CHAPTER V. Dividend Policy and interaction with investment decision

Transcription

1 CHAPTER V Dividend Policy and interaction with investment decision 5.1 Introduction: In the last two chapters we have discussed the factors that affect capital structure decision and optimal capital structure policy of the Indian corporate firms. However, capital structure policy is not a stand-alone decision made by financial managers. Capital structure decision also accompanies the dividend or payout policy as any new investment needs to be either financed by using internal or external finance. In case firm chooses to finance investment through external resources, it has to be financed either by equity or debt. In case it is financed by debt, it has a fixed repayment schedule that firm needs to follow. If it is financed by equity, then appropriate dividend decision has to be made as it may have some impact of the value of the firm. Therefore, dividend policy is an integral part of capital structure decision. In this chapter we look at the dividend policy of Indian corporate sector in the last two decades. There are two contrasting views on dividend policy. The first set of argument is dividend payment increases firm value which is based on bird-in-hand argument of Graham and Dodd (1951). They argue that the sole purpose for the existence of the corporation is to pay dividends (cited in Frankfurter et. al. 2002: 202 & Malkawi et al. 2010:174). Therefore, high dividend paying firms should sell their shares at high price. On the other hand, Modigliani and Miller (1961) dividend irrelevance proposition says that value of a firm cannot be affected by dividend payment and the reason is that as the market value of a firm is the discounted value of future cash flows therefore, value of a firm is only affected by the income generated from investment decision of firms and not by how the distribution takes place. In fact, determination of dividend policy is one of the unresolved issues in corporate finance literature. In the words of Black (1976:5), The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don t fit together. United States and other developed countries have been the focus of extensive research for the study of dividend policy and less is known from the developing country s perspective. Developed and developing countries differ in terms of legal origin, sources of finance, nature of ownership of firms. For instance, La porta, Lopez-de- 103

2 Silanes, Shleifer and Vishny (2000) argued that firms in Common Law countries with good legal protection of investor tend to pay higher dividend compared with firms in countries with weak legal protection. The reason is that there exists a great deal of agency problems in corporations, such as conflicts between managers and shareholders, conflicts between insiders and outside investors. Dividend is a means to reduce the agency costs arising out of conflicts between different stakeholders because dividend payment reduces the expropriation of cash available in the hands of insiders. In Common Law countries, outside investors, including shareholders are given certain powers through corporate and other laws to protect their investment against expropriation by insiders. On the other hand, countries with Civil Law fail to protect the interest of the minority shareholders as well as outside investors. Developing countries, as opposed to the developed economies, are characterized by less developed equity and corporate bond market which induces firms to rely more on banking system. High dependence of almost every firm on the banking system to mobilize funds in order to fulfill the need of financing investment opportunities makes firms financially constrained. Mounting pressure on the banking system may result in increased cost of borrowing, thus placing a burden on the firms. Therefore, in order to mitigate the need for funds, firms might want to build a sound internal capital base. Thus payout policy of firms is crucial in the context of developing economies. Moreover, the nature of ownership is strikingly different in developing countries than that of developed countries in the sense that firms in developing countries are mostly family owned. Nature of ownership pattern gives rise to the conflict between managers and owners which in turn raises the agency cost. For example, ownership in large corporations of developed countries such as United States, United Kingdom, Canada, Australia are dispersed and they are controlled by managers, whereas in developing countries most of the large corporations are family owned and therefore, when majority of shareholding is in the hand of family, controlling mangers is not a difficult task. But in that case inside investors may reap the benefit at the expense of minority shareholders. Dividend policy can act as a device to resolve the conflict between different stakeholders of firms. In addition, nature of ownership prevents firms to float equity in the market due to the fear of losing control over firm. Therefore, managing funds for investment becomes critical and hence once again payout policy is crucial to the firm. 104

