Do Leverage, Dividend Policy and Profitability influence the Future Value of Firm?

Evidence from India

By Saurabh Ghosh saurabhghosh@rbi.org.in and Arijit Ghosh** Indira Gandhi Institute of Development Research Gen. A.K. Vaidya Marg, Goregaon (East), Mumbai-400065, India Email: arijit@igidr.ac.in

Saurabh Ghosh is presently a Research Officer in Monetary Policy Department, Reserve Bank of India. **Arijit Ghosh is Doctoral Fellow in Indira Gandhi Institute of Development Research (IGIDR). Views expressed by the authors are their personal. The usual disclaimer applies.

Electronic copy available at: http://ssrn.com/abstract=1158251

Do Leverage, Dividend Policy and Profitability influence the Future Value of Firm? Evidence from India

Abstract
This paper examines the effect of past dividend policy, leverage and profitability on the probability of increase in future value of the firm (in terms of market to book value ratio (MBVR)) for an emerging economy, India. We use fixed effect logit model to predict the probability of increase in future value of the S&PCNX500 firms, from 1989-90 to 2001-02. We find that there is a non-linear relation between leverage, profitability and probability of increase in future value of the firm. Probability of increase in future value of firm reduces exponentially with the increase in leverage, whereas, it increases with the raise in dividend payout and profitability of the firm. Among the companies from different ownership groups, foreign standalone firms have larger probability to create better future value than group-affiliated firms.

JEL Classification: G 32 G35 C23 C25 Keywords: Dividend Policy, Profitability, Firm Value, Logit Model, Panel Data

Electronic copy available at: http://ssrn.com/abstract=1158251

Do Leverage, Dividend Policy and Profitability influence the Future Value of Firm? Evidence from India

1. Introduction
With the ushering of economic liberalization in 1992, Indian stock market has undergone several changes over the last decade. These include introduction of new exchanges, massive computerization and electronic limit order book integrating the stock exchanges across the nation, establishing of clearing corporation and subsequent introduction of new derivative products in the market. Perhaps the most important among these changes was the establishment of Securities and Exchange Board of India (SEBI) in 1992 as the market watchdog. SEBI, since its inception has strived in the direction of narrowing the information gap between Indian corporations and investors, enforce better corporate governance practices through guidelines, rules and regulations and through active market for corporate control that has marked a new era in the Indian financial arena. The investors reveled their confidence through their participation in the primary and secondary market. Large number of new companies came to the primary market over 1993-96 and the market capitalization of S&PCNX 500 has increased considerably over 1990s. India has emerged as an emerging economy with largest number of companies listed in its stock markets. Over the last decade corporate governance has received considerable importance in Indian financial market. With the initiation of market for corporate control and activities in the merger and acquisition market, CEOs have assigned tremendous importance for creating value for their firms. Accordingly companies from different sectors (and/or ownership groups) have adopted different strategies to signal their earning and growth potential over the years and thereby influence their stock prices. With this in the background this paper attempts to analyze the factors that influenced the future value of the companies listed in Indian stock markets and also how the effect of these factor changes over different categories of firms.

The reminder of the paper is organized as follows. Section 2 gives a brief overview of the literature. Data and the statistical specification used in this study are described Section 3. Section 4 presents the empirical results and their interpretations. Section 5 concludes the paper.

2. Background Literature
The well-developed and vibrant literature in modern corporate finance has its root in the seminal paper by Franco Modigliani and Merton Miller (1958, 1963), (M-M henceforth). This branch of finance started with the assumption of perfect information and complete markets. It postulates that in a typical neoclassical market with perfect competition, absence of agency costs, transaction and banking costs, the average cost of raising fund for any firm is completely independent of its capital structure. With the same set of assumptions M-M (1963) argued that the value of the firm is unaffected by the dividend policy. However, over time many of these simplified assumptions were relaxed and subsequent research showed capital structure does matter and there could exist optimal dividend policy in the modified M-M framework. Academic literature over the last decade has documented the effect of different strategic factors influencing the firm values for the developed countries. Rappaport (1981, 1987) has used value creation literature for corporate mergers and acquisition and underlined the importance of growth rate, operating profit, income tax rate and fixed capital investment as the major factor influencing the firms value. Recently some of the studies concentrated on emerging market to analyze the factors that influenced the firms value in this market. Ben Naceur and Goaied (2002) investigated value creation process for Tunisian stock exchange using a random probit model with unbalanced panel data. It considered that the managers succeeded creating value to its share holders if the market value of the share exceeds the book value of the corporation and vice versa. The authors considered three main determinants of value creation: financial policy, profitability and dividend policy.

