The Market Valuation of Bonus Issues in an Inflationary Environment

Transcription

1 The Market Valuation of Bonus Issues in an Inflationary Environment Cahit Adaoglu * Faculty of Business and Economics Eastern Mediterranean University Gazimagusa, Mersin 10 Turkey M. Ameziane Lasfer Cass Business School City University 106 Bunhill Row London EC1 8TZ U.K. Abstract This paper assesses the market valuation of an unusual form of free stock distributions called bonus issues which are mainly financed by the revaluations of assets equity reserve in an inflationary economic setting. We detect positive excess return on the announcement day for these bonus issues similar to the market reaction to stock dividends and splits in developed and emerging markets. In an institutional environment where cash dividend substitution effect, agency cost effect, transaction cost effect and retained earnings effect are not present, we find empirical support for the enhanced liquidity hypothesis, but interestingly, no support for the attention getting hypothesis and the signaling hypothesis which is the predominant explanation for the positive market reaction to the stock distributions in developed capital markets. We also provide a unique explanation for bonus issues as corporations need to increase their eroding paid-in capital in an inflationary environment in order to have a better debt to paid-in capital ratio for more credibility and borrowing capacity in a market of limited access to external equity financing. JEL Classification: G35 Keywords: Bonus Issues, Stock Dividends, Stock Splits, Signaling, Liquidity, Neglected Version: May 2008 * Address for corresponding author: Dr. Cahit Adaoglu, Faculty of Business and Economics, Eastern Mediterranean University, Gazimagusa, Mersin 10, TURKEY, Tel. (+90) , Fax (+90) cahit.adaoglu@emu.edu.tr (Adaoglu); m.a.lasfer@city.ac.uk (Lasfer).

2 1. Introduction Stock distributions either by stock splits or stock dividends are puzzling corporate behavior. Theoretically, these distributions are cosmetic operations aimed at dividing the corporate pie into more pieces with no change in the total value of the firm. However, the empirical studies report significant positive market reaction to these decisions on the announcement day. 1 This positive market reaction is often related to a combination of the signaling, the liquidity and marketability, the trading range and the retained earnings hypotheses. However, this positive reaction is still controversial as stock distributions can be substitutes to cash dividends (e.g., Baker et al., 1995) and allow managers to increase their flexibility in the corporate dividend policy (Jensen, 1986; DeAngelo et al., 1992). Stock distributions, therefore, exacerbate the free cash flow problem as managers can retain more cash in the corporation avoiding the market monitoring that results from external financing. In this case, the market is expected to react negatively on the announcement date and this effect is known as the cash substitution hypothesis. In this paper, we examine the market valuation of an unusual form of stock distributions called bonus issues. We use the Istanbul Stock Exchange (ISE), an emerging stock market, as a testing ground where corporations distribute regularly bonus/free shares on a pro rata basis in an inflationary environment by using accumulated equity reserves, especially the revaluation of assets reserve known as inflation revaluation equity reserves in Turkey 2. In the ISE, stock distributions are classified into bonus issues and stock dividends 3, and the difference between the two is clear cut. In other prominent emerging markets such as China, India, Australia and Greece, bonus issue is the term used for free issues of shares from accumulated capital reserves and/or retained earnings/distributable profit. In the ISE setting, bonus issue term is used only for free shares financed from accumulated equity (capital) reserves and stock dividend term is used only for free shares 1

3 financed from distributable profit and/or retained earnings. In the United States and in other developed countries, bonus issues are widely known as stock dividends and in the U.K., as scrip dividends. We test the signaling, liquidity and attention getting hypotheses in a closely held market structure where bonus issues are not substitutes for cash dividends as they emanate from an accounting treatment in a high inflationary environment. These bonus issues allow us to eliminate the cash dividend substitution and agency cost effects as these issues are not financed by retained earnings/distributable profit and do not change the ownership distribution (i.e., the typical existing ownership structure between the family group and the remaining shareholders is not altered). Moreover, since the transaction costs are based on the total amount of the transaction rather than on the total number of shares, the transaction costs are not changed due to the bonus issues. Retained earnings effect is not present as well since these issues are not financed by retained earnings. Specifically, the market reaction is examined for different combination of capitalization reserves such as the bonus issue capitalizations from inflation revaluation equity reserves, capital gain equity reserves and other equity reserves. As Rankine and Stice (1997) show, the event classification and the source of capitalization are important due to the potential effects on the announcement reaction. They show that classifications (stock splits, large and small stock dividends 4 ) by CRSP database in the U.S. are not reliable and by correcting the classifications, they find significant differences between two-for-one stock dividend and stock split announcements. In their article, stocks dividends financed by funds other than retained earnings is called capital surplus stock dividends similar to the bonus issue accounting treatment in Turkey. Rankine and Stice explore the differences in market reaction for stock dividends capitilized by different equity reserves. They find that stock dividends reducing capital surplus has a lower market reaction (2.45%) relative to the market 2

