Why Do Firms in India Pay Dividend in Presence of Firm Level Dividend Distribution Tax ? - An Agency Theory Based Explanation

Purpose: The purpose of the study is to analyze motivation behind payment of cash dividend by the firms in India in presence of tax provision that discourages payment of dividend by imposing tax on firms at the time of distribution.Design/methodology/approach First, consistent with Jensen's (1986) view, the paper presents a theoretical model that shows - dividend payout addresses agency problem of free cash flow and then, empirically highlights through event study and OLS regression - the impact of stock price reaction to dividend increase and decrease in respect of 352 announcements during 2006-10 of top 100 companies listed in Bombay stock exchange (BSE). Findings: As predicted by the model, empirical results show that despite adverse tax provision resulting in depletion of shareholder' wealth upon dividend distribution - high payout announcement causes rise in valuation and low pay out has just an opposite impact for stable, profitable, mature and high value firms that hardly need ‘dividend signaling' to address information asymmetry problem as to their worth. Despite tax disadvantage, investors prefer and value dividend as it mitigates agency problem of retention. The finding is consistent with ‘life cycle theory's prediction of high pay out by large and profitable firms.Practical Implication: The corporate managers of India, oblivious of the hidden agency cost associated with high retention, are conservative in setting their dividend policy, perhaps attributable to dividend tax – a direct cost of distribution. The findings of the study may encourage the CFOs and finance executives to have a relook at their existing dividend policy. At macro level as well, the fiscal policy makers should revisit the dividend distribution tax in its present form because of its potential of inefficient build up and use of resources through retention at firm level.Originality/ value: The findings of the study enrich the literature on agency theory and dividend policy formulation at micro level and to an extent public finance at macro level as well