Stock Market Liquidity and Firm Dividend Policy

Stock Market Liquidity and Firm Dividend Policy Suman Banerjee A. B. Freeman School of Business Tulane University 7 McAlister Drive New Orleans, LA 70118 Suman.Banerjee@tulane.edu (504) 865-5558 Vladimir A. Gatchev A. B. Freeman School of Business Tulane University 7 McAlister Drive New Orleans, LA 70118 vgatche@tulane.edu (504) 865-5534 Paul A. Spindt A. B. Freeman School of Business Tulane University 7 McAlister Drive New Orleans, LA 70118 spindt@tulane.edu (504) 865-5413 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 70118. Tel. (504) 865-5534; E-mail: 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.

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

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

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 1976-1984 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 1976. 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

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 1963-1977 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

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

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 1963-2003 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

I. Sample and Variables A. Sample Our study covers NYSE and AMEX firms for the years from 1963 to 2003. 5 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 6000-6999 (financials) and between 4900-4949 (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

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

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 1.00. [Insert Table I about Here] 6 UsingCRSPdatagivessimilarresults. 7 See, for example, Amihud, Mendelson, and Lauterbach (1997), Amihud (2002), and the references therein. 8

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 (1963-1977, 1978-1992, and1993-2003). 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 1963-1977 period is 71.50 percent. Our estimates suggest that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in this probability to 59.55 (81.04) percent. The additional analyses for 1978-1992 and for 1993-2003 also reveal significant sensitivities of dividends to the liquidity of the firm s stock. Using the estimates for 1993-2003 we find that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in the average probability of 48.12 to 41.84 (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

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 1963-1977 coefficient estimate suggests that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in firm probability to pay dividends from 71.49 percent to 58.60 (81.64) percent. The results for 1963-1977 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 1993-2003, for example, one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in the probability of dividends from 48.12 percent to 30.04 (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

is more sensitive to liquidity for the portfolio of firms that are more likely to pay based on firm characteristics. For 1963-1977, 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 1993-2003 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 1963-1977, 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 71.41 percent to 38.02 percent. In the same period, one standard deviation increase in dollar volume results in a decline in the probability of dividends from 71.49 percent to 59.61 percent while one standard deviation decrease in the proportion of days with no trading leads to a decline in the probability to pay from 71.40 percent to 58.44 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

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 2003. 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

The Securities Acts Amendments of 1975 and Rule 19b-3 became effective on May 1, 1975. 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 1960-1980 period to around 0.10% in 2000. 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 1960-1980 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 1960-1980 period to around 0.20% in 2000. 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

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 1978. 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

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 1978-2003. 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 1998-2003, 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

difference between predicted and actual payers is 22.20 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 1998-2003 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 2003. 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 1963-2003 period. The sample size of firms with low share turnover decreases over 16

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 1998-2003 the average predictive error for the low turnover stocks is 14.53 percentage points while the average error for the high turnover stocks is 25.97 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 1963-1977 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 28.76 percentage points as opposed to a predictive error of 13.04 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

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 1998-2003 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

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 1963-1977, 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 1998-2003, for example, the model based only on firm 19

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

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 1993-2003, a model based only on firm ability to pay makes a predictive error of 23.26 percentage points while a model including liquidity reduces the error to 11.73 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 1963-1978 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

adjusted share turnover as a predictor again decreases the predictive error significantly. In the 1998-2003 period, for example, the model based on firm characteristics has a predictive error of 21.91 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 1993-2003, 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

that the coefficient estimates of share turnover are mostly unaffected by the inclusion of these new control variables. For the 1963-1977 period for example the coefficient estimate of share turnover is 1.63 when we control for total shares reserved for conversion. This estimate is very close to our previous estimate of 1.74 when we do not control for shares reserved for conversion. From 1996 onward COMPUSTAT stopped reporting the number of shares reserved for conversion. Therefore our last predicted proportion of dividend payers based on a model that controls for shares reserved for conversion is for 1995. The evidence suggests that, even after we control for shares reserved fro conversion, there is a lower propensity to pay dividends in more recent year. Furthermore, including share turnover again explains most of this lower propensity to pay. 13 VII. Dividend Policy and Liquidity Risk In this section we deviate from our previous framework. Until now we have focused our analysis on the relation between dividend policy and liquidity at the firm level. At this point we address the possibility of a link between dividend policy and aggregate liquidity. Pástor and Stambaugh (2003) propose that assets with high positive sensitivity of returns to aggregate liquidity result in disproportionate decline of investor welfare when aggregate liquidity is low. This is because liquidation is costlier when liquidity is lower and because investors have higher marginal utility of wealth when their wealth declines. Extending our arguments presented in the previous sections of the paper, we argue that investor demand for dividend paying stocks, and therefore the value of such stocks relative to non-paying stocks, is higher in states characterized by low aggregate liquidity. One implication of our argument is that dividend initiations will lead to a reduction in the sensitivity of stock returns to aggregate liquidity. 13 In unreported results we also control for the potential impact of dividend taxation relative to the taxation of capital gains, the debt level of firms, and the Nixon era. The qualitative results of the paper pertaining to liquidity persist in all of our robustness tests. The results are available on request. 23

