INTERNAL CAPITAL MARKETS, FORMS OF INTRAGROUP TRANSFERS, AND DIVIDEND POLICY: EVIDENCE FROM INDIAN CORPORATES

• DOI: http://doi.org/10.1111/jfir.12135
• Author: P. V. Viswanath,Elena Goldman
• Date: 01 December 2017
• Published date: 01 December 2017

INTERNAL CAPITAL MARKETS, FORMS OF INTRAGROUP TRANSFERS,

AND DIVIDEND POLICY: EVIDENCE FROM INDIAN CORPORATES

Elena Goldman and P. V. Viswanath

Pace University

Abstract

Firms in a business group share ownership structures, allowing them access to sources of

intragroup financing not available to independent firms. Resources could be transferred

within a group either through intragroup transactions, primarily operational activities

(internal transfers), or through dividends permitting insiders to make investments in

other group firms (external transfers). The first strategy predicts lower dividends, and the

second predicts the reverse. Using a large data set of listed Indian firms, we look at the

costs of internal transfers versus external transfers and find that dividend policies of

group firms are better explained by the external transfer hypothesis.

JEL Classification: G32, G34, G35, O16

I. Introduction

Stewart Myers, in his 1984 a rticle, notes an empirical regularity: firms prefer i nternally

generated funds to external fina ncing. Myers and Majluf (1985) ex plain this using the

idea that information asymmetry between the firm and capital markets makes external

funds more expensive than int ernal funds. One implication of their theory is that firms

with larger internal capital mar kets would have an advantage beca use they would be

able to obtain funds more easily thr ough internal generation and tra nsmission of funds,

rather than going to the external ca pital markets (ICM hypothesis ). However, it is

difficult to disentangle the ef fect of other variables in the firm, such as growth

opportunities from the operation of internal capital markets within a single firm

(Chahine, Filatotchev, and Pie sse 2007). Business groups, wh ich consist of loosely

related firms linked together by a common, contr olling set of shareholders, pr ovide an

alternative manifestation of such internal capital markets. Ther e is now an established

body of evidence showing that i nternal capital markets of this so rt exist in business

groups. However, there are still many questions that need to be answered about

precisely how such markets work. For one, so me evidence indicates that group

resource movements are used t o enhance efficiency; other evi dence suggests that it is

used to transfer wealth from gr oup firms where insiders have low cash flow righ ts to

The authors thank the associate editor for extremely helpful suggestions that contributed greatly to the final

product. Part of the work on this paper was done while Viswanath was on sabbatical in early 2017 at the

Nabakrushna Choudhury Centre for Developmental Studies (NCDS), Bhubaneshwar, India. He thanks the Centre

for the facilities provided to him during his stay there to enable him to finish this study.

The Journal of Financial Research Vol. XL, No. 4 Pages 567–610 Winter 2017

567

© 2017 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

other firms, where they have hi gh cash flow rights. For anothe r, resource transfers

could be accomplished eith er internally through the use of operations-related

activities, such as transfer pricing or balance-sheet-related activities, such as

intragroup loans or external ly through the payment of divide nds.

What causes firms to choose between one channel and another? In short, there

are many issues that need to be studied with respect to the operation of group-level

internal capital markets. Our article looks primarily at the second question and examines

the implications for dividend policy. If resources are conserved within the group,

affiliated firms would pay lower dividends (internal transfer [IT] hypothesis), whereas in

the alternative scenario (external transfer [ET] hypothesis), dividends would obviously

be higher.

Business groups exist in many Asian countries. These are well known as

keiretsu in Japan and chaebol in Korea; their prevalence in China and India, too, has

been well documented (He et al. 2013). In both Korea and Japan, dividend payouts

are low compared to firms in other countries of similar economic development.

However, it is not clear whether the size of the internal capital market is an important

consideration in the determination of group firms’dividend policies in these

countries. In Japan, usually a banking corporation, called a main bank, is an integral

part of the keiretsu group. As a result, dividend policies are not as important in terms

of obtaining access to capital. In Korea, the state itself promotes chaebols as a

development strategy and uses state-owned banks to direct funds to chaebol

companies. In China, the stock market has not been an efficient mechanism to raise

funds, given that state-owned enterprises (SOEs) form a large proportion of the listed

companies. As a result, access to external capital is limited for most nonstate

enterprises. India, however, is unusual in having both group companies and a

reasonably well-functioning equity capital market. As such, it provides a good

environment to test various aspects of the internal capital markets hypothesis in the

context of dividend policy.

