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

Published date01 November 2016
Date01 November 2016
The Financial Review 51 (2016) 579–611
The Influence of a Credit Rating Change
on Dividend and Investment Policy
Hinh D. Khieu
Prairie ViewA&M University
Mark K. Pyles
College of Charleston
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:
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.
C2016 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
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

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT