Foreign Currency Denominated Debt and Dividend Policy

Transcription

1 Foreign Currency Denominated Debt and Dividend Policy Youngmok Choi College of Economics & Business Administration Cheongju University, Korea Kunsu Park School of Accountancy The Shidler College of Business University of Hawaii at Manoa This Draft: April 22, 2015 Preliminary version; Comments, corrections and suggestions are always welcome.

2 Foreign Currency Denominated Debt and Dividend Policy Abstract We examine whether foreign currency denominated debt affects corporate dividend policy. Specifically, this study tests the prediction that foreign currency denominated debt ratio is negatively related to the likelihood of paying dividends and the levels of dividends. Consistent with our prediction, we find that firms with a higher foreign currency debt ratio are less likely to pay dividends, and pay lower levels of dividends when they do. These findings indicate that foreign currency debt ratio is one of the important factors that affect corporate dividend policy. Our results provide evidence that foreign creditors have the potential in determining corporate dividend policy. Keywords: foreign currency denominated debt, dividend policy, agency cost JEL Classification: G15, G30, G32, G35

3 Foreign Currency Denominated Debt and Dividend Policy 1. Introduction This study examines the role of foreign creditors as one of the key stakeholders in determining corporate dividend policy. Specifically, we investigate the relationship between the foreign currency debt ratio and the likelihood of paying dividends, and its effect on the levels of dividends. To date, prior studies have documented several determinants that affect a firm s dividend policy, such as leverage, ownership structure, cash flow volatility, profitability, growth opportunities, firm size, retained earnings, stock liquidity, and dividend premium (e.g., Easterbrook, 1984; Jensen, 1986; La Porta et al., 2000; Fama and French, 2001; Baker and Wurgler, 2004; Banerjee et al., 2007; Chay and Suh, 2009). This study contributes to the previous literature by showing that the foreign currency debt ratio is an important factor that influences corporate dividend policy. Between 1997 and 1998, Korea experienced a financial crisis and opened up its stock markets to foreign investors. Since then, the level of dividend payout in Korean firms has steadily increased. As a result, the influence of foreign investors, as ownership entities, on the corporate dividend policy has attracted significant interest from both academics and practitioners. Given the extent to which prior studies investigate the role of foreign investors on corporate dividend policy, it is surprising that the role of foreign creditors on corporate dividend policy has not been explored in depth. Corporate dividend policy is closely related to a firm s financing decisions (or leverage) since it affects cash outflow from a firm. From the perspective of the capital structure in Korean firms, debt financing from foreign creditors, in addition to equity financing from foreign investors, accounts for a large percentage of firms total financing. Currently, many Korean firms use high levels of foreign currency denominated debt. As a result, foreign creditors can play a role in determining a firm s dividend policy. According to prior studies, a firm s leverage is negatively related to the levels of dividends. 1

4 Compared to firms with low leverage, highly leveraged firms have lower dividend-paying capacity due to their increased burden on debt repayment. A firm can mitigate agency problems between managers and shareholders by paying dividends (Easterbrook, 1984) or by issuing debt (Jensen, 1986; Stulz, 1990). As a firm s leverage increases, agency costs between managers and shareholders reduce due to frequent monitoring, thus lowering the demand for dividends as a way of mitigating agency costs among shareholders. This study tests the prediction that foreign currency debt ratio is negatively related to the likelihood of paying dividends and the levels of dividends. We provide the following two rationales, one based on agency costs and the other based on foreign currency risk, for the predictions. First, as firms issue foreign currency debt, they are more likely to face monitoring not only from domestic institutions and creditors, but also from foreign ones due to increased expost monitoring. Furthermore, when firms with specific debt covenants that limit their dividend payout issue foreign currency debt, ex-ante monitoring is more likely to be strengthened. As agency costs become lower due to more intense monitoring, the demand for paying dividends among shareholders as a way of mitigating agency costs would decrease. Second, firms with higher foreign currency debt ratio are more exposed to higher foreign currency risk. As a result, they are likely to become more conservative in their financial policy associated with cash outflow, such as dividend policy. When firms operating business activities overseas use foreign currency debt, they can naturally hedge their foreign currency risk. However, if firms intend to use their foreign currency debt for the purpose of speculation or lower debt financing costs, cash flow uncertainty can be increased due to foreign currency risk. As a result, firms with higher cash flow uncertainty pay dividends more conservatively. Using a sample of 4,544 Korean firm-years from 2003 to 2011, this study examines 2

5 whether foreign currency debt ratio is related to corporate dividend policy. In our analysis, we measure foreign currency debt ratio in two ways. The first is calculated as the ratio of foreign currency debt to the market value of total assets. The second is computed as the ratio of foreign currency debt to total liabilities. To test the relation between them, we use a logit model for analyzing the impact of foreign currency debt ratio on the likelihood of paying and omitting dividends. After controlling for other determinants of corporate dividend policy, such as leverage, foreign ownership and majority shareholder's ownership, we find that firms with higher foreign currency debt ratio are less likely to pay dividends. We also find a significantly positive association between foreign currency debt ratio and the likelihood of omitting dividends. Next, using the Tobit model, we investigate the relation between foreign currency debt ratio and the levels of dividends. We use cash dividend to sales ratio as a proxy for the levels of dividends. We find that firms with higher foreign currency debt ratio tend to have lower levels of dividends. To consider stock repurchases, we repeat our analysis using the ratio of total payout [=the sum of cash dividends and stock repurchases] to total sales, as an alternative dependent variable. We obtain consistent results in the analysis, supporting support our central hypothesis. As sensitivity analyses, we also consider whether our results are robust on several estimation methods and alternative measures for levels of dividends. Consistent with previous results, we find that foreign currency debt ratio is negatively related to the levels of dividends. Furthermore, as an additional robustness check, we examine the effect of foreign currency debt on agency costs. We find that foreign currency debt ratio is negatively related to agency costs. It implies that firms with a higher foreign currency debt ratio face more frequent ex-post monitoring from stakeholders, e.g., foreign creditors, thus mitigating agency costs. The findings support monitoring effects of foreign currency debt on corporate dividend policy. Overall, our findings 3

