Effects of Earnings Volatility on Leverage and Dividend Payout

Nusrat Jahan Lecturer Independent University, Bangladesh Chittagong Campus

1. Introduction Earnings and dividends are the powerful indicators of the firms business activities and stability of business growth. Hence, investors, researchers and the academicians should be interested in determining what effect the volatile earnings have on the level of leverage and dividend payout ratio of any firm. Earnings volatility now a days a wide-reaching phenomenon and decisively observed by the researchers. This paper would evaluate the volatility of earnings in the Cement manufacturing sector of Bangladesh. There is a window of opportunity for the researchers to observe the existence of volatile earnings in the corporate sector of Bangladesh. Therefore, this study would be carried out to investigate the relationship among earnings volatility, level of leverage and dividend payout. 2 Problem Statement The Cement manufacturing industry of Bangladesh is an import dependent country which imports raw materials of cement from countries like Thailand, Indonesia, Malaysia, Philippines etc every year. But for the last few years raw material sourcing has become more costly. In the world market, prices of raw materials are volatile, the shipment cost and handling cost becoming more costly and moreover the countrys poor power situation has turned the Cement industry in unfavourable situation. This industry is failing to match the higher production cost with its growth in volume of production. Besides squeezed by surplus production against falling consumption and inability to pass on such additional cost to the consumer, the countrys Cement industry is in critical state. The volatility of price hike in souring of raw materials has resulted in volatile earnings for this industry (The Financial Express, 2008). So, investors who seek fixed income in the form of dividend form their investment in the Cement industry are exposed to the risk that the firms underlying businesses may go through rough times and that earnings and dividend payout could reflect this downturns.

3. Backgrounds and Significance of Study Investment in equity is riskier because equity earnings represent what is left over after everyone has been paid and is thus more volatile than the operating earnings. At one extreme we could find firm that deliver the same level of earnings years after years and thus exhibit no volatility in earnings. On the other hand, there are companies whose earnings fluctuate widely from huge profits to large losses, creating high variances in earnings. A firm that reports higher earnings each year, relative to earnings in prior year, would be viewed as a safe firm. At the other, firms that report increases in earnings in some years and decreases in others would be viewed as risky (New York University). While measuring earnings volatility the number we would be focusing in this research are aggregate net incomes available to shareholders and earnings per share. Besides firms dividend payout ratio and level of leverage would be compared with earnings volatility to prove the hypothesises which are assumed for this research. Therefore this study would be of great importance to the fixed income seeking investors who wants to invest in this relevant firms since this paper will examine the volatility earnings of this firms . 4. Research Objective The core objective of this study is to examine the relationship among earnings volatility, financial leverage and dividend payout ratio. The following hypotheses are assumed, in order to prove the objective of this research. Hypothesis I: Firms with more volatile cash flows, on an average, pay out a greater proportion of their cash flow in the form of dividend. It is evident from the data provided by Scott Paper and Kellog that a pattern of constant growth in dividend per share exists relative to earnings volatility. Per share dividends are maintained and a large portion of earnings is given as dividend even when earnings fell from one year to the next. (Kaen, 1995). Hence, to prove hypothesis I, the objectives are:

