The study of Dividends in the market over the last few decades


Date added: 17-06-26

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The topic of dividend has been studied extensively in last few decades. Still it remained as one of the most debatable issue in the field of Finance. The contradictory nature and massive importance 0f dividend in finance had made it one of the most discussable topics for researchers. Researchers in the past enclosed many aspects of dividend; few among them are views about dividend, dividend payment effects on firm value, dynamics and determinants of dividend policy, and dividend trends of different markets. Lintner (1956) examined the distribution of income of corporations among dividends, retained earnings and taxes using data from the years 1918 to 1941 as a training period and data from the years 1942 to 1951 as the testing period. It was found that the basic determinants of dividends changes are net income and prior year dividends. In addition, firms attempt to continue a steady stream of dividend and tend to make a periodic partial adjustment to a target payout ratio rather than dramatically changing their payout when a change in earnings occurs. In the short run, dividends are smoothed to avoid frequent changes. This dispute is rooted back to the significant work of Modigliani and Miller (1961), in which it was challenged in a perfect market condition dividend policy did not affect the value of firm. In contrast, Lintner (1962) and Gordon (1963) supported "Bird-in-hand" theory and argued that in the world of ambiguity and imperfect information, high dividend payment is linked with high firm value. In addition, Black (1976) called dividend is great puzzle which need extensive researched. Furthermore, the Brealey and Myers (2005) listed dividend as one of the top ten significant vague issues in advance corporate finance. According to Anil and Sujjata (2008) that emerging consensus is that no individual factor alone can describe dividend behavior. The existing corporate theories supported that cash flow and profitability have significant impact on dividend. The aim of this study was to know the impact of cash flow and profitability on dividend payout of non financial firms in Pakistan market. This study considered free cash flow and profitability was most important for non financial firm in Pakistan market. Talat and Mirza(2010) conducted research related to ownership structure and cash flow as determinants of dividend payout policy. According to that individual ownership, cash flow sensitivity, size, and leverage were negatively associated with dividend payout policy. In contrast, operating cash flow and profitability was positively related to cash dividend. In addition, Researcher concluded that managerial ownership, individual ownership, operating cash flow, and size were important determinants of dividend behavior whereas, leverage and cash flow sensitivity did not contribute significantly in determining the level of corporate dividend payment. DeAngelo and DeAngelo (1990) and Reddy (2004) found significant relation between cash flow and dividend changes.

Problem Statement

In the field of corporate finance, the dividend was considered as one of the most noteworthy issues. The main purpose to study the impact of cash flow and profitability on dividend payout of non financial firm in Pakistan market was to analyze the cash dividend behavior of developing countries firm. In addition, study was conducted to find out how strongly these two variables free cash flow and profitability have impact on the dividend payout because, profitability was most likely used as determinants of dividend payout in most of the previous researches' but free cash flow was not taken too much in previous research. Furthermore, how these two variables serve as an indicator for dividend payout.


H1: There is significant impact of free cash flow on dividend payout. H2: There is significant impact of profitability on dividend payout.

Outline of the Study

The research structured follows. Chapter one was consist on the introduction of the thesis, it is essential to review the views and theoretical background of dividend, the statement o problem, scope and objective, hypothesis. Chapter two consisted of review of literature given by various authors, theories on dividend and impact of cash flow and profitability on dividend payout. Chapter three explained methodology, it consisted of justification of the selection of the variables, the sampling and research design, the data technique and hypothesis. Chapter four represent the analysis of results which were taken after the data processing. Chapter five composed of final result, conclusion and recommendation. Chapter six consisted of references.



