The Influence of a Credit Rating Change on Dividend and Investment Policy Interactions

• Author: Hinh D. Khieu,Mark K. Pyles
• Published date: 01 November 2016
• DOI: http://doi.org/10.1111/fire.12104
• Date: 01 November 2016

The Financial Review 51 (2016) 579–611

The Influence of a Credit Rating Change

on Dividend and Investment Policy

Interactions

Hinh D. Khieu∗

Prairie ViewA&M University

Mark K. Pyles

College of Charleston

Abstract

Weexamine firms’ alterations in dividend and investment activities followingcredit rating

changes. We findthat downgraded firms reduce both dividends and investments more than no-

rating-change firms. However, a silver lining of this doubly negative impact for shareholders

is an increase in investment efficiencyin firms that are most likely to overinvest. For upgraded

firms, investments increase, but dividend outlays do not, compared to firms without rating

changes. Our findings of asymmetric dividend stickiness and symmetric investment changes

on a credit shock suggest that dividends and investments should not always be considered

competing uses of funds.

∗Corresponding author: Department of Accounting, Finance, and Management Information Systems,

College of Business, Prairie ViewA&M University, Prairie View,TX 77446; Phone: (936) 261-9210; Fax:

(936) 261-9273; E-mail: hikhieu@pvamu.edu.

The authors are grateful to Bonnie Van Ness, a past editor; Srini Krishnamurthy, a current editor; and

an anonymous reviewer, whose comments and suggestions have significantly improved the paper. We

also thank Alice Bonaime, Michael Furchtgott, Jon Fulkerson, Curtis Price, participants at the Midwest

Finance Association 2014 and Southwestern Finance Association 2015 conferences, participants at the

University of Southern Indiana College of Business Research Colloquium, and participants at Winston-

Salem State University and Prairie ViewA&M University presentations for their insightful comments. All

errors remain ours.

C2016 The Eastern Finance Association 579

580 H. D. Khieu and M. K. Pyles/The Financial Review 51 (2016) 579–611

Keywords: credit rating changes, financial constraints, dividend payout, investment

efficiency

JEL Classifications: G30, G32, G35

1. Introduction

In the perfect and efficient capital world of Modigliani and Miller (M&M

hereafter, 1958, 1961), dividend and investment decisions are independent of each

other since external financing is always availableto fund investments in the event that

internal cash flows are used up in paying dividends. However, numerous subsequent

studies (e.g., Brav, Graham, Harvey and Michael, 2005; Daniel, Denis and Naveen,

2008) find that firms are forced to choose between dividendpayments and investment

in the face of capital restriction. In these subsequent works, the underlying assumption

is that some source of funds, external or internal, must remain available and sufficient

to fund one expense or the other, but not both. It is then the manager’sresponsibility

to determine the reallocation of resources to accomplish this chosen objective.

In this study, we revisit the interrelated decisions of dividend and capital ex-

penditure allocations. Measuring the change in access to funds with credit rating

changes, we ask the question of whether the stylized negative correlation between

these two still holds in a context in which the aforementioned assumption is relaxed.

For example, what happens if either external or internal funds or both shrink, such as

in the event of a credit rating decline? Under such instances, does a dividend cut fully

buffer against a decrease in investments or vice versa? For firms entering a state of

more or less severe financial constraint, can dividend payouts and investment outlays

increase or decrease congruently instead of in opposite directions? Our attempt to

provide a more exhaustive examination of the correlations between two important

corporate decisions constitutes the primary contribution of this paper.

In reality, the relation between the two outlay choices is not as simple as a pure

inversion. There are competing theoretical views and empirical evidence on how the

two decisions interact. First, the dividend stickiness view (e.g., Lintner,1956; Myers,

1984; Jensen, 1986; DeAngelo and DeAngelo, 1990; Leary and Michaely, 2011)

predicts that dividends will not change for either downgraded or upgraded firms.

Managers are reluctant to reduce dividends due to the negative signal conveyed and

are nearly equally reluctant to increase the payout for fear of failure to maintain the

same level in the future.

Second, the residual cash flow view (Jensen, 1986; Stultz, 1990) of dividend

payouts argues that firms pay dividendsout of what is left over after viable investment

opportunities are exhausted. On a negative shock, investments take the first priority

in the line of funding allocations, and dividends sacrifice as a result. However, a

positive shock could possibly trigger an increase in both outlays, if managers feel the

new (higher) level of access to funding is a permanent situation.

H. D. Khieu and M. K. Pyles/The Financial Review 51 (2016) 579–611 581

The third view is similar to that of residual cash flows but incorporates the

well-documented agency problems angle. This managerial protection view posits

that constrained firms’ managers will protect the benefits of both shareholders and

themselves by becoming conservativein spending. That is, such firms tend to cut both

dividends and investments in exchange for financial flexibility. It is not clear from

this view,however, what managers would do on a positive shock. While conventional

logic suggests they would relax the purse strings, there is an alternativeline of thinking

that suggests they would still preserve cash to maintain the newly earned credit rating

(e.g., Kisgen, 2006; Khieu and Pyles, 2012). This latter notion would result in no

surge in new capital expenditures or disbursement of cash to shareholders.

Prior studies, both theoretical (e.g., Stiglitz and Weiss,1981) and empirical (e.g.,

Almeida and Campello, 2007), on investment and financing frictions use a variety

of proxies for adverse shocks to the supply of, or demand for, external finance.

These include dividends (Fazzari, Hubbard and Petersen, 1988), indices (Kaplan and

Zingales, 1997; Whited and Wu, 2006), the funding status of mandatory pension

plans (Rauh, 2006), and firm size and age (Hadlock and Piece, 2010).

More related to our study, Sufi (2009) demonstrates that having a credit rating

alleviates constraint and provides increased access to financing sources. However,

to measure a bidirectional alteration in the level of constraint, we examine corpo-

rate credit rating changes rather than a static rating status for our sample firms. By

definition, a rating change—upgrade or downgrade—represents a change in the per-

ception of the debtor’s ability to meet its financial obligations to the creditor. So, in

using credit rating changes, we can readily investigate both a potential loosening and

tightening of the financial constraint of a firm. In response to this potential change

in future access to capital, managers then have to make decisions pertaining to the

future cash flow expectation of the firm. Concerned about future cash shortfalls,

managers are likely to change their financing policies accordingly. As such, whether

an actual change in constraint occurs (in a way that can be quantitatively measured)

is secondary to the managers’ belief that preventative policy alteration is necessary.

Such a setting allows us to examine internal financing and investmentpolicy in-

teractions and to put managers’ decisions “under duress” beyond the static Modigliani

and Miller irrelevance theory and the stylized tradeoff theory of dividends and in-

vestments. In addition, the extant study seems to focus primarily on negative shocks

to external capital markets, conventionally definedas “financial constraint” while the

implications for these important corporate policies in the face of positive shocks are

less clear. We help to fill this gap in the literature.

The use of credit ratings also provides a direct measure of the firm’s access to

external finance without the need for an identification of the initial levelof constraint,

as other proxies would require. For example, when The Dodd-Frank Wall Street

Reform and Consumer Protection Act of 2010 was enacted, companies such as Ford

Motor Inc. had their security issues delayed or cancelled due to a protest by rating

agencies disallowing their ratings to be used in the security offerings (Purda, 2011).

In studying the evolving role of rating agencies, Purda (2011) finds that ratings play a