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

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1. Introduction
Dividend policy has been talked about for many years in financial literature. Views have been changed very often, starting with Miller and Modiglianis (M&M, 1961) model, in which firms 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 As Baker, Powell and Veit (2002) explain, stocks that pay dividends must offer higher pretax 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 markets inspection for the new funds, hence ensuring that management acts in the best interest of shareholders.

Signalling model When the markets are less than efficient, information asymmetry between managers and shareholders arises, at which point dividend payments can communicate information about the companys 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 companys 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.
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3. Data and Methodology

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:

Pruitt and Gitman (1991) refer to risk as year to year variability and include it among the factors that affect the firms 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 actually depend more on cash flows than on current earnings, as the former reflect the companys 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 Mecklings (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 Slack Company-specific risk Cash flow per share

Relationship Negative Negative 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.

4. Results and Analysis

To analyse the impact of the named factors upon dividend policy, I have used the following model:

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 shareholders lack of monitoring (Jensen 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 Burberrys 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
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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 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 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.

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The STATA results for the 3 regressions as following: 1- Personal Goods 2- Media 3- Total

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