Dividend Policy and Dividend Payment Behavior: Theory and Evidence Cheng-Few Lee Rutgers University

Announcement for Handbook of Financial Econometrics and Statistics The purpose of this handbook is to publish original papers that apply either econometrics or statistics methods in important topics of empirical finance research. Chapters that update or expand upon well-known empirical papers are also acceptable. In this handbook, each paper should have appendices of 5 to 15 pages to demonstrate how empirical research has been executed. The tentative outline of this handbook is as follows: Part I. Introduction In this introduction, we will discuss overall application of econometrics and statistics in finance accounting research.

Part II. Overview of Financial Econometrics and Statistics A. Financial Econometrics B. Financial Statistics Part III. Financial Econometrics A. Asset Pricing Research B. Corporate Finance Research C. Financial Institution Research D. Investment and Portfolio Research E. Option Pricing Research F. Future and Hedging Research G. New Financial Products Research H. Mutual Fund Research I. Financial Accounting Research

Part IV. Financial Statistics A. Asset Pricing Research B. Investment and Portfolio Research C. Credit Risk Management Research D. Market Risk Research E. Operation Risk Research F. Option Pricing Research G. Mutual Fund Research H. Value at Risk Research   We expect to include approximately 100 chapters in this handbook, which will published online and in three print volumes by Springer in 2012. Anybody who wishes to contribute a chapter to this handbook please send a proposal to Professor Cheng-Few Lee at the email: lee@business.rutgers.edu

Flow Chart of Dividend Policy and Dividend Behavior Dividend Relevance Theory without Tax Effect Dividend Relevance Theory with Tax Effect Dividend Irrelevance Theory Time-Series Cross-Sectional CAPM Approach Non-CAPM Approach Dividend Behavior Signaling Hypothesis Free Cash Flow Hypothesis Flexibility Hypothesis Life-Cycle Theory Partial Adjustment Process Information Content or Adaptive Expectations Myopic Dividend Policy Residual Dividend Policy

Empirical Analyses in Dividend Policy Research Descriptive Data Analysis Regression Analysis Time Series Cross-Sectional Time Series Cross-Sectional Panel Data Analysis Probit / Logit Fama-MacBeth Procedure Seemly Uncorrelated Regression (SUR) Fixed Effect Model

Dividend Policy and Dividend Payment Behavior A. Theory Dividend irrelevance (M&M, 1961) and corner solution (DeAngelo and DeAngelo, 2006) Dividend relevance (Gordon, 1962; and Lintner, 1964) - A bird in hand theory (Bhatacharya, 1979) - Signaling theory (John & Williams, 1985; Miller & Rock, 1985; and Lee et al., 1993) - Free cash flow theory (Eastbrook,1984; Jensen, 1986; and Lang and Lizenberger,1989) - Financial flexibility theory (Jagannathan et al. 2000, DeAngelo and DeAngelo, 2006; Blau and Fuller, 2008) - Life-cycle theory (DeAngelo et al., 2006)

Dividend Policy and Dividend Payment Behavior B. Dividend Behavior Models Partial Adjustment Model (Lintner, 1956 AER) (ii) Mixed Partial Adjustment and Adapted Expectation (Fama & Babiak, 1968 JASA) (iii) Generalized Dividend Forecasting Model (Lee et al., 1987, Journal of Econometrics)

Dividend Policy and Dividend Payment Behavior C. Cross-Section Relationship between Stock Prices, Dividends, and Retained Earnings Friend and Puckett (1964 AER) have proposed the relationship between stock prices, dividends, and retained earnings as follows: where Based upon Eq. (1) and discount cash flow model in terms of optimal forecasting, Granger (1975 JF) has shown that B and C can be written in terms of discount rate, , and of Eq. (1). Therefore, it can be concluded that Eq. (3) is a theoretical derived model instead of an ad-hoc model.

Dividend Policy and Dividend Payment Behavior D. Integration of Dividend Policy and CAPM (Litzenberger and Ramaswamy 1982 JF)

Summary of Our Research We propose a dynamic framework and show the existence of an optimal payout ratio under a perfect market. The relationship between firm’s optimal payout ratio and its growth rate is negative in general. The relationship between firm’s optimal payout ratio and its risks. - depends on its growth rate relative to its ROA - separate the considerations of free cash flow problem and flexibility 4. We develop a fully dynamic model for determining the time optimal growth and dividend policy under stochastic conditions. - A convergence process in the optimal growth rate. 5. Empirical evidence on the optimal payout ratio. (Supports our model)

Outline Introduction The Model for Optimal Dividend Policy Comparative Static Analysis of Dividend Payout Policy 3.1 Case I: Total Risk 3.2 Case II: Systematic Risk 3.3 Total Risk and Systematic Risk 3.4 No Change in Risk 3.5 Relationship between the Optimal Payout Ratio and the Growth Rate 4. Joint Optimization of Growth Rate and Payout Ratio 4.1 Optimal Growth Rate v.s. Time Horizon 4.2 Optimal Growth Rate v.s. Degree of Market Perfection 4.3 Optimal Growth Rate v.s. ROE 4.4 Optimal Growth Rate v.s. Initial Growth Rate 4.5 Optimal Dividend Policy v.s. Optimal Growth Rate

