Introduction

The main objective of this research is to explore the current research by investigating factors influencing retail investors' preferences on dividends payouts in China. More specifically, the paper will 英國dissertation網examine the impact of two contradicting factors: tax and agency cost concerns on retail shareholders' preferences.
Dividend policy, as one of the three core components of corporate finance, has been the subject of much research in the last few decades. Generally, the subject was studied from two main research lines: motives for dividend policy and market reaction to dividend policy (Li et al, 2009).
In the last five decades, there has been a sustained academic interest in examining the motives for dividend decisions (Li et al., 2009; Wei and Xiao, 2009; Guo and Ni, 2008). There is a general agreement among researchers that investors' preference is one main determinant and motive for companies' dividends decisions. More specifically, Baker and Wurgler (2004) provided evidence that dividend decision can be interpreted from the perspective of catering theory. That is managers tend to initiate dividends when investors demand for dividend payers increase and tend to omit dividends when investors prefer non-payers.
Shareholders' preferences -as a determinant of dividend policy- and factors influencing their preferences have been investigated from different angles. For instance, some research focused on agency problem and found a relationship between shareholders' legal rights and dividends preference (Jiraporan and Ning, 2006; La Porta et al., 2000). Others focused on other factors such as age, level of income and tax incentives (Graham and Kumar, 2006).
If shareholders' preferences for dividends are explained from agency theory point of view, it is expected that retail investors would prefer cash dividends over stock dividends. That is since retail investors have no control over managers' behaviour and have no information on the profitability of future projects and investments; they prefer to restrict managers' undesired behaviour by reducing the available cash (Li and Huang, 2006).
However, since tax regulations in China differentiate between dividends and capital gains, tax incentives may influence investors' preferences. Cash dividend is subject to 20% tax rate whereas capital gains are tax free in China (Wei and Xiao, 2009). Consequently, if tax was the concern of investors, it is expected that investors would prefer stock dividends over cash dividends. Hence, it is assumed that agency theory and tax are adversely related in terms of their impact on investors’ choice for cash and stock dividends.
Guo and Ni(2008) found that the firms with higher institutional investors are more likely to pay dividends where tax advantage is highly associated with institutional preference for cash dividends. Furthermore, Wei and Xiao (2009) investigated investors’ preferences for cash and stock dividends in China and found that stock dividend is positively associated with the proportion of publicly tradable shares. Tax consideration was among the reasons for this positive relationship (Wei and Xiao, 2009). Graham and Kumar (2006) found that tax is a major concern for young investors and a minor concern for old investors. Investors’ preference was found to be influenced when tax is a major concern.#p#分頁標題#e#
Since tax and agency problem may play a contradicting role in influencing retail investors' preferences for cash and stock dividends, this paper aims at examining the impact of these factors on retail investors in China. Furthermore, this paper aims at investigating circumstances upon which tax and/or agency problem becomes a major concern for retail investors.
Most of previous researchers examined investors' preferences based on companies’ dividends payouts and not based on data collected directly from investors themselves. Furthermore, most of the previous research focused on cash dividends and investigated investor’s preferences for dividends payers and non payers. This paper aims at examining retail investors’ preferences for cash and stock dividends in China based on firsthand questionnaire data targeted retail investors directly so as to examine the following hypotheses:
For the purpose of this study, retail investors will be categorized into two groups based on the length of their investment; long term investors and short term investors. Long term investors those who invest 英國dissertation網in publicly traded firms for the purpose of long run growth. Short term investors buy publicly traded firms’ shares for the purpose of generating capital gains by selling the shares after reaching a targeted price. Hence, it is expected a relationship does exist between the objective of investment and the concern of investors. This relationship will be examined by testing the following two hypotheses:
Hypothesis 1: Long term investment objective is positively related to retail investor’s concern of agency problem.
Hypothesis 2: Short term investment objective is positively related to retail investor’s concern of tax factor.
Furthermore, as discussed previously, when investor’s concern is on agency problem, he would prefer cash dividends over stock dividends. In contrary, when the concern is the tax factor, investor would prefer stock dividend over cash dividend. This will be examined by testing the following two hypotheses:
Hypothesis 3: retail investor’s concern of agency problem is positively related to his/her preference of cash dividends over stock dividends.
Hypothesis 4: short term investor’s concern of taxation is positively related to his/her preference of stock dividends over cash dividends.
The remainder of this dissertation will be structured as follows. The next chapter provides a review of the relevant literature, based on articles, books, websites and relevant regulations. Chapter three discusses the research methodology. This will be followed by a discussion and analysis of the research findings in Chapter four. Chapters five, six and seven provide conclusions, recommendations and research reflections.  
2. Literature Review

