Effects of dividend policy on stock price volatility evidence from viet nam

Dividend policy decisions, which involve the distribution of earnings to shareholders, have the potential to impact share price movements and market volatility.. While dividend payout ra

Dissertation submitted in partial fulfillment of the

Requirement for the MSc in Finance

FINANCE DISSERTATION ON Effects of dividend policy on stock price volatility: Evidence from Viet Nam

TRINH QUANG HUY

ID No: 22080941 Intake 6

Supervisor: Prof Dr Pham Duc Cuong

September 2022

Acknowledgement

I would like to express my deepest gratitude and appreciation to Prof Dr Pham Duc Cuong for his

invaluable guidance, support, and expertise throughout the process of writing this dissertation His

extensive knowledge and passion for research have been instrumental in shaping and refining the

study on the effects of dividend policy on stock price volatility in the context of Vietnam His

mentorship and insightful feedback have greatly improved the quality and depth of this

dissertation.This research would not have been possible without the support and guidance of him

Table of Contents

1.1 Topic Background 5

1.2 Research Objectives 7

1.3 Research Methods 8

1.4 Paper Overview 9

Chapter 2 Literature review and theoretical framework 10

2.1 Dividend definition and dividend policy 10

2.2 Approaches to dividend policies 11

2.2.1 Stable Dividend Policy 11

2.2.2 Constant Dividend Policy 12

2.2.3 Residual Dividend Policy 13

2.3 Literature review 14

2.4 Theoretical framework: Relevant dividend theories 17

2.4.1 Dividend irrelevance theory (MM Theorem) 18

2.4.2 Agency cost theory 19

2.4.3 Bird in hand theory 21

2.4.4 Signaling theory 22

2.5 The dividend puzzle 24

Chapter 3 Methodology 29

3.1 Hypotheses development 29

3.2 Research method 31

3.2.1 Research model 32

3.2.2 Variables definition and measurements 33

3.3 Data 36

3.3.1 Data sources and collection 36

3.3.2 Data analysis 36

Chapter 4 Result of analysis 37

4.1 Descriptive statistics 37

4.2 Correlation analysis 38

4.3 Multiple regression result 39

5.1 Discussion 42

5.2 Limitations 45

Chapter 6 Conclusion 46

Appendices 49

References 52

Chapter 1 Introduction

1.1 Topic Background

Firm’s dividend policies have always been one the main factors that are thoroughly examined by investors, before they enter an investing deal In fact, many researchers have shown their interest in this topic for almost a century, dating back since the early 50s The common sense of most investors would be that dividend payout means the company still functions well and they have great prospects in the future; hence, the stock price is expected to rise higher and higher Is that really the case?

This topic has long been a subject of interest for researchers and practitioners in the field

of finance, and it is still controversial up to this day, whether dividends have any impact on firm’s value or not Dividend policy decisions, which involve the distribution of earnings to shareholders, have the potential to impact share price movements and market volatility Understanding the dynamics of this relationship is crucial for investors, policymakers, and corporate managers seeking to optimize their financial decision-making This study aims to provide an overview of the relationship between dividend policy and share price volatility, with a specific focus on the context of Vietnam

Vietnamese financial market in general, and the stock market in specific, have experienced significant growth and development in recent years, along with its economy, attracting both domestic and international investors, especially within the last few years According to the Vietnamese Ministry of Finance (2020), the percentage of foreign investors invested in the Vietnamese stock market increased 11.6% in 2019, compared to 2018 In the bond market, the foreign investors bought more than 591.5 million USD worth of bond The country's evolving financial background as well as high potential, combined with unique economic factors and cultural influences, requires a specific examination of the relationship between dividend

policy and share price volatility in the nation’s context Vietnamese companies have traditionally displayed a preference for dividend payments, driven by cultural expectations and the desire to reward shareholders While dividend payout ratios have been relatively high, there has been limited empirical research on the impact of dividend policy on share price volatility in Vietnam This study aims to bridge that gap by exploring the factors that influence dividend policy decisions and their subsequent effects on share price volatility

Several factors shape dividend policy decisions in Vietnam Firstly, the legal and regulatory framework plays a crucial role The Vietnamese government has implemented policies

to encourage dividend payments, including tax incentives and regulations promoting transparency and corporate governance These factors can influence the dividend payout ratios and, subsequently, share price volatility To be more specific, a well-structured legal framework offers

a sense of secure to the investors, as well as forcing corporations to be well-behaved, minimizing ethnicity problem within firms and on the market; hence, the share price would become more stable Secondly, the financial characteristics of Vietnamese firms are important considerations Factors such as profitability, cash flow generation, and capital structure can most likely impact dividend policy choices Firms with stable earnings and cash flows may be more inclined to pay dividends, while those with growth opportunities or high leverage may prioritize reinvestment of earnings The interactions between these financial factors and share price volatility requires careful examination Thirdly, investor preferences and market expectations also contribute to dividend policy decisions Vietnamese investors traditionally value dividend income and stability, which may influence companies to adopt a more generous dividend policy However, these preferences seem to be changing in the last few years, as more and more investors prefer taking more risks, in exchange for high and fast returns, companies should definitely take this

into serious consideration Changes in investor sentiment and market conditions can influence share price movements and subsequent volatility

