Stock Market Liquidity and Firm Dividend Policy

Transcription

1 Stock Market Liquidity and Firm Dividend Policy Suman Banerjee A. B. Freeman School of Business Tulane University 7 McAlister Drive New Orleans, LA Suman.Banerjee@tulane.edu (504) Vladimir A. Gatchev A. B. Freeman School of Business Tulane University 7 McAlister Drive New Orleans, LA vgatche@tulane.edu (504) Paul A. Spindt A. B. Freeman School of Business Tulane University 7 McAlister Drive New Orleans, LA spindt@tulane.edu (504) February 2005 JEL classification:g35, G33 Keywords: Dividends; Payout policy; Liquidity; Trading friction Please address correspondence to Vladimir A. Gatchev, A. B. Freeman School of Business, Tulane University, 7 McAlister Drive, New Orleans, LA Tel. (504) ; vgatche@tulane.edu. For helpful discussions and comments we thank Vladimir Atanasov, David Blackwell, Michael Brandt, Valentin Dimitrov, Chitru Fernando, John Graham, Joel Horowitz, Kose John, David Lesmond, Neal Maroney, David Mauer, Tom Noe, Nagpurnanand Prabhala, Michael Rebello, Bill Reese, Ramana Sonti, Venkat Subramaniam and Sheri Tice. The paper has also benefited from comments by seminar participants at Tulane University, University of New Orleans, Southern Methodist University, Kennesaw State University, University of Missouri, Georgia State University, University of Central Florida, Auburn University, University of Cincinnati, University of Oklahoma, the 2003 EFMA meetings, and the 2004 WFA meetings. We would like to thank Michael Lemmon in particular, our discussant at the 2004 WFA meetings, for his comments and insights. We remain responsible for any errors.

2 Stock Market Liquidity and Firm Dividend Policy ABSTRACT We provide evidence of a link between firm dividend policy and stock market liquidity. In the cross-section, owners of less (more) liquid common stock are more (less) likely to receive cash dividends. Over time, the notable increase in US stock market liquidity explains most of the declining propensity of firms to pay dividends documented by Fama and French (2001). We further show that past liquidity is an important determinant of dividend initiations and omissions for individual firms. Extending our analysis, we find evidence that sensitivity of firm value to innovations in aggregate liquidity declines after dividend initiations. JEL classification:g35, G33 Keywords: Dividends; Payout policy; Liquidity; Trading friction

3 Firms dividend policies continue to puzzle financial researchers. In this paper, we argue that investor demand for stocks paying cash dividends is positively related to the trading friction that investors face when creating homemade dividends. We further hypothesize that the likelihood a firm will pay cash dividends is positively related to investor demand for dividend payments and therefore inversely related to the market liquidity of the firm s stock. Examining the empirical evidence, we find strong support for our hypothesis. In their seminal work, Miller and Modigliani (1961) formally developed the dividend irrelevance hypothesis. In perfect capital markets populated by rational investors, a firm s value is solely a function of the firm s investment opportunities and is independent of the firm s payout policy. A large body of theoretical work has tried to evaluate the importance that managers and investors attach to dividend policy in light of the irrelevance proposition. The starting point of these studies is to question some of the assumptions that characterize the perfect capital markets hypothesized by Miller and Modigliani. 1 One notable assumption of the dividend irrelevance proposition, and one central to this paper, is that trading is frictionless. In perfect markets, investors can instantaneously invest or liquidate their investment in any stock without incurring any direct or indirect costs of trading and without changing the price of the underlying security. In markets with no trading friction, rational investors with liquidity needs can create homemade dividends at no cost by selling an appropriate amount of their holdings in the firm. As a result, they will be indifferent between receiving a dollar of dividend and selling a dollar s worth of their investment. In markets with trading friction, stocks that pay cash dividends allow investors to satisfy their liquidity needs with little or no trading in the stock and thus enable them to avoid trading friction. As a result, investors with current or anticipated future liquidity needs may have a preference for dividend paying stocks. This preference will be positively related to the level of trading friction so that higher (lower) trading friction will lead to higher (lower) demand for cash dividends relative to homemade dividends. Dong, Robinson, and 1 Allen and Michaely (2001) provide a survey on the literature. 1

