The following report has been produced to critically explore existing literature concerned with dividend and investment policies. It investigates the factors, both internal and external, that may act as motivators when private listed companies are in the decision making process of how best to distribute retained earnings. Benefits have been deduced for the two differing distribution policies, whilst critiquing the supporting literature to create a balanced and reliable view of both strategies. There is research indicating dividend policies can be a useful indicator for accounting fraud, although this is has been disputed by some. External factors such as tax and exchange rates have been found to have an effect on dividend policies, though there is contrasting evidence as to the permanence of the effect. The role of the shareholders has also been investigated, finding that shareholders will often be attracted to companies directly because of their policies and may possibly pull their investment should the policy change. Different theories have been applied and critiqued in this section of the report.

1. 1
BALANCING THE DISTRIBUTION OF INCOME:
FACTORS AFFECTING DECISION MAKING WITH
REGARDS TO DIVIDEND POLICIES
Module: Accounting in Context
Course: Accounting & Finance
Date: February 4th 2015
Student Name: David Kyson
Student Number: 12015699
Word Count: 4,244

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BALANCING THE DISTRIBUTION OF INCOME:
FACTORS AFFECTING DECISION MAKING WITH REGARDS TO
DIVIDEND POLICIES
EXECUTIVE SUMMARY
The following report has been produced to critically explore existing literature
concerned with dividend and investment policies. It investigates the factors, both
internal and external, that may act as motivators when private listed companies are
in the decision making process of how best to distribute retained earnings.
Benefits have been deduced for the two differing distribution policies, whilst critiquing
the supporting literature to create a balanced and reliable view of both strategies.
There is research indicating dividend policies can be a useful indicator for accounting
fraud, although this is has been disputed by some. External factors such as tax and
exchange rates have been found to have an effect on dividend policies, though there
is contrasting evidence as to the permanence of the effect.
The role of the shareholders has also been investigated, finding that shareholders
will often be attracted to companies directly because of their policies and may
possibly pull their investment should the policy change. Different theories have been
applied and critiqued in this section of the report.
Research indicates that the decision on how best to distribute retained earnings is
dependent on a number of variables and is not simply a case of whether to issue
dividends or not. It explores different reasons for issuing dividends, as well as the
applications/implications of a dividends issue.

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CONTENTS
Executive Summary ..............................................................................................................................................................2
Introduction ..............................................................................................................................................................................4
Dividends Issue ......................................................................................................................................................................4
Valuation...............................................................................................................................................................................4
Signalling..............................................................................................................................................................................5
Fraud......................................................................................................................................................................................5
Reducing risk ......................................................................................................................................................................6
Re-Investment/Retention ....................................................................................................................................................6
Share Repurchases ..........................................................................................................................................................7
Growth...................................................................................................................................................................................8
Shareholder Attitudes.......................................................................................................................................................9
External factors....................................................................................................................................................................10
Influence of Tax...............................................................................................................................................................10
Net Worth Covenant ......................................................................................................................................................11
Exchange Rate Changes.............................................................................................................................................12
Relevance and Reliability.................................................................................................................................................12
Conclusion.............................................................................................................................................................................13
References............................................................................................................................................................................15

