Theories of Dividend Policy and performance of FTSE

Keywords: Important of Dividend Policy, Miller model (irrelevance), Signalling theory, Clientele theory, Bird-in-hand theory, Agency Theory, Finance Assignment Writing Services


The financial crisis of 2007 had the dramatic impact on the financial and capital markets and later these financial troubles affect the companies. This financial crisis has the significant impact on the financial management of the companies during and after the crisis. Companies took range of measure to tackle the problem and changes in dividend payout policy were one the key response (Brigham & Ehrhardt, 2016).

Hoberg & Prabhala (2015) analysed that dividend policy decision plays an important role in the internal financial management of the company along with investment and financing decision. Therefore, this paper examines the effect of financial crisis on the dividend payout policies of companies during and after the financial crisis. The company’s behaviour will be examined in the light of different dividend theories to study how companies have responded to these financial crises (Hauser, 2013).

Importance of Dividend Policy

According to Huda & Farah (2015), dividend policy is an important source of information to investors and capital markets about the performance of firm. In addition, the dividend payout policy directly impacts the share price of the companies. However, during the financial crisis firms changes on dividends policy compare to traditional approach to use dividend to reflect company performance.

Saleh (2014) stated that financial crisis was a situation which causes disturbance to financial markets and there is lack of funds for those who have potential investment opportunities. The range of factors associated with financial crisis is increased uncertainty in market, decline in the stock markets, liquidity problems, decreasing sales as well as banking system problem. Campello (2015) explained that during difficult financial times it is complicated for firm to payout dividend as well as hold cash to manage the liquidity issues.

Dividend Theories

There are number of theories developed on the dividend policy and specify the theories discussed in this paper to examine the financial crisis impact on dividend policy are Modigliani and Miller model (irrelevance), signalling theory, clientele theory, bird-in-hand theory as well as agency theory. Moreover, determinants of dividend will discuss to highlight the interaction of dividend theories and company dividend policy.

Irrelevance Theory – Modigliani & Miller

Modigliani & Miller (1961) stated with assumption that there is no market imperfections and i.e. rational investors, as well as perfect market conditions makes dividend policy irreverent. Therefore, the selection of dividend policy does not matter as it does not create or destroy value of firm as well as no effect for shareholders in terms of total return. Furthermore, they concluded that when firm pays addition dividend, the value of share decrease with the same amount.

For the perfect markets, the range of conditions selected which are; 1) no transaction cost, no taxes, information is equally available to everyone as well as there is no conflict of interest between shareholders and manager of the company (Frankfurter, Wood, & Wansley, 2016).

Bird-in-Hand and Signalling Theory

According to bird-in-hand theory, investor prefers to receive dividend rather than retained earnings because of uncertainty in the future cash flows of the companies. In addition, companies who pay higher dividends usually manage to reduce the rate of return required by investor and this helps to increase the value of the company. Furthermore, according to signalling theory, dividend payout does not have direct effect on the share price of the company (Frankfurter, Wood, & Wansley, 2015).

Investor reacts to change in the dividend policy because of the perceived perception of the future performance of company. Therefore, it is less likely managers will send out negative signals to investor. That is why when the firm has positive earning and management is likely to spread the news to increase the share price and in case of poor performance management is unlikely to spread information (Graham, Smart, & Megginson, 2016).

Agency Theory and Clientele Effect

Agency theory describes that there is a conflict between an agent (managers) and principal (shareholders). The conflict between both parties exists because of difference in interest and flow of information. Therefore, the dividend could be seen as source of inside information. The selection of dividend policies is viewed as a communication mechanism between manager and shareholders about the future and growth of the company. Mueller (2014) the dividend payout is effective way to reduce the cash available for the company which cannot be reinvested in the best of the shareholders.

Florackisa, Kanasb, & Kostakisc (2015) state different clienteles favour various payout policies for dividend. One of the key considerations for the clientele is tax complications. A shareholder with low taxation bracket might prefer a higher rate of dividend whereas; shareholders with higher tax rate prefer no dividend but rather take benefit from capital gains.  Therefore, according to this theory, dividends are directly related tax situation of the individual as well as transaction cost associated with the dividend (Baker & Wurgle, 2014).

Determinants of Dividend

According to Denis (2014), number of factors such as liquidity or cash flow of the company, profitability, revenues as well as transaction cost are principle determinants of the dividends paid by the company. Moreover, company structure and ownership and investment opportunities play an important role in dividend payout. In 2007, when financial crisis started, the normal linkage between shareholder return and dividend policy changed. The factors such as increased financing cost, lack of credit availability, revenues reduction as well as decrease in cash flows forced companies to revise their dividend payout decision (Jesson, Matheson, & Lacey, 2017).

