Dividend Payout And Firm Operation Cash Flow Volatility

I. IntroductionThe objective of this paper is to investigate the relationship between firm’s dividend payout and its operation cash flow volatility. Dividend payout policy has long been a “puzzle” in corporate finance area. Black [1976] concludes, “The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don't fit together.” Thirty years later, new phenomena emerge, new theory and new evidences are presented, and yet, dividend payout still appears to be an unsolved mystery. As discussed much more in detail in next section, a lot of aspects which affect dividend payout policy have been examined, but one thing seems to be ignored, that is, firm’s operation cash flow volatility. Therefore, in this paper, I am trying to reveal cash dividend payout puzzle from the perspective of cash flow volatility. However, the purpose of this paper is not to mute other existing theory or evidence, but to shed additional light on dividend payout literature.
II. Dividend Payout Literature Review
II.1M&M Miller Modigliani [1961] establishes a compelling dividend irrelevancy argument in their “perfect world” , that is, given a firm’s investment decision, the dividend payout policy chosen affects neither the current price of its shares nor the total return to its shareholders. This implies that rational investors have no systematic preference (or avoidance) for dividend-paying stock, and they are indifferent to firm’s dividend payout decision regarding whether dividend is paid or how much dividend is paid. Although Miller and Modigliani’s argument has been widely accepted, field study and empirical evidence have shown that dividend payout is far more complicated in reality.
II.2 Asymmetric Information Imperfect information is one of the winkles in the perfect market, and it also affects dividend payout policy. Easterbrook [1984] argues that dividends may be used in reducing the agency costs of management, and this argument explains why firms pay out dividends and raise new funds in the financial market simultaneously. Other asymmetric information literature also suggests that agency cost could play a role in dividend payout policy. In Myers Majluf [1984]’s pecking order theory, it is shown that, in the presence of information asymmetry, managers may have to give up positive NPV project, and in order to alleviate this underinvestment problem, manager may need to rely on internal source of funds. One implication of this pecking order theory is that firm may restrict dividend payment to build up its financial slack, and this, therefore, suggests a negative correlation between dividend payment and investment opportunities. Similarly, Jensen [1986]’s free cash flow argument also implicitly suggests that dividend payment could be used to control manager’s “empire-building” behavior. Some empirical results support this agency cost explanation. Michaely Roberts [2007], using data from UK, shows that public firms, which have greater investor protection, pay relatively higher dividend and are more sensitive to the changes in investment opportunities.
II.3 Taxes Tax is another imperfection of financial market. Due to IRS tax code, investors in the United States, if not tax exempted, have higher income tax burden on dividend with respect to capital gain. From this point of view, dividends should not have paid out. However, Miller Scholes [1978] uses insurance to show that, under certain conditions, taxable investors are indifferent to dividends, despite of its disadvantage on taxes. It has also long been argued that there exists a tax clientele which prefers dividend-paying stocks . Graham Kumar [2006] provides evidence consistent with this tax clientele hypothesis; in particular, they find that low income retail investors who have lower tax bracket prefer dividend-paying stocks and they cut their holdings of such dividend-paying stocks when their effective income tax rates increase.
II. 4 Signaling Dividends have been arguably considered to have information content. In the presence of imperfect information, Bhattacharya [1979] shows that manager can use costly dividend to signal expected cash flows. Similarly, Miller Rock [1985] establishes a signaling equilibrium in which dividends serve as a signal of “good news” to the market. Some empirical studies do provide evidence of positive relationship between dividend changes and market reaction, consistent with one implication of this signaling hypothesis; however other studies lend little support. Watts [1973] finds that change in future earnings is positively correlated with unexpected current dividend change; however, more importantly, it is also shown that this information content of dividends, if claimed to be, is trivial, since the return from possessing this information content is even smaller than the transaction cost . DeAngelo et al [1996] also finds that favorable dividend decision doesn’t represent reliable signals of superior future earnings performance.
