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Review of Quantitative Finance and Accounting

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01-02-2011 | Original Research

Managerial entrenchment and the value of dividends

Author: Woo-Jong Lee

Published in: Review of Quantitative Finance and Accounting | Issue 2/2011

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Abstract

This study examines the effects of takeover defenses on the value implication of dividends. Using the framework of Fama and French in J Finance 53(3): 819–843 (1998), the paper shows that dividends paid by managers with strong managerial power resulting from takeover protection measures are more valued in the stock market. The results are consistent with the hypothesis of the agency costs of free cash flow built on by Jensen in Am Econ Rev 76(2): 323–329 (1986) in the sense that dividends are important to determine firm value by reducing the free cash flow that would otherwise be deployed for private benefits by entrenched managers. This paper also examines whether the incremental value effect of dividends in entrenched firms is attributable to a numerator effect (changes in the future cash flow) or a denominator effect (changes in the discount rate). The empirical results show that the dividend payout of such firms is more positively related to future performance and more negatively related to information risk, which supports both numerator and denominator effects.

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See Allen and Michaely (2003) for a detailed review on dividend policy.

In this paper, “managerial entrenchment,” “takeover defenses,” and “weak shareholder rights” are used interchangeably.

See Easley et al. (2002) and Lambert et al. (2007) for further discussion on pricing of information risk.

The premise of the argument is that information risk is systematically priced. This paper focuses on the material relation between dividend payout and information risk based on the premise.

This argument ignores the tax effect of dividends, which varies across countries. However, although taxation can complicate the argument, there is no reason to think that the tax effect of dividends varies within a country. The relative homogeneity of the sample in this paper should cause little difference in the tax effect on firm value.

To simplify the notation, I omit the firm subscript that should appear for all variables in Eq. 1.

As NA_t is the deflator, it needs not be included as an explanatory variable because of the presence of the intercept. Except for NA_t, the past, current, and future values of each control variable are separately included.

Following Fama and French (2001), I measure repurchases as net repurchases. I follow their approach and use the increase in common treasury stock (Compustat #226) if the firm uses the treasury stock method for repurchases. If the firm uses the retirement method instead (which can be inferred when the treasury stock is zero in the current and prior year), I measure repurchases as the difference between stock purchases (#115) and stock issuances (#108) from the statement of cash flow. If either of these amounts (the change in treasury stock or the difference between #115 and #108) is negative, repurchases are set to zero.

Fama and French (1998) provided a thorough explanation of the econometric issues associated with their valuation model, and they indicated that some of the problems could be mitigated by estimating the models using the method of Fama and MacBeth (1973).

For example, in 1990, it covers over 93% of the market capitalization of the combined NYSE, AMEX, and NASDAQ markets (Gompers et al. 2003).

To examine this, I estimate the following regression annually and present the average coefficients as well as corresponding t-statistics. I expect c ₃ to be positive for the numerator effect of takeover defenses on the relation between dividends and future performance.

\( \begin{aligned} {\text{OCF}}_{j,t + 1} ({\text{or}}\,E_{j,t + 1} ) = & c_{0} \,+\,c_{1} G_{ \, j,t} \,+\,c_{2} {\text{Div}}_{j,t} \,+\,c_{3} \, G_{j,t} *{\text{Div}}_{j,t}\,+\,c_{4} {\text{Leverage}}_{j,t}\,+\,c_{5} G_{j,t} *{\text{Leverage}}_{j,t} \\ & \,+\,c_{6} {\text{RndEx}}_{j,t} \,+\,c_{7} G_{j,t} *{\text{RndEx}}_{j,t} \,+\,c_{8} {\text{CapEx}}_{j,t} \,+\,c_{9} G_{j,t} *{\text{CapEx}}_{j,t} \,+\,c_{10} E_{j,t} \,+\,c_{11} G_{j,t} *E_{j,t} \,+\,c_{12} {\text{LnME}}_{j,t} \\ & \,+\,c_{13} G_{j,t} *{\text{LnME}}_{j,t} \,+\,c_{14} B/M_{j,t} \,+\,c_{15} G_{j,t} *B/M_{j,t} \,+\,e_{ \, j,t} \\ \end{aligned} \)

I estimate the following regression annually and present the average coefficients as well as corresponding t-statistics. I expect d ₃ to be negative (positive) when the dependent variable is Disp_t+1 (Ivol_t+1 or Turn_t+1) for the denominator effect of takeover defenses on the relation between dividends and information flow. \( \begin{aligned} {\text{Disp}}_{j,t + 1} \, ({\text{Ivol}}_{j,t + 1} {\text{ or Turn}}_{j,t + 1} ) \,= \, & d_{0} + d_{1} G_{ \, j,t} + d_{2} {\text{Div}}_{j,t} + d_{3} \, G_{j,t} *{\text{Div}}_{j,t} + d_{4} {\text{Leverage}}_{j,t} + d_{5} G_{j,t} *{\text{Leverage}}_{j,t} \\ & \,+\, d_{6} {\text{Analysts}}_{j,t} + d_{7} G_{j,t} *{\text{Analysts}}_{j,t} + d_{8} {\text{Inst}}_{j,t} + d_{9} G_{j,t} *{\text{Inst}}_{j,t} + d_{10} E_{j,t} + d_{11} G_{j,t} *E_{j,t} + d_{12} {\text{LnME}}_{j,t} \\ &\, + \, d_{13} G_{j,t} *{\text{LnME}}_{j,t} + d_{14} B/M_{j,t} + d_{15} G_{j,t} *B/M_{j,t} + e_{ \, j,t} \\ \end{aligned} \)

I use the following specification to estimate the normal and the abnormal dividends. The fitted (residual) value of the model is regarded as the normal (abnormal) portion of dividends. \( \begin{aligned} {\text{Div}}_{j,t}\,=\,& e_{0} + e_{1} G - {\text{index }}_{j,t - 1} ({\text{or}}\,E - {\text{index}}_{ \, j,t - 1} ) + e_{2} {\text{RE}}_{j,t - 1} + e_{3} {\text{Leverage}}_{j,t - 1} + e_{4} E_{j,t - 1} + e_{5} E_{j,t - 2 \, } + e_{6} {\text{LnME}}_{j,t - 1} \\ & + e_{7} {\text{Cash}}_{j,t - 1} + e_{8} {\text{SGR}}_{j,t - 1} + e_{9} {\text{RndEx}}_{j,t - 1} + e_{10} {\text{CapEx}}_{j,t - 1} + e_{11} {\text{Tstock}}_{j,t - 1} + v_{j,t} \\ \end{aligned} \)

I am grateful to Professor Andrew Metrick for generously providing us the data from his website (http://finance.wharton.upenn.edu/~metrick/data.htm).

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Title: Managerial entrenchment and the value of dividends
Author: Woo-Jong Lee
Publication date: 01-02-2011
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 2/2011
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-010-0179-y

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