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INTRODUCTION
The United Kingdom has a huge dividend market, accounting for 31% of global
dividend income, which has seen growth of 60% in the five years from 2009.
However, not all firms issue regular dividends, some never at all. With global
dividend income growth rising to by 11% to $1.167 trillion (BBC News, 2015), this
report will seek to investigate both the drawbacks and advantages of issuing
dividends, and any other factors affecting this decision.
The recent economy has seen some major publicly listed companies go into
liquidation, so sustainable growth is almost a necessity in the current market. Re-
investment into the business versus dividends issues will be investigated throughout
this report, summarising the key motivators and effects of both.
This report will investigate the factors affecting dividend policies, ranging from
external contributing factors, to growth strategies and shareholder views. It will
determine the cause and effect of some common applications dividend policies and
how these are influenced by shareholders.
Many theories exist on dividend policies of companies and this report will seek to
summarise the more prominent theories and analyse their importance and effect on
the decision making process firm’s face when deciding policies.
Reliability of sources will analysed throughout this report, using contrasting views to
create a balanced and fair argument, using reliable sources. There will also be a
short section at the end summarising the relevance and reliability of the report as a
whole.
DIVIDENDS ISSUE
An issue of dividends is essentially a company’s way of distributing profits among its
investors. The following sections will assess the applications and benefits of being a
dividend issuing firm.
With dividend income ever increasing, it is important to note that DeAngelo and
Skinner (2004) found that total dividends issued are heavily concentrated amongst
the largest, most profitable firms. Clearly, profitability, size and performance are key
characteristics in firms that pay dividends, not only in the United States, but
internationally (Denis and Osobov 2008). So why are these firms more inclined to
pay dividends than others?
VALUATION
Before a lot of individuals or corporate bodies choose to invest, they will often
calculate the value of the firm to assess how much their investment should be. One
method for company valuation is the Dividend Valuation Model (DVM). The higher

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the rate of dividends a firm issues, that great their valuation will be when calculated
by the DVM, increasing the likelihood of investment from. The model works on the
basis that the value of a share can be estimated as the present value of future
payments, discounted back to shareholder returns.
Drake (2010) states that the DVM is useful when a company pays a constant and
estimable dividend, which often is not the case for many companies. So if a
company does not pay a dividend at all, then the DVM cannot be used to calculate
its value, likewise, if they only rarely issue dividends or issue smaller dividends then
their value will be negatively impacted and obscure.
However, Damodaran (2006) argues that the DVM can indeed be useful even when
firms do not pay dividends, stating that a firm can still be valued based upon the
expectation that it will eventually pay a dividend when the growth rate declines.
Although Damodaran themselves note that these will still be undervalued using this
model.
Finance Practitioner (2013) also notes that the DVM is open to deliberate
manipulation via issuing dividends with the intention of increasing the valuation,
compromising the usefulness of DVM over the long term.
United Utilities is a prime example of how dividend policy can impact company
valuation. Their situation in 2009 meant that United Utilities had to decrease
dividends and increase capital investment (The Guardian, 2010) with an anticipated
20-25% decrease in dividends to fund this investment. Share price in United Utilities
dramatically decreased upon this announcement, showing a direct correlation
between dividend policy and share price valuation.
SIGNALLING
A dividends issue acts as a signalling tool to the market of success; generally
dividends will reflect performance of a company. So an increased dividends issue
will increase shareholders confidence that they have invested their money wisely
and the company is doing well.
However, it may also signal that the firm has reached the height of its success is
unable to grow any further, and so they are not re-investing for growth but
distributing wealth among shareholders. A firm that is unable to sustain growth
usually will not have long left on the market, so shareholders may seek to invest
elsewhere, seeing a plummet in share prices and thus company valuation.
FRAUD
Issuing dividends requires firms to report accounts more accurately and so it has
been suggested that firms are less likely to issue dividends at a consistent rate if
they are involved in fraudulent activities. DeFond (2010) therefore calls for increased
research into this, with policy experts calling for an increase in dividends on the idea

