CHAPTER 1:

The purpose of this paper is to study the impact of dividend policy on shareholders wealth. Dividend policy is at the core of the theory of corporate finance. It is one of the most debated topics in the finance literature and still maintains its prominent position. Many researchers have devised theories and provided empirical evidence regarding the determinants of a firm’s dividend policy. The dividend policy issue, however, remains unresolved. Clear guidelines for an ‘optimal payout policy’ have not yet emerged despite the huge literature. We still do not have an acceptable explanation for the observed dividend behavior of companies. We are yet to understand completely the factors that drive dividend decisions and the manner in which these factors interact. Dividends are payments made by a company to a shareholder usually after a company earns a profit, Dividends are either paid regularly or can be called out anytime, dividend policy is a set of company rules and guidelines used to decide how much the company will pay out to its shareholder. Some companies believe that a no-dividend policy is just as sound as companies with a dividend policy. Companies without a dividend policy can use their profit earnings to reinvest and expand the company shares or buy assets. Having a dividend policy foregoes these opportunities. A cyclical policy or stable policy is a regular dividend payout usually given every quarter. A cyclical dividend policy is set at a fixed fraction of quarterly earnings while a stable policy is set as a fraction of yearly earnings. This produces certainty for investors that they get regular income for their investments.

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 develops 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 because the Government have given the extension till 2010 so before the 2010 no capital gain tax will be collected 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 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.

Fifthly, in the Pakistan several capital market reforms has been implemented by the Securities

Exchange Commission of Pakistan to ensure the market mechanism based economy. From the early 1990’s the Pakistan’s capital market faced many critical issues including among other, weak and outdated regulatory framework, an inefficient, non transparent and stagnant stock market, a poorly Regulated and publicly owned mutual fund industry and a nascent insurance industry that contributed little to capital market development. The impact of the regulations of Securities Commission of Pakistan is over the last few years, there is tremendous increase in market capitalization with a soaring stock market index. The Karachi Stock Exchange (KSE) share index that stood at 1507 points at the end of the year 2000 has crossed the level of 12,274 points on April 17, 2006 registering a growth of 64.7% over June 2005.

1.2 Problem Statement

The problem paper shows a relationship between impacts of dividend policy on shareholders wealth. By this study we want to find out the impact of different policies on the shareholders wealth. Despite the huge literature there is a still confusion that either dividend policy directly impact on shareholders wealth or some other factors.

1.3 Hypotheses

1.4 Outline of the Study

1.5 Definitions

Rate of return

Rate of return is the combination of dividend yield and the capital gain. Shareholders receive the return at the end of the year or when they sales their shares. Shareholders receive the return in terms of dividend and capital gain.

Dividend Yield

Dividend yield is the percentage that companies paid to shareholders from their earnings in terms of dividend.

Capital Gain

Capital gain is the difference between the opening price of share and the closing price of share.

Earning per share

Earning per share is the earning per share of a companies stock. It can be calculate as the net income divided by shares.

Dividend payout ratio

Companies pay some portion from their earning per share to the shareholders to retain the good relations with their shareholders.

Retention ratio

Retention ratio is the ratio which companies retain their some of the portion from the earning. Companies retain their some portion from earnings for the future investments, future uncertainties etc.

CHAPTER 2: LITERATURE REVIEW

Many recent empirical studies have demonstrated that a significantly positive relationship exists between the direction of dividend changes and announcement day common stock returns.

Dividend increase (decrease) will result in an increase (decrease) in leverage; a leverage change can cause wealth transfers among security holders in the absence of enough me first rules as well as signal information to investors in markets with less than perfect information. On announcement day, Dann found significantly positive returns for common stock and insignificant returns for nonconvertible preferred stock and debt. Woolridge are consistent with both a signaling and a wealth transfer hypothesis for dividend change announcements. The dividend change common stock price relationship was corroborated and it was demonstrated that unexpected dividend increases (decreases) are associated with positive (negative) debt and preferred stock returns. Dividend changes are positively associated with stock returns in the days surrounding the dividend change announcement (Aharony and Swary, 1980). Miller and Modigliani (1961), dividend changes trigger stock returns because they convey new information about the firm’s future profitability. However, recent studies have not supported this hypothesized relation between dividend changes and future earnings (Skinner, 1996).