In the modified M-M framework, literature has shown that firms performance depends on the capital structure (or financial policy). Ross (1977) argued that more leverage would signal the investors about the improved firm prospect and influence the firms value in future. Increase in dividend payout increases the investors income at present and signal the expected future cash flow for the corporation. Profitability is undoubtedly one of the major factors determining the firm value. Ben Naceur and Goaied (2002) argued that while profitability and debt have positive effect on the probability of crating future value, the pay-out have reverse effect on the same. India has one of the most developed stock markets in the world with large number of domestic and international players investing in Indian stock market. With maximum number of companies listed in the Indian stock exchanges from different industries and different ownership groups (e.g. business affiliated firms, Indian standalone, foreign standalone) and with the emphasis on corporate governance practices, India has become an important and interesting destination for such studies. Among the available studies in this area, Sahu (2002) used a sample of companies listed in BSE to explain the abnormal stock returns by dividend stability and found no statically significant result. Another study by Tuli and Mittal (2001) used 101 Indian firms and found price earning ratio is significantly influenced by variability of market price and dividend pay out ratio. However, the authors did not find any significant effect of industry and ownership pattern on price to earning ratio. This papers aims at determining the factors influencing the probability of future firm value for Indian corporations after controlling for the industry and time specific effects. In particular this study attempts to answer the following questions: 1. How the probability of future value creation is affected by firms profitability, financing pattern and the dividend pay-out policy? 2. Whether the firms belonging to business groups have different effect on probability of value creation?

3. Data
The primary source of the data for this paper is PROWESS database, compiled by Center for Monitoring the Indian Economy (CMIE). This dataset is similar to the COMPUSTAT database in USA. We have selected the firms that are presently included in S&PCNX 500 index. The accounting and stock price data for these companies are extracted for the year 1989-90 to 2001-02 from Prowess dataset for this study1.

Variable Description Market to book value ratio (MBVR) is defined as the ratio of closing price of the equity to book value of equity at the end of the financial year. MBVR is the dependent variable for the OLS regression. For the logit model the dependent variable is a binary series, which takes the value 1 if price to book value ratio is greater than one (i.e., market perceived that future value of the firm is going to increase) and zero otherwise. The other variables of interest include those representing Leverage Policy, Dividend Policy and Profitability that have key bearing on the firms future value creation. While the ratio of total amount of long-term debt to total amount of equity capital (LEVERAGE) is included to proxy the leverage policy of the corporation, the ratio of total dividend to total earning of the firm (PAY_OUT) is included to capture the dividend policy of the same. The profitability of a company, on the other hand, is captured by the ratio of net profit to net worth of the firm, which is also known as return on equity (ROE). To control for the size of the firm we consider total assets (ASSET) of the firm as a proxy variable. To control for the differenced arising due to the firms belonging to different business groups this paper considers different dummy variables. If the firm is
1

Among the large number of listed companies, those included in S&PCNX 500 are often considered for empirical studies for their liquid nature and representative characteristics.

private Indian standalone then the dummy, D_PVT_IND, take the value one and zero otherwise. If, on the other hand, a firm is private foreign standalone then the dummy,
D_PVT_FOR, take the value one and otherwise zero. Indian companies differ considerably

access the industries. So industry dummies were used to control for industry specific heterogeneity. Since 1990, Indian economy has undergone several changes, which have their influence on the corporate valuation. So time dummies were also included to control for the time trend. All the nominal variables are deflated by GDP deflator and expressed at constant price of 1987-88. (Insert Table-1 here) Table 1 shows the mean values and the standard deviations (in parenthesis) of the variables under consideration under six different cases (namely, all firms, large firms, small firms, group-affiliated firms, Indian standalone firms and foreign standalone firms). The descriptive statistics reported in Table 1 shows that the value of a firm, in terms of MBVR, is higher for the small firms and the foreign standalone firms. Large firms get more leverage than any other category of firms. Profitability of the firm, in terms of ROE, is higher for the Indian standalone companies. Table 2 shows the Pearson correlation coefficient matrix between the variables of interest. It shows that MBVR has significant negative correlation with leverage and size of the firm and positive correlation with dividend policy and profitability of the firm. In the Appendix Figure 1 and 4 show that with the ushering of economic liberalization there is a sharp rise in MBVR and ROE in the year 1992, which have gradually decreased over the years. Figure 2 shows since post liberalization period, the leverage has shown an increasing trend. However, dividend payout policy does not depict any significant trend over this period.

