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Source: http://www.doksinet STATISTICAL MODEL TO ESTIMATE DIVIDEND IN INDIAN PRIVATE SECTOR BANKS V. Charles Department of Quantitative Methods and Operations Research SDM Institute for Management Development, Mysore, Karnataka, India v chals@yahoo.com Roji George Karunya School of Management, Coimbatore, Tamil Nadu, India rojigeo@rediffmail.com R. Hari Hara Subramanian SDM Institute for Management Development, Mysore, Karnataka, India rhsmani2k@yahoo.com A Research Paper Presented at Third AIMS International Conference on Management (AIMS3) January 1-4, 2006 Venue: Indian Institute of Management, Ahmedabad, India Readers and users may note that articles (co)authored /published/ presented by Roji George are registered materials and copy write of the same is vested primarily with the author(s) and secondly with publishers and or with academic sites / on line journals like www.ssrncom , econpaerscom and or with conference organizers. Further, his working papers are also registered

with various research institutions. No part of this material(s) / working paper(s) may be reproduced or copied in any form by any means without prior written permission of all above mentioned parties. Source: http://www.doksinet STATISTICAL MODEL TO ESTIMATE DIVIDEND IN INDIAN PRIVATE SECTOR BANKS V. Charles Department of Quantitative Methods and Operations Research SDM Institute for Management Development, Mysore, Karnataka, India Roji George Karunya School of Management, Coimbatore, Tamilnadu, India R. Hari Hara Subramanian SDM Institute for Management Development, Mysore, Karnataka, India Abstract Banks are classified into three categories based on ownership structure. Public Sector Banks (SBI group Banks and non SBI group Banks), Private Sector Banks, New Generation Banks. The study plans to consider all the private banks in India. The prime objective of any firm is considered as maximization of shareholder’s wealth. Dividend decision, also known as profit allocation

decision is an imperative decision of financial management. Dividends are periodic cash payments by a firm to its shareholders. It is said that one of the most puzzling issues in corporate finance involves dividends. How firms decide their policy? What factors influence it? The extensive research on dividend policy has been unable to reach consensus on a general dividend theory that can neither explain the process of dividend decision-making nor predict an optimal dividend policy. This paper addresses the estimation of dividend payments of twenty one Indian Private Banking Companies. Having considering various factors the above said goal has been achieved with the help of multiple regression analysis. Keywords: Multiple Regression, Durbin Watson Test, Multicollinearity. 2 Source: http://www.doksinet 1. Introduction The prime objective of any firm is considered as maximization of shareholder’s wealth. Dividend decision, also known as profit allocation decision is an imperative

decision of financial management. Dividends are periodic cash payments by a firm to its shareholders Dividend policy of a firm has implications for investors, managers, lenders and economy in general. For investors dividend whether paid or accumulated are not only a means of regular income, but also useful for valuing the firm. The criteria of investment and future requirements of capital depend on dividend policy, in managerial decision-making. It also affects the liquidity of the firm Lenders are interested since cash outflow by way of dividend may reduce the creditworthiness of the firm. Economy is more influenced since dividend decision leads to capital formation in organization level as well as individual level. Dividend policy is a function of retention policy. Retentions are used to finance the viable future projects of the firm. Retained earnings are considered as the most significant source of funds for financing corporate growth, but dividends constitute the cash flows that

accrue to shareholders. Walter (1963) comments that, “a growing firm can maximize its shareholder’s wealth by retaining all the profits and vice versa in the case of declining firm”. The Board of Directors, the decision-making authority, is not to enforce to pay a fixed percentage or minimum dividend, even if the company makes profit. It is expected that they take an optimum policy decision after considering the expectations of investors and future money requirements of the firm, which maximize the shareholders wealth. One of the most puzzling issues in corporate finance involves dividends. How firms decide their policy? What factors influence it? The extensive research on dividend policy in the last fifty years has been unable to reach consensus on a general dividend theory that can either explain the process of dividend decision making or predict an optimal divided policy (Horace, 2003). This paper is organized as follows; in Section 2 review of literature is given. Section 3