Since 1956, dividend has always considered one of the most interested and investigated topic in world of finance. Lintner (1956) analyzed the distribution of income of corporation among dividends, retained earnings, and taxes using data from the years 1918 to 1941. It was founded the basic determinants of dividends changes are net income and prior year dividends. In addition, firms tried to continue a stable flow of dividend and likely made a periodic partial adjustment to a target payout ratio instead radically changing payout when earning changed. Jensen and Meckling (1976) paid attention toward agency cost hypothesis and described that dividend restricted the funds under management control, as a result putting them under strict capital market examination. Owner' responsibility was reduced to manage the quality of investment and to control the expenditure on manager prerequisites. Marke, Langrehr, and Hexter(1998) conducted research on dividend policy determinants. Researchers had taken focus of firm, natural log of sales of firm, inside ownership for firm, no of common shareholder for firm, free cash flow for firm, sales growth of firm, and standard deviation of returns o f firm as determinants of dividend policy. Authors concluded that corporate focus has negative impact on dividend payout. While inside ownership had also negative impact, according to researcher the firms have greater inside ownership have small dividend payout. In addition, the firms with higher free cash flow have higher dividend payout and lower payout ratio of firms with higher standard deviation of returns. William and Nanda (1994) conducted research on free cash flow, shareholder value, and the undistributed profits tax of 1936 and 1937. In this study researcher tried to explore the investor reaction toward the anticipated decrease in free cash flow presented to corporate managers. In addition, researchers suggested agency costs as partial determinants of dividend policy. To avoid the agency problem corporate have to pay higher dividend and imposed higher tax on undistributed profit so the problem of agency cost handled efficiently. The study conducted on determinants of dividend payout ratio in Ghanna byAmidu and Abor (2006). In this study 20 listed firms of Ghana Stock Exchange were used as a sample which shows 76% of the total listed firm in Ghana Stock Exchange. They have taken the Payout Ratio as dependent variable and defined as dividend per share divided by earning per share. The included the explanatory variable profitability, frisk (risk), cash flows (cash), corporate tax (tax), institutional holdings (INSH), Sales Growth and Market to Book value (MTBV).they find that more profitable firms pay more dividend and profitability is positively related to dividend payout. In addition, cash flow and taxes are also positively related to dividend payout. Further, they also concluded there is a positive relationship between increase in liquidity and dividend payout. Their results suggest negative relationship between risk, institutional holding, growth, market to book value and dividend payout. The firms with the earning volatility find difficult to pay low and no dividends. Al-Malkawi (2007) worked on determinants of corporate dividend payout policy in Jordan. Researcher used a firm level panel data of all publicly traded firms on the Amman Stock Exchange between 1989 and 2000. Researcher used dividend payout as a depended variable and agency cost, Ownership, annual share turnover, market to book ratio, market capitalization of common equity, financial leverage ratio, profitability ratio, and taxes as independent variables. By using Tobit specification researcher concluded that positive relationship between size, age, and profitability with dividend payout and negative relationship between signaling device, ownership, and taxes in Jordan. Fairchild (2010) worked on Dividend policy, signaling and free cash flow: an integrated approach. Researcher has tried to examine the dividend policy by taking only two hypothesis signaling and free cash flow. In order to understand the composite environment of dividend policy, signaling game is developed in which most of the information possesses by managers than investors about the quality of the firms. The signaling hypothesis shows that asymmetric information between managers and investor, dividend work as signal regarding current performance and future prospect. The study found that high dividend has positive effect on the firm performance, in term of providing a positive signal for current performance and as will as future scenario. In addition, dividend payout reduces the free cash flow problem, which may attract the manager to invest in negative NPV project for personal interest. But if the project shows positive NPV so investment opportunities are available which lead toward the higher dividend in future. Gill, Nahum, and Rajendra (2007) worked on determinants of dividend payout ratio in United States. In this study researcher extend the Amidu and Joshua, and Anil and Kapoor finding for the American service and manufacturing firms. Researcher took same variables into account such as profitability, tax, market to book value, cash flow, and sale growth. The sample size was 266 out of 500 financial reports. Finding for manufacturing firms that dividend payout ratio is the function of profit margin, tax, and market to book ratio We also found that the results are different when the dividend payout ratio is defined as the ratio between the cash dividend that the after-tax cash flow, not the after tax earnings of the companies. Reddy (2006), studied the dividend behavior of Indian corporate firms, trend, and determinants and tried to determine the behavior of the firms listed on Bombay Stock Exchange (BSE) with the help of trade off theory and signaling theory hypothesis. The analysis of dividend trend shows that stock traded on New York Stock Exchange (NSE) and (BSE) signify that the percentage of firms paying dividends has declined from 60.5% in 1990 to 32.1% in 2001 and there is only few firms paying dividend consistently. Furthermore the dividends paying firms are more profitable, large in size, and growth doesn't seem to discourage Indian firms from paying higher dividends. The corporate tax or tax preference theory doesn't appear to hold true in Indian context. Finally the dividend changes appear to signal contemporary and lagged earning performance rather than future earnings performance. Baker, Farrelly and Edelman (1986) studied 318 New York stock exchange firms and concluded that the major determinants of dividend payments are anticipated level of future earnings and pattern of past dividends. Pruitt and Gitman (1991) asked financial managers of the 1000 largest U.S. and reported that, current and past year profits are important factors influencing dividend payments. Baker and Powell (2000) conclude from their survey of NYSE-listed firms that dividend determinants are industry specific and anticipated level of future earnings is the major determinants. Anil and Kapoor (2008) studies Indian information technology sector for determinants of dividend payout ratio. The period for study 2000-2006 covers both recessionary and booming phase of Indian information technology sector. Researcher concluded liquidity and beta (year to year variability in earnings) was found to be a notable determinant of dividend payout ratio. In addition, authors concluded there was recession and from 2003 onwards IT sector witnessed exponential growth. After 2006 linear growth was seen in IT sector. Recently in Pakistani perspective, Ahmed and Attiya (2009) investigated determining factors of dividend policy in emerging economy of Pakistan on a sample of 320 firms listed at KSE from 2001 to 2006. Researchers concluded that Pakistan's listed firms rely more on the current earnings than past dividend. In addition, authors highlighted some determinants that may influence the dividend payout policies. First the results demonstrated that the firms having high profitability with stable earnings can afford larger free cash flows thus pay out larger dividends. The firms with larger investment opportunities can easily influence and play important role to determinant of dividend payout policies in Pakistan. The ownership structure has the major impact to determine the dividend payout policy in Pakistan. The firms with the major inside share holdings pay more dividends to its shareholders in Pakistan. Moreover the growth of the firms doesn't have any impact on the dividend payout. The market liquidity of the firms has a positive influence which confirms that firms with higher market liquidity pay more dividends. The size is the highly negative and significant which shows the firms invest in their assets rather than paying dividends to its shareholder.