In order to test the above implication, we identify a sample of firms that initiate dividend payments and analyze the changes in sensitivity of their returns to aggregate liquidity. Our methodology for estimating sensitivities to aggregate liquidity is based on Pástor and Stambaugh (2003). We collect a sample of firms that initiate dividends between 1966 and 1999 and use only firms that do not pay dividends in years t-3, t-2, andt-1 and pay dividends in years t+1, t+2, and t+3. We then create two value-weighted portfolios. 14 The first portfolio includes firms in the three years prior to dividend initiation. The second portfolio consists of the same firms but after dividend initiation. For example, the post-dividend portfolio in 1985 consists of all firms that initiated dividend payments in 1982, 1983, or1984. The pre-dividend portfolio in 1985 consists of all firms that initiated dividends in 1986, 1987, or1988. As a result of our sample selection methodology, the post-dividend portfolio in 1989 contains the same firms as the pre-dividend portfolio in 1985. We then estimate the market model, the three-factor model of Fama and French (1993), and the four-factor model (the three Fama-French factors plus a momentum factor) for each portfolio while also including the market-wide liquidity factor of Pástor and Stambaugh (2003). The three-factor model includes the market factor, the size factor, and the bookto-market factor. The market factor is the return of the value-weighted CRSP portfolio minus the risk-free rate, the size factor is the difference in returns between small and large stocks, and the book-to-market factor is the difference in returns between stocks with high and low book-to-market ratios. We use the momentum factor to account for the evidence presented by Jegadeesh and Titman (1993) thatpastperformanceispositivelyrelatedto future performance. 15 The liquidity factor of Pástor and Stambaugh (2003) isbasedonthe idea that order flow induces greater return reversals when liquidity is lower. The construction 14 Pástor and Stambaugh (2003) show that estimates of the liquidity beta are highly imprecise for small stocks and that the problem is mitigated in value-weighted portfolios. 15 We obtain the monthly Fama-French factors and the momentum factor from the Web site of Kenneth French (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/). 24

of the liquidity factor is outlined in the Appendix of the paper. The pre-dividend portfolio has 444 monthly returns and extends from 1963 to 1999. The post-dividend portfolio includes the same firms as the pre-dividend one but covers 444 monthly returns from 1967 to 2002. Both portfolios have a minimum of 10 stocks and a maximum of 88 stocks. Panel A of Table VII reports the estimated pre-dividend and post-dividend liquidity betas for each of the specifications. We find that the pre-dividend liquidity beta is equal to 3.49 in the four-factor model while the post-dividend liquidity beta for the same portfolio declines to 3.35. These two estimates are statistically different (at the 0.10 level) under the assumption of independence. Pástor and Stambaugh (2003) report that, for individual stocks, liquidity betas are significantly and positively correlated over time. Positive serial correlation of the liquidity beta of our portfolio will lead to higher than reported significance levels of the estimated difference. Using the distribution of liquidity betas for the ten portfolios reported by Pástor and Stambaugh (2003), our results suggest that dividend-initiating firms move from the highest liquidity beta portfolio (ten) to liquidity beta portfolio four (see their Table 3). This leads to a reduction in the expected rate of return of the firm of 3.12 percentage points per annum (see their Table 4). We further investigate the possibility that a similar trend is also observed for firms that do not initiate dividends. If we indeed observe such a trend, this would suggest that our results are not related to the dividend initiation decision of firms. Panel B replicates the analysis for firms that do not pay dividends in any year between year minus three to year plus three. The portfolios of non-initiating firms include significantly more stocks with a minimum of 152 and a maximum of 2, 157 stocks per month. We find that both before and after the measurement year this portfolio has negative liquidity betas that are relatively high in magnitude. Prior to the selection year this portfolio of dividend non-payers has a liquidity beta of 2.64 while after the selection year the portfolio s liquidity beta is 3.13 and the two betas are indistinguishable from each other. We conclude that the results reported in Panel 25

