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Impact of Dividend Policies on Firm Performance

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Dividends: Steven M. Sheffrin (2003) Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders.

DIVIDEND PAY-OUT RATIO: Van Horne (2002) it is the ratio of amount of dividend/share to earning per share (EPS).

DIVIDEND YIELD: Van Horne (2002) it is the annual dividend divided by the market price of the stock.

Forms of payment

Cash dividends: These are the dividends that are being paid in cash form to the shareholders of the company. This is the most common form of the dividends that are being paid. The cash dividends are being paid to shareholders in case the company has enough money to pay to the shareholders. Thus if one holds 100 shares and board of directors decide to pay a $0.20/ share then the shareholder would have the right to receive a $20 for 100 shares he is holding.

Stock dividends: this is another type of dividend that the corporations pay to the shareholders in the form of additional shares to the shareholders. This kind of dividend is usually paid to the shareholders in case the company doesn't have enough cash to distribute the declared dividends. This is being paid in ratio form that is a 5% of holding shares would be paid as stock dividend. The stock split is being done in this as the stock split does not change the overall capitalization but impact the par value of the firm stocks.

Dividend Dates

Four dates are most important to be remembered for dividends;

Declaration date: It is a date on which the board of directors makes announcements about the intention of paying the dividend. On this date a liability is declared and it is being written on books.

In-dividend date: It is the last day that is one trading day before the ex-dividend date. In other words, existing holders of the stock and anyone who buys it on this day will receive the dividend, whereas any holders selling the stock lose their right to the dividend. After this date the stock becomes ex dividend.

Record date: Shareholders registered in the stockholders of record on or before the date of record will receive the dividend. Shareholders who are not registered as of this date will not receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date.

Payment date is the day when the dividend checks will actually be mailed to the shareholders of a company or credited to brokerage accounts.

The dividend amount is distributed from the after tax earnings of the company and it is decided by the board of directors that when to pay the dividend and how much the company should pay to the shareholders. The dividend payment is decided in making the dividend policy. The “pay out ratio in this regard tells the amount of the dividend that is being paid”. (Van Horne, 2006)

The dividend issue is very important as it remains always in consideration whether the company should pay the dividend or retain it. As Brealey and Myers (2005) suggested, “The dividend is one of the top ten issues in field of advanced corporate finance.”

Dividends play a vital role in deciding whether to invest in certain stock or not. First of all the dividends paid are being compared to the interests paid on financing a company. A share with high dividends is said to be more attractive as it may pays higher returns to the investors. Second, the consistent payment of cash dividends gives investors a way of assessing that companies are cash generative, as it isn't possible to pay dividends over the long term if there's no cash in the bank. The dividend payment also shows that the company is financially strong and can tell about the performance of the company.

Dividends are also important as they can be reinvested by shareholders in the stocks of the company. Next comes the dividends in several countries are not taxed such as South Africa, the investors are paid with dividends on which they do not have to pay the taxes to the government of the country. An increase in the dividend payout is considered to be good news. The firm is demonstrating that it not only has positive cash flows, but these cash flows are increasing enough to justify a higher payout to shareholders. The firm “proves” its cash flow by paying out some of that cash to its shareholders. Higher dividends may signal permanent higher earnings for the firm.

By initiating periodic dividends, managers also reinforce their loyalty to shareholders as there is an expectation that they will continue to pay dividends for the foreseeable future unless circumstances are beyond their control – if the firm is financially constrained or new management changes this policy.

But it is not compulsory that if the company is generating much profits than it should pay the dividends, as the company can retain the whole after tax profits to grow the business or finance the activity of the business to run the company smoothly and free of obstacles. This is done when the company has opportunity to invest and expand but if there is fewer opportunities for companies to invest or to grow the business, then the company that is generating profits may think of to pay the dividends to the stockholders of the company.

“Dividend policy may not alter firm's value unless these factors alter investment opportunities Modigliani and Miller (1958, 1961) Dividend “irrelevance” means that a firm's decision whether or not to pay a cash dividend cannot impact the value of that firm's stock in a world without market frictions. Investors can create their own “dividends” (cash income) by selling shares, so they find no benefit in receiving dividends. Likewise the firm can either pay or retain cash, but if it pays dividends out the firm must sell new shares to make up the cash flow difference. Ultimately, the company's stock price will be based on the stream of profits generated by the firm's existing assets and its new investments, not on how it finances itself (through retention or new share issuance).

“If one company pays dividends and another comparable firm retains its earnings, then the dividend-paying firm must issue new stock equal to the amount of the dividend in order to continue being truly comparable to the retention firm.” (Miller and Modigliani, 1961), they argued that to compare two competitors both must have enough cash to be compared and for that the dividend paying company would have less funds retained than the retaining company, thus this gap is need to be fulfilled through issuance of new shares to be capable of comparing oneself with the retaining company.

