Firm performance under the interactive moderation of capital structure, dividend policy and state ownership

Moreover, Agency Theory indicates that debt and dividend policy are supposed to be the tool to control agency conflicts between managers and shareholders when the use of debt and the pay

UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM

HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIES

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FIRM PERFORMANCE UNDER THE

INTERACTIVE MODERATION OF CAPITAL STRUCTURE, DIVIDEND POLICY, AND

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CIT THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FIRM PERFORMANCE UNDER THE

INTERACTIVE MODERATION OF CAPITAL

STRUCTURE, DIVIDEND POLICY, AND

STATE OWNERSHIP

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRAN LE KHANG

Academic Supervisor:

DR NGUYEN VU HONG THAI

HO CHI MINH CITY, DECEMBER 2017

DECLARATION

I declare that the thesis entitled “Firm performance under the interactive moderation of capital structure, dividend policy, and state ownership” has been solely conducted by myself under the supervision and guidance of Dr Nguyen Vu Hong Thai from RMIT University I commit that my interpretations throughout the research are completely based

on my academic knowledge and the understanding of previous studies presented in the reference list and that this paper has not been previously submitted to any graduate program for the degree or published in any sources I shoulder all the responsibility for the ideas, contents, and results of this research

TRAN LE KHANG

ACKNOWLEDGEMENT

To have such a successful thesis, I would like to express my deep gratitude to my supervisor, Dr Nguyen Vu Hong Thai, for his dedicated guidance, meticulous care, enthusiastic support during the process of doing my thesis His insightful knowledge, fruitful comments, and precious suggestions make some critical contributions to the completion of my research He has supported and guided me since the beginning of the process and encouraged and reminded me to follow the schedules of the program His motivation is what helps me finish my thesis in time for submission Without his guidance and encouragement, never can I bring my research to light Working with him in the process is the most memorable and enjoyable experience that I have ever had in my life Besides my supervisor, I want to give thanks to all the lecturers and the staff of Vietnam – Netherlands Program for their dedication as well as willingness to spend their priceless time aiding all students in my class

I extremely appreciate my classmates, especially the members in my dear group, for the encouragement and the cooperation during the course They are sometimes the good examples for me to follow I wish that they all can graduate on time at the end of this year

Last but not least, my inexpressible appreciation is dedicated to my beloved family who have sacrificed themselves for me to have all the convenience and support to successfully finish the master program

ABBREVIATION

ADB: Asian Development Bank

DGMM: Difference Generalized Method of Moment

EBIT: Earnings before interests and taxes

EBITDA: Earning before interests and taxes plus appreciation and amortization

EBT: Earnings before taxes

FEM: Fixed Effect Model

GDP: Gross Domestic Product

GMM: Generalized Method of Moment

HNX: Hanoi Stock Exchange

HOSE: Ho Chi Minh Stock Exchange

MOM: Method of Moment

OLS: Ordinary Least Square

POEs: private-owned enterprises

POLS: Pooled Ordinary Least Square

REM: Random Effect Model

ROA: return on assets

ROE: return on equity

SEDS: Socio Economic Development Strategy

SGMM: System Generalized Method of Moment

SMEs: small and medium enterprises

SOEs: state-owned enterprises

as to clarify the moderation of firm policies to state ownership and vice versa This research hopes to contribute an important part to managers’ decisions on how to use debt and dividend policy and the government’s strategy on whether to continue pushing the privatization process among SOEs Using a sample of 663 listed Vietnamese companies

on HOSE and HNX from 2008 to 2015 together with SGMM as an econometric technique

to address the problem of endogeneity caused by the dynamic approach, the study demonstrates that financial leverage, dividend policy, and state ownership are negatively related to firm performance Such a negative impact can be moderated with the combination of any two variables out of the triad, meaning that a suitable decision on either debt or dividend policy can help increase profitability among SOEs Nevertheless, the negative sign of the three-variable interaction implies that SOEs should be careful and cautious when they combine these two policies in their decision-making process The marginal effects of each of the three variables show that firm performance becomes more effective if the other two variables are kept at the high – low and low – high value and

gets less effective when it comes to the high – high and low – low level

Key words: Firm Performance, Financial Leverage, State Ownership, Vietnam

JEL Classification: G31, G35

TABLE OF CONTENTS

DECLARATION i

ACKNOWLEDGEMENT ii

ABBREVIATION iii

ABSTRACT iv

TABLE OF CONTENTS iv

LIST OF TABLES vii

CHAPTER 1: OVERVIEW OF RESEARCH 1

1.1 Vietnam’s corporate context: 1

1.2 Problem statements: 3

1.3 Research objectives: 6

1.4 Research questions: 7

1.5 The importance of the study: 7

1.6 Structure of research: 7

CHAPTER 2: LITERATURE REVIEWS 8

2.1 Theoretical Reviews: 8

2.1.1 Agency Theory: 8

2.1.2 Capital structure Theories: 9

2.1.3 Dividend payout theories: 13

2.2 Empirical Reviews: 15

2.2.1 Firm performance and financial leverage: 15

2.2.2 Firm performance and dividend policy: 18

2.2.3 Firm performance and state ownership: 23

2.3 Research hypotheses: 24

CHAPTER 3: DATA AND METHODOLOGY 30

3.1 Data collection: 30

3.2 Empirical model: 30

3.3 The variable definition and measurement: 31

3.3.1 Dependent variables: 31

3.3.2 Explanatory variables: 32

3.3.3 Instrumental variables: 33

3.4 Estimation method for panel data: 34

3.4.1 The problem of endogeneity: 34

3.4.2 Dynamic approach: 35

3.4.3 Interation terms and marginal effects: 37

CHAPTER 4: RESULTS AND DISCUSSIONS 39

4.1 Summary statistics: 39

4.1.1 Data description: 39

4.1.2 Correlation: 40

4.2 Empirical results: 42

4.3 Robustness check: 48

4.4 Marginal effects: 50

CHAPTER 6: CONCLUSION 55

6.1 Main findings: 55

6.2 Policy implications: 57

6.3 Limitations: 59

REFERENCES 60

APPENDIX 1 79

APPENDIX 2 80

LIST OF TABLES

Table 4.1: Summary statistics 39

Table 4.2: Correlation Matrix 41

Table 4.3: Estimated results using SGMM 42

Table 4.4: Robustness check for different measures of the dependent variable 49

Table 4.5: Marginal effects of three main variables 51

Table A1: Xtabond2 model selection criteria 79

Table A2: Descriptions of variables 80

CHAPTER 1: OVERVIEW OF RESEARCH 1.1 Vietnam’s corporate context:

Before 1986, Vietnam’s economy followed a centrally-planned regime, and almost all corporations operating in this country were only divided into two categories which are state-owned and collective enterprises However, the year 1986 is considered

as a remarkable turning point in Vietnam’s development when the Congress initiated the Doi Moi Program, making a step towards the market-oriented economy with the purpose

of boosting economic growth and helping Vietnam to achieve higher productivity, sufficiency, and prosperity In fact, Su et al (2016) found that Vietnam’s adoption of the economic transformation plays a key role in propelling bilateral and multilateral trade, attracting domestic and foreign investment, alleviating poverty, and ensuring human development Along with this market economic reform comes the privatization process that turned state-owned to private-owned enterprises This process is designed to heighten economic effectiveness, diversify firm owners, modify capital structure, and adjust the practice of using capital among SOEs (Tran, 2015) Starting in 1992, the government’s policy assisted this transitional economy in mitigating the ineffective operations of SOEs, encouraging POEs to develop, creating employment, and facilitating economic growth However, the transformation was conducted at a slow pace, and most of the equitized companies are small and unprofitable Moreover, the government still maintained its control over some large SOEs providing utilities and banking services This reality showed an opposite situation compared to other transitional economies in the world where privatization was rapidly proceeded (Estrin et al., 2009) The explanations for the difference are that the government was afraid of losing their control and benefits, that the evaluation of state-owned enterprises’ assets had some troubles, and that SOEs were fearful of being unable to receive preferential credits supplied by the state commercial banks as well as being imposed some budget constraints (Kornai, 1986; Truong & Ha, 1998) During the course of time, SOEs had been demonstrated to be ineffective than any type of firm ownership Although they were given a relatively large share of the government’s investment and were able to get access to preferential resources, they only contributed a small part to the increase in employment compared to POEs and virtually took advantage of their political connections to drive the economy in a way favorable to themselves Political connections are beneficial to SOEs because they are associated with advantageous protection from the legal system, easy access to loans from the state commercial banks and subsidies as well as supports from the government, improvement

in firm performance, and increase in investment activities together with firm value (Agrawal & Knoeber, 2001; Faccio, 2006; Fisman, 2001; Johnson & Mitton, 2003; Qin

