Rooted in agency theory and in dividend signalling theory are several hypotheses, the most significant and most relevant of which include the market efficiency hypothesis, the substitution hypothesis, and the free cash flow hypothesis.
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The market efficiency hypothesis, better known as the efficient market hypothesis (EMH), suggests that markets are information-capable, or, information-efficient and that therefore, “at any given time and in a liquid market, security prices fully reflect all available information” (Fama 1970, p. 1575). The implication is that in dividend announcement content, then, the same efficiency of information will exist and will be wholly reliable. In addition, as Strom elaborates, “If the market is efficient, prices will instantly adjust to and fully reflect new available information without tendency for further increases or decreases” (2013, p. 10). Yet, where prices are not consistent is where market reactions are delayed or overreactive (Strom 2013; Viswanath 1996; Fama 1970). Figure 1 demonstrates the theoretical stock market reactions to new information (Strom 2013): this includes both delayed reactions and overreactions (Viswanath 1996).
Figure 1 Stock Market Reactions to New Information
More specifically, Figure 2 illustrates overreaction and delayed reaction in particular—whereby in an efficient market, the market price(s) “instantaneously adjust[s] to and reflect[s] new information” (Viswanath 1996, para. 14), with no trends toward change (increase or decrease) and therefore with equilibrium (para. 14). With a delayed reaction, however, market price(s) initially only “partially adjust[s] to new dividend announcement content, taking time to fully “reflect” the new information” (para. 14); and with overreaction, market price(s) initially “overadjust[s] to new dividend announcement content” (para. 14).
Figure 2 Overreaction and Delayed Reaction
In sum, the composite theoretical approach thus far would take into consideration the dynamic of market reactions and the dividend effect to suggest that in an efficient market, the dividend effect is activated when dividend announcements are made, inciting activity, resulting in reaction(s) in/on the market.
An agency theory-based hypothesis, the substitution hypothesis explained by Jensen (1986) points to substitution of dividends by way of a buyback system of share repurchase/debt. This asset substitution activity is acknowledged to reduce agency problems, to transfer wealth from bondholders to shareholders (Yahyaee 2006), and, where applicable, to provide tax breaks. In the latter instance, for example, Jensen explains that, “Interest payments are tax deductible to the corporation, and that part of the repurchase proceeds equal to the seller’s tax basis in the stock is not taxed at all” (p. 326). Moreover, Poterba and Summers assign a valuation effect by taxes on dividends. However, in Oman, with the absence of dividend taxation, combined with the ostensibly high leverage and its concentrated ownership trends [Yahyaee et al, 2011], the substitution hypothesis is displaced—returning theory to the dividend signalling paradigm that suggests that taxed dividends and capital gains are necessary for dividend announcement content to be informative. That is, accordingly, where Oman does not impose taxes, and where theory holds that taxation is necessary for dividend announcement content to be informative, it would follow that in Oman, dividend announcement content information would be expected to be poor (Yahyaee, Pham, & Walter 2011).
Also agency theory-based, the free cash flow hypothesis suggests that in the typical manager-shareholder dynamic, the interests and incentives between the two agents conflict (Jensen 1986); and the greater the cash flows—defined by Jensen as “…more cash than profitable investment opportunities” (1986, p. 323)—the greater the potential for conflict: the greater the free cash flow the greater the insulation for managers from external monitoring/scrutiny. As a result, the free cash flow hypothesis is extended and used to propose that efforts are made to reduce costs, or, to “…motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies” (p. 325). But also signalling theory-based, where dividend announcements come in is where Bhattacharya asserts that dividends themselves “…function as a signal of expected cash flows of firms in an imperfect-information setting” (1979, p. 259). Thus, the dispensing of dividends serves to reduce the amount of a company’s free cash flow (Strom 2011).
Given 1) the uniqueness of the high leverage, tax-free environment of Oman and the high rate of dependency by Omani companies on banking in addition to 2) the “concentrated ownership structure” of Omani companies—whereby the firms are owned by a limited number of investors with the controlling interests (Al-Yahyaee, Pham, & Walter 2011; Al-Yahyaee 2006), and given 3) extant agency theory and dividend signalling theory and their relative hypotheses (as outlined above), it would be typically predicted that a) “…dividend payments may not be necessary to reduce the tendency of managers to overinvest free cash flow…[which] reduce the announcement effects of dividends on stock prices…” (Al-Yahyaee, Pham, & Walter 2011, p. 607); that b) “…concentrated ownership structure should reduce the agency cost between managers and shareholders” (p. 607); and that c) dividend information content would be weak in Oman. However, this study intends to investigate the extent to which these theories, especially dividend signalling theory as it points to dividend announcement content, hold true.
This study offers an investigation into how dividends in the tax-free market environment of Oman impact share prices. The findings reflect both announcements of dividend increases and announcements of dividend decreases that are inconsistent with the tax-based signalling paradigm in particular, but are nevertheless aligned to some extent with dividend signalling theory in general. Many studies have been done on dividend content. Many more studies have been done to propose and/or evidence dividend theory. And several separate studies have been conducted on region-specific information content of dividends as they impact market behaviour. Yet, only one study to date, by Yahyaee (2006), focusses on the dividends in the unique environment that is Oman—and that study spotlights capital structure and dividend policy and explores the determinants including ownership, age, and leverage, etc, as each impacts dividend policy, and not vice versa. This dissertation attempts to cover a phenomenon that is virtually undisclosed in almost any detail at all. In this respect, the researcher hopes to shed light on the practice of dividend announcements in Oman and at the same time perhaps inform dividend policy if not influence future research into dividend policy in Oman.
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The following terms/abbreviations are used throughout this study:
AAR—average abnormal return
EMH—efficient market hypothesis
FCF—free cash flow (hypothesis)
GCC—Gulf Co-Operation Council
MSM – Muscat Securities Market
The remainder of this study is as follows: Chapter 2 is a review of the great body of literature that exists to propose, explain, and reinforce or negate theoretical conceptualisations of the relationship between dividend announcement content and market reaction(s). This chapter is comprised of a review of that theoretical and empirical literature in a discussion of Dividend Signalling Theory, the Dividend Effect, and the Efficient Market Hypothesis.
Chapter 3 offers a discussion of the approach, statistical sampling, and descriptions of the variables used to test the theory and the hypotheses development relevant to the impact of the information content of dividends on market reactions in Oman and on the Muscat Securities Market (MSM).
Chapter 4 chapter discusses the findings based on the SPSS model analysis and the five developed hypotheses.
And Chapter 5 summarises the findings as they align with theory.
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