Dividend Policy and Operating Cash Flow

dividend given to stockholders. The extant literature on dividend payout ratios provides firms with no generally accepted prescription for the level of dividend payment that will maximize share value. Black (1976) in his study concluded with this question is that what the corporation should do about dividend policy. It has been argued that dividend policy has no effect on either the price of a firm’s share or its cost of capital. If dividend policy has no significant effects, then it would be irrelevant. 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.

The behavior of dividend policy is the most debatable issue in the corporate finance literature and still keeps its prominent place both in developed and emerging markets. Many researchers try to uncover the issue regarding the dividend behavior or dynamics and determinants of dividend policy but still don’t have an acceptable explanation for the observed dividend behavior of firms (Black, 1976; Allen and Michaely, 2003 and Brealey and Myers 2005). One of the well known explanations of dividend behavior is the smoothing of firm’s dividends vice versa earnings and growth. In his seminal research, Linter (1956) found that firms in the United States adjust their dividends smoothly to maintain a target long run payout ratio. Several studies appear after this work and evidence suggest that the dividend policy of the companies varies from country to country due to various institutions and capital market differences.

The study examined the relationship between determinants of dividend payout ratios from the context of a developing country like Pakistan. The primary objective of this study is to find out whether several factors as per available literature influence the dividend payout ratio of Sugar Sector in Pakistan.

The purpose of this study is to investigate the dynamics and determinants of dividend policy of sugar firms in Pakistan. The focus is to investigate how Pakistani firms set their dynamic dividend policies in a different institutional environment than that of developed markets. This study examined whether Pakistani firms follow stable dividend policies as in developed markets or they are going to retain their earnings. The paper also identified the areas of firm level factors that influence the degree of dividend smoothing. This paper indicates the importance of institutional features towards the dynamic of dividend policy and also critical out the advantages of examining the dividend policy in different institutional environments. The outcomes of the research will provide meaningful and handy information in the role of institutional factors which creates dividend policy at firm’s level. Several studies appear after this work and evidence suggest that the dividend policy of the companies varies from country to country due to various institutions and capital market differences.

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. 1 The capital markets of Pakistan are much develops as before 2. 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. 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.

Sugar Industry in Pakistan

The sugar industry plays an important role in the economy of the country. It is the second largest industry after textiles. The sugar industry in Pakistan is the 2nd largest agro based industry comprising 78 sugar mills with annual crushing capacity of over 6.1 million tones. Sugarcane farming and sugar manufacturing contribute significantly to the national exchequer in the form of various taxes and levies. Sugar manufacturing and its by-products have contributed significantly towards the foreign exchange resources through import substitution. The Sugar industry employs over 75000 people, including management experts, technologists, engineers, and financial experts, skilled, semiskilled and unskilled workers. It contributes around 4 billion rupees only under the head of excise duty and other levies to the Government are also paramount significance.

In 2008-09, sugarcane production is estimated at 51.5 MMT, a decrease of 19 percent over the previous year due to both a reduction in area harvested and yield. Milling policies and practices, coupled with attractive prices for alternative/competing crops (rice, cotton and sunflower) and insufficient irrigation supplies are major factors limiting crop expansion in the country.

In 2009-10 sugarcane production is forecast at 53.6 MMT, an increase of 4 percent over the previous year due to an expected increase in area and yield. A shortage of cane supply during the current crushing season led to an increase in cane prices. This situation benefitted growers who received prices higher than the indicative prices announced by the Government. This development is expected to contribute to an increase in sugarcane area and productivity in the ensuing year. Moreover, last year’s higher production of rice and sunflower led to lower prices received by farmers, thereby encouraging the switch back to sugarcane.

Purpose of the Study

In Pakistan there are few firms which are paying dividend paying to stockholders consistently. For this investigate thats why the listed sugar firms of Karachi Stock Exchange (KSE) were not able to pay their dividends and the factors which are influencing or determining the dividend policy in Pakistan. In this study we examined the number of firm’s specific factors and their role in dividends policy. The liquidity of the stock market, is the profitable firms are paying dividends in Pakistan, is the firms with greater investment opportunities pay less dividends in Pakistan, is the dividends and debts are substitutes and the degree of leverage is negatively associated with dividends payments and finally examined the firms with greater cash flows pay lesser dividend in Pakistan.

