Dividend Payout Ratio in Pakistan Cement Sector

The purpose of the study is to determine the impact of different variables on the Dividend Payout Ratio. In this paper we study the impact of set of specific variables on the dividend payout policy of Cement Sector of Pakistan in the period of 2003-2008, extending the existing research on dividend payout policy. The paper studies a sample of about 14 Cement companies of Pakistan; data is collected from SBP & KSE, performing the regression test to verify the validity of the results. We analyze the impact of different variables such as annual sales, earning before income and taxes (EBIT), cash from operations (CFO) and corporate tax on the dividend payout policy. We find evidence of a significant, positive relationship between dividend and Earnings before income and taxes and as well as positive relationship between dividend and corporate tax

INTRODUCTION

Dividend policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation. This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

The behavior of dividend policy is the most debatable issue in the corporate finance literature and still keeps its prominent place both in developed and emerging markets. Many researchers try to uncover the issue regarding the dividend behavior or dynamics and determinants of dividend policy but we still don’t have an acceptable explanation for the observed dividend behavior of firms (Black, 1976; Allen and Michaely, 2003 and Brealey and Myers 2005).

One of the well known explanations of dividend behavior is the smoothing of firm’s dividends vis-à-vis earnings and growth. In his seminal research, Lintner (1956) find that firms in the United States adjust their dividends smoothly to maintain a target long run payout ratio. Several studies appear after this work and evidence suggest that the dividend policy of the companies varies from country to country due to various institutions and capital market differences.

For the companies which are operating as joint stock, for those a dividend is due as a fixed amount per share. Therefore, a shareholder gets a dividend in amount to their shareholding. For the joint stock company, dividend payments are not an expense; rather, it is the distribution of an asset among shareholders. Public firms typically pay dividends on a set plan, but may announce a dividend at any time, sometimes called a special dividend to distinguish it from a regular one.

Companies which are cooperatives, on the other hand, distribute dividends according to members’ activity, so their dividends are often considered to be a pre-tax expense.

Those Dividends which are usually developed on a cash basis, store credits (common among retail consumers’ cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public firms offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

LITERATURE REVIEW

During the last fifty years the several theoretical and empirical studies are done leading to the mainly three outcomes: the increase (decrease) in dividend payout affect the market value of the firm or 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 mixed. Furthermore there are numerous theories on why and when the firms pay dividends. Miller and Modigliani (1961) suggest that in perfect markets, dividend do not affect firms’ value. Shareholders are not concerned to receiving their cash flows as dividend or in shape of capital gain, as for as firm’s doesn’t change the investment policies. In this type of situation firm’s dividend payout ration effect their residual free cash flows and the result is when the free cash flow is positive firms decide to pay dividend and if negative firm’s decide to issue shares. They also conclude that change in dividend may be conveying the information to the market about firm’s future earnings. Gordon and Walter (1963) present the Bird in the Hand Theory which says that investors always prefer cash in hand rather then a future promise of capital gain due to minimizing risk. The agency theory of Jensen and Meckling (1976) is based on the conflict between managers and shareholder and the percentage of equity controlled by insider ownership should influence the dividend policy. 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.

Linter’s classic (1956) study found that major changes in earnings “out of line” with existing dividend rates were the most important determinant of the company’s dividend decisions. However, because these managers believed that shareholders preferred a steady stream of dividends, firms tended to make periodic partial adjustments toward a target payout ratio rather than dramatic changes in payout. Thus, in the short run, dividends were smoothed in an effort to avoid frequent changes.

Fama and Babiak’s examination of several alternative models for explaining dividend behavior sup-ports Linter’s position that managers increase dividends only after they are reasonably sure that they can permanently maintain them at the new level. D’Souza (1999) finds negatively relationship between agency cost and market risk with dividends payout. However, the result does not support the negative relationship between dividend payout policies and investment opportunities. The empirical analysis by Adaoglu (2000) shows that the firms listed on Istanbul Stock Exchange follow unstable cash dividend policy and the main factor for determining the amount of dividend is earning of the firms. Omet (2004) comes to the same conclusion in case of firms listed on Amman Securities Market and further the tax imposition on dividend does not have the significant impact on the dividend behavior of the listed firms.

H. Kent Baker, Gail E. Farrelly, and Richard B. Edelman in their study “A Survey of Management Views on Dividend Policy” say that the major determinants of dividend payments today appear strikingly similar to Linter’s behavioral model developed during the mid-1950. In particular, respondents were highly concerned with dividend continuity. Second, the respondents seem to believe that dividend policy affects share value, as evidenced by the importance attached to dividend policy in maintaining or increasing stock price. Although the survey does not uncover the exact reasons for their belief in dividend relevance, it does provide evidence that the respondents are generally aware of signaling and clientele effects. Finally, the opinions of the respondents from the utilities differ markedly from those of the other two industries.

