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

com/abstract=1158251 . Firm Value. Among the companies from different ownership groups. from 1989-90 to 2001-02. We find that there is a non-linear relation between leverage. Probability of increase in future value of firm reduces exponentially with the increase in leverage. foreign standalone firms have larger probability to create better future value than group-affiliated firms. whereas. 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. JEL Classification: G 32 G35 C23 C25 Keywords: Dividend Policy. Logit Model. Panel Data Electronic copy available at: http://ssrn. We use fixed effect logit model to predict the probability of increase in future value of the S&PCNX500 firms. profitability and probability of increase in future value of the firm. Dividend Policy and Profitability influence the Future Value of Firm? Evidence from India Abstract This paper examines the effect of past dividend policy. India.Do Leverage. Profitability. it increases with the raise in dividend payout and profitability of the firm.

India has emerged as an emerging economy with largest number of companies listed in its stock markets.Do Leverage. 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. enforce better corporate governance practices through guidelines. massive computerization and electronic limit order book integrating the stock exchanges across the nation. The investors reveled their confidence through their participation in the primary and secondary market. . 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. since it’s inception has strived in the direction of narrowing the information gap between Indian corporations and investors. CEOs have assigned tremendous importance for creating value for their firms. Over the last decade corporate governance has received considerable importance in Indian financial market. rules and regulations and through active market for corporate control that has marked a new era in the Indian financial arena. Indian stock market has undergone several changes over the last decade. SEBI. With the initiation of market for corporate control and activities in the merger and acquisition market. Introduction With the ushering of economic liberalization in 1992. 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. Perhaps the most important among these changes was the establishment of Securities and Exchange Board of India (SEBI) in 1992 as the market watchdog. establishing of clearing corporation and subsequent introduction of new derivative products in the market. Dividend Policy and Profitability influence the Future Value of Firm? Evidence from India 1. These include introduction of new exchanges.

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. Section 4 presents the empirical results and their interpretations. transaction and banking costs. 2.The reminder of the paper is organized as follows. income tax rate and fixed capital investment as the major factor influencing the firms’ value. absence of agency costs. This branch of finance started with the assumption of perfect information and complete markets. the average cost of raising fund for any firm is completely independent of its capital structure. operating profit. 1963). With the same set of assumptions M-M (1963) argued that the value of the firm is unaffected by the dividend policy. The authors considered three main determinants of value creation: financial policy. 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. profitability and dividend policy. Section 5 concludes the paper. Section 2 gives a brief overview of the literature. . Ben Naceur and Goaied (2002) investigated value creation process for Tunisian stock exchange using a random probit model with unbalanced panel data. Rappaport (1981. Data and the statistical specification used in this study are described Section 3. However. Academic literature over the last decade has documented the effect of different strategic factors influencing the firm values for the developed countries. It postulates that in a typical neoclassical market with perfect competition. (M-M henceforth). 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. 1987) has used value creation literature for corporate mergers and acquisition and underlined the importance of growth rate. Recently some of the studies concentrated on emerging market to analyze the factors that influenced the firms’ value in this market.

However. 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.g. 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. the pay-out have reverse effect on the same. Among the available studies in this area. Whether the firms belonging to business groups have different effect on probability of value creation? . Ross (1977) argued that more leverage would signal the investors about the improved firm prospect and influence the firm’s value in future. With maximum number of companies listed in the Indian stock exchanges from different industries and different ownership groups (e. the authors did not find any significant effect of industry and ownership pattern on price to earning ratio. 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. literature has shown that firm’s performance depends on the capital structure (or financial policy). business affiliated firms. financing pattern and the dividend pay-out policy? 2. In particular this study attempts to answer the following questions: 1. 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. Ben Naceur and Goaied (2002) argued that while profitability and debt have positive effect on the probability of crating future value. Indian standalone. 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. India has become an important and interesting destination for such studies. foreign standalone) and with the emphasis on corporate governance practices.In the modified M-M framework. How the probability of future value creation is affected by firm’s profitability.

