Stability of Dividends in India

Stability of Dividends in India BY Kntika18 NSE Research Initiative, Project Report no. 229 / 2009 Determinants and the Stability of Dividends in India: Application of Dynamic Partial Adjustment Equation using Extended Instrumental Variable Approach Dr. Manoj Subhash Kamat Dr. Manasvi Manoj Kamat Summary This paper improves on earlier research on stability and determinants of dividend policies by using a more advanced estimation methodology, a larger and more representative sample of panel data (PD), and different proxies for a longer time window 1971-2007.

It is aimed to find whether the Indian private corporate sector ollow stable cash dividend policies, whether dividends smoothen earnings in India, to estimate the implicit target payout ratio and speed of adjustment of dividends towards a long run target payout ratio. We further test applicability of dividend stability hypothesis and add to the relatively limited literature on aspects of dividend decision by examining the dynamics of relationship between dividend payouts and a host of other explanatory variables.We estimate the basic static PD model, GMM-in- Levels {GMM (in-Lev)} model, and its other variations GMM-in-first-differences {GMM in-DifO] and GMM-in-Systems {GMM (in-Sys)}so to include other lag structures. This procedure shows us how much the size of the dividend determinants, the speed of adjustment coefficient and the one of the implicit target payout ratio varies across the different estimation techniques. In addition, it will also be useful to compare our results with those of Pooled OLS-estimation with alternate data definitions for checking the robustness of the results.Keywords: Dividends, Determinants, Stability, Panel Data, Partial Adjustment Model, GMM, GMM on-Diff), GMM on-sys), India.

Variable Approach Introduction There is no consensus in the financial markets or in financial literature about the need, importance and factors affecting dividend policy behavior. On one hand there is a view that dividends significantly affect the value of firm and shareholders' wealth as per Jensen (1986); while there prevails a skeptical view about the Value added' by dividends on the other hand according to Modigliani and Miller (1958) and Miller and Modigliani (1961).Though Damodaran (2000) points, dividend decisions like investments and financing decisions are crucial and involve radeoffs, there seems to be little consensus on what should lead us in terms of a and stability of dividend can be grouped into two categories. Those based on the implicit assumption of asymmetric information, and that based on the explicit assumption. The seminal work in that of Lintner (1956), Fama and Babiak (1968) and Marsh and Merton (1986) hypothesize asymmetric information, whereas the theories based on explicit assumption of dividends include the agency theory, pecking order theory and the dividend signaling theory.Among the foremost papers on dividend olicy, Lintner (1956) embodies dominant patterns of decision-making with respect to dividends.

The decisive contribution to the theoretical modeling of dividends by Miller and Modigliani's (1961) view dividend payment policies as a passive residual of retentions; prior to their work it was believed that the dividend payment by firms would increase firm value. Further the proponents of signaling theories like Aharony and Swary (1980) and Kwan (1981) present that the firms change their dividend policies to signal relatively better information to the market.Since Lintner neither onsiders the factors like size, debt, investment, managerial aspects etc. nor considers regulatory constraints in determining dividends, of late this led other researchers to explore and investigate other plausible variables which might possibly be significant. The issue of dividend stability and determinants has been researched and proved for across countries, except for some very recent studies in emerging markets.

Objectives This piece of research is planned in context of an emerging market, India and aims to set the stage for enquiry into relevance of dividend policy by emphasizing its mportance to the firm. As such, this is a first attempt to take a holistic view of dividend using rich set of unexplored panel data pertaining to Indian companies for the period 1971 through 2007. In the backdrop of findings of prior researches we review herein, the objectives are to analyze issues relating determinants and stability of the corporate dividend structures in India.It would be intriguing to find whether the Indian private corporate sector follow stable cash dividend policies, whether dividends smoothen earnings in India and to estimate the implicit target payout ratio nd speed of adjustment of dividends towards a long run target payout ratio.

We further test applicability of dividend stability hypothesis and add to the relatively limited literature on aspects of dividend decision by examining the dynamics of relationship between dividend payouts and a host of explanatory variables.The factors as to how liberalization process affects these determinants and whether these factors have changed over time are also explored. Very particularly, we examine the role of industry type and select macro-economic factors in determining the Indian corporate payout policy behavior by interpreting the existence and mportance of firm and time effects on data and if so, look whether the information in these effects is more parsimoniously captured by our variables, that vary only over firms or only over time..

The proposed study attempts to unearth various factors that determine the dividend policy decisions in India. Although tax policy, depreciation policy, retention policy, interest rate, size of the firm, age of the firm and investment opportunities etc. are theoretically assumed to be major determinants of the corporate dividends, in the light of lower effective corporation tax rate than nominal rate and higher effective epreciation rate than its nominal or general rate, the meager dividend performance in India cannot be attributed to the taxation and depreciation systems.It is contemplated to shed light on several unresolved issues on dividend policy from a developing country perspective.

Detailed empirical evidence for a developing countries' viewpoint is important, because the institutional frameworks can differ significantly from those in the developed countries. Given that the Indian capital market is developing and the economy is targeted to be one of the largest in world, our results could fill an important gap in 3 empirical literature.Dividend policies have implications on financing and investment behavior of firms. Payment of dividends reduces free cash flows and alternatively the scope for investments in newer and efficient projects. Deciding what percentage of earnings to payout as dividends is a basic choice confronting managers because this decision determines not only how much funds flow to investors, but also what firms are retained for reinvestments. Thus, the decisions taken by managers relating dividend are interwoven with that of investments.