6 support our main hypothesis that firms with a higher foreign currency debt ratio are less likely to pay dividends, and pay lower levels of dividends when they do. Our study contributes to the literature on corporate dividend policy and capital structure. To date, a number of studies have shown determinants of corporate dividend policy, but they did not consider foreign currency debt ratio as one of the potential factors that affect dividend policy. To our knowledge, this is the first study to investigate the relationship between foreign currency debt ratio and corporate dividend policy. Before 2003, Korean firms paid dividends less than par value and, as a result, investors became more interested in capital gains. However, the Korean government revamped the Enforcement Decree of the Securities and Exchange Act to mandate that public firms disclose their dividend-to-market value ratios. Since then, firms increase the levels of dividends, causing investors to become increasingly interested in dividend income as well as capital gains. Thus, our study also provides meaningful implications for a firm s decision makers and stakeholders by showing the role of foreign creditors in determining corporate dividend policy. As shown in prior studies, firms with higher foreign ownership are more likely to pay dividends and have higher levels of dividends. Our findings, however, show that firms with a higher foreign currency debt ratio are less likely to pay dividends and have lower levels of dividends, after controlling for foreign ownership. Therefore, our study provides a new perspective on the link between foreign currency debt and corporate dividend policy. The remainder of this paper is organized as follows: Section 2 summarizes the previously known determinants of dividend policy and develops a hypothesis, Section 3 describes details of the sample and defines relevant variables, Section 4 presents the results of the study, and finally Section 5 concludes the paper by summarizing main results. 4

7 2. Determinants of Corporate Dividend Policy and Hypothesis Development What determines a firms payout policy? To date, theoretical and empirical studies in corporate finance have greatly expanded the understanding of when, whether, and why firms pay dividends (Fama and French, 2001; DeAngelo, DeAngelo, and Skinner, 2004; DeAngelo, DeAngelo, and Stulz, 2006). In this section, we review prior literature on the determinants of corporate dividend policy and then provide our rationales on why corporate foreign currency debt can be one of potential candidate in determining a firm s dividend policy. 2.1 Determinants of Corporate Dividend Policy Agency Problems and Corporate Ownership Structure One of the perfect market assumptions of Miller and Modigliani (1961) is that there are no conflicts of interest between managers and shareholders. However, under a firm s separation of ownership and control, managers have incentive to seek their own interests or to use excessive perquisites, thereby resulting in agency problems among managers, shareholders, and debtholders (Jensen and Meckling, 1976; Grossman and Hart, 1980; Jensen, 1986). A number of studies (e.g., Rozeff, 1982; Easterbrook, 1984; Jensen, 1986; Jensen et al., 1992; Holder et al., 1998) have discussed agency problems in the context of corporate ownership structure. For example, Easterbrook (1984) argues that firms can reduce agency costs which arise from the conflicts of interest between managers and shareholders by paying dividends. Similarly, Shleifer and Vishny (1986) and Allen et al. (2000) both emphasize the importance of monitoring by external stakeholders. In particular, Shleifer and Vishny (1986) claim that, as external majority shareholders, institutional investors with higher ownership can mitigate the conflicts of interest between managers and shareholders by directly monitoring managerial actions. On the other hand, majority shareholders with high ownership have incentive to maximize a firm s value rather than to exploit its resources for their own purpose and benefit. In this situation, a firm with 5

8 higher proportion of majority shareholders is more likely to pay dividends since the conflicts of interest between majority and minority shareholders are lower. Agency Problems and Free Cash Flow Jensen (1986) argues that firms can use dividend policy to reduce their free cash flow. He defines free cash flows as remaining cash after a firm invests in all projects that have positive net present values (NPV). He points out that when free cash is available within a firm, a manager may accept the investment plans for which return on investment (ROI) is less than the required cost of capital, thereby resulting in agency problems. He suggests that when a firm lowers cash flows available at the manger s discretion by increasing its dividend payouts, the agency costs between a manager and shareholders due to overinvestment problems can be mitigated. Thus, it is expected that the free cash flow is positively related to the level of dividends since a firm has great incentive to pay dividends due to its high free cash flows available. On the other hand, a firm with high profitability has high cash flows generated from its operation in the current period, thereby being more likely to pay dividends. According to the life-cycle theory of dividends, a large (established), mature firm with high profitability tends to pay dividends (e.g., Fama and French, 2001; Grullon, Michaely, and Swaminathan, 2002; DeAngelo, DeAngelo, and Stulz, 2006). In line with the prediction by the dividend life-cycle theory, the residual theory of dividends (e.g., Miller and Modigliani, 1961) predicts that a firm pays out residual cash flows as dividends to shareholders. The residual cash flow is referred to the cash left over after a firm invests in all projects with positive NPV. According to the residual theory of dividends, a firm with higher profitability is more likely to pay dividends due to its high retained earnings. Uncertainty in Cash Flow Based on survey results by Lintner (1956) and Brav, Graham, Harvey, and Michaely (2005), Chay 6

