Announcement Effect of Dividend in Presence of Dividend Tax: Possible Agency Problem and Macro Level Inefficiency?

Abstract

This article evaluates the efficiency of existing dividend distribution tax in India from the perspective of investors’ preference pattern, as revealed in the market. It investigates the announcement effect of dividend in India in the presence of dividend distribution tax with specific legislative intent of discouraging dividend distribution. Using data on large profitable firms, we show that despite firm-level tax, higher dividend payout announcement leads to significant rise in share price. This implies that despite being tax-disadvantaged, investors of large profitable firms prefer higher payout, because it mitigates agency cost of retention. This shows that dividend distribution tax is inefficient.

JEL Classification: G32, G35

Keywords

Dividend announcement agency theory dividend distribution tax stock price movement

Introduction

There are differences of opinion over the issue of dividend tax. One school of thought argues that a dividend tax amounts to ‘double taxation’, since companies only distribute profit net of tax as dividend. This school argues that instead of corporate paying tax, the burden of tax payment should be on recipients of dividend. In that case, the individuals and trusts who are otherwise exempt from income tax payments will not be obliged to pay tax. But the contending school argues that since corporate is a legal entity and uses public good, it should have the distinct obligation to pay taxes.

Most of the countries in the world have tax on dividend at a rate lower than the rate of income tax. In India, dividend is tax-free income, but there is a dividend distribution tax, the apparent aim of which is to discourage dividend payments. So theoretically, if a company does not pay dividend, the shareholders are exempt from the dividend tax and prima facie; this should enthuse the shareholders. This article makes an enquiry whether it is really the outcome.

In India, income tax is tax-free income in the hands of the investors, but dividend is taxable at firm level upon distribution. The tax arising on capital gain upon sale of shares is taxable in the hands of investors at a lower rate and long-run capital gains are totally tax-free income. If a company earns profit and does not pay dividend, the profit is capitalized in share price. If capital gain resulting from sale of share attracts less or no tax compared to the amount of tax levied on dividend at firm level, it is rational for the investors not to insist on dividend payment. But do the investors really dislike dividend payments? If so, dividend announcement should depress stock prices. But if dividend announcement is found out to raise share prices, we have to search for an explanation of that behaviour and also consider its policy implications. This article focuses on this issue.

The Income-tax Act 1961 as amended by the Finance Act 1997 made a provision for 10 per cent tax to be paid by the companies (firms) distributing dividend out of taxable profit. Consequently, dividend receipts in the hands of the shareholders are exempt from payment of tax. Since 2009–2010, the rate of dividend tax rate (including surcharge) stood at around 17 per cent. When a firm earns profit, it is required to pay either regular corporate tax computed as per the provisions of income tax law or minimum alternative tax (MAT, based on profit arrived at as per the provisions of the Companies Act, 1956), whichever is more. When dividend is paid out of the post-corporate tax profit, dividend tax is levied again on such distributed dividend. This impacts all investors. In this case, if the shareholder is an entity like public charitable trust or individual not being liable to pay tax otherwise, such entity receives ultimately a lower amount in the form of dividend net of tax. As per present rate, if a firm spends a total of ₹ 100 for dividend distribution, the investors receive ₹ 85.50 by way of dividend. Remaining ₹ 14.50 (17 per cent of ₹ 85.50) is paid to the central government by way of dividend distribution tax irrespective of the fact whether such entity or individual is otherwise liable to pay tax or not. Thus entities, not liable to pay tax, suffer on account of dividend tax. On the contrary, if a firm does not pay dividend and the dividend gets capitalized in the stock price, these entities are more benefited, if they hold the stocks for a period exceeding one year before sale. Then the profit arising from sale—defined as ‘long-term capital gain’—is not subject to tax provided the transaction suffers security transaction tax. In fact, any exchange-traded share is subject to security transaction tax. If the shares are held for less than one year before sale, the profit arrived on such sale—defined as ‘short-term capital gain’—is subject to tax at a lesser rate than dividend tax during our period of study with the exception of 2009–2010, when the rate of dividend tax was brought at par with short-term capital gain. Thus, there exists a clear case of many investors, not favouring distribution of dividend from taxation standpoint, provided investors believe that unpaid dividend will be incorporated in the enhanced value of stock.

