1.1 Introduction

There is a running dialogue that contemplates the “dividend puzzle” identified by Black (1976) that involves inquiry into why corporations pay dividends and why investors pay attention to those dividends. A generous body of literature reflects the theoretical conceptualisations of as well as the practical empirical research into and testing those theories and hypotheses on this ongoing conundrum. These specifically start with the incendiary arguments around dividend irrelevance; continue into numerous and multiple theories on market dividend effect and market efficiency; and rest on hypotheses informed by the same—only to result in perhaps more questions and departures from understanding dividend significance.

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The threads of discussion focussed on dividend irrelevance reach as far back as the 1960s with Miller and Modigliani (1961, in Khalaf, 2012; Khan 2011; Black, 1976) and their dividend irrelevance hypothesis proposing that dividend policy of a firm does not affect the value of the firm and therefore, investors place no emphasis on receiving the earnings as dividends or as capital gains.

The lines of discussion on theories on market dividend effect and market efficiency reach back to the 1950s and forward with the information content of dividends theory of Lintner (1956), Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985); agency cost theories of Jensen and Meckling (1976), Jensen (1986), Easterbrook (1984), Poterba and Summers (1984), and Barclay (1987); and the dividend signalling theories of Asquith and Mullins (1972), Gonedes (1978), John and Williams (1985), Lang and Litzenberger (1989), Dennis, Dennis, and Sarin (1994), and DeAngelo, DeAngelo and Skinner (1996). These assign significance to dividends and their impact and propose that the information content of dividends is dispersed upon payment of dividends, information that in turn “signals” with relevant indicators, or with an asymmetry of information, that further impact the market.

And the lines of discussion on hypotheses informed by theories on the market dividend effect and market efficiency reach forward to today, with propositions that include those of the information content or information-signalling hypothesis, originating with Lintner (1956) and developed by Bhattacharya (1979), John and Williams (1985), Ambarash, John and Williams (1987), Comment and Jarrell (1991), and Hertzel and Jain (1991); the substitution hypothesis, originating with Bagwell and Shoven (1989) and furthered by Grullon and Michaely (2001) and Brav, Graham, Harvey, and Michaely (2005); the free cash flow hypothesis, based on agency theory originating with Jensen (1986) and developed by Rozeff (1982), Easterbrook (1984), and DeAngelo and DeAngelo (2000), and La Porta, Lopez-De-Silanes, Shleifer and Vishny (2000); and the market efficiency hypothesis, originating with Fama (1970) and developed further by Keim (1983), Reinganum (1983), and DeBondt and Thaler (1990). These theories suggest there is a relationship between dividend announcement and stock market behaviour, but do so from different and varying perspectives.

1.2 Background to the Problem

Oman has a unique financial institutional character, with share capital participation; tax-free dividends, local listed shares/capital gains, and interest; profit distribution as dividends; minimal corporate transparency; and continuously changing dividend pay-outs by companies as its hallmarks. This puts Oman in prime position for study of the content of its dividend announcements and subsequent market reactions. Especially significant is how in the absence of taxation, the reasons for dividends being informative—provided these reasons are rooted in theory—are other than taxed-based drivers. The problem of interest here then is to take into consideration the dividend effect and the factors that typically contribute to it, add an investigation into dividend signalling theory and agency theory and their relative hypotheses—the market efficiency hypothesis, the substitution hypothesis, and the free cash flow hypothesis—and apply these to an empirical study of cash dividend announcements and stock market changes.

Oman firms announce dividends on an annual basis. This makes for a potential collusion with earnings reporting in a way that can incite market reactions. At the same time, firms listed on the Muscat Stock Exchange (MSE) report on a quarterly basis, so technically, three quarters have already been reported by the time the annual dividend announcements are published. It therefore becomes the goal here to investigate the correlation of dividend announcements and market reactions. And more specifically, by way of event study and regression analysis, this study intends to discern if dividend announcement content impacts market behaviour/pricing.

