INSTITUTIONAL OWNERSHIP AND DIVIDEND POLICY: A FRAMEWORK

BASED ON TAX CLIENTELE, INFORMATION

SIGNALING AND AGENCY COSTS

Lina Zaghloul Bichara, BA, MBA

Dissertation Prepared for the Degree of

DOCTOR OF PHILOSOPHY

UNIVERSITY OF NORTH TEXAS

August 2008

APPROVED: Michael Impson, Committee Chair James Conover, Committee Member and Chair of

the Department of Finance, Insurance, Real Estate and Law

Mazhar Siddiqqi, Committee Member Margie Tieslau, Committee Member John Kensinger, Program Coordinator Niranjan Tripathy, Director of Ph.D. Programs and

Research O. Finley Graves, Dean of the College of Business Sandra L. Terrell, Dean of the Robert B. Toulouse

School of Graduate Studies

Zaghloul Bichara, Lina, Institutional ownership and dividend policy: A framework based

on tax clientele, information signaling and agency costs. Doctor of Philosophy (Finance), August

2008, 107 pp., 29 tables, references, 106 titles.

This study is an empirical examination of a new theory that links dividends to

institutional ownership in a framework of both information signaling and agency costs. Under

this theory put forth by Allen, Bernardo and Welch in 2000, dividends are paid out to attract tax-

favored institutional investors, thereby signaling good firm quality and/or more efficient

monitoring. This is based on the premise that institutions are considered sophisticated investors

with superior ability and stronger incentive to be informed about the firm quality compared to

retail investors. On the agency level, institutional investors display monitoring capabilities, and

can detect and correct managerial pitfalls, thus their presence serves as an assurance that the firm

will remain well run. The study provides a comprehensive analysis of the implications of the

theory by testing various aspects of the relationship between dividends and institutional holdings.

Unlike the prevalent literature on this topic, I give specific attention to the different types of

institutional investors and their incentives to invest in dividend paying stocks. Moreover, I

analyze the signaling and the agency effects on the market reaction to dividend initiations within

the framework proposed by the theory. Finally, I test the smoothing effect institutions have on

dividends by examining the firm’s propensity to increase dividends given the level of

institutional ownership. I find institutional holders to respond positively to dividend initiation

announcements as they adjust their portfolios by buying or increasing their holdings of the

dividend paying stock following the announcement. I also find that this response is displayed

more strongly among tax-favored institutions. My test results also reveal that positive abnormal

returns to dividend initiation announcements are a decreasing function of institutional holdings in

the dividend initiating firm, and that this mitigating effect of institutional ownership on the

market reaction to dividend initiations is stronger for firms with higher information asymmetry

and more potential for agency problems. This evidence lends some degree of support to the

tested theory. Additional support to lies in the test results of its smoothing hypothesis which

reveal that as institutional ownership increases, the propensity of firms to increase dividends

decreases.

Copyright 2008

by

Lina Zaghloul Bichara

ii

iii

ACKNOWLEDGEMENTS

I wish to acknowledge with great appreciation the guidance and help of my dissertation

chair, Dr. Michael Impson.

To my family, I dedicate this to you with my deepest love and gratitude for all you’ve

gone through to make this possible.

To my husband, I couldn’t have done this without your unfading encouragement, and

support. To you I owe this and every future accomplishment I will be blessed with.

To my in-laws, thank you so much for all your help through the rough times leading up to

this day. You have made it all easier on me.

iv

TABLE OF CONTENTS

Page

ACKNOWLEDGEMENTS……………………………………………….………………iii

LIST OF TABLES………………………………………………………………………….v

Chapter

1. INTRODUCTION: THE DIVIDEND PUZZLE…..………………………. 1

2. LITERATURE REVIEW………………………………………………….. 6

3. HYPOTHESIS DEVELOPMENT………………………………………….24

4. DATA DESCRIPTION AND RESEARCH METHODOLOGY………….. 33

5. EMPIRICAL RESULTS…………………………………………………… 59

6. SUMMARY AND CONCLUDING REMARKS…………………………. 69

REFERENCES……………………………………………………………………………..100

v

LIST OF TABLES Page Table 1 Summary of Hypotheses……………………………………………………72 Table 2 Descriptive Statistics - Dividend Initiators and their Non-Dividend-

Paying Matches - Original Sample………………………………………… 74 Table 3 Descriptive Statistics – Dividend Initiators and their Non-Dividend-

Paying Matches - Expanded Sample.............................................................. 75

Table 4 Tests of the Mean Change in Institutional Ownership in Response to Dividend Initiations - Original Sample…………………………………….. 76

Table 5 Tests of the Mean Change in Institutional Ownership in Response to Dividend Initiations - Expanded Sample……………………………………77

Table 6 Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches - Original Sample………………………………………………… 78

Table 7 Tests of the Difference in the Mean Change in Institutional Ownership

Between Dividend Initiating Firms and their Non-Dividend Paying Matches - Expanded Sample……………………………………………….. 79

Table 8 Tests of the Difference in the Mean Change in Institutional Ownership

Between Dividend Initiating Firms and their Non-Dividend Paying Matches – Banks…………………………………………………………… 80

Table 9 Tests of the Difference in the Mean Change in Institutional Ownership

Between Dividend Initiating Firms and their Non-Dividend Paying Matches - Insurance Companies…………………………………………… 81

Table 10 Tests of the Difference in the Mean Change in Institutional Ownership

Between Dividend Initiating Firms and their Non-Dividend Paying Matches – Investment Advisors……………………………………………. 82

Table 11 Tests of the Difference in the Mean Change in Institutional Ownership

Between Dividend Initiating Firms and their Non-Dividend Paying Matches – Other Managers………………………………………………… 83

Table 12 Tests of the Difference in the Mean Change in Institutional Ownership

Between Dividend Initiating Firms and their Non-Dividend Paying Matches - Other Managers versus Banks, Insurance companies and Investment Advisors……………………………………………………….. 84

vi

Table 13 Change in Institutional Ownership Regression Variables - Descriptive Statistics - Original Sample………………………………………………... 85

Table 14 Change in Institutional Ownership Regression Variables - Descriptive

Statistics - Expanded Sample…………………………………………......... 86 Table 15 Change in Institutional Ownership Regression Variables – Correlation

Analysis - Original Sample………………………………………………… 87 Table 16 Change in Institutional Ownership Regression Variables – Correlation

Analysis - Expanded Sample………………………………………………. 88 Table 17 Change in Institutional Ownership Regression Analysis - Controlling for

Other Determinants of Change in Intuitional Ownership - Original Sample………………………………………………………………………89

Table 18 Change in Institutional Ownership Regression Analysis - Controlling for

Other Determinants of Change in Intuitional Ownership - Expanded Sample………………………………………………………………………90

Table 19 Change in Institutional Ownership Regression Analysis Regression

Analysis - Controlling for Other Determinants of Change in Institutional Ownership: With Tax-Period Dummy Variables - Expanded Sample…….. 91

Table 20 Event Study: Mean Abnormal Returns in Response to the Dividend

Initiation Announcement Using the Equally Weighted Market Index…….. 92 Table 21 Weighted Least Squares Regression Variables - Descriptive Statistics…… 93 Table 22 Weighted Least Squares Regression Variables - Correlation Analysis……. 94 Table 23 Weighted Least Squares Regression Analysis……………………………....95 Table 24 Partitioning the Sample by Highest versus Lowest Information

Asymmetry and Agency Costs………………………………………………96 Table 25 Logit Regression Variables - Descriptive Statistics………………………... .97 Table 26 Logit Regression Variables - Correlation Analysis………………………….98 Table 27 Logit Regression Analysis - Controlling for Other Determinants of

Dividend Increase Decisions by Firms………………………………………99

1

CHAPTER 1

INTRODUCTION: THE DIVIDEND PUZZLE

Ever since Black (1976) referred to the determinants of corporate dividend policy as a

“puzzle”, attempts to solve the paradox of why firms pay dividends? have been many. A large

body of literature aimed at explaining the nature and the determinants of dividend policy

continues to emerge. A number of theories of dividend policy have been proposed and tested,

and no clear-cut answers have yet been reached. The lack of consensus on the determinants of

corporate dividend policy results from conflicting empirical findings and conclusions made

within the various dividend theories. Existing empirical literature typically finds that the

observed dividend behavior is consistent with more than a single theory, and the literature fails to

dismiss alternative explanations.

Despite their being a taxable distribution of after-tax income, dividends paid out by a

firm tend to follow a pattern of stable or slightly increasing payouts, even in the face of weak

current income (Lintner, 1956). This means that firms are paying out a higher proportion of their

earnings dividends and/or tapping the debt market to maintain their dividend pattern. When

earnings are higher than expected, higher dividends will be paid out if management is convinced

that the higher dividend level is sustainable in the long term. Black (1976) pointed out the puzzle

of why individuals like dividend-paying stocks and why this method of income distribution

persists even in the presence of the burden of double taxation as in the case of the United States

where dividends have, until recently, been less favorably taxed than capital gains. The fact that

share repurchases carry a smaller tax burden as opposed to dividends, makes repurchases a

superior method of payout to investors. Nevertheless, dividends continue to be an increasing

proportion of earnings: according to DeAngelo, DeAngelo and Skinner (2004), dividends paid by

2

industrial firms increased over 1978-2000 by 224.6% in nominal terms and 22.7% in real terms

as represented by their sample.

Several theories have been put forth to explain why dividends are paid despite their

unfavorable tax treatment. One of the earlier explanations holds that some shareholders whose

personal tax liability is insignificant bear little or no double taxation. Under this theory, investors

will self-sort into clienteles whose personal tax positions match the firms’ dividend policies,

thereby separating themselves into ownership classes of high-, low- or no-dividend-paying firms

according to their marginal tax brackets (Farrar and Selwyn 1967; Elton and Gruber 1970;

Masulis and Truman 1986). This is known as the Dividend Clienteles Hypothesis. A more recent

theory of dividends is based on the presence of asymmetric information flows. This is referred to

as the Signaling Hypothesis where managers are expected to have superior information about the

performance and the future prospects of the firm. By committing to a “costly” dividend payout,

these managers send out a reliably favorable signal about the firm’s prospects (Ross 1977;

Battacharya 1979). These models assume that for a signal to be reliable, it has to be dissipative.

In the context of dividend payout, this means that it will be too costly (increased need for costly

external funding and tax burden on existing shareholders) for managers to give out false signals.

Another theory of dividends is the Agency Cost theory, which states that dividends may

limit insiders’ dissipation (Jensen and Meckling 1976; Jensen 1986) by compelling them to face

the discipline of the market when raising investment funds that would otherwise be freely

available in the form of retained earnings (Rozeff 1982; Easterbrook 1984).

The information asymmetry framework and the agency hypothesis have given way to

ample research on the relationship between a firm’s financial policy and its ownership structure

(Leland and Pyle 1977; Jensen 1986). The majority of the research in this area, however, has

3

been directed toward studying the link between dividend/debt policy and managerial ownership

(Crutchley and Hansen, 1989; Jensen, Solberg and Zorn, 1992; Farinha 2003). Empirical

evidence on this relationship has also been well documented within this range of research

(Rozeff, 1982; Jensen, Solberg and Zorn, 1992; Eckbo and Verma, 1994; Moh’d, Perry and

James, 1995). However, another constituent of a firm’s ownership structure which may also have

a significant impact on a firm’s financial policy, namely institutional ownership, has only

recently started to receive attention in the literature. A potential relationship between the level of

institutional ownership and dividend policy derived from agency and/or signaling considerations

is described in a newer theory by Allen, Bernardo and Welch (2000) – henceforth ABW. The

theory is based on the firms’ use of dividends to attract institutional investors. Institutional

investors may have lower tax burdens on dividends than individuals. Firms that want to reveal

their true value may find attracting institutional investors to be advantageous since institutions

are better able to be informed about the firm’s internal affairs and are more capable of

monitoring the firms’ activities than individuals. The presence of this class of shareholders

serves as either a signal of a firm’s quality (in an information asymmetry framework) or as a

commitment that a firm will be adequately managed (in an agency framework). A more elaborate

discussion of the ABW (2000) theory is presented in a later section.

The purpose of my study is to empirically examine the link between institutional

ownership and dividend policy for a representative sample of U.S. firms in the framework of

ABW. I aim at providing a comprehensive analysis of the major aspects and implications of the

theory. Specifically, unlike the prevalent literature on this topic, I give more attention to the

different types of institutional investors and their incentives for investing in dividend-paying

stock. Moreover, the U.S. tax-law changes that affect the differential tax treatment between

4

dividends and capital gains are utilized as unique opportunities to test any resultant changes in

the relationship between the level of institutional ownership and dividend payout. Additionally, I

analyze the signaling and agency effects on the market reaction to dividend increases within the

framework proposed by ABW. Finally, I test the smoothing effect institutions have on dividends

by examining the firm’s propensity to increase its dividends given the level of institutional

ownership in the firm. In testing the institutional preference for dividend paying stocks through

their response to dividend initiations, I find institutional holders to respond positively to such

announcements by taking positions in the dividend paying stock by the third quarter following

the initiation announcement. I also find that this response is displayed most strongly among tax-

favored institutions which is consistent with the tax clienteles hypothesis. My testing also reveals

a stronger reaction by institutions in periods of high tax-rate differential between institutions and

retail investors. In examining the abnormal returns around dividend initiations, my test results

report these abnormal returns as a decreasing function of institutional holding in the dividend

initiating firm. I also find that the mitigating effect of institutional ownership on the market

reaction to dividend initiations is stronger for firms with higher information asymmetry and more

so for firms with high potential for agency problems. This evidence lends some degree of support

to ABW’s theory of dividend policy. Additional support to ABW lies in test results from their

smoothing hypothesis which reveals that as institutional ownership increases, the propensity of

firms to increase dividends decreases.

Finally, this paper’s contribution to the literature lies in offering empirical support to a

new explanation of the drivers behind a firm’s dividend policy, and opens the door for a newly

directed research focusing on the role of institutional ownership in a firm’s payout decisions.

5

The rest of the paper is organized as follows: Chapter 2 surveys the existing literature on

institutional ownership in the context of the tax clientele, signaling, and agency hypotheses. I

also present a discussion of the existing literature on institutional ownership and dividends.

Additionally, I present ABW’s hypothesis, along with a detailed description of their information

and signaling models. Chapter 3 covers the hypothesis development. The data description and

the data selection procedure are covered in Chapter 4 followed by the testing methodology.

Chapter 5 presents a discussion of the results, and Chapter 6 concludes.

6

CHAPTER 2

LITERATURE REVIEW

2.1 The Growing Trend in Institutional Ownership

Despite the fact that managers are responsible for formulating corporate policy, it can be

argued that with institutional holdings becoming an increasingly significant component of

corporate ownership structure, this class of investors is becoming more and more influential in

corporate decision making, whether directly or indirectly. In standard financial theory, large

publicly traded corporations are commonly characterized as having highly diffuse ownership

structures that effectively separate ownership of residual claims from control of corporate

decisions. However, a growing body of literature is pointing to a change in the ownership

structure of corporations, and the implications of this change on corporate decision-making. A

study by Gompers and Metrick (2001) reveals that large institutional investors nearly doubled

their stock market share between 1980 and 1996, from 19% for the one hundred largest

institutions in 1980 to 37.1% in 1996. The study also shows that, overall, this increase in demand

by institutional investors was directed towards larger companies. A more recent study by Binay

(2005) reveals that institutional investors have increased their U.S. equity market ownership

from 35% in 1981 to 58% in 2002. Despite the documented reduction in the propensity to pay

dividends over the period 1978–2000 (DeAngelo et al. 2002; Fama and French 2001), the

aggregate amount of dividends paid increased by 10% in real terms, and that the concentration of

dividends in large firms has increased over this period.

7

2.2 The Role of Institutional Ownership

2.2.1 Institutional Ownership and Dividend Policy

There is a vast array of literature describing the firm’s incentives to pay out dividends,

and the theories discussed above, namely: The Tax Clienteles Hypothesis, the Signaling

Hypothesis, and the Agency Hypothesis are the most dominant. The following discussion shows

how institutional ownership of a firm’s equity plays a significant role in determining dividend

policy within each of those theories.

2.2.2 Institutional Owners and the Tax Clienteles Hypothesis

As summarized earlier, the tax clienteles hypothesis stems from the nature of a tax

system that treats dividends less favorably than capital gains. According to the tax clienteles

hypothesis, heavily taxed investors avoid high-payout firms. The opposite is true for investors in

low-tax brackets who favor high-payout shares. Institutional investors in the United States, such

as public pension funds, colleges and universities, labor unions, foundations, and other

corporations are either fully or largely exempt from taxes. Hence, they generally tend to be

indifferent or slightly in favor of dividend-paying stocks.

From another perspective, institutional shareholders face a need for funds on an ongoing

basis. Institutions generally invest in equities in order to provide returns to fund their activities,

such as funding pensions, paying out insurance policies, and so on. This further pushes

institutions towards favoring dividends rather than capital gains, in order to fund their liabilities,

regardless of their tax bias (Short, Zhang and Keasey, 2002). Those two factors, combined with

common “institutional charter” and “prudent-man” restrictions, make it more likely for

institutions to purchase investments with high dividend payout. In this respect, ABW argue that

dividends may be considered one way of attracting institutions. ABW (2000), moreover,

8

observed that many tax-exempt institutions, such as universities and charities, do not have direct

restrictions, and still hold significant amounts of dividend-paying stock. Thus, it may be

hypothesized that institutional investors self-select into clienteles that favor dividend-paying

stock (Short et al. 2002).

