Profitability to the effects caused by debt given to

Profitability of the firm as the state of yielding financial
profit or gain. According to McCabe (2011), Profitability is an important key
indicator giving the knowledge about insurance company on income level raise.
Companies with high profitability are expected to pay high dividends to
shareholders. Friend and Puckett (2004) perceive that high dividend policy
ratios are not always a reliability indicator, as earnings not paid out in
dividends can be used for company’s future growth. Studies carried out by Black
and Scholes (1974) indicate that it is impossible to demonstrate difference on
expected returns on high yields and on low yields, since some investors
logically prefer high dividend yields. Since different companies, firms, trust
institutes find it convenient to receive dividends than to sell or borrow
against their shares. According to Brennan (1970), investors preferring low dividend
yield cannot afford to pay higher taxes on dividend income than on capital
profit. The changes in dividend policy may not effect a firm since shareholders
can be replaceable. And finally Black and Scholes (1974) indicate that
before-tax returns on common stock are unrelated to corporate dividend payout
policy.

2.3 Debt Policy

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Debt policy is related to the effects caused by debt given
to a firm on offer and/or demand basis. Likelihood of firm’s employing debt
include business, risk, profitability, R&D expenditures, and fixed asset
levels. The features that increase the costs of monitoring the company’s
activities should decrease the supply of debt to the firm. Ravid (1988), by
deducing a compelling review of the debt policy literature, discusses the
market imperfections relationships regarding to effects of fixed asset ratios,
profitability, high business risk and R expenditures on debt policy. The
quantity of debt at random interest rate taken by the company should be
considerably 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 decrease
their demand for debt due to considerable amount of internal funds available to
finance investment; therefore, they tend to build their equity compared to
their debt. Studies of Long and Malitz (1985) indicate that the R&D
expenses are to be cater for by the organization if external stakeholders
handle major monitoring costs when considerable investment cost is allocated to
intangible units. R&D expense, in short, demonstrate future growth
potential of a firm, indicating inverse relationship with debt taken by the
firm.

2.4 Liquidity Risk

Pastor and Stambaugh (2003) suggest that assets with high
positive sensitivity of returns to aggregate liquidity result in a
disproportionate decline in investor welfare when aggregate liquidity is low,
the reason is that lower liquidity results in costlier liquidation and investors
have higher marginal utility of wealth during wealth crisis. The investor is
expected to demand dividend-paying stocks which is higher in states with low
aggregate liquidity compared to non-paying stocks, allowing them to avoid
market trading friction. The dividend initiations lead to reduction in the
sensitivity of firm value to aggregate liquidity. The Fama and French (1993)
demonstrate the three-factor model comprising the market factor, the size
factor and the book-to-market factor; the market factor is the return of the
value-weighted CRSP portfolio minus the risk-free rate, the size-factor is the
difference in returns between large and small stocks and the book-to-market
factor is the difference in returns between stocks with low versus high book-to-market
ratios. The four-factor model (Fama and French three-factor plus a momentum
factor) includes a momentum factor evidenced by Jagadeesh and Titman (1993)
demonstrating that past performance is positively related to future
performance. Pastor and Stambough (2003) present the liquidity factor based on
the idea that order flow induces greater return reversals when liquidity is
lower. It is evidenced that the pre-dividend firm value increases in liquid
markets and decreases in less liquid markets, the firm values are inversely
related after the companies initiate dividend payments. Pastor and Stambaugh
(2003) indicate that for individual stocks, liquidity betas are significantly
positively correlated over time. The liquidity betas of non-initiating firms are
negative, like the betas of dividend-initiating firms after dividend
initiation. Likeably, firms with higher liquidity risk are more likely to
initiate dividends than firms with lower liquidity risk. The sensitivity of
stock returns to aggregate liquidity declines after dividend initiations. Firm
value increases in states after dividend initiations characterized by low
aggregate liquidity and high marginal utility of wealth. The reduced liquidity
risk lowers expected returns by economically significant amounts. The overall
results indicate that stock market liquidity and cash dividends act as
substitutes from investor’s perspective.

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