Chapter II Related Literature and Conceptual Frame This chapter includes review of theoretical literature

Chapter II
Related Literature and Conceptual Frame

This chapter includes review of theoretical literature, empirical research, research gap and theoretical framework. First part of this chapter presents review of different theory of dividend policy. Second part presents different empirical research regarding dividend policy. There are number of empirical studies on dividend in different part of world so some of those studies are presents under this chapter. Third and last part shows research gap and theoretical framework. Research gap shows need of this particular study and theoretical framework defines different variable used in this studies.
2.1 Theoretical Literature
2.1.1 Irrelevant theory
According to this theory value of the firm is unaffected by distribution of dividends. Basically this model is developed by Miller and Modigliani (1961). This theory was presented in the article “Dividend policy, growth and the valuation of shares”. They argue that the value of the firm depends on the firm’s earnings and investment policy. Under certain simplifying assumptions, a firms’ dividend policy does not affect its value. Common assumptions of this theory are:
? There is a perfect capital market in which all investors behave rationally.
? Corporation tax does not exist therefore there is no differences between tax rates in capital gains and dividends.
? The floatation costs on securities are ignored.
? There is neither a constant dividend policy of firm, which will not change the risk complexion nor the rate of return even in cases where the investments are funded by the retained earnings.
Based on above assumptions, MM argued that Firms have two options for utilization of its profit after tax
• To retain the earnings and plough back for investment purposes.
• To distribute the earnings as cash dividends.
If the firm declares dividend, then it will have to raise capital for financing its investment decisions by selling new shares. Here, the arbitrage process will neutralize the increase in the share value due to the cash dividends by the issue of additional shares. This makes the investor indifferent to the dividend earnings and the capital gains since the share value of the firm depends more on the future earnings of the firm than on its dividend policy. Modigliani and Miller also argue that if the company does not pay dividends but the shareholder prefers some dividend, they can sell and equivalent proportion of his stocks hence creating a homemade dividend. If the company pays a higher dividend than the shareholder prefers he can use the surplus dividends to buy additional stocks. Thus, if there are two firms having similar risk and return profiles the market value of their shares will be similar in spite of different payout ratios. Thus MM argued that the value of the firm is based on its basic earning power and its business risk, not how it distributes earnings to shareholders.
The study of Black and Scholes (1974) supports dividend irrelevant theory. They found that a corporation that increases its dividend can expect that this will have no definite effects on its share price. The results showed that the expected return either on high or low yield stocks are the same. Therefore, they concluded that neither high-yield nor low-yield payout policy of firms seemed to influence stock price.

Chen, Firth, & Gao (2002) carried out a study by focusing on the information content of annual earnings and dividend announcements made by listed Chinese companies. Based on a data set of up to 1,232 announcements, they found that unexpected earnings, proxied by earnings changes, were positively related to abnormal returns. Thus, earnings are used by investors in setting market prices. Stock dividends corroborate or attenuate the earnings signal. If the sign of the unexpected stock dividend (increase, decrease) is the same as the sign of the unexpected earnings, then the earnings signal is stronger. If the signs are opposite, the earnings signal is weaker. Unexpected cash dividends have little impact on the earnings signal. Stock dividends per share have a small association with stock returns. In contrast, cash dividends have no discernible association with stock returns and this is consistent with dividend irrelevance arguments.

Uddin & Osman (2008) studied on effects of dividend announcement on shareholders’ value. The result is based on 178 samples of dividend paying companies listed on Saudi Arabian Stock Exchange, between 2001 and 2005 in Saudi Arabia, a non-tax economy, showed that investors lost 2.20 percent of market value after the dividend announcement, although the lost value is recovered from the cash dividend received, and they earned 7 percent of net cash return after recovering the loss of market value. Sub-sample analyses showed that announcement of dividend increase may not signal any good information, while the announcements of dividend decrease and dividend initiation (first time dividend) may contain information, although the information signal of the dividend initiation is somewhat weaker.