4 Veld (2003) present survey evidence that retail investors want dividends, partly because their costs of cashing in dividends are lower than the transaction costs involved in selling shares. 2 It is important to address the question of how investor demand for dividends translates into actual dividend policy. On the one hand, existing literature argues that stock market liquidity affects the valuation of firms both in the cross-section and through time. 3 In this literature, stocks with higher liquidity levels (i.e., lower trading friction) trade at a premium and have lower expected returns relative to stocks with lower liquidity levels (i.e., higher trading friction). Firms, however, can pay cash dividends, reduce investor dependence on the liquidity of the market, and therefore raise their valuations an option more valuable for firms with higher discount rates due to lower liquidity levels. Indeed, Baker and Wurgler (2004a, 2004b) present significant evidence that firms consider valuation effects when choosing a dividend policy. On the other hand, it is also possible that investors directly enforce the desired dividend policy, as suggested by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000). While the possibility of a link between stock market liquidity and the dividend policy of the firm dates at least back to Miller and Modigliani (1961), current literature provides little direct empirical evidence on that issue. Some indirect evidence, however, is consistent with our hypothesis. For example, Long (1978) documents that between 1956 and 1976 the cash dividend class of shares of Citizens Utilities Company on average sold at a premium to the stock dividend class. Subsequent work by Poterba (1986) shows that the two classes of shares trade at similar prices for the period. The disappearing premium on the cash dividend shares is consistent with an increase in the liquidity of the market in that period. 2 Dividend reinvestment, if needed, can result in additional trading costs for investors. In 1954 NYSE implemented the Monthly Investment Plan (MIP) that, among other things, allowed reinvestment of dividends. This program was terminated in Meanwhile, in 1968, Citibank (then First National City Bank of New York) introduced the first dividend reinvestment program (DRIP). DRIPs increased in popularity and since the mid-1970s most firms have such programs (see Davey (1976) and Carlson (1996)). One of the major objectives of such programs is to allow investors to reinvest dividends. 3 See, for example, Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), Brennan, Chordia, and Subrahmanyam (1998), Amihud (2002), Jones (2002), and Pástor and Stambaugh (2003). 2

5 Nevertheless, the question of whether stock market liquidity has an incremental impact on the dividend policy of the firm remains largely an empirical one and its investigation is the focus of the current study. We perform our analysis while taking into consideration firm size, profitability, and growth opportunities. The necessity to control for these variables arises for at least two reasons. First, their use as determinants of dividend policy is consistent with the role of dividends in controlling the agency costs of free cash flow (Easterbrook, 1984; Jensen, 1986) and with a pecking-order model where firms avoid issuing securities due to asymmetric information costs (Myers and Majluf, 1984; Myers 1984) and other flotation costs. The empirical importance of these variables for the firm s decision to pay dividends is examined in Fama and French (2001) and is further confirmed in our study. Second, the liquidity of the firm s common stock can also be related to the size, profitability, and growth opportunities of the firm. Therefore, it is important to examine the link between firm dividend policy and liquidity after controlling for the possibility of such a relation. For the remainder of the paper, we refer to these variables as firm characteristics and to their collective explanatory power over the dividend policy of the firm as the firm s ability to pay dividends. The main results of the paper can be summarized as follows. First, we document that firms with less liquid markets (characterized by low trading activity, high proportion of zero trading days, and high price impact of order-flow) are more likely to pay dividends. These results persist after we control for the characteristics of the firm discussed above and provide direct support for our hypothesis. Second, we present evidence that market liquidity and firm likelihood to pay dividends are negatively related over time. The past four decades are characterized by declining commission rates, declining bid-ask spreads, and a ten-fold increase in market activity measures frequently used to quantify the liquidity of the stock market. When we apply our estimates to predict the proportion of dividend payers in more recent years, we find that increased market liquidity explains most of the lower propensity of firms to pay dividends documented by Fama and French (2001). Furthermore, the predictive accuracy of a model that controls for stock market liquidity, versus a model that does not, is 3

6 more pronounced for firms more likely to pay dividends based on their size, profitability, and growth opportunities (i.e., firms with higher ability to pay) and for firms with more liquid stocks. 4 We further address the question of whether dividend policy determines stock market liquidity and not vice versa. We now perform our analysis conditional on the past dividend policy of firms while at the same time we use a historic measure of liquidity rather than a contemporaneous one. We find that past year market liquidity is an important determinant of dividend initiations and of dividend omissions. Less (more) liquid firms that have never paid dividends are more (less) likely to initiate dividend payments. Similarly, less (more) liquid firms that have paid dividends for the past five years are more (less) likely to continue paying dividends in the future. For dividend initiations, the predictive accuracy of a model that controls for market liquidity, versus a model that does not, is higher and the improvement is comparable to our results for all firms. For dividend omissions, stock market liquidity has no economic power in explaining the dividend omission rates of firms. In fact, we do not find lower propensity to pay dividends for firms with long history of dividend payments. Models based on firms ability to pay dividends and models based on ability and stock market liquidity equally well explain more recent dividend omission rates of firms. In other words, we do not observe lower propensity to pay (i.e., higher propensity to omit dividends) for dividend paying firms. Up to this point of our discussion we have focused on the relation between dividend policy and liquidity at the firm level. Recent studies, however, present evidence of a common liquidity factor across firms. Chordia, Roll, and Subrahmanyam (2000), for example, find that several measures of liquidity co-move with market- and industry-wide liquidity. Pástor and 4 DeAngelo, DeAngelo, and Skinner (2004) find that the reduction in payers documented by Fama and French (2001) occurs almost entirely among firms that paid or would have paid very small dividends. This evidence is consistent with our hypothesis since in more liquid markets investors can hold portfolios with more stocks and replicate small dividend payouts by combining firms with high payouts and firmswithnopayouts in their portfolios. This would effecively reduce the demand for low dividend payout stocks. 4