H. Kent Baker, Gail E. Farrelly, and Richard B. Edelman’s basic objective was divided into three different scenarios. (1) to compare the determinants of dividend policy today with Linter’s behavioral model of corporate dividend policy and to assess management’s agreement with Linter’s findings; (2) to examine management’s perception of signaling and clientele effects; and (3) to determine whether managers in different industries share similar views about the determinants of dividend policy.’ Total 562 firms of different industry groups mainly utility (150), manufacturing (309), and whole-sale/retail (103) were selected, which were listed on New York Stock Exchange (NYSE). A mail questionnaire was used to obtain information about corporate dividend policy. The questionnaire consisted of three parts: (1) 15 closed-end statements about the importance of various factors that each firm used in determining its dividend policy; (2) 18 closed-end statements about theoretical issues involving corporate dividend policy, and (3) a respondent’s profile including such items as the firm’s dividends and earnings per share.

A pilot test of the preliminary questionnaire was conducted among 20 firms selected from the three industry groups but not included in the final sample of 562 firms. The final survey instrument was then sent to the chief financial officers (CFOs) of the 562 firms, followed by a second complete mailing to improve the response rate and reduce potential non response bias. The payout ratio of the responding utilities (70.3%) was consider-ably higher than for manufacturing (36.6%) and wholesale/retail (36.1%).

Shefrin & Statman (1984), introduced concepts such as prospect theory and mental accounting to explain why investors like dividends. Statmen (1977) contends that solving the dividend puzzle is impossible while ignoring the patterns of normal investment behavior. Baker and Powell (2002) in their study “Revisiting Managerial Perspectives on Dividend Policy” examined how managers view dividend policy but used a different data set to extend and refine the scope of previous survey research. Specifically, we survey corporate managers of NASDAQ firms that consistent pay cash dividends to determine their views about dividend policy and value, and four common explanations for paying dividends–signaling, tax-preference, agency costs, and bird-in-the-hand arguments. This study was conducted to determine whether the evidence simply reaffirms what we already know or provides new insights about dividend policy.

Damodaran (1999) notes, a firm’s dividend policy tend to follow the firm’s life cycle. Lintner (1956) reports that the firms have long-run target dividend payout ratios and place their attention more on dividend changes than on absolute dividend levels. He also finds that dividend changes follow shifts in long-run sustainable earnings (managers’ smooth earnings) and managers are hesitant to make dividend changes that may later need to be reversed. Managers also try to stabilize dividends and avoid dividend cuts. Lintner developed a partial adjustment model to describe the dividend decision process that explained 85 percent of year-to-year dividend changes. Gordon (1959) argue that an increase in the dividend payout increases stock price (value) and lowers the cost of equity, but empirical support for this position is weak. Bemstein (1996) maintain that dividend policy makes no difference because it has no effect on either stock prices or the cost of equity.

Miller and Rock (1985), suggest that managers as insiders choose dividend payment levels and dividend increases to signal private information to investors. Managers have an incentive to signal this private information to the investment public when they believe that the current market value of their firm’s stock is below its intrinsic value. The increased dividend payment serves as a credible signal when other firms that do not have favorable inside information cannot mimic the dividend increase without unduly increasing the chance of later incurring a dividend cut. According to Brennan’s (1970) version of the capital asset pricing model, dividend-paying stocks must offer higher pre-tax returns than non-dividend paying stocks, all else equal. Brennan’s empirical tests, however, are mixed.

Easterbrook (1984) argues that firms pay dividends to help reduce the agency costs associated with the separation of ownership and control. By paying dividends, managers must raise funds more frequently in the capital markets where they are subjected to scrutiny and the disciplining effects of investment professionals.

Jensen (1986) makes a similar agency-theory argument where managers pay dividends to reduce the firm’s discretionary free cash flow that could be used to fund suboptimal investments that benefit managers but diminish shareholder wealth. Bhattacharya (1979) correctly argues that the riskiness of a project’s cash flows determines a firm’s risk and an increase in dividend payout today will simply result in an equivalent drop in the stock’s ex-dividend price. Thus, increasing the dividend today will not increase a firm’s value by reducing the risk of future cash flows.

Edelman (1985), and others report that managers believe dividend stability is desirable. If this position is correct, investors should prefer stocks that pay more predictable dividends to those that pay the same amount of dividends in the long run but in a more erratic manner.

