CHAPTER NO.

1 – INTRODUCTION

1. Dividend Policy of Indian Corporate Firms: An Analysis of Trends and

The present study examines the dividend behaviour of Indian corporate firms over the period
1990 – 2001 and attempts to explain the observed behaviour with the help of trade-off theory,
and signalling hypothesis. Analysis of dividend trends for a large sample of stocks traded on
the NSE and BSE indicate that the percentage of companies paying dividends has declined
from 60.5 percent in 1990 to 32.1 percent in 2001 and that only a few firms have consistently
paid the same levels of dividends. Further, dividend-paying companies are more profitable,
large in size and growth doesn’t seem to deter Indian firms from paying higher dividends.
Analysis of influence of changes in tax regime on dividend behaviour shows that the trade-off
or tax-preference theory does not appear to hold true in the Indian context. Test of signalling
hypothesis reinforces the earlier findings that dividend omissions have information content
about future earnings. However, analysis of other non-extreme dividend events such as
dividend reductions and non-reductions shows that current losses are an important
determinant of dividend reductions for firms with established track record and that the
incidence of dividend reduction is much more severe in the case of Indian firms compared to
that of firms traded on the NYSE. Further, dividend changes appear to signal
contemporaneous and lagged earnings performance rather than the future earnings
performance.
From the practitioners’ viewpoint, dividend policy of a firm has implications for investors,
managers and lenders and other stakeholders. For investors, dividends – whether declared
today or accumulated and provided at a later date - are not only a means of regular income,
but also an important input in valuation of a firm. Similarly, managers’ flexibility to invest in
projects is also dependent on the amount of dividend that they can offer to shareholders as
more dividends may mean fewer funds available for investment. Lenders may also have
interest in the amount of dividend a firm declares, as more the dividend paid less would be the
amount available for servicing and redemption of their claims.

However, in a perfect world as Modigliani and Miller (1961) have shown, investors may be
indifferent about the amount of dividend as it has no influence on the value of a firm. Any
investor can create a ‘home made dividend’ if required or can invest the proceeds of a
dividend payment in additional shares as and when a company makes dividend payment.
Similarly, managers may be indifferent as funds would be available or could be raised with
out any flotation costs for all positive net present value projects.

But in reality, dividends may matter, particularly in the context of differential tax treatment of
dividends and capital gains. Very often dividends are taxed at a higher rate compared to
capital gains. This implies that dividends may have negative consequences for investors.
Similarly, cost of raising funds is not insignificant and may well lead to lower payout,
particularly when positive net present value projects are available. Apart from flotation costs,
information asymmetry between managers and outside investors may also have implications
for dividend policy. According to Myers and Majluf (1984), in the presence of information
asymmetry and flotation costs, investment decisions made by managers are subject to the
pecking order of financing choices available. Managers prefer retained earnings to debt and
debt to equity flotation to finance the available projects.

Information asymmetry between agents (managers) and principals (outside shareholders)

The presence of information asymmetry may also mean that managers need to signal their
ability to generate higher earnings in future with the help of high dividend payouts
(Bhattacharya, 1979, John and Williams 1985, and Miller and Rock, 1985). However, the
credibility of signals depends on the cost of signalling – the cost being loss of financial
 flexibility. High payout results in reduction of free cash flow when in fact the firm needs more
funds to pursue high growth opportunities. Rozeff (1994) models payout ratios as a function
of three factors: flotation costs of external funding, agency cost of outside ownership and
financing constraints as a result of higher operating and financial leverage.

To summarize, several theories have been proposed in explaining why companies pay
dividends6. While many earlier studies point out the tax-preference theory, more recent
studies emphasize signalling and agency cost rationale of dividend payments. However, the
dividend puzzle is yet unresolved and the words of Fischer Black (Black 1976) may well
apply in today’s context: “The harder we look at the dividend picture, the more it seems like a
puzzle, with pieces that just don’t fit together”

 Brealey (1992) poses the dividend policy decision as “What is the effect of a change in cash
dividends, given the firm’s capital-budgeting and borrowing decisions?” In other words, he
looks at dividend policy in isolation and not as a by-product of other corporate financial
decisions.
 Lintner (1956) finds that firms pay regular and predictable dividends to investors, where as
the earnings of corporate firms could be erratic. This implies that shareholders prefer
smoothened dividend income.
 Bernstein (1998) observes that given the ‘concocted’ earnings estimates provided by firms,
the low dividend payout induces reinvestment risk and earnings risk for the investors.
 Black (1976) notes that in the presence of taxes, investors “prefer smaller dividends or no
dividends at all”.
 According to Kalay (1982), in the absence of restraining covenants, shareholders can
transfer wealth from bondholders by paying off dividend to themselves either by selling
existing assets or by reducing investment or by using proceeds of a senior debt.
 Baker, Powell and Veit (2002) survey different streams of research work on dividends.