Research Objective

Objective of this thesis has to find out the relationship between dividend policy and operating cash flow, EBIT, Sales and Debt to Equity Ratio. It is very important for investors to examine the factors of dividend policy that whether they have been impact on the sugar sector of Pakistan or not.

Hypotheses Development

H1: There is positive impact of CFO on dividend payout ratio.

H2: There is negative impact of Debt to Equity on dividend payout ratio.

H3: There is positive impact of Annual Revenue on dividend payout ratio.

H4: There is positive impact of EBIT on dividend payout ratio

Thesis Structure:

This thesis is composed of five chapters. After a brief introduction (Chapter I) it evaluate and discuss the literature in (Chapter II). In this chapter we examine the dividend payout policy of firms and the main factors that influence it, theories, models put forward by many renowned researches is examined various studies by different. In (chapter III), we explain methodology and sample in great detail. (In chapter IV), we study the dividend payout policy and the main indicators that affect the dividend payout policy of listed firms on the KSE 100 over the period 2003-2008 and present the interpretation of results. Finally, in (Chapter V), we present and discuss the main contributions and conclusion of this research.

CHAPTER-2

LITERATURE REVIEW

In investigating the determinants of dividend policy of Tunisian stock Exchange, Naceur (2006) find that the high profitable firms with more stable earnings can manage the larger cash flows and because of this they pay larger dividends. Moreover, the firms with fast growth distribute the larger dividends so as attract to investors. The ownership concentration does not have any impact on dividend payments. The liquidity of the firms has negatively impacted on dividend payments. In Indian case Reddy (2006) shows that the dividends paying firms are more profitable, large in size, and growing. The corporate tax or tax preference theory doesn’t appear to hold true in Indian context. Amidu and Abor (2006) find dividend payout policy decision of listed firms in Ghana Stock Exchange is influenced by profitability, cash flow position, and growth scenario and investment opportunities of the firms.

Lease (2000) the firms should follow a life cycle and imitate management’s assessment of the importance of market imperfection and factors including taxes to equity holders, agency cost asymmetric information, floating cost and transaction costs.

Linter (1956) studied 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.

Linter’s (1956) study of dividend policy found that a firm’s bottom line net income is the key determinant of dividend changes, which in his sample are largely dividend increases since he primarily surveys healthy firms.’ If one can extrapolate this finding to dividend decreases, it implies that low bottom line earnings drive dividend reductions.

Jensen (1986) argued that debt is an effective substitute mechanism for dividends in this respect. By issuing debt instead of equity, managers give bondholders the right to take the firm into bankruptcy court if managers do not maintain their promise to make the interest and principal payments. This substitutability between debt and dividends as alternative mechanisms for reducing the agency costs of FCF implies that firms that use low debt ratios will tend to follow a policy of high- dividend payout.

Alli (1993) 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. It reveals 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.

Farzad Farsio, Amanda Geary (1983) in their research The Relationship between Dividends and Earnings say that dividends have no explanatory power to forecast future earnings. They presented four cases for possible effects of earnings on future dividends and show that there should be no significant relationship between dividends and future earnings in the long run. The contribution of this study is that it provides financial managers and investors with evidence that it would be a mistake to base investment decisions on inferences about dividend/earnings relationships that rely on some certain short-term periods.

John and Kalay (1982) Debt covenants to minimize dividend payments are necessary to prevent bondholder wealth transfers to shareholders. Another way dividend policy affects agency costs is the reduction of agency cost through increased monitoring by capital market.

Analysis shows the positive association among profitability and dividend payout ratio, corporate tax and cash flows. The study also suggests that when the liquidity of companies increases the companies disburse more dividends. The companies with dynamic profitability find out hard to disburse dividends. Last but not least, conclusion of the study shows that cash flow, profitability, growth and investment opportunities influence the dividend payout policy.

Amidu and Abor (2006) conducted the study on determinants of dividend policy in Ghana. They have taken the Payout Ratio as dependent variable and defined as dividend per share divided by earning per share. The included the explanatory variable profitability(profit), risk(risk), cash flows (cash), corporate tax(tax), institutional holdings(INSH), Sales Growth and Market to Book value(MTBV). By using the Panel data which involves the pooling of observations on a cross sectional of unit over several time periods and provides the results that are simply not measurable in pure cross-sections or exact time series studies. Because the panel time series is different from a regular time series or cross section regression equation and each variable use the double subscript in the data.

