Corporate Governance, Financial Constraints and Dividend Policy: Endogenous Switching Model

Abstract

Firms operating in the same country normally offer different levels of corporate governance practices. Therefore, it is very important to properly gauge firm-level corporate governance. Eventually, the influence of financial constraints on dividend policies also varies across different corporate governance regimes (i.e., strongly and weakly governed regimes). The current study intends to investigate the impact of corporate governance on dividend policy by explicitly considering the role of external financing constraints faced by firms on listed in the KSE. To investigate how the changes in firm-level governance affect its dividend policy, the sample in the present study was divided into two groups on the bases of corporate governance variables, which were determined via ESM. The results of the ESM analysis suggest that the effect of financial constraints on dividend policies indeed varies across different corporate governance states. Firms in a weak corporate governance regime are especially apt to pay lower dividends in order to avoid costly external financing. Due to the existence of a high agency problem in weakly governed firms, external investors discount the risk of expropriation by requiring a high cost for their capital as a reward for monitoring costs.

Introduction

Dividend payments generate two types of effects: on the one hand, they raise a firm’s dependency on external financing by disgorging cash flows in favor of shareholders and, on the other hand, they reduce the chance that management will expropriate a firm’s resources. Therefore, a firm ought to choose its ideal distributing policy while considering the costs of both the agency problem and external financing. The relative importance of these factors varies as the efficiency of a firm’s governance changes. Firms with high external financing costs do not intend to disburse more dividends in order to decrease their agency problem, particularly when they have good corporate governance, because doing so can curtail the agency problem. The motivation of the current study stems from the hypotheses narrated by La-Porta et al., (2000); however, the country-level investor protections are replaced with firm-level corporate governance. As was done in the study of La-Porta (2000), the researchers of the present study used country-level investor protections as an ideal indicator to categorize countries as either strongly governed or weakly governed. Also, firm-level corporate governance as assumed to be evenly effective in order to better categorize firms in a single country as either strongly and weakly governed.

A firm might increase its dividend payments so that it does not have to face severe external financial constraints(Awwad&Hamdan (2018). The dividend payment is a result of effective governance where shareholders believe that they are legally well protected and, thus, may be keen to keep their funds with firm managers if a firm is facing external financing constraints. Normally, firms do this in order to minimize external financing costs as its corporate governance becomes better. In that case, managers take into consideration the effects of the agency problem, financial constraints, and corporate governance in their dividend payment decisions.A firm with weak corporate governance has two possible options while making a tradeoff between the agency problem and external financing costs in deciding its dividend policy. Firstly, a firm will increase its dividends to produce a positive signal in the market. In fact, firm managers want to build their optimistic repute in front of external fund providers since they want to acquire external financing with attractive terms. Alternatively, a firm will reduce its dividend payments when entrenched managers stockpile resources to avoid costly external funds.

Firms serving in the same country normally observe different levels of corporate governance practices. Therefore, it is very important to properly gauge firm-level corporate governance. In the existing literature, firm-level corporate governance has been measured either by a single firm-level characteristic or by constituting a multidimensional index that covers different dimensions of corporate governance mechanisms. However, most scholars have raised questions on the authenticity of single corporate governance proxies. They suggest that a single trait is insufficient to capture the multi-dimensional aspects of governance (Mitton, 2004; Bebczuk, 2005; Song et al., 2011; Li at al., 2012). In recent research, a multi-dimensional governance index has been constituted to cover the maximum constructs of governance; for example, Gompers et al. (2003) formulated an index of 24 items. Mitton (2004) used a corporate governance index constructed by Credit Lyonnais Securities Asia (CLSA), which covers the most beneficial aspects of governance in developing countries. Black, Jang, &Woochan, (2006) also developed a Korea Corporate Governance Index (KCGI) consisting of five broad and equally weighted sub-indices. Jiraporn&Chintrakarn (2009) introduced new weighting criteria for developing a corporate governance index based on criticisms raised against the use of Gompers’ index. More recently, Chang et al., (2011) have inspected the effect of governance on option backdating firms by using dummy ratings of nine sub-indices of the corporate governance index.

As asymmetrical firm-level governance standards are revealed in a country, firm-level corporate governance changes as a response, and, in turn, firms’ dividend policies also vary. In order to investigate how changes in firm-level governance affect the dividend policies of firms, the sample of the present study has been divided into two groups. The study also makes use of the Endogenous Switching Model (ESM) of Schiantarelli& Hu (1998) to calculate the quality of corporate governance and to classify firms into two groups: Strongly Governed and Weakly Governed, anchored in stochastic threshold parameters. The ESM is a blend of the conventional ESM model of Nelson &Maddala (1975) and the autoregressive threshold model (TAR) proposed by Lim &Tong (1980). This model divides the sample into two regimes based on the threshold indicator. The major difference between the TAR and ESM is that, in the former, the threshold parameter is usually an identified variable, whereas in the ESM, it is a composite index that has been determined endogenously by a linear combination of index variables where their weights are determined simultaneously by means of response functions (Adelegan&Ariyo, 2008; Lin & Shen, 2012).