Denis ; Osobov (2008) provide the strong evidence in the favor of dividend irrelevance theory and does not consider it relevant to the stock prices.
Das and Samanta (2013) conducted a study to analyze the relationship between dividend policy and stock price of information technology sector of corporate India in liberalized era as companies belonging to this sector are to be counted among the best dividend paying companies in the Indian Inc. The study was based on all companies of this sector which were listed on any stock exchange of India over the decade from 2002-2003 to 2011-2012. The study revealed that dividend policy i.e., splitting of total profits into dividend and retained earnings is not at all a decisive factor for stock price behavior in information technology sector.

2.1.2 Relevant theory
According to this approach, the price of share is affected by distribution of dividend. There are numbers of studies that support this theory.
The model of James E. Walter (1963) showed that dividends are relevant and they do affect the share price. He showed the relationship between the internal rate of return (r) and the cost of capital of the firm (k), to give a dividend policy that maximizes the shareholders’ wealth. The Walter’s model is based on following assumptions:
• Retained earnings are the only source of finance available to the firm, with no outside debt or additional equity used.
• r and k are assumed to be constant and thus additional investments made by the firm will not change its risk and return profiles.
• Firm has an infinite life.
• For a given value of the firm, the dividend per share and the earnings per share remain constant.
The model studied the relevance of the dividend policy in three situations:
(a) r ; ke,
(b) r ; ke,
(c) r = ke.
When the return on investment is greater than its cost of equity capital, the firm can retained the earnings, since it has better and more profitable investment opportunities than the investors. It implies that the return of re-investment of the earnings is higher than what they earn by investing the dividends income. In the second case, the return on investment is less than the cost of equity capital and in such situation the investors will have a better investment opportunity than the firm. This suggests an optimal dividend policy of 100% payout. This policy of a full pay-out ratio will maximize the value of the firm. Finally, when the firm has a rate of return equal to the cost of equity capital, the firms’ dividend policy will not affect the value of the firm.
Another relevance model was developed by Myron Gordon which explicitly relates the market value of the firm to dividend policy (Gordon, 1962). Gordon’s model was based on the following assumptions: the firm is an equity firm and it has no debt; no external financing is available; the internal rate of return of the firm is constant; the firm and its streams of earnings are perpetual; the appropriate discount rate for the firm remains constant; corporate taxes do not exist; constant retention and the cost of capital is greater than its growth rate. Gordon model’s conclusions about the dividend policy are similar to that of Walter’s model.

2.1.3 Bird in hand theory
This theory was first mentioned by Lintner (1956) and it has been supported by Gordon, (1963) and various researchers. It was counter point to the MM theory. Bird in hand theory states that investors mostly prefer dividends from the stock than capital gain due to inherent uncertainty of the latter. A bird in hand; (dividend), is worth more than two in the bush; (capital gains). Due to uncertainty of future cash flow, investors will often tend to prefer dividends to possibility of substantially higher future capital gains.
This theory has following assumption:
? Corporation has only equity (it has no debt in its capital structure),
? There is no external financing
? Returns are constant.
? Cost of capital of the corporation is constant.

Gordon and Lintner claimed that Modigliani and Miller made a mistake assuming lack of impact of dividend policy on firm's cost of capital. They argued that lower payouts result in higher costs of capital. They suggested that investors prefer dividend as it is more certain than capital gains that might or might not appear if they let the firm retain its earnings. The authors indicated that the higher capital gains/dividend ratio is, the larger total return is required by investors due to increased risk. Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings, thereby evaluating a higher value of the share. So under bird in hand theory stocks which have high dividend payout are prefer by the investor.
2.1.4 Signaling theory
Signaling theory suggest that announcement of dividend shows strong future performance of the company so that ultimately affect market value of share. The study of Bhattacharya (1979) presented one of the most acknowledged studies regarding signaling theories which states that dividends may function as a signal of expected future cash flows. An increase in the dividends indicates that the managers expect higher cash flows in the future. This study was based on assumption of imperfect information regarding company future cash flow and capital gain and dividend are taxed at higher rate than capital gain. He argues that under these circumstances even though there is a tax disadvantage for dividends, companies would choose to pay dividends in order to send positive signals to shareholders and outside investors. Similarly study of Asquith ; Mullins (1983) shows that increase of dividend payments tends to increase the shareholder’s wealth.
2.1.5 Tax preference theory
The tax preference theory states that investor prefer capital gain rather than dividends. There are two reasons stock price appreciation is taxed more favorable than dividend income. First due to time value effects a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. So even if dividends and gains are taxed equally capital gains are never taxed sooner than dividends. Second if a stock is held by someone until he or she dies on capital gain tax is due at all the beneficiaries who receive the stock can use the stock's value on the death day as their cost basis and thus completely escape the capital gains tax. Because of these tax advantages investor may prefer to have companies minimize dividends. If so investor would be willing to pay more for low payout companies than for otherwise similar high payout companies (Brigham and Ehrhardt)