4 reaction of stock dividends reducing retained earnings (3.67%), but the difference is not statistically significant. We find that, on average, the announcement date abnormal returns are positive (2.79%) and statistically significant as a market reaction. Classified by the source of capitalization, we find statistically significant positive market reaction of 2.92%, 3.52%, 1.65% for bonus issues financed by inflation revaluation reserves only (Category 1), by combination of inflation revaluation and other equity reserves (Category 2), and by reserves including capital gain equity reserves (Category 3) respectively. We have some empirical evidence for the difference in the magnitude of market reaction to bonus issues financed by these three categories, but due to the contamination of the announcement with different combination of reserves, the empirical evidence for difference is not strong, especially for the bonus issues financed by capital gain equity reserves which provide taxation advantage for the corporation. In our regression analysis, the pre bonus issue market price and market value significantly affect the bonus issue size, and the abnormal returns are significantly related to the bonus issue size and the pre bonus issue market price. Additionally, the liquidity measures are positive and statistically significant indicating that bonus issues increase the liquidity (market depth) of the stocks traded. While these results are consistent with the enhanced liquidity hypothesis, the univariate analysis of operating margin (%) and the regression analysis of abnormal returns do not provide support for the signaling hypothesis. The insignificance of the signaling hypothesis is in line with our expectation given the ISE s institutional settings of frequent issue of bonus issues, unstable dividend policies, low cost of sending false signals in a closely held market structure and cost neutral transaction costs. We also find no empirical evidence for the attention getting hypothesis due to the insignificant relationship between the abnormal return (market reaction) and the size of the corporation. 3

5 The unique result of this paper is that the univariate analysis of the financing policies of corporations issuing bonus issues and the regression results of the determinants of bonus issue size indicate corporations need to increase their eroding paid-in capital in an inflationary environment in order to have a better debt to paid-in capital ratio for more credibility and borrowing capacity in order to finance their growth in a market of limited access to external equity financing. The rest of the paper is structured as follows. Section 2 discusses the accounting and taxation treatment of bonus issues, different sources and combinations of capitalization reserves along with descriptive bonus issue statistics compiled from the population collected for the study. Section 3 reviews the literature presenting the prominent hypotheses and the testable hypotheses in the ISE institutional settings. Section 4 presents the sample data and the methodologies. Section 5 reports the empirical results followed by the conclusions in Section Bonus Issues by Corporations Traded in the Istanbul Stock Exchange and Inflation Bonus issues are issued by using accumulated equity (capital) reserves known as internal resources in Turkey. Taking into account the reserve characteristics, these accumulated equity reserves can be categorized under three headings, namely inflation revaluation equity reserves, capital gain equity reserves and other equity reserves. The inflation revaluation equity reserves include the equity accounting entries, namely, the asset revaluation reserve, the cost revaluation reserve and the paid-in capital inflation adjustment reserve. Till the end of 2003, the asset revaluation reserve and the cost revaluation reserve were used as equity accounting entries in which the fixed assets were adjusted for inflation by a constant ratio announced by the Ministry of Finance periodically. Adjusting the 4

6 book value of fixed assets for inflation allowed the corporations to fully utilize the tax shield advantage of depreciation expenses in an inflationary environment and avoid the inflation taxation. In 2004, with the implementation of international inflation accounting standards and declining trend in the inflation, these two revaluation reserves were abolished and the paid-in capital inflation adjustment reserve is introduced. Other reserves include the share premium equity reserve and mandatory special equity reserve which are not related to inflation revaluation. Corporations are allowed to transfer these equity entries to paid-in capital by issuing bonus stocks to shareholders and these bonus stocks are tax-free. The capital gain equity reserves include the reserves of capital gain from the sale of participation shares and capital gain from the sale of corporation property. The capital gain from these sales were tax-free for the corporation only if the corporation transferred these reserves to paid-in capital by issuing bonus issues to shareholders. The government motivation behind this tax-exemption was to strengthen the capital structure of the Turkish corporations. However, for sales after the second quarter of 2006 which is not included in our sample period, the requirement of issuing bonus issues by transferring these reserves to paidin capital is abolished and only 75% of the capital gains is tax free. As it is the case for bonus issues funded from other reserves, bonus stocks distributed to shareholders from the capital gain equity reserves are tax-free. [Insert Table 1] For the period , all seasoned equity issues are compiled from the ISE database ISE Companies Capital Increases and Dividend Payments /06 5. By using this official database, a total of 1,326 bonus issues by non-financial corporations traded in the ISE are collected for further analysis. In Table 1 (Panel A), some descriptive statistics are provided for the bonus issue population. It should be noted that bonus issue ratios (% of paidin capital) range from 0.1% to 11,300% with an average and median values of 166% and 75% 5

