Managerial Finance

Emerald Article: Agency cost, market risk, investment opportunities and dividend policy - an international perspective Juliet D'Souza, Atul K. Saxena

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To cite this document: Juliet D'Souza, Atul K. Saxena, (1999),"Agency cost, market risk, investment opportunities and dividend policy - an international perspective", Managerial Finance, Vol. 25 Iss: 6 pp. 35 - 43 Permanent link to this document: http://dx.doi.org/10.1108/03074359910765993 Downloaded on: 19-04-2012 Citations: This document has been cited by 2 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 2664 times.

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Agency Cost, Market Risk, Investment Opportunities and Dividend Policy - An International Perspective
By Juliet DSouza, Assistant Professor of Finance, Stetson School of Business and Economics, Mercer University, Macon, Georgia 31207-0001; and Atul K. Saxena 1, Associate Professor of Finance, Stetson School of Business and Economics, Mercer University, Macon, Georgia 31207-0001 Abstract In this paper we examine the effects of agency cost, market risk, and investment opportunities on an international firms 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 opportunities. The results show an insignificant relationship between dividend policy and investment opportunities for the international firms in our sample. I. Introduction There are numerous studies on dividend policy using United States data, while only a handful 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 becomes 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 concerned about their dividend policy now than they were in the past. This paper defines dividend policy as a firms dividend payout ratio. It uses the percentage of institutional holdings of a firms 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 firms stock are used as proxies for investment opportunities. The results show statistically significant and negative relationships between dividend policy and market risk, and dividend policy and agency cost as proxied by institutional ownership, however, the relationship between dividend policy and investment opportunities is statistically insignificant. The rest of the paper is organized as follows: Section II discusses the literature on related 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.

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II. Literature Review

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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 stockholders. A high dividend payout ratio will result in lower discretionary cashflows available 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 increasing dividends raises the probability that additional capital will have to be raised externally 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. Collins, 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 firms reported earnings (economic profits) when earning announcements are simultaneously accompanied by dividend payouts consistent with their past growth. If investors are more confident about the financial 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 information effect implies that managers may be able to reduce stock price volatility by increasing 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 payout 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 assumptions 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

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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 firms investment and financing decisions have been made. They further show that Irish firms follow a simultaneous dividend policy. That is, dividend decisions are neither totally residual nor totally independent. Rather simultaneous consideration is given to investment and financing policies along with a desire for dividend stability. Their results, therefore, do not support the views of Miller and Modigliani (1961). Higgins (1972) shows that payout ratio is negatively related to a firms need for funds to finance 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 differences in dividend payout policies between developed and developing countries. Specifically, 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 markets 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 firms 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 firms 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 ownership 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. Second, with dividend payout as the dependent variable and beta and percentage of institutional 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 = 0 + 1(BETA) + 2(INSH) + 3(GROWTH) + 4(MTBV) + - Eq. 1

Managerial Finance
PAYOUT = 0 + 1(BETA) + 2(INSH) + PAYOUT = 0 + 1(GROWTH) + 2(MTBV) +

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- Eq. 2 - 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 relationship between the percentage of shares held by institutions and the dividend payout. Second, 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 dividend 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 between historical sales growth and dividend payout ratio. Finally, we also use market-tobook 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 firms 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 (median) dividend payout ratio for the sample of 349 firms is 40 percent (32 percent), the average (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 Multiple 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 firms common stock (INSH), the firms beta value (BETA), its historical growth in sales over the past three years (GROWTH), and its common stocks 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 findings of prior studies using data on firms in the United States.

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

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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 firms common stock. These variables serve as proxies for a firms future growth prospects, or its investment opportunities. The results show statistically insignificant 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 irrespective of the firms 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 firms 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. Institutional ownership of stock of a firm is looked upon as a factor mitigating agency cost. Beta value proxies a firms 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 international 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 between 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, therefore, are that firms worldwide pay dividends to reduce monitoring (agency) costs and that

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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. Indeed, it seems that several other factors are responsible. The search for these additional explanatory variables, however, is left for future research. Endnote 1. The authors acknowledge the research assistance of Shyam Khandelwal.

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References

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Beaver, William, Paul Kettler, and Myron Scholes, The Association Between Market Determined 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 Dividend 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 Economic 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, International Finance Corporation (World Bank), Washington, DC., July 1995. Green, Peter, Michael Pogue, and Ian Watson, Dividend Policy and its Relationship to Investment 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.

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Table 1 Descriptive Statistics

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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 Dividend Payout Ratio (PAYOUT) Beta Value (BETA) Institutional Holdings (INSH) Past 3-Years Growth (GROWTH) Market-to-Book Value (MTBV) Number of Firms 349 336 301 289 341 Mean 40% 0.79 37% 71% 2.80 Median 32% 0.79 35% 17% 1.61 Skewness 9.2783 -0.0470 0.2507 9.3375 1.7460 Curtosis 117.69 0.0366 -1.0335 93.626 162.33

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 firms 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= 0 1(INSH) + 2(BETA) + 3(GROWTH) + 4(MTBV) + Explanatory Variables Intercept INSH BETA GROWTH MARKET-TO-BOOK VALUE (MTBV) Adjusted R2: 0.013 F-Statistic:1.770 Coefficients 0.9214 -0.4912 -0.3566 0.0000 -0.0006 t values 4.78 -2.24 -2.02 0.39 -0.29 p values 0.0000 0.0261 0.0045 0.6998 0.7696

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Table 3 Dividend Policy and Agency Costs and Market Risk

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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 firms market risk. The equation used for the ordinary least square regression for this model is as follows PAYOUT= 0 + 1(JNSII) + 2(BETA) + Explanatory Variables Intercept INSH BETA Adjusted R : 0.0144 F-Statistic: 3.06**
2

Coefficients 0.7808 -0.2722 -0.3566

t values 5.11 -1.94 -2.00

p values 0.0000 0.0529 0.0466

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 opportunities. The equation used for the ordinary least square regression in this model is as follows PAYOUT=0 + 1(GROWTH) + 2(MTBV) + Explanatory Variables Intercept GROWTH MARKET-TO-BOOK VALUE (MTBV) Adjusted R2: 0.006 F-Statistic: 0.903 Coefficients 0.4297 0.0000 -0.0004 t values 8.68 0.37 -0.23 p values 0.0000 0.8156 0.7125