The Dividend Irrelevance Hypothesis Finance Essay

The dividend policy of houses has long been recognised as an mystery for academicians since the ideal perfect capital market theory suggests that there should non be any value-adding function of dividends in relation to the market value of houses. Again, nevertheless, there is much grounds to propose that capital markets are non efficient, and that dividend payouts do matter every bit far as the value of a house is concerned.

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This survey will concentrate on the assorted surveies carried out in the sphere of dividend payout theories, such as Irrelevance Theory, Lifecycle Theory and Signalling Theory, every bit good as the empirical findings associating to these. More specifically, the survey focuses on the bank dividend payout policies of Saudi Arabian Islamic Bankss. The ground for taking the banking sector is that, although dividend policies have been studied in-depth for non-banking houses, therefore far, an unequal figure of surveies have been centred on banking houses. In add-on to this, there is besides an interesting chance to analyze Islamic banking patterns, which are significantly different from commercial Bankss. It is expected that the survey will cast visible radiation on a so far undiscovered country.

2.2 Theoretical Background

2.2.1 Dividend Irrelevance Hypothesis

Dividend irrelevancy hypothesis was foremost introduced by Miller and Modigliani ( 1958, 1961 ) , the chief statement of which is based on efficiency market hypothesis, which holds that, given no information dissymmetry between outside stockholders and the insider directors of houses, in add-on to no dealing costs, the value of the house is independent of the fiscal construction of the house ; inother words, whether the house is equity-financed or debt-financed, or whether or non the house is denoting dividends, is irrelevant ; the lone affair under consideration is whether or non the house is puting in positive NPV undertakings. Hence, harmonizing to this hypothesis, dividend wage is irrelevant to the rating of the house in the market.

Again harmonizing to the above theory, if a house does non pay dividend so the stockholder will have an sum equivalent to derive in footings of monetary value grasp, and by the same logic, if the house pays dividend, there will so be an tantamount sum of monetary value bead ( referred to as EX dividend cut ) ; hence, stockholders ‘ wealth remains changeless. Along with this, stockholders can besides fabricate alleged home-made dividends: for illustration, if some stockholders want dividends and others do non, and so they merely merchandise and fulfill their demands.

In world, nevertheless, dividend wage is viewed as being relevant since there are imperfectnesss in capital markets, such as information-asymmetry jobs ; therefore, many theoretical theoretical accounts have been presented as proposing that directors make dividend policies in order to keep the market value of the houses ( Black, 1976 ) ; Allen and Michaely, 2002 ) . Dividend signalling theories have besides proposed that houses pay dividends in order to signal the future fiscal wellness of them ; once more, this might assist investors to separate between good and bad houses, therefore assisting to work out the job of inauspicious choice.

2.2.2 Information Signalling Theory

In world, capital markets are non perfect, with the most common imperfectness recognised as the information dissymmetry job, i.e. the difference in information between the insider directors of a house and outsider stockholders. Due to this difference in information, there can be two chief types of job: inauspicious choice and moral jeopardy. Adverse choice is an antique ante job, which occurswhen the house decides to raise capital in the portion market. Importantly, if the investors do non hold adequate information to separate between bad and good houses, an mean pricing is placed on both, which might discourage the good houses to stay in the market. Moral jeopardy is an antique station job, and is related to investing determinations that are made by directors but which are non known to foreigners ; therefore, there is ever a opportunity that stockholders ‘ wealth will be mismanaged ( Hail et al. 2012 ) .

In both of these instances dividends can be used to supply a solution, such asin the instance of the Dividend Signalling Theory, which suggests that dividends be used as signalling by good houses since it can non be copied easy by bad houses since they might happen it hard to go on paying dividends in future ; hence, this might assist investors to separate between good and bad, and therefore work out the inauspicious choice job ( Tsuji 2012 ) .

