Afro-Asian J. Finance and Accounting, Vol. 8, No.

3, 2018 237

Why do firms smooth dividends? Empirical evidence

from an emerging economy India

Nishant B. Labhane
School of Management,
Presidency University,
Bengaluru – 560064, Karnataka, India
Email: nishant.labhane@hotmail.com

Abstract: The present study examines the determinants of dividend smoothing

behaviour of 240 sample companies listed on National Stock Exchange (NSE)
in India, which have continuous data during the period 1994–1995 to
2012–2013. The empirical results show that Indian firms have target payout
ratios, adjust to their targets relatively slowly but not as slowly as the firms in
the developed markets such as the USA, Germany and France and thus, tend to
smooth and stable their dividends and rely on long-term target payout ratios
while making the dividend payment decisions. The firms having high
investment opportunities, low leveraged, riskier and smaller firms tend to
smooth their dividend more. As for the macroeconomic factors, the high
dividend distribution taxes imposed by the government tend the firms to
smooth their dividends more. Overall, the results support the information
asymmetry and agency-based explanations of dividend smoothing.

Keywords: dividends; dividend policy; dividend smoothing; Lintner model;

target payout ratio; India.

Reference to this paper should be made as follows: Labhane, N.B. (2018)

‘Why do firms smooth dividends? Empirical evidence from an emerging
economy India’, Afro-Asian J. Finance and Accounting, Vol. 8, No. 3,
pp.237–256.

Biographical notes: Nishant B. Labhane is an Assistant Professor in Finance

Discipline in the School of Management, Presidency University, Bengaluru –
560064, Karnataka, India. He received his PhD in Corporate Finance from the
Indian Institute of Technology Kharagpur, India. He has completed his
Bachelor of Engineering (BE) in Computer Engineering from the University of
Mumbai and Masters of Business Administration (MBA) in Finance from the
University of Pune. He has also cleared UGC NET-JRF in Management
subject. His area of research includes dividend policy decisions, capital
structure decisions, investment decisions, working capital management and
behavioural finance.

1 Introduction

Dividend smoothing is one of the important issues in corporate finance policy. Lintner
(1956) finds that firms maintain a stable payout ratio in the long-run and therefore, adjust
their payout ratio accordingly. It is argued that managers believe that the market always
puts a premium on firms that follow the smooth dividend behaviour. Subsequent research

Copyright © 2018 Inderscience Enterprises Ltd.

238 N.B. Labhane

by Fama and Babiak (1968), Marsh and Merton (1986), Kumar and Lee (2001), Brav et
al. (2005), Aivazian et al. (2006) and Leary and Michaely (2011) confirm Lintner’s
findings. The determinants of dividend smoothing behaviour are primarily based on
theories such as asymmetric information (Kumar, 1988; Brennan and Thakor, 1990;
Fudenberg and Tirole, 1995; Demarzo and Sannikov, 2008; Guttman et al., 2010) and
agency costs (Allen et al., 2000; DeAngelo and DeAngelo, 2007; Lambrecht and Myers,
2010). The information asymmetry theory argues that the firms facing a high degree of
information asymmetry are likely to smooth their dividends more in order to mitigate the
costs associated with information asymmetry. While on the other hand, the agency-based
explanation suggests that the firms subject to high agency costs tend to smooth dividends
more in order to mitigate such costs. The study by Miller and Scholes (1978) also
suggests that dividend smoothing may also be related to external financing costs or tax
planning. The firms with higher external financing costs are more likely to smooth their
dividends to ensure that there is internally generated capital left after the dividends are
paid. The firms with more individual investors are supposed to smooth their dividends
more as the tax planning by individuals requires certainty of dividends over a longer
period and they can reduce their dividend taxation by long-term tax planning (Leary and
Michaely, 2011).
While the theoretical literature has been developed in explaining the concept of
dividend smoothing, there is limited empirical evidence against those alternate
explanations put forward by the different theories. The available literature on this issue
has been highly concentrated in the developed economies like the USA (Lintner, 1956;
Brittian, 1966; Mueller, 1967; Fama and Babiak, 1968; Aivazian et al., 2006). The
findings of these studies have provided diversified results across the samples, periods and
theories of dividend policy (Fama and Babiak, 1968; McDonald et al., 1975; Marsh and
Merton, 1986; Kumar and Lee, 2001; Brav et al., 2005; Aivazian et al., 2006; Andres
et al., 2009; Leary and Michaely, 2011). Therefore, there is little agreement about the
core determinants of dividend smoothing. In this paper, we address this issue in the
context of an emerging economy like India where the tax regime, institutional setting of
the financial market and economic characteristics are significantly different from other
developed economies.
The Indian capital market which consists of large commercial banks, financial
institutions and stock exchanges was subject to significant reforms in the last two
decades. The introduction of new economic policies starting in the year 1991 changed the
Indian financial system from a public-sector dominated structure to a free market system.
These developments have led to the availability of alternative sources of finance to the
corporate sector and thereby changed its financing behaviour (Agarwal, 2002). The
floatation costs of capital-issuing firms are now lower than earlier as the corporations are
now allowed to issue shares through book building process than mandatory fixed-price
offerings. Thus, Indian firms can distribute their profits in the form of dividends and raise
funds from capital markets at lower costs to meet their positive NPV projects
requirements.
Despite improved information dissemination systems set up by the SEBI, the Indian
capital market is subject to a high level of information asymmetry. In India, as per the
existing tax provisions, income from dividends is tax-free in the hands of the
shareholders and the short-term capital gain is taxable while the long-term capital gain is
tax exempted. On the other hand, the government of India levies a dividend distribution
tax (DDT) of 15% on the amount distributed as dividends to the shareholders of the
 Why do firms smooth dividends? 239