7 respectively. These percentages are in contrast with the New York Stock Exchange rules that prescribe the NYSE corporations to make share distributions of less than 25% through stock dividends rather than stock splits. [Insert Figure 1] In Figure 1, the relationship between the average percentage increase in paid-in capital by internal resources and the consumer price inflation is demonstrated. Between 1986 and 2000 during which the inflation rate was mostly above 50%, the average percentage increase followed the inflation trend, and due to the economic crisis in 2001 and the following considerable decline in the inflation rate as a result of the implementation of major economic reforms, the average percentage followed an erratic trend except for declines in 2005 and There is a significant decrease in 2005 and 2006 due to the fact that with the implementation of inflation accounting standards, 2004 was the last year for distributing bonus issues from the asset revaluation and cost revaluation funds. In Table 1 (Panel B), bonus issue frequency ratio is calculated using only the nonfinancial corporations with at least five years of trading data and is calculated as the number of bonus issues divided by the number of trading years in the ISE. The mean and median are same with a value of 40% indicating that corporations issue on average 2 bonus issues every 5 years of trading. 33% of corporations issued bonus shares more than 2.5 times in 5 years of trading indicating that stock distributions in the form of bonus issues is a frequently used corporate policy in the inflationary environment of Turkey. 3. Theoretical Background and Testable Hypotheses in the ISE settings The positive market valuation of stock distributions has been well established in the U.S. literature with several hypotheses trying to explain this positive valuation effect which is 6

8 predominately explained by the signaling hypothesis. The other not mutually exclusive explanations are the liquidity, trading range, neglected firm (attention-getting), cash substitution and retained earnings hypotheses. The positive announcement effect in several studies of stock distributions is interpreted as evidence in favor of the signaling hypotheses. The signaling hypothesis states that, in the presence of asymmetric information, corporations issue stocks to signal good news or optimistic expectations to investors (e.g., Nichols, 1981; Grinblatt et al., 1984; McNichols and Dravid, 1990; Woolridge, 1983; Banker et al., 1993; Peterson et al., 1996; Rankine and Stice, 1997) and managers are likely to signal that they will have larger increases in future earnings in order to at least maintain or increase their cash dividends and earnings per share. According to the enhanced liquidity hypothesis, the positive abnormal returns are related to the possibility that since stock distributions increase the number of shares in circulation, they increase the liquidity and marketability, and result in a decrease in the bidask spread. The other form of enhanced liquidity is the trading range hypothesis stating that the motive behind stock distributions is to move the stock price into a normal or optimal trading range attracting more investors and hence, increasing liquidity. However, the empirical evidence on the liquidity effect is mixed and inconclusive (e.g., Copeland, 1979; Murray, 1985; Lakonishok and Vermaelen, 1986; Lakonishok and Lev, 1987; Lamouoreux and Poon, 1987; Conroy et al., 1990; McNichols and Dravid, 1990; Ikenberry et al., 1996). The neglected firm or the attention getting hypothesis states that managers who believe that the stock is currently undervalued use the stock distribution as a tool for attracting attention from analysts resulting in the revaluation of their future cash flows (Grinblatt et al., 1984; Arbel and Swanson, 1993). 7

9 In relation to the dividend policy, especially in the case of stock dividends, the cash substitution hypothesis states that managers can keep the cash in the corporation and at same time, satisfy the shareholders by distributing free shares. However, the predicted market reaction is negative as opposed to positive market reaction prediction of the preceding hypotheses. Banker et al. s (1993) study find negative market reaction for announcements of cash dividend omissions especially for corporations with no prior free stock distribution history. Another recent dividend policy related hypothesis is the retained earnings hypothesis which tries to explain the different magnitude of positive market reaction to the two forms of free stock distributions, namely stock dividends and stock splits. The hypothesis states that stock dividends incorporate stronger signals as they decrease the pool of distributable funds signaling that managers believe in strong future cash flows in order to have a stable dividend policy (Rankine and Stice, 1997; Crawford et al., 2005; Bechmann and Raaballe, 2007). Consistent with the hypotheses above and taking into the ISE institutional settings; Hypothesis 1: Corporations are expected to have positive market reaction to the bonus issue announcements. In the Istanbul Stock Exchange, since bonus/free shares are distributed frequently on a pro rata basis by using accumulated equity reserves, especially the revaluation of assets reserve, their decision cannot be related to the cash substitution, the retained earnings and the agency cost hypotheses. This institutional setting allows us to focus on three hypotheses, namely the signaling, the neglected firm and the liquidity hypotheses. The interesting observation regarding the bonus issue distributions in the ISE is the significantly high magnitude and frequency of these distributions. Since companies in the ISE distribute bonus issues frequently, they are unlikely to time their bonus issue distributions weakening the signaling effect. Moreover, another weakening effect on the signaling effect is 8