Information signalling theory suggests that directors do pay out dividends as information signals. Specifically, good houses can utilize dividends as signalling future profitableness. Importantly, it is hard for bad houses to emulate good houses ‘ signalling since they will non be able to stay committed to paying dividends in the hereafter ; hence, dividend payout can assist to work out theadverse choice job ( Tsuji 2012 ) .

Dividends can besides be used to work out the moral jeopardy job since the Dividend Lifecycle Theory argues that it is ever better for full-blown houses with shriveling investing chances to pay dividends so that stockholders have assurance that their wealth is non destroyed ; in other words, this helps to extenuate bureau struggles ( Tsuji 2012 ) .

2.2.3 Free Cash Flow Hypothesis

Jensen ( 1986 ) , on the other manus, proposes a theory that is widely known as the Free Cash Flow Hypothesis.This survey was the first formal probe of the alleged bureau struggle between outside proprietor stockholders and house insiders who have a better information advantage and commanding power ( in this context, the term ‘control ‘ refers to the control over free hard currency flow generated by the concern ) , with the statement keeping that the house has to do the determination of whether or non to plow back the free hard currency flow or to otherwise administer it as dividend addition to stockholders ( Hyderabad 2013 ) .

Consequently, if steadfast directors invest in positive NPV undertakings, stockholders ‘ wealth is created ; otherwise, this might be destroyed by directors if they invest in riskier undertakings or, in some other manner, gamble with stockholders ‘ wealth. Hence, there is importance associated with dividend payout in this respect, i.e. dividend payouts might set constrains on directors, halting them from puting in bad undertakings ( Karpavicius and Yu 2012 ) . This suggestion is farther supported by the empirical grounds on the Dividend Lifecycle Theory ( De Angelo et Al. ( 2005 please cheque ) .

2.2.4 Tax Effect Hypothesis

The MM theory, as highlighted antecedently, was based on the premises of no dealing costs and no revenue enhancement. Realistically, nevertheless, revenue enhancements are charged on both capital additions and dividends ; nevertheless, in many states, dividends are charged at a higher rate than capital additions, therefore giving the inducement to rational investors to demand capital addition more so than dividends ( Carroll and Prante 2012 ) .[ 1 ]

Furthermore, the capital addition revenue enhancement is levied merely when portions are sold, whereas dividend revenue enhancements, on the other manus, are compulsory. Consequently, from this point of position, rational stockholders are better off following the first scenario ( Kenchington 2013 ) .

2.2.5 Agency Cost Theory

The modern corporate finance is centred on the chief agent struggle, which means that the principal proprietors of the houses are non the insiders. In this instance, there is ever a possibility that the insiders do non move in order to maximize stockholders ‘ wealth. Again, insider directors might utilize their superior information and control to mishandle stockholders ‘ wealth and increase their ain personal wealth, such as through the application of fillip strategies and employee stock options ( Ganguli and Chaturvedi 2012 ) .

Hence, the dividends payouts addition importance because regular dividend payouts put a restraint on directors to mishandle stockholders ‘ wealth, which is more relevant for those firmsthat are big and matured since they already have fewer investing chances. With this noted, it can be stated that such houses should pay dividends inorder to continue stockholders ‘ wealth.

2.2.6 Clientele and Substitution Effect

Modigliani and Miller ( 1963 ) claim that there can be clientele of investors related to dividends: for illustration, there may be investors whose immediate demand is a steady dividend, whereas there may be others who need capital grasp more so than dividends. However, the same writers besides suggest that investors can bring forth home-made dividends and trade with each other to fulfill their specific demands, therefore intending the impact of dividend payment overall is negligible.

Brav et Al. ( 2005 ) province that retail investors prefer hard currency dividends more so than when there are no revenue enhancement benefits. The same writer interviewed the directors and found that most of them suggested that retail investors consider dividends to be truly of import, and that penchants for dividends grow with age.

