Dynamics and Determinants of Dividend Policy

Corporate dividend policy is one of the most debated topics in corporate finance. Many researchers have devised theories and provided empirical evidence regarding the determinants of a firm’s dividend policy. The dividend policy issue, however, remains still unresolved as due to the fact that there are so many variables depending upon the type of company, its financial conditions, its industry etc that no single formula could be applicable. Clear guidelines for an ‘optimal payout policy’ have not yet emerged despite the voluminous literature. We still do not have an acceptable explanation for the observed dividend behavior of companies.

During the last fifty years several theoretical and empirical studies have been done leading to mainly three outcomes:

1. The increase in dividend payout affects the market value of the firm.
2. The decrease dividend payout adversely affects the market value of the firm.
3. The dividend policy of the firm does not affect the firm value at all.

However, we can say that empirical evidence on the determinants of dividend policy is unfortunately very complex. Basis on which corporations pay out dividends to the share holders is still an unresolved puzzle. First prominent study that appeared in the literature of finance regarding dividend policy was that of Miller and Modigliani (1961) where they state that there are no deception in a perfect and a rational economic environment. This was the starting point for other researchers to explore dividend payout policy phenomena. Almost all researches that followed referred back to Miller and Modigliani (1961). Various researches were carried out by many researchers to explore the determinants of dividend payout policy, some of them focused on profitability, some on size of the firms, some on growth rate of the firm while others on agency costs. For example researches carried out by Nissim et el (2001), Brook et el (1998), Bernheim et el (1995), Kao et el (1994), and Healy et el (1988) found out a positive association between increase in dividend payout and future profitability. Kalay et el (1986) and Asquith et el (1983) found out that stock returns is positively associated with dividend changes. Sasson et el (1976) conclude that the payout ratio is positive association with average rates of return. On the other hand, studies of Benartzi et el (1997) and DeAngelo et el (1996) find no support for the relationship between future profitability and dividend changes.

On Other side most debated factor affecting dividend policy arguably is agency costs. Jensen (1986). Agency cost argument suggests that cost is reducing by dividend payments and cash flow Rozeff (1982). Researches carried out by Jensen et el (1992), and Lang et el (1989) supported this agency cost hypothesis, while others such as Lie (2000), Yoon et el (1995) and Denis et el (1994) found no support for this hypothesis.

Size of the firm is another factor which seems to have an impact of dividend payout policy. Firms larger in size are considered to have more ability to payout dividends to its share holders. Lloyd et el (1985), and Vogt (1994) pointed that firm size plays a role in clarifying the dividend-payout ratio of firms. They argued that because larger firms are mature and have easy access to capital markets thus they are not really much dependant on internally generated funding which enables them to payout higher dividends.

The purpose of this research is to investigate the dynamics and determinants of dividend policy of oil & gas sector firms in Pakistan. The independent variables selected from the literature include: market capitalization, profitability and annual rate of growth of total assets. Analysis of these variables should reveal there exist an impact of these variables on dividend payout policy of the firms and very nature of the relationship.

The remaining part of this thesis is organized as follows. In section 2 brief reviews of theories about the dividend will be presented. In section 3 of this thesis the data and possible variables that can act as proxy for different influences for analysis are discussed. Section 4 will provide details of methodology used. Section 5 thesis will establish analysis and interpretations and section 6 will present results and drawn a conclusion.

CHAPTER II

LITERATURE REVIEW

There are various theories which provide insight on how a firm pays the dividends.

2.1 Miller and Modigliani theory

According to Miller and Modigliani (of Merton Miller, Franco) (1961) dividend do not affect firms’ value in perfect market. Shareholders are not concerned to receiving their cash flows as dividend or in shape of capital gain, as far as firm’s doesn’t change the investment policies. In this type of situation firm’s dividend payout ratio affect their residual free cash flows, when the free cash flow is positive firms decide to pay dividend and if negative firms decide to issue shares. They also conclude that change in dividend may be conveying the information to the market about firm’s future earnings.

Example:

It’s a common believe that dividend policy is created by shareholder himself for example if a person has 10,000 PKR and wants income of 3,000 PKR a year from that portfolio, simply 3000 PKR money value can be sold by a person this amount as dividend income does not accept by him. This theory says, “Who is anxious about dividends?”