et al., 2011; Ramalho, 2007; B E Roberts, 1990) Vu and Le (2016) criticized that although Vietnam’s legal system has made some progress in enhancing the economy’s transparency, the system remains unfulfilled and ambivalent Hence, its consequence poses several obstacles to companies that are operating outside the state-controlled area They often find it hard to get borrowings from the state commercial banks for their investments because most of the government’s funds are reserved for SOEs (Guriev, 2004; Johnson et al., 2000; McMillan & Woodruff, 1999) They are also regarded as the victims of corruption when they are willing to pay bribes to overcome the strict but ambiguous legal documents and achieve their goals of doing business in Vietnam Besides, they encounter the weaknesses of the legal environment with little protection of their ownership and trading contracts Such actions hampered the development of SMEs which accounted for 90% of the country’s corporations and generated 80% of jobs in the economy Overall, these problems have led to the considerable criticism against the operation of SOEs As a result, in the Socio Economic Development Strategy (SEDS) in the 2011 – 2020 period, the Vietnamese government has put the privatization at a top priority Under SEDS, the government continued mitigating the influence of SOEs on the economy through privatization, improving their corporate governance, and enhancing the legal framework to make public investment more transparent and qualified These attempts have gained satisfactory results as the number of partially or fully privatized companies have been increasing, and SOEs have made a great progress in getting rid of risky operations and revealing more information to the market The statistics indicated that 3759 SOEs are privatized from 1999 to 2013, and the recent number of SOEs in 2015

and 2016 was 806 and 511 respectively

The privatization process of SOEs facilitated the establishment of the two stock market exchanges in Vietnam, Ho Chi Minh Stock Exchange (HOSE) in 2000 and Hanoi Stock Exchange (HNX) in 2005 At the first onset, only five stocks were listed on HOSE, and their market capitalization accounted for 0.2% of Vietnam’s GDP Nevertheless, after

10 years of development, the two stock exchanges were the markets of 649 listed firms with their market capitalization approaching 45% of GDP In spite of getting bigger in size, the country’ stock market is at a small scale compared to other Asian markets Vietnam’s equity market witnessed the rocketing increase in stock prices in the period of

2006 – 2007 as this country became the World Trade Organization’s 150th member and the plummeting decrease in the investment of foreign investors in both stock exchanges

in the 2008 financial crisis The two major problems in the nascent equity market are investors’ herding behaviors and asymmetric information, causing high volatility in the market (Leung, 2009) The former can be solved by providing guidance, training, and knowledge to both domestic and foreign investors, and the latter requires the improvement in legal framework and the adjustment of regulatory institutions so that the equity market can become financially transparent and symmetrically informed (Leung, 2009) In short, although firms can get access to financing sources through the stock market, the mentioned limitations are what makes them hesitate to raise capital via this channel Thus, most of the financial resources are taken from banks However, there is a discrimination against POEs but in favor of SOEs While most POEs can get access to only short-term debt, SOEs can reach both short and long-term debt financing In this case, the conditions of SOEs are completely more favorable than POEs Another market that can help companies find their financing capital is the bond market Unfortunately, this market is underdeveloped and even more nascent than the equity market Right now, Vietnam’s bond market totally makes up 15% of GDP lower than the East Asia average

of 65% because almost all bond issuance in the country comes from the government or government-relevant agencies such as the municipal authorities and the Development Bank (Leung, 2009)

addition, not only does the firm operate better thanks to debt tax shields, but it also enhances efficiency through the control of debt holders in the capital market (Jermias, 2008) Debt holders can require some covenants in their contracts to prevent managers from doing harm to them in any case (Simerly & Li, 2000) Nevertheless, debt is not an issue of the only one side but the two sides, good and bad Too much debt raises the risks

of financial distress and bankruptcy as well as increases the financial costs of the company The divergence among dozens of studies is the driving force for the author to study the impact of financial leverage on firm performance

Dividend policy is relevant to whether a firm should distribute earnings to shareholders or keep them as retained earnings to invest in profitable projects (Ross et al., 2002; Zhou & Ruland, 2006) That is the reason why dividend policy is an essential policy going side by side financial leverage (Alli et al., 1993; H K Baker & Powell, 2000) Very often, outside investors put their money into a company in return for dividends or capital gains as a certain reward for the investments they make and the risks they incur Therefore, which funds to pay out to shareholders as well as to retain in the company and how to keep dividend payouts stable are the most challenging decisions to a manager Miller and Modigliani (1961) said that managers should not feel so serious about dividend policy because firm value varies not by the distribution of income but by the addition of income to the business They then concluded that dividend policy, like capital structure,

is irrelevant to firm value These things show the relationship between shareholders’ wealth and dividend policy (H K Baker et al., 2002) However, based on “Free Cash Flow Hypothesis”, dividend policy is a tool to maximize firm value when it reduces the free cash flow under managers’ control (DeAngelo et al., 2006) Moreover, observations showed that a firm’s share prices often rise up upon the announcement of dividend increases and vice versa (Aharony & Swary, 1980; Asquith & Mullins Jr, 1983; Kalay & Loewenstein, 1985) The paper will analyze the effect of dividend policy on firm performance

In recent years, privatization has become phenomenal throughout the world The surge of privatization has swept through state-owned enterprises (SOEs) in developed and developing countries The last two decades have seen the gradual increase in the number

of SOEs (Buck Filatotchev Wright & Igor, 1998; Laasch & Conaway, 2002; Rodríguez

et al., 2007; Sheshinski & López-Calva, 2003; Uhlenbruck & Castro, 1998) Though so many former SOEs have adopted equitization in order to enhance their performance, some remain unchanged This situation is often less observed in developed than in developing countries where financial markets are in the embryonic stage, market regulations remain

weak, and the public sector still takes control of the whole economy M C Jensen and Meckling (1976) and Shleifer and Vishny (1986) proved that a firm’s type of ownership will affect its performance by changing the agency costs it has to incur Compared to private-owned enterprises (POEs), SOEs are less efficient and profitable because their objectives are not value maximization but social welfare or political power (Frye & Shleifer, 1997; La Porta et al., 1999; Laffont & Tirole, 1993; Shleifer, 1998) Moreover, SOEs often face the most severe problem of agency conflicts since the owners have no incentives to monitor or motivate the managers’ behaviors (Megginson & Netter, 2001; Shleifer, 1998) After privatization, SOEs can improve their performance and gain higher profits (Barberis et al., 1996; D'Souza et al., 2005; Mathur & Banchuenvijit, 2007; Megginson et al., 1994) However, Vickers and Yarrow (1991) indicated that not only SOEs but also POEs confront the same agency problems arising from the conflicts between managers and shareholders Furthermore, Sun et al (2002) said that sometimes

we are not sure whether managers in SOEs will expropriate firms to gain the benefits of politicians and bureaucrats or will provide political and business support to benefit SOEs

If SOEs receive support from the government, they may achieve better performance The contradicting views among researchers require an insight into the relationship between state ownership and firm performance

In reality, a firm does not pursue only one policy but the combination of various policies such as debt and dividend policy This drives the author to analyze the interaction effect of two policies on firm performance Sierpińska (1999) stated that dividend policy and debt policy are interdependent and combined to determine firm performance Frank and Goyal (2004) found that when firms increase dividend payments to shareholders, they have fewer earnings to retain and have to seek for external funds, debt or equity, in the capital market to finance their investments This shows a positive relation between debt and dividends From the viewpoint of “Agency Theory”, both dividends and debt can mitigate the conflicts of interests between managers and shareholders by reducing the amount of free cash flow within the company Finally, the reduction of agency costs helps firms enhance their operations and perform well

State ownership is associated with severe agency costs because of its social and political purposes which go far away from profit maximization Moreover, Agency Theory indicates that debt and dividend policy are supposed to be the tool to control agency conflicts between managers and shareholders when the use of debt and the payout

of dividends reduce the discretionary funds available to managers and tighten the control

of the capital market over them Thus, these two policies play a key role in adjusting firm

performance of SOEs, relieving the negative effect of state ownership Such a situation implies that if a choice of internal policies is appropriately made, there is no need to deprive the government of its control over SOEs The question of whether “new wine in the old bottle” can be effective in this case is unanswered because the remaining of the government’s practices is abundant in SOEs Under the condition, the possibility that internal policies will be distorted to suit the purposes of companies is high Furthermore, SOEs are known for being excessive in hiring employees, being slow in cutting off unnecessary workers, and being careless in appointing politically connected managers to manage firm operations On the contrary, whether privatization, or so-called “a new bottle for the old wine”, can help firms heighten their performance is a difficult question to answer Being free from the government’s control, SOEs simultaneously receive less political support as well as less favorable treatments from the state Firms are no longer protected from financial distress and bankruptcy from the government A refinement of internal policies is in need If companies are always following old policies, they find it hard to boost their performance In short, which way is good for firm performance is what needs to be explained What’s more, is a firm required to have “new bottle, new wine” to

be more effective in its performance?

