‘The Journal of Financial Research * Vol. V, No.3 « Fall 1982 GROWTH, BETA AND AGENCY COSTS AS DETERMINANTS OF DIVIDEND PAYOUT RATIOS Michael S. Rozeff* Abstract A mode! of optimal dividend payout is presented in whieh inereased dividends lower agency costs but raise the transactions cost of external financing. The optimal dividend payout mini mizes the sum of these two costs. A eross-setional test of the model relates dividend payout tu the fraction of equity held by insiders, the past and expected future revenuc growth ofthe fitm, the firm’ beta coefficient, and the number of common stockholders. The coefficients of all variables ate significant in the predicted directions. The results indicate that invest ‘meat policy influences dividend policy Dividend payout ratios vary widely among corporations. This paper presents a straightforward model of the determination of the optimal dividend payout and an empirical test using a multiple regression equation to explain the cross-sectional vati- ation in dividend payout ratios. ‘One factor which seems to influence the dividend payout ratio is the firm's funds requirements for investment purposes (Higgins, 1972). Agreement that investment in- fluences dividend policy is not universal, Fama (1974) being a conspicuous exception. A second factor, suggested by Higgins, is the firm’s debt financing. McCabe (1979) reports that new long-term debt has a negative influence on the amount of dividends paid. A third factor, suggested in this paper as an influence on dividend policy, is ageney costs. ‘The basic elements of the payout model presented below are cost-minimization dia- grams of the type used in inventory theory to explain optimal lot size and in agency cost theory to explain optimal debt/equity ratio. The regression equation provides new evidence on the factors previously suggested in the literature as well as on the in- fluence of agency costs. The evidence presented here is consistent with the following three propositions: (1) Firms establish lower dividend payout ratios when they are experiencing or an- ipate experiencing higher revenue growth, presumably because this growth entails higher investment expenditures. This evidence supports the view that investment pol icy influences dividend policy. The reason investment policy influences dividend pol- icy is that external finance is costly. (2) Firms establish lower dividend payout ratios when they possess higher beta coef- ficients, presumably because higher betas are a reflection of the presence of higher operating and financial leverage. This evidence supports the view that dividend pay- ments are quasi-fixed charges which ate substitutes for other fixed charges. This is because firms with higher fixed charges pay lower dividends in order to avoid the costs of external finance. University of lowa, 249250 The Journal of Financial Research (3) Firms establish higher dividend payouts when insiders hold a lower fraction of the equity and/or a greater number of stockholders own the outside equity. This evi- dence supports the view that dividend payments are part of the firm’s optimum moni- toring/bonding package and serve to reduce agency costs. In section I of the paper, the model is outlined and the variables are defined. Sec- tion II contains the empirical tests. The paper is concluded with a Summary. |. The Model Two uset | theoretical approaches toward understanding dividend policy have been offered by Lintner (1956) and Higgins (1972). Lintner suggests that firms have target payout ratios and adjust dividends to earnings with a lag; the target payout is the re- sult of an unspecified decision process within the firm. Higgins employs the firm's cash flow constraint and its optimal debt/equity ratio to derive an expression relating dividends to profits and investment. In Higgins’ model, the optimal payout results from a residual dividend policy combined with the minimization of the sum of the costs of “excessive current assets” and the costs of external equity financing. Higgins relates the latter to the taxation created when dividends are substituted for capital gains. In this paper a third approach is offered which is similar to Higgins’. Tax effects can be integrated into the model, but this is not necessary to produce an optimum. ‘The optimal dividend payout is determined by the demands of the firm's sharehold- ers, Since dividend policy is indeterminate in perfect capital markets (Miller and Modigliani, 1961), the question is what market imperfections influence the share- holder demand (or aversion) for dividends. It is hypothesized that any rational share~ holder would wish the management, other things equal, to minimize the transactions costs associated with raising funds by external security issues. This factor, by itself, suggests retaining carnings and restricting dividend payout to excess funds that are not currently and will not in the future be used for investment purposes. An opposing factor is that shareholders may demand dividends to minimize, other things equal, the agency costs of external equity. ‘This factor calls