how product market competition affects dividend payments in a weak investor protection economy:...

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  • ional University of Kaohsiung, Kaohsiung 81148, TaiwanSun Yat-Sen University, Taiwan

    dividends is supported when the product market has low competitive-

    anism, and inuencesed on the relationshipg investor protection.

    Pacic-Basin Finance Journal 25 (2013) 2139

    Contents lists available at ScienceDirect

    Pacic-Basin Finance Journal

    j ourna l homepage: www.e lsev ie r .com/ locate /pacf inWe instead investigate the link between product market competition and dividend policy in a countrywith weak investor protection.1. Introduction

    Product market competition is considered a substitute for a governance mechcorporate nancial strategies, such as dividend policies. Previous studies have focusbetween product market competition and dividend payouts in countries with stron 2013 Elsevier B.V. All rights reserved.Agency conictCorporate governanceDividend policyInvestor protectionProduct market competitionG35

    Keywords: We appreciate the helpful comments from an anoConference and the 3rd Global Accounting and Organithe Republic of China, Taiwan for nancially supportMelissa Morgan, and Valerio Puggioni are appreciated Corresponding author at: 70 Lien Hai RD, Depart

    80424, Taiwan. Tel.: +886 7 5252000x4656; fax: +E-mail addresses: lanfeng@nuk.edu.tw (L. Kao), a

    0927-538X/$ see front matter 2013 Elsevier B.V.http://dx.doi.org/10.1016/j.pacn.2013.08.004ness. Productmarket competition alleviates the effects of agency conictsand corporate governance practices on dividend policies.Accepted 1 August 2013Available online 13 August 2013

    JEL classication:G34a b s t r a c t

    We examine the link between the intensity of product marketcompetition and the dividend models of agency conicts in an economywith weak investor protection (Taiwan). Product market competitioncan substitute for governance mechanisms. Our results show that theoutcome agency model of dividends is applicable onlywhen the productmarket is highly competitive. However, the substitute agency model ofLanfeng Kao a, Anlin Chen b,a 700 University RD, Department of Finance, Natb Department of Business Management, National

    a r t i c l e i n f o

    Article history:Received 2 August 2012How product market competition affectsdividend payments in a weak investor protectioneconomy: Evidence from Taiwannymous referee and the participants at the 7th Annual London Business Researchzational Change Conference 2012. We also thank the National Science Council ofing this research under Contract No. NSC100-2410-H-110-020-MY2. Ted Knoy,for their editorial assistance. All the remaining errors are ours.ment of Business Management, National Sun Yat-Sen University, Kaohsiung886 7 5254698.nlin@mail.nsysu.edu.tw (A. Chen)

    All rights reserved.

  • Jensen (1986) and Gomes (2000) argue that dividends protect outside shareholders, particularlyminority shareholders. Whether a rm pays dividends depends on the jurisdiction of where the rm isdomiciled, particularly the enforcement of protections for minority shareholders and the effectiveness ofcorporate governance in situations involving agency conicts. La Porta et al. (2000) address two dividendpolicy models from the agency conict perspective: the outcome model and the substitute model. Theoutcome agency model argues that effective minority shareholders force managers to pay dividends,implying that the amount of dividendpaid increaseswith corporate governance. However, the substitute agencymodel argues that rms pay dividends to establish a decent reputation, so that they can raise capital in themarkets in the future. Therefore, rms domiciled in jurisdictions with strong corporate governance are notrequired to pay high dividends to show decency. Consequently, the substitute agency model implies that theamount of dividends paid decreases when the strength of corporate governance increases.

    Product market competition is closely related to both managerial incentives and interest alignmentbetween controlling and minority shareholders. Hart (1983) and Shleifer (1985) argue that product marketcompetition reduces information asymmetry betweenmanagers and shareholders because shareholders caneasily benchmark a rm's performance to the performance of competitors (the yardstick competitionhypothesis). Schmidt (1997) indicates that intense product market competition increases rm default riskand liquidation risk, thereby reducing managerial agency conicts. Shleifer and Vishny (1997) show thatcompetition reduces the agency costs of free cash ow by discouragingmanager investment in negative NPVprojects. Allen and Gale (2000) argue that product market competition serves as either a monitoringmechanism or a corporate governance mechanism to reduce agency conicts. Bertrand and Mullainathan(2003) show that competition eliminates the quiet life to reduce input costs, overheads, andwages. Fee andHadlock (2000) and Raith (2003) indicate that competition increases CEO turnover, that CEOs aremore likelyto be replaced in a competitive market, and that they typically work harder during severe competition.Guadalupe and Perez-Gonzalez (2010) show thatmanagement interests alignwith shareholder interests in acompetitive product market.