Outline 5. Dividend Behavior Model 5.1 Partial Adjustment Model (Lintner, 1956 AER) 5.2 Mixed Partial Adjustment and Adapted Expectation (Fama & Babiak, 1968 JASA) 5.3 Generalized Dividend Forecasting Model (Lee et al., 1987, Journal of Econometrics) 6. Empirical Evidence 6.1 Sample Description 6.2 Multivariate Analysis 6.3 Fama-MacBeth Analysis 6.4 Fixed Effect Analysis 7. Summary and Concluding Remarks 7.1 Limitations of cross-sectional approach to investigate dividend policy 7.2 We need to use dividend behavior model to supplement cross-sectional approach to obtain more meaningful conclusion for decision making.

Introduction Dividend Policy Miller and Modigliani (1961) - Firm Value is independent of dividend policy. - Assumptions of M&M theory no tax. no capital market frictions (i.e., no transaction cost, asset trade restriction, or bankruptcy cost) firms and investors can borrow or lend at the same rate. firm financial policy reveals no information. only consider no payout and payout all cash flow. DeAngelo and DeAngelo (2006) > M&M (1961) irrelevance result is “irrelevant” because it only considers payout policies that pay out all free cash flow. > Payout policy matters when partial payouts are allowed.

Introduction Signaling Hypothesis - The signaling hypothesis suggests managers with better information than the market will signal this private information using dividends. - A company announcements of an increase in dividend payouts act as an indicator of the firm possessing strong future prospects. [Bhatacharya (1979), John and Williams (1985), Miller and Rock (1985), and Nissam and Ziv (2001)] Free Cash Flow Hypothesis (Agency Cost) - Dividend payment can reduce potential agency problem. [Eastbrook (1984), Jensen (1986), Lang and Lizenberger(1989), Lie (2000), and Grullon et al. (2002)] Financial Flexibility - Management trades off two aspects of Dividends. One is financial flexibility by not paying dividends. Another is deterioration on stock price if not paying dividends. [Blau and Fuller (2008)] 15 15

Introduction Based on the DeAngelo & DeAngelo (2006) static analysis, we derive a theoratical dynamic model and show that there exists an optimal payout ratio under perfect market. We derive the relationship between firm’s optimal payout ratio and its risks. We derive the relationship between firm’s optimal payout ratio and its growth. We further develop a fully dynamic model for determining the time optimal growth and dividend policy under the imperfect market, the uncertainty of the investment, and the dynamic growth rate. We study the effects of the time-varying horizons, the degree of market perfection, and stochastic initial conditions in determining an optimal growth and dividend policy for the firm. When the stochastic growth rate is introduced, the expected return may suffer a model specification. Empirical evidence of the determination of the optimal payout policy.

The Model for Optimal Dividend Policy Let represent the initial assets of the firm and represent the growth rate. Then, the earnings of this firm are given by Eq. (1), which is The retained earnings of the firm, , can be expressed as where is the number of shares outstanding, and is dividend per share at time t.

The Model for Optimal Dividend Policy The new equity raised by the firm at time t can be defined as where = degree of market perfection, 0 <  1. Therefore, the investment in period t can be written as: Rearranging Eq.(4), we can get

The Model for Optimal Dividend Policy The stock price should equal the present value of this certainty equivalent dividend stream discounted at the cost of capital (k) of the firm. Eq.(14) can be formulated a differential Equation: where

Optimal Dividend Policy Optimal Payout Ratio when :

Relationship between the Optimal Payout Ratio and the Growth Rate - The sign is not only affected by the growth rate (h), but is also affected by the expected rate of return on assets ( ), the duration of future dividend payments (T-t), and the cost of capital (k). - Sensitivity analysis shows that the relationship between the optimal payout ratio and the growth rate is generally negative. =>a firm with a higher rate of return on assets tends to payout less when its growth opportunities increase.

Relationship between the Optimal Payout Ratio and the Growth Rate When , there is a negative relationship between the optimal payout ratio and the growth rate. =>when a firm with a high growth rate or a low rate of return on assets faces a growth opportunity, it will decrease its dividend payout to generate more cash to meet such a new investment.

Implications Hypothesis 1: firms generally reduce their dividend payouts when their growth rates increase. The negative relationship between the payout ratio and the growth ratio in our theoretical model implies that high growth firms need to reduce the payout ratio and retain more earnings to build up “precautionary reserves,” while low growth firms are likely to be more mature and already build up their reserves for flexibility concerns. [Rozeff (1982), Fama and French (2001), Blau and Fuller (2008), etc.]

Optimal Payout Ratio vs. Total Risk High growth firms : negative relationship between optimal payout ratio and total risk. Low growth firms : positive relationship between optimal payout ratio and total risk

Optimal Payout Ratio vs. Systematic Risk High growth firms : negative relationship between optimal payout ratio and systematic risk. Low growth firms : positive relationship between optimal payout ratio and systematic risk

Implications Hypothesis 2: the relationship between the firms’ dividend payouts and their risks is negative when their growth rates are higher than their rates of return on asset. - Flexibility Hypothesis High growth firms need to reduce the payout ratio and retain more earnings to build up “precautionary reserves.”  These reserves become more important for a firm with volatile earnings over time. => For flexibility concerns, high growth firms tend to retain more earnings when they face higher risk.