Company Dividend Trend 2007-2009

The dividend policy of UK companies (FTSE) changed in 2007 after the financial crisis hit the financial markets. The changes in market condition forced companies to increase the dividend. If we examine the trend in the light of Modigliani and Miller (M&M), this trend does not represent the situation of the perfect market and rational investor. In order to cope with the financial crisis, we can see that the dividend yield on the shares of companies has increased significantly. Therefore, it is evident that financial markets in the real world in the real world unable to fulfil the condition of perfect markets presented by M&M.

Lintner (1956) stated that when there is no perfect market exists, the relevance of dividend policy does exist. Furthermore, Gordon (1959) argued that company cost of capital increase when the dividend decrease. That is why, investor are not confident whether they will receive any dividend in future. The increase in dividend payout is possible an attempt of the company to decrease the cost of capital. In addition, Linter and Gordon suggest that investor prefer dividend and company should pay stable dividend.

Moreover, in the light of Bird-in-hand theory, investor prefers to receive dividend rather than retained earnings because of uncertainty in the future cash flows of the companies. In the time of financial crisis companies had increased the dividend payout. The Bird-in-hand theory is relevant. Based on the dividend determinant companies were surround by uncertain of low revenues and profitability. This theory suggestion is applicable in time financial crises and companies prefer to payout rather holding the cash. M&M assumption against this model that investors are indifferent between dividend and capital does not hold validate (Papadopoulos & Charalambidis, 2016).

Al-Malkawi, Twairesh, & Harery (2013) stated that investor prefer the dividend rate which is superior especially during the time of uncertainty.  Otherwise, investors may sell the company assuming that company future is uncertain and there is probability of dividends. That is why, companies who pay higher dividends usually manage to reduce the rate of return required by investor and this helps to increase the value of the company. The dividend reduces the uncertainty as well as high payout ratio reduces the cost of capital (Michaely & Roberts, 2015).

When examine the dramatic increase in the dividend payout of the companies between 2007-2009 we can see that management is trying to send strong signals to the shareholders in terms of sustainability and future growth.  Therefore, it concludes that dividend policy have important implication for the company as it helps the investor to provide an idea on company performance. Despite the fact, signalling through dividend is costly practice but it is evident that during financial crisis management ignore the transaction cost (Jesson, Matheson, & Lacey, 2016).

Dividends are an important source of information for the investor as it conveys inside information for the investors. For example, change in company life cycle and firm enter the phase of restricted growth or lack of investment opportunities. It is evident that signalling effect was used by the managers to convey information to investors irrelevant of any other consideration. Therefore, companies payout the dividend rather holding to retain the confidence of shareholder during the difficult trading (Baker, 2014).

Moreover, investigation conducted by Moyer, McGuigan, Rao, & Kretlow (2015), during financial crisis and finds out that dividend policy is linked to economic scenario rather than linked to revenues of the company. Therefore, dividend works as signal for the management during the difficult financial times.

The study conducted by Smits 2012, to study the financial crisis impact on dividend payout found out that dividend during the period was increased for the large firms. In addition, it suggests that investors react to negative information in terms of decreased dividend. The signalling through is closely linked to agency theory. The conflict of interest does exist between the management and shareholder and situation get worse in the time of financial and economic difficulties (Hussainey, Mgbame, & Chijoke‐Mgbame, 2017).

When company have declining revenues, limited investment opportunities as well as lack of credit availability, signalling could play an important role. In such scenario, possible increase in dividend for the investors could ensure investor that company is profitable. (Dividends cannot be paid from retail earning). Once economic conditions improve, companies can return to avail future investment opportunities.  Therefore, agency problem can resolve through signalling effect. Nevertheless, as stated by Mueller (2013) the dividend payout is effective way to reduce the cash available for the company which cannot be reinvested in the best of the shareholders (Florackisa, Kanasb, & Kostakisc, 2013).

Jesson, Matheson, & Lacey (2015) analysed the increasing yield represents that management did not pay attention to taxation to the transaction associated with the dividend. Companies pay the dividend irrespective of preference on the individual. Therefore, investor attracts to companies with favour dividend policy based on the taxation preference. However, the chart below shows that during the period of increase payout during the period of 2007-2009, there is an evident decrease in the index.

This trend shows investor traded shares in terms of their preference. Nevertheless, this trend does not hold valid the bird-in-hand theory which suggests that increase dividend increase the value of the company. Therefore, the trend shows those investors are irrelevant to buy companies equities with increased dividend (Hauser, 2013).

Moreover, companies ignored other factors such as profitability or liquidity. The dividend trend during the financial crisis suggests that management was more concern about sending the strong signal to markets through paying high payout. The dividend policy adjusted based on the need of communication and companies rely on bird-in-hand theory and signalling effect (Campello, 2015).

dividend theory and performance of FTSE

Dividend Policies after Financial Crisis 2009- Present

The financial crisis last in the UK until Q2 of 2009 before it started to recover. It is evident that company payout ratio was declined at the end of 2009 which marks the end of the recession. Moreover, it is evident the payout ratio for medium size companies are much higher compare to large companies. The difference in payout during the financial crisis and after the financial has resulted in dramatic difference. During the financial crisis, large companies return was much lower compared to a large corporation (Hauser, 2014).