“If both firms have equal investment opportunity in each period, the retention firm will grow steadily larger than the dividend-paying firm over time.” (Miller and Modigliani, 1961), this was argued that if the firm that is retaining the profit after tax and the firm who is paying dividends both have equal opportunity to invest the growth and expansion of the retention firm would be more than that of dividend paying firm as the retention firm would have more surplus funds to be invested than that of the dividend paying company. If it is projected to long term the profits of the retention firm would probably increase more than that of the dividend paying firm. Thus this would result in paying better dividends by the retention firm than that of the dividend paying firm after few years.

However Miller and Modigliani have used some assumptions that include, “zero taxes, no transportation cost, easy and cost less access to information, perfect markets, perfect certainty, no transaction cost…” (Miller and Modigliani, 1961), as these are factors that are unable to be achieved in the real world. It is unable to have zero taxes or have transportation for free. These assumptions cannot be attained in the real markets. Next comes the certainty that is impossible to attain perfect certainty as the markets and risks always remain uncertain as in the present world the markets are free and free forces like demand and supply decide about prices and the demand and supply are always have an uncertain behavior. Thus perfect certainty is impossible.

Different analysts have tried to identify the factors influencing the dividend policies and the impact of dividend policies on the performance of the firms, and decisions regarding profit after tax, liquidity and reserve position, changes in equity holding, turnover of shares and size of the firm, etc. Certain financial economists have therefore acknowledged the after tax earnings of any business firm as an important internal source of funds that can be invested and also a basis for dividend payment to shareholders. The decision to retain, reinvest or pay out after tax earnings in form of cash or stock dividend is important for further operations of firms.

The Brealey and Myers (2005) list dividends as one of the top ten important unresolved issues in the field of advance corporate finance. The today's picture regarding the dividend is the same as the Black (1976) says that dividend are the primary puzzle in the economic of finance. Allen and Michaely (2003) conclude in their empirical work that much more empirical and theoretical researches on dynamics and determinants of dividend policy require before consensus can be reached.

The summarize form of the empirical studies done on dividends conclude the following important things. Firstly, when the dividend payout increases it effects positively to the market value of the firm. Secondly, when the dividend decreases then it affects the firm's value. Finally, the third suggest that dividend policy of the firm does not affect the firm value.


Miller and Modigliani (1961) “interpret a change in the dividend rate as a change in management's views of future profit prospects for the firm.” it means that the stock prices are dependent upon the dividends and information content of the dividends. M&M indicate that investors think of change in dividends as a change in intention of management's future profit prospects. Miller and Modigliani (1961) the dividend as primary puzzle mentioned by Black (1976) does not have evidences in perfect capital markets. The pioneering work of Miller and Modigliani (1961) studied about the irrelevancy of the firms' dividend policy in perfect capital markets. The dividend policy does no affect the value of the firm or the current holding of the shareholders.

Harkins and Walsh (1971) reported that majority of firms maintain smooth dividends (even if the company is in loss) to have better view from investors eyes. Furthermore, Baker, Farrelly, and Edelman (1985) studied the strong agreement of managers to maintain dividend record that is not interrupted by any situation. Lau (1987) supported and told that a decrease in dividends is a view for financial suffering.

Some other actions (operational and financial) are often taken with the dividend cuts while the firm is performing poorly as Ofek (1993) reported that firms go for actions like set off the employees and restructure the assets accompanied by the dividend cuts in poor performance era. John et al. (1992) also found firms responding to decrease in earnings by taking operational actions along with decreasing of the dividend. Iqbal and Rehman (2002) noticed that decrease in dividend is directly related to operational actions that's why a firm cannot observe increase in earnings after dividend cut if the firms do not take operational actions along with the dividend cut.

Deilman and Oppenheimer (1984) evidenced from the signaling argument that movement of stock prices takes place when dividend changes and observed an 8.1% decrease in stock price with dividend decrease. Similarly, Healy and Palepu (1988) evidenced a pessimistic stock price reaction to dividend cuts and find a two-day return of -9.5 percent around the announcement of dividend omissions. Healy and Pelepu (1988), Jensen mad Johnson (1995) experienced two years of upward movement in earnings after dividend omitted. Where as Benartzi et al. (1997) found the earnings to increase in one year after omission of dividend.

An unexpected increase in dividend would affect the equity price to react positively to the increase in dividend and vice versa for decrease in dividend. As Lintner (1956) the firm will only increase dividends if the firms have sufficient cash flows to maintain the dividend in future. The unexpected increase in dividend must signify increase in the share prices of the firm as Aharony and Swary (1980) evidenced in their studies. Charest (1978) see the returns on stock are negative when the firms decrease the dividend and positive as the dividend is increased. Aharony and Swary (1980); and Charest (1978) are also consistent with the view that managers send positive information by changing the payout policy.

Gonedes (1978) reported that unexpected dividends have little announcement effect because of little information to the market. Watts (1973) studied dividend-earnings relationship through using annual data. He observed a weak direct relation between dividend changes and future earnings. On the basis of that he told that the information effect of dividends can be only little. But Brickley (1983); and Kalay and Lowenstein (1985) have opposite view and told that unexpected dividends have significant announcement effects. Whereas Born, Moser, and Officer (1987-1988) study the prolonged performance with dividend policy changes and evidenced conflicting results i.e. as some firms' performance is consistent with the change, while other firms do not improve performance with change in dividends.

