IMPACT OF DIVIDEND POLICY ON SHARE PRICES

Supervisor:
Mr. Waseem Ullah Mr. Zeeshan Arshad

Submitted By:
Muhammad Ali Bilal Asghar Mohsin Altaf 10031920-157 10031920-081 10031920-181

Department:
Business Administration M.B.A 6th semester

Submission Date:

20th June 2013

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IMPACT OF DIVIDEND POLICY ON SHARE PRICES

ABSTRACT:
The study intends to focus on the impact of dividend policy on share prices and how the share prices effect by earning per share, size, dividend payout ratio, growth and return on equity. The data was collected from KSE and business recorder for the period of six years comprising from 2006 to 2011. Data sample of ten companies are taken from motor vehicles, trailers and auto parts industry of Pakistan. The result of this study is based on least squares method, Heteroskedasticity Test, and serial correlation LM test to explain the relationship between dividends and stock prices after controlling the variables like Earnings per Share, size, dividend payout ratio and growth.

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TABLE OF CONTENTS
1. INTRODUCTION...............4-6 2. LITERATURE REVIEW...................................6-8 3. SAMPLE SIZE AND VARIABLES.8 4. CONCEPTUAL FRAMEWORK......9-10 5. HYPOTHESIS..................................................10 6. METHODOLGY & RESULTS..................10-14
6.1. Multiple Linear Regression11-12 6.2. Serial correlation....12-13 6.3. Heteroskedasticity....13-14

7. CONCLUSION..............................................15 8. REFERENCES.....................16

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INTRODUCTION:
Dividend policy is one of the most widely researched topics in the field of finance but, the question is whether dividend policy affects stock prices is still remains debatable among managers, policy makers and researchers for many years. Dividend policy is important for investors, managers, lenders and for other stakeholders. It is important for investors because investors consider dividends not only for the source of income but also a way to assess company from investment point of view. It is the way of assessing whether the company is cash generative or not. Selecting a suitable dividend policy is an important decision for the company because flexibility to invest in future projects depends on the amount of dividends that they pay to their shareholders. If company pay more dividends then fewer funds available for investment in future projects. Lenders are also interested in the amount of dividend that a company declares, as more amounts is paid as dividend means less amount would be available to the company for servicing and redemption of their claims and finally it is important for other stakeholders especially for claimholders to help them in reducing agency cost. The basic objective of shareholder is to maximize their return and this return may be in the form of dividends or capital gain. Investors decision regarding the return on investment is affected by dividend policy of the company Once a company makes a profit, management must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors. Dividend Policy refers to a companys policy which determines the amount of dividend payments and the amounts of retained earnings for reinvesting in new projects. This policy is related to dividing the firms earning between payment to shareholders and reinvestment in new opportunities. There are certain important factors that companies consider in designing their dividend policies like managerial and behavioral environment, firms profitability ratios,
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willingness of the company etc. Juma'h & Pacheco (2008) explained that management decision of dividend policy is affected by managerial and behavioral environment in U.S.They explained that sometimes financially strong companies do not pay dividend and financially weak companies pay dividends. It is not important that strong companies always pay dividend. Share prices are the most important indicators used by investors to invest or not to invest on a particular share. Their main objective of investing in the stock market is to maximize the expected return at low level of risk. There are some theories about dividend policies which are as follow:

Dividend Irrelevancy Theory:

This theory was proposed by Franco Modgliani and Merton Miller in 1961 who argued that the value of the firm is determined by the basic earning power and the firm's risk and not by the distribution of earnings. The value of the firm therefore depends on the investment decisions but not the dividend decision. Their argument was however based on the following assumptions: (a) No corporate or personal taxes (b) No transaction costs associated with share floatation (The market is perfect and frictionless) (c) The firm's investment policy is independent of the dividend policy (d) The market is efficient and therefore investors and managers have the same set of information regarding future investment opportunities. They were able to prove that dividend is irrelevant in the determination of the value of the firm using the dividend yield model.