9 and Suh (2009) propose a cash-flow uncertainty hypothesis that a firm with higher cash-flow uncertainty is likely to be lower payout ratios. Using a sample of 26 countries from 1994 to 2005, they show that stock return volatility, as a proxy for cash flow uncertainty, is one of the main determinants that affect corporate dividend policy. A Firm's Financial Life-Cycle Stage The life-cycle theory of dividends (e.g. Mueller, 1972; Fama and French, 2001; Grullon et al., 2002; DeAngelo et al., 2006) predicts that while a firm in the early stages of its life cycle with high investment opportunities tend to pay lower or less dividends, a firm in the mature stage with less investment opportunities is likely to pay more dividends. According to the life-cycle theory of dividends, a firm in the mature stage has more accumulated earnings and profits from retained earnings generated by business operations than from its paid-in capital. As a result, it is likely to increase the likelihood of a firm s paying dividends and the level of dividend. On the other hand, a firm in the early stage has a relatively smaller proportion of retained earnings from business operations relative to its paid-in capital. Thus, such a firm is likely to have less likelihood of a firm s paying dividends and to lower level of dividends. Furthermore, a firm with high growth opportunities has a less likelihood of paying dividends and lower levels of dividends since such a firm prefers to use internal reserve (or internal financing) that is less costly in order to make investments. In contrast, a firm with less growth opportunities maintains a smaller portion of internal reserve and is likely to pay more dividends since such firm has less capital that are needed to investments among earnings generated from business operations. The life-cycle theory of dividends predicts that firm size is positively related to the level of dividends. In generally, a large firm is in the mature stage and such firm generates many free cash flows relative to small firm. Likewise, external financing for a large firm is less costly. Therefore, it is expected that a large firm have a greater level of dividends since such firm can manage its financing more flexibly 7

10 due to its higher earnings or profits and lower financing costs. Stock Liquidity Miller and Modigliani (1961) claim that corporate dividend policy is irrelevant to firm value since, under the perfect market, investors can create homemade dividends through their stock trading. However, in the real business world, there exist financial market frictions such as transaction costs. Investors who hold stocks with less liquidity are likely to pay more transaction costs and, as a result, they may prefer cash flows through dividends to through stock trading. Thus, if investors preference affects corporate dividend policy, a firm with lower liquidity may be likely to pay higher levels of dividends (Banerjee et al., 2007). Catering Incentives The catering theory of dividends that are proposed by Baker and Wurgler (2004), suggests that firms determine their dividend policy on the basis of demand for dividends. That is, when the values of dividend-paying firms are highly evaluated compared to those of non-dividend paying dividends in capital markets, it is considered indicative of higher demand for dividends. Then, firms will adjust their dividend policy in reaction to the investors demand. Baker and Wurgler (2004) calculate a dividend premium by subtracting market-to-book ratio of a non-dividend paying firm from market-to-book ratio of a dividendpaying firm. They find that while a firm with a higher dividend premium is likely to initiate paying its dividends, a firm with a less dividend premium tends to omit its dividends. 2.2 Hypothesis Development We can explain the relationship between leverage and dividend policy from the perspective of a firm's financial risk management. For a firm with high leverage, its variation in net income after taxes is greater than its operating income due to fixed financing costs. The principal repayment capacity of firms with high leverage is likely to significantly decrease if external shocks, such as an economic slump or recession, occur. Furthermore, debt covenants that restrict the levels of dividend payments will be imposed 8

11 on these firms. Relative to less leveraged firms, debt repayment burdens for higher leveraged firms will increase, thus lowering their dividend paying capacity. As a result, managers in higher leveraged firms are more conservative in decision-making associated with cash outflow, e.g., decisions concerning whether to pay dividends. For example, Bates et al. (2009) show that firms with uncertain cash flows tend to reduce their dividend payments and, instead, are more inclined to prepare for future cash flow shocks by holding more cash. Thus, we expect that leverage is negatively related to the level of dividends. The relation between foreign currency debt ratio and dividend policy can be explained using a logic similar to the one that connects leverage to dividend policy. To manage risk associated with debt repayment, firms with higher foreign currency debt ratio are more likely to control cash outflow by using conservative dividend policy. As shown in Kedia and Mozumdar (2003), firms use foreign currency debt to hedge their foreign exchange exposures. A natural hedge occurs when firms with foreign operations use foreign currency debt. Many Korean firms, however, use foreign currency debt even though they have few foreign operations or are more domestic market-oriented. We consider these firms to use their foreign currency debt for the purposes of speculation or inexpensive debt financing. As a firm uses its foreign currency debt for a speculative motive, it is more likely to be exposed to foreign exchange risk, thereby increasing the need for risk management. While firms enjoy the benefits of debt financing costs through the use of foreign currency debt, their debt repayment risk will increase due to fluctuating foreign exchange rates and changing in foreign interest rates. If we assume that variations in values of foreign currency denominated assets are constant, repayment burdens of foreign currency debt will be smaller, as foreign exchange rates fall (i.e., appreciation of domestic currency). In contrast, repayment burdens will be higher as the rates rise (i.e., depreciation of domestic currency). In these situations, firms can hedge their foreign exchange risk by using asset-liability matching, foreign 9