2.1.6 Clientele effects of dividend theory
The clientele effect theory suggests that a firm will attract investor who like the firm's dividend payout policy. Different groups or clienteles of stockholders prefer different dividend payout polices. For example, retired individuals generally prefer cash income so they may prefer current dividend rather than capital gain. On other hand young investor might prefer capital gain rather than dividends. So this theory shows according to group of investor appropriate dividend policy should be followed. Evidence from several studies suggests that there is in fact a clientele effect on determining value of firm.
2.2 Empirical review
There are large numbers of empirical review on dividend policy. Some of them are below.
Akbar & Baig (2010) considered the sample of 79 companies listed at Karachi Stock Exchange to study the effect of dividend announcement on stock prices for the period of 2004 to 2007. The study shows that the announcement of dividends either cashes dividend or stock dividend or both have positive effect on stock prices.
Zakaria et al. (1998) studied the impact of dividend policy on the share price volatility in the context of Malaysian construction and material companies presented using the least square regression method after controlling for debt, firm size, investment growth and earnings’ volatility. A study also examined the impact of firm’s dividend policy and dividend payout ratio on the share price of the Malaysian listed construction and material companies for a period of six year (2005 to 2009). The larger the size of the company, the greater the company needs to face with the volatility of share prices. The study showed that there is a significant positive relationship between the dividend payout ratio of a firm and share price volatility. Dividend yield is insignificant and negatively related to the movement of stock prices. This study has also identified that there was no significant influence between investment growth and earnings volatility on the changes of the company share prices. The study also suggested greater the size of the company, the more significant impacts the volatility of share price would be. Dividend yield, investment growth and earnings volatility insignificantly influence the changes in the company’s share price. Leverage was also negatively influenced to the movement of the share price.

Azhagaiah ; Sabari Priya(2008) conducted a study to measure the impact of dividend policy of shareholders’ wealth in Organic and Inorganic Chemical Companies in India during 1996 – 1997 to 2005-2006 by taking Dividend per Share, Retained Earnings per Share, Lagged Price Earnings Ratio and Lagged Market Price as independent variable, and Market Price Per Share as dependent variables. The study proved that the wealth of the shareholders is greatly influenced mainly by five variables viz., Growth in sales, Improvement of Profit Margin, Capital Investment Decisions (both working capital and fixed capital), Capital Structure Decisions, Cost of Capital (Dividend on Equity, Interest on Debt) etc. There was a significant impact of dividend policy on shareholders’ wealth in Organic Chemical Companies while the shareholders’ wealth is not influenced by dividend payout as far as Inorganic Chemical Companies.

The study done by Farroq, Saoud, &Agnaou (2012) USA, shows the effects of dividend policy in an emerging market as well as looked at the differing affects in diverse market conditions. More specifically, they observed the effects of dividend policy on stock price volatility both, in a period of market growth and market stability. In their findings they discovered that the effects of dividend policy can be much less significant in times of economic growth. They cite the reasoning that in times of high market returns, investors are less prone to be concerned about a relatively small dividend payout when compared to the much larger capital appreciation of the stock price. Their findings show that the effects of dividend policy can vary with both market size and the market’s economic cycle. This makes it clear that when observing the findings of different studies conducted on dividend policy’s effects on price risk, you must take into consideration both the stage of the economic cycle and size of the market’s economy of which the study is being conducted.
A study on volatility estimation and stock price prediction in the Nigerian stock market aimed at understanding the Nigerian stock market with regards to volatility and prediction, to this effect the month end stock price of four major companies from the period January 2005 to December, 2009 was used as proxy. The study made use of the Autoregressive Conditional heteroscedasticity (ARCH) to estimate and find out the presence of volatility. The major result of the study showed stock price volatility could not predict their current stock price and hence volatility was insignificant and negative. The results however, revealed that out of the four companies, only two companies’ stock price was predicted by volatility in their stock prices (Gabriel and Ugochukwu, 2012).