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that dividends force managers to report earnings more honestly, with the intention of
decreasing fraudulent activities.
However, putting out the assumption that simply because a firm doesn’t pay
dividends means they’re fraudulent is almost slanderous. Reading through the
report, it is clear there’s a correlation between fraudulent companies and not paying
dividends, but not necessarily vice versa, as there are many reasons a firm may
choose not to issue a dividend.
This is further supported by Caskey and Hanlon (2005) who found that 43% of
fraudulent firms will actually increase their dividends payments over the years,
paying out in excess of $10.5 billion in dividends whilst involved in creative
accounting. This contradicts DeFond (2010) by demonstrating that dividend
payments and changes are not a wholly reliable indicator of fraud.
REDUCING RISK
Often companies will have either an emphasis on dividends issue, or reinvestment,
by being a company focussed on dividends there will be no investment risk
associated with investment projects. This puts the company in a better position going
forward as they have more capital and often a failed project will have more than just
monetary drawbacks, but can also affect a company’s image and likelihood of future
partnerships/investment.
Lee (2010) also stipulated that if after a dividends issue, a portion of the distributed
equity is replaced by debt, shareholders would benefit due to the transfer of risk from
equity holders to existing bondholders. However, this view is highly sceptical as
many companies will not simply take out loans to mitigate the risks of their
shareholders.
RE-INVESTMENT/RETENTION
The decision to reinvest retained earnings rather than distributing them is mainly
influenced by a firm’s growth and sustainability plans. Reinvestment of retained
earnings will facilitate growth and expansion of the company, consequently
increasing the value of shares and encouraging capital growth.
There are many theories and reasons that may explain why a firm decides to retain
or re-invest their earnings, rather than distributing them among shareholders, some
of which we will investigate below.
As with everything in the economy, businesses go through cycles, with performance
and profitability seeing ups and downs over a certain time cycle. Sometimes the
economic downturns are worse than other, and it’s these times where the decision to
retain earnings may save the business.

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SHARE REPURCHASES
A share repurchase or ‘buy-back’ is when a company either offers tender to current
shareholders in exchange for their shares at a specific price and volume, or
purchase shares in themselves directly through the stock market. Usually when a
share repurchase is announced, share prices will dramatically increase as it is often
interpreted as a signal from the company that their current performance is
underrated by the stock market.
Share repurchases are not as common as dividends issues, with Skinner & Solte
(2009) commenting that they represent less of a commitment than dividends. This
isn’t unusual considering that share buy-backs are often huge announcements that
dramatically increase valuations, as the company believe they are worth more than
they’re currently being traded for – if they did this all the time, then the market would
become less responsive to these repurchase announcements, making them
pointless.
Such as the intentions of dividends are to distribute wealth among shareholders, you
could also say that share repurchases do the same via share price appreciation.
Comment and Jarrell (1991) found that on the day of a buy-back announcement,
return is positively correlated with the percent of outstanding shares repurchased.
This demonstrates how shareholders interpret buy-back announcements and the
positivity associated with them, hence the high percentage of repurchases made.
In terms of the firm’s motives for the repurchase, many firms often feel that the
market has ‘undervalued’ their shares, and so this is their way of telling the market
that they believe they are worth more. However, it could also be a long-term strategy
to increase the returns of the company. Ikenberry et al. (1995) found that firms
stating undervaluation as the reason for repurchases had abnormal returns of 45% in
the four years following the announcement. Whether these abnormally positive
returns are the cause of effect of the re-purchase announcement is unclear, although
it is highly possible that a firm will publicly announce they feel they are undervalued
in an effort to stimulate the market to increase their valuation.
Another possible reason for share repurchases is to improve their financial
performance ratios, which many potential investors and lenders will assess before
they take any action. When a firm repurchases its stocks, they are often then written
off in the Statement of Financial Position, reducing the number of shares in issue, as
well as decreasing the Cash assets by the cost of the repurchase.
By reducing assets, the Return on Assets (ROA) is improved, which will be
perceived as an increase in efficiency of management to utilise their assets to
generate returns. Likewise, the Return on Equity (ROE) ratio increases due to the fall
in ‘outstanding equity’, which measures the profit generated with shareholders’
funds. Both of these ratios will be appealing to potential investors, as ROE will tell