1.2 Research Objectives

The primary objective of this study is to examine the relationship between dividend policies and share price volatility in the Vietnamese HOSE market Specifically, the research aims to achieve the following objectives:

- To analyze the impact of dividend payout on share price volatility: This objective seeks

to investigate the relationship between dividend payout ratios and the volatility of share prices in the Vietnamese market By examining the historical data of 120 companies listed on the HOSE, the study aims to determine whether higher dividend payout ratios lead to lower levels of share price volatility

- To assess the influence of dividend yield on share price volatility: This objective aims to explore the relationship between dividend yield and share price volatility in the Vietnamese context The study will analyze whether companies with higher dividend yields experience reduced levels of share price volatility, indicating the potential role of dividend yield as a stabilizing factor in stock prices

- To utilize the multiple least square method for regression analysis for research purpose: The research objective involves employing the multiple least square method to estimate regression models By utilizing this statistical technique, the study aims to capture the simultaneous impact of dividend payout and dividend yield on share price volatility, controlling for other relevant variables

- To provide insights into the implications for investors and managers: This objective focuses on the practical implications of the research findings By investigating the relationship between dividend policies and share price volatility, the study aims to offer valuable insights for

investors in the Vietnamese market, assisting them in making informed investment decisions Additionally, the research aims to provide guidance for managers in developing effective dividend policy strategies to potentially reduce share price volatility

By addressing these research objectives, this study aims to contribute to the existing body

of knowledge regarding dividend policies and share price volatility in the Vietnamese HOSE market The findings will provide valuable insights for investors, managers, and policymakers, aiding in the understanding and management of share price volatility and dividend policy decisions

1.3 Research Methods

This section outlines the research methodology employed to investigate the relationship between dividend policies and share price volatility in the Vietnamese HOSE market The study utilized the multiple least square (MLS) method to analyze a dataset consisting of information from 120 companies listed on the Ho Chi Minh Stock Exchange (HOSE) The research design, data collection, and statistical analysis procedures will be discussed further in the paper The research design adopted for this study was the framework of Baskin (1989), using quantitative research method It aimed to examine the relationship between dividend policies and share price volatility by employing statistical techniques The utilization of the MLS method facilitated the estimation of regression models to assess the impact of dividend payout and dividend yield on share price volatility The primary source of data for this study was the financial statements and stock market data of the selected 120 companies listed on the HOSE The data encompassed a specific time period, from 2012 to 2018, capturing relevant variables such as dividend payout, dividend yield, and share price volatility The reason for the choice of this specific period is due

to the fact that the economy was operating conventionally during this stage, and that the

Covid-19 epidemic was not burst throughout the world, affecting the entire globe The financial statements were obtained from reputable financial databases such as CafeF or Vietstock, while stock market data, including daily share prices, were acquired from Fiintrade Premium

1.4 Paper Overview

This paper is be organized into 6 main chapters The first chapter would be the

introduction, where the research back ground, research purpose and an overview of the research method are explained Chapter 2 will be a revision of previous literature on dividend policies and its relationship with share price volatility To be more specific, the entire chapter includes 5 subsections, the first part will define dividend and discuss about dividend policies Subsection 2 explains some of the most common types of dividend policies that are used by companies around the world, not just in Viet Nam The next part is the main section of Chapter 2, where some of the most well-known dividend theories will be reviewed and discussed thoroughly, in order to have a firmer grasp of dividend policy, as well as corporate behavior in regard to dividend policies The fourth subsection focuses on another aspect of dividend, which is the famous “Dividend Puzzle”,

in order to understand why firms pay cash dividend The last part of this chapter will provide an overview of the relationship between dividend policies and share price fluctuation Chapter 3 incorporates the methodology, in which it discusses matters related to hypothesis development, including previous research and studies of other scholars in multiple contexts, as well as

specifying the research model and revealing the sources of data collection Chapter 4 and Chapter

5 reveal the regression result and further discussion in terms of those results, as well as specify some of the limitations of the model The final chapter will draw a conclusion of the research model

Chapter 2 Literature review and theoretical framework

Dividend policy has long been a subject of substantial interest and debate in the field of corporate finance The decision on how much and when to distribute earnings to shareholders through dividends is a crucial aspect of corporate financial management The literature plays a vital role in understanding the dividend It also offers various explanations for the reason behind dividend payments Numerous studies and research have examined the determinants, implications, and effects of dividend policies, contributing to an extensive body of literature on the topic This chapter serves as a comprehensive literature review that consolidates existing research and the key theories and trends in the field of dividend policy

2.1 Dividend definition and dividend policy

Dividend is a percentage of a company’s profit that is paid to the company’s shareholders, which usually comes in the form of cash or additional shares Dividend policy refers to the practices and guidelines, in terms of when and how much dividend should be distributed for the shareholders The decision for dividend distribution is usually made by the Board of Directors, who will ensure the benefits and welfare for their shareholders, as well as assure that the company will operate sustainably, in order to generate decent profit for the years to come If a company offers a reasonable dividend policy that can meet the investors preferences and sustain the company's operation at the same time, their stocks will attract more investors and benefit the company in the long run Hence, a good dividend policy is a crucial part of corporate financing strategy Or so we think?

