CHAPTER TWO
LITERATURE REVIEW
2.0. Introduction
The
benefits accruing from shareholders’ investments from their business ventures
are regarded as dividends. Thus, Colombo Stock Exchange dividend policies
provide the firms the important parameters, guidelines, and limitations on the
way the firms can divide its earnings between the retained earnings and
dividend payouts for them to optimize their values. Therefore, this literature
identifies the factors that are taken into account to analyze comparatively the
dividend policy. Moreover, dividend policy is basic to all the managerial and
financial strategies determining an organization’s sustainability in the long
run as a going concern. According to Rustagi (2001), a firm’s primary objective
is the maximization of shareholder’s wealth by optimizing the prices of the
shares. Moreover, the potential firm’s value is affected by financial,
investment, and dividend decisions made by the decision makers. However, the
decisions on ratios that are used in the allocation of net earnings between retained
earnings and dividend payout have implications on the financial strength of
firms and risks. (Howett et al., 2009). Thus, the effect of this factors
cascades to most of the firm’s operational centers hence benefits of dividend
policy. According to Grullon and Michaely (2002), systematic risks
This
chapter, therefore, reviews the literature on the relationship between dividend
policy and firm performance in the industrial sector in Sri Lanka. Moreover,
review of this research is important in defining dividend policy and the firm
performance of industrial sector vise. This comprises the definitions of
dividends, dividend policy, dividend payout, and firm performance. Furthermore,
firm performance and the relationship between firm profitability and dividend
payout are also discussed. In addition, the theoretical framework, empirical
review, dividend policy and firm performance in the industrial sector vise
listed on the Colombo Stock Exchange, a research gap, and the conclusion are
analyzed.
2.1. Dividends
The
profit portion after tax distributed among firm’s shareholders is referred to
as the dividend either in form of cash or stock (Rustagi, 2001). Moreover,
dividends are viewed as benefits that accrue to owners as a return of investing
into a business venture. However, other firms might dividends to the owners as
interim which is paid in parts throughout the year or final dividends paid
immediately after the year ends (Rustagi, 2001). According to Ajanthan (2013), the dividend is
important in decision making because it gives the predictions about the number
of transferred funds to the investors and the earnings retained in a firm to
help in future investment. Moreover, dividends also help risk-averse investors
to maintain the quality and performance especially if the firm operates in a
highly competitive business environment (Rustagi, 2001). Furthermore, dividend
decisions have become of great significance since it helps a company in
deciding the portion to be kept as retained earnings and the portion to be
transferred to the shareholders in order to maintain the attraction of the firm
from the outside world (Dhanani, 2005).
2.1.1. Dividend
policy
The
decision on allocation of dividends is the most important decisions in the
finance sector. Furthermore, dividend policy is the most significant factor in
the corporate finance. Moreover, many firms take dividends as the major cash
expenditure (Beasley, 2016). However, the decisions on dividends are very
important as they determine the funds flowing to the investors or retained by
the organization for their future investments (Jaffe, Ross & Westerfield,
2002). Therefore, dividend policy is the guidelines and regulations used by a
firm in making decisions on how to pay the shareholders their dividends
(Nissim&Ziv, 2001). According to Beasley (2016), dividend policy is
important as it delivers information to the shareholders about the financial
performance of the firm.
Firm’s
dividend policy has its advantages and disadvantages for the managers, lenders,
and the investors. The declared or the accumulated dividends provided at a
later date are a source of steady income to the investors and also a key input
in the process of income valuation of the firm. In the same way, the flexible
nature of managers in investing in projects depends on the number of dividends
they give their shareholders because of the more the dividends, the fewer the
funds to invest. Moreover, lenders may want to know the number of dividends
declared by a firm since the more the dividends, the less the amount for
redemption and servicing of their entitlements (Rustagi, 2001). Furthermore,
dividend policy affects the firm’s cost of investment (Amidu, 2007).
Furthermore, dividend policies show the dividend disbursement ratios in the
company and thus it yields to the emerging economy. Additionally, dividend
policy also gives the investors the financial performance of the firm.