3 Leaving aside the structural difference between developed and developing countries, the common issue relevant for both the countries is the market imperfection, which determines the nature of interactions among financial and real activities. However, the degree of imperfection might differ from market to market and hence the nature of interactions among various activities. Therefore, how market imperfections may influence the dividend policy and nature of interaction with financial and real policy variables is a matter of concern. Given the structural difference between developed and developing countries and nature of market imperfection the present study intends to address three issues in the context of Indian corporate sector. First, trend and pattern of dividend payment of the Indian corporate sector for the period under study Second, it tries to indicate the factors that determine the dividend payment behaviour of Indian corporate firms. The third objective is to study the interaction between payout and investment policy of corporations in India. The rest of the chapter is organized as follows. In the second section we have discussed different theories of dividend. The third section deals with review of empirical studies both at the global level and in the Indian context. The fourth section provides us the details of the data sources. In the fifth section we have discussed about the methodology that has been used for this study. The sixth section discusses the results obtained from the analysis. In the seventh section we conclude. 5.2 Theories of Dividend At the outset, we will discuss the different theories of dividend as it sets the ground for evaluating empirically the dividend policies followed by the corporations. The analysis of existing empirical literature in the light of different theories helps in finding the gaps that exist in the empirical literature. There are five different theories of dividend policy namely, transaction cost theory, tax theory, birds- in- hand theory, signaling theory and agency cost theory Transaction cost theory Transaction cost theory explains how the value of a firm may be affected due to payment of dividends through earnings expectation. A dividend paying firm may have to depend on external finance in order to meet the investment needs and thereby 105

4 incurs transaction cost 17. Transaction cost takes toll on the cashflows of the firms and thereby reduces the value of firms. Since external funds raising is associated with incurring certain transaction cost, dividend should only be paid when this does not result in shortage of internal funds that are required for investment Tax Theories There are two opposing views in tax theories of dividend policy. One strand of literature argues that tax cannot affect market value of firms and the opposite camp argues that taxation is capable of affecting market value of firms. Modigliani & Miller (1961) belong to the first camp in which they argue that tax induced clientele effect reduces the tax cost of dividends. They argued that there are clienteles based on tax positions such as high tax bracket and low tax bracket. Those who are in the high tax bracket will prefer firms with low payout policy and those who are in the low tax bracket will prefer firms with high payout policy. Thus no firms can increase it value by changing dividend policy. On the other hand, opposite camp argues that dividend policy is being determined by the differences between corporate tax on distributions, tax on retained earnings as well as tax on dividends in the hands of shareholders, and tax on capital gains. Higher level of corporate tax on distributions in comparison to that of tax on retained earnings leads to lower expected earnings of a firm which pays dividend and vice versa. Similarly, if the tax on dividend income is higher than that of tax on capital gains, investors should prefer to receive capital gain instead of receiving dividend because the after tax expected return from capital gain may be higher. Therefore, those firms who retain profits instead of distributing in the form of dividend their share price will go up and vice versa. The basic tax hypothesis supports a conservative dividend policy The bird- in- the- hand argument Another theory which explains the dividend policy of firms is known as bird- in- hand theory. The idea of bird-in-hand arguments was put forward by Graham and Dodd 17 There are certain direct and indirect costs associated with the flotation of new securities in the market. Direct costs include flotation costs to the firm of raising additional external finance, such as underwriter fees, administration costs, management time, and legal expenses etc. Indirect cost of paying dividend is the problem of dilution of control over firm and the costs arising out of information asymmetry. 106

5 (1951) and Gordon (1959). This theory argues that a firm can increase its value by paying higher dividends. It can be explained by the fact that the value of a firm can be defined as the discounted value of dividends. Therefore, as the retention ratio increases, it raises the expected future dividends and at the same time, the required return i.e. discount rate demanded by investors increases but the increase in discount rate is much higher than that of expected increase in future dividend. Hence, higher retention ultimately reduces the market value of firms and vice versa. Since dividend payment brings cash inflows forward and thus reduces the uncertainty associated with future cash flows, it raises firm value. Therefore, bird-in-hand argument makes a case in favour of dividend payment The signalling theory In addition to the bird- in- hand theory, signaling theory of dividend argues in favour of paying dividend. The signaling theory of dividend was put forward by Bhattacharya (1979) and subsequently by Miller & Rock (1985), John and Williams (1985) among others. The idea is that as there are information asymmetries between market participants, particularly between insiders and outside investors. In order to reduce the information asymmetry between market participants firm may wish to signal its quality from the rest. In this spirit costly dividend is being used by managers to signal the future performance of firms. On the contrary, dividend decreases is being interpreted as signalling poor performance and lack of managerial confidence. Decrease in dividend therefore reduces the share price. Therefore, dividend payment can be used as a tool to reduce price volatility as it conveys information in the market about the prospect of firms. Moreover, the value of the signal depends on the level of information asymmetries in the market The agency theory of dividend A corporation can be thought of combination of principal and agents. In corporations separation of ownership and control gives rise to agency conflicts (Jensen & Meckling, 1976). Following this it can be argued that managers may not always act in favour of the owners wealth maximization objective. Therefore, as the levels of retained earnings increases, managers are expected to misuse those funds either by investing in bad projects or by consuming perquisites. Hence, dividend payment 107

