Determinants of Dividend Policy: A Case of Banking Sector in Pakistan

Middle-East Journal of Scientific Research 18 (3): 410-424, 2013ISSN 1990-9233© IDOSI Publications, 2013DOI: 10.5829/idosi.mejsr.2013.18.3.12200

Corresponding Author: Hashim Zameer, Iqra University Islamabad Pakistan, Bzu Bahadur Sub Campus Layyah, Pakistan.410

Determinants of Dividend Policy: A Case of Banking Sector in Pakistan

Hashim Zameer, Shahid Rasool, Sajid Iqbal and Umair Arshad

Iqra University Islamabad Pakistan, BZU Bahadur Sub Campus Layyah, Pakistan

Abstract: The aim of the study is to investigate the determinants of dividend policy of Pakistani banking sector.For this purpose, we used data of 27 foreign and domestic banks operating in Islamic and conventional bankingin Pakistan listed at different stock exchanges as a sample. Applying stepwise regression analysis, these fourvariables liquidity, profitability, last year dividend and ownership structure show highly significant relationshipwith the dividend payout of Pakistani banks. Profitability, last year dividend and ownership structureshow positive impact on the dividend payout and liquidity show negative impact on the banking industry.Size, leverage, agency cost, growth and risk show insignificant relationship and have no impact on the dividendpayout.

Key words: Banking Dividend Leverage Payout Risk Ownership Pakistan

INTRODUCTION different” and from the latest literature [8] states that the

Almost each company earns profit each year and that may make the governance of these institutions differentprofit is reinvested in business or distributed to from non financial firms. But there is limited research onshareholders. The process that how much and in which determinants of dividend policy of banking or financialway profit is distributed among shareholders is called sector all over the world, as for my knowledge, this is thedividend policy. first research on “Determinants of dividend policy of

Dividend policy is one of the most debatable issues Pakistani banking industry”. This research will prove ain modern corporate finance and still a puzzle. Dividend milestone for future researches on dividend policy ofpolicy is one of the top ten unsolved issues in corporate banking sector.finance [1]. In 1976, [2] gave a statement about the The purpose of this study is to investigate thedividend policy that “the harder we look at dividend the determinants of dividend policy of Pakistani bankingmore it seems like a puzzle with pieces that just don’t fit sector. This study will examine what are those factorstogether”. which affect the dividend policy of banks in Pakistan.

Dividend policy can be different for different In Pakistan there is no capital gain tax in Pakistan till 2012.countries because of different tax policies, rules, Government has given extension till 2012, but there is 10%regulations and different institutions and capital markets. withholding tax on dividend income. There is another lawThere are three different views about the dividend policy. that if a firm has earned profit but announces dividends toFirst view is of [3], who argued that dividend policy its shareholders then government will charge 35% incomeincreases the shareholders wealth. The second view is of tax. In Pakistan many investors prefer capital gains over[4] and [5], their view is that dividend policy is irrelevant cash dividends; investor preference may be a factorand the third view about the dividend policy is that it which influences the dividend policy of Pakistani firms.decreases the shareholders wealth, this view is given by As described by [8] that regulations may banks different,[6] in 1979. in Pakistan Securities and Exchange Commission has

There is limited research on determinants of dividend implemented many changes in the capital market ofpolicy of Pakistani firms, no doubt the debate that is there Pakistan. This paper will examine that is there any effectany difference between banks and non financial firms is of size, profitability, growth and cash flows of banks onvery old, as [7] left a question in 1985 that “Are banks dividend policy. Is there any impact of ownership

existence of regulations constraining the actions of banks

Middle-East J. Sci. Res., 18 (3): 410-424, 2013

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structure, last year dividends, risk, agency cost and deals with the financial restructuring, while poorcorporate taxes? This study also examine that does profitability results from high operating costs. Thesedividends act as signaling device and also checks that problems deal with operational restructuring, [10].does banks in Pakistan smooth their dividends?. To improve the poor performance of banking sector,

What Is Dividend and Why Companies Pay Dividend?: divided into three categories.Dividends are distribution of a company’s profits whichit distributes to its shareholders, the amount of dividend First generation of reforms (1988-1996)is depends upon the shares on own. Dividends may be in Second generation of reforms (1997-2001)form of cash dividends in which the company pays some Third phase of reforms (2002-2004)cash amount per share to share holder, or it may be interms of stock dividends, in which the company issues In early 1990s; in order to establish more market-new stocks to existing shareholders in proportion of their based monetary management system, SBP introducedexisting shares. For investors dividends are return on their financial reforms. These reforms were introduced toinvestment. increase the competition, allow free entry of private banks,

There are many reasons that why companies pay standardize accounting and auditing system, strengthendividends, it may be the reason to reduce the agency cost SBP supervision and manage the financial sector morearise between managers and share holders or to reduce efficiently. In these reforms government partiallythe uncertainty of investor. As one goal of the investor to privatized the banks and liberalized the interest rates. receive returns on continuous basis, so they prefer to The SBP was granted greater power in February 1994.invest in firms paying dividends. Firms paying more The 1997-98 reforms initiative was aimed to improve bankdividends have easy access to capital market. Dividends regulators and management, the markets and the courts toalso effect the stock valuation. confer effective regulations and governance in order to