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new investors that their funds will be used effectively to generate profits, rather than
sitting idle. Also, an increase in ROA emphasises a firm’s efficiency of using assets
to generate income, which would appeal to potential lenders as they know the firm is
likely to use funds effectively to generate returns.
Share Buy-Back announcements are also commonly accepted under the signalling
theory, constituting a ‘revelation by management of favourable new information
about the value of the firms future prospects’ (Kahle, 2001). Suggesting that
shareholders and the general market will view an announcement as greatly
encouraging, signalling a financially secure future for the firm, thus encouraging
share prices to appreciate.
GROWTH
Many start-up businesses will re-invest their retained earnings to meet their pre-
determined growth forecast over a set amount of years. If they didn’t invest in growth
then they would not reach their desired capacities in order to meet and exceed
competition. This is especially prevalent in technology companies, requiring large
amounts of capital for research and development.
Modigliani & Miller (1961) suggested that the ‘optimal use of funds’ was to invest in
all projects with a positive net present value (NPV). By retaining earnings instead of
issue dividends, a firm will be able to invest in many more potentially profitable
projects.
Denis and Osobov (2008) also found that although large profitable firms will often
make up the majority of dividend payments in a particular country, they found there
were ‘disappearing dividends’ where dividends would sharply increase, then
suddenly ‘disappear’. They were able to narrow this down to newly listed firms who
aim to issue dividends rather than invest in sustainable growth, this initial surge is
almost like a teething phase where the new firms issue a dividends because all the
large companies are doing it, but quickly realise if they want to stay in the game they
are going to need to start reinvesting back into the business to grow – then they can
issue dividends.
Whilst it is agreed that retaining earnings incurs no additional costs to the company,
an issue of dividends will negatively impact the capital budget due to flotation costs
and other expenses (Lee, 2010) thus there are more available funds for investment
in growth.

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SHAREHOLDER ATTITUDES
If a firm continuously retained earnings to reinvest in the future and never issue
dividends, what kind of effect would this have on their shareholders?
The Bird in Hand theory suggests that shareholders want returns right now,
increasing the pressure on firms to issue dividends in order to keep their
shareholders from investing elsewhere. Baker, Powell and Veit (2002) explain the
Bird-in-the-Hand theory by asserting that paying increased dividends will increase a
firm’s value, because dividends are a “sure thing”, which is what attracts
shareholders to dividend paying firms.
Although, in their report they also state that ‘no empirical’ evidence exists in support
of the Bird-in-the-Hand theory – making the theory exactly that, a theory, with no
empirical support or findings to back it up. The theory loses even more credibility as
Bhattacharya (1979) finds that a dividends issue does not increase a firm’s value by
signalling lesser risk, as risk is more accurately determined by the riskiness of future
project cash flows. Thus the theory’s application as a valuation tool becomes
obsolete, as dividend pay-outs are not an accurate determinant of risk, which is the
basis of the theory and its valuation approach.
Though, Hussainey (2011) has said that despite the disadvantages noted in the Bird-
in-Hand theory, managers will still go ahead to issue dividends as a method of
sending a positive signal to shareholders regarding the firms future prospects, also
supported by Lintner (1962) and Walter (1963).
Conversely, the Clientele Effect proposes that shareholders will initially invest in a
company due to its dividend policy, so their loyalty will remain as long as the policy is
maintained. Al-Malkawi (2007) grouped the clientele effect in two; those that
favoured share price appreciation due to their high tax bracket, versus those that
favoured regular dividend payments as they cannot afford the transaction costs
involved with selling shares. Simplified, this categorisation puts high earning, high
tax bracket investors in one group, and smaller investors who depend on dividend
payments for their needs and so are adverse to the high transaction costs.
However, Modigliani & Miller (1961) maintained the premise that dividend policy is
irrelevant even in this case, as they argued one clientele is as good as another, so if
there is a change in policy, any loss of shareholders will be mitigated by new
investors who are attracted to the new policy.
Whilst both are possible theories, Al-Malkawi was able to clearly distinguish two
preferences among shareholders. Combining this with Modigliani & Miller, it could be
assumed that although in the long-term dividend policy is irrelevant, in the short-term
there will be fluctuations as shareholders react to a change in policy.

