Corporate risk management and dividend signaling theory. Georges Dionne and Karima Ouederni. HEC Montréal. (27 January 2010)

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1 Corporae risk managemen and dividend signaling heory Georges ionne and Karima Ouederni HEC Monréal (7 January 010) Absrac This paper invesigaes he effec of corporae risk managemen on dividend policy. We exend he signaling framework of Bhaacharya (1979) by including he possibiliy of hedging he fuure cash flow. We find ha he higher he hedging level, he lower he incremenal dividend. This resul is in line wih he purpored posiive relaion beween informaion asymmery and dividend policy (e.g., Miller and Rock, 1985) and he asserion ha risk managemen alleviaes he informaion asymmery problem (e.g., aal e al., 00). Our heoreical model has esable implicaions. Keywords: Signaling heory; ividend policy; Risk managemen policy; Corporae hedging; Informaion asymmery. JEL classificaion codes: G35; G3; 8. Résumé Ce aricle éudie l effe de la gesion des risques sur la poliique du dividende de l enreprise. Pour ce faire nous avons procédé à l exension du modèle de signalisaion de Bhaacharya (1979) en inroduisan la possibilié de couverure du cash flow fuur. Nous monrons que le niveau de couverure affece négaivemen le aux de disribuion du dividende. Ce résula corrobore les éudes sipulan l exisence d une relaion posiive enre le niveau d asymérie d informaion e la poliique du dividende (e.g., Miller e Rock, 1985) e celles confirman que la gesion des risques allège le problème d asymérie d informaion (e.g., aal e al., 00). Nore modèle héorique a des implicaions empiriques esables. Mos clés: Théorie des signaux; Poliique du dividende; Poliique de gesion des risque; Couverure; Asymérie d informaion. 1

2 1 Inroducion Signaling heory saes ha changes in dividend policy convey informaion abou changes in fuure cash flows (e.g., Bhaacharya, 1979, Miller and Rock, 1985). ividend signaling suggess a posiive relaion beween informaion asymmery and dividend policy. 1 In oher words, he higher he asymmeric informaion level, he higher is he sensiiviy of he dividend o fuure prospecs of he firm. Several empirical sudies aemp o es he informaional conen of dividend changes, ye hey disagree abou he sign and he significance of he effec of informaion asymmery on dividend policy (see Allen and Michaely, 003, for a survey). Anoher srand of lieraure suggess ha corporae risk managemen alleviaes informaion asymmery problems and hence posiively affecs he firm value. Informaion asymmery beween managers and ouside invesors is one of he key marke imperfecion ha makes hedging poenially beneficial. emarzo and uffie (1995) and Breeden and Viswanahan (1989) argue ha hedging reduces noise around earnings sreams and hus decreases he level of asymmeric informaion regarding he firm value. aal e al. (00) provide empirical evidence supporing hese heoreical sudies. In his paper we exploi he documened ineracion beween he level of informaion asymmery and he dividend policy, along wih is ineracion wih corporae risk managemen. We argue ha risk managemen alleviaes he asymmeric informaion problem, which is a main deerminan of dividend policy. Though many sudies ha examine dividend policy deerminans include several measures of informaion asymmery, none, o our knowledge, consider hedging among hese measures. Exending he signaling framework of Bhaacharya (1979), we provide heoreical suppor for he effec of corporae risk managemen on dividend payou policy. We find a negaive relaion beween he hedge raio and he incremenal dividend payou. The remainder of he aricle is organized as follows. In he nex secion we presen he heoreical model and is implicaions. The hird secion concludes. The model We assume ha he firm operaes in a dividend signaling world as modeled in Bhaacharya (1979). We assume ha shareholders have a single-period planning horizon and he manager 1 Evidence ha informaion asymmery posiively affecs dividend policy has also been documened by he free cash flow heory (e.g., Lang and Lizenberger, 1989).