3.e. Dividend Policy and Profitability that have key bearing on the firms’ future value creation. To control for the size of the firm we consider total assets (ASSET) of the firm as a proxy variable. . which is also known as return on equity (ROE). The other variables of interest include those representing Leverage Policy. compiled by Center for Monitoring the Indian Economy (CMIE). Data The primary source of the data for this paper is PROWESS database. To control for the differenced arising due to the firms belonging to different business groups this paper considers different dummy variables. the ratio of total dividend to total earning of the firm (PAY_OUT) is included to capture the dividend policy of the same. 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. The profitability of a company. We have selected the firms that are presently included in S&PCNX 500 index. MBVR is the dependent variable for the OLS regression.. market perceived that future value of the firm is going to increase) and zero otherwise. If the firm is 1 Among the large number of listed companies. 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. on the other hand. those included in S&PCNX 500 are often considered for empirical studies for their liquid nature and representative characteristics. This dataset is similar to the COMPUSTAT database in USA. 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. which takes the value 1 if price to book value ratio is greater than one (i. is captured by the ratio of net profit to net worth of the firm. For the logit model the dependent variable is a binary series.

in terms of MBVR. The descriptive statistics reported in Table 1 shows that the value of a firm. Methodology & Results So far we have done the univariate and bivariate analysis in the previous section. take the value one and zero otherwise. take the value one and otherwise zero. dividend and . (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. 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. So time dummies were also included to control for the time trend. D_PVT_FOR. a firm is private foreign standalone then the dummy. all firms. If. Table 2 shows the Pearson correlation coefficient matrix between the variables of interest. 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 year’s leverage. on the other hand. So industry dummies were used to control for industry specific heterogeneity. which have their influence on the corporate valuation. Large firms get more leverage than any other category of firms. 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.private Indian standalone then the dummy. Figure 2 shows since post liberalization period. small firms. D_PVT_IND. large firms. the leverage has shown an increasing trend. Indian standalone firms and foreign standalone firms). 4. Indian companies differ considerably access the industries. Since 1990. All the nominal variables are deflated by GDP deflator and expressed at constant price of 1987-88. group-affiliated firms. However. Profitability of the firm. is higher for the small firms and the foreign standalone firms. Indian economy has undergone several changes. is higher for the Indian standalone companies. dividend payout policy does not depict any significant trend over this period. in terms of ROE.

35) have positive influence on the corporations’ MBVR. The generic form for this unbalanced panel model is as follows: MBVRit = α + αt + β1LEVERAGEt-1 + β2(LEVERAGEt-1)2 + β3 PAY_OUTt-1 + β4 ROEt-1 + β5(ROEt-1)2 + β6 LOG(ASSETt-1) + β7 D_PVT_INDit + β8 D_PVT_FORit + ∑ 22 k =1 β 8 + k ( IND _ D ) kt + εit (1) To account for the non-linearity in the relationship. which is significant at one per cent level. 2 Companies with total asset more than median of total asset is considered as large size and others are considered as small. Moreover the square term of ROE has a positive coefficient implying that ROE influences MBVR at an increasing rate.profitability on the MBVR of the company in a multivariate framework. The significance of these coefficients prompted separate analysis of the future value creation across different groups and size2.87) and return on equity (0. (Insert table 3 here) From Table 3. which appears from the positive coefficient of the square of LEVERAGE-t-1 term. 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. pay out and profitability were also included in the regression. the square of the previous year’s leverage. For the Indian corporations the previous years pay-off (0.14) on the MBVR of the company. This effect however decreases with the increases in leverage. To account for it ln(asset) was included as a control variable in these sub-groups. However. the previous year’s payout significantly affects MBVR for the all firms sample and especially for the sample of foreign standalone companies. The asset size however differs considerable across the broad classification. The regression results based on the model specified in equation one is reported in Table 3 below. . The log of assets and the dummies for group companies were all significantly different from zero at ten per cent levels. it appears that the previous year’s leverage has a negative effect (0.