Banking Sector in Pakistan: Banking system in Pakistan faster, increase their share in the market, make easier forwas started with the idea of founder of Pakistan “Qauid-e- the customers to take loans; partially private banks wereAzam Muhammad Ali Jinnah”. He proposed that State completely privatizedBank of Pakistan (SBP) will play a pivotal role in elevating In third stage of reforms, focus was on improving andthe Pakistan’s economy. strengthening the banking sector structure. It aims at

There are two type of restructuring mechanism: one privatization, minimum capital requirement, prudentialis market based solutions such as liquidation without regulation and technical enhancement. SBP strengtheneddeposit compensation, sale or merger, shareholder capital banks audit and supervision. SBP established standardinjection etc. and the other one involves the government for rating overall banks.intervention like formation of asset recovery trust, Increasing the profitability requires effective policies,liquidation with deposit insurance, supply side solution. hardworking and efficient management and a strongBoth types of restructuring mechanisms have been used institutional infrastructure. However, Pakistanfor the development of banking industry, sometimes restructured its financial sector effectively within a verymarket base system and sometimes government short span of time, but the profitability and sustainabilityintervention in this sector. of financial sector depends heavily on strong corporate

[9] Proposed two types of restructuring mechanisms: governance, effective risk management and mitigationoperational and financial restructuring. According to them system, macroeconomic stability, prudent supervisorythe function of restructuring mechanism is to return the and regulatory framework, reorientation of bankingprofitability and solvency of the banks. The bank industry and a well diversified and competitive financialsolvency would stem from shorter-term financial system [11].restructuring measures such as long-term borrowing,capital injection, swapping bonds for NPLs etc. While Review of Literatureincreasing the profitability involves more tricky and long Types of Dividend Policiesterm operational restructuring such as cost reduction, Residual Policy: This theory states that firm will only payeffective risk management and improved internal dividends from the earnings left after financing all positivegovernance etc. Hence, the level of bank’s insolvency NPV projects. In this policy, the main concern of the

banking reforms were launched. These reforms can be

enhance the efficient financial intermediation. To grow


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managers is to invest more and more and in this case where,dividend policy becomes irrelevant. Firms adopts this D = The change in dividend per share of firm i fromtype of policy because they more rely on internally time t-1 to t (i.e. D – D )generated funds and are not willing to raise new capital D = The target dividend of firm i in period tfor saving floatation and other costs associated with D = The actual dividend of firm i in period t-lissuing debt and the managers think that high retention c = The speed of adjustment in dividend to thecause more growth to the company. difference between the target dividend and last

Constant Payout Residual Dividend Policy: In this type of a = Intercept andpolicy, firms pay a fix percentage of its earning to the u = A zero mean, constant variance, non-autoshare holder each year called dividend payout ratio correlated error term.calculated by dividend per share divided by firm earningper share. If the earning of the firm reduces or firm face Work of [7] and [13] are example of early work onloss in any year, the dividends will be reduced or dividend policy. [7] Used [12] model and they have alsodiminished, so this is the problem with this type of policy same view as [12] had. They said that Linter model can beand rare firms chose this policy. improved by adding last year earnings; they argued that

Smooth Residual Dividend Policy: Many firms adopt this policy. [13] used model of [14] and argued that earningtype of policy. In this type of policy, firms pay fixed effect more on the dividend policy instead of last yearamount of dividend to shareholder each year, firms don’t dividends.cut dividend after announcing the dividend. Firm usingthis policy only increase the dividends when they are sure Dividend Irrelevance Theory: [4] give irrelevance theory,that firms earning have increased. in which they state that “In perfect capital market, where

Small Quarterly Dividend with Annual Bonus: Some investor are rational, all investors have samefirms chose this type of policy. In this type of policy firms opportunities and information symmetry is there, dividendpay low regular dividends, if the earning increases than policy is irrelevant. Dividend policy has no impact onnormal earning then firms pay additional dividend market value of firm or its cost of capital. It means that itdesignated as extra or special dividends. By designating doesn’t matter that firm pay dividends or retain cash.the additional amount of dividends as special dividends But in real world there is no concept of perfect capitalfirms avoid giving investor false hope. This type of policy market, there are transaction costs, investor and firmsis chosen by those firms who have temporary shifts in have to pay taxes, there is information asymmetry.their earnings. This theory is foundation of modern corporate finance.

Theoretical Background dependent on present and future cash flows and dividendOverview: In his seminal work of dividend policy, [12] doesn’t affect the value of firm. [15] and [5] also has viewconducted a research and makes interviews of to same to the [4].management of 28 US firms and concluded that dividenddecision are mostly dependent on current year profits and Bird In Hand Theory: In 1963, [3] presented the bird inpast year dividend. He also found that managers have hand theory. This theory states that dividends arelong term dividend payout policy and managers change relevant and they affect the firm’s value. As from thedividend when they are certain about future earning and name of theory we can guess the old proverb “A bird inthey are reluctant to reverse the decision in near future. hand is worth than two in the Bush”, most investors areHe also concluded that managers don’t make sudden risk averse, so they prefer the prefer cash in hand insteadchanges in dividends they make partial adjustments in of future capital gains, here bird is referred to cashdividends to target payout ratio. Linter has given dividend and bush is referred to future capital gain.following mathematical model for partial adjustment He also discussed that dividend paying firms are seemrelationship. to be more profitable and have easy access to capital

D = a + c (D – D ) + u stock.it i i i t i t-1 i t*

it

i t i t-1*i t

i t-1

i

period's dividendi

it

last year profits have a strong influence on the dividend

there is no transaction cost, no taxes, no bankruptcy cost,

MM irrelevance theory suggests that value of firms is

market and paying dividends effect the valuation of the


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Dividend Signaling and Information Asymmetry Theory: shareholders. And their view about the external funds isIn 1961, [4] found that dividends have a signaling effect; that firms prefer debt over external funds because duegiving dividends transmit information to the market. to sale of new shares, price of existing shares decreasesGenerally increase in dividends transmit positive signal to and it is against the existing shareholders and theythe market and appreciate the price of stock and cuts in have view that risk free debt has no impact ondividends transmit negative signal to the market and it will shareholders wealth. If the debt is risky it has less effectreduce the share price [16]. Also concluded that on the existing shareholders rather than the effect ofcompanies use dividends as signaling device to the issuing new shares.market. He also discussed that managers can forecast thefirms future earning and they have proper knowledge Free Cash Flow Theory / Agency Theory: The concept ofabout the earnings of the firm and all the insiders have the this theory starts from agency problem and agency cost.proper knowledge but the outsiders don’t have the proper Agency problem refers to the problem arise betweenknowledge about the firms earning and it creates principal and agent, principal are shareholder and agentsinformation asymmetry, so for information symmetry are managers. Main duty of managers is to run thebetween the insiders and outsiders managers announce business efficiently and increase the shareholder wealth.dividends. The agency problem arises when managers have excess

Tax Preference Theory: [17] Was the first scholar who and uses that cash for their leisure and comfort and thisresearch dividend policy with context to the taxes and is agency problem. So shareholders have to monitor theconcluded that higher pretax returns are the compensation managers, cost of monitoring is referred to agency cost.for the investors for facing tax disadvantage. Tax To reduce the agency cost [21] give explanation that topreference theory states that investors consider taxes and reduce the agency cost dividends are given to theit plays an important role for personal investment shareholders, when dividends are issued then managersdecisions as well as corporate investment decisions. has less cash in hand and they can’t misuse it. [22] arguedCapital gains are taxed at lower rate and it is taxed it that when managers have less cash in hand, so forrealized (when the asset is sold) but cash dividends are financing new projects managers will move towards thetaxed at higher rate and taxed when the company gives capital market and capital market impose some restrictionsdividend to the share holder so many investors prefer to the managers for misusing the money and capitalcapital gains. markets also monitor the managers.

Pecking Order Hypothesis: Pecking order hypothesis Share Repurchase: Share repurchase are also used asstates that firms prefer internally generated funds for signals but it transmit different information as dividendinvestment opportunities and for issuing dividends and do, shares are repurchased by firms when they have noif internally generated funds are less then firms prefer debt profitable investment opportunity and it shows thatover external equity. earning will be reduce in near future [23]. [24] States that

There are two different views about “why firms prefer and firm is fully financed by debt and its leverage ratio willpecking order hypothesis” increase and also chances of bankruptcy also increases.

First view is given by [18] in 1961, he argues that Clientele Effect: Preference of investor to receive a cashfirms prefer internally generated funds over debt because dividend capital gain is referred to clientele effect. In thethey want to avoid floatation and other cost associated clientele effect tax rate matters. The investors who arewith the debt and firms prefer debt over external equity paying heavy taxes want to invest in the stock that retainbecause the cost of external financing is higher than the cash and pay fewer dividends because they want capitalcost of debt. gains but the investors who are paying less tax want

The other view is given by [19] and [20] they have return in form of dividends and they invest in highview that total benefits of debt financing are greater than dividend paying stocks. Mostly old age or retiredthe floatation and other costs associated with debt in investors invest in dividend paying stocks. We areterms of tax shield and financial distress risk. They argue studying Pakistani context, in Pakistan government hasthat firms depend upon internally generated funds given extension that no capital gain tax will be collectedbecause firms want to maximize the wealth of existing till 2010.

cash flow, they invest in low or negative NPV projects

share repurchase will cause change in capital structure


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Banking Dividend Studies: Financial sector has some the firm share price or its capital cost. If there is nodifferent characteristics, so research on dividend policy is significant impact of dividend policy, then it means it isless and from the sample research on dividend policy irrelevant [4]. Suggest that value of firm is only affectedbanking sector also excluded. by its business risk and basic earning power. From the