2.2.3 Institutional Owners and the Signaling Hypothesis

As mentioned earlier, the proportion of stocks owned by institutional investor groups has

been significant for many years, and has increased substantially since 1980. In terms of taxed

versus tax-exempt institutions, the fastest growing institutional investors in the U.S. are pension

funds, as well as mutual funds. The assets of pension funds reportedly grew at a compound

annual growth rate of 14% in the 1990s (Davis and Steil 2001), and, as of 2001, these funds held

8% of the total U.S. equity market.1 Because of their scale, the tax-exempt institutions have

greater incentives to become informed about corporate affairs, and are more likely to conduct

“due diligence” in order to detect whether the firm is well run or poorly managed (ABW 2002).

In terms of dividend policy, the signaling hypothesis customarily states that managers

with better information than the market will signal their expectations of the future earnings of the

firm by paying out dividends (Battacharya 1979). In tying dividends as a signal to institutional

holdings, Zeckhauser and Pound (1990) argue that dividends and institutional shareholders may

be viewed as alternative signaling devices. The presence of a large shareholder may mitigate the

use of dividends as a signal of good performance, as the large shareholders themselves can act as

a more credible signal. The presence of institutional owners may signal to the market that agency

costs are reduced due to the monitoring activities of this class of shareholders – a point more

elaborately discussed in the following section. On the same note, Short et al (2002) further

argued that given the superior information that the institutional shareholders are likely to have 1 From the Institutional Investment Report, The Conference board, March 2003- from Qiu 2003.

9

concerning the future prospects of the firm, it is possible that the market may interpret the

presence of an institutional shareholder as a signal of good news regarding the firm’s future

prospects. Finally, with respect to dividends, it has further been suggested (Fluck 1995; Gomes

1996) that firms pay them to establish a reputation for good treatment of the outside

shareholders. As an investor base notably growing in importance, institutions may as well be a

primary target of such a signal.

In a recent significant departure from the traditional line of thinking in the area of

dividend policy, a potential link between dividends and the level of institutional ownership in the

signaling sense was introduced by ABW (2000). They argue that firms use dividends to attract

institutional investors. By doing so, management will be signaling good firm “quality.” Through

attracting a more “inquisitive” shareholder, the firm would be demonstrating no fear of detection

by an investor with greater incentives and resources to become more informed about the firm.

This theory is discussed in more detail in a later section.

2.2.4 Institutional Owners and the Agency Hypothesis

The agency theory of dividends holds that when shareholders’ and managers’ goals

diverge, regular dividend payments can mitigate agency conflicts by distributing investment

returns, thereby reducing the scope of potential abuse of resources by management (Rozeff 1982;

Easterbrook 1984). Under this hypothesis, the payment of dividends forces firms to access the

external capital markets whenever the need for funding arises and, hence undergo monitoring by

the capital market. The role of institutions in this hypothesis is derived from the institutions’

preference for the distribution of free cash flows to mitigate agency costs (Eckbo and Verma

1994). The influential status of the institutional investor is expected to have an impact on

corporate financial policies including dividend policy. Accordingly, institutional shareholders

10

may counter a tendency for managers to prefer the excessive retention of cash flow and, by

virtue of their voting power, force managers to pay out dividends (Short et al. 2002).. In this

respect, a study by Gugler (2003) revealed that target dividend levels, the smoothing of

dividends, and the reluctance to cut dividends depend on the identity of the (ultimately)

controlling owner.

The highly significant role of institutions in corporate decision-making has been taken to

a more advanced level in a segment of the literature on corporate governance. Institutional

investors are increasingly viewed as activists and proactive monitors who can take corrective

measures whenever management underperforms and, make sure that the firm will remain well

run.

2.2.4.1 Institutional Investors as Monitors

In recent years, institutions have become increasingly involved in corporate governance,

through their ability to influence corporate decision makers. Institutions negotiate with

management and vote in large blocks in matters relating to changes in corporate charter and

board composition and membership. They also have the ability to make a quick sale of a large

block of shares to potential raiders (Admati, Pfleiderer and Zechner 1994; Smith 1996; ABW

2000). One of the earliest theoretical studies that tackled the potential importance of institutional

investors is Shleifer and Vishny (1986). In their paper, they explain that “a large shareholder is

assumed to have exclusive access to technology for finding valuable improvements of the

incumbent’s operating strategy through monitoring and independent research.” Such a

technology, they argue, is expected to induce an added value to the firm, especially if the large

investor has the power to replace inefficient management. Shleifer and Vishney also add that the

importance of the large shareholder is not limited to his role as a monitor. Large shareholders can

11

also facilitate takeovers by well-informed outsiders who have no initial position in the firm. In

this framework, dividends are paid out (despite their detrimental effect on the value of the firm to

smaller shareholders) to compensate large shareholders for the monitoring costs that they incur.

A significant study by Smith (1996) analyzes the activist role of institutional investors by

examining targets by one institutional investor regarded as a leader in shareholder activism: the

California Public Employees’ Retirement system (CalPERS). He concludes that shareholder

activism is largely successful in changing governance structures and, when successful, results in

a statistically significant increase in shareholder wealth.

In the same sense, institutional ownership is also hypothesized as having a positive effect

on the quality of financial reporting. A recent working paper by Han (2005) reveals results that

are consistent with large outside shareholders demanding better financial reporting, to alleviate

agency problems. Another incentive suggested by Han for institutional owners to monitor relates

to portfolio turnover. Han argues that if institutions do not trade based on a firm’s short term

performance, they may have strong incentives to monitor. Specifically, he classified banks,

insurance companies, investment advisors and investment companies as a high-turnover group,

while he included pension funds, private foundations, and colleges and universities in the low-

turnover group.

In testing the competing views of whether institutional investors create or reduce the

phenomenon of managerial myopia, Bushee (1998) investigates whether institutional ownership

affects Research and Development (R&D) spending. It is argued that by acting as “traders”

rather than “owners,” institutional investors place excessive focus on short-term developments,

leading managers to engage in myopic investment behavior (Graves and Waddock 1990; Eames

1995). The counter argument holds that institutional owners’ sophistication and large

12

stockholdings allow them to monitor and discipline managers, ensuring that managers choose

investment levels to maximize long-run value rather than to meet short-term earning goals.

Bushee demonstrates that managers are less likely to cut R&D to reverse an earnings decline

when institutional ownership is high, implying that institutions are sophisticated investors who

typically serve a monitoring role in reducing the pressure for myopic behavior.

We can conclude that the functions of institutional owners in corporate governance are

vigorously analyzed and their positive role in reducing agency costs is well buttressed in the

literature. However, the link between such a role and dividend policy is yet to be established.

The question to be raised in this respect is whether a firm’s dividend policy is a result of the

management’s attempts to cater to the preferences of an exogenously determined shareholder

base (Short et al. 2002; Perez-Gonzalez 2003), or whether it serves as a mechanism by which

management affects ownership structure by attracting (or otherwise discouraging) institutional

monitors as conjectured by ABW (2000). In the following section, I present ABW’s theory on

the relationship between institutional ownership and corporate dividend policy. In a later section,

I develop the hypotheses that test the implications of the theory and the extent to which any

attainable empirical evidence supports (or otherwise rejects) the theory.

2.3 Existing Empirical Evidence on the Relationship between Dividends and Institutional

Ownership.

A number of studies have analyzed the association between dividend policy and institutional

ownership. However, the mixed evidence reached by these studies, and the different frameworks

within which each is carried out calls for a more comprehensive investigation of the relationships

between these variables before generalizable conclusions (if any) can be reached.

13

In the context of the tax-clienteles hypothesis, Michaely, Thaler and Womack (1995)

study the change in institutional ownership in response to dividend omissions, and do not find

any significant reaction, while Brav and Heaton (1998) find that institutional holdings drop after

omissions and increase after initiations. Dhaliwal, Erickson and Trezevant (1999) use aggregate

institutional ownership as a proxy for ownership by tax-exempt, tax-deferred, and corporate

investors to show that institutional ownership, as a percentage of assets, is positively affected by

dividend initiations. They hypothesize that when non-dividend-paying firms initiate dividends,

tax exempt, tax-deferred and corporate investors will purchase shares of an initiator’s stock that

are being sold by individual investors for whom dividends are tax disadvantaged. Their test

results also reveal that this relationship is mitigated when tax reform laws reduce the differential

tax treatment between dividends and capital gains. A more recent study by Grinstein and

Michaely (2005) concludes that institutional holdings are affected by payout policy. Their test

results reveal that institutions have a stronger preference for dividend paying stocks over non-

dividend paying stocks, while at the same time favoring low over high payout.

On the international level, and in the context of both the dividend clienteles and the

agency cost hypotheses, Short et al. (2002) finds that for a sample of U.K. firms, a consistently

positive association exists between changes in dividend payout and institutional holdings (treated

as an exogenously determined variable). On the other hand, Elston, Hofler and Lee (2004) study

this relationship for a sample of German companies and show that institutional ownership is not

significant in determining dividend payout. The implications of these findings, however, need to

be interpreted with caution, given the different legal environments and the variations in the tax

laws across different countries.

14

The effect of ownership characteristics on dividend policy was recently analyzed by

Perez and Gonzalez (2003) who find that dividends respond to the tax preferences of the largest

shareholders. Their test results reveal that dividend payout increase (decrease) when the firm’s

largest equity holders are more favorably (less favorably) affected by tax-law changes. However,

they find that this effect is more emphasized for firms whose largest owners are individuals than

for those whose largest owners are institutions.

2.3.1 Institutional Differences

One common problem in most of the above listed studies is their use of aggregate

institutional ownership as a proxy for tax-advantaged institutions. For U.S. firms, this measure is

usually obtained from Standard and Poor’s Stock Guide and includes banks, insurance

companies, mutual funds, corporate investors, pension and retirement funds, broker-dealers, and

other investment advisors. Of all these institutions, only corporate investors and pension and

retirement funds are considered in the low-tax or the tax-exempt group. The inclusion of taxable

institutions, most significant of which are mutual funds, makes aggregate institutional holdings

an imperfect proxy for low-tax and tax exempt groups.

Lang and McNichols (1997) argue that the power of tests of hypotheses about

institutional investors’ behavior may be reduced by using aggregate measures without

considering the type of institution.

Del Guercio (1996) finds that aggregate institutional investors tilt their portfolios

towards “high quality” firms as measured by Standard and Poor’s (S&P) Earnings and Dividend

Rankings on Common Stocks. She also shows that this outcome is primarily driven by banking

firms, and is a result of prudent-man rule restrictions. She also finds that after controlling for

size, liquidity, risk and S&P ranking, dividend yield has no power in explaining the portfolio

15

choice of major institutional investors such as banks and mutual funds. Although her evidence

does indicate that the prudent-man rule plays an important role, it did not reveal any role for

dividend yield.

Hotchkins and Lawrence (2003), on the other hand, find that dividends are an important

factor in institutions’ portfolio choice. They show that as dividend yield increases, a higher

portion of the stock is held by institutions whose portfolio consists of high yield firms’ stock.

2.4 The Relationship Between Dividend Policy and Institutional Ownership: Allen Bernardo and

Welch (2000)

ABW base their theory on the assumption that different groups of investors are taxed

differently and have different incentives to become informed about corporate affairs. The authors

assume two groups of investors: untaxed institutions, such as pension funds, colleges and

universities, labor unions, and so on, and taxed individuals.

The argument holds that because of their scale, institutions have greater incentives to

become informed about the firm and they are more likely to conduct “due diligence” to evaluate

managerial performance. Moreover, they are more likely to facilitate mechanisms by which

potential shortcomings are corrected. Hence, ABW conjecture that the presence of institutional

shareholdings can be associated with higher firm value because of signaling effects, agency

effects, or both.

On the other hand, ABW assume that dividends are one way of attracting institutions.

Restrictions and need for liquidity make dividend-paying stocks a primary target for investment

for institutions. Yet, as ABW observe, many tax-exempt institutions such as universities and

charities do not have direct restrictions, and still hold significant amounts of dividend-paying

stock. Thus, they conclude that:

16

1. Dividend-paying firms’ equilibrium market prices make them a relatively better purchase

for institutions than for retail investors, due to tax differentials between the two groups.

2. This comparative advantage results in an endogenously higher fraction of ownership by

institutions for dividend-paying stocks.

Generally ABW’s assumptions 1 and 2 imply:

1. By paying dividends, firms can attract more institutions as shareholders.

2. Dividend-paying firms will perform better than otherwise equal non-dividend-paying

firms.

2.4.1 The Hypotheses of ABW

In a more formal statement of their hypotheses, ABW conjecture:

1. The Signaling Hypothesis In the presence of asymmetric information, taxable dividends are signals of “good” management quality. Paying dividends increases the chance that firm quality will be detected by the institutions. Therefore, “bad” firms dislike attracting institutions, as their presence increases the probability that quality will be revealed. They will not find it worthwhile to incur the dividend tax cost to imitate higher-quality firms.

2. The Agency Hypothesis

Taxable dividends exist to attract informed institutions whose presence ensures that the firm will remain well run. If management underperforms, then institutional shareholders will take corrective measures such as facilitating takeovers by selling large blocks of stock or becoming directly involved in the corporate governance process.

2.4.2 The Models

The theoretical models presented by ABW aim at demonstrating how financial policy can

determine the composition of shareholders and the relationship of this clientele composition to

firm pricing. The purpose is to show that tax-advantaged institutional shareholders tilt their

optimally diversified portfolio in favor of firms for which they enjoy a comparative tax

advantage. The institutional presence, in turn, enhances the release of information about the firm

which is itself reflected in the equilibrium price.

17

2.4.2.1 The Signaling Model

The following set of assumptions form the basis behind ABW’s Signaling Model:

• Managers have superior information about the quality of the firm

• Managers signal this quality through their dividend policy

• Managers choose a dividend policy that maximizes p (the current share price)

• Total payout (dividends and share repurchases) is held constant

• Capital gains tax is zero

• The economy consists of N firms which can either be of high quality (H) or of low

quality (L) type

• There exist two groups of investors, institutions (I) or retail (R)

• Institutional investors face a lower tax rate on dividends than retail investors (τI < τR)

• Investors in the same group are identical

• A one-period framework

The model is structured such that after the firm’s dividend policy is announced, investors

trade shares at prices determined in a competitive market. The model focuses on a separating

equilibrium in which high-quality firms pay a dissipative dividend to attract more institutional

monitors and to signal their higher quality.

The Investors’ Problem

The investors’ problem is to maximize the expected utility of their wealth (Wi) by

allocating it among the N stocks and a riskless asset (yielding a certain gross return that is

normalized to unity).

18

{ }[ ]jW DeE ii

ij

~max γ

θ

−− (1)

Where,

( ) ( )[ ][ ]

∑ ∑∈ ∈

⎥⎦

⎤⎢⎣

⎡−−+−=

LHj LHjjijijiojijiji pWDVW

, ,,

~~ θθτθ (2)

Suppose investors conjecture that all firms paying dividends D* are high-quality and

firms paying D = 0 are low quality. Therefore, investors believe that their after-tax payoffs for a

dividend-paying firm are normally distributed with mean [μH - τiD*] and variance σ2, and that

their after-tax (and pretax) payoffs for low-quality firms are normally distributed with mean μL

and variance σ2.

The equilibrium shareholdings and prices for dividend-paying (type H) firms are: Institutional Shareholdings:

*)(

)(2

* DRI

IR

IR

RIH ⎥

⎦

⎤⎢⎣

⎡+−

++

=σγγ

ττγγ

γθ (3)

Retail Shareholdings:

*)(

)(2

* DRI

IR

IR

IRH ⎥

⎦

⎤⎢⎣

⎡+−

++

=σγγ

ττγγ

γθ (4)

Equilibrium Price: *2 Dkp HH τσμ −−= (5)

The equilibrium shareholdings and prices for non-dividend-paying (type L) firms are: Institutional Shareholdings:

IR

RIL γγ

γθ

+=* (6)

Retail Shareholdings:

IR

IRL γγ

γθ

+=* (7)

19

Equilibrium Price: 2σμ kp LL −= (8)

The above results reveal that shareholdings of high-quality firms consist of the usual

optimal risk-sharing term and a novel clientele term, which depends on the relative institutional

tax advantage and dividend level. Moreover, because of the tradeoff between after-tax returns

and risk sharing, the clientele effect is dampened when investors are more risk averse, and

investments are more risky and share prices are reduced by the equilibrium tax loss.

The Value of Dividend-Paying Stocks

The main interpretation by ABW of the Signaling Model is that retail investors value

dividend-paying stocks less than institutional investors, on the margin, because of taxes. As a

result, dividend-paying stocks have a lower price than non-dividend-paying stocks. This makes

the dividend-paying stocks more attractive to the institutional investors because they offer a

higher pretax return.

Optimal Dividend Policies

The competitive equilibrium in the share trading stage described above assumes that dividend

policies of the two types of firms prove revealing. For this equilibrium to exist, managers of

high-quality firms must prefer to pay D* (>0), and managers of low-quality firms must prefer not

to mimic high-quality types and, therefore, to pay zero dividends, D = 0.