for further explanation. ‘Agency costs (Jensen and Meckling, 1976) arise when owner-managers sell off por- tions of their stockholdings to so-called “outside” security holders who have no voice in management. The discrepancy between the value of the 100 percent owner-man- aged and less than 100 percent owner-managed firm is a measure of the agency cost. To decrease this cost, owners may find it in their interest to incur bonding costs, mon- itoring costs, and auditing costs, ete, These expenditures may be worthwhile if they are more than paid for by reducing the discrepancy between the values of the firm when wholly owned by the insider and when partly owner by the insider. A wealth- maximizing firm adopts an optimal “monitoring/bonding” package which acts to reduce agency costs. ‘The conjecture is that the payment of a dividend is a device, like a bonding cost or an auditing cost, which is employed to reduce agency cost of equity. In analyzing divi- dend policy, it is usually assumed that the return of capital to stockholders in the form of cash dividends is accompanied by raising capital by external issue to financeDividend Payout Ratios 251 existing and future investment. Hence, it is assumed that rational stockholders realize that the firm is financing the dividend by new funds and that this is costly. Neverthe- less, they find this process desirable because they observe the terms on which new funds are raised and perhaps the identity of the new funds suppliers. Furthermore, since it is likely that new lenders and/or equity suppliers will not supply funds unless they receive new information about the uses intended for the funds, the shareholders also may gain new information about management intentions. The alternative to this roundabout process, by which the current shareholders learn the market's current evaluation of the firm's investment program, is that the firm retains the funds and provides “equivalent” information to its current owners; this allows owners to choose whether or not to retain their ownership in the firm, This course is followed to an ex tent by the provision of audited financial statements. However, it is conjectured that the cost of informing shareholders by this means may simply rise enough that this method of informing shareholders becomes inferior to the dividend process accom- panied by the firm’s raising funds in external markets. ‘Two opposing influences on dividend payout have now been introduced; this is enough to produce an optimum. If agency costs decline as dividend payout is inereased and if transactions costs of financing increase as dividend payout is increased, then minimization of the sum of these two costs produces @ unique optimum for a given firm. Figure I portrays the optimum payout for a given firm. Diagrams like Figure I can be used to rationalize different payout policies. If the firm has high prospective growth and thus funds requirements, the transactions cost curve will be high at higher payout ratios. This will tend to create an optimum at a lower payout ratio. On the other hand, if the firm is held primarily by outsiders so that agency costs are high when dividend payouts are low, this will tend to raise the optimum towards a higher dividend payout ratio. Suppose two firms, A and B, have identical transactions cost curves and different agency cost curves. Firm A has high inside ownership and a lower agency cost curve while Firm B has low inside ownership and a higher agency cost curve. Then it is easy to see that Firm A’s optimal payout ratio lies to the left of firm B’s optimal payout ratio. Taxes on dividends and capital gains can be superimposed on a firm's cost curves, but tax factors play no necessary role in determining optimum payout; an optimum payout ratio is possible without appeal to tax factors. Under the Miller and Scholes (1978) scenario in which taxes on dividends ean largely be avoided, the optimun shown in Figure I would still occur. On the one hand, if dividends were preferred by stockholders to obtain the tax exclusion on small dividend amounts or to avoid the transactions costs of selling shares, this preference could be graphed as an increment to the agency cost curve. Similarly, if investors avoided dividends because of the taxes on dividends, this aversion could be treated as an increment to the transactions cost curve. The transactions cost curve is directly related to the firm's risk—the firm's operat- ing and financial leverage. Other things equal, if a firm has relatively high operating and financial leverage, the volatility of its cash flows is increased. Hence, the firm's dependence on external financing is increased. Consider two firms whose overall funds for reinvestment (before dividend payments) are identical over a three-year per-252 The Journal of Financial Research Ca (PAY) = C,(PAY) + C5 (PAY) on (Page) o, (Pay) Agency Costs and Transactions Costs ° Paya 100 Pay (%) Percentage of Earnings Paid Out as Dividends Figure I. Total of agency costs and transactions costs C, (PAY), 28 a function of the percentage of earn- ings paid out as