In 1999, [25] find the effect of announcement of previous studies we have identified the following factorsdividend cut by money center banks has a contagion that affect the dividend payout policies of the firms.effect in stock returns and they concluded that on stockof non announcing money center banks there are Leverage: High debt means that firms have high interestabnormal negative returns and on stock of large regional expense, which will lead to a low net income and thus lessbanks it has lesser effect. The main factor which influence earning will be available for shareholders. Dividendthe dividend policy of North American banks are growth payments to shareholders may suffer the financing andof profit and number of shareholders and there is no investment plans especially in case of high leveragedsignificant impact of past growth level, beta and insider firms. Earnings of highly leveraged firms are more riskyownership on dividend policy of North American banks, and volatile and accordingly pay low dividends [32], [33].but these variables have significant impact on the [21], [34] found negative relationship between financialdividend policy of other industries [26]. In 2005 [27] leverage and dividend payout ratios, providing support toworked in Nigerian banking industry and show the tax the free cash flow hypothesis of [21] that in case of freeeffect on that industry, they identified following cash flow managers prefers to pay dividends. Highlydeterminants which affect the dividend policy of Nigerian leveraged firms tend to low dividends payouts in order tobanking industry, current profits, financial leverage, reduce transaction cost of external capital [35]. [36] Foundcapital structure, past dividends and legal restrictions. negative relationship between leverage and dividendShare repurchase has strong influence for reducing payout ratios of firms listed in kualalumpur stockagency cost and a signal for future profits for North exchange and concluded that highly leveraged firms retainAmerican banks but for non financial sector these results more instead of distributing profits to shareholders. [37]are opposite [28].[29] worked on public and private banks also found negative relationship of leverage with dividendand concluded that private banks give more dividend than payout In Jordan, concluding that firms using more debtpublic sector banks and also concluded that dividend commits itself to fixed financial charges in forms ofpolicy is affected by control structure.[30] surveyed the interest payments, failure to pay these periodic interestNASDAQ listed firms and identified four determinants payments leads to business liquidation- so a risk iswhich affect the dividend policy, but their weights for associated with highly leveraged firms that results in lowfinancial and non financial sector are different. For dividend payments. [38] found negative and insignificantfinancial sector the sequence of impact is profit stability, relationship of leverage with dividend payout ratio ofpast dividends, current year profits and projected profits, companies listed on Karachi stock exchange andfor non financial sector their sequence is past dividends, concluded that leverage has no impact on firms’ dividendprofit stability, projected profits and current year policy. In order to fund increasing dividend paymentsprofits.[31] found that for Indian banking industry past firms are willing to increase the level of debt in theirdividends and current profits are the most important capital structure, as dividends act as signaling device todeterminants of dividend policy. the investors [39]. [40] explored positive relationship of

Empirical Literature are consistent with the expected return pattern at differentOverview: “The harder we look at dividend the more it levels of economic stability. [41] also found positiveseems like a puzzle with pieces that just don’t fit together” relationship between leverage and dividend payout ratios.[2].

Numerous literatures on dividend policy provide no Size: [42], [43] concluded that size plays a prominent roleevidence about generally accepted rules for the level of in explaining firms’ dividend policy. As firm grow, theypayout ratios that maximize shareholders wealth [2]. mature, have easy access to financial market and becomeConcluded his study with the question: “what should the less dependent on internally generated funds whichfirms do about dividend policy? We don’t know” [12]. allows them to pay higher dividends. Larger firms payArgued that last period dividends and current year lower transaction cost as compared to smaller ones forearning has positive influence on the dividend policy. raising new financing and pay more dividends [44]. [41]It is argued that there is no effect of dividend policy on also found positive relationship between firm size and

leverage and dividend payout, arguing that these findings


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dividend payments. Investor perceive that larger firms follow a generous dividend payout policy. On contraryless risky hence these firms have a better position in the young and new firms need cash reserves to financemarket and can raise more funds as compared to the investment plans and pay lower dividends.smaller ones and pay higher dividends. Additionally, the As dividends payments and investments both aremanagement of large firms is inclined to pay higher linked to the firm’s cash flow, so firms in growth stagedividends [45]. [37] has concluded that size positively have investment opportunity, following pecking ordercorrelate with dividend payout ratio. His study supports hypothesis pay low dividends [54]. [55] Suggested thatthe agency cost explanation, in large firms excessive dividends announcements as a way for stock pricecash flow results in significant agency cost. Thus evaluation, because dividend announcements serve asdividend could play important role in reducing agency signal for growth and lack of investment opportunity. [56]cost. Size plays significant negative impact on dividends using America stock market data found that higherreasoning that large firms reinvest their profits into assets dividend payouts were associated with higher futureinstead of paying dividends to shareholders [46]. [47] growing firm. [21] suggested that highly growing firmsusing the data of 245 non financial companies found have relative lower amount of free cash flow (cash inpositive impact of size on the dividend payout ratio. excess of funds required for all the projects havingMaking comparison of Pakistani and Chinese listed firms positive NPV) as compared to firms having few growthconcluded that in Pakistan larger firms pay dividends opportunities- having lower amount of free cash flowwhere as in china smaller firms offer more dividends [48]. reduces the agency cost and ultimately the need to pay