M&M explains that under certain assumptions including rational investors and a perfect capital market, the market value of a firm is independent of its dividend policy.

Smirlock & Marshall, (1983) stated that relationship between the Dividend and Investment Decisions indicates that no causality between the dividend and investment decisions of the firm. The fact that the firm-specific data conclusively supported the separation principle is particularly convincing. This is the first application of causality tests to a large sample of firms.

2.2 The bird in the hand theory

Investors always prefer cash in hand rather than a future promise of capital gain due to minimizing risk Gordon (1963).

Gordon believes that he is anxious about investing in dividends and dividend stocks. Gordon say that when he is paid hard cash by the company, he knows that the company is not just telling him that it is making money but the fact it that it is really making money . This is the idea that cash payment is valued by the investors for the hope of future profits.

2.3 The agency theory

Traditionally, corporate dividend policy has been examined under the assumptions that the firm is one homogenous unit and that the management’s objective is to maximize its value as a whole. The agency cost approach differs from the traditional approach mainly in this way that it explicitly recognizes the firm as a collection of groups of individuals with conflicting interests and self-seeking motives. According to the agency theory, these behavioral implications cause individuals to maximize their own utility instead of maximizing the firm’s wealth.

The agency theory of Jensen and Meckling (1976) is based on the conflict between managers and shareholder and the percentage of equity controlled by sponsor ownership should influence the dividend policy. The theory focuses on the relationship between an agent of the principal (company’s managers) and a principal (shareholder).

Jensen and Meckling (1976) in corporations, agency problem arise from external debt and external equity. Jensen and Meckling (1976) analyzed that how firm value is affected by the distribution of ownership between inside shareholders and outside shareholders who can consume perquisites, and who cannot. Within this framework, increased managerial ownership of equity alleviates agency difficulties by reducing incentives to consume perquisites and expropriate shareholder wealth. Jensen and Meckling (1976) argue that equity agency costs would be lower in firms with larger proportions of inside ownership. Managers are better understanding their interest with stockholders when they increase the shareholders’ ownership of the firm.

Dividends are plays an important role to reduce conflicts between stockholders and managers. Any dividend policy should be designed to minimize the sum of capital, agency and taxation costs.

According to Bathala (1990), in the agency costs and dividends, two lines of thought can be found explaining cross-sectional variations in payout ratios.

First view

Holds that a firm’s optimal payout ratio is the results of a trade-off between a reduction in the agency costs of external equity and an increase in the transaction costs related with external financing resulting from dividend payments as the payout ratio increases.

Second view

Argues that inside ownership and external debt are substitute mechanisms in mitigate agency costs in a firm.

Basic study for the first line of thought is based on Rozeff’s (1982) propositions. He suggests that dividend payout ratios may be explained by reduced agency costs when the firm increases its dividend payout and by increased more expensive external capital.

Easterbrook (1984) gives further explanation regarding agency cost problem and says that there are two forms of agency costs; one is the cost monitoring and other is cost of risk aversion on the part of directors or managers.

The agency theory is related with resolving two issues that can be held in an agency relationship.

PROBLEMS:

The desire of the principal and agent conflict and it is expensive or complicated for the principal that it cannot check that the agent has behaved appropriately.

Risk sharing is a problem that occurs when the agent and principle have different behavior towards hazard. The issue here is that the principal and the agent may prefer separate actions because of the separate risk preferences.

According to (Naceur, Goaied, & Belanes, 2006) profitable firms with more stable earnings can pay larger dividend. Whenever they are growing very quick, dividend policy doesn’t get any impact from financial leverage and ownership concentration. Also the dividend payment is being impacted negatively by the liquidity of stock market and

size.

Oskar kowalewski and Ivan Stetsyukand Olesksandr Talavera (2007) study that how corporate governance determines dividend polices in Poland. They have established for the first time, quantitative measures on the quality of corporate governance for 110 non- financial listed companies. Their result suggested that large and more profitable companies have higher dividend payout ratio. Furthermore, risky and more indebted firms prefer to pay lower dividend s. The results finally, based on the period of 1998-2004, Reveals that dividend policy is quite important in the valuation process of companies, but the issues still remain scantily investigated in transition countries. A study on the determinant s of dividend policy and its association to corporate governance in a transition economy both offers an interesting subject and complements the existing corporate governance literature.