The study of Hashemijoo et al. (2012) showed significant negative relationship between share price volatility with two main measurements of dividend policy which are dividend yield and dividend payout. Moreover, a significant negative relationship between share price volatility and size was found. Based on findings of the study, dividend yield and size have most impact on share price volatility amongst predictor variables. This study was to examine the relationship between dividend policy and share price volatility with a focus on consumer product companies listed in Malaysian stock market. For this purpose, a sample of 84 companies from 142 consumer product companies listed in main market of Bursa Malaysia.
Uwuigbe et al.(2012) observed in their study that there is a significant positive association between the performance of firms and the dividend payout of the sampled firms in Nigeria. The study also revealed that ownership structure and firm’s size has a significant impact of the dividend payout of firms too.
Truodi and Milhem (2013) studied all industrial firms listed on the Amman Stock Exchange over the period from 2005 to 2010. The results of this study show a positive and significant relationship between cash dividends, retained earnings, earnings per share, and stock price while stock price is positively but non-significant associated with financial leverage.
The study of Ajanthan (2013) concluded that dividend policy is relevant and that managers should pay attention and devote adequate time in designing a dividend policy that will enhance firm profitability and therefore shareholder value. The study was conducted on listed hotels and restaurant companies in the Colombo Stock Exchange (CSE).
Mokaya Nyang’ara (2013) carried out the research to determine the effects of dividend policy on the market share value in the banking industry in Kenya, using National Bank Kenya (NBK). The study applied an explanatory research design covering a proportionate sample of 100 shareholders drawn shareholders of National Bank of Kenya. The study established a strong and positive correlation between dividend payout and market share value. There was a positive between dividend growth rate and market value of shares. There was a positive correlation between regularity of dividend declaration and market share value. Dividend policy had a significant effect on the market share value.
Kyle and Frank (2013) conducted a study on dividend policy and stock price volatility in the U.S. equity capital market. The study attempts to identify the impact of certain financial variables on the volatility of a stock’s price overtime by analyzing the financial data of over 500 publicly traded firms found through the value line investment survey database using ordinary least squares (OLS) regression. The study tests the effects of financial variables (deemed appropriate by the finance literature) on stock price volatility for a sample of firms screened from the value line investment survey database. The study used a given stock’s standard deviation as the dependent variable to represent the stock’s volatility. Independent variables tested include: dividend yield, payout ratio, size, leverage, and growth. As hypothesized by the literature, dividend yield and size related negatively to the stock’s price volatility. Contrary to the literature, leverage and growth both varied negatively with stock price volatility. The positive relationship observed between the payout ratio and the stock price volatility produced anomalous results.

Michael &Benson (2014) The research was conducted on 22 companies listed on Nigerian Stock Exchange (NSE) using secondary data from 2009 to 2013.The findings revealed that both dividend payout and retained earnings are significantly relevant in the market price per share of the companies.
Ordu (2014) carried out the research on effect of dividend payment on the market prices of shares in Nigeria using time series data on dividend per share, dividend yield and dividend payout ratio that ranges between 2000 and 2011. The model specification for the analysis of data was ordinary least squares techniques applied as panel estimation. The researchers empirical results arising from the panel least squares suggested a positive effect between market price per share and dividend per share confirming that a rise in dividend per share brings about an increase in the market price per share of quoted firms; that dividend yield does not have a significant positive effect on the market prices of shares of quoted firms in Nigeria; that there exists a direct relationship between market prices per share and dividend payout ratio of selected firms on the NSE. Further, the study revealed that significant variations exist in the movement of the share prices of the selected firms which in theory could be attributed to the forces of demand and supply while in practice could be attributed to some other exogenous and endogenous variables such as economic policies, corporate managerial decisions, psycho-social variables, political situations and institutional parameters. Thus the study concluded and recommended that, earnings remain the most significant determinant of dividend payment averagely, hence it has significant influences on the market value of public owned firms in Nigeria and the world all over. The dividend payment, dividend per share, dividend yield, dividend payout ratio and earnings per share are significant in explaining the observed differences in share market prices of quoted firms in Nigeria. The government must contribute by relaxing laws that spell threat to the objectives of firms i.e. maximization of shareholders’ wealth.

