and decreases. Therefore, firms are not willing to increase their dividends even when earnings are increased. They also found that many managers would prefer if their dividend level were much lower from the beginning. Many studies have also shown that dividends convey information about the current or future level of earnings (Baker and Powell, 1999). However, there are authors such as Kumar (1988) who showed that changes in dividends signal changes in the firm's perspectives, but that they are weak predictors of earnings.

According to Fama and French (2000), three characteristics that affect the decision to pay dividends are profitability, investment opportunities and size. They found that the dividend payers have higher profits than those who are not. Companies with low profits distribute lower dividends. The second factor mentioned by Fama and French (2000) is the investment opportunities where, firms with higher investment opportunities pay fewer dividends, as a big portion of their profits would go into investments. The third factor, which is the size of the company, also has an impact on the dividend policy. According to Fama and French (2000), the bigger the company, the higher the dividends.

According to DeAngelo, DeAngelo and Stulz (2006), they reported the propensity to pay dividends is most strongly associated with the company's earned or contributed equity mix, that is, the proportion of the firm's equity that is internally generated. The company's earned or contributed equity mix is measured by the book value of equity. As a result, they found that dividend payers tend to have substantially higher book value of total equity than non-payers.

In another study by Mollah et al. (2002), the findings showed there was a direct relationship between financial leverage and debt-burden level that increases transaction costs. As a result, firms with high leverage ratios have high transaction costs, and are in a weak position to pay higher dividends. However, on the other hand, there have been studies that have found that the level of leverage negatively affects dividend policy (Al-Malkawi, 2005).

From the arguments above by other academics on the determinants of corporate dividend policy, it raises the question on the relationship between these particular determinants and the dividend policy in the companies in UK. This paper's objective is to test profitability, size, investment opportunities, debt ratio and proportion of equity and observe the relationship between these determinants and the dividend payout in the selected industries.

Data and Methodology

Data was exported from the FAME database onto Excel, where the calculations for the determinants were done. There are a total of 54 observations for this study. 10 years of data was extracted from each company. The determinants chosen to be tested are those that are most analyzed in the literature in the past years and also those thought suitable for UK companies. The data of the companies that were taken from the FAME Database are assessed using linear regression, which is run on Stata.

All the determinants were calculated based on the respective formulas. The dependent variable is the dividend payout ratio, which is calculated as dividend over earnings. There are five independent variables in this study. The first three determinants, which are profitability, size and investment opportunities, are according to Fama and French (2000) as they have proved in their study that they are really significant. The fourth determinant is debt ratio and the fifth is proportion of equity.

The first determinant will be the profitability of the company. It is calculated as the ratio of earnings before interest and