But despite this adverse fiscal legislation in respect of dividend distribution, profitable companies pay cash dividend regularly. Though companies generally announce cash dividend once in a year, some cash-rich companies pay handsome interim dividend more than once in a year as well. The company law¹ requires the firms to pay dividend out of profit arrived at as per schedule² provided in the law read with accounting standards in force. The firms are to file quarterly unaudited accounts with the stock exchanges. The announcement of earning for a full financial year through audited accounts and dividend recommendation happen concurrently in the same board meeting and are placed for approval in the annual general meeting by the shareholders. In other words, audited annual earning figure and final dividend become public information simultaneously. In this backdrop, the article investigates empirically the reaction of stock price to cash dividend announcement in order to understand whether in the presence of firm-level dividend tax such dividends impact all—the high and low tax bracket investors similarly. We focus on the impact of dividend payout (total dividend scaled by profit after tax) on firm valuation through event study methodology and regression. We consider that higher payout represents proxy for an attempt by the management to distribute more cash to the stockholders in order to address agency problem associated with free cash flow. Though a number of studies have been made to investigate dividend announcement impact in the USA and Europe stock markets in the context of taxability of dividend income in the hands of the investors, there has been hardly any attempt to examine announcement reaction in the presence of firm-level tax with specific legislative intent to discourage dividend payment having implication to revisit policy of dividend tax from public finance angle. The study simultaneously enriches literature relating to public finance, agency cost and dividend policy at micro level in a number of ways. First, the article highlights through a simple economic model how the present income tax legislation leads to conservative dividend payout in India relative to other countries that in turn gives rise to possible agency problem of retention ignored by the fiscal policymakers. Second, despite adverse tax provision, consistent with the model, the empirical result shows that higher dividend payout impacts valuation positively whereas lower payout has an opposite impact. We also document that retention has a negative impact on firm value.

The remainder of the article is organized in the following way. The second section discusses major existing literature on theory and empirical studies pertaining to dividend. The third section highlights the motivation of the study. The fourth section describes the model. The fifth section elaborates data source and other specifics. The sixth section details the methodology of empirical study, the seventh section presents the empirical results and the eighth section concludes the article with summary of findings.

Literature Survey

Ever since the publication of dividend irrelevance theory by Miller and Modigliani (1961) dividend decision has become one of the most dominant areas of research (both theoretical and empirical) in financial economics for over half a century. Miller and Modigliani’s (MM) theory is based on ‘no tax’ assumption.

When dividend distribution attracts income tax in the hands of the recipient shareholders, why does a firm pay dividend at all (‘dividend puzzle’)? This question was raised by Black (1976) and Feldstein and Green (1983). In the subsequent literature, dividend is said to serve two purposes—(i) despite firm-level tax, dividend may convey superior information regarding performance even in a common law origin country like India (La Porta et al., 1998) and (ii) investors may actually like management to distribute rather than retain to address problem associated with free cash flow (Jensen, 1986) even when tax implication is unfavourable as dividend mitigates agency problem of retention.

Bhattacharya (1979) argues that dividend gives a signal of firm’s expected future cash flow and tangible evidence of a firm’s prospect. This signalling theory has got strong empirical support in the studies conducted by Healy and Palepu (1988) and Caton et al. (2003). Al-Yahyaee et al. (2011a, 2011b) have made an event study in Oman where there is no tax on dividend and capital gain and found out that stock prices responded significantly to increase and decrease in cash dividend. However, in a survey made among the practising managers, Baker et al. (1985) find that taxes do not play a major role in a firm’s dividend policy.

Another well-tested theory with regard to tax impact of dividend payment is ‘clientele hypothesis’ (Gordon and Bradford, 1980). It postulates that entities such as trusts, pension funds, which are not liable to pay tax but require regular cash flow and individuals subjected to low marginal tax rates (‘low-tax clientele’) prefer investing in companies with high dividend yield. On the contrary, investors with high taxable income (‘high-tax clientele’) will invest in companies having low dividend yield.