The Bird-In-Hand Theory:

This theory was advanced by Myron Gordon and John Litner in 1963 who argued that a bird in hand is worth two in the bush and thus when a shareholder receives cash dividend he is better off than one receiving capital gain. Investors therefore value dividend more than capital gains and a firm that pays dividend will have a higher market value. They concluded that dividend decisions are relevant and a firm that pays higher dividend has higher value.
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Tax Differential Theory:

This theory was advanced by Litzenberger and Ramaswamy in 1979 who noted that the tax rate on dividend is higher than the rate on capital gain (In Kenya Capital gain tax has been suspended). A firm that pays dividend will therefore have a lower value since shareholders will pay taxes on this dividend. Dividend decisions are relevant and a firm that pays no dividend has the highest value.

Signalling Theory:
Stephen Ross in 1977 argued that in an inefficient market, management can use dividend payment to signal important information to the market which is only known to them. If management increases dividend, it signals expected high profit and therefore share prices will increase. Therefore dividend decisions are relevant and a firm that pays higher dividend will have a higher value (especially in an inefficient market).

The Clientele Effect Theory:

This theory was proposed by Richardson Pettit in 1977 who stated that different groups of shareholders have different preference for dividend. For example the low income earners will prefer higher dividend to meet their consumption needs while the high income earners will prefer less dividend so as to avoid the payment of taxes. Therefore when a firm sets a certain dividend policy there will be shifting of investors to it and out of it until equilibrium position is reached. At equilibrium, the dividend policy set by the firm will be consistent with the clientele it has. Therefore dividend decision is an irrelevant decision especially at equilibrium

LITERATURE REVIEW:
Many studies have been conducted on dividend policies previously which explain the relationship between dividend policy and stock prices. These studies are very helpful for new researchers to explore the dividend policy in a modern way. Murhadi (2008) explores the study on dividend policy. This paper was conducted in Indonesia. This study examines the relationship between the dividend policy and its impact on the share prices. This paper shows that the
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companies which enter in growth phase tend not to pay a lot of dividend than compared to companies at matured stage. This paper based on three keywords signaling theory, agency theory and life cycle theory. This study shows that there is a positive relationship between dividend policy and share prices. Hashemijoo et al(2012) explores the impact of dividend policy on shares price volatility. This paper was conducted in Malaysia. The purpose of this paper is to examine the relationship of dividend policy and share prices. This volatility is measured by dividend yield , dividend payout and multiple regeression. The results of this study shows a negative relation .This study shows that how firms attracts investors in different tax brackets and how firm can increase the market value of firm and share repurchases. In(1963) Gordon gave his view about the dividend policy which he present with the dividend relevance theory. Which explained that dividend policy affect the market price of share and the value of firm. Investors also prefer secure and current income in the form of dividends over capital gains. The Studies which conducted by Travlos, Trigeorgis, & Vafeas in (2001), Baker, Powell & Veit (2002), Myers & Frank (2004), Dong, Robinson & Veld (2005) and Maditinos, Sevic, Theriou, & Tsinani (2007) they all support dividend relevance theory. Black & Scholes in (1974) found that there is no relationship between dividend policy and stock prices. Their results also show that dividend policy does not affect the stock prices and it is only depends on investors decision to keep either they want high or low yielding securities; return earned by them in both cases remains the same. A article of Barclay and Smith in (1995) they said The Maturity Structure of Corporate Debt found that high growth companies have lower Dividend Payouts and Debt Ratios with respect to low growth companies, and they have higher Debt Ratios and Dividend Payouts ratios. In this case investors prefer high Dividend Payouts and consider that it is less risky than the capital gain. In (1996) Allen & Rachim found by their study that there is no relationship between the dividend yield and stock market price even after studying 173 Australian listed stocks but it show positive relation between stock prices and size, earnings and leverage and negative relationship with stock prices and payout ratio but in another study which held in (1989) by Baskin examine 2344 U.S common stocks from 1967 to 1986, and he found a significant negative relationship between dividend yield and stock price. There is another study which was conducted by Ho (2002) tells relevant to the dividend policy in thi model or study he use the panel data approach and fixed effect regression model. His study show the liquidity of Japanese firms
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and positive relation between dividend policy and size of Australian firm. He also found the negative relationship between dividend policy and risk in only Japanese firms. In the overall industrial effect is found to be significant in both Japan and Australia. In an article of Baker, Powell & Veit (2002) Reinvesting Managerial Perspectives on Dividend Policy provided new evidence of managers decision about dividend policy. They did a survey of managers of NASDAQ firms that are consistently paying cash dividends. Their survey shows at the end of their study that managers are mostly aware of historical pattern of dividends and earnings. So this is the reason, they design their dividend policies after considering all that things in their mind. In(2003) Pradhan also tell the effect of dividend payment and retained earnings on stock market price of the Nepalese companies. Results of his study show that stock price has strong relationship with dividend but stock market price has weak relation with retention ratio. Adefile explores the effect of dividend policy on the market price of shares. This paper was conducted in Nigeria. This paper tells us about that how much companies pay to their share holders. The study examines the possible effects of firms dividend policy on the market price of its common stock .The Pearsons product movement correlation is adopted to evaluated the data of companies. The main objective of this study is to examine the possible effects that a firms dividend policy might have on the market price of its common stock. The study shows insignificant results. Waithaka(2012) explores the effects of dividend policy on share price. This study was conducted in Nairabi(Kenya). This study shows the relationship between the dividend policy and the market price of share. The management primary goal is to maximize share holders profit. The objective of this study is to identify how clientele effect influence share price of Nairobi stock exchange. The study concluded that an increase in firm stock trading volume effect the share price. Khan (2012) explores the effects of dividend on stock prices. This paper was conducted in Pakistan. This paper tells about how dividend effect on stock prices. The time series graph and pivot graphs are plotted on data for results. The results indicate that the stock prices of all sample companies change with the change in dividend per share .The exchange rate effects stock prices by changing the firms operating profit and cash flows. The finding of study shows that stock prices of all sample companies change with the change in dividend per share.