6 reduces the amount of free cash flows in the hands of managers and this helps in controlling the problem of over investment (Jensen, 1986). In addition to the reduction of free cash flows in the hands of managers, dividend payment compels firms to raise external funds to finance investment and that leads to scrutiny of firms by financial intermediaries (Easterbook, 1984). Monitoring by financial intermediaries reduces the agency cost and thereby helps in appreciating the firm value. 5.3 Review of empirical studies Global Literature In this section we have made an attempt to examine the body of literature that either supports or rejects the theories discussed above. The first empirical study on dividend policy was conducted by Lintner in the year The attempt was made to resolve the dividend puzzle by interviewing the managers of US firms. He pointed out that firms have a target payout ratio and that is dependent on current earnings. To verify the findings of Lintner (1956), Lee (1996) conducted a study to assess the relationship between earnings and dividends. He differed from his predecessor by saying that it is permanent earnings that explain dividend behaviour more appropriately than current earnings. This finding supports signalling hypothesis because permanent earnings are a good indicator of the long-term financial position, and this induces managers to utilise dividends as signal to convey their status. The validity of Lintner (1956) partial adjustment model was once again tested by Fama & Babiak (1968) in the context of United States as well as in the Indian context by Mookherjee (1992). Based on their findings it can be said that Lintner (1956) hypothesis holds equally good for developed and developing countries. Several attempts have also been made to empirically verify the basic proposition of tax hypothesis. Hubbard and Michaely (1997) and Papaioannou and Savarese (1994) tested the validity of tax hypothesis by studying the effect of tax reforms on stock price and dividend policy changes. Gentry (1994) and Lasfer (1996) have tested the implications of tax hypothesis by regressing dividend policy on proxies for the tax cost of dividends and finds support in favour of tax hypothesis. Papaioannou and Savarese (1994) focused on firms reaction to the United States Tax Reform Act of 1986 and they have observed that in response to the changes in tax 108

7 system firms adjust their dividend policies and this is indicative of supporting the tax hypothesis. The signalling hypothesis of dividend changes is being tested by numerous scholars. Price reaction of rival firms in response to the announcement of a change in dividend of a firm has been studied by Laux, Starks and Yoon (1998) and Howe and Shen (1998). It has been seen that those firms which increase dividend payment experience significant abnormal returns at the time of announcement. Moreover, it shows that rival firms returns move in opposite direction. It means that dividend changes convey information in the market and this is consistent with signaling hypothesis. In contrast, DeAngelo DeAngelo and Skinner (1996) by investigating the issue whether dividend change announcements are followed by changes in earnings, the scholars have concluded that there is no evidence in favour of signalling hypothesis of dividends. They argued that dividend changes for the sample of firms is not a reliable signal for the changes in earnings, it s a temporary phenomena. Another study by Lipson, Maquieira and Meggison (1998) by comparing the performance of newly public firms that initiated dividends as compared to that of similar firms that did not, they found that earnings surprises in the first and second years following dividend initiations are significantly greater as compared to the similar newly listed firms that did not initiate dividends. In the similar line, Benartzi, Michaely and Thaler (1997) hypothesized that if signalling is costly then larger dividend changes should be followed by larger unexpected earnings. It is found that there is strong contemporaneous correlation between dividend changes and earnings changes. Jensen and Johnson (1995) investigating the same issue only for dividend decreasing firms concluded that earnings decline follows decline in dividend. These are supportive evidence in favour of signaling hypothesis of dividend. Agency theory points out managers have tendency to misuse the resources of firms for the benefit of its own. A number of studies have investigated the validity of this hypothesis. Opler, Pinkowitz, Stulz and Williamson (1999) have seen that excess cash is being accumulated by managers when they have scope to do so. At the same time, they didn t find any evidence for the fact that excess cash is being is overinvested by managers. Moreover, they also argued that when investment opportunities are low excess cash is returned to shareholders in the form of dividend. Long, Malitz 109