Easterbrook (1984) and Jensen (1986) consider the decision of dividend distribution from agency theory perspective. Dividend reduces the quantum of available free cash flow (cash flow from operation minus investment in assets) in the hands of the managers and thereby prevents them from empire building investment and consumption of costly perquisites. On the contrary, if high dividend payout makes retained earnings inadequate to finance investment and management has to resort to equity or debt financing, the managers subject themselves to scrutiny by lenders and capital market. Thus, high dividend payout plays a role in reducing agency problem. DeAngelo and DeAngelo (2006) propose life-cycle theory that predicts that, in their earlier years during growth phase, the firms pay low dividends as fund required to finance investment projects exceeds internally generated capital from operation. In subsequent years, when internally generated fund exceeds capital required to exploit investment opportunities, firms pay out more dividend to address and mitigate agency problem of free cash flow. Consistent with the theory, DeAngelo et al. (2006) find positive relation between dividend and ratio of retained earnings to equity—taken as proxy for the firm’s life cycle stage. Denis and Osobov (2008) on the basis of evidence of dividend policy in USA, Canada, UK, Germany, France and Japan conclude that distribution of free cash is the primary determinant of dividend policies. They do not find much support for signalling and clientele explanation of dividend. On the basis of evidences from the USA, DeAngelo et al. (2004) document that dividends are more common among the biggest and most profitable firms that hardly require dividend payment to signal future profitability.

There has been a revival of interest in the theory of dividend taxation after the cut in dividend tax rate in the USA in 2003 (Howton and Howton, 2006). Originally, there are two leading theories of dividend tax. Old view (Harberger, 1962) assumes that firms finance their investment by new issue of equity and thus argues that dividend taxes increase the cost of capital and reduce investment. The new view (Auerbach, 1979) assumes that investment is financed by retained earnings, and therefore dividend tax does not affect the cost of capital. But as shown in Chetty and Saez (2007), the empirical findings of the impact of dividend tax cut are better explained by agency theory of dividend taxation.

Motivation of the Present Study

In the budget speech introducing the Finance bill 1997, the then finance minister of India conveyed the legislative intent of introducing dividend tax. He said on the floor of the parliament,

Another area of vigorous debate over many years relate to the issue of tax on dividends. I wish to end this debate. Hence, I propose to abolish tax on dividends in the hands of the shareholders. Some companies distribute exorbitant dividends. Ideally, they should retain the bulk of their profits and plough them into fresh investments. I intend to reward companies who invest in their future growth. Hence, I propose to levy a tax on distributed profit at the moderate rate of 10% on the amount so distributed.³

Accordingly, Section 115–O (1) of the Income Tax Act (I-T Act) imposed 10 per cent tax on the distributed profit in addition to the income tax chargeable in respect of total income of domestic companies. In 2009–2010, the rate together with surcharge was increased to 17 per cent.

Through dividend tax, the legislation sought to discourage payment of dividend so that fund is retained internally for investment in profitable projects. More corporate profit means more tax in government coffer to finance increased government spending. At firm level, if there exist positive net present value (NPV) projects, non-payment of dividend would mean possibility of exploiting profitable opportunities through retained earnings and this should translate into higher valuation of firms in capital market. But at the same time, there lies the risk of agency problem. The management of a profit-making company even in the absence of profitable investment opportunities will be disinclined to distribute dividend on the plea of dividend tax payment. Undistributed profit means availability of free cash flow in the hands of the managers. This encourages managers to enjoy costly perquisites and engage in empire building through costly acquisition and excessive investment that do not generate positive NPV always. This raises the possibility of wastage of resources with important macroeconomic implications. If profit is distributed by way of dividend and management approaches capital or debt market for raising fund to finance investment projects, it exposes the firm to scrutiny by the investors, analysts and lenders leading to better utilization of funds.

In the context of the above two conflicting views on profit retention—one being presumed to lead to capital investment and thereby value-addition by macro-level fiscal legislation and the other having the risk of agency problem of free cash flow—we can say that the purpose of the legislature to encourage retention should find support in the market perception. If lower dividend announcement results in higher valuation of stock, it can be argued that dividend tax facilitates corporate growth. On the other hand, if higher dividend announcement results in higher valuation of firms (and/or lower dividend announcement has negative impact on value), we may say that dividend confirms investors’ preference for dividend distribution although it reduces cash in the hands of management on account of erosion of corporate resources in the form of dividend tax outgo. Given the legislative provision of India that encourages retention of cash over distribution, the main objective of the study is to explore the relation between dividend announcement and firm value in the backdrop of various theoretical frameworks and empirical findings. Previous studies (e.g., Al-Yahyaee et al., 2011) make an attempt to find the impact of increase or decrease of dividend on firm value through event study methodology basically to find out how the stock market incorporates dividend information in share prices. Ganguli (2011) using constant mean return model in event study methodology finds support of signalling and agency explanation of free cash flow in explaining stock price behaviour post dividend payout announcement. In this article, in the backdrop of the legislative provision in India that encourages lower payout, we consider the impact of increase or decrease of dividend payout announcement on firm valuation in order to investigate how information as to higher or lower payout is incorporated in value from agency and signalling perspective. This helps us to verify whether the fiscal legislation on dividend tax serves the intended purpose or not.

