Signaling theory

Dividend policy of government owned company in China ——study from signaling theory

Chapter 1

This dissertation examines the possible association between government control level and cash dividend, other emphasized elements and dividend policy of the listed companies in Chinese security market, using sample of 456 stated owned listed companies which pay dividends in 2006-2008. This paper concludes that the higher level of government control, the more dividends would be paid. There is no great significant of investment opportunities and profitability for dividend in government owned firms. But profitability does go the same direction with dividend while investment is negative related to dividend. However, in zero-government share owned firms, two variables are all negative to dividend. They do not have regression relation with dividends, except profitability in government owned companies.

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1.1 dividend policy

The Modigliani-Miller (1961) dividend policy theory implies that the perfectly efficiency market have full information and the dividend policy is no relative to the future earnings or the firm value or cash flows in the firms. This theory has been criticized by most practitioners and financial managers, who argue that the MM theory is based on perfect capital market, which is not true in the real world. The differentiation in tax rate, interests and information between managers and shareholders leads to different policy in dividend. The controversial in dividend policy have been listed as ‘puzzle’ in the corporate finance. There is no single explanation can solve it, and now, the theory of dividend has been developed in five main streams: the signaling theory and the information problem, the agency theory, the transaction cost and residual theory, bird in hand, the taxation effect hypothesis and clientele preference (Baker et al., 2002).

The asymmetric information between managers and shareholders is generated in signaling models. The proponents of this theory believe that the dividend is used as a means to signal future earnings, especially, the higher value firms (see the studies of Harada and Nguyen, (2005); Manakyan and Carroll, 1990).; and the controversial findings indicate indicates that changes in payout policies are not motivated by firm’s desire to signal their true worth to the market (Benartzi, 1997; Dhillon), while others find no evidence such as DeAngelo et al. (1996).

The agency hypothesis indicates that the high payment of cash dividends results in more frequently capital rising in the capital market which causes the higher levels of market monitoring and lower agency costs as a result of increased scrutiny the capital market places on the firm (Easterbrook, 1984). According to Troung (2007), largest shareholder can influence the dividend decision of a listed company to benefit his or her own interest.

1.2 Research Objective

This dissertation will employ dividend policy in perspective of ownership structure to explain the effectiveness of government shareholders of shares on dividend policy of Chinese listed firms. This dissertation studies the signaling content of dividend policy of Chinese listed firms under the background of the reform of share structure and dividend policy. China is a civil law country with weak investor protection in the perspective of corporate governance. Consistent with La Porta et al.(2000),who document that companies in civil law countries have a lower dividend payout ratio, among the lowest in the world and around 57% of Chinese listed companies do not pay out dividends at all in 2006 to 2008. According to the report of Kui and Mako (2006), there was almost zero dividend payment for government and other shareholders before 2005. All the dividends were used as re-investment or accumulated as equity in firms. However, there exists some high dividend payout across Chinese listed companies, with some as high as 170% (calculation based on the Wind Information_2009).This phenomenon induces me to explore the different dividend policies of Chinese listed companies, as the researches of dividend policy in Chinese security market is still staying in large, especially, the dividend policy in government owned companies. Thus, research on the dividend policy in Chinese market can benefit from several aspects.

1.3 structure of this thesis

This thesis organized in 5 sections. The first section reviews the relative theories on signaling model, as well as agency theory, ownership structure, taxation effect hypothesis and clientele preference. The second part will review the empirical studies on signaling theory of dividend as well as some empirical studies in Chinese market. And the forth section provides some background about dividend policy in government owned firms in Chinese market. And the last section, follows empirical study in examines all the variables in signaling model for government controlling firms. The last section is conclusion.

Chapter 2: Literature Review

2.1 introductions

This chapter discusses previous studies related to dividend policy; focus on signaling model and agency theory. Other theories and explanations also presented in this chapter, namely: ownership structures, taxation effect hypothesis and clientele preference.