A are specific to dividend initiating firms. [Insert Table VII about Here] In summary, this section provides preliminary evidence that sensitivity of stock returns to aggregate liquidity declines after dividend initiations. One possible interpretation of this result is that, after dividend initiations, the value of the firm increases in states characterized by low aggregate liquidity and high marginal utility of wealth. Combined with existing evidence by Pástor and Stambaugh (2003), the results further suggest that reduced liquidity risk lowers expected returns by economically significant amounts. The overall results are consistent with the idea that stock market liquidity and cash dividends act as substitutes from the perspective of investors. VIII. Conclusion We hypothesize that, all else equal, the payout policy of the firm is related to the liquidity of its common stock. In illiquid markets investors will have greater demand for cash dividends from the stocks they hold. In highly liquid markets, however, investors can cheaply create homemade dividends. As a result, firms with more (less) liquid stock markets will have lower (higher) incentives to distribute cash dividends to their shareholders. We find a strong empirical relation between the dividend policy of the firm and the liquidity of its common stock. These results are prevalent throughout the analyzed period and remain after we control for the ability of firms to pay dividends. The documented declining propensity of firms to pay dividends over time is significantly related to the significant changes in the liquidity of US security markets. A period of fewer dividend payers is characterized by lower trading costs and increased market activity. We further present evidence that our results are more relevant for more liquid firms and firms that have the ability to pay cash dividends to their shareholders. 26

In this paper we take the repurchase policy of the firm as given and we show that, while share repurchases consume cash that can otherwise be distributed as dividends, our results are not driven by the increased popularity of open market share repurchases. It is also possible, however, that the proliferation of market share repurchase programs is, at least to some extend, stimulated by the improved liquidity of the stock markets over time. We additionally find that liquidity is a significant determinant of dividend initiations and dividend omissions. Our results suggest that firmswithless(more)liquidstocksaremore (less) likely to initiate dividend payments. Similar to our overall results, improvements in stock market liquidity over time account for most the declining propensity of firms to initiate dividends as well. Finally, we investigate one possible extension of our analysis. Our findings suggest that cash dividends and stock market liquidity act as substitutes from investors standpoint. Firms that initiate dividend payments reduce the sensitivity of their returns to aggregate liquidity, possibly because they lower investor exposure to systematic liquidity risk. This link is important since it further suggests that dividend policy can have an impact on firm value due to market imperfections. 27

Appendix For each firm i, for a given month t we estimate the regression: r e i,d+1,t = θ i,t + φ i,d,t + γ i,t sign r e i,d,t νi,d,t + ε i,d+1,t,d=1,...,d, (1) where r i,d,t is the return of stock i on day d in month t, ri,d,t e is r i,d,t minus the CRSP ³ value-weighted market return, and sign ri,d,t e ν i,d,t is the signed dollar volume for stock i on day d in month t in millions of dollars. We use only common shares with at least 15 daily returns ( D>15), that are listed on NYSE or AMEX at the end of year t-1, thatare priced between $5 and $1000 at the end of the previous month, and for which t is not the first or the last month of listing. Using the estimates of γ i,t for all firms in a given month NP that satisfy these conditions, we compute their equally-weighted average as bγ t = N 1 bγi,t. We then define: i=1 4bγ t = µ mt m 1 1 NP bγi,t bγ N i,t 1, (2) i=1 where m t is the market value of all firms used in the estimation for month t and m t corresponds to August of 1962. Finally, we estimate: 4bγ t = a + b4bγ t 1 + c µ mt 1 m 1 and set our measure of aggregate liquidity equal to bγ t 1 + u t, (3) L t = 1 100 bu t. (4) 28

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2.50% 200% 2.00% 160% 1.50% 120% 1.00% 80% 0.50% 40% 0.00% 0% 1963 1968 1973 1978 1983 1988 1993 1998 2003 Figure 1. NYSE Commission Rates and Stock Market Activity. Annual commission revenues of NYSE members and annual dollar volume on the exchange between 1966 and 2003 are obtained from the NYSE Fact Book. The annual NYSE commission rate (dashed line; left axis) is equal to total commission revenues divided by total dollar volume on NYSE for a given year. The sample used to calculate the average share turnover (solid line; right axis) consists of all firms with publicly traded common stock on NYSE with available information in the CRSP monthly files and the COMPUSTAT annual files. Share turnover is the ratio of shares traded to shares outstanding for calendar year t. 33

100% 200% 80% 160% 60% 120% 40% 80% 20% 40% 0% 0% 1963 1968 1973 1978 1983 1988 1993 1998 2003 Figure 2. Dividend Payers and Stock Market Liquidity. The sample consists of all firms with publicly traded common stock on NYSE or AMEX with available information in the CRSP monthly files and the COMPUSTAT annual files. Dividend payers (%) is the proportion of firms that paid dividends in fiscal year t (bars; left axis). Average share turnover (%) is the average percentage ratio of shares traded to shares outstanding for calendar year t (line; right axis). 34