2.2.7 The Bird in the Hand Theory

Alzomaiaand Al-Khadhiri ( 2013 )

This theory criticises the MM statement, and farther holds that investors prefer dividends since, with the addition in dividend payouts, the hazard for keeping stocks lessenings. In this respect, the statement is contrasting ; since capital addition is riskier compared dividends, it is good for houses to pay dividends and continue stockholders ‘ value ( Gordon, 1963 ; Lintner,1962 ) .

2.2.8 Fiscal Lifecycle Model

It is of import to reexamine latter developments, such asthe Lifecycle Model, harmonizing to this theory owing to the fact that dividend payout forms alteration over the lifecycle of houses. For case, houses that are in the growing phase would seek to retain free hard currency flow and put, whereas matured houses may hold fewer investing chances.

De Angelo et Al. ( 2005 ) observe that, even on a cross-country footing, dividend-paying houses are mature and big ( as indicated antecedently by the Agency Cost Model/ Free Cash Flow Problem Model above ) , which is related straight to the fewer investing chance available. More in-depth, the theoretical account is based on the comparative cost benefit, like the cost is the bureau cost involved ( compatible with the Agency Cost Model described above ) , whereas the benefit is related to flotation costs/costs of external debt ( since retained net incomes are available for reinvestments ) , the cost-benefit tradeoff alterations over the lifecycle of houses, as found byFamaand French ( 2001 ) , Grullon ( 2002 ) , De-Angelo and De Angelo ( 2006 ) , amongst others.

It seems that dividend-signalling theories are non capable of explicating why full-blown houses pay more dividends since they already have less investing chances ; hence, dividends can non be used as the signal of future profitableness, and as such, the bureau struggle position seems more relevant.

The really study utilizations RE ( retained net incomes ) /TA ( book value of assets ) and RE/TE ( book value of equity ) as the placeholder variables for the lifecycle phase, and argues that this alleged ‘ retained net incomes to lend capital ‘ mix signals steadfast adulthood owing to the fact that, if the ratio is relatively low, it might signal that the house is still in the ‘capital extract ‘ phase, and may therefore necessitate more external capital to finance undertakings, whereas a relatively high value means that there is adequate cumulative net income that the house can utilize to finance undertakings, i.e. self-finance ; this is characteristic of full-blown houses. This paper convincingly drives place the point that, when controlled for factors such as house size, current and recent profitableness, growing andleverage, there is a important positive association between dividend payout determination and the ratios.

2.3 Empirical Evidence

2.3.1 Dividend Irrelevance Hypothesis Empirical Evidence

Early on empirical surveies focus on the dividend irrelevancy theorem. One of the innovators in the field is the survey by Black and Scholes ( 1974 ) , during which theauthors studied 25 portfolios uniting the high-dividend output and low-dividend output stocks, and analysed the correlativity between stock returns and dividend output. The consequences clearly showed no important difference in stock returns between the two categories ; in other words, dividend outputs are non significantly correlated to stock returns. This consequence was the same both before and after revenue enhancement. Hence, this was an empirical support to the dividend irrelevancy theorem ; in other words, the market value of a house is independent of dividend output.

Recent grounds from the UK goes against the Irrelevance Theory. Dhanani ( 2005 ) deployed a study method to research the dividend policies of UK houses across sectors. This was a more explorative survey based on elaborate questionnaire sent to directors across industries. The consequences show support for the dividend relevancy hypothesis.

During more recent times, there have besides been surveies carried out in Asiatic economic systems. For case, the work of Conroy et Al. ( 2000 ) examined the impacts of expected dividends and net incomes of the undermentioned twelvemonth on the dividend proclamations of the current period. However, this study-similar to many other event studies-showed that net incomes proclamations are more of import in footings of explicating stock monetary value behavior instead than dividends proclamations. Dividend proclamations by house directors have an undistinguished impact on stock monetary value motions.

The general consensus is that, under imperfect market conditions, the dividend Irrelevance Theory does non keep. Overall, there is ever assorted support for the Irrelevance Theory, with earlier empirical surveies demoing some support ; nevertheless, more recent surveies find small support for the same.