8 and Sefcik (1994) by investigating the problem of under investment concludes that there is a possibility that firms sometimes raise dividends after the issuance of debt as a means of expropriating wealth from debt holders to equity holders. In contrast Long, Malitz and Sefcik (1994) investigating the wealth expropriation hypothesis concludes that this is not always true as firms attach more value to its reputation than the benefits from wealth expropriation. The combination of transaction cost theory and agency theory of dividend which resulted into the cost minimization model of dividend policy was constructed and tested by Rozeff (1982). According to Rozeff (1982) the optimal dividend payout is at the level that minimizes the sum of transaction costs and agency costs. Rozeff (1982) tested the cost minimization model using Ordinary Least Squares cross sectional regression. Rozeff (1982) has found the estimated coefficients of explanatory variables to be significant and to bear the signs predicted by the cost minimization model Indian Literature In the last section we have discussed the studies that have been conducted in the global context. Since the focus of the thesis is India, we now turn to the studies in the Indian context. Barring a few, studies in Indian context have primarily deal with the identification of the factors that determine the payout policy of the Indian corporate sector (Majumdar, 1959; Rao & Sharma, 1971; Murthy, 1976; Mishra & Narender, 1996). Apart from identification of factors influencing payout policy researchers have tried to gauge the impact of tax on dividend policy of the Indian corporate sector (Narashiman and Asha, 1997; Reddy, 2002; Narashiman & Krishnamurthy, 2004; Sharma, 2007). The studies on determinants of payout policy reveal that profitability is considered to be an important factor in the determination of payout policy. There are inconclusive effects of tax on payout policy of Indian corporate sector. On one hand, Narashiman & Asha (1997) found that lower tax on dividend as compared to that of higher capital gain tax induced investors to move in favour of high payout firms. On the other hand, Reddy (2002), Narashiman & Krishnamurthy (2002) and Sharma (2007) did not find any conclusive evidence for the fact that introduction of corporate dividend tax has altered the payout policy of the corporate sector in India. Moreover, signaling hypothesis has been tested by Sharma (2006) and he found that 110

9 dividend is being used as a signaling tool to convey the performance of firms in the capital market. Pandey (2004) examined the dividend behaviour of Indian companies and found that the Indian firms have lower target ratios and higher adjustment factors. They have shown that the restricted monetary policies have significant influence on the dividend behaviour of Indian firms, causing about 5-6 percent reduction in the payout ratios. The significance of macroeconomic policy variables suggest that monetary policy restrictions do have impact on the cost of raising funds, and the information asymmetry between lenders and borrowers increases, which in turn forces companies to reduce their dividend payout. To sum up, most of the studies in the Indian context attempted to find out factors affecting the dividend policy. It has been found that profitability, size, cash flow, growth opportunity etc. are main factors which determine dividend policy in India. Moreover, attempts have also been made to test the validity of tax theory, signaling theory. The validity of Lintner (1956) model of target payout policy has also been tested. Review of literature tells us that most of the studies are decade old and in the last decade Indian economy has entered into high growth trajectory which has been possible due to the well performance of its corporate sector. This calls for an update on the dividend payment behaviour of the Indian corporate sector. Second, we have seen that capital structure or financing decision varies with the ownership structure i.e., among government owned, private Indian, private foreign, and group firms in India. A great matter of concern is whether this ownership structure is affecting the dividend payment behaviour of the firms. Third, none of the studies, to the best of our knowledge, have considered investment as a potential determinant of dividend policy. Fourth, dividend payment decision cannot be expected to remain uniform across different growth oriented firms. For example, for high growth firms the need for funds is more than that of low growth firms, as investment opportunities are more for high growth firms. Apparently, since dividend payments and investment decisions are two competing uses of funds, this interaction needs to be investigated for different growth oriented firms. Therefore, in this chapter we would like to address three issues. First, to look at the recent trends of payout for Indian corporate sector and evaluate whether dividend acts a signaling instrument. Second, to measure the impact of ownership structure and investment on the payout policy of firms in 111

10 Indian corporate sector. Third, to study the interaction between payout and investment decision across different growth oriented firms. 5.4 Data The present study examines the dividend behavior of Indian corporate firms over the period for all companies listed for trading on one of the two major stock exchanges, namely National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) during the said time period. The accounting data pertaining to these nonfinancial firms had been collected from the Centre for Monitoring Indian Economy s (CMIE) electronic database Prowess. 5.5 Methodology To analyze the trends in dividend payment pattern, number of companies paying dividend as percentage of total firms, payout ratio are computed for the period 1990 to Further, the entire sample is categorized into payers and non-payers to examine the trends in dividends across different subgroups. Payers are those firms that have paid dividend in the current year, whereas non-payers have not paid dividend in the current year. To analyze signaling hypothesis, consistent with Healey and Palepu (1988), earning patterns of firms initiating and omitting dividend for 3 years before the year of event and 3 years after event are examined. For this part of the analysis, a firm is classified as initiator if it has paid dividend in the current year but has not paid dividends for the preceding 3 years. Similarly, a firm is categorized as an omission firm, if the firm has not currently paid dividend but has paid dividend in the preceding three years. Analysis pertaining to initiations and omissions only cover a particular sample of extreme events and excludes firms not having a dividend track record of less than 3 years. To find out the determinants of payout policy, we have employed a panel probit regression model. The panel probit model is as follows: Y it * = X it`β 0 + ε it where t = 1,2,.,T, and i= 1,2,,N..(1) Y it =1 (Y it * >0) The data consist of N observations on Z i = (y i,x i ) where y i = (y i1, y i2,., y it ) and the T rows of the T K matrix X i are The disturbances T-variate normally 112

