Corporate Payout Policy, Cash Savings, and the Cost of Consistency: Evidence from a Structural Estimation

• Author: Hamed Mahmudi,Michael Pavlin
• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/fima.12018
• Date: 01 December 2013

Corporate Payout Policy, Cash Savings,

and the Cost of Consistency: Evidence

from a Structural Estimation

Hamed Mahmudi and Michael Pavlin∗

We develop a dynamic structural model to better understand how corporate payout policy is

determined in conjunction with other corporate decisions. In a first-best model, a manager

maximizes equity value by choosing the firm’soptimal f inancing, investment,dividends, and cash

holdings. By using simulated method of moments, we show that, on average, firms excessively

smooth their payout while making corporate savings overlyvolatile and retaining excess cash. We

then extend the model to capture the effect of a manager, who perceives a cost to cutting payouts.

Estimating the model, we infer the magnitude of this cost. We find that a managerial preference

for consistent payout explains the smooth payout and high volatility of cash holdings.

Since Lintner (1956), it has been widely acknowledged that managers have a tendency to

smooth corporate dividends.1While it is well understood that firms prefer to practice a consistent

payout policy, the motivation for this behavior remains a contentious issue in the literature.

One reason for the lack of consensus is because payout policy has close ties to other corporate

decisions on corporate cash holdings, investments, and financing. Increasing payout diminishes

resources available to increase investment and savings in current and future periods. This paper

sheds light on the payout smoothing puzzle by studying the relationships between these policies

simultaneously in a dynamic setting. We examine how manager-shareholder conflicts, more

specifically a manager’s perceived cost associated with payout reductions, explain observed

payout patterns. We estimate the magnitude of this cost, as well as shareholder value loss due to

this distortion.

The predominant explanations for payoutsmoothing in the literature are agency and information

asymmetry. The agency explanations proposed byJensen (1986) and Easterbrook (1984) suggest

that paying a dividend that is both high and smooth forces firms to raise external capital to meet

their financing needs. This exposure to the discipline of capital markets may reduce agency costs.

However, this argument neglects the fact that in a dynamic world, a manager who perceives a

cost to cutting dividends has an incentive to pile up excess cash to avoid future reductions in

This paper benefited extensively from discussions with JanMahrt-Smith, Craig Doidge, Raymond Kan, Sergei Davydenko,

Alexander Dyck, and Marcel Rindisbacher. We are also grateful for suggestions from Bill Christie (Editor) and an

anonymous referee that have greatlyimproved the paper. We would like to thank the Rotman Finance Lab for providing

computational facilities that made this study possiblewhile we were at the University of Toronto.All errors arethe authors’

responsibility.This paper was previously circulated under the title “What Drives Corporate Excess Cash? Evidence from

a Structural Estimation.”

∗Hamed Mahmudi is an Assistant Professor in the Price College of Business at the University of Oklahoma in Norman,

OK. Michael Pavlin is an Assistant Professor in the School of Business and Economics at Wilfrid Laurier University in

Waterloo, ON, Canada.

1For evidence regardingdividend smoothing, see Fama and Babiak (1968) and Brav et al. (2005).

Financial Management •Winter 2013 •pages 843 - 874

844 Financial Management rWinter 2013

dividends. The joint determination of payout and cash savings by the manager and the dynamic

effect of requiring smooth dividends, which, in turn, motivates even larger levels of savings, are

ignored in this remedial view of dividend smoothing.

The endogenous choice of corporate policies may also underlie the conflicting and ambiguous

results observed in the payout smoothing literature (Booth and Xu, 2008; Li and Zhao, 2008;

Aivazian,Booth, and Clear y,2009; Leary and Michaely, 2011). We suggest that these inconclusive

findings may be due to disregarding the joint determination of variables such as payout ratio,

operating profits, leverage, capital expenditures, and cash holdings.

Structural estimation is a reliable approach to avoiding these types of endogeneity problems.

The model we propose captures both the manager’s immediate trade-offs under a rich set of

frictions and the manager’s future considerations. We exploit this model to predict optimal levels

of payout and cash holdings for firms that invest in capital, save cash, raise equity, issue/retire

debt, and pay dividends, all contingent on uncertain future productivity.

Weexamine two models: 1) a first-best model where the manager maximizes the value of equity

and 2) an agency model where the manager also considers a cost associated with any reduction

in payout. We estimate a set of parameters for both of these models using a simulated method of

moments (SMM). The SMM procedure estimates parameters by minimizing the error between

simulated and empirical moments from corporate financing, payout, and investment choices. The

empirical sample includes nonfinancial, unregulated US fir ms from 1988 to 2006 constructed

from the annual 2006 Compustat industrial files.

We show that the first-best model fails to capture the dynamics of dividend policy. Similar to

other dynamic structural models that include dividends such as Hennessy and Whited (2007),

the best parameter fit results in a payout policy that is far more volatile than what is observed

empirically. The simulated variance of payout is 0.0024, which is significantly larger than the

empirical variance of 0.0016. Simulated varianceof investment and cash holdings are significantly

over and underestimated, respectively. The average cash-to-assets ratio from the simulated panel

(0.0689) is smaller than the corresponding empirical moment (0.1631). These results also indicate

that firms, on average, maintain more cash than can be explained through the dynamic trade-

off model alone. This is consistent with the empirical literature on cash holdings which argues

that firms typically maintain too much cash (Opler, Pinkowitz, and Stulz, 1999; Dittmar and

Mahrt-Smith, 2007).