A. If high-quality managers paid D = 0, they would avoid the dissipative dividend, but the

market would believe them to be of low-quality, unless later revealed otherwise. Their

expected share price will be

( )( )[ ]( ) ( )( )( )22

, 001 σμθπκσμθπ kS HILILH −+−−= (9)

20

where, π(θI(0)) denotes the probability that a manager of a high quality firm is revealed to

be a high quality type given institutional holding, which will depend on the level of

dividend.

If they pay dividends D = D*, the expected share price will be

( )2*

, κστμ −−= DS HHH (10)

Thus, a necessary condition for a separating equilibrium is

( )( )[ ]( )τ

μμθπ LHILHHH DSS −−

≤⇔≥01*

,, (11)

The above equilibrium indicates that high quality firms must not pay too large a

dissipative dividend. It also shows that as the difference in average quality increases, the upper

bound increases (being recognized as high quality becomes more valuable), and as the

preference-weighted average tax rate increases, the upper bound decreases (signaling with

dividends becomes more costly).

B. If the low-type managers do not pay a dividend, the share price reflects the fact that the

market believes the firm is low quality. In this case

( )2, σμ kS LLL −= (12)

If they pay dividends D*, the firm will be revealed to be low quality with probability

π(θI(D*)) (13)

The necessary condition for a separating equilibrium is

( )( )[ ]( )τ

μμθπ LHIHLLL

DDSS −−≥⇔≥

**

,,1

(14)

21

The optimal level of dividends for a high-quality firm

• is the minimum dividend that satisfies both equations (11) and (14).

• is unique,

• increases in μH - μL,

• deceases in τ , holding (τR - τI) and γs constant,

• decreases in (τR - τI), holding τ constant, and

• increases in σ2.

2.4.2.2 The Agency Model

In this model, the ability of institutions to monitor is substituted for the previously

assumed ability to differentiate between existing high- and low-quality firms.

Assumptions (in addition to the assumptions in the signaling model above)

• M is an endogenous amount of monitoring by institutional investors,

• Retail investors are unable to monitor,

• M units of monitoring increases firm value by Mα/α,

• One unit of monitoring costs c dollars.

2.4.2.2.1 Model Structure

After managers commit to dividends and institutional and retail shareholdings are

determined, institutional investors choose an optimal amount of monitoring, M, given their

shareholdings. The optimal level of monitoring increases in the institutional shareholdings and

the effectiveness of monitoring, and decreases in the cost of monitoring. This is the mechanism

by which dividends can enhance firm value.

22

2.4.2.2.2 The optimal dividend

• decreases in cost of monitoring, c,

• decreases in τ, holding (τR - τI) constant,

• increases in (τR - τI), holding τ constant,

• increases in monitoring efficiency, and

• decreases in firm risk.

2.4.2.3 A Multi-period Extension: Smoothing

Considering an infinite horizon version of the model in which the firm chooses its

dividend policy each period, and institutional monitoring increases firm value only in that period,

the total payout each period is such that the size of the firm remains constant. In this case, the

one-period model is representative of every period in the infinite horizon model. If the

parameters {γI, γR, τI, τR, σ2, c} remain constant each period, managers would choose the same

dividends each period.

In a more dynamic setting, if a firm pays dividends in the first period, it will have

attracted an institutional clientele. This is precisely the clientele that can punish managers for

poor behavior reflected in cutting dividends, and/or incurring the cost of additional unnecessary

dividend increases. This represents dividend smoothing pressure on dividend-paying firms.

2.5 The Empirical Implications of ABW

Some direct implications of the theory can be described as follows.

• A novel implication is that the tax differential between institutions and retail investors,

rather than the absolute tax payment (John and Williams, 1985), determines the dividend

payout.

23

• Firms initiating/increasing dividends attract new institutional clientele. Firms

omitting/reducing dividends lose institutional clientele. For empirical testing of these

implications, institutional shareholders with a preference for dividends (tax-exempt

institutions) need to be identified.

• Under the Signaling Hypothesis, the more severe the asymmetric information problem,

the more likely is the dividend payout, and the more valuable is the payout in the eyes of

outside investors.

• Under the Agency Hypothesis, firms experiencing increases in large, activist institutional

shareholders, experience increases in future performance, due to the control services

provided by these institutions. Firms increasing dividends have unexpected future

performance increases.

ABW and the Signaling Framework

The question that may be raised at this point is whether the signaling framework

developed by ABW satisfies the signaling criteria as set by the seminal work on this subject

(Spence, 1973, 1974; Ross, 1977). According to Spence (1974), a potential signal becomes an

actual signal if it is (a) observable, (b) alterable, (c) the signaling costs have a negative

correlation to the unobservable (positive) attribute (here the quality of the firm), and (d) if there

is a sufficient number of possible signaling levels in the appropriate cost range. Under ABW,

signaling through dividends satisfies the above criteria as being observable, subject to

management’s discretion, and costly, where the cost is reflected by the dividend tax burden.

Finally, the level of dividend payout chosen by management to signal quality satisfies the last

requirement. In ABW terminology, the optimal dividend increases as the difference in average

quality between high-quality and low-quality firms increases.

24

CHAPTER 3

HYPOTHESIS DEVELOPMENT

3.1 Institutional Preference for Dividend Paying Stocks

ABW’s (2000) theory of dividends is based on the conjecture that dividends are one way

of attracting institutions and that by willingly catering to institutional investors, managers will be

transmitting a signal of the “good” quality of their firm to the outside market, and/or promising

effective monitoring that would reduce the agency cost burden. This is justified by the

institutional investors’ alleged superior capabilities of detecting firm quality and correcting

managerial flaws through the mechanisms discussed in detail in earlier sections.

Institutions as a Proxy for Tax-Favored Investors: A discussion

Earlier theories of dividends based on tax clienteles (Modigliani and Miller, 1961; Farrar

and Selwyn, 1967; Masulis and Trueman, 1986) imply that different categories of shareholders

have different preferences for dividends. Namely, investors that pay a lower effective tax rate on

dividends than capital gains (e.g. corporations) prefer to receive their equity return as dividends

rather than capital gains; individuals for whom dividends are taxed at a higher rate than capital

gains will prefer the latter; and, finally, tax-exempt investors (some institutions) will be

indifferent towards the two forms of return. Although ABW clearly assume that institutional

investors are attracted by dividends, they were not explicit as to the role of taxes in this process,

given their theorized indifference under the tax clienteles hypothesis. This assumption may be

better justified by institutions’ preference for dividends induced by non-tax-related factors

(continuous need for liquidity, prudent-man restrictions etc.). An investor group that better fits

the tax-clientele explanation is represented by corporate investors with tax-favored dividend

treatment, assuming they possess the same power of oversight as institutional investors by value

25

of their size or through other “synergistic linkages.” Hence, it is the investor’s degree of

sophistication and preference for dividends that is intended to grant value to the signaling

hypothesis of ABW. In this sense, and for empirical purposes, institutional ownership may be

used as a proxy for investor sophistication (Dahliwal et al 1999; Bartov, Gul and Stui et al.

2000). Other studies that use aggregate institutional owners as low-tax-rate and/or tax-exempt

investors include Stulz, Walking and Song (1990), Brown and Ryngaert (1992) and Michaely,

Thaler and Womack (1995) (from Dhaliwal et al., 1999). Based on the prediction of ABW’s

theory, a positive relationship is expected between dividend payout and institutional holding.

Specifically, firms that initiate/increase dividends are expected to attract new institutional

clientele.

ABW’s dividend theory argues that tax-exempt dividends induce institutional investors to

tilt towards them. However, for empirical testing purposes, it omits considerations such as

measurable institutional beliefs (about stock return performance, firm characteristics, individual

institutions’ preferences, and information differences). Such factors affect the decisions relating

to institutional shareholdings for different firms. To better control for these omitted variables, an

empirical study should relate the effect of changes in dividends on changes in shareholdings.

This methodology has the advantage of removing the effects of contemporaneous variables that

influence institutional ownership. Hence, tests relying on the effects of unexpected changes in

dividends are likely to be more powerful. Furthermore, Michaely et al. (1995) argue that

dividend initiations (as opposed to unexpected dividend increases) represent “an extremely

visible and qualitative change” in corporate dividend policy. Also, as determined by Asquith and

Mullins (1983), the choice of dividend initiations reduces the bias in estimating the dividend

surprise because the announcements are less likely to be anticipated. In addition, for dividend

26

initiations, the ex-ante dividend yield is zero, so the reactions to such announcements are

unlikely to be distorted by the investor’s preference for dividends. Based on this argument, I use

dividend initiations as events reflecting major shifts in firms’ dividend policies. The first

hypothesis to be tested in this paper may thus be stated as follows:

Hypothesis 1: Institutional ownership levels are unchanged or reduced by dividend initiations. Hypothesis 1.A: Institutional ownership levels in a given firm increase when the firm initiates a dividend.

3.2 Differences Between Different Types of Institutions

The relationship between dividends and institutional holdings as described under ABW’s

theory, is a direct result of institutions’ preference for dividends. This preference, as discussed

earlier, is derived from the tax advantage of this group of investors. therefore, it is, reasonable to

assume that any hypothesized relation between dividends and institutional holdings is stronger

for institutions that enjoy more favorable tax treatment on dividend income.

Hypothesis 2: Tax status has no effect on the relationship between dividend initiations and the level of institutional ownership. Hypothesis 2.A: Institutional ownership increases following dividend initiations are greater for tax-exempt institutions (universities charities and pension funds).

3.3 The Effect of Tax-Law Changes

Another related hypothesis addresses the extent to which changes in the tax law that

affect the tax rate on dividends for the marginal investor impact the prevalent relationship

between dividends and institutional ownership. ABW’s model implies that the tax differential

between institutions and retail investors, rather than the absolute tax payment (John and

Williams, 1985) is what determines the dividend policy. Hence it can be argued that any change

27

in the tax code that affects this differential will impact the relationship between dividends and

institutional ownership. In three instances since 1980, tax reform acts have been passed that

changed the marginal tax rate on dividends for the retail investor (τR). Assuming that the

marginal tax rate for the institutional investor (τI) is zero, these tax reform acts have affected the

tax differential on dividend income between the institutional and the retail investors (τR - τI). If

tax characteristics dominate the institutions preference for dividends, then the relationship

between dividend initiation and institutional ownership is expected to be stronger in periods

where this tax differential is high. This is stated formally in the following hypothesis:

Hypothesis 3: There is no relationship between dividend-tax-rate differentials and any observed relationship between dividend initiations and the level of institutional ownership. Hypothesis 3.A: The increase in institutional ownership following dividend initiations is greater the larger the prevailing tax differential between institutional and retail investors.

3.4 Institutional Ownership and the Market Reaction to Dividend Initiations

ABW’s signaling hypothesis implies that dividends represent a positive signal. When a

firm initiates dividends, it is relaying the message that it welcomes institutional investors with

better information gathering and/or monitoring capabilities than retail investors. In the signaling

sense, this sends the message that management deems itself as high quality and does not fear

detection. In the agency view, this event is expected to stimulate positive market reaction as

investors become optimistic about the firm’s prospects now that more institutional monitoring is

expected to reduce agency costs. Accordingly, the theory predicts a positive market reaction to

announcements of dividend initiations.

The implication of ABW’s theory is that positive reaction to dividend initiations is either

a signaling effect, agency effect, or both. Regardless of the trigger to the positive reaction to

28

dividends, whether it is information asymmetry problems or high agency costs, the belief by the

market that more institutions will now join the shareholder base serves to stimulates the positive

reaction. However, there may be an optimal level of institutional ownership. When this

ownership is low, dividend initiations are perceived as a means of attracting more institutions,

and hence dividends will become a more valuable signal. Accordingly, the positive market

reaction to dividend initiation announcements is likely to be lower for firms where institutional

ownership is high, and higher where institutional ownership is low. This is formally stated by the

following hypotheses.

Hypothesis 4: There is no effect of institutional ownership on any observed price reaction to unexpected dividend initiations. Hypothesis 4.A: The price reaction to unexpected dividend initiations is stronger (more positive) for lower levels of institutional ownership in the dividend-initiating firm prior to the dividend announcement.

3.5 Explaining the Market Reaction to Dividend Initiation Announcements: The Role of

Institutional Ownership in the context of the Information and Agency Hypotheses

Under the signaling explanation, the market will interpret dividend initiation

announcements as the firm’s way of communicating its good quality to outsiders. This is the case

since by increasing dividends, it is showing willingness to attract institutional investors who have

superior informational advantage and will be better able to detect and reveal the firm’s quality. In

this sense, “bad” quality firms, as ABW explain, dislike attracting institutions, as their presence

increases the probability that their quality will be revealed. They will not find it to their benefit to

incur the dividend tax cost to imitate higher quality firms.

The agency hypothesis, on the other hand, states that the market will perceive dividend

initiation announcements as a means of mitigating agency costs. By attracting institutional

29

investors who have a stronger power of oversight and better monitoring capabilities, the market

will interpret any action that invites more of this type of investors as an indicator of lower

agency costs.

ABW explain that the favorable perception of decisions (such as dividend initiations) that

increase institutional ownership may not be uniquely explained by one of the two hypotheses. It

can be a product of both informational as well as agency concerns, depending on the degree of

each of those two problems in a given firm. While the dividend policy may be explained in the

ABW framework, this does not negate the role attributed to dividends under the traditional

signaling and agency theories. Any segregation between the role of dividends as explained by the

traditional signaling and agency hypotheses and their role through affecting institutional

ownership becomes an empirical question.

In this study, I construct tests that differentiate between the signaling and monitoring

effects of dividend policy, by tying the relationship between the reaction to a dividend

announcement and the level of institutional ownership in a given firm to the degree of

information asymmetry and the degree of agency costs faced by the firm. If the signaling

hypothesis explains the market reaction to dividend initiation/increase announcements, then a

firm with high information asymmetry should experience a stronger market reaction to dividend

initiation announcements with lower levels of institutional ownership in the firm prior to the

announcement. This is the case, due to the expectation that higher institutional presence caused

by dividend initiations will reduce the informational gap between the firm’s insiders and the

outside market. Alternatively, the less severe the information asymmetry problem in a given

firm, the weaker (less negative) is the relationship between announcement day abnormal returns

and institutional ownership. This is formally stated in the following hypothesis:

30

Hypothesis 5: There is no effect of information asymmetry on the relationship between institutional ownership level and the price reaction to unexpected dividend initiations. Hypothesis 5.A: The inverse relationship between the price reaction to dividend initiation announcements and the level of institutional ownership is stronger for firms with more severe information asymmetry problems.

If, on the other hand, the relationship is explained by the agency hypothesis, then a firm

that more free cash flow and/or overinvestment problems will experience stronger market

response to dividend initiation announcements for lower levels of institutional ownership in the

firm prior to the announcement. The expectation of better monitoring by the institutional

investors that will be attracted by the dividend will invoke a stronger market reaction to the

announcement. Alternatively, the less prone the firm is to agency problems of equity, the weaker

the inverse relationship between announcement day share-price reaction and institutional

ownership.

Hypothesis 6: There is no effect of agency costs on the relationship between institutional ownershiplevel and the price reaction to unexpected dividend initiations. Hypothesis 6.A: The inverse relationship between the market reaction to dividend initiation announcements and the level of institutional ownership is stronger for firms with higher potential for agency problems.

3.6 Institutional Ownership and Dividend Smoothing: The Propensity to Increase Dividends

The agency model of ABW also explains the tendency of firms to smooth dividends

(ABW, p. 2501). Assuming that the firm is successful at attracting new institutional owners

upon dividend initiation/increase, then it can be assumed that these new shareholders will begin

their monitoring service and their oversight of managerial operations and will ultimately reduce

agency costs. The role of dividends will then be to maintain the institutional ownership or to

31

attract more institutions by paying out dividends up to an optimal level that equates the marginal

benefit of increasing dividends to the marginal costs of displeasing institutions if the chosen

dividend level cannot be maintained in the future.

3.6.1 The Signaling Hypothesis and the Propensity to Increase Dividends

In earlier sections, it is argued that dividend initiations are expected to invoke a positive

share-price reaction, as dividends are expected to attract institutional investors and thereby relay

a positive signal about the quality of the firm. It is also hypothesized that the market reaction to

initiations is a decreasing function of institutional ownership. Since the higher the level of

institutional ownership, the narrower is the information asymmetry gap between insiders and

outsiders. Accordingly, it can be argued that given the effectiveness of the dividend initiation

decision at attracting institutions, subsequent dividend increases will be less needed as a

signaling mechanism as the level of institutional ownership increases. Under the signaling

hypothesis, higher levels of institutional ownership are expected to mitigate the information

asymmetry problem. It can therefore be argued that the higher the level of institutional

ownership, the less likely it is that managers will increase dividends.

3.6.2 The Agency Hypothesis and the Propensity to Increase Dividends

In explaining the relationship between institutional ownership and dividends, the agency

hypothesis suggests that the market is expected to react positively to attracting institutional

investors who are viewed as effective monitors, which will alleviate the potential agency

problems. On the other hand, ABW argue that since dividends are costly, firms will keep

increasing them but only up to the point where the marginal benefit from increased institutional

monitoring is equal to the marginal cost of higher dividends (the dividend tax cost and the cost of

outside financing when the need for funds arises).