Panel A. Dividend initiations (bars) and share turnover (solid line) 20% 200% 16% 160% 12% 120% 8% 80% 4% 40% 0% 0% 1963 1968 1973 1978 1983 1988 1993 1998 2003 Panel B. Dividend omissions (bars) and share turnover (solid line) 10% 100% 8% 80% 6% 60% 4% 40% 2% 20% 0% 0% 1963 1968 1973 1978 1983 1988 1993 1998 2003 Figure 3. Dividend Payers and Stock Market Liquidity Conditional on Dividend Policy in Year t-1. The sample consists of all firms with publicly traded common stock on NYSE or AMEX with available information in the CRSP monthly files and the COMPUSTAT annual files. Panel A uses firms that did not pay dividends in fiscal year t-1. The figure plots the proportion of firms that pay dividends in year t (bars; left axis) and the average percentage ratio of shares traded to shares outstanding for the sample for calendar year t (solid; right axis). Panel B uses firms that paid dividends in fiscal year t-1. The figure plots the proportion of firms that do not pay dividends in year t (bars; left axis) and the average percentage ratio of shares traded to shares outstanding for the sample for calendar year t (line; right axis). 35

200% 1.50% 150% 1.00% 100% 0.50% 50% 0.00% 0% 1963 1968 1973 1978 1983 1988 1993 1998-0.50% Figure 4. Stock Market Liquidity and the Relative Valuation of Non-Payers. The sample consists of all firms with publicly traded common stock on NYSE, AMEX, or Nasdaq with available information in the CRSP monthly files and the COMPUSTAT annual files. The figure plots the average percentage ratio of shares traded to shares outstanding for calendar year t (bold solid; left axis), the valuation of non-payers relative to dividend payers (solid; left axis), and the average price reaction to dividend initiations (dash; right axis). Share turnover for Nasdaq firms is scaled by 50%. The valuation of nonpayers relative to payers for year t is equal to the exponent of the negative value-weighted dividend premium for year t reported by Baker and Wurgler (2004). The average price reaction to dividend initiations for year t is equal to the standardized announcement returns reported by Baker and Wurgler (2004) and averaged over years t-1, t, and t+1. 36

Table I Variable Definitions We gather all data from the COMPUSTAT annual files except where indicated. COMPUSTAT item numbers are presented in parenthesis. For COMPUSTAT variables, t refers to fiscal year t of the firm. Variable Dividend Payer NYP t E t /A t Definition A firm is defined as a dividend payer in year t whenever COMPUSTAT reports positive Dividends per Share (26) for fiscal year t. Otherwise a firm is defined as a non-payer. The proportion (in %) of NYSE firms with lower market capitalization of common stock in June of year t. Share price and number of shares outstanding for June of year t are obtained from the CRSP monthly files. [Earnings before Extraordinary Items (18) + Interest Expense (15) + Income Statement Deferred Taxes (50) if available] divided by Assets (6). Preferred Stock Book Equity V t /A t Preferred Stock Liquidating Value (10) [or Preferred Stock Redemption Value (56), or Preferred Stock Par Value (130)]. Stockholder s Equity (216) [or Common Equity (60) + Preferred Stock Par Value (130), or Assets (6) Liabilities (181)] Preferred Stock + Balance Sheet Deferred Taxes and Investment Tax Credit (35) if available Post Retirement Assets (330) if available. [Assets (6) - Book Equity + Stock Price (199) times Common Shares Outstanding (25)] divided by Assets (6). da t /A t [Assets t (6) Assets t-1 (6)] divided by Assets t (6). TURN t Common Shares Traded (28) divided by Common Shares Outstanding (25). DVOL t Natural logarithm of [1.00 + Share Price (24) times Common Shares Traded (28) divided by the 1996 Consumer Price Index]. ILLIQ t NOTRD t We use the CRSP daily files. For every trading day in year t, we divide the absolute return by the dollar volume. Dollar volume is expressed in 1996 US dollars using the Consumer Price Index. We then create the illiquidity variable by averaging the daily estimates over all trading days of year t and then taking natural logarithm. If there are less than 30 daily observations for a given year this variable is missing. This variable is equal to the proportion of days with no trading volume on the CRSP daily files for year t. The variable is missing if there are fewer than 30 daily observations. 37

