1. 0 How corporate governance affects dividend policy under both agency problems and external financing constraints? Joon Chae, Sungmin Kim and Eunjung Lee December 11, 2008

2. 1 1 Motivation Two typical problems under information asymmetry Agency problems under information asymmetry between managers and shareholders External financing constraints under information asymmetry between insiders and outside investors Paying dividends generate two counteracting effects Decreased free cash flow → decrease managerial agency problems (Easterbrook (1984), Jensen (1986), Myers (1998), Gomes (1998), and Zwiebel (1996)) Increased dependence on external financing → increase cost of external financing (Rozeff(1982)) Firms face a tradeoff between ‘lower agency costs’ and ‘higher external financing costs’ with increased cash dividends → We provide empirical evidence on the effect of corporate governance on dividend policy where both agency problems and external financing constraints

3. 2 2 Existing literature Large literature on the direct relationship between agency problems and dividend payments (La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) (LLSV (2000)), Jiraporn-Ning(2006), Knyazeva(2008)) They focus on the direct relation between agency problems and dividend payments, and show that better corporate governance will induce more dividends (Outcome Hypothesis) However, they do not consider external financing constraints → This is the first empirical paper that analyzes the relation between corporate governance and dividends where both agency costs and external financing costs

4. 3 3 Hypotheses [Hypothesis 1] Without external financing constraints, firms with better corporate governance will pay more dividends when they have free cash flows. Companies with agency problems need to minimize free cash flow Strong corporate governance induces higher dividend level

5. 4 44 Hypotheses [Hypothesis 2] With both agency problems and external financing constraints, firms with better corporate governance may pay less dividends even though they have free cash flows. The relative sizes of external financing and agency costs will decide dividend payouts As long as corporate governance can control agency problems, companies with strong corporate governance will pay less dividends

6. 5 55 Hypotheses Firms with Free Cash Flows Agency Costs Corporate Governance Firms with Efficient Corp. Governance External Financing Constraints Payout Policy W/O Ext. Fin. Constraints With Ext. Fin. Constraints More Payouts Less Payouts

7. 6 6 The data from IRRC Governance data from Gompers, Ishii, and Metrick(2003) and Bebchcuk, Cohen, and Ferrell(2005) Date years - 1993, 1995, 1998, 2000, 2002, and 2004 We exclude financial firms and utility firms firms that do not have data on the governance index Sample selection and Data

8. 7 7 Two measures to represent corporate governance Gompers, Ishii, and Metrick (2003) corporate governance index Bebchuk, Cohen, and Ferrell(2005) corporate governance index Two measures of free cash flow as a proxy for agency costs (Chi-Lee(1995), Lehn and Poulsen(1989), Wu(2004)) [Operating income - {(total income taxes-the change in deferred taxes from the previous year to the current year) +gross interest expenses on debt +dividend payments}] / book value of assets (Earnings before interests, taxes, depreciation, and amortization) / book value of assets Three measures of information asymmetry as a proxy for the level of external financing constraints (Leary and Roberts(2007), Krasker(1986)) Analyst coverage Firm age Firm size Variables

9. 8 8 Regressions with Newey and West(1987) standard errors and fixed effect analysis Dependent variables dividend ratios Independent variables CGI : corporate governance index CGI*DFCF : DFCF is a dummy variable with the value of 1 if firm’s agency cost variable exceeds the sample median CGI*DFCF*EXD : EXD is a dummy variable with the value of 1 if firm’s external financing constraint exceeds sample mean Other control variables such as Leverage, Firm size, Profitability and Growth Methodology

10. 9 9 Table 1. Sample distribution by year Sample distribution YEARNPERCENT 199356712.79 199563014.21 199873016.46 200072416.33 200281718.43 200496621.79 TOTAL4,434100

11. 10 The effect of corporate governance on dividend payments under agency problem and external financing constraint Hypothesis 1 supported → Firms with agency problems will pay more dividends as corporate governance improves Hypothesis 2 supported → Firms with agency problems and external financing constraints will pay smaller dividends as corporate governance improves Parameter DIV/SALES (1) (2) DIV/EQUITY (3) (4) DIV/EARNINGS (5) (6) DIV/ASSETS (7) (8) CGI*DFCF 0.1780***0.0677***0.5917***0.08080.88970.03850.182***0.055*** (9.26)(3.37)(5.17)(0.64)(1.27)(0.04)(11.55)(3.43) CGI*DFCF* EXD - 0.1225*** - 0.0593*** -0.3356**0.0040 - 1.95*** -1.1486*-0.07***0.0026 (-5.96)(-2.92)(-2.32)(0.03)(-3.23)(-1.76)(-3.93)(0.14) CGI - 0.0821*** - 0.0543*** - 0.4082*** - 0.1685*** - 2.21*** -1.69***-0.11***-0.07*** (-4.43)(-2.83)(-7.14)(-2.79)(-3.67)(-2.69)(-6.93)(-4.49) Control variables Included INDUSTRY & YEAR DUMMY YES ADJ RSQ0.05700.10930.02740.09660.01410.01610.07950.1650 Panel A. EXD : Analyst coverage