The
major determinants of dividend policy are the dividend payout, dividend cover,
and the dividends per share. However, dividend payout is different from
dividend policy since it is one of the major determinants of dividend policy of
a firm. Dividend policy is the set of
regulations and guidelines used by a firm uses in deciding the number of
earnings to allocate to the shareholders (Amidu, 2007). However, the dividend
payout ratio shows the ratio of the total amount of funds allocated to the
shareholders relative to the firm’s net income (Beasley, 2016).
2.1.2. Determine the
factors influencing dividend policy and dividend payout
According
to Pruitt and Gutman (1991), factors influencing dividend decisions are the
current and past year’s profits, earnings variability, and earnings growth
earlier before dividends. Moreover, a review done on factors related to the
previous studies shows that there are many factors that can influence the
dividend decisions made by firms regarding dividend decisions. These factors
include flow considerations, returns on investment, after-tax earnings,
liquidity, future earnings, past dividend practices, inflation, future growth
projection, interest, and legal framework. According to Amidu (2007), said that
the dividend paid by the company is directly proportional to the size of the
firm. This showed that the dividend paid by a firm to the shareholders is a
function of the size of the firm. Moreover, Howett et al. (2009) said that
there is a positive relationship between dividend payout and the cash position
of a firm as changes in the dividend policy might be related to firm’s
liquidity. Therefore, liquidity affects dividend policy and payout ratio
because when dividends paid to the shareholders in cash, it means that cash
must be available to shareholders.
2.2. Firm
performance
Performance
is making something successful using the available resources. Moreover,
performance deals with outcomes, results, and achievements achieved by an
individual group, or an organization. Pradhan (2003) defined on the other hand
defined performance as a progressive achievement of tangible, specific,
measurable, worth will, and personally meaningful goals. In other instances,
people define performance based on the financial aspects of the firm. However,
in finance, performance is viewed as the way a firm enhances its shareholders’
wealth and their capabilities to generate earnings from the invested capital to
the shareholder’s. Priya and Namalthasan (2013) said that firm performance can
be measured in ways that include profitability, cash flows, sales growth, and
the book value. Firm profitability describes the amount of wealth a firm makes
after paying after payment of all its expenses and charges (Dhanani, 2005). The
higher the profits of the firm the better its financial performance and the
lower the profits the poor the performance. Moreover, profitability can be
measured by the net profit, return on assets, and return on equity.
2.2.1. Measures of
analyzing firms performance
According
to Pani (2008), there are three broad measures of organizational performance
namely accounting, market, and hybrid measures.
Accounting measures
The
accounting measures that might be helpful that might be used to evaluate
business performance are the return on assets, return on sales, return on
equity, return on investment, return on capital employed, and the sales growth.
These measures are used widely due to the fact that the government demand firms
to publish their accounting data and internal controls promote reliability (Paviththira,
2014). Moreover, these measures are easy
to calculate and they also integrate organizational results into less complex
metrics (Dhanani, 2005). In addition, the accounting measures are used by
managers to monitor the performance of a firm and making strategic decisions
(Rustagi, 2001). However, accounting measures focus on historical performance
and not future performance thus limiting the use of the measure by
organizations.
Market measures
Market
measures can be divided into two groups, shareholder-value, and
competition-based measures. The shareholder-value measures propose that firms
need to optimize investment capital used thus maximizing returns gained from
both investments in both the short and long run. This has resulted in financial
measures based on shareholders to incorporate debt and equity capital (Amidu,
2007). On the other hand, the competition-based measures is an economic theory
that suggests an organization can increase its sales through its ability to
become more efficient and to lower its prices through the use of modern
technology (Howett et al. 2009). This will help them to overcome competition.
The competition measures that can be used to compare firm performance are
market share, labor productivity, and the sales per employee (Amidu, 2007).