Liquidity: [49] Found positive relation between the between growth opportunity and financing needs,liquidity and profitability explaining that firms earning reasoning that normally working capital needs exceed thestable cash flow (high liquidity) are in position to pay incremental cash flows from additional cash flows fromhigher dividends as compared to firms facing unstable new sales. So dividend payout ratio is inversely related toearning. [50] also found positive relationship between firm’s financial need to fund growth opportunities. [58]liquidity and dividend payout policy suggesting that due stated that investment and dividends depend on eachto shortage of cash, poor liquidity results in less generous other, In case of growth opportunities investment needdividend payout policies. [51] argued that firms having arises and dividend payments fall, on the other hand inimproved financial position initiates dividend increments absence of growth opportunities firms pay dividends towhile companies facing financial problems triggered by reduce agency cost. [46] found no relationship betweendecreasing profitability and low liquidity levels are forced growth and dividend payout of listed firms of Karachito cut dividends. [46] also concluded that dividend stock exchange.reducing firms face liquidity problems. [39] found negativerelationship between liquidity and payout ratio, Profitability: The decision about paying dividends startssuggesting that increasing dividend payout ratios reduce with firms profits; therefore it seems logical to thinkthe liquidity and higher return on equity stimulates the profitability as threshold factor and profitability level asfirm need to retain more to reinvest or lower the dividend. one of the most significant variable in explaining dividendIn case of Indian firms [52] also found opposite relation payout decision.between liquidity and dividend payout ratios. [41] The pecking order hypothesis provides someexplored that liquidity does not have a significant impact explanation for the interrelationship of dividend payouton dividend policy. and profitability, taking into consideration the cost

Growth: [37] found negative relationship between growth profitable firms find it difficult to pay dividends, whileand dividend payout, suggesting that firms in growth highly profitable firms are in the situation to internallyphase has investment opportunities, to finance these generate funds to finance investment needs and payopportunities from internally generated funds, firms have dividends. The classical work on dividend policy was ofto retain more and to pay very little or no dividend. [12]. After consulting 28 well established us firms heThese findings are providing support to the pecking order developed a model for “How managers make dividendhypothesis. [53] found that mature companies are likely to decision”. His study concluded that dividends pattern ofbe in low growth phase and less attractive investment a firm are influenced by its current year earning and pastopportunities, these firms don’t have any incentive to year dividends. [59] surveyed the financial managers ofretain more as a result of less capital expenditure firms US firms and reported that both current and past year

dividends. [57] Indicated that there is a direct relationship

associated with issuing debt and equity financing less


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profits have influence on the dividend payout. [60] decrease when insiders executives, managers andusing sample of Malaysian companies summarized that directors increase their ownership because in this caseprofitability level measured by return on assets has a interest of both managers and shareholder will align andpositive and statistically significant impact on dividend there will be no need to use dividends as a device topayout ratio. [21] concluded that firms earning high alleviate agency cost. [65] stated that high agency costprofits prefer to pay more dividends if they have no result in high dividend payout and its solution is firm’sinvestment opportunity. [61] Found positive relationship ownership structure. [66] suggest that firms having morebetween profitability and dividend payout ratio, collateralize assets have lower agency cost betweenconcluding that Greek firms prefer to pay each year rather stockholder and bondholder, as these assets cab be usedthan following a constant payout. [62], in case of Indian as collateral against the money borrowed. Managerialfirms concluded that dividend payouts fluctuate efficiency of the firm can have influence on the dividenddepending on the firm’s profits. As explained by pecking payments trend with the agency cost framework.order hypothesis, [37] found a significant positive Firms where management is more efficient, assetsrelationship between profitability and dividend payout of turnover will be high and more value will be paid to shareJordan firms but 1% increase in profitability (Proxied by holders- shareholders will prefer to reinvest becauseEPS) leads to an increase of only. 167% to dividend yield. agency cost will be low and less dividend payment willIn case of Nigerian banks [27] concluded that both current result. [55] surveying the previous studies, concludedyear profits and past year dividends are the determinant possible reasons for why firms prefer to pay dividends.of current year dividends. [63] Reported that due to family There are resulting decrease in agency cost, market signalowned business environment in Pakistani context of dividend payment (signaling theory) and bird in handbiasness at the time of director announcements results in theory. [67], in their study found that high dividendhuge pays and fringe benefits. Due to these extra costs payment in case of principal agent problem forcesnet profit are declined and it becomes difficult for the firms management to move towards the capital market to fulfillto declare the dividends, mainly shareholder suffer in all the financing need. In such environment high dividendthis game. [64] for diverse firms showed that dividend are payout minimizes the agency cost. [58] found negativesensitive to firm’s profitability, but this relationship is non relationship between agency cost and dividend payout.linear when firms profitability achieve a certain point, [43] validate the view that high insider ownershipreinvesting profits again can return more profits in future, (lower agency cost), lower dividend payments will result.the opportunity cost of holding dividends will increase [68] viewed that in agency costs and dividends payoutand tendency to pay dividend decrease. [39] found that literature, two perspectives explain dividend payoutfirm profitability is negatively correlated to the dividend variation. First firm’s dividend payout ratio is the functionpayout. [30] stated that in case when a firm needs to of tradeoff between agency cost reduction and increasedplough back a major proportion of its profits to supports transaction cost resulting from need of external financingrapid growth, low dividend may results. [41] found that as dividend payout ratios increase. Second, higher insiderprofitability is irrelevant in explaining the dividend payout ownership and external debt financing are substituteratios. means to reduce agency cost.