12 exchange risk insurance, and derivatives. However, firms with higher foreign currency debt ratio cannot perfectly hedge such risk, thereby increasing the need for control of cash outflows. Thus, we expect levels of dividends in firms with higher foreign currency debt ratio to be lower. On the other hand, agency theory can also explain the effect of leverage on corporate dividend policy. Under the perfect capital market, the conflicts of interest between managers and shareholders do not exist (Miller and Modigliani, 1961). However, in a real business where ownership and control are separated, managers may pursue their private interests and overinvest in projects with low profits or negative net present values (NPVs), thus leading to conflicts of interest with shareholders. As a result, shareholders bear costs related to the monitoring of managerial actions, which refer to agency costs that arise from the conflicts of interests. Easterbrook (1984) argues that firms can mitigate agency costs by paying dividends. He hypothesizes that as firms increase dividend payouts, they raise new capital from external capital markets. In this situation, firms are more likely to face frequent monitoring from banks, credit rating agencies, and financial analysts. Consequently, shareholders can monitor managerial actions at the least cost. This means that the larger the dividend payouts, the more frequent the monitoring of managers actions, thus preventing managers from seeking their private interests. Jensen (1986) claims that a firm can lessen agency costs by reducing free cash flows through its dividend policy. He mentions that a manager has an incentive to adopt projects with a cost of capital less than the return on investment (ROI), thereby causing agency problems. In this situation, agency problems due to overinvestment can be addressed by removing free cash flows available at a manager s discretion through an increase in dividends. Firms that use debt can mitigate agency problems between managers and shareholders through some channels. First, when firms that use debt financing make regular interest payments to creditors, their available free cash flow is reduced, thus mitigating agency costs (Jensen, 1986; Stulz, 1990). Second, firms 10

13 are likely to be closely monitored by creditors, such as banks, when they use debt. As a result, managers face increasing pressure to invest in profitable projects (Ang et al., 2000). Third, as firms increase their debt, the likelihood of bankruptcy is higher. The possibility of bankruptcy prevents managers seeking excessive perquisites and potentially threatens managerial reputation and careers, which consequently enables them to efficiently manage their firms (William, 1987). Furthermore, debt covenants imposed on firms that use debt can help mitigate agency costs between managers and shareholders. When a firm that uses debt makes a decision against the interests of creditors, they are likely to be compensated on additional risk by increasing lending rates. On the other hand, a firm will bear higher debt financing costs than before, thus causing agency costs of debt. In particular, (negative) debt covenants usually restrict dividend payments to shareholders in order to protect bondholders from wealth transfer to shareholders. For example, DeAngelo and DeAngelo (1990) show that the level of dividends in a highly leveraged firm tends to decrease due to its debt covenants that restrict dividends and stock repurchases. Therefore, if agency costs between managers and shareholders can be reduced through dividend payments or use of debt, it is expected that leverage is negatively related to the levels of dividends. The rationale for the relation is as follows: As firms use debt, agency costs are mitigated due to monitoring effects, indicating more alignment of interests between managers and shareholders. As a result, it may lead to a decreased demand for dividends among shareholders since they have less incentive to mitigate agency costs. In a similar way, we can apply the logical connection to the relation between foreign currency debt ratio and dividend policy. As a firm s foreign currency debt ratio increases, agency costs between managers and shareholders would decrease due to more frequent ex-ante and ex-post monitoring, thus decreasing the demand for paying dividends among shareholders. In Korea, it has been recognized that domestic financial institutions do not effectively monitor borrowing firms. Thus, as firms use more foreign currency debt, the 11

14 role of foreign institutions and creditors in monitoring borrowing firms becomes more important. If foreign institutions and creditors act as effective monitors, their ex-post monitoring on borrowing firms are more strengthened than before. In the framework of agency costs, as ex-post monitoring on firms using foreign currency debt from stakeholders (e.g., foreign creditors) strengthens, agency costs is lower than before. As a result, the demand for paying dividends as a mechanism to mitigate agency costs among shareholders will decrease. Likewise, as firms use foreign currency debt, ex-ante monitoring on them also increase. The Korean bond markets are relatively underdeveloped compared to the other countries, such as the U.S., U.K. and Japan. Thus, restrictive covenants in bond issuance contracts are used in limited levels. The Korea Financial Investment Association (KOFIA) has set four types of restrictive covenants that are applied to a contract agreement for non-guaranteed bonds: (1) maintenance of proper financial ratios; (2) restrictions on asset disposal; (3) restrictions on collaterals and guaranties; and (4) restrictions on use of financing. Thus, if firms use foreign currency debt with specified debt covenants, such as restrictions on dividend payment, in compliance with international conventions, its ex-ante monitoring will be much stronger. Based on the above explanations, we hypothesize as follows: H1: Firms with a higher foreign currency debt ratio are less likely to pay their dividends, and pay lower levels of dividends when they do. 3. Data and Variable Definition 3.1. Data and Sample Selection We obtain annual financial data from the KIS-Value Database provided by Korea Investors Service (KIS) from 2003 to We use a sample of non-financial firms listed on the Korea Exchange (KRX). We also restrict the sample to firms with fiscal year end in December in order to ensure compatibility across 12