1.3 Research objectives:

The examination of the research covers the influence of financial leverage, dividend policy, and state ownership on firm performance among financial and non-financial Vietnamese firms listed on Hanoi Stock Exchange and Ho Chi Minh Stock Exchange during the 8-year period from 2008 to 2015 The study aims at explaining not only the single but the combined effects of these main variables on profitability so as to give policy implications to Vietnam’s government and corporate companies All variables necessary for the research are collected and calculated from the financial statements and annual reports of all listed firms on the two stock exchanges The dataset initially comprises of 687 Vietnamese companies However, only firms with 4 consecutive years

in operation are researched That is why the data reduces to 663 listed companies Finally, the following objectives of this research are given below

- To evaluate the separate and combined impacts of financial leverage, dividend policy, and state ownership on firm performance in Vietnam’s listed firms

- To point out the interactive moderations among financial leverage, dividend policy, and state ownership

- To identify the regression model and techniques suitable for the research data so that the problem of endogeneity can be mitigated to the minimum level

- To ensure consistency of the adopted model through analytical tests as well as robustness check

- To outline some policy recommendations for not only companies but also the government on the basis of the estimated results

1.4 Research questions:

Based on the research objectives, the study focuses on the questions as follows

- What effects do financial policies and state ownership have on firm performance?

- Do financial policies and state ownership moderate each other so as to decide whether

a firm performs effectively or not?

1.5 The importance of the study:

Although numerous studies have previously been done on the effect of financial leverage, dividend policy, and state ownership on firm performance in various countries

as well as markets across the globe, hardly ever does a combination of these three elements are simultaneously analyzed Moreover, this is the first paper that take into account the interaction of two and three variables of these elements in order to identify the moderation of one or two factors on the relationship between the other factor and firm performance The research also contributes to a myriad of studies that have been conducted in discovering the determinants of firm performance in developing and developed countries The results are of great importance in the situation that Vietnam is attempting to cut off state ownership rates so as to enhance the effectiveness of firm operations among former SOEs Not only does the study give corporate companies suggestions on how to adjust their policies to boost their performance, but it also provides the government with some recommendations on whether privatization is a right way to follow

1.6 Structure of research:

Section two refers to the important theories of capital structure and dividend policy Section three highlights the theoretical and empirical studies relevant to the research Section three discusses the methodology used to conduct the research study It includes the way of collecting data, variable descriptions, hypothesis statements, and tools and techniques Section four shows the results and analyses It is related to the descriptive statistics and estimated results Section five is the conclusion of what has been done in

the paper It presents the précis of the research and suggests some policy implications

CHAPTER 2: LITERATURE REVIEWS 2.1 Theoretical Reviews:

2.1.1 Agency Theory:

Agency relationships are one of the important issues about which a firm has to concern Moreover, according to Agency Theory, the conflicts of interests between managers, the agents, and shareholders, the principals, are very costly to a firm (M C Jensen & Meckling, 1976) The two main reasons causing agency costs in a business are the wasted resources the managers use to benefit themselves and the costs the firm has to spend to reduce the agency problem

Firstly, while the owners wish the managers to increase firm market value, the managers want to maximize their owner power and wealth in the company Because the managers often get better access to the information about the firm’s operations, they act

in their own interests by seeking higher salaries, perquisites, job security, and direct capture of assets or cash flows of the firm They tend to buy other companies to enhance their power of management and make unprofitable investments instead of maximizing firm value

Secondly, the firm has to pay a certain fee to fill the gap of interests between managers and shareholders It has to incur the costs of hiring independent directors for supervision of the managers, reducing the risks of takeover, and compensating managers with equity payment for their management The two popular agency conflicts existing in

a business are between equity owners and managers and between equity owners and debt owners

2.1.1.1 Conflicts between shareholders and managers:

The difference in interests is the cause leading to the conflicts between equity owners and managers in a company To align their interests to each other, the firm should restore to Free Cash Flow Theory of M C Jensen (1986) In a firm with excess free cash flow, the managers have discretionary funds in order to benefit their own interests but not the shareholders’ (M C Jensen, 1986) They then expand the firm to enlarge the sources under their control and gain more compensation (Gaver & Gaver, 1993) They even invest

in projects with negative NPV and exacerbate the problem of overinvestment Therefore, the reduction of available funds can limit the free cash flow under the hands of the managers and prevent them from investing in poor projects In this case, debt and dividends are a very important solution The use of debt and the payment of dividends force the managers to generate and pay out cash to the shareholders They also put the

managers under the control of different investment professionals when they try to raise funds in the capital market (Easterbrook, 1984) As a result, using more debt and paying more dividends will reduce the agency costs between managers and shareholders However, when the firm pays out more dividends and raises funds in the capital market, the shareholders have to tolerate the risk of the firm being more indebted and accept paying higher personal tax rates on dividends

2.1.1.2 Conflicts between shareholders and debt holders:

The conflicts between shareholders and debt holders arise when the firm faces the risk of default and when the managers pay out more dividends to the shareholders With the assumption that the managers’ interests are in line with the shareholders’, the managers will attempt to transfer the value from the debt owners to the equity owners or sometimes expropriate wealth from the debt holders Firstly, the managers will invest in riskier projects that bring more profits to the stockholders but lead the company to default

as well as do harm to the creditors Secondly, the managers will borrow more from the debt holders and then pay out cash to the stockholders In this situation, the shareholders gain at the expense of the debt holders because the market value of the existing debt declines, while firm value is constant Thirdly, the managers will finance investment projects with debt more than equity Knowing that the increase in the market value of debt makes it costly for the firm to invest in debt-financed investments and pay out cash

to shareholders, debt holders require debt covenants in their contracts to restrict additional debt of the firm and decrease dividend payouts to stockholders Moreover, if the firm violates the covenants, it has to pay the debt immediately

2.1.2 Capital structure Theories:

2.1.2.1 Capital Structure Irrelevance Proposition:

Modigliani and Miller (1958), who proved that capital structure is irrelevant to the market value of a firm, developed the Capital Structure Irrelevance Proposition The proposition is hold under some major assumptions Firstly, firms operate in perfect capital markets without taxes, transaction costs, financial distress, and bankruptcy costs Secondly, asymmetric information between investors and managers does not exist, meaning that they can get equal access to the information of a firm’s operations Thirdly, firms and investors, when using debt, incur the same borrowing costs in the capital market Given these assumptions, Modigliani and Miller (1958) argued that whether a firm is leveraged or unleveraged is independent of its market value However, under the circumstances of a real world where a firm often faces taxes, transaction costs, and bankruptcy costs with debt financing, these untrue assumptions fail to help explain the

relationship between capital structure and firm value The failure of the Capital Structure Irrelevance Proposition has led to the introduction of a new theory for the capital structure

2.1.2.2 Trade Off Theory:

As long as the assumptions of Modigliani and Miller (1958) on a perfect capital market without taxes and bankruptcy costs are unquestioned, capital structure is irrelevant

to the market value of a firm However, in practice, taxes and the risks of financial distress

as well as bankruptcy are what a firm always pays attention to when making financing decisions As a result, Trade-off Theory came out to shed light for the relationship between capital structure and firm value The theory refers to the trade-off between the gains from avoiding paying much tax and the losses from having financial distress and going bankrupt when a firm decides to increase the amount of debt in the capital structure

The benefits of using debt in the capital structure are shown through debt tax shields, or tax savings, which reduce a firm’s tax liability The firm can benefit from this reduction because the interest payments paid on debt are deducted from the tax-charged earnings Nevertheless, besides the observable advantages of debt financing, the increase

in debt means higher risks of financial distress and bankruptcy to the firm Financial distress is the situation in which a firm finds it hard to satisfy all of its obligations for debt When in financial distress, a firm may incur the costs of enhancing its creditworthiness in the market, relieving the pressure on debt payments from creditors, and resolving the conflicts between bondholders and shareholders If the firm experiences financial distress for a long time, the risks of bankruptcy increase and the firm may lose its ability to settle debt If a firm goes bankrupt, the process of filing for bankruptcy is very costly Once the costs of financial distress and bankruptcy outweigh the benefits of debt tax shields, debt financing, at this point, does harm to firm value

These two opposite aspects remind a firm off a debt level that can optimize its capital structure and balance the benefits and costs of debt financing (Myers, 1984) Upon reaching an optimal capital structure, a firm can maximize its value in the market (Kraus

