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Variations in Corporate Dividend Policy

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Variations in Corporate Dividend Policy in Pakistan

This research examines different factors that determine cross sectional variations in corporate dividend policy such as profitability, growth opportunities and riskiness. Another aim of this is to check the significant relationship between losses and dividend cuts. Manages cater to investors by paying them dividends when investors put a stock price premium on payers. To test this prediction, I used companies that are listed on Karachi Stock Exchange (Pakistan) and test there are three stock price based measures of investor demand for dividend payers to check if catering theory of dividend exits in Pakistan.


They are many reasons for the existence of dividend payments, but Miller and Modigliani (1961) prove that dividend policy is irrelevant to share value in the perfect and efficient capital markets. Which means there was no preference between the dividend payment or the capital gains. Arbitrage ensures that dividend policy is irrelevant. But in reality this doesn't happens. Firms cater investor needs to fully increase the share price, ownership and become a high profitable firm. Management make dividend policy with the consent of their investors. The determinant of dividend policy helps to predict the future growth and the stability of the firm; it also caters to the best interest of the investors.

The aim of this paper is to find the determinant of dividend policies in Pakistan, and check whether these determinants have some impact of significance in the share value. And also check whether these determinants are same as in other under developed countries. the corporate sector of Pakistan is going to a bad phase these days due to the terrorism and internal imbalance political situations , so I want to check if Pakistani companies still giving the dividends to their investors and if not then what is the main reason for this and how will they cater new investors.

And how this will affect the share price of that company in the stock market. All the regulations have been signal out concerning dividend payments, in effort to compare the results with those from previous research. Although there is no such research has been conducted in Pakistan, all the research related to dividend policy is done in India and other developing country unlike Pakistan.

But this study will play an important role in determining the factors which influence the dividend policies of the country and the impact of these policies on the share value of the firm. Institutions have preference for dividend paying companies but there is little evidence that they prefer higher payout ratios or dividend yield.

Lintner's model (1956) of partial adjustment works reasonably well for the large number of companies. Mostly there is a negative relationship between the growth and the dividend payout and leverage and the payout. So this will also be tested in this paper. Companies having a higher growth opportunity are less likely to have free cash flow; if they don't have a free cash flow then they are unable to give dividends which give a bad signal to the market. Mostly managers are reluctant to cut dividends and that they will not increase dividend unless they are reasonably sure that they will not have to reverse this move soon. Basically managers want to carter the needs of the investors in their best interest so they hesitate to cut their dividend because this will discourage the investor. The cutting of dividend is a bad move as this gives negative signal to the market about the firm and also tells that the firm is full of risks. There is no proper cash flow coming into the firm so the person who has invested in the firm has greater risk of losing their money.

So this also a very important determinant of dividend policy making. Managers hesitate to reduce the dividend because they want to play safe to not to repeat this move again. As dividend increases signal a reduction in risk because this shows that the managers are confident enough about the stability of future earnings. This also includes the agency theory which tells that dividends can be used as a means to control firm's management.

Distributing dividends reduces the free cash flow problem and increase the management's equity stake. Another agency problem that affects the dividend policy is between shareholders and debt holders. The risk that shareholders will expropriate debt holders by paying themselves excessive dividends has led to the often encountered covenants restricting dividend policy in bond contracts. So this is another determinant of dividend policy which helps to cut down the dividend.

Catering theory also plays an important role in determining the dividend policy. Baker and Wurgler proposed the decision to pay dividends is driven by prevailing investor demand for dividend payers. Some investors have an uninformed and perhaps time varying demand for dividend paying stocks. Arbitrage fails to prevent this demand from driving apart the prices of payers and non payers.

Managers rationally cater to investor demand, they pay dividends when investors put higher prices on payers and do not pay when investor prefer nonpayer. The propensity to pay dividends depends on a dividend premium in stock prices. This is will be tested using the time varying variables or proxies for dividend premium.

Testing catering theory using Pakistani data is an objective of this research. This kind of study has not been done in Pakistan before, the determinant of dividends of corporate companies establish their policies according to these. The catering theory plays an important role in this. I will test the BW(2004) model of catering theory on Pakistani companies related to oil and gas, beverages, pharmaceuticals, fertilizer, financial, textile and FMGC etc sectors. All the companies register on Karachi Stock Exchange who pays dividend for that specific year is taken as the sample. The catering theory of dividends suggests that real financial markets are imperfect and inefficient, and corporations decide their dividend initiation and continuation decisions by catering to investor's demands for dividends.