10 that corporations trading in the ISE follow unstable dividend policies 6. Adaoglu (2000) shows that, unlike the stable and sticky dividend policy behavior in developed capital markets, corporations trading in the ISE follow unstable dividend policies. Another factor weakening the signaling effect is the low cost of sending false signals. For a signaling device to be valid, there should be a cost associated with sending a false signal such as the case for stock splits resulting in administrative costs and the increased transaction costs for investors. The brokerage commission in the ISE is based on the total market value of the transaction unlike the case in the U.S. where it is based on the number of shares traded. Consequently, the transaction costs incurred by investors are not altered by bonus issues and the administrative cost of the frequent bonus issues is low 7. Additionally, the closely held ownership structure, especially family controlled corporations, diminishes the need to use the bonus issues as a signaling device. Consequently, the market reaction to bonus issues based on the signaling effect in the ISE is expected to be none or lower than the U.S. empirical evidence on signaling effect. The market reaction to stock distributions in the ISE is likely to reflect enhanced liquidity rather than signaling. The ISE investors are typically short-term investors (e.g., Bildik and Gulay, 2007). For example, Ozden (1996) reports that short-term capital appreciation is the paramount investment concern of investors in the ISE while the dividend income is clearly at the bottom of their concern list. The lack of long-term institutional investors in the ISE makes the market very volatile which is a typical characteristic of all emerging markets. Based on the observations of low diffusion of ownership and an average public openness (free float) of 24% in the ISE, financial practitioners in Turkey argue that equity issues are welcomed by investors since new equity issues, especially bonus issue distributions, increase the number of shares in circulation resulting in enhanced liquidity and marketability. Additionally, bringing the stock price into an optimal trading range can be 9

11 another motivation for bonus issues especially taking into account the fact that there has been a significant growth in the ISE index during the study period. Within the framework of attention getting, bonus issues can also be used as a tool to attract the analysts attention. It is expected that the announcement effect will be positive reflecting the positive effects of enhanced liquidity and marketability, and attention getting hypotheses. Hypothesis 2: The liquidity and the neglected firm effect proxies are expected to be associated with the market reaction, but not the information signaling proxy for better future earnings. Booth et al. (2001) show that there is a country effect on the determinants of capital structure focusing on the capital structures in several developing countries including Turkey. They conclude that different institutional factors can result in different capital structures as well as different corporate governance systems. Unlike the market oriented countries such as the U.K. and the U.S., the amount of paid-in capital has more legal as well as corporate policy implications in the bank oriented countries such as Turkey, Germany, Denmark and Switzerland (Booth et al, 2001; Wulff, 2002; Kunz and Rosa-Majhensek, 2007; Bechmann and Raabelle, 2007). Even though the proportional increase in the paid-in capital favors the debtholders at the expense of shareholders due to greater security, in Turkey, with institutional settings of high inflation, weak shareholder rights and high creditor rights, heavy dependency on short-term bank financing for growth, unavailable corporate bond market and closely held ownership structure 8, shareholders in the ISE welcome the paid-in capital increases due to positive effects on borrowing capacity for growth as well as due to the fact that paid-in capital (i.e., known as legal capital in the U.S. and generally defined as the total par values of outstanding shares) has more legal protection than the other equity items that can be abused by the controlling shareholders, typically family members controlling the management and voting power both in the board of directors and shareholder meetings. For 10

12 instance, dividends can not be paid out of legal capital and it is very difficult to decrease the legal capital due to stringent legal protections. In the announcements, board of directors typically state that the paid-in capital will increase due to the bonus issue distribution. Similarly, in Denmark, Bechmann and Raaballe (2007) state that even though share capital increases through stock dividends improve security for creditors, this appears to be a necessary step for these firms in order to finance steady growth by debt (at an unchanged debt to equity ratio) and retained earnings alone (p.602). Gonenc (2003) shows that due to high inflation, political and economic uncertainty in Turkey, financial structure of Turkish industrial corporations in the ISE are heavily dependent on short-term debt with an average 12% long-term debt to total debt ratio for the period In these economic conditions, Gonenc states that it is very difficult to find external equity and corporations need bank financing to support their growth. Interestingly, unlike the relationship found in developed and some developing countries, Gonenc shows empirically that there is a positive relationship between the growth opportunities and the debt ratio due to the institutional characteristics of Turkish corporations and economy. Hypothesis 3: In an inflationary environment, the increase in paid-in capital is expected to be associated with the market reaction as well as with the bonus distribution ratio. As stated in Section 2, in order to avoid the corporation tax, the VAT and stamp duties, corporations were required to transfer any capital gain from property sale and/or sale of participation shares to paid-in capital through bonus issues. Even though there is a tax advantage for the corporation, the sale of property and/or participation shares can also indicate cash squeeze problem for the corporations. Consequently, both negative and positive effects are present affecting the expected magnitude of the market reaction. 11

13 Hypothesis 4: Bonus issue announcements that include the bonus issues financed from capital gain equity reserves are expected to have different market reaction relative to the bonus issue announcements that include the inflation revaluation equity and/or other equity reserves. 4. Data and Methodology We identify 161 uncontaminated bonus issue distribution news 10 that are announced by non-financial corporations (i.e., excluding utilities, banks, insurance, holding, finance and investment companies) in the official ISE daily bulletin over the period by searching through the electronic news database in the Finnet Haber Analiz 4.0 software. The adjusted/unadjusted stock prices and trading volume data are obtained from the electronic databases Tekaredi-Veri v and Rasyonet Hisse XL v software. [Insert Table 2] Table 2 presents the descriptive statistics for the bonus issue announcements sample as well as the sources of capitalizations. In 155 out of 161 bonus issue announcements, the sources of capitalizations are announced by the Board of Directors. As it can be seen in Panel A and Panel B, 110 of 155 (70%) bonus issues includes the inflation revaluation equity reserves and in terms of total amount in New Turkish Lira (YTL), they account for 81% of the total. In 30 out of 155 (30%) bonus issue announcements, capital gain equity reserves are used mainly due to the corporation tax advantage, but they account only for 5% of the total amount of bonus issues in YTL. As shown in Panel C, the average (median) bonus issue ratio measured as a percentage of paid-in capital 12 in the ISE are 221% (100%) which is substantially higher than other markets such as 100% in India, 69% in Greece, 30% in China, 18% in Australia, 11% in US and 9% in Japan (Lukose and Rao, 2002; Papaioannou et al., 2000; Balachandran et al., 12