32

The agency hypothesis further implies that institutional monitoring services are valuable

to the same firms period after period, so the same firms will keep seeking them, which explains

firms’ tendency to smooth dividends.

The implication of those arguments is that when the level of institutional shareholders is

deemed high enough to perform the monitoring services expected from them, firms will be

concerned with retaining this investor group which will push them to smooth dividends in a way

that caters to the present institutional investor base. It will also make them less likely to increase

dividends and incur the dividend-tax cost.

As discussed above, both the signaling and the agency hypotheses imply that firms with

higher institutional ownership are less likely to increase dividends. This leads to the following

hypothesis:

Hypothesis 7: There is no relationship between the level of institutional ownership in a given firm and the propensity of the firm to increase dividends. Hypothesis 7.A: The higher the level of institutional ownership in a given firm, the lower is the propensity by the firm to increase dividends.

33

CHAPTER 4

DATA DESCRIPTION AND RESEARCH METHODOLOGY

4.1.The Sample of Dividend Initiating Firms

4.1.1 The Original Sample Set

Dividend initiations are an “extremely visible and qualitative change in dividend policy”2,

which makes it a more reliable indicator of major shifts in dividend policy than dividend

increases (Michaely et al., 1995; Dhaliwal et al.,1999). My sample consists of non-financial U.S.

firms that have initiated dividends during the period 19783-2004. I restrict my sample to only

those dividend-initiating companies that have not paid a dividend in the five years prior to the

initiation date following Ryan, Besley and Lee (2000).

I collect my dividend initiation data from the Center for Research in Security Prices (CRSP).

My initial sample consists of 28034 dividend initiations. To allow for the measurement of

holding period return prior to the initiation, as well for the estimation of the information

asymmetry measure, firms with CRSP history of less than 120 days are excluded (1845 firms). I

also exclude utilities and financial institutions, totaling 484 observations5.

Aggregate institutional ownership is used in the literature as a proxy for investor

sophistication (Bushee, 1998; Bartov, Gul and Stui, 2000; Han, 2005), as well as a proxy for tax-

favored investors (Stultz et al. 1990; Michaely et al. 1995; Dhaliwal et al., 1999). For the

purpose of this study, institutional ownership will serve as a proxy for both investor

characteristics, as they both describe the type of investors targeted by a management upon its 2 Michaely et al. (1995) 3 This is the year when the13F filing requirement was introduced. 4 2770 observation are from CRSP and 33 observations are manually collected from Lexis Nexis. 5 It has been suggested by a number of studies (Demsetz and Lehn, 1985; Filbeck and Hatfield 1999) that ownership structure of these firms is affected by regulation. Demsetz and Lehn find that the average concentration of ownership for the regulated firm is significantly less than that for other firms. On the signaling level, Filbeck and Hatfield show that the role of regulators confounds that of institutional investors in reducing information asymmetry.

34

deciding to pay out dividends. However, aggregate institutional ownership for U.S. firms in most

of these studies is obtained from Standard and Poor’s Stock Guide and includes banks, insurance

companies, mutual funds, corporate investors, pension and retirement funds, broker-dealers, and

other investment advisors. Of all these institutions, only corporate investors and pension and

retirement funds are considered in the low-tax or the tax-exempt group. The inclusion of taxable

institutions, most significant of which are mutual funds, makes aggregate institutional holdings

an imperfect proxy for low-tax and tax-exempt groups. In this study, I classify institutional

investors into different groups based on their tax characteristics. To better assess the viability of

the dividend clienteles hypothesis, and to specify the true sources of the identified relationships

(if any) between dividends and institutional ownership, I partition institutional investors by type

to better assess their preferences based on their tax requirements.

A 1978 amendment to the Securities Exchange Act of 1934 required all institutions with

greater than $100 million of securities under discretionary management to report their holdings

to the SEC. Holdings are reported quarterly on the SEC’s form 13-F. Under this filing,

institutions are classified into 5 types: banks and bank trust departments, insurance companies,

investment companies (mutual fund families), and investment advisors, and others (others

include public and corporate pension funds, university endowments and philanthropic

foundations) (Binay, 2005). I use 13-F filings as a more comprehensive source of data on

institutional ownership (obtained on a quarterly basis from the CDA Spectrum database provided

by Thomson Financial). Of the 474 net number of dividend initiators collected from CRSP,

institutional ownership data was available for only 230 of these firms in Thomson Database.6 To

avoid survivorship bias in my analysis, especially in tests of tax-law changes over time, I

manually searched for institutional ownership data for the remainder of these firms from the 6 Those firms have missing data in Thomson Database because they are no more active.

35

Standard and Poor’s Stock Guide, where I found data for 122 of the remaining dividend

initiators. The problem with this set of data is that, unlike Thomson Financial which provides a

detailed breakdown of ownership by type of institution, the S&P Stock Guide gives only

aggregate institutional ownership figures. I collect data on the number of owners and the

percentage of their ownership of the total shares outstanding for the calendar quarter preceding

the initiation date, and for one, two and three quarters after the initiation announcement.

4.1.2 The Matched-Sample Set

To perform the regression analysis on the relationship between changes in institutional

ownership and dividend initiations, I use a matched sample of non-dividend-paying firms. First, I

identify firms that have the same first two digits of the SIC as the dividend initiating firm that did

not pay any dividends during an interval that runs from 2.5 years before to one year after the end

of the month during which the dividend initiator announced its initiation of a dividend. I collect

15 possible matches per dividend initiator from Standard and Poor’s COMPUSTAT ® (North

America) based on the first two digits of the SIC and return on assets (ROA), in the fiscal year-

end preceding the dividend initiation announcement. The ROA matches fall in the range of 80%

to 120% of the ROA of the dividend initiating match. Out of the 15 matches per firm, the one

with the ROA closest to the dividend initiating firm that also has ownership data in Thomson 13-

F database is selected as the matching observation. Of the 230 original firms with detailed

ownership data from Thomson Database, I find matches for 115 of these in COMPUSTAT that

also have institutional ownership data in Thomson. For the 122 observations manually collected

from the S&P Stock Guide, I find 33 matches that fit the above criteria.

36

Both samples were finally filtered for firms with beginning institutional ownership no

greater than 70%.7 My final sample thus is comprised of 86 pairs of firms with detailed

institutional ownership data and 24 pairs with aggregate ownership measures.

4.2 Testing Hypothesis 1: The Change in Institutional Ownership in response to Dividend

Initiation Announcements

4.2.1 Initial tests

Following Dhaliwal et al (1999), I tested for any significant change in the number of

aggregate institutional owners as well as for the change in the percentage (of total shares

outstanding) of aggregate institutional ownership in the dividend initiating firm in response to

initiation announcements. I perform the same test on the change in ownership by type of

institution according to the above listed attributes. I measure the change in institutional

ownership in terms of both number of institutional holders (∆IO#) and as a percentage of shares

outstanding (∆IO%) for each dividend-initiating firm. Given that data on institutional ownership

is available from 13-F filings on a quarterly basis, I measured these changes from the end of the

quarter preceding the dividend initiation until the end of two and three quarters after the

initiation announcement.8

As initial testing of the relationships described in Hypothesis 1, I performed a t-test of the

hypothesis that the change in institutional ownership levels in response to dividend initiations is

greater than zero, a binomial z-test of the hypothesis that greater than 50% of the changes in

institutional ownership are positive, and a sign rank z-test of the hypothesis that the median

change in institutional ownership is greater than zero.

7 To allow for observable movement in ownership in response to the initiation announcement. 8 Dhaliwal et al. test the change over two intervals, the first running from one month before to 6 months after the dividend initiation, and the second running from one month before to one year after the initiation. They report the same results for both intervals.

37

4.2.2 Controlling for Omitted Variables

To test for the possibility that any results from the tests of the initial hypotheses are not

due to omitted time-dependent factors [Dhaliwal et al. (1999)], I estimate a regression that

controls for such factors while testing the relationship with institutional ownership of dividend

initiating firms against their non-dividend-paying matches.

Prior research has revealed an association between institutional ownership and the

following variables:

1. Size: Del Guerico (1996) finds that institutional managers tilt their investments towards

stocks with high S&P rankings, and that these in turn tend to be those of larger

companies as well as companies with high market-to-book ratios. Moreover, Gompers

and Metrick (2001) find a strong positive relation between aggregate institutional

ownership and size, as a proxy for liquidity. In line with both findings, I include size as

measured by market capitalization as a control variable. I expect a positive relationship

between size and institutional ownership.

2. Market-to-Book Ratio: As discussed above, high market-to-book ratios represent one

characteristic of stocks with high S&P rankings for which institutional investors exihibit

high preference (Del Guerico, 1996). Additionally, Lankonishok, Shleifer and Vishny

(1994) argue that there is an observable preference by both retail and institutional

investors for “glamour” stocks which they define as those with high market-to-book, low

earnings-to-price, low cash-flow-to-price, and high growth in sales. In light of these

findings, I include the market-to-book ratio as another variable that may influence

institutions’ investment targets. I expect a positive relationship between market-to-book

ratio and change in institutional ownership.

38

3. Liquidity: Del Guericio (1996) and Gompers and Metrick (2001) report a high preference

by institutional investors for liquidity as measured by share volume scaled by shares

outstanding. In line with the findings by both studies, I predict a positive sign on the

coefficient of turnover.

4. Momentum: Stocks exhibit momentum at intermediate horizons, where those earning

positive returns or experiencing positive earnings surprises over the last three to twelve

months outperform past losers over the next three to twelve months (Jegadeesh and

Titman (1993); Foster, Olsen and Shelvin, 1984). This is suggested to be a result of

investor underreaction or continued overreaction to stock related news (Barberis, Shleifer

and Vishny, 1998; Daniel, Hirshleifer and Subramaniam, 1998) or a form of

compensation for unspecified fundamental risk (Fama, 1998). A good number of studies

have concluded that a relationship exists between institutional trading and momentum

(Nofsinger and Sias, 1999; Lakonishock, Sleifer and Vishney, 1992; Cohen, 1998;

Cohen, Gompers and Vuolteenaho, 2001), where results mostly point to a positive

contemporaneous correlation between institutional buying and stock returns. This is

typically interpreted as evidence of institutional herding. Alternatively, Gompers and

Mertrick (2001) conclude that institutions are not momentum traders as they find that

after controlling for size, the current level of their ownership is negatively correlated with

the past three months’ as well as the past 12 months’ return. By looking at changes in

institutional ownership as opposed to levels of ownership, Burch and Swaminathan

(2001) find evidence supporting a positive correlation between institutional buying and

momentum. Due to data limitations, I use only the last three months’ momentum

preceding the dividend initiation date. As for the direction of the relationship, given the

39

conflicting findings of the above listed literature, the regression results determine whether

institutions are momentum traders or not.

The Model

(15)

Where,

iIO%Δ = The change in institutional ownership for firm i as a percent of shares outstanding for both dividend initiators and their non-dividend-paying counterparts [from Dhaliwal et al. 1999]

iDIVIN = a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is

not a dividend payer [from Dhaliwal et al. 1999; positive relationship expected]

iSIZE = Log of market capitalization for firm i at the fiscal year-end preceding the dividend initiation announcement [from Del Guerico1996 and Gompers and Metrick 2001; positive relationship expected]

iMTB = The market-to-book ratio for firm i at the end of the fiscal year-end preceding the year

during which the firm announced its initiation of a dividend [from DelGuerico1996 and Gompers and Metrick 2001; positive relationship expected]

iLIQ = Turnover of firm i’s shares measured as Log of volume divided by shares outstanding for

the month prior to the dividend initiation month [from Del Guerico1996 and Gompers and Metrick 2001; positive relationship expected]

iRET = Gross returns for the 3-months preceding the dividend initiation month [Gompers and

Metrick 2001; direction of the relationship is to be determined] 4.3 Testing hypothesis 2: The reaction to the Dividend Initiation Announcement by Type of

Institution – The Role of Firm Tax Characteristics

iiiiiii RETLIQMTBSIZEDIVINIO εαααααα ++++++=Δ 543210%

40

To test hypothesis 2, I repeat the above described tests after partitioning institutions by tax

characteristics:

1. Banks: not tax exempt

2. Insurance Companies: not tax exempt

3. Mutual funds and investment advisors: not tax exempt

4. Other Managers (Pension funds and university endowments: tax exempt)

If favorable tax treatment is an important factor in attracting institutions through dividends,

then the change in ownership in response to the dividend initiation announcement should be the

most significant for pension funds and university endowments.

4.3.1 Testing Hypothesis 3: The Effect of Tax Law Changes on the Institutional Investors’

Reactions to Dividend Initiations

In three instances between 1986 and 2003, there have been significant changes in the tax

law through three different tax acts affecting the tax differential between institutions and retail

investors:

1. The “Tax Reform Act of 1986” – enacted on 10/22/1986 – decreased the individual

marginal tax rate on dividend income to 38.5%, down from 50%. The full phase brought

this tax rate down to 28% by 1990 and back up to 31% by 1991.

2. The “Revenue Reconciliation Act” – enacted on 8/10/1993 – increased the individual

marginal tax rate up to 39.6%.

3. The “Jobs and Growth Tax Relief Reconciliation Act of 2003” – enacted on 5/23/2003 –

decreased the individual marginal tax rate on dividend income to 15%.

I add time-period dummy variables to the above model to partition different tax periods

based on the changes in the marginal tax rate on dividends introduced by the different tax reform

41

acts. I add one dummy variable that equals one if the observation falls in the period between

19879 and 1992 (TDUMM1), and a second dummy variable equaling 1 if the observation falls in

the period between 1993 and 2002 (TDUMM2). To specifically test the tax period effect for

those firms that initiate, I introduce two interaction terms (TDUMM1xDIVIN) and

((TDUNMM2xDIVIN), each of which equals 1 if both the dividend initiator dummy as well as

the tax period 1 and tax period 2 dummies equal 1, respectively. The model is defined as:

(16)

If the investor tax characteristics dominate the relationship between dividends and

institutional ownership in the manner described by ABW, the coefficient on the second dummy

variable should be more positive and significant than the coefficient on the first dummy variable,

while the first and the second interaction terms should be negative and positive, respectively.

The results as predicted by Hypothesis 3 can be interpreted according to following

summary:

9 The final sample with the matched pairs of dividend initiators and non-payers does not include any observations prior to 1986.

iI

iiii

DIVINTDUMMDIVINTDUMMTDUMMTDUMM

RETLIQMTBSIZEDIVINIO

εαααα

αααααα

+×+×++

++++++=Δ

2121 9876

543210%

42

4.4 Testing Hypotheses 4, 5 and 6: Explaining the Market Reaction to Dividend Initiation

Announcements: The Role of Institutional Ownership in the context of the Information and

Agency Hypotheses

To test these hypotheses, initially, I conduct a standard event study to estimate abnormal

returns to my sample of dividend initiating firms for the period 1987 to 2004. I then regress

abnormal returns on the level of institutional ownership using Weighted Least Squares

analysis, where the weight factor is the inverse of the variance of the ordinary least squares

residuals

After cleaning up the sample of any confounding event/announcements for the [-3,+3]

window centered at the dividend announcement date, I am left with a total of 98 observations

whose abnormal returns for the window [-1,+1] are calculated based on the Market Model

defined below and used for the subsequent WLS analysis that tests Hypotheses 4 through 6.

Table 20 provides the details of the daily and cumulative abnormal returns produced by the

market model.

4.5 Event Study Methodology: The Market Model

The return generating process for the two sample firms is derived from the single-index

market model:

JjTtRR jtmtjjjt ,...,1;,...,1 ==++= εβα (17)

where,

=jtR observed return to stock j at day t, =jα the intercept, =jβ the slope coefficient (a measure of systematic risk), =mtR observed return to the market index on day t, and =jtε the OLS-based disturbance term of firm j on day t.

43

The dividend-initiation announcement date is the designated event date, day 0, for each

stock j. The estimation period is defined as a 250-day non-event window starting on day -280

through day -31. Accordingly, any possible market adjustments prior to day -30 are not

examined. Equation (1) is estimated with ordinary least squares, and the abnormal return

(prediction error) for each day in the prediction interval is defined as follows:

mtjjtjtjt RRu βα ˆˆ −−= (18)

where, jα̂ and jβ̂ are the estimated OLS parameters from the estimation window, and

jtR and mtR are the observed security i and market returns, respectively, from the event window.

The market index on which the sample firms’ daily returns are regressed is the CRSP equally

weighted index.

Aggregate results are generated by calculating the cumulative prediction error (CPE) for

each security i as a sum of the prediction errors over the event window of interest [-t1,+t2]:

∑=

=2

1

t

ttjtj uCPE (19)

To test the null hypothesis of no abnormal performance, each CPEj is standardized as

follows:

)(/ jjj CPEVARCPESCPE = (20)

where VAR(CPEj) is the estimated variance of CPEj:

⎥⎥⎦

⎤

⎢⎢⎣

⎡

−

−++=∑ =

1

12

11

212

22

1222

2

)()(

)/(ˆ)( N

t mm

mmjj

RRRRN

NNNCPEVAR σ (21)

44

where,

=2ˆ jσ variance of OLS residuals, =1N number of days in estimation interval, =2N number of days in event interval, =1mR the mean of market return in estimation interval, and =2mR the mean of market return in event interval.