A Simple Theoretical Model of Dividend Tax

In this model, we have a firm where ownership and control are separate. We capture the behaviour of the stockholders (owners) and the behaviour of the manager by looking at the optimizing behaviour. This is a principal agent setting of Jensen and Meckling (1976) where the stockholders are the principals and the manager is the agent. The stockholders have little control over the benefits the self-interested manager derives for his assumed control over the corporate resources.

We assume that the utility of the manager depends on the fixed salary (S), incentive bonus as a percentage (a) of return on investment (R), entertainment activity (L) such as spending time in exotic places, sports field, etc., and personal prestige-generating activities of corporations such as empire building activities (A). In the literature, the manager’s utility influencing factors are divided into two groups—(i) firm valuations and (ii) on the job consumptions. S and aR are the factors of the first group and L and A are the second group factors. The return is negatively related to L and A. The benefits are captured by the following utility function.

U {\overset{}{S}}^{} {aR}^{} L^{} A^{}

(1)

The return has the following function.

R(2)MgLhA

Where M is the possible maximum return of investment of the shareholders’ fund at the begining of the period (T) but positive L and A makes the actual return (R) less than M.

The manager maximizes his utility subject to constraint, given by (2).

We form the following lagrange equation.

V {\overset{}{S}}^{} {aR}^{} L^{} A^{} (M gL hA R)

\frac{V}{R} a R^{1} L^{} A^{} 0

\frac{V}{L} a R^{} L^{1} A^{} g 0

\frac{V}{A} a R^{} L^{} A^{1} h 0

\frac{V}{} M gL hA R 0

We also checked that second order condition is satisfied. The above four first order conditions solve four variables R, A, L and m.

In this model, we are concerned with the utility maximizing value of R.

R * \frac{M}{}

(3)

This is the returns earned by the manager on shareholders’ (principal) fund at the beginning, if fully invested. Note that RM

Let us now consider the utility of the representative investor. This utility depends on dividend and capital gains received, and income from other sources.

Under the assumption of no agency cost M is expected return. Then the utility function is

U u (\overset{}{Y} vM G)

(4)

where $\overset{}{Y}$ is the income of the investor from other sources, vM is the dividend received, v being the rate of dividend and G is the capital gain received from undistributed dividend (when v < 1). Under efficient market hypothesis, the undistributed profit inflates reserves and surplus and is reflected in increased share price. Thus, undistributed profit generates capital gains. We assume that investor looks at the income from its present value.

When there is no agency cost and maximum return is generated, we get

G (1 v) M and U u (\overset{}{Y} M)

(5)

If entire profit is paid as dividend i.e. v = 1 and G = 0, then also

U u (\overset{}{Y} M)

(6)

If no return is paid as dividend i.e. v = 0 and G = M, then also we get

U u (\overset{}{Y} M)

(7)

This is the idea of dividend irrelevance.

Let us consider the second best solutions when agency cost is present. In this case, the investors expect that the manager maximizes his utility and company earns only R* from the investment.

If there is a dividend distribution tax at rate t, then the above Equation under no agency cost is

U u (\overset{}{Y} v (1 t) M G) u (\overset{}{Y} M vtM)

Obviously under no dividend payment

U u (\overset{}{Y} M) > u (\overset{}{Y} M vtM)

(8)

This implies that in the event of no agency cost and dividend distribution tax investors should prefer no dividend payment.

But as we introduce agency cost in our model, the result is revised since the investor gets R* < M and expected capital gain is less.

When there is no agency cost, we get G = M under no dividend payment.

If there is agency cost and on the job consumption

R R * \frac{M}{}

(9)

Now the firm pays dividend at the rate v, but the undistributed profit generates R* on account of agency cost.

From equation (9)

\begin{matrix} U u (\overset{}{Y} vM (1 v) \frac{M}{}) \\ u (\overset{}{Y} \frac{v () M}{}) u (\overset{}{Y} M) \end{matrix}

(10)

since $\frac{v ()}{} 1$ .

So, under no tax, dividend payment is preferred.

This is because undistributed profit does not generate maximum return in presnece of agency cost and investor prefers to get the dividend that she can optimally use.

If there is tax on dividend distribution, the result is uncertain.