Hybrid measures
Hybrid
measures that have the ability to overcome all drawbacks and keep the
advantages of accounting and market measures should be used to measure firm
performance. Tobin’s q may be used to measure the market value of the firm
relative to the value of the total assets (Nissim&Ziv, 2001). The Altman’s
Z-score might also be used to indicate the likelihood of bankruptcy (Beasley,
2016). However, although the two measures provide the information on risk and
future contingencies that are likely to occur in a firm, they might also be
volatile over the periods.
2.3. Firm
profitability and dividend payout relationship
The
performance of a firm is measured by the generated earnings of the company in
form of profitability. Therefore, there has been a considerable literature on
the relationship between profitability and dividend policy. Thus, dividends are
significant to both shareholders and the potential investors and illustrate the
earnings generated by the firm. Furthermore, health dividend payouts show that
a company is generating real earnings. Zhou and Ruland (2006) found out that
when dividend payout is high, firms experience strong earnings in the future
but a moderately low past earnings growth rate despite the contradicting findings
from market observers. The study done by Arnotte and Asness (2003) revealed
that the growth in earnings in the future is associated with high dividend
payout and not a low ration. The conclusion was that from past pieces of
evidence, expected earnings growth is faster with high current payout ratios
and slow with low payout ratios. However, Nissim and Ziv (2006) argued that
there is no important relationship between dividends and earnings in the long
run. Moreover, other studies that support this association have been done on
short periods thus misleading the investors. The two researchers proposed three
situations that reduce to insignificant the relationship between dividends and
the future earnings.
The
first illustrated that a dividend increase leads to a decline of funds to be
re-invested into the firm. Thus, those firms that pay high dividends and not
considering the needs of the investments experience lower earnings in the
future (Nissim&Ziv, 2006). Therefore, this shows that there is a negative relationship
between dividend payout and retained earnings. Furthermore, a slight increase
in dividends might be as a result of the policies of the management to satisfy
investors and stop them from selling stock during the period where the
expectation is that the future earnings will decline or current ratios to
continue (Nissim&Ziv, 2006). Thus,
this is the incident of rising dividends preceded by declining dividends.
Additionally, an increase in dividends may result from good performance during
the past periods and might even continue into the future. Thus, this supports
the opinion of a positive casual association between dividends and future
earnings. From these situations, they claim that the general long-term
relationship is insignificant because there exists a positive relationship
between future earnings and dividends during other periods and a negative
relationship in some other periods.
Pruitt
and Gitman (1991) showed that the increase in dividends is directly
proportional to future earnings in each of the years after the changes in
dividends. They found out that the increase and decrease in dividends are
asymmetric. Thus, dividend the increase in dividends is associated with the
future firm profitability for at list two years after the changes in the
dividends. However, a decrease in the dividends has no relationship with the
future profitability after the control of the current and expected
profitability. Moreover, they propose that the lack of association is described
by conservation in accounting. Thus, they concluded that there is a stronger
positive relationship between the dividend payout and the future earnings,
especially for the abnormal earnings.
Amidu
(2007) studied the effects of divided policies on firm performance more so the
profitability measured in terms of return on assets of firms listed in the
Ghana Stock Exchange. The findings revealed a positive relationship between the
return on assets, sales growth, return on equity, and dividend policy. This
confirmed that a firm’s profitability is influenced by its policy for dividend
payment. Moreover, the results showed that there is a statistically important
relationship between firm profitability and the dividend payout ratio.
Furthermore, Howatt et al. (2009) said that the positive changes in firm
performance come from the positive changes in the future in the earnings per
share.
In
a study by Uwalomwa, Jimoh, and Anijesushola (2012) that investigated the
relationship between dividend payout and firm performance among the firms
listed in Nigeria Stock Exchange, it was concluded that the ownership
structures and the size of the firm have a positive impact on dividend payout.
The variables were firm size, dividend payouts, and the ownership structures.
Additionally, they found out that there is a significant positive association
between firm performance and the dividend payout of firms in Nigeria.
