The Market Valuation of Bonus Distributions in an Inflationary Environment MEZIANE LASFER

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1 The Market Valuation of Bonus Distributions in an Inflationary Environment MEZIANE LASFER In inflationary environments, companies can avoid paying cash dividends to their shareholders. Instead they give them free shares, referred to as bonus distributions. This form of dividend allows companies to probably desperately needed cash, and more importantly, from an accounting perspective, they can use the inflation revaluation equity reserves, instead of the retained earnings. Therefore, this method gives more flexibility to companies to carry on paying dividends without a significant impact on their cash balance as well as their balance sheet. This issue has not been analysed in previous studies, partly because the inflation in many western countries is relatively low and stable. However, in many emerging countries, including China where according to recent news the inflation is increasing, inflation remains a threat and companies need to find ways of circumventing its effects, particularly in the case of keeping the return to their shareholders in the form of dividends steady. In general, stock distributions either by stock splits or stock dividends are puzzling corporate behaviour. In theory, these distributions are cosmetic operations aimed at dividing the corporate pie into more pieces with no change in the total value of the firm. However, previous empirical studies report a significant positive market reaction on the announcement day, often related to a combination of signalling, liquidity, attention-getting, and retained earnings hypotheses. This positive reaction is still controversial, as stock distributions can be substitutes to cash dividends, and allow managers to conserve cash, implying that the market reaction should be negative, since such distributions may exacerbate the free cash flow problem and signal cash shortage. In a recent study, 1 my co-author, Cahit Adaoglu, and I assessed the market valuation of this unusual form of stock dividends which are carried out by transferring the accumulated equity reserves, mainly the inflation revaluation equity reserves, to paid-in capital leaving the total equity unchanged. We use the Istanbul Stock Exchange (ISE) as a testing ground where firms distribute regularly bonus/free shares on a pro-rata basis in an inflationary environment by using accumulated 1 Cahit Adaoglu and Meziane Lasfer, 2011, The Market Valuation of Bonus Issues in a Closely Held Market, Journal of Business Finance and Accounting 38(5-6), , June/July.

2 equity reserves, especially the revaluation of assets reserve known as inflation revaluation equity reserves. This inflation-adjustment of the book value of fixed assets allows companies to pay dividends, and to fully utilize the tax shield advantage of depreciation expenses, and to avoid the inflation taxation as well as the adverse effects of inflation on the paid-in capital. In terms of accounting, these bonus distributions are transfers from the accumulated equity reserves (i.e., equity reserves other than retained earnings) to paid-in capital. 2 However, stock dividends, referred to in the UK as scrip dividends, are transfers from distributable profit and/or retained earnings to paid-in capital. Overall, both bonus distributions and stock dividends do not change the amount of total equity, but only alter its composition. Since bonus distributions are not financed from retained/distributable profit, and the transaction costs are based on the total amount of the transaction rather than the number of shares, they are not affected by the cash substitution and the transaction costs considerations. Unlike market-oriented countries such as the UK and the US, the amount of paid-in capital has more legal as well as corporate policy implications in bank-oriented countries such as Turkey, Germany, Denmark and Switzerland. From an accounting perspective, stock dividends are significantly different from stock splits. By reducing the par value of shares, stock splits do not change the amount of paid-in capital and do not change the capital structure. However, stock dividends allow firms to transfer retained earnings to paid-in capital, increasing the amount of paid-in capital, and specifically, changing the equity composition of capital structure. Similar to the increase in paid-in capital through stock dividends, bonus distributions also change the equity composition of capital structure and increase the paid-in capital with a higher number of shares having the same par value as the old shares. Consequently, bonus distributions have significant implications on the dividend policy and on the debt financing capacity. The paid-in capital is a legally non-distributable equity item and has a higher legal protection than the other distributable equity items, which the controlling shareholders, typically family members in Turkey, can abuse. Specifically, the amount of paid-in capital has direct implications on the borrowing capacity 2 In other prominent emerging markets such as China, India, Australia and Greece, the classification of stock distributions is mixed, and bonus distribution (bonus stock or bonus issue) is the term used for all free issues of shares from accumulated capital reserves and/or retained earnings/distributable profit. However, in Turkey, the distinction between stock dividends and bonus distributions is made clear for investors.