2.2 Signaling model of dividend

Miller and Modigliani (1961) demonstrate that given the firm’s operation policy, the dividend policy would not effect on the market value of the firm which measure the return on the cash flow of the firm. Now, signaling theory concerns the use of dividends to act as a signal to transfer information to the outside market. The assumption is that managers know more about the true value of the firm than the outside investors. And the managers, especially the undervalued firms, prone to transfer private information; hence there would be fewer gaps in information holdings between the investor and managers.

Bhattacharya (1979, 1980) developed inter-temporal signaling model from non-dissipative labor market signaling model which based on Spence’s term ‘costless signal’ that relative to the full information equilibrium, with the assumptions that the tax rate in dividend is higher than capital gains, the investors know less about profitability and the managers maximize the shareholders interests. The most important assumption in Bhattacharya’s model is that if the payoff is insufficient to cover the dividends, the firms have to collect outside funds and pay the cost for it. Thus the equilibrium for this is to pursuit for a high return from the new project which will offset the disadvantage of dividend payoffs (e.g. the tax of dividend). In Bhattacharya model, the insiders of firms are assumed to solve the one-period earning to maximize the shareholders’ objective function, and after the dividend payment, they sell to the new group of shareholders who receives the payoff generated by the project at the second period.

It was criticized that why do firms use dividends to signal their prospect? Some proposed that the repurchases would be better in signaling. Although it ignored the incorporation of other sources of information (e.g. moral hazard), the model reveals the positive relationship between future dividends and future cash flow, and showed the positive relationship between dividend changes and the price reaction which consistent to other model, John and Williams (1985), Miller and Rock (1985). The reasons for the firms use the dividend as signal was explained in John and Williams (1985) model, for the shareholders tend to dilute their ownership for rising cash in the second period, and the firms intent to retain the original shareholders simultaneously to rise their stock price, which complement to the short of Bhattacharya’s model. John and Williams’ (1985) simple equilibrium model begins under the condition that there exists a signaling equilibrium with dissipative dividends; taxes are paid only on dividend, no transaction cost on issuing, retiring and trade shares, sources and uses of funds are fully observed. In this model, the tax is the critical. It narrowed the Bhattacharya’s (1980) model; give the dividends distribution only when the cash demand for the firm and stockholders exceeds its internal supply of cash. The contribution of the John and Williams’s model provided great extension on signaling equilibrium research, such as applied it into the securities dividends rather than on common stocks, extend it into the repeated game theory.

To extend the previous models of the signaling, Miller and Rock (1985) developed a new model which links the earnings and time with 2 periods. They affirmed John and Williams’ simple model of that the outsiders compute the investment, which is also the only signal, of corporate from dividends, current cash flows and the amount of external financing if all the parameters are announced. Meanwhile, they combine the risk-adjustment discount rate for the firm’s expected earning from the Fisherian optimum and a persistence parameter for the effect of the dividend announcement together. The assumption of this model is the uncertainty of the firm’s dividend, investment and financing decision and future earnings, which are the main conditions for firms to violate the Fisher rule, especially the poor performance company who is going to fool the market, pays a higher dividend currently by cutting investment below the optimal level of the second period.

It is obviously that this model is not tax basis which is totally different from Bhattacharya (1980), John and Williams (1985), according to Miller and Rock (1985), the feature of their model abandon one or more of the troublesome assumption. The strengths are the timing consistency, preannouncement value and post-announcement value, which also count the discount rate in. In the financing perspective, it filled relationship between the expected internal cash flow and the financing announcement in detail. Miller and Rock (1985) also illustrate the consistent condition under asymmetric information, and weight the proportional value of each holders based on MM theory, equally, imply the dividend make sense as signals for good news, not for bad-news firm. Their model more tends to support MM theory while Bhattacharya’s tends to amend the original model, also, without tax, dividend can substitute for the share repurchase.