Dhanani
(2005) study showed that dividend policy is significant in shareholder value
maximization. Furthermore, the study revealed that the dividend policy of a
firm has an influence on the imperfections in the real world such as agency
problems, taxes or the information asymmetry between managers and the
shareholders. However, in an imperfect market, dividends have an influence on
shareholders’ wealth through the provision of information to investors or the
redistribution of wealth among the shareholders (Dhanani, 2005). Moreover, a
firm’s policy considers the different circumstances of the shareholders thus
enhancing the value of the firm to the shareholders (Dhanani, 2005). However,
firms formulate their dividend policies to meet shareholders’ needs depending
on their preferences.
Thus,
the dividend does not provide information themselves about future earnings but
create a custom drawn to the firms with the dividend policy they prefer.
Moreover, most firms make their dividend policies depending on shareholder’s
preferences for the dividends (Amidu, 2007). However, other shareholders may
prefer cash dividends, other prefer stability dividends while others might
prefer capital gains that are earned re-investment of dividends and therefore
there are no cash dividends (Howatt et al. 2009). The theory of bird in hand
since investors may see dividends as a more current and certain return than the
capital gains. Additionally, the tax preferences of individual investors
influence their preferred dividends. However, investors who are afraid of high
taxes prefer low or no dividend payouts with the intention of reducing the
taxable income hence preferring the capital gains (Howatt et al. 2009). Thus,
firms that meet investors’ needs are likely to get a higher share price premium
thus enhancing the value of the firm. However, according to (Amidu, 2007), if
the investors move to other firms that can pay them dividends matching their
needs, the firms’ value should not be affected by the dividend policies.
Therefore, the value and performance of a firm are enhanced by higher returns
from optimal investments. Furthermore, dividend payments pressurize firms to increase
the external funds to be used for new investments in increasing the level of
external monitoring of the corporate market activities corporate acts (Atrill,
2006).
2.4. Theoretical
Review
Many
kinds of literature have been studied on dividend policy and firm performance
in order to get a clear understanding of the relationship between the two
factors. Subsequently, this study has established the necessary which has
established the relationship between the two variables. Therefore, this chapter
provides an understanding of some of the most important concepts about dividend
policy and firm performance. Furthermore, this chapter reviews theories that
prove the association of dividend policy on the firm performance essential to
this study. Therefore, it discusses the agency theory, signaling theory,
trade-off theory, bird-in-hand theory, and the dividend irrelevance theory.
2.4.1. Agency Theory
This
theory assumes that a firm is a collection of a group of individuals with
interest that conflict each other and self-seeking motives. According to Jensen
and Meckling (1976), an agency relationship is a contract where one person
referred to as the principal engages another person referred to as the agents
to do a service on their behalf including delegation authorities involving
decision making. However, conflicts may arise between the principal and the
agent wherever is an agency relationship. This conflict arises when the
management makes decisions which are not in the best interest of the
shareholders. Therefore, these conflicts might lead to an increase in agency
costs. Thus, in case of occurrence of such cases, firms usually prefer to
increase the dividends and reduce their agency costs through the distribution
of the cash flow. According to Ajanthan (2013), dividend payout ratios are
explained by the reduction of costs when the firm increase its dividend payout.
Amidu (2007) says that the agency theory makes sure that managers maximize
wealth attributed to the shareholders rather using them for their own personal
benefits.
2.4.2. Signaling
Theory
This
dividends theory was developed by Miller and Rock (1985) and it states that
dividends provide the information about a firm’s future earnings. This theory,
therefore, supports the notion that can conclude the information about the
future status of a firm and the cash flows on the bases of the announced
signals of firm’s dividends considering both the stability and changes in
dividends. Therefore, there is a positive reaction due to an increase in
dividends and a negative reaction with a decrease in dividends. Moreover, the
theory agrees with the fact that dividend policy affects the performance of a
firm positively.
Miller
and Modigliani (1961) on the other hand argues that the top management of a
firm possess all information about firm’s strategies and operations and thus
they are in a position to give a clear forecast of firm’s earnings in the
future. Therefore, due to this fact, an information asymmetry can occur making
investors translate everything the company does as a sign of the future
earnings and thus dividends acts as a signal of the performance of the firm in
the future. According to Griffin (1976), dividends carry the information to
investors and to the market on the firm’s financial performance even the sign
might not be perfect. Thus, the reaction of the investors on the changes in the
dividend policy does not mean that the investors prefer dividends from retained
earnings. However, they indicate the important information in announcements of
dividends.