Baker & Wurgle (2015) added that after the crisis the payout ratio of the medium size corporation is much higher. The determinants of dividends such as profitability and investment opportunities are the fundamental difference here. The M&M model for a perfect market condition does not exist, however, it can be seen that the dividend is relevant policy is relevant. The small corporations are likely to have fewer investment opportunities when with large firms. Therefore, these corporations reinvesting the profits to keep the capital cost minimum as highlighted by Linter theory (Jesson, Matheson, & Lacey, 2014)

The signalling effect is important to convey information to the investor in terms of future growth and profitability of the company. Therefore, changes in dividend results in reduction stock prices as this is perceived as a negative signal by the market. This can examine through at beginning of 2009. When firms reduced their payout it resulted in a decrease in the value of the index. The inside information is delivered to the shareholders in terms of a dividend. The availability of information based on semi-strong market efficiency suggests that the customer does react to dividend and changes into policy send a strong signal to the market (Booth & Johnston, 2016).

The chart suggests that management have deployed a dividend policy which is constant and have increasing value. The studies of various researchers have evident that signalling has positive relationship with company dividend and share price. When company decrease the dividend, the value of company shares decreases whereas, with increase in dividend value of share increase. Therefore, company use the signalling effect to communicate dividend polices which helps to maintain positive relationship with shareholders (Mcinish, 2017).

Mueller (2013) suggested that the agency theory helps to resolve the agency problem. The conflict of interest between the management and shareholder is resolved through signalling effect. Companies who hold constant and increasing dividend have better level of trust compare to firms which do not pay dividends. One thing is evident the size and structure of the company play an important role to devise an effective dividend policy. The large corporation prefers to make an announcement to highlight the development and research opportunities for growth and profitability.

On the other smaller firm does not have as many opportunities compare to large firms. The index shows that the large corporation does not pay many dividends. Therefore, signalling theory is fundamental in order to resolve the agency problem (Morris, 2016)

In the light of bird-in-hand theory, investor prefers to receive dividend rather than retained earnings because of uncertainty in the future cash flows. Nevertheless, despite the economic stability, company return is increasing trend of payout ratio. Therefore, dividend policy is relevant to share price stability. The total yield represents a continuous trend for the medium size even after the financial crisis (Florackisa, Kanasb, & Kostakisc, 2016).

Therefore, management believe that paying out constant dividend is action of the management to reduce the rate of return required by investor and this helps to increase the value of the company. Therefore, bird-in-hand theory helps the management devise a dividend framework to minimise the cost of capital (Baker & Wurgle, 2014).

The chart shows that the firm total returns are much higher as management believe that it will increase the value of company. The limitation attached to bird-in-hand model is that it considers company is totally structure based on the equity and its fails to consider the debt portion of cost of equity. At last, not least, it ignores the marginal utility concept that after sometime the return on investment becomes constant (Moyer, McGuigan, Rao, & Kretlow, 2014).

Clientele effect suggests that investor prefer dividend based on their tax preferences. There two major implications involve which are transaction cost and taxation. Some investor prefers the dividend while other prefer to capital gains. The return shows that large companies usually don’t pay dividend when compare to medium size companies. Therefore, investor with immediate return possibly invests in small firms. On the other hands investors need capital gains, invest in large firm (Michaely & Roberts, 2013).

Payout ratio is important factor for the company to attract a particular class of investors. When company devise a policy it should consider the class of investor needs to attracted. The post financial crisis scenario firms have continued a practice of increasing dividend especially the smaller firms. Therefore, it financial crisis have no direct impact and company prefer a policy of constant payout (Papadopoulos & Charalambidis, 2014).


Dividend policy has major implication on the firm long-term investment and financing decision. There are ranges of dividend theories available which address the different issues in order to determine the effective dividend policy. The determinants of dividend are profitability, cash flow and liquidity of the firm. However, the financial crisis of 2007 present challenging condition for financial markets which consequently affected the companies. When financial crisis hit the financial market and subsequently to companies, in return companies unexpected firm increase the rate of payout to all time high.

The signalling affect is largely used by the companies to send positive message to the investors. The dividend payout of these companies were high irrelevant of the dividend determinant at the start of financial crisis. Despite the economic and financial constraints on the companies share yield remains high and company followed the approach of dividend relevance models.

The companies prefer to purse a constant and increasing dividend payout irrespective of the financial crisis. The most effective theory deployed by the companies is signalling to communicate the performance and future perspective of company. The major significant is size of frim as medium size firm have high payout ratio compare to companies listed on FSTE 100.

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