OWNERSHIP STRUCTURE AND CORPORATE DIVIDEND POLICY. Savita Verma

Transcription

1 OWNERSHIP STRUCTURE AND CORPORATE DIVIDEND POLICY By Savita Verma A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY in THE FACULTY OF GRADUATE STUDIES COMMERCE AND BUSINESS ADMINISTRATION We accept this thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA 1990 Savita Verma, 1990

2 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of Commerce and Business Administration The University of British Columbia 1956 Main MaU Vancouver, Canada Date:

3 Abstract This study investigates the potential role of ownership structure as a determinant of the corporate dividend policy. A firm's dividend policy is modelled as the outcome of a voting game among groups of asymmetrically informed shareholders, who also have different marginal tax rates for dividend income. The outcome of the voting game is determined by the relative voting powers of these shareholder groups. Voting power is denned as the probability that a particular block of shares will be pivotal in determining the outcome of the voting game. Using Shapley values as instruments for shareholder groups' voting powers, data on firms which traded on the Toronto Stock Exchange during the period are employed to test the model's predictions.

4 Table of Contents Abstract ii List of Tables vi List of Figures x Acknowledgement xi 1 INTRODUCTION 1 2 CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE Dividend policy under differential taxation of dividends and capital gains Dividends, taxes, and firm valuation Existence of tax-based clienteles Dividend policy as a signal of firm value under asymmetric information Dividend signalling models Empirical evidence on dividend signalling Dividend policy as a vehicle for minimizing agency costs Summary 19 3 POTENTIAL DETERMINANTS OF OWNERSHIP STRUCTURE Value of Control The Mechanics of Shareholder Voting 23 iii

5 3.2.1 Potential problems with voting by proxy Ownership structure and firm valuation Shareholder voting behaviour: empirical evidence Proxy contests Summary 33 4 A MODEL OF THE CONSENSUS DIVIDEND POLICY The consensus dividend policy Properties of the Dividend Equilibrium Summary 48 5 DATA, METHODOLOGY AND EMPIRICAL RESULTS Data sources and sample characteristics Sample size Sample distribution by year, industry and corporate ownership Ownership of voting rights by managers Constraints on dividend payments Asset size and capital structure Aggregate dividend yields Test strategy Seemingly Unrelated Regressions analysis Accounting for D max and Z? m, n Linear structural model (LISREL) formulation Empirical results: SUR analysis Total sample Empirical results: LISREL formulation Total sample 71 iv

6 5.4.2 Cases with absolute voting power Cases with non-absolute voting power Summary and conclusions 80 6 CONCLUSIONS 120 Appendices 124 A TAXATION OF INVESTMENT INCOME 124 A. l The Canadian Tax System 124 B SHAPLEY VALUE IN OCEANIC GAMES 128 B. l Distribution of Voting Power Among Firm Shareholders 128 B.2 Assumptions Underlying Shapley Value 132 B.3 Shapley value and the dividend voting game 134 Bibliography 136 v

7 List of Tables 5.1 Data sources and sample size Annual distribution of sample firms classified by country of control, Distribution of sample firms by industry classification as of Corporate ownership of voting rights in sample firms under domestic control, Corporate ownership of voting rights in samplefirmsunder foreign control, Managers' ownership of voting rights in sample firms, Constraints on dividend payments imposed by debt covenants in the sample firms Capital structure of sample firms under domestic control, Capital structure of sample firms under foreign control, Annual dividend yields onfirmsunder domestic control, Annual dividend yields onfirmsunder foreign control, SUR estimates of regressions of cash (DIVC) and non-cash (DIVS) dividend yields on percent ownership of voting rights by large corporate shareholders (IOWN), managers (MOWN), IOWN-sqrd, MOWN-sqrd and IOWNxMOWN SUR estimates of regressions of cash (DIVC) and non-cash (DIVS) dividend yields on voting powers of the large corporate shareholders (ISHAP) and managers (MSHAP) 93 vi

8 5.14 Distribution of the 1188 sample observations by zero- and non-zero dividend yields and by absolute- and non-absolute voting power Descriptive statistics for the two voting power variables ISHAP and MSHAP, the two dividend yield variables DIVC and DIVS, eleven financial variables NE, SE, TA, CA, CL, LD, PE, STDR and MVE, and their correlations Pearson correlation coefficients for dividend yield variables, financial variables, and voting power variables LISREL measurement model (design matrix A) Total sample and subsample of cases with non-absolute voting power LISREL measurement model (design matrix A) using ISHAP Cases with absolute voting power LISREL measurement model (design matrix A) using MSHAP Cases with absolute voting power SUR estimates of regressions of cash (DIVC) and non-cash (DIVS) dividend yields on voting powers of the large corporate shareholders (ISHAP) and of the managers (MSHAP) and the financial variables NE, LDIVC, SE, TA, PE, STDR and MVE OLS regression estimates of parameters for calculating D max and D m,, based on 353 absolute voting power cases i.e. cases for which either ISHAP=1 or MSHAP= Coefficients of OLS regressions of DIVC on estimated D max, estimated D m i n, and shareholder voting powers (ISHAP and MSHAP) for the 170 cases of non-absolute voting power (neither ISHAP nor MSHAP has value 1) Estimates of the LISREL measurement model (design matrix A) for the total sample 103 vii