7 Stambaugh (2003) propose that assets with high positive sensitivity of returns to aggregate liquidity result in disproportionate decrease of investor welfare when aggregate liquidity is low. They find significant evidence that investors price this liquidity risk so that stocks with high sensitivities of returns to aggregate liquidity have higher expected returns than stocks with low or negative sensitivities. Extending our previous arguments, we now suggest that the demand of investors for dividend paying stocks, and thus the value of such stocks relative to non-paying stocks, is higher in states characterized by low aggregate liquidity. We therefore expect that dividend initiating firms will reduce their return sensitivity to innovations in aggregate liquidity. We build upon the work of Pástor and Stambaugh (2003) and indeed find that, after firms initiate dividend payments, their stock returns become less sensitive to aggregate liquidity. This result further suggests that investors, when valuing firms, view cash dividends and stock market liquidity as substitutes. The rest of the paper is organized as follows. Section I describes the data and the variables of this study. Section II provides our cross-sectional results. Section III outlines the changes in the qualities of US security markets for the period of and the changes in firm dividend policy. Section IV investigates the effectiveness of liquidity in explaining the changes in firm dividend policy over time. Section V reports separate results for past payers and past non-payers. Section VI describes our robustness tests. Section VII examines the changes in systematic liquidity risk around dividend initiations, and Section VIII concludes. 5

8 I. Sample and Variables A. Sample Our study covers NYSE and AMEX firms for the years from 1963 to We gather data from the COMPUSTAT annual files, and the Center for Research in Security Prices (CRSP) monthly and daily files. We exclude firms with CRSP Standard Industrial Classification (SIC) codes between (financials) and between (utilities) and restrict our main sample to firms with publicly traded common stock with CRSP share codes of 10 or 11. Our main sample consists of all firms for which we can obtain the earnings-to-assets ratio, the market capitalization, the market-to-book ratio, the growth in assets from the previous year, and share turnover. Data requirements on additional variables used in some of the tests dictate the actual sample sizes of these tests. B. Variables In this section we present and motivate the variables that we use in our empirical tests. The precise computation of these variables is outlined in Table I. A firm is defined as a dividend payer in year t whenever COMPUSTAT reports positive dividends per share for fiscal year t. Our results, however, do not change if we use CRSP data to identify dividend-paying firms by comparing returns including distributions to returns excluding distributions. The first set of variables that we use to explain the dividend decision of firmsisbased on the size, profitability, and growth opportunities of the firm. We construct these variables as in Fama and French (2001). For a given year t and for every firm i the measure of firm size is equal to the percentage of NYSE firms with market capitalization lower than the market capitalization of firm i. The firm s market capitalization for year t is equal to the 5 Nasdaq trading volume is overstated relative to NYSE and AMEX trading volume and this does not allow us to use all firms. However, we have performed our analysis also separately for Nasdaq stocks and obtain similar results, which are available on request. 6

9 product of its share price and shares outstanding for June of year t as reported in the CRSP monthly files. This measure of firm size is constructed under the assumption that the NYSE market capitalization percentiles have constant implications for the dividend policy of the firm throughout the examined period. The profitability and growth opportunities proxies are calculated using COMPUSTAT data for fiscal year t. Firmprofitability for year t we measure as earnings divided by assets for that year (E t /A t ). To proxy for growth opportunities we use the value-to-assets ratio of the firm for year t (V t /A t )andtheproportionatechangein assets for year t (da t /A t ). The second set of variables that we use to explain the dividend decision of firmsisaimedat capturing the market liquidity of the firm s common stock. It is unlikely that a single empirical measure can capture all aspects of market liquidity. Therefore, in our cross-sectional analysis we use several proxies for stock market liquidity. Three of the proxies are directly related to the trading activity in a firm s common stock, and one is related to the price impact of trades. The trading activity in the stock of the firm has both theoretical as well as empirical appeal as a measure of liquidity. Constantinides (1986) showsthatlargerfixed transaction costs broaden the region of no transaction while Amihud and Mendelson (1986) develop a model where assets with higher bid-ask spreads have longer holding periods, thus lower trading activity. Atkins and Dyl (1997) provide empirical support for these models. Additionally, the combined evidence of Stoll (1978) and Stoll (2000) suggests that a measure of trading activity plays an important role in explaining the cross-sectional variation in bid-ask spreads both in historic and current data. Trading activity also has implications for the execution risk of an investor where firms with higher trading activity have lower execution risk, all else equal. Finally, trading activity may also have a more direct impact on investor demand for cash dividends. When there are economies of scale in trading, the marginal cost of creating homemade dividends is lower when investor trading activity is higher. As a result, investor demand for cash dividend paying stocks should decline when trading activity is high. Our first 7

