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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 15 (2008)

EuroJournals Publishing, Inc. 2008

www.eurojournals.com/finance.htm

Determinants of Dividend Payout Ratios-A Study of

Indian Information Technology Sector

Institute of Management Studies, Ghaziabad, India

Abstract

Profitability has always been considered as a primary indicator of dividend payout

ratio. There are numerous other factors other than profitability also that affect dividend

decisions of an organization namely cash flows, corporate tax, sales growth and market to

book value ratio. Available literature suggests that dividend payout ratio is positively

related to profits, cash flows and it has inverse relationship with corporate taxes, sales

growth and market to book value ratio. This paper is an attempt to empirically analyze the

determinants of dividend payout ratio of Indian Information Technology sector. The paper

also focuses on identifying whether various factors available as per literature influence

dividend payout ratio in IT sector in India in existing scenario or not. Statistical techniques

of correlation and regression have been used to explore the relationship between key

variables. Thus, the main theme of this study is to identify the various factors that influence

the dividend payout policy decisions of IT firms in India.

Keywords: Dividends, determinants, IT sector

1. Inroduction

Dividend payout has been an issue of interest in financial literature. Academicians & researchers have

developed many theoretical models describing the factors that managers should consider when making

dividend policy decisions. By dividend policy, we mean the payout policy that managers follow in

deciding the size and pattern of cash distribution to shareholders over time. In seminal paper, Miller

and Modigliani (M&M) (1961) argue that given perfect capital markets, the dividend decision does not

affect the firm value and is, therefore, irrelevant. Most financial practitioners and many academics

greeted this conclusion with surprise because the conventional wisdom at the time suggested that a

properly managed dividend policy had an impact on share prices and shareholder wealth.

Since the M& M study, other researchers have relaxed the assumption of perfect capital

markets and offered theories about how dividend affects the firm value and how managers should

formulate dividend policy decisions. Over time, the number of factors identified in the literature as

being important to be considered in making dividend decisions increased substantially. Thus, extensive

studies were done to find out various factors affecting dividend payout ratio of a firm. The setting of

corporate dividend policy remains a controversial issue and involves ocean deep judgment by decision

makers. There has been emerging consensus that there is no single explanation of dividends.

Previous empirical studies have focused mainly on developed economies. The undertaken study

examines the relationship between determinants of dividend payout ratios from the context of a

International Research Journal of Finance and Economics — Issue 15 (2008)

developing country like India. The study looks at the issue from emerging markets perspective by

focusing specifically on Indian Information Technology sector. The primary objective of this study is

to find out whether several factors as per available literature influence the dividend payout ratio of

Indian Information Technology sector.

This article now proceeds as follows: Section2 gives brief overview of IT sector in India.

Section 3 briefly reviews the existing literature. Section 4 presents the data and variable constructions.

The methodology used and the obtained results are presented in section 5. Finally, some concluding

remarks are presented in section 6.

2. Backdrop of Indian Information Technology Industry

The Indian IT industry has a prominent global presence today and has emerged as the fastest growing

segment of the Indian industry both in terms of production and exports. Information technology

industry in India is one of the fastest growing industries. Indian IT sector has built up valuable brand

equity for itself in the global markets. IT has a major role in strengthening the economic and technical

foundations in India. The sector can be classified into 4 broad categories- IT services, Engineering

services, ITES- BPO services, E business.

The origin of IT sector can be traced to 1974, when mainframe manufacture, Burroughs, asked

its India’s sales agent, Tata Consultancy services to export programmers for installing system software

for a U.S. client.The IT industry originated under unfavorable conditions. Local markets were absent

and government policy towards private enterprises was hostile.

During that time Indian economy was state controlled and the state remained hostile to software

industry through the 1970’sGoverment policy towards IT sector changed when Rajiv Gandhi became

prime minister in 1984.His new computer policy consisted of recognition of software exports as a

“delicensed industry”, permission of foreign firms to set up wholly owned, export- dedicated units and

a project to set up a chain of software park that would offer infrastructure below market costs. These

polices laid the foundation for the development of a world class IT industry in India.

The profile of the industry has changed considerably since then. Today, Indian IT companies

such as TCS, Wipro, Infosys, HCL etc. are renowned in the global markets for their IT prowess. Some

of the major factors which played a key role in India’s appearance as key global IT players include

escalating number of skilled professionals in IT, vast academic infrastructure of India. India has second

leading English speaking work force in the world. The cost of software development and other services

in India is very competitive as compared to west. Indian IT industry has also gained enormously from

the availability of a robust infrastructure (telecom, power and roads) in the country. Incentives such as

income tax holiday until 2010 have been provided for the export of IT enabled services.

