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The Relationship between Capital Structure and Dividend Policy of Firms Listed In
London Stock Exchange

(Research Proposal)

[Writer]

[Institute]

[Date]
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Table of Contents
1.0 Introduction ............................................................................................................................... 4

1.1 Contextual Background ........................................................................................................ 4

1.2 Research Problem ................................................................................................................. 5

1.3 Research Aim and Objectives ............................................................................................... 6

1.4 Research Hypothesis ............................................................................................................. 6

1.5 Rationale of the Study ........................................................................................................... 6

1.6 Structure of the Research ...................................................................................................... 6

2.0 Research Methodology ............................................................................................................. 7

2.1 Research Approach ............................................................................................................... 7

2.2 Research Design.................................................................................................................... 7

2.2.1 Quantitative Research .................................................................................................... 8

2.2.3 Descriptive Survey ......................................................................................................... 8

2.3.4 Data Collection Methods ............................................................................................... 8

2.3.5 Data Analysis ................................................................................................................. 8

3.0 Literature Review...................................................................................................................... 8

3.1 Introduction ........................................................................................................................... 8

3.1.1 Dividend Policy ............................................................................................................. 8

3.1.2 Capital Structure ............................................................................................................ 9

3.2 Dividend Theories ................................................................................................................. 9

3.2.1 Irrelevance Theory ......................................................................................................... 9

3.2.2 Information Content/Signalling Effect Theory ............................................................ 10

3.2.3 Bird in the Hand Theory .............................................................................................. 10

3.3 Capital Structure Theories .................................................................................................. 11

3.3.1 Trade-Off Theory ......................................................................................................... 11

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3.3.2 Pecking Order Theory .................................................................................................. 11

3.3.3 Agency Cost Theory .................................................................................................... 12

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The Relationship between Capital Structure and Dividend Policy of Firms Listed In
London Stock Exchange

1.0 Introduction
Organisations have both sources, internal and external, and they can use them effectively with
the aim of financing their investments. Retained earnings and depreciation are both internal
sources, while external sources mean new borrowings or the stock related issue. So, the decision
related to financing involves in-depth valuation of two corporate financial policy options, which
are the dividend policy in terms of pay-out ratio and the capital structure choice as a fraction of
finance from external sources to be borrowed and the fraction to be raised in the new equity
form.

There are lots of research studies on these corporate financial policies, which have two important
aspects. The first one is the dividend policy related theories that differ from the capital structure
theories, as, these theories or policies have been treated by literature as two distinct choices,
although some reasons lead people to believe that common factors are there that can affect both
choices (Asquith and Weiss, 2016). In the second place, the empirical achievement of these
theories has been mixed at best, which left a range of unanswered queries. These two theories are
collectively ascertained as an integral part of a range of control allocations within the firms
between managers and investors, and for this very reason, the same basic factors drive the cross-
sectional variations in both theories.

With this consideration in mind, this research study aims to evaluate whether there is an
association between the capital structure and dividend policy in terms of pay-out ratio of
organisations listed in the London Stock Exchange (LSE).

1.1 Contextual Background

For firms, decisions associated with the highly favourable choice of financing sources as well as
related to dividend policy are indeed very difficult. Dividend policy helps in ascertaining the
degree of internal financing by an organisation. The core responsibility is on the shoulders of the
finance manager whether to release corporate earnings from the enterprise’s control. Because
such areas may be affected by dividend policy as the financial structure, business liquidity, the
liquid funds flow, stock prices and satisfaction of the investor, it is undoubtedly a very crucial
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facet of financial management (Sogorb-Mira and Lopez-Gracia, 2003). The reason behind why
questions related to dividend policy are exciting is that, agreeing upon the percentage of the
firm’s earnings to be paid out to shareholders or investors is indeed a crucial and critical decision
faced by the management personnel of a company (Franklin and Winton, 1995). Besides this, it
is necessary to comprehend dividend policy properly for various corporate finance areas,
including capital structure, planning process of capital budgeting or investment assessment,
theories related to asset pricing, and mergers and acquisition (M&A) and since they depend on
how and why a certain part of the earnings of a firm are compensated (Franklin and Winton,
1995).

Dividends refer to previous or present earning distribution in real assets among the firm’s
shareholders or investors according to their investment in the company. Dividend policy implies
a policy related to pay-out to shareholders, and which managers make decisions regarding the
dividends’ size, volume and pattern. Organisations have the absolute right to go with the specific
level of dividend, even though various determinants including legal necessaries, debt agreements
and the cash resources and their availability create certain limitations on this specific decision.
Diverse variations are noted amongst organisations (Gugler, 2003). There are some concrete
examples from Saudi Arabia and America that their organisations paying dividends to their
shareholders incline to large and lucrative, while there typically small and less lucrative non-
payers but they are enjoying the greatest opportunities of investment.

