The theory of science is introduced with philosophical traditions where positivistic and social constructivist philosophical traditions are discussed. Thereafter follow data collection, quantitative or qualitative method, the research design and research goals of this thesis are clarified and the section is concluded with the quality of research.
2.1.1 Philosophical traditions
There are two philosophical contrasting traditions within theory of science; Positivism and Social Constructivism. Each view has a list of associated assumptions and methodology implications. It is not common that one view is followed strictly; usually a mix of both worlds is used. The standard list of each view is summarized in table below:
[Table 1-1]
2.1.2 Research Questions
Based upon the analysis and reviews of literature, there could be following possible research questions related to this study.
Does the standard theory of finance throw any light on relevance of dividend policy to corporate valuation?
Is the dividend puzzle solved?
Why dividend policy is so important for the management of the companies and also for the investors who have a stake in them by holding their stocks?
Can a company increase its value by just changing its dividend policy?
Is there any model justifying previous research in order to solve dividend and other corporate finance puzzles?
Using the method of social constructivism we have collect qualitative data, exploratory research design, findings and analysis through various sources includes journals, books, magazines, newspapers to solve questions mentioned above.
2.1.3 Data Collection
There are different ways of collecting data; quantitative and qualitative method. There is a difference between positivism and social constructivism that affects the approach chosen. In positivism the research process is divided in three steps; collection of data, analysis of data and writing of the findings. In contrast to positivistic view of sequential steps, social constructivism methods take the form of circular process. Data collection can be analyzed immediately and the analysis affects future data collection. This is made visible in figure below:
[Figure 2-1]
Data collection used in this thesis
The data collection was qualitative according to social constructivism theories and the form of qualitative data used in this project is secondary data, contains literature background studies, published texts, magazines, newspapers, and books.
2.1.4 Research Design
There are two types of research design available, exploratory and conclusive. Conclusive design can then be divided into descriptive and casual; and performance-monitoring research (Orr, & Persson, 2003)
Exploratory research aims to increase the understanding of problems in a certain topic. It is not common with conclusions from exploratory studies because it is only exploration of the surroundings.
Conclusive research means evaluation of different alternative actions.
Descriptive research is a common research design and differs from exploratory research design. It aims to answer specific questions and solve a certain goal.
Casual research aims to find the facts and origin of a problem. This is applicable when the researcher is well read in the topic. This is used to verify gathered information.
Performance monitoring research gives information about possibilities and/or problems.
Research design used in this thesis
The research of this thesis is exploratory as well as conclusive, means it aims to understand the problem that why dividend policy is still a puzzle since 1956?, and is there any theory of finance is able to solve this puzzle?
2.1.5 Research Goals
There are two types of research goals, deductive and inductive. Deductive research has its starting point in theory. A hypothesis based on theory is compared with the empirical studies and the goal is to validate the theory studied. Inductive research has its starting point in empirical studies opposite to deductive studies. The goal is to find new theories with support from empirical studies.
Research goal used in this thesis
The research goal for this thesis is to validate if theory is applicable to practice, if theory matches empirical studies. Therefore the research goal is deductive.
2.1.6 Quality of Research
In business studies a good research is based on all the true information available from reliable resources; as opposed a bad research starts with conclusion and identifies supporting factoids (individual facts taken out of context). (Shalom, 1985)
A good research should contain a well defined research question requires judgement and honesty along with description of context and existing information about an issue. The research should be able to acknowledge possible contradictory evidences, errors and limitations. Consideration of various perspectives, critically discussing assumptions, carefully defines excluded factors, cautiousness in drawing conclusions and their implications and at the end proper references including original sources makes the research more appropriate and meaningful.
In contrast, a bad research contains misrepresentation legitimate facts to support introduction and conclusion as well it is unstructured with unwanted information. Due to these reasons relevant data can be ignored or distorted.