14 2004; Lakanishok and Lev, 1987; Kato and Tsay, 2002). Panel C shows that 85% of bonus issue distributions are between 1% and 300%. In terms of distribution ratio, the bonus issue distributions in the ISE are more similar to the stock split factors, but still at a significantly higher magnitude relative to 85% average stock split distribution in the U.S. (Lakonishok and Lev, 1987). However, as stated before, bonus issues are different in terms of accounting treatment relative to stock splits. 4.1 Market reaction We adopt the traditional event study approach to assess the market reaction to bonus issue announcements by using the market adjusted model 13 using the estimation period -140 to relative to the event day 0. The event window is taken as -5 to +5 relative to the announcement day during which there are no other corporation specific news other than the bonus issue announcement. Three announcement sub-event periods are also defined as the pre-event period (-5 to -1), the announcement day (event) period (0 to +1) and the post-event period (+2 to +5). The cumulative market reaction (CAR) for each sub-event period is also calculated and is tested for statistical significance. The return on the market portfolio is proxied by the value-weighted ISE 100 index which includes 100 corporations based on their market value and liquidity characteristics. The ISE 100 index is a representative index and is the most widely used index by the investment banking industry as well as by the financial researchers as a proxy for the market return. Moreover, it is the only index whose data is available for the period of analysis. The non-parametric generalized sign test is also used as a robustness check in order to avoid the dependence on normality of return distributions. 4.2 Liquidity 13

15 In the literature of stock distributions, the three most commonly used measures of trading activity are the volume (daily number of shares traded), the volume turnover (daily number of shares traded divided by shares outstanding) and the number of days with trades. We do not use the volume turnover since on average, the free float percentage of outstanding shares is around 25% in the ISE and there is a lack of percentage free float data for specific periods 15. We could not use the number of days of trading yardstick since all stocks in our sample do not have any missing trading data. Alternatively, we adopted the following yardsticks for testing the enhanced liquidity effect. In line with arguments of Amihud et al. (1997) for the case of the Tel Aviv Stock Exchange, liquidity of stocks cannot be measured by bid-ask spreads in the ISE, since there are no market makers or specialists who post bid and ask prices. In the ISE, it is the investors providing liquidity to the market by entering their limit orders into the electronic trading system. Investors act as market makers and do not have to hold stock inventories in the ISE s price competitive and order-matching trading system (multiple price continuous auction system). We follow Amihud et al. (1997) and use three different measures of liquidity, namely the stock s raw and relative trading volume, and the stock s market depth ratio. Theoretically, stock s trading volume is an increasing function of its liquidity, ceteris paribus (Amihud and Mendelson, 1986). Therefore, an increase (decrease) in the trading volume shows an increase (decrease) in liquidity. The change in raw trading volume for security i is measured as the difference between ln(vol i,after ) and ln(vol i,before ) where VOL i,after and VOL i,before are the average daily trading volume in lots before the announcement day and after the ex-day. The average trading volumes are calculated for the period (-140 to -21) before the announcement day and for the period (+21 to +140) after the ex-day 16. Similarly, the change in relative trading volume for security i is measured as the difference between ln(relvol i,after ) and ln(relvol i,before ) where 14

16 relvol i,after and relvol i,before are the average daily relative trading volume in lots. The daily relative trading volume in lots is calculated by dividing the unadjusted trading volume by market volume for each day. The third measure is the market depth ratio which is considered as a good proxy for liquidity in several microstructure studies (e.g., Khan and Baker, 1993; Berkman and Elaswarapu, 1998; Muscarella and Piwowar, 2001). The market depth ratio measures the trading volume associated with a unit change in the stock price. In other words, a high ratio indicates that investors can trade a large number of shares with little price change. Therefore, an increase (decrease) in the market depth ratio shows an increase (decrease) in liquidity or market depth for a stock. The ratio is measured as: m m m MD k i = V i, t Ri, t, (1) k k where V i,t and R i,t are the trading volume in lots and the absolute return respectively for stock i on day t, comparing the MD for the period (-140 to -21) before the announcement day to the MD for the period (+21 to +140) after the ex-day. The change in the market depth ratio for security i is measured as the difference between ln(md i,after ) and ln(md i,before ). Taking into account the finding by Wulff (2002) for the German stock splits that less liquid shares have a relatively larger improvement in liquidity and a stock split does not improve liquidity if the stock s liquidity is already high, the sample is portioned into three groups (1-50, , ) sorted by the pre-bonus issue average raw and relative trading volume, and market depth. The statistical significance of mean and median changes for all and sorted groups is tested by using the parametric paired t-test and the non-parametric Wilcoxon test respectively. 4.3 Univariate analysis: Operating performance and financing 15