Other interpretation of dividend signaling exists as well. Grullon et al [2002] finds that, while profits do not increase after a dividend increase, the systematic risk for such dividend-increasing firms declines around the dividend announcement; therefore, they reject the notion that dividend increase can signal future profit, but argue that dividend increase is a signal showing a firm moves from growth phase to a more mature phase, and they term this as maturity hypothesis. Very much differently, in an asymmetric information model, Allen et al [2000] argues that taxable dividends exist to signal that firms’ management is “good”, and thus to attract institution investors.
II.5 Disappearance of dividend and repurchase In recent decades, corporate payout policy shows a pattern different from “old days”. Fama French [2001] finds that more and more firms with characteristics typical of not paying dividends (small size, low profitability and strong growth opportunities) have been listed in exchanges, and therefore, the proportion of firms paying cash dividends falls in the population; more strikingly, it is further shown that, after controlling for the characteristics, firms have lower propensity to pay dividends. DeAngelo et al [2004] compliments Fama French [2001]’s finding by showing that while the number of dividend payers decreases, the aggregate real dividends paid by industrial firms increase. Grullon Michaely [2002] provides further evidence showing that share repurchase activities have increased dramatically, much faster than cash dividend payout growth, and therefore concludes that corporations have been substituting share repurchase for cash dividend. However, Grullon Michaely [2002]’s substituting hypothesis is not consistent with the finding of Jagannathan et al [2000]. Jagannathan et al [2000] argues that stock repurchases and dividends are used at different times and by different kinds of firms, more specifically, they show that dividends are paid by firms with higher “permanent” operating cash flow whereas repurchases are used by firms with higher “temporary” non-operating cash flow.
II. 6 Catering While neoclassical finance scholars fail to solve the dividend payout puzzle, behavioral finance scholars also provide their insights. Baker Wurgler [2004] proposes a catering theory, that is, since limits on arbitrage fail to eliminate some investors’ demand for cash-dividend-paying firms and such a demand affects current share prices, managers rationally take advantage of the benefit from current mispricing net of long-run cost and make dividend payment decision accordingly. However, Hoberg Prabhala [2007] demonstrates that this catering theory cannot explain dividend payout policy after controlling for risk.
III. Hypothesis
It has been pretty clear that all the above-discussed theories and hypotheses successfully, albeit not completely, explain dividend payout policy from different perspectives; however, the puzzle still exists.
Recent survey paper Brav et al [2005] indicates that managers believe maintaining dividend level is crucial and perceived stability of future earnings is also an important factor affecting dividend policy; with respect to tax, it is shown that managers generally put it as a second-order consideration; broadly speaking, the interview results provide little support for agency, signaling and clientele hypothesis. However, it is notable that the evidence provided by Brav et al [2005] is not new to the dividend payout literature, and it can be traced back to Lintner [1956]. In particular, Lintner’s results, termed as “stylized facts” in Marsh Merton [1987], are summarized as follows : (i) Managers believe that firms should have some long-term target payout ratio; (ii) In setting dividends, they focus on the change in existing payouts, not on the level; (iii) A major unanticipated and nontransitory change in earnings would be an important reason to change dividends; (iv) Most managers try to avoid making changes in dividends that stand a good chance of having to be reversed within the near future. Basing on the interview evidence, Lintner [1956] provides a simple partial adjustment model in which change of dividend is a function of contemporaneous earnings and dividend a year prior. This model has obtained empirical support, for example, Lintner [1956], Fama Babiak [1968] and Fama French [2002]. Allen Michaley [2003] provides a detailed review.
One major implication of Lintner [1956] is that managers are conservative on dividend payout decision making. Accepting this point of view, in this paper, I further argue that managers take firm’s historical cash flow volatility into consideration while making cash dividend payout decision. More precisely, I hypothesize that the level of a firm’s cash dividend payout and the propensity of a firm to initiate cash dividend payout are negatively correlated with its past operation cash flow volatility, that is, the more volatile a firm’s past operation cash flow is, ceteris paribus, the smaller the cash dividend payment is and the less likely it will initiate cash dividend.
