Dividend Policy Literature Review

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2. Literature Review 2.1 Theoretical Review Given that there are many contentious issues surrounding dividend policy, many researches were conducted in an attempt to unravel the dividend puzzle. The earliest study on dividend policy was performed by Lintner (1956) who conducted his research on American companies. He concluded that dividend decision is largely based upon the current profitability and the previous year’s dividends. This is due to the assumption that investors prefer a certain rate of dividend. Fama and Babiak (1968) tested the Lintner’s model on the dividend data of 392 major firms in the USA for the years 1946-1964. The results showed that Lintner’s model has succeeded well in explaining the dividend trends of individual firms.…show more content…
Central to the theory is the conflict of interest between the managers and shareholders which cause a company to incur agency cost, such as the cost of monitoring to prevent misappropriate behaviours of management. Dividend policy is a mechanism for mitigating agency costs related to factors such as free cash flows, firm size and risk that arise from such principal-agent problem (Jensen, 1986). In other words, these factors could have a potential impact on dividend policy. It is claimed that substantial cash flow may lead to the occurrence of agency problem as managers may be tempted to pursue their private benefits (Rozeff, 1982). Dividend is a way to eliminate excess cash flows from managerial control, particularly in companies with limited investment options. It reduces agency cost problem by lowering the risk perception of the investors about the likelihood of the managers to act against their best interest (Easterbrook,…show more content…
Liquidity refers to the company’s ability to convert assets into cash instantaneously to meet its debt or other obligations and a poor liquidity position will pose a threat to solvency of the company (Weiner, 2006). Generally, payment of cash dividends implies cash outflows. Since profits held as retained earnings will usually be invested in the business operation, retained earnings from previous years are mostly not held in cash form. Kent (1960) thus in his study observed that a company with a good record of sufficient earnings to declare dividends may be less capable to pay dividends due to poor liquidity position. It is claimed that a strong liquidity position will strengthen a company’s ability to pay dividends. This is supported by Watson and Head (2007) who dispelled the notion that profitable firms can afford high dividends. They argued that profits and cash are not equivalent and hence in spite of high profits, a company before paying dividends must consider also its liquidity or its ability to

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