The Effect of Asymmetric Information on Dividend Policy

Introduction
Ø Several theories exist on why firms pay dividend → based on the market imperfection
Ø The various explanation of dividend policy → classified into three categories of market imperfection → agency cost, asymmetric information, and Transaction cost
Ø Rozeff and Easterbook argue→ dividend payments may serve as a mechanism to → reduce agency cost of external equity
Ø Agency costs arise from → cost associated with monitoring managers and/or risk aversion on the part of managers
Ø The impact of dividend change announcements on share prices → indicated a positive relation between the stock price response and the sign on the announced change → because dividend convey information about current and future earnings
Ø Residual theory → firm can minimize transaction costs associated with new capital issues by restricting dividends to funds not required for investment purposes
Ø This paper will → examine an alternative explanation of dividend policy based on asymmetric information
Ø Myers and Majluf → firm can reduce underinvestment by financing investment with slack that can be accumulated through retention
Ø The higher the level of asymmetric information → the lower the dividends
Ø Miller and Rock → develop a model → higher dividends are associated with higher earnings
Ø If other things equal → value of dividend payments as a sign increases with the level of asymmetric information between the firm and its investors
Ø That’s why → the prediction of Pecking Order theory → is opposite to that provided by the dividend–signaling framework of Miller and Rock
Ø Second contribution stems → inclusion of both dividend-paying and non-dividend-paying firms
Ø One results indicate → inclusion of an asymmetric information variable allows us to draw a distinction between the two competing asymmetric information explanations of dividend policy that has nit been drawn before
Ø Firms with less asymmetric information pay higher dividends → consistent with the pecking order theory but → inconsistent with the signaling theory
Ø One more findings → Role of insider ownership in determining dividend policy appear to be more strongly relate to → asymmetric information and pecking order theory → than to agency costs
Ø First we examine → relation between asymmetric information and issue costs for a sample of seasoned equity offerings → result → issue costs increase with the level of asymmetric information
Ø Second → estimated empirical between issue costs and asymmetric information → to compute predicted issue costs for the sample of firms → to analyze dividend policy
Ø Third → examine dividend policy in the presence of these predicted issue costs → result → dividend are negatively related to predicted issue costs and are consistent → with the implication o the pecking order theory

Asymmetric Information, Testable Hypothesis, and Control Variables
§ Pecking Order Theory
Ø In the presence of asymmetric information, a firm may under-invest in certain states of nature
Ø Firm can reduce underinvestment and the resulting ex-ante loss in firm value by accumulating slack through retention
Ø To control the underinvestment problem→ firm can accumulate slack by decreasing its dividend → the dividend policy may used to control the underinvestment problem that stems from asymmetric information
Ø Pecking order theory predicts → higher level of asymmetric information → lower the dividend
§ Signaling Theory
Ø Higher dividend are associated → Higher Earnings
Ø Asymmetry pertains to current earnings and the level of investment → dividend convey information about current earnings through the sources and uses identity → indirectly serve as a signal of future earnings of the firms
Ø Firms with higher level of asymmetric information → will have to pay a higher level of dividends → to signal the same level of earnings as a firm with a lower level of asymmetric information
Ø Higher the level of asymmetric information → the higher the dividend
Ø Analyst play important role providing information to investors about the condition of the firm → The higher the number of analyst following a firm → less asymmetric information between the firms and its investors

Control Variables
§ Agency Cost of (External) Equity
Ø Dividend payments may serve as mechanism to → reduce agency cost of external equity
Ø Two forms of agency costs → arise from the monitoring of managers and from managerial risk-aversion
Ø Rozeff → dividend payment as a bonding device used to reduce agency costs → dividend should be inversely related to insider or managerial ownership
§ Growth of Investment Opportunities
Ø The size of the investment increases → underinvestment also increases → the firm now has to rely more on external sources for funds
Ø Investment problem → can be controlled by the increasing amount of slack available
Ø Book value assets – Book Value of Equity = Book value of total liabilities
Ø Book value of total liabilities + Market value of equity = Market Value of Assets
§ Cash Flow
Ø Firm with higher current earning or cash flow → will pay higher dividends
Ø Firms with higher current earnings → projected to pay higher dividend
Ø Higher cash flow from existing assets → will translate into higher dividend → as the need for slack is now lower
§ Agency Cost of Debt and Financial Distress
Ø Dividend Payments → source of conflict between the stockholders and the debt-holders of a firm and → may give rise to agency cost of debt
Ø Managers are more likely to cut dividend at the onset of financial trouble to avoid omitting them in the future
Ø Managers’ reluctance to omit dividend → may be another determinant of dividend policy when firms are in financial distress
Ø Firm with a higher likelihood of financial distress → may pay lower dividend so as to maintain a stable dividend policy and avoid omitting dividend in the future
Ø Firms with higher likelihood of financial → may pay lower dividend