In the presence of tax, under no dividend payment, the investor’s utility is

U u (\overset{}{Y} \frac{M}{})

(11)

Under dividend payment at the rate v and consequent payment of tax, this utility is

\begin{matrix} U u (\overset{}{Y} v (1 t) M (1 v) \frac{M}{}) \\ u (\overset{}{Y} \frac{M}{} \frac{v () M}{} vtM) \end{matrix}

(12)

Since $\frac{}{} 1$ and also t < 1 sum of last two terms may be positive or negative. Therefore (12) may be greater than (11) and investors may prefer dividend payment in spite of dividend tax.

The above result shows that under dividend distribution tax, dividend payment may be preferred to no dividend even if the entire profit is distributed as dividend. This is more likely if b and c have high values, implying that manager derives high utility from on the job consumption such as entertainment and empire building activities.

We can also introduce uncertainty in this model. Suppose b and c follow a probability distribution and the investor gets an expected return. If now investors are risk averse, they will prefer an amount with certainty to an equal expected amount. This will reinforce our result of investor preferring dividend payment.

Whether investors prefer dividend payment in spite of dividend distribution tax or not can be understood only empirically and we try this empirical analysis in the subsequent sections of the article. If investors presume agency cost, the share price will show abnormal return after announcement of a higher dividend payout ratio. If such abnormal return is observed even under the presence of dividend distribution tax, it will be a strong result, putting into question the justification of dividend distribution tax itself. If investors prefer dividend payment, such tax causes distortion in capital market and favours the corporate managers who want to get free cash reserve for non-productive pursuance of their utility maximization. Thus, dividend distribution tax besides being firm-level policy issue alone also becomes an important public finance and macroeconomic issue.

Data for Empirical Investigation

Initially for data analysis, we targeted top 100 companies in terms of market capitalization of Bombay Stock Exchange (BSE 100), which paid cash dividends between accounting years ending 31 March 2006 and 31 December 2010. Ultimately, we could gather data on a consistent basis in respect of 75 companies on announcement dates of cash dividends, earning and daily stock prices from ‘Prowess’ database of the Centre for Monitoring Indian Economy (CMIE). Altogether, we could measure the market reaction of 352 dividend announcements on share price during the study period. Data on dividend payout and dividend yield on major international indexes have been collected from Bloomberg database.

Table 3 suggests that except for SSE 50 of Shanghai stock exchange and S&P 500 of 2006, dividend yield of 2007 and 2009 of S&P 500, the sample companies in India have lower dividend payout and dividend yield ratios relative to some major global indexes mostly in statistically manner.

Table 1.

Aggregate Dividend Payout and Dividend-yield (2006–2010) of the Sample Companies. DIV = Dividend, EAT = Earnings after Tax, MV = Market Value

Year	N	ΣDIV/REAT (%)	ΣDIV/RMV (%)
2006	75	29.99	1.52
2007	75	26.72	1.61
2008	75	23.94	1.37
2009	75	24.82	2.01
2010	75	27.66	1.46

Source: Prowess database.

Table 2.

Descriptive Statistics as to Dividend Payout Change

Year	No. of Firms Increasing Payout	No. of Firms Decreasing Payout	No. of Firms with No Dividend Payout
2006	35	39	1
2007	18	56	1
2008	25	49	1
2009	44	31	0
2010	37	37	1

Source: Prowess database.

Methodology

Event Study

We first follow standard event study methodology (Campbell et al. 2006) using market model to find out abnormal daily share price return around dividend announcement of the sample firms. According to Mackinlay (1997), the market model represents a potential improvement over the constant mean return model used by Ganguli (2011). Date of final dividend declaration is taken as event date (day 0). We use an event window of altogether 11 days ranging from −5 to +5 day. The estimation window has been taken as 149 days, −155 day to −6 day.

Table 3.

Mean Dividend Payout (DP) and Dividend Yield (DY)—Sample Companies and Some Major Global Indexes (2006–2010)

Year	Sample Cos		S&P 500 USA		FTSE 100 London		Hang Seng Hong Kong		SSE 50 Shanghai
Particulars	DP (%)	DY (%)	DP (%)	DY (%)	DP (%)	DY (%)	DP (%)	DY (%)	DP (%)	DY (%)
2006	31.35	1.33	36.52	1.77	57.57*	2.36*	45.55*	2.21*	29.18	1.17
2007	26.55	1.76	34.79*	2.01	44.68*	2.67*	40.82*	2.01	27.00	0.65
2008	25.19	1.48	46.35**	3.16*	56.96*	4.38*	139.35**	3.22*	99.43	1.91
2009	25.07	2.27	50.64*	2.11	78.78*	3.27*	43.49*	2.29	26.71	0.98
2010	27.41	1.41	57.24**	1.87**	42.15*	2.93*	37.28*	2.46*	26.64	1.58

Source: Bloomberg database.

