DIVIDEND POLICY CATERING THEORY OF DIVIDEND
CATERING THEORY OF DIVIDENDEVIDENCE FROM KARACHI STOCK
EXCHANGE1. IntroductionIn dividend policy theory, Miller and
Modigliani, described that in perfect and efficient market dividend
policy is absolutely irrelevant to share value or stock price. Due
to this irrelevancy, no rational investor has a preference between
dividend and capital gain. MM indicated that value of firms share
is not dependent to dividend payout ratio only. Dividend and share
(buying and selling) are substitute to each other. This means that
either dividend or share purchase or repurchase, which ever is
greater, it contributes to the value of a firm.
This theory was given by them in 1961 and was criticized time to
time. About forty years later, the assumption made in MM theory
i.e. of market efficiency has been proofed thoroughly. The theory
called as Catering theory given by Baker and Wurgler (BW) in 2004.
In this theory, the assumption of perfect and efficient market was
relaxed. This theory states that management of a company initiate /
declares dividend when they sees that the investors relatively high
preference is those stock which is dividend payer and management
omit dividend when they think investors are now preferring
non-payers. Catering theory proposed that managers, in order to
meet the preference of investors, consider /chooses the dividend
policy. It also suggests that when there is a dividend premium
existing in the stock, managers tends to pay Cash Dividend. In
other words firms distribute cash dividends only when investors put
higher prices on dividend payers and when investors prefer
non-payers manager omit cash dividend. Catering theory does not
build a relationship between dividend policy and investor as we can
see in usual that provide emphasizes on irrelevancy of dividend on
investors preferences. Catering theory strictly suggest that the
demand for dividend is directly concern with the investors
sentiment. Also catering theory preferred those share which are
dividend payers i.e. catering focuses on those shares that pays the
dividend. It does not prefer all the shares trading in the stock
exchange. 2. Problem Statement:
In common practice, researcher all over the world has done a lot
of research on dividend and its declaration. Normally they found
the impact of dividend announcement on share price, companys
performance, calculating earning per share, dividend policy impact
on company and others. In precise, every research conducted on
dividend was impact after the declaration of dividend. But no or
some work has been done on declaration of dividend as what factor
drives the company to declare the dividend. Similarly: how, when
and why management declares the dividend. On talking and consider
the behavior finance issue, management also consider the behavior
of investor towards declaration of dividend. In this paper we
investigated how management declares the dividend by considering
the behavior of investor. 3. Research Question:
Does the Management declare dividend by keeping its stock
holders perspective in their mind or they just declare dividend as
and when profit occurs?
4. Objective of the Research Paper:The objective of this paper
is to find out:
1. How the management declares the dividend. Either they declare
it when A company earns profit, A company have high retained profit
and want to distribute it into shareholders or Management reads the
mind of investors and they conclude that its time to declare the
dividend. 2. What is the percentage of payers and non-payers in the
sample of financial sector of Karachi Stock Exchange? 5.
Significance of the StudyThis type of research work has not been
carried out previously. Although there is a lot research work done
on dividend to get the share price/ growth of the company/ market
value of the company etc. But in perspective of declaration of
dividend on catering basis of share holders, this research is being
done for the first time as in the case of KSE. This would have huge
significance over future research work, as this will open the doors
for researcher to deliver the dividend theory in a new perspective.
6. Related Theories:
Theories related to this paper are 1. Catering Theory of
Dividend; developed and presented by M.Baker & J.Wurgler in Jun
2002 in his paper titled A Catering Theory of Dividends. In this
theory, the author / researcher concluded that the decision to pay
dividends is driven by investor demand. This means that the
Dividend Payer firms are dependent to the investors demand for
dividend. This theory satisfies our assumption and hence related to
our research. 2. Second theory that relate to this paper is, Choice
Behavior Theory. This theory was developed and presented by
D.I.Maditinos, eljko evi, in 2007 in his paper, Individual
Investors Perceptions towards Dividends. In this paper the
researchers assumed that there exists a strong preference for
dividends among individual investors. In this theory, they
concluded that majority of investors did show a strong preference
for dividends in their case of Greece Stock Exchange. Hence the
theory satisfies that management has to consider the preference and
demand of investors and declares dividend accordingly. 3. Dividend
signaling theory, suggests that the announcement of dividend payout
is a strong indicator of strong future prospect of the company.
This paper satisfies this research paper to some extent that
management, for strong future prospect of the company and getting
the trust of the investors, declares the dividend. 7. Literature
ReviewJeffrey Wurgler (2002) developed a theory, Catering Theory of
Dividend, in which he described that the decision to pay dividends
is driven by investor demand. Managers cater to investors by paying
dividends when investors put a stock price premium on payers and
not paying when investors prefer non-payers. To test this
prediction, we construct four time series measures of the investor
demand for dividend payers. By each measure, non-payers initiate
dividends when demand for payers is high. By some measures, payers
omit dividends when demand is low. Further analysis confirms that
the results are better explained by the catering theory than other
theories of dividends.
