THE FIRM LIFE-CYCLE HYPOTHESIS AND DIVIDEND POLICY: TESTS ON PROPENSITY TO PAY, DIVIDEND INITIATION, AND DIVIDEND GROWTH RATES

Transcription

1 THE FIRM LIFE-CYCLE HYPOTHESIS AND DIVIDEND POLICY: TESTS ON PROPENSITY TO PAY, DIVIDEND INITIATION, AND DIVIDEND GROWTH RATES A dissertation submitted to: Kent State University Graduate School of Management in partial fulfillment of the requirements for the degree of Doctor of Philosophy by Richard P. Hauser July, 2012

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3 Dissertation written by Richard P. Hauser B.S., Purdue University, 1989 M.B.A., California Coast University, 2006 Ph.D., Kent State University, 2012 Approved by Dr. John Thornton Dr. Jayaram X. Muthuswamy Chair, Doctoral Dissertation Committee Members, Doctoral Dissertation Committee Dr. Eric Johnson Accepted by Dr. Murali Shankar Dr. Frederick W. Schroath Doctoral Director, Graduate School of Management Associate Dean, Graduate School of Management ii

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5 Table of Contents Page CHAPTER 1. 1 INTRODUCTION Overview Hypotheses Summary of Empirical Findings Contribution CHAPTER REVIEW OF THE LITERATURE Dividend Policy Irrelevance Dividend Clienteles Optimal Dividend Policy Dividend Policy and Taxes Information Asymmetry and Dividend Signaling Dividend Policy and Agency Costs Behavioral Models of Dividend Policy Summary of Dividend Policy Theories Propensity to Pay and Disappearing Dividends Corporate Governance and Disappearing Dividends Firm Maturity or Life-Cycle Hypothesis Dividend Initiation Macroeconomics and Dividend Policy Dividend Policy and Firm Value Dividend Growth Dividend Policy and Complexity CHAPTER MODELS Dividend Growth Model Sustainable Growth A Statistical Model for the Dividend Growth Rate 42 CHAPTER DATA AND METHODOLOGY Propensity to Pay 44 iv

6 4.1.1 Data Sample Control Variables Other Control Variables Maturity Hypothesis Variables Industry Dummy Variables Year Dummy Variables Dependent Variable Fama and MacBeth Logit Model Panel Logit Model Dividend Initiation Data Sample and Variables Logit Models Hazard Model of Dividend Initiation Valuation Regressions on M/B Dividend Payout Policy Dividend Growth Logits Dividend Cut Logits Regressions on Dividend Payout Ratio Regressions on Dividend Yield Regressions on Dividend Growth Rate. 60 CHAPTER EMPIRICAL RESULTS Descriptive Statistics Overall Sample and Time Series Maturity Variables Valuation Parameters Dividend Policy Economic Sector Analysis Maturity and the Propensity to Pay Dividends Probability of paying dividends-fama and MacBeth method Probability of paying dividends-panel logistic method Implications of the Life-cycle Models Outlier Analysis Over-zealous payers and disappearing dividends Panel Logistic Regression with Year Effects Maturity and Life-cycle Valuation M/B Regressions as a Function of Maturity Factor M/B Regressions in Maturity Factor Ranges M/B Regressions in Maturity Composite Ranges Life-cycle and Firm Value Dividend Payout Policy and Firm Value Maturity and Dividend Initiation Time Series of Dividend Initiators 100 v

7 5.4.2 Probability of initiating a dividend- Fama and MacBeth method Probability of initiating a dividend- panel logistic method Dividend initiation and the life-cycle Dividend initiation and year effects Survival analysis of dividend initiation Maturity and Dividend Payout Policy Probability of dividend growth Probability of a dividend cut Maturity and dividend payout ratio Maturity and dividend yield Dividend growth rates Maturity and the dividend growth rate Estimating the dividend growth rate. 137 CHAPTER CONCLUSIONS, LIMITATIONS, FUTURE RESEARCH Summary and Conclusions Maturity and the propensity to pay a dividend Maturity and firm value Maturity and dividend initiation Maturity and dividend policy Hypotheses findings Limitations Future Research Appendix A: Listing and Detailed Explanation of Variables Used REFERENCES. 160 vi

8 LIST OF TABLES Table Page Table 1 Summary Statistics for the Sample, Table 2 Summary Statistics for Dividend Payers and Non-payers Table 3 Summary Statistics for Dividend Payers by Maturity Factor Decile Table 4 Summary Statistics for Non-payers by Maturity Factor Decile Table 5 Valuation and Returns for Dividend Payers and Non-payers, Table 6 Valuation and Returns by Maturity Factor Deciles for Table 7 Summary Statistics for Dividend Growers and Dividend Cutters Table 8 Summary Statistics by Economic Sector Table 9 Economic Sector Composition for Dividend Payers by Maturity Decile Table 10 Economic Sector Composition for Non-payers by Maturity Decile Table 11 Table 12 Table 13 Logit Analysis of the Decision to Pay Dividends-Fama and MacBeth approach, Models 1-6 (No control variables). 176 Logit Analysis of the Decision to Pay Dividends-Fama and MacBeth approach, Models 7-12 (With control variables) Logit Analysis of the Decision to Pay Dividends-Fama and MacBeth approach, Models (With variable combinations and controls) 179 Table 14 Average Partial Effects of Maturity Components Table 15 Table 16 Table 17 Logit Analysis of the Decision to Pay Dividends-Panel logistic method, Models 1-6 (No control variables) Logit Analysis of the Decision to Pay Dividends-Panel logistic method, Models 7-12 (With control variables). 183 Logit Analysis of the Decision to Pay Dividends-Panel logistic method, Models (With variable combinations and controls). 185 Table 18 Analysis of Maturity Model Predictions. 187 vii