11 distributed with T T positive definite covariance matrix Σ. The typical element of Σ is denoted σ ts. The standard deviations are denoted σ t. The data on x it are assumed throughout to be strictly exogenous, which implies that Cov[x it,ε js ] = 0 across all individuals i and j and all periods t and s. This rule out state persistence or the presence of lagged dependent variables in (1). To measure the interaction between dividend and investment decision we have relied on the methodology provided by Chang et al. (1982). Methodology basically relies on the model put forward by Lintner (1956) with certain modifications. Lintner (1956) model can be written as follows: D it * = α 1 P it + ε it (1) ΔD it = γ (D it * - D i, t-1 ) 0< γ 1.(2) i= 1,2,3,,N t = 1,2,,T where D it is the dividend of firm i in period t, P it is the profit of the same firm in the same period, ε is the disturbance term. D * is the equilibrium (or desired) value of D. α 1 and γ are parameters to be estimated. The co-efficient of adjustment γ should be greater than zero and less than or equal to one and α 1 is a positive fraction. Combining equation (1) and (2), the following equation can be obtained: ΔD it = γα 1 P it γd i, t-1 + γε it.....(3) Changes in capital stock has been added to equation (1) to incorporate the probable impact of investment on dividend. The modified equation becomes as follows: ΔD it = γα 1 P it + γα 2 ΔK it γd i, t-1 + γε it.(4) Miller & Modigliani (1961) have shown that dividend payment gets affected by earnings, net investment and amount of external financing. The implication of the above equation is that if the amount of investment is larger than that of external finance, dividend payment will be affected in a adverse manner. When they are equal, there is no impact of investment on dividend payment. Chang et al. (1982) have also pointed out that equation (4) is biased towards positive association between dividend and investment decision of a firm as inflation may affect both dividend and investment decision and move in the same direction and vice versa. In an attempt to get rid off such misspecification Chang et al. (1982) have 113

12 suggested to divide the variables on the both side by profitability of the current year. Therefore, the final equation estimated is as follows: (D it /P it ) * = β 0 + β 1 (ΔK it /P it ) + ε it. (5) Δ(D it /P it ) = γ [(D it /P it ) * - D i, t-1 /P i, t-1 ] (6) By combining equation (5) and (6) we arrive at the following equation: Δ(D it /P it ) = β 0 γ + β 1 γ ΔK it /P it - γd i, t-1 /P i, t-1 + γε it... (7) Since both dividend and investment have been divided by profitability, we can avoid the possibility of positive relationship between investment and dividend in the specification of equation (7). Since investment and dividend decisions are endogeneous, the equation (7) can be estimated by simultaneous equation model. Investment decision is being affected by many factors which is not possible to take into account, and hence specification errors are likely to affect simultaneous equation estimates adversely. In that case OLS is a better method of estimation. The error component model is used to take into account the effect of omitted variable on the estimated coefficients. According to the model suggested by Balestra and NerSoledad (1996) and Wallace and Hussain (1969) the error term in Equation (7) can be written in terms of the sum of three components: ε i = w i + v t + u it.....(8) To estimate equation (7) containing three components, Generalised Least Square (GLS) technique has been adopted. D it = P it ΔK it + F it..(5) Where F it is the amount of external financing. 5.6 Results Basic Characteristics revealed by data The accounting data of the non-financial firms shows a temporal decline in the payout trend, if we consider the number of dividend paying firms, with stability in the payout ratio in the later years. Table 5.1 reveals that over the time period under consideration it can be observed that more number of firms had stopped paying dividends to their shareholders. The percentage of dividend paying firms has declined from the level of 114