This chapter will provide an overview on our literature review that covered the topic of this research and related topics. The following sub-section will provide a brief discussion on dividend policy as one of the three core components of corporate finance and its impact on shareholders’ wealth. This will be followed by providing a discussion on the empirical studies that investigated topics related to the impact of tax on dividends decisions and shareholders’ preferences for dividends. Then the preference of shareholders for cash and / or stock dividends will be discussed from the perspective of agency theory.#p#分頁標題#e#

2.1 Dividend Policy and Shareholders’ Wealth

Simply, Dividend policy is defined as “The determination of the proportion of profits paid out to shareholders” (Arnold, 2008: 840).
The return investors expect to generate from their investment in publicly traded companies may come from dividends payments and / or capital gain (the gain from selling the shares for an amount higher than the cost of those shares).
The value of the firm (the wealth of shareholders) is influenced by (among other factors) the pattern and size of dividend payments (Arnold, 2008).
Despite the fact that commercial companies put shareholder value in second or third place behind other objectives, it is argued that shareholders’ wealth maximization must be the first objective and managers should aim to create as much wealth as possible (Arnold, 2008). He argued that concentrating on maximizing shareholders’ wealth will benefit the society as a whole. This (according to him) can be achieved by directing sources to their most valuable uses which will maximize the productivity and enable high economic growth and higher standards of living which will benefit the society as a whole.
Several theories discussed the impact of dividend policy on shareholders’ wealth. Over the last century, three schools of thought have emerged. The first is that dividends are neutral and irrelevant in stock price valuation. A second view believes that stock prices are negatively correlated with dividend payout levels and consequently destroy value for shareholders. The third group of theories maintains that firm dividend can be value increasing (Frankfurter and Wood Jr., 2002).
Miller and Modigliani (1961) argued that if some assumption can be made, dividend is irrelevant to share value. Their proposition assumed a perfect world (markets) with no tax, no transaction costs (including buying, selling and issuing shares), free access to information, no difference between dividends and capital gain and investors can borrow and lend at the same interest rate. With these http://www.ttc-switch.com/Thesis_Tips/Reference/Literature_Review/assumptions in place, managers should not spend time and effort on deciding the size, pattern and type of dividends to be paid out to shareholders. As (according to them) weather dividends paid or retained as a profit to finance potential investments with positive net present value, the share’s value will not be affected. If dividends paid, the firm can borrow or issue new shares with no additional transaction cost and no tax differences to compensate for the funds paid to shareholders. And if the firm maintains the profit for the potential investments, shareholders can compensate for the dividends by selling part of their portfolio without transaction cost and with no tax differences. So, with these “irrelevant” assumptions dividend is irrelevant.
Since the assumptions upon which Miller and Modigliani’s proposition was based don’t exist in the real world, other theories were proposed and argued that the pattern and size of dividends influence #p#分頁標題#e#Litrature Review樣本the shareholders’ wealth. For instance, some models considered the tax factor and argued that if shareholders are taxed more heavily on dividends than on capital gains, shareholders wealth is positively (negatively) influenced by less (more) cash dividends (Farrar and Selwyn,1967; Brennan, 1970; Auerbach, 1970a; Auerbach, 1979b). The following sub-section will provide more insight into taxation a
2.2 Taxation and Dividend Payouts

