The Effect of Recession on Dividend Policy - Dissertation Example

? The Effect of Recession on Dividend Policy Analysis and Discussion The research methodology adopted sought to answer the research questions in an attempt fulfill the research objectives these are: to determine whether there was a change in capital structure during the recession and whether or not this resulted to a change in the dividend payout, to determine whether there was a change in the payout ratios of companies in Saudi Arabia after the recession. Some of the logical explanations on how the various sectors were affected by the recession in terms dividend payout. Background Information The research covered various economic sectors of the economy namely; banking and financial Services, real estate companies, petrochemical companies, Agriculture and food industries, industrial investment and telecommunications. A total of 26 companies financial over a period of 5 years were thoroughly analyzed to come up with efficient analysis of our study topic. Difference in Dividend policy between different Economic Sectors We use the one way Anova to determine if there is a difference in mean between the average dividend pay for the various companies. The analysis generates the results table below. ANOVA Sum of Squares df Mean Square F Sig. Between Groups 96.613 7 13.802 2.162 .092 Within Groups 108.514 17 6.383 Total 205.127 24 As seen in the table above the value of significance from the table is .092 which is larger than the significance value of 0.05 hence we accept the null hypothesis which states that there is no statistically significant difference in the dividend policies adopted by the various sectors of the economy. Sectors from which various companies in the study. Correlation between Capital Structure and Earnings per Share Earnings per share give the actual performance of a company’s stock and the actual market value or the worth of a company. Comparing the relationship between the capital structure of the company (using shareholders equity as the indicator) and the earnings per share gives us the view on how these two variables interrelate. The results are shown in the table below .We use the Pearson’s correlation at 95% level of confidence to test for the correlation. Correlations Equity Eps Equity Pearson Correlation 1 .466(*) Sig. (2-tailed) .019 N 26 25 Eps Pearson Correlation .466(*) 1 Sig. (2-tailed) .019 N 25 25 Correlation is significant at the 0.05 level (2-tailed). The correlation coefficient is positive 0.466 which means a positive relationship between the two variables. At 95 percent level of confidence means that we reject ho hence conclude that there is a significant correlation between the capital structure and in particular the equity shareholding and the earnings related to them. Correlation between Capital Structure and Dividend Yield. The dividend yield is compared to the return on investment in our study as it is the annual dividend amount payout per share by a firm in relation to the share value. We measure the relationship between equity shareholding and the return on investment. We run the Pearson’s correlation coefficient from the variables dividend yield versus equity. The results of running leverage for the companies against the dividend yield give no significant correlation between the two variables. Correlation: Capital Structure (Using shareholder Equity) and Dividend Policy Adoption (payout). We shall run the Pearson’s correlation to find out if there exists a linear relationship between the two variables. For the purpose f this test the null hypothesis is set as: There exists no significant correlation between the two variables. Running the data we generate the output below. Correlations Equity pre Equity Pearson Correlation 1 .187 Sig. (2-tailed) .370 N 26 25 Pre Pearson Correlation .187 1 Sig. (2-tailed) .370 N 25 25 From the table above it is clear that there a moderate relationship between the shareholders equity and the dividends paid out of the rather the dividend policies adopted by the various companies. Since the significance value from the table which is .035< 0.05 we reject ho at 95% level of significance. This clearly illustrates of reaffirms the various economic theorems such as the Pecking order and the substitution theorems. Which try to elaborate on how the capital structure of a firm might influence the dividend policy adopted by the company? The positive correlation implies that the higher the equity ratio of a firm the higher the dividends paid. Difference in Dividend Policy Post and Pre Recession Period. We shall determine if there exists a significant difference in mean of the dividends payout by the various companies before and after the recession period. We shall use the paired Student-T test as we assume the data is normally given the central limit theorem. This Test is suitable as it takes into account the fact that each company adapts different dividend policies in pursuit of their long-term or shorter financial objectives determined by the managers of the company. The test is at 95% level of confidence. Paired Samples Statistics Mean N Std. Deviation Std. Error Mean Pair 1 post 1.9054 25 2.13273 .42655 