company. Despite the tax disadvantage of dividend payments, dividends can be utilised
as a credible signal for the value of a firm (Bernheim, 1991; Bhattacharya, 1979; John
and Williams, 1985). Thus, the firms tend to smooth dividends even further as the tax
treatment of dividend income becomes more unfavourable.
In this context, this study tries to identify the factors affecting the firms’ dividend
smoothing in the changed and liberalised regime of the Indian economy. The empirical
evidence shows that Indian firms have target payout ratios; they adjust dividend payment
relatively slowly to their targets and tend to stable and smooth their dividends and rely on
long-run target payout ratios while making the dividend payment decisions. For the
determinants of dividend smoothing, low leveraged, riskier and smaller firms and firms
with high investment opportunities, tend to smooth their dividends more. The high DDT
imposed by the government induces the firms to smooth their dividends more.
The remainder of the paper is organised as follow: Section 2 reviews the empirical
literature on dividend smoothing; Section 3 discusses the measures of the degree of
dividend smoothing and determinants of dividend smoothing; Section 4 describes the
data and methodology; Section 5 discusses the empirical results of the study and the last
section concludes the paper.

2 Review of literature

Among the early literature on dividend smoothing Lintner (1956) finds that firms prefer
to maintain a stable payout ratio and the level of current earnings and the lagged value of
the dividend payout have been the major factors which explain dividend smoothing
behaviour of the firms. In the same line Fama and Babiak (1968), Partington (1984) and
Choe (1990) suggest that dividend smoothing has been prevalent across the firms and
every firm has a target payout ratio and they always try to achieve this. Further, studies
have examined the cross-sectional differences in companies’ dividend smoothing
behaviour. Dewenter and Warther (1998) notice that Japanese firms which are the
members of a keiretsu group smooth their dividend less as they are likely to face lower
information asymmetry and fewer conflicts of interest.
Using the data from US Compustat during the period 1981–1999, Aivazian et al.
(2006) examine the dividend policy of the firms that regularly access public debt (bond)
markets versus the firms that rely exclusively on private (bank) debt and observe that the
firms that regularly access public debt (bond) market smooth their dividend more than the
firms that rely exclusively on private (bank) debt. Further, they also observe that the
firms with bond ratings smooth their dividend, but the firms without bond ratings follow
a residual dividend policy and exhibit very little dividend smoothing behaviour.
Examining the dividend policy of a sample of 220 industrial and commercial firms that
are quoted in at least one of the eight German Stock Exchange (GSE) for the period from
1984 to 2005. Andres et al. (2009) discover that the German firms adjust their dividends
faster in relation to changes in firm’s earnings as compared to firms in the USA and UK.
Al-Najjar (2009) observes evidence that the Jordanian firms have target payout ratios and
the firms adjust to this target ratio. The study also observes that Jordanian firms adjust to
their targets relatively slowly but not as slow as the firms in the developed markets such
as the USA and thus, smooth and stable their dividends.
240 N.B. Labhane

By using a dataset from Global Vantage database provided by standard and poor’s,
Chemmanur et al. (2010) compare corporate dividend policies in Hong Kong and the US
that differs significantly in terms of tax regime and equity ownership structure during the
period from 1984 to 2002. They notice that the firms in Hong Kong smooth their
dividend significantly to lesser extent than those in the USA by using a panel data of a
sample of MSM-listed firms in Oman during the period 1989–2004, Al-Yahyaee et al.
(2010) notice that Omani firms follow a stable dividend policy and tend to smooth their
dividends in the same manner as that of firms in the USA. This way of smoothing of
dividends is consistent with the predictions suggested by the weak corporate governance,
government ownership and dividend signalling; whereas it is inconsistent with the
predictions suggested by the high bank leverage, absence of taxes and the variability of
dividend payments. Al-Yahyaee et al. (2011) investigate the stability of the dividend
policy of sample Omani MSM-listed firms during the period 1989–2004 and discover
that Omani firms have target payout ratios and move quickly towards this target payout
ratio and have unstable dividend policies.
Michaely and Roberts (2012) show that dividend smoothing is more pronounced in
public firms relative to private firms in the UK. Leary and Michaely (2011) examine the
dividend smoothing behaviour and the determinants of degree of dividend smoothing for
the US non-financial firms and the firms that are not involved in major mergers or
acquisitions and detect a steady increase in dividend smoothing over the past 80 years;
the average speeds of adjustment diminished from around 0.5 in the 1930s and 1940s to
around 0.2 over the last two decades. The younger and smaller firms, firms with more
volatile earnings and returns and low dividend yields and firms with fewer and more
disperse analyst forecasts tend to smooth dividends less. While the firms with low growth
prospects, weaker governance, greater institutional holdings and the firms that are cash
cows are likely to smooth dividends more. Overall, their results suggest that the dividend
smoothing is most common among firms that are not financially constrained, face low
levels of asymmetric information and are most vulnerable to agency conflicts.
Jeong (2013) investigates the dividend smoothing behaviour of a sample of firms
listed on the Korean Stock Exchange (KSE) over the 32-year period, (i.e., from 1981 to
2012) in Korea where the financial market has different institutional settings and tax
regime, from those of developed countries. This study discovers that the firms in Korea
smooth dividend to a lesser extent than those in the USA and the factors such as size,
risk, growth and large shareholder ownership significantly affect the degree of dividend
smoothing. Larger firms, low growth firms, riskier and the firms with concentrated
ownership tend to smooth dividends more during the whole period while safer firms
smooth dividends more during the post-liberalisation period. The macroeconomic factors
such as tax and interest rates have significant positive relationships with the degree of
dividend smoothing. Müller and Svensson (2014) study the phenomenon of dividend
smoothing and the characteristics affecting the degree of dividend smoothing for Swedish
companies listed on Stockholm Stock Exchange (SSE) by collecting data from Thomson
Reuters DataStream and Thomson Reuters Eikon database during the period from 2001 to
2012. They notice that the Swedish public firms tend to smooth their dividends to a lesser
extent than those in the USA, but to a greater extent than those in East Asia. Further, the
larger firms, firms with high asset tangibility, low leveraged firms, firms with less
disperse analysts’ forecasts, low stock return volatility firms and the firms that are
considered cash cows are likely to smooth dividend more. Overall, their results obtain
 Why do firms smooth dividends? 241