& Litzenberger, 1973) In short, Trade-off Theory indicates that firms financed with debt are often more valuable than those financed with only equity because they can take advantage of debt tax shields to maximize their market value and that firms with high profitability and low risks of financial distress and bankruptcy tend to have more debt in their capital structure because they can reduce their tax payments However, Wald (1999) showed that the most profitable firms tend to use less debt in the capital structure Furthermore, Fama and French (1998) found no evidence for the benefits of tax savings

to the market value of the firm These findings are different from what Trade-off Theory suggests and foster the birth of a new theory for the capital structure

2.1.2.3 Pecking Order Theory:

Pecking-order Theory suggests that a firm adopts the hierarchy of funds to finance its investments (Myers & Majluf, 1984) Based on the theory, the firm prioritizes internal financing over external financing when making financing decisions Retained earnings,

or internal financing, are the first choice because this source helps the firm avoid the flotation costs of debt and equity as well as the problem of asymmetric information For external financing, debt is preferable due to its lower issue costs compared to those of equity To sum up, firms go from the most to the least secured securities: debt, convertible

stock, preferred stock, and common stock (Myers, 1984)

Adverse Selection Model is the basis for Pecking-order Theory Adverse Selection Model refers to the problem of asymmetric information Asquith and Mullins (1986) found that the wedge of information between inside managers and outside investors causes firm value to decrease upon the issuance of new shares in the market It shows that asymmetric information is always present between managers and outside investors The issuance of equity of a firm with high growth opportunities can benefit outside investors However, investors are doubtful that the firm will issue overvalued shares because managers have the clearer understanding of a firm’s operations, current assets, growth opportunities, prospects, risks, and value Therefore, outside investors often place low prices on the value of the new stocks In this case, the firm should regularly publicize its operations through the announcement of activities, projects, or the financial statements (D'Mello & Ferris, 2000) Another way to keep the firm away from this problem is to use internal financing for new investments because it forces managers

to disclose information about the firm to outside investors External financing contains a lot of asymmetric information and costs a firm so much that it cannot use this source to finance its profitable projects To a firm, retained earnings are internal, and debt and equity are external If debt is risk-free, it is the same as internal financing If it is risky, it may lie between retained earnings and equity (Myers, 1984) However, the hierarchy of funds varies through different situations When only managers have information about the firm (one-sided asymmetric information), retained earnings are the best choice On the other hand, when both the managers and outside investors are not well-informed (two-sided asymmetric information), equity or the combination of equity and retained earnings are preferable If a firm intends to carry out mergers, equity is the top priority (Myers & Majluf, 1984) Furthermore, if the adverse selection refers to value, debt is favored rather

than equity as what Pecking-order Theory states, and if the adverse selection mentions risk, equity but not debt is chosen The two different aspects show that Pecking-order Theory is only one of the various circumstances of Adverse Selection Model (Heider & Halov, 2005) After all, the model still supports an order of retained earnings with no adverse selection, debt with minor adverse selection, and equity with serious adverse selection

Besides Adverse Selection Model, Agency Theory is also the foundation for Pecking-order Theory Agency Theory assumes that there is an alignment of interests between managers and shareholders For the reason, never do the managers issue new equity when the firm’s shares are undervalued (Myers & Majluf, 1984) The use of retained earnings can help the firm get rid of the monitoring of the outside investors and help the outside investors avoid the risks of buying overvalued shares in the capital market (Butters, 1949) In general, internal financing is beneficial not only to the managers but also to the outside investors The use of debt gives a positive sign when it signals the outside investors that the firm is operating so efficiently that it can bear more debt, while the use of equity carries a negative sign because it makes the outside investors feel that the company is overvalued As a result, the issue of new equity will reduce the market value of the firm Finally, the use of funds in a hierarchy helps managers keep their control over the firm, cut back on agency costs, and stay away from the negative reaction of outside investors to the market share prices upon an announcement of new equity issuance (Hawawini & Viallet, 1999)

In short, Pecking-order Theory aims to explain why most profitable firms tend to use less debt in the capital structure and why firms restore to equity rather than debt as the last source in external financing Profitable firms often have a large source of retained earnings, so they raise funds for investment projects through internal financing, and firms with few profits accumulate more debt in the capital structure Consequently, asymmetric information between managers and outside investors is the driving force for a firm to use internal financing to maximize its market value However, Pecking-order Theory has its own limitations Compared to Trade-off Theory, it does not take into account taxes, financial distress, equity issuance costs, agency costs, and the managers’ accumulation of assets with high liquidity These limitations prove that Pecking-order Theory can complement but cannot substitute Trade-off Theory

2.1.2.4 Marketing-timing Theory:

Marketing-timing Theory states that a firm’s decision to use debt or equity to finance its new investment projects rely on the current situation in the capital market (M

Baker & Wurgler, 2004) In other words, the firm often does not focus on the benefits and costs of debt as Trade-off Theory or asymmetric information like Pecking-order Theory but on the market’s conditions The assumptions on the theory are that the firm is in the mispricing case and gets better information about its price than do investors in the market What’s more, Marketing-timing Theory does not explain what causes mispricing of a firm

as well as whether it is good or bad to the firm but explain what the firm will do after being mispriced The firm is inclined to issue equity when it is overvalued in the market (Graham & Harvey, 2001; Myers, 1984) M Baker and Wurgler (2002) also found that the firm chooses the source of financing most suitable to its present situation in the capital market It means when the capital market is favorable, it will use financing although it does not really need and when the capital market is unfavorable, it will defer financing though it really needs financing After all, the issuance of a firm’s debt or equity follows market conditions

2.1.3 Dividend payout theories:

2.1.3.1 M&M Theorem:

Miller and Modigliani (1961) said that dividend policy does not affect firm value

if the capital market is perfect and investors are rational M&M Theorem assumes that (1) no taxes, both personal and corporate, are imposed on the income of individuals and businesses, (2) no transaction and stock flotation costs are included in every trade deal, (3) no asymmetric information exists, (4) no agency problem between managers and firm owners, (5) and no control over the market price happens Under these assumptions, a firm’s share price depends on the income from profitable investments but not on the way the firm pays out dividends to its shareholders M&M Theorem, as a result, supports the irrelevant relationship between firm value and dividend policy

2.1.3.2 Bird-in-hand Theory:

Bird-in-hand Theory states that the increase in dividend payouts accompanies the increase in firm value Since dividend payouts can mitigate the uncertainty of a firm’s cash flows in the future, investors are inclined to prefer holding cash dividends in their hands at present to getting higher returns in their capital gains in the future M J Gordon and Shapiro (1956), M J Gordon (1963), Lintner (1962), and Walter (1963) supported the theory when they found a significant impact of dividends but not retained earnings on firm value Sometimes, investors worry that the firm will pay out more dividends to provide them a false sign that it is operating well (Friend & Puckett, 1964) However, Rozeff (1982) and G R Jensen et al (1992) proved that the riskier the firm is the lower dividends it pays out to investors

2.1.3.4 Clientele Effect Hypothesis:

Clientele Effect Hypothesis suggests that the preference of the investors for capital gains or dividends is affected by such imperfections in the capital market as transaction costs and taxes The investors will choose securities that can minimize their costs in accordance with their current situations Therefore, firms will have different dividend policies to be suitable with certain kinds of investors Firms with high growth opportunities often pay low or little dividends to shareholders and attract a clientele that prefers capital gains to dividends On the other hand, investors who prefer high dividends are the clientele of the firms that pay out more earnings as dividends Institutional investors tend to invest in shares with high dividend payouts because they have tax advantage over individual investors (Allen et al., 2000) In addition, institutional charters also restrict them from buying non-paying or low-paying stocks Well-performed companies prefer to attract institutional clienteles by paying out more dividends because these clienteles are better informed than individual investors and have more abilities to monitor companies’ operations

2.1.3.5 The Signaling Hypothesis:

According to M&M Theorem’s assumption, both managers and outside investors can get equal access to the information inside the company However, in reality, managers often understand their firm better than do outside investors because they directly take care

of its operation The gap of information between the two makes the market price and firm value bias To handle this problem, managers need to share inside information with the outsiders so that they can more accurately measure the true value of the firm However,

rarely is complete, accurate, and instant information available to the shareholders In this case, dividends are a way to convey the firm’s private information because the shareholders often rely on the cash flow they receive from equity to value the firm (Baskin