3 operaes in he bes ineres of curren shareholders. The model is developed in erms of marginal analysis for a new projec aken on by he firm. We assume ha he manager is beer informed han ouside invesors abou he firm s fuure prospecs. Thus he manager is he only agen informed abou he disribuion of he new projec fuure cash flow (x). He aemps o signal his privae informaion via he commimen of an incremenal dividend (). ividends are axed a he rae while capial gains are no axed. There is a penaly (β) incurred by shareholders in case of cash flow shorfall o cover he commied dividend. could be considered as he cos of exernal financing. When he cash flow (x) exceeds he commied dividend, he amoun of fuure exernal financing is reduced by (x-) and vice versa. We exend he model by assuming ha i is possible for he manager o hedge a fracion (h) of he fuure cash flow using a linear sraegy. The reasoning behind his exension is simple. Ouside invesors ofen use esimaes of earnings and cash flows as measures of firm value. Hedging reduces he noise around earnings and fuure cash flows by reducing he exposure of he firm o facors beyond he manager s conrol. Consequenly, hedging lessens he asymmeric informaion regarding firm value by reducing he noise in evaluaion measures. We expec ha he more willing he firm is o hedge is fuure cash flow, he less informaive he dividend changes and he lower he manager s incenives for cosly signaling hrough dividends. We make he implici assumpion ha corporae hedging aciviy is observable by ouside invesors. This assumpion is realisic given he implemenaion of many disclosure requiremen regulaions by he Financial Accouning Sandards Board (FASB) since he beginning of he 90s (e.g., FAS105, FAS107, FAS119, FAS133, FAS138 and FAS161). Equaion (1) illusraes he new uncerain cash flow resuling from he linear hedging sraegy: x1 hx0 1 h x (1) where 0 h 1 is he hedge raio and x 0 he expeced cash flow. The incremenal par of he objecive funcion of curren shareholders is given by equaion (). The four erms in he equaion are respecively: (i) he rise in he firm s liquidaion value V(); (ii) he afer-ax promised dividend; (iii) he expeced gain when he hedged cash flow is greaer han he commied dividend; and (iv) he expeced loss when he hedged cash flow is lower han he commied dividend: 3

4 x V ( ) (1 ) ( x0 h (1 h) x ) f ( x) dx 1 x W (, h) () x 1 r (1 ) ( x0 h (1 h) x ) f ( x) dx x where r is he afer-ax ineres rae; V() he response liquidaion value of he firm resuling from he commimen and he paymen of, and x he minimum cash flow needed o pay he promised dividend wihou penaly. Is value is given by equaion (3): x hx 0 (3) (1 h ).1 Opimal dividend for a given hedge raio Following Bhaacharya (1979) we assume ha he fuure cash flow is uniformly disribued over [0, ]. Thus he maximizaion problem is reduced o: The firs order condiion solves: 1 1 h max W(, h) V( ) (4) 1r 8 1h h V ( ) (5) (1 h) A he opimum, he marginal profi from he dividend increase (he increase of he firm value) equals is marginal cos (axes and expeced cos of exernal financing). The second order condiion is given by equaion (6): 1 W(, h) V( ) (6) 1 r (1 h) Since V() is increasing and concave, h lower han one is a sufficien condiion for he second order condiion o be saisfied. The hedge raio h lies beween 0 and 1 given ha speculaion and over hedging are no considered in his model.. Signaling equilibrium The signaling equilibrium demands ha V(()) mus be equal o he rue value of fuure cash flows for he projec whose cash flows are signaled wih dividend ( Bhaacharya (1979), p. 64). Under he assumpion of a saionary dividend, he equilibrium funcion V( ()) is given by equaion (7): 4

5 1 h V K 8 1 h (7) where K=1/r. iffereniaing equaion (7) wih respec o and subsiuing for V ( ) from equaion (5), we obain: K 1 h d K h (8) 1h 1h d 81h 1h Assuming a linear soluion for he firs order differenial equaion (8), () A, we obain he following quadraic equaion: K K 1 K A 1h ha 1h h 0 (9) K 1 K 1 4 K 1 The posiive roo of he quadraic equaion is equal o: h h K K 1 1 A K K 1 1h h K K K 1 41 h h (10) When h=0 we obain he corresponding values for (9) and (10) in Bhaacharya (1979). A is he incremenal dividend payou. I also illusraes he sensiiviy of dividend increases o earnings prospecs. For reasonable values of ax rae ( 40%) and exernal financing cos (β 0%), A is decreasing in he hedge raio. In Figure 1, we show he funcion wih some feasible parameers. We observe a negaive effec of he hedge raio on he incremenal dividend payou. This resul is inuiive. I is in line wih sudies suggesing ha cash flows predicabiliy decreases he marginal gain from cosly signaling hrough dividends (e.g., Chang e al. 006) and he asserion ha corporae hedging decreases cash flows volailiy and hus increases heir predicabiliy. 5