2.4.3. Bird in the
Hand Theory
According
to Gordon (1963), this theory states that dividends are relevant in assessing
the value of the firm. This theory bases its assumption on the belief that
dividend is valued differently from earnings in the world of imperfection and
uncertainty. Furthermore, investors are viewed as rational beings as they
prefer the “bird in hand” in the case of cash dividends. However, in the case
of “two in the bush” in the case of capital to be gained in the future.
Moreover, the theory proposes that there exist a relationship between firm
value and dividend payout and that the risk associated with dividends is less
compared to capital gains because they are more certain. (Amidu, 2007).
According to Lintner (1956), dividend policy
is developed from the need of investors to get annual returns rather than
capital gains. Furthermore, it is challenging to leave the information about
the decision on issuance of dividends to the directors and managers because
investors have different views on cash dividends and capital gains. Thus, the
investors would be forced to pay higher share prices where current dividends
are paid. The current dividend payment reduces the uncertainty of investors
thus resulting in high values for the firm. Therefore, investors will prefer
the dividends on capital gains (Amidu, 2007). This is due to the fact that a
higher dividend ratio reduces uncertainty about future cash flows while a
higher payout ratio reduces the capital cost hence increasing the value of
shares.
2.4.4. Dividend
Irrelevance Theory
The
irrelevance theory is based on the unrealistic assumptions such as no taxes or
brokerage costs. Investors are uninterested in dividends and retention of
generated capital gains. According to Miller and Modigliani 1961), the firm
value is not affected by its dividend policy in perfect market conditions. The
theory of Miller and Modigliani (1961) assumes that the management of a firm is
interested in the maximization of the value of the shareholder and that the
corporate insiders and outsiders share the information on the operations and
prospects of the firm.
2.5. Empirical
Review
Ajanthan
(2013) reviewed the relationship between dividend payout and firm profitability
among firms listed in Sri Lanka. The findings illustrated a strong significant
positive relationship between dividends payout and company performance.
Furthermore, the dividend payout was the major factor affecting the performance
of a firm.
In
the study by Velnampy, Nimalthasan, and Kalaiarasi (2014) on the dividend
policy and firm performance among manufacturing companies listed in Colombo
Stock Exchange, there is a significant negative relationship between the two
variables. Moreover, the study found out that the determinants of dividend
policy are not correlated with the performance measure of a firm in an
organization.
Prasangi
and Wijesinghe (2016) reviewed the effect of dividend payout ratio on the
future growth earnings of firms listed in the Colombo Stock Exchange. The
findings demonstrated that payout ratio is positively linked to the future
growth earnings and the relationship is significant over a period of time.
Moreover, the study concluded that high dividend ratio influences one-year
future earnings of firms listed in Sri Lanka.
Jafaru
and Uwuigbe (2012) studied the relationship between dividend payout and firm
performance on firms listed in the Nairobi Stock Exchange. In the study, the
dividend payout was measured by the actual dividends paid whereas the firm
performance was measured by net profit after tax. The findings showed that the
dividend payout, firm size, and revenue have a strong positive relationship
with the firms’ performance. They concluded that dividends are relevant and
thus managers should dedicate most of their time to scheme a dividend policy
that will heighten firm performance. However, this study has been criticized
that it did not incorporate the future revenues thus ignoring the concept of
the signaling theory that dividends might be useful in increasing profitability
in a less costly manner.
Ashraf
and Khani (2014) studied the dividend payout ratio as a function of some
factors the case of Pakistan Service Industry in firms listed in Karachi Stock
Exchange. They concluded that a negative relationship exists between the two
variables. This means that the dividend payout ratio is not the function of
corporate profitability, tax, sales growth, and cash flow except the debt to
equity ratio.