Based on the above literatures, one hypothesis have been confirmed and come to agree that the dividend changes are indeed convey future earnings, but if the direction of the dividend changes leads to the changes of earnings has not. Bhattacharya (1980) focus on the transaction cost for outside financing , John and Williams(1985) ascribe the taxes are the core costs of singling, then Miller and Rock (1985) explain the dissipative cost as the manager’s manipulation. They all suggest other alternative model which carries the same signal but with lower cost can be used. Thus the share-repurchase was mentioned, but John and Williams (1985) hold that the corporate insiders should covey information more efficiency and less costly, not only trough share-repurchase. Allen, Bernardo, and Welch (2000) involve the different roles for dividends and repurchases and evidenced they are not substitutes. They indicate that firms with more asymmetric information and more severe agency problem will use dividend rather than repurchases.

Ambarish, John and Williams (1987) explained it is the signal of dividends and investment. They give the efficiency equilibrium model when the dividends and new issues transfer private information at a lower cost than only the new issue. Investment is the core element in their model, but all the factors are subject to the non-mimicry constraint in efficient signaling equilibrium when analysis the efficient signaling equilibrium of the valuable firms. This model extended the model of John and Williams (1985) and deeper the discussion of Miller and Rock (1985) in the conflict between the firm and investors. The two different types of firms will be distinguished by selecting different fractions of firms with attributes of above elements, for the valuable firms prefer to report its true attribution, the less valuable firm would not follow it. The limitation is how to compare a total different projects invested by two firms, it is not realistic for investors to learn the private attribute, symmetric information exception. In the resulting signaling equilibrium, almost every firm invests less than its optimum under symmetric information, distributes a larger residual dividend, and thereby reveals its current cash. Also, Myers and Majluf (1984) show that insiders optimally forego projects with positive present value if their firms must sell risky securities to raise the required capital.

Other model about dividend signaling as Bernheim (1991) who examined the relationship of dividend and share repurchase with the condition that taxes on dividend is more than that on repurchases. In his model, the firm can control the proportion of the total payout to affect the amount of taxation payment, and the payout form is dividend rather than repurchases. And a high quality firm can choose the optimal amount of taxes to transfer the positive information.

Allen, Bernardo and Welch (2000) present the explanation on the inclination of dividend payment rather than repurchase, and the inclination on dividend smoothing. There are different groups of investors who are taxed differently, public and corporate pension funds, labor unions and other untaxed institutions are the primary holders who have greater incentive to be informed about the firm. They state their assumption of dividend is one way of attracting institution, for the restrictions in institutional charter and prudent man rules that make it more difficult for many institutions to purchase investments with low dividend payouts. Then they develop the model with asymmetric information, and attract institutions via clientele effects. According to the competitive equilibrium model, the high quality firms must prefer to pay dividend while the low quality firms must do not have the incentive to mimic high quality types and pay zero dividends, since once they mimic it will lead to a higher share price if institutions do not detect their true quality, if they do no be detected, the share price will be lower than the price before dividend payment because of dissipative tax in dividend. Thus, taxable dividends are desirable because they allow firm’s management to signal the good quality of their firms. Paying dividends increases the chance that institutions will detect the firm’s quality. In the perspective of dividend smoothing, firms that pay dividends are unlikely to reduce the amount of the dividend, because the clientele precisely a kind of investors that will punish them for it. Thus the managers would keep dividends relatively smooth after weight the positive share price response to the announcement of dividends against the consequences of the shareholders force to cut the dividends in response to poorer performance later.

Above all, we reviewed the literatures of dividend on cash flow, and know the proportion has reach an agreement, and equally important, cost of dividend and its substitute for share repurchase is still in controversial, one comment from Amihud and Murgia (1997) is that dividend news would not be informative if not for the higher tax that they impose on shareholders. And other theories on dividend include reputation (Gillet et al., 2008), maturity (Grullon et al., 2002) and risk (Kumar, 1988) is arising currently.

