Liquidity shocks and industry payout policy.

Author:Wann, Christi

    Firms strive to maintain dividend levels, while avoiding dividend cuts (Lintner 1956, Brav, Graham, Harvey, and Michaely, 2004). Excess cash can provide a cushion that allows firms to maintain or change dividend policy during times of negative or positive shocks to cash levels. Prior literature finds that the existence of high cash levels allows firms to invest more and perform better during and following industry sales downturns (Harford, Mikkelson, and Partch 2003). Do high cash levels allow industries to maintain or increase dividend payout policy following large negative or positive shocks to liquidity?

    This study incorporates Lintner's (1956) suggestion that firms adjust dividends to a long-run target payout ratio. Dividend payout ratio deviations from long-run targets are related to the magnitude of liquidity shock and cash balances prior to liquidity shocks. For example, positive liquidity shocks preceded by high cash levels are followed by higher payout ratio deviations from target payout ratios. Target payout is defined as the five-year rolling average payout ratio by industry.

    The study also examines the relationship between liquidity shocks and stock repurchases. Are high cash levels used by industries to make share repurchases? I find a relationship between large positive liquidity shocks and repurchase activity. Also, positive liquidity shocks precede higher repurchase transactions.

    This paper makes several empirical contributions. This is the first industry-level study to empirically demonstrate that high cash levels provide a cushion that allows industries to payout ratios above target ratios after positive and negative liquidity shocks. Payout ratios do not deviate as far below target when cash levels are high in the event of positive or negative liquidity shocks. Additionally, the relationship between cash levels and repurchases has not been examined at the industry level. The remainder of the paper is organized as follows. Section 2 provides a review of the relevant literature. Section 3 describes the sample characteristics and methodology. Section 4 reports the major findings of the study. Finally, Section 5 concludes.


    Information asymmetry suggests that managers have more knowledge about their firms' risks, future projects, and values than do investors. Information asymmetry affects firms' choices between internal versus external financing (market friction) and between dividend increases versus share repurchases (signaling).

    2.1 Information Asymmetry: Market Friction and Excess Cash

    Liquidity in the form of excess cash can diminish the unfavorable financing effects of information asymmetry. Specifically, cash is the least expensive financing choice for transitory working capital needs and for investment opportunities when external sources of capital are expensive or not readily accessible (Myers and Majluf, 1984). Conversely, excess cash can generate less than optimal overinvestments or diversifying acquisitions (Harford, 1999).

    Miller and Modigliani (1958) suggest in their capital structure irrelevance model that internal cash reserves are nonessential to the firm in perfect capital markets. They argue that firms lacking internal cash flow can easily turn to external sources of financing. This conclusion follows if the firm faces no information asymmetries. On the contrary, if information asymmetries do exist, then internal cash reserves are relevant to firms. In this case, excess internal funds may be built up, even when information asymmetries are small, to protect against future times of limited access to capital markets (Myers and Majluf, 1984). For example, high cash firms invest more and perform better throughout and after industry sales downturns (Harford, Mikkelson, and Partch 2003).

    Firms may also hold excess cash to finance investment and maintain dividends to shareholders. Holding excess cash for transactions purposes implies that cash levels are related to the firm's investment opportunities, uncertainty of future cash flows, and external financing costs (Keynes, 1936). For instance, long-term cash rich firms have a higher operating income to assets ratio, capital expenditures, growth in assets, and market-to-book ratios (Mikkelson and Partch, 2003).

    On the other hand, firms may hold excess cash just as a precautionary balance. In one study, short-term excess cash is not used for distributing cash dividends, investment, or acquisitions (Opler, Pinkowitz, Stulz, and Williamson, 1999). Similar to the theoretical predictions of Keynes (1936), the level of excess cash is positively related to the firm's investment opportunities, riskier (uncertain) future cash flows, and external financing costs (Opler, Pinkowitz, Stulz, and Williamson, 1999). Also, smaller firms hold more cash than do larger firms with higher credit ratings.

    2.2 Information Asymmetry: Excess Cash and Corporate Payout Policy

    The study of corporate payout policy in the context of liquidity levels has received little attention in the prior literature. In particular, stock price reactions to dividend changes and repurchases in relation to excess cash have received some attention (Guay and Harford, 2000). However, the relationship between payout policy and excess cash has not yet been thoroughly examined. The following summarizes the extant literature on stock price reactions to dividend changes in relation to cash flows.

    The decision to increase dividends or repurchases is associated with the permanence of cash flow shocks and to market reactions (Guay and Harford, 2000). When the announcement of the payout form does not match the market's expectations concerning future cash flows, stock returns respond in the following ways. For example, when the market perceives a permanent cash flow increase and the firm chooses a temporary payout method, such as a repurchase, stocks experience negative returns. Likewise, when the market has estimated a transient cash flow shock and the firm chooses a more permanent payout, such as an increased dividend, stocks experience positive returns.

    Firms with excess cash within their industry are also firms that increase dividends or repurchase shares (Lie 2000). This use of excess cash is attributed to alleviation of the agency problem of free cash flow. Excess cash flow is defined as operating income before depreciation, minus interest expenses, taxes, and depreciation. Stock prices react only to the announcement of special dividends and repurchases, and not to regular dividend increases.

    Instead of using liquidity levels, one study investigates the permanence of earnings deviations to determine why stock repurchases have fluctuated so widely (Dittmar and Dittmar, 2002). Repurchases increase after increases in both permanent and transitory earnings. Dividends increase only after permanent increases in earnings. Dividends and repurchases are found to be substitutes for distributing permanent earnings, but repurchases are also used to distribute transitory earnings.

    In summary, extant literature examines how information asymmetry affects firm cash holdings or payout policy. Research has not determined if high cash levels allow industries to maintain or increase dividend payout policy following large negative or positive shocks events.


    3.1 Sample

    Annual data is obtained by merging the Compustat industrial and full coverage files with the research industrial...

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