Incomes Can Invested Operating Assets Retire Debt Shareholders Finance Essay - Free Essay Example

Sample details Pages: 8 Words: 2343 Downloads: 3 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? INTRODUCTION Incomes are earned by successful companies. These incomes can be invested in operating assets, used to retire debt or repurchase shares, or distributed to shareholders in the form of dividends. When investors buy an ordinary share in a company, they become a shareholder of the business and to that extent they will have certain entitlements, including the right to receive dividend payments. Don’t waste time! Our writers will create an original "Incomes Can Invested Operating Assets Retire Debt Shareholders Finance Essay" essay for you Create order Dividends are defined as a form of rational income distribution offering to shareholders (Baker et al, 2007). Dividends are a way for companies to reward shareholders for their investment and risk-bearing. Besides, dividends also give shareholders additional returns in addition to capital gains. Normally, dividends will be distributed in the form of cash, though it can also come in the form of stock dividends. Dividends are decided upon and declared by the board of directors. Nevertheless, this pay-out is not guaranteed and the amount that shareholders will receive varies from company to company and year to year. Generally, there are two types of cash dividends, which are interim dividends and final dividends. Interim dividends are declared and distributed before the companys annual earnings are known. These interim dividends are paid out of undistributed profits brought from previous periods. A company may choose to pay interim dividends quarterly or half yearly as long as it has adequate undistributed profits brought forward from previous periods. These dividends usually accompany the companys interim financial statements. On the other hand, final dividends are declared at the end of the financial period at the time when the directors are aware of the companys profitability and financial health. Normally, final dividends are declared before the books are closed and will be paid the following year. Thus final dividends will appear as dividends payable or proposed dividends under current liabilities in the balance sheet of that period. In Malaysia, companies are free to decide when and how much to pay out in dividends for a specific financial business year as long as they comply with the Companies Act, 1965. According to Section 365 of the Act, No dividend shall be payable to the shareholders of any company except out of profits or pursuant to Section 60. In other words, the Act requires that dividends of a company can only be distributed from the profits of the company except pursuant to Section 60 of the Act. Besides, the unique characteristic of dividends in Malaysia is the tax exemption feature. With effect from the year of assessment 2008, a single-tier income tax system will replace the imputation system. Under the imputation system, a Malaysian resident company is required to deduct taxes at the prevailing corporate tax rate on taxable dividends paid to its shareholders. This tax is already accounted for through the tax paid by the company on its taxable profits, which is accumulated as dividend franking credits (Section 108 credits). When shareholders receive taxable dividends, they are entitled to a tax credit for the tax already paid by the company in respect of the income. Those credits are then used to offset the shareholders tax liability. However, under the single-tier system, profits are only taxed at the company level; thus, dividends paid under this system will be tax-exempt in the hands of shareholders. Since Modigliani and Millers seminal studies (1958, 1961), dividend policy has been an issue of great interest in the finance literature. Following their irrelevance dividend policy hypothesis many explanations have been provided in order to solve the so-called dividend puzzle. Despite a large body of literature on dividends and payout policy, researchers have yet to reach a consensus on why firms pay dividends and what determines the payout ratio. Some of the theoretical principles underlying the dividend policy of firms can be described either in terms of information asymmetries, the tax-adjusted theory, or behavioral factors. The information asymmetries encompass several aspects, including the signaling models, agency costs and the free cash flow hypothesis. 1.2 PROBLEM STATEMENT Dividends are payments made by a company to its shareholders, usually after a company earns a profit. Thus, dividends are not considered as a business expense but are a sharing of recognized assets among shareholders. Dividends are either paid regularly or can be called out anytime. Consequently, a dividend policy is a set of company rules and guidelines used to decide how much the company will pay out to its shareholders. Dividend policy is an essential financial decision made by the board of directors and the management and this decision is one of the fundamental components of corporate policy. Dividend policy has been viewed as an issue of interest in the financial literature and one of the most controversial topics in finance. Despite a large body of literature on dividends and