17 We use the operating margin (%) 17 as a proxy for the signaling hypothesis in an univariate analysis framework. We test the hypothesis that if companies issue bonus shares to signal good future performance, we would expect an increase in operating margin in the postevent period. We use only one year operating margin in the pre-event and post-event periods in order to avoid the previous and subsequent bonus issues by the same corporation. Taking into account the heavy dependency on short-term borrowing by the ISE industrial corporations and the eroding paid-in capital in an inflationary environment, we analyze the financial structures of our sample corporations by using several financial ratios such as debt to equity ratio (%), debt to paid-in capital ratio (%), total debt growth rate (%), short-term debt to total debt ratio (%) and short-term debt growth rate (%). We try to provide evidence whether there is a need for an increase in the paid-in capital in order to finance growth by borrowing. Similar to the operating margin s time period analysis, we calculate these ratios for the pre-event year, the event year and the post-event year. Using parametric t- test and non-parametric Mann-Whitney U-test, we test for differences in mean/median for (t- 1) to t, t to (t+1) and (t-1) to (t+1) where t is the event year. 4.4 Multivariate analysis: Bonus distribution ratio and market reaction Following the model adopted in McNichols and Dravid (1990) study, we use the regression analysis to capture the factors that determine the bonus issue distribution ratio, especially focusing on the enhanced liquidity effect and the debt to paid-in capital ratio effect. Taking into account the ISE institutional settings, we regress the bonus distribution ratio on the following explanatory variables: BDR i = α 0 + α 1 P i + α 2 MV i + α 3 DCP i + ε i (2) 16

18 where BDR is the bonus distribution ratio; P is the natural log of unadjusted stock price at the end of quarter before the bonus issue announcement; MV is the natural log of market value of equity in US$ at the end of quarter before the bonus issue announcement; DCP is the debt to paid-in capital ratio at the end of quarter before the bonus issue announcement. We approximate the liquidity explanation for bonus issue distribution by using the unadjusted stock price (P). The relationship between the BDR and P is expected to be positive based on the reasoning that higher stock prices need a higher BDR to bring it down to a more attractive level. McNichols and Dravid state that larger corporations prefer to maintain a higher stock price (i.e., a higher targeted stock price range) indicating a negative relationship between the BDR and MV. The relationship between the BDR and DCP is expected to be positive as a higher bonus distribution is needed to bring down the DCP ratio to a reasonable level. We also regress the level of market reaction (CAR(0, +1)) as the dependent variable on the following explanatory variables based on the model adopted in Rankine and Stice (1997): CAR (0,+1),i = α 0 + α 1 BDR i + α 2 MV i + α 1 P i + α 4 CAR (-21,-140),i + α 5 DBON i + α 6 DCGR i + ε i (3) where the definitions of BDR, MV and P are as stated above. CAR (-21,-140) is the cumulative abnormal return for the period -21 to -140 relative the announcement day 0. The DBON is a dummy variable having a value of 1 if the corporation does not have a bonus issue in the previous year and captures the surprise effect; DCGR is a dummy variable having a value of 1 if the bonus issue announcement includes capital gain reserves as one of the sources of the capitalization. The DCGR dummy variable tries to capture whether there is difference in market reaction for announcements that include the capital gain reserves in addition to other equity reserves. We expect a positive relationship between BDR and CAR as greater bonus issue distribution sends a more favorable signal to investors with more free float shares in circulation (i.e., higher liquidity). Small corporations tend to be analyzed less extensively 17

19 and less information is available for these corporations. Hence, we include the natural logarithm of market value of equity (MV) and expect a negative coefficient indicating a greater market reaction for relatively smaller corporations (i.e., attention-getting hypothesis/neglected firm hypothesis). Since stock distributions can be used as a tool of returning the stock price to an optimal trading range, corporations with a higher stock price (P) are more anticipated by the market to declare a bonus issue distribution indicating a negative relationship between the market reaction and the stock price (Rankine and Stice, 1997). Lastly, as a proxy for signaling hypothesis, we use the pre bonus distribution run up (CAR (-21,-140) ) since if a bonus distribution is a costly signal, managers would announce a bonus issue distribution if they believe that the run-up reflects fundamental value and there is a momentum of prices into the future (Leledakis et al., 2008). 5. Empirical findings In Table 3, the daily mean abnormal returns, the cumulative abnormal returns for the selected periods, the percentage of positive mean abnormal returns along with the t-value and the generalized sign test result for each event day are presented. The mean abnormal returns on event days 0 and +1 are 1.79% and 1.00% respectively with statistical significant t-values and generalized sign tests. The cumulative abnormal return for on-event period (0, +1) is 2.79% with statistical significance (Hypothesis 1). The cumulative abnormal return for both pre-event (-1, -5) and post-event (+2, +5) are statistically insignificant supporting the permanency of the announcement effect and supporting the correct detection of the announcement day as well as the robustness of the methods used in measuring the market reaction. [Insert Table 3 and Figure 2] 18