support for agency based explanation with regard to dividend smoothing and obtain little
evidence for the information asymmetry and tax clientele based explanations.
In the context of India, the survey evidence found by Anand (2002) concludes that
firms do have a long-run target dividend payout ratio and this is driven by the long-run
sustainable earnings. Their findings are consistent with the results of Lintner (1956). This
study also concludes that dividend payment acts as a signalling device to convey future
prospects of the firm and it affects the firm’s market value. Pandey and Bhat (2007)
examine the dividend behaviour of 571 Indian manufacturing companies by collecting
data from Centre for the Monitoring of the Indian Economy (CMIE) prowess database
during the period from 1989 to 1997. Their results validate the Lintner model in the
emerging Indian market and show that the Indian companies have lower target payout
ratio and higher speed of adjustment and the restrictive monetary policies cause about
5%–6% reduction in the payout ratios.
Bodla et al. (2007) examine the applicability of Lintner’s (1956) model to analyse the
dividend policy in the banking sector in India by using a sample comprising of 16 public
sectors, 14 private sectors and three foreign banks during the period 1996–2006. The
study observes that the commercial banks in India follow a stable dividend policy and the
major determinants of the current dividend are lagged dividend and the current earnings;
the management of the banks uses dividend policy as a signalling device. Kanwal and
Kapoor (2008) notice that Indian IT industry has a target payout ratio of about 30% and
the partial adjustment factor is 1.089, which is much higher than adjustment factor
suggested by Lintner’s findings. The current year profit is the major determinant of
dividend decision in IT sector and the dividend payout of IT companies fluctuate with the
earnings.
Acharya and Mahapatra (2012) examine the validity of the Lintner’s dividend
behaviour model in three major commercial banks of India namely HDFC Bank, ICICI
Bank and State Bank of India and their findings support the Linther’s model and the
profit after tax has been the major determinant of the dividend payout ratio. By using the
unpublished data of the non-government, non-financial public limited companies from
‘annual studies on company finances’. Kamat and Kamat (2013) enquire the stability of
dividend policy in India during the period 1971–2010 and recover that the tendency of
firms to smooth dividends has decreased considerably over the post-reform period with
the estimated speed of adjustment factor of 0.63 and 0.34 in the former periods. In the
post-reform period, Indian firms have a target payout ratio of 11% as compared to 16% in
the pre-reform periods which indicates that Indian firms are averse to pay dividends in
later periods. Overall, during their entire period of study, i.e., 1971–2010, Indian
companies have a target payout ratio of 10% and pay dividends with an average speed of
adjustment factor of 0.43.
While most of the previous studies tried to investigate the prevalence of dividend
smoothing, few studies have examined the factors influencing the dividend smoothing
behaviour of a firm (Berk and DeMarzo, 2007; Lambrecht and Myers, 2010). Until date,
there is little agreement regarding why firms smooth their dividends or what determines
the dividend smoothing phenomenon of a firm (DeMarzo and Sannikov, 2008; Baker and
Wurgler, 2010; Guttman et al., 2010; Lambrecht and Myers, 2010). Also, most of the
studies have examined the dividend smoothing phenomenon in developed capital markets
such as USA, France and Germany, etc. while few studies have examined such
phenomenon in emerging capital markets such as India. The present study tries to fill this
242 N.B. Labhane

gap by examining the factors affecting firms’ dividend smoothing behaviour in India as a
case of emerging market.

3 Empirical framework

3.1 Measure of degree of dividend smoothing

Following Lintner (1956) the speed of adjustment, estimated from a partial adjustment
model, has been used as the measure of the dividend smoothing. The partial adjustment
model has been specified as follows:

D i,t  D i,t1  a i  ci  D*i,t  Di,t 1   u i,t (1)

where, D*i,t is target level of dividends, ai is a constant; ci is the speed-of-adjustment

coefficient, with 0 ≤ ci ≤ 1; (Di,t – Di,t – 1) = Δ Dit is the actual change in the dividend and
(D*i,t – Di,t – 1) is the desired change in the dividend, ui,t is a normally distributed random
error term.
Assuming that target level of dividends, D*i,t for firm i in any given year ‘t’, is
associated with current year’s earnings Ei,t, by a desired payout ratio ri. Then
D*i,t ri Ei,t (2)

If ai = 0 and ci = 1, the actual changes in dividends become exactly equal to desired

changes in dividends. On the other hand, if ci = 0, then changes in dividends towards the
desired level are not undertaken.
Now substituting equation (2) into equation (1) we get:
D i,t  D i,t 1 a i  ci  ri E i,t  Di,t 1   u i,t (3)

'D it a i  ci ri E i,t  ci Di,t 1  u i,t (4)

where ΔDit = (Di,t – Di,t – 1)

Let bi,1 = ciri and bi,2 = –ci
Thus, equation (4) becomes
'D it a i  bi,1E i,t  bi,2 Di,t 1  u i,t (5)

Our basic, empirically testable, model is based on equation (5)

A speed of adjustment coefficient, ci value close to 1 indicates no proportionate
change in dividend smoothing with respect to the percentage change in earnings; whereas
very low value of the speed of adjustment shows that dividends move independently of
earnings, which implies that higher the speed of adjustment, lesser will be dividend
smoothing. The value of the speed of adjustment coefficient ci is used to measure the
degree of dividend smoothing and it is estimated as –bi,2 in equation (5). Equation (5) has
been used across the years to estimate the adjustment speed of each individual company.