9 5.24 Estimates of the LISREL structural equations (design matrix T) for the total sample Estimate of the LISREL variance-covariance matrix of the unobservable attributes (design matrix $) for the total sample Estimates of the normalized residuals S XJ for LISREL for the total sample Estimates of the LISREL measurement model (design matrix A) using ISHAP for cases with absolute voting power Estimates of the LISREL structural equations (design matrix T) using ISHAP. for cases with absolute voting power Estimate of the LISREL variance-covariance matrix of the unobservable attributes (design matrix $) using ISHAP for cases with absolute voting power Estimates of the normalized residuals S for LISREL using ISHAP for cases with absolute voting power Estimates of the LISREL measurement model (design matrix A) using MSHAP for cases with absolute voting power Ill 5.32 Estimates of the LISREL structural equations (design matrix T) using MSHAP for cases with absolute voting power Estimate of the LISREL variance-covariance matrix of the unobservable attributes (design matrix $) using MSHAP for cases with absolute voting power Estimates of the normalized residuals S for LISREL using MSHAP for cases with absolute voting power Estimates of the LISREL measurement model (design matrix A) for cases with non-absolute voting power 115 vm

10 5.36 Estimates of the LISREL structural equations (design matrix T) for cases with non-absolute voting power Estimate of the LISREL variance-covariance matrix of the unobservable attributes (design matrix for cases with non-absolute voting power Estimates of the normalized residuals S S for cases with non-absolute voting power 118 B.39 Examples of Shapley Values for Given Ownership Structures 131 ix

11 List of Figures 4.1 Shareholder Marginal Tax Rates The dividend voting game 40 x

12 Acknowledgement I wish to express my sincere thanks to Professor B. Espen Eckbo for the encouragement and guidance he has provided throughout the course of this work. I have benefitted greatly from the challenges he has posed and from the criticisms he has offered. I would also like to thank Professor Alan Kraus for the many helpful suggestions and comments, for prompt feedback, and for his doing so with a very supportive touch. Professor Piet de Jong has helped keep the perspective. His comments and feedback on the editorial as well as the statistical aspects of this work, are greatly appreciated. Finally, I would like to acknowledge my appreciation of the stimulating work environment provided by colleagues in the doctoral program and the Finance Seminar, in the Faculty of Commerce and Business Administration at the University of British Columbia. Savita Verma March, 1990 xi

13 Chapter 1 INTRODUCTION This study investigates the potential link between a firm's dividend policy and its ownership structure. The proposed link is a simple one: Firm policies over which shareholders disagree, get resolved at meetings through the outcome of a vote. K they face different marginal tax rates for dividend income, then shareholders will favour different dividend policies and will vote for the one which maximizes their net-of-taxes income. The extant literature suggests several explanations as to why firms pay dividends in spite of the apparent tax penalty to their shareholders: the existence of shareholder tax clienteles, information signalling through dividends under asymmetric information, and dividends as vehicles for minimizing agency costs. The explanation of dividend payments proposed here assumes the coexistence of different shareholder tax-clienteles in a firm's ownership structure and arrives at an equilibrium dividend policy which is determined by the outcome of a vote held among the firm shareholders. This is in contrast to the explanations available in the literature which treat shareholders alternatively as unanimous, or as passive investors who either do not have a say in setting firm policies, or choose not to exercise it. In the proposed model, some shareholders of a firm hold sizeable blocks of votes, with the remaining votes are distributed among a large number of individual shareholders. It is assumed that some of the large block-holders do not pay any taxes on dividends. The rest of the shareholders the remaining large block-holders as well as the small shareholders, are taxed on their dividend receipts although at different rates. Also, it is assumed that 1

14 Chapter 1. INTRODUCTION 2 the distributions of relative tax rates of shareholders are only imperfectly known. Based on their relative tax rates for dividends and capital gains firm shareholders can be divided into two groups: one group prefers dividends to capital gains and the other group prefers capital gains to dividends. The distribution of votes among the two shareholder groups also implies a certain distribution of voting power. Voting power here means the ex ante probability of winning a vote for a group of shareholders. Given the voting power distribution for a particular firm, it is shown that in equilibrium its dividend policy has to coincide with the one that would emerge if a vote were to be held among the firm shareholders. This leads to the central proposition that corporate dividend policy is in part determined by the relative voting powers of the shareholder groups in different tax brackets. The above proposition and other implications of the proposed model are tested using data on firms which traded on the toronto Stock Exchange during the period. The period covers part of the tax regime in Canada when taxes on capital gains were determined as set down by the 1972 tax reform legislation. Prior to 1972, capital gains were not taxed at all. Since 1985, individuals have a life time tax exemption on the first $100,000 of their capital gains. Thus in the period prior to 1972 and since 1985, the implied tax penalty of receiving dividends rather than capital gains would seem to be higher compared to that during the period. Decisions by investors and policies of firms which may be sensitive to differential taxation of dividends and capital gains during the period, are likely to be even more so during the other two regimes. The rest of this study is organized into five chapters. Chapter 2 contains a discussion of the existing theories of corporate dividend policies and the available empirical evidence. As this literature overview suggests, neither the theoretical models nor the available empirical evidence have put the dividend puzzle to rest.