9 Table 19 Summary of Maturity Model Outlier Analysis Table 20 Residual Analysis of Dividend Paying Firms-Model Table 21 Residual Analysis of Dividend Paying Firms-Model Table 22 Residual Analysis of Dividend Paying Firms-Model Table 23 Residual Analysis of Non-paying Firms-Model Table 24 Residual Analysis of Non-paying Firms-Model Table 25 Residual Analysis of Non-paying Firms-Model Table 26 Residual Analysis of Dividend Paying Firms-Model 11, 1982 vs Table 27 Residual Analysis of Non-paying Firms-Model 11, 1982 vs Table 28 Logit Analysis of the Decision to Pay Dividends-Panel logistic method, Model11 (With year effects and controls). 197 Table 29 M/B Regressions for Dividend Payers as a Function of Maturity Factor Table 30 M/B Regressions for Non-payers as a Function of Maturity Factor Table 31 Summary Statistics for Dividend Payers by Maturity Factor. 201 Table 32 Summary Statistics for Non-payers by Maturity Factor. 202 Table 33 M/B Regression as a Function of Maturity Factor Range Table 34 Summary Statistics for Dividend Payers by Maturity Composite Range Table 35 Summary Statistics for Non-payers by Maturity Composite Range Table 36 M/B Regression as a Function of Maturity Composite Range Table 37 M/B Regressions for Non-payers by Maturity Composite Range Table 38 M/B Regressions for Dividend Payers by Maturity Composite Range Table 39 M/B Regressions with Dividend Policy by Maturity Composite Range Table 40 Summary Statistics for Non-payers that initiate a dividend viii

10 Table 41 Table 42 Table 43 Table 44 Table 45 Table 46 Logit Analysis of the Decision to Initiate Dividends-Fama and MacBeth method Logit Analysis of the Decision to Initiate Dividends-Panel Regression method Summary Statistics for Dividend Initiators by Maturity Composite Range Logit Analysis of the Decision to Initiate Dividends by Maturity Composite Range Logit Analysis of the Decision to Initiate Dividends-Panel Regression method with year effects. 215 Analysis of the Decision to Initiate Dividends-Cox proportional hazard model Table 47 Summary Statistics for Dividend Growers versus Non-growers Table 48 Table 49 Table 50 Table 51 Logit Analysis of the Decision to Increase Dividends-Fama and MacBeth method. 219 Logit Analysis of the Decision to Increase Dividends-Panel Regression method. 221 Summary Statistics for Dividend Growers by Maturity Composite Range Logit Analysis of the Decision to Increase Dividends by Maturity Composite Range 224 Table 52 Summary Statistics for Dividend Cutters versus Non-cutters 226 Table 53 Table 54 Table 55 Table 56 Logit Analysis of the Decision to Decrease Dividends-Fama and MacBeth method. 227 Logit Analysis of the Decision to Decrease Dividends-Panel Regression method. 229 Summary Statistics for Dividend Payers by Dividend Payout Ratio Decile Dividend Payout Ratio Regressions for Dividend Payers as a Function of Maturity ix

11 Table 57 Dividend Payout Ratio Regressions for Dividend Payers as a Function of Maturity with control variables Fama and MacBeth method Table 58 Summary Statistics for Dividend Payers by Dividend Yield Decile Table 59 Table 60 Table 61 Table 62 Table 63 Table 64 Table 65 Table 66 Dividend Yield Regressions for Dividend Payers as a Function of Maturity with control variables Fama and MacBeth method Summary Statistics for Dividend Growers by Dividend Growth Rate Decile Dividend Growth Rate Regressions for Dividend Growers as a Function of Maturity Dividend Growth Rate Regressions for Dividend Growers as a Function of Maturity with control variables Fama and MacBeth method Dividend Growth Rate Regressions with Sustainable Growth Fama and MacBeth method. 239 Sustainable Growth Rate Regressions for Dividend Growers as a Function of Maturity Dividend Growth Rate Regressions by Maturity Composite Range Fama and MacBeth method Time Series of Maturity and Dividend Growth Rates for Proctor & Gamble Co., x

12 LIST OF FIGURES Figure Page Figure 1 Percentage of Dividend Paying Firms in Sample, Figure 2 Median CRSP Age for Dividend Payers and Non-payers, Figure 3 Percentage of Dividend Paying Firms as a Function of Sample Median CRSP Age. 245 Figure 4 Median RE/TE for Dividend Payers and Non-payers, Figure 5 Figure 6 Figure 7 Figure 8 Percentage of Dividend Paying Firms as a Function of Sample Median RE/TE. 247 Median Standard Deviation of Monthly Returns for Dividend Payers and Non-payers, Percentage of Dividend Paying Firms as a Function of Sample Median Standard Deviation of Monthly Returns 249 Median Maturity Composite Score for Dividend Payers and Non-payers, Figure 9 Median Maturity Factor for Dividend Payers and Non-payers, Figure 10 Median Maturity Factor for Sample Firms, Figure 11 Percentage of Dividend Paying Firms as a Function of Sample Median Maturity Factor Figure 12 Percentage of Dividend Payers in Maturity Factor Deciles Figure 13 Equal-Weighted M/B Ratio for Dividend Payers and Non-payers, Figure 14 Average Monthly Returns for Dividend Payers and Non-payers, Figure 15 Equal-Weighted M/B Ratio in Maturity Factor Deciles 257 Figure 16 Equal-Weighted Average Monthly Returns in Maturity Factor Deciles xi

