Essays On Corporate Payout Policy

The first essay examines the impact of insider trading law enforcement on dividend payout policy. We posit and confirm that firms use dividend payouts to mitigate agency costs caused by gaps in country-level investor protection. We find that first-time enforcement of insider trading laws leads to a lower likelihood of paying dividends, lower dividend amounts, lower dividend smoothing and target payout ratios. We also show that market value of dividends declines significantly following the enforcement of insider trading laws. These results suggest that dividends serve as a substitute bonding mechanism through which managers establish a reputation for the fair treatment of minority shareholders when insider trading is not restricted. Firms mitigate the shortcomings of a weak institutional environment by committing to higher and more consistent payout policies. The second essay investigates the interaction among dividend smoothing, equity value and agency costs. Using a comprehensive cross-country sample from 21 countries, we show that market puts a premium on smooth dividends and dividend smoothing increases with agency costs of equity. Most importantly, we find that the premium for smooth dividends is decreasing in shareholder rights, suggesting that when agency costs are small the market puts a low premium on smooth dividends. The bonding framework of dividend smoothing might also shed some light on why smoothing in the US has increased over time. Consistent with our findings, we argue that the necessity to smooth dividends has increased over time due to increasing repurchase-for-dividend substitution that is previously documented in Grullon and Michaely (2002). Further analyses show that on average $1 paid out through dividends contributes to equity value by about 40% more than $1 paid out in repurchases using the most conservative model. Put differently, in order not to reduce the value of equity, firms need to substitute $1.4 in repurchases for $1 decrease in dividends. To manage the enormous payout burden of dividend-repurchase substitution and to maximize equity value, managers have been increasingly compelled to make dividends smoother. Consistently, we show that firms that pay smoother dividends substitute dividends for repurchases at 23% faster rate than the firms with less smooth dividends. Overall, these results support the view that dividend smoothing is a bonding mechanism used to undo the agency cost discount on equity valuation.

This dissertation comprises two independent essays that examine how the shareholder-creditor conflicts affect corporate investment, and how the enhanced labor power influences corporate payout policies. In the first chapter, I analyze the impact of shareholder-creditor conflicts on corporate risk-taking. In particular, I examine the role played by institutional dual-holders (i.e., those simultaneously holding a same firm's debt and equity) in corporate innovation. I find that firms held by dual-holders generate fewer but more valuable patents. To establish causality, I use a difference-in-differences approach based on the quasi-natural experiment of financial institution mergers. I further find that the decreased sensitivity of managerial compensation to firm risk might be one possible channel through which dual-holders affect risk shifting. The results suggest that shareholder-creditor conflicts indeed exist and lead to risk shifting, and that institutional dual ownership can partially mitigate this problem. The second chapter studies labor power as an important but largely under-explored determinant of corporate payout policy. Using a regression discontinuity approach that exploits locally exogenous variation in labor's collective bargaining power, I find that an increase in labor power lowers corporate payout. Operating flexibility is a plausible underlying mechanism through which labor power influences corporate payout. Firms use the saved earnings from reductions in payout to invest in net working capital rather than paying off debt or increasing cash holdings. This essay sheds new light on the determinants of payout policy and the role of labor power in corporate finance decisions.