Empirical Specification, Methodology and Measures for the Dependent Variable
Optimum dividend level of firms can be measured by → β vector of explanatory variables + disturbance term.
§ Dependent Variable Measures
Ø Conventional dividend yield = ratio of dividend per share → divided by → price per share
Ø Dependent variable = measured dividend yield for dividend-paying firm
Ø 0 → if for non-dividend-paying firms
§ Data
Ø Dividend yield → computed by dividing the average dividends per share by the average price per share
Ø Data contains → Dividend-Paying firms Vs. non-Dividend-Paying firms
§ Empirical Result
Ø Dependent variable is dividend yield → assumes a value of zero for non-dividend-paying firms and equals the measured dividend yield otherwise
Ø Independent variables used → insider ownership variable, analyst following, growth opportunities, cash flow measure, and dummy variable → identifies firms with higher likelihood of distress
Ø Positive coefficient on analyst following → firms with less asymmetric information → pay higher dividend → consistent with the pecking order theory but → inconsistent with the signaling theory
Ø Negative coefficient on the growth measure and the positive coefficient on cash flow measure → consistent with the predictions of the pecking order theory
Ø Positive coefficient on DIST → firms with both low cash flow and low growth opportunity → pay higher dividend
Ø Analyst following → negatively related to insider ownership
Ø Pecking order theory predicts an inverse relation between dividend and the level dividend and the level of asymmetric information
Ø Alternatively → The pecking order theory predicts a positive relation between dividend and analyst following → also implies an inverse relation between dividend and insider ownership given the inverse relation between analyst following and insider ownership
§ Dividend Policy and Insider Ownerships
Ø Indicate → dividends → unrelated to the insider ownership variable
Ø There is no relation between → dividends and insider ownership
Ø Analyst following → negatively related → to insider ownership
Ø Analyst following will be higher for firms with → lower insider ownership → imply a negative relation between them
Ø Pecking order theory predicts → inverse relation between dividends and the level of asymmetric information
Ø Pecking order theory predicts → positive relation between dividends and analyst following → implies an inverse relation between dividend and insider ownership → and inverse relation between analyst following and insider ownership
Ø The role of insider ownership in determining dividend policy → appear more strongly related to asymmetric information than to agency costs

Dividend Policy and Equity Issues: A Further Test of Pecking Order Theory
The pecking order theory suggest → firms should exhaust their internal funds → before resorting to external financing → firms that raise fund through external sources → must use a higher amount of internal funds
Pecking order theory implies → firms that issue equity → should pay lower dividend
Firms that resort to external sources for fund → attempt to first exhaust their internal fund → by paying lower dividend
§ Dividend Policy and Firm Size
Ø Positive relationship between dividend yield and size → no explanation for this relation
Ø Firm size is calculated as the logarithm of the book value of assets → results → the relation between dividends and analyst following → larger firms, which have less asymmetric information → pay higher dividend → consistent with pecking order theory
Ø Collinearity diagnostics → provide a more powerful way to detect linear dependencies among the explanatory variable → than simple pair-wise correlation → it indicate the presence of a high degree of collinearity → which appears to be degrading the estimate of the coefficient on analyst following and hence its significance
§ Dividend Policy, Asymmetric Information, and Issue Costs
Ø The pecking order theory → asymmetric information problems → exacerbate the underpricing → associated with new capital issues
Ø Consequently → firms may be reluctant → to issue equity when their stock is undervalued → and may forgo positive net present value investment
Ø Underpricing → result from the asymmetric information problem → may be viewed as one component of issue cost → associated with raising capital through external sources
Ø Issue cost can be controlled by → financing investment with slack → which can be accumulated by paying lower dividends
Ø Asymmetric information problem → adversely affect issue cost which can be controlled by → paying lower dividends
Ø The significance of analyst following in the issue cost regressions suggest that → level of asymmetric information adversely affect issue cost → which in turn are negatively related to dividends