15 firms. 1 We remove firms with impaired capital, qualified audit opinions, or are engaged in mergers and acquisitions (M&A) to obtain more reliable estimated coefficients. Lastly, we winsorize all continuous variables at the 1 percent and 99 percent levels to reduce the effect of extreme observations. The final balanced sample is composed of 4,544 firm-year observations and represents 585 firms for the period of Dependent Variables This study uses logit and Tobit regressions to examine whether a firm s use of foreign currency debt affects the likelihood of paying dividends (or of omitting dividends) and the level of dividends. In the logit models, we consider a firm paying dividend as well as omitting dividends to reflect a firm s decision on whether to pay dividends. Specifically, we assign an indicator variable (Cash_Dividend) to one if a firm pays its dividends, and zero otherwise. We also set the value of an indicator variable (Dividend_Omission) to one if a firm that paid cash dividends in the prior year does not pay cash dividends in the current year, and zero otherwise. Furthermore, it is known that firms use stock repurchases as a substitute for cash dividends. We consider the possibility of effect of the foreign currency debt on cash outflows, such as stock repurchases. To do this, we also use total payout and total payout omission. We set an indicator variable (Total_Payout) that equals to one if a firm pays cash dividends or repurchases stocks.. Likewise, we consider an indicator variable (Total_Payout_Omission) that equals to one if a firm that paid dividends or repurchased stocks in the prior year does not pay dividends or repurchases stocks in the current year, and zero otherwise. Next, for the Tobit models, we use two proxies for the level of dividends as a dependent variable. First, following La Porta et al. (2000), Brockman and Unlu (2009), and Chay and Suh 1 Most of Korean firms have their fiscal year ending in December, so sample selection problem is not a serious concern for our sample. 13

16 (2009), we use the ratio of cash dividends on common stocks to net sales ( dividends-to-sales ratio ; Dividend_Sales), as a proxy for the level of dividends. Second, we use the ratio total payouts (=the sum of cash dividends and stock repurchases) to net sales (Dividend_Stock_Sales). The reasons we don t use cash dividends on common stocks to net income ( dividends payout ratio ) and cash dividends per share price ( dividend yield ), as proxies for dividend level, in our main analysis are as follows. For the cash dividends on common stock to net income, there is a potential problem associated with net income since it can be easily modified or change in different accounting methods. Next, in the case of negative net income (also called as net loss), dividends to net income ratio is meaningless. Thus, if one deletes firm-years with negative net income from the sample, sample size is much smaller. Furthermore, if net income is extremely small, dividends to net income ratio has abnormal values, e.g., the ratio is greater than one. As a result, the estimated coefficients can be distorted. For the cash dividends per share price, if the change in stock price is greater or is lower, the estimated coefficients may be distorted. In contrast, a firm s sales are independent of accounting methods and of managerial discretion Explanatory and Control Variables We use foreign currency debt ratio as a main explanatory variable. We measure a firm s foreign currency debt ratio in two ways. We calculate the first proxy as the ratio of foreign currency debt to the market value of total assets (Foreign_Debt_Mva). The market value of total assets is measured as the sum of total liabilities and market value of equity. Higher foreign currency debt ratio can indicate increased debt repayment burdens for borrowing firms and lower likelihood of collecting bond payments for foreign creditors. The reason we don t use foreigncurrency denominated assets in measuring foreign currency debt ratio is that firms can use their entire assets as well as foreign-currency denominated assets to repay their foreign currency debt. 14

17 Next, we calculate the second proxy as the ratio of foreign currency debt to total liabilities (Foreign_Debt_Liabilities). We use this measure to reflect that the influences of foreign creditors are greater in firms with a higher proportion of foreign currency debt to total liabilities. Based on previous studies (e.g., Smith and Watts, 1992; Faccio et al., 2001; Fama and French, 2001; Baker and Wurgler, 2004; Von Eije and Megginson, 2008, Brockman and Unlu, 2009), we control for leverage (Leverage), foreign ownership (Foreign_Ownership), controlling shareholder s ownership (Control_Ownership), free cash flow ratio (Free_Cashflow), return on assets (Return_Asset), stock return volatility (Stock_Vol), retained earnings ratio (Retained_Earnings), market-tobook ratio (MTB), sales growth rate (Sales_Growth), research and development (R&D) intensity (R&D_Intensity), firm size (Firm_Size), stock trading turnover ratio (Stock_Turnover), dividend premium (Dividend_Premium), and industry and year dummy variables. We measure leverage as the ratio of total non-current liabilities to market value of total assets. For variables for ownership structure, foreign ownership is calculated as the ratio of the sum of common stock owned by foreign investors to total shares outstanding. The controlling shareholder s ownership is measured as the sum of common stock owned by controlling shareholders, divided by total shares outstanding. The free cash flow ratio is calculated as the ratio of the operating income before depreciation minus capital expenditures to net sales. We measure return on asset as the ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to total assets. Following Chay and Suh (2009), we use stock return volatility as a proxy for uncertain cash flow, calculated as the standard deviation of a firm s daily stock returns over the current fiscal year. As in DeAngelo et al. (2006), we use retained earnings ratio as a proxy for a firm's financial life-cycle, measured as the ratio of retained earnings to total equity. As proxies for a firm s growth opportunities, we use marketto-book ratio, sales growth rate, and R&D intensity. The market-to-book ratio is calculated as the ratio of the sum of the market value of equity and the book value of total liabilities to book value of total assets. The 15