Salari, Abbsian and Pakizeh (2014) conducted a study to determine the impact of dividend policy on stock price volatility by taking firms listed on Tehran stock exchange. They selected 68 listed companies from Tehran stock exchange for a period from 2001 to 2012. They found a significant negative relationship between share price volatility and two main dividend policy measures (payout ratio and dividend yield) and positive relationship between price volatility and size and also debt of firms. They also found that there is no relationship between stock price volatility and earning volatility and growth of the firms

Dewasiri N J’s research (2014) shows that dividend yield has a significant impact on stock price volatility in the short run and the first to discuss the same phenomenon in the Sri Lankan context, to the best of the author’s knowledge.

Similarly, Mausam (2014) conduct study which explain the relationship between dividend and stock price after controlling the variables like earning per share, return on equity, retention ratio has positive relation with stock prices and significant explain variation in the market prices of shares while the dividend yield and profit after tax have negative, insignificant relation with the stock prices. Overall result indicates that dividend policy has significant positive effect on stock prices. This paper selects all the thirty banks listed in Dhaka Stock Exchange for the period of 2007 to 2011.
Kavidayal ; Kandpal (2015) conducted a study to analyze the effect of dividend policy on shareholder wealth of thirty selected Indian banks listed and traded in Bombay Stock Exchange (BSE). In this study market price was taken as dependent variable. Dividend payout ratio, return on Net worth, Debt Equity ratio and total assets were used as independent variables. The study included the financial data from the period 2003-04 to 2012-13 of selected Indian banks (15 Public and 15 Private). The results of the data analysis concluded that dividend policy has significant impact on the share price of organization.

Nepalese Scenario
In Nepalese context there are few studies have conducted on dividend and share price. The study of Pradhan (2003) on “Effects of Dividend on Common Stock Prices: The Nepalese evidence” found that dividend has the strong effect on the market price of the share and less effect of retained earnings. Moreover, dividends are relatively more attractive to Nepalese stockholders. This study was based on the pooled cross section data of 29 companies from 1994 to 1999 with total of 93 observations. The study showed relationship of market equity, market value to book value, price earnings and dividend with liquidity, leverage, profitability, assets turnover and interest coverage. The major findings of the study were that larger stocks have larger price earnings ratios, larger ratio of market value to book value of equity, lower liquidity, lower profitability and smaller dividends. Dividend payment is more important as opposed to retained earnings in Nepal. The results revealed the customary strong dividends effect and a very weak retained earning effect indicating the attractiveness of dividends among Nepalese investors.
A study on comparative study of dividend policy and practices of commercial banks found that there were irregularities in the dividend payment by the commercial banks of Nepal and no stability in the dividend payout ratio of the commercial banks (Adhikari, 2006). Thus he has recommended the investors to consider the select company having high profit companies for purchasing shares.
Chhetri (2008) examined a relationship between dividend and stock price; the study explained that there are differences in financial position of high dividend paying and low dividend paying companies. The study revealed that there is a positive relationship between dividend and stock prices. Further, the coefficient of dividends is higher as compared to the coefficient of retained earnings.
Joshi (2012) found that DPS is a motivating factor in the Nepalese financial sector which is strong enough to increase market price per share of the banking and non-banking firms. Comparatively, it is also found that the effect of DPS greater than REPS on the impact of market price per share. The impact of dividend, however, is much more pronounced than that of the retained earnings. The relation of dividends and retained earnings on share price is positive in all cases. A descriptive and analytical research design had been administered. The secondary data were used to test this impact in order to examine the impact of dividends on stock prices; a multivariate liner regression analysis had been implied in which current market stock.