& Miranti, 1997) Signaling Hypothesis assumes that managers possess information inside their company and have incentives to deliver it to the market and that there is no false signal in the market, that is, firms with poor performance cannot increase dividend payouts According to the hypothesis, an increase in dividend payouts signals good news for the firm’s future profitability, and the market price will react favorably, while a decrease in dividends may be bad news, and the share price will react unfavorably Lintner (1956) and Lipson et al (1998) supported the hypothesis by arguing that the firm increases its dividend payouts only when it has sustainable earnings and growth prospects

in the future

2.2 Empirical Reviews:

This section pays attention to some previous studies that have been conducted throughout the world on firm performance It will take a closer look at some important factors that have been demonstrated to have a certain relationship with a company’s effectiveness in operations These major factors include financial leverage, dividend policy, and state ownership In short, the empirical review is an overall picture that will summarize what has been done on the relationship between firm performance and explanatory variables by many researchers and lays the foundation on the explanations of the author in the research hypothesis section later on this paper

2.2.1 Firm performance and financial leverage:

The effect of financial leverage on firm performance remains highly confused with various findings from a handful of studies on corporate finance

Firstly, financial leverage is considered to be irrelevant to firm value under the conditions of a perfect capital market (Modigliani & Miller, 1958) Although the assumptions of Capital Structure Irrelevance Theory seem to be misleading in practice, some research has found no relationship between these two variables for companies in Hong Kong, Korea, Singapore, Malaysia, and the UK (Krishnan & Moyer, 1997; Phillips

the risks of financial distress and bankruptcy However, the adverse effect of leverage is weak compared to a huge benefit from debt tax shields (Miller, 1977; Warner, 1977) For that reason, Trade Off Theory is in support of the positive association between firm performance and leverage (M C Jensen & Meckling, 1976) Grossman and Hart (1983) considered financial leverage as a motivation for managers to perform more effectively because they will be punished through losing their salaries or perquisites in case the firm suffers financial distress or goes bankrupt Therefore, companies which finance investments with merely equity are not surely more profitable than those which have both debt and equity in the capital structure Moreover, leverage usually comes with debt covenants that impose constraints on managers’ financial decisions so that the manager and shareholders’ interests are parallel to each other, mitigating the agency costs within the company (Harris & Raviv, 1991; M C Jensen, 1986) During the course of time, some researchers have attempted to demonstrate a positive impact of financial leverage

on firm performance Taub (1975) collected the sample of 89 American companies in a 10-year period and found a significant positive effect of financial leverage on a firm’s profitability Jermias (2008) identified the benefits of tax savings and debt covenants among listed firms doing business in the US manufacturing sector Margaritis and Psillaki (2010) maintained that the higher leverage a firm uses the more effective it can become

In developing countries, the ratio of total debt to total assets is proven to be positively related to firm performance among listed Ghanaian companies (Abor, 2005; Kyereboah-Coleman, 2007)

Thirdly, financial leverage is believed by many scientists to negatively affect firm performance Myers (1977) argued that when part of profits a company earns must be paid to debtholders, the firm may lack available funds to make productive investments and tend to underinvest its projects, resulting in an ineffective performance Fama and French (1998) held that the use of debt will create the agency problems between shareholders and debtholders, negatively affecting firm performance They found few benefits of debt tax shields The negative effect of debt outweighs the positive effect of tax savings when the firm uses financial leverage Their opinion goes against Trade Off Theory When the amount of debt reaches the high level, the agency problems between shareholders and bondholders will become more serious when the firm’s debt level is highly risky Such a situation may lead to a negative impact of leverage on profitability (Fama & Miller, 1972; M C Jensen & Meckling, 1976; Myers, 1977) Berger and Di Patti (2006) made the clearer point that while the increase in financial leverage can mitigate agency problems between managers and shareholders, it increases the problem

between shareholders and creditors When the amount of debt is relatively high, the agency cost of debt becomes a serious problem because it reduces a firm’s effort to lower the risks, resulting in high expected costs of financial distress, bankruptcy, or liquidation Another viewpoint that can explain for the negative relationship between firm performance and financial leverage is based on the problem of asymmetric information, which results in the changes in financing costs among various sources of funds Internal funds, retained earnings, do suffer no asymmetric information Out of external funds namely equity and debt, the former has higher asymmetric information problem than the latter Finally, a firm should follow Pecking Order Theory with a hierarchy of retained earnings, debt, and equity (Myers & Majluf, 1984) Until now, dozens of studies have been carried out to strongly support the negative effect of leverage on performance in some countries all over the world Kester (1986) researched a sample including 452 American and 344 Japanese companies at a certain point of time and found the negative effect of leverage on profitability Friend and Lang (1988) later did research on 984 companies listed on the New York Stock Exchange in the period of five years and came

to the same conclusion Rajan and Zingales (1995) expanded the research scope to cover G7 nations including America, Japan, Italy, France, Canada, and England in the year 1991

on their research to support this idea So did Wald (1999), who evaluated this relationship with the data from 4404 companies in France, Japan, Germany, the US, and the UK Gleason et al (2000) discovered that the agency problems resulted from the use of leverage make firms in 14 European countries operate in an ineffective way Singh and Faircloth (2005) emphasized on the adverse effect of the reduction on investment in R&D caused by a high debt level on firm performance among US manufacturing companies While the negative effect of leverage in developed countries can be blamed on underinvestment and agency costs, the impact in developing countries is mostly attributed

to the problem of asymmetric information (Eldomiaty et al., 2007) Majumdar and Chhibber (1999) showed that the increase in debt ratios negatively affects firm performance with the sample of 1000 Indian companies in a 7-year period Shah and Khan (2007) had the same finding for the case of listed Pakistani companies Booth et al (2001) are in support of Pecking Order Theory and against Trade Off Theory when they demonstrated the existence of a hierarchy of financing funds in ten developing countries including Brazil, India, Korea, Jordan, Malaysia, Mexico, Pakistan, Thailand, Turkey, and Zimbabwe Abor (2007) conducted a study examining the relationship between debt and return on assets (ROA) for 160 companies in Ghana and 200 firms in South Africa from 1998 to 2003 The research found a negative relationship between the two elements

Profitability of non-financial listed companies in Nigeria is demonstrated to be negatively affected by financial leverage due to agency conflict (Onaolapo & Kajola, 2010) Deesomsak et al (2004) said that Pecking Order Theory is apparent in Malaysian companies because they always harness internal funds when their profits are at high level Later, San and Heng (2011) showed a negative relation between capital structure and firm performance in 40 construction firms in Malaysia from 2005 to 2008 El-Sayed Ebaid (2009) hold that capital structure is negatively associated with return on assets (ROA) with the data of 64 companies in Egypt from 1997 to 2005 Khan et al (2012) concluded

a negative effect of leverage on both ROA and Tobin’s Q in Pakistani firms in the period

of 2003-2009

Fourthly, there are some cases in which financial leverage will have a positive as well as negative effect on firm performance at different levels of debt The use of debt can help reduce the agency costs of equity when it constrains and motivates a firm’s manager to manage the company in the way that benefits shareholders, but when the firm continues to increase its debt ratios, the costs of financial distress, bankruptcy, or liquidation will get higher and higher, causing the agency costs of debt to overwhelm those of equity At this point, firm performance becomes worse and worse (Berger & Di Patti, 2006)

2.2.2 Firm performance and dividend policy:

Economists’ perspectives in dividends come in many and various definitions Dividends are the distribution of earnings after tax and interest payments on debt to shareholders Dividends are the returns paid to shareholders for their investment in a company’s stocks (Eriki & Okafor, 2002) Dividends are the compensation to investors for the time they wait to receive their returns, the efforts they make to look over a firm’s operation, the consumption they ignore to make investments, and the risks they undertake

to choose the company (Uwuigbe et al., 2012) Unlike the point of view on dividends, dividend policy has the same opinion from most researchers that it refers to the decisions

a manager makes on whether a firm should pay out dividends to shareholders at present

or retain them for reinvestment to raise firm value in the future (Lease et al., 1999; Nissim

& Ziv, 2001; Zhou & Ruland, 2006) Dividend payments not only make shareholders satisfied with the returns they obtain from their investments but also heighten their confidence in the firm’s performance in the upcoming periods (Olimalade et al., 1987) Nevertheless, the payouts of dividends themselves capture the cash flow that could be retained to invest in profitable projects in order to increase the firm’s future value Moreover, the reduction in the retained earnings accompanies the issuance of new equity,

causing the ownership rights in the company to dilute Two sides of dividend policy have brought about a puzzle that trigger a series of debates among scientists in corporate finance (Frankfurter & McGoun, 2000) Until now, the analysis for dividend payout behaviors has not come to the consensus of opinion (Agyei & Marfo-Yiadom, 2011) Regardless of arguments surrounding this policy, it remains what the manager of a company confronts when they make financial decisions (H K Baker & Powell, 2000) and remains a policy essential to companies in both developed and in emerging countries (Hafeez & Attiya, 2009)

Dividend policy has received much attention from administrators, investors, stakeholders, and researchers who seek to examine its influence on firm performance The collection of research studies continues to give evidence for the puzzle of this policy

by indicating the insignificant, positive, and negative relationship between dividend policy and firm performance

