Changing Dividend Policy in Korea: Explanations Based on Catering, Risk, and the Firm's Lifecycle

• Date: 01 December 2013
• Author: Taekyu Kim,Injoong Kim
• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/ajfs.12034

Changing Dividend Policy in Korea:

Explanations Based on Catering, Risk, and

the Firm’s Lifecycle*

Injoong Kim**

College of Business Management, Hongik University

Taekyu Kim

College of Business, Hallym University

Received 23 July 2012; Accepted 5 August 2013

Abstract

We examine the dividend payment patterns of Korean firms and test competing hypotheses

that explain the decreasing dividend patterns since the Asian crisis. We run a horse race to

explain this decreasing propensity to pay dividends (PPD). Although catering theory, when

used alone, explains 22% of this decreasing PPD, it loses most of its explanatory power when

risk and lifecycle measures are used together. We observe dramatic and permanent changes in

systematic and idiosyncratic risks after the crisis. Firms are affected heterogeneously, such that

large and stable firms face less risk after the shock, while small and unprofitable firms face

greater uncertainty, which in turn results in high concentrations of dividend payments among

the top payers. We also find evidence of firms’ time varying risk aversion toward costly divi-

dend payments. Firms in boom periods become less risk averse and do not reduce dividends

for the same perceived level of risks as they do during an economic downturn, when firms

tend to react to risks more sensitively. Risks explain over 30% of the decreasing PPD when

combined with a lifecycle measure. The added contribution of a lifecycle measure is mainly

driven by the sign of retained earnings and not the magnitude of positive retained earnings.

Keywords Asian crisis; catering; dividend; idiosyncratic risk; Korea; lifecycle; systematic risk

JEL Classification: G01, G15, G35

1. Introduction

Fama and French’s (2001) pioneering work documents that, since 1978, U.S. firms

are less likely to pay dividends, even after controlling for changing firm characteris-

*Acknowledgement: The authors acknowledge the support of the Hongik University new

faculty research fund.

**Corresponding author: Injoong Kim, College of Business Management, Hongik University,

2639, Sejong-ro, Jochiwon, Sejong, 339-701 Korea. Tel: +82-41-860-2218, Fax: +82-44-864-

7533, email: kij@hongik.ac.kr.

Asia-Pacific Journal of Financial Studies (2013) 42, 880–912 doi:10.1111/ajfs.12034

880 ©2013 Korean Securities Association

tics. Their empirical study uses logit regression models and forecasts the probability

of dividend payments as a function of firm characteristics, such as size, growth

opportunity, and profitability. The actual probabilities of dividend payments, how-

ever, are consistently lower than the values forecasted by their logit models, a

phenomenon Fama and French call “disappearing dividends.”

The historical pattern of dividend payers in Korea suggests a huge decline in the

actual percentage of dividend payers since the late 1990s, possibly due to the impact

of the Asian crisis. In this paper, we investigate the disappearing dividend payment

pattern of Korean firms after the crisis and examine the validity of several candidate

explanations for this systematic change in Korean firms’ dividend policies. It is par-

ticularly interesting to investigate Korean firms because Korea was one of the

nations most severely hit by the Asian crisis but it recovered completely from the

shock in a very short period. The Asian crisis engendered permanent changes in

firm characteristics, as well as transitory changes in macroeconomic conditions, that

potentially affect corporate dividend payments. The crisis was an exogenous shock

for companies. Unlike in Korea, the disappearance of dividends in the United States

was not triggered by macroeconomic shocks. Therefore, the implications and nature

of the disappearing dividend phenomenon can be quite different. We investigate

the effect of economic shocks on the key variables that are believed to affect

dividend payments. These variables are also the main inputs of the competing

hypotheses that explain disappearing dividends. The investigation of Korean firms

would enlighten us as to how firms’ dividend policies can be affected both perma-

nently and temporarily by major external macroeconomic shocks.