4. Methodology & Results

So far we have done the univariate and bivariate analysis in the previous section. To examine the factors effecting the future value creation of the firms listed in the Indian stock exchange we first examine the effect of previous years leverage, dividend and

profitability on the MBVR of the company in a multivariate framework. The generic form for this unbalanced panel model is as follows: MBVRit = + t + 1LEVERAGEt-1 + 2(LEVERAGEt-1)2 + 3 PAY_OUTt-1 + 4 ROEt-1 + 5(ROEt-1)2 + 6 LOG(ASSETt-1) + 7 D_PVT_INDit + 8 D_PVT_FORit +

22

k =1

8 + k ( IND _ D ) kt

+ it

(1)

To account for the non-linearity in the relationship, the square of the previous years leverage, pay out and profitability were also included in the regression. The regression results based on the model specified in equation one is reported in Table 3 below. (Insert table 3 here) From Table 3, it appears that the previous years leverage has a negative effect (0.14) on the MBVR of the company, which is significant at one per cent level. This effect however decreases with the increases in leverage, which appears from the positive coefficient of the square of LEVERAGE-t-1 term. For the Indian corporations the previous years pay-off (0.87) and return on equity (0.35) have positive influence on the corporations MBVR. Moreover the square term of ROE has a positive coefficient implying that ROE influences MBVR at an increasing rate. The log of assets and the dummies for group companies were all significantly different from zero at ten per cent levels. The significance of these coefficients prompted separate analysis of the future value creation across different groups and size2. The results reported in table 3 substantiate conclusions of the pooled model as the signs of the independent variables coefficients as they are obtained in the pooled model. However, the previous years payout significantly affects MBVR for the all firms sample and especially for the sample of foreign standalone companies.
2

Companies with total asset more than median of total asset is considered as large size and others are considered as small. The asset size however differs considerable across the broad classification. To account for it ln(asset) was included as a control variable in these sub-groups.

This paper also attempts to model the probability of increase in the future value of the firm. The binary variable (Y) takes value 1 if MBVR is greater than one (i.e., if the market value of the firm is greater than the book value), otherwise zero. The logistic model is as follows: Pr ob(Yit = 1 | X it )= e 1+ e
+ it + t + X it + it + t + X it

(2)

where Xit are the same explanatory variables used in equation (1). This model aims to predict how the probability of improvement of the future value of the firm influenced by the previous years dividend and leverage policy and profitability of the firm. The empirical results of the logit model is reported in the table-4 below The coefficient of lagged value of leverage (-O.44) and its square term (0.007) imply that as the leverage of the firm increases, the probability of raise in future firms values declines at a decreasing rate. The negative influence of leverage on the probability of future value creation was observed across the ownership groups and size. The profitability of the firm (as apparent from the coefficient of ROE) increases the probability of increase in future value creation. Point to note is, this increase is higher for foreign standalone firms as compare to Indian standalone or group-affiliated firms. Unlike the OLS model, the dividend payout did not significantly explain the chance of future value creation. Neither in the pooled model nor in the size and ownership group specific regression the coefficient of payout was significantly different from zero at 10 per cent level. This paper analyzed the accounting factor that influence the probability of increase in future market valuation of the firms listed in Indian stock exchange after controlling for the time and industry specific effects. The empirical results indicate that the increase in leverage has a negative impact on the chance of future value increase of the firm. It could be because more reliance on credit increases the conflict of interest between shareholders and creditors, giving more control to the managers/promoter, which in turn have a negative influence on the future valuation. Alike Naceur and Goaied (2002), we found previous years profitability positive influences future firms value, as

increase in profitability might have signaled better quality of management. However, the pay-off did not significantly influence the probability of future MBVR increase in the pooled model as well as the models across ownership group and size. This finding could be because of the fact that the dividend payment the future performance varied considerably across firms listed in Indian stock exchange.

5. Conclusion
This paper investigates the value creation process of the firms listed in the Indian stock market and their dependence on the accounting variables. It used an unbalanced logit model and found that the increase in profitability has a positive influence on the probability of creating future value and the relation is stronger for foreign standalone firms as compared to private Indian standalone or business group owned firms. Leverage, one the other hand, has negative impact on the chances of increase in future value of the corporation and this relation was uniform across size and ownership group. It could be because of the potential conflict of interest between the equity holders and the creditors that got reflected in the stock prices. The dividend pay-off policy of the firm, however, could not significantly influence the probability of future value creation of the firms listed in Indian stock market.