discusses about baking industries. The need and research methodology for the study is provided in Section 4 and 5 respectively. Section 7 deals with empirical analysis, the data specification of the study along with hypothesis is provided in Section 6. Section 8 draws conclusion of the present study. 3 Source: http://www.doksinet 2. Review of Literature One-way to explain the dividend puzzle or understanding of why corporate pay dividend is to examine the views of corporate managers. Researchers went through some studies conducted worldwide to view the decision maker’s opinions (Lintner, 1956, Baker et al, 1985, Baker and Powel, 1999, Baker et al, 2002). Indian studies are explained later John Lintner (1956) who has conducted numerous studies on dividend behavior reports that firms have long run target dividend payout ratios and place their attention more on dividend changes than on absolute dividend levels. Managers try to stabilize dividends and avoid dividend cuts. Lintner

developed a partial adjustment model to depict the dividend decision process that explained 85 percent of year-to-year dividend changes. Many researchers like (Fama and Babiek, 1968, Baker et al, 1985, Benartzi et al, 1997 and Baker and Powel, 1999) supported his model. In his classic model, Lintner proved that the firms establish their dividends in accordance with the level of current earnings as well as dividend of the previous year. More preference is given for dividend pay out ratio than the dividend per share (DPS). Firms change their dividend policy with changes in earnings per share (EPS). According to him, current year’s dividend is a function of current year’s earning and dividend for the previous year which in turn depends on that year’s earnings and the dividend in the year before. If Lintner is correct, the dividend can be predicted in terms of weighted average of current and past earnings (Brealey and Myres, 1996). The other way to investigate the puzzle is empirical

analysis of performance of firms. Most of the studies in this area are devoted to such a line. Darling et al (1957) found that the dividend is determined by net profit after tax, amortization recoveries, sales changes, liquidity index and past profits. He observed that the dividend rate tend to vary directly with current profits. DeAngelo and DeAngelo (1990) comment that firms consider their image while deciding dividend pay out ratio. He found that during financial crisis, firms with good track record of dividend payments tend to cut dividend rather than omitting dividends. Aivazeian et al (2003) explained that dividend policy is affected by profitability, size, debt, risk, tangibility and growth and it differs from country to country. High Return on Equity (ROE) tends to mean high dividend payments in emerging markets like India. According to them higher 4 Source: http://www.doksinet debt ratios correspond to lower dividend payments. In addition, there is little evidence that

business risk affects dividend policy in a significant way. After analyzing 2235 firms’ year-wise observations from 332 firms of Australia and Japan, (Horace, 2003) comments that agency; signaling and transactions cost theories of dividend policy are relevant. His regression model reveals that size and liquidity factors influence dividend decision. Considering the heterogeneous environments and divergent objectives of firms, firms may have different dividend policies that are specific to firms, industries, markets and regions. Lease et al (2000) support it and comments that dividend policies must be made at the firm specific and micro level. In such a case, the firms from same industry, which are in the same region, may be having similarities. 2.1 Indian Studies In India there are few studies that addressed the dividend behaviour of firms. A study by (Rao and Sarma, 1971) may be considered as one of the preliminary studies in this area. After analyzing many companies for a period

of 10 years, they commented that, Lintner’s model adequately explains the dividend behavior of Indian firms. The same was the conclusion of a study conducted among manufacturing firms for a period of 16 years by (Swamy and Rao, 1975). Krisnamurty and Sastry (1971) found that current profit is not significant in many industries. They analyzed dividend behavior of 360 companies for 6 years Khurana (1985) commented that majority of Indian companies consider the dividend decision as a primary and active decision. After analyzing 68 companies from various industries, he found that only half of the companies were able to follow stable dividend policy. The dividend decision of the most of the companies is mainly governed by the current earnings and lagged dividend. Kevin (1992), studied dividend behavior of 650 Indian non-finance companies for a period of one year and found that Indian firms are following sticky dividend policy. He also found that change in profitability does not influence

change in dividend policy. Mahalpatra and Sahu (1993), observed that the cash flows as a major determinant followed by net earnings. They used Lintner’s model for analysing dividend behavior of 90 Indian companies for a period of 11 years (1977-78 to 1988-89). Supporting Lintner, they found that 5 Source: http://www.doksinet past dividend and not past earnings is the important factor in influencing the dividend decision of the firm. Based on a study among 39 Indian State Owned Enterprises, (Mishra and Narender, 1996), established that dividend per share has remained stagnant irrespective of the continuous increase in earning per share. They have also analyzed the relevance of Lintner’s model and concluded that coefficient of lagged dividend (previous year’s dividend) is greater than that of earnings per share. Mohanty (1999) analyzed the bonus issue aspects of dividend policies for 200 firms over a period of 15 years. Indian firms have maintained the dividend percentage after