10 measure of trading activity is the annual share turnover the ratio of shares traded to shares outstanding for calendar year t from COMPUSTAT (TURN t ). 6 Existing research has widely used share turnover as a proxy for liquidity (see, for example, Datar, Naik, and Radcliffe (1998) and Chordia, Subrahmanyam, and Anshuman (2001)). Because of its theoretical and empirical appeal, we use share turnover to proxy for liquidity when we analyze the relation between liquidity and dividend payers over time. In these tests we assume that share turnover has relatively constant implications for the dividend policy of firms over time. We construct two additional proxies for the trading activity in a stock using the annual traded dollar volume in the stock (DVOL t ) (Brennan, Chordia, and Subrahmanyam (1998) and Chordia, Subrahmanyam, and Anshuman (2001)) and the proportion of days with zero traded volume as an inverse measure of trading activity (NOTRD t )(GlostenandMilgrom(1985), Kyle (1985), Constantinides (1986), Dumas and Luciano (1991)). Our final proxy for liquidity is the illiquidity ratio (ILLIQ t ). This measure, or its inverse (the Amivest measure of liquidity), is used in existing research to proxy for the depth of themarketandtheimpactoforder-flow on stock prices as analyzed by Kyle (1985). 7 It is calculated as the average ratio of absolute daily return to daily dollar volume using data from the CRSP daily files. In order to ensure that outliers do not drive our results, we winsorize all variables based on their annual 0.5th and 99.5th percentiles, excluding the proxy for size, which by construction is bounded between 0.00 and [Insert Table I about Here] 6 UsingCRSPdatagivessimilarresults. 7 See, for example, Amihud, Mendelson, and Lauterbach (1997), Amihud (2002), and the references therein. 8

11 II. Empirical Evidence in the Cross-section In this section we first perform annual cross-sectional logistic regressions between 1963 and 2003 to explain the dividend policy of the firm. We report the average coefficient estimates for several time periods to assess the importance of the variables and their robustness over time. InTableIIwepresenttheaveragecoefficient estimates for different specifications for three sub-periods ( , , and ). Panel A of Table II uses only share turnover to predict the probability of dividends. The results suggest that there is a significant negative relation between a firm s stock market liquidity and its likelihood to pay dividends. This relationship is significant at the 0.01 level for all examined sub-periods. Further investigation reveals that the impact of liquidity on dividends is nontrivial. The likelihood of a dividend for the average firm for the period is percent. Our estimates suggest that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in this probability to (81.04) percent. The additional analyses for and for also reveal significant sensitivities of dividends to the liquidity of the firm s stock. Using the estimates for we find that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in the average probability of to (54.46) percent. We now turn to multivariate tests where we also control for several firm characteristics that existing research relates to firm dividend policy. As explanatory variables, we first use proxies for firm size, firm profitability, and firm growth opportunities. Results are presented in Panel B of Table II, columns (1), (4) and(7). The estimates are similar to the ones reported by Fama and French (2001). Larger and more profitable firms are more likely to pay dividends, while firms with higher growth opportunities are less likely to do so. We also add several measures of liquidity to the set of explanatory variables. The results with share turnover are presented in Panel B while the results with all other measures are 9

12 presented in Panel C of Table II. Columns (2), (5), and (8) of Panel B, Table II show that share turnover is again negatively and significantly (at the 0.01 level) related to the likelihood of dividends for the three examined sub-periods. The coefficient estimate suggests that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in firm probability to pay dividends from percent to (81.64) percent. The results for are very similar to the univariate results presented in Panel A. In later periods, however, the impact of liquidity on the likelihood of dividends is more significant when we control for the firm characteristics discussed above. For , for example, one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in the probability of dividends from percent to (66.70) percent. The increased importance of liquidity, after controlling for the growth opportunities of the firm, is not consistent with the idea that theimpactofliquidityonfirm dividend policy is mainly driven by a possible positive link between liquidity and growth opportunities in the cross-section. The tests that we perform above assume that liquidity has the same impact on the dividend decision of firms regardless of their characteristics. In general, this need not be the case. In particular, liquidity should be more relevant for the dividend decision of firms with higher ability to pay dividends (i.e., large, profitable firms and firms with low growth opportunities) since such firms have more flexibility in their decision to pay or not to pay dividends. Alternatively, if it is prohibitively costly for the firm to provide dividends (e.g., small firms with no profit and high growth opportunities), then stock market liquidity may have little or no effect on the dividend policy of the firm. To analyze whether liquidity has differential impact on the dividend policy of firms depending on their firm characteristics, we allow for different coefficient estimates of share turnover for two portfolios of firms. The first portfolio consists of firms that are less likely to pay dividends (probability less than 70 percent) based on firm characteristics while the second portfolio consists of firms that are more likely (probability more than 70 percent) to pay dividends based on firm characteristics. The estimates are given in columns (3), (6), and (9). We find that the probability of dividend payments 10