1.2.1 The Dividend Effect

At the centre of dividend announcement theory and market reaction perspectives is what is commonly referred to as the dividend effect—the phenomenon according to Khalaf is backed by the conceptualisation that says “…capital markets take into consideration dividend announcements as information for evaluating share price…” (2012, p. 17); and the logic holds that that as dividend announcement information changes so changes market share price (evaluation). Or, where there is announcement of an increase in dividends, there theoretically would follow an increase in market activity, and vice versa. This theory and phenomenon have been pursued by researchers who have consistently concluded that “[t]he magnitude of the initial dividends [can be] found to be statistically and positively related to the abnormal returns on the announcement day…; [and] the level of the dividend changes can also be of significance for share returns” (Khalaf 2012, p. 17) Factors Contributing to Dividend Effect

The dividend effect is typically considered separate from or in lieu of the earnings effect. [see Strom, 2013] As Khan (2011) and Strom (2013) intimate, for example, several studies focussed on the dividend effect have found that “‘the dividend effect [hypothesis] is comparatively stronger than the retained earning [influence]’” (Khan 2011 p. 89, citing Nishat 1992, p. 60). Moreover, Tai-Yuan (2006) conducted a recent study that also evidenced that “…dividend effect exists even when dividend and earnings are announced simultaneously” (2006, p. iii). Indeed, in a study by Nishat (1992), further analysed by Khan (2011), often industries investigated for the dividend effect versus the retained earnings coefficient, it was found that the dividend effect was significantly stronger for six out of the ten industries; and that of these ten industries—representing among them cement, chemicals, engineering, fuel and energy, jute, sugar, textiles, and vanaspati and allied industries—two revealed a regression coefficient for dividends which was higher than it was for retained earnings, whereas the effect of retained earnings was stronger than dividends in only two of the ten industries investigated (paper and board and “other” industries).

1.2.2 The Theories Dividend Signalling Theory

First, the premise behind dividend signalling theory maintains that companies use dividends to convey information to the market. The logic holds that an organisation typically seeks to make certain that a dividend increase will indeed connote increased cash flows at succeeding times. According to Khalaf, this is considered symmetric information that is being conveyed in a dividend announcement. For given the tendency of many current organisations to instead tend toward asymmetric information—or information leaked by “…those managers who are confident about the future prospects of their company [who] will announce an increase in the dividends as a signal to the shareholders…” (2012, p. 16)—organisations’ investors rely on the ability (and credibility) of the firm to “…measure the likelihood that the future cash flow will indeed correspond to the present increase in the dividend” (p. 16).

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Agency theory serves as a rationale behind a firm’s act of paying dividends to begin with, but also offers support for dividend payout practices and their subsequent announcements in less-restricted environments. First, according to the U.S. National Bureau of Economic Research (NBER), agency theory assumes that between dividend payouts and retained earnings, retained earnings are less likely to engender management behaviour that “…maximize[s] shareholder value,” (2005, para. 1) and retained earnings are more likely to foster corporate complications (given the massive amounts of X), whereas dividend payouts reduce managerial clout and discretion “…to make value-reducing investments” (para. 1) and reduce interagency or agency-client conflict. Second, agency theory proposes that capital contributions go hand-in-hand with “…additional monitoring” (para. 2) that allows the outside investor to monitor management activity at the same time as it curbs managerial control. In addition, according to Tai-Yuan, unlike signalling theory, agency theory “…assumes that dividends are related to past earnings and unrelated to future earnings” (2006, p. 37). This premise is significant in its departure from prediction or foreshadowing that signalling theory suggests is the dynamic behind dividend announcement information, and again, this premise also serves to minimise non-value-adding behaviour on the part of management and thus lessen the chance of conflicts of interest between “…shareholders and bondholders [which might] compel managers to pay out the unexpected earnings for the purpose of avoiding windfalls taken advantage of by the bondholders” (p. 37). Or, as Khalaf summarises, “Agency theory [recognises] that the costs associated with conflicts between shareholders and managers can be reduced by dividends [as opposed to by retained earnings]” (2012, p. 31).

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