Effect of Dividends on Stock Prices– A Case of Chemical and Pharmaceutical Industry of Pakistan

Corporate sector of Pakistan is adversely facing competition due to economic downturn in the world and making efforts to survive in a competitive and uncertain economic environment. Th is study will help to ameliorate div idend decisions of corporate sector through felicitously appropriate implementation of their div idend policies. This paper is an attempt to explicate the affect of d ividend announcements on stock prices of chemical and pharmaceutical industry of Pakistan. A sample of twenty nine companies listed at KSE-100 Index is taken from the period of 2001 to 2010. Results of this study is predicated on Fixed and Random Effect Model which is applied on Panel data to exp licate the relationship between dividends and stock prices after controlling the variables like Earnings per Share, Profit after Tax and Return on Equity. The Results show that Stock Dividend, Earnings per Share and Profit after Tax have a significant positive relation to stock market prices and significantly explicates the variations in the stock prices of chemical and pharmaceutical sector of Pakistan while Retention Ratio and Return on Equity have the negative insignificant relat ion with stock prices. This paper further shows that Dividend Irrelevance Theory is not applicable in case of chemical and pharmaceutical industry of Pakistan.


Introduction
Div idend policy is one of the most widely researched topics in the field of finance but the question whether dividend policy affects stock prices still remains debatable among managers, policy makers and researchers for many years. Div idend policy is important for investors, managers, lenders and for other stakeholders. It is impo rtant for investors because investors consider dividends not only the source of income but also a way to assess company from investment point of v iew. It is the way o f assessing whether the company is cash generative or not. Select ing a suitable dividend policy is an important decision for the co mpany because flexibility to invest in future projects depends on the amount of dividends that they pay to their shareholders. If a company pays more dividends than fewer funds available for investment in future projects. Lenders are also interested in the amount of dividend that a company declares, as mo re amounts is paid as dividend means less amount would be available to the company for servicing and redemption of their claims and finally it is important for other stakeholders especially for claim ho lders to help them in reducing agency cost.
The basic objective of shareholder is to maximize their return and this return may be in the form of d ividends or capital gain. Investors' decisions regarding the return on investment are affected by the dividend policy of the company. Arnold (2008) exp lains the main objective of dividend policy is to maximize shareholders' wealth by maximizing their purchasing power. So maximizing shareholders' wealth depends on the dividend policy of the company because of these shareholders would satisfy their purchasing and consumption patterns.
There are certain important factors that companies consider in designing their dividend policies like the managerial and behavioural environ ment, firms' profitability ratios, the willingness of the company etc. Ju ma'h & Pacheco (2008) believe that management decision of div idend policy is affected by the managerial and behavioural environ ment in the U.S. They further exp lain that sometimes financially strong companies do not pay dividend and financially weak companies pay dividends. According to their opinion dividend paying companies are generally larger in size, profitability, in terms of liquidity ratio and in research and developments as compared to non-dividend paying companies. Ling, Mutalip, Shahrin, & Othman (2008) studied the characteristics of dividend paying companies of Malaysia. The results of their study show that dividend paying companies are more p rofitable, less risky and mo re mature in their act ivities as compared to non-dividend paying companies. Their results also indicate that managers of Malaysian co mpanies understand the importance of paying dividends and they pay dividends even if the companies are not earning profits.
The objective of this research is to see the effect of cash dividend and stock dividend on stock prices of chemical and pharmaceutical industry of Pakistan. For this purpose different articles written in Pakistan and abroad are reviewed and dividend theories have been empirically tested and their effect on stock prices has been observed. There are main ly two schools of thoughts available in the field of finance that presented two different opinions about the dividend policy. One school of thought followed the opinion of Miller and Modigliani (1961) and considered dividend policy irrelevant while the second school of thought followed the point of view of Go rdon (1963) and considered dividend policy relevant. Since the half century passed, the question still remains i.e. whether div idend policy is relevant or not. This dilemma yet exists, which theory the companies should apply for making their div idend decisions.