Consistent with Mikkelson and Partch (1988), the following Z test is employed for testing the

significance of the abnormal performance10:

∑=

=J

jj JSCPEZ

1/ (22)

4.4.1 Testing Hypothesis 4: The Relation Between Dividend Initiation Announcements and the

Level of Institutional Ownership in the Dividend Initiating Firm

The main measure of institutional ownership is total institutional ownership defined as

the number of shares held by institutional investors divided by the total number of shares

outstanding in the firm. It has also been documented in the literature that the role of institutional

investors is driven by the concentration of their ownership (Demstz and Lehn, 1985; Shleifer and

Vishney, 1986; Hartzell and Starks, 2003; Mello, Schlingemann and Subramaniam, 2003).

Hence, following Mello et al. (2003). I also use two measures of concentration of institutional

ownership in a firm, C5, which measures the total proportion of shares owned by the five

institutional investors with the largest holdings of the firm’s shares, and Herfindahl’s index

(Pham, Kalev and Steen, 2003), which is defined as the sum of squares of the proportions of the

firm’s shares held by institutional investors. 10 According to Karafiath and Spencer (1991), this test statistic, which is standard normal in the absence of abnormal performance has greater test power than other tests of abnormal performance.

45

∑=n

i iPH

1

2 , (23)

where, outstndingsharesTotal

kninstitutioofngsshareholdiPk =

Hypothesis 4 is tested by regressing the abnormal returns from the above event study on

the level and concentration of institutional ownership. In addition to ownership measures,

abnormal returns are regressed on two alternate proxies for information symmetry and two

alternate proxies for agency costs along with interaction terms that measure the impact of these

variables on the relationship between institutional ownership and the market reaction to dividend

increase/initiation announcements. The information asymmetry and agency cost variables serve

to differentiate between the signaling effect and the monitoring effect of the market reaction to

dividend announcement, while the interaction terms should shed light on whether the importance

of institutional ownership is driven by signaling concerns, agency concerns or both.

4.4.2 Testing Hypothesis 5: The Effect of the Firm’s Information Asymmetry Gap on the

Relationship between Institutional Ownership and the Market Reaction to Dividend Initiations.

4.4.2.1 Information Asymmetry Proxies

The signaling hypothesis assumes that managers have either better or more timely

information about the firm’s prospects than outside investors. This information asymmetry

causes the managers of “high-quality” firms to seek means of signaling their superior quality in a

reliable manner, and in a way that separates them from “low-quality firms.” In the current

framework, dividend initiations/increases represent the means by which managers can signal

their quality by indicating their willingness to attract institutional investors.

46

Since there is no direct measure for information asymmetry, several proxies have been

used in the literature to account for this variable. The most widely used proxies include firm size

(Atiase, 1985; Bamber, 1987; Frank and Goyal, 2003; Llorente, Michaely, Saar and Wang,

2002), analyst coverage (Hong, Lim and Stein, 2000) and bid-ask spread (Copeland and Galai,

1983; Venkatesh and Chiang, 1986; Lin, Pope, Ryan and Zarowin, 1995). Hong, et al. (2000)

show that holding all else equal, the more analysts covering the company, the more firm-specific

information is produced and the faster its transmittal. As for the bid-ask spread, market makers

widen those spreads when they suspect a high level of information asymmetry. For the purpose

of this study, both measures are used as alternative proxies for information asymmetry.

4.4.2.1.1 The Adverse Selection Component of the Bid-ask spread

There is extensive literature indicating that the bid-ask spread consists of three primary

components: an order processing component, an inventory component and an adverse selection

component (Copeland and Galai 1983; Venkatesh and Chiang 1986). Of the three components,

the adverse selection element of the spread compensates the market maker for transacting with

better-informed traders and increases with the degree of information asymmetry. One class of

models that attempt to extract the adverse selection component is based on a trade indicator

regression model (e.g. Lin, Sangar and Booth, 1995; and Madhaven, Richardson, and Roomans,

1997). This model is advocated by Clarke and Shastri (2000) who analyzed a number of

information asymmetry proxies used in the literature and concluded that these models yield

adverse selection components that are highly correlated with measures of insider trading. For the

purpose of the current study, I use the model of Lin et al (1995) defined as follows:

47

11 ++ +=− tttt ezQQ λ (24)

where,

2BidAskQt

+= , is the midpoint of the quote at time t,

tt Qpricez −= , is the effective half spread, and

λ reflects the adverse selection component.

Yearly regressions by firms are estimated using daily changes in the quotes to extract λ ,

which represents an annual measure of information asymmetry for a given firm. I expect a

positive relationship between abnormal returns to dividend initiations/increases and λ . Data for

this proxy was collected from the CRSP database.

4.4.2.1.1.1 The Interaction with Institutional Ownership

I assess the impact of the information asymmetry measures on the relationship between

institutional ownership and abnormal returns by using the interaction term, [Institutional

ownership x λ ]. The importance of institutional ownership is more pronounced in firms with

more information asymmetry, i.e. the marginal effect of institutional ownership on the market

reaction to dividend announcements is larger (more negative) when information asymmetry is

high. Thus the signaling hypothesis predicts the coefficient on this interaction term to be

significantly negative.

4.4.2.1.2 Analyst Coverage

Another common proxy for information asymmetry is the number of analysts following

the stock. Brennan and Subrahmanyam (1995) find that greater analyst coverage tends to reduce

adverse selection costs as measured by the inverse of market depth. Clarke and Shastri (2000)

found similar results. Finally, Ayers and Freeman (2003) conclude that prices of firms followed

48

by analysts incorporate future earnings earlier than the prices of other firms. In a more direct link

to this study, Ayers and Freeman report a similar effect for the level of institutional ownership

and conclude that each of those effects is incremental to the other. This lends support to the

information-signaling hypothesis which suggests that the effect of institutional ownership levels

on abnormal returns in response to dividend announcements becomes more and more important

the lesser the presence of other agents that reduce the information gap between insiders and

outsiders. I expect a negative relationship between abnormal returns and analyst coverage.

I use the number of analyst forecasts in the nine months preceding the initiation month as

the proxy for analyst coverage. I collect this information from the Institutional Brokers Estimate

System (I/B/E/S). The number of analyst forecasts is defined as the average number of analysts

for the months -12 through -4 relative to the announcement date. Of the 98 clean-sample firms,

55 had data on analyst forecasts.

4.4.2.1.2.1 The Interaction with Institutional Ownership

As a test of the presence of signaling effects, I assess the impact of this variable on the

relationship between institutional ownership and abnormal returns by using the interaction term,

[Institutional ownership x analyst coverage]. The importance of institutional ownership is

expected to be more pronounced in firms with less analysts following the stock, that is, the

marginal effect of institutional ownership on the market reaction to dividend announcements

proves stronger (more negative) when analyst coverage is low. Thus the signaling hypothesis

predicts the coefficient on this interaction term to be positive.

4.4.3 Testing Hypothesis 6: The Effect of the Firm’s Agency Problems on the Relationship

between Institutional Ownership and the Market Reaction to Dividend Initiations.

49

4.4.3.1 Proxies for Agency Costs of Equity

The agency hypothesis states that since decisions within firms are made by management,

conflicting interests between them (as agents) and the investors (as principals) may lead to

suboptimal allocation of resources. Some of the agency costs associated with this kind of

asymmetric information result from shirking by the agent, diversion of resources by the agent for

private consumption, differential time horizon of the agent and principal, and differential risk

aversion of the two {Jensen and Meckling, 1976; Lambert, 2001). Jensen relates the agency

problem directly to the ability of the firm to produce free cash flow (cash flow in excess of that

needed to fund positive NPV projects). Jensen explains that firms with limited investment

opportunities are especially prone to such agency costs, which he labels as the free cash flow

problem. Moreover, Jensen and Meckling (1976) show that incomplete monitoring provides

managers with incentives to expand the scale of the firm faster than is optimal. Accordingly, the

greater the potential for agency costs of equity, that is, the higher the overinvestment problem in

a given firm, the stronger the need for monitoring to mitigate it.

4.4.3.1.1 Free Cash Flow

Free cash flow is defined as the excess of the cash required to invest in positive-net-

present-value projects that is not paid out in dividends (Jensen 1986, 1989). Managers of firms

with low growth opportunities and/or firms with high FCF are expected to be involved in non-

value maximizing activities including an increase in perquisite consumption at the expense of

shareholders as well as the manipulation of accounting numbers (Jensen 1989; Shleifer and

Vishny 1989; Lang et al. 1991). This has made free cash flow a widely used proxy for the agency

costs of equity in the literature. I define free cash as follows:

100×−−−

ASTSQDIVTAXINTOIBD (25)

50

where,

OIBD = operating income before depreciation

INT = interest payments

TAX = tax payments

QDIV = quarterly dividend

ASTS = total assets

All variables are measured for the quarter end preceding the dividend initiation

announcement.

Lang et al. (1991) demonstrate how their test results do not change substantially when

alternate free cash flow measures are used. In Jensen’s agency framework, the higher the free

cash flow in a given firm, the higher the potential agency problems in that firm. In the context of

the agency explanation of dividend policy, this extends to a stronger impact of the dividend

payout on the share value. I therefore expect the coefficient on FCF to be positive and

significant.

4.4.3.1.1.1 The Interaction with Institutional Ownership

I measure the impact of free cash flow on the relationship between institutional

ownership and abnormal returns by using the interaction term, [Institutional ownership x FCF]

variable. I expect the importance of institutional ownership to be more pronounced in firms

where the agency costs associated with free cash flow are higher, that is, the relationship

between institutional ownership and abnormal returns is expected to be more negative for firms

with high agency costs. Thus, the agency hypothesis predicts the coefficient of the FCF

interaction term to be significantly negative.

51

4.4.3.1.2 Independent Board Directors

Rozeff (1982) was among the first to explicitly recognize the role of outsiders as one of

monitoring the managers. Later literature (Fama and Jensen 1983; Baghat, Brickley and Coles

1987; Gibbs 1993; Block 1999) argues that independent board directors, defined as board

members neither employed by nor affiliated with the company, are among the outsiders who help

promote the interests of shareholders. Their desire to maintain their “reputational” capital as well

as fear of stockholder lawsuits tends to ensure that they will properly monitor the actions of

management. Hermalin and Weisbach (1988) find that outside directors are more likely to be

appointed following poor stock performance. Furthermore, Brickley et al. (1987) and Byrd and

Hickman (1992) show that the presence of outside directors neutralizes the anticipated negative

market reaction to the adoption of poison pills and to acquisition announcements. Lin, Pope and

Young (2003) find that share prices respond more favorably to appointment announcements

when board ownership stands low. Similarly, Borokhovich et al. (2005) report significantly

lower abnormal returns to sizeable dividend increases when a majority of the board is strictly

outside directors. Based on this evidence, the number of outside directors is used as an

alternative proxy for monitoring that should mitigate the agency cost of equity. Under the agency

hypothesis, the higher the percentage of outside directors11 on the board, the stronger is the

monitoring, and the weaker is the market reaction to dividend increases. Accordingly, the agency

hypothesis predicts a negative relationship between abnormal returns to dividend announcements

and the number of outside directors. The data on the board composition is manually collected

from proxy statements accessed through Lexis-Nexus Academic (LNA) Database. Of the 98

clean-sample firms, 78 had data on independent directorship.

11 This measure is taken from Lin, Pope and Young (2003)

52

4.4.3.1.2.1 The Interaction with Institutional Ownership

I measure the impact of independent directorship on the relationship between institutional

ownership and abnormal returns by using the interaction term, [Institutional ownership x number

of independent directors]. I expect the role of institutional ownership to be less important in

firms with more independent directors on their board. This is backed by a study by Block (1999)

who finds evidence supporting the notion that institutional ownership and independent

directorship are substitute monitoring agents. Block finds that the higher the institutional

ownership, the more redundant the monitoring role of the outside director. Accordingly, the

importance of institutional ownership will be less pronounced in firms with more independent

directors, that is, the marginal effect of institutional ownership on the market reaction to dividend

announcements is stronger (more negative) when outside directorship is low. Therefore the

agency hypothesis predicts the coefficient of the interaction term to be positive.

4.4.4 Other Control Variables

Several variables have been shown in the literature to affect the market reaction to

dividend initiation announcements. In the current context, if certain types of firms are more

likely to initiate dividends, then initiations by such firms will be less surprising and generate a

lower market reaction in absolute terms. Such determinants include size, age, and market-to-

book12 ratio. To introduce some control for other determinants of market reaction to the dividend

initiation announcement, I include only one control variable – Market-to-book ratio—that is a

commonly utilized determinant of dividend payout policy, and is one of the most significant

determinants of abnormal returns around dividend initiations (Bulan et. al, 2007). This should

alao minimize the noise arising from the extent to which the potential control variables impose

12 It has been suggested in a recent paper by (Bulan et al., 2007) that dividend initiating firms have some distinct characteristics depending on their life cycle – for example, initiating firms are larger, more profitable, and have low growth opportunities as proxied by MTB.

53

some indogeneity concerns arising from their effect on some of the signaling and governance

attributes of a firm (e.g., larger firms tend to have lower information asymmetry than smaller

firms), In this context, higher MTB is associated with higher growth opportunities, and is

therefore expected to be negatively related to abnormal returns to dividend initiation

announcements.

The Joint F-test

When interaction terms are in an equation, the hypothesis that one explanatory variable

does not influence the dependent variable means that the coefficients of "all" the regressors

involving this variable are jointly equal to zero. This implies that the appropriate test of the

significance of institutional ownership on abnormal returns to dividend initiation announcements

is a joint test of the pairs of coefficients on IO and each of the information asymmetry and the

agency interaction terms.

The model

The following regression is estimated for the sample of dividend initiation

announcements. Separate regressions are estimated for percent institutional ownership,

concentration measured by C5, and concentration measured by H.

iiiii

iii

uproxyCostAgencyIOproxyAsymmetrynInformatioIOproxyCostAgencyproxyAsymmetrynInformatioIOABN

+×+×++++=

5%4

32%10

ββββββ (26)

where,

iABN = abnormal returns for the window [-1,+1] for firm i’s stock in response to the dividend initiation announcement.

%IO = institutional ownership for firm i at the end of the quarter preceding the announcement, measured as a percentage of total equity (this variable is replaced with concentration of ownership in a separate regression).

54

Information Asymmetry Proxies:

iλ = adverse selection component of bid-ask spread for firm i for the year preceding the announcement.

iANCOV = an alternative measure of information asymmetry, defined as the number of analyst

forecasts in the twelve months preceding the announcement month. Agency Cost Proxies:

=iFCF free cash flow in the quarter preceding the dividend initiation announcement (defined by equation 26 above)

iINDEPD = an alternate measure of agency costs defined as the number of independent directors

on the board of firm i in the year of the announcement. These are defined as the directors who are not current or former officers of the firm and who are not currently employed at an accounting firm, a commercial bank, an insurance company, an investment bank, a law firm, or a consulting firm providing services for the company.

The Joint-F test will test the significance of the combined coefficients on the institutional

ownership variable (IO) in the following version of model (26) above:

iiii

iii

uproxyCostAgencyIOproxyCostAgencyproxyAsymmetrynInformatioIOproxyAsymmetrynInformatioABN

+×+++++=

53

2%410 )(ββ

ββββ (26a)

iiii

iii

uproxyAsymmetrynInformatioIOproxyCostAgencyproxyAsymmetrynInformatioIOproxyCostAgencyABN

+×+++++=

43

2%510 )(ββ

ββββ (26b)

4.5 Testing Hypothesis 7: The Effect of Institutional Ownership on the Firm’s Propensity to

Increase Dividends

In testing this hypothesis, I follow the methodology of Fama and French (2001) who

studied the propensity of firms (and the change in this propensity over time) to pay dividends. In

the spirit of Fama and French, and to avoid any strong assumptions about the normality of the

distribution of the tested variables, I use the logit regression to analyze the propensity of the

firms to increase dividends given the level of institutional ownership in the firm. I define the

55

dependent variable as dichotomous in the dividend event. The outcome yi is whether company i

increases a dividend in the test period t (yi = 1) or not (yi = 0), where i indexes companies i =

1…N. This dependent variable is regressed on institutional ownership as a percentage of shares

outstanding for the year of the dividend increase.

4.5.1 The Control Variables

Fama and French (2001) analyze the propensity of firms to pay dividends over the period

1963-1998. They conclude that three factors, namely, profitability, investment opportunities, and

size are factors in the decision to pay or not to pay dividends. They find that dividend payers

tend to be large, profitable firms with earnings on the order of investment outlays. Finally, they

use the logit regression analysis to test the marginal effect of each of those factors on the

likelihood that a firm pays dividends.

Following Fama and French’s conclusions, the marginal effect of earnings and

investment opportunities (Fama and French, 2001) as well as size, are included as control

variables in the regression that tests the relationship between institutional ownership and the

propensity to increase dividends in light of the smoothing hypothesis suggested by ABW.

1. Profitability: Fama and French demonstrate that profitability is an important factor that

affects the likelihood that a firm is a former dividend payer. I use Return on Assets

(ROA) for the firm in the year of the dividend increase as a measure of a firm’s

profitability. Fama and French find that the higher the profitability, the more likely that

the firm will pay dividends. Accordingly, profitability as measured by ROA is expected to

have a positive effect on the propensity of a firm to increase dividends.