Sujata Kapoor and Kanwal Anil (2008) in their study “Determinants of Dividend Payout Ratios-A Study of Indian Information Technology Sector” examine the determinants of dividend payout ratios of CNX IT listed companies in India. The period undertaken for study i.e. 2000-2006 covers both recessionary and booming phase of Indian information technology sector. Till 2003, there was recession and from 2003 onwards IT sector witnessed exponential growth. After 2006 linear growth was seen in IT sector. This sector is now, steadily approaching towards maturity. The Return on equity of this sector is very high compared to other sectors of Indian economy. IT sector is a human intensive sector and do not require huge capital asset base like manufacturing companies for their operations. The major asset of this sector is manpower. Therefore the funds required for recruitment and retention of manpower is comparatively less than funds required for purchasing capital assets. So these firms can easily release funds for payment of dividends. Thus, IT firms in India have high liquidity and it is an important determinant of dividend payout ratio. Since the profitability of the companies is also very high so even if there is year to year variability in the earnings of the firms they can easily pay huge dividends.

Alli et.al (1993) found that dividend expenses depend more on cash flows, which reproduce the company’s ability to pay dividends, than on current earnings, which are less heavily influenced by accounting practices. They claim current earnings do not really reflect the firm’s ability to pay dividends. Green et. al. (1993) questioned the irrelevance argument and investigated relationship between the dividends and investment and financing decisions. Their study showed that dividend payout levels are totally decided after a firm’s investment and financing decisions have been made. Dividend judgment is taken all along with investment and financing decisions.

Higgins (1981) indicated that a direct connection between growth and financing needs: growing firms have outside financing requirements because working capital needs normally go beyond the incremental cash flows from new sales. Higgins (1972) shows that payout ratios are negatively related to firms’ need top fund finance growth opportunities.

D, Souza (1999) however shows a positive but insignificant relationship in the case of growth and negative but insignificant relationship in case of market to book value. Husam-Aldin Nizar Al-Malkawi (2007) in the study “Determinants of Corporate Dividend Policy in Jordan: An Application of the Tobit Model” examined the main determinants of corporate dividend policy in Jordan. Tobit specifications were used to examine the determinants of the level or the amount of dividends paid. The data showed that ownership dispersion as measured by the natural log of the number of stockholders seems to not be related to dividend policy in Jordan. The fraction held by insiders (INSD), the second proxy for the agency costs hypothesis, has negative impact on the level of dividends paid. Similarly, the existence of government or its agencies in a firm’s ownership structure (controlling shareholder) affects the amount of dividends (positively). Other variables of ownership structure seem to have no influence on dividend policy. The firm’s age, size, and profitability positively and significantly affect its dividend policy. The use of age, and especially age squared as proxies for growth has not been used in empirical testing of dividend policy to the best of the author’s knowledge, and these results therefore suggest interesting avenues for future research.

According to Gordon (1959) a higher payout ratio will reduce the required rate of return (cost of capital), and hence increase the value of the firm.

According to Miller and Rock (1985) dividends contain this private information and therefore can be used as a signaling device to influence share price. An announcement of dividend increase is taken as good news and accordingly the share price reacts favorably, and vice versa. Only good-quality firms can send signals to the market through dividends and poor-quality firms cannot mimic these because of the dissipative signaling costs. According to Easterbrook (1984) the agency costs thesis predicts that dividend payments can reduce the problems associated with information asymmetry. Dividends may also serve as a mechanism to reduce cash flow under management control, and thus help to mitigate the agency problems. Reducing funds under management discretion may result in forcing them into the capital markets more frequently, thus putting them under the scrutiny of capital suppliers. The tax-preference theory posits that low dividend payout ratios lower the required rate of return and increase the market valuation of a firm’s stocks. Because of the relative tax disadvantage of dividends compared to capital gains investors require a higher before-tax risk adjusted return on stocks with higher dividend yields

Farzad Farsio, Amanda Geary, and Justin Moser in their research “The Relationship between Dividends and Earnings” say that dividends have no explanatory power to predict future earnings. They presented four cases for possible effects of earnings on future dividends and illustrate that there should be no significant relationship between dividends and future earnings in the long run. Applying regression analysis and the Granger causality test to quarterly earnings and dividends of S&P 500 index data over 1988-2002, they found strong support for their hypothesis. The contribution of this study is that it provides financial managers and investors with evidence that it would be a mistake to base investment decisions on inferences about dividend/earnings relationships that rely on some certain short-term periods.

According to them the causal relationship from dividends to earnings suggested by some studies reviewed in the paper does not hold in the long run. In practice, while during some periods an increase in dividend payout may be followed by an increase in future earnings, during other periods such an increase may well be associated with declines in future earnings. As a result, no significant relationship between dividends and earnings is expected in the long run.

