Dividend, investment and the direction of causality

In this study, we address an econometric issue which has so far been neglected by the empirical studies on separation principle. The earlier studies largely applied Granger causality test by differencing the data if they are integrated time series. Such approach produces specification bias if integrated variables in level are cointegrated and thus, ignoring the long run dynamics among the variables. To circumvent this problem, we test for cointegration between investments and dividends and estimate a dynamic panel vector error correction model. Annual time series data over the period 1995 to 2008 for various sectors chosen on the basis of the available sectoral indices of National Stock Exchange (NSE) are considered for empirical analysis. The empirical evidence derived from group mean and lambda-Pearson tests seem to indicate that there is long run causal link between investments and dividends and therefore, firms’ decisions regarding dividend payout and investments are inseparable.