CATERING THEORY OF DIVIDEND

EVIDENCE FROM KARACHI STOCK EXCHANGE

1. Introduction
In dividend policy theory, Miller and Modigliani, described that in perfect and
efficient market dividend policy is absolutely irrelevant to share value or
stock price. Due to this irrelevancy, no rational investor has a preference
between dividend and capital gain. MM indicated that value of firms share is
not dependent to dividend payout ratio only. Dividend and share (buying and
selling) are substitute to each other. This means that either dividend or
share purchase or repurchase, which ever is greater, it contributes to the
value of a firm.
This theory was given by them in 1961 and was criticized time to time.
About forty years later, the assumption made in MM theory i.e. of market
efficiency has been proofed thoroughly. The theory called as Catering theory
given by Baker and Wurgler (BW) in 2004. In this theory, the assumption of
perfect and efficient market was relaxed. This theory states that
management of a company initiate / declares dividend when they sees that
the investors relatively high preference is those stock which is dividend
payer and management omit dividend when they think investors are now
preferring non-payers.
Catering theory proposed that managers, in order to meet the preference of
investors, consider /chooses the dividend policy. It also suggests that when
there is a dividend premium existing in the stock, managers tends to pay
Cash Dividend. In other words firms distribute cash dividends only when
investors put higher prices on dividend payers and when investors prefer
non-payers manager omit cash dividend.
Catering theory does not build a relationship between dividend policy and
investor as we can see in usual that provide emphasizes on irrelevancy of
dividend on investors preferences. Catering theory strictly suggest that the
demand for dividend is directly concern with the investors sentiment. Also
catering theory preferred those share which are dividend payers i.e. catering
focuses on those shares that pays the dividend. It does not prefer all the
shares trading in the stock exchange.

2. Problem Statement:
In common practice, researcher all over the world has done a lot of research
on dividend and its declaration. Normally they found the impact of dividend
announcement on share price, companys performance, calculating earning
per share, dividend policy impact on company and others. In precise, every
research conducted on dividend was impact after the declaration of dividend.
But no or some work has been done on declaration of dividend as what
factor drives the company to declare the dividend. Similarly: how, when and
why management declares the dividend.
On talking and consider the behavior finance issue, management also
consider the behavior of investor towards declaration of dividend. In this
paper we investigated how management declares the dividend by
considering the behavior of investor.
3. Research Question:

Does the Management declare dividend by keeping its stock holders

perspective in their mind or they just declare dividend as and when
profit occurs?

4. Objective of the Research Paper:

The objective of this paper is to find out:
1. How the management declares the dividend. Either they declare it
when
o A company earns profit,
o A company have high retained profit and want to distribute it
into shareholders or
o Management reads the mind of investors and they conclude that
its time to declare the dividend.
2. What is the percentage of payers and non-payers in the sample of
financial sector of Karachi Stock Exchange?

5. Significance of the Study

This type of research work has not been carried out previously. Although
there is a lot research work done on dividend to get the share price/ growth
of the company/ market value of the company etc. But in perspective of
declaration of dividend on catering basis of share holders, this research is
being done for the first time as in the case of KSE.
This would have huge significance over future research work, as this will
open the doors for researcher to deliver the dividend theory in a new
perspective.
6. Related Theories:
Theories related to this paper are
1. Catering Theory of Dividend; developed and presented by M.Baker &
J.Wurgler in Jun 2002 in his paper titled A Catering Theory of
Dividends. In this theory, the author / researcher concluded that the
decision to pay dividends is driven by investor demand. This means
that the Dividend Payer firms are dependent to the investors demand
for dividend. This theory satisfies our assumption and hence related to
our research.
2. Second theory that relate to this paper is, Choice Behavior Theory. This
theory was developed and presented by D.I.Maditinos, eljko evi, in
2007 in his paper, Individual Investors Perceptions towards
Dividends. In this paper the researchers assumed that there exists a
strong preference for dividends among individual investors. In this
theory, they concluded that majority of investors did show a strong
preference for dividends in their case of Greece Stock Exchange.
Hence the theory satisfies that management has to consider the
preference and demand of investors and declares dividend accordingly.
3. Dividend signaling theory, suggests that the announcement of dividend
payout is a strong indicator of strong future prospect of the company.
This paper satisfies this research paper to some extent that