3.2 Determinants of dividend smoothing

Following the brief review of the literature on dividend smoothing in Section 2, this
section develops certain hypotheses and identifies the proxy variables that may influence
 Why do firms smooth dividends? 243

a firm’s decision to smooth dividends. According to Leary and Michaely (2011), these
variables represent proxies for the different market frictions such as information
asymmetry, agency problems and taxes clientele which are possible sources of reasons
for dividend smoothing.
Hypothesis 1 The firms with high investment opportunities are likely to smooth
dividends more.
The signalling theory of dividends entails that the firms with high growth and investment
opportunities are more likely to smooth dividends to signal the better future prospects to
the market. Since, it is difficult for the investors to evaluate the investment opportunities
of the companies due to the information asymmetry between incumbent managers and
outside investors, the cost of raising equity funds increases. In this respect, the firms
signal the market about their growth opportunities through the stable payout ratio.
Therefore, a direct relationship can be hypothesised between the investment opportunity,
which is measured as the ratio of market value of equity to book value of equity and the
degree of dividend smoothing.
Hypothesis 2 The firms with high financial leverage tend to smooth dividends less.
According to agency-based explanations, dividend smoothing arises as a mean of
mitigating or controlling the agency costs of free cash flow (Jensen and Meckling, 1976).
Easterbrook (1984) and Jensen (1986) suggest that the firms that pay a high dividend and
smooth their dividends are forced to raise external capital to meet any financing needs
and such continual exposure or dependence on external financial markets reduces their
agency costs. Thus, low financial leverage preserves financial flexibility but exposes
firms to the agency costs of free cash flow. The debt-to-equity ratio is used as a proxy for
financial leverage and it is measured as the ratio of total debt to total equity of a firm. We
hypothesise an inverse relationship between the financial leverage and the degree of
dividend smoothing as higher financial leverage results in a lower degree of dividend
smoothing due to lower agency costs.
Hypothesis 3 The firms with greater asset tangibility tend to smooth dividends less.
The nature of a firm’s assets can also be considered as an important aspect of information
asymmetry. The outside investors can value a firm’s tangible assets easily as compared to
either intangible assets or growth opportunities (Harris and Raviv, 1991). Consequently,
the firms having a high proportion of tangible assets are likely to have lower information
asymmetry and thus, tend to smooth dividends less. Therefore, we hypothesise a negative
relationship between the asset tangibility and the degree of dividend smoothing. The
tangibility of assets is measured by net fixed assets scaled by total assets.
Hypothesis 4 The firms with high risk are likely to smooth dividends more.
In order to develop a reputation for having a low systematic risk, the riskier firms tend to
smooth dividends more (Kumar, 1988; Guttman et al., 2010). Leary and Michaely (2011)
obtain no significant correlation between dividend smoothing and systematic risk, but
discover the significant role of unsystematic risk factors on determinants of dividend
smoothing. Further, their evidence suggests that the firms that are less risky and face a
lower degree of information asymmetry are likely to smooth their dividends less. The
business risk, i.e., unsystematic risk is used as a proxy for risk and it is measured as
244 N.B. Labhane

standard deviation of first difference of operating income divided by total assets. We

expect a direct relationship between the risk and the degree of dividend smoothing.
Hypothesis 5 The firms with less financial slack are likely to smooth dividends more.
The financial slack can also be considered as an important factor that may affect a firm’s
decision to smooth dividend. The presence of higher financial slack will reduce firm’s
dependence on external finance to meet its investment opportunity need and thus, solve
the ‘underinvestment’ problem. Therefore, higher financial slack reduces the signalling
needs of the firm, thereby reducing the incentive to smooth dividends (John and
Nachman, 1988; John and Williams, 1985; Myers and Majluf, 1984). As a result, we
hypothesise an inverse relationship between the financial slack and the degree of
dividend smoothing. Following Jeong (2013) the financial slack is measured as the ratio
of accumulated retained earnings to total assets.
Hypothesis 6 The firms facing a higher degree of information asymmetry are likely to
smooth dividends more.
In presence of asymmetric information between insiders (managers) and outsiders
(shareholders), the dividend signalling theory indicates that a firm’s dividend policy can
convey private information about the firm’s future prospects to the investors that is held
by the managers. The asymmetric information model as designed by John and Williams
(1985) proposes that a firm’s asymmetric information environment is related to its degree
of dividend smoothing with respect to change in its earnings. This indicates that higher
asymmetry of information a firm faces the higher will be degree of dividend smoothing
for it with respect to change in its earnings and vice-a-versa. We use size and age of a
firm as a proxy for firms’ asymmetric informational environments. Leary and Michaely
(2011) argue that comparatively, larger and older firms are well-known to the investor
and market participants and thus face lower information asymmetry in the capital market.
The older firms are generally expected to generate more public information to the
investors and thus, the firms with a longer listing year will have less serious problem of
information asymmetry. The availability of information is comparatively less for smaller
firms than larger firms to the investors and the market prices of larger firms reflect their
earnings more accurately than smaller firms (Atiase, 1985; Freeman, 1987; Kross and
Schroeder, 1989). From above discussion, we hypothesise a positive relationship between
the degree of information asymmetry and the degree of dividend smoothing. The size and
age of the company have been used as the proxy for the information asymmetry. The size
of a firm is measured as the natural log of market capitalisation. The age of a firm is
measured by the number of years a firm is listed on National Stock Exchange (NSE). Lu
et al. (2010) use the similar proxy, (i.e., the age of a firm) for information uncertainty.
Hypothesis 7 The high DDT causes the firms to smooth dividends more.
Various studies show the relationship between the dividend signalling and the DDT as
imposed by the government. Though the tax on dividend payment is high, the manager of
a company uses the dividend as credible signal to convey private information on firms to
investors. Rozycki (1997) provides evidence that dividend smoothing has increased the
wealth for investors who pay taxes, thereby reducing the present value of the investor’s
future expected income tax liabilities and this motivates managers to smooth dividend
payments. Chemmanar et al. (2010) notice that the firms in Hong Kong smooth dividends
 Why do firms smooth dividends? 245