3 since listed firms in the ISE can only issue debt up to 600% of their paid-in capital. In regards to the dividend policy implication, bonus distributions can signal better future earnings and future cash dividends at least proportionally to the increase in paid-in capital in order to maintain the same cash dividends per share in a desired stable dividend policy environment. 3 Finally, we strengthen the corporate policy implications of the amount of paid-in capital by analysing the prospectuses of ISE companies where we find that directors state that bonus distributions will increase the amount of paid-in capital in almost all announcements. 4 In the ISE, such announcements appear to convey good news to the existing shareholders, particularly given the settings of high inflation, weak shareholder but high creditor rights framework, closely held market structure, heavy reliance on bank financing as corporate bond market is unavailable, and limited access to external equity financing. Main findings: We first analyze all the 1,326 bonus distributions by non-financial firms over the period 1986 to We find that the number of bonus distributions follow the inflation index, increasing monotonically from 20 in 1986 to 97 in 1995, as inflation rate rose from 35% to 106%, and then decreasing to 31 in 2006, as inflation decreased progressively to single digit rates. The implementation of international inflation accounting standards in 2004 is likely to have also contributed to the sharp decline, particularly in 2005 and We then focus on the market reaction to the announcement of such distributions using the standard event study methodology. Our sample is limited to 371 announcements over the period , as the ISE established a formal mandatory process of news announcements only in late We find positive and statistically significant average abnormal returns of 1.49% (t = 8.44) on the announcement day 0, and 0.94% (t = 5.33) on day +1. We also report that the pre-event period cumulative abnormal returns, CAR -5,-1, are positive and significant, but the post-event period, CAR +2,+5, are negative but not significant. We obtain relatively similar results when we use a sample of 157 and 213 events with no confounding events 3 In bank-oriented markets such as Denmark and Turkey, the commercial code states that firms cannot pay out cash dividends if the paid-in capital is less than the book value of equity. In Denmark, cash dividends are strictly constrained by the amount of paid-in capital. 4 Similarly, in Denmark, as required by the listing requirements, 67% of Danish firms distributing stock dividends declare the primary motivation as improving the paid-in capital.

4 over the -5 to +5 and -1 to + 2 periods, respectively, except that both the pre- and post-event period CARs are positive, but not significant. We assess the drivers of such positive event period abnormal returns by focusing mainly on the paid-in capital hypothesis underlined within the ISE institutional setting. We argue that in the case of Turkey where the inflation is high and the access to external equity financing is limited, firms are more likely to recur to bonus distributions as the high level of inflation erodes their paid-in capital, increases their book-value of leverage measured by debt-to-paid-in capital ratio, and reduces their credibility and borrowing capacity. We also test the previously documented hypotheses, namely the retained earnings, signalling, liquidity, and attention-getting hypotheses. Our results provide strong support for the paid-in capital hypothesis. In particular, we find that both the market reaction and the bonus distribution ratios are positively related to debt-to-paid-incapital ratio. In addition, we find a significantly higher market reaction for non-dividend payers of 4.40% compared to 1.18% for dividend-paying firms. Previous studies refer to such difference in the market reaction as a puzzle. We provide evidence that the non-dividend-paying firms are more likely to benefit from bonus distributions under our paid-in capital hypothesis, as they are smaller, less profitable, and have lower growth opportunities, and have higher financial leverage (i.e., in terms of both debt-to-paid-in-capital and debt-to-equity ratios) than dividend-paying firms. Our results suggest that bonus distributions allow these non-dividend-paying firms to increase the amount of paid-in capital as a stronger covenant and to sustain their debt financing in a heavily debt oriented capital market. Our results also imply that companies use bonus distributions as a financial policy tool to gain more credibility in an inflationary environment for the continuity of their debt financing, even though bonus distributions affect negatively the wealth of existing shareholders by providing more security for debtholders in terms of a larger amount of legally non-distributable paid-in capital. In our regression results, we find that the improvement in paid-in capital is more important and imminent for nondividend-paying firms in a market of limited access to external equity financing. We find mixed evidence on the impact of liquidity. Our univariate analysis of the various measures of liquidity, including the adjusted trading volume, the relative trading volume, the market depth ratio, the number of positive volume-zero return days, and the share turnover, provide support

5 for the enhanced liquidity, but only for firms with the lowest liquidity prior to the announcement. We find no evidence for the attention-getting hypothesis as the abnormal returns are not related to firm size. We show that the market reaction is significantly higher in when the inflation rate is very low, and the signalling through bonus distributions is stronger. We also find some evidence that the market reaction is higher for firms that underperformed in the previous six months before the bonus distribution announcement, suggesting that firms make such announcements to signal future recovery. We also focus on whether bonus distributions convey positive signal that the increase in the number of shares, and the reduction in the pool of distributable reserves, will not negatively affect future dividends. Our regression results provide support for the positive effect of dividend changes on the market reaction, even after controlling for other factors. Conclusion: Overall, we find positive excess returns on the announcement dates, particularly for the financially weak firms, such as the non-cash-dividend-paying firms. We relate our results to the paidin capital hypothesis under which firms opt for bonus distributions to mitigate the impact of inflation on their eroding paid-in capital, to reduce their leverage defined as debt-to-paid-in-capital ratio, and to increase their credibility and borrowing capacity in a market of limited access to external equity financing. Although our results are also consistent with the retained earnings and signalling hypotheses, we find no support for the attention-getting, and a weak support for the liquidity enhancement hypotheses observed in other markets.