Reduced Dividends: Life Cycle Theory Or Agency Cost Theory?

Research on the theory of dividend policy has mainly focused on the two hypotheses of the Agent Cost Theory in the past,including the Tunneling Hypothesis and the Free Cash Flow Hypothesis.In recent years,the Life Cycle Theory of dividend policy has also been developed.According to the Tunneling Hypothesis,cash dividends are a tool for delivering interests of major shareholder before China's non-trade shares reform;according to the Free Cash Flow Hypothesis,when a company has large amount of free cash flow,management has an incentive to inefficiently occupy it,incurring agency costs.Issuing cash dividends can reduce management's occupation of free cash flow and curb agency costs.According to the Life Cycle Theory,companies in growth period pay less cash dividends,while companies in mature period pay more.Gree Electric Appliances is a white goods giant.It has long ranked first in China's air-conditioning industry in terms of production and sales,and because of its continuous and stable high dividends,it has become a ‘white horse stock' favored by investors.Gree has been conducting a relatively continuous and stable dividend policy.In a word,it is a good case study company.Gree's dividend distribution over the years can be explained by the Tunneling Hypothesis,Free Cash Flow Hypothesis,and Life Cycle Theory.According to the lifecycle judgment factors,Gree Electric Appliances was in the start-up period in 2002 and before.It was in the growth period from 2003 to 2011.It entered the mature period from 2012.Excluding the years before the non-trade shares reform,it was found that the cash dividend distribution level in the growth period was lower than in the maturity period,which is in line with the Life Cycle Theory.However,in 2017,the cash dividend distribution rate was abnormally reduced.Through the non-trade shares reform,Gree's shareholding structure changed from single dominance structure to a more decentralized shareholding structure.The dividend distribution rate also decreased as the proportion of major shareholders held shares decreased,which is in line with the Tunneling Hypothesis.Since 2012,Gree Electric has met the premise of the Free Cash Flow Hypothesis.Managers may occupy the free cash flow and reduce the distribution of cash dividends;however,the level of cash dividend distribution in 2012-2016 was relatively high until 2017,when abnormalities occurred.In 2017 and 2018,Gree Electric Appliances,which is mature and rich in free cash flow,should continue to distribute high cash dividends,but chose not to pay dividends in 2017,and the cash dividend distribution rate in 2018 also decreased to 48%.Therefore,based on the Life Cycle Theory and the Free Cash Flow Hypothesis,two explanations are proposed:Explanation 1: The decrease in cash dividends in 2017 and 2018 is because Gree Electric has entered a new growth period.In order to seize new investment opportunities,it is beneficial to the company's value.Explanation 2: The decrease in cash dividends in 2017 and 2018 is due to the management occupying free cash flow,generating agency costs,which is damaging the value of the company.Testing "explanation 1" based on three life cycle judgment factors,it was found that although the two factors of main business growth rate and operating cash flows in total assets in 2017 and 2018 showed the characteristics of growth period,Gree Electric did not enter the growth period again.The growth of Gree Electric's main business income from 2017 came from the industry boom,when the change in operating cash flows came from channel sales strategies.Meanwhile,Gree did not invest in capacity expansion.As a result,the changes in cash dividends in 2017 and 2018 are not caused by life cycle changes,and explanation 1 is not supported.In order to test explanation 2 and examine the level of free cash flow for dividends and investment,it was found that when the dividend distribution rate decreased in 2017 and 2018,Gree's investment level increased,but most of it was invested in time deposits and wealth management products,when only a few was invested in those that are beneficial to the future development of the company.Therefore,management's occupation of free cash flow is inefficient and explanation 2 is supported.Further analyzing the background of management decision-making,it was found that Gree Electric's agency conflict was very serious.Analysis shows that management's purpose of occupying free cash flow and reducing cash dividends may be to avoid obstacles from shareholders that external financing may encounter,hoping to invest through internal funds when future investment opportunities arise.The company's value was examined to further test two explanations.It was found that the profit distribution plan in the 2017 annual report and the 2018 semi-annual report damaged the company's value,which supports explanation 2.It indicates that the management of Gree Electric occupied the free cash flow and generated agency costs.It does not support explanation 1,Gree Electric has not entered a new growth period.The 2018 annual report profit distribution plan did not significantly affect the company's value,and the support for explanation 2 was less obvious.The reasons may be that although the 2018 cash dividend distribution rate is low,it's still within the shareholders' expectations,or the management's occupation and intention are within the scope of acceptance by shareholders.Finally,it is suggested that the inefficient occupation of free cash flow by management can be monitored and controlled through internal and external control means.Internal control includes optimizing the governance structure of the Board of Directors and introducing independent institutional investors.External control includes returning dividends to shareholders,and investing through debt and equity financing,forcing the company to accept the supervision of creditors and the capital market.Looking forward to Gree's future corporate governance and dividends,Gree's management teamed up with strategic investor Hillhouse Capital in 2019 to transfer 15% of the equity of Gree Group,the major shareholder.While designing a governance structure to balance management power,the management and the Shareholders' interests are more consistent.Meanwhile,a management equity incentive plan is promised.Those changes relieve agency conflicts,reduce management's external financing barriers,and enhance management's incentives for dividends.This article developed the research on the Life Cycle Theory and the Free Cash Flow Hypothesis of dividend policy from a case perspective.It is helpful for other companies to imitate reasonable dividend policies,safeguard shareholders' interests,and provide optimization directions for corporate governance issues,thereby contributing to the construction of China's capital market.