First Objective: Determination of the volatility of earnings of cement industry during the last 5 years. Second Objective: Comparing the volatile earnings with dividend per share of this industry over the past five years. Hypothesis II: Firms with higher levels of earnings volatility will have less leverage and vice versa. Financial leverage refers to the extent to which a firm relies on debt. Use of financial leverage magnifies gains as well as losses of the company. The positive effect of financial leverage depends on the companys higher level of operating income. Moreover, the volatile operating income would have adverse affect on the companys earning per share given a higher degree of financial leverage in the companys capital structure. Thus, shareholders become exposed to more risk when there is a higher level of financial leverage in the companys capital structure. Because of the possibility of adverse impact of financial leverage on earnings per share, when a companys earnings are expected to be volatile, that firm would likely to consider less financial leverage in its capital structure. ( Ross et al., 1995) Hence, to prove hypothesis II, the objectives are: First Objective: Determination of the volatility of operating income of Cement industry during the last 5 years. Second Objective: Determination of the level of debt in the capital structure and the degree of financial leverage of cement industry during the last 5 years. Third Objective: Comparing the level of debt and degree of financial leverage to volatile operating income of cement industry during the last 5 years. Hypothesis III: Firms with higher leverages have a lower dividend payout ratio and firms with lower leverages have a higher dividend payout ratio. According to the bankruptcy cost theory the level of debt in the capital structure and dividend payout ratio have an adverse relation. The low dividend payout ratio means, increase in the equity base for debt capital and low probability of going into liquidation. As a result of low probability of bankruptcy, the bankruptcy cost is low. According to the bankruptcy cost theory, the low bankruptcy cost implies high level of debt in the capital structure (Baral, 2004). Hence, to prove hypothesis III, the objectives are:

First Objective: Determination of the level of debt or financial leverage of Cement industry during the last 5 years. Second Objective: Determination of the dividend payout ratio of cement industry during the last 5 years. Third Objective: Comparing the level of debt with dividend payout ratio and determining the correlation between them. 5. Methodology of the study The study will be the product of two types of work - library work and fieldwork. Library work will be focused towards the compilation and review of the various literatures that are relevant to studying the effect of earnings volatility. Fieldwork will be the collection of firm specific information that would be gathered from the annual reports to shareholders. This secondary database would include balance sheet, income statement and cash flow statement of the relevant organization. In order to prove the hypothesis, data for this study will be collected from all the Cement manufacturing firms that are publicly traded in Bangladesh. This research would focus on at least five years of data relevant to the sample organization. There are number of techniques to measures earnings volatility of a firm. In this research, the standard deviation or variance in earning would be considered as statistical measures of volatility. Besides, the information regarding dividend payout ratio, level of debt, cost of debt, and debt to equity ratio would be collected from the companys annual report. Regression analysis would be done to show the relationship among these variables and to prove the hypotheses. 6. Benefit of the study An exploration into this particular field of financial management is rare in Bangladesh, hence this study would be of great contribution since this will enrich the literature relevant to the subject of earnings volatility. This study would be informative for the students and researchers, since it will enrich their knowledgebase and also will enlarge the scope further research opportunities in this area. Besides, this research would have realistic value to those fixed income seeking investors who are investing or planning to

invest in the relevant firms of this study. Moreover, this study would also be beneficial for the relevant firm in managing their financial volatility. 7. Work plan: Use Gantt chart 8. Project cost schedule 9. Concluding Remarks After reviewing number of different literature relevant to earnings volatility, dividend policy and financial leverage, the aim of this study is to bring out a rigorous study showing the interrelationship among these variables. The main focus was to determine whether the firms level of dividend payout is affected by the volatile earnings. Considering the significance of the research topic and its implications on the financial management sector of Bangladesh, this sort of research effort should be embraced to broaden our knowledgebase.

7. References Baral, Keshar J., (2004). Determinants of Capital Structure: A Case Study of Listed Companies of Nepal. The Journal of Nepalese Business Studies. December. 1. 3-5. [online] Available from: <http://www.nepjol.info/index.php/JNBS/article/viewArticle/34> Coakely, J. et al. Does Volatility Improve UK Earnings Forecasts? University of Essex. [online] Available from: <http://www.efmaefm.org/efma2006/papers/565253_full.pdf> Kaen, Fred R., (1995). Corporate Finance. Cambridge: Blackwell Publishers Ross, Stephen R. et al., (1995). Fundamental of Corporate Finance. Chicago: Irwin Inc. Stable Earnings, Better Investment? New York University. [online] Available from: <www.stern.nyu.edu/~adamodar/pdfiles/invfables/ch5new.pdf> The Financial Express (2008). High raw material cost pushes local cement price up. Financial Express. July 15, 2008.