Volume 25 Number 6 1999 35

Agency Cost, Market Risk, Investment

Opportunities and Dividend Policy - An
International Perspective
By Juliet D’Souza, Assistant Professor of Finance, Stetson School of Business and Eco-
nomics, Mercer University, Macon, Georgia 31207-0001; and Atul K. Saxena 1, Associate
Professor of Finance, Stetson School of Business and Economics, Mercer University, Ma-
con, Georgia 31207-0001

Abstract

In this paper we examine the effects of agency cost, market risk, and investment opportuni-
ties on an international firm’s dividend policy. We use institutional holdings, beta, and past
growth and market-to-book value of stock, or its investment opportunity set, as proxies for
agency cost, market risk, investment opportunities, respectively. The results support the
earlier findings of negative effects of agency cost and market risk on dividend payouts, but
do not support the negative relationship between dividend policy and investment opportu-
nities. The results show an insignificant relationship between dividend policy and invest-
ment opportunities for the international firms in our sample.

I. Introduction

There are numerous studies on dividend policy using United States data, while only a hand-
ful of studies have been done using international data. This is the first study examining the
relationships between dividend policy and agency cost, dividend policy and market risk,
and dividend policy and investment opportunities using worldwide data. This research be-
comes even more important given the recent findings of Glen, Karmokolias, Miller, and
Shah (1995) on dividend policy of firms in the so-called emerging markets of the world.
While their findings are discussed in more detail in the section on literature review later,
one of their conclusions is that managers of the firms in emerging markets are more con-
cerned about their dividend policy now than they were in the past.

This paper defines dividend policy as a firm’s dividend payout ratio. It uses the per-
centage of institutional holdings of a firm’s common stock as a proxy for agency cost. It also
proxies market risk of a firm by its beta value. Finally, the past three years’ sales growth of a
firm and market-to-book value of the firm’s stock are used as proxies for investment oppor-
tunities. The results show statistically significant and negative relationships between divi-
dend policy and market risk, and dividend policy and agency cost as proxied by institutional
ownership, however, the relationship between dividend policy and investment opportuni-
ties is statistically insignificant.

The rest of the paper is organized as follows: Section II discusses the literature on re-
lated topics while data and the empirical methods employed in this research are discussed in
Section III. Section IV describes the empirical results and Section V concludes the paper
with a summary.
Managerial Finance 36

II. Literature Review

Most empirical studies on dividend policy to date have used data on US firms, hence most
of the literature reviewed here pertains to results on US data only. In their seminal piece on
agency costs and firm behavior, Jensen and Meckling (1976) suggest that one way to reduce
agency costs of equity is to use more debt financing. Using more debt reduces total equity
financing, reducing the scope of manager-stockholder conflict. Another way of reducing
agency cost is for a firm to pay a larger proportion of its earnings as dividends to its stock-
holders. A high dividend payout ratio will result in lower “discretionary” cashflows avail-
able to be squandered away by managers.

Rozeff (1982), Easterbrook (1984), and Collins, Saxena, and Wansley (1996) provide
some agency-cost explanations of dividend policy which are based on the observation that
firms pay dividends and raise capital simultaneously. Easterbrook (1984) argues that in-
creasing dividends raises the probability that additional capital will have to be raised exter-
nally on a periodic basis and consequently, the firm will be subject to the constant
monitoring by experts in capital markets. Rozeff (1982) presents evidence that dividend
payout level for unregulated firm is negatively related to its level of insider holdings. Col-
lins, Saxena, and Wansley find that the relationship between dividend payouts and insider
holdings is negative for unregulated firms but statistically insignificant for regulated ones.
They conclude that insiders act as perfect substitutes for regulators in reducing agency costs
in unregulated firms.

In addition to the agency cost reduction, dividends are regarded as a credible source of
signaling to investors in capital markets, in other words, dividends have some information
content. According to the “information content” explanation, dividends convey important
financial information. Investors have greater confidence in the firm’s reported earnings
(economic profits) when earning announcements are simultaneously accompanied by divi-
dend payouts consistent with their past growth. If investors are more confident about the fi-
nancial strength of a firm, they will react less to questionable sources of information, and
their expectations of firm value may be insulated from irrational influence. Notably, the in-
formation effect implies that managers may be able to reduce stock price volatility by in-
creasing the target payout ratio.