Dividend tax clientele theory suggests that firms with lower dividend payout ratios tend to attract investors with higher marginal tax rates whereas firms with higher dividend payout are favored by tax advantaged investors (Arnold, 2008). This theory has been the subject of much research worldwide. Investigating the relationship between dividend clientele theory and taxation, Elayan et al. (2009) provided evidences support dividend tax clientele theory. Their study aimed at exploring the relationship between tax-induced dividend clientele theory and the recent changes to the taxation of income trusts in Canada after the announcement of Tax Fairness Plan (TFP) on October 2006. This announcement called for the elimination of the considerable tax advantage enjoyed by income trusts, and imposing a 31.5% tax increase on tax-exempt and tax-sheltered investors, a 27.5% tax increase on nonresident investors and a slight tax decrease of 0.50% for taxable Canadian investors.
Their results suggest that taxes on dividends reduce the net return to investors, increase the firm’s cost of capital and lower the firm’s ability to access capital markets. Furthermore, they found that trusts with a larger percentage of their units held by the group of investors that face significant increase in tax rate (tax-exempt, low-tax, and foreign investors) had a higher decline in value when compared with trusts held by Canadian taxable investors. Finally, they found that tax-exempt, low tax and foreign investors reduced their investment in trusts as a result of this announcement during the twelve months period following the announcement.

Moser and Pucket (2009) investigated the dividend preferences of tax-advantaged and taxable institutions across different tax regimes during the period from 1987 to 2004 in USA. Their investigation examined two hypotheses. The first is that tax-advantaged (taxable) institutions’ preference for dividends is positively (negatively) related to the magnitude of the dividend tax penalty. The second hypothesis stated that changes in tax-advantaged (taxable) institutions’ preference for dividends are positively (negatively) related to changes in the dividend tax penalty. The sample period faced many changes in tax rates on dividend and capital gain tax rates. The following table presents the changes in tax rates and the differences between dividends and capital gain tax rates during this period

Period Dividend Tax Rate (Td) Capital Gain Tax Rate (Tcg) Dividend Tax Penalty [(Td – Tcg) / (1 – Tcg)]#p#分頁標題#e#
1987 38.5% 28% 14.6%
1988 to 1990 28% 28% 0
1991 to 1992
31% 28% 4.2%
1993 to 1996 39.6% 28% 16.1%
1997 to 2000 39.6% 20% 24.5%
2001 39.1% 20% 23.9%
2002 38.6% 20% 23.3%
2003 to 2004 15% 15% 0

Their findings revealed that when the dividend tax penalty increases, tax-advantaged shareholders purchase dividend-paying stocks, and taxable institutional shareholders generally sell dividend-paying stocks. In contrast, after decreases in the dividend tax penalty, they found opposite result. This indicates that tax factor is highly considered by investors (institutional investors in the above mentioned study) and their decisions of buying and selling shares is influenced by this factor. If firms considered this factor and aim at attracting specific type of investors, their dividend decisions will also be influenced by the tax factor.
In another study, Guo and Ni (2008) aimed at examining the linkage between dividend policy and institutional ownership within the context of the dividend model of Allen, Bernando and Welch (2000). This model suggests that a tax differential between institutions and retail investors effects dividend policies. Using merge data of US industrial firms from 1980 to 2000, they provided evidence supports Allen, Bernando and Welch’s (2000) model. Particularly, they found that the firms with higher institutional investors are more likely to pay and continue to pay dividends where tax advantage is highly associated with institutional preference for cash dividends. Furthermore, they found that tax credit or deferred taxes significantly contribute to the initiation of the dividend and the dividend amount.
Studying stock holdings and trading behavior of more than 60,000 households, Graham and Kumar (2006) found that tax is a major concern for young investors and a minor concern for old investors. Investors’ preference for cash dividends was found to be influenced when tax is a major concern.