18 sales growth rate is the calculated as the change in net sales from the previous year, divided by the lagged sales. We calculate R&D intensity as the ratio of R&D expenditures to net sales. We measure firm size using the logarithm of the market value of total assets. The market value of total assets is the sum of the book value of total liabilities and the market value of common equity. We use stock trading turnover ratio as a proxy for stock liquidity, calculated as the ratio of the total value of shares traded for the fiscal year divided by average annual market capitalization. As a proxy for catering incentives, we use dividend premium. Following Baker and Wurgler (2004), we calculate the dividend premium as the difference in the logarithm of average market-to-book ratios between dividend-paying and non-dividend-paying firms. 4. Empirical Results 4.1. Descriptive Statistics and Correlation Coefficients Table 1 presents descriptive statistics for our sample and the correlation coefficients among variables used in our analysis. Panel A in the table shows historical trend in foreigncurrency denominated debt from 2003 to The amounts of foreign currency debt have increased nearly tripled from about 39 trillion KRW in 2003 to about 110 trillion KRW in This trend shows that, for our sample firms, the use of foreign currency debt have dramatically increased for the period. The percentage of number of sample firms that use foreign currency debt, on annual average, is approximately 75%, indicating that most of sample firms use foreign currency debt. Although our sample include firms that are export-oriented, run foreign operations, and domestic-market oriented, the high proportion of number of sample firms using foreign currency debt means that most of firms use it for their purpose of hedging and for cheaper financing costs as well as for speculative motive. It implies that foreign creditors, as a firm s stakeholders, can affect corporate financial policies, such as dividend policy. 2 The amounts of foreign currency debt are expressed in Korean Won (KRW), the currency of South Korea. 16

19 Panel B in Table 1 shows descriptive statistics of full sample. While the mean (median) values of Cash_Dividend and Total_Payout are about 73% and 77%, respectively, the mean (median) value of Dividend_Omission and Total_Payout_Omission are about 5.5% and 6.7%, respectively. It indicates that most of sample firms pay dividends. The mean (median) values of Dividend_Sales and Dividend_Stock_Sales are 1.4% (0.6%) and 1.8% (0.8%), respectively. The mean (median) values of Dividend_Sales in our sample firms are similar to those reported in Brockman and Unlu (2009) even though our sample period is different from theirs. 3 The mean (median) value of Foreign_Debt_Mva is 7.0% (2.4%) and its 95th percentile is about 31.4%. Furthermore, the mean (median) value of Foreign_Debt_Liabilities is 13.7% (5.6%) and its 95th percentile is approximately 55.4%. It shows that our sample firms have a high foreign currency debt ratio, implying that foreign creditors or institutions can play an influential role in a firm s determination of dividend policy. In addition, control variables used in the analysis are evenly distributed between top and bottom of the 5%, centered at the mean. It indicates that there is no possibility of sample selection bias. For example, a variable, firm size, calculated by the market value of total assets corresponding to 5th and 95th percentile are about 37.2 billion KRW (= e /100,000,000) and about 8,926.1 billion KRW (= e /100,000,000). Panel C in Table 1 presents the Pearson correlation coefficients among main variables used in our study. We find negative and significant (p<0.01) correlation between Cash_Dividend and Foreign_Debt_Mva. Likewise, the correlation between Dividend_Sales and Foreign_Debt_Mva is negative and significant (p<0.01).the correlation coefficients between Cash_Dividend and Dividend_Sales, and Leverage is negative and significant (p<0.01), respectively. On the other hand, we find positive and significant (p<0.01) correlations between 3 Using a sample of 52 countries during the period, Brockman and Unlu (2009) show that countries with poor credit rights have less likelihood of paying dividends. In their study, they report that the mean and median values of dividends-to-sales ratio are 1.2% and 0.5%, respectively. 17

20 Dividend_Omission and Foreign_Debt_Mva. Furthermore, the correlation between Dividend_Omission and Leverage is positive and significant (p<0.01). These results show that firms with high leverage or foreign currency debt ratio are more likely to pay dividends, and pay lower levels of dividends, which supports our main hypothesis. [Please insert Table 1 here] Figure 1 graphically shows the relationship between Dividend_Sales and Foreign_Debt_Mva. While Foreign_Debt_Mva had decreased from 8.57% in 2003 to 6.03% in 2007, Dividend_Sales had increased from 1.11% to 1.48% for the same period. In 2008, while Foreign_Debt_Mva increased up to 9.03%, Dividend_Sales went down 1.24%. Until 2011, Foreign_Debt_Mva decreased to 6.45% and Dividend_Sales went up to 1.68%. [Please insert Figure 1 here] 4.2. Portfolio Analysis Table 2 shows the results of analyzing relationship between Foreign_Debt_Mva (Foreign_Debt_Liabilities) and Dividend_Sales through portfolio analysis. To do this, we categorize firms into five groups by Foreign_Ownership, Leverage, and Control_Ownership, respectively, and then partition for each group by Foreign_Debt_Mva and Foreign_Debt_Liabilities, respectively. In other words, 25 portfolios are formed on foreign currency debt ratio and each variable, such as foreign ownership, leverage, and controlling shareholder s ownership. In Panel A, High-Low indicates the differences in Dividend_Sales between the highest and the lowest Foreign_Debt_Mva (Foreign_Debt_Liabilities) within each group by Foreign_Ownership. As shown in Panel A, all values for High-Low are negative and significant. These results suggest that Foreign_Debt_Mva (Foreign_Debt_Liabilities) is negatively related to Dividend_Sales, after controlling for Foreign_Ownership that is known to 18

