Profitability of the firm as the state of yielding financialprofit or gain. According to McCabe (2011), Profitability is an important keyindicator giving the knowledge about insurance company on income level raise.Companies with high profitability are expected to pay high dividends toshareholders. Friend and Puckett (2004) perceive that high dividend policyratios are not always a reliability indicator, as earnings not paid out individends can be used for company’s future growth. Studies carried out by Blackand Scholes (1974) indicate that it is impossible to demonstrate difference onexpected returns on high yields and on low yields, since some investorslogically prefer high dividend yields. Since different companies, firms, trustinstitutes find it convenient to receive dividends than to sell or borrowagainst their shares. According to Brennan (1970), investors preferring low dividendyield cannot afford to pay higher taxes on dividend income than on capitalprofit.
The changes in dividend policy may not effect a firm since shareholderscan be replaceable. And finally Black and Scholes (1974) indicate thatbefore-tax returns on common stock are unrelated to corporate dividend payoutpolicy.2.
3 Debt Policy Debt policy is related to the effects caused by debt givento a firm on offer and/or demand basis. Likelihood of firm’s employing debtinclude business, risk, profitability, R&D expenditures, and fixed assetlevels. The features that increase the costs of monitoring the company’sactivities should decrease the supply of debt to the firm. Ravid (1988), bydeducing a compelling review of the debt policy literature, discusses themarket imperfections relationships regarding to effects of fixed asset ratios,profitability, high business risk and R expenditures on debt policy.
Thequantity of debt at random interest rate taken by the company should beconsiderably reduced by high business risk or R expenditures. Conversely,company’s level of fixed assets should be positively related to debt levels.According to Myers and Majluf (1984), highly profitable companies decreasetheir demand for debt due to considerable amount of internal funds available tofinance investment; therefore, they tend to build their equity compared totheir debt. Studies of Long and Malitz (1985) indicate that the R&Dexpenses are to be cater for by the organization if external stakeholdershandle major monitoring costs when considerable investment cost is allocated tointangible units. R&D expense, in short, demonstrate future growthpotential of a firm, indicating inverse relationship with debt taken by thefirm.2.4 Liquidity RiskPastor and Stambaugh (2003) suggest that assets with highpositive sensitivity of returns to aggregate liquidity result in adisproportionate decline in investor welfare when aggregate liquidity is low,the reason is that lower liquidity results in costlier liquidation and investorshave higher marginal utility of wealth during wealth crisis.
The investor isexpected to demand dividend-paying stocks which is higher in states with lowaggregate liquidity compared to non-paying stocks, allowing them to avoidmarket trading friction. The dividend initiations lead to reduction in thesensitivity of firm value to aggregate liquidity. The Fama and French (1993)demonstrate the three-factor model comprising the market factor, the sizefactor and the book-to-market factor; the market factor is the return of thevalue-weighted CRSP portfolio minus the risk-free rate, the size-factor is thedifference in returns between large and small stocks and the book-to-marketfactor is the difference in returns between stocks with low versus high book-to-marketratios. The four-factor model (Fama and French three-factor plus a momentumfactor) includes a momentum factor evidenced by Jagadeesh and Titman (1993)demonstrating that past performance is positively related to futureperformance. Pastor and Stambough (2003) present the liquidity factor based onthe idea that order flow induces greater return reversals when liquidity islower.
It is evidenced that the pre-dividend firm value increases in liquidmarkets and decreases in less liquid markets, the firm values are inverselyrelated after the companies initiate dividend payments. Pastor and Stambaugh(2003) indicate that for individual stocks, liquidity betas are significantlypositively correlated over time. The liquidity betas of non-initiating firms arenegative, like the betas of dividend-initiating firms after dividendinitiation. Likeably, firms with higher liquidity risk are more likely toinitiate dividends than firms with lower liquidity risk. The sensitivity ofstock returns to aggregate liquidity declines after dividend initiations.
Firmvalue increases in states after dividend initiations characterized by lowaggregate liquidity and high marginal utility of wealth. The reduced liquidityrisk lowers expected returns by economically significant amounts. The overallresults indicate that stock market liquidity and cash dividends act assubstitutes from investor’s perspective.