13 Figure 17 Median M/B Ratio as a Function of Maturity Factor for Dividend Payers and Non-payers. 259 Figure 18 Median Dividend Payout Ratio for Dividend Paying Firms, Figure 19 Median Dividend Growth Rate for Dividend Paying Firms, Figure 20 Figure 21 Percentage Dividend Growers, Cutters, and Initiators as a Function of Maturity Factor Median Percentage Dividend Payout and Growth Rate as a Function of Maturity Factor Figure 22 Percentage of Dividend Paying Firms by Economic Sector, Figure 23 Percentage of Firms in Sample by Economic Sector, Figure 24 Median Maturity Factor by Economic Sector, Figure 25 Figure 26 Figure 27 Percentage of Dividend Paying Firms by Economic Sector as a Function of Sector Median Maturity Factor Percentage Dividend Paying Firms in Sample, Models Versus Actual. 268 Percentage Dividend Paying Firms in Sample, Models Versus Actual. 269 Figure 28 Over-zealous Dividend Payers, Figure 29 Disappearing M/B Ratio Dividend Premium for Model Outliers Figure 30 Percentage Dividend Paying Firms in Sample, Model Versus Actual (Model 11 with Year Effects). 272 Figure 31 The Life-Cycle of Firm Value Maturity Factor Scale. 273 Figure 32 The Life-Cycle of Firm Value Maturity Composite Scale Figure 33 The Life-Cycle that Maximizes Firm Value Figure 34 Percentage of Dividend Initiators, Figure 35 Empirical Hazard Function in Life-Cycle Time. 277 Figure 36 Empirical Survival Function in Life-Cycle Time xii

14 Figure 37 Empirical Hazard Function in Event Time 279 Figure 38 Empirical Survival Function in Event Time Figure 39 Growth Rates as a Function of Maturity Composite Figure 40 Dividend Growth Rate and Sustainable Growth Rate for Wal-Mart Stores, xiii

15 CHAPTER 1 INTRODUCTION 1.1 Overview Dividend policy remains one of the great puzzles in Finance. According to Miller and Modigliani s (1961) seminal paper, dividend policy is irrelevant to firm value in a perfect world. Considering the tax disadvantage of dividends, Black (1976) proposes that investors should not want dividends, yet dividends are paid. Theoretical and empirical research on dividend policy tries to explain why firms pay dividends with market frictions and market imperfections such as taxes, agency costs, and information asymmetry. As if research in the field of dividend policy were not difficult enough, Fama and French (2001) report that the dividend policy of industrial firms in the United States has changed significantly over the period from 1978 to Specifically, Fama and French (2001) show that the propensity to pay dividends declines dramatically over the period. While 66.5% of listed firms paid dividends in 1978, only 20.8% of listed firms paid dividends in Furthermore, Fama and French (2001) find that the decline in the percentage of industrial firms that pay dividends is only partly explained by firm characteristics. Even after controlling for firm characteristics, the propensity to pay a dividend still declines over the 1978 to 1999 period. Fama and French (2001) refer to this phenomenon as disappearing dividends. Several research paths have been taken to resolve the disappearing dividends phenomenon. Grullon, Michaely, and Swaminathan (2002) refute prior signaling models that indicated dividend policy conveys information regarding future cash flow. Rather Grullon et al. (2002) show evidence that dividends convey information about the firm s systematic risk. 1

16 2 Specifically, they propose the maturity hypothesis to describe the process where changes in dividend policy relate to a firm s transition from a high growth phase to a lower growth phase. Grullon and Michaely (2002) show that stock repurchases may be substitutes for dividends. Julio and Ikenberry (2004) explore the extent to which stock repurchases have functioned as a substitute for dividends and show that the total percentage of earnings paid out as dividends and repurchases is relatively stable over the Hence, to some extent, the reduction in dividends is simply the substitution to repurchases, which can be argued to be a more flexible distribution to shareholders (Brav el al. (2005)). While Julio and Ikenberry (2004) show that total payouts are stable, they still question whether the reduced fraction of firms paying dividends represents a fundamental shift in payout policy. Julio and Ikenberry (2004) test several hypotheses including Grullon et al. s (2002) maturity hypothesis. Julio and Ikenberry (2004) follow Fama and French (2001) and argue that part of the declining percentage of dividend payers in the 1990 s has to be attributed to the increased number of IPO firms. Such newer and riskier firms are much less likely to pay dividends than large, mature firms with more stable cash flows. DeAngelo, DeAngelo, and Skinner (2004) show that indeed the reduction in payers occurs almost entirely among firms that paid very small dividends. Furthermore, Julio and Ikenberry (2004) show that firm age explains the decline in the propensity to pay a dividend in the 1990 s and further explains the subsequent increase in propensity to pay a dividend after A firm specific example of the maturity hypothesis is Microsoft. When Microsoft first traded on the NASDAQ in the late in 1980s, Microsoft did not pay a dividend, while its growth opportunities were large compared to its market values. By 2003, Microsoft was one of the largest publicly-traded corporations and had