21 be positively associated with Dividend_Sales. Panel B shows the result of relation between Foreign_Debt_Mva (Foreign_Debt_Liabilities) and Dividend_Sales, after controlling for Leverage. As indicated in Panel B, all values for High-Low for each group by Leverage are negative and significant. Lastly, Panel C shows that there is a negative and significant relation between Foreign_Debt_Mva (Foreign_Debt_Liabilities) and Dividend_Sales, after controlling for Control_Ownership. Overall, Table 2 provides evidence that supports our main hypothesis. [Please insert Table 2 here] 4.3. Foreign Currency Debt Ratio and Likelihood of Paying Dividends In this section, we examine the relationship between foreign currency debt ratio and the likelihood of paying dividends. To do this, we use logit models, after controlling for previously identified determinants affecting corporate dividend policy. We specify the logistic regression model as follows: Prob (Payout i,t = 1) = F(β 0 + β 1 Foreign_Debt i,t + β 2 Leverage i,t + β 3 Foreign_Ownership i,t + β 4 Control_Ownership i,t + β 5 Free_Cashflow i,t + β 6 Return_Asset i,t + β 7 Stock_Vol i,t + β 8 MTB i,t + β 9 R&D_Intensity i,t + β 10 Sales_Growth i,t + β 11 Firm_Size i,t + β 12 Retained_Earnings i,t + β 13 Stock_Turnover i,t + β 14 Dividend_Premium i,t ), (1) where Payout presents two indictor variables, Cash_Dividend and Total_Payout. Our main variable of interest is the foreign currency debt ratio (Foreign_Debt). Foreign_Debt indicates two variables, Foreign_Debt_Mva and Foreign_Debt_Liabilities. For the definitions of the variables, please refer to Appendix A. We winsorize all the continuous variables at the 1% and 99% levels to reduce the impact of extreme observations in the regression models. For the 19

22 analysis, we include industry and year dummies. We also use White s (1980) robust-standard errors to compute test statistics for the statistical significance of regression coefficients. Table 3 shows results of logistic regressions. In Columns (1) and (2), we use an indicator variable, Cash_Dividend, as a dependent variable. Column (1) shows that the coefficient on Foreign_Debt_Mva is negative and significant (p<0.01). More specifically, the coefficient is , which indicates that the likelihood of paying dividends decreases with foreign currency debt ratio. Similarly, in Column (2), we find a negative and significant (p<0.01) coefficient on Foreign_Debt_Liabilities. Overall, these findings support our main hypothesis that firms with a higher foreign currency debt ratio are less likely to pay dividends. In Columns (3) and (4), we repeat our analysis using an indicator variable, Total_Payout, as a dependent variable. In the analysis, we consider a firm s payout policy, including stock repurchases. Column (3) shows that the coefficient on Foreign_Debt_Mva is negative and significant (p<0.05), supporting our main hypothesis. On the other hand, in Column (4), the coefficient on Foreign_Debt_Liabilities is negative but insignificant. Furthermore, in all regression models, we find that the estimated sign of each control variable is mostly consistent with findings from previous studies. Specifically, the coefficient on Leverage is negative and significant in all columns. Columns (1) and (2) show that while the coefficient on Foreign_Ownership is positive but insignificant, the coefficient on Control_Ownership is positive and significant. Columns (3) and (4) demonstrate that the coefficients on both Foreign_Ownership and Control_Ownership are positive and significant. While the coefficient on Free_Cashflow is negative but insignificant in Columns (1) and (2), its coefficient is negatively significant in Columns (3) and (4). Next, we find consistent signs of other variables in all models. Specifically, the coefficient on Return_Asset is positive and significant. We find a negative and significant coefficient on Stock_Vol. While the coefficients on MTB and R&D_Intensity are 20

23 negative and significant, the coefficient on Sales_Growth is positive and significant. As expected, we find that the coefficients on Firm_Size and Retained_Earnings are positive and significant. The Stock_Turnover is negative, but insignificant. Lastly, unlike our expectation, the coefficient on Dividend_Premium is negative and significant. [Please insert Table 3 here] 4.4. Foreign Currency Debt Ratio and Likelihood of Omitting Dividends In this section, we examine the relationship between foreign currency debt ratio and the likelihood of omitting dividends. As in previous section, we use logit models, after controlling for previously identified determinants of corporate dividend policy. The logistic regression model is as follows: Prob (Omission i,t = 1) = F(β 0 + β 1 Foreign_Debt i,t + β 2 Leverage i,t + β 3 Foreign_Ownership i,t + β 4 Control_Ownership i,t + β 5 Free_Cashflow i,t + β 6 Return_Asset i,t + β 7 Stock_Vol i,t + β 8 MTB i,t + β 9 R&D_Intensity i,t + β 10 Sales_Growth i,t + β 11 Firm_Size i,t + β 12 Retained_Earnings i,t + β 13 Stock_Turnover i,t + β 14 Dividend_Premium i,t ), (2) where Omission indicates two indictor variables, Dividend_Omission and Total_Payout_Omission. Foreign_Debt presents two variables, Foreign_Debt_Mva and Foreign_Debt_Liabilities. Please see Appendix A for the variable definitions. We winsorize all the continuous variables at the 1% and 99% levels to mitigate the impact of extreme observations. For the analysis, we include industry and year dummies. We also use White s (1980) robuststandard errors. 21