to greater extent than those in the USA as there were no adverse tax effects of dividends
versus capital gains in Hong Kong compared to that in the USA. Shinozaki and Uchida
(2013) compared the dividend payout of firms operating in classical tax system and
partial or full imputation system and discover that the firms operating in classical tax
system tend to smooth dividends more than those operating in partial or full imputation
system. Therefore, we expect a direct relationship between taxes and degree of dividend
smoothing. The DDT is measured as the ratio of total DDT to the net profit after tax of
the company.
DDSi α  β1INVT  β 2 LEV  β3TANG  β 4 BR
(6)
β5SLACK  β 6SIZE  β 7 AGE  β8 DDT  u i

where, DDSi = Degree of dividend smoothing as captured by the coefficient of speed of

adjustment, INVT = is investment opportunity measured as market value of equity
divided by book value of equity, LEV = is financial leverage measured as the ratio of
total debt to total equity, TANG = is tangibility of assets measured as the ratio of net
fixed assets to total assets, BR = is business risk measured as standard deviation of first
difference of operating income divided by total assets, SLACK = is financial slack
measured as the ratio of accumulated retained earnings to total assets, SIZE = is firm’s
size measured as the natural log of market capitalisation, AGE = is age of a firm
measured as the number of years a firm is listed on NSE, DDT = is tax variable measured
as the DDT divided by net profit after tax, D is a constant, Es are the slope coefficients, ui
is the residual term.

4 Data and methodology

The required data on firm-specific information has been collected from PROWESS
database maintained by Centre for Monitoring Indian Economy (CMIE), which is a
leading business, and economic database and Research Company in India. Our initial
sample consists of all the firms enlisted on NSE. Presently, a total of 1730 companies are
enlisted on NSE. The reasons to choose companies from NSE are that, first, it is
mandatory for all the companies enlisted on NSE to follow the regulatory and financial
reporting norms set by Securities and Exchange Board of India (SEBI). Second, NSE was
established after the liberalisation, privatisation and globalisation of Indian Economy
which led to the enlisting of many new firms on NSE and also led to a drastic change in
equity ownership pattern for these companies with the availability of many alternative
sources of finance.
Following the sample selection procedure by Fama and French (2001) and several
other consecutive studies, we exclude the financial services and utilities sector firms. The
financial services and utilities sector firms are excluded from the sample as they follow
different accounting practices and regulatory norms compared to non-financial and
non-utilities sector firms. We also exclude the public-sector enterprises from our sample
as the dividend policies of these firms are highly influenced by social obligations and
government’s financial constraints.
The sample is selected in the following way:
246 N.B. Labhane

Table 1 Sample selection

Type of companies No. of companies

Total NSE listed firms 1,730
Financial services firms 179
Utilities sector firms 28
Public sector enterprises 35
Remaining NSE listed firms excluding financial, utilities and public-sector 1,488
enterprises
Firms with continuous data for independent/explanatory variables out of 781
1488 firms
Firms paying dividends continuously from 1995 to 2013 240

The period of our empirical study is from March 1995 to March 2013, (i.e., from the
fiscal year 1994–1995 to the fiscal year 2012–2013). The government of India considers
its financial year from 1st April midnight to 31st March midnight. Henceforth, we will
refer the financial year 1994–1995 as 1995 and accordingly the financial year 2012–2013
as 2013. There are two main reasons to choose the above period as the period of study.
First, this period represents the post-liberalisation period in India and second, this is the
period during which maximum financial information regarding firm-specific
characteristics is available in the database.
The partial adjustment model specified in the equation (5) has been estimated using
the time series data for the period mentioned above and a cross-sectional regression
model has been estimated on the equation (6) to determine the factors affecting the
dividend smoothing of the companies in India.

5 Empirical results

This section discusses the results found from the estimation of equation (5) and
equation (6). In the first part of this section we have reported the results estimated from
the partial adjustment model and subsequently, the cross-sectional results estimated from
equation (6) has been discussed.

5.1 Measurement of adjustment speed and target payout ratio

Table 2 shows the result of Lintner’s partial adjustment model for Indian firms. The aim
of utilising the Lintner model for this study is to investigate whether Indian firms follow
stable dividend policies or not. Ultimately, we are interested in the speed of adjustment
coefficient which states that how quickly firm adjusts its dividends towards the target
payout ratio. The higher the speed of adjustment, the less the smoothness and the stability
in dividends. Another variable of interest is whether Indian firms have a target payout
ratio or not. Lintner (1956) hypothesises that firms set a long-term target payout ratio and
adjust dividends gradually towards the target. From Table 2 we observe the following
evidence. The average speed of adjustment is 56.86% and the average target payout ratio
is 22.09%. The Lintner model is able to explain 50.47% of the variation in dividends in
 Why do firms smooth dividends? 247

India. Table 2 exhibits that the Lintner model is able to explain the dividend behaviour in
India to lesser extent as compared to that in the USA. For example in the USA context,
Lintner estimated the average speed of adjustment approximately equal to 30% with a
target payout ratio of 50% and the model explained 85% of the variations in dividends of
US firms. The coefficient of the constant has a positive sign indicating that the managers
of Indian firms are reluctant to cut dividends. This result is consistent with the findings of
Ahmed and Shaikh (2008) who detect that the Malaysian-listed firms are reluctant to
reduce dividends from one period to the next period.
Table 2 Results from the partial adjustment modela