17 3 lower growth opportunities. Julio and Ikenberry (2004) argue that Microsoft s decision to initiate a dividend in early 2003 was consistent with a natural maturation process. Julio and Ikenberry (2004) also test Baker and Wurgler s (2004a, 2004b) catering theory, where firms cater the dividend policy to investor preferences, but find no support. In order to explain disappearing dividends, Baker and Wurgler (2004a, 2004b) suggest that firms reduced dividend payouts since dividends were out of favor with investors. Hoberg and Prabhala (2009) also test the catering theory to explain the disappearing dividends. However, Hoberg and Prabhala (2009) find that Baker and Wurgler s (2004) catering variables are insignificant when controlled for risk. In fact, Hoberg and Prabhala (2009) attribute 40% of the disappearing dividends to risk factors. Hoberg and Prabhala s (2009) findings that risk explains dividend policy confirms prior empirical work of Grullon et al. (2002) and Rozeff (1982). DeAngelo, DeAngelo, and Stulz (2006) further the maturity hypothesis by showing that the firm s financial maturity or life-cycle, which is characterized by its earned capital ratio, significantly explains a firm s propensity to pay a dividend. DeAngelo et al. (2006) show that firms with high earned capital ratios are dividend payers while firms with low earned capital ratios tend not to pay dividends. While DeAngelo et al. (2006) explain that the earned capital ratio represents the firm s financial maturity, they test the statistical significance of the earned capital ratio as an explanatory variable of a firm s propensity to pay a dividend only using the Fama and French (2001) firm characteristics as control variables. Thus in review of the current literature regarding disappearing dividends, three separate versions of firm maturity hypothesis explanations exist. In each maturity hypothesis, there exists a different measure of firm maturity. Grullon et al. (2002) characterize the firm maturity hypothesis with risk variables, specifically beta and systematic risk. Hoberg and Prabhala

18 4 (2009) show that both systematic risk and idiosyncratic risk explain disappearing dividends although idiosyncratic risk has a greater marginal effect. Julio and Ikenberry (2004) regress the variable firm age to test the maturity hypothesis. Finally, DeAngelo et al. (2006) represent the firm s financial maturity or life-cycle by the firm s earned capital ratio. Not only does the prior literature use different measures of maturity, the conclusions of the different maturity variables on the disappearing dividends puzzle conflict each other. Both Julio and Ikenberry s (2004) and Hoberg and Prabhala s (2009) measures of maturity partially explain the disappearing dividends puzzle. However, DeAngelo et al. (2006) report that with the earned capital ratio as the measure of maturity the disappearing dividends phenomena is roughly twice as large as reported by Fama and French (2001). In the first part of the dissertation, I determine which maturity hypothesis variable (or combinations of variables) best explains the firm s propensity to pay a dividend. Furthermore, this dissertation provides better definition of the concept of firm maturity and provides some further insights on the disappearing dividends puzzle. Since the decision to initiate a dividend is fairly similar to the decision to pay a dividend, the life-cycle hypothesis has been applied to dividend initiation. Baker and Wurgler (2004a, 2004b) study the rate of dividend initiation and find evidence of investor fads or catering. However, Julio and Ikenberry (2004) show that Baker and Wurgler s (2004a, 2004b) dividend premium disappears when dividend initiation announcement returns are adjusted for firm size and firm age. DeAngelo et al. (2006) find that the earned capital ratio is statistically significant in the decision to initiate dividends. Hoberg and Prabhala (2009) find that risk is negatively related to the decision to initiate dividends and find the results consistent with the firm maturity view of dividend policy. As with the propensity to pay research, the dividend initiation research uses

19 5 different measures of firm maturity- firm age, earned capital ratio, and risk. Thus, I determine which maturity hypothesis variable (or combinations of variables) best explains the firm s decision to initiate a dividend. In each case of the prior literature, the dividend policy time series have been studied with the Fama-Macbeth (1973) method. There are econometric advantages to analyzing the time series data using panel methods. One advantage of using a panel method is that it allows direct hypothesis testing of time effects on dividend policy with the base firm maturity or life-cycle model. Thus, the prior literature, which has developed the firm maturity hypothesis on dividend policy, has been tested with an econometric technique that has enabled only testing the microeconomics of the firm. It seems that time varying macroeconomic factors such as the growth rate of the gross domestic product have the potential to affect the growth prospects of the firm and thus impact corporate dividend policy. The only macroeconomic factor that has been extensively reviewed in the literature is the impact of taxes on dividend policy. However, recently Dittmar and Dittmar (2008) show evidence of financing waves or cycles that are related to economic growth. In as much as dividend policy should be related to corporate financing activity, it seems that economic growth may affect dividend policy. The panel regression methods employed in this research enable the testing of time effects on dividend policy. Since the life-cycle model of dividend policy is based on the trade-off between the costs of earnings retention and the costs of earnings distribution, this implies that a firm selects a dividend policy that maximizes the value of the firm. I consider the firms that have dividend policies that are in conflict with the dividend policy predicted by the life-cycle model, which contains the control variables and the maturity variables. The primary interest is the analysis of a conflicting dividend policy on firm value. In other words, testing the prediction of the life-cycle

