Are dividend changes a Sign of Firm Maturity? (HAFIZ TURAB SAEED 01-321192-047) Summary Change in dividend policy conveys news about future cash flows. Dividend increases conveys good News while Dividend Decreases it is a bad sign. Key implications of these models were, change in Dividend must be followed by changes in profitability. Firms that increases dividend experience significant growth in earning growth rate (for short term). Price reaction to increase or decrease suggest that investor interpret these changes as positive or negative news either about future profitability or something else i.e. discount rates. If good news about dividend changes is not about future cash flows, then it may be about systematic risk. Goal of this study is relate changes in dividend to life cycle of firm. Main idea is when firms become more mature, they pay more Dividend (reduce plowback rates) because of diminishing investment opportunities. Sample was 7642 dividend changes announced between 1967 and 1993. Findings have strong implications for existing theories about dividend policy and evidence is inconsistent with traditional cash flow signaling models which states that there is positive association between dividend changes and subsequent change in earnings. This study does not completely negate all previous theories but validates some of them for example it provides some support for free cash flow hypothesis. Study suggests that increase in dividend convey information about changes in firm’s life cycle. When firm enters from high growth stage to low growth stage then payout of dividend increases. This manifests that rate of reinvestment is declining that results into declining return in investment and growth rates and ultimately declining systematic risk. Declining reinvestment rate gives rise to excess cash which should be ultimately paid out. This is idea about firm growing from different phases of life cycle (growth stage →maturity stage) and this is called maturity hypothesis. Another finding is about risk changes in risk are associated with price of that security and when price changes risk also changes. Study suggests that in long run price change is positively associated with profitability and negatively associated with future changes in risk. When price increases due to increases in profitability then risk will decrease. Results from study completely reject the implications of cash flow signaling models. Profits of firms do not increase after dividend increases but they decrease. And for dividend decreasing firms show tendency to recover and their profits increase in long run. For dividend increasing firms systematic risk declines and that results in decrease in their cost of capital. This study supports theory of dividend smoothing as dividend payout ratio of dividendincreasing firms increase permanently. But this theory doesn’t discuss systematic risk or impact of dividend change on price. Study also supports free cash flow hypothesis like decline in ROA, cash levels, and stable or declining capital expenditure is persistent with free cash flow models. Finally study proposes an alternative explanation of findings. Authors refer to this finding as maturity hypothesis. According to this explanation firms in mature phase doesn’t have NPV projects and they just payout dividend to get rid of access cash and that leads to decline in systematic risk of these firms. And that is causing decrease in cost of capital of firm. Typically, in growth phase a firm has many NPV positive projects available it earns large economic profits. As firm continues to grow competitors enters in market cannibalize the firm’s market share and reduce the economic profits. As investment opportunities decline need for resources for investment should also decline. And as firm doesn’t have any positive NPV projects then cost of capital must also decline causing decline in systematic Risk On interesting finding from this study is profits of dividend increasing firms decrease and profits of dividend decreasing firms decrease in long run negating dividend signaling model. What Do We Know about Capital Structure? Some Evidence from International Data (Maheen Ahmed Group) 4 Factors 1. Tangibility The rationale underlying this factor is that tangible assets are easy to collateralize and thus they reduce the agency costs of debt. Berger and Udell (1994) show that firms with close relationships with creditors need to provide less collateral. They argue this is because the relationship substitutes for physical collateral. If so, we should find tangibility mattering less in the bank-oriented countries. it is interesting to note that deviation increase in tangibility increases book leverage by about 20 percent of its deviation in all countries except Japan where it increases leverage by 45 percent (we check that the coefficient estimate is not influenced by outliers). A possible explanation comes from the market leverage regressions where the importance of Tangibility in Japan is not very different from its importance in other countries. Perhaps Japanese firms with fixed assets such as land could borrow more because the collateral value of the land is appreciated (and the appreciation was not reflected in the book value). So on a market basis, firms with a lot of fixed assets are not highly levered. But it is still not clear that if tangibility is only as important in Japan as elsewhere for the apparently stronger bank-firm relationships in Japan should imply a lesser role for tangibility. 