( Uddinand Chowdhury ( 2005 ) studied 137 companies enlisted on the Dhaka Stock exchange with the purpose of analyzing any relationship between dividend payout and stock monetary value motions. The survey showed the opposite impact on stock returns: for illustration, runing from 30 yearss before to 30 yearss after the dividend proclamations, falls in stock monetary values were witnessed, which gave rise to 20 % loss in stockholder value. Therefore, the bookmans suggested that current dividend output can reimburse the lessened value to some extent ; hence, by and large, this survey supported the Irrelevance Theory.

2.3.2 Free Cash Flow Empirical Evidence

In add-on, Brav et Al. ( 2005 ) claims that the corporate directors consider the dividends as of same importance as the investing decisions.This survey lends support to the dividend relevancy theory. Last, Foley ( 2007 ) paperss that big US houses prefer to keep big hard currency on their balance sheet to avoid revenue enhancement ; hence, the FCF theory does non keep good for big MNCs.

2.3.3Tax Empirical grounds

In the recent yesteryear, bookmans Hassettand Auerbach ( 2006 ) analysed the impact of the income revenue enhancement alleviation programme on dividend payouts. The research stated that a important impact was witnessed across the equity market as a consequence of revenue enhancement cut, where dividend-paying administrations witnessed increases in stock monetary values in add-on to dividend payment, as opposed to a diminution in capital costs. In contrast, nevertheless, non-dividend-paying administrations witnessed diminutions in their finance costs, every bit good as an investing stimulation, which is regarded as being in-line with the dividend revenue enhancement hypothesis. Consequently, it remains ill-defined whether cost of capital decrease is significantly correlated with dividend payouts.

2.3.4 Other Empirical analysis

Rahman, Amin and Siddikee ( 2012 ) studied the impact of assorted dividend proclamations on stock monetary value motions. The survey utilises a figure of different signifiers of event survey method, such as CAAR/MAAR, and consequently analyses the impact of proclamations on stock monetary value motions and finds undistinguished consequences. Significant negative stock returns are found prior to the proclamation of stock dividends ; this might propose the bad nature of investors. Again during the station proclamation period, positive additions are seen since rational investors realise the possibilities of unnatural additions ; nevertheless, every bit far as the hard currency dividend impact is concerned, there is no important consequence for companies listed under Dhaka Stock Exchange for 60 yearss following the proclamation. AAR shows no important unnatural returns for hard currency dividends ; nevertheless, for the stock dividend proclamation, there are important returns in the scope of 6 % .

Zakaria, Muhammad and Zulkifli ( 2012 )

Suleman et Al. ( 2011 ) analysed the correlativity between monetary value volatility and dividend proclamation in Pakistan, with the method adopted similar to surveies mentionedearlier. The information was extracted from the Karachi Stock Exchange for the period 2005-2009. The technique utilised was multiple arrested development method, which showed a clear and positive important relationship between dividend proclamations and stock monetary value volatility ; nevertheless, a negative important correlativity between growing and dividend proclamations was besides apparent.

Hussainey et Al. ( 2011 ) performed similar arrested development analysis for analyzing the correlativity betweenstock monetary value volatility and dividends for 123 UK houses over a big period of clip. Their work was based on that of Baskin ( 1989 ) . Similar to Baskin ( 1989 ) , the theoretical account was modified by adding firm-level and country-level control variables.

Consistent with Allen and Rachim ( 1996 ) , Australia consequences ( Hussainey et al. , 2011 ) showed a important negative correlativity between stock monetary value volatility and payout ratio. In add-on, a important negative correlativity was besides identified between monetary value volatility and dividend output. Overall, the payout ratio turned out to be the most of import driver of stock monetary value volatility, with the debt degrees and house size recognised as the most of import of variables amongst control variables.