Agency Cost: The agency theory by [24] focus on the Last Year Dividend: [69] Conducting a research on Greekconflict of interest between the owners and managers and banking industry concluded that previous year dividendproportion of assets controlled by insiders. When there are not predictor of current year dividend. They arguedis separation of ownership and control, managers tend to that due to high earning volatility in banking industry,invest much part of free cash flow prerequisite/self managers don’t follow the long term dividend payout ratiointerest that results in significant agency cost. To reduce that is unaffected by the firm’s financial performance.the agency cost owners may feel it in their interest to [70], in case of Nigerian firms found that last yearincur bonding cost and distribute more individuals. [35] dividend significantly affect the current period payoutsupports the preposition that firms whose insiders have and firms strive not to cut dividends payment from thea low proportion of equity; significant agency cost preceding years, instead they try to increase the payoutresults- ultimately firm spay dividends to reduce the ratio. [71] viewed that firms usually set a target dividendagency cost. [37] using firms common stock held by the payout ratio and try to adjust dividend payments to thisinsider as the proxy for agency cost found significant target. Furthermore firms follow a stable dividend payoutimpact on dividend payout, arguing that agency cost will policy and gradually increase the dividend according to


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target payout ratio. These findings point out that current have choice to distribute earnings in order to minimizeyear dividends are also affected by previous year manager’s discretion and shield their own interest. [38]dividends. [72] found that Indian firms set a lower target using the data of Pakistani firms listed at Karachi stockpayout ratio and face high level of adjustment. exchange found positive relation between insider

Risk: Generally it seems to exist a negative relationship strategy dividends will go to pockets of directors, thebetween risk and profitability because firms in risk chance of dividend payout will be low if significantconditions are not able to distribute earning rather amount of distributed earnings is paid to the outsiders.preferred to retain [73]. measuring risk a year to year [77] found strong negative relationship between insiderfluctuations in earning, found inverse relationship. ownership and dividend payout ratios. This relationshipHe concluded that these firms which have relatively stable may be interpreted in different ways: first banks haveearning can easily predict their future earnings. Such firms higher level of managerial ownership may choose to payhave relatively low risk and pay higher proportion of its lower dividends because owners/managers want to avoidearnings then the firms facing high variation in earnings. penalty cost of double taxation, second higher level of[35] using beta value as a measure of risk found negative insider ownership may lead financial institutions to retainand statistically significant relationship of risk with the more money to invest in other opportunities. [78] founddividend payout. His findings also suggest that firms that firms with higher level of institutional holdings andfacing high market risk payout lower dividends. [49] high rate of return on equity distribute more earnings inAlso found negative relationship between risk and dividends. [43] found that greater the insider ownershipprofitability, suggesting that it difficult for the firms to pay lower will be the dividends, while in case of large numberhigh dividends experiencing high volatility, such firms of shareholders firms will pay high dividends to overcomeprefer to pay either low or no dividends. In case of the agency problem. [79] concluded that higherNigerian banks [27] concluded that firms dividend institutional holding have no impact on the firm’spayment announcement convey information to the market dividend payout ratio. [47] Ramli (2010) concluded thatabout the firms risk. [39] and [58] found that greater the payout ratio increases as percentage of ownership offirms risk, lower will be its payout ratio. [74] proposed that large shareholders increases.managers formulate change in corporate policies whenthey anticipate changes in corporate earnings or business MATERIALS AND METHODSrisk. Two lines of managerial decisions have a significantimpact on stock prices, these are, 1. choice of capital Research Design: Our study is exploratory in nature thatstructure and 2. How much earnings to distribute as we want to investigate the determinants of dividenddividends. policy in context of Pakistani banking industry, which is

Ownership Structure: Ownership has been discussed the firms.widely in context of dividend puzzle, literature yieldsmixed findings. [37] And [35] viewed that greater the Population and Sampling: Our population is bankingpercentage of insider ownership, lower will be the industry of Pakistan listed at different stock exchanges.dividend payout ratio. The plausible explanation is that Our sample size is the data of 27 banks (foreign andfirms pay higher dividends to reduce cost associated with domestic) listed at different stock exchanges of Pakistan.the agency problem. In case of higher insider ownership For the purpose of this study we develop the databaseagency cost will be lower and firms will retain more. using annual reports collected from the concerned banksInsider ownership serves as substitute for dividends to and library of state bank of Pakistan. The coverage isreduce agency cost. [75] analyzing the data of 4000 firms restricted to the period of 2003 to 2009. We have selectedin 33 countries found that firms operating in those all those banks whose annual reports for at least 3 yearscountries where government legislation provides greater were available. There is a limitation in data that someshield to minority shareholder, pay more dividends and banks came late in Pakistan and annual reports of somedividends payments are the result of legal protection of banks were missing.investors instead of agency problem. [76] In case ofTunisians firms found no relationship between ownership Sampling Technique/Procedures: We use the convenientconcentration and dividend payout ratio. Due to less sampling as the data of as much banks was easilyprincipal agent problem in Tunisians firms, owners don’t available, we have included in our sample.

ownership and dividend payout. Because in such a

based on secondary data collected from annual reports of


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Research Instrument /Tools: We have used stepwise in profitability) is used as proxy for risk and natural log ofregression analysis. Using this regression method, each number of shareholders is used as proxy for ownershipvariable is being added to the model in view of its structure.estimation power over the dependent variable. Every timea variable enters to the model, all the others are Model and Variable Selection: We developed thereexamined. Those that lose their estimation power in following statistical model using stepwise regressionfunction of the new variable entered are being excluded of analysis.the analysis and so on, until we have a set of significantvariables. Div = + sz + lvrg + liq + prof + agnc +