20 Figure 2 shows the mean abnormal return and cumulative abnormal return movements over the event period. For the cumulative abnormal return, there is a major up swing on days 0 and +1 leveling off to a permanent trend between 3.50% and 4.00%. The trends can also be observed for mean abnormal returns with positive values on days 0 and 1 along with erratic movements during the pre-event and post-event periods. The positive market reaction is in line with the market reaction of free stock distributions in developed and emerging markets such as U.S., U.K., Australia, Canada, China, Denmark, Germany, Greece, Hong Kong, India, Japan, Korea and Switzerland (see endnote 1). Specifically, the positive market reaction is in line with the announcement reaction of 2.45% for the 100% stock dividends reducing capital surplus in Rankine and Stice (1997) study. [Insert Table 4] Table 4 (Panel A) shows the on-event (0, +1) cumulative abnormal returns for three subsamples categorized by the sources of capitalization and shows test results for testing the differences in means/medians for these three subsamples. In shown in Panel A, we find relatively strong statistically significant market reaction for announcements that do not include the capital gain equity reserves. The mean (median) cumulative abnormal returns for inflation revaluation reserves only announcements and combination of inflation revaluation reserves and other equity reserves are 2.92% (2.31%) and 3.52% (2.21%) respectively. For announcements that include the capital gain equity reserves in addition to all other equity reserves, the mean cumulative abnormal return is 1.65% and the median is 0.02% indicating there is a distributional problem in this type of announcements. Moreover, the non-parametric generalized sign test is statistically insignificant. Typically, the bonus issues are financed with a combination several sources of equity reserves. We could not find any uncontaminated announcements that only include the capital gain equity reserves so that 19

21 we can isolate the effect. The ANOVA F-statistic and Kruskal-Wallis tests could not detect statistically significant difference in mean/medians of the three categories of capitalization. In Table 4 (Panel B), we detect no statistically significant difference in mean/median of inflation revaluation equity reserves only and combination of inflation revaluation equity reserves and other equity reserves. However, we detect a statistically significant difference in the median when the rest of all announcements is compared with the announcements that include the capital gain equity reserves. [Insert Table 5] In Table 5, the three measures of liquidity, namely raw trading volume, relative trading volume and the market depth ratio, are shown. In Panel A, the mean, the trimmed mean and median of the difference between ln(vol after ) and ln(vol before ) are shown for all and sorted groups. For all, the difference results are positive but statistically insignificant. For the first sorted group (1-50), the mean, trimmed mean and median differences are all positive with statistical significance. The last sorted group ( ) has a negative change in mean, trimmed mean and median with statistical significance. The results show that less liquid shares (1-50) have a relatively larger improvement in liquidity followed by statistically insignificant positive change for the second sorted group (51-100) and statistically significant negative change for the last sorted group ( ) having the pre-announcement largest liquidity. The results in Panel B are stronger for the relative trading volume taking into account the effect of market volume changes. For all, the first (1-50), and the second (51-100) sorted groups, the results are statistically significant and positive with the highest liquidity improvement for the first sorted group with the relatively less pre-bonus issue liquidity. The last sorted group does not have a statistically significant change in the liquidity. Overall, the last sorted group ( ) results indicate that a bonus issue does not improve liquidity if the stock s liquidity is already high. These results support the Wulff s (2002) finding for the 20

22 German stock splits that the less liquid shares have the relatively larger improvement of liquidity and might reconcile the mixed evidence on liquidity in the US empirical studies. Similarly, for the market depth ratio in Panel C, there is a statistically significant positive change in the market depth ratio for all bonus issues driven by the first sorted group (1-50) which has less liquidity and is more sensitive to changes in the number of shares available in the market. All three measures are consistent with the enhanced liquidity effect showing that bonus issue distributions increase the liquidity (market depth) of the stocks traded in the ISE (Hypothesis 2). [Insert Table 6] In Table 6, we could not detect a statistically significant change in the operating margin for periods (t-1) to t, t to (t+1) and (t-1) to (t+1) where t is the event year. This result supports the no signaling effect of the bonus issue distribution announcements due to the institutional settings in Turkey (Hypothesis 2). Focusing on the financing structures of our sample corporations, we look at several ratios before the event, during the event and after the event. In Table 6, due to the transfer of equity reserves to paid-in capital, there is a statistically significant decline in the mean and median debt to paid-in capital ratio between (t-1) and (t), and then the ratio increases at (t+1) but not to the pre bonus issue level at (t-1). With respect to total growth in debt, results show that in the pre bonus issue and bonus issue years, there is an increase in the level of debt with a statistically significant decline in post bonus issue year. In regards to the maturity of debt (Short-term Debt/Total Debt), consistent with Gonenc (2003) findings, results show that around 75% of total debt is short term borrowing with a slight decline in the post bonus issue year. Similarly, short-term debt growth rates show that short-term debt grows in both pre and bonus issue years with a statistically significant decline in growth during the post bonus issue year. All preceding ratios indicate that there is an increase in the level of debt in both pre 21