24 Table 4 shows the results from the regressions. In support of our central hypothesis, it is expected to be positive and significant relationships between Dividend_Omission and Foreign_Debt_Mva (Foreign_Debt_Liabilities). As expected, we find that the coefficients on Foreign_Debt_Mva in all models are positive and significant (p<0.05). These results indicate that firms with a higher foreign currency debt ratio are more likely to omit dividends. The relations between Dividend_Omission and Foreign_Debt_Liabilities are positive and but insignificant in all models. Furthermore, we find that the coefficient on Leverage is negative and significant in all Columns. While the coefficient on Foreign_Ownership is negative and significant, the coefficient on Control_Ownership is insignificant. Among other control variables, we find negative and significant coefficients on Return_Asset and Sales_Growth. These results indicate that a firm with high return on assets or sales growth rates is less likely to omit its dividends. In contrast, we find that the coefficients on Firm_Size and Retained_Earnings are positive and significant, suggesting that a firm with a larger size or a higher retained earnings ratio is more likely to omit its dividends. [Please insert Table 4 here] 4.5. Foreign Currency Debt Ratio and Levels of Dividends So far, we examine the effect of foreign currency debt ratio on the likelihood of paying or omitting dividends. In this section, we investigate the relationship between foreign currency debt ratio and the levels of dividends. To do this, we use both Dividend_Sales and Dividend_Stock_Sales, as proxies for the levels of dividends. Each dependent variable, Dividend_Sales and Dividend_Stock_Sales, has a number of observations at zero, i.e., the variable is censored at zero. Thus, some of the desirable properties of the ordinary least squares (OLS) estimators may not longer hold, e.g., inconsistent estimates of the parameters, (Kennedy, 2003). To address these problems, we follow Brockman and Unlu (2009) and use a Tobit regression model, also called 22

25 a censored normal regression model, on censored data including many zeros. The Tobit regression model is given by Payout_Sales i,t = β 0 + β 1 Foreign_Debt i,t + β 2 Leverage i,t + β 3 Foreign_Ownership i,t + β 4 Control_Ownership i,t + β 5 Free_Cashflow i,t + β 6 Return_Asset i,t + β 7 Stock_Vol i,t + β 8 MTB i,t + β 9 R&D_Intensity i,t + β 10 Sales_Growth i,t + β 11 Firm_Size i,t + β 12 Retained_Earnings i,t + β 13 Stock_Turnover i,t + β 14 Dividend_Premium i,t + Σ i,t Industry_Dummy + Σ i,t Year_Dummy + ɛ i,t. (3) where Payout_Sales presents two dependent variables, Dividend_Sales and Dividend_Stock_Sales. As in previous sections, Foreign_Debt indicates two explanatory variables, Foreign_Debt_Mva and Foreign_Debt_Liabilities. For the definitions of the variables, please refer to Appendix A. For an empirical analysis, we winsorize all continuous variables at the 1% and 99% levels to mitigate the impact to extreme firm-years. We include industry and year dummies. We also use White s (1980) robust-standard errors to calculate test statistics for the statistical significance of regression coefficients. Table 5 presents the results of the Tobit regressions. The results reported in all regression models show that coefficients on Foreign_Debt_Mva and Foreign_Debt_Liabilities are negative and significant (p<0.01). The results are consistent with those in Table 3. These findings support our main hypothesis that firms with a higher foreign currency debt ratio pay lower levels of dividends. These findings are consistent with those in Table 3. Furthermore, we find consistent sign of coefficients on each control variables, except for MTB and Stock_Turnover, in all regression models. Specifically, the coefficient on Leverage is negative and significant. Next, we 23

26 find positive and significant coefficients on Foreign_Ownership and Control_Ownership. While the coefficients on Free_Cashflow and Return_Asset are positive and significant, the coefficient on Stock_Vol is negative and significant. We find that the coefficients on MTB and R&D_Intensity are negatively significant in Columns (1) and (2), but insignificant in Columns (3) and (4). The Sales_Growth is negative and significant. Furthermore, the coefficients on Firm_Size and Retained_Earnings are positive and significant. Lastly, we find insignificant coefficients on Stock_Turnover and Dividend_Premium. Overall, Table 5 suggests that, in addition to domestic creditors (or institutions), foreign investors and controlling shareholders, foreign creditors are important entities that can affect corporate dividend policy. [Please insert Table 5 here] 4.6. Additional Robustness Tests Sensitivity Analysis to Estimation Methods In this section, we perform a sensitivity analysis to check whether our empirical results are robust on estimation methods. To do this, we use pooled OLS with cluster-robust standard errors at the firm level (Petersen, 2009), fixed effects panel regression models, and the Heckman (1979) two-stage procedure. We report coefficients on coefficients on main variables, Leverage, Foreign_Ownership and Control_Ownership for brevity. Panel A in Table 6 shows the results from the pooled OLS regressions using firm-year clustered standard errors. As in previous analyzes, we use Dividend_Sales and Dividend_Stock_Sales, respectively, as a dependent variable. As shown in Panel A, we obtain results, consistent with findings from the previous analysis. In support of our central hypothesis, we find that the coefficients on Foreign_Debt_Mva and Foreign_Debt_Liabilities are negative and significant in all models (p<0.01). Next, the coefficient on Leverage is negative and significant (p<0.01) in all models. Lastly, we find that while the coefficient on Foreign_Ownership is positive and significant 24