This dissertation consists of two essays. The first essay examines how corporate payout policies and debt can be interchangeably used as substitutes in controlling free cash flow (FCF) problems. The roles of retained earnings/total equity (RE/TE) and various risk measures, such as equity beta, cash flow beta, and volatility are also analyzed in the choice of different payout policies as substitute for debt. Evidence suggests that firms with lower debt tend to payout more to control for free cash flow problems, and this relation is mainly driven by dividends, suggesting that dividends are more direct substitute to debt in controlling FCF problems. Also, the results support that RE/TE significantly affects dividends, but the substitution effect induced by FCF problems is unaffected by the inclusion of RE/TE. Furthermore, contrary to the recent literature, when leverage is considered, the effect of FCF problem on dividends dominates the effect of RE/TE. Therefore, FCF problem still plays a very important role in explaining firm's payouts. Furthermore while equity beta and RE/TE have symmetric effects on dividends and repurchases, cash flow beta has asymmetric effects. Cash flow beta weakens the degree of substitution between dividends and leverage in favor of repurchases. Even after controlling for RE/TE, size and equity beta, cash flow beta has a significant explanatory power for a firm's dividend payments. The second essay examines the behavior of managers who are endowed with executive stock options and investigates a possible distortion of corporate payout policy and its fixing mechanism. Executive managers awarded with large stock options may have an incentive to substitute repurchases for dividends in their payout policy and this may results in an agency problem between managers and shareholders. Surprisingly, dividend protection that can fix this distorted managerial incentive by compensating managers for the amount of dividend payments is rarely adopted in US. Various hypotheses are tested to explain the observed low dividend protection rate. First, the accounting consideration based on the EPS dilution effect is studied. Second, the relationship between executive options and dividends is estimated after controlling for possible endogeneity issues using structural models. Third, investors' preferences between dividends and repurchases over the past history are studied controlling for various firm characteristics. Evidence suggests that while option grants makes executives more likely to pay out through repurchases, there is a concurring trend in investors' preferences. Taken together, the aligned preferences of managers and investors towards repurchases can help explain the observed low dividend protection rates.

This dissertation consists of two essays on corporate policy. The first chapter analyzes whether being labeled a "growth" firm or a "value" firm affects the firms dividend policy. I focus on the dividend policy because of its discretionary nature and the link to investor demand. To address endogeneity concerns, I use regression discontinuity design around the threshold to assign firms to each category. The results show that "value" firms have a significantly higher dividend payout - about four percentage points - than growth firms. This approach establishes a causal link between firm "growth/value" labels and dividend policy. The second chapter develops investment policy model which associated with duration of cash flow. Firms are doing their business by operating a portfolio of projects that have various duration, and the duration of the project portfolio generates different duration of cash flow stream. By assuming the duration of cash flow as a firm specific characteristic, this paper analyzes how the duration of cash flow affects firms investment decision. I develop a model of investment, external finance, and savings to characterize how firms decision is affected by the duration of cash flow. Firms maximize total value of cash flow, while they have to maintain their solvency by paying a fixed cost for the operation. I empirically confirm the positive correlation between duration of cash flow and investment with theoretical support. Financial constraint suffocates the firm when they face solvency issue, so that model with financial constraint shows that the correlation between duration of cash flow and investment is stronger than low financial constraint case.

Abstract: This dissertation examines two issues that are related to corporate payout policy. The first essay investigates the impact of financial development on dividend policy across countries, an issue that has largely been overlooked by the literature. The second essay investigates the relation between managerial entrenchment and firms' propensity to pay dividends in the U.S. Financial development has a positive influence on dividend policy because it improves a firm's access to external finance and it helps control the agency conflicts between corporate insiders and outside shareholders. Such influence reduces the firm's incentive to retain profits. Therefore, financial development should encourage higher dividend payouts and earlier dividend initiations. The first dissertation essay, presented in Chapter 2, tests this hypothesis. I find it to be true using a large sample of industrial firms across 44 countries. The results are robust to various measures of financial development. Moreover, I show that this effect is not driven by the difference in legal protection of minority shareholders across countries. In the second essay, presented in Chapter 3, I find that firms with entrenched managers, as measured by strong managerial power resulting from takeover protections, are more likely to pay dividends. Their high propensity to pay persists over time. While these results are surprising in light of the conventional wisdom, they support the view that firms choose a combination of governance provisions and dividend policy to maximize value. A large cash reserve can be used to deter hostile takeovers. Paying dividends reduces cash holdings, leaving the firm more vulnerable to hostile takeovers. In equilibrium, value-maximizing firms with weak investment opportunities protect managers against takeovers to induce them to distribute cash rather than build a warchest of cash against unwanted takeovers.