It has been observed that, as expected, corporate governance effects dividend policies in Pakistan. Normally, companies are reluctant to announce dividends. Because of this reluctance, corporate governance practices are not well established in Pakistan, and so majority shareholders continue to expropriate resources from minority shareholders (Maher, 2005). The structure of ownership is concentrated in Pakistan, and most of the control remains with majority shareholders or family members (Ibrahim, 2005). Moreover, ownership concentration affects dividend policies because dividend payments not only dilute a company’s reserves but also lead towards potential equity dilution in cases of equity financing for investments opportunities. Opportunistic managers want to retain control with them. So, they also want to finance investment opportunities with internal financing by squeezing dividend payments (Ahmed &Javid, 2009& Salah & Jarboui 2021). The decision-making process at the top level in companies is not transparent or participative. The average board size ranges from 7 to 8 members and is mostly dominated by either majority shareholders or family members (Rehman et al., 2012). Fair decision-making requires the true representation of all stakeholders, which is missing in Pakistani business ventures.The level of shareholders’ rights protection given by corporate vigilance authorities is quite weak in Pakistan. For example, Companies Ordinance 1984 entails that shareholders must own a proportion of at least one-quarter of a company to file acase against that company. However, minority shareholders the real victims, and they can only file a complaint to the SECP if they are not paid a fair amount of dividends by a company. Additionally, shareholders who have less than 10% shares cannot avail any legal remedy for corporate injustices (Ibrahim, 2005; Afzal &Sehrish, 2010).Thecorporate governance code was introduced in 2002 and was revised in 2012. However, it has not determined any measures regarding dividend payment decisions. The payment of dividends is voluntary and remains at the full discretion of managers. There is a need or a strong corporate governance code that could transform boards of directors to enhance independence in board and increase audit quality, transparency, and proper disclosure. These changes would confirm shareholders’ rights to protection and, resultantly, would offer higher dividend payments to shareholders (Batool & Javid, 2014). The relevant statutory requirements regarding dividend payments are not only vague but are also weakly enforced. Generally, two types of laws deal with corporate dividend policies: Companies Ordinance 1984 and a list of requirements posed by the KSE. Neither of these decreases the severity of the issue (Khan et al., 2011). The capital market is an alternative means of financing for business ventures. In the last decade, plenty of capital market developments have been witnessed in Pakistan, like the introduction of the sectoral indices (the KSE Meezan Index, Oil and Gas Tradable Index, and Bank Tradable Index), the establishment of Pakistan’s own clearing house (National Clearing Company), the formation of a depository (Central Depository Company), and the launch of a formal bond market (Bond Automated Trading System) receiving best performance award in 2003.

The capital market can provide debt and equity financing to companies. The propensity of companies towards equity financing is very low for a number of legal, economic, and procedural reasons. With the passage of time, the inclination of companies toward equity financing is decreasing for a number of reasons: IPO underpricing, low participation of the general public, and a weak regulatory framework.

Companies also raise financing by issuing tailor-made corporate bonds in the capital market. In the 1990s the Government of Pakistan started liberalization reforms to develop bond and money markets. However, the proportion of credit extended by the domestic bond market is just 30% of the country’s GDP.Almost all 34 industries can be potential players in bond market activities. Still, the demand side of the bond market has become quite potent with the involvement of new participants (e.g., commercial banks, mutual funds, investment banks, and insurances companies). In spite of the rich demand side, the higher level of transaction costs in terms of listing, issuance, trustee fees, advisory fees, rating fees, and stamp duties discourage companies from using this medium as a means of financing. Additionally, the trading of corporate bonds has been done in the ‘over the counter market’ (OTC) since 2009. As a result, the market has remained illiquid, and, due to the unavailability of an active central trading system, it has also created inefficiencies in price discoveries and information asymmetry among investors. In the meantime, corporate regulatory authorities have made extensive reforms for the development of financial markets and institutions in Pakistan. Resultantly, the level of liquidity in financial markets has improved, although the need for improvement persists. Firms still face financial constraints from the financial sector. The extent of financial frictions faced by firms does affect its value-creation process by not letting it play liberally. All the fundamental financial decisions function with the availability of funds. The investment and distribution decisions of a firm are generally based on its financial smoothness. As the extent of constraints gets higher, the levels of investments and distributions in Pakistan will be lower (Mohsin, 2014; Haque et al., 2014).It has been established that Pakistani firms pay dividends, particularly during high growth periods. However, the amount of dividends paid is not as great as it should be. The reason for this could be that the cost of external financing is higher than the cost of internal financing, and thus, managers prefer to retain internal funds for investment purposes (Azam & Anum, 2011).It entails that the decision of dividend payments is sensitive to a firm’s level of cash flow (Afza& Mirza, 2010). Javid and Ahmed (2011) posited that profit is the key driver for dividend initiation in Pakistan. However, the payment of dividends is susceptible to the level of availability of earnings (Asif et al., 2010; Abdullah et al., 2012; Batool&Javid, 2014). Market liquidity and the profitability of firms have positive influences on distribution, which implies that firms with higher profitability and market liquidity pay more dividends (Ahmed &Javid, 2008). Furthermore, the payment of dividends is highly correlated with the ease of use of funds after the deduction of expenditures and funds for investment (Ayub, 2005).

