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

Share Repurchase - To Buy or No to Buy

Introduction
Ø 39% of the respondents → instituted a share repurchase program → in order to improve their earnings per share numbers
Ø 28% → their companies were using buybacks as a way to distribute excess cash to shareholders
Ø 21% → reported that their companies were trying to reduce the cost of employee stock option plans
Ø 12% → adjusting capital structure was the main reason for their stock buybacks
Ø This research mission → to determine the long-term effect of stock buyback program on the company’s stock price and to access which companies benefit most from this program

Why repurchase shares?
Ø First → to increase share price → when the company’s stock undervalued by market analysis
Ø Second → to rationalize the company’s capital structure → allows the company to sustain a higher debt-equity ratio
Ø Third → to substitute share repurchase for cash dividend payouts → since capital gains may be taxed at lower rates than dividend income → a share repurchase program offers long term shareholders some major tax advantage
Ø Fourth → to prevent dilution of earnings → share repurchases can enhance a company’s growth in earnings per share → conversely prevent an EPS decrease that may be caused by exercises of stock option grants
Ø Fifth → to deploy excess cash flow → stock buybacks can be attractive alternative investment for any cash flow left over → once the company has meet its capital investment need
Ø Company that want to repurchase shares has several different options
o Conduct open market repurchases
o Tender offers → both fixed-price and Dutch auction
o Privately negotiated repurchases

Four Key Findings
Ø First → Shares Outstanding → although the company repurchase majority of its shares → there were still a small proportion of the total shares outstanding abaout 5%
Ø Second → no subtitle for dividend payouts → companies don’t seem to be using share repurchases as a substitute for dividend payments to shareholders → although the dividend payments have smaller amount than the buyback shares → the dividend payout ratios increase once the stock buyback program is over
Ø Third → Effect on Earnings Per Share → after the repurchase program → there is a significant increase in EPS growth → although not as big as company that do not repurchase stocks → so repurchasing firms are effectively closing the gap between their EPS growth rates with their industry peer that aren’t buy back stock
Ø Finally → Effect on Debt → increased by a modest amount for the sample → even though 27% of the funds used to repurchases stocks are come from theexcess operational cash flow

Guidelines for Getting Going
Ø If company considering a stock repurchase plan → CFO have to wonder whether this program really will rev-up company’s EPS growth?
Ø As general guidelines: Companies repurchase equity only under these two circumstances
o When they have excess debt capacity and → the supply of funds exceeds the demand
o When they’re underperforming in terms of → profitability and sales growth rates relative to their industry’s average
Ø Companies should avoid stock buybacks under these two circumstances
o When they’re over-leveraged and sales growth rates excess industry averages
o When both their profitability and sales growth rates excess industry average
Ø Stock buybacks also have regulations
o Volume limit on repurchases and contains a host of other procedural requirements
o Company cannot conduct a share repurchase program at the same time → it is engaging in a securities offering
o Cannot allow buybacks to exceed one quarter of the trading volume of the stock for the prior 30 days

The Value Connection
Ø Shareholder Value Based Management (SVBM) Framework → demonstrates that long-term shareholder value → created by the firm’s growth and profitability prospects from its product market positions
Ø Share repurchase program can either create or destroy value → depend on how they affect investor’s perceptions → about the firm’s long-term prospects
Ø Without a clearly expressed rationale → the company’s decision to conduct a repurchase program could be misinterpreted by investors → as a negative signal
Ø Financial executives must start their decision making by evaluating the demand for investment funds → as determined by the availability of investment opportunities
Ø Also supply of invest-able funds → determined primarily by the company’s profitability
Ø Conclusion → developing and implementing a share repurchase program is no simple task
Ø To conduct a successful buyback → must figure out how to bring the two major aspect of the job → Strategy and Finance → together in the most effective way possible

