Asymmetric Cost Behavior and Dividend Policy

• Date: 01 September 2020
• DOI: http://doi.org/10.1111/1475-679X.12328
• Author: XUAN TIAN,JIE HE,LUO ZUO,HUAN YANG
• Published date: 01 September 2020

DOI: 10.1111/1475-679X.12328

Journal of Accounting Research

Vol. 58 No. 4 September 2020

Printed in U.S.A.

Asymmetric Cost Behavior and

Dividend Policy

JIE HE,∗XUAN TIAN,†HUAN YANG,‡AND LUO ZUOSS

Received 30 July 2018; accepted 2 July 2020

ABSTRACT

Costs are sticky on average, that is, they fall less for sales decreases than they

rise for equivalent sales increases. We examine the effect of this asymmetric

cost behavior on a firm’s dividend policy. Given investors’ aversion to divi-

dend cuts, we predict that firms with higher resource adjustment costs and

stickier costs pay lower dividends than their peers because they are less able

to sustain any higher level of dividend payouts in the future. We find evidence

consistent with this prediction. Further, using a regression discontinuity de-

sign that exploits variation in labor adjustment costs generated by close-call

∗Terry College of Business, University of Georgia; †PBC School of Finance, Tsinghua Uni-

versity; ‡Isenberg School of Management, University of Massachusetts Amherst; SSJohnson

Graduate School of Management, Cornell University

Accepted by Christian Leuz. Our friend and colleague Huan Yang passed away in Decem-

ber 2019, after two previous versions of the paper had been prepared. This project would

not have been possible without his years of dedicated work and invaluable contributions. We

gratefully acknowledge helpful comments from an anonymous associate editor,an anonymous

reviewer, Anup Agrawal, Ashiq Ali, Rajiv Banker, Sanjeev Bhojraj, Dmitri Byzalov, Lin Cheng,

Todd Gormley, Rong Huang, Bin Li, Ningzhong Li, Yi Liang, Bradley Paye, and Suresh Rad-

hakrishnan, as well as seminar participants at Cornell University, the University of Texas at

Dallas, the American Finance Association 2016 Annual Meeting, the 2018 China Interna-

tional Conference in Finance, and the 2018 MIT Asia Conference in Accounting. Tian ac-

knowledges financial support from the National Natural Science Foundation of China (Grant

nos. 71825002, 71790591, 91746301) and the Beijing Outstanding Young Scientist Program

(BJJWZYJH 01201910003014). We remain responsible for all errors and omissions. An online

appendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/journal-

of-accounting-research/online- supplements.

989

© University of Chicago on behalf of the Accounting Research Center, 2020

990 j. he, x. tian, h. yang, and l. zuo

union elections, we provide evidence suggesting that the negative relation be-

tween cost stickiness and dividend payouts is driven by resource adjustment

costs. Our paper sheds new light on the determinants of dividend policy and

demonstrates the role of cost behavior in corporate decisions.

JEL codes: G31, G35, J51, M41

Keywords: asymmetric cost behavior; cost stickiness; dividend payouts; re-

source adjustment cost

1. Introduction

What determines a firm’s dividend policy? Since Lintner [1956] and Miller

and Modigliani [1961], financial economists have proposed a number of

economic and behavioral factors that determine a firm’s dividend policy.

DeAngelo, DeAngelo, and Skinner [2008] develop an asymmetric informa-

tion framework that combines security valuation costs of Myers and Majluf

[1984] with agency costs of Jensen [1986], and conclude that “reported

earnings are the key driver of firms’ payout policy” (p. 161). Because costs

are a fundamental determinant of earnings, cost behavior can have a first-

order impact on a firm’s dividend policy.In this paper, we examine whether

an important feature of cost behavior, cost stickiness, affects a firm’s divi-

dend payouts.