Paola Sapienza (2010) tested catering theory and described how
stock market mispricing might influence individual firms investment
decisions and found a positive relation between abnormal investment
and discretionary accruals. He concluded that abnormal investment
is more sensitive to discretionary accruals for firms with higher
R&D intensity (opaque firms) or share turnover (firms with
shorter shareholder horizons) Also he described that firms with
high abnormal investment subsequently have low stock returns and
the larger the relative price premium, the stronger the abnormal
return predictability. Hence he concluded that patterns in abnormal
returns are stronger for firms with higher R&D intensity or
share turnover.
Malcolm Baker & Jeffrey Wurgler (2003) proposed that the
decision to pay dividends is driven by prevailing investor demand
for dividend payers. To test this prediction, they constructed four
stock price-based measures of investor demand for dividend payers.
By each measure, non-payers tend to initiate dividends when demand
is high. By some measures, payers tend to omit dividends when
demand is low. Further analysis confirms that these results are
better explained by catering than other theories of dividends.
Chikashi Tsuji (2010) tested the catering theory of dividends
using data from firms in the Japanese electrical appliances
industry. Their empirical results suggested that in the Japanese
electrical appliances industry, corporate managers do not consider
catering behavior in either their dividend initiation decisions or
their continuation decisions. This finding is different from
existing evidence for the US and other countries. Japanese
electrical appliances industry firms is the value-weighted dividend
yield in the industry as the value-weighted dividend yield
declines, Japanese firms in the industry tend to initiate dividend
payments.
Joseph Yagil (2004) extended the paper of Baker and Wurglers
(BW) Catering Theory of Dividends and addressed by their model is
whether or not to pay dividends, the extended model offered here,
in contrast, incorporates other dividend related issues such as the
expected cash dividend and the dividend payout ratio. Their
extended model predicts a negative relationship between the
expected dividend per share and the ratio of information about the
cost of the dividend (C) held by category investors and
arbitrageurs, the percent of stock ownership held by category
investors as well as the risk, tax and investment premiums. He also
suggested that one implication of his extended model is that the
dividend sum depends on its short-term and long-term effect on the
stock price, and also depends on the financial leverage and
investment opportunities.
The cost of the dividend includes of three types of premiums
i.e. tax, risk and investment. (Joseph Yagil (2004). The tax
premium is due to the personal taxes paid upon receiving dividends.
The risk premium consists of two components. The first is the
increase in the financial leverage resulting from the dividend
payment, and the second is the semi contractual obligation of the
dividend-paying firm to maintain the dividend payment. The
investment premium involves the opportunity cost associated with
the rejection of profitable investments in order to pay
dividends.
The dividend initiation decisions of Japanese electrical
appliances industry firms have no predictive power for relative
future negative returns of payers over non-payers. This evidence is
inconsistent with the suggestions of catering theory of dividends
by BW (2004a), Chikashi Tsuji (2010). Chikashi Tsuji (2010) tested
the catering theory of dividends in the Japanese electrical
appliances industry and derived the results as (1) The dividend
initiation decisions of Japanese electrical appliances industry
firms have no predictive power for the relative future returns of
payers over non-payers. While BW (2004a) documented that US firms
dividend decisions for both initiations and continuations have
strong predictive power for relative negative future returns, their
results were different from them. (2) Determinants of the dividend
initiations, the first difference between the US and Japan is that
the value-weighted dividend yield is a strong determinant of
one-year-ahead dividend initiations in the Japanese electrical
appliances industry firms. Most importantly, the dividend premium
is not a determinant of the dividend initiations of the Japanese
electrical appliances industry firms. This means that these firms
do not behave as predicted by catering theory. Hafeez Ahmed &
Attiya Y. Javid (2007) examined the dynamics and determinants of
dividend payout policy of 320 nonfinancial firms listed in Karachi
Stock Exchange. Their results consistently support that Pakistani
listed non-financial firms rely on both current earning per share
and past dividend per share to set their dividend payments. The
listed nonfinancial firms having the high speed of adjustment and
low target payout ratio show the instability in smoothing their
dividend payments. Furthermore the ownership concentration and
market liquidity have the positive impact on dividend payout
policy. Besides, the investment opportunities and leverage have the
negative impact on dividend payout policy. The market
capitalization and size of the firms have the impact on dividend
payout policy which shows that the firms prefer to invest in their
assets rather than pay dividends to their shareholders.