dividends, PAY. C, (PAY) = agency costs associated with outside equity, Cp (PAY) = transactions costs assoclated with extemal financing. Cy (PAY*) = minimum total costs at optimal payout ratio. iod, but that have differences in operating and/or financial leverage. Suppose firm A with low leverage generates a steady cash pattern of $4 each year while firm B with high leverage generates $2, 310, and 34. B will have to borrow in year 1 and incur finance costs. Whatever dividend payout ratio A finds optimal, it is hypothesized that, other things equal, B will pay out a lower fraction of earnings to lower its depen- dence on external financing. Higgins (1972) points out that substitutes are available for a lower dividend payout in such forms as a buildup of current assets and unused debt capacity. Leverage produces fixed charges. Dividend payments are substitutes for these charges. Since firm B with higher fixed charges depends more greatly on costly exter- nal financing, the opportunity cost of its dividends is higher than for firm A. Hence, firm B will choose to pay lower dividends, other things equal. The transactions cost effect of external financing for higher risk firms can be treated graphically as an in- crement to the transactions cost curve.Dividend Payout Ratios 253 U1. Empirical Results Sample The sample of stocks is drawn from editions 1-13 of the Value Line Investment Survey of June 5, 1981, Data are for all firms except for the intentional omission of the following industries: regulated (gas, telephone and electrical utilities, air trans- port, railroad, bank, insurance, savings and loan, investment companies), foreign, and petroleum exploration. Regulated firms are not selected because their financing policies may be significantly affected by their regulatory status. These firms ic beyond the scope of the model presented in this paper. Foreign firms and oil explor: tion firms are omitted because they tend to follow accounting practices which may sig- nificantly influence the observed dividend payout ratio. A small number of new firms which Value Line has not yet classified as to industry are also omitted. After these omissions, a census of all non-financial and nonregulated firms remains. The sample size is 1,000 and spans 64 different industries. The sample includes a broad range of industry types, and the results of the regression analysis can be viewed as typical of the major unregulated domestic firms. Variables in the Regression Model The cost minimization model tests if dividend payout ratios are systematically re- lated in the predicted directions to variables which surrogate for agency costs and transactions costs of external financing. The dependent variable in the multiple regression model is the firm's target divi- dend payout ratio, With the exceptions noted below, the target dividend payout ratio is measured as the arithmetic average of each of a firm's seven dividend payout ratios over the seven years 1974-1980. The choice of a seven-year averaging period is a result of a visual inspection of a pilot sample of 200 firms’ payout patterns; this revealed a substantial degree of stationarity in payout ratios over this time period. Seven years appears to be a long enough time period to smooth the usual fluctuations in earnings that occur through time, but not so long as to produce serious measurement errors due to systematic changes in the payout ratio's mean value. In certain instances, an estimate of the dividend payout other than a seven-year arithmetic average of ratios is used. First, if a firm initiated dividend payments in this, time period, less than seven observations are used. Second, if a firm initiated divi- dends in this period, the first year's observation is omitted if less than a full year's dividends are paid and/or the initial dividend is a token amount. Third, if a company has a deficit in earnings, the payout ratio for that year is undefined. To replace this observation, the sample is extended backwards in time to include an additional year such as 1973 or 1972. Fourth, if a firm has three or more deficits in the period 1974-1980, or if a firm had two or more deficits whose size was so large that they es- sentially equalled in magnitude the firm’s positive earnings, the firm is eliminated from consideration. In these instances, it appears that measurement of target payout is subject to considerable measurement error. Fifth, if a firm has “small” nonnegative254 The Journal of Financial Research earnings in a given year and maintains its dividend so that the payout ratio is 90 per- cent or above, a slightly different averaging procedure is used in order to give this year less weight; all dividends and all earnings over the period are added separately, and then the ratio of these sums is taken. It is doubtful that any of these procedures materially biases the results to be re- ported or affects the representativeness of the results, since the sample size is large (1,000). ‘These measures are used to reduce the measurement error in the dependent variable. ‘As a surrogate for the transactions cost