2.2.1 Investment Environment in China

Chinese listed companies comprise of non-publicly tradable share shares (NPTS) and Publicly Tradable shares (PTS). NPTS are twice the size of PTS and held by government agencies, state-owned enterprises (SOE) and other institutions. PTS held by private investors and foreign investors and can be traded publicly in the stock exchange (Cheng et al., 2009).
Chinese listed companies, unlike other European and U.S companies, tend to pay both cash and stock dividends. For instance, during the period from 1993 to 2006, 34 percent of listed companies Chinese companies paid stock dividends while 47 percent paid cash dividends (Wei and Xiao, 2009). Regardless the factors that influence the dividend decision worldwide, the investment environment upon which Chinese listed companies operate may influence their decision. For instance, in 2000 and 2001, China Securities Regulatory Commission (CSRC) considered cash dividend payment as a necessary condition for listed companies to offer a right issue or to raise new finance through a capital market (Wei and Xiao, 2009). These regulations may influence cash dividend payment decisions. In terms of stock dividends, Regulations may influence Chinese listed companies in two dimensions. The first is that starting from 1994; the corporate law prohibited listed companies from splitting their stock. Unlike other countries, where stock split may substitute for stock dividends, Chinese companies have no alternative other than stock issue to adjust the share price and increase its liquidity. Secondly, when companies tend to prepare a right issue, announcement of stock dividends may increase the stock price which will be fixed in the right issue. This related to the process and upon which companies propose the annual dividend payment plan and the right issue. #p#分頁標題#e#
In terms of tax, in China tax regulations differentiate between cash dividends and capital gains on one hand and between NPTS and PTS holders on the other hand. For PTS holders (Private investors) Cash dividend is subject to 20% tax rate whereas capital gains are tax free in China (Wei and Xiao, 2009). Whereas, NPTS holders are free of tax on any cash dividends but subject to corporate income tax for any capital gain. Furthermore, retail investors can benefit from stock dividends payment from both a significant capital gains and a tax saving relating to the capital gains. Significant capital gain may be generated due to the positive reaction of market to stock dividend announcement. According to Wei and Xiao (2009), it is evidenced that share price significantly increases on the announcement of stock dividends. Furthermore, Cheng et al (2009) examine data for Chinese firms listed on the Shanghai and Shenzhen Stock Exchanges to explore reasons why firms pay out stock or cash dividends. Their findings revealed that stock dividends typically generate positive market reactions, despite earnings increases or declines and that the market views stock dividends positively and cash dividends negatively.
Using an unbalanced panel dataset of non-financial companies listed on the Chinese financial markets, Wei and Xiao (2009) investigated from a shareholder preference perspective. Their findings revealed that NPTS holders prefer cash dividends over stock dividends and PTS holders prefer stock dividends over cash dividends. Their results were explained from tax point of view. As NPTS holder benefit from tax saving on cash dividends as they are subject to corporate tax on capital gains but free tax on cash dividends. In contrary, PTS holders are subject to 20% tax rate on cash dividends and their capital gain is tax free.
Based on this discussion, it is expected that individual investors would prefer stock dividends over cash dividends when the tax is their main concern. Since the above mentioned studies mainly depend on statistical published data, this study aims at exploring these researches by collecting primary data from retail investors. Consequently, retail investors concern for tax factor and its impact on their preference for cash or stock dividends will be examined via questionnaire directed to this particular group of investors. This group was targeted for this research because previous studies indicated that their power to influence firms’ dividend decision is relatively low comparing with NPTS holders. Consequently, it is expected that their investment decision may be influenced by their preference and the Litrature Review樣本firms’ dividend policy but may not influence the dividend decision. Accordingly, the results of this research may have implication on highlighting the preferences of this group of investors that may be considered by firms’ and policy decision makers in China.