We look at all the firms in the Korea Composite Stock Price Index (KOSPI)

and the Korean Securities Dealers Automated Quotations (KOSDAQ) markets,

excluding financial firms such as banking, insurance, and security trading industries,

whose dividend policies are highly regulated. We employ Fama and French’s (2001)

method of deriving propensity to pay dividends (PPD) for Korean firms. Usi ng

their logit model, we define PPD as the difference between the actual and predicted

percentages of payers. A clear pattern of decreasing PPD since 1997 for Korean

firms is investigated, using both Baker and Wurgler’s (2004a) catering theory and

Hoberg and Prabhala’s (2009) risk-based explanation. In addition, we employ

DeAngelo et al.’s (2006) lifecycle measure and re-estimate the PPD because they

argue that Fama and French’s (2001) original firm characteristic measures, such as

profitability and investment opportunity, are inferior to their lifecycle measure in

terms of predicting the probability of dividend payments.

When used alone, Baker and Wurgler’s (2004a) catering theory, which asserts

that firms tend to adjust their dividend policies according to investors’ changing

fads toward dividend payments, seems to explain well the decreasing PPD of Kor-

ean firms. We find that the dividend premium measured by the difference in the

logs of the average market to book ratios of dividend payers and nonpayers is sig-

nificantly related to the PPD, and in a simple time series regression we obtain an

R

2

value of 22%. However, catering theory’s explanatory power weakens greatly

Changing Dividend Policy in Korea

©2013 Korean Securities Association 881

when we incorporate Hoberg and Prabhala’s (2009) risk measures and is only mar-

ginally significant at the 10% level, with R

2

dropping to 13.7%. This result is

consistent with Hoberg and Prabhala’s (2009) study using U.S. data, although the

effect of risks on the PPD for Korean firms is not as dramatic as their claim.

When the lifecycle measure of DeAngelo et al. (2006) is incorporated together

with risk measures in the estimation of the decreasing PPD, the explanatory power

of catering theory disappears. Lifecycle measure is statistically very significant and

explains the orthogonal part of the PPD that other firm characteristic variables can-

not. In particular, the information content of the lifecycle measure in explaining a

firm’s dividend decision mainly comes from whether a firm has positive or negative

retained earnings. However, the economic effect of the lifecycle measure is not as

significant and the major contribution is still made by risks, which explain over

30% of the decreasing PPD after the Asian crisis.

It is interesting that both systematic and idiosyncratic risks have permanently

increased since the Asian crisis. Not only the level of risks but also the variability of

risks among firms has increased permanently after the Asian crisis, which means

that the shock heterogeneously affected firms and firms have become more diverse

in their exposure to risks. Top dividend payers’ risks were reduced after the crisis,

while their size and profitability increased significantly. On the contrary, the bottom

payers’ size and profitability were reduced and they have faced greater risks since

the crisis. These changes naturally led to dividend concentration and contributed to

the decrease in PPD. We also find evidence that firms’ risk aversion toward costly

dividend payments changes over time as economic conditions change and that firms

adjust their dividend policies accordingly.

We extensively investigate other candidate explanations for disappearing divi-

dends, such as dividend concentration, an alternative cash payout method such as

share repurchase, and macroeconomic factors, to answer the disappearing dividend

puzzle in Korea.

2. Literature Review

Fama and French (2001) document that the proportion of firms paying cash divi-

dends fell from 66.5% in 1978 to 20.8% in 1999. This drop cannot be explained by

structural changes in firm characteristics and has led many researchers to focus on

the nature of changing corporate payout policies in the United States. Although the

proportion of firms paying dividends has decreased, the total amount of dividends

has increased steadily over time, as DeAngelo et al. (2004) point out. Grullon and

Michaely (2002) also report that total cash distributions including both dividends

and repurchases have increased over the past decades.

Many researchers have attempted to find the causes of the decreasing PPD, among

which one of the most popular explanations is probably the catering theory of divi-

dends suggested by Baker and Wurgler (2004a). Within the framework of behavioral

finance, the authors suggest that investor preference for nondividend-paying stocks

I. Kim and T. Kim

882 ©2013 Korean Securities Association