∆Di,t = ai + ci (riEPSi,t – Di,t – 1) + ui,t (3)

or
∆Di,t = ai + bi,1EPSi,t + bi,2Di,t – 1 + ui,t (5)
Independent variables
Actual
Period Target
Adj. R- payout
Mean ai bi,1 bi,2 payout ratio
squared ratio
(bi,1/–bi,2)
(DPS/EPS)
1995–2013 Parameter 2.8571 0.1256 –0.5686 0.5047 0.2209 0.1612
estimates
Note: a∆Di,t is the actual change in dividend per share for firm i in year t; ci is a speed of
adjustment coefficient; ri is the target payout ratio; bi,1 = ciri and bi,2 = –ci.
Table 3 depicts the speed of adjustment and the target payout ratio estimated for the
present study and various other previous studies conducted in different countries and
environments. Table 3 shows that Indian firms have a higher speed of adjustment
coefficient, i.e., 56.86% and lower target payout ratio of 22.09%. This suggests that the
Indian firms adjust to their target payout ratio relatively slowly, but not as slow as the
firms in the developed markets such as the USA, Germany and France (see Table 3). The
speed of adjustment coefficient obtained in our study is significantly higher than that
obtained for the developed markets such as USA, France and Germany, whereas, the
target payout ratio is lower than that obtained for the developed markets (see Lintner
1956; Fama and Babiak, 1968; McDonald et al., 1975; Andres et al., 2009; Aivazian
et al., 2006). In the case of developing markets, the speed of adjustment coefficient in the
present study is lower than that reported by Pandey and Bhatt (2007) in India (71%),
Al-Yahye (2011) in Oman (94.12%) and Jeong (2013) in Korea (68.82%). Our speed of
adjustment coefficient is higher than 0.429 and 0.2535 documented by Al-Najjar (2009)
in Jordan and Al-Yahyaee (2010) in Oman respectively in their empirical studies.
The value of average target payout ratio in our present study is significantly lower
than that obtained by Pandey and Bhatt (2007), Al-Najjar (2009), Al-Yahyaee (2010) and
Al-Yahyaee et al. (2011). While our estimated target payout ratio is higher than 0.1312
reported by Jeong (2013) for Korean firms. When we compare the average actual payout
ratio with the average target payout ratio, the actual payout ratio of 0.1612 is much lower
than the target payout ratio of 0.2209. The high corporate taxes and high DDT relative to
capital gains imposed by the government may be one of the reasons for the lower value of
actual payout ratio compared with target payout ratio in India. Also, this suggests that
248 N.B. Labhane

Indian firms adjust their payout ratio relatively slowly to their targets and their dividend
payment decision is based on long-term target payout ratios.
Table 3 Estimated speed of adjustment and target payout ratio across the countries

Target Average
Speed of
Study Country Sample Period payout payout
adjustment
ratio ratio
Lintner USA All US 1918– 0.30 0.50
(1956) corporations 1941
Fama and USA 392 major 1946– 0.32–0.37 0.40–0.82
Babiak industrial US 1964
(1968) firms
McDonald France 75 French firms 1962– 0.12–0.33 0.41–1.01
et al. (1975) randomly 1968
selected from
400 largest firms
in nine industries
Pandey and India 571 sample 1989– 0.71 0.25 0.32
Bhatt Indian firms in 1997
(2007) the
manufacturing
sector
Aivazian USA All US firms in 1981– 0.24 0.50 0.26
et al. (2006) Compustat 1999
database
Al-Najjar Jordan 86 Jordanian 1994– 0.429 0.478 0.257
(2009) non-financial 2003
companies
Andres et Germany 220 industrial 1984– 0.21–0.49 0.128– 0.67
al. (2009) and commercial 2005 0.273
firms quoted in
atleast one of the
eight Germany
Stock Exchange
Al-Yahyaee Oman MSM listed 1989– 0.2535 0.6970 0.48
(2010) companies in 2004
Oman
Al-Yahyaee Oman MSM listed 1989– 0.9412 0.5668 0.41
et al. (2011) companies in 2004
Oman
Jeong Korea 279 sample firms 1981– 0.6882 0.1312 0.3250
(2013) listed on the 2012
Korea Stock
Exchange (KSE)
Present India 240 sample firms 1995– 0.5686 0.2209 0.1612
study listed on the 2013
National Stock
Exchange (NSE)

Overall, from Tables 2 and 3 we discovered that the Indian firms smooth and stable their
dividends but not in the same manner and not with the same speed as in the developed
 Why do firms smooth dividends? 249

and other developing markets. In addition, the Indian firms rely on the
long-run target payout ratios while making the dividend payment decision and adjust
relatively slowly to this target, in comparison to other emerging economies. The results
are consistent with the signalling hypothesis and thus, support the use of dividends
payment as a signalling device by the Indian firms. This result is inconsistent with the
findings of Anoruo (2014) who notice that dividends do not act as a signal to investors.
The differences in the findings regarding the value of the speed of adjustment coefficient
and target payout ratio for the previous studies may be resulted due to the differences in
tax systems and the period of study.
Table 4 Summary statistics