Data Collection: Data for the thesis is collected from theconcerned bank’s websites, their head offices and from where,the library of State Bank of Pakistan. Div = Dividend per share and it is dependent

Methodology: Variables and their proxies are selected on = Constantthe basis of past studies. We have selected following , …. = Coefficients of the independent variables variables which affect the dividend decisions of firm.These variables are size, leverage, liquidity, profitability, whereas sz, lvrg, liq, prof, agnc, grth, div , risk, ownagency cost, growth, last year dividend, risk and represents size, leverage, liquidity, profitability, agencyownership structure. cost, growth, last year dividend, risk and ownership

For the size [43] used natural log of sales as a proxy structure and all these variables are dependent variables.and [46] used natural log of total assets as a proxy.For leverage, debt to equity ratio is used as proxy by [37] We have generated following hypothesis:and debt to total assets ratio is used by [80, 39, 69, 36].For liquidity natural log of cash from operation is used by H = There is positive relationship between size and[50], log natural of net cash flow of firm by [81, 80] and dividend payout.current ratio is used by [39]. EPS is used by [37, 46] as aproxy for profitability, ROA (EBIT / T.A) is used by H = There is negative relationship between leverage[41, 82, 30]. Another proxy for profitability, ROE and dividend payout.(Net income / Equity) is used by [39]. For agency cost freecash flow is used as proxy by [43] and other proxy H = There is positive relationship between liquidity andwhich is used for agency cost is operating expense ratio. dividend payout.For growth, annual sales growth is used by [50, 39] andinvestment opportunity is used by [46]. Last year H = There is positive relationship between profitabilitydividend is used as proxy for Last year dividend by and dividend payout.[12, 80, 69, 82, 39]. Beta (variability in profitability) is usedas proxy for risk in by [58, 50, 49, 80] and other proxy H = There is positive relationship between agency costfor risk is variability of earning which is used by [39]. and dividend payout.For ownership structure natural log of number ofshareholders is used by [37] and number of shareholders H = There is positive relationship between growth andhaving more than 5% shares is used as proxy by [46, 43]. dividend payout.%age of total shares held by insiders is used by [43, 39],whereas %age of institutional holding is also used as H = There is positive relationship between last yearproxy for by [49]. dividend and dividend payout.

We used natural log of sales as a proxy for size, debtto equity as proxy for leverage, natural log of cash from H = There is negative relationship between risk andoperations as a proxy for liquidity, EPS as proxy for dividend payout.profitability, free cash flow as proxy for agency cost,annual sales growth as a proxy for growth, last year H = There is positive relationship between ownershipdividend as proxy for last year dividend, beta (variability structure and dividend payout.

1 2 3 4 5 6

grth + div + risk + own 7 t-1 8 9

variable

1 2 9

t-1

1

2

3

4

5

6

7

8

9


419

RESULTS AND DISCUSSIONS have easy access to external market, can raise funds at

Following are the results of stepwise regression ultimately distribute more as dividends. Discussinganalysis obtained by using “SPSS”. positive relationship of both last year dividend and

Table 2 represent the overall model output. Value of profitability with the current and future dividendR , .782 shows that overall model explains the 78.2% payments in context of signaling theory and information2

variation in the dependent variable, dividend payout. asymmetry, insiders/managers have more informationValue of R shows that suggested model provides the about the current situation and future prospects for the2

substantial explanation about the dependent variable. company. This case is severe in medium and large sizeIn ANOVA table (Table 3), model p-value is .000 that firms where mangers are controlling on the behalf of

depicts that relationship is highly significant. Overall, shareholders. Little information to the shareholders mayfigures shows that results are quite explanatory. Table 4 result in low investment from outsiders or underand Table 5; results about the different independent valuation. Dividend signaling occurs only when firmvariables shows that; profitability, last year dividend and increases or decreases dividend payments. Last yearownership structure have strong positive relationship dividend or distributing current year profits as dividendswith the dividend payout, while liquidity has strong serve as a signal for the investors about the companynegative impact on dividend payments. Future more, financial conditions and future growth opportunities.effect of size, leverage, agency cost, growth and risk is When a signal goes to the market, level of informationobserved insignificant. asymmetry reduces and investors act according to their