(JOB) Rolls-Royce Increases Dividend

Ø Rolls-Royce, the aircraft engine maker, raised its dividend by more than a three times → reflected its continuing confidence in future growth.
Ø Rolls-Royce is benefiting from a boom in aviation in → the Middle East and Asia.
Ø It revealed a record order book → 45.9 billion Pounds → an increase of 76 per cent
Ø The company increased the total pay-out → 35.6 per cent to 13 points following a year-long strategic financial review.
Ø Some analysts had predicted a share buy-back or special dividend of as much as 1 Billion Pounds.
Ø The decision to → rebase the dividend and commit to a progressive dividend policy subject to earnings was → "the most powerful way” → showing confidence in the future of the business
Ø However, the return to investors’ → much less than the market had expected → and the shares fells 49 points → or more than 10 per cent → to 431 points.

Relation to the other two articles:
Ø Not every investors are aware about what analyst said nowadays → investors tend to find out themselves and make their decision by their “peer groups”
Ø Investors are tend to be “the expert” of the dividend payment “games” → many company are trying to convinced investors by increasing the dividend payments → nowadays people are more suspicious for this kind of moves

Rolls-Royce increases dividend; [LONDON 1ST EDITION]

SYLVIA PFEIFER. Financial Times. London (UK): Feb 8, 2008. pg. 20

Abstract (Summary)
Sir John Rose, chief executive, said the decision to rebase the dividend and commit to a progressive dividend policy subject to earnings was "the most powerful way of showing confidence in the future of the business".
After last year's record order in-flow Sir John said the group was still seeing "order activity". In the first month of this year, Rolls-Royce took about Pounds 2.5bn worth of orders.
"This is a completely unforgiving market right now and people only want to see negatives," said Steve East, analyst at Credit Suisse. He stressed, however, that "for a company that is still cyclical to take the dividend up by 35 per cent and say that it's sustainable, that is good news."
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Full Text (423 words)
(Copyright Financial Times Ltd. 2008. All rights reserved.)
Rolls-Royce, the aircraft engine maker, raised its dividend by more than a third, a move it said reflected its continuing confidence in future growth.
The company increased the total pay-out by 35.6 per cent to 13p, following a year-long strategic financial review.
Rolls-Royce is also making a one-off cash injection of Pounds 500m into its pension fund.
However, the return to investors was much less than the market had expected and the shares fell 49p, or more than 10 per cent, to 431p.
Some analysts had predicted a share buy-back or special dividend of as much as Pounds 1bn.
Sir John Rose, chief executive, said the decision to rebase the dividend and commit to a progressive dividend policy subject to earnings was "the most powerful way of showing confidence in the future of the business".
The company needed to remain flexible, both in terms of its balance sheet and its capacity, to be able to respond to customers' demands as well as new opportunities.
It had net cash at the year end of Pounds 888m.
Rolls-Royce is benefiting from a boom in aviation in the Middle East and Asia.
It revealed a record order book of Pounds 45.9bn, an increase of 76 per cent, with nearly half - Pounds 20bn - coming from those two regions.
The company is predicting that by 2010, more than 500 aircraft in China will be powered by Rolls-Royce engines, up from 41 in 1997.
The company expects to achieve continued growth in profitability and a positive cashflow in 2008. This is in spite of a weak dollar and rising raw material prices.
After last year's record order in-flow Sir John said the group was still seeing "order activity". In the first month of this year, Rolls-Royce took about Pounds 2.5bn worth of orders.
The company reported that underlying profits rose from Pounds 705m to Pounds 800m in the year to end-December. That figure was distorted by foreign exchange hedging.
With much of its revenue in dollars, Rolls-Royce has Dollars 9.4bn of hedges in place at an average sterling exchange rate of Dollars 1.83, equivalent to 2.6 years cover.
"This is a completely unforgiving market right now and people only want to see negatives," said Steve East, analyst at Credit Suisse. He stressed, however, that "for a company that is still cyclical to take the dividend up by 35 per cent and say that it's sustainable, that is good news."Pre-tax profits fell to Pounds 733m (Pounds 1.4bn) and earnings per share were 32.9p