DO DIVIDENDS MATTER MORE IN DECLINING MARKET?

Table of Contents
Chapter 1: Introduction .................................................................................................. 3
1.1 Introduction and Background of the study............................................................... 3
1.2 Objective of the study .............................................................................................. 4
1.3 Hypothesis................................................................................................................ 4
1.4 Contributions of the study........................................................................................ 4
1.5 Limitations of the study ........................................................................................... 5
1.6 Scheme of the study ................................................................................................. 5
References ...................................................................................................................... 9

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Chapter 1: Introduction

1.1 Introduction and Background of the study

Dividends tend to be a common source of investment for the investors. The

companies are able to distribute the profits to the shareholders as it supports and
encourages investment. Dividends also reflect the success of a company as they are
given to the shareholders from the retained earnings. Investors are usually interested
in the stocks that pay constant dividends. Some of the companies also increase the
dividends each year and these companies are perceived to be stable financially.
However, when the consistent dividends are given, then it grabs the attention of the
investors. If a company does not give dividends, then its reflects that the company is
going through tough times. The companies tend to declare dividends and this
encourages the investors to purchase the stock. As people. Buy the stock, the stock
price increases and generally the increase tends to be the same as the dividend
amount.
Dividend has been researched in a wide manner so far, however, it is still under
question if it impacts the stock prices. It tends to be integral for managers, for the
stakeholders, lenders and investors. The objective of the shareholders is to maximize
their returns. This return can be in the form of capital or dividends. The main
objective of the dividend policy is to maximize the purchasing power of the
shareholders. The consumption patterns of the shareholders are often defined by the
dividend policy of the companies (Arnold, 2008). Juma’h and Pacheco (2008) further
explain that the dividend policy’s management decision is impacted due to the
managerial environment. Often the financially strong companies do not pay dividend
and at times companies that are financially weak tend to pay dividends. The
companies that pay dividend are often larger in size, are more profitable than the
companies that do not pay dividend. Ling, Mutalip, Shahrin and Othman (2008) in
their study also concluded that the companies that tend to pay dividends are more
mature and are more profitable than the companies that do not pay dividends.
Dividends tend to have variety of unique features (Grullon and Michely, 2002). They
further argue that repurchases are only more beneficial for the investors that are more
informed. The payment of the dividend tends to be transparent as they are first
announced and then they are paid by the company on a specific date defined. This

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reflects clearly to the shareholders whether the obligation has been met or not.
Therefore, the performance of the stock greatly depends on the dividends as investors
decide whether to invest or not on the basis of dividends as well.

1.2 Objectives of the study

The objectives of the study is as follows:

• To find out the impact of market condition on the stock performance

• To judge the stock performance using their dividend policy in different
market situation
• To find whether the dividend payment in declining market helps the
firms to maintain or increase its value

1.3 Hypothesis

The hypothesis of the study is as follows:

H1: Payout policy impacts the stock performance.
H0: Payout policy does not impacts the stock performance.

1.4 Contributions of the study

This is one of the pioneering studies on the market conditions and stock performance
in Pakistan. The political and economic uncertainty in Pakistan increases needs for
research and detail study of the market condition. This research is conducted in order
to help the corporate sectors in Pakistan so that they can design their dividend policies
according to the market conditions as the uncertainty in Pakistani markets is very high
and thus the research would enable them to follow the right dividend policy based on
the market conditions whether advancing or declining. The research will also help the
investors to select the right set of securities for their portfolio keeping in mind the
market conditions. The research work will help the investors to make wiser decisions
based on the collected data. The data and analysis will be highly useful for the
shareholders, managers, lenders and investors.

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1.5 Limitations of the study

The limitations of the study include limited access to the updated information
regarding the stock market and firms. Furthermore, secondary data collection is
another limitation, as the data available on the official websites of the firms and stock
market has been collected.

1.6 Scheme of the study

The first chapter of the study discusses the objectives, background, hypothesis,
contributions and limitations. In the second chapter, the literature is discussed in
detail and previous studies are highlighted. The third chapter focuses on the
methodology used in the study, which includes the population, sample, research
design and conceptual framework. The fourth chapter analysis the data using suitable
software. Lastly, the fifth chapter focuses on conclusion and discussion.
Recommendations are also made in the last chapter.