2.1 Dividend irrelevance theory:

Miller and Modigliani (1961) proposed that dividend policy is irrelevant to the shareholder and stockholder wealth was constant in the world of perfect market condition and any growth in the current payout is financed by literally priced stock sales. The basic assumption was that management paid 100 percent payout in every period. Other assumptions were as follow. First, market is perfect capital market that means no taxes on transaction cost, single buyer and seller not influenced price, and everyone have free access to information. Second, investors are rational and value of securities was based on the discounted future cash flow to investor. Third, manager act as a agent of shareholders, and there was no uncertainty about the investment policy of the firm.

2.2 Bird-in-hand theory:

Al-Malkawi (2007) emphasized that dividend valued differently from retained earnings (capital gains) in world of uncertainty and asymmetry information. "A bird in hand (dividend) is valued more than two in the bush (capital gain)". Investors always preferred dividends to retained earnings due to uncertainty of future cash flow. Although, this argument has been widely criticized and has not received strong empirical support, but, it was supported by Gordon and Shapiro (1956), Lintner (1962), and Walter (1963). The basic assumptions were as followed Firstly, investors have inadequate information regarding the profitability of a firm. Secondly, cash dividend was taxed at a higher rate when capital gain was realized on the sale of share. Thirdly, dividend serves as a signal of expected cash flow.