A test of the catering theory of dividends of Japanese electric appliances industry was done by Chikashi Tsuji (2010) all the sample they took was Japanese firms, they studied the affect of catering theory on the valuation of stock price. They replicate the methodology used by Baker and Wurgler to test whether the results holds true in Japan as they indicated. They concluded that corporate managers do not consider catering behaviour in either their dividend initiation decision or their continuation decision. These results were different from existing evidence for U.S market. They took dividend initiation as value weighted dividend yield where as Baker and Wurgler used equally weighted. So they conclude that value weighted dividend yield declines, when Japanese firms tend to initiate dividend payments.

Catering theory of nominal share prices by Malcom Baker, Robin Greenwood and Jeffrey Wurgler (2009) suggests that typically the supply of different stocks cater to different incentives of investors.

Manager increase the low priced securities supply that investors are willing to pay premium for it. So this existing literature is dealing with stock splits which eventually decrease the value f the stock price but this increased the supply which leads to high valuation for the firms rather than high priced and large firms.

Many board of director chooses to split their shares to manage the nominal value and increase the number of outstanding shares but this doesn't help them to change the overall market value of the firm. This only done to cater the needs of investors and initiate their paying power of premium for even through that their fundamental values don't increase. Manager increase the supply of low priced shares for which the investors are paying premium for them. So the splits increases and help them to increase the valuation of the firm as the low priced firm are more attractive to investors then high priced firms.

Catering theory also affects the post split prices for the large capitalization firms rather than small firms, according to the author that is also telling the reason that why firms initiate to go for the share splits. Price management appears to over valuate the low priced firms so the more often firms go for splitting shares they often end up with low returns.

According to Jain, Shekhar and Torbey (2009) study, they evaluated the economics of the choice of form of payout initiation mechanism adopted by IPO firms. Their results suggest that IPO firms demonstrate preference for repurchases over dividends as the specific form of payout initiation mechanism. They compared the results of pre IPO and post IPO announcements, and found out that the market views post IPO payout initiation favourably then pre IPO. But the market was in different to the specific form of payout initiations adopted.

The model they introduced in this study was the test the dividends and repurchases represent distinct payout mechanism adopted by IPO firms with fundamentally different characteristics and motivation to initiate payouts during post IPO phase. The conclusion they drawn was that the dividend initiation are primarily driven by life cycle and catering theory considerations. So the signalling theory provides accurate explanation for the payout initiations through share repurchases.

The study for the international presence of dividend catering across a sample of twenty three countries was done by Ferris, Jayaraman and Sabherwal (2009) these firms incorporated in common law not the civil law nations. They conclude that when legal regime and its accompanying set of investor protections permit, investors force dividends from managers but they also attempt to extract such payouts indirectly by placing a high value on dividend paying firms. The variables they took were size, premium, operating income and book to market. This will give a the determinants of dividend will leads to the increase in stock price.

In 2008, Polk and Sapienza came up with the corporate investment decisions which will eventually leads to discover the impact on stock market. Catering theory plays a major role in this, as mispricing might influence individuals firm's decisions. For this purpose they used discretionary accruals as the proxy for mispricing. They conclude that there was a positive relationship between abnormal investment and discretionary accruals. The firms who have high R&D or share turnover are more sensitive to discretionary accruals. And whereas the firms with high abnormal investment have low stock returns.

In the theoretical model tested by Aghion and Stein (2008) explained the revenue catering theory. They proposed that investors have time varying demand for revenue growth and manager will cater to this demand by offering higher revenue on which investors are putting premium on the revenue. They took the sample from high tech and health sectors. Firms in these sectors are more likely to meet analyst forecasts of revenue when previous year's revenue premium is high.

Catering theory of dividends also involve a big cost, these cost involves cost of premium tax , cost of risk and opportunity cost, all these costs were studied by Cohen and Yagil (2008). The main issue addressed by their model was the negative relationship between the expected dividend per share and the ratio of information about the cost of the dividend held by “category” investors and “arbitrageurs”. The cost of dividend has been shown in to three types: premium tax, risk and investments. So in this article the author conclude that there is a linkage between investment, financing and dividend polices decisions, and this is mainly affected by the catering theory which was proposed by Baker and Wurgler.