1.2 Research Problem

Although there is extensive research, the dividend policy in terms of pay-out percentage and
capital structure still remain the contentious areas of debate. It is the fact that there are many
unanswered questions regarding shareholders’ likeness of dividends and the reason they reward
managers for paying properly dividends. In past, there are many researchers who conducted
research studies with the aim of unearthing and highlighting the issue related to the dividend
patterns but there is no any satisfactory description yet for the witnessed dividend behaviour of
organisations (Myers and Marcus, 2007; Michaely and Roberts, 2012).

In their empirical study, Benartzi, Michaely and Thaler (1997) determined the association
between the firms’ dividend policy and capital structure, and they eventually come to a
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conclusion that changes in the dividend is highly sensitive. The current research study aims to
gather the present data of the firms listed on the LSE.

1.3 Research Aim and Objectives

The key aims of this research study are to find and evaluate the association between the capital
structure and dividend policy of the firms listed at the LSE and how these two corporate financial
policies can explain and support the financial decisions in the United Kingdom. In doing so, the
objectives of the study are:

 To find and evaluate the association between the capital structure and dividend policy of
organisations listed at the LSE; and
 To find and evaluate whether capital structure and dividend policy support and explain the
UK firms’ financial decisions.

1.4 Research Hypothesis

H1: There is a strong relationship between the firms’ capital structure and dividend policy.

1.5 Rationale of the Study

To find and evaluate the association between capital structure and dividend policy, the literature
provide conflicting views and instances of various researchers regarding direct and indirect
relationship between them. According to some researchers, there is a direct association between
a firm’s dividend policy and the capital structure. As an instance, if a company pays to its
shareholders, it can use the internal sources with the aim of minimising the levels of financing of
equity capital successfully, and therefore may require sources of financing from external world
(Rzeszowski and Sierpińska, 2012). However, other researchers, such as Franc-Dabrowska
(2009), reported that there is no direct relationship, even though they do apply a powerful impact
on the value of equity capital. Thus, it appears that there is an ambiguity because of unclear
association between the firms’ dividend policy and capital structure.

1.6 Structure of the Research

 The first chapter is ‘Introduction’ where the contextual background of the study, research
problem, aims and objectives, rationale of research, significance of research, and study
limitations will be discussed.
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 The second chapter is “Literature Review” where the existing research studies on the
association between dividend policy and capital structure will be discussed, while explaining
dividend policy as a controversial area with strong stress on the recent past empirical studies.
 The third chapter is “Research Methodology” where research approach, research design and
strategy, method of data collection, research instrument, sampling method and data analysis
will be presented. For this, Research Onion will be used to illustrate various stages by which
the researcher needs to pass while developing an effective research methodology.
 The fourth chapter is “Results and Findings” where main research findings will be presented.
 The fifth chapter is “Data Analysis” where the results and findings will be analysed and
presented.
 The sixth and last chapter is “Discussion and Conclusion” where major insights and
understanding, along with the concluding points of the study, will be summed up.

2.0 Research Methodology

2.1 Research Approach

The deductive and inductive are two research approaches. The deductive approach develops the
research hypothesis (es) upon a preceding theoretical assumption and then develops the research
approach to examine it. However, the inductive approach moves from the specific to the general
(Heit and Rotello, 2010). In this research study, the deductive research approach will be used
because this is best suited to such contextual backgrounds where the research problem is about
the investigation whether the observed processes or developments fit with expectation developed
on the basis of past research works.

2.2 Research Design

A descriptive design will be followed in this research through which the association between
capital structure and dividend policy of the organisations listed in the LSE. For this reason, the
aim of this research study is to find and evaluate the association between two corporate financial
policies as two variables. In doing so, a descriptive survey will be conducted. The descriptive
designs may lead to a description of the data, either in the form of texts, graphs or tables, and
point out whether the statistical relationships is revealed by data analysis or is simply descriptive
in nature (McCrary, 2010).
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2.2.1 Quantitative Research

As the research topic is about finding the relationship between two variables, quantitative
research will be used in this study. This research approach includes some important highly
recognised statistical standards for the approach and its validity, like the participants’ number
required with the intention to get the statistically substantial outcomes (McCrary, 2010).