2. Literature Review:

The dividend may be defined as the part of the income or profit by the firm that is
distributed among the shareholders of the firms and it is distributed according to their
contribution and investment in the shares of an organization (Forti et al, 2015).
Most of the times the firms pay dividends to the stockholders in the form of cash. At
times some corporations pay dividends in form of shares that are equivalent to the
profits that are realized by the shareholders as a form of payment by the firm as a
profit for the shares that are already held by the shareholder (Correia et al, 2013).
Firms do face problems in the payment of cash dividends because of the reason that
most of the time the profits realized by the firms are not in cash form hence this
causes problems in long run with regard to the payment of dividends in form of cash
flows.
The major objective of an organization is to maximize the profits and to minimize the
expenses. Therefore, the major question that arises while devising the dividend policy
of the firm is that either it should be provided to the shareholders or not, also either it
is beneficial for the firm or not such that it increases or decreases the value of the
firm.
The payment of dividend and the policy regarding payment of the dividend is a sort of
trade-off between the payment of cash to the stockholders and the retained earnings of
the firm (Firer et al, 2012).

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According to Magni (2010) there are three different views regarding the effect of
dividend on the value of the firm
1. The payment of dividend and dividend policy is irrelevant in a competitive
market
2. High dividends do increase the value of the firm
3. Lower the dividend higher will be the value of the firm

The first perspective was presented by Miller and Modigliani which is also known as
the dividend irrelevance theorem.
Before the publication of the theorem regarding the irrelevance of dividend and its
importance with regard to the value of the firm by Miller and Modigliani (1961), it
was considered widely that the more the dividend was paid by any firm the higher
would be the value of the corporation.
Miller and Modigilani (1959) studied in detail the existing concepts in the literature
and after extensive research, they developed a new framework for analyzing the
dividend policy of firms.
Miller and Modigilani (1961) determined the effect of dividend policy on stock
prices. According to Miller and Modigilani (1961) in the existence of a perfect capital
market, the dividend policy of a firm would not affect the overall value of the firm.
The basic concept behind their theorem was that the value of the firm is determined
by the number of cash flows that are realized by the firm either in the current period
or in the future. enunciated that the wealth of the shareholders is not affected by the
dividend payment decisions by the firms so that the investors of various firms are
mostly indifferent while choosing dividend payments and capital gains as their
realized profits. Furthermore, they discussed that if an investor needs cash dividends,
so they themselves can earn cash by selling out the stocks of the firm which are held
by themselves hence by liquidating their own shares they can earn cash easily.
According to M-M (1961), irrespective of the fact that the how does a firm earn its
profits, the overall value and income of the firm are calculated by the basic earnings
power and the decisions regarding the investments by the firm.
The idea presented in dividend irrelevance theory was based on the assumption that in
case if the existence of a perfect capital market and rational decision makers and
investors, such circumstances would exist in a market. In this perfect capital market,
all the investors and traders would be having equal opportunities to invest and
complete and perfect information regarding the prices of the shares and all the other
relevant characterizes of the stocks of a firm. Secondly, the investors in a perfect
capital market are considered to be rational and they would be considered to be
indifferent in gaining profits from a firm either in the form of payment of a dividend
or the excessive increments that may term ass capital gains. This can also be achieved
by increasing the value of the shares hence when the investors resell their own stocks
they would be able to easily earn benefits in cash form as well. Thirdly, the idea of
dividend irrelevance theory is based on the argument that there is a condition of
perfect certainty existing in the market, which implies that the investor would have
complete information regarding the future prospective developments and programs by