The risk premium consists of two components, first is the increase in financial leverage resulting from dividend payment and the second is the semi contractual obligation of dividend paying firm to maintain the dividend payment. So the model predicts that there is negative relationship between these three premiums and expected dividend per share. This also predicts that if the firm is operating in financially risky environment prior to dividend payment, then it will be negatively related to financial leverage. Researchers came up with this conclusion that the dividend sum depends on its short term and long term impact on the stock price and also depends on the financial leverage and investment opportunities.

A study on dividend policy and the behaviour of investors, Sabur Mollah and Asma Mobarek (2007) came up with the satisfactory explanation of the firms who is catering investors sentiments on this. They suggested that mostly dividend decision is governed by those managers who have somewhat their personal interest involved in. The findings also suggests that the investors are willing to invest in those firms who has enough cash flow to pay out the dividends, as cash flow is a better measure of the company's capacity to pay out dividends and profitability.

Dividend policy, risk and catering have a positive relationship; this was found out by Hoberg and Prabhala (2006). They reported that risk is significant determinant of propensity to pay dividends and explains up to 40% of the disappearing dividends puzzle. The second thing they found out was that the catering in insignificant once there is an account for risk.

Share holder rights also play an important role in dividend policy. This was studied by Jiraporn and Ning (2006) agency costs as a determinant of dividend policy. They determined that how dividends are related to the strength of share holder rights so they found out that firms which plays higher dividends their share holder rights are more suppressed. So they studied the impact of share holder rights on dividend policy of a firm. As a result, dividend acts as a substitute for share holder rights. So the evidence is there that the regulations influence the relationship between dividends and the share holder's rights.

Another aspect of catering theory by Richard and Zhang (2005) is given by comparing the share repurchase with giving out dividends and what is the impact of mangers and investors in this.

They discussed that market immediately react to the dividend announcements rather than repurchase, but manger's decision is based on his time horizon and his own incentives attached to it. Investor does positively react to dividend news but mostly managers discourage this due to the signalling hypothesis. They consider that it will incorporate the firm's news immediately into the market. So when making decision of dividends the firm caters to investor demands. So according to these researchers they cater

to investor demands by paying dividends and repurchasing shares. Also they found that firm free cash flow is reinvested in new NPV projects impact on the investors and the valuation or their share prices. So they concluded that catering through dividend and repurchases is inefficient though it has strong reaction from the market but the managers are more willing to invest in positive NPV projects.

Determinant of dividend policy have a great impact on stock price of the firm. This eventually affects the value of the firm. Mostly investors invest in those firms who have a regular pattern of giving dividends. Bogdan Stacescu (2004) examined dividend policy for a sample of Swiss companies. They came up with determinants which affect the dividend policy, such as profitability, growth opportunities and riskiness. Past and present income growth is more relevant then the future growth of dividend changes. Price volatility seems the most significant factor in these changes. They also determined the relationship between losses and the decrease in dividends, when the firms don't give dividends they occur losses as in investors are reluctant to invest in those firms whose cash flow is not certain. So managers hesitate to cut out the dividends as it gives negative informational signal to the Swiss market and to dividend changes.

According to Malcom Baker and Jeffrey Wurgler (2004) came up with the explanation of dividend payment. They proposed that dividend payment is done on the basis of investor's demand. Mostly managers cater to investors by giving them incentives such as dividend premium. By putting a premium non payer is initiated when the demand is high, there is expectation of future earnings, whereas when there is no premium that implies that more investment is done and is discouraging for the investors as psychological point of view. They constructed four stock price based measure for the investor demand, the broadest one was

about to check average between market-to-book ratio, second one was checking the difference between the cash dividend and stock dividend share classes, third one was related to dividend initiations this will affect the stock price of company, and lastly future stock returns of payer and non payers.

Some investors have time varying demands for dividend payments and if it's not fulfilled then essentially it effects the value of the stock prices. So dividend initiations and omissions is connected with the value of share prices. According to this article, when managers pay a dividend premium only then investors are ready to invest and for that reason they studied what sentiments of investors are attached with this time varying dividends premium and what is the most they are interested in. So they came up with the explanation that when dividend premium is high, investors are seeking firms that depicts safety, security in the long run and excess of cash, whereas firm with no dividends means increase in capital and future earnings expectations. So sentiments have a strong correlation between dividend premiums and investors expectations. The relationship between initiations and omissions of dividend premium is apparent to clientele demands. So by concluding these author came up with the result that managers only cater those investor by paying dividends when the investors is willing to put a stock price premium on payers not by when they actually doesn't want it. This is due to the initiation of the high and low demand of dividends.