The elimination of elements contributing to the imperfection of the market drives Miller and Modigliani (1961) to their conclusion that the variation in firm value, or particularly the value of the shares the investors are holding, is independent of whether a firm pays out dividends or not Based on M&M theory, dividend policy is irrelevant to firm value because it does not interfere with a company’s assets, future cash flows, and costs of capital This theory gains the support from the findings of Stulz (2000) and Dhanani (2005) for the irrelevance of dividend policy to firm value in a perfect capital market The first time when M&M theory was introduced to the public, it only considered firm value to be unchanged with dividend policy However, recent studies turn their research to the effect of dividend policy on firm performance measured by return on assets (ROA) and return on equity (ROE) Osegbue et al (2014) found the non-significant relation between dividend payment and firm performance in Nigeria’s banking industry from 1990 to 2010 Velnampy et al (2014) came to the same conclusion for the case of

287 listed manufacturing firms in Colombia from 2008 to 2012

No sooner had M&M theory become popular among the scientific community than it was criticized by a group of scientists who insisted on an imperfect capital market with the existence of taxes, transaction costs, asymmetric information, and agency costs

in reality (Allen & Michaely, 2003; Amidu & Abor, 2006; Fama & French, 2002; M J Gordon, 1962b, 1963; Kajola et al., 2015; Lease et al., 1999) When the information between inside managers and outside investors is asymmetric, dividend payments to shareholders are in charge of telling them about a company’s operation (Adesola & Okwong, 2009; Travlos et al., 2001) Therefore, dividend policy truly has a certain stand

in financial decisions and should be considered as the determinant of firm performance (Oyinlola et al., 2013) Dividends are critical to a company because they can retain its investors’ loyalty when they are paid out to shareholders and they can increase its sales and profitability when they are retained to promote production growth Another point of view suggests that few shareholders who make investment in a company want to receive fewer dividends than they expect unless the reduction in dividends can assure them of a higher return in the future The clientele effect makes this position clearer by dividing a company’s investors into two groups, one who are in favor of dividends and one who are not The proposition argues that dividend policy has some effect on firm value only when its investors are the ones who care about dividend payments The other situation results

in the irrelevance of dividend policy

When the arguments against the relevance of dividend policy to firm value are gradually demolished by a series of studies in support of an imperfect capital market in reality, the debates on the advantage and disadvantage of dividend policy emerge among researchers They constantly give evidence that advocates not only the positive but the negative sign of dividend policy towards firm performance Supporters for dividend policy are categorized into pro-dividend, anti-dividend, and neutral school

The pro-dividend school starts with the introduction of Bird-in-hand theory M J Gordon (1962a) In a market where nothing is perfect and uncertain, dividend payments are highly evaluated Earnings that are retained to invest in questionable projects to increase future gains do not receive preference from earnings that are certainly paid out

to shareholders at present since the uncertainty of the future earnings makes dividends less risky than capital gains (Amidu, 2007) Moreover, the probability that a firm distort its financial statement is lower if it pays out dividends to outside investors Unlike M J Gordon (1962a), Shefrin and Statman (1984) explained Bird-in-hand theory with the difference in preferences among shareholders but not the uncertainty of the future income They found that dividends are critical to the elderly who heavily rely on dividends for their living due to their unemployment and low-income level This theory eventually suggests raising dividend payments in order to maximize firm value (Bhattacharya, 1979;

M J Gordon, 1963; Lintner, 1962; Miller & Rock, 1985; Walter, 1963)

Another explanation which combines the theories of Agency cost and Free cash flow greatly enhances the pro-dividend school A wedge that exists between shareholders, the principals, and managers, the agents, is the cause leading to the problem of principal agency in which managers will make decisions that are beneficial to themselves but detrimental to shareholders The payouts of dividends can mitigate agency costs by

reducing the excess free cash flow available to managers and keeping the company under the control of stakeholders (Al-Malkawi, 2005; Dempsey & Laber, 1992; Gaver & Gaver, 1993; G R Jensen et al., 1992; M C Jensen, 1986) The reduction in free cash flow will limit the possibility that managers can utilize its for personal gains and ignore the maximization of shareholders’ wealth (DeAngelo et al., 2006) Smaller amount of cash flow prevents managers from making suboptimal but optimal investments, pushing a company to operate more effectively (Bartram et al., 2009) This situation is more obvious

in the case that the company cannot find any profitable project for its investment (Mizuno, 2007) The increase in dividend payments forces a company to participate in the capital market to raise new equity for financing, which places the company in the monitoring of government, outside investors, and financial institutions in the market (Arnott & Asness, 2003; Easterbrook, 1984; Jiraporn et al., 2011)

Signaling is another theory that is in support of increasing dividend payments to shareholders In a market where information is asymmetric between managers and outside investors, the reveal of private information to the public is important to the firm’s operation In this case, dividends are a useful tool to fill the gap of asymmetric information because the payment will be a good signal that the firm has bright future prospects and effective performance (Bhattacharya, 1979; Miller & Rock, 1985) Investors then base their predictions on such signals to set up a suitable value for the firm

in which they intend to invest their money (Zakaria et al., 2012) However, the signal is significant only if the dividend announcement is true and firms with poor quality cannot imitate the acts of good firms in increasing dividend payments due to high costs of imitation (Asquith & Mullins Jr, 1983; Bali, 2003; Nissim & Ziv, 2001; Pettit, 1977; Travlos et al., 2001) Bad signals to shareholders are the reason why companies are reluctant to pay low or no dividends and are eager to maintain a satisfactory and consistent dividend policy over time in order to attract as many investors as possible and improve their profitability in doing business (Adediran & Alade, 2013; Bhattacharya, 1979; Fama

& Babiak, 1968; Lintner, 1956; Miller & Rock, 1985)

Several studies across a wide range of markets have clearly shown the importance

of paying out dividends to firm performance In developed countries, Easterbrook (1984) hold that shareholders consider dividend payments as a tool that drives managers to make financial decisions serving their best interests when a company’s activities are placed under the monitoring of other subjects in the capital market This point of view is proven

by Kent Baker et al (2007), who indicated the positive relationship between dividend payments and profitability for the case of Canadian companies In developing countries,

the positive effect of dividend policy on firm performance is present in Nigeria, Iran, Kenya, and Ghana (Agyei & Marfo-Yiadom, 2011; Amidu, 2007; Amidu & Abor, 2006; Kajola et al., 2015; Ouma, 2012; Oyinlola et al., 2014; Salehnezhad, 2013; Uwuigbe et al., 2012)

Farrar et al (1967) are the pioneers who opposed constantly paying out dividends

to improve a company’s performance Since shareholders might take into account the marginal tax rates of the dividends they receive and the capital they gain, the increase in dividend payments when the rate of dividend tax is higher than that of the capital gain tax completely does harm to shareholders themselves The anti-dividend school gained its popularity after the introduction of Tax Preference theory (Litzenberger & Ramaswamy, 1979) With the assumption that the tax charged on dividend payments is higher than the tax paid on capital gains, paying lower dividends to shareholders comes with a bright sight in firm performance However, in reality, it is unsure that tax brackets on dividend payments are always higher than those on capital gains in some countries In this case, whichever source a firm’s profits after tax will flow to, between dividends and retained earnings, depends on how much these two sources cost shareholders (Kalay & Michaely, 2000; Poterba & Summers, 1984)

Unlike these two mentioned schools above, the neutral-dividend school indicates both the positive and negative impact of dividend policy on firm performance Clientele Effects theory is likely to be classified into this type According to this theory, the divergent interests among groups of the company’s investors are what makes the impact

of dividend policy unprecedented If a firm’s clienteles are dividend lovers, dividend payments will have a good influence on firm performance The reverse is a bad effect if they love capital gains When the assumption from Tax Preference theory is integrated into Clientele Effects theory, companies that pay higher dividends will attract those who prefer dividends, and companies that are operating in a high tax bracket will attract those who favor capital gains (Allen et al., 2000; Dhaliwal et al., 1999; Seida, 2001; Short et al., 2002) Farsio et al (2004) outlined two possible circumstances that stand for both positive and negative association between dividend policy and profitability If a company does not look over its investment opportunities but pays out more dividends, the reduction

in the funds that should have been used to reinvest in profitable projects brings a negative effect to firm performance They added that the payouts of dividends sometimes are a company’s resulting management policy trying to satisfy investors and prevent them from shifting their investment to other companies although the firm at this time has losses but not profits The behavior of hiding its failure from outside investors mistakenly open the

way for a harmful effect of dividend policy on firm performance However, if a company does have good performance, the increase in dividends is a hopeful sign