20 6 model and analyzing the firms that do not fit the model, enables the study of the fundamental question does dividend policy matter? While there are many measures of firm value, Baker and Wurgler (2004) provide evidence in the literature on dividend policy that suggests that the market to book ratio (M/B) is a good firm valuation measure. They report that although the M/B ratio is time-varying, the M/B ratio of dividend payers is consistently lower than the M/B of nonpayers. The Baker and Wurgler (2004) results imply a systematic difference in M/B ratio between payers and non-payers. From the logit model on propensity to pay, there will be dividend payers that fit the model and non-dividend payers that fit the model. I first compare the M/B ratio of non-payers that do not fit the life-cycle model to the M/B ratio of non-payers that fit the life-cycle model. Then, I compare the M/B ratio of dividend payers that do not fit the lifecycle model to the M/B ratio of payers that fit the model to determine if the "market" places a valuation premium on the firms following the expected (or model predicted) dividend policy. After testing the maturity hypothesis on the propensity to pay dividends, I extend the firm maturity hypothesis to develop an empirical method for estimating dividend growth rates. It seems that a likely extension of the life-cycle hypothesis would be that the firm maturity continues to impact dividend policy even after the firm has decided to pay. As the firm s tradeoff between the costs of retention of cash flow and the cost of distribution of cash flow evolves with the firm s life-cycle, so should the firm s dividend growth rate. As the dividend paying firm matures, it should have declining growth opportunities and increasing free cash flow, which suggests that dividend distributions should increase. Dividend growth rates are required inputs for dividend discount stock valuation models. Although dividend discount stock valuation models have existed since Williams (1938), stock analysts have done little to formalize the process of estimating dividend growth rates. In their popular textbook Fundamentals of

21 7 Investments, Jordan and Miller (2009) describe three methods that financial analysts use to estimate the dividend growth rate: (1) using the company s historical average dividend growth rate, (2) using the industry median or average growth rate, or (3) using the sustainable growth rate based on ratio analysis. However, Jordan and Miller (2009) also note that a historical average growth rate may or may not be a reasonable estimate of future dividend growth. An empirical method to estimate the dividend growth rate based on the firm maturity variables could be useful for financial analysts. 1.2 Hypotheses In the first part of the dissertation, the emphasis involves integrating three existing yet distinct versions of the firm maturity hypothesis regarding dividend policy and the different firm maturity variables. The firm maturity variables of risk, firm age, and earned capital ratio or combinations of the variables have not been tested jointly in the prior literature for significance in the propensity to pay dividends. Combinations of the maturity variables may describe firm life-cycles better than any single maturity variable. Consider the singular variable firm age. Some firms may quickly grow and reach a point of limited investment opportunity while others may continuously develop new investment opportunities. Likewise, the earned capital ratio variable does not capture whether the capital mix occurs on the ascent or descent of the firm s life-cycle, which seems relevant to dividend policy. Therefore, I test the following hypothesis related to propensity to pay dividends: Hypothesis 1a. Total risk significantly determines a firm s propensity to pay dividends when controlled for the Fama-French (2001) firm characteristics, firm age, earned capital ratio, and combinations of risk, firm age, and earned capital ratio.

22 8 Similarly, the measures of firm maturity have been only tested independently in the research on the decision to initiate a dividend. Therefore, I test the following hypothesis related to the decision to initiate dividends: Hypothesis 1b. Total risk significantly determines a firm s decision to initiate dividends when controlled for the Fama-French (2001) firm characteristics, firm age, earned capital ratio, and combinations of risk, firm age, and earned capital ratio. As stated above, the prior research has utilized the Fama-Macbeth (1973) method to analyze the time series data. In this study, I analyze the time series data using panel methods. This enables the direct hypothesis testing of time effects on dividend policy. Since macroeconomic factors such as economic growth can alter the growth prospects of firms over time, these time varying macroeconomic factors may impact corporate dividend policy. In highly profitable periods, firms may generate abnormal free cash flows, which would influence dividend policy. Each year in the data panel can be represented by a dummy variable that is assigned 1 for data occurring in the given year or 0 if otherwise. The Fama-Macbeth (1973) method used in the prior literature is unable to discern a step change in dividend policy from a gradual shift in dividend policy. While the prior literature has focused on the microeconomics of the firm, I investigate the effects of both firm characteristics and (yearly) time effects on dividend policy. Based on the use of the panel method, I test the following hypothesis with the propensity to pay model: Hypothesis 2a. Relative to the base firm life-cycle model, yearly time effects captured by year dummy variables are significant determinants of the firm s propensity to pay a dividend. dividends: Similarly, I propose to test the following hypothesis related to the decision to initiate