12. 11 The effect of corporate governance on dividend payments under agency problems and external financing constraints Parameter DIV/SALES (1) (2) DIV/EQUITY (3) (4) DIV/EARNINGS (5) (6) DIV/ASSETS (7) (8) CGI*DFCF 0.1421***0.0639***0.5445***0.1930**-0.0515-0.7920 0.1736** * 0.0892** * (7.83)(3.36)(6.11)(2.00)(-0.08)(-1.16)(10.75)(5.71) CGI*DFCF*EX D - 0.0601*** - 0.0581*** - 0.2541*** -0.1890**-0.31190.1758 - 0.0594** * - 0.0547** * (-2.94)(-2.79)(-2.65)(-1.96)(-0.48)(0.27)(-3.31)(-3.13) CGI - 0.0842*** - 0.0488*** - 0.4021*** - 0.1519*** - 2.3283* ** - 1.7041** * - 0.1081** * - 0.0689** * (-4.39)(-2.54)(-7.29)(-2.57)(-3.65)(-2.66)(-6.49)(-4.16) Control variables Included INDUSTRY & YEAR DUMMY YES ADJ RSQ0.05700.10930.02740.09660.01410.01610.07950.1650 Panel B. EXD : Firm age

13. 12 The effect of corporate governance on dividend payments under agency problems and external financing constraints Parameter DIV/SALES (1) (2) DIV/EQUITY (3) (4) DIV/EARNINGS (5) (6) DIV/ASSETS (7) (8) CGI*DFCF 0.2377***0.1452***0.6621***-0.00432.0540*0.4495 0.1900** * 0.0592** * (8.42)(5.08)(5.75)(-0.03)(1.85)(0.36)(9.03)(2.82) CGI*DFCF* EXD - 0.1514*** - 0.1296*** -0.3060**0.0987 - 2.6592* * -1.2836 - 0.0587** * -0.0020 (-5.40)(-4.50)(-2.36)(0.68)(-2.49)(-1.11)(-2.62)(-0.09) CGI - 0.0820*** - 0.0560*** - 0.4152*** - 0.1670*** - 2.1928* ** - 1.7087** * - 0.1120** * - 0.0738** * (-4.33)(-2.88)(-7.49)(-2.75)(-3.53)(-2.72)(-6.89)(-4.49) Control variables Included INDUSTRY & YEAR DUMMY YES ADJ RSQ0.05700.10930.02740.09660.01410.01610.07950.1650 Panel C. EXD : Firm size

14. 13 The effect of corporate governance on dividend payments (firm fixed effects) Parameter DIV/SALES EXD1 EXD2 DIV/EQUITY EXD1 EXD2 DIV/EARNINGS EXD1 EXD2 DIV/ASSETS EXD1 EXD2 CGI*DFCF 0.0499***0.0483***0.04840.1445**0.1466-0.6711 0.0433** * 0.0718** * (3.20)(3.35)(0.48)(1.98)(0.20)(-1.33)(3.35)(5.92) CGI*DFCF* EXD - 0.0453*** - 0.0461*** 0.0125-0.1538** - 1.0228* 0.31620.0059 - 0.0431** * (-2.83)(-2.87)(0.11)(-2.12)(-1.74)(0.57)(0.40)(-3.11) CGI - 0.0491*** -0.0438** - 0.1530*** -0.1354** - 1.8029* ** - 1.8396** * - 0.0678** * - 0.0628** * (-2.66)(-2.36)(-2.60)(-2.37)(-2.95)(-2.90)(-4.16)(-3.83) Control variables Included INDUSTRY DUMMY YES ADJ RSQ0.05700.10930.02740.09660.01410.01610.07950.1650

15. 14 This paper investigates how dividend policies change according to corporate governance under external financing constraints and agency problems When agency problems are more severe, firms pay more dividends with more efficient corporate governance When external financing constraints matter, companies decrease dividends as their corporate governance improves The paper shows firms optimize their payout policy by considering both agency costs and external financing costs Corporate governance can be a mechanism to control agency problems. Conclusion

16. 15 Thank you!