payout policy, researchers have yet to reach a consensus on why firms pay dividends and what determines the payout ratio. The extent literature on dividend payout ratios provides firms with no generally accepted prescription for the level of dividend payment that will maximize share value. Some researchers believe that dividends increase shareholder wealth (Gordon, 1959) while many others believe otherwise. Miller and Modigliani (1961) in their irrelevant dividend hypothesis, asserts that under perfect market conditions, characterized among others by the non-existence of taxes, transaction costs and asymmetric information, dividends are irrelevant since shareholders can create homemade dividends by selling a portion of their portfolio of equitiesÂÂ  if they want cash and that there is a tradeo ff between current dividends and future capital gain. Taking into consideration various capital market imperfections, a considerable amount of theory and model are suggested to explain the dividend policy of companies. Signaling models are based on the assumption that managers have more information about the companys future cash flow than do individuals outside the company, and they have incentives to signal that information to investors (Gugler, 2003). Unexpected changes in dividend policy are used to mitigate information asymmetries between managers and owners (Frankfurter and Wood Jr., 2002). On the other hand, agency theory posits that by distributing resources in the form of cash dividends, internally generated cash flows are no longer sufficient to satisfy the needs of the companies. As a result, companies will visit the capital market more frequently for financing needs, thereby bring them under the greater scrutiny of the capital market (Easterbrook, 1984). Therefore, the payment of dividends provides the incentive for managers to reduce the costs associated with the principal/agent relationship. Agency theory seeks to explain corporate capital structure as a result of attempts to maximize shareholder wealth since dividends can act as a bonding mechanism to reduce the agency costs arising from the conflict between managers and shareholders. Starting with Jensen and Meckling (1976), researchers have been addressing the agency problem in finance from many angles. Nowadays, extensive research has been carried out regarding the issue of agency costs of dividends and the standard findings shows that dividends mitigate the free cash flow and therefore limit the managers ability to enlarge his or her own perks. However, this finding is still inconclusive since other studies have questioned the validity of this finding. For example, Noronha et al. (1996) had regressed five factors as a proxy for agency costs on the dividend payout ratio, but they found that the dividend policy is not the product of an attempt to mitigate the free cash flow problem. Agency costs happen because of conflicts of interest between agents and shareholders. Therefore, agency costs are zero in a 100% owner-managed firm. As a companys ownership structure changes and ownership is separated from control, incentive alignment problems become more important. It is assumed that if managers and shareholders are left alone, they will attempt to act in his or her own self-interest. Self-motivated management behavior includes direct expropriation of funds by the manager, consumption of excessive perquisites, shirking and suboptimal investment. The nature of monitoring and bonding contracts, the managers taste for no pecuniary benefits and the cost of replacing the manager make the actual magnitude and impact of this self-seeking behavior vary across company and country (Jensen and Meckling, 1976). Agency theory has also brought various external and internal monitoring and bonding mechanisms to the forefront of theoretical discussion and empirical research. Recent studies emphasize the potential conflicts of interest between controlling shareholders and other shareholders. For example, Shleifer and Vishny (1997), Faccio et al. (2001) and Holderness (2003) argued that when large owners gain nearly full control of the corporation, they prefer to generate private benefits of control that are not shared by minority shareholders. Hence, firms with large controlling shareholders may exhibit a different type of agency conflict, namely the expropriation of minority shareholders by majority shareholders. On the other hand, in the presence of large shareholders, managerial discretion can be restrained to some extent and agency costs between managers and shareholders are reduced because large shareholders have the ability and the incentives to monitor and discipline management (Shleifer a nd Vishny, 1986). However, this would imply a lesser role for corporate payout policy to address agency problems between corporate insiders and outside shareholders. Despite a great deal of prior research on the subject, few studies investigated the agency and ownership-based explanations of dividend policy. It is also important to note that the extent to which the companys dividend payout policy is effective in reducing the expected agency costs may also depend on its ownership and control structure. Nevertheless, one study by Mat Nor and Sulong (2007) had examined the relationship between ownership structure