2.4 Brief History of Islamic Banking

This subdivision will look into the history of Islamic banking, and will foreground the differences between commercial banking and Islamic banking. One of the dramatic differences is that Islamic banking is an involvement rate-free banking system. The suggestion was made to invent and implement an interest-free banking model centred on the cardinal Islamic rules of profit-sharing, referred to as Musharakah, and cost-plus ( Murabaha ) ( Gafoor, 1995 ) .

The rise of Islamic banking began during the 1970s when the several economic systems became more mature. As a consequence, several research surveies were published, including those by Al-Araby ( 1967 ) , Siddiqi ( 1961, 1969 ) , al-Najjar ( 1972 ) and Al-Sadr ( 1974 ) .In add-on, a important grade of attending was directed towards the field of Islamic Finance in media, with a figure of of import academic conferences held in London. As such, involvement grew-not merely in Islamic states but besides in developed states ( Gafoor, 1995 ) .

As a effect of the above activities, a figure of big Islamic Bankss were established during the 1970s, with noteworthy growthat a rate about of 10 % perineum recognised by such houses, with their operations rapidly expanded across boundary lines ( Hassoune, 2004 ) . As a direct consequence of such wide-reaching development, the enlargement of the industry spanned the universe, with the full banking systems of a figure of different states, such as those of Iran and Sudan, changed wholly in order to guarantee attachment to the criterions of the Shariah.The growing of Islamic finance has been driven by increasing demand by Muslim populations for Islamic fiscal merchandises to be made available across the Earth.

It would be an interesting survey to analyze the dividend payout policies of Islamic Bankss, every bit good as how such policies impact stockholders ‘ wealth.

2.5 Decision

Throughout this study, the cardinal empirical researches and polar theories centred on dividend policy have been introduced and explained. Notably, dividend policy-related theories are described below:

Classical Dividend Irrelevance Hypothesis argues that, in the presence of ideal capital market conditions, a house ‘s dividend policies do non impact the market value of the same. Again, shareholders can make alleged homemade dividends and trade with each other.

The statement is based on the Agency Conflict Theory, which suggests that, although insider directors should move in order to maximize stockholders ‘ wealth, since insider directors have more information advantage, they are in a place to chance with shareholders’money ; therefore, paying out dividends might be one manner of curtailing the bad behavior of directors.

Tax Effect Hypothesis argues that, since dividend additions are taxed at a higher rate than capital grasp, it is much more rational for stockholders to prefer the 2nd option. However, as has been established, this simple hypothesis is non really good supported by empirical grounds.


When reexamining the empirical and theoretical parts in the literature, a figure of spreads were seen, as discussed below:

Since most surveies are focused on developed markets, emerging economic systems are non explored ; hence, there is immense potency to study the dividend policy impacts on stockholders ‘ wealth in these countries.

Most researches are focused on non-financial and non-regulated houses ( Partington, 1985 ) .There are really few surveies centred on regulated industry/banks ; these surveies show that dividend payouts by Bankss are different ( Dickens et al. , 2002 ) .Again, more recent surveies ( Onali, 2009 ) suggest that dividend payouts by Bankss might besides impact the hazard of single Bankss ; this seems to be an wholly new country of research.

Another motive for this work is that there is no of import survey carried out on the dividend policy of Islamic Bankss. Hence, this survey might cast some visible radiation in this country and consequently animate farther surveies. Although Muslim Bankss are besides regulated, regulative regulations are significantly different from commercial Bankss, intending this opens up another chance to analyze the impact of dividends under a different regulative environment wholly.

Hence, overall, it is expected that this survey will assist concentrate to be placed on a therefore far undiscovered country, although this would be disputing since there is minimum literature and surveies available on the dividend policies of Muslim Bankss. The economic system chosen is Saudi Arabia since it is recognised as being a aggressive economic system, whichhas besides accepted fiscal liberalization ; hence, there is much competition in the banking sector,


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