Implications Hypothesis 3: the relationship between the firms’ dividend payouts and their risks is positive when their growth rates are lower than their rates of return on asset. - Free Cash Flow Hypothesis 1. Low growth firms are likely to be more mature and most likely already built such reserves over time. 2. They probably do not need more earnings to maintain their low growth perspective and can afford to increase the payout [see Grullon et al. (2002)]. 3. The higher risk may involve higher cost of capital and make free cash flow problem worse for low growth firms. => For free cash flow concerns, low growth firms tend to pay more dividends when they face higher risk

Optimal Payout Ratio vs. Total Risk and Systematic Risk where Relative effect on the optimal dividend payout ratio

Optimal Payout Ratio when No Change in Risk When there is no change in risk, the optimal payout ratio is identical to the optimal payout ratio of Wallingford (1972).

Joint Optimization of Growth Rate and Payout Ratio The new investment at time t is where Retained Earnings New Equity New Debt

Joint Optimization of Growth Rate and Payout Ratio The model defined in the equation (3) is for the convenience purpose. If we want the company’s leverage ratio unchanged after the expansion of assets then we need to modify equation (3) as we can obtain the growth rate as which is the generalized version of Higgins’ (1977) sustainable growth rate model. Our model shows that Higgins’ (1997) sustainable growth rate is under-estimated due to the omission of the source of the growth related to new equity issue which is the second term of our model. Our Model Higgins’ sustainable g

Joint Optimization of Growth Rate and Payout Ratio Discount cash flow The price per share can be expressed as PV of future dividends with a risk adjustment. => maximize p(o) by jointly determine g(t) and n(t). Future Dividends Risk Adj.

Optimal Growth Rate Logistic Equation – Verhulst (1845) => a convergence process

Case I: Optimal Growth Rate v.s. Time Horizon

Case I: Optimal Growth Rate v.s. Time Horizon Convergence Process - Firms with different initial growth rates all tend to converge to their target rates (ROE).

Case II: Optimal Growth Rate v.s. Degree of Market Perfection

Case II: Optimal Growth Rate v.s. Degree of Market Perfection

Case III: Optimal Growth Rate v.s. ROE When initial growth rate is lower than the target rate (ROE), eq. (22) is positive. => If the target rate (ROE) is higher, the adjustment process will be faster.

Case IV: Optimal Growth Rate v.s. Initial Growth Rate Eq. (23) is always positive. => The higher initial growth rate is, the higher optimal growth rate at each time.

Optimal Dividend Payout Ratio where Assuming , - Wallingford (1972), Lee et al. (2010)

Optimal Dividend Payout Ratio v.s. Growth Rate The relationship between optimal dividend payout and growth rate is negative in general cases.

Sample Stock price, stock returns, share codes, and exchange codes are CRPS. Firm information, such as total asset, sales, net income, and dividends payout , etc., is collected from COMPUSTAT. The sample period is from 1969 to 2008. Only common stocks (SHRCD = 10, 11) and firms listed in NYSE, AMEX, or NASDAQ (EXCE = 1, 2, 3, 31, 32, 33) are included. Utility firms and financial institutions (SICCD = 4900-4999, 6000- 6999) are excluded. For the purpose of estimating their betas to obtain systematic risks, firm years in our sample should have at least 60 consecutively previous monthly returns. 44 44

Summary Statistics of Sample Firm Characteristics 45 45

Summary Statistics of Sample Firm Characteristics 46

Multivariate Regression – Fama MacBeth Model 47

Multivariate Regression (with Growth Dummy) 48

Multivariate Regression – Fixed Effect Model 49 49

Conclusion We derive an optimal payout ratio using an exponential utility function to derive the stochastic dynamic dividend policy model. - Different from M&M model, our model considers 1) partial payout; 2)uncertainty (risks); 3) stochastic earnings. A negative relationship between the optimal dividend payout ratio and the growth rate. The relationship between firm’s optimal payout ratio and its risks depends on its growth rate relative to its ROA. - high growth firms pay dividends due to the consideration of flexibility and low growth firms pay dividends due to the consideration of free cash flow problem.

Conclusion We derive a dynamic model of optimal growth rate and payout ratio which allows a firm to finance its new assets by retained earnings, new debt, and new equity. The optimal growth rate follows a convergence processes, and the target rate is firm’s expected ROE.

Potential Future Research Time-series v.s. cross-sectional research Relationship among discount cash flow, dividend partial adjustment model, and price multiplier model Tax effect on dividend policy in terms of CAPM with dividend Effect Limitations of cross-sectional approach to investigate dividend policy We need to use dividend behavior model to supplement cross-sectional approach to obtain more meaningful conclusion for decision making. The impacts of Integrated Tax System enacted in Taiwan on Dec 26, 1997 can be explored.