Over the past decade, information technology industry has become one of the fastest growing

industries in India. Strong demand over past few years ha placed IT markets in the Asia – Pacific

region. The Indian software and ITES industry has grown at a CAGR of 28 % during last five years. It

is expected that the contribution of IT and ITES to national GDP will rise to 7 % by 2007-08 against

4.8% in 2005-06. The Government of India projects an export of US $ 50 billion by the year 2008 for

the Indian software industry.

Along with the growth opportunities, IT sector is one of the highest paying sectors. The average

augment in salary in IT sector across the levels was around 16%.The recruitment of engineers and IT

professionals in their industry is growing at the compound annual rate of 14.5 % approximately.

According to National Association of software and services Company (NASSCOM), the Indian

IT software and services sector grew by 31.4%during 2005-06, notching up aggregate revenues of US

$ 29.6 billion, up from US $22.5 billion in 2004-05. Encouraged by the 2005-2006 performance, The

IT and ITES sector is confident of achieving the US $60 billion in exports by 2010.

Thus, it is evident that the information technology sector in India has grown leaps and bounds

in last five years. Consequently the financial performance of IT sector has surged in terms of revenue,

profitability and shareholders’ wealth maximization. India is ahead of competitors such as Singapore,

International Research Journal of Finance and Economics — Issue 15 (2008)

Hong Kong, China, Philippines, Mexico, Ireland, Australia and Holland, among others Therefore, it

would be an attention-grabbing task to study how the dividend distribution pattern of this sector has

changed and various factors influencing the DP ratio of the sunshine sector of the Indian economy.

Through this paper we make an attempt to add to this existing body of knowledge

3. Literature Review

“The harder we look at dividend the more it seems like a puzzle with pieces that just don’t fit

together.”

Black (1976) in his study concluded with this question:” What should the corporation do about

dividend policy? We don’t know”

Researchers have proposed many different theories about the factors that influence a firm’s

dividend policy .A number of factors have been identified in previous empirical studies to influence the

dividend policy decisions of the firm. To, enumerate few profitability, risk, cash flows, agency cost,

growth, taxes, price earning ratio etc.

Profits have long been regarded as the primary indicator of the firm’s capacity to pay dividends.

Linter (1956) conducted a classic study on how U.S. managers make dividend decisions. He developed

a compact mathematical model based on survey of 28 well established industrial U.S. firms which is

considered to be a finance classic. According to him the dividend payment pattern of a firm is

influenced by the current year earnings and previous year dividends. Baker, Farrelly and Edelman

(1986) surveyed 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 determi8nant.

Pruitt and Gitman (1991) find that risk (year to year variability of earnings) also determine the

firms’ dividend policy. A firm that has relatively stable earnings is often able to predict approximately

what its future earning will be. Such a firm is more likely to pay a higher percentage of its earnings

than firm with fluctuating earnings. In other studies, Rozeff (1982), Lloyd et. al. (1985), and Colins et.

al. (1996) used beta value of a firm as an indicator of its market risk. They found statistically

significant and negative relationship between beta and dividend payout. Their findings suggest that

firms having higher level of market risk will payout dividends at lower rate. D’Souza (1999) also finds

statistically significant and negative relationship between beta and dividend payout.

The liquidity or cash flows position is also an important determinant of dividend payouts. A

poor liquidity position means less generous dividends due to shortage of cash. Alli et.al (1993) reveal

that dividend payments depend more on cash flows, which reflect the company’s ability to pay

dividends, than on current earnings, which are less heavily influenced by accounting practices. They

claim current earnings do no really reflect the firm’s ability to pay dividends.

Green et. al.(1993) questioned the irrelevance argument and investigated the relationship

between the dividends and investment and financing decisions .Their study showed that dividend

payout levels are not totally decided after a firm’s investment and financing decisions have been made.

Dividend decision is taken along with investment and financing decisions. The results however do not

support the views of Miller and Modigliani (1961).Partington (1983) revealed that firms’ use target

payout ratios, firms’ motives for paying dividends and extent to which dividends are determined are

independent of investment policy. Higgins (1981) indicates a direct link between growth and financing

needs: rapidly growing firms have external financing needs because working capital needs normally

exceed the incremental cash flows from new sales. Higgins (1972) shows that payout ratios are

negatively related to firms’ need top fund finance growth opportunities. Rozeff(1982), Lloyd et

al.(1985) and Collins et al .(1996) all show significantly negative relationship between historical sales

International Research Journal of Finance and Economics — Issue 15 (2008)

growth and dividend payout. D, Souza (1999) however shows a positive but insignificant relationship

in the case of growth and negative but insignificant relationship in case of market to book value.