15 Chapter 1. INTRODUCTION 3 The model being proposed in this study treats a firm's ownership structure as exogenous. The potential determinants of the ownership structure are nevertheless of interest in their own right. 1 In Chapter 3, the various theories and available evidence on the determinants of ownership structure, and how they relate to the proposed model, are discussed. In Chapter 4, the proposed model linking ownership structure with corporate dividend policy is presented. The assumptions underlying the model and its implications are discussed and the hypotheses to be tested axe set up. Chapter 5 contains the details of the data gathered, the sample characteristics and the results of the empirical analysis. A measure employed to proxy for shareholder voting power is Shapley value. Tables containing data description and analysis are included at the end of the chapter. Chapter 6 the last chapter, contains conclusions drawn from the results and details of the related future work planned. Two appendices are included. Appendix A contains a description of the Canadian tax code with a focus on the differences in the tax regimes in effect over the years. Appendix B contains a discussion of oceanic games and Shapley value as a measure of shareholder voting power in these games. 1 In a full equilibrium characterization, an investor might arrive at his optimal portfolio by simultaneously controlling for his fractional ownership of the firm (and his implied voting power) and the firm's financial policies. The financial policies would then in turn, account for the shareholders' voting powers to incorporate the possibility of disagreement among them. The proposed partial equilibrium model is offered as a first step towards this ultimate goal.

16 Chapter 2 CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE The determinants of corporate dividend policies constitute one of the central unresolved issues in financial economics. While corporate managers tend to view the firm's payout decision as economically important, 1 it remains a puzzle why firms continue to pay dividends, given the relative tax penalty on cash distributions. Miller and Modigliani (1961) have shown that in a perfect capital market with no transaction costs, agency costs, taxes or information asymmetries, the firm's choice of dividend policy does not affect the value of the firm. Their central insight is that, given these market conditions, individual shareholders can costlessly generate their own preferred dividend policy (say by selling off shares), precluding a positive price for dividends generated at the corporate level. Following the Miller and Modigliani "dividend irrelevance proposition", theoretical as well as empirical research has appealed to various forms of market imperfections and the interdependence between dividends, capital structure and the firm's investment policy to explain the dividend puzzle. For instance, the tax codes of most countries favour capital gains over dividends as a source of income to individual investors. Not only is the nominal capital gains tax rate typically lower than the nominal rate applied to dividends; investors have the option to defer capital gains taxes indefinitely. Thus, paying cash dividends almost certainly imposes a relative tax penalty on a large number of individual shareholders. 2 Nevertheless, while a substantial amount of research has been devoted 1 Lintner (1956) presented some first systematic evidence that corporate managers set target yield ratios as a function of expected earnings. 2 This conjecture is supported by Feenberg (1981) who, based on a sample of 86,000 of the universe 4

17 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 5 to the question of whether equilibrium security prices reflect this tax disadvantage, 3 empirical tests do not reliably support the existence of tax effects in expected stock returns. 4 Similarly, studies of the ex-dividend day price drop do not conclusively support the hypothesis that the marginal investor in the firm's stock faces a relative tax penalty on dividends. 5 The literature also explores the role of agency costs, 6 costs of financial distress and information asymmetries 7 to explain the observed patterns in firm dividend policies. Dividend policy in these models is treated alternatively as a signal of the firm's future prospects or as a means by which managers minimize their own access to funds generated by the firm. By voluntarily contracting (via the announced dividend policy) to pay out the funds as dividends, the managers supposedly curb their own temptation to make low or negative net present value investments on behalf of the firm. While the above and other theories provide plausible explanations of the dividend decision at a detailed level, no consensus has emerged as to how they combine to explain the overall dividend picture. There does, however, appear to be widespread agreement that unanticipated changes in dividends convey new information to the market and therefore affect market prices. 8 In the following, we look at the theories and evidence referred to above in greater of 86 million U.S. federal tax returns in 1977, shows that the total dividend reported for taxation was 27 billion dollars, resulting in over 8 billion dollars in taxes. 3 E.g., Brennan (1970), Long (1977), Litzenberger and Ramaswamy (1980), Shaefer (1982), Constantinides and Ingersoll (1984), and Dybvig and Ross (1986). 4 E.g., Black and Scholes (1974), Litzenberger and Ramaswamy (1979,1982), Morgan (1980), Miller and Scholes (1982), and Hess (1983). 5 See, e.g. Elton and Gruber (1970), Kalay (1982), Hess (1982), Booth and Johnston (1984), Eades, Hess and Kim (1984), Barone-Adesi and Whaley (1986), and Barclay (1987). 6 E.g., Jensen and Meckling (1976), Smith and Warner (1979), Easterbrook (1984), Schleifer and Vishny (1986). 7 E.g., Ross (1977), Bhattacharya (1979), Miller and Rock (1985), Ambrish, John and Williams (1987). 8 E.g., Charest (1978), Asquith and Mullins (1983), Grinblatt Masulis and Titman (1984), Eades, Hess and Kim (1985), Kalay and Loewenstein (1985), and Handjinicolaou and Kalay (1984).