Conflicting opinions exists regarding whether dividend is decided first and retained earnings are residual, or etained earnings is a active variable and dividends the result thereof. This attempt could highlight the importance of dividends by enquiring its specific role and significance amongst other investment and financing decisions. The question we wish to address is whether corporate investments and financing patterns lead to payouts or it is the other way round. According to Stable Dividend hypothesis, a firm's value is influenced by the regularity of its dividend payout.Firms with stable dividend policies enjoy better valuation in the capital markets than those with variable dividend policy. It therefore follows that the investors of firms following stable dividend policy will enjoy better opportunity for wealth creation.

Stable dividend policy results in more predictable cash flows in the hands of the shareholders; this reduces uncertainty and consequently the required rate of return whereas variable dividend policy makes the cash flow in the hands of shareholder more variable and hence increases their risk and subsequently, the required rate of return.Managers may then have to satisfy the share holder's preference for increases in rate of return; else the value of the firm will be subsequently affected. Likely Contribution to Knowledge The proposed study is different from rest in many ways. Unlike earlier studies we take a holistic view of dividend using Panel Data (PD) pertaining to Indian companies for the years 1971 through 2007. Second, earlier studies on dividend policy did not explanatory variables causing Ordinary Least Squares (OLS) and Within-Groups estimators to be biased and inconsistent.

We use the Generalized Method of Moments technique developed by Arellano and Bond (1991), Arellano and Bover (1995) and Blundell and Bond (1998). 4 We hypothesize that dividend policy of the firms is chosen, and is not randomly istributed among companies. We also expect the strong influence of industry, financial and macroeconomic factors. We demonstrate specifically the firm, inter and intra-industry effects across varying periods and the significance or otherwise, of time and random effects by pooling time series and cross- sectional data.Few studies in the West demonstrate that dividend payments tend to follow aggregate economic activity in the economy. Some macro-economic indicators like interest rates, inflation, etc.

are likely to affect dividends in some particular way. Thus dividends are roughly ssumed be influenced by, or may interalia influence macro economic policies like that of general price levels and interest rate cycles based on aggregate demand activity in the economy. The analysis of behavior of corporate cash payouts therefore assumes significance from the point of macro-economic and microeconomic policies.An enquiry into a number of such variables and the analysis of plausible impact of structural reforms could make study of the Indian case more interesting.

Literature on dividend policies reviewed herein for purpose of present work reinforces the fact hat number of studies on dividends in emerging market context is scanty. Dividend policy theories are exhaustively propounded; critically evaluated and empirically tested in the West, and mostly in the context of developed markets. Use of reliable databases, wide and deep sample frame and use of contemporary econometric techniques characterize research on the given subject.Given the limited published work in developing countries like India, a need is felt to attempt a comprehensive integration of both, qualitative support to the quantitative findings on dividend policy.

Further, the limited numbers of studies in emerging markets most of them we are able to review, suffer from inadequateness due to scanty coverage of data. This is also true for India. No major private players were able to collect and disseminate widebased data, till some limited sources very recently.The rich data compiled by Reserve Bank of India (RBI) on Company Finances is extensive, but scantly used by researchers. In fact the RBI has been regularly publishing studies on financial performance of Private Corporate Sector for over three decades. The usage of such a onsistent, reliable and wider data canvas can improve reliability of tested models.

Panel Data Analysis (PDA) on corporate dividend policies has emerged in dividend related literature over past decades in the developed economies, due to presence of strong and reliable long run databases at government and at a private level.Only a couple of studies on dividends in the context of India make use of PD, though for maximum period of ten-fifteen years. Majority of studies either use time series 5 determinants over few industries. Major manufacturing industries like Jute, Textile, and Chemicals etc.

are mainly considered. It is for this reason the usage of PD covering Private and Public limited companies spread over different industries for the longer time frame could be insightful. The tendency to pay dividends is under going a metamorphosis in developed and developing countries as well.The earlier studies explore typical dividend determining variables, examine influence of traditional theories and fit basic regressions on time series or cross-sectional data.

Recent developments in interdisciplinary research and advances in computational methods have led to use of different variables, test of emerging explanations, use of ooled data analysis, lag dependent variables, and qualitative variables to explain dividend behavior in developed markets.No systematic attempt to comprehensively apply these emerging techniques in discovering the determinants of corporate dividend policies in Indian context is yet evident. We resort to the use of classical OLS based analysis, static panel analysis (time, firm and random effects) and also dynamic panel data analysis for our interpretations. We subject our PD estimates to a host of alternate model specifications across three different time series, over a longer time frame of 35 years.This study aims to extend understanding of the importance and determinants of dividend policy and may provide guidance on forecasting dividend yields of a company. Moreover, complements the emerging body of literature on payout policies in emerging economies.

One could rely on the methods and models empirically tested and those which have been proved to be most useful in explaining dividend behavior of firms in developed countries by attempting to exploit the theoretical advances and analytical advances in this area.