Literature Review
Many studies have been conducted on dividend policies earlier which exp licate the relationship between dividend policy and stock prices. These studies help new researchers explore the div idend policy in a new way. Discussion of dividend policy cannot be completed without including the work of Linter (1956 Black & Scholes (1974) found no relationship between dividend policy and stock prices. Their results further explain that dividend policy does not affect the stock prices and it depends on investors' decision to keep either high or low yielding securities; return earned by them in both cases remains the same. Barclay and Smith (1995) in their article "The Maturity Structure of Corporate Debt" found that high growth companies have lower Dividend Payouts and Debt Rat ios than the low growth companies, which have higher Div idend Payouts and Debt Ratios. So investors prefer higher Div idend Payouts and consider it less risky than capital gain. Allen & Rachim (1996) found no relationship between the dividend yield and stock market price even after studying 173 Australian listed stocks but it shows the positive relation between stock prices and size, earnings and leverage and negative relation stock prices and payout ratio while Baskin (1989) examines 2344 U.S co mmon stocks from the period of 1967 to 1986, and found a significant negative relationship between dividend yield and stock price.
Another study conducted by Ho (2002) relevant to the dividend policy in which he uses the panel data approach and fixed effects regression model. The results of his study show the positive relation between dividend policy and size of Australian firm and liquidity of Japanese firms. He found the negative relation between dividend policy and risk in case of only Japanese firms. The overall industrial effect of Australia and Japan are found to be significant. Baker, Powell & Veit (2002) in their article "Reinvesting Managerial Perspectives on Div idend Policy" provided new evidence of managers' decision about dividend policy. They conducted a survey of managers of NASDAQ firms that are consistently paying cash dividends. Their survey result shows that managers are mostly aware of historical patterns of div idends and earnings. So, they design their div idend policies after considering it.
Pradhan (2003) also explained the effect of d ividend payment and retained earnings on stock market price of the Nepalese co mpanies. The results of his study show that dividend payment has strong relation with stock price wh ile retained earnings have very weak relation with stock market price. His results further explain that Nepalese stockholders give more importance to dividend income than capital gains. The results of the study conducted by Amidu (2007) studied the effect of dividend policy on the performance of the companies listed on the Ghana Stock exchange. The results of his study showed that there is a positive relation between Return on Assets, Dividend Policy and Growth in Sales and there is a negative relation between Return on Assets, Div idend Payout Ratio and Leverage. His results also support the results of previous studies that provide the strongest evidence for the relevance of dividend policy to the firms' perfo rmance. Pan i (2008) took the samp le of 500 companies fro m the six sectors of Bombay Stock Exchange in order to study the relationship between dividend policy and stock market prices. The results of his study show that the dividend retention ratio is positively related to stock returns in case of individual sector but there is no statistically significant relat ion between these variables. These results further show that debt equity ratio has the negative relation with stock return while the size o f the firm has positive relationship with stock return. Another study conducted by Raballe & Hedensted (2008) in Den mark during 1988-2004 identified the positive relationship between cash dividends and net earnings of the company, return on equity, retained earnings, size and last year profit but fail to find out any relation between the debt equity ratio and dividend decision in Den mark.
Denis & Osobov (2008) emp irically tested the trends of companies for designing their dividend policy. The results of their study show that the general trend in the US, Canada, UK, Germany, France, and Japan is that the companies having a higher profitability ratio and a higher fraction of retained earnings to total equity pay dividends to their investors. On the other hand, the co mpanies that have lower profitability rat io and a lower fraction of retained earnings to total equity do not either pay dividend or pay at a low rate but still this all depends on the managerial and behavioral environment of the countries to decide whether they want to pay dividends or not Ahmed & Javaid (2009) conducted a study to analyse the determinants of dividend policy in the emerg ing economy of Pakistan by taking the sample of 320 co mpanies listed on Karachi Stock Exchange for the period of 2001 to 2006. The results of their study show that most of the Pakistani companies decide their dividend pay ment on the basis of profits i.e. current year or previous year profits. So the companies having high net profits pay a larger amount of dividends to their shareholders. Furthermore, their results showed that market liquidity is positively related to the dividend payout ratio and negative relationship was found between the firm size and payouts while there is no relationship between growth opportunities and dividend payment. The results of the study conducted by Adesola & Okwong (2009) in which they empirically tested the factors affecting the d ividend decisions of Nigerian co mpanies show that dividend policy is significantly associated with earn ings, earnings per share and previous year dividends but firms' growth and size have no effect on dividend policy.
Akbar & Baig (2010)  Habib, Kiani & Khan (2012) used cross sectional regression analysis to find out the effect of dividend yield and payout ratio on stock prices. The results of their study show that dividend yield has a positive effect on stock prices while the payout ratio, size and debt negative effect on stock prices. This study suggests that dividend yield is better and more important determinant factor in determining share price volatility in KSE 100 index rather than payout ratio. Another study conducted by Nazir, Abdullah & Nawaz (2012) to find out the effect of d ividend policy on price volatility of financial firms of Pakistan. The results of their study show negative relation between div idend yield and div idend payout with price volat ility. They also consider dividend policy as an important indicator for determining the stock prices in Pakistan. Friend (1987) and Liaonly (2009) also found the positive association between dividends and stock market prices while Baskin (1989) found an inverse relat ionship between dividends and stock market prices whereas Black & Scholes (1974) and Rach im (1996) failed to find out any type of relationship Allen &between the dividend and stock price.

