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Table of Contents

DIVIDEND POLICY AND THE STOCK MARKET REACTION TO DIVIDEND ANNOUNCEMENTS IN PAKISTAN - Part 2

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2. LITERATURE REVIEW

This section provides the references of the various researches done by different author on the topic in order to build a sound background of the topic. The section has the literature about the different perceptions about the dividend payments in the developed markets of the world. After it, the literature is drawing the attention towards the reviews of the researchers in the developing or emerging markets, the trends, the dividend policies and the impacts. This section will provide sound information about the various stocks of South Asia. The section will end up by comparing, the stocks and their impacts due to dividends, the markets of South Asia and Pakistan. It is due to the reason that there is much similarity among the stock markets of these regions.

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2.1. PREFACE

As discussed above, the basic objective of the research is to establish the connections between dividends policies of the companies listed on Karachi Stock Exchange (KSE). The theoretical framework for the current study is presented by various researchers such as Miller and Modigliani (1961), Al-Malkawi, Rafferty and Pillai (2010), Bhattacharya (2009), Singhania (2006), Khan, Burton and Power (2011), Tahir, Sabir, Alam and Ismail (2013), Salman (2005), and Tahir (2011). Miller and Modigliani (1961) presented dividend irrelevance theory that refused the impact of dividends on stock price. Al-Malkawi, Rafferty and Pillai (2010) presented several theories explaining behavioral aspect of dividend policies and stock price including the theory of bird-in-hand. Bhattacharya (2009) examined the signaling effect of dividends and its impact on investors. Singhania (2006) described distinguishing features of Islamic stock markets including Pakistani Stock Exchange. Khan, Burton and Power (2011), shed light on the most common practices in dividend announcements and the impact of the tax system in Pakistan on paying dividends. Tahir, Sabir, Alam and Ismail (2013) presented a comprehensive research of Pakistan stock market based on the analysis of Pakistani firms listed on KSE. Tahir (2011) analyzed the efficiency of capital market in Pakistan.

2.1.1. Dividends & Dividend Policy

Dividend is the payout given to the stakeholders out if the earnings of the owners of the firm. Dividends are of various kinds depending on the liability and preference level. The dividend can be on cash basis cash dividend, stock dividend or the liquidating dividend. The dividend is the one of the most important decisions of a firm. It is the reason the organizations have developed a well-developed dividend policy. There is a confused version of the information about the payment of the dividends along with the choice of the specific dividend policy. There is no proper way to identify the effect of the specific dividend policy on the value of the firm. There are three schools of thoughts about the dividend policies.

The first school of thought believes that with the dividend the value of a firm also increases (McCluskey et al., 2006). The second school of thought is of the view that there is a negative relationship between the dividend and the share prices. With the increase in the dividend, there is a decrease in the value at the share of the firm (Woolridge, Ghosh, 1985). There is another view about it; it says that all of it is responsible for higher taxation due to which the actual amount of tax to be paid is much higher than the total income or capital gains (Litzenberger, 1979). The third school of thought is of the view that there is no relation between the value of the share of the firm and the dividend payments (Miller, Modigliani, 1961).

Various earlier studies have researched the profit strategies of Pakistani organizations (like, Nishat 1992; Kanwer, 2002; Kaleem and Salahuddin, 2006; Zaman, 2007; Mubarik, 2008; Ahmed also Javid, 2009). For a better understanding of work around there, the writing about profit arrangements in Pakistan is partitioned into two sections.

2.1.2. Dividend-Positive Signal

The studies indicate that the share price is dependent on the dividend. The increase in the dividend increases the share price, and share prices fall with a reduction in the dividend (McCluskey et al., 2006). Other studies support the idea that increases in the dividend amount can be viewed as the company has no opportunities of further investment. The decrease in the dividend amount suggests that a company finds opportunities for investing in the growth. The decreased dividends mean increased future growth of the company (Woolridge and Ghosh, 1985). De Angelo studied 80 poor performing companies of the US and stated that the cut in the dividend amount is the result of low profitability of the company. The companies are less profitable, therefore; no or fewer dividends are given to the shareholders. This study was conducted over the period of 1971-82. There sample was divided into three groups or categories. The first category was of the firms which faced loss prior to dividend. The second category was of the firms which had profit prior to the dividend announcement. The third category was of the firms which faced loss after the dividend announcement.

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The results of this study showed that a market responded in a negative direction when the dividends were cut. This response was noted initially. Later on the prices of the shares showed an improvement of 9 percent in the next quarter, and 16 percent in the next year. Such companies witnessed a growth in their size, and their dividend cut was followed by the profitable extension. The dividend cutting firms also witnessed an increase of 10 percent in their share performance. The view of the researchers was that dividends decrease leads to better share performance and growth. The market needs to be educated about the dividends policies and trends so that they can better understand the reasons. They proposed that the market should be educated for better understanding dividend cuts so that investors should take their decisions by understanding the position of a company in a better way.