This has been one of the most common, as well as fascinating subjects for economic researchers for several decades (Lintner, 1956; Miller & Modigliani, 1961; Black, 1976;

Modigliani,1982; Baskin, 1989) The more we look into dividend, the more we realize it is not as simple as we all think

The results of various research, conducted in nearly a century, showed that dividend also closely linked to other problems within corporation, such as corporate evaluation (Miller & Modigliani,1961), agency cost (La Porta, Lopez‐de‐Silanes, Shleifer & Vishny, 2000), asymmetric information (Miller & Rock, 1985; Li & Zhao, 2008) and many more All of which will be discussed further in the paper

2.2 Approaches to dividend policies

Obviously, the choice of dividend policy has become a crucial decision, not only in the past, but also in the modern financial world It impacts both firm value and shareholder’s benefits and wealth Understanding the various types of dividend policies and their implications is essential for stakeholders seeking to navigate the complex dynamics of corporate finance

2.2.1 Stable Dividend Policy

A stable dividend policy refers to a consistent and predictable approach followed by a company when distributing dividends to its shareholders Under a stable dividend policy, the company aims to maintain a steady dividend payout over time, typically at a fixed rate or incremental increases This policy is characterized by regular and reliable dividend payments, providing shareholders with a stable income stream Gordon (1959) included the assumption into his model, that companies pay a stable stream of dividend, while investors actually expect to receive the dividend payment, and found a correspondence between changes in stock price (with dividend) and retained earnings Gordon argued that if the company’s retained earnings are held constant, a highly precise prediction in terms of stock price changes can be conducted Generally,

companies adopting a stable dividend policy would prioritize maintaining a stable dividend payment, which tend to reflect their commitment to shareholder benefits and financial stability In fact, companies that have more access to the capital market can flexibly switch between borrowing money and issuing securities This flexibility allows them to reduce transaction costs, leading to more consistent and potentially increased dividend payouts (Alli, Khan & Ramirez; 1993) These companies would try to avoid any significant fluctuations in dividend payments, even during periods of economic uncertainty or varying financial performance This policy is particularly appealing to income-focused investors or risk averse, who seek reliable and predictable dividend income investment

2.2.2 Constant Dividend Policy

The constant dividend policy refers to the annual payment of dividends by a company as a fixed percentage of its earnings Consequently, investors will experience the entire fluctuations of the company's earnings, as well as the full volatility of its financial performance While this policy is straightforward to implement when a company's earnings are stable, if the earnings witness significant fluctuations, maintaining such policy could be challenging When earnings are time varying, it is crucial that a company follow this policy to accumulate surpluses during years

of higher-than-average earnings These surpluses serve as reserves for dividend equalization, ensuring that dividends can be maintained during years of under average earnings In practice, the company designates this surplus as a reserve to distribute dividend equally and invests it in current assets such as marketable securities This allows a more convenient conversion into cash when paying dividends during unfavorable financial years The constant dividend policy, which pays a consistent amount of dividend each year, treats ordinary shareholders in a manner similar

to preference shareholders, without considering the firm's or shareholders' investment

opportunities Investors who rely solely on dividend income tend to prefer the constant dividend policy and are less concerned about changes in share prices This behavior, in the long run, contributes to stabilizing the market price of the company's shares (Mitra, 2013) Hence, in terms

of financial flexibility, the stable policy may limit financial flexibility as the fixed amount of dividend may be challenging to sustain during periods of financial difficulty or economic downturns Constant dividend policies, on the other hand, offer more financial flexibility by allowing adjustments to dividend payments based on the company's financial performance and business conditions

2.2.3 Residual Dividend Policy

The residual dividend policy is an approach to dividend policy that suggests companies should first invest in all positive net present value (NPV) projects and then distribute the remaining profits as dividends to shareholders It is based on the concept that dividends should be paid from the residual or remaining earnings after fulfilling the company's investment requirements (Smith, 2009) The concept behind this approach is that company managers’ primary objective is to maximize the wealth of shareholders, and this can be achieved by reinvesting funds into projects that generate positive NPV, which are expected to generate higher returns than the cost of capital It also suggests that if a company has more positive NPV projects than it can finance with retained earnings, it should use external financing to fund these investments Dividends are then paid from the remaining earnings after all investment opportunities with positive NPV have been done And if there is no residual cash, the dividend payment would be zero (Baker & Smith, 2006) However, most company managers would not implement the “original” residual dividend policy, as it will make it harder to predict the future dividend pattern and will not be able to meet the investors preferences, most of which are risk

averse It is more likely that managers would adhere to a modified residual policy, in an attempt

of dividend smoothing

2.3 Literature review

Share price volatility refers to the movement of increase or decrease of stock price within

a certain time period, which could be as short as a week or a month, or in long terms, such as 5 or