Table II Estimates from Logistic Regressions to Explain Dividend Payers For each year t between 1963 and 2003 we estimate logistic regressions to explain whether a firm pays dividends in year t. The sample contains all NYSE/AMEX firms with available information. Panel A uses only share turnover (TURN t ) as an explanatory variable. As explanatory variables for the rest of the models we use the proportion of NYSE firms with lower market capitalization (NYP t ), the earnings-to-assets ratio (E t /A t ), the market-to-book ratio (V t /A t ), and the growth rate of assets (da t /A t ). We refer to these four variables as firm characteristics. We then add several variables that proxy for the market liquidity of the firm s stock. In Panel B we add share turnover (TURN t ). We also allow for different coefficients of share turnover for firms that are less likely (TURN_L t ) and for firms that are more likely (TURN_M t ) to pay dividends based on firm characteristics. Firms that have an estimated probability below 70% (the average proportion of payers for 1963-1977) to pay, based on their firm characteristics and the average coefficient estimates from the 1963-1977 period, are classified as less likely to pay. Firms for which this probability is above 70%, are classified as more likely to pay. In Panel C we further use the illiquidity ratio (ILLIQ t ), the traded dollar volume (DVOL t ), and the proportion of non-trading days (NOTRD t ) as explanatory variables. When we use the illiquidity ratio we also include the natural log of the monthly average of the share price for year t as a control for microstructure effects resulting from minimum tick size rules. The table reports the average estimated coefficient for a given period and the t-statistic of whether the average estimate is significantly different from zero. Firms is the average number of firms used in the regressions. Payers is the average percent of payers for a given period. Payers (+) is the estimated percent of payers if the examined liquidity measure improves by one standard deviation while Payers ( ) is the estimated percent of payers if the examined liquidity measure deteriorates by one standard deviation. The effects of a, b, liquidity changes on the percent of payers are examined at the presented average percent of payers. c indicate significance respectively at the 1%, 5%, and 10% levels from a two-tailed t-test. Panel A. Dependent variable is whether a firm pays dividends in year t 1963-1977 1978-1992 1993-2003 (1) (2) (3) Intercept 1.60 a 1.00 a 0.18 b (10.28) (6.23) (2.40) TURN t 1.62 a 0.50 a 0.33 a ( 5.93) ( 3.66) ( 5.53) Firms 1,374 1,389 1,432 Payers 71.50 67.06 48.12 Payers (+) 59.55 62.29 41.84 Payers ( ) 81.04 71.51 54.46 38

Panel B. Dependent variable is whether a firm pays dividends in year t 1963-1977 1978-1992 1993-2003 (1) (2) (3) (4) (5) (6) (7) (8) (9) Intercept 0.22 0.33 c 0.28 0.18 0.29 0.24 1.03 a 0.58 a 0.62 a ( 1.62) (1.99) (1.70) ( 0.91) ( 1.47) (1.24) ( 15.33) ( 7.91) ( 8.70) NYP t 4.17 a 4.13 a 4.40 a 4.28 a 5.08 a 5.26 a 3.19 a 4.17 a 4.30 a (32.11) (18.71) (22.16) (73.06) (42.67) (48.79) (25.68) (34.36) (32.20) V t /A t 0.84 a 0.74 a 0.79 a 0.73 a 0.66 a 0.70 a 0.34 a 0.35 a 0.37 a ( 9.44) ( 8.90) ( 10.02) ( 6.35) ( 7.29) ( 7.21) ( 10.54) ( 12.28) ( 13.08) da t /A t 0.54 0.05 0.09 0.66 a 0.34 b 0.39 b 1.32 a 1.05 a 1.07 a ( 1.25) ( 0.13) ( 0.22) ( 4.21) ( 2.24) ( 2.62) ( 7.31) ( 5.08) ( 5.18) E t /A t 16.57 a 15.87 a 16.56 a 8.18 a 7.97 a 8.58 a 5.11 a 4.72 a 5.16 a (13.10) (14.62) (14.40) (11.61) (10.77) (10.36) (27.73) (23.85) (24.05) TURN t 1.74 a 1.45 a 1.00 a ( 14.91) ( 23.42) ( 12.21) TURN_L t 1.59 a 1.26 a 0.87 a ( 9.50) ( 24.09) ( 10.96) TURN_M t 1.99 a 1.56 a 1.05 a ( 15.22) ( 20.27) ( 11.94) Firms 1,374 1,389 1,433 Payers 71.49 67.06 48.12 Payers (+) 58.60 52.61 30.04 Payers ( ) 81.64 78.88 66.70 39