23 9 Hypothesis 2b. Relative to the base firm life-cycle model, yearly time effects captured by year dummy variables are significant determinants of the firm s decision to initiate a dividend. Testing the predictions of the life-cycle model and analyzing the firms that do not fit the model enables the study of the fundamental question does dividend policy matter? The Baker and Wurgler (2004) results imply a systematic difference in M/B ratio between payers and nonpayers. The research question here, of course, is what about the firms that do not fit the model. I first compare the M/B ratio of non-payers that do not fit the life-cycle model to the M/B ratio of non-payers that fit the life-cycle model. The non-payers that are "immature" with high growth potential will fit the life-cycle model. The non- payers that seem mature and have less growth will not fit the model. If there is a difference in M/B ratio between these groups, it suggests that the "market" places a valuation premium on the firms following the expected (or model predicted) dividend policy. For example, if the non- payers that do not fit the model (against type 1 ) have a lower M/B ratio than the non-payers that fit the life-cycle model, I would argue the "market" senses the agency costs of free cash flow and discounts the firm value of the againsttype, non-payers accordingly. Based on this, I test the following hypothesis: Hypothesis 3a. The non- payers that do not fit the model (against type) have a significantly lower M/B ratio than the non-payers that fit the life-cycle model. Again based on the Baker and Wurgler (2004) results, I sort the dividend payers from the non-payers. I then compare the M/B ratio of dividend payers that do not fit the life-cycle model to the M/B ratio of payers that fit the model. The payers that are "mature" with limited growth potential should fit the model. However, dividend payers that are not mature and still have 1 In the empirical finance literature, firms that have characteristics contrary to the model classification are regarded to as against type firms. Here, against type firms have a dividend policy that is contrary to the model prediction. Jung, Kim, and Stulz (1996) use this terminology in an empirical study of capital structure.

24 10 growth potential should not fit the model. If there is a difference in the M/B ratio between these groups, it could again suggest the "market" places a difference on valuation for following the expected dividend policy. I then test the following hypothesis: Hypothesis 3b. The dividend payers that do not fit the model (against type) have a significantly lower M/B ratio than the dividend payers that fit the life-cycle model. The final part of the dissertation tests whether the firm maturity hypothesis can describe the firm s dividend growth rate. It would be expected that if the firm maturity variables or combination of variables can describe a firm s life-cycle, then these variables could be used to estimate the dividend growth rate. As the dividend paying firm matures, it should have declining growth opportunities and increasing free cash flow, which suggests that dividend distributions should increase. Although the maturity hypothesis implies that the dividend distributions should increase with firm maturity, the Law of Large Numbers 2 applied to finance suggests that the probability of sustaining a large percentage growth rate declines. It seems that as a dividend paying firm matures, its dividend growth rate should decline. Based on the firm life-cycle model, I test the following hypothesis: Hypothesis 4. Total risk, firm age, earned capital ratio, and combinations of these firm maturity variables describe the cross section of firm dividend growth rates, and the dividend growth rate declines with firm maturity. 1.3 Summary of Empirical Findings The main premise of this dissertation is that firm maturity is related to dividend policy, and in turn, dividend policy affects firm value throughout the firm s life-cycle. While prior 2 Although the Law of Large Numbers generally refers to the statistical rule, which states that as the number of samples increases, the average of the samples approaches the mean of the population, it is often applied to financial growth rates. As related to finance, the Law of Large Numbers suggests that as a company grows the chances of sustaining a large percentage growth rate diminish. As the company size approaches the size of the economy, the growth rate approaches the growth rate of the economy.

25 11 research advances a life-cycle or maturity hypothesis to explain corporate dividend policy, prior investigations utilize firm age, the earned capital ratio and risk independently to proxy firm maturity. Consistent with the prior literature, I show that firm maturity is positively related to the probability that a firm pays a dividend. The logit analysis of the probability of paying a dividend indicates that each individual definition of maturity reported in the prior literature captures a statistically significant dimension of firm maturity. Of the individual measures of maturity, the earned capital ratio, measured by the ratio of retained earnings to total equity (RE/TE), has the largest partial effect on the decision to pay a dividend. However, the combination of maturity variables provides the most complete definition of the life-cycle. The panel logistic regression analysis with year effects indicates that after controlling with the maturity model, the propensity to pay dividends is lower than 1982, and the reduction in propensity to pay each year after 1982 is statistically significant. Although this indicates that disappearing dividends and the reduced propensity to pay is statistically significant, the analysis failed to relate any specific macroeconomic factors to the year effects. Analysis of firms that do not follow the life-cycle model s predictions for dividend policy provides further insight into the disappearing dividends phenomena. While the life-cycle models with combination maturity variables correctly classify about 85% of the observations, the majority of outliers or firms with a dividend policy contrary to the model are dividend paying firms in the time series. I consider the dividend paying outliers to be over-zealous dividend payers as a group since they have low median maturity, low median profitability, and small size. My analysis shows that the decline in the propensity to pay dividends (or disappearing dividends ) is due to the decline in these over-zealous dividend payers. Further investigation of the over-zealous dividend payers reveals that the decline in the over-zealous

26 12 dividend payers is related to the relative market valuation of the outliers. In the early 1980 s, there was no significant valuation difference between immature dividend payers and mature dividend payers that fit the life-cycle model. However, as market valuations became less favorable to over-zealous dividend payers, fewer immature firms paid dividends. With fewer over-zealous dividend payers since the 1980 s, the aggregate percentage of dividend payers declines. This dissertation resolves an empirical anomaly in the prior dividend literature. Prior empirical studies show that the median valuation of non-paying firms, as measured by the M/B ratio, is greater than the median valuation of dividend paying firms. If the median valuation of non-paying firms is greater than the median valuation of dividend paying firms, then why would a value maximizing firm ever pay a dividend? My research shows that firm valuation as measured by the M/B ratio is related to the firm maturity and the life cycle. Early in the lifecycle, non-paying firms have high growth potential and high M/B ratios. However, the M/B ratio of non-paying firms continues to decline monotonically as non-paying firms mature. On the other hand, the M/B ratio of dividend paying firms increases as dividend paying firms mature over the life-cycle. The opposing valuations with maturity set up a crossover point where eventually a maturity is reached where the M/B ratio of dividend payers is greater than the M/B ratio of non-payers. At this crossover maturity, a non-paying firm should begin a dividend payout as it matures further in order to maximize firm value. Otherwise, the firm s value will continue to decline as it matures. Dividend payers do not become more valuable because they are more mature. Higher profitability is the major explanatory variable for the increase in valuation for dividend payers as they mature over the life-cycle. In summary, the life-cycle of firm value resolves the questions of when and why a firm should pay a dividend.