management, for strong future prospect of the company and getting

the trust of the investors, declares the dividend.
7. Literature Review
Jeffrey Wurgler (2002) developed a theory, Catering Theory of Dividend, in
which he described that the decision to pay dividends is driven by investor
demand. Managers cater to investors by paying dividends when investors
put a stock price premium on payers and not paying when investors prefer
non-payers. To test this prediction, we construct four time series measures
of the investor demand for dividend payers. By each measure, non-payers
initiate dividends when demand for payers is high. By some measures,
payers omit dividends when demand is low. Further analysis confirms that
the results are better explained by the catering theory than other theories of
dividends.
Paola Sapienza (2010) tested catering theory and described how stock
market mispricing might influence individual firms investment decisions and
found a positive relation between abnormal investment and discretionary
accruals. He concluded that abnormal investment is more sensitive to
discretionary accruals for firms with higher R&D intensity (opaque firms) or
share turnover (firms with shorter shareholder horizons) Also he described
that firms with high abnormal investment subsequently have low stock
returns and the larger the relative price premium, the stronger the abnormal
return predictability. Hence he concluded that patterns in abnormal returns
are stronger for firms with higher R&D intensity or share turnover.
Malcolm Baker & Jeffrey Wurgler (2003) proposed that the decision to pay
dividends is driven by prevailing investor demand for dividend payers. To
test this prediction, they constructed four stock price-based measures of
investor demand for dividend payers. By each measure, non-payers tend to
initiate dividends when demand is high. By some measures, payers tend to
omit dividends when demand is low. Further analysis confirms that these
results are better explained by catering than other theories of dividends.
Chikashi Tsuji (2010) tested the catering theory of dividends using data from
firms in the Japanese electrical appliances industry. Their empirical results
suggested that in the Japanese electrical appliances industry, corporate

managers do not consider catering behavior in either their dividend initiation

decisions or their continuation decisions. This finding is different from
existing evidence for the US and other countries. Japanese electrical
appliances industry firms is the value-weighted dividend yield in the industry
as the value-weighted dividend yield declines, Japanese firms in the industry
tend to initiate dividend payments.
Joseph Yagil (2004) extended the paper of Baker and Wurglers (BW)
Catering Theory of Dividends and addressed by their model is whether or
not to pay dividends, the extended model offered here, in contrast,
incorporates other dividend related issues such as the expected cash
dividend and the dividend payout ratio. Their extended model predicts a
negative relationship between the expected dividend per share and the ratio
of information about the cost of the dividend (C) held by category
investors and arbitrageurs, the percent of stock ownership held by
category investors as well as the risk, tax and investment premiums. He
also suggested that one implication of his extended model is that the
dividend sum depends on its short-term and long-term effect on the stock
price, and also depends on the financial leverage and investment
opportunities.
The cost of the dividend includes of three types of premiums i.e. tax, risk
and investment. (Joseph Yagil (2004). The tax premium is due to the
personal taxes paid upon receiving dividends. The risk premium consists of
two components. The first is the increase in the financial leverage resulting
from the dividend payment, and the second is the semi contractual
obligation of the dividend-paying firm to maintain the dividend payment. The
investment premium involves the opportunity cost associated with the
rejection of profitable investments in order to pay dividends.
The dividend initiation decisions of Japanese electrical appliances industry
firms have no predictive power for relative future negative returns of payers
over non-payers. This evidence is inconsistent with the suggestions of
catering theory of dividends by BW (2004a), Chikashi Tsuji (2010).
Chikashi Tsuji (2010) tested the catering theory of dividends in the Japanese
electrical appliances industry and derived the results as (1) The dividend
initiation decisions of Japanese electrical appliances industry firms have no

predictive power for the relative future returns of payers over non-payers.
While BW (2004a) documented that US firms dividend decisions for both
initiations and continuations have strong predictive power for relative
negative future returns, their results were different from them. (2)
Determinants of the dividend initiations, the first difference between the US
and Japan is that the value-weighted dividend yield is a strong determinant
of one-year-ahead dividend initiations in the Japanese electrical appliances
industry firms. Most importantly, the dividend premium is not a determinant
of the dividend initiations of the Japanese electrical appliances industry
firms. This means that these firms do not behave as predicted by catering
theory.
Hafeez Ahmed & Attiya Y. Javid (2007) examined the dynamics and
determinants of dividend payout policy of 320 nonfinancial firms listed in
Karachi Stock Exchange. Their results consistently support that Pakistani
listed non-financial firms rely on both current earning per share and past
dividend per share to set their dividend payments. The listed nonfinancial
firms having the high speed of adjustment and low target payout ratio show
the instability in smoothing their dividend payments. Furthermore the
ownership concentration and market liquidity have the positive impact on
dividend payout policy. Besides, the investment opportunities and leverage
have the negative impact on dividend payout policy. The market
capitalization and size of the firms have the impact on dividend payout policy
which shows that the firms prefer to invest in their assets rather than pay
dividends to their shareholders.
Day-Yang Liu & Yen 2012 described that managers cater to investor
demands by paying cash dividends when investors put a dividend premium
on payers. In contrast, when investors put a dividend discount on dividend
payers, managers choose to distribute no dividends. Investors are willing to
pay a premium for cash dividends for several reasons. (1) A clientele effect
exists in that the capital market prefers cash dividends. (2) Some investors
believe that dividend paying firms are less risky. (3) Investors may be highly
risk averse so that the distribution of cash dividends is preferred
Yordying Thanatawee (2012) developed a theoretical model to demonstrate
that the firms payout/investment decision may be affected by the relative
magnitude of dividend and repurchasing premia. The model he used showed