    Giroud andMueller (2011) indicate that if product market competition can force managers to maximizerm value to survive, then corporate governance is unnecessary in intensely competitive markets.Corporate governance on manager monitoring is affected by product market competition. However, rmsin low-intensity competition markets require corporate governance to discipline managers. Because of thethreats of defaults and liquidation, and the interest alignment between insiders and outsiders, increasedproduct market competition forces managers to focus their efforts and reduce managerial slack to survive,even without strong corporate governance.

    Schmidt (1997) argues that product market competition reduces the prot margin, and thus, rmprotability. Consequently, rms facing intense product market competition cannot offer a sufcientlyattractive compensation scheme to fully motivate managers. Karuna (2007) argues that product marketcompetition can either substitute for or complement managerial incentives. Product market competitioncan act as a disciplinary mechanism and reduce the need for managerial incentives. However, rms mustprovide greater incentives to managers, to motivate them in a more competitive market. Therefore, rmsmight offer managers higher allowances in a more intensely competitive market. Consequently, the totaleffect of product market competition on managerial incentives should be ambiguous.

    Beiner et al. (2011) show a nonlinear relationship between product market competition andmanagerialincentives which depends on the absolute level of competition. The rationale for Beiner et al. (2011) is abusiness stealing effect and a scale effect. The business stealing effect indicates that a more intensecompetition implies a higher demand elasticity, facilitating a rm with a cost advantage to lure businessaway from its competitors. The marginal benet of reducing costs increases with competition intensity.Consequently, the rm offers higher managerial incentives to reduce marginal costs with increasingcompetition. The scale effect indicates that competition reduces the rm's protability, resulting in lowergains from reducing costs. Thus, the rm offers lower managerial incentives with increasing competition.During low competition, the scale effect dominates because competition reduces the value of managerialdecisions, whereas during high competition, the business stealing effect dominates because competitionincreases the value of good managerial decisions. Beiner et al. (2011) state that the relationship betweenmanagerial incentives and competition intensity is dependent on the absolute level of competition; themarginal effect of competition on managerial incentives increases with competition, and competition

    22 L. Kao, A. Chen / Pacic-Basin Finance Journal 25 (2013) 2139reduces the rm's prots.

  • Grullon andMichaely (2008) indicate that the link between product market competition andmanagerialincentives has implications for corporate dividend policies. They argue that intense competition ispositively related to dividend payout in the outcome agency model of dividends. Intense competitionincreases rm liquidation risk, thus reducing overinvestment risk.With a reduced likelihood of overinvestment,rms havemore free cash ows for dividend payments.When competition is not erce, rms aremore likely toinvest than to distribute cash to shareholders through dividends. The yardstick competition hypothesis impliesthat competition reduces information asymmetry between managers and shareholders, forcing managers to

    23L. Kao, A. Chen / Pacic-Basin Finance Journal 25 (2013) 2139distribute excess cash ows to shareholders.On the other hand, intense competition is negatively related to dividend payout in the substitute agency

    model of dividends, in which competition substitutes for external governance mechanisms. Under intensecompetition,rmmanagers are not required to pay dividends for alleviating agency conicts betweenmanagersand shareholders. Grullon andMichaely (2008) show that in a country with strong investor protection, such asin the United States, the outcome agency model of dividends prevails. However, information is scant regardingthe relationship between the agency model of dividends and product market competition in countries withweak investor protection.

    We explore the inuence of productmarket competition on dividend policy in a countrywithweak investorprotection, particularly the inuence of market competition on the effect of governance (agency conict) ondividend policy. In economies with poor investor protection, minority shareholders are more likely toexperience serious agency conicts, and are less

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