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2.3 Overview of Chinese stock market

2.3.1 Dividend policy in Chinese stock market

2.3.1.2 Agency theory of dividend policy

Decisions concerning whether to distribute value to shareholders, and what percentage of earnings to distribute as dividends, are very important financing decisions that have implications for a firm’s future investment and capital structure policies. To date, the weight of earlier research often investigates stock dividends and cash dividends separately and pays much more attention to the US and other international markets. The literature focuses on shareholder preferences for stock dividends mainly through signalling theory (Grinblatt, Masulis, and Titman, 1984; Rankine and Stice, 1997), the cash dividend substitution hypothesis (Lakonishok and Lev, 1987), and the trading range hypothesis (McNichols and Dravid, 1990). However, the weight of earlier research on both stock dividends and cash dividends pays much more attention to the US and other international markets.

On the other hand, the literature focusing on cash dividends offers a wide range of explanations for the so-called dividend puzzle (Black, 1976), mainly through the clientele theory (Miller and Modigliani, 1961), bird-in-hand theory (Gordon, 1963), agency cost theory (Easterbrook, 1984; M. Jensen, 1986; Rozeff, 1982), self-control (Shefrin and Statman, 1984), and the more recent catering theory (Baker and Wurgler, 2004). Of these, signalling theory and agency cost theory are particularly popular. Signalling theory argues that dividend payments can signal future earnings and profitability to the markets (Bhattacharya, 1979; Boudoukh, Michaely, Richardson, and Roberts, 2007; Miller and Rock, 1985; Nissim and Ziv, 2001). However, the evidence on signalling theory is mixed, as recent papers find the link between earnings and dividends is weak today (Brav, Graham, Harvey, and Michaely, 2005; DeAngelo, DeAngelo, and Skinner, 1996; Grullon and Michaely, 2004).

Agency theory, as it relates to dividend policy, stems from the work of Rozeff (1982) and Easterbrook (1984). Under the agency cost view of dividend policy, it is argued that

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increased dividend payout ratios lower agency costs of external financing, but raise the transactions costs of external financing. Rozeff (1982) tests this view by employing a cross-sectional model that regresses dividend payout against proxies for the agent cost/transaction cost trade-off. He finds that the percentage of stocks held by insiders is negatively related, and the number of shareholders is positively related, to the dividend payout ratio. Easterbrook (1984) develops two agency-cost explanations of dividends, which could be useful in reducing agency costs of management. He posits that continuing cash dividends compel firms to raise new money in order to carry out investment activities, thereby reducing agency costs as they are subject to the scrutiny of the capital marketplace. Dempsey & Laber (1992) confirm Rozeff’s (1982) results by using a longer time period over the years from 1981 to 1987. Moreover, Moh’d, Perry, & Rimbey (1995) find that firms do act to minimise the sum of agency costs and transaction costs toward an optimal level of dividend policy through time-series cross-sectional analysis.

Under the agency cost of the free cash flow hypothesis, Jensen (1986) expands on Easterbrook’s (1984) argues that leaving excess resources under management control will lead self-interested utility maximising managers to squander them and use them for perquisite consumption all at shareholders’ expense. Unless a firm’s earnings are paid out as dividends, corporate insiders are capable of using these profits for personal use or pursue unprofitable investment projects that provide private benefits to themselves (LLSV, 2000a). As a result, dividends play a basic role in the limitation of expropriation because they remove the excessive earnings from under insiders’ control.

LLSV (2000a) classify two distinct agency models of dividends. The first one is the “outcome model”, under which one considers dividends as an outcome of investor protection. The second is the “substitute model”, under which one views dividend policies as a substitute for weak legal protection. LLSV test their agency models of dividends using an international sample of 4103 firms from 33 countries and present empirical evidence supporting the agency “outcome model” of dividends. They show that firms in countries with poor legal protection (often based on civil law) distribute lower dividends to shareholders. While those countries with better investor protection (often based on common law) make higher dividends.

A few prior studies have examined the relation between dividend payment and ownership structure. For instance, Faccio, Lang, and Young (2001) investigate expropriation problems through the perspective of dividend policies in European and East Asian firms. They find that (1) group-affiliated corporations in Europe pay higher dividends than in Asia; (2) loosely-affiliated groups whose control links all exceed 10% but do not exceed 20% do not pay higher dividends; and (3) a wider discrepancy between ownership and control is associated with lower dividend rates. They suggest that ownership structure does affect dividend payments. Focusing on Finnish listed firms, Maury and Pajuste (2002) find that the dividend payout ratio is negatively associated with the controlling ownership, and the presence of another large shareholder also affects the payout ratio negatively. They also conclude that controlling shareholders often have managerial ties (crony capitalism), which makes collusion between managers and controlling shareholders likely and tends to expropriate outside shareholders by paying lower dividends. In addition, Khan (2006)

examines the relationship between dividends and ownership structure of 330 large UK companies from 1985 to 1997. He finds that dividends are negatively associated with ownership concentration, suggesting that controlling ownership affects dividend payments.