Note: * and **indicate that difference between sample firms and index is significant at 5 per cent and 10 per cent level, respectively.

Daily return (R_it) of each of the sample company has been derived for the estimation window as well as event window as under: R_it(13)P_itP_it₋₁P_it₋₁

where P_it_{and P_it₋₁ represent closing share price on a particular day and previous day respectively after adjusting split, bonus and right.}

Under market model the expected return of a firm in event window is estimated as under: R_it(14)a_ib_iR_mtf_it

where R_it and R_mt are individual daily security and 30 share BSE Sensex return (representing market portfolio return). E(f_it) = 0, and Var [f_it] = $_{i}^{2}$ . We estimate b_i and a_i by regressing ith security’s daily return on BSE Sensex return in estimation window from Equation (14).

The daily abnormal return (AR) is then computed for each day during the event window (i.e., −5 to +5 day) as under: AR_i(15)R_ita_ib_iR_m

We then compute cumulative average abnormal return (CAAR) for each day during event window, report results in tabular form and plot graph of AAR_t and CAAR_t as a part of empirical findings for both dividend payout increase and decrease, respectively.

We test the null hypothesis that the cross-sectional average cumulative abnormal return for different intervals in event window, that is, $\overset{}{CAR (}$ t₁, t₂) is zero. In other words, cash dividend payout increase and decrease announcements have no systematic impact on stock price movement. We perform parametric t test to test our hypothesis. First, we compute $\overset{}{CAR (}$ t₁, t₂), using the sample cumulative abnormal return for dividend payout increase as well as decrease. For N number of dividend payout increases or decreases (as the case may be)

\overset{─}{C A R (t_{1}, ​ ​ t_{2})} = \frac{1}{N} \sum_{i =1}^{N} C A R_{i} (t_{1}, ​ ​ t_{2})

(16)

We then compute variance as under

VAR \overset{─}{[C A R (t_{1}, ​ ​ t_{2})} = σ^{2} (t_{1}, ​ ​ t_{2}) = \frac{1}{N^{2}} \sum_{i =1}^{N} σ^{2}_{i} (t_{1}, ​ ​ t_{2})

(17)

Finally, we use sample as a consistent estimator and proceed to test hypothesis using

(18)

Regression Analysis

To verify whether dividend contains information beyond that contained in earning, Amihud and Murgia (1997) and Al-Yahyaee et al. (2011) regressed abnormal return around announcement on dividend change and earnings per share (EPS) change—both scaled by price. They found both the variables statistically significant in explaining abnormal return.

In India where generally annual audited accounts and dividend declaration take place and become public information concurrently, we first construct a regression equation to investigate the impact of dividend and earning (profit after tax denoted as PAT) change on CAR from day 1 to day 5 post-announcement. We do not include day 0 in reckoning post-announcement impact on stock price, because information might reach too late to impact price on day 0 or market may take some time to factor in information content of the dividend and earning announcement fully.

Thus CAR_i(19)_{(1, 5)}d₁d₂∆D_id₃∆P_i

where ∆D_i = $\frac{{Dividend}_{it}}{{Dividend}_{it 1}} 1$

and ∆P_i = $\frac{P A T_{i t}}{P A T_{i (t - 1)}} - 1$

If there exists investment opportunity, in a well-functioning capital market with low floatation cost, a firm can retain cash from operation to finance investment. Alternatively, it may distribute cash first and then approach capital market for fund and thereby subject itself to market scrutiny. The agency argument suggests that the alternative funding mitigates the possibility of wasteful expenditure and empire building by the entrenched managers associated with financial slack. The market should react positively when a firm attempts to address agency problem through higher dividend. On the contrary, under tax-based argument in the presence of firm-level tax on dividend distribution, retention should be preferred. We construct a second regression equation to investigate the impact of post-announcement, that is, CAR_i_{(1, 5)} on retention (RET_i) and change in dividend.

\begin{array}{l} C A R_{i (1, 5)} = β_{1} + β_{2} R E T_{t} + β_{3} Δ D_{i} \\ R E T_{i} = (1 - \frac{D i v i d e n t_{i t}}{P A T_{i t}}) \end{array}

(20)

Empirical Result

We present the AARs and CAARs during event window for dividend payout increases and dividend payout decreases during the study period (2006–2010) in Tables 4 and 5, respectively. We then plot AARs and CAARs for payout increase and decrease in Figures 1 and 2, respectively.