2.2.3 Firm performance and state ownership:

The effect of state ownership on firm performance remains a debatable issue among quite a huge number of researchers While SOEs are found to be an effective type

of ownership in some studies, they are demonstrated to be the cause of bad performance

in others

According to Bos (1991), the dominance of the government in a firm’s ownership structure means a closer monitor to its operation and management, resulting in the reduction in agency costs and the increase in profitability Lu (2000) showed that state ownership can reduce agency costs and improve a firm’s effectiveness due to its manipulation of laws and regulations, taxes, or decisions to borrow loans It is obvious that SOEs receive political support from and have business connections with the government, which enhances their firm performance (Sun et al., 2002) Thus, political connections play an imperative role in helping state-owned companies obtain some advantages to improve their operations such as loans that are borrowed from financial institutions, taxes that are treated favorably, and power that is taken from the market (Adhikari et al., 2006; Claessens et al., 2008; Johnson & Mitton, 2003) Liao and Young (2012) declared that state ownership is positively related to firm performance when carrying out the research with the sample of 514 privatized companies from 1999 to 2004 Rafiei and Far (2014) came up with the same result for the case of non-financial companies in Iran from 2009 to 2011 Zeitun (2014) researched a group of five nations including Bahrain, Kuwait, Oman, Qatar, and Saudi Arabia in the period of 10 years to

prove the positive relation between state ownership and return on assets (ROA)

On the other hand, the negative relationship between state ownership and firm performance is clearly shown in some studies Shleifer and Vishny (1998) stated that the government may impose political objectives on companies and harness their assets with the grabbing hand, causing a negative effect on firm performance Li et al (2008) emphasized that the pursuit of a political purpose but not value maximization is what makes SOEs less likely to operate more effectively than private companies Moreover, SOEs are less effective and profitable than private firms because they are forced to hire more employees than necessary, to appoint those who are politically connected to the manager position instead of those who are well-qualified, and to focus on social and political objectives but not profit maximization (Boycko et al., 1996; Dewenter & Malatesta, 2001; Krueger, 1990) These obstacles make SOEs less market-oriented,

which deteriorates their firm performance (Hunt & Morgan, 1995; Kirca et al., 2005; Kohli & Jaworski, 1990; Song et al., 2015) Stiglitz (1998) made some comparisons between private and state-owned enterprises Firstly, while private companies pay attention to profitability and investment, public ones pursue alternative goals Secondly, SOEs are less likely to look over management because profitability belongs to the public but not the firm representatives Thirdly, job security is higher in SOEs than in private ones so that workers have no incentives in their work in order to enhance firm performance When comparing the performance of companies before and after privatization in 18 countries from 1961 to 1990, Megginson et al (1994) indicated that lower rates of state ownership go hand in hand with the increase in sales, profits, capital, efficiency, and dividend payouts as well as the decrease in debt levels among SOEs Boubakri and Cosset (1998) did research covering 79 companies in 21 developing countries from 1980 to 1992 and gave the consistent findings with previous studies Dewenter and Malatesta (2001) supposed that state-owned firms are not as profitable and effective as private firms based on the sample of 1369 firm-year observations in total Using the data of 59 listed Jordanian companies from 1989 to 2002, Zeitun and Gang Tian (2007) suggested reducing state ownership in order for companies to perform more

effectively

Interestingly, in case the relation follows a nonlinear form, a decrease in state ownership rates will benefit firm performance up to the level where another increase will result in a worse operation Therefore, Sun et al (2002) highly evaluated the role of the government in SOEs Delios and Wu (2005) confirmed the U-shaped relationship between the two variables by indicating that the large holding of shares causes the government to make more attempts to monitor the companies, while the small holding below 35 percent will lower firm value because the influence of the government on mitigating agency costs and manipulating market regulations is negligible Ng et al (2009) gave support to the fact that the form of state ownership-performance relationship can be convex, concave, and linear in different situations with the data including 4315 Chinese companies in the period of eight years

2.3 Research hypotheses:

Capital structure is not related to firm value in a perfect capital market with the absence of taxes, transaction costs, bankruptcy costs, and asymmetric information (Modigliani & Miller, 1958) However, these assumptions are not well-suited to what is happening in the capital market Although Capital Structure Irrelevance Theory has got some supports from empirical studies, most researchers in the field of corporate finance

demonstrated that capital structure is associated with how well a manager runs his business In fact, when relaxing the assumption of taxes, Modigliani and Miller (1963) are in support of borrowing as much debt as possible to maximize firm value On the other hand, they only paid attention to the positive but not negative side of an issue Trade Off Theory is successful in identifying the double-sided financial leverage Based on this theory, the benefits of saving taxes, encouraging managers to operate more effectively, and imposing debt covenants can outweigh the losses of financial distress and bankruptcy

At last, Trade Off Theory tilted to the positive relationship between financial leverage and profitability In contrast to Trade Off Theory, Pecking Order Theory gives evidence for the positive association between firm performance and capital structure The theory provides a hierarchy of financing funds from internal to external sources The hierarchy

is based on the level of asymmetric information, meaning that the fund from retained earnings has no problem, and the problem of asymmetric information of equity is more serious than that of debt The limitations of Pecking Order Theory are that it ignores taxes, financial distress, equity issuance costs, and agency costs According to Agency Theory, debt can mitigate the agency costs between managers and shareholders Debt places certain constraints not only on the free cash flow that is discretionary for managers but also on financial decisions that they make in their management Moreover, debt covenants help keep the interests between shareholders and managers balanced and force firms to perform effectively in order to satisfy all their obligations and not to fall into financial distress and bankruptcy Nevertheless, what is considered to be positive can turn out to

be negative When firms use debt in the capital structure, they have to pay interests from debt to lenders, losing part of their profits The reduction of the free cash flow accompanies the lack of funds that companies can utilize to invest in profitable projects The resulting underinvestment causes firms’ operations to worsen Moreover, the constraints from debt covenants will become a barrier to managers’ creativity and innovation in managing their businesses Debt can relieve the conflict between shareholders and managers but exacerbate the agency problems between shareholders and bondholders In this circumstance, it is uncertain whether agency costs will be reduced or not Fama and French (1998) opposed Trade Off Theory by demonstrating that the use of debt at a risky level can exert such a negative impact on profitability that it surpasses the benefits of tax savings The negative effect happens as the risk of financial distress and bankruptcy is becoming more serious, causing companies to suffer enormous agency costs Besides, high levels of debt make managers risk-averse and unwilling to make risky but profitable investments (Balakrishnan & Fox, 1993) In Vietnam, Tran (2015) pointed

out the negative relationship between financial leverage and ROA for a sample of 165 listed companies from 2008 to 2012, and D C Le (2013) was in favor of Pecking Order Theory, indicating that ROA is negatively related to the capital structure In short, the research comes to the first hypothesis

H1: financial leverage has a negative effect on firm performance

Under the conditions of a perfect capital market, dividend policy is not relevant

to firm value (Miller & Modigliani, 1961) In reality, with the presence of taxes, transaction costs, asymmetric information, and agency costs, M&M Theory is no longer appropriate in the capital market Dividend payments are useful in reducing the free cash flow, preventing managers from making suboptimal investments and aligning the interests between managers and shareholders (Bartram et al., 2009; DeAngelo et al., 2006) Dividend payouts mean that companies have to find external financing funds in case the cash flow is not enough for new investments The participation in the capital market puts firms under the control of multiple partners and market regulations, facilitating good firm performance Nevertheless, if firms pay out dividends but take no care about the needs of investment, the lack of financing sources will cause firms to skip productive investments necessary to raise future earnings which heighten operation efficiency Furthermore, if the companies’ management policy is paying out dividends to satisfy shareholders’ needs and mitigate the possibility of their shifting to another kind of stock in the market regardless of difficulties they are experiencing, dividend payments in this circumstance bring no good than harm to firm performance due to the decline in future earnings (Farsio et al., 2004) Doing research on the data of 95 listed companies in the period of 2008 - 2013, Dinh and Nguyen (2014) found the negative relationship between firm value and dividend per share Although the study does not mention how effectively Vietnamese firms operate with the increase in dividends, it has, to some extent, signaled a reverse association between dividend policy and performance At last, the paper proposes the second hypothesis