1

As noted above, there is evidence of various kinds of resource transfers among

group firms. For example, Gopalan, Nanda, and Seru (2015) provide evidence that

dividends by group-affiliated firms are systematically related to concomitant equity-

financed investments by other group affiliates. Gopalan, Nanda, and Seru (2007) show

that group-affiliated firms provide loans to other firms in the same group that are

experiencing financial distress. Basu and Sen (2015), too, find that resource movements

out of a group firm are lower if the firm has higher capital needs. Bertrand, Mehta, and

Mullainathan (2002) find evidence of tunneling. They find that cash flow shocks are

propagated from the group-affiliated firm where they originate to other group-affiliated

firms in accordance with cash flow rights of insiders. Manos, Murinde, and Green (2012)

look at differences in dividend policies of group-affiliated firms versus stand-alone firms.

1

Gopalan, Nanda, and Seru (2015) look at dividend policies of group firms in a large set of countries, both

developing and developed. However, some of the intragroup data that are available for India are not available for

these other countries; hence, controlling for other theories of dividend policy is still an issue. In any case, they do

not consider the possibility of group firms transferring resources to other group firms through means other than

loans and dividends.

568 The Journal of Financial Research

They find that group-affiliated firms pay higher dividends than stand-alone firms.

2

What

is interesting in looking at all these studies is that there is little evidence of intragroup

flows accomplished through operational activities affecting the income statement. This

is not entirely surprising given that data on transfer pricing and asset sales to group firms

at advantageous prices are, for obvious reasons, not reported. Thus, the only resource

transfers conserving funds within the group that are examined are loans from one group

firm to another firm. Using an expanded data set, Prowessdx, and new measures of

the cost of intragroup funds transfers, we investigate the reasons for a broader category

of resource transfers in group firms. In addition, we look at the impact of group transfers

on group firms’dividend policies and seek to establish whether internal transfers are

more important than external transfers.

3

Bertrand, Mehta, and Mullainathan (2002) and Gopalan, Nanda, and Seru (2007)

do not look at dividend policies, which are the focus of our article. Gopalan, Nanda, and

Seru (2015) do look at dividend policies, as do Basu and Sen (2015). However, Basu and

Sen’sfindings depend strongly on their interpretation of recent changes in sales as

evidence of a firm’s need for financial resources; this may be the reason for their inability

to explain why firms retain earnings when their need for funds is low (as measured by

declining sales). Furthermore, they look at competing power structures within a group

and their effect on group firms’dividend policies, whereas we look at the group as a

whole.

4

Our article is perhaps most comparable to Gopalan, Nanda, and Seru (2015).

They show that group firms pay higher dividends and that these dividends are correlated

with equity-financed contemporaneous and future investments by affiliated firms, a

finding that is consistent with the ET hypothesis. Following their specification, we also

include contemporaneous and one-year-ahead aggregate group investments to explain

firm dividend payouts. In addition, we use group capital expenditures for the previous

year. Just as they do, we find that dividends are higher, the higher are aggregate group

investments. Gopalan, Nanda, and Seru (2015) corroborate their results by looking at the

effect of shocks to the investment opportunity set of a group-affiliated firm and find that

the shock is transmitted to the dividend policies of other group firms. We use a different

approach to obtaining evidence that group firm dividends are paid with the intention of

allowing insiders to transfer resources to other group firms. Specifically, we look at the

costs of moving funds internally across group firms and find that dividend policy is

responsive to the level of these costs. One of the strengths of the Gopalan, Nanda, and

Seru (2015) study is that they use a multicountry data set; however, this restricts their use

of variables that are not available for all of the countries in their data set. We are able,

2

Manos, Murinde, and Green (2012) control only for a few relevant firm-related variables. They include some

variables such as standard deviation of residuals from a market model and noninstitutional shareholder holdings to

measure information asymmetry, but they do not use industry affiliation or capital intensity or any measures of

expected firm growth rate.

3

Our article is possibly the first to investigate dividend policies of group firms to use the new Prowessdx data

set, which has increased the number of firms covered by about 28% according to the Centre for the Monitoring of

the Indian Economy, which publishes data on Indian firms.

4

Basu and Sen (2015) find that firms retain earnings and pay out less dividends when their sales are declining,

afinding that supports neither efficiency nor opportunism approaches.

Internal Capital Markets 569