of financing required by external issues, three variables are employed. The first is the realized growth rate of the firm’s reve- nues over the five-year time period 1974-1979. The second variable is Value Line's forecast of the growth of sales revenue over the five-year period 1979-1984. The rea- soning behind the choice of these variables is straightforward. If past growth has been rapid, other things equal, then the firm has required funds for investment to create the sales. In this case, the firm would tend to retain funds to avoid external financing with its attendant costs. Similarly, if rapid growth were anticipated in the future, then fa prudent management will conserve on funds by establishing a lower payout ratio now. Hence, it is hypothesized that dividend payout ratio is negatively related to both past growth of revenues and predicted future growth of revenues of the firm. Value Line's forecast of growth is a measure of the management's expectations of growth It is hypothesized above that if firm has higher operating and financial leverage, other things equal, the firm will choose a lower dividend payout policy to lower its costs of external financing. A natural surrogate for operating and financial leverage is the firm’s beta coefficient—the covariance of its stock return with the market return dividend by the variance of the market return. The role of beta in reflecting operating leverage and financial leverage is well known. (See Lev, 1974, and Hamada, 1971, re- spectively.) Beta is higher insofar as a firm has higher operating and financial lever age. Beta is the third variable surrogate for the transactions cost of external finance. Hence, it is hypothesized that the dividend payout ratio is negatively related to the firm’s beta coefficient. ‘To measure the beta coefficient, Value Line's beta is used as reported in the Value Line Investment Survey. This is a value-weighted beta obtained using five years of weekly data on the stock's returns and the returns on the Value Line Index. In addi- tion, Value Line's betas are adjusted for regression towards the mean. The use of Value Line's betas is necessitated since many of the stocks cited in the 1981 issues of the Value Line Investment Survey do not have return data on the 1979 CRSP tape. ‘Two variables are used to measure the agency cost decrease associated with increas- ing the dividend payout ratio. The hypothesis is that as outside equity holders own a larger share of the equity, they will demand a higher dividend as part of the optimum monitoring package. Hence, one variable included in the regression equation is the percentage of stock held by insiders (as reported by Value Line). The prediction is that the dividend payout will be negatively related to the percentage of stock held by insiders. The fraction of stock held by outsiders may not be the only determinant of dividend demand. If this fraction were held by fewer stockholders, their ownership will be more concentrated and may more easily influence insider behavior, thereby reducing agencyDividend Payout Ratios 255 costs and leading to a lower optimal dividend payout. Hence, dispersion of ownership among outside stockholders may influence the dividend decision, with more disper- sion leading to higher dividends. To measure ownership dispersion, the number of common stockholders is used. ‘The prediction is that the dividend payout is positively related to the number of shareholders in the firm—the latter variable being used to measure dispersion of ownership. To correct for scale effects, the results reported below include the natural log of the number of shareholders as an independent variable. If the raw numbers of sharehold- ers were used, an increase in shareholders from 1,000 to 2,000 would be expected to have the same impact as an increase from 999,000 to 1,000,000, yet it seems clear that the increase in dispersion is far greater in the former instance. On a natural log scale, a doubling of the number of shareholders from 1,000 to 2,000 and from 500,000 to 1,000,000 produces approximately equal increases in the transformed independent variable. Table 1 provides the variables in the regression model, abbreviations, the hypothe- sized signs of the regression coefficients, and the overall averages of the variables. Estimation of the Regression Equation The results of estimating the regression model over the sample of 1,000 firms are shown in Table 2, line 1. ‘The regression is highly significant and explains 48 percent of the cross-section variation in dividend payout ratios. All the independent variables have r-statisties well above 2.0 and enter the regression with the hypothesized signs. Higher growth rates in the past and forecasts for the future are associated with lower dividend payouts. Higher beta coefficients are associated with lower dividend pay. outs. Higher inside ownership is associated with a reduced dividend payout ratio and a greater number of shareholders is associated with a larger dividend payout. The matrix of simple correlation coefficients among the regression variables is shown