18 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 6 details. The focus is on the insights provided by them as well as the aspects in which they fall short of resolving the dividend puzzle. This critical survey of the literature is conducted under the following three headings: Dividend policy under differential taxation of dividends and capital gains. Dividend policy as a signal of firm value under asymmetric information. Dividend policy as a vehicle for minimizing agency costs. 2.1 Dividend policy under differential taxation of dividends and capital gains We start with a look at those investigations in the literature which focus on differential taxation of dividend and capital gains incomes and different marginal tax rates for investors as the determinants of dividend policy. These investigations can be broadly classified into two groups. One group consists of those investigations which hypothesize that investors require a premium from high dividend yield stocks as compensation for the tax penalty incurred. The other group includes explorations which take the view that dividend policy may be irrelevant to firm valuation, but that existence of tax-based clienteles may nevertheless govern firms to set dividend policies in a non-trivial manner Dividends, taxes, and firm valuation Brennan's (1970) general equilibrium model was the first one to be set in an economy with taxes and in which dividend income is taxed at a rate higher than the capital gains tax rate. In such an economy, investors designing portfolios to maximize expected utility of wealth require a higher rate of return from higher dividend yield stocks for a given level of risk. Brennan' model is thus an extended CAPM with dividend yield constituting a second factor, the first one being the systematic risk of the security.

19 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 7 In an early test of Brennan's model, Black and Scholes (1974) found that the riskadjusted returns of two portfolios one of high dividend yield stocks and the other of low yield stocks, do not differ significantly from each other. In other words, they reject the hypothesis that investors require differential returns from stocks with different dividend yields. To explain why this could happen despite differential taxation, Miller and Scholes (1978) argued that firms or investors ought to be able to neutralise the tax penalty on dividends through the use of appropriate investment strategies. The firms could do so by paying dividends through stock repurchases rather than as cash payouts. And the investors may neutralize the dividend tax penalty through "dividend laundering". Dividend laundering involves (i) levering the purchase of equities so as to offset taxable dividends with interest deductions, and (ii) removing unwanted risk in this levered position by purchasing tax-deferred insurance. An assumption underlying this strategy is that interest payments on borrowings for investment can be used to reduce taxable income from other investments. In practice however, it may not be so straight forward to undo the firm dividend policy in this manner either by the firm itself or by its shareholders. Firms would need to repurchase stock on the open market 9 in order to keep the tax authorities from treating the proceeds to sellers as taxable dividends. This would force the amount paid out in dividends to be determined by the prevailing market price of shares and therefore uncertain from period-to-period. In turn, this would take away from the amounts paid to shareholders through share repurchases, the one key feature identifying them as dividends namely, the predictability of timing and amounts of dividend payments. Indeed the fact that managers can, and very likely do, control their size and timing 10 rules out 9 Any pro-rata repurchases of shares on a regular basis directly from the shareholders would be deemed taxable as ordinary dividends. 1 0 Evidence of favourable stock price reactions when firms make repurchase announcements, is discussed in the next section along with other models of dividends as signals of firm value.

20 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 8 repurchases as a mere means of making predictable, periodic distributions to shareholders. Furthermore, this would be true even if there were no tax-related complications associated with using repurchases as a vehicle for paying dividends. Shareholders, like firms, may not be able to undo a firm's dividend policy either because they may not be able to borrow at an interest rate no higher than the rate of return from the tax shelter. 11 Besides, there is the question of how elastic the supply of tax-sheltered investment will be in equilibrium. In another test of the tax-adjusted CAPM, Litzenberger and Ramaswamy (1979) reported significant premia being charged for dividends in equilibrium stock returns. In a similar test using data on Canadian firms, Morgan (1980) found that prior to 1972, there were significant premia being charged for dividends, but that these premia disappeared for the period. 12 Morgan concluded that dividends and capital gains became substitutes, albeit imperfect, when capital gains taxes were introduced. Tests such as the above involving measurement of dividend yields and their premia have been strongly criticised however, by Miller and Scholes (1982) for their "inappropriate" yield measurements. Miller and Scholes note that the dividend yields are measured using the cash dividend amounts paid during the period over which the returns are calculated. These short-run dividend yields are then linked in these tests with the riskadjusted returns which, in reality, may be compensation for the dividend announcement effect rather than the dividend tax burden, if any. Miller and Scholes suggest that yield calculations using only the dividends declared in advance, measure the appropriate expected long-run dividend yield. This way, the dividend announcement effect is eliminated u Feenberg (1981) argues that less than 3 percent of the taxpayers in his 1977 sample of the US taxpayers could have made use of the dividend laundering scheme suggested by Miller and Scholes (1978). 1 2 Capital gains taxes were introduced in Canada in They were subsequently eliminated in 1985 for the first $100,000 in capital gains for individuals. For details of taxation in Canada, see Appendix A.