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EXTERNAL FACTORS
The decision on dividend policies is not simply an internal management decision, as
there are many external factors that can affect how income is distributed.
INFLUENCE OF TAX
There are different approaches to dividend taxation among countries, however the
most common is the ‘double-taxation’ method; whereby the dividends are taxed at
year end as retained earnings and then again under personal income tax when the
dividends are received by the shareholders.
This system historically favoured by the United States of America (USA), with
relatively high tax rates on dividends at the personal income level compared to other
countries. However, they have sought to combat this on several occasions, most
recently in their Jobs and Growth Tax Relief Reconciliation Act of 2003, lowering the
individual tax rate on dividends to 15%, from its previous 38% tax rate.
However, Brav et al. (2008) challenges the role of personal tax rates on dividend
initiation through their paper investigating the effects the 2003 tax cut. They found
that tax rates are not an important factor for dividend decisions made by firms
already paying dividends, or by firm’s initiation a dividend for the first time.
Their findings further supported the view that tax rates had a short-term effect on
dividends, however in the long-run there was little impact on dividend issues. Miller
and Scholes (1978, 1982) also support this finding, by asserting that the effects of
tax cuts on dividends have not been convincingly demonstrated using long-run
measures, only in the short-term.
Further, Brav et al. (2008) support their findings through an investigation conducted
to seek the reason for new dividend initiations, with 63% of companies they surveyed
confirming strong cash flows as the reason for initiating dividends, rather than tax
rates. However, this information was gathered through press releases made by
managers/directors and so cannot be wholly reliable, as the agency problem may
occur and the true reasons behind dividend issues may not be made public, rather,
reasons are given that will appeal to shareholders. This may explain why only 17%
of companies confirmed tax rates as a deciding factor when determining dividend
policies, as perhaps a company does not want to make public that they’re only doing
something because it’s now ‘cheap’ but instead because they have good financial
prospects and promising future cash flows.
In summary, Brav et al. (2008) came to the conclusion that the tax cut did not ‘create
a whole new class of dividend-payers’ but rather encouraged some firms who were
already ‘sitting on the fence’, and so the tax cut acts as more of a catalyst to push a
firm to do something they may have done soon in the future anyway.

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NET WORTH COVENANT
It’s a fact that almost every business has to borrow funds or assets from a lender at
some point and sometimes the lenders will implement something called a net worth
covenant. This basically means that the company can default on their agreement if
the net worth of the company drops below a certain point, whilst incurring enormous
fees for doing so.
Jing Li (2008) states that debt covenants restrict firms from engaging in specific
activities, such as issuing dividends or investing in new projects. Therefore a debt
covenant will directly encourage a company to retain their earnings, rather than
distribute them among shareholders or investment projects. As a consequence a
company’s risk appetite is directly decreased, as there will be greater consequences
of investments should they fall through, as they will lose out both on the value of the
investment, and the value of the violation fee for the investment in the first place.
This prohibiting of investments means firms may often lose out on potentially
extremely profitable investments, both halting their growth and potential cash flows.
Even given their huge fines and vulnerable collateral, Smith (1993) found that there
is a high frequency of violations and re-negotiations between firms and lenders. This
suggests that the impact of covenant violations may often be overlooked as they can
simply be renegotiated, especially if an attractive investment opportunity occurs.
DeFond and Jiambalvo (1994) also found that the majority of firms that violated their
debt covenants had a going concern qualification in the year of violation. This can be
interpreted as a firm doing all it can to ensure long term success; a covenant
violation fine may be more appealing than missing out on a project with potentially
massive returns, in the short-term they’ll incur a fine, but in the long term if the
project pays off, they will have increased their overall net worth.
Going concern is good for neither the company nor the lender, so actions that get
them out of that qualification, benefits both parties. Although a company may violate
terms with a lender, if the lender then see’s that they have increased their net worth
through investments, they will be more confident that the company is able to cover
their debt, hence the frequent renegotiations.
However, the reliability of this study in decreased quite dramatically as they sought
out firms specifically who had violated their covenants, creating a sample bias
through their narrow selection. They noted themselves that violating firms may have
not been selected in their study as they found a way to get away with it due to
successful manipulations or ‘auditors actions’.