The proposed negative correlation between cash dividend payout and firm past operation cash flow volatility is intuitively appealing. Prior research has presented evidence that market imposes “penalty” on dividend cutting incidence. For example, Michaley et al [1995] finds not only that the short-run price impact of dividend omission is negative but that there is also a significant long-term (negative) drift following the dividend omission event. If the manager’s interest is closely aligned to the shareholders, manager has the incentives to avoid such a penalty discussed above, and one way to do so is to choose a conservative cash dividend policy. This leads to my prediction that firms with more volatile operating cash flow will have lower cash dividend payout. A negative correlation between operation cash flow volatility and cash pay out is also consistent with the finding in Harford [1999] which shows that firm cash holdings are significantly positively related to its cash flow volatility.
Although it has not been heavily explored in prior literature of dividend payout, past cash flow volatility has been shown to be an important factor in managers’ other corporate finance decision making. Minton Schrand [1999] provides evidence that higher past cash flow volatility is associated with lower average levels of investment, such as capital expenditures, R&D, and advertising, and higher cost of accessing external capital. In Minton Schrand [1999]’s investment decision making process, past cash flow clearly plays a role. The reason is straightforward. Volatile cash flow increases the likelihood that a firm will need to assess to external financial market, and it also increases the cost of doing so, as a result, a firm with volatile cash flow may forgo some investment. Although Minton Schrand [1999] is aiming at firm’s investment decision making, it could imply that past cash flow volatility is also an important consideration in dividend payout decision making. Presumably, if a firm has higher cost of capital due to its higher past cash flow volatility and is forced to forgo investment consequently, this firm might want to keep cash in its hand and thus might be conservative in cash dividend payout as well. In other words, such a firm pays less cash dividend, ceteris paribus. The intuition of the argument is that if it eventually has to borrow funds from external financial market at a higher cost in order to maintain its dividend payout level, a firm may simply pay less cash dividend in the first place.
This paper is related to both cash flow and dividend payout literature, and it is close to prior research in several ways. Guay Harford [2000] hypothesizes and finds that firms choose dividends to distribute relatively permanent cash-flow shocks. However, my research is different from theirs. First, in Guay Harford [2000], the cash flow measure is ex post. More specifically, they term and define cash-flow shock reversion as the difference between average cash flow (deflated by total assets) in years +1 to +3 and average cash flow (deflated by total assets) in years -1 and 0, and cash-flow shock permanence as the difference between average cash flow (deflated by total assets) in years +1 to +3 and average cash flow (deflated by total assets) in years -4 and -2. In my research, I use historical data to calculate the operating cash flow volatility. Secondly, Guay and Harford essentially are focusing on the (level) persistence, whereas I am focusing on a conventional definition of volatility. Moreover, I also explore the relationship between cash flow volatility and the propensity of cash dividend payout.
Baker Wurgler [2004] finds that the rate of dividend initiation shows time variant pattern (figure 2). Baker and Wurgler argue that time varying dividend premium explains this phenomenon well. I, from a different point of view, argue that time varying operation cash flow volatility can also explain time varying rate of dividend initiation. Givoly Hann [2000] (figure 3) confirms that operation cash flow has time-varying pattern. In particular, operation cash flow variance increased in late 1960s, decreased in early 1970s, and then increased afterwards. This changing pattern is the opposite of changing pattern of dividend initiation, especially prior to early 1980s. The negative relationship seems to break down in the recent two decades, but this is also what Baker and Wurgler found, and this could be explained by higher net income volatility. Overall, this visual evidence is consistent with my prediction that the volatility of operation cash flow is negatively correlated with the initiation of cash dividend. In order to further investigate my hypothesis, I conduct time-series analysis similar to Baker Wurgler [2004].

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