Lintner (1956) in his study of determinants of dividend policy proposed the change in dividend policy due to change in the earnings of a firm, and told in his study that firms maintain a steady stream of dividends in early stages, thus they try to make changes periodically but not at once. The smoothness of dividends is maintained through this. Lintner (1956) also argue that a dividend cut signifies a permanent drop in earnings.

The Lintner and M&M studies are very important as they focus on what dividends contribute to the future and to the investor. Some think of it as a signaling model for future. Some says that what is being motivated by changing the dividends. Most of the researchers try to identify the announcement effect of the dividends.

Bhattacharya (1979) was the first who develop a model in which he told that both the current and expected future earnings change due to change in the signaling information of dividends change. John and Williams (1985), and Miller and Rock (1985) supported the Bhattacharya view as told above.

The dividend signaling theory tells that there is an asymmetry of information about the future operational earnings of the firms - i.e. managers have more information about the firm's future prospects than outsiders do. Thus the change in the dividend eases this asymmetry among managers and outsiders.

DeAngelo and DeAngelo (1990) studied the relationship between earnings and dividends. They have taken NYSE firms that are making losses for three or more years, and reach the evidence that long term problems in earnings play a vital role in cutting the dividends. Furthermore, DeAngelo, DeAngelo, and skinner (1992) evidenced from NYSE that firms with loss have greater reduction in dividends (i.e. 50.9%) than non loss firms (i.e. 1%).

The empirical findings from the studies referenced above are consistent with the signaling theory of dividends. In particular, dividends are generally smoothed and lag earnings because managers understand the negative signal sent by a dividend reduction and, hence, are reluctant to increase their dividend because it increases the possibility that the dividend will need to be reduced in the future. Unexpected changes in dividends produce significant announcement effects because investors understand the reluctance of managers to change the dividend and, thus, interpret a change in dividends as an information event.

Recent findings reported by DeAngelo, DeAngelo, and Skinner (1992) and Healy and Palepu (1988) create uncertainty concerning the information a dividend reduction conveys to the market. Specifically, these two studies find evidence that, on average, firm earnings increase following a dividend reduction. As noted by Healy and Palepu, it is puzzling that firms omit a dividend prior to a rebound in earnings, especially given the negative market reaction that accompanies a dividend drop.

Significance of the Study

The significance of this study is widely studied in the present world. Some of the analysts ignore the dividend as relevant to the performance of the firms in which the Miller and Modigliani stood at the top. They oppose the dividend to be of high importance and they think that the firm value is determined by the earning power of the firm or the investment policy but some other analysts keep dividend as a key point for the performance of the firms. Investors also have different views of the dividend policy. Some investors suggest the firms to grow through the earnings of the company but some says that dividend must be paid to the investors and the growth program should be kept as a slow and steady process. McConnel and Servaes (1995) suggest that the impact of firm dividend policy, debt policy on firm value should be analyzed under the presence and absence of growth opportunities.

Bhattacharya (1979) think of the dividend as a signaling agent in the field of corporate finance that's why this study again gain scope in the world as it signals information and remove the information asymmetry among mangers and outsiders. Black (1976) identifies dividend as puzzle that is not defined till today.

As for as this study concerns, it have a great impact on the performance of the firms in Pakistan. In Pakistan the policies regarding dividends are very important and too little data is available that includes the dividend data and investors almost try to evaluate the firms on the basis of the dividends as other information is too low in Pakistan. The dividend policies have a great impact on the growth of the firm and growth of earnings of a company. These views have widens the scope of the dividend policy impact on the firms performance and the survival of the firms. Secondly the dividend policies play a pivotal role in determining the wealth of the shareholders. The dividend policies have also a great impact on the shares prices in the stock market. The ups and downs in these prices are all impacted by the announcement of the dividend policies.

Research Objectives

The objectives of this research are;

  • This study would give an insight into the dividend policies that how they have impact on firm performance performance,
  • This research would tells the intentions of the mangers about what future prospects for earnings they need to focus and by increasing dividends or decreasing dividends what message did the managers want to convey to the market,
  • This research would also tell why mangers feel reluctant to increase the dividends,
  • To know that why it is necessary to make dividend policies and why dividend policies are studied while evaluating the performance of firms,
  • It focuses on what signals does the dividend send to the investors and share prices.

Research Methodology

The purpose of this research is to contribute towards a very important aspect of financial management known as dividend policy and its impact on the performance of firms with reference to Pakistan. Here the researcher will see the relationship between dividend policy and its impact on firm's performance of Pakistani companies listed on Karachi stock Exchange, and data of the companies would be taken from publications Issued by State Bank of Pakistan “Balance Sheet Analysis This section of the article discusses the firms and variables included in the study, the distribution patterns of data and applied quantities techniques in investigating the relationship between dividend policy and firm performance.

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