21 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 9 and only the long-term tax differential effect is measured. Thus modifying the dividend yield measurement, Miller and Scholes still do not find any premia for dividends. Confounding the debate further on whether dividends are undesirable or simply irrelevant, is the study by Long (1978) of the Citizens Utilities case. Under a special IRS ruling, the firm has two classes of shares outstanding which are identical except in their dividend payouts. One class of shares pays only stock dividends which are not taxable as ordinary income under the IRS ruling. Shares in the other class pay only cash dividends. Shares in the former class are freely convertible into the latter type on a one-to-one basis, but not the other way around. Historically, the stock dividends have been higher than the cash dividends. Long shows that in this case the cash dividend shares seem to be preferred by investors in the sense that the required rate of return is lower for them than for the stock dividend shares Existence of tax-based clienteles The question of whether differential taxation affects investors' valuation of firms is unresolved, as seen from the evidence so far. As Miller and Modigliani (1961) argued however, even if dividends were to be irrelevant to firm valuation in reality, this would not be inconsistent with the existence of differential taxation-induced investor clienteles. Investors' relative tax rates would determine whether they hold high dividend yield or low-yield stocks. As far as firm valuation is concerned though, one clientele would be as good as any other. In equilibrium, some firms would pay higher and others lower dividends, but no firm would be able to increase its value relative to another firm by merely changing its dividend yield. H the aggregate dividends demanded changed due to some exogenous change such as a relative tax rate change, equilibrium would be reattained by a resorting of individuals among the various clientele groups rather than through a change in relative values of firms.

22 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 10 Empirical evidence supports the assertion noted above that the aggregate supply of dividends is affected by the differential in tax rates for dividends and capital gains. Khoury and Smith (1977) show that Canadian firms significantly increased their dividend payouts when a capital gains tax was introduced in Canada in The hypothesis that clienteles re-sort among themselves when firms change their dividend policies, is also supported by Richardson, Sefcik and Thompson's (1986) finding that for firms which announce dividends for the first time, both the trading volume and firm value go up significantly around the announcement date, and that the pattern of abnormal trading volume around the announcement date persists even after the announcement effect has been accounted for. In particular, this suggests that investors can have a preference for one or another dividend policy, its irrelevance to firm value notwithstanding. Elton and Gruber (1970) present a model in which the marginal tax rates of some traders would allow them to make arbitrage profits through trading around the exdividend dates. 13 To eliminate these profits, the ex-dividend day drop in price for a stock must be of the magnitude which makes the marginal trader indifferent between selling the stock cum-dividend and ex-dividend. From the data on actual drops in prices when stocks go ex-dividend, the tax rates of the marginal trader can be inferred. Existence of different implied marginal tax rates for different dividend yield stocks then implies the existence of tax based dividend clienteles as suggested by Miller and Modigliani. Using data on US firms for the period April,1966-March, 1967, Elton and Gruber find that the implied marginal tax rate decreases when dividend payout increases. They conclude that this is evidence in support of the existence of tax-based clienteles. Elton and Gruber's interpretation is based on the assumption that the cum- and 13 Certain jurisdictions such as UK, explicitly restrict tax arbitrage by individual investors and taxexempt corporations through progressive taxation of trading proceeds, the closer the trading dates are to the ex-dividend dates. Based on the UK data, Poterba and Summers (1984) find premia being charged for dividends.