that the manager of high-quality firm may pass up a positive NPV project in
order to cater to investors demand for dividends or share repurchases if the
catering premia are substantial. On the other hand, the manager of lowquality firm may have strong incentives to return free cash flows to
shareholders if the catering premia are higher than the private benefits from
investing in a negative NPV project. Under this case, the agency costs of free
cash flows are mitigated.
Wei Li, Erik Lie (2005) extended Baker and Wurglers [2004a] catering
theory of dividend to include decreases and increases in existing dividends.
They found that the decision to change the dividend and the magnitude of
the change depend on the premium that the capital market places on
dividends. The stock market reaction to dividend changes depends on the
dividend premium. Thus, the capital market rewards managers for
considering investor demand for dividends when making decisions about the
level of dividends.
There is more to the story than dividend catering. While the dividend
premium has significant explanatory power in our analyses, so do individual
firm characteristics, suggesting that both internal and external factors affect
decisions to change dividends and the capital markets reaction to such
decisions. The role of other non catering factors is especially apparent in the
negative stock market reaction to dividend decreases, which the dividend
catering theory cannot explain by itself. Thus, it would be unwise for
corporate managers to look solely to the capital market for guidance in their
dividend policy. W. Li, E. Lie (2005).
Ming-Hui, Lin 2012, examined the dividend policy with a prediction to
catering theory of dividend. They examined the consistent results that
managers choose a dividend policy to cater to the demand of investors which
Jeffrey Wurgler (2002), defines as the catering theory. They explained that
Dividend payers experience higher market-to-book ratios than those for nonpayers. Moreover, among dividend payers, firms distribute more stock
dividends than other types of dividends when the dividend premium for
stock dividends is positive. In contrast, firms shift from stock dividends to
other types of dividends such as mixed dividends and cash dividends when
the dividend premium for stock dividends is negative.

6. Data Sample & Methodology

6. Theoretical Framework
Our independent variable i.e. dividend payer, measures there worth / market
value through market-to-book ratio. In theory, those companies who are
dividend payers experience higher market-to-book ratio. This aspect is
measured in sample of Karachi Stock Exchange.
Considering the dividend types, dividend payer companies issues more stock
dividend than any other dividend types as and when there dividend premium
of stock is positive. And when the dividend premium is negative, firms
(dividend payers) shift this type of dividend from stock dividend to other
types of dividend i.e. Cash Dividend or Mixed Dividend.
To measure the catering effect of dividend, we measure the stock price
premium, an independent variable. In theory, when stock price premium is
high or positive, management declares the dividend and when the stock
price premium is negative, this means investors prefer the non-payers of
dividend. This is measured through the market-to-book ratio of dividend
payers and non-payers.
Dividend payout ratio is also measured to know
7. Data & Methodology
Data for this study has collected from the Karachi Stock Exchange (KSE), a
Companies financial report, which was also obtained from companies official
websites for the period 2005 to Jun 2012.
In the sample, data of two sectors is taken i.e. Banking Sector and Textile
Sector for the period 2005 to Jun 2012.
We follow Baker and Wurgler (2004b) in order to test the catering theory.

a. First of all we measure the dividend premium. This is measured by

taking the log of dividend payers and non payers and then divides it
with average market to book ratios.
b. Apart from this, we also measure dividend premium between the
companies those who pays dividend (payers) and those do not (nonpayers).
When considering the dividend payers, it is notified that there are
different types of dividend payers i.e. stock dividend, cash dividend and
mixed dividend which include both cash and stock dividend.
c. In order to examine whether the dividend premium is related to the
dividend policy, we use the multivariate regression model, to measure
the different types of dividend payers i.e. cash dividend, stock dividend
and both cash and stock dividend payers. We count the total payers by
the following method:
Total Dividend Payers=
Cash dividend payers + Stock dividend payers + Mixed dividend payers

d. After measuring the relation, we then examine the significance of

correlation coefficient of dividend premium.
e. We also measure dividend payout ratio of all the firms included in both
the sector by the formula:

We measure the dividend payout ratio to get an idea of how well

earnings support the dividend payments.
8. Dependent and Independent Variables:
Independent Variable

Dependent Variable
Market-to-Book Ratio
Dividend Premium

Dividend Payers
Stock Price Premium
Dividend Pay out Ratio
9. Hypothesis:
H0: Management does not cater the demand of investors when declaring the
dividend.
H1: Management caters the demand of investors when declaring the
dividend.

<Intro:
The performance of firms as well as the financial strength of a company can
be judged by its share price. Higher the share price of the firm, higher will
be its share value and vice versa. Effect of dividend on share value and price
volatility has been researched by the researcher in Pakistan frequently. Most
of this research has been carried out in the prospect of Karachi Stock
Exchange (KSE). In the context of investors perception, there is rare any
research being conducted on this point in Pakistan. In this paper investors
perception towards declaration of dividend has been focused and measured
through a regression model in a sample of two sectors of KSE.
In Pakistan, more firms are family owned which means they are not
interested in declaration of dividend as the profit is being distributed within a
family as and when needed. Also the share price is not affected by its
declaration, as other investors are interested in Capital gain by fluctuation of
share price.
The announcement of dividend is an important in corporate industry because
it does not only create cash out flow from company to share holders but also
represents the companys performance and its future plans in the industry.
MM theory has described this phenomenon in this way that the declaration of
dividend does not add value to the company. On the other hand, investment
policy clearly represents the value of the company and its trust over share
holders.
>