27 13 Consistent with the prior literature, the results from the logit analysis of the decision to initiate a dividend are very similar to the results from the logit analysis of the decision to pay a dividend. As a non-paying firm matures, its propensity to initiate a dividend increases. Furthermore, each separate definition of maturity captures a statistically significant dimension of firm maturity, but the combination maturity variables seem to provide the most complete definition of maturity in the life-cycle. As with the propensity to pay a dividend, the RE/TE percentile has the largest effect of the maturity variables on the decision to initiate. As firms become larger and more profitable, their propensity to initiate a dividend increases. Consistent with the maturity hypothesis, firms are less likely to initiate a dividend if they have significant growth potential as measured by the M/B ratio. In addition to firm characteristics, there are significant economic sector effects on the decision to initiate a dividend. As expected from the analysis of firm maturity and valuation, most firms initiate a dividend near the crossover maturity in the life-cycle. While a time series plot suggests a declining propensity to initiate from the early 1980 s to about 2003, the panel logit analysis with year effects confirms that the reduction in propensity to initiate is statistically significant even after controlling for maturity, firm characteristics, and economic sector. However, I find no significant negative year effect (from the base year of 1982) at the 5% level until the mid-1990 s, which is over a decade after the adoption of the safe-harbor rule (in 1982). Rather the panel logit results with year effects are consistent with my assertion that the macroeconomic environment shifted from one that favored distribution of earnings in the early 1980 s to one that then favored earnings retention in the mid 1990 s when the development of the internet and related new technologies provided corporations with new growth opportunities.

28 14 Firm maturity is positively related to the probability of a dividend increase and negatively related to the probability of a dividend cut. However, the relationship between dividend payout policy and maturity is more complex than with the propensity to pay and propensity to initiate analysis. With dividend payout policy analysis, the components of maturity are often inconsistent with the net effect of maturity. Interestingly, as the firm s age increases, the probability of dividend growth declines and the probability of a dividend cut increases. However, standard deviation is the maturity variable with the largest effect, and as the firm matures and becomes less volatile, the probability of dividend growth increases and the probability of a dividend cut decreases. Therefore, the dominant effect of standard deviation cancels out the offsetting effect of firm age so that the net effect is still that the probability of dividend growth increases with maturity. The RE/TE ratio, which is the largest effect of maturity variables in the propensity to pay and propensity to initiate logits, is insignificant to the probability that a firm increases its dividend. Firm maturity is positively related to the dividend payout ratio. As a dividend paying firm matures, the dividend payout ratio increases. However, the significant maturity components that determine the dividend payout ratio are only age and volatility. The analysis also reveals that the sales growth rate is negatively and significantly related to the dividend payout ratio. These results are consistent with the maturity hypothesis. Young firms with large growth opportunities (high sales growth rates) will retain most of their earnings and have low distribution (low dividend payout ratios). Mature firms with lower growth opportunities (low sales growth rates) will retain less of their earnings and have higher distribution of earnings (higher dividend payout ratios).

29 15 Finally, the dividend growth rate for dividend growers declines as a firm matures. All of the components of maturity are significant and consistent with the overall effect of maturity on the dividend growth rate. Consistent with the maturity hypothesis and the Law of Large Numbers, the dividend distribution increases as the firm matures, but the dividend growth rate occurs at a diminishing rate. Further investigation of the dividend growth rate shows that the sustainable growth rate only approaches the dividend growth rate at the very mature stage of the life-cycle. 1.4 Contribution The firm maturity variables of risk, firm age, and earned capital ratio have not been tested jointly in the prior literature for significance in the propensity to pay dividends and the probability of dividend initiation. I contribute to the dividend literature by finding that each maturity variable is significant even when tested jointly. Furthermore, the combinations of maturity variables provide the most complete and quantitative definition of the life cycle. My analysis indicates that the earned capital ratio has the largest partial effect on the decision to pay a dividend and the decision to initiate a dividend. The prior literature suggests industry effects on the decision to pay a dividend but no study reports comprehensive industry effects. I report significant industry effects on the decision to pay a dividend and the decision to initiate a dividend. Although the prior literature utilizes only the Fama and MacBeth method for the logit anlaysis, I demonstrate that the panel logistic regression is essentially equivalent to the Fama and MacBeth method. While the prior literature focuses on the relationship between maturity and the propensity to pay, my research investigates the implications of the life-cycle model. My analysis indicates that the valuation of firms that fit the life-cycle model is significantly greater than the valuation