pre 2.4300 25 1.94610 .38922 The mean difference in the average in amount of dividend given to firms shareholders is seen in the above descriptive statistic table. This may be attributed to various factors mentioned in the discussions on policy dividend theories. Difference in Capital Structure Pre and Post Recession We Use the paired T test to try and establish any change in the capital structure after the recession period. Leverage becomes the indicator of capital structure; from the table below we see that the average for the 25 companies leverage index moved from 44.1 to 45.5. Further analysis using the Paired student –T Test gives us the result as in the paired sample test table further below. The value is less p=0.05 at 0.007 hence we reject Ho meaning there is a significant difference in mean. This means the companies have more leverage after the recession period. Paired Samples Statistics Mean N Std. Deviation Std. Error Mean Pair 1 VAR00011 17.2196 26 44.11815 8.65228 VAR00012 22.4908 26 45.54566 8.93224 Paired Samples Test Paired Differences t Df Sig. (2-tailed) Mean Std. Deviation Std. Error Mean 95% Confidence Interval of the Difference Lower Upper Pair 1 Post-Pre -5.27120 9.06028 1.77687 -8.93073 -1.61167 -2.967 25 .007 Relationship between Company profits, capital Structure and Dividend Policy Decisions. We further set to establish if there exists a liner model or relationship between the predictor variables and dependent variable in the case dividend payout. The predictor variables in our research are the earnings per share, leverage and equity. We attempt to fit the linear regression model in our study. The model is Y=C +?0 X + ?1 X………… The null hypothesis is ?0 = ?1=……………………………= 0. When we run the analysis we generate the table below. ANOVA Model Sum of Squares Df Mean Square F Sig. 1 Regression 63.616 3 21.205 8.941 .001(a) Residual 47.434 20 2.372 Total 111.050 23 a Predictors: (Constant), Equity, leverage, eps b Dependent Variable: divpost From the table above the significance value is 0.001 from the F test which is less than 0.05 meaning that we reject the null hypothesis hence accepting the model fits at 95% level of confidence. We move one to determine the value of the model coefficients and fit the model. Coefficients Model Unstandardized Coefficients Standardized Coefficients T Sig. B Std. Error Beta 1 (Constant) .929 .715 1.299 .209 Eps .609 .123 .820 4.966 .000 Leverage -.002 .007 -.043 -.290 .775 Equity -.021 .017 -.201 -1.224 .235 Dependent Variable: dividends payout. The linear model becomes Y = 0.92 + 0.602X1-0.02X2-0.021X3. The model shows that the dividend amount payout depends on the earnings per share .This means as the earnings per share increases, the amount of dividend paid to the shareholders increases. On the other hand, the leverage and equity negatively influence the level of dividends paid. This means that when leverage increases the dividend pay decreases. Conclusion and Recommendations The question of determining the optimal source of companies financing it business activities has been a deliberation engaging great finances and economist. Dividend policy forms a major part of these discussions. Entrepreneurs are in search of a debt to equity ratio that can maximize companies’ value1. The risk of financing with debt is offset by the tax advantages gained as a result of leverage. This is further in the value based management theory or concept. This theory is referred as the substitution theory or the trade off concept as the risk associated debt financing compared to tax advantages2. The theory highlights the risks connected to cost financial structure problems as a result of debt financing; the higher the debt capital the higher the risk of bankruptcy or loosing liquidity. Financial liquidity is an essential component when capital structure as lack of it may result to looming bankruptcy3. As echoed by Ross Westerfield and Jordan, once tax payout has been announced by management, this becomes a financial obligation which the company must fulfill4. This theory as we have seen therefore focuses on substituting equity with debt until an optimum capital structure is attained that favors maximum business value with limited capital cost. The recession affected all the sectors as it affected all the labor markets. The banking and financial services and the housing industry were more adversely affected by the recession. This explains the difference in dividend policy in these sectors. This is mainly because the banking sector sells financial services and hence must have been affected to a large extent by the recession. On the other hand the real estate sector depends on the banking sector vastly in its operations and financing more than the other sectors, mortgages 5mostly. This theory focuses on the following key factor that aid in establishing the optimum capital structure: the level if taxable income and effective tax rates, the degree of operational risk and the type of assets held by the company. The findings from our research, to some extent, support each of the dividend policy theories. There is a slight difference in the dividends payout by the companies before and after the recession period