All the aforementioned facts reveal that firms operating in Pakistan face financial constraints, and therefore, they mostly use internal resources to fulfill their financing needs. While deciding on the amount of dividends, the management of a company makes a tradeoff between investment and distribution decisions; more often than not, paying dividends remains a low priority.It is an imperative concern for researchers to properly gauge firm-level corporate governance practices. In the existing literature, firm-level corporate governance has been measured either by a single firm-level characteristic or by constituting a multidimensional index that covers different dimensions of corporate governance mechanisms. However, most scholars have raised questions on the authenticity of single corporate governance proxies.The dividend policy of a firm varies with the level of corporate governance in a country; in countries where the corporate governance practices are closely observed, firms pay higher dividends, and vice versa. A systematic pattern may exist that enables dividend payout ratios to differ among firms in a single country based on the relevant governance quality. Hence, it is deemed necessary to divide the sample of the present study into strongly and weakly governed firms separately. In order to access the varying effects of financial constraints on dividend policies in different corporate governance regimes, the present study has made use of the ESM model of Schiantarelli& Hu (1998) for calculating the quality of corporate governance and for ultimately classifying firms into two groups (i.e., strongly governed and weakly governed) based on stochastic threshold parameters.

Literature Review

Prior research has suggested a positive relationship between the availability of free cash flows and investment (Hubbard & Glenn, 1998). There are two possible explanations for this relationship in light of the existing literature. Firstly, as Myers &Majluf (1982) stated, information asymmetry among managers and external investors creates financial constraints for a company because investors charge a risk premium in the cost of the financing. The inflated cost of external funds squeezes the firm’s ability to make effective investments and leads towards underinvestment problems (Fazzari et al., 1988; Hoshi et al., 1991 and Hubbard & Glenn, 1998). Likewise, Richardson (2006) probed that the over-investment is most likely in firms which have the highest levels of free cash flow, demonstrating a sign of an agency problem, where managers are involved in wasteful expenditures (Jensen & Meckling,1986; Stulz, 1990). Though it is suitable for firms to keep some amount of cash in order to finance daily activities orto serve as a cushion against the expensive external financing for investment purposes, as suggested by Myers &Rajan (1998), excessive cash holdings may force entrenched managers to expropriate for their private benefits rather than add value to the shareholders. In such situations, a dollar may not be worth a dollar if there are chances of its being misused.

Actually, managers consider internal funds as being cheaper than external funds and they try to spend internal funds lavishly, which creates an overinvestment problem for a firm (Stulz, 1990& Salah & Jarboui (2021). In case of an overinvestment problem, managers intend to invest in those projects which are beneficial for them, but may not be beneficial for the shareholders. Normally, monitoring by external parties may suppress the free arms of the entrenched managers. As Opler et al., (1999) concluded, low-leveraged firms are less disciplined by capital market participants and tend to hold more cash and distribute less as per their opportunistic behaviors.Predominantly, the problem of overinvestment is common in firms which have substantial free cash flows and weak monitoring by external shareholders (Richardson & Scott, 2006). Overall, the afore-mentioned research evidence indicates that managers prefer to retain cash flows instead of distributing them to the shareholders because they expropriate resources for their own benefits, following the predictions of the agency theory..An effective mechanism of corporate governance can control the adverse effects of agency problems, formally, as suggested by La-Porta et al., (2002). Weakly governed firms have more overinvestment problems as compared to strongly governed firms because in the case of weakly governed firms, external investors are not so powerful to drive money from the company as they find fault with the intentions of the managers.

Dittmar&Mahrt (2007) also suggested that good corporate governance reduces the agency problems associated with overinvestment and enhances firm value. Additionally, Kalcheva&Lins (2007) explained that when shareholders have strong protection, they will, easily, be able to force managers to pay cash as dividends and thus, keep managers from stockpiling cash resources for expropriation. Agency problems and governance practices simultaneously affect the managerial intentions of retaining more cash and distributing less (D'Mello& Miranda, 2010). An excess of cash within the firm results in overinvestment problems in the country where an investor’s protection is weak, managers try to accumulate more and distribute less in order to maintain their discretion over the resources (Yanchao, 2009&Awwad&Hamdan (2018).The extent of the investors’ protection varies from country to country; particularly, significant differences exist in the corporate governance practices of civil and common law countries (La-Porta et al., 2002). Particularly, with respect to corporate governance, developing countries are ranked lower as compared with the developed countries (Kalcheva&Lins, 2007). Normally, shareholders gain legal strength either through a country’s legal protection or by the course of the firm’s governance practices; in developing countries both of these layers of protection complement each other. Strong firm-level corporate governance along with effective country-level investor protection effectively controls agency problems (Mitton, 2004). Firm-level governance varies in a country based on the financial structure and legal system of that country (Gupta & Anderson, 2009). Normally, firms have concentrated ownership structures in the East Asian region, additionally, the separation of control and ownership has weakened the legal and other institutional frameworks. It ultimately offers little legal protection to the investors (Claessens et al., 2000; Mitton, 2004). In circumstances where the firm’s ownership structure is concentrated, the majority and minority shareholders exist, as a result, the issue of utilizing cash flows and their investment becomes adverse. According to Wei et al., (2011), agency problems have been categorized into type one (between managers and owners) and type two (between the major and minority shareholders); in Asian countries, type two agency problems are more pronounced.