Jensen (1986) concluded that funds remaining after financing all positive net present value projects cause conflicts of interest between managers and shareholders. Dividends and debt interest payment decrease the free Dividend payout ratios in Ghana cash flow available to managers to invest in marginal net present value projects and manager perquisite consumption.

Crutchley and Hansen (1989) examined the hypothesis that financial leverage, dividends and managerial ownership are jointly determined by firms’ attempts to minimize the total agency costs of debt and equity. Their findings are consistent with this hypothesis. Chaplinsky and Niehaus (1992) examine whether financial leverage and managerial ownership share common determinants. In addition to the agency costs of debt and equity, they also assess whether these decisions are governed by the tax advantage of debt, the costs of issuing securities and the demand for risk sharing by insiders.

Avazian (2006) conducted the study on United Stated listed firms at NYE and find that decision to smooth dividends depend at the part of public market access as proxies by the rating of bonds. In their study dividend payment is the optimal for firms raising debts in the public Unknown bond markets but not for firms in the private informed bank markets. In this logic the dividend decision is related to information asymmetric between the managers and the creditors of the firms.

Pruitt and Gitman (1991) found that risk (year-to-year variability of earnings) also important determines firms’ dividend policy. A company that has constant earnings is often able to predict approximately what its future earnings will be. Such a company is therefore more likely to pay out a higher percentage of its earnings than a firm with unpredictable earnings.

The liquidity or cash flow from operation is an important determinant of dividend payouts policy. A poor liquidity position means less generous dividend due to shortage of cash. Alli (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 not really reflect the firm’s ability to pay dividends.

Green (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 investment and financing decisions. Their results however, do not support the views of Miller and Modigliani (1961). Partington (1983) revealed that firms’ use of 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.

Daniel et al (2007) conducted the study that they found that firms are more likely to manage their earnings upward when their earnings would otherwise fall down of expected dividend levels. The earning management behavior significantly impacts the likelihood of dividend cut. The firms made discretionally accruals because reported earnings to exceed the expected dividend levels are significantly less likely to cut dividends than those firms whose reported earnings fall down of expected level of dividends. They conclude that managers treat expected dividend levels as a vital earning threshold.

Higgins (1972) and McCabe (1979) et.al the leverage (Lev) also influence the dividend behavior of the firm, if the level of the leverage is high its mean the firm is more risky in the cash flows. The negative effect of leverage on dividends payments is documented in the literature, finds that the firms with higher leverage pay lower dividends in order to evade the cost of raising external capital of the firm.

Higgins (1972) shows that payout ratio is negatively related to a firm’s need for funds to finance growth opportunities. Rozeff (1982), Lloyd et al. (1985), and Collins et al. (1996) all show a significantly negative relationship between historical sales 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 the case of market-to-book value.

Lintner (1956) founded that past dividends and current earnings are the primary determinants of current dividends and managers prefer to maintain stable dividends and make periodic adjustments toward a target payout ratio.

Arditti (1976) carried out research in order to evaluated dividend policy with respect to taxes and uncertainty. The purpose of this paper has been to tackle the distressing dilemma of the zero dividend solution by clearly incorporating M&M’s original proposal that dividends have an information aspect that is of potential worth to investors. The analysis of ambiguity they have offered is only one of many possible hypotheses which can account for the experimental fact that companies naturally do not take on intense dividend policies.

Arnott and Asness (2003) have challenged the familiar wisdom. Such wisdom advocates that a higher payout ratio results in low future growth. Arnott and Asness based their study on America stock market (S&P 500) and found that higher aggregate dividend payout ratios were associated with higher future earnings growth.

Modigliani and Miller (1985) carried out research to evaluate dividend Policy under asymmetric information. The Standard finance model of the firm’s dividend/investment/financing decisions gives manager more appropriate information regarding the firm’s current earnings. The purpose of this research is to replace the assumption built by Miller and Modigliani that the outside investors and inside managers have the same information about companies profit and future earnings with the assumption that inside managers know more than outside investors about the actual situation of firm’s current earnings.

James A. Gentry (1990) informed about free cash flow analysis, shows that the financial health of a company depends upon its ability to generate net operating cash flows that are sufficient to cover a hierarchy of cash outflows. The profiles generated from a large sample of companies show that relative cash flow components vary across company size and across industry groups. The researcher hopes that these profiles will serve as benchmarks for comparing cash flow components and encourage financial analysts to use cash flow analysis.