Reference:
Ben-Naceur, Samy and Mohamed Goaied (2002), The Relationship between Dividend Policy, Financial Structure, Profitability and Firm Value, Applied Financial Economics, 12(12), 843-49. Modigliani, Franco and Merton Miller (1958), "The Cost of Capital, Corporation Finance, and the Theory of Investment." American Economic Review, 48, 261-97. Modigliani, Franco and Merton Miller (1963), "Corporate Income Taxes and the Cost of Capital." American Economic Review, 53, 433-43. Rappaport, A. (1986) Linking Competitive Strategy and Shareholder Value Analysis. The Journal of Business Strategy, 3, 58-67 Rappaport, A. (1987) Corporate Performance Standards and Shareholder Value. The Journal of Business Strategy 4, 28-38. Ross. S (1977). The Determination Of Financial Structure The Incentive Signaling Approach. Bell Journal of Economics. 8, 23-40 Sahu, Chinmoy (2002), An Empirical Test of Stable Dividend Hypothesis, Finance India, 16(2), 613-26. Tuli, Nishi and, R K Mittal (2001), Determinants of Price-Earnings Ratio, Finance India, 15(4), 1235-50.

Table 1: Descriptive statistics

(MBVR) is ratio of closing price of the equity to book value of equity at the end of the financial year. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital. PAY_OUT is the ratio of total dividend to total earning of the firm. Return on equity (ROE) is the ratio of net profit to net worth of the firm. ASSET total assets of the firm.
Variable MBVR LEVERAGE DIVIDEND PAY OFF PROFITABILITY (ROE) SIZE All Firms 3.137 (5.993) 1.726 (4.140) 0.023 (0.029) 0.138 (0.367) 13.795 (75.556) Large Firms Small Firms Group Firms 2.133 (3.537) 3.057 (7.151) 0.025 (0.028) 0.095 (0.449) 66.395 (170.110) 3.349 (6.372) 1.441 (3.063) 0.023 (0.029) 0.148 (0.346) 2.500 (2.248) 2.833 (5.659) 1.973 (4.470) 0.024 (0.030) 0.133 (0.372) 16.639 (84.509) Indian Standalone Firms 2.850 (5.119) 1.247 (3.094) 0.024 (0.026) 0.168 (0.283) 3.632 (9.212) Foreign Standalone Firms 5.776 (8.255) 0.319 (0.484) 0.020 (0.023) 0.148 (0.397) 2.146 (6.210)

Table 2: Pearson Correlation Matrix.

(MBVR) is ratio of closing price of the equity to book value of equity at the end of the financial year. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital. PAY_OUT is the ratio of total dividend to total earning of the firm. Return on equity (ROE) is the ratio of net profit to net worth of the firm. ASSET total assets of the firm.
MBVR MBVR LEVERAGE PAY-0FF ROE SIZE 1.000 -0.158 (<.0001) 0.028 (0.060) 0.074 (<.0001) -0.042 (<.0001) 1.000 -0.093 (<.0001) -0.210 (<.0001) 0.076 (<.0001) 1.000 0.124 (<.0001) -0.011 (0.450) 1.000 -0.021 (0.155) 1.000 LEVERAGE POLICY DIVIDEND POLICY PROFITABILITY SIZE

Table 3: OLS regression results

(MBVR) is ratio of closing price of the equity to book value of equity at the end of the financial year. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital. PAY_OUT is the ratio of total dividend to total earning of the firm. Return on equity (ROE) is the ratio of net profit to net worth of the firm. If firm is Indian standalone then the dummy, D_PVT_IND, take the value one and zero otherwise. If a firm is private foreign standalone then the dummy, D_PVT_FOR takes value one otherwise zero. LN(ASSET) is the log of total assets of the firm.
Variables INTERCEPT LEVERAGEt-1 (LEVERAGEt-1) PAY_OUTt-1 ROEt-1 (ROEt-1)
2 2

All Firms 0.6103 (<.0001) -0.1396 (<.0001) 0.0024 (<.0001) 0.8781 (0.0609) 0.3483 (<.0001) 0.0584 (<.0001) -0.0177 (0.0751) 0.1071 (0.0133) 0.6224 (<.0001) 0.49 0.49 113.77 4461