2.3 Agency cost and free cash flow theory:

Ross (2008) agency cost is the cost of the conflict of interest that exists among shareholders and management. It was happened when management act for own interest rather than shareholders interest who own the firm. This could be direct and indirect. It was in contrast to assumption of Millar and Modigliani (1961) that mangers act as a agent of shareholders This is somewhat dubious, as the owners of the firm are different from the management. Managers are bound to carry out some activities, which could be costly to shareholders, such as undertaking unprofitable investments that would yield excessive returns to them, and unnecessarily high management compensation (Al-Malkawi, 2007). These costs are borne by shareholders; therefore, shareholders of firms with excess free cash flow would require high dividend payments instead. Agency cost may also arise between shareholders and bondholders: while shareholders require more dividends, bondholders require fewer dividends than shareholders by putting in place a debt covenant to ensure availability of cash for their debt repayment. Easterbrook (1984) also identified two agency costs: the cost of monitoring managers and the cost of risk aversion on the part of managers. Jensen's free cash flow/overinvestment hypothesis (1988) provides an alternative explanation for the positive relationship between the direction of the dividend change and the stock price reaction. Jensen argues that managers tend to hold cash to invest in negative NPV projects for their own utility maximization. The agency costs that result from this overinvestment decrease the value of the firm. Like the signaling hypothesis, the FCF argument suggests there should be a positive relationship is the direction of the dividend policy change and the stock price reaction. However, the FCF argument differentiates itself with respect to the level of growth opportunities faced by the firm. If a firm initiated a cash dividend, FCF arguments postulate there are fewer funds available for costly overinvestment. Likewise, if company did'nt pay dividend, the strongest form of a decrease would reduce the value of the firm because there are more funds available to invest in less present value projects. The FCF hypothesis assumes larger stock price volatility for the firms who have few growth opportunities as compared to the firms with many growth opportunities. There is disagreement between different researchers on dividend policy. Allen and Rachim (1996) in Australia found no significant relationship between dividend policy and stock price volatility. According to Gordon (1963) the stock price volatility is influenced by dividend payout. The firms who pay large dividend have minimum risks in terms of stock price value. Some of hypothetical mechanism also suggests the universal relationship of dividend yield and dividend payout ratio with stock price volatility. Jensen's and Meckling in (1976) developed Agency cost argument which proposed that dividend payout lower the cost of funds and increase the cash flows for the company. The company after paying cash dividends to stock holders would have less cash in hands of the managers to invest at below the cost of capital. According to Miller and Rock (1985); Asquith and Mullin, 1983; Born, Moser and Officer (1984) dividend declaration provide information to the share holders to forecast the financial position of the company and the present firm's earnings. This also depends on the source of information that either it is doubtful or not to respond on announcement of dividend. Hence, there remains disagreement till yet, the relation of dividend yield and stock price volatility and it is still unexplained and is considered as debatable in corporate finance.

2.4 Signaling hypothesis:

Though Miller and Modigliani (1961) assumed that investors and management have perfect knowledge about a firm, this has been countered by many researchers, as management who look after the firm tend to have more precise and timely information about the firm than outside investors. This, therefore, creates a gap between managers and investors; to bridge this gap, management use dividends as a tool to convey private information to shareholders. (Al-Malkawi,2007). Petit (1972) observed that the amount of dividends paid seems to carry great information about the prospects of a firm; this can be evidenced by the movement of share price. An increase in dividends may be interpreted as good news and brighter prospects, and vice versa. But Lintner (1956) observed that management are reluctant to reduce dividends even when there is a need to do so, and only increase dividends when it is believed that earnings have permanently increased. Rate of return effect, as discussed by Gordon (1963), is that a firm with low payout and low dividend yield may tend to be valued more in terms of future investment opportunities (Donaldson, 1961). Consequently, its stock price may be more sensitive to changing estimates of rates of return over distant time periods. Thus expanding firms although may have lower payout ratio and dividend yield, exhibit price stability. This may be because dividend yields and payout ratio serves as proxies for the amount of projected growth opportunities. If forecasts of profits from growth opportunities are less reliable than forecasts of returns on assets in place, firms with low payout and low dividend yield may have greater price volatility.



3.1 Method of Data Collection

Required data was collected from Karachi Stock Exchange as given by State Bank of Pakistan in publication of Balance Sheet Analysis of Joint Stock Companies Listed on the KSE (2005-2009). The period of study covered five years, 2005-09. The sample size of 100 non-financial firms was taken from all non financial firm listed at KSE. The required sample was chosen on the basis of cash dividend paid by firms' at-least for two years. The sample represents almost every industry.