As Cai (2012) has investigated the case of China, he explored that the role of governance is stronger for mitigating the problem of overinvestment of free cash flows. Furthermore, the role of corporate governance in constraining overinvestment is stronger for private-owned companies with high free cash flows along with few investment opportunities. Furthermore, the level of cash holdings by firms in East Asian countries is higher than in the developed countries just because of the weak investors’ protection along with the underdevelopment of the capital markets (Song & Lee, 2012). Firms operating in developing countries having less developed capital markets face difficulties in getting external financing with attractive terms (Agca&Mozumdar, 2008). Especially, poorly governed firms are victims of agency problems and managers’ expropriations. That is why external funds providers require the higher rate of return on their capital as a compensation for excessive risk. That makes the substance of external financing expensive for managers and, resultantly, they tend to stockpile internal resources for investment (Jensen &Meckling 1986; Myers &Majluf, 1984 and Francis et al., 2012). In that case, managers try to make more dividend cuts and stimulate the retention of resources for the sake of future needs. This sentiment is stronger in countries where the financial markets are underdeveloped coupled with weak shareholder protection (Dittmar et al., 2003). As the agency theory suggests, outsider investors have strong preferences for dividends over retained earnings because retained funds might be exploited by insiders (Easterbrook & Frank 1984; Jensen, 1986 and Myers, 2000). The inclination of shareholders may be higher for dividends in a weak investor’s protection environment. As La-Porta et al., (2000) established that in countries with strong corporate governance, firms pay higher dividends because shareholders can effectively use their powers to extract dividends. In this case the dividend payments are the outcome of strong corporate governance, but in weak investor protection countries, where firms have weak corporate governance, external investors do not have sufficient powers to force the company to pay dividends (Dittmar et al., 2003). Particularly, in poorly governed firms with weak shareholder’s protection, managers expropriate the resources for their own ends instead of the wealth maximization of the shareholders (Jiraporn& Ning, 2006). It implies that firms operating in developing countries where the quality of corporate governance is not so strong are likely to be financially constrained, and retain more resources instead of paying it to the shareholders (Khurana et al., 2006).

Alternatively, as Myers &Majluf (1982) stated, information asymmetry between managers and outside investors can create potential external financial constraints for a company. Hence, the company’s ability to raise external financing with attractive terms depends on the investor’s confidence in the company (Xu et al., 2009). In that case, large dividend payments will raise the firm’s dependency on external financing and companies start retaining cash with them in order to avoid costly financing (Rozeff, 1982). On the other hand, large cash flows in the company can generate agency problems like managers’ expropriations. Therefore, the underdevelopment of the financial sector along with weak the investor’s protection compels the managers to retain funds within the firms by skipping dividend announcements.

H1: Company with poor corporate governance and having external financing constraints pay lower dividends

Sometimes, cash dividends function as an indication of expected future returns in the context of information asymmetry. The major signaling costs lead dividends to function as a signal of future earnings (Bhattacharya, 1979). The external investors are not in a position to differentiate the earnings by a cross-section of companies because, existing shareholders are used to giving importance to the market value of the shares which is assigned by outsiders on the basis of a firm’s cash flows.

The alternate view of the agency theory states that dividend payments are the substitution of weak legal protection. This argument is based on the desire for firms to get external financing, at least occasionally, form the capital market (La-Porta et al., 2000). In order to get financing with suitable provisions, a business must have to set up its fair standing for the moderation of expropriation. A firm can do this, just by distributing cash as dividends to the shareholders. For the effective working of this strategy, a firm ought to by no means want to “cash in” its standing by skipping dividends. The managers would never desire to cash in if there is uncertainty for cash flows in the future as the option for capital market financing is, for all times, valuable (Bulow & Kenneth, 1989).The level of investor’s protection varies from country to country; particularly, there are significant differences existing in the corporate governance practices of common and civil law nations (La-Porta et al., 2002). A reputation for fair behavior with external shareholders works the most in countries where legal protection is weak and dividend payments may serve as a sign of relief for external investors. Contrarily, in countries where investors’ protection is strong, there is no need to build good reputations through dividend payments because the legal system provides safeguards against any infringements.In order to get financing with suitable provisions, a firm has to set up its fair standing for moderation in expropriation. Dividend payments will reduce the resources which can be exploited by managers (La-Porta et al., 2000). The reputation mechanism is more worthy for firms in those countries where the investors’ protection is weaker than in countries where the investors’ protection strong¹.

Especially, weakly governed firms get more benefits from externalinvestors by establishing their good reputations in the market (Jiraporn& Ning, 2006). Because, weakly governed managers are imperfectly aligned with the interests of the shareholders who leads to the expropriation of resources. Therefore, the dividend payments reduce the managers’ expropriation potential resources by disgorging excessive funds to shareholders, and firms with weak corporate governance use dividend payments as a device to reduce agency conflicts (John &Knyazeva, 2006).

Normally, firms operating in underdeveloped financial markets having severe information asymmetry use dividends as a tool to establish their good repute in the market for moderation in expropriating the shareholders’ resources. By disgorging more cash flows as dividends managers make sure that the external shareholders do not have enough resources to expropriate. In order to follow this mechanism, firms must adopt a stable dividend policy which has few dividend cuts; in this way, firms may be able to attract financing from the capital market (Bulow &Rogoff, 1989). Particularly, the reputation mechanism works the most in countries where investors’ protection is weak. Moreover, a firm having a good growth potential often also has strong motivation to establish good repute since it requires more funds to cover investment opportunities. Furthermore, according to this view, a firm having good growth opportunities also has a stronger motive to establish its reputation as it has a substantial potential need for external funds; by doing this, it will be able to get external financing with suitable terms (La-Porta et al., 2000). Harford et al., (2008) established that a firm having weak corporate governance uses it to hold less cash reserves and distributes more as compared to a firm having stronger shareholders’ rights protection. An alternative view of the agency theory states that dividends are substitutes for legal protection.

The argument is based on the necessity for companies to get funds from the capital market with attractive terms. In response to the expected agency problem in a firm, the external shareholders are hesitant to provide funds or compensate risk of expropriation by adding a risk premium in the cost of the capital, which leads to external funds being expensive for managers (Myers, 2000). As, Lin & Shen (2012) also suggested that dividends are the substitute for legal protection in countries where investors’ protection is weak; in that case, growing firms pay higher dividends since they have to establish their good reputation.