in Table 3. The simple correlation coefficients of the dividend payout ratio with each of the independent variables are consistent with the results in the multiple regression. There are two relatively strong intercorrelations of the independent vari- ables, The two growth variables have a correlation coefficient of 0.566. The fraction TABLE 1, Variables in Regression Model and Hypothesized Signs Variable Definition Hypothesized Sign Variable Name Mean Intercept term in regression none const Percentage of common stock held by insiders = INS 18.07 Average growth rate of revenues, 1974-1979 - Growl 13.62 Value Line's forecast of average growth rate - GRow2 1257 of revenues, 1979-1984 Beta coefficient - BETA 1.07 Natural logarithm of number of common + STOCK 9.13 stockholders ‘Average payout ratio, 1974-1980, the na, PAY 30.48 dependent variable256 The Journal of Financial Research ‘TABLE 2. Estimated Regressions of Payout on Indepenclent Variables” CONSTANT INS GROW! GROW? BETA STOCK. F-statistie (1) 4781 0.090 0.321 0.826 26.543 2.584 0.48 185.47 (12.83) (4.10) (6.38) (6.48) (17.05) (7.73) QO m7 0.068 0.474 —0.758 2517 0.33 123.23 (627) (- 2.75) (8.48) (8.28) (6.03) @ 7068 = 0.402 0.608 —25.409 = Oat 231.46 (00.35) (758) (6.98 (=15.35) @ 956 0.116 — 33,505 3.181 0.39 218.10 40.07) (4) 1.28) (8.82) o 103-0102, — - = 3429 0.12 69.33 (024 (=3.60) (797) rstatistics are shown in patentheses under estimated values of the regression coefficients. R? is adjusted for degrees of freedom. TABLE 3, Mats of Simple Correlation Coefficients of Regression Variables INS GROW] GROW2—- BETA STOCK Pay INS 10 0.163 0.126 =0011 0.495 0,257 GROW! 10 0.566 0.205 0.185 0.166 GROW? - 10 0.301 —0.164 0.456 BETA ES - = 10 0.027 = 0.529 - 10 0.333 STOCK - - of inside ownership and the log number of stockholders have a negative correlation of —0.495. The correlations between the beta coefficient and the growth variables is ap- proximately 0,30. These intercorrelations constitute a nonnegligible degree of multi- collinearity, but the multicollinearity is probably not so high that the individual influ- ences of the variables cannot be disentangled. To see this and to gauge the regression’s robustness and sensitivity to specification error, selected yatiables are omitted from the complete model and the regressions re-estimated. These results are shown in Table 2, lines 2-5. When the beta coefficient is omitted as an explanatory variable, the growth terms with which it is correlated gain in significance, and vice versa. Omission of either beta, the growth variables, or the pair of agency cost variables noticeably decreases the explanatory power of the regression model. At the same time, the regression coef- ficients are not remarkably sensitive to these alterations and each of the re-estimated regressions is highly significant. The impression one gains is that the complete cross sectional mode! is reasonably well-specified in the sense that each variable is impor- tant to the regression, and the regression coefficients are not highly sensitive to the specification.Dividend Payout Ratios 257 Discussion These results are consistent with the hypothesis that outside shareholders demand a higher dividend payout if they own a higher fraction of the common equity and if their ownership is more disperse. That is not the only plausible explanation of the signifi- cance of these variables. However, their inclusion in the regression model is motivated by this theory and is not the result of a search over a list of potential variables. ‘There is another interpretation which relies on tax effects. Suppose taxes on divi- dends matter. If a director holds only 100 shares of stock and this represents a small fraction of his wealth, his decision on the dividend is far less likely to be influenced by consideration of the personal income tax than a director who has much of his wealth in shares of the firm. The variable “percentage of stock held by insiders” is a proxy for the variable “percentage of insider wealth in the form of common equity.” Hene: if tax-avoidance on dividends is less than complete, the higher the percentage of stock held by insiders, the lower the dividend payout ratio, This, of course, is only part of the conclusion. Since the number of shareholders is associated with dividend payout also, for a consistent tax analysis, one would have to assume that number of shareholders is a proxy for tax bracket in an inverse direction: the more shareholders, the lower the tax bracket, and thus less of an aversion for ceiving dividends. Attempts to distinguish these and similar theories from the idea that dividends lower agency costs must be left for future research. Higgins (1972) has argued that management establishes dividends hased on the long-term or trend values of investment. ‘The fact that the future predicted growth variable is of greater quantitative importance than the past realized growth variable seems consistent with this view, because the forecast may measure the long-term growth rate more accurately than the most recent realization. Like Higgins and unlike