Yet another relationship studied in the past comprises dividend payout and firms’ beta
value. As we know, the beta value of a firm is used as an indicator of its market related risk.
Rozeff (1982), Lloyd, Jahera and Page (1985), and Collins, Saxena and Wansley (1996)
find statistically significant and negative relationship between betas and the dividend pay-
out for US firms.2 Their findings suggest that firms having a higher level of market risk will
pay out dividends at a lower rate. No prior study has looked at this relationship using data
from international companies.

Finally, according to the Miller and Modigliani (1961) hypothesis, under the assump-
tions of perfect capital markets, rational behavior, no taxation and transaction costs, it is the
investment policy that determines the firm value while the dividend policy is irrelevant.
Their position on this issue is often referred to in the literature as firms having a residual
dividend policy, or that dividend payments are irrelevant to firm value.

Among other researchers, Green, Pogue and Watson (1993) question the irrelevance
argument and investigate the relationship between dividends and investment and financing
Volume 25 Number 6 1999 37

decisions. Moreover, in their study they use data on firms in Ireland. They find that for Irish
firms dividend decisions are not residual ones. That is, dividend payout levels are not to -
tally decided after a firm’s investment and financing decisions have been made. They fur-
ther show that Irish firms follow a simultaneous dividend policy. That is, dividend
decisions are neither totally residual nor totally independent. Rather simultaneous consid-
eration is given to investment and financing policies along with a desire for dividend stabil-
ity. Their results, therefore, do not support the views of Miller and Modigliani (1961).
Higgins (1972) shows that payout ratio is negatively related to a firm’s need for funds to fi-
nance growth opportunities. Collins, Saxena and Wansley (1996), Lloyd, Jahera and Page
(1985) and Rozeff (1982) all show a significantly negative relationship between historical
sales growth and dividend payout.

More recently, Glen, Karmokolias, Miller, and Shah (1995) comment on the dividend
policy of firms in developing nations (emerging markets). They find some notable differ-
ences in dividend payout policies between developed and developing countries. Specifi-
cally, they find that in 1994 the dividend payout ratios of firms in developing countries were
two-thirds of those in developed countries. Moreover, they find that firms in emerging mar-
kets place more emphasis on dividend payout ratios than on monetary amounts. Thus, their
dividend payments tend to be rather volatile when compared with firms in developed
economies.

III. Data and Empirical Methods

We use a sample of 349 firms worldwide to determine the relationship between dividend
payout, agency costs, market risk, and investment opportunities. The dividend policy of a
firm is defined as its dividend payout ratio (the ratio of dividends per share and earnings per
share). The percentage of institutional holdings of a firm’s common stock is used as a proxy
for controlling agency costs while its beta value is used to reflect its market risk. The past
three years’ sales growth and market-to-book value of common stock are used as proxies
for the firm’s investment opportunities in the near future. The dividend payout variable
used in the study is a three year average for the period 1995 to 1997, while the institutional
holdings, beta value, growth, and market- and book-values all pertain to the year 1997. We
obtain dividend payout, beta and growth data from Datastream, while institutional owner-
ship is obtained from WorldScope Disclosure.

Multiple regression analyses are done to explain the relationships between dividend
payout, agency cost, market risk, and investment opportunities. Dividend payout ratio
(“PAYOUT”) is the dependent variable while beta (“BETA”), past three years’ sales
growth (“GROWTH”), percentage of institutional holdings (“INSH”), and market-to-book
value (“MTBV”) are the independent variables. We analyze three regression equations;
first with dividend payout as the dependent variable, and beta, percentage of institutional
holdings, three years sales growth, and market-to-book value as explanatory variables. Sec-
ond, with dividend payout as the dependent variable and beta and percentage of institu-
tional holdings as explanatory variables. Finally, with dividend payout as the dependent
variable and past growth and market-to-book value as explanatory variables.