The signaling problem can be analyzed by transforming it into an equivalent problem, labeled the non -mimicry problem which had been developed by Bar- Yosef and Huffman (1988), who derived the equilibrium dividend signaling model form the Black- Scholes option pricing formula with the assumption that the expected value for managerial compensation is the optional dividend decision, then the equilibrium dividend contains penalty part of the manager’s compensation, which will deters the manager from signaling false information. It treats the cash dividend payment as a function of the cash flow risk. The theoretical results explain the empirical results reported on the relationship between dividend and risk while the empirical results is negative between these variables

Ambarish, John and Williams (1987) constructed a signals period model with dividends, investment, and stock repurchases. However, Ambarish, John and Williams (1987) quoted the sources and uses of funds to explain the demand of stockholders for liquidity; and deducted that dividends have not been shown to be an efficient signal competitive with other technologies for transfer information to the market. But it indeed maximizes the current wealth of shareholders while the outsiders ignore other information or other information would not increase the cost, such as personal tax information. Williams (1988) developed a multi-period model with these elements and showed that in the efficient signaling equilibrium, firms typically pay dividends, choose their investment in risky assets to maximize net present value, and issue new stock. Constantinides and Grundy (1989) focused on the interaction between investment decisions and repurchases and financing decisions in a signaling equilibrium. They indict that a straight bond issue cannot act as a signal when investment fixed, but a convertible bond issue can. When investment is not fixed but chosen optimally, the conclusion would no longer true, a straight bond issue can act as s signal.

2.3 Agency theory

Agency costs arise from the conflicts between the firm’s stakeholders. This is because higher dividend payouts make it more likely that firms will have to resort to external finance more frequently, which in turn facilitates the monitoring of firms by external capital markets (Easterbook, 1984). Given the emphasis placed on dividends as a signal of future prospects by institutions, it would appear that institutions do not regard themselves as substitute signaling mechanisms (zhang, 2002). Although Miller and Modigliani (1961) assume that managers and shareholders have the same objectives, this is not true in the real world. Managers may have different objectives to shareholders, allowing them to operate in a way which is not optimal for the shareholders, and this leads to a conflict between the two parties. Managers tend to take the entire benefit at the expense of the shareholders. This explanation has been developed as part of the agency cost theory of dividend policy (Al-Malkawi, 2005).

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The payment of dividends has been suggested as a possible solution to reduce this agency problem. For example, Easterbrook (1984) explained that paying a large dividend would drive a firm to finance from capital markets in the long term. As a result, professional investors would be able to monitor the behaviors of managers, which in turn would allow shareholders to monitor managers at lower cost. Therefore, dividend payments increase management scrutiny by outsiders and hence motivate mangers to disclose new information and reduce agency costs in order to secure needed funds. Therefore, increasing dividends will cause managers to act more in line with the interest of shareholders rather than their own interest (Al-Malkawi, 2005).

Jensen (1986) makes a similar argument based on the shareholder-manage agency relationship, where managers pay dividends to reduce the firm’s discretionary free cash flow that they could use to fund sub-optimal investments and gain privates from them, but diminish shareholder’ wealth. That is, excessive cash balances give mangers more investment opportunity and flexibility, which may be harmful to shareholders. Agency explanations of corporate dividend policy are hence based on the implicit assumption that dividend payout policy can be used as a corporate governance mechanism, acting as a monitoring and/or disciplining device (George, 2004).

Equally important, the firm’s dividend policy is effective in reducing the expected agency costs may also depend on its ownership structure (which will be discussed in next section). The conflicting between controlling shareholders and other shareholders has raising in recent literatures, such as Shleifer and Vishny (1997), Horndness (2002). According to the ownership separation and control literature, government ownership is likely to control incentive problems between managers and fixed claim-holders by reducing discretion over firm’s projects (Gul, 1999). Additionally, the agency relationship between shareholders and bondholders may be reflected in the firm’s dividend policy (Jensen and Meckling, 1976; Myers, 1977). According to this view, shareholders can expropriate wealth from bondholders by means of excessive dividend payments, financed by reducing investments (investment-financed dividends) or issuing new debt (debt-financed dividends). This would in turn imply a negative relationship between dividend payouts and agency proxies for those firms that are more susceptible to this type of agency problem (Al-Malkawi, 2005). For example, shareholders of firms with greater growth options can be argued to have

2.4 Ownership structure

Walker and Petty (1978) report that private or closely held companies in Anglo- Saxon countries like USA and UK, rarely pay any dividends at all, while publicly traded companies pay out sizeable cash dividends. As regards other less developed countries, Naser et al. (2004) and Al-Malkawi (2005) report that the main corporate feature in Arab countries is that organizations are run and controlled by controlling shareholders. They highlight the feature of families as controlling shareholders who executive a degrees of management activities or at least influence on management activities. These activities are based on recommendations from influential family members, which may cause problems between the interests of minority and majority shareholders. The large shareholders may take the role of effectively monitoring the activities of the firm’s managers and insider shareholders (Redding ,1997) and they also have the power to expropriate the small outside shareholders (Gugler and Yurtoglu, 2001).