Ahmed
and Muhammad (2014) studied the determinants of dividends with industry wise
effect. The findings showed there are other determinants of dividends apart of
profitability and they include life-cycle factors and asset tangibility whereas
capital structure, size of the firm, and cash flows per share do not
significantly determine dividends.
2.6. The Conceptual
Framework
The
comparative analysis of the relationship between dividend policy and firm
performance is examined in this research study. Furthermore, a conceptual framework
that consists of independent variables of the dividend payout ratio and
dividend per share is also examined. Moreover, the dependent variables are net
profit margin, the return on investment, and the return on equity among listed
firms listed in the Colombo Stock Exchange. In addition, this study is
concentrated on a narrow scope to explain the kind of relationship that exists
between dividend policy and firm performance in a changing business
environment. Figure 2.1 shows the conceptual framework
Independent
variableDependent variable
 |
2.6.1. Dividend Payout Ratio
Dividend
payout shows the relationship between the net income and the dividends paid to
the shareholders (Atrill, 2006). This means that the ratio represents the
number of the firm’s earnings paid to the shareholders as dividends. According
to Ajanthan (2013), dividend payout is the number of funds paid to the
stockholders in relation to the firm’s total net income. Thus, dividend payout
is the percentage of the earnings that are paid to the shareholders in form of
dividends. The dividend payout ratio is useful to the investors as it shows
them how much of the firm’s profits go back to the shareholders (Rustagi,
2001). Furthermore, the dividend payout ratio indicates the financial health of
a firm all the time (Beasley, 2016). According to Ajanthan (2013), investors’
view an increase in firm’s dividend payouts as good news but a decrease is
expected to cause a negative reaction in the market. Old companies have higher
dividend payout ratio because they have higher financial capabilities to pay
more dividends to the shareholders (Priya&Nimalthasan, 2013). However,
other companies especially the new ones prefer lower payout ratios for them to
retain earnings to be used for the company growth.
The payout ratio is calculated as:
= Annual dividends per share /
Earnings per share
2.6.2. Dividend per
Share
According
to Howett et al. (2009), dividend per share is money that the company has
declared to issue to its ordinary shareholders. Moreover, Beasley (2016) said that
dividend per share measures dividend policy. Dividend per share is calculated
by dividing the total dividends paid by the company by the number of issued
ordinary shares. According to Dhanani (2005), dividend per share is important
to the investors because they use the ratio in calculating their dividends from
the shares owned over a certain period of time. The more the dividends per
share, the higher the company growth (Rustagi, 2001). This is because the
management of a firm believes that the increase in the ratio sustains their
growth.
2.7. Conclusion
Dividend
puzzle has become an enduring issue in finance and it is yet to be resolved.
Researchers have described it as a puzzle that many researchers have tried to
resolve for a long time. Uwalomwa, Jimoh, and Anijesushola (2012) concluded
from their study that although many theories have been put across to determine
dividends, the variable still remains one of the hard puzzles in the corporate
finance. This dilemma has gone on and on as many schools of thought have had
conflicting interpretation on whether investors favor capital gains or cash
dividends. Therefore, in this case, the empirical studies have failed to give a
conclusion to support the arguments on dividends’ relevance (Gordon, 1963).
Furthermore, from the empirical review, researchers have contradicting finding
on dividend policy and payout. Ajanthan
(2013) found out a significant positive relationship whereas Velnampy,
Nimalthasan, and Kalaiarasi (2014) found out that dividend policy is not correlated
with dividend policy. However, many studies have clearly shown that dividend
policy is among the factors that affect the financial performance of a firm.
However,
past reviewed literature shows that most researchers have put their
concentration on the relationship between dividend payout and firm performance
but only studied the payout ratio as the only factor on dividend policy. In Sri
Lanka, few studies have analyzed the behavior of dividends on firms as well as
the way the behavior of earning distribution affect the future performance of
firms. Thus future researchers should not only look at the issue from not only
the point of view of the distribution of earnings but also the forms and timing
of industrial sector firms divided payments in Sri Lanka.
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