Handjinicolaou and Kalay (1984) analyze bond returns around dividend changes, and report that bond prices are not affected by dividend increases but react negatively to dividend reductions”. Dividend increases (decreases) indicate that current-year earnings will be higher (lower) than the previous year’s earnings. For subsequent years, however, BMT find no significant relation between dividend changes and earnings changes. Jayaraman and Shastri (1988) find insignificantly negative bond price reactions to special dividend announcements. The large dividend decrease sample confirms wealth transfer, with stock price declines accompanied by positive bond excess returns. Positive reaction to large dividend increases in the stock market and a negative price reaction in the bond market, which is consistent with the wealth redistribution hypothesis. Miller and Modigliani (1961) study shows that the there is no any impact on the shareholders wealth when the announcement made. Their study shows that this result may survive even if there is differential taxation of dividends and capital gains; dividend income suggests a negative wealth impact because dividend is taxed at a higher rate.

Brennan (1970) suggests that if risk is held constant then the before tax returns are increasing the dividend yield. Dividend changes are positively correlated with current ROE, the expected change in earnings is likely to be negatively correlated with the dividend change. A lack of correlation between earnings changes and dividend changes would actually indicate that dividend changes are informative about future earnings. The information content of dividends hypothesis, management increases dividends when it receives information that indicates that future earnings will be higher than previously anticipated. It may not have the same level of confidence about the timing of those earnings increases.

Dividend changes trigger stock returns because they convey new information about the firm’s future profitability, which in turn determines equity price. Future earnings are affected by value creating activities, but they are also affected by actions that are not directly relevant for current price, such as future retained earnings, stock issues and stock repurchases. Dividend increases are positively related to profits in each of the four subsequent years, but dividend decreases are not related to future profits. We found out that after controlling for the expected change in future earnings, dividend changes are positively related to earnings changes in each of the two years following the dividend change. Fama (1981) rational market responses to an increase (decrease) in expected future output are increases (decreases) in both stock prices and in the demand for real money. The negative relationship between stock returns and inflation is observed because stock prices and the price level react oppositely to changes in expected future output. Hess (1981) suggests that the negative wealth impact may result from other costs associated with paying dividends. But many researchers had suggested that the there is positive impact on the shareholders wealth. Dividend may provide the helpful information to the management, by dividend the management can know the performance of the company and can predict about the future.

Charest (1978) found that the announcement of a dividend increase generates an excess return of about 1%. The study suggests that the initiating cash dividend is associated with a significant positive excess return. Factors that increase shareholders’ wealth include the present values of (1) establishing a system for communicating managerial information (2) reducing institutional constraints on investors and (3) benefits associated with the traditionalist. Gordon (1959) finds that the investors prefer the returns in the form of cash dividends. Factors which decrease shareholders’ wealth include the present values of (1) the additional tax burden associated with receiving dividends now and in the future and the adjustment costs incurred by tax induced changes in clienteles and (2) any other costs (e.g. administrative costs, transaction costs associated with issuing new equity) incurred in paying dividends now and in the future. The study suggest that the almost 70% of the firms examined there is a positive market reaction to the announcement of initial dividend.

The returns on the option around the ex dividend day are compared to those on a randomly selected day. It should be noted that we make no assumption regarding the process generating returns on the underlying stock or the call option written on it, other than the stationarity of the latter process. The median excess return on the ex dividend day is not different from that on a randomly selected day. Options which should have been exercised on the last dividend day exhibit significantly negative excess returns if held during the ex dividend interval of time. The traditional interpretation of Fisher (1930) is that nominal returns adjust one for one with expected inflation. Dividends and capital gains are related differently to inflation. Proxy effect reflects not just a negative correlation between expected output and inflation, but a positive relationship between inflation and excess returns. Positive shocks to the economy are associated with increases in expected cash flows, increases in price/dividend ratios, and decreases in required (excess) returns. (Boudoukh et al) inflation output relationship at the industry level cannot account for the entire cross sectional differences in the relationships between industry stock returns and inflation. Price/dividend ratios are that the two components of a stock’s return are likely to be related differently to expected inflation. This difference can be used to isolate the co variation between expected price/dividend ratios and expected inflation and to estimate its influence on the observed relationship between stock returns and inflation. Dividends and capital gains relate differently to inflation in foreign markets as well. The cause of the differing relationships is a negative relationship between real price/dividend ratios and expected inflation, which supports the conclusion that the proxy effect reflects not just a negative correlation between expected output and inflation, but a positive relationship between inflation and excess returns.

Black and Scholes (1974) states that if investors required higher returns for holding higher yield stocks, corporations would adjust their dividend policy to restrict the quantity of dividends paid, lower their cost of capital, and increase their share price. Similarly, if investors required a lower return on high-yield stocks, value maximizing firms would increase their dividend payouts to increase their share price. Black and Scholes (1974) find no statistically reliable link between a portfolio’s monthly stock return and its long-run dividend yield.