This paper also attempts to model the probability of increase in the future value of the firm. The profitability of the firm (as apparent from the coefficient of ROE) increases the probability of increase in future value creation. Alike Naceur and Goaied (2002). This model aims to predict how the probability of improvement of the future value of the firm influenced by the previous year’s dividend and leverage policy and profitability of the firm.44) and its square term (0. Point to note is. The negative influence of leverage on the probability of future value creation was observed across the ownership groups and size. this increase is higher for foreign standalone firms as compare to Indian standalone or group-affiliated firms.e. The binary variable (Y) takes value 1 if MBVR is greater than one (i. as . The empirical results of the logit model is reported in the table-4 below The coefficient of lagged value of leverage (-O. which in turn have a negative influence on the future valuation. otherwise zero.007) imply that as the leverage of the firm increases. Unlike the OLS model. 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. The logistic model is as follows: Pr ob(Yit = 1 | X it )= e 1+ e ′ β +ε it α +α t + X it ′ β +ε it α +α t + X it (2) where Xit are the same explanatory variables used in equation (1).. giving more control to the managers/promoter. 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. the probability of raise in future firm’s values declines at a decreasing rate. if the market value of the firm is greater than the book value). the dividend payout did not significantly explain the chance of future value creation. 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. we found previous year’s profitability positive influences future firm’s value.

However. . The dividend pay-off policy of the firm. could not significantly influence the probability of future value creation of the firms listed in Indian stock market. 5. This finding could be because of the fact that the dividend payment the future performance varied considerably across firms listed in Indian stock exchange.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. one the other hand. It could be because of the potential conflict of interest between the equity holders and the creditors that got reflected in the stock prices. 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. has negative impact on the chances of increase in future value of the corporation and this relation was uniform across size and ownership group. Leverage.

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

119) 1.993) 1.168 (0.639 (84.133 (3.283) 3.397) 2.151) 0.319 (0.024 (0.850 (5.556) Large Firms Small Firms Group Firms 2.138 (0. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital.063) 0.057 (7.833 (5.146 (6.030) 0.470) 0.484) 0.148 (0.133 (0.346) 2. Variable MBVR LEVERAGE DIVIDEND PAY OFF PROFITABILITY (ROE) SIZE All Firms 3.029) 0.632 (9.029) 0.148 (0.973 (4.659) 1.726 (4.023 (0.025 (0.247 (3.795 (75. Return on equity (ROE) is the ratio of net profit to net worth of the firm.026) 0. PAY_OUT is the ratio of total dividend to total earning of the firm. ASSET total assets of the firm.395 (170.248) 2.095 (0.140) 0.509) Indian Standalone Firms 2.500 (2.255) 0.094) 0.372) 1.441 (3.449) 66.349 (6.210) .028) 0.537) 3.023) 0.137 (5.776 (8.020 (0.023 (0.110) 3.024 (0.372) 16.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.367) 13.212) Foreign Standalone Firms 5.

076 (<.155) 1.000 -0. MBVR MBVR LEVERAGE PAY-0FF ROE SIZE 1.0001) -0.0001) 1.000 0.210 (<.060) 0.000 LEVERAGE POLICY DIVIDEND POLICY PROFITABILITY SIZE .0001) 0.021 (0. ASSET total assets of the firm.Table 2: Pearson Correlation Matrix.011 (0.0001) -0.042 (<. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital.450) 1. PAY_OUT is the ratio of total dividend to total earning of the firm.0001) -0.0001) 0.000 -0.124 (<.000 -0.093 (<.0001) 1. Return on equity (ROE) is the ratio of net profit to net worth of the firm.028 (0. (MBVR) is ratio of closing price of the equity to book value of equity at the end of the financial year.158 (<.074 (<.