23 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 11 ex-dividend prices axe set by investors, who have decided to buy and sell shares around the dividend payment date for reasons other than dividend receipts and taxes. The tax-adjusted prices then emerge so as to make these investors indifferent between buying/selling their shares cum-dividend and ex-dividend. Kalay (1982b) argues however, that additional information is required before the marginal tax rates can be inferred from calculations such as suggested by Elton and Gruber. Kalay (1982b) and Lakonishok and Vermaelen [(1983), (1986)] test the alternative hypothesis that the ex-dividend day prices are determined by the short-term traders whose tax rates are identical for dividend and capital gains incomes. They argue that these traders may make arbitrage profits by trading around the ex-dividend dates even though they axe taxed at the same rate for dividends and capital gains. Their evidence suggests that the short-term traders do have an impact on the ex-dividend day prices, thereby ruling out the possibility of inferring the marginal tax rates of the presumed tax clienteles. 14 Barclay (1987) compares ex-day price behaviour of stocks before and after the enactment of the federal income tax in US. 15 He finds that in the before-tax period, ex-day prices fell by the full amount of the dividend on the average, and that investors valued dividends and capital gains as perfect substitutes. This is different from the after-tax enactment evidence which suggests that investors discount taxable dividends more than they discount capital gains. The following overall picture thus emerges from the differential taxation-based models of dividends: If all investors are assumed to have the same marginal tax rate and if 1 4 Lakonishok and Vermaelen (1983) find that the ex-dividend day decline in price is smaller in Canada compared to the drop in US. For US firms, Barone-Adesi and Whaley (1983) find the ratio of the price decline to the amount of dividend paid, to be equal to unity. For Canadian firms, Booth and Johnston (1984) find it to be between zero and unity. Also they find the ratio to be monotonically increasing in dividend yield and attribute this link to another finding that the ex-dividend trading volume increases as dividend yield decreases. 1 5 Barclay covers the years for pre-tax enactment and the years for the post-tax enactment data. The federal income tax was fully enacted in the US in 1913.

24 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 12 dividends axe taxed at a higher rate than capital gains, then the required rates of return reflect this tax penalty. If however, the investors are in different tax brackets and there are opportunities for tax arbitrage, then the classical tax clienteles emerge with low tax rate clienteles holding high dividend yield firms and high tax clienteles holding low dividend yield stocks. There are so far no pricing implications for the assets, though. But as Dybvig and Ross (1986) show, once short selling restrictions are introduced which curb tax arbitrage, then heterogenous marginal tax rates across investors can result in two or more distinct tax clienteles coexisting among a firm's shareholders. Full implications of this simultaneous existence of investors with different marginal tax rates among a firm's shareholders are yet to be explored in the literature. In the next section, we look at the literature which explores dividend policy as a potential signalling tool. 2.2 Dividend policy as a signal of firm value under asymmetric information The existence of the dividend announcement effect noted earlier suggests that dividends, and specially changes therein, have to be looked upon as more than just a means available to firms for distributing their cash flows based on the shareholders' tax rates. The early empirical model of dividends proposed by Lintner (1956) was based on his survey results that firm managers set dividends to gradually attain a target payout ratio over time, and that there is reluctance among them to cut dividends below their prevailing levels. The reluctance stems from the belief that a cut may be interpreted by investors as unfavourable information. More recently however, Kalay (1980) has argued that in the presence of bond covenants restricting dividend payments, cutting of dividends cannot be a decision made entirely at the discretion of the managers, and therefore cannot be interpreted as a signal. Kalay does not find a large enough percentage

25 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 13 of forced dividend cuts though, in order to be able to refute their information content. Further, in a subsequent study of the debt covenants of a random sample of firms, Kalay (1982a) finds that most firms pay dividends which are well below the maxima allowed by the covenant restrictions. Thus the debt covenants do not appear to impose a binding constraint on firm dividend payments. If dividends are in fact being used as signalling devices by firms, then Kalay's evidence noted above suggests that the observed dividend policies are possibly the outcomes of the cost-benefit trade-off from this signalling. We next look at the models in the literature which formalize this notion, followed by the available empirical in support thereof Dividend signalling models Formal models which establish corporate financial decisions as signals of the future prospects of a firm in the event of asymmetric information, are proposed by Ross (1977), Bhattacharya (1979) and Miller and Rock (1985). The model by Ross employs capital structure as the signal; it is easily altered to use dividend policy as the signalling device (Kalay (1980)). In the two models by Bhattacharya, and Miller and Rock dividends are employed as signals by managers to communicate their private information to the market. Offsetting the resulting benefits from signalling axe the various direct and indirect costs of paying dividends providing thereby a theory of an optimal dividend policy. Hakansson (1982) develops sufficient conditions which can make dividend policy an informative and therefore a valuable signal. These conditions require either that investors have different probability assessments of dividend payouts, or that they have different preferred allocations of consumption over time, or that the financial markets are incomplete. Ambrish, John and Williams (1987) propose a model in which multiple signals using dividends and investment axe employed by a firm. Their model is able to explain the positive announcement effect of dividends on stock prices and the negative effect of