10 years It is considered as a precise measurement of how risky the stock is for investors If a stock price fluctuates violently, compared to other stocks on the market, within a given period of time, it is regarded as risky Since most investors are risk averse, it is easy to understand that they would want to avoid risky stocks, in order to minimize their exposure to risks when making investing decisions And holding companies’ shares, receiving quarterly or annual dividends sounds like a safe move to make So, do companies that pay dividends will be more attractive to risk averse investors, and will be evaluated higher than companies that do not pay? Does “better” dividend policy mean less risky stock?

This has been under the scope of many economic researchers for many years, up to the present day As much as this research has been conducted multiple times, the results seem to be inconsistent Miller and Modigliani (1961) suggested that dividends do not affect firm value, hence, have no relationship with share price volatility They argued that, under certain

assumptions, the value of a firm is independent of its capital structure In other words, MM theorem suggests that the way a company finances its operations, using a combination of debt and equity does not affect its overall value in a perfect and frictionless market, assuming all other factors remain constant This led to the birth of multiple dividend theories, in the attempt to explain the effect that dividend policy has on share price volatility, which will be investigated further in this paper

In contrast with Miller and Modigliani (1961), Baskin (1989) found empirical evidence, while studying 2344 companies in the U.S., showing that the relationship between dividend yield and share price volatility is negatively correlated, as dividend yield increases, stock price will become more stable and vice versa To be more specific, based on the work of Miller and Modigliani (1961), Baskin developed a model consists of two main independent variables, namely dividend yield and dividend payout, representing dividend policies, to explain the dependent variable, which is price volatility, while several control variables would be added to prevent bias in the model The end result offered great implication in the field of corporate finance: Company managers may have the potential to utilize dividend policy, specifically dividend yield, as a means to manipulate the risk associated with the stock of the company Increasing the dividend yield could reduce the stock price fluctuation; hence lower the associated risks and vice versa Baskin model can be considered as a more complete model of Miller and Modigliani theory, in which it provides a more realistic look at the real world financial market when accounting for numerous factors that can affect dividend policies It has become one of the most popular researched frame work of this topic in many different countries around the world (Allen and Rachim, 1996; Conroy, Eades and Harris, 2000; Rashid and Rahman, 2008;

Hussainey et al., 2011; Ashemijoo et al., 2012; Ilaboya and Aggreh, 2013) However, the results

are not consistent among nations, as some support the theory of Baskin (1989), some proved it to

be the other way around To be more specific, in Allen and Rachim's (1996) paper, they examined the relationship between dividend payout and stock price volatility in the Australian market, adopting the model as similar as Baskin (1989) Their findings indicated a significant negative association between dividend payout and stock price volatility However, their investigation of dividend yield demonstrated a positive but statistically insignificant impact on stock price volatility, which contradicted Baskin's (1989) results Similar outcomes were

observed in Conroy, Eades, and Harris's (2000) study on dividend policies and earnings' pricing effects in Japan, as well as Rashid and Rahman's (2008) research on the same relationship in Bangladesh Both studies demonstrated a negative correlation between dividend payout and price volatility, and an insignificant influence of dividend yield Rashid and Rahman (2008) further incorporated industry dummy variables into their regression model, but these did not alter the results In the UK market, Hussainey et al (2011) suggested that both dividend yield and payout ratio have a negative impact on price volatility at a significance level of 1% Similarly, Hashemijoo et al (2012) arrived at the same conclusion in their studies conducted in the Malaysian Stock Market They found that price volatility is negatively affected by dividend yield, dividend payout ratio, and firm size, with dividend yield and firm size exerting the most substantial influence Conversely, the study by Ilaboya and Aggreh (2013) in the Nigerian Stock Market yielded contrasting results to the aforementioned studies Their research indicated a statistically significant positive relationship, at a significance level of 5%, between dividend yield and price volatility, while the impact of dividend payout on volatility was statistically insignificant