6 A Hedge Raio Figure 1 The curve illusraes A for 0<h<1, = 40%; β = 0% and r = 5%. The sraigh line illusraes A for h=0 (Bhaacharya, 1979). Noice ha A is no sricly decreasing in he hedging level for all values of ax raes and exernal financing coss. For high bu less feasible values of > 40% and β> 0%, A firs increases and hen decreases in h. For all values of he parameers, A always converges o 0.5 when h is near 1..3 Opimal hedge raio Anoher way o emphasize he ineracion beween he dividend policy and he corporae hedging policy is o maximize he incremenal shareholders wealh in (4) wih respec o he hedge raio. The firs and second order condiions along wih he signaling equilibrium condiion provide he following opimal hedge raio (See appendix for deails): h (1 ) (11) The opimal hedge raio is decreasing in he dividend payou raio. This resul is in line wih empirical sudies suggesing a negaive effec of he dividend policy on he hedge raio (e.g., ionne and Garand, 003). I is also in line wih dividend signaling heory inuiion. I 6

7 suggess ha managers wih higher expecaions abou fuure performance of he firm disribue higher dividends while reducing heir hedge raio. Thus, in a signaling world shareholders are beer off when he firm deviaes from he full hedging sraegy. Finally, (11) indicaes clearly ha and h are inerdependen decision variables. In fac we can verify ha 0h 1 1 as 1. 3 Conclusion The findings of his paper reconcile dividend signaling heory wih risk managemen heory. We conribue o he dividend signaling lieraure by emphasizing he ineracion beween corporae risk managemen policy and dividend policy. The ineracion beween hese wo corporae policies has received less aenion in he lieraure despie heir common link o informaion asymmery. Using an exension of Bhaacharya s signaling model, we find ha he hedging of fuure cash flows reduces he sensiiviy of dividends o fuure earnings. A sraighforward implicaion of his resul is ha he informaional conen of dividend changes decreases wih he hedge raio. I leads o he empirical es of wheher corporae risk managemen reduces he power of dividend changes o predic fuure changes in earnings. I hus represens a new es of he dividend signaling heory. References Allen, F., Michaely, R., 003. Payou policy, in: G.M. Consaninides & M. Harris & R. M. Sulz, eds., Handbook of he Economics of Finance, Vol. 1, Chaper 7, Bhaacharya, S., Imperfec informaion, dividend policy and he bird in he hand fallacy. Bell Journal of Economics 10, Breeden,., Viswanahan, S., Why do firms hedge? An asymmeric informaion model. Working Paper, Fuqua School of Business, uke Universiy. Chang, C., Kumar, P., Sivaramakrishnan, K., 006. ividend changes, cash flow predicabiliy, and Signaling of Fuure Cash Flows. SSRN online library N o aal, P., Gay, G., Nam J., 00. Asymmeric informaion and corporae use of derivaives. The Journal of Fuure Markes, emarzo, P., uffie,., Corporae incenives for hedging and hedge accouning. Review of Financial Sudies, Fall,

8 ionne, G., Garand, M., 003. Risk managemen deerminans affecing firms values in he gold mining indusry: new empirical evidence. Economics Leers 79: Lang, L., Lizenberger, R., ividend announcemens: cash flow signaling vs. free cash flow hypohesis? Journal of Financial Economics 4, Miller, M., Rock, K., ividend policy under asymmeric informaion. The Journal of Finance 40,

9 Appendix The firs order condiion of he maximizaion of (4) wih respec o h equals: 1 1 (1 h )( h) ( h) W (, h) 0 h 1 r 8 (1 h ) ( h )( (1 h) ( h)) 0 The second order condiion wih respec o h is equal o: 1 1 1h 84hh 8 W(, h) 3 h 8 1 r (1 h) The maximizaion problem has wo complemenary soluions: 1 if h 1 1 if When we subsiue for h= / in he equilibrium payou raio (10) we ge: A h 1 K ( K 1) I is sraighforward o show ha A is bigger han 0,5. Noice ha A=/ and when i is bigger han 1/ he second order condiion of he maximizaion of shareholders wealh wih respec o h is no saisfied so we do no reain his poenial soluion. When we subsiue for h= (1-/) in he equilibrium payou raio (10) we ge: A h 1 K 1 (1 K) I is sraighforward o show ha for feasible values of β and τ, A is bigger han 0,5 which saisfies he second order condiion of he maximizaion of shareholders wealh wih respec o h. 9