Table 4.

Stock Market Reaction to Dividend Payout Increase

Event Day and Around	AAR (%)	CAAR (%)
−5	0.4680	0.4680
−4	0.0119	0.4799
−3	0.2670	0.7469
−2	0.0830	0.8299
−1	0.1332	0.9631
0	0.2161	1.1792
1	−0.0591	1.1201
2	0.3574	1.4775
3	0.0932	1.5707
4	0.1958	1.7665
5	0.3245	2.0910

Source: Authors’ findings.

Note: The sample consists of market reaction of 152 dividend payout increase announcements (2006–2010).

Figure 1.

Source: Authors’ findings.

From Table 4, it is apparent that during six-day window (−5, 0) positive abnormal returns took place for each day prior to and on the day of the dividend payout increase announcement. Table 6 reveals that cumulative abnormal returns during each of two-day window (−5, −4), (−4, −3), (−3, −2) and (−1, 0) are positive in statistically significant manner. Abnormal return prior to dividend payout increase announcement may be the result of information leakage.⁴ Subsequent price decline (Table 4) for a single day (day 1) post-announcement may be the result of profit booking after increase of shareholders’ wealth for six consecutive days. Again Table 6 reveals statistically significant positive cumulative abnormal return for each of two-day window (2, 3), (3, 4) and (4, 5) subsequent to announcement of increase. In other words, we witness short-term post-announcement drift subsequent to announcement of payout increase rather than instantaneous price adjustment as advocated by efficient market hypothesis (Fama, 1970). Market gradually incorporates the information content of announcement of payout increase.

Table 5.

Stock Market Reaction to Dividend Payout Decrease

Event Day and Around	AAR (%)	CAAR (%)
−5	0.0950	0.0950
−4	0.2162	0.3112
−3	0.0244	0.3356
−2	0.2145	0.5501
−1	0.2986	0.8487
0	0.0753	0.9240
1	−0.2809	0.6430
2	−0.1172	0.5258
3	0.0263	0.5521
4	−0.0632	0.4889
5	0.0033	0.4922

Source: Authors’ findings.

Note: The sample consists of market reaction of 200 dividend payout decrease announcements (2006–2010).

Figure 2.

Source: Authors’ findings.

Table 6.

Cumulative Abnormal Return CAR(t₁, t₂) for Dividend Payout Increase and Decrease

Days	Dividend Payout Increase		Dividend Payout Decrease
Days	CAAR	t-Value	CAAR	t-Value
−5, −4	0.0048	3.2326*	0.0031	2.5669*
−4, −3	0.0028	1.9281***	0.0011	2.1609**
−3, −2	0.0035	2.2596*	0.0011	2.1086**
−2, −1	0.0022	1.4185	0.0051	4.3817*
−1, 0	0.0035	2.2271**	0.0038	2.7091*
0, 1	0.0016	0.8595	−0.0021	−1.4098
1, 2	0.0029	1.6182	−0.0040	−2.6411*
2, 3	0.0045	2.8658*	−0.0009	−0.7569
3, 4	0.0029	1.7469***	−0.0004	−0.2965
4, 5	0.0052	3.1955*	−0.0006	−0.4677
−5, −1	0.0118	5.9202*	0.0092	5.9010*
1, 5	0.0091	4.1667*	−0.0043	−2.4479**

Source: Authors’ findings.

Note: *, ** and *** indicate significance at 1per cent, 5 per cent and 10 per cent level, respectively.

Table 5 reveals that prior to announcement of dividend decrease, there is a continuous positive abnormal return during six-day window (−5, 0). Table 6 demonstrates cumulative abnormal returns for each of two-day window (−5, −4), (−4, −3), (−3, −2), (−2, −1) and (−1, 0) before dividend decrease announcement are positive and significant statistically. Immediately post-announcement, there arises erosion of shareholders’ wealth sharply in the form of negative cumulative abnormal return which is statistically significant in two-day (1, 2) window. It appears that information content of the dividend decrease is more pronounced. That expectation runs high based on publicly available information as to performance and other parameters is reflected in significant rise in stock price prior to dividend announcement, but upon decrease of dividend the stock price declines sharply. Also market incorporates the information content of dividend payout decrease more efficiently in pricing. This appears from statistical insignificant cumulative abnormal return for each of two-day window (2, 3), (3, 4) and (4, 5) after posting significant decrease during (1, 2)—indicating absence of momentum effect unlike dividend payout increase announcement.