The matter of whether dividend policies affect share price volatility or not is still

controversial up to the recent years In terms of Vietnamese market, Nguyen et al (2019) studied

the relationship in the Vietnamese market A dataset of 141 companies in 13 industries, ranging from consumer goods manufacturing, mining and quarrying, transportations to art and entertainment, was observed during a period of 6 years, from 2011 to 2016 The model that was used in the research was similar to that of Baskin (1989) and the regression result showing that share price volatility is negatively affected by dividend policies, which was consistent with the said study However, the period started in 2011, which was 2 years after the global financial crisis The economy just stepped out of the worst period and at the first stage of the recovery

process, the inflation rate was still at high level around 18.58% and the growth rate low at only 5.9% (Minh, 2011), this may create some potential bias in the model, since the situation did not reflect the entire economy truly In the same year, Phan and Tran (2019) examined the association between the two factors in Viet Nam, examining a dataset of 480 companies from Ho Chi Minh Stock Exchange (HOSE) and Hanoi Stock Exchange (HNX) in the period of 8 years, from 2008 to 2015, using panel data method Similarly, a negatively correlated relationship between dividend policies and share price volatility was found 1 year later, another study in the Vietnamese market was conducted by Nguyen et al (2020) On a much larger scale, a sample of

260 companies on HOSE was observed in between 2009 and 2018, while applying the model of

Baskin (1989) The result was consistent with that of Nguyen et al (2019) and Phan and Tran

(2019), where they found a negative correlation between dividend payout ratio and share price volatility, as well as dividend yield and share price volatility Once again, the first stage of the period (2009 – 1011) was extremely sensitive, not just in Viet Nam but throughout the world, which could potentially cause some bias in the model in terms of level of fluctuation in the stock price This paper will focus on the post crisis period, avoiding the high inflation rate period and study the stage where the economy is normally functioned

2.4 Theoretical framework: Relevant dividend theories

As mentioned previously, in order to explain and understand dividend more clearly, many theories were born, to explain in detail the main purpose of dividend, the behavior of company managers in terms of dividend policy, as well as how investors would react to changes in these policies These are referred to as share price volatility, and the theories related to this include Dividend irrelevance theory, clientele effect, the signaling effect, the bird-in-hand theory, the agency cost theory and the catering theory

2.4.1 Dividend irrelevance theory (MM Theorem)

A study conducted by Miller and Modigliani (1961) showed that there is an irrelevance between dividend policy and shareholders wealth As long as the company does not change any investment policy, still operates as usual, or even has a breakthrough in terms of revenue, it does not matter whether the company decides to increase the dividend payout or cut it off entirely, the stockholders’ wealth is not affected by this change This had been proven under these certain assumptions:

 The cost of each share should be set in a way that ensures the consistent rate of return (including dividends and capital gains) per dollar invested remains equal across the entire market during any specific given time period

 The existence of a perfect market: This is based on the work of Fama (1970) The perfect market hypothesis (EMH) stated that in a perfect market, there are no anomalies, all entities compete equally on the market, there will be no significant advantage in terms of capital size and information that can have a dramatic impact on the share price Furthermore, the price for share related information and transaction fee is none, which means no taxes, no brokerage fees, and many other related expenses when the stock is issued or traded on the market

 Investors’ behavior is rational: This means that all investors in the market prefer to have more wealth and will be pleased no matter whether the increase of asset is in the form of dividend, cash payment or the prices of the shares that they are holding increase

 Perfect certainty for investments: This means that all market entities’ investments, including the present and future investment, are assured by all corporations, in terms of profit And that all stockholders will be aware of firms’ future cash flow

Miller and Modigliani were able to prove that under these hypotheses, there was no correlation between dividend policy and shareholders’ welfare, and the company's current value

is unaffected by any current or future dividend payment While the MM theorem provides useful insights, it simplifies real-world complexities, in which most of the assumptions above are too good to be true and does not account for factors such as taxes, financial distress costs, agency issues, or market imperfections, which can indeed influence a firm's capital structure decisions and overall value in practice Therefore, it is worth noticed that MM theorem can only exist in the form of a theory However, this theory played an important role in understanding corporate finance, and was the foundation for the birth of many other theory, which support economists unveiling the mystery of dividend policies, as well as dividend behaviors

2.4.2 Agency cost theory

The concept of agency relationship and the agency cost theory in corporate finance were introduced by Jensen and Meckling (1976), and then expanded further in the context of overvalued equity (Jensen, 2005) However, this was brought up even before Jensen and Meckling (not specifically mentioned as the agency) by Berle and Means (1932) in the research

of the modern corporation and private property Before engaging this theory, the definition of agency relationship should be elaborated first

The agency relationship arises when individuals or entities (principals) delegate making authority to other parties (agents) to act on their behalf It is rooted in the separation of ownership and control This delegation of authority necessitates a degree of trust and reliance of the principals on the agents, in order to act in the best interests of the principals

decision-The agency relationship is characterized by an inherent conflict of interest, as agents may pursue their own self-interests, potentially diverging from the objectives of maximizing the

benefits for the principals and their preferences This conflict stems from information asymmetry, where agents possess superior knowledge and informational advantages over principals, granting them the ability to exploit their position for personal gain As a result of this risk relating to the relationship, it is necessary that the principals take action on the agents, thereby reducing the risk

of the agents acting in their own interest, instead of that of the principals This leads to the birth

of agency cost

Agency costs manifest as a consequence of the agency relationship, representing the expenses incurred by principals in their attempts to mitigate agency conflicts and align the interests of agents with their own These costs encompass various forms, including monitoring and supervision expenses, bonding costs, residual loss from suboptimal decision-making, and potential opportunistic behavior by agents