In a country where the capital market is imperfect, there is higher asymmetric information and investors’ protection is weak, the importance of firm-level governance increases (Francis et al., 2012). Due to the massive prevalence of managerial opportunism in badly governed firms, external financing friction, substantially, hinders a firm’s distribution behavior (Hovakimian, 2009; Petersen & Brown, 2009). With the existence of a high level of agency problems, external investors discount the risk of expropriation by requiring a cost for their funds as a reward for their monitoring expenses (Jensen &Meckling, 1986 and Stulz, 1990). Particularly, in developing countries, poorly governed firms normally have imperfect access to different external financing options due to their awful reputations (Bill et al., 2011). Additionally, dividend cuts in weakly governed firms pose two types of threats; formally, it disturbs investors’ confidence by exposing agency threats and investors counter this hazard by cutting the future supply of funds to the firm or by raising the cost of funds (Myers, 2000). Secondly, the managers can also face the threat of intervention or attempted additional scrutiny on the part of the existing shareholders (Zwiebel,1996; Fluck, 1999). Especially, firms with weak corporate governance usually have to pay higher dividends in order to build a good reputation in the market to avoid the risk of the additional scrutiny imposed by capital market players. Frequent dividend payments gives a signal to the market that there are fewer chances of agency problems in a firm and the shareholders will not be exploited.

In a period of financial constraint, firms usually have to pay higher dividends because they want to soften up the problem of the agency by giving confidence to the external investors (Yang et al., 2000). It is well-known that, external investors remain shaky with a firm having weak corporate governance because there are more chances of expropriation by the managers due to the prevalence of information asymmetry. So, firms with weak corporate governance usually have to pay higher dividends because managers want to give a signal of the low agency problem and want to get financing from external investors with attractive terms (Ginglinger&Saddour, 2007; Officer, 2011). Contrarily, if a firm with frail corporate governance reduces its dividend payments, it further execrates financial frictions for the firm due to the irritation of the shareholders. So, by establishing a reputation through dividend payments, financial frictions can be reduced (Chen et al., 2012). Hence, it implies that firms with weak corporate governance have to pay higher dividends in order to build a reputation to further soften up the external financing constraints.

H2: Company with poor corporate governance and having external financing constraints pay higher dividends

The divergence of priorities among the firms’ managers and their shareholders creates a hindrance in the course of the firms’ value creations (Jensen &Meckling, 1976). Particularly, the intensity of the aforesaid issue varies from country to country and, especially, in developed countries where the firm’s ownership structure is diverse and fewer agency problems prevail as compared to the developing countries which are characterized by the concentrated ownership structure (Wei et al., 2011). Ultimately, the extant of the investors’ protection also changes from country to country; particularly, there are significant differences existing in corporate governance practices of the common and civil law nations (La-Porta et al., 2002). Most of the East Asian countries have inherited the feature of the common law regime where firms are characterized by ownership concentrations, director interlocking and the pyramidal ownership structure in which managerial control remains with a few individuals, and they are not selected through proper scrutiny (Silanes& La-porta, 1999). Normally, firms have concentrated ownership structures in the East Asian region; additionally, the separation of control and ownership has weakened the legal and other institutional frameworks. It ultimately offers little legal protection to investors (Claessens et al., 2000 & Mitton, 2004). The level of governance practices largely varies across firms, especially in developing countries more so as compared to the developed ones (Kalcheva&Lins, 2007). Especially, poorly governed firms are victims of agency problems and managers’ expropriations (Francis et al., 2012). In those cases managers try to make more dividend cuts and stimulate the retention of resources for the sake of future needs. This sentiment is stronger in countries where the financial markets are underdeveloped coupled with weak shareholder protection (Dittmar et al., 2003). In that case, La-Porta et al., (2000) also confirmed that in countries where corporate governance practices are strong, firms pay higher dividends because shareholderscaneffectivelyuse their powers to extract dividends. So, poorly governed firms normally offer weak shareholder protection and, resultantly, managers expropriate the resources for their own ends instead of the wealth maximization of the shareholders (Jiraporn& Ning, 2006 &Yanchao, 2009). It is well-known that, external investors remain shaky with a firm having weak corporate governance because there are more chances of expropriation by the managers due to the prevalence of higher information asymmetry (Officer, 2011). Hence, in a country where the investor protection and the firms’ governance practices are weak, the chances of internal expropriation of resources rise. Due to the massive prevalence of managerial opportunism in badly governed firms, the propensity for distribution remains low, however, they have an excess of funds with them.

H3: Company poor weak corporate governance and without having external financing constraints pay lower dividends

[1]Dewenter and Warther 1998 established that there is less need of dividends signaling in Japan than in the United States. Because, external investors are more informed about firms in Japan than in U.S.A.