The agency theory points that dividend may mitigate agency costs by distributing free cash flows that otherwise would be spent on unprofitable projects by the management. It is argued that dividends expose firms to more frequent analysis by the capital markets as dividend payout increase the likelihood that a firm has to issues new common stock. On the other hand, scrutiny by the market helps alleviate opportunistic management behavior, and thus, agency costs. Agency cost, in turn, is related to the strength of shareholders rights and they are associated with corporate governance. Furthermore, agency suggested that shareholders may prefer dividends, particularly when they fear expropriation by insider. They test the determinants of dividend policy in a multiple regression framework to control for firm specific characteristics other than governance. All the variables enter the regressions with expected signs. Size and return on assets are positively associated with variable cash dividend. Leverage is negatively associated with variable cash dividend. Their results provide evidence that in Poland listed companies where corporate governance practices are high and as a result shareholders rights are for strong payout higher dividend.

Jianguo Chen and Nont Dhiensiri (2009) suggest that relationship between dividend pay-out ratio (POR) with the pro Cash flow variability (CFV), ownership dispersion, insider ownership, free cash flow, collateral stable assets, Past growth (GROW1), future growth (GROW2), stable dividend policy and imputation credit (IMP). They analyze the determinants of the corporate dividend policy using firms listed on New Zealand Stock Exchange. They examined that firms traditionally have high dividend payouts compared with companies in the US. They find that there is a negative relationship between dividend payout ratio and CFV, Insider, Beta, growth and positive relationship between ownership dispersion ,free cash flow, collateral stable assets stable dividend policy and imputation credit. Their conclusion provides strong support to the agency cost theory and partially supports transaction cost and residual dividend theory. They do not have any evidence to support the dividend stability theory and the signaling theory.

2.4 Signaling theory

The explanation about the signaling theory given by Bhattacharya (1979) and John, Kose and Williams (1985) dividends allay information symmetric between managers and shareholders by delivering inside information of firm future prospects.

2.5 Effect of tax preferences theory

Miller and Scholars (1978) find that the effect of tax preferences on clientele and conclude different tax rates on capital gain and different tax rates on dividends leads to different clientele.

“Tax Preference theory”

Investor gave an important consideration to the taxes. This should by keep in mind that the dividends are taxed at a higher rate than the capital gains. As such, capital gains are preferred by the investors as compared to the dividends. This is known as when the investments are actually sold only then the capital gains are paid. When capital gains are realized inverse’s can control, but dividend payments are uncontrollable by them and the related company controls the dividend payment. In an estate situation, capital gains are not realized.

For example:

If a stock is purchased by an investor 50 years ago and is held by him until his or her death it is then passed on to an heir after he is expired. Now that heir does not have to pay taxes on stock’s appreciation.

2.6 Life Cycle Theory

Life Cycle Theory and Fama and French (2001) states that the firms should follow a life cycle and reflect management’s assessment of the importance of market imperfection and factors including taxes to equity holders, agency cost asymmetric information, floating cost and transaction costs.

2.7 Catering theory

According to Baker and Wurgler (2004) in Catering theory suggest that the managers in order to give incentives to the investor according to their needs and wants and in this way cater the investors by paying smooth dividends when the investors by not pay when investors prefer non payers but put stock price premium on payers.

2.8 Lintner’s Model

John Lintner (1956) initiates with his theory relies on two important things that he studied about dividend policy:

According to the amount of positive net-present-value (NPV) projects the companies tend to set long-run target dividends-to-earnings ratios.

Earnings increases are not always bearable. As a result, until managers can see that new earnings levels are bearable, dividend policy is not changed.