The equations for the three regressions are as follows:

PAYOUT = ß0 + ß1(BETA) + ß2(INSH) + ß3(GROWTH) + ß4(MTBV) + ∈ - Eq. 1

Managerial Finance 38

PAYOUT = ß0 + ß1(BETA) + ß2(INSH) + ∈ - Eq. 2

PAYOUT = ß0 + ß1(GROWTH) + ß2(MTBV) + ∈ - Eq. 3

Jensen and Meckling (1976) argue that external monitoring activity is an important
controlling element when agency conflicts exist. One group of external monitors includes
security analysts employed by investment bankers, brokerage firms, and large institutional
investors. If large institutional investors act as monitoring agents, and if dividends are paid
to reduce agency cost, then according to this theory, the results should show a negative rela-
tionship between the percentage of shares held by institutions and the dividend payout. Sec-
ond, beta is used as a proxy for firm-specific market risk, and if a bigger beta value reflects a
higher level of market risk, then one should observe a negative relationship beta and divi-
dend payout ratio. Third, an increase in historical sales growth is a good indication for
things to come in the future (investment opportunities), which in turn means more funds
needed to finance these investment opportunities. Holding everything else constant, this
implies lower dividend payouts. Therefore, we should observe an inverse relationship be-
tween historical sales growth and dividend payout ratio. Finally, we also use market-to-
book value as a proxy for investment opportunities. Hence, applying the same argument,
we should observe an inverse relationship between dividend payout and market-to-book
value of a firm’s common stock.

IV. Empirical Results

IV (A). Descriptive Statistics and Correlation Coefficient Matrix

Table 1 presents the descriptive statistics for all the regression variables. The average (me-
dian) dividend payout ratio for the sample of 349 firms is 40 percent (32 percent), the aver-
age (median) beta for the sample of 336 firms is 0.79 (0.79), the average (median)
percentage of institutional holdings for the sample of 301 firms is 37 percent (35 percent),
the average (median) past three years sales growth for the sample of 289 firms is 72 percent
(17 percent), the average (median) market to book value for the sample of 341 firms is 2.8
(1.6).

IV (B). Dividend Payout, Agency Cost, Market Risk, and Investment Opportunities: A Mul-
tiple Regression Analyses

Table 2 presents the regression results for Equation 1. In this model dividend payout ratio is
regressed against four explanatory variables. These variables are institutional ownership of
a firm’s common stock (INSH), the firm’s beta value (BETA), its historical growth in sales
over the past three years (GROWTH), and its common stock’s market-to-book value
(MTBV). The results show a significantly negative relationship for explanatory variables
INSH and BETA, and insignificant relationship for explanatory variables GROWTH and
MTBV. These results confirm the findings of prior studies on dividend policy and agency
cost and market risk using US firms’ data. The results on dividend policy and investment
opportunity, on the other hand, confirm the Miller and Modigliani theory that investment
decisions are independent of dividend policy. These results are inconsistent with the find-
ings of prior studies using data on firms in the United States.
Volume 25 Number 6 1999 39