Baker and Wurgler (2003) came up with the appearing and disappearing dividends and they linked this with catering incentives. They used the methodology of Fama and French (2001) to identify a total of four distinct trend in the propensity to pay dividend between the period 1963 and 2000.

The propensity to pay dividends increases when a proxy for the stock market dividend premium is positive and decreases when it is negative. They conclude that dividend tends to disappear during pronounced booms in growth stocks and reappears after crashes in such stocks.


The methodology used for testing different determinants of dividend which has an impact on the profitability, growth and riskiness on Pakistani firms listed on Karachi Stock Exchange for the year 2010. The test will also be constructed to find the relationship between share price reactions to the announcement of divined changes. Another methodology will be used to check the catering theory of dividend and its impact on the investors demand for the certain premium stock on payers. This will follow Baker and Wurgler model (2004), so the existing theory of BW (2004) is used to check whether catering theory exists in Pakistani companies or not. No one has ever done this kind of research in Pakistan before, so this will help in understanding the behaviour of investors towards the premium stocks and will also help us to identify which determinants have more predictive power to explain the changes in dividend policies. So there is theoretical contribution in this research as the theory developed is unique, the sample which is to tested is also recent observations so it will give the clear view about today's market.

3.1 Economic model:

For testing the major determinants of dividend policy in Pakistan which affects investor's perception about the firm's value and the affect of the catering theory on this will be done by using the economic model Ordinary Least Squares (OLS). As the data is cross sectional so it will be useful to test through OLS model. The coefficient will be also of OLS.

3.2 Variables:

The variables used to test the factors that influence the payout ratio and the dividend yield were ROA, Capital gearing ratios, Price volatility, TA, voting rights and market-to-book ratios. All these values can be taken from the annual report.

A firm-year observation is called as a payer if it has positive dividend per share by the ex date, else it is a non payer. The variables taken are :

Payersáµ¼ = New Payersáµ¼ + Old Payersáµ¼ + List Payersáµ¼

Old Payersáµ¼ = Payersáµ¼-1 - New Non payersáµ¼ - Delist Payersáµ¼

The first identity defines the number of payers and second describes the evolution. Payers is the total number of payers. New payers is the number of initiators among last year's non payers, Old payers is the number of payers that also paid last year, List Payers is the number of payers this year that were not in the sample last year, New payers is the number of omitters among last year's payers and Delist Payers is the number of last year's payers not in the sample this year.

Note that Lists and Delists refer to companies added to and removed from the Karachi Stock Exchange first section. But this will include the data for the previous years too, so this will be difficult eventually to find list payers as the data we will cross sectional. Note that the new lists include the IPOs firms.

Below are the three variables defined to capture dividend payment dynamics as in BW (2004) :

Initiateáµ¼ =

Continueáµ¼ =

List Payáµ¼ =

In words, the rate of initiation (Initiate) is the fraction of surviving non payers that become new payers. The rate at which firms continue paying is the fraction of surviving payers that continue paying. It can also be taken as one minus the rate at which firms omit dividend. The rate at which new lists in the sample pay List pay is the payers as percentage of new list at time t. These variables capture the decision whether to pay dividends, not how much to pay.

The investors categorize shares based on whether they pay dividends as it could be taken as “safety”. Another reason for this is the payout ratio is sensitive to profitability and dividend yield is sensitive to changes in share prices. The decision to initiate or omit is always a policy decision.

3.3 Hypothesis:

The hypothesis to be tested states that there is no difference in the dividend premium determinants which can cause the dividend policies to change. And the second hypothesis states that there is no impact of catering theory of dividends that exists in Pakistan. To test the propensity to pay dividends depends on dividend premium in stock prices, use time variation in three proxies.

The first is the stock market dividend premium variable, which is the difference between log average market-to-book ratio of dividend payers and non payers. The market-to-book ratio is book assets minus book equity plus market equity, all divided by book assets. This could be taken as equal and value weighted averages of market-to-book ratios separately for payers and non payers in each year.

The second measure of the relative stock market valuation of dividend payers is the difference between the future value-weighted returns of payers and non payers. According to BW (2004) model, managers rationally initiate dividends to exploits an apparent market mispricing. The high rate of initiations should forecast low returns on payers relative to non payers as the relative overpricing of payers reverses. Market valuation of dividend premium and the future returns is the difference between future returns on value weighted index returns of payers and non payers.