13 is more sensitive to liquidity for the portfolio of firms that are more likely to pay based on firm characteristics. For , one percentage point increase in share turnover results in approximately 0.33 percentage points decrease in the likelihood of dividend payments for firms that are less likely to pay based on firm characteristics. In contrast, one percentage point increase in share turnover for firms that are more likely to pay, based on their characteristics, results in a decrease in the likelihood to pay dividends by 0.41 percentage points. This evidence is consistent with the notion that liquidity is more relevant for the dividend policy of firms with lower costs of issuing dividends. The rest of our liquidity measures are also related to the likelihood of dividends in line with our hypothesis. Columns (1), (4), and (7) of Panel C, Table II show that firms with higher illiquidity ratios are more likely to pay dividends. Similarly, firms with lower trading volume and firms with higher proportion of days with no trading are also more likely to pay dividends. All of the examined relations are significant at the 0.01 level for all sub-periods except the illiquidity ratio in the sub-period when it is significant at the 0.05 level. We also analyze the impact of one standard deviation change in the different liquidity measures on the probability of dividends. In , for example, one standard deviation decrease in the illiquidity ratio (i.e., increase in liquidity) results in a decline in the probability of dividends from percent to percent. In the same period, one standard deviation increase in dollar volume results in a decline in the probability of dividends from percent to percent while one standard deviation decrease in the proportion of days with no trading leads to a decline in the probability to pay from percent to percent. While all liquidity variables have a nontrivial impact on the probability of dividends, the illiquidity ratio (for the first two periods) and share turnover (for the last period) have the most notable impact on the estimated probability of dividends. [Insert Table II about Here] In additional tests we have investigated the possibility that measurement error in value- 11

14 to-assets is driving our cross-sectional results (Erickson and Whited (2000)). We have used an instrumental variable approach where as instruments for the value-to-assets of the firm we use research and development expense divided by assets and our results remain unchanged. Further, we have examined whether share turnover is capturing firm growth rather than liquidity. When we regress each year share turnover on value-to-assets, change in assets, and research and development to assets, the R 2 of the regression is around 5% and rarely above 10%. Further, we have also included additional proxies for growth to explain the firm s decision to pay dividends in the attempt to better control for growth. These proxies include research and development-to-assets, change in assets in year t+1, and change in assets in year t+2. The qualitative as well as the quantitative results pertaining to liquidity are robust to these tests and the magnitude of the coefficients and the predictive ability are insensitive to these inclusions. Thus, even though we cannot rule out the above-mentioned problems, we do not find any evidence that such problems are responsible for our findings. The evidence presented in this section provides significant direct support for our hypothesis. After controlling for the impact of firm characteristics on firm dividend policy, we find that holders of common stock with less liquid market are also more likely to receive dividends. This link is robust across the 41 years of data we have gathered and across different measures of market liquidity. III. Stock Market Liquidity and Dividend Payers over Time A. Changes in Market Liquidity from 1963 to 2003 In this section we briefly outline the significant changes in the features of US stock markets between 1963 and Prior to 1975 the cartel on NYSE was characterized by fixed commission rates, limited entry, and rules that prohibited price-cutting and that limited brokerage services per seat. Potential competition from other exchanges in the trading of NYSE listed stocks was reduced through additional regulations. 12

15 The Securities Acts Amendments of 1975 and Rule 19b-3 became effective on May 1, These amendments resulted in the abolition of fixed commission rates and mandated a national market system for securities in which competitive forces would play a much more significant role. The deregulation of the industry was accompanied by the emergence and expansion of discount brokers. In more recent years, the emergence of Internet brokers has led to even higher competition in the industry. By the first quarter of 1976, commissions of institutional firms have declined by 31.6% (see Stoll (1979)). The decline in overall commission rates continued for the remainder of the century. Evidence in Jones (2002) shows a steady decline of average commission rates from around 0.80% in the period to around 0.10% in Furthermore, Jones (2002) finds that the average proportionate quoted bid-ask spread for the 30 Dow Jones Industrial Average (DJIA) stocks has declined from around 0.60% in the period to around 0.20% by the end of the 1990 s. Combining commissions and bid-ask spread costs, Jones (2002) argues that total one-way costs have decreased from around 1.30% in the period to around 0.20% in The above outlined changes in the competitive environment of US security markets and the direct costs of trading were accompanied by a dramatic increase in trading activity. Average (median) annual share turnover has increased from approximately 25% (17%) in1963 to around 101% (82%) in2000. The decline in trading costs and the increase in trading activity suggest that the liquidity of the stock market has improved significantly over time. [Insert Figure I about Here] B. Stock Market Liquidity and Dividend Payers a Graphic Interpretation In this section we look at the time trends in stock market liquidity, measured by the average share turnover, and the proportion of dividend paying firms. Figure II shows that the steady increase in liquidity after 1978 is accompanied by a steady decline in the proportion 13