and dividends in Malaysia. They had used four types of ownership, namely ownership concentration, government ownership, foreign ownership and managerial ownership. However, their findings show a low explanatory power (between 0.118 and 0.124). On the other hand, a study in UK by Short, Zhang and Keasey (2002) that examined the link between corporate dividend policy and the ownership of shares by institutional investors and managers, using four models of dividend policy, the full adjustment model, the partial adjustment model, the Waud model and the earnings trend model found a very high explanatory power (between 0.843 and 0.993). Their study is the first example of using well-established dividend payout models to examine the potential association between ownership structures and dividend policy. These four models, which describe the adjustment of dividends to changes in several measures of corporate earnings, have been modified by the addition of dummy variables representing institutional and managerial ownership, in order to determine whether the presence of the specific classes of investors in the ownership structure affect the process of determination of the level of the earnings that are being distributed. Thus, this situation brings up a question whether it is true that ownership structure has a low impact on corporate dividend policy in Malaysia. Therefore, this study attempts to examine the hypothesized relationship between corporate dividend policy and the various types of ownership structure by using dividen d payout models. 1.3 OBJECTIVE OF THE STUDY Main Objective: To investigate the adoption of agency costs theory in explaining dividend policy in Malaysian listed companies. Specific Objective: To examine the relationship between various ownership structures based agency cost proxies on dividend policy. To identify which agency cost proxy is dominant in influencing dividend policy over the company. To identify which dividend model is superior in explaining the corporate dividend policy with variables associated with ownership structures. 1.4 SIGNIFICANCE OF THE STUDY This study contributes to the growing body of survey research on dividend policy. For example, the current study not only updates previous research by Mat Nor and Sulong (2007) but is also applied in a different model, namely, the Full Adjustment Model, the Partial Adjustment Model and the Waud Model. These three types of dividend models had been modified to account for the possible effect of ownership structure and dividend policy. This study utilizes these three types of dividend models since it was found from previous research that dividend models can have the significant effect on ownership structure. In addition, this study is expected to support the agency theory, especially in explaining the ownership structure policy to reduce agency conflict. Consequently, this study would assist each ownership class to understand the explanation of the agency relationship. Shareholders with respect to stock investment in companies should be concerned with the agency conflict between ownership classes. Therefore, shareholders should justify that dividend policies are better control mechanisms for the agency conflict. Lastly, this study is also important in helping policy makers and companies to appropriately address the issues of agency costs. 1.5 LIMITATIONS OF THE STUDY The main limitation of this study is that the data period covers only on the year 2007. The shorter period of study may not be representative of the way companies operate their business cycle. Thus, a longer period of study might be good to provide better results for this research. The data for ownership structure was gathered from the list of the thirty largest shareholders disclosed in the company annual report. Consequently, the data may not be representative of the entire company. The study only covers 150 public-listed companies in the selected sectors. Hence, the results cannot be treated as conclusive for all sectors. Besides that, since the study was limited to publicly-held companies, the results may not necessarily be applicable to privately-held companies. 1.6 CONCLUSION Dividends distribution is one of the simplest ways for companies to communicate their financial well-being and shareholder value. Dividends send a clear, powerful message about future prospects and performance. Dividends are important for more than income generation since it also provides a way for investors to assess a company as an investment prospect. This study tests the relationship of ownership structure and corporate dividend policy via three types of dividend models, namely, the Full Adjustment Model, the Partial Adjustment Model (Litner, 1956) and the Waud Model (1966). It examined the adoption of agency costs theory through ownership structure and dividend policy. Significant results could act as guidance for companies and policy makers to appropriately address the issues of agency costs. The next section of the study briefly reviews the theoretical and empirical literature. Then, the third chapter describes the data, develops the theoretical model and also discusses the research framework. Chapter Four will reveal the empirical results while the summary and conclusion of the study are presented in Chapter Five.