13 80.9 percent in 1990 to the level of 62.5 percent in It may be due to the fact that by paying lower dividends firms have started building a strong internal source of funds to avoid uncertainty of obtaining the external funds in forms of equity and debt. Table 5.2 presents an industry wise payout ratio of the Indian corporate sector. Industry wise decomposition shows that on an average transport, chemical and food and beverage industry have higher payout ratios than other industries during the study period. Industry wise payout ratio shows that food & beverage, machinery, metal products, transport have experienced steady decline in payout ratio during the period to On the other hand, chemical, non metal and textile industry have experienced a sudden increase in the payout during , although declining afterwards. The result may be an outcome of SEBI listing regulation. In the year , to deter ingenuine firms to enter into the market to raise capital, SEBI mandated that unlisted companies should have a track record of dividend payment of at least three years out of preceding five years. However, in between and , payouts of all industries have gone up marginally. This may have occurred because in the year SEBI declared firms having distributable profit of at least three years out of preceding five years is sufficient for fund raising from capital market. 115

14 Table 5.1 Percentage of firms paying dividend during Paid Not paid Year Dividend Percentage Dividend Percentage Total Firms Source: Author s calculation from CMIE Prowess database Table 5.2 Industry wise mean payout ratio during to Year Chemical Food & Metal Non Machinery Beverage Products Metal Textile Transport Source: Author s calculation from CMIE Prowess database We have already seen that payout of the firms have declined in recent years. Still there could be substantial variations within dividend paying firms and nondividend paying firms. What are the reasons behind these variations? Is there any difference amongst firms in terms of profitability, growth orientation and size? Table 5.3 depicts the trend of profitability, growth and size of the firms across different dividend and non-dividend paying firms. In terms of profitability it has been observed that non-payers have consistently incurred losses during the study period, whereas profits of the payers have increased more than ten times between 1990 and Profitability of initiators is consistently 116

15 higher than that of current payers since One of the striking features that can be observed is that the profitability of the regular payers is not only high but about 8-9 times higher than initiators and current payers. The implication is that profitability is a major determinant of dividend policy of firms. Growth wise analysis reveals that, payers on an average have twice growth as compared to non-payers, except for few years. It can be seen that, except for few years, initiators on an average have high growth potential as compared to that of current and regular payers. Hence, one can argue that for initiators dividend payment acts as a signal for high growth opportunities. In fact, the growth pattern is quite similar for the current and regular players. Amongst non-payers, never-paid firms have consistently maintained higher growth. Size wise analysis shows that assets of dividend payers are much more as compared to the non-payers. Of the dividend payers, regular payers have more than five times more assets compared to the current payers and the initiators. Although the initiators have a lower asset size than current payers, there has been a consistent growth of the asset size of the initiators in comparison to the current payers. Amongst non-payers, current non- payers have on an average twice assets base than that of never paid firms. Therefore, it can be argued that profitability, growth, and size of the firms matter for dividend payment. 117

16 Table 5.3 Growth, Size, and profitability of firms Profitability (Rs. Cr) Current Payers Initiators Regular Payers Total Payers Current Non Payers Former Payers Never Paid Total Non Payers Growth Current Payers Initiators Regular Payers Total Payers Current Non Payers Former Payers Never Paid Total Non Payers Size (Rs. Cr.) Current Payers Initiators Regular Payers Total Payers Current Non Payers Former Payers Never Paid Total Non Payers Source: Author s calculation from CMIE Prowess database 118

17 To analyze the signaling hypothesis consistent with Healey and Palepu (1988), earning patterns of firms initiating and omitting dividend for three years before the year of event and three years after the event are examined. In Table 5.4, we have presented the number of firms initiated and omitted dividends over the years. On an average 35 companies have initiated dividend each year of study period, while omissions have increased from 4 in year 1990 to 107 in In fact, while the number of initiators is marginally higher during , and also between 2004 and 20009, the number of omissions is significantly higher than initiators between Industry wise analysis shows that chemical industry has registered highest number of initiations followed by metal products and transport. In case of omissions chemical industry leads followed by machinery textiles. Table 5.4 Number of firms initiated and omitted dividends Year Initiators Omissions Year Initiators Omissions Source: Author s calculation from CMIE Prowess database In Table 5.5, nature of profitability shows that the initiators have experienced decline in loss in the previous three years of initiation of dividend payment, whereas dividend omitting firms profitability declined in the previous three years of omitting dividend and subsequently started incurring loss. This proves that dividend payment is highly dependent on profitability of the firm and dividend changes are a signal for changes in profitability. This observation has been confirmed by performing chi-square test after cross-tabulating the dividend and profit across three categories namely decreased, unchanged and increased. Table 5.6 shows that there is an association between dividends and profit since the chi-square test conducted leads to the rejection of the null hypothesis that there is no association between profitability and dividend payment. 119