16 of dividend payers. We further find that improved liquidity in the late 1960 s is also followed by a decline in the proportion of dividend payers. [Insert Figure II about Here] To further investigate this issue, we examine dividend decisions of firms based on their past dividend policies. Figure III, Panel A examines firms that did not pay dividends in year t-1 and reveals that dividend initiation (and resumption) rates are negatively related to the liquidity of the stock market. We also observe that changes in stock market liquidity and dividend initiation rates are closely aligned over time. When we analyze the dividend decisions of firms that pay dividends in year t-1 (Panel B), we see that dividend omission rates are higher after However, this result does not seem to be as pronounced as the decline in dividend initiation rates for the sample of non-payers and former payers. [Insert Figure III about Here] BakerandWurgler(2004a) document that firms cater to the preferences of investors so that when dividend payers sell at a premium (discount) more firms tend to pay (not pay) dividends. Baker and Wurgler (2004b) further use the catering theory to explain the declining propensity of firms to pay dividends. Our paper provides one possible explanation for the variation in the dividend premium over time - namely changes in the liquidity of the stock market. We use the dividend premium reported by Baker and Wurgler (2004a) to compare its variation to the variation in stock market liquidity over time. Figure IV suggests that when liquidity levels are high dividend payers tend to sell at a discount while the opposite is true for low levels of liquidity. Also, we find that the standardized returns to dividend initiation announcements (again obtained from Baker and Wurgler (2004a)) are low when stock market liquidity is high and vice versa. This evidence is consistent with our hypothesis that firms cater (possibly through market valuation) to the liquidity preferences of investors. [Insert Figure IV about Here] 14

17 The initial results of this section are consistent with the notion that stock market liquidity is related to the proportion of dividend payers over time and suggest that the declining proportion of dividend payers is related to improved market liquidity. The link seems to be more pronounced for firms that do not pay dividends in year t-1, i.e. thosefirms that are the main source of the decline of dividend payers. IV. Predicting Dividend Payers over Time A. The Predictive Ability of Liquidity In this section we further extend the tests of our hypothesis by analyzing the ability of improved market liquidity to predict the proportion of dividend payers for the period of In the base model we use the estimated coefficients from column (1) oftableii, Panel B to predict the proportion of dividend payers based on the ability of the firm to pay dividends. In the second model we add share turnover as an explanatory variable so that we use the estimated coefficients from column (2) of Table II, Panel B to predict the proportion of dividend payers. In the third model we use the coefficient estimates from column (3) of Table II, Panel B where we allow for differential impact of market liquidity on firms that are less able and firms that are more able to pay based on their size, profitability and growth opportunities. The actual and the predicted proportions of dividend payers for the three models are presented in Table III. 8 [Insert Table III about Here] When we analyze the predictive ability of the three models we see that the model that takes into account market liquidity significantly decreases the difference between the predicted payers estimated from the base model and the actual payers. In , for example, the 8 We have also used variability in earnings as another predictor of the probability to pay dividends. While the results in terms of prediction of payers over time improve, lower propensity of firms to pay is still evident and liquidity still explains most of it. 15

18 difference between predicted and actual payers is percentage points using the original model based only on firm characteristics. This difference declines to 6.36 percentage points when liquidity is taken into account. There is even further improvement in predictive ability when we allow for differential impact of liquidity on the portfolios of firms with higher ability to pay and for firms with lower ability to pay - the predictive error in is reduced to 4.69 percentage points. The results in this section provide evidence over time consistent with our hypothesis that the likelihood of dividend payments is negatively related to the liquidity of common stocks. Improved liquidity is one of the reasons (though not the only one) for the decline in dividend paying firms for the past quarter century. In more recent work, Julio and Ikenberry (2004) find that during 2003 and 2004 the propensity of firms to pay dividends has increased. They attribute this increase to the maturing of firms, the desire of firms to signal confidence in the wake of corporate governance scandals, and the dividend tax cut of It is important to note that our hypothesis and the hypotheses advanced by Julio and Ikenberry (2004) arenot mutually exclusive. As a result, the evidence in Julio and Ikenberry (2004) is not inconsistent with our hypothesis. B. ThePredictiveAbilityofLiquidity for Several Portfolios In this section we first analyze the predictive ability of the different models for two portfolios based on the market liquidity of the firm s common stock. We then analyze the predictive ability of the different models for two portfolios based on the likelihood of dividend payments as predicted only by firm characteristics. We expect that improved market liquidity should explain the declining propensity of firms to pay dividends better for more liquid firms and for firms with higher ability to pay dividends. In Panel A of Table IV we create two portfolios based on the median share turnover for the period. The sample size of firms with low share turnover decreases over 16