3.2 Sample Size

Sample of 100 non-financial firms was collected from KSE. Only firms were used in the samples that paid cash dividend for at least two years firms that included the industrial firms and service providing firms listed on the KSE 100 Index form 2005-2009. The impact of the cash flow and profitability on dividend payout was analyzed on all of the non-financial firms selected as the sample.

3.3 Research Model Developed

There were various financial factors of the non-financial firms which affected the Dividend payout of the firms. This research study analyzed the impact of free cash flow and profitability on the dividend payout.

3.3.1 Dividend payout

Dividend payout and dividend amount are taken as the dependent variables. Since dividend payout is the generally used alternative for dividend policy, almost every financial researcher has used payout as a proxy for corporate dividend policy (See for example Gugler, 2003; Reddy and Rath, 2005; Papadopoulos, 2007; Al-Malkawi, 2007; Ahmed & Attiya, 2009). In order to calculate dividend payout was calculated as cash dividend per share divided by earning per share.

3.3.2 Earning per share

According to Hafeez and Attiya (2009) high profitability with constant earnings can manage to pay for larger free cash flows as a result to pay out larger dividends. The earnings per share after tax were used as independent variable. Earning per share after tax was used because dividend has been paid after interest, taxes and after depreciation and calculated as net earnings divided by number of shares. H1: There is significant impact of earning per share on dividend payout

3.3.3 Return on Equity

This variable is used in different previous studies such as: Abor (2005), Miller (2007), Al-Ajmi et al. (2009), and Ebaid (2009) etc. Some authors measured profitability or performance by three measurements such Gross profit margin (GPM), Return on Equity (ROE), and Return on Assets (ROA) and same predictors Ebaid (2009). Likely results with this variable are same as revealed by Abor (2005) and Ebaid (2009) such as: Significance and positive relationship with dividend payout. Return on Equity is considered best measure of firm profitability. Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. ROE was calculated by dividing Net Income minus preferred dividend by Share holder equity H2: There is significant impact of Return on Equity on dividend payout.

3.3.4 Free Cash flow

According to Jensen's (1986) free cash flow hypothesis, companies choose to use their cash resources to invest in profitable projects first; dividend is paid out of residual. From a company's point of view, cash generated from operations plays an important role in deciding the level of payout, among all three sources of cash flows i.e. operating; investing and financing, cash generated from operations is considered as most desirable source of funds for the company for distribution of dividends. Anil and Sujjata (2008) also found cash flow from operations as the most significant determinant of dividend policy in Indian IT industry. A measure of financial performance calculated as Net income minus depreciation minus change in working capital minus change in capital expenditure. Free cash flow (FCF) represents the cash that a company is able to generate after placing out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. H3: There is a significant impact of free cash flow on dividend payout. The model developed was a linear model and its specifications are provided below: Div payout = a0 + a1EPS + a2ROE + a3FCF + Ñ” Dividend payout = Dividend per share divided by earning per share EPS = Net income divided by number of share outstanding ROE =Net income minus preferred dividend divided by common shareholder equity FCF =Net income minus Depreciation minus change in working capital minus change in Capital expenditure Є = the error term

3.4 Statistical Technique

Multiple Linear Regression Analysis (MLR) technique was used for this research study to examine the impact of the distinctive financial characteristics of the non-financial firms on their dividend payout of the selected firms; Statistical Package for the Social Sciences (SPSS) was used for the examination of the secondary data.



The sample of 100 non-financial firms from Karachi Stock Exchange was taken into consideration. This research study used multiple regression analysis (MLR). Researcher examined the behavior of non-financial firms of KSE about dividend payout. The selected technique was used to study the impact of cash flow and profitability on dividend payout.

4.1 Finding and Interpretation of the results

In the beginning, the regression technique was applied on collected data by using SPSS, and there was no single variable was significant. It was clear from the result that there was the high co-linearity among the independent variables of the dividend payout and this means there was strong interrelationship present among the predictors. Return on assets and net profit margin was omitted from the data, thus, the issue of co-linearity was resolved. Now, proceeding with the analysis of the results because issue of co-linearity was addressed. The interpretation and analysis is presented in the next sections of this research study. Table 4.1: Model Summary Mod R R Sq. 1 .289 .084 Tables 4.1 depict the summary about the regression model. The R square of 8.4% showed that all the predictors of dividend payout together explained 8.4% variation in the dependent variable and the remaining variation was unexplained or hidden predictor were not included in the model.