Variable Min Max Mean Median Std. dev. Skew Kurtosis

DDS 0.33 1.35 0.57 0.39 0.75 0.37 –1.38
TPR 0.17 0.29 0.22 0.15 0.18 0.22 0.64
APR 0.01 0.61 0.16 0.14 0.10 1.37 2.38
INVT 0.06 0.48 0.19 0.17 0.08 1.21 1.64
LEV 0.00 2.86 0.79 0.65 0.59 0.88 0.47
TANG 0.05 0.64 0.33 0.33 0.12 0.14 –0.51
BR 6.45 53.25 17.64 15.62 1.53 1.76 3.31
SLACK 0.01 0.14 0.05 0.05 0.02 0.78 0.54
SIZE 2.40 11.88 6.51 6.49 1.79 0.43 –0.20
AGE 11.00 125.00 39.47 36.50 2.46 0.97 0.75
DDT 1.06 9.35 3.54 3.29 1.51 1.20 1.92
Notes: This table presents descriptive statistics for all the variables used in the study.
DDS is a degree of dividend smoothing measured by the speed of adjustment
factor –bi,2 in equation (5), TPR is target payout ratio measured by bi,1/–bi,2 in
equation (5), APR is actual payout ratio measured as the average of the ratio of
annual dividend paid per share to earnings per share over the period of study,
INVT is a firm’s investment opportunity measured as market value of equity
divided by book value of equity, LEV is a firm’s financial leverage defined as
total debt divided by total equity, TANG is the tangibility of assets measured as
the ratio of net fixed assets to total assets, BR is a firm’s business risk defined as
the standard deviation of first difference of operating income divided by total
assets, SLACK is a firm’s financial slack measured as the ratio of accumulated
retained earnings to total assets, SIZE is firm’s size measured as natural log of
market capitalisation, AGE is firm’s age measured as the number of years a firm
is listed on the NSE, DDT is tax variable defined as DDT divided by net profit
after tax for a firm.

5.2 Determinants of dividend smoothing results

Before discussing the results, we have reported the summary statistics and the correlation
matrix of the variables used in the analysis to know their behaviour and to check the
possible multicollinearity problem. Table 4 presents the descriptive statistics of all the
dependent and independent variables used in the analysis. The mean value of the degree
of dividend smoothing is 0.57 which suggests that Indian firms have an average speed of
adjustment of 57%. The average target payout ratio of 22% is higher than the average
250 N.B. Labhane

actual payout ratio of 16%. The risk, size, age and tax variables, i.e., business risk,
market capitalisation, year of incorporation and DDT respectively are highly volatile
among all the variables. The skewness and kurtosis values are within the acceptable range
for all the dependent and independent variable, i.e., skewness value is between –3 and +3
and kurtosis value is between –10 and +10, suggesting that the data is normalised (Kline,
2005).
Table 5 shows the correlation matrix of all the independent variables used in the study
and the value of variance inflation factor (VIF). The financial slack and the leverage
variables are moderately correlated, i.e., –0.5264. The correlation matrix shows that the
correlations between some of the independent variables are significant. However, the
correlation between the independent variables is either of low degree or of moderate
degree, which suggests that the problem of multicollinearity is absent. Moreover, the
estimated values of VIF are very low, i.e., much smaller than five which is a rule of
thumb, suggesting that the problem of multicollinearity between the independent
variables is absent.
Table 5 Correlation matrix and VIF of all the independent variables

Variable INVT LEV TANG BR

INVT 1.0000
LEV 0.1896*** 1.0000
TANG –0.0433 0.3791*** 1.0000
BR 0.1584** –0.0386 –0.2499** 1.0000
SLACK 0.2020*** –0.5264*** –0.2646*** 0.2218***
SIZE 0.2213*** –0.1644** –0.2008*** 0.3294***
AGE –0.2815*** –0.0702 –0.2011*** 0.1758***
DDT –0.2792*** –0.2499*** –0.1249* –0.1572*
VIF 1.455 1.888 1.268 1.234
Variable SLACK SIZE AGE DDT
INVT
LEV
TANG
BR
SLACK 1.0000
SIZE 0.2860*** 1.0000
AGE –0.0838 0.2204*** 1.0000
DDT –0.0897 0.0968 0.1805*** 1.0000
VIF 1.780 1.364 1.307 1.261
Notes: This table reports the correlation matrix between the independent variables used in
this study. For variable explanation see notes in Table 1. ***indicates significance
at 1% level, **indicates significance at 5% level and *indicates significance at
10% level.
Table 6 shows the results for a multivariate regression for the entire sample of the study.
The significant F-statistics suggests that the model is correctly specified.
 Why do firms smooth dividends? 251

The speed of adjustment coefficient which captures the degree of dividend smoothing
suggests that how fast the target payout ratio is adjusted in relation to changes in firm’s
earnings. The slower the target payout ratio is adjusted with respect to the firm’s
earnings, the higher is the degree of dividend smoothing. The coefficient of the
investment opportunity INVT is negative and statistically significant. This indicates that
the firms facing high investment opportunities tend to smooth their dividends more to
convey the credible information to the market. The result is as per our hypothesis and
supports the information-based explanations. The result is inconsistent with that of Jeong
(2013). The financial leverage has a significant positive coefficient, which indicates that
the firms having a high proportion of debt in their total capital are likely to smooth
dividend less. The reason might be that the managers of highly leveraged firms are better
monitored and constrained by the debt holders and these firms certainly face lower
agency costs. Therefore, the firms with low leverage have higher agency costs and in
order to mitigate this agency problem, they have to smooth their dividends more. The
result is consistent with the findings of Aivazian et al. (2006) and Müller and Svensson
(2014) and it is in line with the agency-based explanation.
Table 6 Determinants of dividend smoothing