the bonus issue also so that the payout to the shareholders is increased. Narasimhan and Vijayalakshmi (2002) analyzed the dividend behavior and found no influence of insider ownership on dividend behavior. They used regression model to analyze the dividend behavior of 186 Indian firms. Another study conducted on non-finance Indian companies for the period 1990 – 2001 comments that dividend changes are impacted more by contemporaneous and lagged earnings performance rather than by future earning performance, (Reddy, 2002). In a large sample he identified that dividend paying firms are more profitable and large in size. But he concluded that only few firms have consistency in paying same level of dividend. A very recent study conducted by (Panda, 2005), look into the dividend payment behavior of India’s private corporate sector. The very special feature of this study is that, it compares the dividend behavior before and after privatization. Their results show that profits, capital

structure, sales change and lagged dividend have an influence in dividend decision. Further there is shift in the dividend behavior in the post 90’s. A survey by (Bhat and Pandey, 1994) among financial managers reveals that the current year’s earnings as the most significant factor in deciding dividend policy. The interesting findings of their study are (i) increasing equity base has a positive impact and (ii) industry factor has the least influence. In a very recent survey conducted by Harish (2004) on thirty Non Financial Indian Companies, it is found that current earnings is the most influencing factor while deciding on the dividend policy followed by ‘pattern of past dividends’, ‘availability of cash’ and ‘expected future earnings’ in order of importance. 6 Source: http://www.doksinet 3. Banking Industry The banking industry in India is in the midst of transformation, thanks to the economic liberalization, which has changed business environment in the country.

During the preliberalisation period, the industry was merely focusing on deposit mobilization and branch expansion. Based on the recommendations of Narasimhan committee, Government of India started diluting its stakeholdership in Public Sector Banks (PSBs). Banks have been asked to maintain a minimum Capital Adequacy Ratio (CAR) and make provision for Non Performing Assets (NPAs). The sector has become very competitive with the entry of many foreign and private sector banks. The face of banking is changing rapidly There is no doubt that banking sector reforms have improved the profitability, productivity and efficiency of banks; but, in the days ahead, banks will have to prepare themselves to face new challenges. It is decided and accepted that Indian banks will follow the Basel II Accord by December 2006, which envisage more stringent policies and sound Capital Adequacy Ratio (CAR). Two options are available to banks to have sound CAR, one is to increase the equity base by tapping the

capital market and other is to increase the retained earnings by maximizing and retaining the profit. More number of public issues of banks in the recent period shows that Indian Banks prefer the former. But it is expensive and suitable only to profitable and efficient banks considering the cost and premium chargeable in public offering. The later, is a cost free method (of course opportunity cost is to be considered). Less the dividend outflow more the retention and vice versa. Less dividend leads to investor dissatisfaction and may influence market price Walter (1963) comments that, “a growing firm can maximize its shareholder’s wealth by retaining all the profits and vice versa in the case of declining firm”. Rakesh (2005) comments, “another important factor in the improvement in capital position of banks operating in India stemmed from deployment of retained earnings out of increased profits”. RBI in its latest circular advised banks to take into account the factors

like Basel II capital requirements and the bank’s long term growth plans while deciding the dividend policy (RBI Guidelines vide no DBOD. BPBC 88/2102067/2004-05 Dated 4th May 2005) 7 Source: http://www.doksinet 3.1 RBI Policy Banks in India are not free to declare dividend as like their counterparts in the corporate sector. RBI stipulates that, it needs prior permission to declare the annual dividend After opening up this sector, RBI has permitted banks, which comply some prudential requirements on CAR and NPA can declare dividends without prior approval of RBI 4. Need for the Study As discussed, bank’s dividend policy not only affects its corporate finance policy but also its Capital Adequacy Ratio and future financing plans. Further it has an impact in the capital market too. So it is an area to be explored and analyzed It is interesting to note that almost all the studies conducted on this subject do not consider banks (Sastry, 1968, Rao, 1971, Khurana, 1985, Kevin,