Coming towards the explanation of individual perception about the signal. In this way, last yearvariable, last year dividend has a positive impact and its dividend payment/current profits distribution result inp-value .000, depicts highly significant relationship. overvaluation and ultimately increased investment in theThese findings reflect that previous dividend payment company. As the investment level rises, futurerecords of any firm serve as a signal about future time expectation about high level of profits rises and aperiod. If past records show that firms pay high dividend, relationship of high profits and increased dividendthen such a payment behavior can be expected about payments is expected.the future and vice versa. Considering the dividend According to our findings liquidity is the singlepayout policies, such a dividend payment behavior variable that has a highly significant (p value = .005) butprovides support to the smooth dividend payout policy. negative relationship with the dividend payout,These firms don’t cut but try to increase the payout ratio. suggesting that the firms that have a better liquiditySuch findings about the last year dividends are position pay low dividends. These findings are confirmedconformed by [70] that firms strive not to cut the dividend by [39] that high return on equity stimulates the firms topayments from the previous year, rather they trend to reinvest more, as dividend payment reduce the amount ofincrease it. Sustaining/ losing the previous dividends funds available for reinvestment, so firms pay lowpayment pattern also suggest about the stability/volatility dividends. Another explanation for this relationship mayof the earning. These findings suggest that in Pakistani be that banks have high need of liquid cash as comparedcontext, till 2009, earnings of banking industry was quite to any other industry, because their total operationshigh, resulting from flexible lending and leasing policies involve either payment are receipts of cash. Moreover,that generates huge income in form of interest receipts. banks try to lend more in order to increase their returns.The second most important variable that has highly So in order to achieve smooth flow of operations andsignificant (p- value .000) and positive relationship with increase the future return, banks tend to maintain highthe dependent variable is the profitability. The plausible level of liquidity. So, in such scenario negativeexplanation behind the profitability level of banking relationship between the liquidity and dividend payoutindustry is discussed above. So, the firm earning high can be expected. Ownership structure also has highalso distribute more. Such findings about the profitability significant (p-value=.014) and positive relationship withare confirmed by [60, 61]. Another explanation about the the dividend payout we have used “Log natural ofpositive relationship of profitability and dividend payout number of shareholders” as a proxy for ownershipwas provided by [35], that firms that are highly profitable structure. When ownership is divided into large number

lower cost as compared to less profitable firms and


420

Table 1: Variables Description

Variable Description Proxy Used By

Size Natural log sales ln sales Holder, Langrehr, Hexter (1998)Leverage Debt / equity Al Malkawi (2007)Liquidity ln Cash from operations Kanwal and Sujata (2008)profitability EPS EPS after tax Al Malkawi (2007), Hafez and Attiya javed (2009)Agency cost Free cash flow (Net income + deprecation + interest – Holder, Langrehr, Hexter (1998)

capital expenditure)/ total assetsGrowth Growth rate Annual sales growth Kanwal and Sujata (2008), Kania and Bacon (2005)Last year dividends Last year dividend Linter (1956), Baker, Farrellay and Edelman (1985),

Eriotis, Vasiliou and Zisis (2007), Aivazian, Booth,Cleary (2003), Kania and Bacon (2005),

Risk Beta Variability in profit D’Souza (1999), Kanwal and Sujata (2008),Amidu and Abor (2006), Baker, Farrellay andEdelman (1985)

Ownership structure Insider ownership ln of # of shareholders Al Malkawi (2007)

Table 2: Model Summarye

Model R R Square Adjusted R Square Durbin-Watson

1 .884 .782 .774 2.314a

a. Predictors: (Constant), last year dividend, Profitability, Liquidity, ownership structuree. Dependent Variable: dividend

Table 3: ANOVAe

Model Sum of Squares Df Mean Square F Sig.

1 Regression 443.984 4 110.996 89.840 .000a

Residual 123.549 100 1.235

Total 567.533 104

a. Predictors: (Constant), last year dividend, Profitability, Liquidity, ownership structuree. Dependent Variable: dividend

Table 4: Significant coefficientsa

Unstandardized Coefficients Collinearity Statistics---------------------------------- -----------------------

Model B T Sig. Tolerance

1 (Constant) 2.586 2.155 .034last year dividend .699 10.008 .000 .564Profitability .144 6.088 .000 .537Liquidity -.235 -2.904 .005 .788ownership structure .088 2.069 .041 .915

a. Dependent Variable: dividend

Table 5: Excluded variablese

Collinearity Statistics------------------------

Model Beta In T Sig. VIF

A Size .066 .886 .378 2.554a

Leverage -.013 -.255 .800 1.117a

Agency cost .023 .387 .699 1.539a

Annual Sales growth .019 .397 .692 1.057a

Risk -.014 -.297 .767 1.014a

e. Dependent Variable: dividend


421

of shareholders then each shareholder has only small ownership base is diversified, small investors requireproportion of total ownership, referred to as small current period dividends instead of future returns andinvestor. These small investors require and prefer current firms pay more dividends to control the agency problemperiod dividends instead of future period increased resulting from reduced insider ownership. Impact ofreturns, so a positive relation between ownership Liquidity is negative as it can be expected in bankingstructure and dividend payout is expected. Another industry because their total operations are based on liquidexplanation may be that, in case of large number of cash so even in case of high liquidity banks prefer toshareholders, level of insider ownership falls and firms maintain a substantial amount of liquid cash to smoothprefer to pay more dividends in order to reduce resulting out operations. Size, leverage, agency cost, growth andagency cost. These findings are confirmed by [83]. risk do not have any significant impact on the dividndOur findings about the ownership structure are in contrast behavior of Pakistani banks.with another study in Pakistan context by [46], that firmswhere insider ownership is high pay more dividends REFERENCESbecause in such a strategy large proportion of dividendswill go into the pockets of insiders. 1. Brealey, R.A., S.C. Myers, et al., 2005. Principles of

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Determinants of Dividend Policy: A Case of Banking Sector in Pakistan