In the context of corporate finance, this theory is completely opposite to Miller and Modigliani’s rational behavior hypothesis In this case, the shareholders (principals) authorize the company’s managers (agents) to act on their behalf, increase their asset value (in this case, the asset would be shares) The agency cost may arise when managers have a conflict of interest with the shareholders (Jensen, 1986) Any actions that might affect the welfare of shareholders; for instance, a decrease in payouts, changes in company’s policy which lead to a plummet of share price, could lead to insecurity of investors, and agency cost problems may occur

There were a number of solutions that were proposed to solve this problem Jensen (1986) proposed to tackle the agency cost of free cash flow by issuing debt instead of stock By doing so, any company’s future cash flow would be restrained, in order to meet its obligation; hence, bring down the amount of available cash that can be used in discrete by the manager Another solution

proposed by La Porta et al (2000) is to enact corporate laws which allow shareholders to be

entitled to a certain amount of power as a means to protect their investment from being dispossessed of by the insiders

2.4.3 Bird in hand theory

This is a famous theory that was contributed by many research works such as Gordon (1595) or Lintner (1956) and Miller and Modigliani (1961) Their research acts as a foundation for the birth of this theory To be more specific, the works of Gordon in 1959 investigated the relationship between dividends, earnings, and stock prices He argued that investors have a preference for current dividends due to their certainty and the income they provide As for Lintner (1956), he examined the distribution of corporate incomes among dividends and retained earnings Lintner's work delved into the factors influencing dividend distributions and provided insights into how firms make decisions regarding dividend payouts The research of Miller and Modigliani (1961) provided an opposite perspective, as the bird in hand theory accepts the imperfect capital market These insights are consistent with the principles of the Bird-in-Hand theory, which emphasize the importance of dividend payments and their impact on shareholder wealth in the real world

In terms of this theory, Al-Malkawi (2007) and Shao, Kwok & Guedhami (2010) mentioned in their works that in an imperfect capital market, with the existence of uncertainties, investors would prefer dividend to retained earnings This preference is drawn by the fact that most investors are risk averse and would prefer certainty, rather than taking high risk, in exchange for high reward In simple terms, investors would like to have dividends (bird) in hand, rather than having it in a bush (retained earnings) without knowing what will happen

This theory suggests that companies with high dividend payment would be more attractive to risk averse investors, which opposed clearly with the statement in the dividend

puzzle (Black, 1976) Furthermore, opposite with the dividend irrelevance theory (Miller & Modigliani, 1961), the bird in hand theory was able to explain why companies pay dividends while adopting the assumption of an imperfect market, where taxes, transaction costs, signaling effects, and investor preferences have a tremendous impact on stock price Despite all the drawbacks of taxes, the uncertainty aspects of the market would increase the desire for safe profit and earnings; hence, there would always be a number of risk averse investors who fascinate stocks that pay dividends

2.4.4 Signaling theory

Signaling theory played a major role for corporations when deciding the suitable dividend policy Lintner (1956) laid a foundation to the development of this theory when examining dividends in corporate finance He argued that dividend decisions can convey information to investors about a firm's financial health, future prospects, and management's confidence in the company's future earnings By maintaining a stable dividend policy or adjusting dividends in accordance with earnings, companies can send signals to the market regarding their expected future performance The theory was then brought to discussion by Jensen (1976), who mentioned the concept of signaling through dividend payment, as a mechanism used by corporations to convey private information to external parties, such as investors or creditors According to the signaling theory, in corporate finance, when firms face information asymmetry with external stakeholders, they have an incentive to signal their true quality to reduce adverse selection problems Firms may undertake certain actions, such as dividend payouts or issuing new securities, instead of publicly stating the information, to signal their quality of investment or the future prospects to the market, as well as differentiate themselves in the market

This theory received great interest from many scholars ever since One year after Jensen (1976), Myers (1977) expanded the signaling theory by examining the role of corporate borrowing as a signal of a firm's future prospects and quality Myers argued that firms can use their borrowing decisions to convey information about their internal characteristics, such as their investment opportunities, profitability, and risk levels Myers and Majluf (1984) conducted a study on corporate financing and investment decisions under severe information asymmetry They argued that a firm’s operating cash flow can be revealed under the condition of fixed amount of investment and external source of finance; this was supported by Miller and Rock’s model (1985) To be specific, high dividend payment signals a high prospect of future cash flow, which will increase the stock price On the other hand, an increase in debt or issuing new securities (external financing) reveals a weakening cash flow, which lowers the firm’s future prospects and leads to a decrease in stock price Similarly, Smith and Watts (1992) expanded this theory further in their model while studying the options of corporate financing, dividend and compensation policy Their result showed that companies which have more growth options, under a high level of asymmetric information, might have to borrow more, which means low equity to value ratio, as well as pay higher dividends (signaling to the market) Hausch and Seward (1993) studied the signaling theory through dividend payout and share repurchase Dividend was considered as a certain payment method, while share repurchase was thought to be