Clarification
The clarification of the result would be conducted in progressive style. This means that misunderstandings and clarifications will be making after reviewing the background literature studies. While, during this research an attempt will be made to respect the main criteria of the research in order to avoid biased information. However, due to the time limit of this study, it is not possible to contact company executives regarding their formation of dividend policy.
Our background
One of the major challenges during this study is to critically analyse the arguments and evidences of researcher community. I have studied this topic during the course 'Corporate Finance' and 'Financial Management' and have used the literature available for aid in conducting analysis and drawing conclusions. The supervisor of the project is experienced in the field of Corporate Finance.
2.2 Methodology of Dividend Policy
There are three main theories available to explain the methodology of dividend policy and all based on the idea of remitting residual earnings to investors. According to Baker and Wurgler (2004) "Residual dividend policy is one which a firm pays dividend from the amount remaining after undertaking all desirable projects from internally generated cash flows". Here desirable projects refer to projects with positive net present value and stockholders normally receive excess cash as dividend. But basically, amounts received from desirable projects and from internally generated cash flows are unpredicted. So, it can be said that residual dividend's amount is usually zero or highly variable and investors are uncertain because of such instability of dividend payments.
2.2.1 Pure Residual Dividend Policy
According to pure residual dividend policy, when the return of the company on equity capital becomes larger then the actual rate of return, the investor reinvests those dividends as another investment of equivalent risk. On the other hand, investor reinvests the earnings instead of issuing a dividend. A corporation normally decide which option is beneficial for investor with prior discovery of its optimal capital budget. Although dividends depend on earning fluctuations and this technique caused important ups and downs in dividends with changes in firm's investment opportunities and earnings. As the result, dividend payout ratio fluctuate because of changes in residual earnings are paid out. Kania and Bacon (2005) explained it by referring Droms (1990) that pure residual policy also results in a dividend varies from year to year but when equity investment becomes greater then the earnings, equity financing must be initiated to create a residual.
2.2.2 Smoothed Residual Dividend Policy
Smoothed or modified residual dividend policy states that dividend fluctuations should keep to a minimum point. As Kania and Bacon (2005) referred Shapiro (1990) statement from his book 'Modern Corporate Finance', "Dividends are set equal to the long-run residual between forecasted earnings and investment requirements. Dividend changes, in turn, are made only when this long-run residual is expected to change; earnings fluctuations believed to be temporary are ignored in setting dividend payments. The clear preference is for a stable, but increasing, dividend per share" so, on the bases of above argument, it can be said that if earnings are unexpectedly low, dividend payout ratio also fluctuates with the payment method.
According to few traditional scholars such as John Linter, dividends are sticky, paid by mature companies tied to long-term sustainable earnings smoothed from year to year. Few other practitioners and researchers confirmed these findings with more empirical evidences regarding dividend data, but nobody was able to explain why firms are so keen to smooth their dividends. There are some indications for firms believe that this type of behaviour is directly linked to firm publicly trade.
Empirical studies also show that the investor's reactions partially drive the management to cut the dividends. Michaely, Womack, and Thaler (1995) mentioned in his article 'Shareholder heterogeneity, adverse selection, and payout policy', there are severe consequences can occur by omitting dividend; equity prices fall, on average, by 6.1%. In another article 'Dividends, share repurchases and the substitution hypothesis', Grullon, Michaely and Swaminathan (2002) indicate that the reaction to increment or decrement of dividend is asymmetric: the abnormal returns associated with dividend increase and decreases are 1.34% and -3.71%, respectively (Grullon, Michaely, and Swaminathan, 2002). So, it can be said that there is an existence of empirical evidence regarding public capital markets in formation of dividend policy, and there is direct evidence on its irrelevance as well. Another point to be noticed is that public companies specifically less likely to amend their dividend policies through omissions, decrease or increase as compare to private firms.
2.2.3 Constant Payout Residual Dividend Policy
Constant payout residual dividend policy emphasize on maintaining a constant dividend payout ratio, which causes dividends to fluctuate with earnings.