The third measure is the difference in the prices of Citizen Utilities (CU) cash dividend and stock dividend share classes. This can be calculated as the difference in the log price of the cash payout share and the log price of the stock payout share. CU dividend premium doesn't reflect anything about investment opportunities. This an advantage over the broader dividend premium variable. And if we talk about the disadvantage of CU dividend premium it is only one, which is stock payout share is more liquid than cash payout class.

3.4 Regression:

To examine this relation between dividend premium and the rate of dividend initiation (continuation) formally, the estimates are as follows:

Initiateáµ¼ = a + + +

Continueáµ¼ = a + + +

whereas the dividend premium and Citizen Utilities dividend premium is denoted by this .


Sample criterion

This proposal includes the data of Pakistani companies which are listed on Karachi Stock Exchange (KSE). The companies which had paid the dividends in 2009-2010 year are included in the sample. The main data will be collected by the annual reports. Every company has reported dividend paid to the shareholders in their annual reports so this is easy to gather information through this. Foreign companies and the financial companies listed on KSE are also included as the sample criterion.

Pakistani firms pays dividend once a year unlike the American companies who pays quarterly. So the Ex dividend days are usually in June and July. So the analysis of this research is based on yearly observations.

The sample collected includes all the firms in the fertilizer industry, transportation industry, textile industry, financial institutions, FMGC, oil and gas industry and pharmaceutical sector which are listed on KSE and pays dividend for the year 2010. The following data which is being collected through KSE from the annual reports are : Total assets, stock Price and share outstanding at the end of fiscal year, income before extra ordinary items, interest expense, cash dividend per share ex date. The firms with book equity below Rs. 250,000 or assets below Rs. 500,000 are excluded.

To calculate the impact of firm characteristics and dividend yield and the payout ratio we need the data of market –to-book ratio, return on equity, return on assets, sales, capital gearing ratio and the previous dividend yield and the payout ratio is also needed. This will tell what factor causes the change in dividend policy and which has more significance on these that will affect the value of the firm. Approximately all the firms who have given the dividend in the year 2009-2010 are included in the sample.

Econometric Limitations

There are some limitations and assumptions related to our research.

Only those firms are included in the sample who has paid dividend in year 2009-2010

The population is assumed to be normal.

All samples are Pakistani companies which are listed on only Karachi Stock Exchange.

The sample is taken for the one year so the delist companies is not included

The sample is random and is a true representative of the population.

The firm which has assets below Rs. 500,000 is not included in the sample.

The sum of the OLS residual is zero, while the sample average is also zero.

The sample covariance between the independent variable and the error term is zero.

Other variables were not included due to the non-availability of data.


The contribution of this research has realistic impact on the corporate dividend policies of Pakistan. This research will eventually help to determine the main determinants of dividend policy and the impact of that on stock prices. Catering theory of dividends is also another important determinant which influences the policies made for the dividends. This will tell how managers cater to their investors interest and how can they charge a premium for their stock prices. This has not been tested in Pakistani firm's data yet, so this is also another contribution that this theory is been tested. The time period is also latest so that will also give a recent view about the today's market and today's investor's interests. All the firms that are listed in KSE index and who gives dividend for the specific year are included, and the reasoning of those firms which are not giving dividend that year will also be tested. There will be the comparison between the different corporate sectors of Pakistan who pays dividend and due to this, what is the impact on their share price will also be tested. For example fertilizer sector vs. car industry, how managers cater their investor's interest in both. And how can this influences the decision of dividend policies that to be made of that specific industry.

Although there is no such research has been conducted in Pakistan, all the research related to dividend policy is done in India and other developing country unlike Pakistan. So this will give new horizon in this field of corporate finance. The basic model presented by Baker and Wurgler (2004) of catering theory of dividends will be tested on Pakistani companies (which are listed on KSE).

Baker and Wurgler proposed the decision to pay dividends is driven by prevailing investor demand for dividend payers. Some investors have an uninformed and perhaps time varying demand for dividend paying stocks. . Managers rationally cater to investor demand, they pay dividends when investors put higher prices on payers and do not pay when investor prefer nonpayer. This will be tested that the propensity to pay dividends of corporate sector of Pakistan depends on a dividend premium in stock prices.

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