a more random action It was proved that corporations can signal the amount of cash that was generated within the financial year to the market, simply by choosing in between the two methods Specifically, as the absolute risk aversion decreases (or increases), firms would prefer

to signal with a stochastic (or deterministic) cash distribution

2.5 The dividend puzzle

The dividend puzzle was firstly brought to discussion by Black (1976) According to this research, the less dividend a company pays, the more appealing the stock would be to investors Black explained the reason behind this phenomenon is that dividends are taxed more than capital gains, and since investors do not have to pay taxes until they realize their gains, companies that pay little, or do not pay any dividend at all, tend to be more attractive than the ones that pay

On the contrary, under the scope of corporations, company directors would prefer not to cut the dividend If the dividend increases due to the high expectation of the company’s prospect, the stock price would increase also and vice versa Hence, by studying the changes of dividend, investors would be able to know more about the company than what the company managers present in the media and on the financial statement

In terms of debt, Black indicated that there is a substantial conflict of interest between the debtors and shareholders Creditors tend to limit the amount of dividend that the company should pay, in order to ensure that the company can meet its debt obligation when the due date comes Therefore, any increase in dividend would put creditors at higher risk of not getting back the money and vice versa Any changes that benefit the creditors could affect shareholders One proposed solution for this is that the company can eliminate this by negotiating to not paying any dividend from the beginning This puzzle has been researched multiple times ever since it was

introduced (Bhattacharya, 1979; Bernheim, 1990; La Porta et al., 2000; Baker et al., 2002; Baker

& Weigand, 2015), in order to find a proper explanation and up to this day, it is still controversial

Bhattacharya (1979) offered an answer for the dividend puzzle, using a framework where cash dividend payments serve as an indication of anticipated cash earnings of companies within

an asymmetric information environment between company managers and outside investors He

suggested that firm managers who possess more insider information have the incentive to strategically determine the amount of dividend payment, as well as increase them as a means to communicate or public the private information to outside investors Managers are motivated to share this confidential information with the public when they realize that the current market value

of the company's stock is less than its true worth By raising the dividend payment, they provide a reliable signal to those who are interested, as other firms lacking favorable insider information would struggle to mirror the dividend policies without significantly raising the risk of potential dividend reductions in the future The study is persistent with John and Williams (1985), who then identified an equilibrium of signaling taxable dividend payout In this equilibrium, the insiders who have more valuable discrete information can strategically allocate larger dividends and receive higher stock prices when both their company and its existing shareholders require more cash than what is internally available

Bernheim (1990) formulate a model that provided an insight, an explanation to the dividend puzzle through the perspective of taxes He argued that despite of the disadvantage of tax rate on dividends, which is higher than repurchases tax, companies tend to pay dividends, and sometimes even combine it with issuing new equity, in order to differentiate themselves from the low valuated firms This idea had been raised earlier by Ofer and Thakor (1987), studying how share price responses to two methods of cash distribution, specifically dividend payments and share repurchases However, their model failed to prove that the cost of share repurchases is large enough in the real market condition, in order to prevail against the disadvantage of dividends in terms of taxes In addition, they failed to cover up one of the most common practices of many firms in the real world: paying dividend and issuing new shares at the same time The study of Bernheim (1990) was able to fix these defects, using the standard signaling model, which is similar to the model of Bhattacharya (1979) Not only did he include the practice into the model,

he also found proof that firms that have low quality can only mirror the repurchase strategy, due

to the lower tax rate advantage of the cash distribution method, and failed to mimic the dividend policy of higher quality firms As for the high quality firms themselves, the transition from dividend payment to share repurchase impose a much larger amount of payment to shareholders

on themselves, in order to signal their future prospect As the result, the net income reduces quite substantial This is in line with the reexamination of Kalay and Michaely (1993) in terms of tax effect and dividend yield

Meanwhile, La Porta et al (2000) provided a different explanation for the reason why

company pays dividend, through the view of agency cost problem, based on the theory of Jensen (1986) The study of a Jensen (1986) implied that there would always be a presence of conflict of interest between company managers (insiders) and the outside investors (outsiders) The insiders can take advantage of asymmetric information and the ability to control company’s assets, using them to engage a range of projects that are non-profitable for the company but benefit

themselves Porta et al (2000) suggested that enacting law that protection to shareholders would

be an efficient remedy for the situation, and in this case, dividends would act as either an outcome of the said law or a substitute for the law To be more specific, a study on some of the largest firms listed on the stock market in 46 nations was conducted, using two distinguish agency models, one as an outcome model and one as a substitute model The outcome of the first model showed that companies pay dividend as a result of a protective legal environment of the country, in order to protect its shareholders from agency problem The second model suggested that the act of paying large dividends is a way to signal companies’ goodwill, showing how well treated their shareholders are; hence, attracting more investors in an unprotected legal environment