2.2.3 Descriptive Survey

As it is a quantitative research, descriptive survey will be conducted to explore and describe
events with the aim of finding relationship between two variables. Descriptive research studies
aim to find ‘what is’, so the approach of survey is often applied to gather descriptive data
(McCrary, 2010).

2.3.4 Data Collection Methods

Secondary sources will be approached to collect data. In doing so, annual financial reports of the
LSE listed firms and other highly informative information related to association between capital
structure and dividend policy will be sourced. The data from the financial reports as statements
from 2006 to 2016 of five UK-based firms listed in the LSE will be gathered.

2.3.5 Data Analysis

The secondary data will be organised in a systematic way to facilitate analysis. At this stage of
the research, the collected data will be prepared in terms of coding and editing that will make the
processing easier. For this SPSS software will be used. In this regard, regression model will be
used with the intention of finding the association between two variables. The variation between
these variables will be explored and explained by using correlation analysis approach.

3.0 Literature Review

3.1 Introduction
This section will discuss and analyse a variety of capital structure and dividend theories that are
not consistent with each other, and the association between capital structure and dividend policy.

3.1.1 Dividend Policy

A firm’s dividend policy refers to the strategy adopted with the intention of deciding on the
dividends’ size and the payment timing. A firm’s dividend policy is framed by a variety of
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determinants. A firm’s dividend policy can be affected by availability of the greatest

opportunities for investment, flotation costs and projected instability of prospective earnings,
deliberations about tax, financial flexibility and a variety of other legal restrictions. (Gugler,
2003)

3.1.2 Capital Structure

The capital structure of a company means the association made between debt and equity finance
in its funding planning and organisation for the long-term. It has been defined by Gill, Biger and
Mathur (2011) as how a company provides money for its all operational activities and overall
business growth through diverse funding sources. The bond issues or long-term notes payable is
the form of debt, while equity comes in the form of common stock, chosen stock or retained
earnings. The working capital requirements as a short-term debt are also viewed as an integral
component of a firm’s capital structure.

3.2 Dividend Theories

3.2.1 Irrelevance Theory

According to Modigliani and Miller (1961) (cited in Hussainey, Oscar Mgbame and Chijoke-
Mgbame, 2011), the dividend policy is not relevant in a world which is perfect and with no taxes
or cost related to bankruptcy. They also added that there is no effect of a firm’s dividend policy
in terms of pay-out ratio on its stock price or capital structure (Hussainey, Oscar Mgbame and
Chijoke-Mgbame, 2011). Moreover, if dividend is received by shareholders, which is beyond
their expectation then they can invest again in the stock of firm with the surplus cash flow.
Likewise, in case of too little dividend, then they has the right to sell a specific percentage or all
of the shares, while duplicating the same cash flow they would receive if the disbursement was
what they projected. (Hussainey, Oscar Mgbame and Chijoke-Mgbame, 2011) Shareholders, in
both situations, are irrelevant to what the dividend policy set by a firm is because their own cash
flows can be created by them. They come to a conclusion that due to the companies’ best
investment policy, there is no impact of their dividend policy on the wealth of shareholders,
suggesting that all the policies are equivalent (Hussainey, Oscar Mgbame and Chijoke-Mgbame,
2011).
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3.2.2 Signalling Effect Theory

By conducting empirical studies, Stephen Ross (1979) (cited in Allen and Morris, 1998)
advanced this theory, in which he suggested that an increase in share price also increases
dividend in general. Typically, dividends are preferred by shareholders to capital benefits (Allen
and Morris, 1998). The announcements about the dividend fund communicate information to
shareholders concerning the firm’s expectations (Bhattacharyya, 2007).

According to this dividend theory, changes in the policy communicate information related to
changes in future cash flows (Bhattacharya 1979, Miller and Rock, 1985). A positive association
is suggested by this theory made between dividend policy and information imbalance, meaning
that the high level of the imbalance information makes the dividend’s sensitivity to company’s
future projections. There are many researchers conducting empirical studies with the intention of
testing the informational content after changes in the dividend policy, but they all have
contradictory views regarding the sign and the implication of the information imbalance and its
effect on the policy (Grullon and Michaely, 2002). Moreover, this theory also gives an account
about the predilection for dividends over stock redemptions regardless of the latter’s tax benefit.