Panel C. Dependent variable is whether a firm pays dividends in year t 1963-1977 1978-1992 1993-2003 (1) (2) (3) (4) (5) (6) (7) (8) (9) Intercept 3.88 a 0.68 b 0.54 a 0.66 0.24 a 0.38 b 1.92 a 0.42 a 1.09 a (5.91) (2.30) ( 3.49) (1.34) (1.36) ( 1.71) ( 4.02) ( 3.08) ( 19.09) NYP t 3.39 a 5.68 a 4.69 a 3.29 a 5.85 a 4.59 a 1.76 a 5.04 a 3.27 a (11.38) (29.39) (31.83) (21.01) (25.10) (47.28) (5.11) (13.25) (22.07) V t /A t 0.91 a 0.80 a 0.84 a 0.86 a 0.69 a 0.72 a 0.37 a 0.32 a 0.34 a ( 9.25) ( 8.60) ( 8.96) ( 5.99) ( 6.52) ( 6.21) ( 14.57) ( 10.38) ( 10.78) da t /A t 1.66 a 0.13 0.50 1.36 a 0.49 a 0.61 a 1.91 a 1.13 a 1.30 a ( 4.25) ( 0.34) ( 1.19) ( 7.29) ( 3.23) ( 3.94) ( 9.04) ( 5.72) ( 7.06) E t /A t 11.71 a 16.59 a 16.54 a 4.68 a 8.35 a 8.22 a 3.28 a 5.10 a 5.12 a (8.93) (13.73) (13.28) (9.97) (11.48) (11.29) (13.74) (27.42) (27.10) ILLIQ t 0.65 a 0.37 a 0.11 b (10.60) (12.27) (2.54) DVOL t 0.31 a 0.23 b 0.26 a ( 5.34) ( 8.90) ( 6.46) NOTRD t 5.22 a 1.57 a 0.60 a (3.27) (5.46) (3.63) Firms 1,379 1,374 1,380 1,386 1,389 1,387 1,432 1,433 1,433 Payers 71.41 71.49 71.40 67.08 67.06 67.08 48.11 48.12 48.12 Payers (+) 38.02 59.61 58.44 42.49 55.33 64.22 39.50 32.57 46.62 Payers ( ) 91.05 80.99 81.59 84.89 76.99 71.71 56.84 64.05 49.62 40

Table III Actual and Predicted Percent of Dividend Payers Using Average Logistic Regression Estimates from 1963-1977 For each year between 1963 and 1977 we estimate logistic regressions to explain whether a firm pays dividends in year t. As explanatory variables in model (1) we use the proportion of NYSE firms with lower market capitalization (NYP t ), the earnings-to-assets ratio (E t /A t ), the market-to-book ratio (V t /A t ), and the growth rate of assets (da t /A t ). We refer to these four variables as firm characteristics. In Model (2) we add share turnover (TURN t ) as an explanatory variable. In Model (3) we estimate different slope coefficients for share turnover for firms that are less likely (TURN_L t ) and for firms that are more likely (TURN_M t ) to pay dividends based on firm characteristics. Firms that have an estimated probability below 70% (the average proportion of payers for 1963-1977) to pay, based on their firm characteristics and the average coefficient estimates from the 1963-1977 period, are classified as less likely to pay. Firms for which this probability is above 70%, are classified as more likely to pay. Firms is the number of firms for a given year. Actual Percent is the average actual percent of payers in a given period. For each model, we estimate the individual firm s probability to pay dividends using the average coefficients from 1963-1977 and the values of the explanatory variables for year t in the logistic regression. We then average these probabilities across firms to estimate the Predicted Percent of payers in a given year t. Finally, we average our annual predictions for a given period. (1) (2) (3) Actual Predicted Predicted Predicted Predicted Predicted Predicted Firms Percent Percent Actual Percent Actual Percent Actual 1978-1982 1,545 77.24 76.27 0.97 73.76 3.48 73.31 3.92 1983-1987 1,338 65.97 69.69 3.72 64.42 1.55 63.82 2.14 1988-1992 1,283 57.98 68.58 10.60 64.26 6.28 63.62 5.65 1993-1997 1,485 51.16 67.36 16.20 59.50 8.34 58.63 7.47 1998-2003 1,390 45.58 67.78 22.20 51.95 6.36 50.27 4.69 41