19 time due to the increase in share turnover for the average firm. The model based only on firm characteristics (model (1) of Table II, Panel B) results in higher prediction error for the portfolio of high turnover stocks. For the six-year period of the average predictive error for the low turnover stocks is percentage points while the average error for the high turnover stocks is percentage points. When we add share turnover as an explanatory variable (model (2) of Table II, Panel B) we see that the predictive ability improves mostly for the portfolio of more liquid (high turnover) stocks. More important, there is a reversal in the predictive error the predictive error now is lower for the portfolio of stocks with higher share turnover (0.98 percentage points) as opposed to the portfolio with low share turnover (16.83 percentage points). We now create two portfolios of firms based on the predicted probability of dividend payment using only firm characteristics. Firms that are more likely to pay dividends (a predicted probability above 70%), based on firm characteristics and average estimates from the period enter into the first portfolio. The second portfolio consists of firms that are less likely to pay dividends (a predicted probability below 70%) based on firm characteristics. In the tests to follow, we allow stock market liquidity to differentially influence the dividend choice of firms in the two portfolios. The results are presented in Panel B of Table IV. Trying to predict dividend payers based only on firm characteristics (model (1) oftable II, Panel B) results in higher predictive error for the portfolio of firms that are more likely to pay - larger, more profitable firms, and firms with fewer growth opportunities. The predictive error for such firms is percentage points as opposed to a predictive error of for firms with the characteristics of non-payers. This result is to be expected in view of the findings of Fama and French (2001) thatfirms with the characteristics of payers are less inclined to pay dividends in more recent years. Adding share turnover as an explanatory variable (Model (3) of Table II, Panel B) produces a reversal in predictive ability so that now the predictive error is lower for the portfolio of firms that are more likely to pay based on 17

20 firm characteristics. The reduction in the predictive error for the portfolio of firms more able to pay dividends based on their characteristics is noteworthy. In the period, for example, the predictive error when we control for liquidity declines to 3.27 percentage points. For the portfolio of firms that are less able to pay dividends the predictive error declines to 6.60 percentage points. [Insert Table IV about Here] We summarize the above discussion by concluding that a model that attempts to predict dividend payers based on firm characteristics fails to perfectly predict the proportion of dividend payers in more recent years. Further examination shows that such a model is less accurate when applied to firmsthathavemoreliquidstockmarketsandfirms with higher ability to pay dividends. Controlling for stock market liquidity improves the overall predictability of the model. The predictability improves more significantly for firms with more liquid stock markets and firms that, for a given level of stock market liquidity, are more able to pay dividends. These findings further support our hypothesis that stock market liquidity is relevant for firm dividend policy and that improved market liquidity has influenced firms with the characteristics of dividends payers to not pay dividends in more recent years. 9 V. Dividend Initiations and Omissions Existing research has found that the dividend decisions of firms that do not pay dividends are not the same as the dividend decisions of firms that already do. To address this issue we perform our tests separately for past payers and past non-payers. Furthermore, differences in the present and past dividend policy across firms may lead to differential trading of investors in those firms. In other words, there is a possibility that our 9 When we use the portfolio approach of Fama and French (2001) we obtain similar patterns in the overall predictive ability of the two models under consideration. The overall difference between predicted and actual payers, however, is larger than in the logistic predictive model. 18

21 results are a manifestation of reverse causality where dividend policy determines the liquidity of the market. By performing separate analysis for past payers and past non-payers we also address the question of causality. We split our sample in two - firms that have never paid dividends and firms that have either always paid dividends or have paid dividends in all of the five years prior to year t. This separation controls for the past dividend policy of the firm. Furthermore, we use share turnover for year t-1 as an explanatory variable, which controls for possible effects that present dividend policy may have on current share turnover. The results for the two portfolios are presented in Table V. We find that liquidity is significantly (mostly at the 0.01 level) negatively related to the dividend policy of the firm regardless of whether the firm has historically paid dividends or not. However, the additional sensitivity analyses show that liquidity has a nontrivial explanatory power only for dividend initiation rates and not for dividend omission rates. In , for example, one standard deviation increase in liquidity leads to a decline in the dividend initiation rates of non-payers from 9.55 percent to 7.33 percent. [Insert Table V about Here] We finally predict dividend initiation rates of firms that have never paid dividends prior to year t and the dividend continuation rates for past dividend payers using the estimates from above. The actual and predicted-minus-actual probabilities are presented in Table VI. For past payers, both models - the model based on firm ability to pay and the model that also controls for market liquidity - predict equally well the probability of firms to continue paying dividends. However, for firms that have never paid dividends, liquidity again proves to be an important predictor of dividend initiation rates. Overall, the model that uses only firm characteristics to predict initiation rates results in predictions that are higher than the actual initiation rates. The magnitude of the errors is significantly reduced when we introduce share turnover as an explanatory variable. In , for example, the model based only on firm 19