Fama, the result here is that investment has a negative influence on dividends paid. One possible explanation for the difference in findings is simply that Fama’s test lacks power. Fama searches for a significant explanatory effect of a disturbance in in- vestment policy on the firm's dividend policy in the same year. The possible weakness of the test arises (1) from the smail intertemporal shifts in investment policy that oc- cur for a given firm or that may have occurred in his test years and (2) from the small reaction of dividend policy to any given one year's disturbance in investment policy even if it were sizeable. By contrast, cross-sectional tests like Higgins’ and those pre- sented here, ignore shifts in equilibrium values but seek relationships among vari- ables that are assumed to be in equilibrium. The difference in methodology is analo- gous to the problems encountered in showing that financial leverage influences beta. It is relatively easy to show this using a cross-section of firms, but it is difficult to show that beta changes through time as a result of a given firm's alteration in its financial leverage. There are numerous reports in the literature that beta is negatively related to divi- dend payout, but explanations of this phenomenon are in short supply. The author's view is that high beta firms are more likely to require costly external financing, other things equal. Hence, they intentionally choose lower dividend payout policies. This explanation relies on the fact that beta incorporates operating and financial leverage.258 The Journal of Financial Research A better test of this hypothesis is undoubtedly possible by constructing two samples of firms with the same betas but with different degrees of leverage and examining their dividend payout policies. This is left for future research. Ill, Summary and Conclusions Dividend policy continues to be an area of some mystery among financial econo- mists with many questions unanswered, some questions answered in conflicting ways, and some questions remaining to be asked. This paper rationalizes an optimal divi dend payout by appealing to two market imperfections, the agency costs of external financing and the transactions cost associated with issuing external finance. It is ar- gued that increased dividends relative to earnings lower agency costs but raise the transactions costs of external financing. The sum of these two opposing costs deter- mines an optimal dividend payout. The results of an empitical test of the model are consistent with these hypotheses. The dividend payout is a significantly negative func- tion of the firm’s past and expected future growth rate of sales, a significantly nega- tive function of its beta coefficient, # significantly negative function of the percentage of stock held by insiders, and a significantly positive function of the firm's number of common stockholders. One question often raised is whether investment policy influences dividend policy. The answer reported here is “yes,” in the sense that holding other factors constant, firms with greater investment, as measured by greater current and prospective growth rates of revenues, have lower dividend payouts. Dividend payout ratios are not randomly distributed among firms. If they were, the results observed above would not be theoretically reasonable. Further progress in un- derstanding the determinants of dividend policy is fostered by moving away from a concentration upon perfect capital market results which, although quite correct, can- not illuminate how a firm actually selects a dividend policy, and moving towards more rigorous analysis of the market imperfections which produce an optimal dividend pol- icy. (See Miller and Rock, 1982.) References Pama, E. P. (1974) “The Coapisicat Relationships Betwoen the Dividend and Investment Decisions o Firms.” American Economic Review, 64, (une), pp. 304-318 Hamada, R, $. (1971) “The Effeet of the Firm's Capital Structure on the Systematic Risk of Common Stocks.” Journal of Finance, 26, (May), pp. 435-452. Higgins, R. C. (1972) “The Corporate Dividend-Saving Decision.” Journal of Financial and Quantita: tive Analysis, 7, (Mareh), pp. 1527-1541 Jensen, M. C. and Meckling, W. H, (1976) “Theory of the Firm: Managerial Behavior, Ageney Costs and Ownetship Structure." Journal of Financial Economies, 3, (October), pp. 305-360. Johnston, J. (1963) Econometric Merhods, New York: McGraw-Hill Book Company Lev, B. (1974) “On the Association Between Operating Leverage and Risk.” Journal of Financial and Quantitative Analysis, 9, (September), pp. 627-641, Lintner, J, (1956) “Distribution of Incomes of Corporations among Dividends, Retained Earnings and Taxes.” American Economie Review, 46, (May), pp. 97-113.Dividend Payout Ratios 259 McCabe, G. M. (1979) “The Empirical Relationship Between Investment and Financing: A New Look.” Journal of Financial and Quantitative Analysis, 14, (Match), pp. 119-135. Miller, M. H. and Modigliani, F. (1961) "Dividend Policy, Growth, and the Valuation of Shares." 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