18 Table 5.5 Profitability of firms before and after initiation and omission of dividend Initiations Omissions Mean std No. of Firms Mean Std No. of Firms Source: Author s calculation from CMIE Prowess database Table 5.6 Association between changes in dividend and changes in profitability Dividend\Profit Decreased Unchanged Increased Total Decreased Unchanged Increased Total Pearson Chi 2 =2500 Pr=0.00 Source: Author s calculation from CMIE Prowess database However, results obtained from descriptive analysis may be misleading as it does not simultaneously control for the influence of other firm specific factors which could have influenced the dividend payment behaviour. For example, nature of ownership, investment pattern, capital structure decision etc. can also influence the payout decision of firms. Therefore, after the descriptive analysis, we perform regression analysis which simultaneously controls for other firm specific factors and net out the effect of above mentioned variables Factors determining dividend: An econometric analysis In the regression analysis we have considered explanatory variables namely, size, profitability, leverage, investment, and ownership pattern. Scott & Martin (1975) have considered firm size as one of the significant factors which affect the firms debt and dividend policies. Size has been measured in terms of logarithm of sales. Size of the firm is expected to be positively related to the payout decision. Profitability has been measured as earnings before interest and tax divided by total assets. As we have already observed that profitable firms are expected to pay dividend, a positive relationship between profitability and dividend payment is expected. Leverage has 120

19 been measured as ratio of long term debt to total assets. More debt in the capital structure is expected to reduce the dividend payment. Investment has been measured as the changes in fixed assets in two successive years. Following descriptive statistics, we expect investment and dividend decision to be positively related. In case of ownership pattern we have considered four groups of firms namely, group firms, private Indian firm, private foreign firms, and government owned firms. We have considered dummy variables for each of these categories. Government owned firms has been considered as the base category. Table 5.7 Determinants of dividend payment (Logistic regression) Variables Coefficients Marginal Effects Size 0.84* (14.1) 0.84 Profitability 23.2* (25.1) 23.2 Leverage -5.25* (-13.2) Investment 0.001** (2.16) Group Dummy 3.37* (3.8) 3.37 Private Foreign Dummy 1.89 (1.56) 1.89 Private Indian Dummy 2.04** (2.3) 2.04 Constant -6.45* (-6.7) Log Likelihood Number of Observations 7880 Number of firms 597 Wald Chi Source: Author s estimate from CMIE Prowess database Table 5.7 presents the results of logistic regression. In the logit model size has been used as one of the explanatory variables. It can be seen from the above table that current size of the firm is positively related to the payout, which means that as size of the firm increases, the likelihood of the firms payout increases. This may be due to the fact that smaller firms grows faster through retention in contrary to the larger firms, which have already established reputation in the market to mobilize resources from different sources. Among the other explanatory variables, profitability is considered since the decision to pay dividends starts with profits of the firms. Therefore, it is logical to consider profitability as a threshold factor, and the level of profitability as one of the most important factors that may influence firms' dividend decisions. The theory 121

20 suggests that dividends are usually paid out of the annual profits, which represents the ability of the firm to pay dividends. Thus, firms incurring losses are unlikely to pay dividends. In his classic study, Lintner (1956) found that a firm's net earnings are the critical determinant of dividend changes. Furthermore, several studies have documented a positive relationship between profitability and dividend payouts (Jensen et al, 1992, Han et al., 1999, and Fama and French, 2002). Evidence from the emerging markets also supports the proposition that profitability is one of the most important factors that determine the dividend policy (Adaoglu, 2000, Pandey, 2001, and Aivazian et al., 2003). As expected profitability is found to be positively related to the payout, implying that as a firm becomes profitable, its likeliness of paying dividends also increases. It has been explained earlier that the financial structure of a firm consists of both debt (liabilities) and equity financing. Long-term financing usually refers to the firm's capital structure, while the extent to which a firm relies on debt financing is called financial leverage. The use of debt financing can lever-up shareholders' return on equity. However, leverage entails risk; that is, when a firm acquires debt financing it commits itself to fixed financial charges embodied in interest payments and the principal amount, and failure to meet these obligations may lead the firm into liquidation. The risk associated with high degrees of financial leverage may therefore result in low dividend payments because, ceteris paribus, firms need to maintain their internal cash flow to pay their obligations rather than distributing the cash to shareholders. Moreover, Rozeff (1982) pointed out that, firms with high financial leverage tend to have low payouts ratios to reduce the transaction costs associated with external financing. In addition, some debt covenants have restrictions on dividend payments. Therefore, other things being equal, an inverse relationship between debt and dividend payouts seems plausible. A large body of research has reported a negative association between debt and dividends (Jensen et al., 1992, Agrawal and Jayaraman, 1994, and Gugler and Yurtoglu, 2003). The above regression models also shows that firms with high leverage pay less in terms of dividend, which means that debt-holders put pressure on firms to pay for the debt first. Interaction between investment and payout is positive. Higher investment implies higher growth opportunities for firms which may be risky for firms and 122