22 characteristics makes an error of 4.5 percentage points while including share turnover reduces the error to 1.75 percentage points. [Insert Table VI about Here] The evidence presented in this section is consistent with our hypothesis that stock market liquidity is an important (although not the only) determinant of the firm s decision to pay or not pay dividends. The results further show that liquidity is an economically important variable for dividend initiations but not for dividend omissions. VI. Robustness Analyses 10 A. Share Repurchases Since the mid-1980s the share repurchase activity of firms, especially open market share repurchase activity, has increased significantly (see, for example, Jagannathan, Stephens, and Weisbach (2000) and Grullon and Michaely (2002)). Share repurchases constitute an alternative means through which firms can distribute cash to shareholders and firms that repurchase shares may have lower ability to also pay dividends. Furthermore, share turnover, as a measure of liquidity, can be affected by open market share repurchases performed by the firm. We address these issues in the current section. Before we continue, it is important to note that dividends and share repurchases are not necessarily perfect substitutes. On the one hand, dividends are usually taxed at higher rates than capital gains and they are less flexible as a payout policy (see Jagannathan, Stephens and Weisbach (2000)). On the other hand, repurchases can impose additional costs on investors (see Barclay and Smith (1988), Brennan and Thakor (1990), and Chowdhry and Nanda (1994)) because they can lead to transfer of wealth among investors. Finally, open market repurchases do not lead to investor avoidance of trading friction since investors still have to trade in order to create homemade dividends. 10 For the sake of brevity we do not tabulate the results of this section. All tables are available upon request. 20

23 Fama and French(2001) show that share repurchases are largely performed by dividend paying firms and that repurchases do not account for the declining propensity of firms to pay dividends. In this section, we argue that our own results are not driven by the increased share repurchase activity of firms. First, we find that stock market liquidity is negatively related to the dividend policy of the firm in the cross-section for a portfolio of firms that do not repurchase shares. This relation is significant at the 0.01 level in all the sub-periods and is economically important. When we predict the proportion of dividend payers for , a model based only on firm ability to pay makes a predictive error of percentage points while a model including liquidity reduces the error to percentage points. Second, to take into account the effect of share repurchases on the ability of the firm to pay dividends we subtract the repurchased amounts from the earnings available to common shareholders and use this adjusted measure of profitability to predict dividend payers. We additionally adjust share turnover for the impact that open market share repurchases may have on it from the traded shares in a given year we subtract the repurchase dollar amounts divided by the share price of the firm. Since we use total repurchases and not only open market repurchases, this adjustment overestimates the total number of repurchased shares. However, the error should be smaller in the 1970s 11 when firms rarely repurchased shares and for the end of our sample when most of the share repurchases are open market repurchases (Stephens and Weisbach (1998); Jagannathan, Stephens, and Weisbach (2000)). As a result, our predictions for later years based on estimates should be relatively unaffected. 12 We find that the coefficients on the adjusted share turnover are very similar to the coefficients on the unadjusted share turnover presented in Table II, Panel B. We also find that, based on firm characteristics, there is a lower propensity of firms to pay dividends over time. Including 11 COMPUSTAT has repurchase data from 1971, so we do not adjust values prior to that year. Using only years for which we have share repurchase data (1971 to 1978) as the estimation period leads to similar results. 12 We calculate share repurchase amounts as in Grullon and Michaely (2002). Their measure is similar to the one used by Jagannathan, Stephens, and Weisbach (2000). Using change in treasury stock as in Fama and French (2001) gives similar results. 21

24 adjusted share turnover as a predictor again decreases the predictive error significantly. In the period, for example, the model based on firm characteristics has a predictive error of percent on average. Including share turnover reduces that error to 5.93 percent. The overall results exhibit little differences from our previous findings. B. Institutional Clienteles It is possible that changes in institutional clienteles have resulted in changes in the dividend policies of firms. In this section we control for institutional ownership. We collect institutional ownership data from SDC Thomson Financial and we create a variable that is equal to the proportion of firm shares held by institutional investors. We then use this variable as another predictor of firm dividend policy. We find that the estimated coefficients for share turnover, after controlling for institutional ownership, are still significantly negative (at the 0.01 level) and even larger in magnitude. For , for example, the coefficient for share turnover is 1.15 as opposed to 1.00 when we do not control for institutional ownership. Therefore, even after we control for institutional ownership, we still find that stock market liquidity is negatively related to the probability of dividend payments. C. Stock Option Compensation The past two decades have also witnessed a significant growth in stock option compensation to firm top management. Since managerial stock options are not protected for dividend payments, they may provide incentives to managers to not pay cash dividends. We collect data from COMPUSTAT on shares reserved for conversion for the exercise of stock options (data item 215) and on total shares reserved for conversion (data item 40). We express these variables as a proportion of total shares outstanding and use them as additional control variables in our cross-sectional regressions. Our findings suggest that firms with more shares reserved for conversion (either for the exercise of stock option of for other reasons) are less likely to pay dividends. We further find 22