H2: dividend policy is negatively related to firm performance

Companies with high state ownership rates are considered to be highly politically connected They are easy to get access to credits from the state commercial banks, are favorably treated in taxes, especially corporate tax, by the government, and are powerful

in manipulating financial instruments in the market (Adhikari et al., 2006; Claessens et al., 2008; R H Gordon & Li, 2003; Johnson & Mitton, 2003; Lin, 2004) As a consequence, state ownership goes hand in hand with increased earnings, reduced costs, and improved performance (Lu, 2000) Besides, the dominance of shares possessed by

the state in the ownership structure imposes a strict monitoring on the management of the managers, mitigating agency problems and making firms more profitable (Bos, 1991) On the other hand, it is the political connections that worsen firm performance Unlike privatized firms whose purpose is to maximize firm value, companies with high rates of state ownership are the government’s tools in implementing political and social objectives Therefore, the pursuit of various aims makes their operations inefficient (Li et al., 2008; Shleifer & Vishny, 1998) Obviously, companies that are more market-oriented are demonstrated to operate more effectively (Hunt & Morgan, 1995; Kirca et al., 2005; Kohli & Jaworski, 1990; Song et al., 2015) Within SOEs, managers are unlikely to care much about their management because the representatives cannot enjoy the profits they attempt to make The number of employees is often higher than necessary, jobs are so highly secured that workers virtually have no incentive to proceeding their work, and managers are appointed not because they are qualified for this position but because they have certain political relations These long-standing issues place some restriction on the effectiveness of SOEs Vo et al (2014) gave evidence on Vietnamese companies that the higher state ownership rates are the lower profits a firm earns D H Le et al (2016) indicated the negative relationship between firm performance and state ownership and suggested that 30.3% is the optimal state ownership rate Such empirical studies in Vietnam lead to the third hypothesis

H3: higher state ownership rates imply worse firm performance

Previously, capital structure and dividend policy are often analyzed separately, but they are in reality interrelated to each other Firms figure out their dividend policy not after but at the same time of making financing and investment decisions (Green et al., 1993) Therefore, it is necessary to research them jointly The combination of these two policies is supposed to help reduce the negative effect which either financial leverage or dividend policy has on firm performance When a firm pays out high dividends to shareholders, small retained earnings make the firm difficult in having adequate funds to invest in profitable projects in the future, reducing firm profitability In this case, a lack

of fund can be replenished with an access to debt in the capital market Therefore, with similar dividend payments, firms that have higher financial leverage tend to perform more effectively When a firm uses debt in its capital structure, paying dividends to shareholders means that the company is allocating its financing sources so effectively that

it can earn enough profits so as to afford dividend payments Hence, at the same debt level, those who pay out higher dividends than others are more effective in their operations The study subsequently provides the fourth hypothesis

H4: the interaction of dividend and debt policy has a positive impact on firm performance

Debt and dividend policy are considered as a moderator in the relationship between state ownership and firm performance State ownership is expected to have a negative effect on firm performance due to the manager’s distraction in managing his business The question is whether financial leverage and dividend payments will acerbate

or relieve such a negative relation Interest and debt payments reduce the free cash flow, lowering the probability that managers can use this excessive funds for other purposes but profit maximization (M C Jensen, 1986; M C Jensen & Meckling, 1976) Some research in China’s market gave evidence that companies with high state ownership rates often utilize debt in the capital structure to mitigate agency problems, enhancing firm performance (Dharwadkar et al., 2000; Park & Luo, 2001; Peng & Luo, 2000) Moreover, Vietnamese government remains a subject that controls tax policy, state commercial banks, corporate laws, markets, and firm activities Therefore, companies with high state ownership rates are less likely to fall into financial distress due to the support from the government In this case, the adverse effect of debt on firm performance decreases to a negligible level (J J Chen, 2004) Hence, the interaction of debt and state ownership is predicted to positively adjust the negative influence of state ownership in firm performance Similarly, dividend policy is a substitute for financial leverage in cutting down agency costs by decreasing managers’ sources of funds at discretion, increasing stakeholders’ control of firm operation, and mitigating asymmetric information between shareholders and managers Often, dividend payments accompany the lack of funds for lucrative investments, pushing down firm profitability However, SOEs are not capital-constrained, meaning that they can have access to other sources of funds to invest in profitable projects in order to heighten their performance This truth partly eliminates dividend policy’s negative effect on firm performance Thus, the interaction of dividends and state ownership is anticipated to positively moderate the negative impact of state ownership on firm performance Nevertheless, SOEs should be careful about combining these two policies If the use of debt exerts a positive effect on these firms’ performance, the payout of dividends at the same time may force them to raise the debt level When the amount of debt gets to such a high level that the companies’ risks of financial distress and bankruptcy cannot be covered by the government, a negative impact is obviously the resulting consequence Therefore, debt and dividend policy should be employed carefully

to make firms operate more effectively In short, the research proposes the hypotheses

H5: the interaction of state ownership and financial leverage positively affects firm performance

H6: the interaction of state ownership and dividend policy has a positive impact on firm performance

H7: the three-variable interaction of financial leverage, dividend policy, and state ownership shows a negative effect on firm performance

CHAPTER 3: DATA AND METHODOLOGY 3.1 Data collection:

The financial data in the research comes from two sources The first source is the financial statements, namely the balance sheet and the income statement, and the second

is the annual report Both are collected and compiled by Stock Plus Corporation The research chooses and calculates the necessary variables for all firms in the two major stock exchanges in Vietnam for a period of eight years from 2008 to 2015 The early dataset comprises of 687 companies listed on HNX and HOSE However, the study only takes the financial data from companies that have 4 consecutive years in operation Therefore, a number of firms are eliminated from the sample The panel data covers up

to 663 financial and non-financial companies with 364 on HNX and 299 on HOSE

In Equation (1), the dependent variable ROAi,t is the return on assets of firm i at time t; αi,t is the constant term ROAi.t−1 is the lagged variable of the dependent variable LEVi.t is the leverage of firm i at time t; DPSi,t represents the dividend policy of firm i at time t1; SOEi,t measures the percentage of state ownership in the ownership structure of firm i at time t; Xi,t is a set of control variables including size, risk, liquidity, asset growth, and sales of firm i at time t; LEVi.t× DPSi,t , DPSi,t× SOEi,t , and LEVi,t× SOEi.t are the interaction terms of financial leverage and dividend policy, dividend policy and state ownership, and financial leverage and state ownership of firm i at time t respectively; LEVi.t× DPSi,t× SOEi,t is the interaction term of financial leverage, dividend policy, and state ownership of firm i at time t; and εi,t is the error term

1 It is said that firms often pay out dividends after calculating their net earnings Therefore, dividend payments cannot affect profitability of the same year However, dividend policy can be made before companies have information on their income The policy is also combined with debt and investment policy

in order to adjust firm performance at the end of the year In this case, dividend policy this year is likely to have a certain effect on profitability at the same time

3.3 The variable definition and measurement:

3.3.1 Dependent variables:

Many measures have been used by the huge number of researchers around the world to measure firm performance Generally, these measures are classified into two categories which are accounting-based and market-based measures Accounting-based measures primarily rely on the previous information in the financial statements and only take partial depreciation and amortization into consideration Moreover, these measurements are heavily influenced by the way the accountant outlines the financial statements, the accounting standards set up by the legal system, and accounting practices (Kapopoulos & Lazaretou, 2007) On the other hand, market-based measures describe a firm’s future prospects based on firm performance in the past and at present (Ganguli & Agrawal, 2009; Shan & McIver, 2011) ROA and Tobin’s Q are respectively the most popular accounting and market-based measure ROA is used to evaluate a company’s financial performance (Klapper & Love, 2002) The higher this measure is the more effectively the firm uses its assets to satisfy shareholders’ interests (Haniffa & Hudaib, 2006; Ibrahim & Samad, 2011) Unlike ROA, a measurement of short-term performance, Tobin’s Q gives an insight into a firm’s long-term performance (Bozec et al., 2010) It can bring information on future growth opportunities to not only managers but also investors so that they can make suitable managerial and financial decisions (Demsetz & Villalonga, 2001; Shan & McIver, 2011) The higher Tobin’s Q is the more successful the company becomes in making investments that help raise its market value (Kapopoulos

& Lazaretou, 2007) At first, this paper intends to put these two measurements of firm performance into the regression as alternative elements However, ROA is proven to be more suitable to this research than Tobin’s Q is The first reason is that this study focuses

on the relationship between firm performance and financial leverage, dividend policy, and state ownership which is mostly related to corporate governance In this case, the accounting-based measure is more appropriate because it can point out the outcomes of the managerial behaviors (Hutchinson & Gul, 2004; Mashayekhi & Bazaz, 2008) The second reason is that Tobin’s Q is often inflated in the case of inefficient underinvestment, making it a misleading measure of firm performance (Dybvig & Warachka, 2015) The third reason is that Tobin’s Q considers the market value of debt in the measurement; however, Vietnam has not established the market reserved for debt and has not gathered official statistics on debt Therefore, debt usually takes the book value instead of the market one, causing Tobin’s Q to be incorrectly measured In short, the research chooses

an accounting-based measure, return on assets (ROA), as the dependent variable (Chan