Methodology

The sample of the current study is derived from the listed firms on the Karachi Stock Exchange (KSE). Different filters have been applied to derive sample firms from the population. Firstly, the firm should have been listed during the entire period of interest (from 2004 to 2012) in the KSE, because dividend policies of companies vary among listed and unlisted firms (Pindado et al., 2011). Secondly, a company should have declared dividends in more than four years during this study period because it is are requirement for companies to declare dividends once in five years. Therefore, in a period of eight years, two dividend declarations is compulsory, so the benchmark for sample selection has been set at four years.Thirdly, firms belonging to financial and utilities sectors have not been considered because these industries follow different accounting and legal provisions (Wei et al., 2011; Li et al., 2012). Fourthly, firms with either missing corporate governance or financial data have been excluded from the sample. After applying the aforementioned filtering criteria, 139 firms have been selected^[2].The period from which data was gathered starts in 2004 (the corporate governance code was introduced in Pakistan one year prior, and its effects started to emerge a year later) and ends in 2012 (the code of corporate governance was amended in this year). Fourdifferent proxieshavebeenusedinthisstudy^[3].Thefirstonewas thedividenddivided bythe equity andthesecondwasthedividenddivided bythetotal assets. The thirdproxy wasthe cashdividendoverthe earnings andtheforthonewasthe cashdividend overthesales(Bebczuk,2005;Kowalewski et al.,2007;Adjaoud& Ben-Amar,2010;Kan et al.,2010 andJiraporn et al.,2011).Asthedividendpolicy ofafirm changeswithitslife cycle,in order to calculate its properties, thesedifferent proxies havebeen used.Additionally, the dividend yield ratio is a widelyused proxyforthedividend policyin existingliterature. The higher amountof volatilityinthe market price of the shares maymislead the result, that is why ithas not been considered in this study(Subramaniam&Devi, 2010;Ramachandra&Packkirisamy, 2010). The variables that appropriately categorize a firm as either financially constrained or unconstrained are the firm’s size and its age. Firm size and age consistently and accurately predict different states of business with respect to financing needs (Murillo, John,& Harvey, 2009; Hadlock& Pierce, 2010; Farre-Mensa &Ljungqvist, 2013). Among several other methods for measuring the intensity of financial constraints faced by a firm, researchers believe that its size and age predict its constrained or unconstrained status better than other factors (Silva & Carreira, 2012). Financial friction in smaller firms has several causes. For one, the issuance cost of securities decreases as the issue size increases, which makes external financing expensive for smaller firms.Hence, there are three measures for external financing constraints: age, size, and assets tangibility. Three dummy variables have been created for each financial constraint proxy, where a value of 1 denotes that a firm is facing financing constraints; otherwise, a value of 0 is given^[4].Growth opportunitieshavebeen by the useofthe Market to bookratio(Li Lin &Hua, 2012).Inorderto calculatethesize ofafirm,thelogvalueofthetotal assets hasbeen calculated (Bae et al.,2012).In orderto calculatetheprofitabilityofthe firms,thereturnon equity has been calculated (Adjaoud&Ben-Amar, 2010).Furthermore,leverage alsoinfluencesdividendpoliciesbecause of itsrolein mitigating agency costs anddebt covenantsonthedividends imposed bydebtholders (Jiraporn et al., 2011).

Endogenous Switching Model:

OLS simply makes predictions on the bases of predictors, whereas the ESM first splits the sample into two regimes based on a threshold equation and then regresses the predictors of response variables with respect to different regimes. Therefore, in the current study, the ESM has been used for the sample of 139 dividend-paying firms. Firm-level governance varies within any given country and across countries based on the financial structures and legal systems of those countries (Gupta & Anderson, 2009). As the firm’s level of governance varies, its dividend policy also changes. In order to investigate how changes in governance level affect the dividend policies of firms, the sample of the study has been divided into two groups based on corporate governance variables by using the endogenous switching model (ESM) (Anandarajan et al., 2008;Chang& Kang, 2010; Jiraporn et al., 2011; Officer,2011). 

The study intends to investigate how dividend policy changes in strong (SCG) and weak (WCG) corporate governance regimes. The two regimes have been divided by the threshold indicator, which consists of the linear combination of four corporate governance variables with a random error. Firm i at time t operates in a strong governance regime with response functions defined by:

DIV_it=X_itβSCG +ε1,_it...................................................................................(1);                            

 if Z_itγ+ u_it ≥ 0……....................................................................................(2);

or it operates in a WCG regime with response functions:           

DIV_it=X_itβWCG +ε2,_it…………………………………………………...(3);

if Z_itγ+ uit< 0…………………………………………………………(4);                                          

X_it=[EXD_it, PROFIT_it ; MBVit ; LEVERAGEit]

and

Z_it=[INST-OWN_it; BOD-SIZE_it; DIR-IND_it; DUEL_it]

where subscript t indicatethe tth year and i symbolizes the ith firm, consisting from 2004 to 2012. At here, DIV represents dividend payout ratio the dependent variable and X represents the vector of explanatory variables, where EXD narrates external financing constraints, PROFIT represents Return on equity; MBV stands for market to book value ; LEVERAGE signifies liabilities with respect to assets. Whereas, Term Z corresponds to the vector of governance variables, such as; INST-HOLD donates institutional holdings, DIR-IND is the percentage of independent directors, DUEL explains CEO duality and BOD-SIZE symbolizes number of directors in board. 