Data Collection and Variable Definition
Sample of t wenty nine dividend paying companies are taken fro m the chemical and pharmaceutical industry of Pakistan for the period of ten years from 2001 to 2010 and dividend paying companies for this research are those that made at least four dividend payment in one of the ten years under study (2001)(2002)(2003)(2004)(2005)(2006)(2007)(2008)(2009)(2010). The data has been collected from the audited annual reports of the companies listed on Karachi Stock Exchange for the period of 2001 to 2010. The purpose of this art icle is to see the relat ion between Div idend Policy and Stock Prices after controlling Earnings per Share, Profit after Tax and Return on Equity.
Price Vo latility is taken as dependent variable which is calculated by using Parkinson (1980)  Retention Ratio is calculated by subtracting Total Div idend fro m Total Earnings and then divided the resulting amount by Earnings. The negative or positive relation between Retention Ratio and Stock market Prices will depend on perception of investors. If investors think that company has more profitable opportunities than outside then it will positively affect the Stock market Prices otherwise it will negatively affect the Stock market Prices. Pani (2008) found a positive relation between dividend to Retention Ratio and Stock Prices while Khan, Aamir, Qayyum, Nasir, & Khan (2011) found negative relation between dividends and stock prices.
Profit after Tax is also used as an important explanatory variable in this study and it is that it is positively related to Stock Prices. Th is relation is further confirmed by Pani Return on Equity is also considered as important variables in this study. Return on Equity is calculated by dividing profit after tax with shareholders' equity. It is expected that Return on Equity is positively associated with Stock market Prices. Liu