2. Market-to-Book The theory predicts that firms with high market-to-book ratios have higher costs of financial distress which is why we expect a negative correlation. There may be other potential reasons for why the market-to-book ratio is negatively correlated with leverage. The shares may be discounted at a higher rate because distress risk is priced. If this is the explanation, the negative correlation should be driven largely by firms with low market-to-book ratios. But the negative correlation appears to be driven by firms with high market-to-book ratios. It is unlikely that financial distress is responsible for the observed correlation. The market-to-book ratio to be negatively correlated with book leverage stems from the tendency for firms to issue stock when their stock price is high relative to earnings or book value. This would imply that the correlation between the market-to-book ratio and leverage is driven by firms who issue lots of equity. The evidence is puzzling. If the market-to- book ratio proxies for the underinvestment costs associated with high leverage, then firms with high market-to-book ratios should have low debt, independent of whether they raise equity internally via retained earnings, or externally. An alternative explanation suggested by the above evidence is that firms attempt to time the market by issuing equity when their price (and hence, their market-to-book ratio) is perceived to be high. Thus, these firms have temporarily low leverage. Evaluating the importance of each explanation is a task for future research. 3. Size Size may be an alternate for the probability of default. If so, it should not be strongly positively related with leverage in countries where costs of financial distress are low. Some Economists have suggested that Japanese firms tied to a main bank may face a lower cost of financial distress because the main bank organizes corporate rescues. Yet size is important in Japan; a standard deviation increase in size increases standard deviation of book leverage by 33 percent. This suggests that size does not simply an alternate for a low probability of default. Another argument against the association of size with low expected costs of financial distress is that firms tend to be liquidated more easily in Germany. Under the assumption that liquidation is very costly, small firms should be especially wary of debt in Germany. However, large firms have substantially less debt than small firms in Germany. An alternative argument for size is that informational asymmetries between insiders in a firm and the capital markets are lower for large firms. So large firms should be more capable of issuing informationally sensitive securities like equity and should have lower debt. Unfortunately, this neither squares with the negative correlation between size and leverage observed for most countries, nor is it true that large firms issue more. In all four countries for which we have flow of funds data, net equity issuances by firms in the largest size quartile is significantly less over the period 1986-1991 (as a fraction of the market value of assets in 1985) than for firms in the smallest size quartile. We have to conclude that we do not really understand why size is correlated with leverage. 4 Profitability Finally, profitability is negatively correlated with leverage. If in the short run, investments are fixed, and if debt financing is the dominant mode of external financing, then changes in profitability will be negatively correlated with changes in leverage. As we have just noted, large firms tend to issue less equity. The negative influence of profitability on leverage should become stronger as firm size increases. This is indeed the case for firms in the United States. The relationship across quintiles is nearly monotonic; the negative effect of earnings on leverage Is considerably more important for large firms. Of course, as already discussed, we do not quite understand why large firms are reluctant to issue equity. Furthermore, there may be other forces at work, and we cannot at present disentangle them. For instance, profitability for small firms may proxy for both the amount of internally generated funds and the quality of investment opportunities, which have opposing effects on the demand for external funds (debt). Looking at other countries, the leverage of larger firms is considerably more negatively correlated with profitability than for small firms in Japan, Italy, and Canada, while in the United Kingdom it is more positively correlated. There is no relationship in Germany and France. One explanation for why the United Kingdom differs so much from the United States may be that the dominant source of external finance in the United Kingdom is equity. So, firms that are profitable and have few investment opportunities (i.e., large firms) will reduce equity issues drastically. These firms will have a more positive correlation between leverage and profitability. By contrast, if profitability is also correlated with the investment opportunities small firms have, then an increase in profitability may lead to greater equity issuances, reducing the correlation between profitability and leverage. Why do firms repurchase stock? Motives for Stock Repurchases There are several reasons a firm may repurchase stock. It is therefore important to consider all motives when investigating why firms repurchase stock. In the following section, I discuss each of the motives examined in this paper. 