How corporate governance affects dividend policy under both agency problems and external financing constraints?

1. How corporate governance affects dividend policy under both agency problems and external financing constraints? Joon Chae, Sungmin Kim and Eunjung Lee December 11, 2008

2. Motivation • Two typical problems under information asymmetry • Agency problems under information asymmetry between managers and shareholders • External financing constraints under information asymmetry between insiders and outside investors • Paying dividends generate two counteracting effects • Decreased free cash flow → decrease managerial agency problems (Easterbrook (1984), Jensen (1986), Myers (1998), Gomes (1998), and Zwiebel (1996)) • Increased dependence on external financing → increase cost of external financing (Rozeff(1982)) • Firms face a tradeoff between ‘lower agency costs’ and ‘higher external financing costs’ with increased cash dividends → We provide empirical evidence on the effect of corporate governance on dividend policy where both agency problems and external financing constraints

3. Existing literature • Large literature on the direct relationship between agency problems and dividend payments (La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) (LLSV (2000)), Jiraporn-Ning(2006), Knyazeva(2008)) • They focus on the direct relation between agency problems and dividend payments, and show that better corporate governance will induce more dividends (Outcome Hypothesis) • However, they do not consider external financing constraints • → This is the first empirical paper that analyzes the relation between corporate governance and dividends where both agency costs and external financing costs

4. Hypotheses • [Hypothesis 1] Without external financing constraints, firms with better corporate governance will pay more dividends when they have free cash flows. • Companies with agency problems need to minimize free cash flow • Strong corporate governance induces higher dividend level

5. Hypotheses • [Hypothesis 2] With both agency problems and external financing constraints, firms with better corporate governance may pay less dividends even though they have free cash flows. • The relative sizes of external financing and agency costs will decide dividend payouts • As long as corporate governance can control agency problems, companies with strong corporate governance will pay less dividends 4

6. Agency Costs Corporate Governance External Financing Constraints Payout Policy With Ext. Fin. Constraints Less Payouts Firms with Free Cash Flows Firms with Efficient Corp. Governance W/O Ext. Fin. Constraints More Payouts Hypotheses 5

7. Sample selection and Data • The data from IRRC • Governance data from Gompers, Ishii, and Metrick(2003) and Bebchcuk, Cohen, and Ferrell(2005) • Date years - 1993, 1995, 1998, 2000, 2002, and 2004 • We exclude • financial firms and utility firms • firms that do not have data on the governance index

8. Variables • Two measures to represent corporate governance • Gompers, Ishii, and Metrick (2003) corporate governance index • Bebchuk, Cohen, and Ferrell(2005) corporate governance index • Two measures of free cash flow as a proxy for agency costs (Chi-Lee(1995), Lehn and Poulsen(1989), Wu(2004)) • [Operating income - {(total income taxes-the change in deferred taxes from the previous year to the current year) +gross interest expenses on debt +dividend payments}] / book value of assets • (Earnings before interests, taxes, depreciation, and amortization) / book value of assets • Three measures of information asymmetry as a proxy for the level of external financing constraints (Leary and Roberts(2007), Krasker(1986)) • Analyst coverage • Firm age • Firm size

9. Methodology • Regressions with Newey and West(1987) standard errors and fixed effect analysis • Dependent variables • dividend ratios • Independent variables • CGI : corporate governance index • CGI*DFCF : DFCF is a dummy variable with the value of 1 if firm’s agency cost variable exceeds the sample median • CGI*DFCF*EXD : EXD is a dummy variable with the value of 1 if firm’s external financing constraint exceeds sample mean • Other control variables such as Leverage, Firm size, Profitability and Growth

10. Sample distribution Table 1. Sample distribution by year

11. The effect of corporate governance on dividend payments under agency problem and external financing constraint Panel A. EXD : Analyst coverage • Hypothesis 1 supported → Firms with agency problems will pay more dividends as corporate governance improves • Hypothesis 2 supported → Firms with agency problems and external financing constraints will pay smaller dividends as corporate governance improves

12. The effect of corporate governance on dividend payments under agency problems and external financing constraints Panel B. EXD : Firm age

13. The effect of corporate governance on dividend payments under agency problems and external financing constraints Panel C. EXD : Firm size

14. The effect of corporate governance on dividend payments (firm fixed effects)

15. Conclusion • This paper investigates how dividend policies change according to corporate governance under external financing constraints and agency problems • When agency problems are more severe, firms pay more dividends with more efficient corporate governance • When external financing constraints matter, companies decrease dividends as their corporate governance improves • The paper shows firms optimize their payout policy by considering both agency costs and external financing costs • Corporate governance can be a mechanism to control agency problems.

16. Thank you!