Miller and Modigliani (1961) suggest that in perfect markets, dividend do not affect firms’ value. Shareholders are not concerned to receiving their cash flows as dividend or in shape of capital gain, as for as firm’s doesn’t change the investment policies. In this type of situation firm’s dividend payout ratio effect their residual free cash flows and the result is when the free cash flow is positive firms decide to pay dividend and if negative firm’s decide to issue shares. They also conclude that change in dividend may be conveying the information to the market about firm’s future earnings.

Gordon and Walter (1963) present the bird in the hand theory which says that investors always prefer cash in hand rather than a future promise of capital gain due to minimizing risk.

Jensen and Meckling (1976) the agency theory is based on the conflict between managers and shareholder and the percentage of equity controlled by insider ownership should influence the dividend policy. Easterbrook (1984) gives further explanation regarding agency cost problem and says that there are two forms of agency costs; one is the cost monitoring and other is cost of risk aversion on the part of directors or managers.

The firm size (SIZE) defined as natural logarithm of total assets is expected to have a positive effect on dividend payouts as large more diversified firm are likely to have very low chance of bankruptcy and can sustain higher level of debt.

In investigating the determinants of dividend policy of Tunisian stock Exchange Naceur (2006) find that the high profitable firms with more stable earnings can manage the larger cash flows and because of this they pay larger dividends.

Baker (2007) reports that Canadian dividend paying firms are significantly larger and more profitable, having greater cash flows, ownership structure and some growth opportunities.

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.

Megginson and Eije (2006) examined that the dividend paying tendency of fifteen European firms decline dramatically over this period 1989 to 2003. The increase in the retained earnings to total equity doesn’t increase the payout ratio, but company age does.

The empirical study of Adjaoud (1986) found that Canadian dividend-paying firms try to maintain stable dividends per share, are reluctant to decrease the payout level, and smoothly adjust the level of payout based on level of expected future earnings.

Easterbrook (1984) argues that increasing dividends raises the probability that additional capital will have to be raised externally on a periodic basis and consequently, the firm will be subject to constant monitoring by experts and outside suppliers in the capital market.

Green (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 investment and financing decisions.

Partington (1983) revealed that firms’ use of target payout ratios, firms motives for paying dividends, and extent to which dividends are determined are independent of investment policy.

Lipson (1998) conducted study to examine the factors that derives dividend initiations and earnings surprises, look at the performance of newly firms that started dividends with those that did not. Earnings increases following the dividend initiation and earnings revelations for initiation firms are more constructive than for those non initiating firms. In an economy that charges taxes on investment income, dividends are obviously a disadvantageous means of transferring wealth to shareholders. To validate dividend costs, two clarifications are typically given: dividends are used to solve agency problems inside the firm, or dividends are used to communicate information to the market.

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.

H. Kent Baker, Gail E. Farrelly (1983) in their study A Survey of Management Views on Dividend Policy say that the major determinants of dividend payments today appear strikingly similar to Linter’s behavioral model developed during the mid-1950. In particular, respondents were highly concerned with dividend continuity. Second, the respondents seem to believe that dividend policy affects share value, as evidenced by the importance attached to dividend policy in maintaining or increasing stock price. Although the survey does not uncover the exact reasons for their belief in dividend relevance, it does provide evidence that the respondents are generally aware of signaling and clientele effects. Finally, the opinions of the respondents from the utilities differ markedly from those of the other two industries.

Smith and Watts (1992) investigated the relations among executive compensation, corporate financing and dividend policies. They concluded that a firm’s dividend policy is affected by its other corporate policy choices. In addition, Jensen, Solberg and Zorn (1992) linked the interaction between financial policies (dividend payout and leverage) and insider’s ownership to informational asymmetries between insiders and external investors. They found that corporate financial decisions and insider ownership are interdependent.

Lintner (1956) suggested that the firms have long run target dividend payout ratios and place their attention more on dividend changes than on absolute dividend levels. He also finds that dividend changes follow shifts in long-run sustainable earnings and managers are hesitant to make dividend changes that may later need to be reversed. Managers also try to stabilize dividends and avoid dividend cuts. Linter developed a partial adjustment model to describe the dividend decision process that explained 85 percent of year-to-year dividend changes. Gordon (1959) argue that an increase in the dividend payout increases stock price (value) and lowers the cost of equity, but empirical support for this position is weak.