1.1. Excess Capital Hypothesis: Repurchases and Distribution policy When a firm’s capital exceeds its investment opportunities, the firm can either retain the excess cash or distribute it to shareholders. Repurchasing stock, like paying dividends, is one method to distribute excess capital to shareholders. A repurchase may be preferred to dividends for two reasons. First, in open market repurchases, the firm does not have a commitment to repurchase. Additionally, unlike a dividend, there is no expectation that the distribution will recur on a regular basis. Thus, a repurchase is a more flexible means of distributing capital since a penalty is incurred if dividends are subsequently reduced. Firms may therefore choose to repurchase to distribute excess capital. We expect firms with high levels of excess cash or cash flow to repurchase stock. Stock repurchases may also be preferred over dividends as a means of distribution due to the personal tax rate advantage of capital gains. This tax advantage of stock repurchases exists because capital gains are often taxed at a lower rate than dividend income, only the portion of the repurchase that is a capital gain is taxed, and investors can defer the capital gains tax until they realize the gain and sell their stock. If repurchases and dividends are substitutes, then stock repurchases should be negatively related to a firm’s dividend payout ratio. 1.2 Undervaluation Hypothesis: Repurchases and Investment policy Stock repurchases offer flexibility not only in the choice to distribute excess funds but also when to distribute these funds. This flexibility in timing is beneficial because firms can wait to repurchase until the stock price is undervalued. The undervaluation hypothesis is based on the premise that information asymmetry between insiders and shareholders may cause a firm to be mis-valued. If insiders believe that the stock is undervalued, the firm may repurchase stock as a signal to the market or to invest in its own stock and acquire mispriced shares. According to this hypothesis, the market interprets the action as an indication that the stock is undervalued. The positive stock price reaction at the announcement of a stock repurchase program should correct the mis-valuation. It is shown that this increase may not be sufficient to correct the price since repurchasing firms, particularly low market to book firms, earn a positive abnormal return during the four years subsequent to the announcement. The amount of information available and the accuracy of the valuation of firms by the market can affect firms repurchase decisions. 1.3 Optimal Leverage Ratio Hypothesis: Repurchases and Capital Structure policy In section 1.1, I explain how repurchases can be used to distribute excess funds to shareholders. When the firm distributes this capital, it reduces its equity and increases its leverage ratio. Assuming that an optimal leverage ratio exists, firms may use a stock repurchase to achieve this target ratio. A firm is therefore more likely to repurchase stock if its leverage ratio is below its target leverage ratio. Thus, a firm’s capital structure will affect its decision to repurchase. 1.4 Management Incentive Hypothesis: Repurchases and Compensation policy By absorbing equity, a stock repurchase not only alters the firms’ leverage ratio, but it also allows the manager of the firm to distribute cash without diluting the per share value of the stock. Preserving the stock price may be of particular interest when management holds stock options. Thus, stock options encourage managers to substitute repurchases for dividends since repurchases do not dilute the per share value of the firm and the shares provided to managers when they exercise options are often from treasury stock. A firm that compensates its executives with a large number of stock options may find it beneficial to repurchase stock. 1.5 Takeover deterrence hypothesis: Repurchases and corporate control Each of the previously discussed hypotheses relate the decision to repurchase to an internal company decision that impacts the firm and its investors. However, repurchases may also impact the relationship between the firm and outside parties. In the presence of an upward sloping supply curve for shares, a potential target can increase the cost of an acquisition by repurchasing stock. Stock repurchases increase the acquisition price because shareholders selling in a stock repurchase are those with the lowest reservation values. Thus, a repurchase can be used as a takeover defense because a repurchase can increase the lowest price for which the stock is available. According to this hypothesis, firms that are at a higher risk of becoming takeover targets are more likely to repurchase stock. Each of these hypotheses explains one reason why firms repurchase stock.