Day-Yang Liu & Yen 2012 described that managers cater to
investor demands by paying cash dividends when investors put a
dividend premium on payers. In contrast, when investors put a
dividend discount on dividend payers, managers choose to distribute
no dividends. Investors are willing to pay a premium for cash
dividends for several reasons. (1) A clientele effect exists in
that the capital market prefers cash dividends. (2) Some investors
believe that dividend paying firms are less risky. (3) Investors
may be highly risk averse so that the distribution of cash
dividends is preferredYordying Thanatawee (2012) developed a
theoretical model to demonstrate that the firms payout/investment
decision may be affected by the relative magnitude of dividend and
repurchasing premia. The model he used showed that the manager of
high-quality firm may pass up a positive NPV project in order to
cater to investors demand for dividends or share repurchases if the
catering premia are substantial. On the other hand, the manager of
low-quality firm may have strong incentives to return free cash
flows to shareholders if the catering premia are higher than the
private benefits from investing in a negative NPV project. Under
this case, the agency costs of free cash flows are mitigated.
Wei Li, Erik Lie (2005) extended Baker and Wurglers [2004a]
catering theory of dividend to include decreases and increases in
existing dividends. They found that the decision to change the
dividend and the magnitude of the change depend on the premium that
the capital market places on dividends. The stock market reaction
to dividend changes depends on the dividend premium. Thus, the
capital market rewards managers for considering investor demand for
dividends when making decisions about the level of dividends.
There is more to the story than dividend catering. While the
dividend premium has significant explanatory power in our analyses,
so do individual firm characteristics, suggesting that both
internal and external factors affect decisions to change dividends
and the capital markets reaction to such decisions. The role of
other non catering factors is especially apparent in the negative
stock market reaction to dividend decreases, which the dividend
catering theory cannot explain by itself. Thus, it would be unwise
for corporate managers to look solely to the capital market for
guidance in their dividend policy. W. Li, E. Lie (2005).Ming-Hui,
Lin 2012, examined the dividend policy with a prediction to
catering theory of dividend. They examined the consistent results
that managers choose a dividend policy to cater to the demand of
investors which Jeffrey Wurgler (2002), defines as the catering
theory. They explained that Dividend payers experience higher
market-to-book ratios than those for non-payers. Moreover, among
dividend payers, firms distribute more stock dividends than other
types of dividends when the dividend premium for stock dividends is
positive. In contrast, firms shift from stock dividends to other
types of dividends such as mixed dividends and cash dividends when
the dividend premium for stock dividends is negative.6. Data Sample
& Methodology
6. Theoretical Framework
Our independent variable i.e. dividend payer, measures there
worth / market value through market-to-book ratio. In theory, those
companies who are dividend payers experience higher market-to-book
ratio. This aspect is measured in sample of Karachi Stock
Exchange.
Considering the dividend types, dividend payer companies issues
more stock dividend than any other dividend types as and when there
dividend premium of stock is positive. And when the dividend
premium is negative, firms (dividend payers) shift this type of
dividend from stock dividend to other types of dividend i.e. Cash
Dividend or Mixed Dividend. To measure the catering effect of
dividend, we measure the stock price premium, an independent
variable. In theory, when stock price premium is high or positive,
management declares the dividend and when the stock price premium
is negative, this means investors prefer the non-payers of
dividend. This is measured through the market-to-book ratio of
dividend payers and non-payers.Dividend payout ratio is also
measured to know 7. Data & MethodologyData for this study has
collected from the Karachi Stock Exchange (KSE), a Companies
financial report, which was also obtained from companies official
websites for the period 2005 to Jun 2012. In the sample, data of
two sectors is taken i.e. Banking Sector and Textile Sector for the
period 2005 to Jun 2012. We follow Baker and Wurgler (2004b) in
order to test the catering theory. a. First of all we measure the
dividend premium. This is measured by taking the log of dividend
payers and non payers and then divides it with average market to
book ratios. b. Apart from this, we also measure dividend premium
between the companies those who pays dividend (payers) and those do
not (non-payers).
When considering the dividend payers, it is notified that there
are different types of dividend payers i.e. stock dividend, cash
dividend and mixed dividend which include both cash and stock
dividend.
c. In order to examine whether the dividend premium is related
to the dividend policy, we use the multivariate regression model,
to measure the different types of dividend payers i.e. cash
dividend, stock dividend and both cash and stock dividend payers.
We count the total payers by the following method:d. After
measuring the relation, we then examine the significance of
correlation coefficient of dividend premium. e. We also measure
dividend payout ratio of all the firms included in both the sector
by the formula:
We measure the dividend payout ratio to get an idea of how well
earnings support the dividend payments. 8. Dependent and
Independent Variables:Independent Variable
Dependent Variable
Market-to-Book Ratio
Dividend Premium
Dividend Payers
Stock Price Premium
Dividend Pay out Ratio
9. Hypothesis:H0: Management does not cater the demand of
investors when declaring the dividend. H1: Management caters the
demand of investors when declaring the dividend.
Total Dividend Payers=
Cash dividend payers + Stock dividend payers + Mixed dividend
payers