Fischer Black (Black 1976) may well apply in today’s context: “The harder we look at the
dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together”. One
of the striking aspects that have been noticed in recent periods is the lower dividend paid by
corporate firms in the US. Fama and French (2001) analyze the issue of lower dividends paid
by corporate firms over the period 1973-1999 and the factors responsible for such a decline.
They attribute the decline to changing firm characteristics of size, earnings and growth.
However, it is to be seen whether the change towards lower dividends is a permanent feature
or will there be reversal.
1.1 Indian Scenario

In the Indian context, a few studies have analyzed the dividend behaviour of corporate firms.
Mahapatra and Sahu (1993) find cash flow as a major determinant of dividend followed by
net earnings.
Bhat and Pandey (1994) undertake a survey of managers’ perceptions of dividend decision
and find that managers perceive current earnings as the most significant factor.
Narasimhan and Asha (1997) observe that the uniform tax rate of 10 percent on dividend as
proposed by the Indian union budget 1997-98, alters the demand of investors in favour of high
payouts.
Mohanty (1999) finds that firms, which issued bonus shares, have either maintained the pre-
bonus level or only decreased it marginally there by increasing the payout to shareholders.
Narasimhan and Vijayalakshmi (2002) analyze the influence of ownership structure on
dividend payout and find no influence of insider ownership on dividend behavior of firms.
However, it is still not clear as to what is the dividend payment pattern of firms in India and
why do they initiate and omit dividend payments or reduce or increase dividend payments.
Hence it is proposed to analyze the dividend payout of firms in India and analyze the dividend
initiations and omissions and other changes in dividends and the signals that these events
convey.
Following Fama and French (2001), the present study also attempts to analyze the impact of
profitability, size and growth on the dividend payout of firms. Similarly, following Healy and
Palepu (1988) an attempt is made to analyze the signaling hypothesis, i.e. earnings
information conveyed by dividend initiations and omissions.
Since, initiations and omissions construe extreme dividend events, changes in dividends i.e.,
increases and decreases and the information that they convey is also examined following
DeAngelo, DeAngelo and Skinner (1992).
There have been several changes in the tax regime in the last few years. The union budget
1997-98 made dividends taxable at the hands of company paying them and not in the hands of
investors receiving them. Similarly there have been changes in the capital gains tax and
exemption of dividend income under Section 80 L of the Income Tax Act 1961.
All these changes have implications for the dividend policy of corporate firms.
According to tax-preference or trade-off theory, favourable dividends tax should lead to
higher payouts.
Hence it is proposed to analyze the impact of tax regimes on dividend policies of corporate
firms.
1.2 Objectives of Corporate Firms.

 To study the trends in the dividend payment pattern of Indian corporate firms
 To analyze the impact of changes in dividend tax on the propensity to pay dividends
 To analyze the influence of firm characteristics such as profitability, growth and size on
the dividend payment pattern.
 To analyze the signalling hypothesis, specifically earnings information conveyed by
dividend initiations and omissions.
 To analyze the influence of loss on dividend reductions.

.
In other words, the present study focuses on an analysis of dividend trends and attempts to
analyze the determinants of these trends with the help of trade-off or tax-preference theory
and signaling hypothesis.

There are other important determinants of dividend behavior such as transactions costs,
which we will not analyze, in the present study. In the next Section, we review the
relevant literature, followed by a description of the database employed and methodology
adopted in Section 3.

Dividend trends are discussed in Section 4, and the analysis of characteristics of dividend
payers is presented in Section 5. Sections 6 and 7 deal with the signaling hypothesis: first
the case of dividend initiations and omissions and second dividend reductions. Section 8
summarizes the finding of study, points out limitations and concludes with directions for
further research.
1. Introduction