Add government owned firms on dividend policy

2.5 Taxation effect hypothesis and Clientele preference

Another explanation for the relevance of dividend payout policy is the taxation effect hypothesis, which suggests that dividends are subject to a higher tax cut than capital gains. It is further argued that dividends are taxed directly while capital gains tax is not realized until the stock is sold. Therefore investors prefer to retain profit in firms rather than distributing cash dividends because of the higher tax. The advantage of capital gain treatment may lead investors to favor a low dividend payout rather a high payout. This theory suggest that firm should keep dividend payments low if they want to maximize stock prices (e.g. Brennan, 1970; Bhattacharya, 1979; Miller and Rock, 1985; John and Williams, 1995; Baker et al., 1999).

However, one of the important studies that discussed the tax effect hypothesis is Brenan’s paper (Brennan, 1970), which show that there is a positive linear relationship between pre-tax returns of stocks and dividend yield based on the after- tax capital asset pricing model, suggesting that an increase in dividend yield should be associated with an increase in the pre-tax returns in order to compensate investors for the tax disadvantages (Al-Malkawi, 2005).

However, several studies related the dividend tax association to the Clientele effect. Miller and Modigliani (1961) coined the term the ‘dividend clientele effect’ for the tendency of certain investors to be attracted to a specific dividend paying stock. Miller and Modigliani agreed that the clientele theory does affect the firm’s dividend policy, but due to their assumption of perfect capital market, no single client can have an affect on the market, thus leaving the firm value unaffected by dividend or capital gain. In the real world, taxes (clientele effects) exist and this allows the creation of specific types of client. Therefore, each firm will look to attract their clientele, represented by the investors that favor the firm’s payout ratio. Thus, tax-included clientele preference may affect the firm’s dividend policy.

The discussion regarding clientele theory is elaborated here by stating the tax clientele effect. Due to different rate of tax among different investors in the market, the investors tend to be attracted to dividend policies that are most suitable to their tax requirements/cuts, thus giving them the most revenue. This notion is known as the tax clientele effect, as highlighted in the above paragraph. Elton and Gruber (1970) published one of the earlier studies which support empirically the idea that the dividend-tax clientele effect is a strong factor affecting investors’ decisions. Furthermore, several recent studies also came to the same conclusion, such as Long (1978), DeAngelo and Masulis (1980).

Chapter 3 Empirical Studies in Dividend Policy

3.1 Introduction

Various empirical studies on dividend policy found in the literature are discussed in this chapter with consideration to the signaling model, agency theory, ownership structures.

3.2 signaling model

Empirical test involves the signaling explanation yield mixed results, even in conflicting.

Much evidence e.g., Asquith & Mullins (1983), Kalay & Lowenstein (1986), shows that dividend changes are positively associated with stock returns in the days surrounding the dividend change announcement. Bernheim and Wantz (1995), Brooks, Charlton and Hendershott (1998), and Nissim and Ziv (2001) support the signaling hypothesis by finding an association between dividend increases and future profitability. While other studies, e.g. Watts (1973), Benartzi, Michaely, and Thaler (1997) and DeAngelo, DeAngelo and Skinner (1996), do not support the hypothesized relation between dividend changes and future earnings. Most of the empirical examined the signaling theories from varies hypotheses:

the dividend change is in the positive relationship to the earnings change; the dividend change implies the change of stock price, and they are in the same direction; the tax on the dividend constraint the behavior of a firm, and they are in different direction.