30 16 of firms that have a dividend policy contrary to the life-cycle model. This provides strong empirical evidence that dividend policy does affect the value of the firm. Furthermore, my research demonstrates when and why a value-maximizing firm pays a dividend. The results also resolve an empirical anomaly in the prior dividend literature. I demonstrate that firm value, as measured by the M/B ratio, is related to firm maturity and the life-cycle. These valuation results are important to corporate boards of directors of U.S. industrial firms. Value-maximizing managers will want to ensure that they implement a dividend policy that follows the life-cycle model and consequently maximizes the value of the firm. Over the time series, about 15% of the firm observations have dividend policies that are contrary to the life-cycle model. This implies about 15% of U.S. industrial firms have lower valuations than they would if they followed the life-cycle model. It should also be noted that one of the complexities of dividend policy is timing. My analysis of the crossover maturity indicates that paying a dividend too soon lowers valuation while not paying a dividend after the crossover maturity also lowers valuation. My analysis of valuation provides the literature further insight into the disappearing dividends phenomena. While DeAngelo et al. (2004, 2006) report that dividend policies change most with marginal dividend payers, they fail to explain the disappearance. My analysis reveals that the over-zealous dividend payers responded to shifts in the market valuation. As the relative M/B ratio of over-zealous dividend payers declined, fewer immature firms were over-zealous to pay dividends. This contribution not only offers an explanation to the disappearing dividends phenomena, my analysis indicates that disappearing dividends was beneficial to the economy as firms shifted dividend policy to maximize their valuations.

31 17 While the prior literature contains studies on the relationship between maturity and the propensity to pay a dividend as well as the relationship between the propensity to initiate a dividend and maturity, none explicitly studies dividend payout policy and the maturity hypothesis. I extend the maturity hypothesis and investigate the relationship between maturity and dividend payout policy. I show that the relationship between firm maturity and dividend payout policy is more complex than with the propensity to pay. With dividend payout policy, the individual maturity components are often inconsistent with the net effect of maturity. This may provide the best empirical evidence that the reported measures of maturity are independent and capture different dimensions of maturity. For example, the earned capital ratio (RE/TE) has the largest effect of the maturity variables in the propensity to pay logits, but it is insignificant to the probability that a firm increases its dividend or the dividend payout ratio. I extend the maturity hypothesis and show that firm maturity is positively related to the dividend payout ratio while the sales growth rate is negatively related to the dividend payout ratio. Young dividend paying firms with larger growth opportunities (or higher sales growth rates) will retain most of their earnings and have lower distributions (lower dividend payout ratios). Mature dividend paying firms with lower growth opportunities (or lower sales growth rates) will distribute most of their earnings and have higher distributions (higher dividend payout ratios). Finally, while the dividend distribution increases as the firm matures, the dividend growth rate declines with maturity. Further investigation of the dividend growth rate shows that the sustainable growth rate only approaches the dividend growth rate at the very mature stage of the life-cycle. In the early part of the life cycle, the dividend growth rate is significantly greater

32 18 than the sustainable growth rate. Furthermore, as firms progress in the life-cycle, the dividend growth rate continues to decline even in the most mature stage of the life-cycle. In addition to the academic contribution of providing empirical evidence for the maturity hypothesis with dividend payout policy, there is again much of interest to corporate boards of directors that seek to maximize firm value. My analysis reveals the complexity of dividend payout policy on the value of the firm. While positive dividend growth increases the firm s valuation, the effect is most significant only in the most mature stage of the life-cycle. On the other hand, an excessively high dividend yield decreases firm value, especially for immature dividend payers. The investigation of the dividend growth rate offers investors and financial analysts a new technique for empirical estimates of the dividend growth rate. Investors and financial analysts often use estimates of the dividend growth rate in dividend discount models for firm valuation and in dividend discount models for the cost of equity. Financial analysts often estimate future dividend growth rates with the sustainable growth rate. I quantify the part of the life-cycle where the sustainable growth rate is a good estimate of the dividend growth rate. Since the dividend discount models often use the assumption of constant dividend growth rate, I define conditions where the assumption is valid. Life-cycle analysis of the dividend growth rate should enable financial analysts to replace ad hoc judgments regarding future dividend growth rates with more quantitative analysis.

33 CHAPTER 2 LITERATURE REVIEW 2.1 Dividend Policy Irrelevance The purpose of this chapter is to provide a review of the relevant research on corporate dividend policy and firm maturity. Sections 2.1 to 2.6 discuss the underlying theories for dividend policy. Sections 2.7 and 2.8 describe the current research relating the firm life-cycle hypothesis to dividend policy. Although I review recent studies regarding dividend policy and firm value in Section 2.10 and dividend growth in Section 2.11, I find no prior research relating firm maturity to firm value or dividend growth. The literature regarding corporate dividend policy is a study of how corporations should deliver value to shareholders. Thus while capital structure theory and dividend policy both relate to corporate valuations, dividend policy distinctly focuses on the delivery of value. The focal question of dividend policy is then how should a firm deliver value to shareholders in a way that maximizes the shareholders wealth? Miller and Modigliani (1961) show that the value of the firm is unaffected by dividend policy in a world without taxes, agency costs, information asymmetry, or other market imperfections. In this idealized world without taxes and market imperfections, it makes no difference whether (or even how) the firm s cash flows are distributed to shareholders or reinvested in the firm because the shareholders wealth is the same in either case Dividend Clienteles Miller and Modigliani (1961) also show that even if different groups are attracted to stocks with different dividend payouts, the implication on firm value is the same as their perfect 19