Model
DDSi = D + E1INVT + E2LEV + E3TANG + E4BR + E5SLACK + E6SIZE + E7AGE + E8DDT + ui
Variables Coefficient T-statistic
Constant –2.20 –0.75
INVT –10.83 –1.80*
LEV 1.59 1.72*
TANG 4.19 1.17
BR –0.144 –3.12***
SLACK 23.79 1.09
SIZE 0.80 3.09***
AGE 0.01 0.69
DDT –1.01 –3.43***
No. of obs. 240
Adjusted R-squared 0.2526
F-test F (8,231) = 11.10
0.0000)
Notes: For variable explanation see notes in Table 4. ***indicates significance at 1%
level; **indicates significance at 5% level and *indicates significance at 10%
level.
The risk variable BR has a negative sign and is statistically significant at 1% level,
indicating that riskier firms are likely to smooth their dividends more. The riskier firms
smooth their dividends more in order to develop a good reputation in the market to lower
their systematic risk. Also, the riskier firms have greater earnings volatility resulting into
more asymmetric information and to reduce this information asymmetry the riskier firms
have to smooth their dividends more. The result is consistent with the predictions made
252 N.B. Labhane

by Kumar (1988) and Guttman et al. (2010) and the findings of Jeong (2013), Leary and
Michaely (2011) and Müller and Svensson (2014).
The size of firm (SIZE) is statistically significant at 1% level and has a positive
coefficient suggesting that relatively larger firms tend to smooth dividends less whereas,
relatively smaller firms are likely to smooth their dividends more. The result is consistent
with the theoretical predictions proposed by the signalling theory of dividends which
states that smaller firms are relatively unknown to investors and market participants and
thus, faces greater information asymmetry with respect to their future prospects (Eddy
and Seifert, 1988). Also, the smaller firms can reveal significant information with
dividend changes and thus, have greater incentive to smooth dividends (Dewenter and
Warther, 1998; Ghosh and Woolridge, 1988). Thus, in order to reduce the information
asymmetry, smaller firms tend to smooth dividends more. The result is inconsistent with
the finding of Jeong (2013), Leary and Michaely (2011) and Müller and Svensson (2014).
The coefficient of tax variable DDT, i.e., DDT is statistically significant at 1% level
and has a negative sign. This suggests that the high tax rates imposed by the government
on the dividends distributed to the shareholders tend the firm to smooth their dividend
more. The result is consistent with the fact that the personal income tax motivates
managers to smooth dividends more because the dividend smoothing increases the wealth
for a tax-paying investor, thereby reducing the present value of the investor’s future
expected income tax liabilities (Rozycki, 1997). The result is consistent with the finding
of Jeong (2013).
Table 7 Stepwise regression of smoothing variable on firm specific factors

Starting model
DDSi = D + E1INVT + E2LEV + E3TANG + E4BR + E5SLACK + E6SIZE + E7AGE + E8DDT + ui
Ending model
DDSi = D + E1INVT + E2LEV + E3BR + E4SIZE + E5DDT + ui
Variables Coefficient T-statistic
Constant –2.12 –0.99
INVT –9.93 –1.80*
LEV 2.44 3.42***
BR –0.16 –3.57***
SIZE 0.90 3.65***
DDT –0.99 –3.45***
No. of obs. 240
R-squared 0.2672
Adjusted R-squared 0.2516
F-test F (5,234) = 17.07
(0.00000)
Notes: For variable explanation see notes in Table 2. ***indicates significance at 1%
level; **indicates significance at 5% level and *indicates significance at 10%
level.
 Why do firms smooth dividends? 253

5.3 Results of stepwise regression of smoothing variable on firm-specific

factors
Table 7 shows the stepwise regression results of smoothing variable on firm-specific
factors. There might be the presence of multicollinearity problem among the independent
variables which may affect the results of multivariate regression in Table 6. In order to
minimise the problem of multicollinearity, the multivariate regression is re-estimated
using a stepwise regression technique. The INVT, LEV, BR, SIZE and DDT variables are
statistically significant and all the variables have expected sign according to our
hypothesis. This suggests that the empirical findings of our study are robust to the
multicollinearity problem.

6 Conclusions and policy implications

The present study examines the determinants of dividend smoothing behaviour for 240
sample firms listed on NSE in India during the period from 1994–1995 to 2012–2013.
The result of Lintner’s partial adjustment model shows that the Indian firms have 56.86%
average speed of adjustment, 22.09% average target payout ratio and the model is able to
explain 50.47% of the variation in dividends in India. The speed of adjustment coefficient
which captures the degree of dividend smoothing suggests how fast the target payout
ratio is adjusted in relation to changes in firm’s earnings. The slower the target payout
ratio adjusted with respect to the firm’s earnings, the higher is the degree of dividend
smoothing. The Indian firms adjust to their target payout ratio relatively slowly but not as
slowly as the firms in the developed markets such as the USA, German and France and
thus, smooth and stabilise their dividends. The actual payout ratio of 16.12% is much
lower than the long-term target payout ratio of 22.09% which may be attributable to the
high corporate and DDT imposed by the government. This suggests that Indian firms
have target payout ratios, they adjust dividend payment relatively slowly to their targets
and their dividend payment decision is based on long run payout ratios. The managers of
Indian firms are reluctant to cut dividends.
The firm-specific characteristics such as investment opportunities, financial leverage,
business risk and size of firm are found to be important factors influencing the degree of
dividend smoothing. The firms facing high investment opportunities, low levered firms,
riskier firms and small size firms tend to smooth their dividend more. The firms facing
high investment opportunities tend to smooth their dividends more to cover the credible
information to the market. The firms with low leverage tend to smooth their dividends
more to mitigate the agency costs of free cash flow. The riskier firms smooth their
dividends more in order to develop a good reputation in the market to lower their
systematic risk. Also, the riskier firms smooth their dividends more in order to reduce
information asymmetry resulting due to the greater earnings volatility. The smaller firms
tend to smooth their dividends more in order to reduce the information asymmetry. As for
the macroeconomic factors, the DDT has a significantly positive relationship with the
degree of dividend smoothing which suggests that the high taxes imposed by the
government on the dividend distributed to the investor, induce the firms to smooth their
dividends more. Overall, the result supports the information asymmetry and agency based
explanation of dividend smoothing behaviour. The incumbent managers can use these
254 N.B. Labhane

findings while formulating the pay-out policy of the companies. It also has implications
for the investors as they can use stable pay-out ratio as one of the factors while deciding
their equity portfolios for investments.

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