3.2.1 The relation between earnings, profit, stock price and dividend

Watts (1973) tested directly the relationship between future changes of profitability and current and past dividend policy with the sample from 1947 to 1966 for a total of 310 firms with complete information for the period and run firms by time series estimations. The average and median coefficients, although positive, are small and insignificantly different from 0 in most of his specifications. He thus argues that there must be other reasons besides signaling for the positive reaction of stock prices to dividends. DeAngelo et al. (1996) also find no evidence after examined the relationship of them. While Benartzi et al. (1997) show that earnings growth rate does not increase as dividend changes, which has been argued that it supposed be attributed to inadequate controls for expected changes in profitability (Nissim and Ziv 2000). Grullon et al.(2002) find that increase dividends experience increases in earnings during the same year, but no increase thereafter, while firms that decrease dividends experience decrease in earnings during the same year and increases thereafter. Their result was supported by Dhillon et al.(2001), who also shows that earnings increase relative to analyst forecast after dividend increases that exceed forecasted dividend increases, but unexpected future earnings are unrelated to dividend decreases. Erik Lie (2003) exam quarterly data from 1980 to 1998 as a sample and find that 661 dividend decreases and 484 dividend omissions. The results show that operating performance declines before both dividend decrease and omission announcements and increases thereafter. Other evidence from Brickley (1983) and Haely and Papelu (1988) are also support the signaling hypothesis.

Haely and Papelu (1988) find that dividends are more related to present and past changes in profitability than to future changes in profitability. So is Lintner (1956), who provided the empirical observation that dividend depends in part of the current earnings and part of the dividend of the previous year, thus challenging the dividend signaling hypothesis. Later it was confirmed by Fama and Babiak (1968). They found that the frequency of a dividend increase depended on both the number of occasions on which earnings had risen and on how recently these had risen, after studying of 392 companies in the United States between 1946 and 1964. According to Lintner(1956), firms increase dividends only when they are sure they can sustain the higher dividends, this means, the firms determine payout ratio when they have long-run target in mind (Grullon et al., 2002).

Harada and Nguyen (2005) examine the relationship between dividend adjustments, and subsequent operating performance and long-term stock returns for a large sample of Japanese firms. Compare to the previous conflict results, the condition under which the dividend adjustment take place can substantially improve the relationship between dividend changes, earnings changes, and stock returns. They generate a logic model based on five fundamental variables, the most significant of which are the level and the change of operating profits, and the level of dividend payments. Firms are expected to increase their dividends when operating profits are high and increasing, and when their dividend payments are low relative to other firms. The assumption is that expected dividend increases (decreases) are more informative than unexpected increases (decreases). In particular, unexpected dividend increases appear to derive from overly optimistic managers whose signaling behavior adds more noise than information. Removing these cases produces a more significant association between dividend changes and subsequent earnings. Risk-adjusted stock returns are also shown to be consistent with the predicted change in earnings.

Manakyan and Carroll (1990) use the Granger tests of causality and nonparametric test to exam the relationship of dividend and earning. Results are consistent with the hypothesis that dividend signals are followed by unanticipated changes in earnings in the subsequent two quarters. The necessary condition for the existence of this functions is that dividend signaled changes in performance be realized. The evidence supports the existence of a signaling value function that dividend signals are associated with unanticipated changes in short-term earnings. Results of the Wilcoxon signed-rank tests support the assertion that unexpected dividend changes precede changes in short-run earnings in a direction consistent with the signal given. The causality tests indicate that in general, earnings cause dividends, while there is evidence of a simultaneous relationship between unexpected dividends and earnings in the near tem. These conclusions are robust to different measures of dividend signals and different measures of resulting unexpected performance.

The timing of observation is a core factor in testing the relationship between stock price change, earnings, and dividend. The study of Brickley (1982) analyzes the behavior of stock prices, earnings and dividends around dividend announcements and compares the relationship between these variables for special dividends versus regular dividends. The specially designated dividends means that dividend is labeled as extra or special compare to the unlabeled dividend increases by the manager. The basic sample used consists of 165 specially designated dividend declared from 1969 through 197