2. Growth Opportunities: High-growth firms with high investment opportunities are

expected to build slack to finance such investments by restricting dividends (Myers and

56

Majluf 1984; Myers 1984). Alternatively, stable firms with larger cash flows and fewer

projects tend to pay more of their earnings out as dividends. This conclusion is supported

by Fama and French (2001). The same relationship is expected to prevail in this model.

As a measure of growth opportunities, the Market-to-Book ratio (MTB) of a firm at the

fiscal year-end preceding the dividend increase announcement is expected to negatively

affect the decision to increase dividends. The agency hypothesis predicts that firms with a

low Market-to-Book ratio (i.e. those with low growth opportunities) are more likely to

increase dividends. Thus, the MTB variable is expected to have a negative coefficient in

this model.

3. Size: As discussed above, Fama and French (2001) report that dividend payout in general

is more important for larger firms. Kahle (2002) also notes that size is a proxy for

financing costs, and that smaller firms have weaker cash flows and higher financing costs

than larger firms. Therefore, smaller firms are more likely to be concerned with building

slack, and less likely to increase dividends. Therefore, the likelihood of dividend

increases is expected to be positively related to size of the firm, as measured by the log of

the firm’s market capitalization at the fiscal year-end preceding the dividend increase

announcement.

4. Industry Dummy Variables: Finally to control for differences across industries, industry

dummy variables13 (based on 2-digit GICS codes) will be included as interaction terms

with the institutional ownership variable. The optimal level of monitoring that affects a

firm’s dividend decisions as predicted by the agency hypothesis of ABW may differ

across industries. Kor, Watson and Mahoney (2005) highlight the differences in the

13 The industries are Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care and Information Technology.

57

effects of industry-specific uncertainties on the choice of different governance

mechanisms. A major conclusion of their empirical study is that the use of monitoring by

boards and institutional investors and the use of executive performance-based incentives

increase significantly with demand uncertainty and with competitive uncertainty in the

industry. Accordingly, I use industry dummy variables to control for any inter-industry

differences in monitoring needs, and their subsequent effect on the firms’ dividend

decisions.

Due to data constraints, namely, that on institutional ownership, I limit this test to one

year of data on dividend increase announcements. Institutional ownership data is usually readily

available on COMPUSTAT for the latest update of the database. The data for testing the

dividend increase hypothesis is thus limited to the period running from June 2005 to early 2007

(to be consistent with the institutional ownership data which, depending on the fiscal year of the

dividend increasing firm, may run anywhere from late 2005 to early 2007). The total number of

dividend increase announcements for this period is 1047. After removing financial firms and

utilities from the sample (consistent with the sampling methodology for the preceding

hypotheses), the final sample consists of 420 observations.

The model is defined as follows:

iiiiiiii uSECTORSECTORSIZEMTBROAIOy ++++++++= 61215432%10 ... βββββββ (27)

where,

iIO% = institutional ownership for firm i at the end of the quarter preceding the announcement, measured as a percentage of total equity.

iROA = profitability measure defined as earnings before interest divided by total assets for firm for the year of the increase (from Fama and French 2001).

58

iMTB = a measure of growth opportunities for firm i defined as the Market-to-Book ratio of firm i at the fiscal year-end preceding the dividend increase. (from Bulan et al. 2007.1).

iSIZE = log of market capitalization for firm i at the fiscal year-end preceding the dividend increase announcement.

iSECTOR = the industry dummy variable based on firm i’s 2-digit SIC.

59

CHAPTER 5

EMPIRICAL RESULTS

5.1 The Change in Institutional Ownership in Response to Dividend Initiation Announcements

The objective of the first part of this study is to retest the hypothesis that institutional

investors are truly attracted by dividends. This would set the base for the core analysis around

ABW’s theory, which is positioned entirely on this premise. Table 2 provides some descriptive

statistics of the original sample of dividend initiating firms, along with their matches. We can see

that the t-tests of the differences in means between the original firms and their matches show no

difference between the two samples in terms of Market Value of Equity, Total Assets, Return on

Assets, and Initial Institutional Ownership which amount to 32% and 31% for the original

sample and the matched sample, respectively. For this and the following tests in the first part of

this paper (specifically Hypotheses 1 and 3), I conduct similar tests on both the original sample

and on an expanded sample that includes the manually collected aggregate ownership data from

the S&P Stock Guide. For the descriptive statistics (Table 3), the expanded sample yielded very

similar results.

My initial tests on the response by institutional investors to dividend initiation

announcements are in line with those conducted by Dhaliwal et al. (1999). However, unlike their

aggregate institutional ownership data, I use detailed ownership numbers that are broken down

by type of institution. This allows for similar tests by type of institutional investor, and provides

better insight into the tax clientele effect on the hypothesized relationship between dividend

initiations and institutional ownership. As shown in Table 4, for the interval running from the

quarter preceding the dividend initiation to two quarters after, the mean increase in the number of

institutional owners in the dividend initiating firms is 10.6 (significant at the 1% level) where

60

77% of the firms show an increase in the number of institutions owning their stock. Those

numbers are 12 owners (significant at the 1% level) and 76% for the interval running from the

quarter preceding the initiation to three quarters after. The mean change in institutional

ownership as a percentage of shares outstanding two quarters after the initiation is 3.4%

(significant at the 0.01 level) where 67% of the firms show an increase in institutional

ownership. For three quarters after the initiation, the mean change in percent institutional

ownership is 4.71% (significant at the 0.01% level) with 73% of the sample firms showing an

increase in ownership. These results are similar for the expanded sample of dividend initiating

firms (Table 5).

To control for the effect of time-dependent factors such as the steady increase in

institutional ownership over the last 3 decades (Gompers and Metric, 2001), I conduct tests of

the difference in the mean change in institutional ownership as a result of the dividend initiation

between the original sample and the matched sample of non-dividend-paying firms. As reported

in Table 6, the mean difference in the change in the number of institutional owners between the

dividend initiators and the non-dividend payers two quarters after the initiation is a positive 6.6

institutional investors (significant at the 10% level). This difference is a positive 7.2 investors for

three quarters after the initiation (significant at the 10% level). The difference in the mean

change in institutional ownership as a percent of shares outstanding two quarters after the

initiation announcement is a positive 2.6% (significant at the 10% level). However, the most

significant difference in the change in institutional ownership between the dividend initiators and

their matches is observed in the difference in the percent institutional ownership over the interval

running from the quarter preceding the dividend initiation to three quarters after. For this

category, the difference in the mean change in percent institutional ownership between the two

61

groups is a positive 5.4% (significant at the 0.01% level). This result implies that the full

response to dividend initiation announcements by institutional investors takes three quarters to

take effect. This is not necessarily different from Dhaliwal et al’s (1999) results where the impact

appears to take 6 months to materialize. Unlike Dhaliwal et al. (1999) who use monthly

institutional ownership data, I use quarterly ownership data which means that for part of the

observations where the initiation is at the end of the quarter, the actual months between the

initiation date and the end of the third quarter may be only slightly over 6 months. These results

are similar for the expanded sample of dividend initiating firms (Table 7).

5.2 The Reaction to the Dividend Initiation Announcement by Type of Institution – The Role of

Firm Tax Characteristics

This section reports the post-initiation change in institutional ownership broken down by

type of institution. As argued in section 3.1 above, this hypothesis predicts that if investor tax

characteristics are the major determinant of the reaction by institutional holders to dividend

initiations, then we should see different reactions by the different types of institutions depending

on the extent to which each is tax favored relative to retail investors. This breakdown by tax

characteristics discussed in detail in section 4.2 above, predicts that the strongest reaction to

dividend-initiation announcements should be observed among the “Other Managers” category,

which includes public and corporate pension funds, university endowments, and philanthropic

foundations. Among all institution types, this is the most tax-favored. Consistent with

expectations, the most significant difference in the change in the number of institutional

shareholders between dividend initiators and their non-dividend-paying matches, is reported in

the “Other Managers” category (Table 11), in the percent of institutional ownership of shares

outstanding. The mean post-initiation change for this group three quarters after the initiation is a

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positive 4.68% (significant at the 0.01 level). No significant difference is reported for the

insurance companies and the investment companies. Banks, on the other hand, show an increase

in percent ownership that is significant albeit at a weaker level than the other managers. The

mean change for the banking institutions is 1.7% (significant at the 5% level). The significance

of the reaction in this category may be explained in the context of Prudent Man laws.14 Payment

of dividends is widely considered as a firm characteristic that is relevant in the determination of

prudence [McLaughlin, 1975; Black, 1976; Korshot, 1977; Badrinath et al., 1989; Brav and

Heaton,1998]. While banks are not a tax exempt group, they are considered among the most

constrained under prudent-man laws [Longstreth 1986; Del Guerico 1996]. This would lend

some merit to the significant result demonstrated by this category of investors, knowing that the

stronger response by the Other Managers group indicates that tax characteristics are a more

important determinant of institutional investors’ interest in dividend paying firms.

Formal test results of the significance of the reaction among Other Managers are reported

in Table 12. The stated test statistics represent t-tests of the difference in means between the

dividend initiators and the non-payers in the Other Managers group, tested against the same

results among each of the other groups of investors. As shown in Table 12, the results show that

14 Earlier research on institutional investment focused on the preference of these investors for dividend-paying stocks triggered by the passage of the Employee Retirement Security Act of 1974 (ERISA). Under these laws, the institutional managers, in their fiduciary capacity, are expected to behave in the manner of a prudent person. Badrinath et al. (1989) argue that institutional investors are motivated to concern themselves with investments that qualify as prudent by others “acting in a like capacity.” Accordingly, they define investments of choice by institutional managers that comply with a “safety-net potential” which represents a vector comprised of firm characteristics that are relevant in the determination of prudence. They define dividend history as one such criterion, and provided empirical evidence in support of this hypothesis. This notion was introduced earlier by Black (1976) who argues that investing in non-dividend-paying stock may be considered imprudent by certain portfolio managers. (Brav and Heaton (1998) also explain that “case law that approved the prudence of common stock investments often did so in language suggesting that prudent stock investments paid dividends.” This led to the belief that ERISA’s prudent-man rule would lead concerned institutional investors, such as pensions fund managers, to avoid non-dividend-paying stocks (McLaughlin 1975; Korshot 1977). In the context of the current hypothesis, institutional investors may be classified into different groups based on their tax characteristics as well as their subjection to “Prudent-Man Rule” restrictions. Universities and charities are among the tax-exempt institutions not subject to prudence or other restrictions. Banks, on the other hand, are not tax exempt, but are considered among the most constrained under prudent-man laws [Longstreth 1986; Del Guerico 1996.

63

the reaction among the Other Managers is significantly different from that for Banks, Insurance

Companies, and Investment Advisors (at significance levels of 0.01%, 0.01% and 10%,

respectively). This result is consistent with the hypothesis which predicts the weakest reaction

among other managers.

5.2.1 Controlling for other Determinants of Institutional Ownership:

Since the most significant change in institutional ownership for the dividend initiating

firms in comparison to their non-dividend-paying matches is observed in the third quarter after

the initiation, I base my regression analysis on this set of results. Therefore, I define the

dependent variable as the change in the percent institutional ownership of total shares from one

quarter before to three quarters after the initiation regressed on the dividend initiator dummy

variable, in addition to the control variables defined in section 4.2 above. Table 17 reports the

regression results. Consistent with Hypothesis 1, the coefficient on dividend initiator dummy

variable is positive and significant at the 0.01 level. On the other hand, except for the return

variable which is marginally significant (at the 10% level), all other control variables are not

significant, showing that they play no noteworthy effect in determining the post-initiation change

in institutional ownership. Those results are consistent for both the original as well as for the

expanded sample, and are also in line with Dhaliwal et al. (1999).

5.3 The Effect of Tax Law Changes on the Institutional Investors’ Reactions to Dividend

Initiations

This hypothesis is intended as an additional test of the importance of taxes in determining

institutional ownership. To test this hypothesis, I introduce tax-period dummy variables that

assign each observation to one of three tax periods based on its associated initiation date. These

64

time periods are discussed in detail in section 4.2 above. No significant results are produced by

this regression.

5.4 Explaining the Market Reaction to Dividend Initiation Announcements: The Role of

Institutional Ownership in the Context of the Information and Agency Hypotheses

These hypotheses test the association between institutional ownership and information

asymmetry and agency characteristics of the firms. The test performed for this purpose is an

indirect one that looks at the perceived role of institutions in mitigating information asymmetry

and agency problems. This is reflected in the market reaction to dividend initiation

announcements in association with the institutional ownership level of the initiating firm prior to

the dividend initiation announcement. The test is a weighted least squares regression of the

cumulative abnormal returns registered around the dividend initiation announcement on the

percent institutional ownership in the quarter preceding the initiation, λ (as an information

asymmetry proxy), Free Cash Flow (as a proxy for agency costs), and interaction of institutional

ownership and each of the asymmetry and agency proxies. Descriptive statistics associated with

each of the regression variables are presented in Table 21.

5.4.1 The WLS Regression Results

The WLS regression results are reported in Table 23. The left hand column in Table 23

reports the result of the univariate regression of the cumulative abnormal returns on the percent

institutional ownership (IO) prior to the initiation. As predicted by Hypothesis 4, the coefficient

on IO is negative and significant at the 5% level. This implies that the higher the institutional

ownership in a firm prior to its announcing a dividend initiation, the lower the abnormal returns

to initiation announcement. Whether this effect is explained by the information signaling

65

hypothesis or the agency hypothesis is addressed by the regression results on the right hand side

of Table 23.

The multivariate analysis results are outlined in Table 23. Regression 1 includes them as

independent variables, institutional ownership, market-to-book ratio, λ , and FCF. Regression 2

includes the same variables in addition to the interaction terms of IO with λ and FCF. As

evident from the results, Institutional ownership is still significant (with the correct sign at the

5% level) in explaining the cumulative abnormal returns to the stock of the dividend initiating

firm. However, no significant results are registered in this model for the information asymmetry

and agency cost measures. Although this may imply that when controlling for institutional

ownership, information asymmetry and agency costs are irrelevant in explaining the reaction to

dividend initiations by a firm, it has no implications as to the effect of the degree of information

asymmetry and/or agency problems on the relationship between IO and abnormal returns. To test

these particular relationships, we have to look at the interaction terms between IO and each of

the information asymmetry and the agency proxies. This is done in regression 2 in the rightmost

column of Table 23. By examining this set of results, we do see that none of the coefficients in

the model are significant. This, however, may be the result of high multicollinearity induced by

the interaction terms. On the other hand, a joint F-test of the coefficients on IO and each of the

interaction terms tell a different story. The F-test results show that taken together, IO and IOxλ

are significant (at the 5% level) in explaining the abnormal returns to dividend initiations, while

IO and IOxFCF combined are significant (at the 10% level) in explaining this market reaction.

The directions of the relationships as evident in the signs on the coefficients are in line with the

predictions of Hypotheses 4 through 6.

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Given these results, I perform an additional test on both hypotheses in an attempt to give

more insight into the validity of the above tested relationships (Table 24). For that purpose, I

combine the top 25 observations with the highest λ and the bottom 25 observations with the

lowestλ in one regression. Then, to test whether the negative relationship between ABN and IO

is stronger for the high-λ subsample, I regress ABN on IO, a λ dummy variable that takes the

value of one if the observation falls in the high-λsample and zero otherwise, and an interaction

term that combines both IO and the λ dummy variable. Then, I conduct a joint F-test on IO and

the interaction term to test for any significant results implying that the higher the λ , the stronger

is the relationship between ABN and IO. I repeat the same process for FCF in regression 2. The

results in Table 24 show high significance for the partitioned FCF model, and limited

significance for the partitioned λ model. In regression 2, IO as well as the IOxFCF dummy

variable are significant both individually (at the 5% level) as well as jointly (at 1%). As for

regression 1, IO and IOxλ are only jointly significant and only at the 10% level. These results,

therefore lend additional support to the agency explanation of the relationship between IO and

ABN. A weaker support is provided for the information asymmetry hypothesis.

5.4.2 Alternate Measures of Institutional Ownership

No significant results are registered when aggregate institutional ownership percentage is

replaced with the concentration measures (C5 and Herfandal index). I also find no significant

results when Analyst Coverage is used as an alternate measure to Information asymmetry and

when the FCF is replaced with the percentage of Independent Board Directors to proxy for the

agency cost of equity.

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5.4.3 Discussion

In analyzing the above discussed results from testing the signaling and the agency

hypotheses, there is marginally stronger support for the agency framework for explaining the

association between institutional ownership and a firm’s dividend policy. A recent study by

Bulan, Subramaniam and Tanlu (2007) also lends some support to this conclusion. When testing

the factors affecting dividend initiations, their results contradict the signaling theories of

dividend policy and “partially” support the agency hypothesis. More specifically, in the signaling

framework, they find no significant change in the profitability of dividend initiators in the three

years following the initiation as compared to non-payers. Under the agency hypothesis, they

observe a decline in capital expenditures that is more evident among firms with low growth

opportunities. It can therefore be concluded that the attained test results jointly point in the same

direction and in support of the signaling and the agency explanations of the relationship between

dividend payout and institutional investors.

5.5 The Effect of Institutional Ownership on the Propensity of Firms to Increase Dividends

The results presented in Table 27 fully support the smoothing hypothesis which suggests

that the higher the level of institutional ownership in a firm, the less likely that management will

be willing to incur the cost of increasing dividends.