3.2.3 Bird in the Hand Theory

Gordon (1962) and Lintner (1962) (cited in Ali and Chowdhury, 2010) developed this theory,
which was basically a response to irrelevance theory, mentioned earlier. According to theorists,
in their theory a mistake was made by Modigliani and Miller (cited in Hussainey, Oscar Mgbame
and Chijoke-Mgbame, 2011) by imaging a firm’s dividend policy lacks impact on its capital cost.
They maintained that the higher capital costs are due to lower pay-outs; hence, they proposed
that dividend is preferred by the shareholders because it is surer as compared with capital
advantages that might or might not emerge if the company is allowed by them to keep its
earnings. Litner and Gordon concluded that because dividend has a less risky nature, the
company’s dividend flow will be discounted by shareholders at a low rate of return hence
enhancing the shares’ worth. However, Modigliani and Miller (1961) and Hussainey, Oscar
Mgbame and Chijoke-Mgbame, (2011) criticised this theoretical concept by maintaining that the
risk of a company is ascertained by the insecurity of its operating cash flows, not through how
the earnings are distributed by it (cited in Al-Malkawi, Rafferty and Pillai, 2010; Hussainey,
Oscar Mgbame and Chijoke-Mgbame, 2011). So, this approach of Gordon and Lintner (cited in
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Ali and Chowdhury, 2010) is considered by Modigliani and Miller as the bird-in-the-hand
fallacy.

3.3 Capital Structure Theories

3.3.1 Trade-Off Theory

Popularised by Modigliani and Miller (1961) (cited in Luigi and Sorin, 2009), it is assumed by
this theory that within a capital structure there are advantages to leverage up to a time that the
desired capital structure is achieved. The tax benefit from interest payments is also recognised by
this theory; nevertheless, the researchers maintain that there is less leverage of the majority of the
firms as compared with this theoretical approach that would suggest is optimal.

As compared with the irrelevance theory, the possible benefit from debt in a capital structure has
been found as a key dissimilarity, and this benefit emerges from the interest payments and their
tax benefit (Luigi and Sorin, 2009). Since taxes are not assumed by irrelevance theory, this
benefit is not acknowledged, different from the trade-off theory of leverage, in which taxes and
consequently the interest payments’ tax benefit are recognised (Luigi and Sorin, 2009).

3.3.2 Pecking Order Theory

It is predicted by this theory that owing to the information imbalance between a company and
shareholders concerning the actual worth of present operational activities and future prospects,
debt and equity as the external capital will always be comparatively expensive than the firm’s
retained earnings. According to Myers (1984) (cited in Zoppa and McMahon, 2002), information
imbalance will result in company equity’s miss-pricing in the market, meaning that the company
will loss it wealth for existing investors. The reason behind this is the contrary selection problem
arising as the management personnel are more well-informed compared to outside shareholders.
Moreover, the securities will be under-priced in case if new assignments are financed by a
company and for this it issues new securities. The reason here is that the management personnel
lack the communication skills because they cannot communicate the attributes of their current
possessions and available opportunities for investment to prospective shareholders. Thus, outside
investors may not be recognise or distinguish between unfavourable projects. (Zoppa and
McMahon, 2002)
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However, Adedeji (2002) do not support the arguments of Myers, According to Adedeji (2002),
the pecking order theory only suggests the lack of internal funds that encourage companies to
raise funds on or from the outside is called into question. The reason here is that other theories
are overlooked by it and the impacts made by the institutional determinants that might impact the
company’s option of financing approaches.

3.3.3 Agency Cost Theory

Jensen and Meckling (1976) (cited in Anderson, Mansi and Reeb, 2003) developed this theory
and argue that to ascertain a company’s optimal capital structure, it is necessary to reduce the
costs emerging due to disputes constituted between the groups involved because the part
contributed by agency costs is pivotal in decisions associated with financing because of the
dispute that may possibly emerge between the investors and the debt holders. According to
researchers, due to higher agency costs with a dispute mentioned, an optimum blend of external
debt and equity would be there to minimise absolutely the agency costs (Anderson, Mansi and
Reeb, 2003). The argument of Shleifer and Vishny (1997) and Grossman and Hart (1982) (cited
in Anderson, Mansi and Reeb, 2003) is that agency costs can be minimised by debt, and for this,
a company needs to increase the likelihood of liquidation and to provide a managerial
punishment. Findings of Bradley et al. (1984) (cited in Onaolapo and Kajola, 2010) and
Hussainey, Oscar Mgbame and Chijoke-Mgbame (2011) are that the costs of bankruptcy will be
enhanced by the factor of unpredictability or instability in earnings, which ultimately will lead to
an escalation in the agency costs, hence, less debt is frequently employed by organisations.
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