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SAMPLE SIZE AND VARIABLES:

Sample of ten companies are taken from motor vehicles, trailers and auto parts industry of Pakistan for the period of six years from 2006 to 2011.The data is taken from the listed companies in Karachi stock exchange for the period of 2006 to 2011. The purpose of this article is to see the relation between Dividends either Cash Dividend or Stock Dividend with Stock Prices after controlling Earnings per Share, growth, size, dividend payout ratio and Return on Equity. Market Price of share is calculated by taking the average of high and low market prices of the shares. It is expected that Cash Dividends are positively related to Stock Prices. If the company pay larger amount of cash Dividends then it will result in high market value of shares. Return on Equity is also considered as important variables in this study. Return on Equity is calculated by dividing profit after tax with shareholders equity. It is expected that Return on Equity is positively associated with Stock market Prices. Liu & Hu (2005), Raballe & Hedensted (2008), Ling, Mutalip, Shahrin, & Othman (2008) and Khan, Aamir, Qayyum, Nasir, & Khan (2011) found positive relation between Return on Equity and Stock Prices. Retention Ratio is calculated by subtracting Total Dividend from Total Earnings and then divided the resulting amount by Earnings. Negative or positive relation between Retention Ratio and Stock market Prices will depend on the perception of investors. If investors think that company has more profitable opportunities than outside than it will positively affect the Stock market Prices otherwise it will negatively affect the Stock market Prices. Pani (2008) found positive relation between dividend to Retention Ratio and Stock Prices while Khan, Aamir, Qayyum, Nasir, & Khan (2011) found negative relation between dividends and stock prices.

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CONCEPTUAL FRAMEWORK:
Here is the conceptual framework of dependent and independent variables. We take share price as a dependent variable and growth, size, dividend payout ratio and earnings per share as independent variable. The conceptual frame work shows that dependent variable share price is dependent on the other five independent variables. The arrow shows towards dependent variable

HYPOTHESIS:
Ho: There is no relationship between dividend and share prices H1: There is a relationship between dividend and share prices.

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METHODOLOGY:
We used panel data approach to measure the relationship between dividend and share prices. For this purpose we used least squares method Heteroskedasticity Test serial correlation LM test on the panel data. All the stable characteristics of the selected companies for this research is controlled by OLS method. This method is used for the better results. The serial correlation method is used to see the correlation between the variables. The characteristics of selected companies are different in terms of amount of capital, size and number of shareholders etc. So, this method is used for the better results to explain the relation between the companies. We applied these results on our data to see the significance of data. Our results become significant after taking the log of all the values of data.