As regards the empirical literature the roots of the literature on determinants of dividend Policy is related to Lintner (1956) seminal work after this work during the period of 1996-2002 this work model was extended by The Samy Ben Naceur, Mohamed Goaied and Amel belanesthe (2006) on the Tunisian Stock Exchange. Lintner’s model is applied using static and dynamic panel data regressions. They examined that Tunisian firms rely more on current earnings that past dividends to fix their dividend payments in the way that the current earnings are more sensitive to the dividend than the prior dividend and earnings of the cooperation are directly reflected by any inconsistency in the level of dividends. Samy Ben Naceur, Mohamed Goaied and Amel belanesthe (2006) focused on the relationship between dividend and ownership, liquidity, return on assets (ROA), profitability, investment, leverage ratio, size. The results indicate that highly profitable firms with more stable earnings can payout large dividends as they can afford large free cash flows. Moreover, fast-growing firms distribute larger dividends so as to demand to investors. On the other hand, ownership concentration does not have any impact on dividend payment. In fact, being closely held Tunisian firms witness less agency conflicts and shareholders do not resort to dividends in order to reduce managerial discretion and protect their interests. The liquidity of the stock market has a negative influence, which confirms that the use of the electronic transaction system in the TSE has facilitated the realization of capital gains, which has reduced the need for dividend payments. At last, the negative coefficient on size found in the full sample has disappeared when regulated firms are excluded, which reduces the strength of this factor. Researchers have proposed many different theories about the factors that affect a firm’s dividend policy.

Kanwal Anil and Sujata Kapoor (2008) analyzed that The Determinants of Dividend Payout Ratio-A Study of Indian Information Technology Sector. The period under study is 2000-2006 as it is known that the period of 5 to 6 years covers both recession and booming of IT industry. They stated that profitability has always been considered as a primary indicator of dividend payout ratio. There are numerous other factors other than profitability also that affect dividend decisions of an organization namely cash flows, corporate tax, sales growth and market to book value ratio. They suggest that dividend payout ratio is positively related to profits, cash flows and it has inverse relationship with corporate taxes, sales growth and market to book value ratio. Statistical techniques of correlation and regression have been used to explore the relationship between key Variables. Thus, the main theme of this study is to recognize the various conditions that effect the decision of dividend payout policy of IT firms in India.

In short factors influencing the corporate dividend policy, according to them, may substantially vary from country to country because of inconsistency or variations in legal, tax and accounting policy between countries.In view of these facts, the present study aims at identifying the variables influencing corporate dividend policy in Pakistan.

CHAPTER III

VARIABLES

Objective of this study is to determine factors that have an impact on dividend of Oil & Gas Exploration and Oil & Gas Marketing sector of KSE. Dividend yield is dependent variable and the three independent variables are size, profitability and growth. These variables are discussed here.

3.1 DEPENDENT VARIABLES

3.1(a) Dividend yield (DY)

Arthur a Thompson in his book Crafting and Executing Strategy says that the measure of the return that shareholder receives in the form of dividend is called dividend yield (DY). A typical dividend yield is 2 -3%, the dividend yield for fast growth companies in often below 1%(may be even 0) and the dividend yield for slow-growth companies can run 4-5%.

Dividend yield can measure by annual dividend per share divided by current market price per share.

Samy Ben Naceur et el(2006)The DY (dividend yield ) as our measure of the dependent variable equals to dividend per share to price per share, payout ratio cannot be used as a measure of dependent variable because sample contains firms with negative earnings.

Khamis Al-Yahyaee et el (2006) and Hafeez et el (2009) also used dividend yield (DY) as the dependent variable.

3.2 EXPLANATORY VARIABLES

This thesis selected 3 variables used by different researchers Samy Ben Naceur et el (2006) and Hafeez et el (2009).

3.2 (a) Firm Size

Hafeez et el (2009) The firm size has been calculated as the total assets of the firm because a positive coefficient is expected from this variable as there is a very low chance of bankruptcy in large more diversified firms and it can sustain higher level of debt.

Scott and martin (1975) found that the size of the firm is very important factor, which can affect the firm’s dividend policy and debt policy.

A negative impact has been found on the dividend payout policy by size of the firms and the market capitalization which shows that instead of paying dividends to the shareholders the firm prefers to invest in their assets. The financial characteristic of size has been explained by the size of the firm and market capitalization. According to the null hypothesis for this financial characteristic there is no relation between the market capitalization and size with dividend payout ratio but the results show that there is a inverse and significant relationship between dividend payout and MV. Hence null hypothesis is rejected. The evidence supported by the finding of Belans et al (2007), Jeong (2008) deviate from Avazian et al (2006).

