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Definition
Dividends are payments made out of earnings to a firms owners (shareholders). They are therefore viewed as a reward to the shareholder for providing equity finance to a corporation. Dividends are paid in three ways:
cash dividends paid in the form of cash; stock dividends an issue of additional shares to shareholders; and liquidating dividends paid at the time of liquidation of the firm
A Bigger Picture
Dividend Puzzle
The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just dont fit together (Black, 1976, p. 5). Numerous researchers have attempted to solve the dividend puzzle identified in Black (1976) but these studies have not yet arrived at an unequivocal solution (Brealey et al., 2008). A mix of opinion therefore exists about why firms pay dividends and whether the selection of a particular dividend policy can influence the value of a firm.
Dividend Relevant
They argued that in the presence of taxation and transaction costs, the argument of the dividend irrelevance hypothesis may seem unrealistic. On the other hand, many researchers rejected the MM hypothesis on the basis of empirical evidence (Pettit, 1972; Lonie et al., 1996; McCluskey et al., 2006) and theoretical considerations (Lintner, 1956; Baker et al., 1985; Baker and Powell, 1999, Brav et al., 2005; McCluskey et al., 2007).
How
Lintner (1956) documented US firms base their current dividend on current earnings and prior years dividend. Darling (1957) put forwarded a model of dividend policy where two extra variables (current investment and the usage of external funds) were added to Lintners model to adapt it for the UK. According to Darlings hypothesis, dividends were a function of current investment needs and the availability of external financing, along with the current years earnings and previous years dividend.
How
In line with this view, Brittain (1966) documented that cash flow was the most influential factor in the dividend decisionmaking process. Brittains (1966) model of dividend policy included a cash flow (liquidity) measure and a lagged dividend payout ratio as explanatory variables.
How
Fama and Babiak (1968) conducted an empirical analysis of data for 392 US firms over the period 1946-64. Fama and Babiak (1968) found that the inclusion of a lagged earnings value also improved the explanatory power of Lintners model. (Dit = ai + B1Dt-1+B2Eit +B3Eit-1) Moreover, the Fama and Babiak (1968) found that a lagged earnings value slightly improved the explanatory power of Lintners equation.
Lintner (1956)
According to Lintner (1956), management had a flexible but definite payout policy; they had a target payout ratio with an average level of about 50.0%. There was an incremental adjustment on a yearly basis to achieve the target payout level; specifically, the average adjustment factor was found to be 30.0% for the entire sample.
Lintner (1956)
On the basis of his fieldwork, Lintner (1956) suggested a behavioural model of dividend policy which can be summarised in the following equations: Dit = ai+ ci (D*it Di t-1) + Uit [3.1] Or Dit = ait + b Pit + d Di t-1 + Uit [3.2] Where Dit is the change in dividend; Dit is the dividend in current year; Di t-1 is the dividend in the previous year; ait is the constant term; ci is the speed of adjustment factor; Uit is error term; and D*it or ri Pit, is the target payout which is a function of the current years profits (Pit).
Lintner (1956)
Equation [3.1] showed that a change in dividends was a function of the difference between a firms target dividend payout and the previous years dividend payout multiplied by a speed of adjustment factor. Moreover, these equations also showed that the dividend depended upon the earnings in the current year (Pit) and the dividend in the previous year (Di t-1).
WHY
The Signaling Hypothesis Taxation effect Bird in the hand falacy Etc.
Signaling And MM
The information content of dividend was also alluded to in the pioneering study of dividend irrelevance by MM (1961). In a section entitled The information content of dividends, the authors asserted that: [A] change in dividend rate is often followed by a change in the market pricecalled the informational content of dividendswhere a firm has adopted a policy of dividend stabilization with a long-established and generally appreciated target payout ratio investors are likely to (and have good reason to) interpret a change in the dividend rate as a change in managements views of future profit prospects for the firm. The dividend change, in order words, provides the occasion for the price change though not its cause, the price still being solely a reflection of future earnings and growth opportunities.(p. 430)
Signaling And MM
In the last sentence of this quotation, MM (1961) still supported their argument about the irrelevance of dividends on the grounds that the share price was a reflection of the future earnings as well as the growth opportunities of a company and a change in dividend might be used to manipulate the share price. However, the authors still believed in the information content of dividend about future earnings which in turn increased the share price of the firm
In addition, this section elaborates on the clientele hypothesis which states that investors in certain tax brackets tend to gravitate towards certain types of dividendpaying firms. For example, the high earnings investors will wish to have dividend from the firms which are tax exempted.
Taxation Effect (Ex-date Effects) and Clientele Effects When the effective rate of taxation on dividend income is more than the effective rate on capital gains, companies tend to pay less dividends. This is because shareholders attempt to avoid dividend income to benefit from the tax advantage associated with the capital gain. Investors responses to actual dividend payments (rather than announcements) by calculating share returns on ex-dividend days.
Taxation in Pakistan
According to the Income Tax Ordinance of Pakistan 2001, the tax on cash dividend is 10.0% (Section 5) while there is no taxation on share dividends. Up until June 2010, there was no taxation on capital gains; however, from July 2010 and onward, capital gains are taxable (Section 37A). The rate of tax to be paid for the tax year 2010 is 10.0% on securities traded for less than six months and 7.5% for securities traded for more than six months and less than one year. There is still no taxation on capital gains of securities traded for more than one year.
Other Reasons
Each year the Karachi Stock Exchange also identifies a list of the top 25 companies on the basis of their efficiency in different areas especially the declaration of sizable dividends for shareholders . The prerequisite for inclusion of a company in the ranking is the declaration of a minimum of a 40.0% dividend for the year (including at least a 15.0% cash dividend).
Other Reasons
For the selection of the top 25 companies for 2009, the criteria and weighting of the different variables were: distribution of profit (40.0%); return on equity (30.0%); free-float of shares (5.0%); corporate social responsibilities (5.0%) and 20.0% for other variables including the holding of regular meetings and Annual General Meetings (AGMs) etc. (www.kse.com.pk)