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the organization so that maximum information is available to the investor while
making the decisions for investments (Lambrecht and Myers, 2010).
According to Barman (2012) this theory of dividend irrelevance, “the overall value of
a corporation is determined by the financial decisions and its investments in other
firms and business alongside with an optimal and concrete capital structure and not by
the dividend policy”. Thus, the conclusion of this theory can be explained as the
management should not worry about the dividend policy of the firm when they have
to analyze the value of their firm, as the decision of the firm to pay dividends or to not
to pay the dividend has no impact of the value of the firm. This can only happen in a
market that is free of imperfections and there are no taxes and transaction costs on a
firm. Thus, they are free to trade in the market.
The second aspect of the dividend irrelevance theorem is that to view the effect of
dividend policy on the firm value such that it decreases the value of the firm. The
main argument that is presented by some of the researchers is that the income that is
earned from dividend is taxed. Hence the shareholders have to incur a loss in the form
of double taxation (Ajanthan, 2013). This concept of double taxation is overall
ignored in the dividend irrelevance theorem. Also, if the taxes that are imposed on the
earning from dividends are more as compared to those from the capital gains than it is
obvious that the investors and shareholders would prefer to have the capital gains
instead of the dividend on shares held by the stockholders (DeAngelo and DeAngelo,
2007). On the other hand, this taxation system would be preferred by those investors
who are frequent taxpayers and prefer to earn a clean profit after paying off their
taxes. In these sorts of circumstances where the earning from dividends are taxed
heavily, the total cash flows that are retained by the firms or in the other way if held
by the shareholders, this would result in higher benefit as compared to the payment of
dividends. Thus, if the dividends are taxed and the capital gains are taxed at a rate that
is lower than that of the dividends than the firms would prefer to pay a minimal
amount of dividends to their shareholders than paying up the capital gains (Murekefu,
2012).
Khan et al. (2011) conducted a research to determine either the decisions of the firm
regarding the payments of dividends have an effect on the prices of stocks of firms.
This research was conducted on the firms that are listed on Karachi stock exchange
and they also do pay dividends to their stockholders. The control variables in this
research included the net profits earned after deduction of taxes and interests, earnings
per share, and the returns on equity as well. The sample for this research included
companies that were listed on the Karachi stock exchange. The data was collected for
a time period of 10 years i.e. from 2001 to 2010. The regression models used in this
research were the random effect model and the fixed effect model. The results showed
that there was a direct and positive relationship between the stock prices and profit
after interest and tax deduction, return on equity, earning per share and dividend yield
of the firm. While on the other hand, the stock prices were having an inverse and
negative relationship with the prices of shares for the firms under observation.
The results of this research showed that the investors do expect firms to pay dividends
as the dividend enables them to get information about the internal condition of the

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firm. This is also termed as the signaling effect i.e. the higher the dividends paid by
the firm the better would be internal financial conditions of the firms and vice versa.
Akbar et al. (2010) conducted a study to determine the reaction of the prices of shares
to the announcements of the dividends and the efficiency of the market in Pakistan.
This research was based on the concept of the efficient market hypothesis that was
presented by Fama (1965). According to this hypothesis, the market is fully efficient
and there is no asymmetry of information. Hence the information is readily available
for the investors and them are willing to invest at any point of time given that the
information that is provided to them is authentic and is without any omissions and
errors. The research conducted by Akbar et al. (2010) was thus an in-depth analysis to
investigate the relation and the reaction of stock prices on the dividend
announcements. The variables included in this research were shares, cash, and
simultaneous cash and the dividends on the stocks that are paid by the firms. The
firms included in this observation were 79 in number. These firms were registered on
the Karachi stock exchange, i.e. the KSE-100 index. The data was collected for a time
period of four years ranging from 2004 to 2007. The returns that were realized were
analyzed on the basis of there abnormality. The results showed that there were a very
negligible amount of abnormalities found for the cash returns in the form of
dividends.
The literature suggested that those firms who do have a viable opportunity of
investment available for their investors should invest in other financial prospects.
Thus, when the firms announce dividends in cash, this shows that there is a lack of
opportunity for investment and thus it should be considered negatively (Uddin et al.
2005).
Another explanation of the linkage between the dividend payments and the
performance of stocks is given as the investors dislike those dividend payments that
are paid in the form of cash because of the heavy tax slabs on the income as well the
on the earnings that are made form the dividends. This implies that dividend returns
of stocks should be resulting in the negative normal returns (Atmaja, 2009).

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