Samy ben naceur et el (2006) the size of the firm by total market value (LNSIZE) and it is expected to be positively correlated with dividend paid. The literature suggests that size may be inversely related to the probability of bankruptcy (Ferri and Jones 1979; Titman and Wessels 1988; Rajan and Zingales 1995). In particular, larger firms should have an easier access to external capital markets and can borrow on better terms, Moreover, larger firms tend to be more diversified and their cash flows are more regular and less volatile. Thus, larger firms should be more willing to pay out higher dividends. Even the conflicts between creditors and shareholders are more severe for smaller firms than the larger ones.

Khamis Al-Yahyaee et el (2006) they measure size of the firm from Log of sales. Firm’s dividend policy is influenced by variables such as size. There is an advantageous position for larger firms to raise external funds in the capital markets and are less dependent of internal funds. Therefore there is a negative relationship between dependence on internal financing and the size of the firm. Moreover, there is a chance of lower bankruptcy probabilities in larger firms and thus they are able to pay more dividends.

Thus as per this research the hypothesis is

H1= Firm size is positively associated with dividend payouts.

3.2(b) Firm profitability

Empirical research found that there is a positive relationship between dividend yield and profitability. The more profitable the firms are, the more internal financing they will have, and thus are able to afford larger dividends. Some of them are as follow.

Khamis Al-Yahyaee et el (2006) measured profitability by earnings before interest and taxes to total assets as our surrogate for profitability. Hence a positive relationship between profitability and dividend is expected. Since the annual profits pay the dividends therefore it’s logical that more dividends are paid by profitable firms.

Samy Ben Naceuret et el (2006) measure the profitability by the return on assets (ROA) net income/total assets and it is positively correlated with dividend payments. Firms with high profitability can afford larger free cash flows and hence new investment opportunities. Therefore, paying higher dividends does not disturb them. In the same vein and according to the pecking order theory, firms prefer using internal sources of financing first, then debt and finally external equity obtained by stock issues. The more profitable the firms are, the more internal financing they will have, and thus are able to afford larger dividends.

Hafeez et el (2009) measured Profitability Net Earnings and Earnings Per Share after tax. The net earnings show the positive relationship with the dividend yield. The net earnings after interest, depreciation and after tax have been used as the explanatory variable to examine the role of earnings to pay dividends.

Thus as per this research the hypothesis is

H2= There is a positive relationship between a firm’s profitability and dividend payouts.

3.2 (c) Firm Growths

Samy Ben Naceur et el (2006) measure investment and growth by MBV (market value of equity/ book value of equity) and annual rate of growth of total assets. Firms anticipate higher growth, when they establish lower dividend payout ratio because growth entails higher investment expenditures. When firms retain higher proportion of earning to finance future investment need due to high cost of external financing, their dividend pay out in anticipation of future growth stands reduced. Hence, a negative relationship between dividend payout and expected growth is expected.

Khamis Al-Yahyaee et el (2006) measure the growth opportunities through market-to-book ratio. A negative relationship is expected between growth opportunities and dividend. Large additions of capital are required by the firms experiencing substantial success and rapid growth. Consequently, lower dividend payout policies are expected by growth firms. Similarly, the pecking order theory predicts that more earnings are retained by the firms having a high proportion of market value followed by growth opportunities hence they are able to minimize the need to raise new equity capital. Free cash flow theory also predicts that there will be a lower free cash flow and lower dividend is paid by the firms with high growth opportunities.

On the other hand Hafeez et el (2009) argued with the above researcher. According to the signaling theory the higher the firm grows, the higher they pay dividends to shareholders. The shareholders get signals from the growth of the firms having high growth opportunity. The sales growth has been used as proxy of Growth in the empirical analysis of the study and has been used as percent age change in sales annually as proxy of the growth.

Whereas Kanwal Anil et el (2008), measured growth and investment by sales growth and MTBV. Hafeez Ahmed et el (2009) measures investment as SLACK = accumulated retained earnings/ total asset.