Table 7.

Regression Result of Post-announcement Abnormal Return on Dividend Change and Earning Change

Variable	Coefficient	t-Statistics
Constant	−0.0024	−0.6049
DD	0.0082	2.3241**
DP	−0.0006	−0.7327
R ²	0.016
F-statistics	2.78
Observations	348	–

Source: Authors’ findings.

Note: **Significant at 5 per cent.

Table 8.

Regression Result of Post-announcement Abnormal Return on Retention and Dividend Change

Variable	Coefficient	t-Statistics
Constant	0.0230	1.5890
RET	−0.0349	−1.8360***
DD	0.0069	1.9713**
R ²	0.024
F-statistics	4.22
Observations	348

Source: Authors’ findings.

Note: ** and *** significant at 5 per cent and 10 per cent, respectively.

Table 7 demonstrates that the post-announcement abnormal returns have a statistically significant positive relation with dividend change but no statistically significant relation with earning change. Table 8 reveals that abnormal returns have statistically significant negatively association with surplus retention but positive association with change in dividend. As to robustness check of the regression results reported in Tables 7 and 8, respectively, White test (1980) suggests that the chosen models do not suffer from heteroskedasticity problem.

Conclusion

Our results suggest that the sample Indian firms are niggardly in their dividend payout policy relative to the firms listed in some of the major stock exchanges of the world (S&P 500, FTSE 100, Hang Seng). One of the reasons of such niggardly payout policy may be attributable to firm-level tax on payout. Despite uniform firm-level tax on dividend distribution, higher dividend payout announcement leads to significant stock price rise and lower dividend payout results in significant stock price decline. Contrary to even weak form of market efficiency, we also record short-term momentum effect of stock price rise pursuant to dividend payout increase. Based on behaviour of the stock price movement, it appears that the information content of the payout decrease is more pronounced. Also, the market is more efficient in incorporating announcement of decrease in dividend payout in pricing process, as there appears to be absence of momentum effect post-announcement that indicates weak form of market efficiency. The study also documents that though change in dividend and change in audited result-based earning become public information simultaneously, the former information counts and the latter does not. Though it may seem that dividend speaks louder than the reported earning, we argue that as per listing requirement the firms are required to file quarterly results with the exchanges. As such, market efficiently incorporates earning information in price before the audited result covering the entire financial year is published. Despite legislative intent that encourages retention over payout, we find a significant inverse relation between retention and change in stock price suggesting that the investors prefer dividend payout. In a common law origin country like India (law emanating from Anglo-Saxon tradition) with fairly sound statute-enforced disclosure policy, audit and accounting system, the sample firms that consist of the largest firms in terms of market capitalization hardly require payments of dividend to signal future prospect. Consistent with theoretical model and life-cycle theory’s finding, we posit that despite higher tax burden, dividend payout increase by large and profitable firms in India sends a positive signal to the market as to management’s intention to reduce the agency cost associated with free cash flow and this in turn leads to enhancement of firm valuation. Conversely, reduction of dividend payout signals financial slack leading to possibility of wasteful expenditure and empire building. This has a negative impact on stock price despite lesser tax. The price reaction to change in dividend payout is consistent with Black’s (1986) view— ‘I think we must assume that investors care about dividends directly.’ Our study thus shows that the stock market’s response is quite contrary to the policymakers’ assumption that retention encourages investment and creates value. Rather market feels that tax on payout at firm level may motivate the corporate tycoon and entrenched managers to retain cash that might lead to wastage of resources by unprofitable investment, costly acquisition, etc. Therefore, fiscal policymakers should revisit the issue of dividend tax and should not provide an opportunity to the corporate management to avoid dividend payments by using the argument of tax. They should be aware of the likely agency problem and macroeconomic inefficiency that their policy might create.

Footnotes

Acknowledgements

The authors thank the anonymous referee for insightful comments on an earlier version of the article. The revision of the article on the basis of these comments has improved the clarity of the article. The authors also thank the seminar participants in IMT and Debasis Maitra in particular for their suggestions. The usual disclaimer however applies.

Notes

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