1992, Mahapatra et al, 1993, Bhat et al, 1994,, Mishra et al, 1996, Mohanty, 1999, Harish, 2004,, Panda, 2005). Unfortunately, in India, an exclusive study especially after opening up this sector is not undertaken. Most of the post liberalization banking studies is concerned with performance (Bhattacharya et al, 1997, Das, 1997, Sarkar et al, 1998, Ram Mohan, 2002, and Ram Mohan and Ray2004). May be the peculiar rules and regulations which governing the banking industry is the reason for it? 5. Research Methodology The present study attempts to analyze and predict dividend policy of Indian Private Sector Banks. We propose a multiple linear regression model which helps us to predict the dividend A multiple linear regression allows the simultaneous testing and modeling of multiple explanatory variables. The explanatory variables for the model are Interest Earned, Interest Expended, Profit after Tax (PAT) and Dividend Payout Ratio along with the dependent variable Dividend. It is to 8

Source: http://www.doksinet be noted that multiple regression is still not considered a “multivariate” test because there is only one dependent variable. The proposed model for a multiple linear regression takes the form: β 0 β 1IE tb + β 2 IEX tb + β 3 PAT tb + β 4 DPR tb + ε tb Div tb =+ where β0 - Constant Div tb - Dividend (Dependent Variable) IE tb - Interest Earned (Explanatory Variable) IEX tb - Interest Expended (Explanatory Variable) PAT tb - Profit after Tax (Explanatory Variable) DPR tb - Dividend Payout Ratio (Explanatory Variable) ε tb - Error t - Time period from 1999 - 2004 b - Name of the Bank We wish to estimate the β 0, β 1, β 2, β 3 and β 4 by obtaining  Div tb = b 0 + b1IE tb + b 2 IEX tb + b 3 PAT tb + b 4 DPR tb The b’s are termed as the regression coefficients. All the basic assumptions underlying multiple linear regression has been taken into account. 6. Data and Hypotheses 6.1 Data We observed four important variables,

which contribute to the estimation of dependent variable (dividend in terms of percentage). The four important contributing explanatory variables are Interest Earned, Interest Expended, Profit after Tax (PAT) and Dividend Payout Ratio. We have considered 21 private banks for our observations, ranging from the time period of 1999 to 2004. 9 Source: http://www.doksinet The 21 private banks are namely, Bank of Punjab, Bank of Rajasthan, Bharat Overseas Bank, Catholic Bank, Centurian Bank, City Union Bank, Development Corporation Bank, Dhanalakshmi Bank, Federal Bank, HDFC Bank, ICICI Bank, IndusInd Bank, ING Vysya Bank, J&K Bank, Karnataka Bank, Karur Vysya Bank, Kotak Mahindra Bank, Lakshmi Vilas Bank, Lord Krishna Bank, South Indian Bank and UTI Bank. Some of the data missing in the above said period that are replaced with respective banks mean of each variables under study and the data set has been divided by corresponding standard deviation for standardization. 6.2 Hypotheses

Hypotheses for overall significance: H 0 : Interest Earned, Interest Expended, Profit after Tax and Dividend Payout Ratio does not explain any of the variation in estimation of dividend of private banks. Hypotheses for individual significance: H 0a : Interest Earned does not explain any of the variation in estimation of dividend of private banks, beyond the variation explained by the other explanatory variables. H 0b : Interest Expended does not explain any of the variation in estimation of dividend of private banks, beyond the variation explained by the other explanatory variables. H 0c : Profit after Tax does not explain any of the variation in estimation of dividend of private banks, beyond the variation explained by the other explanatory variables. H 0d : Dividend Payout Ratio does not explain any of the variation in estimation of dividend of private banks, beyond the variation explained by the other explanatory variables. 7. Results From Table 1, the multiple