Thus as per this research the hypothesis is

H3= Firm growth is negatively associated with dividend payouts.

Table 1

Summary of Proxy Variables and Research Hypotheses

H1: Size

MCAP = market capitalization

Positive

H2: Profitability

ROA= net income/total assets

Positive

H3: Growth

GROWTH = sales growth

Negative

CHAPTER V

METHODOLOGY

DATA COLLECTION METHOD

The data is collected from Securities Exchange Commission of Pakistan, State Bank of Pakistan and the Karachi Stock Exchange. The variables of the study are calculated from the Audited Annual Accounts of 6 firms for the period of 2001 to 2008 resulting in about 240 observations for each variable and as such it is a long period enough to smooth out variable fluctuations. (Rozeff, 1982).

SAMPLE

Sample Size consists of six companies from oil and gas exploration and marketing sectors in Pakistan, listed on Karachi Stock Exchange (KSE) Total of six companies listed on Karachi Stock Exchange (KSE). Data collected from year 2001 to year 2008.

STATISTICAL TEST

Linear Regression test was performed to analyze data. Dividend yield is a dependent variable and growth, size and profitability are taken as independent variable.

REGRESSION MODEL

This study uses multiple regression analysis. This thesis estimate that

Y= α + β X1 + β X2 + β X3 + e

Y = Dividend yield.

α = Intercept of the equation.

β X1= Change in coefficient of Firm size.

β X2= Change in coefficient of Firm profitability.

β X3= Change in coefficient of Firm sale growth.

e = Error Term.

CHAPTER VI

DATA ANALYSIS AND INTERPRETATION

Table 2

MODEL

R SQUARE

F

Sig.

1

.223

3.917

.015(a)

Table 2 above shows F Ratio for the regression model is significant which indicates that regression model is a best fit. Total variation in the dependent variable explained by the regression model as indicated by R square is .223 i.e. 22.3% change in dividend yield is explained by these three independent variables.

Table3

UNSTANDARDIZED COEFFICIENT

STANDARDISECOEFFICIENT

t

Sig.

B

Std. Error

Beta

(Constant)

0.066

0.011

5.826

0

Size

-1.10E-06

0

-0.503

-2.879

0.006*

Profitability

0.16

0.094

0.269

1.709

0.095**

Sale growth

2.17E-07

0

0.484

3.038

0.004*

*Significant at 1%

**Significant at 10%

Table 3 reports the ordinary least square results of the regression analysis.

Results indicate that size of the firm is significant as shown in table 3 and shows that size is negatively correlated with dividend at 1%. According to researcher’s hypothesis, the size will present a positive relation BUT here its coefficient is negative which rejects researcher’s hypothesis. Since, the size is also statistically significant but the hypothesis for this thesis shows that the growth is negatively related to dividend hence, this hypothesis rejected.

Some researcher’s results found the size to be positive. Fama and French (2000 and 2001) concluded that more dividends are payable by large and more profitable firms.

Lloyd and Jahera (1995 cited on holder 1998) concluded that those larger firms have easier access to capital markets, which are more mature hence, allowing for higher dividend payout ratios and reducing their dependence on internally generated funding.

Aneel Kanwer (2002) measured size with total sale and researchers found out that the size is positive related to dividend yields. Smaller company gives lower dividends as compared to larger company.

Oskar kowalewki et el (2007) made a research in Poland and they measured size with total assets. They found out that size is positively related to dividends because more dividends are paid by companies, which are larger in size and assets.

Some researcher’s result found the size to be negative. The result of the research by Hafeez Ahmed et el (2009) on KSE (non financial firms) is similar to this thesis result i.e. they measured size with natural logarithm of total assets.

This result indicates that the firm prefers to invest in their assets rather than paying dividends to their shareholder’s having a negative impact on dividend’s payout policy.

Samy Bin Naem et el (2006) made their research on the firms of the Tunisian Stock Market and they measured the size with logarithm of stock market capitalization. They concluded that there is a negative relationship between size and dividend, but the negative relationship disappears when regulated firms are removed.

Since the result of the researcher Fama and French (2000 and 2001), Lloyd and Jahera (1995 cited on holder 1998), Aneel