Research Methodology
This paper has used the panel data approach to measure the relation between Dividend Policy and Stock Prices. Fixed and Random Effect Models are applied on this panel data. Fixed Effect method is used to control all the stable characteristics of the companies included in the study over a fixed period of time. This method provides statistically better results by removing the biases from the data and explains only within the sample variations. Rando m Effect method is applied when characteristics of samp le differs. As the characteristics of companies are different in terms of size, amount of capital, no. of shareholders, nature of business, earnings etc. so this method is suitable to explain variations between the companies. These methods are also adopted by Ho (2002) The objective of this study is to see the effect of Dividend Policy and Stock Prices after controlling the variables like Earnings per Share, Profit after Tax and Return on Equity. It is expected that Stock Div idend, Earnings per Share, Return on Equity and Profit after Tax will be positively associated to Stock Market Prices i.e. increases in Stock Dividend, Earnings per Share, Return on Equity and Profit after Tax will result in increasing the stock prices of chemical and pharmaceutical industry of Pakistan while Retention Ratio is expected to have a negative relation with stock prices.
Following regression line is used in this study: PV=α 0 + α 1 SD i -α 2 RR i + α 3 PAT i + α 4 ROE i + α 5 EPS i Table 1 shows the descriptive statistics including mean, standard deviations, minimu m and maximu m value of all variables. The mean value of Pro fit after Tax variable is the highest i.e. 159.18 while mean value of Price Vo latility is .0285. The lowest mean value is -6.34, wh ich is the mean value of Retention Rat io. Standard Dev iation shows the variation in the data. The highest value Standard Dev iation is 894.4 which show that the great variation in the Market Prices of chemical and pharmaceutical sector of Pakistan is due to Profit after Tax. Return on Equity has a min imu m value of Standard Deviation i.e. 1.258 wh ich shows that Return on Equity causes minimu m variation in the Stock Market prices of Chemical and pharmaceutical sector of Pakistan. Table 2 shows the correlation among the different explanatory variables and with dependent variable i.e. Stock Market Prices. For this purpose Pearson Correlat ion method is used and the significance of these variables is tested at 1%, 5% and 10% level of significance. Stock Market Prices of chemical and pharmaceutical sector of Pakistan have a significant relation with Stock Div idend, Profit after Tax, Return on Equity and Earnings per Share wh ile Retention Rat io has insignificant relation to Stock M ar ket P rices. T his r elations hip is signifi cant at 1 %, 5 % or 10% level of significance. Stock Div idend has insignificant relation with Earn ings per Share, Retention Ratio and Return on Equ ity and significant relation with Profit after Tax at 5% or 10% level of significance. Retention Ratio has insignificant relat ion to Earnings per Share, Return on Equity and Profit after Tax. Profit after Tax has a significant relation with Earnings per Share and Return on Equity at 1%, 5% and 10% level of significance. Earnings per Share has a significant relat ion with Return on Equity at 10% level of significance. Table 3 shows the results of Fixed Effect Model and Table  4 shows the results of the Random Effect Model that further validates the results of Table 2. These results explain the significance of indiv idual determinant of dividend policy in the model and overall significance of the model.

Results and Discussions
Results of Fixed and Random Effect Models show that Stock Div idend, Profit after Tax and Earnings per Share has positive significant relation to Stock Market Prices while Retention Ratio has negative an insignificant relation to Stock Market Prices in case of both models. Return on Equity also has an insignificant relation with Stock Prices but this relation is negative in the case of Fixed Effect Model and positive in case of Random Effect Model. These results confirm that shareholders prefer dividends i.e. Stock or Cash Div idends. If companies pay Cash Div idend, it will positively affect its Stock Market Prices and if the co mpany is unable to pay cash dividend then they prefer Stock Div idend because stock dividend increases their number of share and next time they will be able to receive mo re dividend on these shares.

Conclusions
This study is conducted to answer the questions that do dividend policy of chemical and pharmaceutical industry of These results show the preference of Pakistani investors for cash dividend and if the company is unable to pay cash dividend then they prefer stock dividend. Thus the div idend policy of chemical and pharmaceutical industry of Pakistan is an indicator of consistent performance of chemical and pharmaceutical industry and investors of these industries still prefer dividends either cash or stock in spite of tax advantage on capital gain. The significant F value in the Fixed and Random Effect Model suggests that all the exp lanatory variables included in the model are considerably explaining the variations in the stock prices and dividend policy has significant positive effect on stock prices. These results further show that Div idend Irrelevance theories are not applicable in case chemical and pharmaceutical co mpanies of Pakistan. The findings of this study show positive significant effect of dividend policy on stock prices and also the positive attitude of investors towards dividends either cash or stock. Although dividend policy play effective ro le in exp lain ing the price volatility in emerging economy like Pakistan but still these results cannot be generalized to other developing countries because corporate structure of firms is different in these countries.
This research also has a constraint of including only dividend paying companies fro m Chemical and Pharmaceutical Industry of Pakistan listed at KSE-100 Index for the period of 2001 to 2010 and Div idend paying companies for this research are those that made at least four dividend payment in one of the ten years under study (2001)(2002)(2003)(2004)(2005)(2006)(2007)(2008)(2009)(2010). Therefo re, it is suggested that this study will help the future researchers to explore other sectors of Pakistan with small and large firm size and with the comparison of dividend paying and div idend non-paying companies. It also help them to conduct more researches on various determinants of dividend policy that may forecast the potential of financial markets, economic situations and price volatility in the emerging economies like Pakistan.