correlation coefficient value for the proposed model is 0.782 (ie) R = 0.782, which shows the high correlation between the observed and predicted values of the dependent variable, namely dividend. The proportion of variation in the dependent variable (dividend) explained by the regression model is R2=0.612 The adjusted R2 value is 0599 which 10 Source: http://www.doksinet reflects the goodness of fit of the model in the population. It is clear that 599% of variation is explained by the proposed regression model. Table 1 Model Summary Model R 1 R2 Adjusted R2 Std. Error of the Estimate 0.782 0612 0599 2.5361 Table 2 ANOVA Model Sum of Squares 1 Regression df 1228.468 Mean Square 4 Residual 778.224 121 Total 2006.692 125 F Sig. 307.117 47751 0000 6.432 The Table 2 summarizes the results of an analysis of variance. It is very clear from the ANOVA table that the sum of the squares of regression value is greater than the sum of squares of residual, which means that

the model accounts for most of the variation in the dependent variable namely dividend. Also from the Table 2 we can infer that significant value of F statistic is 0.000 (not exactly zero) which is less than 5% level of significance Hence we can reject our null hypotheses H 0 , and conclude that the explanatory variables namely, interest earned, interest expended, profit after tax (PAT) & dividend payout ratio, did a good job explaining the variation in the dependent variable (dividend). Table 3 Coefficients Model Un standardized Standardized Coefficients Coefficients B Std. Error t Sig. Beta (Constant) -2.748 0.612 0.378 0.078 Interest Expended -0.096 0.044 PAT 1.194 0.145 0.516 8.243 0000 Dividend Payout Ratio 0.626 0.100 0.402 6.281 0000 1 Interest Earned 11 -4.493 0000 0.370 4.825 0000 -0.173 -2175 0032 Source: http://www.doksinet Form the Table 3 the following regression model has been obtained. Dividend = -2.748 + 0378 Interest Earned –

0096 Interest Expended + 1194 Profit after Tax (PAT) + 0.626 Dividend Payout Ratio From Table 3, the t statistics can help us to determine the relative importance of each variable in the model. We can see that all the t statistics values are well below -2 or above +2, which clearly indicates that all the predictors involved in the model are useful to predict the dependent variable (dividend). And also from the table 3 one can infer that all the significant values are less than 5% level of significance, which is an indication to reject null hypotheses (H0a, H0b, H0c, H0d), hence all the parameters involved in the model are statistically significant. The coefficient of Durbin-Watson is 0.564, which falls in the interval 15 to 25, indicates independence of observations (Interest Earned, Interest Expended, PAT, and Dividend Payout Ratio). Hence proposed observations are free from multicollinearity Figure 1 Histogram Dependent Variable: Dividend 40 30 20 Frequency 10 0 -3 -2 -1

0 1 2 3 Regression Standardized Residual 12 4 Mean =-3.47E-17 Std. Dev =0984 N =126 Source: http://www.doksinet Figure 1, clearly depicts that a histogram of standardized residuals along with a roughly normal curve, indicates that the error terms are normally distributed. Figure 2 Normal P-P Plot of Regression Standardized Residual Dependent Variable: Dividend 1.0 0.8 Expected Cum Probability 0.6 0.4 0.2 0.0 0.0 0.2 0.4 0.6 0.8 1.0 Observed Cum Probability A normality plot, also called a P-P plot, is an alternative method, plotting observed cumulative probabilities of occurrences of the standardized residuals on the Y axis and of expected normal probabilities of occurrence on the X axis. Figure 2, clearly shows normality validation of our model. 8. Conclusion An attempt has been made to estimate dividend policies of twenty-one Indian private banks using the secondary data for the period from 1999 to 2004. We found that there is relationship exist between

dividend with interest earned, interested expended, profit after tax, and dividend pay out ratio and also identified that all the explanatory variables under consideration were contributed to the depend variable (dividend). The proposed multiple linear regression accounts for 599% of 13 Source: http://www.doksinet the variation. Improving the accuracy of explaining maximum percent of the variation is the direction of the future study. 9. References 1. Aivazian V Laurence B and Cleary S “Do Emerging Market Firms Follow Different Dividend Policies from U S Firms?” The Journal of Financial Research. 2003 Vol 26 (3) p 371-87. 2. Baker H K, Powel E G “How Corporate Managers View Dividend Policy” Quarterly Journal of Business & Economics. 1999 Vol 38 p 17-35 3. Baker H K, Farrelly G, Richard B E “A Survey of Management Views on Dividend Policy” Financial Management. 1985 Vol 14 p 78-84 4. Baker H K, Powel E G, Theodore E V “Revising Managerial perspectives on Dividend

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