Dividend policy and residual dividend theory: evidence from Indonesia

Summary of “Dividend Policy and Residual Dividend Theory: Evidence from Indonesia” (Wirama et al., 2024, Asian Journal of Accounting Research)

Purpose and Focus of the Study

This paper examines how capital expenditure (CAPEX) and working capital (WC) affect the dividend policy of Indonesian listed companies within the framework of residual dividend theory. The theory proposes that dividends are distributed only after a firm’s optimal investment needs have been met—implying that dividends are residual outcomes rather than managerial priorities.

The study seeks to answer the main question:

Do capital expenditure and working capital decisions influence dividend payout behaviour in Indonesian listed firms, consistent with the residual dividend theory?

The authors aim to test whether this classical theory, widely validated in developed markets, holds in Indonesia’s emerging market context, where capital markets are less efficient, external financing is costly, and ownership concentration is high.

Background and Context

Dividend policy has long been debated in corporate finance. While Western markets often view dividend distribution as a signal of stability and governance quality, in emerging economies—particularly Indonesia—dividend behaviour is shaped by different institutional realities.

Indonesian firms, many of which are family-controlled or state-owned, often prioritise retained earnings for reinvestment due to limited access to external capital. Consequently, dividends become residual—declared only when investment and liquidity needs are satisfied.

The residual dividend theory, originally proposed by Miller and Modigliani (1961), suggests that optimal investment decisions come first, followed by financing decisions, and dividends are paid from the remaining profits. However, empirical evidence from emerging economies remains limited. This study fills that gap by testing the theory using comprehensive financial data and robust econometric techniques to reflect Indonesia’s corporate and institutional landscape.

Theoretical Foundation

The research is grounded in the residual dividend theory, complemented by supporting ideas from pecking order theory and free cash flow theory. Together, these frameworks explain how firms allocate cash between investment, financing, and dividend distribution.

Residual Dividend Theory predicts a negative relationship between investment needs (CAPEX and WC) and dividend payouts.
Pecking Order Theory supports this logic by asserting that firms prefer internal financing (retained earnings) to external capital.
Free Cash Flow Theory warns that excessive reinvestment without oversight may reduce dividends and potentially enable managerial opportunism.

The paper integrates these perspectives to evaluate whether Indonesian companies behave rationally within financial constraints or are influenced by ownership and institutional dynamics.

Research Method

The study uses secondary financial data from non-financial companies listed on the Indonesia Stock Exchange (IDX) covering the period 2011–2020. The final sample includes 870 firm-year observations.

Dependent variable:

Dividend Policy (proxied by Dividend Payout Ratio – DPR).

Independent variables:

Capital Expenditure (CAPEX).
Working Capital (WC).

Control variables:

Firm Size (SIZE), Sales Growth (SG), Leverage (DER), Profitability (ROA), Liquidity (CR), and State-Owned Enterprise dummy (SOE).

The study employs panel data regression models, supplemented with quantile regression analysis (Q25, Q30, Q50, Q60) to assess how determinants vary across different levels of dividend payouts. Robustness checks (e.g., heteroskedasticity and endogeneity tests using Coarsened Exact Matching) ensure the reliability of the results.

Key Findings

(a) Negative Relationship Between CAPEX and Dividend Payouts

The results strongly support the residual dividend theory: higher capital expenditure significantly reduces dividend payouts. Firms allocate profits primarily to fund investment projects before distributing residual earnings as dividends.
This trend is most evident in medium-dividend firms, suggesting that companies balance shareholder expectations and internal financing capacity.

(b) Working Capital Also Reduces Dividend Payments

Working capital shows a similar negative effect on dividend payout. Firms with higher short-term liquidity needs retain cash to ensure operational stability, demonstrating that liquidity management takes precedence over shareholder returns.

Firm Size, Profitability, and Liquidity positively affect dividend payouts—larger, more profitable, and liquid firms are more capable of paying dividends.
Sales Growth and Leverage negatively affect dividend payouts—rapid growth and high debt burdens constrain available cash.
State Ownership (SOE) slightly decreases dividend levels, suggesting that government-controlled firms prioritise reinvestment and social objectives over consistent shareholder returns.

(d) Quantile and Robustness Analysis

Quantile regressions reveal that CAPEX’s negative influence is strongest among firms in the 25th–60th percentile of dividend distribution.
For low-dividend firms, liquidity constraints dominate; for high-dividend firms, investment needs become less restrictive due to accumulated reserves.
Robustness and endogeneity tests confirm the consistency and stability of the results across different model specifications.

Discussion and Interpretation

The findings demonstrate that Indonesian firms exhibit rational financial behaviour consistent with residual dividend theory. Firms prioritise capital and working capital investment to sustain long-term growth and competitiveness, distributing dividends only after these commitments are met.

However, the study also highlights institutional characteristics unique to Indonesia that shape this behaviour:

High internal financing dependence due to costly external capital markets.
Family and state ownership concentration, leading to conservative dividend practices.
Weak investor protection, reinforcing managerial discretion over cash retention.

This context explains why dividends are treated as residual outcomes rather than mandatory commitments. It also challenges the assumption that dividend cuts automatically signal financial weakness—within Indonesia’s institutional setting, they often reflect prudent reinvestment decisions.

Practical and Policy Implications

For managers:

Aligning investment, liquidity, and dividend decisions is vital to maintaining financial flexibility. Firms should communicate investment rationales clearly to reduce shareholder misinterpretation of dividend reductions.

For investors:

Dividend omissions should not be automatically interpreted as negative; they may indicate strategic reinvestment aligned with long-term value creation.

For regulators:

Clearer reporting standards and disclosure requirements on dividend policy rationales could enhance transparency and investor confidence.

For policymakers:

Strengthening access to external financing and improving corporate governance mechanisms would allow firms to balance growth financing with equitable dividend distribution.

Research Limitations and Future Directions

The study’s reliance on archival financial data limits understanding of managerial intentions and stakeholder perceptions behind dividend decisions.
It also focuses solely on non-financial Indonesian companies, excluding potential variations across industries or regional markets.

Future research could:

Incorporate qualitative interviews with managers and investors to explore the decision-making logic behind dividend policy.
Conduct comparative analyses across ASEAN or emerging economies to assess institutional effects.
Examine how corporate governance quality, ESG performance, or ownership concentration moderate the relationship between investment and dividends.
Explore longitudinal causal models to measure whether changes in CAPEX or WC predict subsequent dividend adjustments over time.