IV (C). Dividend Policy and Agency Cost and Market Risk

Table 3 presents the regression results for Equation 2. In this model, dividend payout ratio is
regressed against two explanatory variables. These variables are institutional holdings
(INSH) and beta value (BETA). This regression confirms the statistically significant and
negative relationship of dividend payout with the explanatory variables INSH and BETA,
with INSH showing significance at the five percent level and BETA showing significance
at the ten percent level. As mentioned in the previous section, these findings are consistent
with those of prior studies using United States’ data.
IV (D). Dividend Policy and Investment Opportunities
Table 4 presents the regression results for Equation 3. In this model, dividend payout ratio is
regressed against the historical sales growth rate (GROWTH) and the market-to-book
value (MTBV) of the firm’s common stock. These variables serve as proxies for a firm’s fu-
ture growth prospects, or its investment opportunities. The results show statistically insig-
nificant relationship for both the proxies of investment opportunities, GROWTH and
MTBV. Interestingly, this is inconsistent with the earlier findings of studies using US data.
Typically, if a firm has grown at a fast rate in the past, chances are that it will have a lower
dividend payout rate. A fast growing firm needs more funds to grow, hence it would like to
retain most of its earnings instead of paying a higher dividends. Similarly, a firm with a high
market-to-book value will have a bigger investment opportunity set. Hence, it will have a
lower payout ratio.
In the context of international firms, however, it seems that dividend are paid irrespec-
tive of the firm’s investment opportunities. In other words, the dividend policy of these
firms is independent of their investment decisions. This is the crux of Miller and Modigliani
(1961) argument, and at least in the case of our sample of international firms, it appears to
be true.
V. Conclusion
In this paper we examine the relationship between dividend policy and four explanatory
variables for international firms. The explanatory variables are percentage of institutional
holdings of a firm’s common stock, its beta value, past sales growth, and market-to-book
value of common stock. Since prior studies on dividend policy concentrate on United States
data this paper contributes by extending the literature into the international arena. Institu-
tional ownership of stock of a firm is looked upon as a factor mitigating agency cost. Beta
value proxies a firm’s riskiness, while three years’ sales growth and market-to-book value
are used as proxies for investment opportunities available to the firm in the future.
Some interesting results are obtained that have important implications for interna-
tional investing. The results are partially consistent with the findings of studies using US
data. Specifically, the significant and negative relationship between dividend policy and
agency cost is borne out with international firms also. Indeed, the higher the institutional
holdings the lower is the dividend payout ratio. Similarly, the negative relationship be-
tween market risk (beta) and dividend payout is consistent with the US data. Interestingly,
however, the results do not support the negative relationship between dividend policy and
investment opportunities. Indeed, dividend payout ratio shows insignificant relationships
with past growth rate and market-to-book value. The implications of these results, there-
fore, are that firms worldwide pay dividends to reduce monitoring (agency) costs and that
Managerial Finance 40

dividend decisions and investment decisions are independent of each other. Moreover, if a
firm is perceived to be having a higher level of risk relative to the market, then that firm will
not have a high payout rate.

One note of caution, however, is appropriate at this point. Referring to the rather low
R2 values for all of our regressions, one must conclude that the explanatory variables used in
this study are not the only determinants of international firms’ dividend payout ratios. In-
deed, it seems that several other factors are responsible. The search for these additional ex-
planatory variables, however, is left for future research.

Endnote

1. “The authors acknowledge the research assistance of Shyam Khandelwal”.

Volume 25 Number 6 1999 41

References
Beaver, William, Paul Kettler, and Myron Scholes, “The Association Between Market De-
termined and Accounting Determined Risk Measures,” The Accounting Review, October
1970, pp.654-682.
Collins, M. Cary, Atul K. Saxena, and James W. Wansley, “The Role of Insiders and Divi-
dend Policy: A Comparison of Regulated and Unregulated Firms,” Journal of Financial
and Strategic Decisions, Vol. 9, No. 2, Summer 1996, pp.1-9.
Easterbrook, Frank H., “Two Agency-Cost Explanations of Dividends,” American Eco-
nomic Review, Vol. 74, September 1984, pp.650-659.
Glen, Jack D., Yannis Karmokolias, Robert R. Miller, and Sanjay Shah, “Dividend Policy
and Behavior in Emerging Markets: To Pay or Not to Pay,” Discussion Paper No. 26, Inter-
national Finance Corporation (World Bank), Washington, DC., July 1995.
Green, Peter, Michael Pogue, and Ian Watson, “Dividend Policy and its Relationship to In-
vestment and Financing Policies: Empirical Evidence Using Irish Data,” IBAR, Vol. 14,
No. 2, 1993, pp.69-83.
Higgins, Robert C., “The Corporate Dividend-Saving Decision,” Journal of Financial and
Quantitative Analysis, Vol. 7, No. 2, 1972, pp.1527-1541.
Jensen, Michael C. and William H. Meckling, “Theory of the Firm: Managerial Behavior,
Agency Costs, and Ownership Structure,” Journal of Financial Economics, Vol. 3, No. 4,
pp.305-360.
Lloyd, W.P., John S. Jahera, and D.E. Page, “Agency Costs and Dividend Payout Ratios,”
Quarterly Journal of Business and Economics, Vol. 24, No. 3, Summer 1985.
Miller, Merton H., and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of
Shares,” Journal of Business, Vol. 34, October 1961, pp.411-433.
Rozeff, Michael S., “Growth, Beta and Agency Costs as Determinants of Dividend Payout
Ratios,” Journal of Financial Research, Vol. 5, Fall 1982, pp.249-259.
Managerial Finance 42