in 2007-2008. Despite the recession there is a lack of a significant change in the dividend paid out to their share holders. The overall market capitalization for all the Saudi 6Arabian companies fell from 1946 to 925 billion but the dividends payout did not fall significantly at 5 percent significance level. This supports both the irrelevance theory of Modigliani and Miller. The theory states that the market value of firm’s assets is independent of the dividends distributed to the shareholders of the company78. He argues that the shareholder replicates a policy of their own. The Clientele effect where the type of shareholder determines the kind of policy that is more favourable to them. Here tax exempted institutions and retirees who face lower marginal tax favor high dividends (Bird –in –the hand theory) while Investors who are subjected to high marginal tax rates would prefer capital gains hence choose the tax Preference Theory, that is, they prefer capital gains as they are taxed at a lower rate9 . The theory states that the adoption of a particular dividend policy does not influence the shareholders decision making. According to Modigliani and Miller, when the dividend payout is low the stockholder simply sells his stock and reduces his holdings similar to what he does when the company payout goes up10. According to Modigliani and Miller, when the dividend payout is high the investor chooses to reinvest some of his cash earned back into the company stock hence his or her cash holdings remain almost same are moderately higher than before the dividend payout11. The M &M II theory is non-operational in the realistic world. There are several other factors such as taxes and information irregularity that when introduced will definitely change the view as dividend policy then is no longer irrelevant. Our findings will introduce us to a more practical theory which is the Pecking order theory mentioned earlier in our study. This theorem is also called the Hierarchy theory where by the entrepreneur identifies the main sources of capital as opposed to the optimal relationship between equity and debt capital. The theory underline the following assumptions: the entrepreneur have a preference for internal financing such as retained earnings less dividends issued, depreciation amount and returns from disposal of short term securities. If there is need for more financing the policy favors the issuance of debt securities first before issuing new shares1213. The manager or entrepreneurs are in search of the cheapest source of capital so as to minimize the risk and reduce the cost of equity issue or repayment of interests accrued from loans14. In the event that the company needs debt capital it opts for debt securities15. This has created the problem of deciding whether to reinvest profits or pay dividends to shareholders. The substitution theory is in contradiction with the pecking order theory. The pecking order theory argues that large and financially stable companies that have huge profits reinvest them are not set to pay huge dividends and acquire debts.on the contrary, the substitution theory is in support of the opinion that financially sound companies are the disposed to raise their debt levels16. The theory focuses on the asymmetry of information which influence the managers to decide to sell shares when stock is overvalued17. The sudden decrease in stock value is as a result of misinterpretation by stock holders due to low dividends payments. From the results in the research, despite the change in company earnings due to recession the managers of the firms attempted to maintain the company’s dividend policies. There is no statistically significant difference in the dividends paid to the shareholders before and after the recession. This is corresponding to the Hierarchy theory by managers who prefer internal capital sources as well as limiting any alterations in the dividend policies of the firm. When the earned profits are not adequate for investments or dividend needs the company gets rid of short term securities to cover these costs. According to Poterba and Lawrence, dividend is a steady source of income18. Poterba and Lawrence note that an increase in share price leads to negative influence on the value of stock. The study findings revealed the following about the Saudi Arabia companies and their dividend policy, capital structure and how these were affected by the recession in the 2007/2008 recession. The study showed that the dividend policy using the payout is not different for the various sectors. Most Saudi Arabian Companies across all sectors made decision to have a steady dividend payout to the clients. There is a significant correlation between the paid dividends and value of equity capital as well as leverage which is an indicator of the capital structure. This affirms a relationship between the amounts of dividend payment and the share of equity capital which supports the domination of the pecking order theory which focuses on reinvestment of earned profits back into the business. Further this to some extents discredits the practical importance of substitution theory. 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