For the reliability of this argument another study was made by Soter et al. This research studied the effects of decreasing dividends by and company named FPL. The company reduced the dividends from .62$ to 0.42$ in 1994. This decrease was in response to market regulations. These regulations changed the company to a riskier organization. They reduced the dividends in response to these deregulations so that they become medium risk bearers by increasing their equity. The sole purpose was to increase the financial flexibility of the organization. Moreover, they also introduced a share repurchase policy. They repurchased shares of ten million worth. The share price of the company fell when this announcement was made. The price of their shares started to rise after they started educating their investors. The increase in share price was 30 percent after one month of the announcement. This trend of increase in share price was witnessed after the two years as well. They educated their investors about the aims and motives of the company and regained their interest in the company policies.

2.1.3. Dividend and Value

There is no relevance of the dividend to the value as long as there is no taxation system (M.M, 1961). However, in the view of different researchers and scholars, the value matters in the presence of formal taxation system. Therefore, there are two distinct groups of researcher- one supporting the idea of relevance of dividends and others negating this concept. The only way to test both these assumptions is to analyze the effect of share price on the dividends. Both these group of researchers had focused on the taxation system and paid a least attention to the information content (Litzenberger, 1979).

According to a research study, the dividend decision is not only affected by the taxation system. There are many other factors affecting this decision. One of these decisions is the preference of the shareholders either they want in cash or they want in shares. He in his study examined the case of a company named Citizen Utilities (CU). The investors of the company were given a choice of cash or shares of equal value. According to results of the study, more preference was given to cash dividends by the investors of that firm. He stated that investors are more inclined to cash dividends than the lower income after tax in case of equity (Long, 1975). However, the results of the study made by Poterba were totally opposite. This study stated that investors are more likely to prefer those companies paying a dividend in the form of equity shares (Poterba, 1986).

2.1.4. Theory of Irrelevance

Miller and Modigliani (1961) in their publication “Dividend Policy, Growth, and the Valuation of Shares” developed dividend irrelevance theory. According to this theory, the dividend payment does not affect capital cost and stock price. Therefore, Miller and Modigliani (1961) considered dividend policy irrelevant of the value of the share prices of the firm. They also presented a valuation approach to assets of the firms’ valuation. In addition, Miller and Modigliani (1961) suggested theoretical framework for empirical tests of correlation between share price and “insufficient” dividends. According to them, the theory is only applicable when there are certain assumptions to be held. They are of the view that the investor has no interest either the payment is made in the form of capital gain or dividends. They also elaborated that the issue of shares balanced the dividend payments in the stock market. The theory also elaborated that the value of the firm is assessed on the basis of the investment opportunities and the earning capacity not on the capacity of dividend payment (Miller, Modigliani, 1961).

There were many researchers that support the idea of Miller and Modigliani such as Scholes and Black. They discussed the impact of the policy of dividends for the expected returns of the shares of the company. They concluded that the idea of Miller and Modigliani is worthwhile as there is a yield of 0.94 t-values for co-efficient of dividend. Apart from them, there are many other who opposes the idea on the basis of the empirical results and theoretical framework they had made. They said that the implications of the taxation and the transaction cost have failed the idea of Miller and Modigliani.

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2.1.5. Theory in South Asia: Signaling Theory

The countries like Bangladesh, India; and Sri Lanka; are the countries of active stock markets in south Asia. All these nations are developing stock exchanges that are not quite the same as their created partners, where most profit studies have been directed. All the South Asian nations particularly Pakistan, Bangladesh and India are proximate in a monetary and topographical sense and additionally imparting a solid basic verifiable legacy and close ties. Therefore, an audit of profit studies from these South Asian nations will stretch our seeing about the offer value response to the profit publications of organizations of this geographic area of the world. A lot of writing has been distributed among these nations.  In the Bangladeshi market, Uddin (2003) observed the impact of profit publications on shareholder esteem for 137 different organizations, recorded on the Dhaka Stock Exchange (DSE) from September 2002 to October 2003.

For the Bangladeshi market, Thirumalvalavan and Sunitha (2006) found that profit affirmations had a positive effect on offer costs in the Indian market 106. The results demonstrated that, on normal, the CAR was certain around the 10-day window encompassing profit affirmations by the Indian firms; demonstrating the presence of a positive indicating effect on offer costs. Azhagaiah and Priya (2008) additionally found comparative results while dissecting the effect of profit arrangements on shareholders risk is for the natural and inorganic substance organizations of India.

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