Finally, the coefficients β SCG,  β WCG and γ are the parameter vectors, where the first two describe the responses of dividend  payouts to   firm characteristic   variables  in strong and weak regimes, respectively, while the third   indicates the  weight of the governance variables, and ε1it ε2it and uit are   error terms. Equations (1) and (3) denote the response functions, which describe the responses of dividend payout ratio to firm characteristics, while equations (2) and (4) represent the threshold equations.  Thus, the model based on two regimes and in ex-ante, I do not know which regime belongs to the strong governance regime and which belongs to the weak one. However, previous acquaintance derived from the literature argues that the greater values of independent directors in board absence of CEO duality and lower proportion of institutional holding are probably to imply strong governance regime. Accordingly, once the coefficients of Ind-Board and Board-Size will be positive, CEO duality and INST-HOLD will be negative, it determinestrong corporate governance regime. Conversely, a weak corporate governance regime will be determined when their linear combination is falls below the threshold value. The ESM can be viewed as a unique blend of the threshold autoregressive model (TAR) of Tong and Lim (1980) and the traditional ESM model of Maddala and Nelson (1975). This model is similar to TAR model because it also divides the sample into two regimes based on threshold indicator. The major difference between TAR and ESM is that in former model the threshold indicator is typically a known variable, but in ESM model, it is an index. The index has been determined endogenously by a linear combination of governance variables where their weights are estimated simultaneously with the response functions. The other difference between TAR and ESM is that the separation of the two regimes in ESM is unknown ex-ante, whereas in the conventional switching model it is known before. As far the usage of this model is concerned formerly, Roy (1951) has used this model in scientific research for classifying the individual occupations e.g., hunting and fishing on the bases of comparative advantage. Whereas, Trost, (1977) had also made use of this model to indentify the disequilibrium in economic market forces. The ESM model has not been extensively used particularly, in management science, researches only few studies have utilized this estimation technique for inferences (Hu &Schiantarelli, 1998; Adelegan&Ariyo, 2008 & Li et al., 2012). It is the essence of the study to examine the impact of financial constraints on dividend policy in different corporate governance regimes. Based on the existing literature, the study has selected three different proxies of financial constraints (i.e., firm size, age, and assets tangibility. The switching model suggests that the relationship between financial constraints and divided policy either stays the same or varies with the quality of firm-level corporate governance. As far as the governance variables are concerned, four provisions have been selected: institutional holdings, proportion of independent directors, CEO duality, and size of the board. Independent directors and appropriate bard sizes enhance the quality of governance and disburse more cash to external shareholders (Fluck, 1999; Swicki, 2009 &Afza& Mirza, 2010). CEO separation and lower fractions of institutional holdings in a firm lead to fewer dividend cuts and a higher distribution of cash to shareholders (Chintrakarn&Jiraporn, 2009; Li et al., 2012). As in traditional indexes, the selection of weighting criteria makes them suspicious (Bozec & Bozec, 2012), although in the ESM, estimated regression coefficients endogenously determine the weights in the index. Strongly and weakly governed regimes decide if the index is above or below the threshold indicator.

Results

A systematic pattern might subsist which wouldenable payout ratios to vary among firms operating in the samecountry dependingon their firm-level governance quality (Gupta & Anderson, 2009). The governance quality of firms operating in the same country varies; few firms may exhibit good corporate governance practices.Therefore, all firms do not follow the same dividend paying practices. In order to investigate how changes in firm-level governance affect thedividend policies of firms, the sample of the study has been divided into two groups. The study also makes use of the ESMof Schiantarelli& Hu (1998) to calculate the quality of corporate governance and classify firms into two groups (strongly governed and weakly governed) based on stochastic threshold parameters. This model divides the sample into two regimes based on threshold indicators, such as an index that determines governance regimes endogenously viaa linear combination of governance variables, where the weights of these variables are estimated simultaneously with the response functions (Adelegan&Ariyo, 2008; Lin & Shen, 2010). Firm-level corporate governance is not a directly observable phenomenon.Therefore in empirical research, scholars have developed different proxies,such as a single observable firm’s characteristics or multidimensional indexes, to measure its quality. However, one can argue that there is not a single best proxy for measuring firm-level corporate governance since it is based on multiple factors (Bhagat et al., 2008; Bebchuck&Hamdan, 2009). Moreover, the multifactor index for a single country reflects a better measurement because it closely covers the rules, practices, and procedures of that country (Khanna et al., 2008).Therefore, by considering the capacity of the model and the characteristics of the local business environment, and through the use of existing literature, four measures of corporate governance have been used in the ESM in the present studyto split the sample into two regimes. Fair decision-making is very important for good governance because it preserves the stakes of all members. Hence, an appropriate board size, director independence, and CEO duality considerably capture the effects of board autonomy, structure, and effectiveness (Jiraporn& Ning, 2006; Javid& Iqbal, 2008; Sawicki, 2009; Chang et al., 2011; Sami et al., 2011). The ownership structure of a company (i.e., the proportion of shares held by directors, CEO, financial institutions, and the general public) defines the myth of financial decision-making of the company. Generally, the statement “bigger is better” appears to be very much relevant in the case of institutional investors who are imperative in business decision-making.Due to the inheritance of some special features, such as the large size of shareholding, high proficiency in monitoring and building effective liaisons with other stakeholders' financial institutions control the pulse of management (Oliveira et al., 2012; Amin et al., 2014). This is especially true in Pakistan, where institutional owners oppose the decision of paying dividends for a number of reasons. Firstly, they require an assurance of repayment of their arrears and secondly, they invest their free cash flows in various classes of securities for their debt security and to establish their fair financial position in the market (Afza&Hammad, 2011; Bushra& Mirza, 2014). In the ESM, four measures of governance (board size, director independence, CEO duality, and institutional ownership) are included as parameters in the threshold equation to endogenously determine different governance regimes present in a firm.The results of the ESM analysis are reported here and all tables for the coefficients of threshold equations have been shown. With respect to the three different proxies of financial constraints (firm size, firm age, and assets tangibility), three different models have been estimated against the four measures of dividend policy.It is interesting that the coefficients of financial constraints are less significant and even positive in strong corporate governance regimes but arenegative and significant even at 1% level inweak governance regimes. The results of the ESM analysis suggest that the effects of financial constraints on dividend policies indeed vary across different corporate governance states. Firms pay lower dividends in weak governance regimes in order to avoid costly external financing. With respect to all dividend policy measures,the ESM has produced consistent results and confirm that the effects of financial constraints on dividend policiesarenot the same acrossdifferent governance regimes. Particularly, in frail corporate governance regimes, firms pay lower dividends because of an extensive agency problem, which causes external investors to discount the risk of expropriation by requiring a high cost of their capital as a reward for monitoring costs (Jensen &Meckling,1986;Stulz, 1990).As a result,managers’ accessto external funding is reduced, and their reliance on retained earnings to finance its investment opportunities in increased. Other studies haveproduced the same results and confirmed that weakly governed firms accumulate more internal funds because of their feeble access to external money (Hovakimian, 2009; Petersen & Brown, 2009;Bill et al., 2011).Additionally, firms operating in Pakistan face severe external financial frictions due to probable underdevelopment of local financial markets, and most of the time appropriate investment opportunities are waived by firms because the availability of financing decreases(Ahmed & Hamid, 2011).A few other local studies have confirmed thatthe level of external financing constraints determines a firm’s investment and distribution decisions; the higher the level of constraints, the lower the amount of investments and distributions (Mohsin, 2014; Haque, Naeem, & Qureshi, 2014).