Table IV Actual and Predicted Percent of Dividend Payers for Different Portfolios Using Average Logistic Regression Estimates from 1963-1977 For each year between 1963 and 1977 we estimate a logistic regression to explain whether a firm pays dividends in year t. We present the actual proportion of payers and the difference between the predicted and the actual proportion of payers for several periods. As explanatory variables in Models (1) and (3) we use the proportion of NYSE firms with lower market capitalization (NYP t ), the earnings-to-assets ratio (E t /A t ), the market-to-book ratio (V t /A t ), and the growth rate of assets (da t /A t ). We refer to these four variables as firm characteristics. In Models (2) and (4) we also add share turnover for year t (TURN t ) as an explanatory variable. In Panel A we create two portfolios based on share turnover (TURN t ) using the average of its 50 th percentile for the 1978-2003 period. In Panel B we create two portfolios based on the predicted probability of dividend payment. Firms with an estimated probability below 70% (the average proportion of payers for 1963-1977) to pay, based on their firm characteristics and the average coefficient estimates from the 1963-1977 period (Table I, Panel B, model 1), are classified as less able to pay while firms, for which this probability is above 70%, are classified as more able to pay dividends. In models (2) and (4) of Panel B, we estimate different slope coefficients for share turnover for firms that are less likely (TURN L t ) and for firms that are more likely (TURN M t ) to pay dividends based on the above classification (Table II, Panel B, model 3). Firms is the average number of firms in a portfolio for a given period. Actual Percent is the average percent of payers in a given portfolio for a given period. We estimate the individual firm s probability to pay dividends using the average coefficients from 1963-1977 and the values of the explanatory variables for year t in the logistic model. We then average these probabilities across the firms in a given portfolio for a given year t to estimate the Predicted Percent of payers for that portfolio in that year and then obtain the value of Predicted minus Actual payers. For each period, the table presents the averages of the annual values. Panel A Actual Predicted Predicted Actual Predicted Predicted Firms Percent Actual Actual Firms Percent Actual Actual (1) (2) (3) (4) Less liquid (low share turnover) More liquid (high share turnover) 1978-1982 1,131 80.96 5.24 3.50 414 66.95 10.69 3.39 1983-1987 757 65.48 0.14 1.44 581 66.48 8.74 5.08 1988-1992 786 57.74 6.58 9.16 497 58.69 16.86 1.68 1993-1997 708 53.48 9.41 11.76 777 48.93 22.48 5.33 1998-2003 480 40.92 14.53 16.83 910 47.85 25.97 0.98 Panel B Less able to pay dividends More able to pay dividends 1978-1982 519 54.97 4.59 5.82 1,027 88.51 0.92 2.94 1983-1987 569 42.18 1.49 1.66 770 83.63 5.40 2.50 1988-1992 551 31.99 9.92 8.81 732 77.43 11.17 3.34 1993-1997 646 28.81 11.73 7.93 838 68.55 19.56 7.05 1998-2003 574 26.02 13.04 6.60 816 59.34 28.76 3.27 42

Table V Estimates from Logistic Regressions to Explain Dividend Payers for Past Non-payers and Past Payers For each year t between 1964 and 2003 we estimate logistic regressions to explain whether a firm pays dividends in year t. We separate firms into two portfolios. The first portfolio consists of firms that have never paid dividends up to year t. The second portfolio of firms includes firms that have paid dividends every year from t-5 to t-1. If a firm is present for less than five years then we require that the firm has paid dividends in all past years. As explanatory variables we use the proportion of NYSE firms with lower market capitalization (NYP t ), the earnings-to-assets ratio (E t /A t ), the market-to-book ratio (V t /A t ), and the growth rate of assets (da t /A t ). We refer to these four variables as firm characteristics. We also add the share turnover for year t-1 (TURN t-1 ) as a proxy for the firm s stock market liquidity. The table reports the average estimated coefficient for a given period and the t- statistic of whether the average estimate is significantly different from zero. Firms is the average number of firms used in the regressions. Payers is the average percent of payers for a given period in a given portfolio. Payers (+) is the estimated percent of payers if the examined liquidity measure improves by one standard deviation while Payers ( ) is the estimated percent of payers if the examined liquidity measure deteriorates by one standard deviation. Standard deviations are calculated separately for each portfolio. The effects of liquidity changes on the percent of payers are examined at the presented average percent of payers. a, b, c indicate significance respectively at the 1, 5, and 10 levels from a two-tailed t-test. * Estimates are based on 12 years since in 1964 and 1965 all firms continued paying dividends and the model cannot be estimated. Dependent variable is whether a firm pays dividends in year t Never Paid Dividends up to Year t Paid Dividends up to Year t 1964-1977 1978-1992 1993-2003 1964-1977 * 1978-1992 1993-2003 Intercept 2.18 a 3.32 a 3.37 a 1.27 a 1.47 a 1.84 a ( 5.18) ( 10.36) ( 8.74) (4.67) (4.36) (5.84) NYP t 1.32 c 2.15 a 3.03 a 3.89 a 4.42 a 3.69 a (1.88) (4.59) (6.57) (6.91) (7.44) (6.61) V t /A t 1.45 a 0.55 b 1.01 c 0.73 c 0.61 c 0.75 a ( 3.78) ( 2.33) ( 2.18) (1.82) (2.09) (3.28) da t /A t 1.24 0.26 0.25 3.84 a 3.39 a 0.88 (1.55) (0.59) ( 0.62) (3.58) (9.87) (1.68) E t /A t 16.40 a 7.73 a 5.10 a 18.95 a 10.55 a 5.24 b (3.87) (4.30) (3.36) (6.40) (6.09) (2.64) TURN t-1 0.69 c 0.71 b 0.66 a 0.89 b 1.04 a 0.92 a ( 1.79) ( 2.71) ( 4.15) ( 2.93) ( 4.09) ( 5.58) Firms 307 263 505 771 791 584 Payers 9.55 6.02 3.41 97.90 97.01 97.27 Payers (+) 7.33 4.21 1.90 97.41 95.87 95.68 Payers ( ) 12.35 8.54 6.05 98.30 97.84 98.29 43