Another perspective that may provide an answer to the question of why firms pay dividend, despite the obvious tax disadvantage, is through the recognition of company managers

in terms of the demand to receive dividends as a signal of the ongoing company’s value Looking through this scope, it would be logical for the managers to pay a steady or stably increase stream

of dividend to meet their investors’ needs (Frankfurter and Lane, 1984) This idea was originated

by Shefrin and Statman (1984), whose research was based on studying financial behavior, using the economic self-control theory (Thaler and Shefrin, 1981) and the theory of making decisions under risks developed by Kahneman and Tversky (1979) Empirical evidence had been found, showing that numerous investors have a particular preference for dividend payout Shefrin and Statman (1984) also take into account the demographic characteristics of investors who favor stocks with low or high dividend payout ratios For instance, individuals who have retired, seeking a steady and substantial amount of dividend payment to support their daily expenses may lean towards companies with high dividend payout ratios By receiving significant dividend payments, these individuals can avoid the inconvenience and expenses associated with selling their shares to generate the necessary cash flows In addition, Shefrin and Statman also argue that certain investors have an incentive to receive dividend payment in cash, due to self-control motives (apparently, dividends tend to help them manage spending without depleting the principal) and others prefer dividends to avoid regret (the feeling that arises when they sell stocks

to receive cash for expenditure right before an uptrend in the stock market)

The debate of dividend puzzle is still a hot topic up until the recent two decades Baker et

al (2002) revisited this puzzle almost 30 years later, comparing and contrasting between the two

cash distributing methods – cash dividends and share repurchases, after a significant period of financial market development Their perspective on cash dividends – share repurchases was that share repurchases is indeed much more beneficial in terms of tax effect, as they are taxed less

than cash dividend, as well as offering their shareholders the power of self-selectivity, which means shareholders who do not want to receive cash and being taxed on that money, they can just simply hold the stocks and not realizing the capital gains, as for those who prefer cash over company ownership, they take the offer and sell the stocks to the company However, the presence of adverse selection costs introduces a significant consideration Share repurchases, while offering flexibility, can suffer from adverse selection costs whereby informed investors exploit their superior knowledge by selectively selling overpriced stocks back to the firm On the other hand, dividends do not provide an advantage to informed investors, as all shareholders receive the same amount as everyone else Brennan and Thakor (1990) argue that informed investors prefer share repurchases due to the adverse selection problem, while uninformed shareholders favor dividends Moreover, the signaling effects associated with dividend increases and share repurchases differ in many ways Dividend increases are often regarded as positive signals, indicating sustainable and stable cash flows Firms tend to be cautious about increasing dividends, unless they can maintain them in the long term In contrast, share repurchases may signal temporary cash flows or serve as defensive measures against takeovers Additionally, share repurchases can impact the ownership structure as cash distributions tend to be disproportional Firms may utilize repurchases to consolidate voting power, particularly if managers and insiders abstain from selling their shares

It sounds quite logical on theory, however, in the real world, cash dividend payment seemed to be fading away Fama and French (2001) found a quite solid proof that the percentage

of firms that pay dividend decreased substantially in the U.S market, specifically on NYSE,

AMEX, and Nasdaq Until recently, Baker et al (2015) stated that despite all the efforts of

academic literature of trying to analyze dividend policy, no existing model has presented a comprehensive framework that seamlessly incorporates all the components of the dividend

puzzle This occurrence is mostly due to the fact that most academic researchers often follow a process of developing theoretical frameworks in an abstract form and subsequently seek empirical evidence to support those theories In doing so, they often concentrate on individual aspects of the dividend puzzle separately, and not consider all problems as a whole As a result, many of the theories or explanations regarding why firms choose to pay dividends are relatively straightforward Nevertheless, these researchers acknowledge that conducting a comprehensive analysis of the interactions among various market imperfections can be an overwhelming and intricate task

Chapter 3 Methodology

The purpose of this chapter is to delve into the heart of the paper, aiming to unravel the intricate relationship between dividend policy and stock price volatility Recognizing the significance of dividends as a vital component of corporate finance, a rigorous examination of how dividend policy influences the volatility of stock prices is required By employing a comprehensive methodology, the aim of shedding light on the intricate dynamics that underlie this critical relationship should be achieved

3.1 Hypotheses development

In the field of empirical research, hypotheses serve as guiding beacons, guiding the way

on the path through darkness, unveiling the shining bright knowledge As this paper embarks on the quest to explore the relationship between dividend policy and stock price volatility, this section lays the foundation for the investigation, formulate hypotheses that will shape the analysis and provide the answer to the problem As mentioned previously, Allen and Rachim (1996)