The second model considers the maximization problem faced by a manager who perceives a

downward adjustment cost from cutting payoutswhen making f inancial and real decisions within

the firm. The manager’sobjective function is extended from solely maximizing the value of equity

by adding a cost linear in the magnitude of any reduction in payout.This model is consistent with

a survey study (Brav et al., 2005) that reports that 94% of managers of dividend paying firms

strongly or very strongly agree that they actively try to avoid reducing dividends. This model

provides a possible explanation for what motivates corporate payout smoothing, but we do not

directly explore the sources of this disutility imposed on the manager. Through an estimation

exercise, we find the managerial perceived cost for cutting payout that best explains observed

payout, saving, financing, and investment dynamics.

The estimation of the agency model indicates a payout consistency cost parameter equal to

0.119 that translates to a typical firm behaving as if it has a manager who associates an average

cost for cutting payout equal to $81,000 for a million dollars of shareholders’ equity value.

These parameter estimates support the view that: 1) on average, managers anticipate fairly large

costs associated with cutting payouts, and 2) that firms are sensitive to this managerial agency

parameter. Our estimates also determine a loss of approximately 6% in shareholders’ equity value

due to the perceived cost of cutting payouts.

Mahmudi & Pavlin rCorporate Payout Policy, Cash Savings, and the Cost of Consistency 845

In addition to reducing the variability of payouts, changes in the perceived cost from cutting

payouts has a pronounced impact on cash and investment policies. These relationships are illus-

trated through a series of comparative statics exercises. An increase in the payout consistency

cost produces smoother investments, whilecash holdings largely absorb the volatility and become

more variable. Higher cash levels are also maintained in order to decrease both the probability

and magnitude of any future reduction in payout. While this may shed some light on the excess

cash puzzle, our comparative statics and estimation results indicate that effect is relatively small

and is likely only a mild contributor to the high observed levels of liquid assets.

These comparative statics results are not particularly supportive of the remedial view of payout

smoothing suggested by Easterbrook (1984). From our results, it is not clear that imposing a large

cost to cutting payouts onto a manager would enhance shareholder value. It is important to note

that the empirical positive association between cash holdings and payout smoothing documented

in Leary and Michaely (2011) may also be due to the endogenous relationship between these

policies. This interpretation differs from the Leary and Michaely (2011) explanation that cash

cows adopt payoutsmoothing to reduce agency costs. This notes the signif icance of the structural

approach in enabling us to account for endogeneity among corporate policies.

Weexplore different motives for payout smoothing and possible heterogeneity on the impact of

a managerial perceived cost to cutting payoutsby performing estimations on subsamples of firms

split by a variety of manager-firm characteristics. Through this exercise, we find some supporting

results for both agency and information asymmetry explanations for payout smoothing.

To provide evidence pertaining to the agency explanation, the sample is split based upon

Chief Executive Officer (CEO) incentive pay, proxied by pay-performance-sensitivity (PPS).

Consistent with Easterbrook (1984), we find that managers who receive contracts with high PPS

tend to associate lower costs with cutting payouts. Allen, Bernardo, and Welch (2000) argue that

institutional investors, who may also lower agency costs through their monitoring activities, are

attracted to firms paying larger dividends due to their tax status. These institutional investors, in

the case of cutting dividends, may impose large costs on management. Supporting their theory,

we find firms with larger institutional ownership behave as if they have managers with larger

preferences for smooth payouts. Our estimates also result in larger managerial payoutconsistency

costs for firms that pay larger fractions of their payout in the form of dividends rather than share

repurchases. This is consistent with the empirical literature that suggests that managers do not

smooth repurchases in the same manner as they smooth dividends (Skinner, 2008).

The information asymmetry explanation is studied through a sample split based on analyst

forecasts dispersion. In the presence of information asymmetry, smooth dividends convey more

information than erratic payouts. Studies such as Almeida, Campello, and Weisbach (2004) and

Bates, Kahle, and Stulz (2009) argue that if future dividend cuts are viewed as costly, financially

constrained firms will be reluctant to increase dividends even following a positive cash flow

shock. This argument suggests that when investor information is poor, firms have a greater

incentive to smooth their dividends. This prediction is consistent with signaling explanations

such as Kumar (1988), Kumar and Lee (2001), and Guttman, Kadan, and Kandel (2001).

In support of this hypothesis, we find that firms suffering from greater information asymmetr y

tend to have managers with larger payout consistency costs. Interestingly, this result is masked

when the empirical results are reviewed in isolation as the payout variances are similar between

the subsamples of high and low information asymmetry firms.

While Leary and Michaely (2011) finds support only for the agency based explanations of

payout smoothing, wedeter mine that information asymmetry may also contribute to this practice.

As in their paper, we also document that payoutvariance is not related to measures of information

asymmetry. It is only by estimating the unobservable variable of the manager’s disutility from