A number of factors influence payout policy. For instance, because of the tax difference between institutions and retail investors, firms tend to determine payout policy according to different shareholders (Allen, 2000). Firms that are subject to information asymmetry are less likely to pay dividends (Li and Zhao, 2008). Meanwhile, firms facing high levels of financing constraints choose low dividend payout ratios to reduce the probability of being forced to raise external funds in the future (Fazzari et al., 1988). Although there are numerous factors affecting payout policy, the present paper focuses on the agency problem and growth opportunity when deciding on dividend payout policy.
Jensen (1986) proposes the free cash flow hypothesis, which implies that managers of firms are likely to undertake low-benefit or even value-destroying decisions when firms have a large free cash flow. Free cash flow refers to cash flow in excess of that required to invest all projects with positive net present values when discounted at the cost of capital. Based on this definition, it can be stated that managers have conflicts when firms generate free substantial cash flow. The problem is how to induce managers to disgorge the cash rather than invest on a project, which is below the cost of capital. Easterbrook (1984) and Jensen (1986) point out that dividends and debts are substitute mechanisms for controlling the agency cost of free cash flow. Zwiebel (1996), Fluck (1999), and Myers (2000) highlight the idea that dividend payout policy can solve agency problems between inside managers and outside shareholders.
Managers tend to invest surplus cash unproductively if left to their own device (Richardson, 2006; Dittmar and Mahrt-Smith, 2007). From the research above, we infer that the best way to solve agency problems is either to pay cash dividends or increase debts.
In the early years of a company, when firms pay few dividends, investment opportunities exceed their internally generated capital. As firms become more mature, the investment opportunity becomes smaller, thus facilitating the firm’s transition from a high growth phase
to a low growth phase. Firms pay out the excess funds to mitigate the possibility that the free cash flow would be wasted or overinvested when internal funds exceed investment opportunities. Some studies refer to this explanation as the maturity hypothesis (Grullon et al., 2002). Smith and Watts (1992) argue that if firms have a high investment opportunity, they are likely to pursue a low dividend payout policy. Jones (2001) and Abor (2010) find out that high growth firms are associated with significantly low dividend payout policy. Fama and French (2001) as well as Grullon et al. (2002) argue that firms optimally alter payout policy through time according to the evolution of their opportunity set.
We know that growth opportunity and payout policy have a negative relationship. However, agency problems and payout policy have a positive relationship. Thus, if firms want to grow quickly, they must retain large cash to invest in the future. If firms want to solve agency problems, they have to pay more dividends. Moreover, firms have to make a choice as to whether they should face the trade-off between growth opportunity and agency problems. In this paper, we highlight not only the relationships among growth opportunity, agency problems and payout policy, we also examine the relationship between product market
competition and payout policy. We want to know whether or not there are different degrees of agency problems and growth opportunities in different levels of product market competition.
In this paper, we also aim to discuss the relationship between payout policy and production market competition.
The literature confirms the positive relationship between competition and managerial incentives. If managers have more incentives, there will be less agency costs in firms. This concept can be traced back to the influential book, Wealth of Nations, written by Adam Smith.
In this work, the author states that monopoly is actually an enemy of good management. In the past years, numerous studies have tried to prove this argument in different ways. For example, Hart (1983) shows that greater competition provides strong implicit managerial
incentives by modeling the effect of competition on the agency problems between a firm's owners and managers. Nickle (1996) examines productivity directly to support his view that competition reduces managerial slack. Likewise, Schmidt (1997) shows that an increase in competition increases the possibility of liquidation, which has a positive effect on managerial effort. In such a case, managers are motivated to work harder in order to retain their jobs.
Ravi (2000) proves this view using the indirect method. He argues that an unanticipated increase in cash flow due to high past returns can cause an unnecessary reduction, hence, a lowering of returns in less competitive environments. Finally, Kruna (2007) provides a direct test of the relation between competition and incentives based on three dimensions of competition, given the level of industry concentration (i.e., greater product substitutability, greater market size, and lower entry costs reflect greater price competition). In summary, competition can reduce managerial slack from the points of the productivity, liquidation, and cash flow. We support this concept from the point of free cash flow. In order to solve agency problems and provide strong managerial incentives, firms prefer to pay more dividends in order to reduce their free cash flow and encourage managers to work hard. If free cash flow decreases, these managers must have to work hard and avoid wasting resources by overinvesting.
The relationship between competition and growth opportunity within an industry or country is a topic of policy debate. In a highly publicized book, Michael Porter (1990) strongly argues that companies gain advantage through differentiation against the world’s best competitors brought about by pressure and challenge; thus there exists a positive causal relation between competition and growth. Some authors (e.g., Romer, 1990; Aghion and Howitt, 2002) claim that innovation is the engine of growth. Other authors (Lee and Wilde, 1980; Bertschek, 1995;
Blundell et al., 1995; Nickell, 1996) point out that competition favors innovation and drives companies to increase their research and development (R&D) efforts. Therefore, market
competition induces companies to innovate to become stronger, and in turn, companies can expect to have more growth opportunities to invest in. However, the theoretical literature on competition and growth is somewhat one-sided. For example, Loury (1979) establishes a patent-race model, whereas Martin (1993) establishes a Cournot principal-agent model, which proves that market competition has a negative effect on firms’ incentives to increase their R&D efforts. From the point of growth bottleneck, Caballero and Jaffe (1993) obtain the same conclusion when they find that competition raises the elasticity of substitution between goods, thus reducing monopoly rents and destroying a firms’ creation at the same time. Grossmann and Helpman (1991) indicate that competition curbs R&D and growth when firms facilitate imitation. It is clear that there are two different opinions to show the effect of market competition on firms’ innovation and growth. In this study, we aim to explore whether the relationship between product market competition and growth opportunity is positive or negative.
Different levels of concentrated industries correspond to different levels of agency problems and growth opportunities. We know that agency problems and payout policy have a negative relationship, while growth opportunity and payout policy have a positive relationship.
The question is, in less concentrated industries, will firms pay more dividends to solve agency problems, or retain cash to invest in the future? Our issue is to explore the choice firms make in relation to payout policy. We hypothesize that if payout policy and product market competition have a negative relationship, then firms would prefer to invest in the future. In addition, if payout policy and product market competition have a positive relationship, then firms would prefer to pay dividends to solve agency problems.