RESULTS AND DISCUSSION:

Multiple Linear Regression:

Share price is dependent variable size, growth, dividend payout ratio and earnings per share are independent variables. Equation used for linear regression is.

SP = + 1SIZE+ 2EPS+ 3Growth+ 4DPR+ Error terms

Table 1
Dependent Variable: SP Method: Least Squares Date: 07/10/13 Time: 13:07 Sample (adjusted): 2 60 Included observations: 59 after adjustments Variable SIZE GROWTH EPS DPR C R-squared Adjusted R-squared Coefficient 0.744496 -0.429731 0.050644 0.067079 -1.020326 0.668719 0.536772 Std. Error 0.227769 0.165118 0.007919 0.023820 0.798015 t-Statistic 3.268644 -2.602569 6.395486 2.816026 -1.278579 Prob. 0.0019 0.0119 0.0000 0.0068 0.2065 1.270857 0.692949

Mean dependent var S.D. dependent var

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S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic)

0.471627 12.01132 -36.76258 17.80210 0.000000

Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

1.415681 1.591743 1.484408 1.482148

Individual prob
In multiple regression model 59 observations of 5 variables are included after adjustment. Multiple linear model shows that size has significant positive relation with share price. If size has increased by1$ then share price is increased by 0.744$.Dividend payout ratio, earning per share and growth has also significant positive relation with share price. We can say that there is a 66% confident level that these variables play a significant role in determining share price in Pakistan.

Jointly prob(F-statistics)
Jointly all explanatory variables determine the share price and have significant relation with share price. prob (F-statistics) is 0.0000 which is less than 5%.Hence it can be said that there is 100% confidence level that these variables play a significant role in determining the share prices in Pakistan.

(R2)
R2 is 0.66 which is near to 1 and shows the fitness of model. This showed high explanatory power of the variables in determination of share prices in this model.

No Autocorrelation
It is one of the OLS assumptions that there should be no the serial correlation among the observation of variables and should be random walk. prob chi square (2) is 0.086 which is more than 5% and Durbin-Watson stat is 1.92 which is near to 2 it means there is no autocorrelation.

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Table 2
Breusch-Godfrey Serial Correlation LM Test:
F-statistic Obs*R-squared 2.349343 4.889399 Prob. F(2,52) Prob. Chi-Square(2) 0.1055 0.0868

Test Equation: Dependent Variable: RESID Method: Least Squares Date: 07/10/13 Time: 13:11 Sample: 2 60 Included observations: 59 Presample missing value lagged residuals set to zero. Variable SIZE GROWTH EPS DPR C RESID(-1) RESID(-2) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient -0.148683 0.074865 -0.003437 -0.000156 0.441515 0.325731 -0.062293 0.082871 -0.022951 0.460266 11.01593 -34.21062 0.783114 0.587042 Std. Error 0.245856 0.169880 0.008156 0.023384 0.838853 0.151463 0.148514 t-Statistic -0.604757 0.440691 -0.421433 -0.006651 0.526332 2.150556 -0.419443 Prob. 0.5480 0.6613 0.6752 0.9947 0.6009 0.0362 0.6766 -1.51E-15 0.455073 1.396970 1.643458 1.493189 1.917497

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

Heteroskedasticity:
The condition of linear regression model implies that there should be Homoskedasticity between the variables. There is no Heteroskedasticity between the Variables and prob chi square (4) is 0.067. Which is more than 0.05 which shows the presence of homoskedasticity and there is no Heteroskedasticity. For this we applied Breusch-Pagan-Godfrey and Harvey tests to check the Heteroskedasticity. After applying these tests we check that there is no Heteroskedasticity in data.