Previous literature on payout policy has focused on the effects of firm-level characteristics on firms' dividend payouts or stock repurchases. My dissertation investigates whether industry characteristics affect these payout decisions. The first chapter focuses on effects of strategic interaction between firms in product markets on a firm's dividend policy, and the second chapter examines effects of input market rigidity, particularly the strength of labor unions, on corporate payout policy. My empirical results show that these industry characteristics significantly influence firms' payout policy, and their economic impacts are non-trivial. Overall, my dissertation suggests that research in corporate payout policy should incorporate the effects of industry characteristics on firms' optimal payout decisions.

This dissertation contains 3 essays on dividend/payout policy. In the first essay, using a sample of 76,129 firm-years from 32 countries, I show that both the probability and amount of dividend payments are significantly lower in countries with poor creditor rights. These results are consistent with the hypothesis that poor creditor protection exacerbates the agency costs of debt. Poorly-protected creditors have a strong incentive to protect their investment by restricting dividend payments through formal debt covenants and multiperiod contracting. Firm managers also have an incentive to restrict dividends in order to build reputation capital, thereby reducing moral hazard problems and financing costs. The second essay examines the impact of managerial myopia on dividend catering and is based on US firms. I find strong evidence that the sensitivity of dividend changes to dividend premiums increase with managerial myopia. These findings are robust to firm-characteristics, idiosyncratic risk, taxes, time trends and potential sample selection biases. The last essay documents that increasing use of repurchases largely explains the disappearing dividends puzzle documented by Fama and French (2001). I find no evidence of consistent declining propensity to pay out cash for US firms after controlling for changing firm characteristics. By extending the Fama and French (2001) methodology, I examine the behavior of abnormal payout amount. Results show that most firms pay out 92.8% of the predicted payout amount. These findings are consistent with dividend-repurchase substitution documented by Grullon and Michaely (2002).

This dissertation is comprised of two essays on dividend policy. In the first part of the first essay, I ascertain whether the outcome, the substitution, or the predation model explains the relationship between dividend payouts and product market competition in each of the Group of Seven (G7) countries for the period from 1995 through 2010. I find that the substitution model explains dividend policy in Canada, France, Germany, the United Kingdom, and the United States, and the outcome model describes it in Japan, while in Italy, the results are inconclusive. In the second part of the same essay, I pool the sample across the G7 countries and examine whether the outcome or the substitution model explains the relationship between payouts and product market competition. Additionally, I study the impact of various country characteristics - legal origin, religion, presence of corruption, and gross national income -on the relationship between payouts and industry competition. The results show that the substitution model explains dividend policy across the G7 nations. In addition, in countries with better investor rights dividend policy is explained by the substitution model, while in countries with poor investor protections the outcome agency model explains dividend policy. Thus, this essay first tests the three theories on dividend policy, and then it addresses how dividend policy responds to changes in external environments - country characteristics - in the presence of changing levels of competition. In the second essay, I explore whether managers utilize behavioral finance such as the convenience hypothesis, the attraction hypothesis, and the left digit effect in establishing dividend policy. Specifically, I examine whether clustering and rigidity exist in dividends per share (DPS) ending in zero and five. The study is conducted using Compustat dividend-per-share data for Canada and the United States for the period from 1995 through 2010, and for France, Germany, and Italy for the period from 1999 through 2010. I find that clustering (frequency) and rigidity (duration of DPS and number of DPS changes) are prevalent in DPS ending in zero and five, as hypothesized. Moreover, clustering and rigidity in zero-ending DPS are more prevalent than in those ending in five, as predicted. Finally, clustering and rigidity are nonexistent in DPS ending in nine in all countries tested. These findings would suggest that managers are utilizing behavioral finance in establishing dividend policy.