The Effect of Asymmetric Information on Dividend Policy

1. Introduction
§ Several theories exist on why firms pay dividends
§ The various explanations of dividend policy → classified into at least three categories:
i. Agency cost
ii. Asymmetric information
iii. Transaction Cost
§ Alternative explanation on dividend policy is based on pecking order theory
§ The underinvestment → when the firm has inadequate funds for investment purposes → does not want to bear the lemons-premium associated with new capital issues
§ Firms find it optimal not to pay dividend → their exclusion from any empirical analysis may create a selection bias in the sample → resulting in biased and inconsistent estimates of the underlying parameters

2. Asymmetric Information, Testable Hypotheses, and Control Variables
§ Pecking Order Theory
i. Myers and Majluf → the precense of asymmetric information → a firm may underinvest in certain states of mature
ii. Firm can reduce underinvestment → by accumulating slack through retention
iii. Higher the control of asymmetric information → lower the dividend to control the underinvestment problem

§ Signaling Theory
i. Higher dividends → higher current earnings
ii. Dividend convey information about current earnings → trough the source and uses identity (time)
iii. Firms with higher current earnings → pay high enough dividend
iv. Firms with higher level asymmetric information → have to pay more dividend → to signal the same level of earnings as firm with a lower level of asymmetric information

§ Control Variable
i. The potential importance of asymmetric information in determining dividend policy does not rule out other factors affecting dividend policy

§ Agency Cost of (External) Equity
i. Dividend payments → reduce agency cost of external equity
ii. Two Forms of agency cost
a. From the monitoring of managers
b. From risk -aversion
iii. Value of dividend in controlling agency cost → is likely to be lower in the presence of some other control mechanism → such as managerial ownership of shares
iv. Higher managerial or insider ownership → lower agency cost

§ Growth or Investment Opportunities
i. Size of the investment increase → the ex-ante loss resulting from underinvestment also increase
ii. Firm that expect rapid growth should lower its dividend payout
iii. Pecking-order and residual theories → Higher growth opportunities of the firm → Lower the dividend

§ Cash Flow
i. Residual theory, pecking-order theory, signaling argument → higher current earnings → pay higher dividend

§ Agency Cost of Debt and Financial distress
i. Firms may face binding debt covenants when they are in financial distress
ii. Firms reduce dividends early during period of financial distress
iii. Firms with higher likelihood of financial distress may pay lower dividend

3. Empirical Specification, Methodology and Measures for the Dependent Variable
i. The optimal dividend policy is determined by the firm-specific attributes
ii. Non-dividend paying firms find it optimal not to pay dividends → should not be ignored in any analysis of corporate dividend policy

§ Dependent Variables Measures
i. Dependent variables → conventional dividend yields → equals the ratio of dividend per share to price per share
ii. Dependent variable → equals the measure dividend yields for dividend-paying firms → equals zero for non-dividend-paying firms

§ Data
i. Date were obtained from the industrial annual COMPUSAT database for period 1988-1992
ii. Sample consist of manufacturing firms that trade on either NYSE or the AMEX
iii. Five year period were chosen
iv. Firms that had no data and firms initiating or omitting dividends in the sample period → dropped from sample
v. The final sample → 446 firms, 158 of which are non-dividend-paying firms

4. Empirical Results
i. Independent variables → insider ownership variables, analyst following, growth opportunities, the cash flow measure, dummy variables
ii. Analyst following and cash flow → positive and significant at 1 percent level
iii. The coefficient on growth opportunities → negative and significant at 1 percent
iv. The coefficient on distress variables → positive and significant at 10 percent
v. Positive coefficient on analyst following → firms with less asymmetric information pay higher dividend → consistent with pecking order theory, inconsistent with signaling theory
vi. Negative coefficient on the growth measure → consistent with pecking order theory
vii. Positive coefficient on DIST → firms with low cash flow and low growth opportunities → pay higher dividends

§ Dividend Policy and Insider Ownership
i. Analyst following is negatively related to insider ownership
a. The demand for analyst services → stems from outsider to the firm
ii. Lower analyst follower → higher asymmetric information
iii. Dividends → negative relationship with insider ownership

5. Dividend Policy and Equity Issues: A further Test of the Pecking Order Theory
i. Pecking order theory
a. Firms should exhaust their internal funds first before resorting to external funds
b. Firms that issue equity should pay lower dividend
ii. Result → Firms that resort external sources for funds attempt to first exhaust their internal funds by paying lower dividend

§ Dividend Policy and Firm Size
i. Positive relationship between dividend yields and size
ii. Firm size → calculated as the logarithm of the book value of assets
iii. Larger firms → have less asymmetric information → pay higher dividend
a. Consistent with pecking order theory
iv. While size is positive and significant → analyst following is significant

§ Dividend Policy, Asymmetric Information, and Issue Cost
i. Pecking order theory → asymmetric information problems exacerbate the under pricing associated with new capital issues
ii. Firms may be reluctant to issue equity → when their stock is undervalued
iii. A higher analyst following → less asymmetric information
iv. Issue cost increase with the level of asymmetric information between the firms and its investors