The negative sign on the IO% coefficient (significant at 1%) implies that even after

controlling for other factors known to affect a firm’s dividend payout policies, the higher the

percent of institutional holdings in a firm, the lower is the propensity by the firm managers to

increase dividends. These results agree with the findings of Grinstein and Michaely (2005) who

find that institutions exhibit an aversion to high dividends, and rather prefer firms that pay lower

dividends. Grinstein and Michaely also conclude that neither institutional ownership nor

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concentration of institutions cause firms to increase payout. In the current context, and

specifically under the agency framework of ABW, this can be explained by the institutional

holders’ vigilance to prevent unnecessary costly payout when they assume their active role as

monitors. Under ABW’s signaling hypothesis, the effectiveness of the dividend initiation

decision at attracting institutions subsequent dividend increases will be less needed as a signaling

mechanism as the information asymmetry problem is mitigated with higher levels of institutional

ownership.

Table 27 also reveals a significant positive relationship between the propensity to

increase dividends and profitability measured by returns on assets (significant at the 10% level)

and the propensity for dividend increases by large firms measured by the log of market

capitalization (significant at the 0.01% level). On the other hand, growth opportunities proxied

by MTB do not seem to have any effect on the propensity for increasing payout and neither does

the industry type.

Evidently, the significant negative effect of institutional holdings even after controlling

for other important determinants of payout decisions lend good support to ABW’s smoothing

hypothesis, suggesting an aversion to unnecessary dividend increases whenever the marginal

benefit to the higher dividends no longer covers the cost of this increase. Yet, no conclusion can

be made from these results about whether this pattern is effectively explained under the signaling

hypothesis or the agency hypothesis of ABW. This serves as material for potential future

research.

69

CHAPTER 6

SUMMARY AND CONCLUDING REMARKS

I empirically test a theory on dividend payout policy developed by Allen, Bernardo and

Welch (2000) linking the firm’s dividend payout decisions to institutional ownership in both a

signaling and an agency framework. Unlike existing empirical research attempting to explain

dividend payout decisions directly under the traditional clienteles, signaling and agency theories,

this study focuses on the direct association between dividend payout, specifically dividend

initiations, and ownership by institutional investors, while explaining any observable

relationships in the context of signaling and agency costs. The value of this new approach at

examining dividend policy lies in building on ABW’s novel theory to take a closer look at

alternate motives behind payout decisions by managers, especially in light of the inconclusive

evidence by the immense volume of empirical research around this topic.

Under ABW’s theory, dividends are paid out to attract institutional investors, thereby

signaling good firm quality and/or raising expectations of more efficient monitoring by this

group of investors. This is the case, since institutional owners are considered sophisticated

investors with superior ability and stronger incentive to be informed about the firm quality

compared to the retail investors. On the agency level, institutional investors have displayed

monitoring capabilities, and can detect and correct managerial pitfalls, whose presence will serve

as an assurance that the firm will remain well run. My study provides a comprehensive analysis

of the implications of the theory by testing different aspects of the relationship between dividend

payout and institutional holdings, and the implications this relationship has on firm value.

Specifically, unlike the prevalent literature on institutional investment, I look at the different

types of institutional investors and their different incentives to invest in dividend-paying stock.

70

My initial testing aims at validating the hypothesized preference by institutions for

dividend-paying stocks. I specifically look at dividend initiations and examine any evidence of

increase in institutional ownership subsequent to the initiation announcements. I find that

institutional holdings in the dividend initiating firm, as a percentage of total shares outstanding,

increase in the two quarters following the initiation announcement. Among the different types of

institutions, the most tax-favored group represented by pension funds and university endowments

exhibits the strongest preference for dividends, which is explained by the tax clienteles

hypothesis.

In an attempt to shed some light on the role of institutional shareholders as perceived by

the market, the next part of my paper examines the market reaction to dividend initiation

announcements, where I find that the positive abnormal returns to initiations are a decreasing

function of the level of institutional ownership in the dividend-increasing firm. This finding

supports the hypothesis that higher institutional ownership in a firm is perceived by the market as

a favorable factor that contributes to firm value. This validates the implication by ABW that as a

favorable outcome to dividend initiations, increasing institutional ownership may well be at the

root of any dividend payout decision by the firm. Cross-sectional analysis that aims at explaining

the perceived role by institutions in adding to firm value within signaling and agency theories

yield some support for the signaling hypothesis and more so for the agency hypothesis. This is

evident by the significant results of joint F-tests of the effect of the level of institutional

ownership and the interaction of that variable with measures of information asymmetry on

abnormal returns to dividend initiation announcements, and similar tests combining institutional

ownership and agency costs. These results imply that the mitigating effect of higher institutional

ownership levels on the abnormal returns to dividend initiations becomes more important as the

71

information asymmetry gap widens and as the potential for agency problems increases, with

stronger evidence in favor of the latter. The evidence supporting these hypotheses lends some

degree of support to ABW’s theory of dividend policy, and makes ample room for further

research to disentangle the true relationships among all the relevant factors depicting this theory

and firms’ dividend policy.

Finally, tests of the smoothing hypothesis are also significant. This hypothesis

suggests that when the level of institutional shareholders is deemed high enough to perform the

signaling/agency role expected from them, firms will be concerned with retaining this investor

group which will push them to smooth dividends in a way that caters to the present institutional

investor base. It will also make them less likely to increase dividends and incur the dividend-tax

cost. As predicted by this hypothesis, the logit regression analysis reveals a significant negative

relationship between the level of institutional ownership and the propensity by the firm to

increase dividends.

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Table 1. Summary of Hypotheses

Hypotheses Methodology Literature Hypothesis 1: Institutional ownership levels in a given firm increase when the firm initiates a dividend.

T-test of the difference in the mean change. Binomial z-test. Sign rank z-test. OLS Regression

Analysis: Change in institutional ownership on dividend Initiation dummy variable plus

control variables

Allen, Bernardo and Welch

(2000) Dhaliwal et al. (1999) Del Guerico (1996)

Gompers & Metric (2001) Cohen (1998)

Hypothesis 2: Institutional ownership increases following dividend initiations are greater for tax-exempt institutions (universities charities and pension funds).

OLS Regressions Analysis:

Change in institutional ownership for each type on institution at a time, on dividend initiation dummy variable plus

control variables

Allen, Bernardo and Welch (2000)

Hypothesis 3: The increase in institutional ownership following dividend initiations is greater the larger the prevailing tax differential between institutional and retail investors.

OLS Regression Analysis: Change in on

dividend Initiation dummy variable plus control variables plus tax- period dummy

variables

Allen, Bernardo and Welch (2000)

Dhaliwal et al. (1999) Longstreth (1986)

Del Guerico (1996)

Hypothesis 4: The price reaction to unexpected dividend initiations is stronger (more positive) for lower levels of institutional ownership in the dividend-initiating firm prior to the dividend announcement.

Event Study – Market Model

Weighted Least Squares Regression Analysis: Abnormal returns to dividend initiation on

institutional ownership.

Mikkelson & Partch (1988) Mello et al.(2003) Pham et al.(2003)

73

Hypothesis 5: The inverse relationship between the price reaction to dividend initiation announcements and the level of institutional ownership is stronger for firms with more severe information asymmetry problems.

Weighted Least Squares Regression Analysis: Abnormal returns to dividend initiation on

institutional ownership plus information

asymmetry and agency cost proxies

Copeland & Galai (1983) Venkatesh & Chiang

(1986) Lin et al. (2000)

Brannan & Subramanyam (1995)

Hypothesis 6: The inverse relationship between the market reaction to dividend initiation announcements and the level of institutional ownership is stronger for firms with higher potential for agency problems.

Weighted Least Squares Regression Analysis: Abnormal returns to dividend initiation on

institutional ownership plus information

asymmetry and agency cost proxies. Joint F-Test.

Jensen & Meckling (1976) Perfect & Wiles (1994)

Barclay & Litzeneberger (1988)

Chung & Pruitt (1994) Fama & Jensen (1983)

Block (1999)

Hypothesis : The higher the level of institutional ownership in a given firm, the lower is the propensity by the firm to increase dividends.

Logit Regression Analysis:

The propensity to increase dividends on

institutional ownership plus control variables.

Fama & French (2001)

Dividend Initiators

Non-Dividend-Paying Matches

Dividend Initiators

Non-Dividend-Paying Matches

Dividend Initiators

Non-Dividend-Paying Matches

Dividend Initiators

Non-Dividend-Paying Matches

Sample Size 86 86 86 86 86 86 86 86

Mean 575 544 669 1,039 8.46 8.43 32% 31%

Median 130 102 180 124 6.59 6.50 28% 28%

Standard Deviation 1,882 1,120 1,788 4,654 8.62 8.47 19% 21%

t-test

Dividend Initiators and their Non-Dividend-Paying Matches

For the matched sample of non-dividend-paying firms, I identify firms that have the same first two digits of the SIC of the dividend initiating firm that did not pay any dividends during an interval that runs from 2.5 years before to one year after the end of the month during which the dividend initiator announced its initiation of a dividend. I collect 15 matches per dividend initiator from COMPUSTST based on the first two digits SIC, and Return On Assets (ROA) in the fiscal year-end preceding the dividend initiation announcement, that falls in the range of 80% to 120% of the ROA of it’s dividend initiating match. Both samples where finally filtered for firms with maximum beginning institutional ownership of 70%. The t-test is a test of difference in means between initiators and their matches; $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Return on Assets

Table 2. Descriptive Statistics - Original Sample

Initial Institutional Ownership

0.02-0.31 0.64 -0.29

Total AssetsMarket Value of Equity

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Dividend Initiators

Non-Dividend-Paying Matches

Dividend Initiators

Non-Dividend-Paying Matches

Dividend Initiators

Non-Dividend-Paying Matches

Dividend Initiators

Non-Dividend-Paying Matches

Sample Size 110 110 110 110 110 110 110 110

Mean550 447 618 821 7.86 7.82 32% 30%

Median130 92 181 115 6.41 6.40 27% 27%

Standard Deviation1,685 997 1,577 4,071 7.77 7.64 18% 20%

t-test

Table 3. Descriptive Statistics - Expanded Sample

Initial Institutional Ownership

-0.54-0.71 0.46 -0.44

Total AssetsMarket Value of Equity

Dividend Initiators and their Non-Dividend-Paying Matches

For the matched sample of non-dividend-paying firms, I identify firms that have the same first two digits of the SIC of the dividend initiating firm that did not pay any dividends during an interval that runs from 2.5 years before to one year after the end of the month during which the dividend initiator announced its initiation of a dividend. I collect 15 matches per dividend initiator from COMPUSTST based on the first two digits SIC, and Return On Assets (ROA) in the fiscal year-end preceding the dividend initiation announcement, that falls in the range of 80% to 120% of the ROA of it’s dividend initiating match. Both samples where finally filtered for firms with maximum beginning institutional ownership of 70%. The t-test is a test of difference in means between initiators and their matches; $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Return on Assets

75

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 86 86 86 86

Mean 10.60 3.41% 12.00 4.71%

Median 4.00 1.37% 4.00 2.07%

Standard Deviation 31.34 9.87% 33.80 10.02%

t-Statistic 3.14 ** 3.21 ** 3.29 ** 4.36 ***

Percent Positive 76.70% 67.40% 75.60% 73.20%

Binomial z-test <.0001 *** <.0001 *** <.0001 *** <.0001 ***

Sign rank z-statistic <.0001 *** <.0001 *** <.0001 *** <.0001 ***

Table 4. Tests of the Mean Change in Institutional Ownership in Response to Dividend Initiations - Original Sample

∆IO # is the change in the number of institutional owners; ∆IO % is the change in the percentage of shares owned by institutions to the total shares outstanding. The t-statistic reports the paired t-statistic associated with the alternative hypothesis that the difference in the mean change in institutional ownership for the period running from one quarter before to two quarters after, and from one quarter before to three quarters after the dividend initiation is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of the differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median change in ownership is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Two Quarters after Initiation Three Quarters after Initiation

76

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 110 110 110 110

Mean 10.62 3.61% 10.62 4.82%

Median 4.00 1.55% 4.00 2.22%

Standard Deviation 31.18 9.15% 31.18 9.40%

t-Statistic 3.57 ** 4.14 *** 3.57 ** 5.37 ***

Percent Positive 74.50% 73.60% 72.70% 77.30%

Binomial z-test <.0001 *** <.0001 *** <.0001 *** <.0001 ***

Sign rank z-statistic <.0001 *** <.0001 *** <.0001 *** <.0001 ***

Table 5. Tests of the Mean Change in Institutional Ownership in Response to Dividend Initiations - Expanded Sample

∆IO # is the change in the number of institutional owners; ∆IO % is the change in the percentage of shares owned by institutions to the total shares outstanding. The t-statistic reports the paired t-statistic associated with the alternative hypothesis that the difference in the mean change in institutional ownership for the period running from one quarter before to two quarters after, and from one quarter before to three quarters after the dividend initiation is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of the differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median change in ownership is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Two Quarters after Initiation Three Quarters after Initiation

77

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 86 86 86 86

Mean 6.55 2.62% 7.24 5.37%

Median 2.00 1.13% 4.00 3.87%

Standard Deviation 34.14 12.85% 39.94 14.60%

t-Statistic 1.78 $ 1.89 $ 1.68 $ 3.41 **

Percent Positive 64.29% 57.14% 66.67% 61.90%

Binomial z-test 0.0152 * 0.1928 0.0010 *** 0.0503 $

Sign rank z-statistic 0.0711 $ 0.0670 $ 0.0040 ** 0.0004 **

Table 6. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches

Original Sample

Two Quarters after Initiation Three Quarters after Initiation

∆IO # is the change in the number of institutional owners; ∆IO % is the change in the percentage of shares owned by institutions to the total shares outstanding. The t-statistic is a test of the difference in means associated with the alternative hypothesis that the difference in the mean change in institutional ownership between the dividend initiating firms and their non-dividend-paying matches is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of these differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median difference is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

78

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 110 110 110 110

Mean 5.40 2.60% 6.10 4.86%

Median 2.00 1.35% 4.00 3.54%

Standard Deviation 31.01 11.89% 37.12 13.86%

t-Statistic 1.83 $ 2.31 * 1.72 $ 3.69 **

Percent Positive 62.96% 57.14% 64.81% 61.90%

Binomial z-test 0.0148 * 0.0696 $ 0.0014 ** 0.0167 *

Sign rank z-statistic 0.0984 $ 0.0207 * 0.0108 * 0.0002 **

∆IO # is the change in the number of institutional owners; ∆IO % is the change in the percentage of shares owned by institutions to the total shares outstanding. The t-statistic is a test of the difference in means associated with the alternative hypothesis that the difference in the mean change in institutional ownership between the dividend initiating firms and their non-dividend-paying matches is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of these differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median difference is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Table 7. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches -

Expanded Sample

Two Quarters after Initiation Three Quarters after Initiation

79

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 86 86 86 86

Mean 1.83 1.61% 0.77 1.70%

Median 1.00 0.00% 0.50 0.21%

Standard Deviation 7.67 7.69% 16.09 7.04%

t-Statistic 2.21 * 1.94 $ 0.44 2.22 *

Percent Positive 52.33% 50.00% 48.84% 55.81%

Binomial z-test 0.0444 * 0.9142 0.3019 0.3261

Sign rank z-statistic 0.0351 * 0.5540 0.0914 $ 0.0541 $

Table 8. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches -

Banks

Two Quarters after Initiation Three Quarters after Initiation

∆IO # is the change in the number of institutional owners classified as Banks; ∆IO % is the change in the percentage of shares owned by these institutions to the total shares outstanding. The t-statistic is a test of the difference in means associated with the alternative hypothesis that the difference in the mean change in institutional ownership between the dividend initiating firms and their non-dividend-paying matches is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of these differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median difference is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

80

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 86 86 86 86

Mean 0.50 1.02% 0.97 1.39%

Median 0.00 0.00% 0.00 0.00%

Standard Deviation 2.95 7.42% 3.56 7.21%

t-Statistic 1.57 1.28 2.51 * 1.78 $

Percent Positive 36.05% 44.19% 41.86% 50.00%

Binomial z-test 0.5966 1.0000 0.0163 * 0.4397

Sign rank z-statistic 0.2451 0.5404 0.0126 * 0.0566 $

Two Quarters after Initiation Three Quarters after Initiation

Table 9. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches -

Insurance Companies ∆IO # is the change in the number of institutional owners classified as Insurance Companies; ∆IO % is the change in the percentage of shares owned by these institutions to the total shares outstanding. The t-statistic is a test of the difference in means associated with the alternative hypothesis that the difference in the mean change in institutional ownership between the dividend initiating firms and their non-dividend-paying matches is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of these differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median difference is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

81

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 86 85 86 86

Mean 1.06 1.68% 1.06 1.35%

Median 1.00 0.08% 1.00 0.37%

Standard Deviation 14.05 17.32% 14.05 14.37%

t-Statistic 1.14 0.90 1.14 0.86

Percent Positive 55.81% 61.63% 53.49% 55.81%

Binomial z-test 0.0000 *** 0.3857 0.0000 *** 0.2723

Sign rank z-statistic 0.0000 *** 0.5072 0.0000 *** 0.1350

Table 10. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches -

Investment Advisors ∆IO # is the change in the number of institutional owners classified as Investment Advisors; ∆IO % is the change in the percentage of shares owned by these institutions to the total shares outstanding. The t-statistic is a test of the difference in means associated with the alternative hypothesis that the difference in the mean change in institutional ownership between the dividend initiating firms and their non-dividend-paying matches is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50% of these differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median difference is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Three Quarters after InitiationTwo Quarters after Initiation

