Dividend policy and firm performance: Hotel REITs vs. Non-REIT hotel companies

1. Introduction
§ Mid-1990s → Real Estate Investment Trusts (REITs) à experienced rapid growth fueled by readily available external equity and debt financing
§ The authors → Economies of scale are the driving force behind recent mergers and acquisitions in the industry
§ REITs → over invest → must distribute 95% of their taxable income to shareholders in order to maintain their preferential tax status
i. Reits → less likely to suffer from agency problems associated with free cash flow
§ REITs have less internally generated equity financing and are more likely to seek external financing for acquisitions
§ Nobel and Tarhan (1998) → demonstrate improved operating performance for over-investing firms making larger distribution of cash to stockholders

2. Data and Methodology
§ Sample:
i. Sixteen hotel REITs and fifty-one non-REIT corporations from 1993 to 1999
ii. Examine whether differences in internally generated equity financing can explain differences in performance
§ The control group → consists of firms identified from COMPUSTAT as non-REIT corporations → whose primary business involves investment in hotels and motels
§ More than thirty variables of both types of companies have been collected
§ Examine the free cash flow hypothesis → create two sets of variables to capture the free cash flow for a company:
i. FCF1 → measures the total amount of post-tax free cash flow that is discretionary for mangers before they determine the amount of either interest or dividend payments
ii. FCF2 = EBITDA - TAX - INTEXP – TOTDIV
a. TOTDIV is the total dollar of dividends declared on common and preferred stock
iii. This definition → based on the assumption → depreciation and amortization expenses are at managers' discretions in both types of companies

3. Empirical Results
§ Structural differences
i. T-tests → conducted on collected variables → to examine the differences between the two types of firms
ii. Non-REIT hotel firms are about the same size as the hotel REITs
iii. Non-REIT companies produce higher income adjusted by firm size than REITs
iv. On annual returns of common stock (Stock Return) → non-REIT companies:
a. Perform marginally better than REITs
b. Riskier investments measured by Beta although the t-Statistic is insignificant
v. Return on assets (ROA) → REITs have significantly higher means than the non-REIT companies
vi. Mean of the market-to-book ratio → statistically higher for non-REITs than for REITs
vii. Non-REIT companies are more highly leveraged
a. Non-REIT companies have higher means than REITs on total liability, total debt and total interest expenses
viii. Non-REIT companies → higher means than REITs in total capital expenditure and total acquisition
ix. Non-REIT companies → higher depreciation and amortization expenses → which is typically considered an additional source of free cash flow
x. The means of dividend per share, common dividends and total dividends → higher for REITs than for non-REITs → maintaining high dividend payouts

§ The impact of free cash flow
i. Examine:
a. The relationship between a firm's market-to-book ratio and free cash flow controlling for whether the firm is a REIT
b. A firm's assets (size), leverage, debt coverage ratio, change in assets (growth) and profitability
ii. The asset growth variable → RASSET → proxies for opportunities for profitable reinvestment of cash flow
iii. Free cash flow has a negative impact on firm performance
iv. Market-to-book ratio is significantly greater for:
a. Larger firms (where size is measured by assets)
b. More heavily leveraged firms and more profitable firms
v. Market-to-book ratio → negatively related to free cash flow net of common dividends
vi. Market-to-book ratio decreases with the free cash flow measured at both before and after common dividend distribution levels
vii. Examine further → the relationship of the excess market value of the company and free cash flow
viii. Market-to-book ratio → positively dependent on the leverage level, the asset growth rate, the asset-adjusted operating income and the debt coverage ratio

4. Conclusion
§ Two types of companies statistically significant differences → in means across asset-adjusted earnings, leverage level, dividend policy, and most importantly, free cash flow levels
§ Non-REIT companies → more heavily leveraged and pay lower dividends than the REIT
§ Larger amount of free cash flow is retained by non-REIT firms than their REIT
§ Market-to-book ratio is negatively related to free cash flow

Share Repurchase:To Buy or Not to Buy

1. Introduction
§ Stock buybacks have leap-frogged corporate stock issues by ever-increasing amounts
§ Total number of shares repurchased in the last six years → far outstripped the total number of new shares issued
§ FEI members → Key findings:
i. 39% of the respondents instituted a share repurchase program → to improve their earnings per share numbers
ii. 28% → to distribute excess cash to shareholders
iii. 27% → their companies were trying to reduce the cost of employee stock option plans
iv. 12% → main reason → adjusting capital structure
§ Financial Executives Research Foundation → mission:
i. Determine the long-term effects of stock buyback programs on a company’s stock price
ii. Assess which companies benefit most from this programs
§ Data → 200 firms that announced, conducted and completed share purchase programs from 1991 to 1996
§ Completed Repurchase Plans → The firm announced and later purchase at least 50% of the shares authorized for the program
§ Firms that announced buyback program → usually just buy very little stock

2. Why Repurchase Shares?
§ Five commonly reasons:
i. To increase share price
ii. To rationalized the company capital structure
iii. To substitute share repurchases for cash dividend payouts → tax advantages
iv. To prevent dilution of earnings
v. To deploy excess cash flow → become alternative investment
§ Firm repurchases shares has different options:
i. Open market repurchases
ii. Tender offers
iii. Privately negotiated repurchases
§ Sample → Firms were consent in a range of industry and market capitalization:
i. 48% → have market caps below %200 million
ii. 10% → have market caps in excess of $10 billions
iii. 42% → along the continuum

3. Four Key Findings
§ Shares Outstanding
i. Proportion of share repurchases →5%
ii. This proportion → repurchases were measured in terms of numbers of shares or in terms of dollar value
§ No substitute for dividend payouts
i. Dividend payouts ratio → increase once the stock buyback program is over
ii. Large-cap and small-cap companies → reported the same increase in dividend payout ratios
§ Effect on earnings per share
i. The repurchasing firms → effectively closing gap → between their EPS growth rates and those of industry peers that aren’t buying back stock
§ Effect on debt
i. 27% of the fund used to finance the stock repurchases → stem from excess operational cash flow

4. Guidelines for Getting Going
§ A stock buyback program signaling:
i. Management won’t be funneling anymore money into markets or product lines that are dead ends
ii. The company isn’t hunting around for an acquisition
§ Companies repurchase equity only under these circumstances:
i. When they have excess debt capacity, and the supply of funds exceed the demand
ii. When they’re under-performing → profitability and sales growth rates→ relative to their industry’s averages
§ Companies should avoid stock buybacks under these circumstances:
i. When they’re over-leveraged and sales growth rates exceed industry averages
ii. When both their profitability and sales growth rates exceed industry average
§ A share repurchase program → must be conducted in strict accordance with federal securities laws to avoid liability for market manipulation or insider trading
§ Company’s board of directors → must determine that any purposed buyback program is a sound course of action and that it’s in the best interests of shareholders

5. The Value Connection
§ Shareholder Value Based Management → demonstrates that long-term shareholder value is created buy the firm’s growth and profitability prospects from its product market positions
§ The company’s decision to conduct a repurchase program could be misinterpreted by investors as a negative signal
§ But also can be a positive sign → because investors interpret the repurchases as the welcome return of capital and an indication that management is turning the business around
§ Conducting a successful stock buybacks → he or she must figure out how to bring the two major aspect – strategy and finance – together in the most effective way possible

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