Table VI Actual and Predicted Percent of Dividend Payers Using Average Logistic Regression Estimates from 1964-1977 for Past Non-payers and for Past Payers For each year t between 1964 and 2003 we estimate logistic regressions to explain whether a firm pays dividends in year t. We separate firms into two portfolios. The first portfolio consists of firms that have never paid dividends up to year t. The second portfolio of firms includes firms that have paid dividends every year from t-5 to t-1. If a firm is present for less than five years then we require that the firm has paid dividends in all past years. As explanatory variables in Models (1) and (3) we use the proportion of NYSE firms with lower market capitalization (NYP t ), the earnings-to-assets ratio (E t /A t ), the market-to-book ratio (V t /A t ), and the growth rate of assets (da t /A t ). In Models (2) and (4) we also add share turnover for year t-1 (TURN t-1 ) as a proxy for the firm s stock market liquidity. For each model, we estimate the individual firm s probability to pay dividends using the average coefficients from 1964-1977 and the values of the explanatory variables for year t (year t-1 in the case of share turnover) in the logistic regression. We then average these probabilities across portfolios to estimate the Predicted Percent of payers in a given year t for a given portfolio and the value of Predicted minus Actual payers. Never Paid Dividends up to Year t Paid Dividends up to Year t (1) (2) (3) (4) Actual Predicted Predicted Actual Predicted Predicted Firms Percent Actual Actual Firms Percent Actual Actual 1978-1982 196 7.13 5.37 2.22 968 97.64 0.14 0.06 1983-1987 250 5.15 3.36 0.87 803 96.41 0.07 0.08 1988-1992 344 5.79 1.43 0.68 602 96.98 0.22 0.32 1993-1997 473 3.89 2.67 0.28 614 98.14 0.69 0.75 1998-2003 532 3.01 4.50 1.75 560 96.55 0.05 0.76 44

Table VII Dividend Initiations and Stock Return Sensitivity to Aggregate Liquidity Risk For Panel A, we identify COMPUSTAT firms that do not pay dividends in fiscal years y-3, y-2, and y-1, that initiate a dividend payment in fiscal year y, and that continue paying dividends in fiscal years y+1, y+2, and y+3. We then construct two value-weighted monthly portfolios -- pre-dividend and post-dividend. The pre-dividend portfolio for year t includes the firms for which t equals y-3, y-2, or y-1. The post-dividend portfolio includes the firms for which t equals y+1, y+2, or y+3. We further restrict our sample to firms with common shares listed on NYSE, AMEX, or Nasdaq and share price between 5 and 1000 dollars at the end of year t-1. Finally, we use only firms that have available returns for all months in which they are included in both the pre-dividend and the post-dividend portfolios. Share codes, exchange listing, share prices, and return data are obtained from the CRSP monthly files. The pre-dividend portfolio has 444 monthly returns and extends from 1963 to 1999. The post-dividend portfolio includes the same firms as the pre-dividend one but covers 444 monthly returns from 1967 to 2003. We winsorize all variables at the 0.5 th and the 99.5 th percentile. We then regress the monthly returns of each portfolio on the liquidity factor of Pástor and Stambaugh (2003) while sequentially including the market factor (Market Model), the three Fama-French factors (Three-factor Model), and the three Fama-French factors plus the momentum factor (Four-factor Model). We compute the liquidity factor as in Pástor and Stambaugh (2003) and obtain the monthly Fama-French factors and the momentum factor from the Web site of Kenneth French (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/). The estimated models control for serial correlation present in the portfolio returns. Panel B replicates the analysis for firms that do not pay dividends in any year between y-3 to y+3. The table reports the estimated liquidity betas from each specification and their standard errors (in parenthesis). b, c indicate that the post-dividend liquidity beta is significantly different from the pre-dividend liquidity beta at the 5 and 10 percent levels respectively from a two-tailed t-test assuming independence. Market Model Three-factor Model Four-factor Model Panel A: Dividend Initiating Firms Pre-dividend Liquidity Beta 5.91 3.34 3.49 (2.78) (2.61) (2.60) Post-dividend Liquidity Beta 2.57 b 3.25 c 3.35 c (2.70) (2.60) (2.61) Panel B: Non-initiating Firms Pre-dividend Period Liquidity Beta 1.61 2.61 2.64 (1.39) (1.36) (1.36) Post-dividend Period Liquidity Beta 2.12 3.20 3.13 (1.50) (1.42) (1.42) 45