Bemstein (1996) maintain that dividend policy makes no difference because it has no effect on either stock prices or the cost of equity. According to Gordon (1959) a higher payout ratio will reduce the required rate of return (cost of capital), and hence increase the value of the firm.

Miller and Rock (1985) dividends contain this private information and therefore can be used as a signaling device to influence share price. An announcement of dividend increase is taken as good news and accordingly the share price reacts favorably, and vice versa. Only good-quality firms can send signals to the market through dividends and poor-quality firms cannot mimic these because of the dissipative signaling costs. According to Easterbrook (1984) the agency costs thesis predicts that dividend payments can reduce the problems associated with information asymmetry. Dividends may also serve as a mechanism to reduce cash flow under management control, and thus help to mitigate the agency problems. Reducing funds under management discretion may result in forcing them into the capital markets more frequently, thus putting them under the scrutiny of capital suppliers. The tax-preference theory posits that low dividend payout ratios lower the required rate of return and increase the market valuation of a firm’s stocks. Because of the relative tax disadvantage of dividends compared to capital gains investors require a higher before-tax risk adjusted return on stocks with higher dividend yields.

Higgins (1981) indicated that a direct connection between growth and financing needs: growing firms have outside financing requirements because working capital needs normally go beyond the incremental cash flows from new sales. Higgins (1972) shows that payout ratios are negatively related to firms’ need top fund finance growth opportunities.

De Angelo (2004) conducted a study on dividend policy, agency cost and earned equity. The study consists on why firms pay dividends? If they didn’t have their assets and capital structure, would eventually become unsustainable as the earnings of successful firms exceed their investment opportunities. They found that dividend payments prevented significant agency problems since the retention of the earnings would have given the managers command over an additional $1.6 trillion without access to better investment opportunities and without any monitoring. This sense suggests that firms with high retained earnings are especially likely to pay dividends. In this view, firms pay high dividend when earned equity to total equity is high, and decline when this ratio declines and when this ratio is zero or near to zero, meaning that firms don’t have the earned equity. They finally found that the highly significant association between the decision to pay dividends and the ratio of earned equity to total equity controlling for size of the firm, profitability, growth, leverage, cash balance.

CHAPTER-3

RESEARCH METHODS

As per available literature some factors have been identified that affect the dividend policy decisions of the companies. This thesis contains some important variables in order to arrive at some positive conclusions. Multiple linear regressions model has been developed to conduct the research, which consisted of dependent variable and independent variables. Dependent variable in this study has dividend payout that is defined as the percentage of earnings disbursed as dividends. While the independent variables include of profitability (EBIT), sales, debt equity ratio and cash flow from operation. These four variables are used as predictors in order to conclude that how much each of the variables affects the dividend payout of sugar firms listed on the Karachi Stock Exchange over the period of eight years (2001-2008).

Model:

DP = α + β1 EBIT + β2 sales + β3 CFO + β4 DER+ ε

DP is the annual dividend paid by firms during the period, while α is Alpha constant in the model. Whereas β (beta) shows the times of the variable in the theoretical model and ε represents the error term. Variables include in the model are Earning before interest and tax, Sales per year, Cash flow from operation and Debt equity ratio.

Dependent Variable:

Dividend payout ratio:

The corporate dividend policy is the one of the very important issue of advance corporate finance. It developed the dividend model which becomes very famous and known as Linter Partial Adjustment Model. According to the Linter each firms i has target dividend payout ratio. By using the target payout ratio linter calculated the target dividend at time (Dit*) as percentage of net earnings of the firms i at the time t (Eit), i.e Dit*= ri. Eit. John Linter (1956)

In this study we used dividend payout ratio as dependent variable. It is calculated by percentage of net earnings of the firms paid at the end of period. The set of determinants of dividend payout ratio consist of following variables. CFO (cash flow), Sales, EBIT (earning) and Debt to Equity Ratio (leverage).

Independent Variable:

Four explanatory variables are used in this study, to find out their impact on the dependent variable as dividend payout.

Operating Cash Flow:

The liquidity or cash flows position is also an important determinant of dividend payouts. A poor liquidity position means less generous dividends due to sh