Blume (1980) and Keim (1985) relation between risk adjusted returns and yields, with zero yield stocks realizing larger returns than dividend paying stocks and higher yield stocks realizing larger risk adjusted returns than lower yield stocks. Christie finds that zero yield stocks earn significantly lower returns than dividend paying stocks. Chen et al. (1990) show that tests relating returns to dividend yields are sensitive to the method of risk return adjustment. Gordon (1959, 1962) and Lintner (1962) claim that dividend policy does affect the firm’s cost of capital, and they provide some early evidence to support the view that a higher dividend payout reduces the cost of capital (i.e. investors prefer dividends). Others argue that personal and corporate taxes cause dividend policy to affect the firm’s cost of capital, but in the direction that a higher payout raises the cost of capital (i.e. investors prefer capital gains).

The tax effect hypothesis proposed by Brennan (1970) predicts that investors receive higher before tax, risk adjusted returns on stocks with higher anticipated dividend yields to compensate for the historically higher taxation of dividend income relative to capital gain income. Initial dividend announcement results in positive excess returns even when there is no other information released simultaneously. These results suggest that the market’s positive reaction to the dividend announcement is not due to other events. If dividend increases are expected and received as good news, the announcement day excess return reported by earlier studies under states the market reaction to an increase in dividends. The regression results support the hypothesis that part of the larger excess return associated with initial dividends is due to the larger increase in the dividend yield. Dividend policy does matter, probably as an information source, and that the market reaction is strong and positive. Campbell (1991) found that stock returns appear predictable over long horizons. Stock price reactions to changes in dividends (where changes are used to proxy unexpected dividends) and the direction and magnitude of the abnormal returns are positively related to the sign and degree of the dividend surprise (Pettit 1972).

A large majority of studies have documented statistically significant stock price reactions to changes in dividends (where changes are used to proxy unexpected dividends) and the direction and magnitude of the abnormal returns are positively related to the sign and degree of the dividend surprise (Pettit, 1972). The magnitude of the information transfer is related to the magnitude of the dividend change, the correlation of stock returns between the announcer and non announcer, and the immediately prior dividend change history of the other company. Carroll (1995) provides evidence that dividend changes are associated with revisions in financial analysts’ forecasts of future corporate earnings and the profit estimates become more accurate.

Unexpected dividend changes and abnormal stock returns is that the dividend change signals changes in future earnings and cash flows (Lintner, 1956). The announcement day excess return for the group of firms with either insider buying or no insider trading is significantly higher than that for the insider selling group (Asquith and Mullins 1983). Equilibrium returns are non constant, and that existing models of time varying equilibrium returns provide sufficient variation in discount rates so that prices are not excessively volatile. The earliest information transfer study Firth (1976) found that earnings announcements by British companies affected not only their own stock prices but also the returns of other firms in the same industry. This information transfer was positive and its magnitude depended on the degree of surprise contained in the announcing firm’s profit number. Changes in dividends are associated with expected (and actual) future earnings, corporate profits display positive cross sectional correlations among firms in the same industry Brown and Ball (1967) and positive intra industry earnings information transfer has been documented in a number of studies. Therefore, a signal of future earnings prospects (via dividends) for one firm may be extrapolated to other companies.

An unexpected dividend increase (decrease) for one firm led to increased (decreased) stock returns for non reporters. The abnormal stock returns of both the dividend announcers and the non announcers were positively associated with changes in analysts’ earnings forecasts of the other companies and positively associated with the actual changes in future profits and dividends.

CHAPTER 3: RESEARCH METHODS

3.1 Method of Data Collection

For the purpose of this study secondary data has been used. All the data has been acquired from Karachi stock exchange and company’s websites.

3.2 Sample size

The sample used in this study covers 9 years period (2001 to 2009) beginning at January 2001 and ending at December 2009. The yearly data of earning per share, dividend per share, payout ratio and retention ration was obtained from 30 companies listed in the Karachi stock exchange. The companies are from the 6 different sectors, top five companies in every sector in terms of volume.

3.3 Research Model developed

In our model there is one dependent and three independent variables. We used a statistical technique in order to evaluate the affects of independent variables on dependent variable.

3.4 Statistical Technique

We used a multiple linear regression. Multiple linear regressions is a technique for determining the linear relationship between one dependent variable and two or more independent variables.

The equation of multiple linear regression of our model can be presented as below:

Rate of Return = α+ β1 (earning per share) + β2 (retention ratio) + β3 (dividend payout) +έ

Where as,

α = the intercept of the equation.