2.3 Agency Theory and Dividends Payout#p#分頁標題#e#

Agency problem refers to the conflict of interest between shareholders (the owners of the firm) and the management (who controls the firm). The problem is that managers may not act to maximize the stockholders wealth and instead they act for their self-interest and take decisions that increase their salaries, bonuses, power, prestige and fame on the account of stockholders’ benefits (Arnold, 2008).
Solutions to agency problem (and agency costs) tend to come in two categories, incentives and monitoring. The incentive solution is to tie the wealth of executives to the wealth of the shareholders, so that executives and shareholders want the same thing. This can be done by aligning executives’ incentives (compensations) with shareholders desires. Mainly three types of compensations were argued to achieve this objective; bonus linked with accounting – based performance measures, stock options and stock grants (Damodaran, 2006). Accordingly, it is said that when executives’ compensation is linked with corporations’ profit and stock price, they will take decisions to increase the profit and stock price and consequently, shareholders’ wealth. The second solution is to set up mechanisms for monitoring the behavior of managers. Monitoring (corporate governance) mechanisms include monitors exist inside the corporate (board of directors), outside the corporate (auditors, analysts, bankers, credit agencies) and government bodies.
Cash dividends is perceived to play a role as a control and monitoring mechanism (Damondaran, 2006; La Porta et al., 2000; Jiraporan and Ning, 2006; Li et al, 2009). Due to the lack of shareholders’ control over the management’s investment decisions; they may not believe that the angers will always keep maximization of shareholders’ value as their behavior principal for investment decisions (Li et al, 200). Consequently, the availability of free cash flow with the hand of management may used for expanding corporation size regardless of the negative net present value associated with the invested projects (Li and Huang, 2006). La Porta et al (2000) pointed out that paying earning to shareholders in terms of dividends reduces the available cash for managers and may restrict their undesired behavior. This can provide outsider shareholders a control power by enforcing the managers to come to the capital market to raise external fund for potential investment. Capital market has the monitoring mechanisms to ensure the feasibility of the potential investment weather the fund to be raised was sought from creditors (banks or issuing bonds) or from new shares issue (equity).
Empirically, agency problem and its association with dividends payout has been the subject of much research. Jiraporn and Ning (2006) examined the relationship between shareholders strength and payout. They examined to contradicting hypotheses; the managerial opportunism hypothesis and the substitution hypothesis. The empirical prediction of the first hypothesis is a positive association between dividend payouts and the strength of shareholder rights - the weaker the shareholder rights, the less paid out in dividends. Whereas the other hypothesis stated that all else equal, dividend payouts should be higher in firms with weaker shareholder rights. Their results indicated that the strength of shareholder rights does affect dividend payouts. Specifically, the relation is negative, i.e. firms where shareholder rights are more restricted pay higher dividends. This evidence is in favor of the substitution hypothesis.#p#分頁標題#e#
By examining agency theory and dividend policy in 33 countries, La Porta, et al., (2000) found that investors preferences vary based on the strength of the legal rights of investors. For instance, it was found that legally protected shareholders are willing to wait for their dividends when investment opportunities are good and consequently they may not prefer cash dividends in such situations. On the other hand, they found that poorly protected shareholders prefer to take as much as possible cash dividends regardless of investment opportunities.
The results of La Porta et al. (2000) may explain Jiarporn and Ning’s (2006) findings if clientele effect theory was considered. That is firms with weaker shareholder rights pay higher dividends may be explained by La Porta’s et al. (2000) results that poorly protected shareholders prefer cash dividends whereas legally protected shareholders may not prefer cash dividends when investment opportunities are good.
In China, agency problem and its relationship with dividend policy has been the subject of only few researches. Li et al. (2009) analyzed the decision-making policy and the reasons for dividends policy selection in Chinese non-state-owned and found that western agency theory for dividend is applicable for non-state-owned listed companies in China. That is the owners impose greater influence on dividend policy than the manger do. Li and Huang (2006) stated that corporations’ decisions for cash dividend is more influenced when institutional investors have higher holdings percentage.
If shareholders' preferences for dividends are explained from agency theory point of view, it is expected that retail investors would prefer cash dividends over stock dividends. That is since retail investors have no control over managers' behaviour and have no information on the profitability of future projects and investments; they prefer to restrict managers' undesired behaviour by reducing the available cash (Li and Huang, 2006). However, as discussed earlier, if retail investors consider the tax factor they would prefer stick dividends over cash dividends. This may raise a question; when retail investor’s concern is agency problem and when the concern is tax factor?
Since tax and agency problem may play a contradicting role in influencing retail investors' preferences for cash and stock dividends, this paper aims at examining the impact of these factors on retail investors in China. Furthermore, this paper aims at investigating circumstances upon which tax and/or agency problem becomes a major concern for retail investors.

 
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