RELIABILITY OF DIVIDENDS

There are two metrics which are commonly used to gauge the sustainability of a firm’s dividend policy. Payout ratio is calculated by dividing the company’s by the earnings. A payout ratio of more than 1 means the company is paying out more in dividends for than year than it earned. Dividend cover is calculated by dividing the company’s cash flow from operation by the dividend.

PAKISTANI MARKET

The Pakistan’s capital market and the economy have several important features for examining the dynamics of dividend policy.

Firstly, Pakistan is moving towards the development and improving the economy position in the world since the 1980. The capital markets of Pakistan are much developed as before. Many studies conclude that firms are likely to pay stable dividend during the high growth period and it is interesting to find that how dynamic dividend policy is determined in growing economy like Pakistan.

Secondly, due to weak corporate governance the ownership structure of Pakistani firms is often characterized by the dominance of one primary owner who manages a large number of affiliated firms with just a small amount of shares or investment which result in the agency conflict between the shareholders and the owner, where controlling shareholders confiscate value from minority shareholders and can influence the dividend policy easily.

Thirdly, the tax environment in Pakistan is totally different as compare to developed markets. There is no capital gain tax on stocks in Pakistan while 10% withholding tax is charged on dividend incomes and it is important to mention here that if the firms earned the profit and not announced the dividend that the 35% of the income tax is charged by the Government of Pakistan. There is a possibility of differences in the tax system may influence the dividend policy and also influence the degree of dividend smoothing in Pakistan since this adverse tax treatment of dividend income is a more serious issue than the developed countries like United States.

Fourthly, in the Pakistan the payment of dividend is voluntary. In Korea for example, it is mandatory for listed companies to pay the annual dividend divided by its face value at a level equal to the interest rate of one year time deposit. In fact, in Pakistan the many major investors are still disagreed with dividends and consider stock prices appreciation as the major component of stock returns therefore, it is assumed that investor attitude towards dividends is expected to have an impact on the way in which firms set their dividend policy in Pakistan. The theoretical and empirical evidences suggest that there are many firm specific factors related to governance related which play an important role in dividend signaling and agency cost explanation of dividend behavior.

The main focus of the study is to examine factors could empirically explain cross sectional differences in firm’s dividend smoothing behavior in Pakistani market. The main reason to examine the smooth dividends behavior is that the firms’ dividend behavior affects it capital structure. During the last fifty years the several theoretical and empirical studies are done leading to the mainly three outcomes: the increase (decrease) in dividend payout affect the market value of the firm or 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 mixed. Furthermore there are numerous theories on why and when the firms pay dividends.

THEORETICAL CONSIDERATION

The Bird-in-Hand theory (a pre-Miller-Modigliani theory) asserts that in a world of uncertainty and information asymmetry dividends are valued differently to retained earnings (capital gains). Because of uncertainty of future cash flow, investors will often tend to prefer dividends to retained earnings. As a result, a higher payout ratio will reduce the required rate of return (cost of capital), and hence increase the value of the firm. This argument has been widely criticized and has not received strong empirical support.

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

Gordon and Walter (1963) present the bird in the hand theory which says that investors always prefer cash in hand rather then a future promise of capital gain due to minimizing risk. The agency theory of Jensen and Meckling (1976) is based on the conflict between managers and shareholder and the percentage of equity controlled by insider ownership should influence the dividend policy. 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 explanation regarding the signaling theory given by Bhattacharya (1980) and John Williams (1985) dividends allay information asymmetric between managers and shareholders by delivering inside information of firm future prospects.

Miller and Scholes (1978) find that the effect of tax preferences on clientele and conclude different tax rates on dividends and capital gain lead to different clientele. Life Cycle Theory explanation given by the Lease et al. (2000) and Fama and French (2001) is 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 Catering theory given by Baker and Wurgler (2004) 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 put stock price premium on payers and by not paying when investors prefer non payers.

Fama and Babiak (1968). D’Souza (1999) finds negatively relationship between agency cost and market risk with dividends payout. However, the result does not support the negative relationship between dividend payout policies and investment opportunities. The empirical analysis by Adaoglu (2000) shows that the firms listed on Istanbul Stock Exchange follow unstable cash dividend policy and the main factor for determining the amount of dividend is earning of the firms. Omet (2004) comes to the same conclusion in case of firms listed on Amman Securities Market and further the tax imposition on dividend does not have the significant impact on the dividend behavior of the listed firms.