Table 1
Descriptive Statistics
This table presents the descriptive statistics for the dependent variable, dividend payout ratio
(“PAYOUT”) and all the explanatory variables, namely, percentage of institutional holdings
(“INSH”), beta (“BETA”), past three years’ sales growth (“GROWTH”) and market- to-book
value of common stock (“MTBV”).
Regression Variables Number Mean Median Skewness Curtosis
of Firms
Dividend Payout Ratio 349 40% 32% 9.2783 117.69
(PAYOUT)
Beta Value (BETA) 336 0.79 0.79 -0.0470 0.0366
Institutional Holdings (INSH) 301 37% 35% 0.2507 -1.0335
Past 3-Years’ Growth 289 71% 17% 9.3375 93.626
(GROWTH)
Market-to-Book Value 341 2.80 1.61 1.7460 162.33
(MTBV)

Table 2
Dividend Policy, Agency Costs, Market Risk, and Investment Opportunities
This table presents the regression result for the regression of the dividend payout (“PAYOUT”) on
explanatory variables percentage of institutional holdings (“INSH”), beta (“BETA”), past three
years’ sales growth (“GROWTH”) and market-to-book value (“MTBV”). INSH is used as a proxy
to explain agency costs, BETA proxies a firm’s market risk, while GROWTH and MTBV are used
as proxies for investment opportunities. The equation used for the ordinary least square regression
in this model is as follows
PAYOUT= β0 ± β1(INSH) + β2(BETA) + β3(GROWTH) + β4(MTBV) + ∈
Explanatory Variables Coefficients ‘t’ values ‘p’ values
Intercept 0.9214 4.78 0.0000
INSH -0.4912 -2.24 0.0261
BETA -0.3566 -2.02 0.0045
GROWTH 0.0000 0.39 0.6998
MARKET-TO-BOOK VALUE -0.0006 -0.29 0.7696
(MTBV)
Adjusted R2: 0.013
F-Statistic:1.770
Volume 25 Number 6 1999 43

Table 3
Dividend Policy and Agency Costs and Market Risk
This table presents the regression result for the regression of the dividend payout (“PAYOUT”)
on explanatory variables percentage of institutional holdings (“INSH”) and beta (“BETA”).
INSH is used as a proxy to explain agency cost while BETA proxies a firm’s market risk. The
equation used for the ordinary least square regression for this model is as follows
PAYOUT= β0 + β1(JNSII) + β2(BETA) + ∈
Explanatory Variables Coefficients ‘t’ values ‘p’ values
Intercept 0.7808 5.11 0.0000
INSH -0.2722 -1.94 0.0529
BETA -0.3566 -2.00 0.0466
2
Adjusted R : 0.0144
F-Statistic: 3.06**

Table 4
Dividend Policy and Investment Opportunities
This table presents the regression result for the regression of the dividend payout (“PAYOUT”) on
explanatory variables past three years’ sales growth (“GROWTH”) and market-to-book value
(“MTBV”). Both of the explanatory variables are used as proxies to explain investment opportuni-
ties. The equation used for the ordinary least square regression in this model is as follows
PAYOUT=β0 + β1(GROWTH) + β2(MTBV) + ∈
Explanatory Variables Coefficients ‘t’ values ‘p’ values
Intercept 0.4297 8.68 0.0000
GROWTH 0.0000 0.37 0.8156
MARKET-TO-BOOK VALUE -0.0004 -0.23 0.7125
(MTBV)
Adjusted R2: 0.006
F-Statistic: 0.903