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Table 3
Heteroskedasticity Test: Breusch-Pagan-Godfrey
F-statistic Obs*R-squared Scaled explained SS 3.660559 12.58543 7.386823 Prob. F(4,54) Prob. Chi-Square(4) Prob. Chi-Square(4) 0.0104 0.0672 0.1168

Test Equation: Dependent Variable: RESID^2 Method: Least Squares Date: 07/10/13 Time: 13:14 Sample: 2 60 Included observations: 59 Variable C SIZE GROWTH EPS DPR R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 1.153602 -0.288686 0.135178 0.001464 -0.032853 0.213312 0.155039 0.223428 2.695678 7.316308 3.660559 0.010389 Std. Error 0.378051 0.107903 0.078223 0.003751 0.011285 t-Statistic 3.051449 -2.675424 1.728113 0.390133 -2.911290 Prob. 0.0035 0.0099 0.0897 0.6980 0.0052 0.203582 0.243063 -0.078519 0.097544 -0.009791 1.718845

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

CONCLUSION:
This paper is an effort to reveal the factors which determine the share prices with reference to Motor Vehicles, Trailers and Auto parts listed in the KSE-100 Index. The data of 10 companies were identified from the Motor Vehicles, Trailers and Auto parts listed in the Karachi Stock Exchange that have been setting share prices for the past 6 years (2006-2011). In light of previous study, key explanatory variables were identified to disclose their relationship and effect on determination of share prices. These variables earning per share, dividend payout ratio, size and growth was identified as the most appropriate tool for econometric analysis of the data. The descriptive statistics revealed that
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data is normally distributed. OLS were tested, the data was found to be homoskedastic and there is no autocorrelation. Results show that earning per share, size and dividend payout ratio shows significance and positively related to share prices whereas growth has significant negative relation with share prices. Jointly results show that all explanatory variables jointly determine the share prices with prob(0.000). Since share price can be solved further, thus there is need for future research for better results.

REFERENCES:
Adefila, J. J., Oladipo, J. A., & Adeoti, J. O. (2004). The Effect of Dividend Policy on the Market Price of Shares in Nigeria: Case Study of Fifteen Quoted Companies. International Journal of Accounting. University of Ado-Ekiti, 2 (1). Baker, H. K., & Powell, G. E. (2012). Dividend Policy in Indonesia:Survey Evidence from Executives. Journal of Asia Business Studies , 6 (1), 79 - 92. Baker, H. K., Mukherjee, T. K., & Paskelian, O. G. (2006). How Norwegian Managers View Dividend Policy. Global Finance Journal , 17 (1), 155-176. Baker, H. K., Powell, G. E., & Veit, E. T. (2002). Revisiting Managerial Perspectives on Dividend Policy. Journal of Economics and Finance (26), 267283.

Chen, D.-H., Huang, H.-H. L., & Cheng, T. (2009). The Announcement Effect of Cash Dividend Changes on Share Prices: An Empirical Analysis of China. The Chinese Economy , 42 (1), 62-85. Evidence from Dhaka Stock Exchange. Journal of Business Research, 7, 61-72. Walter, J. E. (1956). Dividend polices and common stock prices. The Journal of Finance, 16, 29-41. 6511 Ho, H. (2002). Dividend policies in Australia and Japan. International Advances in Economics , 2 (9), 91-100.
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Khan, K. I., Aamir, M., Qayyum, A., Nasir, A., & Khan, M. I. (2011). Can Dividend Decisions Affect the Stock Prices: A Case of Dividend Paying Companies of KSE. International Research Journal of Finance and Economics (76), 67-74. Myers, M., & Frank, B. (2004). The Determinants of Corporate Dividend Policy. Academy of Accounting and Financial Studies Journal , 8 (3), 17-28. Nazir, M. S., Nawaz, M. M., Anwar, W., & Ahmed, F. (2010). Determinants of Stock Price Volatility in Karachi Stock Exchange: The Mediating Role of Corporate Dividend Policy. International Research Journal of Finance and Economics (55), 100-107. Nishat, M., & Irfan, C. M. (2003). Dividend Policy and Stock Price Volatility in Pakistan. 11th Pacific Basin Finance, Economics and Accounting Conference. Pradhan, R. S. (2003). Effects of Dividends on Common Stock Prices: The Nepalese Evidence. Research in Nepalese Finance. , 1-13. Travlos, N., Trigeorgis, L., & Vafeas, N. (2001). Shareholder Wealth Effects of Dividend Policy Changes in an Emerging Stock Market: The Case of Cyprus. Multinational Finance Journal , 5 (2), 87-112. Uddin, M.H., & Chowdhury, G.M. (2005). Effect of dividend announcement and shareholders Value:

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