DeAngelo et al. (2004) document highly significant association between the decision to pay dividends and the ratio of earned equity to total equity controlling for size of the firm, profitability, growth, leverage, cash balance and history of dividends. In addition, the dividend payments prevent significant agency problems since the retention of the earnings give the managers’ command over an additional access to better investment opportunities and without any monitoring. Eriotis (2005) reports that the Greek firms distribute dividend each year according to their target payout ratio, which is determined by distributed earnings and size of these firms. Stulz et al. (2005) observe significant association between decision to pay dividends and contributed capital mix.

In investigating the determinants of dividend policy of Tunisian stock Exchange Naceur et al. (2006) find that the high profitable firms with more stable earnings can manage the larger cash flows and because of this they pay larger dividends. Moreover, the firms with fast growth distribute the larger dividends so as attract to investors. The ownership concentration does not have any impact on dividend payments. The liquidity of the firms has negatively impacted on dividend payments. In Indian case Reddy (2006) show that the dividends paying firms are more profitable, large in size, and growing. The corporate tax or tax preference theory doesn’t appear to hold true in Indian context. Amidu and Abor (2006) find dividend payout policy decision of listed firms in Ghana Stock Exchange is influenced by profitability, cash flow position, and growth scenario and investment opportunities of the firms.

Another closely related theory is the clientele effects hypothesis. According to this argument, investors may be attracted to the types of stocks that match their consumption/savings preferences. That is, if dividend income is taxed at a higher rate than capital gains, investors (or clienteles) in high tax brackets may prefer non-dividend or low-dividend paying stocks, and vice versa. Also, the presence of transaction costs may create certain clienteles. There are numerous empirical studies on the clientele effects hypothesis but the findings are mixed. Taking different paths, Pettit (1977), Scholz (1992), and Dhaliwal, Erickson and Trezevant (1999) presented finding weak or contrary evidence include Lewellen et al. (1978), Richardson, Sefcik and Thomason (1986), Abrutyn and Turner (1990), among others. Despite the tax penalty on dividends relative to capital gains, firms may pay dividends to signal their future prospects. This explanation is known as the information content of dividends or signaling hypothesis. The intuition underlying this argument is based on the information asymmetry between managers (insiders) and outside investors, where managers have private information about the current performance and future fortunes of the firm that is not available to outsiders. Here, managers are thought to have the incentive to communicate this information to the market. The information asymmetry between managers and shareholders, along with the separation of ownership and control, formed the base for another explanation for why dividend policy may matter; that is, the agency costs thesis.

This argument is based on the assumption that managers may conduct actions in accordance with their own self-interest which may not always be beneficial for shareholders. For example, they may spend lavishly on perquisites or overinvest to enlarge the size of their firms beyond the optimal size since executives’ compensation is often related to firm size (see Jensen, 1986). The agency costs thesis predicts that dividend payments can reduce the problems associated with information asymmetry. Dividends may also serve as a mechanism to reduce cash flow under management control, and thus help to mitigate the agency problems. Reducing funds under management discretion may result in forcing them into the capital markets more frequently, thus putting them under the scrutiny of capital suppliers

WHY DO FIRMS PAY DIVIDENDS

In Dividend Policy, Agency Costs, and Earned Equity authors Harry DeAngelo, Linda DeAngelo, and René Stulz document that, for the 25 largest long-standing dividend payers in 2002, a decision to retain earnings instead of paying dividends would have resulted in firms with little or no long-term debt and enormous cash balances, far outstripping any reasonable estimate of their attractive investment opportunities.

Had they not paid dividends, those firms would have cash holdings of $ 1.8 trillion (51 percent of total assets), up from $ 160 billion (6 percent of assets), and $1.2 trillion in excess of their collective $ 600 billion in long term debt. Paying dividends also prevented these firms from having significant agency problems- the incremental costs and inherent conflicts of having managers make decisions for investors- because the retention of earnings would have given managers command over an additional $ 1.60 trillion without access to better investment opportunities and with no additional monitoring. Agency theory assumes that large-scale retention of earnings encourages behavior by managers that doesn’t maximize shareholder value. Dividends, then, are a valuable financial tool for these firms because they help avoid asset/capital structures that give managers wide discretion to make value- reducing investments

The evidence presented in this paper uniformly and strongly supports this view of dividend policy. This view also makes sense when one considers the rationale behind agency theory. This view also makes sense when one considers the rationale behind agency theory. Managers acquire control over corporate resources either from outside contributions of debt or equity capital, or from earnings retentions. From an agency perspective, one advantage of contributed capital is that it comes with additional monitoring, because rational suppliers of contributed capital is that it comes with additional monitoring, beca