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research review

research review

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Published by Syed Ameer Hayder

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Published by: Syed Ameer Hayder on Nov 18, 2012
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MS Fall 2011 Section 02
Impact of financial Leverage on Dividend policy; evidence from IslamabadStock exchange Listed Companies
Muhammad Asad Bilal A hmed
Dividend payout decision is one of the fundamental components of corporate policy and hasbeen viewed as an issue of interest in the financial literature. Dividend, reward to stockholder fortheir investment and risk bearing, depends on various factors. Foremost of these determinants arelevel of profits, financing constraints, investment opportunities, size of the firm, and pressurefrom shareholders and regulatory authorities. Dividend paid is the source of satisfaction and wayto increase their confidence on management that their resources are used economically optimallyby the directors. Almost every corporation use financial mix in its capital structure in order thecoup with the growth opportunities offered by the external environment. This means the firmsfinance its capital structure partly by owner and partly by debt equity. This tendency to financethe economic resources of the organization impacts the corporate management decisionsregarding dividend policy. This research paper is aimed to see the impact of financial leverage ondividend payout decisions of the firms.
Financial leverage signifies the firm’s ability to make
potential use of fixed financial cost to magnify the impact of changes in earning before interestand taxes on earnings per share (Gitman J Lawrence). In simple words it illustrates that how debt
financing is contributing towards the firm’s profitability
and ultimate dividend payout. No doubtthat firm using debt equity tends to generate high profit on one hand but also subject to higherobligation to outsiders on other hand. The level of risk in firms with mixed capital structure istoo high because there is always possibility that firm may be not in position to cover its fixedfinancial cost in coming time. Especially the firms which are operating in those countries whereeconomic conditions are not certain always remain in such brackets. So every year firms setaside a part of its earning as contingency reserve to meet such situations so that firm credibility
couldn’t be shaken in the eyes o
f creditors and
competitors. That’s why;
while making dividendpayout decisions corporate management has to keep this factor under consideration along with
MS Fall 2011 Section 02varied factors. To see the leverage and profitability impact we attempted use the secondary dataof companies listed on the Islamabad stock exchange.
Key Words:
Leverage, Debt ratio, profitability, dividend policy (Payout), ISE (Pakistan)
Literature Review
Dividend policy is the issue of interest in financial literature since many years. Lot of work hasbeen done on this by many experts.
Among early theories of dividend Miller and Modigliani(1956-1961) presented the roots of irrelevance of dividend policy that in perfect capital marketdividend payout has to do nothing with value of firms and its shares value. They supported theirargument by the fact that firm value is solely determined by the earning power of its assets andrisk associated. They argued that dividend paid by firm should be viewed as residual left overafter all acceptable investment opportunities have been under taken. Later on Lintner (1961) andGorden (1962) came up with the view of relevance of dividend policy. They argue that the firm
 value is strongly affected by the dividend payout tendency. Their
theory was based on “Bird inHand” argument.
They said that
one bird is of more worth then two in bush
. That currentdividend
 payout decreases shareholder’s uncertainty
and put high value on stock prices.Corporate dividend policy is subject to influence by many factors which managers keep in mindwhile labeling the dividend policy. Leverage is most dominant factor among all. Talat Afza andHammad Hassan Mirza(2010) concluded that The companies in which high proportion of sharesare held by managers and individual are more reluctant to pay high dividends as compared withthe companies in which managerial and individual ownership is low. However, high operating
cash flows increase companies’ potential to pay high dividends.
Large and highly leveragedfirms are more reluctant to pay high dividend as compared to small and low leveraged firms,while profitability increases
the companies’ dividend payouts.
S. Franklin John and K. Muthusamy (2010) inferred that Earnings per share and price earningsratio are negatively related to dividend payout. They find that the leverage is negatively relatedwith the corporate dividend payout.
Xi Wang, David Manry and Scott Wandler infer from theirresearch study that dividend payouts and dividend likelihood are both increasing in the largest
shareholder’s percentage ow
nership, although both are increasing at a lower rate when economic
MS Fall 2011 Section 02growth diminishes. These findings are clearly mapping the scenario of uncertain situation if firmis highly leveraged. Dr. Syed Zulfiqar Ali Shah, Wasim Ullah and Baqir Hasnain (2010) arguedthat the presence of shareholders in board of directors direct the dividend policy in favor of shareholders. This argument is contrary to Franklin findings because influence of shareholderson BOD will make the negative impact of leverage on payout insignificant. Dominic H. Chai(2010) founded that dividend policy is the function of firm size, capital structure (measured asDebt ratio) valuation and profitability. And foreign ownership has significant influence ondividend policy.
Mihaela Dragotă, Victor Dragotă, Lucian
TATU and Delia TATU (2009)inferred that dividend policy of Romanian is not much influenced by Tax regulations whichmainly due to delay in implementation. Dividend payout is positively associated with the grossearning of the firms.José María Díez Esteban an
d Oscar López de Foronda Pérez’s (
2001) research study comes upwith results which show positive relationship between earnings and dividends such that anincrease in profits enables higher payouts. As for financial leverage, the results mapped that,company with a higher level of debt pay out lower dividends.Corporation often seems much conscious while deciding about the dividend policy. As firmcould not afford in long run if it distribute its maximum earnings among shareholders because itleft less then required funds to make the firm sufficient for internal financing. Further more if firm is highly leveraged then this strategy would lead to increased level of risk to cover fixedfinancial costs which will shake the external in
vestor’s confidence.
Previous research studieshave discussed in different context the dividend policy along with the different factors whichcould effect corporate decisions regarding dividend policy. They also have seen some how therelation of leverage with dividend payout along with main variables of their study. This study isintended to specifically analyze the impact of leverage and profitability on dividend policy of thefirms in Pakistan context. Investigation is aimed to answer that; is financial leverage effect firmdividend policy and if so then what relation exists between leverage and payout.
Study Objectives
The Purpose of research study is to see the impact of debt financing; that if organization isgoing to finance its capital structure by debt equity equal to the proportion of owners equity or

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