4. Data and Varaible Construction

This subsection is subdivided into two parts: in sub section 1, we briefly focus on some key variables.

Sub section 2, we introduce our data.

4.1. Key Variables that Affect the Dividend Payout Ratio of a Firm

As per available literature following factors have been identified that affect the dividend policy

decisions of the firm. Enumerated below are the key variable along with the relationship with dividend

payout ratio of the firm.

Table I:

Key Variables Affecting Dividend Payout Ratio

Key Variables

Relationship with Dividend Payout Ratio

Current and anticipated earnings

positive

Cash flows or liquidity

positive

Corporate tax

negative

Risk (beta)

negative

Growth opportunities (sales growth and MTBV)6

negative

4.2. Data and Sample

Information Technology (IT) industry has played a major role in the Indian economy during the last

few years. A number of large, profitable Indian companies today belong to the IT sector and a great

deal of investment interest is now focused on the IT sector. Over the past decade, IT has become one of

the fastest growing industries in India. It has grown at a CAGR of 28% during last five years. IT sector

has been chosen for study because it is a sunshine sector of India. It currently accounts for almost 4.8%

of India’s GDP. It will account for 7% of India’s GDP by 2010.

In order to have a good benchmark of the Indian IT sector, IISL (India Index services and

Product Ltd.) has developed the CNX IT sector index which provides investors and market

intermediaries with an appropriate benchmark that captures the performance of the IT segment of the

market. The sample selected for study consists of all the companies, which are constituents of CNX IT

index of NSE (list attached to the annexure). Companies in this index are those that have more than

50% of their turnover from IT related activities like software development, hardware manufacture,

vending, support and maintenance. The sample companies’ amount to a major chunk of IT sector

revenue and occupies a dominant position in terms of market share. The average total traded value for

the last six months of CNX IT Index stocks is approximately 91% of the traded value of the IT sector.

CNX IT Index stocks represent about 96% of the total market capitalization of the IT sector as on

March 31, 2005.

The period under study is 2000-2006.As it is known that period of 5 to 6 years covers 2

business cycles. That is why period chosen is 2000-2006, which covers both recessionary and booming

phase of IT industry. The data has been sourced from Prowess database of CMIE. Hinduja TMT Ltd

and I-Gate Global Solutions Ltd. have been excluded from our analysis due to non- availability of data.

The variables that have been identified can be stated as follows:

Y= dividend payout ratio

X1=earnings before interest and taxes /total assets

X2= cash from operations (Rs. crore)

Sales growth and MTBV ratio (also known as PB ratio) has been used as proxies to represent firm’s future prospects and investment opportunities

available to a firm.

International Research Journal of Finance and Economics — Issue 15 (2008)

X3=corporate tax /profit before tax

X4=annual sales growth

X5= Market to book value ratio

The statistical techniques of correlation and regression were used to explore the relation ship

between these variables.

5. Empirical Analysis of the Data

For the analysis of pooled data for seven years i.e. 2000 to 2006 correlation matrix was constructed and

the technique of multiple linear regression analysis was used. An attempt was made to develop a

multiple regression equation using identified key variables. The dividend payout (Y) was used as

dependent variable and other variables (x1 ,x2, x3, x4, x5) were used as independent variables. On this

basis under mentioned multiple linear regression equation was developed.

Y= +b1x1+b2x2+b3x3+b4x4+b5x5

Where, is the regression constant and b1, b2, b3, b4 and b5 are regression coefficients

respectively.

The regression coefficient indicates the amount of change in the value of dependent variable for

a unit change in independent variable.r2 –the coefficient of determination, gives an estimate of the

proportion of variance of dependent variable accounted for by the independent variable. It suggests the

covariance between changes in dividend rate and earnings rate. The value of r2 varies between 0 and

1.An r2 of zero means that the predictor accounts for none of the variability of ‘Y’by ‘X’. An r2 of 1

means perfect prediction of y by x and that 100% of variability of ‘Y’ is accounted for by ‘X’.The

higher the value of r2, the closer the relationship between the variables.

5.1. Correlation Matrix

The first step was to construct correlation matrix for various possible combinations of dependent and

independent variables. The outcome of this exercise was the understated correlation matrix

Table II: Correlation Matrix