82

∆IO # ∆IO % ∆IO # ∆IO %

Sample Size 86 86 86 86

Mean 0.44 -4.25% 0.44 4.68%

Median 0.00 0.18% 0.00 0.59%

Standard Deviation 19.99 110.91% 19.99 10.35%

t-Statistic 0.20 -0.36 0.20 4.12 ***

Percent Positive 45.35% 50.00% 63.95% 65.12%

Binomial z-test 0.3356 0.0004 *** 0.3356 <.0001 ***

Sign rank z-statistic 0.3783 <.0001 *** 0.3783 <.0001 ***

Two Quarters after Initiation Three Quarters after Initiation

Table 11. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches -

Other Managers ∆IO# is the change in the number of institutional owners classified as Other Managers; ∆IO% is the change in the percentage of shares owned by institutions to the total shares outstanding. The t-statistic is a test of the difference in means associated with the alternative hypothesis that the difference in the mean change in ownership between the dividend initiating firms and their non-dividend-paying matches is greater than zero. The "Percent Positive" represents the percentage of positive differences in the change in ownership between the dividend initiating firms and their non-dividend-paying matches. The binomial z-test reports the p-value associated with the alternative hypothesis that greater than 50%of the differences are positive. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median difference is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

83

Sample Size 86 86 86

Mean 0.036 0.037 0.031

Median 0.010 0.003 0.003

Standard Deviation 0.091 0.089 0.153

t-Statistic 3.531 ** 3.707 ** 1.823 $

Binomial z-test 0.074 $ 0.002 ** 0.310

Sign rank z-statistic 0.003 ** <0.0001 *** 0.260

Table 12. Tests of the Difference in the Mean Change in Institutional Ownership Between Dividend Initiating Firms and their Non-Dividend Paying Matches - Other Managers versus Banks,

Insurance companies and Investment Advisors

The test statistics represent t-tests of the difference in the mean difference between the dividend initiators and their non-dividend-paying matches in the change in ownership of the Other managers group versus each of the other three groups of investors. Those results are tested for the percent change in IO three quarters after the initiation. The sign rank z-test reports the p-value associated with the alternative hypothesis that the median change in ownership is positive. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Other Managers vs.Banks

Other Managers vs.Insurance companies

Other Managers vs.Investment Advisors

84

Mean Median Minimum MaximumStandard Deviation

∆IO % 6.95 2.00 -25.00 187 24.02

MKTCAP 11.81 11.70 6.94 16.55 1.57

MTB 1.38 1.28 0.16 3.75 0.78

LIQ -6.14 -5.91 -10.86 -1.47 1.32

RET 0.15 0.11 -0.75 1.43 0.34

Number of observations: 140

Table 13. Change in Institutional Ownership Regression VariablesDescriptive Statistics - Original Sample

The dependent variable ∆IO# is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quaters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month.

85

Mean Median Minimum MaximumStandard Deviation

∆IO % 6.33 2.00 -25.00 187 23.11

MKTCAP 11.75 11.65 6.94 16.55 1.54

MTB 1.47 1.28 0.16 4.89 0.92

LIQ -6.12 -5.90 -10.86 -1.47 1.31

RET 0.13 0.10 -0.75 1.43 0.33

Total Number of observations: 186

The dependent variable ∆IO % is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quarters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month.

Table 14. Change in Institutional Ownership Regression VariablesDescriptive Statistics - Expanded Sample

86

∆IO % DIVIN CAP MTB TURN RET

∆IO % 1.0000

DIVIN 0.2922 1.00000.0005 ***

SIZE 0.0955 0.0563 1.00000.2619 0.5085

MTB 0.0508 -0.0891 0.2945 1.00000.5508 0.2954 0.0004 **

LIQ -0.0063 -0.2408 0.0939 0.1403 1.00000.9410 0.0042 ** 0.2700 0.0983 $

RET 0.1542 0.0733 $ -0.0184 -0.1558 -0.0099 1.00000.0690 $ 0.3898 0.8288 0.0660 $ 0.9076

Table 15. Change in Institutional Ownership Regression VariablesCorrelation Analysis - Original Sample

The dependent variable ∆IO % is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quarters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

87

∆IO % DIVIN CAP MTB TURN RET

∆IO % 1.0000

DIVIN 0.2784 1.00000.0001 ***

CAP 0.1207 0.1355 1.00000.0999 $ 0.0645 $

MTB 0.1198 0.0270 0.3135 1.00000.1025 0.7140 <.0001 ***

TURN 0.0373 -0.1948 0.1526 0.1498 1.00000.6126 0.0076 * 0.0371 ** 0.0408 *

RET 0.1403 0.1183 0.0178 -0.1465 -0.0339 1.00000.0554 $ 0.1067 0.8092 0.0454 * 0.6451

Table 16. Change in Institutional Ownership Regression VariablesCorrelation Analysis - Expanded Sample

The dependent variable ∆IO % is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quarters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

88

Predicted Sign Coefficient

INTERCEPT -0.05259 -0.670

DIVIN + 0.060863.510 **

MKTCAP + 0.00391 0.660

MTB + 0.00903 0.890

LIQ + 0.00401 0.610

RET n/d 0.043711.740 $

Number of observations: 140

Model R 2 0.1185

Table 17. Change in Institutional Ownership Regression Analysis Regression Analysis - Controlling for Other Determinants of Change

in Institutional OwnershipOriginal Sample

The dependent variable ∆IO % is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quarters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

iiiiiii RETLIQMTBSIZEDIVINIO εαααααα ++++++=Δ 543210%

89

Predicted Sign

Intercept -0.025 -0.370

DIVIN + 0.051933.660 **

MKTCAP + 0.00291 0.570

MTB + 0.01144 1.430

LIQ + 0.0053 1.000

RET n/d 0.03651.740 $

Number of Observations 186Model R 2 0.1134

Coefficientt_Test

Table 18. Change in Institutional Ownership Regression Analysis Regression Analysis - Controlling for Other Determinants of Change

in Institutional OwnershipExpanded Sample

The dependent variable ∆IO % is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quarters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month. $, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

iiiiiii RETLIQMTBSIZEDIVINIO εαααααα ++++++=Δ 543210%

90

Mean Minimum Maximum Predicted Sign

Intercept 0.002 0.020

DIVIN + 0.0722.000 *

SIZE + 0.003 0.670

MTB + 0.008 1.520

LIQ + 0.007 1.380

RET n/d 0.031 1.490

TDUMM1 0.290 0.000 1.000 - 0.014 0.440

TDUMM2 0.575 0.000 1.000 - -0.037 -1.280

TDUMM1xDIVIN + -0.068 -1.550

TDUMM2xDIVIN - 0.002 0.050

Joint F-TestDIVIN _ TDUMM1xDIVIN 2.020DIVIN _ TDUMM2xDIVIN 10.160 ***

Number of Observations 186Model R 2

Coefficientt-Test

0.1529

Table 19. Change in Institutional Ownership Regression Analysis Controlling for Other Determinants of Change in Institutional Ownership: With Tax-Period

Dummy VariablesExpanded Sample

The dependent variable ∆IO % is the change in institutional ownership as a percent of shares outstanding for the period running from one quarter before to three quarters after the dividend initiation for both dividend initiators and their non-dividend-paying counterparts; DIVIN is a dummy variable that equals 1 if the firm is a dividend initiator, and zero if the firm is not a dividend payer; SIZE is the Log of market capitalization at the fiscal year-end preceding the dividend initiation announcement; MTB is the market-to-book ratio at the end of the fiscal year-end preceding the year during which the firm announced its initiation of a dividend; LIQ is the turnover of shares measured as Log of volume divided by shares outstanding for the month prior to the dividend initiation month; and RET is the gross return for the 3-months preceding the dividend initiation month; TDUMM1 is a dummy variable that equals 1 id the observation falls in the period between 1987 and 1992; TDUMM2 is a dummy variable that equals 1 if the period falls in the period between 1993 and 2002.$, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

iI

iiii

DIVINTDUMMDIVINTDUMMTDUMMTDUMM

RETLIQMTBSIZEDIVINIO

εαααα

αααααα

+×+×++

++++++=Δ

2121 9876

543210%

91

Day Number of Observations Mean Abnormal Return Z-test Generalized z

Sign

(-2,2) 98 2.12% 1.266 47 : 51 -0.404

(-1,0) 98 0.77% 1.711 $ 54 : 44 1.010

(0,+1) 98 2.25% 3.344*** 53 : 45 0.808

(-1,1) 98 3.02% 3.550*** 53 : 45 0.808

$, *, ** and *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Positive:Negative

Table 20. Event Study: Mean Abnormal Returns in Response to the Dividend Initiation Announcement

Using the Equally Weighted Market Index

92

Number of Observations Mean Median Minimum Maximum

Standard Deviation

ABN 71 0.0117 0.0095 -0.0991 0.0993 0.0413

IO % 72 36% 29% 0% 91% 27%

MTB 69 1.38 1.23 0.00 3.96 0.89

70 0.46 0.47 -0.77 1.25 0.36

FCF 67 -0.41 0.07 -8.83 6.68 3.50

Table 21. Weighted Least Squares Regression VariablesDescriptive Statistics

λ

93

ABN IO LAMBDA FCF MTB IO_LAMBDA IO_FCFABN 1

IO % -0.28405 10.0164 *

LAMBDA 0.04588 0.30502 10.7081 0.0102 *

FCF -0.12604 -0.02441 -0.38866 10.3095 0.8446 0.0013 **

MTB 0.06883 -0.11214 -0.06467 0.09667 10.5742 0.3554 0.6003 0.4437

IO_LAMBDA -0.12629 0.68109 0.79307 -0.23076 -0.06722 10.2975 <.0001 *** <.0001 *** 0.0603 $ 0.5832

IO_FCF -0.21061 -0.01002 -0.29962 0.80388 0.03784 -0.24031 10.0801 $ 0.9339 0.0117 * <.0001 *** 0.757 0.0435 *

Table 22. Regression Variables - Correlation Analysis

The independent variable, ABN represents the cumulative abnormal returns for the window [-1,+1] on a firm's stock in response to the dividend initiation announcement; IO % is the institutional ownership as a percent of shares outstanding at the end of the quarter preceding the initiation announcement. "Lambda" is the adverse selection component of the bid-ask spread for the year preceding the announcement. FCF is the free cash flow defined as the excess over the cash required to invest in positive-net-present-value projects and that is not paid out in dividends, scaled by total assets in the quarter preceding the dividend initiation date. The weight is the inverse of the variance of the abnormal returns. *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

94

Predicted Sign

1 1 2

INTERCEPT 0.02819 0.02132 0.00636

3.56 ** 1.5800 0.3500

IO % - -0.04804 -0.04722 -0.02275

-2.86 ** -2.4700 * -0.7400

MTB - 0.0016 0.0043

0.2600 0.6900

+ 0.0069 0.0356

0.4600 1.1700

FCF + -0.0014 0.0036

-0.7800 1.1000

IO x - -0.0616

-1.1300

IO x FCF - -0.0116

-1.7700

Number of Observations 64 64Adjusted R2 0.0464 0.0657

Joint F-Test

IO _ IO x 4.100 *

IO _ IO x FCF 2.570 $

Table 23. Weighted Least Squares Regression Analysis

Multivariate AnalysisUnivariate Analysis

The independent variable, ABN represents the cumulative abnormal returns for the window [-1,+1] on a firm's stock in response to the dividend initiation announcement; IO % is the institutional ownership as a percent of shares outstanding at the end of the quarter preceding the initiation announcement. "Lambda" is the adverse selection component of the bid-ask spread for the year preceding the announcement. FCF is the free cash flow defined as the excess over the cash required to invest in positive-net-present-value projects and that is not paid out in dividends, scaled by total assets in the quarter preceding the dividend initiation date. The weight is the inverse of the variance of the abnormal returns. *** refer to significance at the 10%, 5%, 1% and 0.1% levels respectively.

Coefficientt-Test

λ

λ

λ

iiiiiiii uFCFIOIOFCFIOABN +×+×++++= %5%432%10 βλββλβββ

95

Regreggion 1:Regression 2:

Predicted Sign Regression 1 Regression 2

INTERCEPT 0.017 0.0241.500 1.830 *

IO % - -0.031 -0.018-1.160 -0.670

HIGH- DUMMY + 0.0261.360

IO x HIGH- DUMMY - -0.021-0.540

HIGH-FCF DUMMY + 0.0160.860

IO x HIGH-FCF DUMMY - -0.092-2.290 *

Joint F-Test 2.510 $ 6.890 **

Number of Observations 50 50Model R 2 0.059 0.297

Table 24. Partitioning the Sample by Highest versus Lowest Information Asymmetry and Agency Costs

For regression 1, I combine the top 25 observations with the highest Lambda and the bottom 25 observations with the lowest Lambda in one regression. Then, to test whether the negative relationship between ABN and IO % , is stronger for the higher "Lambda" subsample, I regress ABN on IO % , a "Lambda" dummy variable that takes the value of one if the observation falls in the high Lambda sample and zero otherwise, and an interaction term that combines both IO % , and the "Lambda" dummy variable. Then I conduct a joint F-test on IO % , and the interaction term to test for any significant results that support the hypothesis that the higher the "Lambda", the stronger is the relationship between ABN and IO % , I repeat the same process for FCF in regression 2.

Coefficientt-Test

λ

λ

iiiii uDUMMYIODUMMYIOABN +×+++= ,%4,2%10 λλ ββββ

iiFCFiiFCFi uDUMMYIODUMMYIOABN +×+++= ,%5,3%10 ββββ

96

Mean Median Minimum MaximumStandard Deviation

y i 0.64 1.00 0.00 1 0.48

∆IO % 64.54 70.29 0.00 99.8 23.06

ROA 2.42 2.38 0.34 4.00 0.85

MTB 11.28 10.27 -1.06 47.72 5.46

MCAP 3.18 3.16 1.27 5.59 0.79

SECTOR n/a n/a n/a n/a n/a

Number of observations: 420

Table 25. Logit Regression Variables - Descriptive Statistics

The dependent variable, y i takes the value of one if the firm increases its dividends in the test period, and zero otherwise. IO % is the institutional ownership as a percent of shares outstanding at the end of the quarter preceding the announcement; ROA is a profitability measure defined as earnings before interest divided by total assets for the year of the dividend increase; MTB a measure of growth opportunities defined as the Market-to-Book ratio at the fiscal year-end preceding the dividend increase; SIZE is defined as the log of market capitalization for firm i at the fiscal year-end preceding the dividend increase announcement; SECTOR is the industry dummy variable based on the firm i’s 2-digit SIC.

97

DIVIN ∆IO % MTB ROA SIZE

DIVIN 1.0000

∆IO % -0.0408 1.00000.4048

MTB 0.1779 0.0292 1.00000.0002 ** 0.5505

ROA 0.1484 0.0056 0.3988 1.00000.0023 ** 0.9096 <.0001 ***

SIZE 0.2174 0.3806 0.2278 0.1529 1.0000<.0001 *** <.0001 *** <.0001 *** 0.0017 **

Table 26. Logit Regression Variables - Correlation Analysis

The dependent variable, y i takes the value of one if the firm increases its dividends in the test period, and zero otherwise. IO % is the institutional ownership as a percent of shares outstanding at the end of the quarter preceding the announcement; ROA is a profitability measure defined as earnings before interest divided by total assets for the year of the dividend increase; MTB a measure of growth opportunities defined as the Market-to-Book ratio at the fiscal year-end preceding the dividend increase; SIZE is defined as the log of market capitalization for firm i at the fiscal year-end preceding the dividend increase announcement; SECTOR is the industry dummy variable based on the firm i’s 2-digit SIC.

98

Predicted Sign

Intercept -0.67330.000

IO % - -0.0143

7.127 **

MTB - 0.21842.224

ROA + 0.04233.133 $

SIZE + 0.773220.024 ***

SECTOR n/aJoint 9.396

Number of observations: 420

Measures of Fit:

Likelihood Ratio 48.873 ***

Score 45.43 ***

Wald 40.47 ***

Table 27. Logit Regression Analysis - Controlling for Other Determinants of Dividend Increase Decisions by Firms

The dependent variable, y i takes the value of one if the firm increases its dividends in the test period, and zero otherwise. IO % is the institutional ownership as a percent of shares outstanding at the end of the quarter preceding the announcement; ROA is a profitability measure defined as earnings before interest divided by total assets for the year of the dividend increase; MTB a measure of growth opportunities defined as the Market-to-Book ratio at the fiscal year-end preceding the dividend increase; SIZE is defined as the log of market capitalization for firm i at the fiscal year-end preceding the dividend increase announcement; SECTOR is the industry dummy variable based on the firm i’s 2-digit SIC.

CoefficientWald Chi-Square

iiiiiiii uSECTORSECTORSIZEMTBROAIOy ++++++++= 61215432%10 ... βββββββ

99

100

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