As far as the control variables are concerned,investment opportunities have shown a varying effect in different corporate governance regimes. Most prominently, in weak corporate governance regimes, the coefficient of MBV has a negative and significant relationship with dividend policy. This relationshipimplies that as the quality of firm-level governance decreases, the firmtries to squeeze the size of their dividendsso that they can finance investments with internal funds. The results have also established that profitability is more sensitivetodividend disbursements in weakly governed firms. The dividend policies of weakly governed firms rely heavily on profitability due to a high prevalence of the agency problem,an inefficient use of resources, and the probable denial of external investors to provide funds onattractive terms.The empirical results of the ESM analysisreveal that the influence of financial constraints on dividend policy varies across different corporate governance regimes.Particularly, weakly governed firms respond attentively to external financial frictions while deciding theirdividend policies. Because of the likely underdevelopment of the financial sector and the probable existence of managerial expropriations by virtue of weak investor protection, firms have to rely heavily on internal financing.

In a trade-off between distribution and retention, the management of local firms are more inclined toretain earnings by holding backdividend payments. Particularly, the extent of financial denial effects weakly governed firms harshly. In weak governance regimes, firmspay lower dividends due to the existence of the agency problem, which is coupled with financing constraints, whereas,in sound corporate governance regimes, the effect of financial constraints on dividend policy is mild. This differenceentails that the exercise of good governance practices not only softens theagency problem but also makes it easier for firms to acquire external financing.

Conclusion

External investors also know very well that the corporate regulatory machinery of Pakistan is inefficient to provide legal protection. However, not all firms exhibit the same level of corporate governance. This is especially true of young and small firms, which tend to follow weak governance mechanisms. Consequently, investors remain hesitant to invest in these firms. In Pakistan firms that face financial friction often try to take advantage of investment opportunities by using internal funds. To do this, they reduce dividend payments. Firms operating in the same country normally offer different levels of corporate governance practices. Therefore, it is very important to properly gauge firm-level corporate governance. Eventually, the influence of financial constraints on dividend policies also varies across different corporate governance regimes (i.e., strongly and weakly governed regimes). To investigate how the changes in firm-level governance affect its dividend policy, the sample in the present study wasdivided into two groups on the bases of corporate governance variables, which were determined via ESM. The two regimes were divided by the threshold indicator, which consists of the linear combination of corporate governance variables. The results of the ESM analysis suggest that the effect of financial constraints on dividend policies indeed varies across different corporate governance states. Firms in a weak corporate governance regime are especially apt topay lower dividends in order to avoid costly external financing. Due to the existence of a high agency problem in weakly governed firms, external investors discount the risk of expropriation by requiring a high cost fortheir capital as a reward for monitoring costs.Additionally, the effect of investment opportunities causes dividend policiesto vary as the firm-level governance practices change. In Pakistan, most young and small firms reduce theirdividends, as they have the healthy potential to grow. Furthermore, profitability also plays an important part in defining the dividend policy of weakly governed firms. As a firm accumulates an adequate level of financial slack, the dependency of that firm on external financing reduces, and the propensity of dividend disbursements surges. Firm-level corporate governance practices have significance in strategic decision making. By itself, fair governance guarantees good monetary results. Particularly, board independence contributes heavilytoforming effective governance mechanisms in Pakistan. Additionally, over thepast few years, the corporate stake of financial institutions has surged.Resultantly, they are becoming influential partners in firms’ decision-making and oppose the decision of disbursement in order to secure their own concerns are prioritized. In Pakistan, dividendsare an Outcome of governance practices. As the quality of firm-level governance increases, more legal strength is given to shareholders, who can ultimately convince management to releasedividend payments. Furthermore, strong investor protection makes financial embezzlement legally risky for insiders, and this accordingly enhances the importance of dividend payments. Thisimplies that shareholders demand dividends but that weak legal support induces entrenched managers to exploit outsiders.

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Appendix

Appendix A is not available with this version