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EXCHANGE RATE CHANGES
Many larger companies will have operations across the globe and often these
subsidiaries will trade in the currency local to their geography. This can be both an
advantage and disadvantage to companies, as a slight change in in exchange rates
can have a potentially huge impact on the profit when the group accounts are drawn
up.
The effect of exchange rates can be used alongside hedging, should an investor’s
portfolio include regular dividends from one denomination, they could choose to also
have dividends coming from a currency that is negatively correlated, which should
hedge against any large losses made dude to exchange rates. However, this will
also hedge against large gains, as the weaker currency will weigh down the stronger
one. Also, predicting future exchange rates and correlations is very risky, as there’s
no guarantee or exact science for doing so.
Although, the Hunter (2014) said recently that ‘small fortunes’ can be made by those
who are not just backing the right shares, but also the ‘winning currencies’. As an
example, they note the 3% increase seen in the British based BP, an extremely
popular share option, which rose purely because they declare their dividends in US
Dollars, which had strengthened during the period.
A report by Dividend Tree (2010) found that 59% of investors experienced a loss or
gain of at least 5% due to currency fluctuations, up 40% on the previous year.
However, leading stockbroker Killik & Co (2014) also state that over the long term,
currencies have a ‘self-correcting mechanism’ meaning any benefits/drawbacks of
currency fluctuations will likely be lost in the longer term, as the currency reaches its
natural equilibrium.
Also, the time during question of Dividend Tree’s report was shortly after the
recession, where the dollar was impacted greatly so should not be used to support
the effect of every day fluctuations. With this in mind, it’s also important to note that
the survey consisted of only 275 investors from a Pennsylvania-based research
company, so sample size and location negatively affect the reliability of the report.
RELEVANCE AND RELIABILITY
Throughout this report numerous literatures have been cited in support on a view or
theory. I specifically aimed to gather information from academic sources to increase
the reliability of the report.
However, the report also includes support from news sites such as BBC and the
Telegraph, which use individual reporters to present their ‘opinion’ on a subject
matter. In these cases I have also tried to include additional supporting literature, so

13. 13
not to state an opinion as fact. This has been achieved by using academic
articles/journals often written by established professors with specific strengths in
their reporting topic.
In other circumstances, other factors have been taken into consideration, for
instance; Dividend Tree’s report and it’s timing with regards to the financial collapse
of 2008 along with its sample size and location.
Often, where one viewpoint was stated, it was either supported by additional
literature, or conversely contradicted by literature of a different viewpoint. This
ensured a fuller, less bias report.
CONCLUSION
This report has sought to investigate the underlying motivators for the differing
dividend policies among various firms. Dividend issues versus re-investment
frequently came down to short-run versus long run targets. A fresh start-up business
will re-invest in order to achieve long term goals, whereas an established business
may issue dividends as a form of shareholder retention.
Many times companies have outside influences that determine their dividend
policies, the report found that in the case of debt covenants and exchange rates,
most external factors are only short-term and will often ‘self-correct’ in the long run.
Companies that have fewer costs and more consistent incomes will generally have a
consistent annual dividend policy, as seen in the majority of utility companies, with
already hugely established operations they have little need for expansion or research
and development and so can distribute this as dividends. Conversely, companies
with great intentions for expansions and developments such as tech companies
often do not issue dividends, simply because the capital is better invested back into
the business.
However, as Denis and Osobov (2008) observed, newly listed firms will often stop
issuing dividends as soon as they started, leaving the lion share of dividend issues to
larger more profitable companies. Thus supporting the theory that once a business
must first invest in itself to grow, until it reaches a certain performance level and
growth begins to slow, it will then begin to distribute its earnings to shareholders,
rather than to itself.
There are many external factors that impact the decision on dividend policies, which
no matter how large the company, cannot be altered. With regards to shareholders
then, I believe it is most financially beneficial to them to hedge their investments in
order to mitigate these external factors.

14. 14
With this in mind it is clear that there is no right or wrong answer with regards to
distributing retained earnings, every company has its own strategies and targets,
which will greatly impact on whether they choose to issue dividends or reinvest in the
business.
Throughout my research I can conclude that that whether a firm decides to issue
frequent dividends, or re-invest their retained earnings, the shareholder will gain
value, through either the monetary value of the dividends, or the share appreciation
gained from the re-investment – which is the ultimate aim of both policies.

15. 15
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