26 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 14 net new stock issue. The beginnings of a realization that the shareholders of a firm may not be unanimous regarding dividend payouts can be seen in the approach taken by Brennan and Thakor (1988). They model the choice of corporate cash disbursement method when the objective is to maximize the wealth of a majority of shareholders. They note that unlike cash dividends, share repurchases are not (and cannot be) pro-rata in order to qualify for favourable tax treatment. In view of the associated information asymmetries, repurchases can result in a wealth transfer from uninformed to informed shareholders. When the costs of information acquisition are fixed, the large shareholders are likely to be better informed than the small shareholders and further, as the size of the distribution increases there is better incentive for the large shareholders to become informed. In view of their informational disadvantage then, the small shareholders axe likely to prefer cash distributions to share repurchases in general, and to prefer open market repurchases to self-tenders within the repurchase option. Brennan and Thakor conclude that if the choice outcome is determined by the potentially informed shareholders, then cash dividends will be preferred for small distributions, open market operations for medium-sized distributions, and self-tenders for the largest distributions. Any further refinement of this conclusion specially to a testable hypothesis, would require the firm ownership structure to be explicitly incorporated into the model. But Brennan and Thakor leave their conclusions stated in terms of "an unspecified majority of shareholders" only. Masulis and Trueman (1988) also recognize the possibility of heterogeneity among shareholders on preferred dividends, and propose that the preference of some firm shareholders to defer cash dividends because of the tax penalty is tempered by the costs of doing so at the firm level. The funds retained by the firm must either be invested in real assets at diminishing returns, or else must be put in financial assets resulting in double taxation. Other uses of the retained funds such as debt redemption may move

27 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 15 the firm from some other optima and would give rise to costs of their own. One consequence of all this is an agreement among shareholders to counter these costs and receive cash dividends, their tax penalty to some shareholders notwithstanding. The differential personal rates of taxation for different shareholders and the implied benefits of dividend deferral do however cause disagreement among them regarding the investment strategy. Shareholders in low tax brackets for instance, derive less benefit from the deferral and therefore prefer less investment specially when it is financed by retained funds. Masulis and Trueman also show that this disagreement disappears when investment is externally financed Empirical evidence on dividend signalling Empirical validation of the information content of dividends is provided by Eades (1982) who tests a dissipative signalling costs version of the signalling-through-dividends hypothesis. Further, Kalay and Loewenstein (1986) find information content in the timing of the dividend announcements as well. They find evidence of positive market reaction to earlier-than-expected announcements and negative or insignificant reaction to the laterthan-expected ones. The proportion and magnitude of dividend reductions associated with the late announcements are larger than those on the average. One issue with a direct bearing on dividend policy is the manner in which dividends are paid. Most dividend paying firms do so by paying cash dividends at regular intervals quarterly, semi-annually or annually. Once in a while there may be an "extra" or a "special" dividend which may not be repeated. Other methods of paying dividends include stock dividends and share repurchases. Theoretically a stock dividend is akin to a stock split, and a share repurchase its opposite. The former increases and the latter decreases the total number of shares outstanding without changing the underlying characteristics of the firm.

28 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 16 Brickley (1982) analyses stock returns, earnings and dividend patterns around the announcements of "extra" and "special" labelled dividends as well as the unlabelled, regular dividends. Judging by the stock price reactions, he suggests that increases in the unlabelled, regular dividends convey the most positive information among all dividend announcements. Grinblatt, Masulis and Titman (1984) analyze price reactions to announcements of stock splits and stock dividends. After adjusting for firm-specific announcement effects, they find that stock split and stock dividend announcements result in significant positive price reactions on ex-days. They also note that the reaction is stronger for dividends than for splits. Evidence on stock splits indicates that investors view them as signals of future increases in firm cash flows (Fama, Fisher, Jensen and Roll (1969)). Based on their comparison of firms which split stock with those that did not during the period, Lakonishok and Lev (1987) find that stock splits typically follow a period of abnormal growth in share prices. Also, they find that stock dividends are generally distributed by firms which pay lower than average cash dividends, and that the distribution of stock dividends appears to be on the decline. Share repurchases, like stock splits, are interpreted by investors as favourable news as shown by the share price appreciation on repurchase announcements [Dann (1981), Masulis (1980) and Vermaelen (1981)]. But favourable news notwithstanding, Barclay and Smith (1988) suggest that the observed dominant use of cash dividends over share repurchases must indicate higher costs (net of benefits) associated with the latter. These costs would include (i) the out-of-pocket expenses higher for self-tenders because of the underwriter's involvement and lower for cash dividends and open market operations, and (ii) those arising from increase in the information asymmetry around repurchase events, since managers have control over the timing and size of repurchase. Barclay and Smith observe that the bid-ask spreads widen around repurchases and offer this as evidence

29 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 17 supporting their argument. Further evidence of the potential for this adverse selection in the repurchase timing and size by firm managers, is offered by Eckbo and Masulis (1988). They observe that stock repurchases typically do follow a significant run-up in stock price and that there is a drop in price subsequent to the repurchase announcement which is proportional to the run-up. Macdonald and Lindstrom (1986) investigate the financing hierarchy proposition, namely that firms with low free cash flows institute financing policies so as to minimize the probability of future equity issues and that those with high free cash flows use dividends only as a marginal source financing. They do so by comparing the dividend policies of firms at the time they are issuing equity with when they are not doing so. They show that in the latter case dividends depend only on the lagged stock returns. On the other hand, firms smooth dividend payouts when they are issuing equity. Thus dividends appear to serve as signals not only of future firm performance but also of the firm's current and expected future capital requirements. Marsh and Merton (1987) obtain similar evidence similar at the aggregate economy level. They show that the aggregate real dividend changes are driven by the one-period lagged real changes in stock prices, and that no other contemporaneous or lagged variables significantly contribute to these changes. They conclude that in view of this observed systematic time-series behaviour of aggregate real dividends, something more than the strictly firm-specific theories such as signalling, are needed to explain the dividend puzzle. Marsh and Merton do not however offer suggestions as to what these, possibly economywide, determinants of the dividends behaviour might be.