Model Sum of Squares df Mean Square F 1 Regression 31503.936 3 10501.312 15.236 Residual 345316.428 501 689.254 Total 376820.364 504 The table 4.2 checked the significance of the linear regression model in such a way that the reliability of the data file regarding the applicability of the regression technique can be understood from the above table; however, ANOVA table was reliable test of checking the linear regression model's ability to explain any variation in the dependent variable of liquidity. This was perfectly obvious from the sig value of .000 that meant that the linear regression model was highly significant for the data collected for the research study conducted. In addition, ANOVA explained that all means are not equal.

TABLE 4.3:Coefficients

Model Unstandardized Coefficients Standardized Coefficients t Sig. Co-linearity Statistics B Std. Error Beta Tolerance 1 (Constant) 28.626 1.617 17.704 .000 ROE .216 .042 .261 5.110 .000 .704 EPS -.123 .051 -.120 -2.420 .016 .750 FCF .001 .000 .125 2.815 .005 .922 In table4.3 the final model of regression included only three independent variable that were free cash flow, earning per share, and return on equity These variables were included in the model due to highly significantly describing the relation with dependent variable dividend payout.

4.2 Hypothesis Assessment Summary

The hypothesis of research was unique financial factors had significant impact on the non-financial firms' dividend payout decision. These financial characteristics were cash flow taken as free cash flow of firms and profitability taken as earning per share and return on Equity of firms. This research tasted individual financial characteristics and concluded the result as follow.

TABLE 4.4: Hypothesis Assessment Summary

S.No. Hypothesis β SIG. H1 There is significant impact of free cash flow on dividend payout. .001 .005 H2 There is a significant impact of Return on equity on dividend payout. .216 000 H3 There is as significant impact of Earning per Share on dividend payout. -.123 .016





It was concluded with support of results of this research study return on equity, earning per share, and free cash flow were significant independent variables in Pakistani market. These result were matching with the study under taken by Hafeez and Attiya (2009) in Pakistani context, Researchers concluded firms with high profitability and with stable earning can afford larger free cash flow therefore pay out larger dividends to its shareholder. In addition, Talat and Hammad (2010) examined the ownership structure and cash flow as determinants of dividend policy. Researchers concluded that companies in which high proportion of share were occupied by managers and individual were more reluctant of pay high dividends. In contrast, companies in which managerial and individual ownership is low paid less dividends. It was also concluded that companies having high operating cash flow increase companies potential to pay high dividend and it was considered cash flow sensitivity reduce the companies payout but still it was not determined as potential determinants of corporate payout in Pakistan.

5.2 Discussions

Profitability and free cash flow could lay significant impact on dividend payout in Pakistani context. Hafeez and Attiya(2009) was also considered profitability as significant determinant of dividend payout, But study conducted by Talat and Hammad (2010) concluded operating cash flow can not consider significant determinant of dividend payout in Pakistani market. This research considered that free cash flow and profitability measured through earning per share and returns on equity have significant impact on dividend payout of the companies.

5.3 Implication and Recommendations

This research was limited to non-financial companies listed on Karachi Stock Exchange Pakistan. The required data collected from 100 non-financial firms listed at KES for the period of 2005 t0 2009. Only firms were included in samples which were paid cash dividend for atleast two years. It is suggested that such type of study should be carried out in other countries of Asia. Further, it also suggested that other factor except one analyzed in this study should be researched in more extensive manner so the dividend payout policy and its dynamics became clearer.

5.4 Future Research

This research addressed the problems of investor, management and other researcher conductor in analyzing and observing the behavior of firm regarding their investment decisions. Research students who want to work further on dividend payout could be benefited by this study. In addition, all non financial firm will get benefit from this study because this research study taken all major sector into the consideration and study clarified the impact of free cash flow and profitability on dividend payout.
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