Manandhar (2013) studied on dividend policy and share price volatility: evidence from Nepal stock exchange. The study found that the dividend yield and share prices are negatively related but payout ratio is positively related. This study suggest that dividend policy effected the share price volatility in Nepalese stock market and also proposed that signaling effect is also relevant in determining the share price volatility. The study was conducted by utilizing the cross sectional regression analysis of five sample banks (BOK, NABIL, EBL, HBL and SBL) based on 10 years’ data from 2001/02 to 2010/11.
Hasan, (2013) investigated on 28 companies covering four industries- automobile, cement, textile and pharmacy for the period of 2005 to 2009. The result indicated that there is positive relationship between MPPS and DPS, and MPPS and REPS. The highly payout industries have more MPPPS than low payout industries. The study has proved that there is significant effect of dividend policy on MPPS.
Dhungel (2013) analyzed the impact of dividend on the stock price movement on Nepalese bank and financial institution for the period 2004 to 2010. Secondary data were obtained from the websites and published material of five commercial banks. There is significant co-relation between market price per share and earnings per share as well as dividend per share in case of only one commercial bank but there was no significant co-relation among these various in other four commercial banks. The result revealed that there is no significant impact of dividend on share pricing in most of banks.

Maharshi & Malik (2015) conducted a study by taking the samples of 30 companies listed in the BSE, which have made dividend policy during the financial year of 2011-12 and the study shows that price volatility and dividend yield have strong positive correlation but price volatility is highly negatively correlated with growth in assets. Growth in assets has impact on the price volatility for this time period.

Devkota (2015) found that there is positive relationship between dividend and market value of share of Nepalese commercial bank.

2.3 Research gap and theoretical framework
2.3.1 Research gap
It is clear that there is a non-conclusive harmony being expressed by the many finance scholars that have been reviewed above. While it is apparent from prior literature that the effects of dividend policy on market price still up for debate. In case of Nepal there are some of studies regarding dividend policy and market price. Most of studies focus on banking sector or whole sector. So there is gap in the financial literature concerning the effect of dividend on stock prices particularly in hydro sector of Nepal. So this research is going to study about how dividend policy affects to price of the stock particularly hydro companies which are listed in NEPSE.

2.3.2 Theoretical framework
There are number of factors that affect stock price. Basically this study focuses on dividend policy related factors. So market price per share (MPS) is taken as dependent variable and dividend, earning, retained earning lagged price earning lagged market price and lagged dividends of the companies are independent variables. Size and financial leverage of the company are taken as moderating variables. Theoretical frame of this study can show in following figure.

Figure 2.1: Theoretical Framework

Independent Variables Dependent Variable

Moderating variables
o Size of company
o Financial leverage

Definition and significant of the variables
Dependent variable
The market price per share of the hydro companies listed at NEPSE is a dependent variable. The closing price at the end of fiscal year is taken as market price.

Independent variables
These are variables those determine market price of the stock. Independent variables for this study are: dividend per share, earning per share, retained earnings per share, lagged market price per share, lagged price earnings ratio, lagged dividend per share. Dividend includes cash and stock dividend. Dividend per share is total dividend provided by company in a year divided by total number of share. The earnings per share is net income divided by total number of shares. Similarly retained Earnings per share is difference between EPS and DPS. The market price of the stock is also affected by previous year’s market price per share, dividend per share and price earnings ratio. The riskiness of the firm is correlated with previous year’s dividend payout and share prices. This study use lagged MPS, lagged DPS and lagged P/E ratio as independent variables.

Moderating variables
These variables have strong contingent effect on the dependent –independent variable relationship. Size and leverage of the company are taken as moderating variables. Because they determine the riskiness of the company so before purchasing share, investor also consider those factor. So those variables also affect the market price of the company. Various researchers have argued that the size of the company is one of the factors that have the largest influence on the stock prices of firms (Allen and Rachim, 1996). But even though the majority of the previous studies have concluded that size is an important factor, the measurements of size have varied between studies. In this study, total assets used as a proxy for firm size. Leverage is one of the key indicators of a company’s financial health. For this reason, this variable used as a moderating variable. One commonly used measurement is the debt ratio which is the expressed total debt/total assets. Debt ratio reflects the broader picture of company’s liabilities