Corporate Governance, Financial Constraints and Dividend Policy: Evidence from Pakistan

Abstract

Information asymmetry between insiders and outsiders creates various issues for a firm, such as the agency problem where managers pursue their own interests even at the cost of the wellbeing of the firm’s shareholders and probable external financial constraints where external investors discount risk by causing a surge in the cost of financing. Normally, a firm manages the issues of the agency problem and external financing constraints by omitting or initiating dividend payments. In most existing studies, scholars have focused on the direct relationship between corporate governance and dividend policies and, thus far, they have produced inconclusive and contradictory results. Most probably, these studies have not considered the role of financial constraints in dividend payment decisions. Moreover, the substantial emergence of corporate scams, along with weak regulatory environments coupled with the underdevelopment of the financial sector of Pakistan, has encouraged the study of the aforesaid tradeoff. Therefore, this study investigated the impact of corporate governance on dividend policies in the presence of financial constraints using a sample of 139 non-financial firms listed in the KSE in Pakistan, where a weak regulatory framework generates agency problems and the underdevelopment of financial sector causes financing constraints for businesses. The results reveal that, in Pakistan, dividends are an Outcome of governance practices. As the quality of firm-level governance improves, shareholders are provided with the legal strength to ultimately force firm managersto pay dividends.Along with the agency problem, the availability of external financing is an important factor related to dividend payment decisions in Pakistan. When a company is confronted with the agency problem and financial constraints simultaneously, managers try to avoid costly external financing rather than reducing agency problem. The corporate regulatory machinery of Pakistan completely inherits the characteristics of low efficiency, and as a result, the issue of unsymmetrical firm-level governance practices has emerged. Eventually, the influence of financial constraints on dividend policies also varies across different corporate governance regimes.