Large Firms Small Firms 0.9979 (<.0001) -0.1157 (<.0001) 0.0018 (<.0001) -0.0083 (0.9933) 1.1370 (<.0001) 0.1030 (<.0001) -0.0166 (0.5201) -0.1375 0.2501) -0.0864 (0.7694) 0.57 0.56 32.40 803 0.6602 (<.0001) -0.1668 (<.0001) 0.0037 (<.0001) 0.5878 (0.2577) 0.3225 (<.0001) 0.0903 (<.0001) -0.0003 (0.9850) 0.1384 (0.0029) 0.6222 (<.0001) 0.51 0.50 97.31 3657

Group Firms 0.7241 (<.0001) -0.1606 (<.0001) 0.0033 (<.0001) 0.5399 (0.2794) 0.2582 (<.0001) 0.0484 (<.0001) -0.0195 (0.0680)

Indian Standalone 1.4736 (<.0001) -0.1105 (<.0001) 0.0020 (<.0001) 0.8481 (0.6080) 0.9664 (<.0001) 0.2622 (0.0032) 0.0723 (0.0717)

Foreign Standalone 1.0004 (<.0001) -0.2021 (<.0001) 0.0025 (0.0013) 4.4517 (0.0211) 0.4165 (0.0181) 0.0698 (0.0622) 0.0501 (0.2965)

LOG(ASSETt-1) D_PVT_IND D_PVT_FOR R-Square Adj. R-Square F Value N

0.51 0.50 100.14 3536

0.47 0.43 11.78 469

0.47 0.42 11.46 454

Table 4: Logit Model

(MBVR) is ratio of closing price of the equity to book value of equity at the end of the financial year. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital. PAY_OUT is the ratio of total dividend to total earning of the firm. Return on equity (ROE) is the ratio of net profit to net worth of the firm. If firm is Indian standalone then the dummy, D_PVT_IND, take the value one and zero otherwise. If a firm is private foreign standalone then the dummy, D_PVT_FOR takes value one otherwise zero. ASSET total assets of the firm.

Variable INTERCEPT LEVERAGEt-1 (LEVERAGEt-1) PAY_OUTt-1 ROEt-1 (ROEt-1)

2 2

All Firms 2.7600 (<.0001) -0.4360 (<.0001) 0.0072 (<.0001) 0.1380 (0.9186) 0.7577 (0.0015) 0.1106 (0.0043) 0.0079 (0.8062) 0.2314 (0.0755) 1.1884 (<.0001) 1805.28 38.00

Large Firms 4.2975 (<.0001) -0.5412 (<.0001) 0.0076 (<.0001) -3.3405 (0.3194) 2.4710 (0.0153) 0.2200 (0.0282) -0.0644 (0.4948) -1.0167 (0.0155) -1.6773 (0.1886) 319.90 31.00

Small Firms 3.6718 (<.0001) -0.5455 (<.0001) 0.0142 (<.0001) -0.7560 (0.6159) 2.0384 (<.0001) 1.9982 (<.0001) 0.1003 (0.0558) 0.4163 (0.0045) 1.3467 (<.0001) 1369.90 31.00

Group Firms 2.8716 (<.0001) -0.4940 (<.0001) 0.0102 (<.0001) -0.5285 (0.7196) 0.6067 (0.0203) 0.0829 (0.0115) 0.0171 (0.6258)

Indian Standalone 3.3319 (0.0102) -0.2410 (0.0422) 0.0047 (0.1803) 3.5130 (0.4677) 1.4478 (0.2860) 10.9652 (0.0007) 0.0842 (0.5473)

Foreign Standalone 1.7466 (0.0635) -0.3466 (0.1855) -0.0109 (0.1208) -16.3592 (0.1716) 5.3722 (0.0023) 20.3404 (0.0023) -0.2233 (0.3070)

LOG(ASSETt-1) D_PVT_IND D_PVT_FOR Log likelihood Likelihood Ratio

1416.72 36.00

143.90 33.00

99.44 24.00

Annexure Figure 1
Price-Book Value Ratio Trend
12 10 P-B Ratio 8 6 4 2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year
(PBVR) is ratio of closing price of the equity to book value of equity at the end of the financial year.

Figure 2
Leverage Trend
3.5 3 Leverage 2.5 2 1.5 1 0.5 0 1990 1991 1992 1993 1994 1995 1996 Year 1997 1998 1999 2000 2001 2002

LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital.

Figure 3
Dividend Payout trend
0.03 Divedend Payout 0.025 0.02 0.015 0.01 0.005 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year
PAY_OUT is the ratio of total dividend to total earning of the firm.

Figure 4 ROE trend

0.25 0.2 ROE 0.15 0.1 0.05 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year
Return on equity (ROE) is the ratio of net profit to net worth of the firm.