4517 (0.1030 (<.0622) 0.9979 (<.6222 (<.51 0.0133) 0.43 11.1071 (0.0698 (0.0717) Foreign Standalone 1.0001) -0.0001) 0. R-Square F Value N 0.0003 (0.47 0.0001) 0.2794) 0.1606 (<. D_PVT_FOR takes value one otherwise zero.0001) 0.0032) 0.0001) -0.0001) -0.50 100.5201) -0.0903 (<.50 97.0001) 0.0018 (<.0001) 0.7241 (<. Variables INTERCEPT LEVERAGEt-1 (LEVERAGEt-1) PAY_OUTt-1 ROEt-1 (ROEt-1) 2 2 All Firms 0.2965) LOG(ASSETt-1) D_PVT_IND D_PVT_FOR R-Square Adj.77 4461 Large Firms Small Firms 0.0024 (<.1375 0.0484 (<.1668 (<.0083 (0.0001) -0.2622 (0.6103 (<.0584 (<.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.0001) 0.0680) Indian Standalone 1.0609) 0.2582 (<.0001) -0.0025 (0.2577) 0.4736 (<. Return on equity (ROE) is the ratio of net profit to net worth of the firm.1370 (<.5878 (0.0001) 0.4165 (0.9933) 1.0013) 4.0001) 0. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital.0001) -0.14 3536 0.1396 (<.8481 (0.0020 (<.0751) 0.2021 (<.0001) 0.5399 (0.0037 (<.47 0.6602 (<.0501 (0.0001) 0.0001) -0.0001) 0.0166 (0. take the value one and zero otherwise.7694) 0. If a firm is private foreign standalone then the dummy.78 469 0.51 0.49 0.42 11.1157 (<.9664 (<.0001) 0.31 3657 Group Firms 0.6224 (<. If firm is Indian standalone then the dummy.6080) 0. LN(ASSET) is the log of total assets of the firm.0001) 0.0723 (0. PAY_OUT is the ratio of total dividend to total earning of the firm.40 803 0.0211) 0.2501) -0.0001) -0.0001) 0.0181) 0.3225 (<.0001) 0.9850) 0.3483 (<.1105 (<.0004 (<.0195 (0.0029) 0.49 113.0033 (<.1384 (0.0177 (0.0001) 0.0001) -0. D_PVT_IND.56 32.0001) -0.0001) -0.0001) 0.57 0.8781 (0.0864 (0.46 454 .

0102) -0.0001) 0.1716) 5.6159) 2.0171 (0.72 36.0001) -0.0755) 1.0001) -0.0047 (0.5285 (0.3404 (0.0001) 0.0023) 20. D_PVT_IND.0043) 0.1886) 319.2200 (0.0076 (<.0102 (<.7466 (0.90 33. If a firm is private foreign standalone then the dummy.2410 (0.4478 (0.7577 (0. LEVERAGE is the ratio of total amount of long-term debt to total amount of equity capital.2314 (0.0142 (<.0153) 0.3592 (0.0001) 1369.0115) 0.2975 (<.0422) 0.00 Small Firms 3.0001) -0.6773 (0.0001) -3.9186) 0.3070) LOG(ASSETt-1) D_PVT_IND D_PVT_FOR Log likelihood Likelihood Ratio 1416.1803) 3.1884 (<.5455 (<.3467 (<.0001) 0.9982 (<.90 31.4677) 1.0007) 0.0001) -0.3405 (0.0384 (<.0558) 0.1855) -0.6067 (0. Return on equity (ROE) is the ratio of net profit to net worth of the firm.0045) 1.4710 (0. ASSET total assets of the firm. PAY_OUT is the ratio of total dividend to total earning of the firm.2233 (0.5473) Foreign Standalone 1.4163 (0.0023) -0. Variable INTERCEPT LEVERAGEt-1 (LEVERAGEt-1) PAY_OUTt-1 ROEt-1 (ROEt-1) 2 2 All Firms 2.0635) -0.0155) -1.3319 (0.0829 (0.0079 (0.0644 (0.44 24.0001) 0.0015) 0.7196) 0.9652 (0.0109 (0.0001) 1.0282) -0.00 99.6718 (<.1003 (0.0072 (<.4948) -1.0203) 0. If firm is Indian standalone then the dummy.3194) 2. D_PVT_FOR takes value one otherwise zero.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.0001) 1805.3722 (0.0001) 0.1106 (0.00 143.3466 (0.2860) 10.0001) -0.00 Large Firms 4. take the value one and zero otherwise.0167 (0.0001) -0.0842 (0.8062) 0.1380 (0.5412 (<.28 38.00 .0001) 0.4360 (<.7560 (0.00 Group Firms 2.1208) -16.7600 (<.4940 (<.6258) Indian Standalone 3.90 31.5130 (0.8716 (<.

.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.

5 2 1.5 3 Leverage 2.5 1 0. .Figure 2 Leverage Trend 3.5 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.

015 0.025 0.02 0.01 0.03 Divedend Payout 0.Figure 3 Dividend Payout trend 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.

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.25 0.1 0. .2 ROE 0.Figure 4 ROE trend 0.15 0.