Prior research documents that costs fall less for sales decreases than

they rise for equivalent sales increases on average (see Banker and Byzalov

[2014] and Banker et al. [2018] for reviews). Intuitively, this asymmet-

ric cost behavior stems from differential managerial responses to sales

changes: in the presence of resource adjustment costs, managers retain

slack resources and do not cut costs proportionally when sales decrease,

but they tend to add required resources and increase costs proportionally

when sales increase. This cost model is based on the two primitives of cost

behavior (adjustment costs and managerial decisions), and it is broader

than the traditional bifurcation of costs into fixed and variable compo-

nents. Many resources are neither predetermined (i.e., fixed) nor mechan-

ically determined (i.e., variable). A case in point is labor, a key ingredient

of a firm’s production function. When adjusting the amount of labor to

use, firms have to incur firing costs for existing employees and/or search-

ing and training costs for new employees. Such labor adjustment costs are

substantial, but neither small enough to make labor costs variable nor large

enough to make them fixed. Anderson, Banker, and Janakiraman [2003]

refer to these types of resources as “sticky” resources.

In the presence of higher adjustment costs, firms are less willing to cut

or expand resources (e.g., Banker, Byzalov, and Chen [2013]). However,

because firms cannot fully meet the increased demand unless they add the

needed resources, this effect of adjustment costs is likely to be stronger for

resource reduction than for resource expansion. Thus, firms with higher

adjustment costs are likely to exhibit greater cost stickiness. When sales

asymmetric cost behavior and dividend policy 991

decrease, firms with higher adjustment costs cut fewer resources and suf-

fer a bigger decline in earnings than their peers.

This “ratcheting” notion behind cost stickiness naturally links to the in-

herent asymmetry of observed dividend policies: dividend increases are

small and frequent, whereas dividend decreases exhibit the reverse pattern

(Skinner and Soltes [2011]). Survey evidence in Brav et al. [2005] suggests

that managers follow these asymmetric dividend policies because they be-

lieve that dividends convey information to investors and that there are neg-

ative consequences to cutting dividends. Empirically, the market reaction to

a dividend reduction typically ranges between –6% and –10% (DeAngelo,

DeAngelo, and Skinner [2008, p. 182]). To explain these empirical pat-

terns, standard signaling models propose that firms use dividends to show

that they are good-quality firms with high intrinsic value, as they can bear

the costs associated with keeping a high level of dividends, such as raising

external funds through borrowing, passing up investment opportunities, or

paying taxes (Bhattacharya [1979], John and Williams [1985], Miller and

Rock [1985]). Behavioral models argue that loss-averse investors mentally

account for dividends and capital gains separately (Thaler [1999]) and that

dividend decreases bring more pain than symmetric increases bring plea-

sure (Kahneman and Tversky [1979], Shefrin and Statman [1984], Baker,

Mendel, and Wurgler [2016]). We hypothesize that given investors’ aver-

sion to dividend cuts, firms choose a lower level of dividend payouts to start

with in the presence of higher resource adjustment costs and stickier costs

because they are less able to sustain any higher level of dividend payouts in

the future.

Our hypothesis builds on two ideas grounded in the payout literature

(DeAngelo, DeAngelo, and Skinner [2008]). First, to maximize investor

welfare, a firm’s payouts should roughly match its free cash flows over

the lifecycle because (1) cash accumulation fosters agency costs (Jensen

[1986]) and (2) external financing is costly (Myers and Majluf [1984]).

Second, a firm’s current-period dividend payment is the reference point

against which investors will judge future dividends. Baker, Mendel, and

Wurgler [2016] formalize these ideas and develop a behavioral dividend

signaling model with reference dependence. In their multiperiod model, a

reference point is embedded in a representative investor’s utility function,

where the investor is particularly hurt by a drop in dividends below the ref-

erence point. The manager’s objective function then reflects both a desire

for a high stock price today (by paying a higher level of dividends to sig-

nal private information about the firm’s ability to pay) and a preference

for avoiding a dividend cut in the future. Thus, when deciding on the level

of dividend payouts in the current period, the manager considers not only

the firm’s budget constraints in the current period (e.g., current earnings

or free cash flows), but also its ability to sustain the same level of payouts in

the future should economic conditions change.

We argue that, ceteris paribus, firms with stickier costs pay a lower level

of dividends in the current period because they are less able to sustain any