21 shareholders. This phenomenon can be explained by the fact that firms with high growth needs huge funds for financing investment activities and therefore nonpayment of dividend would not help preventing it to resort to external funds. On the other hand, in order to avoid the risk shareholders prefer to receive dividend (current income) rather than obtaining a higher future income in terms of capital gain. Thus dividend acts as an instrument for controlling overinvestment problem. It is also observed that group firms on an average pay higher dividend than that of government firms. This may be due to the agency cost that arises between owners and managers. Private foreign firms dividend payment is not significantly different from that of government owned firms. Foreign firms may be more interested to receive return in forms of capital gain or foreign promoters may be efficient in handling the managers that causes less agency cost to crop up. In the last section we have discussed the factors that can affect the dividend decision of Indian corporate sector. Investment decision and dividend decision are found to be positively related and significant. However, whether this relation holds true across all high, medium, and low growth firms is a matter of further enquiry. Therefore, in the next section we have discussed the relation between investment and dividend decision across different growth oriented firms Interaction between Investment and dividend decision The review of literature reveals that there are two contrasting views regarding the relationship between dividend and investment decisions for different growth oriented firms. The first theory suggests that for high growth firms the investment and dividend decisions might be positively related, while it is negatively related for low growth firms. According to this theory, for a high growth oriented firm there is huge demand for investment funds which cannot be solely met through the use of internal funds. Hence, to maintain a good flow of external funds, firms need to maintain a good relationship with the investors in the capital market, which leads to high payment of dividend. Therefore, for high-growth firms, investment and dividends are likely to be positively related. In contrast, for low growth firms which have lesser needs of external funds, one may expect dividend and investment decisions to be negatively related, as these are competing uses of internal funds. The second theory argues that as the liquidity position of high growth firms gets adversely affected due 123

22 to high growth, there is a possibility that high growth firms will end up paying lower dividend (Weston and Brigham, 1981). Hence, in this section we have tried to empirically test these competing theories on investment and dividends based on the growth-orientation of firms. To measure the association of dividend and investment, sample firms have been classified into three groups namely, low growth, medium growth, and high growth based on the average annual growth rate of total assets. The mean values of payout ratio (D i /P i ) and investment-earnings ratio (ΔK i /P i ) are then calculated for each firm in the sample period. Growth rates and payout ratios for these groups are listed in Table 5.8. As a preliminary study on the relationship between dividend and investment decisions of firms, the mean of payout ratio was regressed on the mean of investment-earnings ratio for the groups of high-growth and low-growth firms. Regression results are presented in Table 5.9, which show that the relationship between D i /P i and ΔK i /P i are similar between high growth and low growth firms- both are positive and significant. 124

23 Payout Growth Table 5.8 Payout ratio and growth of different types of firms Low Growth Medium Growth High Growth Min Mean Max Median Min Mean Max Median Source: Source: Author s estimate from CMIE Prowess database Table 5.9 Ordinary Least Square regression results Dependent variables is: D i /P i Constant ΔK i /P i R bar Sq No. of Observations Low Growth 0.06* 0.12* (2.46) (112.3) High Growth 0.14* (18.5) 0.03* (70.1) Source: Source: Author s estimate from CMIE Prowess database Table5.10 Ordinary Least Square & GLS regression results Dependent Variable: D it /P it R bar Constant K it /P it D i,t-1 /P i,t-1 sq Observations Low Growth OLS 0.20* 0.008* -0.95* (6.23) (4.11) (-42.4) GLS 0.06* (11.2) 0.001** (2.14) -0.59* (-28.9) 1932 High Growth OLS 0.21* 0.002* -0.91* (14.2) (6.7) (52.7) GLS 0.09* (20.7) 0.005*** (1.86) -0.45* (26.4) 3221 Source: Author s estimate from CMIE Prowess database To further study the relationship between dividend and investment decisions of firms, the error component model is applied to the data described above for both high-growth and low-growth firms and results are presented in table The estimated co-efficients of D i, t-1 /P i, t-1 has correct sign regardless of the estimation method. The co-efficients of ΔK it /P it are positive for both low and high growth firms. This indicates that firms are not likely to reduce payout as that may detract them from their ability to attract external funds. Our results are in contradiction to the findings of Fama (1974) which show that there is no relation between dividend and investment 125