23 bonus issue and bonus issue years indicating a need for an increase in paid-in capital as a stronger covenant for creditors in order to finance growth through borrowing (Hypothesis 3). Additionally, we detect no statistically significant change in the debt to equity ratio as shown in Table 6 indicating growth in equity possibly through inflation revaluation reserves. [Insert Table 7] In Table 7, the regression results on the bonus distribution ratio choice (model 2) are presented and the results are in line with the findings of McNichols and Dravid (1990). The intercept and all coefficients are statistically significant with an adjusted R 2 of 40.37%. The coefficients of pre bonus issue market price and the market value have the predicted sign supporting the enhanced liquidity hypothesis (Hypothesis 2). Managers set their bonus distribution ratio to return the stock price to an optimal range and the optimal range is set higher for larger corporations. Additionally, the coefficient of debt to paid-in capital ratio has the predicted sign supporting the hypothesis that corporations with a higher debt to paid-in capital ratio declare a higher bonus distribution ratio to bring down the ratio for more credibility and borrowing capacity (Hypothesis 3). [Insert Table 8] The regression results for the cumulative abnormal return and the five explanatory variables are presented in regression 1 of Table 8. As predicted, the coefficients of bonus distribution ratio (BDR) and the pre bonus market price are positive and negative respectively with statistical significance. The coefficients of the market value (MV) and bonus dummy (DBON) have the correct sign but are statistically insignificant. The CAR (-21,-140) coefficient has the wrong sign and is statistically insignificant. Overall, the statistically significant BDR and P coefficients support the enhanced liquidity hypothesis. We could not find empirical support for the attention-getting/neglected firm hypothesis with a statistically insignificant 22

24 MV coefficient (Hypothesis 2). The statistically insignificant CAR (-21,-140) coefficient supports the expectation of no signaling effect for better future earnings due to the unique institutional settings of the ISE (Hypothesis 2). To control for the effect of having capital gain reserves as one of the capitalization sources, the dummy variable DCGR is added to regression 1 and the results are presented in regression 2 of Table 8. The coefficient is statistically insignificant indicating no effect (Hypothesis 4). However, we should mention that the statistically insignificance of this coefficient can be due to the fact that the event is contaminated with the effects of other capitalization sources such as the inflation revaluation reserves. 6. Conclusions We examine the market reaction to bonus issue announcements in a market setting where the cash dividend substitution, agency cost, transaction effects and retained earnings hypotheses are not prevalent and bonus issues are capitalized in the paid-in capital amount mainly from equity reserves which are created due to the revaluation of assets in an inflationary environment. We provide empirical evidence for the signaling, enhanced liquidity and neglected firm hypotheses as well as for the importance of the amount of paid-in capital in an inflationary environment. We find that, on average, the abnormal returns are positive and significant on the announcement day. We try to provide empirical evidence by relating the bonus distribution ratio as well as the market reaction abnormal returns to the corporation s stock liquidity, to the neglected firm effect and to the signaling of future prospects hypotheses. In addition to regression results, we use three liquidity measures, the change in the stock s trading volume, the change in relative trading volume, and the change in the market depth ratio in order to test 23

25 the enhanced liquidity hypothesis which states that stock distributions increase the number of shares in circulation in a closely held market structure, and hence, increase the liquidity and marketability of the stocks. Additionally, the motivation can also be to return the stock price to a normal trading range, especially in a market where the stock market index has continually increased significantly during the period of analysis. In the absence of agency cost, cash substitution, transaction cost and retained earnings effects, the positive announcement effect provides evidence for the enhanced liquidity expectation. The three liquidity measures, namely the raw trading volume, the relative trading volume and the market depth ratio, are significantly positive indicating that bonus issue distributions increase the liquidity (market depth) of the stocks traded in the ISE. Especially, the improvement in liquidity is stronger for distributions with relatively less liquid stocks. We also find that if the stock s liquidity is already high, the bonus issue distribution does not change the liquidity. The result of no change in liquidity for stocks which are already highly liquid might reconcile the mixed liquidity evidence of stock distributions in the U.S.. In a regression analysis framework, bonus distribution ratio is related to the size of corporation as well as to the pre bonus issue price level. The magnitude of market reaction is also explained by the pre bonus isse price level as well as the size of bonus distribution ratio. In the ISE settings, bonus issues are associated with an increase in liquidity and this empirical finding contributes to the liquidity effect studies of stock distributions which have had mixed results in the U.S. and in other developed capital markets. Our univariate analysis of operating margin around the event year and the statistically insignificant relationship between the market reaction abnormal returns and the pre bonus issue stock price run up do not provide support for the signaling hypothesis which is expected to less relevant given the ISE s institutional settings where bonus issues are frequent and emanate from an accounting treatment in an inflationary environment. Additionally, 24