30 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE Dividend policy as a vehicle for minimizing agency costs The one shortcoming of the signalling explanation of dividends as it stands today is that it does not explain the variation in payouts across firms. One explanation for this variation is the differences in agency costs for different firms. For instance, Easterbrook (1984) argues that maintaining regular dividends requires a firm to go to capital markets frequently for raising funds and that this brings the firm under frequent scrutiny. The frequent scrutiny has the effect in turn of reducing the monitoring and other agency costs to the external shareholders of such a firm. This benefit when traded off against the costs of raising external financing then prescribes an optimal dividend policy even in the absence of taxes. The study by Rozeff (1981) of non-regulated US firms demonstrates that dividend payouts are negatively related to a firm's growth rate, it's stock beta and the percentage of the firm owned by the managers, and positively related to the number of outside shareholders. Thus, a growing firm makes better use of its cash flows by re-investing them rather than pay them out as dividends and at the same time, saves the costs of frequent trips to the capital markets as does a firm with high variance (high stock beta) in its cash flows. Further, the fewer the outside shareholders the less the need to monitor and therefore lower the dividends. Similarly, the greater the number of outside shareholders the more diffuse the ownership and thus higher the dividends in lieu of the greater need to monitor. In what is possibly a first explicit reference to dividends as a tacit compromise reached between different shareholder groups, Schleifer and Vishny (1986) suggest that dividends act as subsidies paid to large shareholders from small shareholders towards the formers' monitoring costs. Those shareholders who own too small a fraction of the firm for monitoring to be worth their while and who pay taxes on dividends agree to receive some

31 Chapter 2. CORPORATE DIVIDEND POLICIES: THEORIES AND EVIDENCE 19 dividends despite the tax penalty to them. Other shareholders who own a large enough fraction of the firm for monitoring to be worthwhile then have an added incentive to monitor if they receive dividends tax-free, with their tax savings subsidising their monitoring costs. It is not clear in the Schleifer and Vishny model why the large shareholders have to look to small shareholders at all to receive this tax-free dividend subsidy. All they need do is exercise their supposedly greater say in firm decision making in general, and the dividend decision in particular, since they control proportionately greater number of votes in the firm. 2.4 Summary The available models of a firm's dividend decision variously describe it as arising from differential personal taxation of dividends and capital gains, as a signalling device, and as a vehicle for curbing agency problems. Empirical evidence of the relevance of dividends to firm's valuation is mixed. These models tacitly assume shareholders to be unanimous regarding firm policies. This is true even of the models which derive relevance of dividends based on the existence of tax-clienteles which may have conflicting interests, but which do not try to influence dividend policy. Thus the potential role of ownership structure of a firm and, in particular, that of the distribution of votes among diverse shareholder groups, on various firm policies has thus far been ignored.

32 Chapter 3 POTENTIAL DETERMINANTS OF OWNERSHIP STRUCTURE In the present study the ownership structure of a firm specifically, the distribution of voting power among groups of shareholders with divergent interests, is assumed to be given. Its effects on dividend policy axe then explored under the assumption that the dividend policy does not affect firm value and therefore does not affect ownership structure in turn. 1 This raises the question of exactly what factors do determine the distribution of voting power among the firm's shareholders and whether these factors affect the dividend decisions directly or indirectly in view of the assumption made of dividend irrelevance to firm valuation. Extant literature identifies these factors to be typically the ones which make control over the decision-making process in the firm valuable. Also, the focus in this study on the distribution of voting power aspect of ownership structure sets it apart from the prevailing approaches to investigate the effect of ownership structure on firm behaviour. Typically, in the existing studies the proxies employed for distinguishing between different ownership structures axe the various ownership concentration indices such as the fractions of a firm owned by the five or the ten largest shareholders. Further, in the model proposed in this study, the equilibrium dividend is arrived at by shareholder groups playing a voting game. In practice however, a firm's dividend policy may not be (and typically is not) and, more importantly, need not be set by shareholders 1 This is in contrast to the equilibrium models such as Brennan's (1973) in which required returns from investment in a firm include premia charged for receiving dividends. Thus the equilibrium investor portfolios are affected by dividend policies, thereby giving rise to different firm ownership patterns than if dividends did not enter asset pricing relations. 20