The Economic Implications of Corporate Financial Reporting

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The Economic Implications of The Economic Implications of Corporate Financial ReportingCorporate Financial Reporting

John R. GrahamDuke University, Durham, NC USA

Campbell R. HarveyDuke University, Durham, NC USA

National Bureau of Economic Research, Cambridge, MA USA

Shiva RajgopalUniversity of Washington, Seattle, WA USA

September 28, 2004University of Chicago

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Graham/Harvey/Rajgopal: Corporate Reporting

Background

• In 1995, Duke and Financial Executives International make a deal to conduct a quarterly CFO survey

• The deal allows for some special ‘academic’ surveys outside of the quarterly survey that would use the FEI e-mail list

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Background

1. Graham and Harvey conduct a survey on capital structure and project evaluation– “Theory and Practice of Corporate Finance: Evidence from

the Field” appears in JFE 20012. Brav, Graham, Harvey & Michaely survey on

dividend and repurchase policy– “Payout Policy in the 21st Century” forthcoming in JFE

20043. Graham, Harvey and Rajgopal survey on corporate

financial reporting

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Methodology

General goals our research program:• To examine assumptions• To learn what people say they believe• To provide a complement to the usual research

methods: archival empirical work and theory

5


Methodology Approach contrasts with Friedman’s (1953)

“The Methodogy of Positive Economics”• Goals of positive science are predictive• Don’t reject theory based on “unrealistic

assumptions”• Also, rejects notion that all the predictions of a

theory matter to its validity – goal is “narrow predictive success”

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Methodology

Alternative view, Daniel Hausman (1992)• “No good way to know what to try when a

prediction fails or whether to employ a theory in a new application without judging its assumptions.”

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Narrow goals Insight on following issues:• Importance of reported earnings and earnings

benchmarks• Are earnings managed? How? Why?

– Real versus accounting earnings management– Does missing consensus indicate deeper problems?

• Consequences of missing earnings targets• Importance of earnings paths• Why make voluntary disclosures?

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Strengths and limitations Strengths:• Surveys enable us to ask decision-makers specific qualitative

questions about motivations• Less of a variable specification problem• Complements large sample analyses • A unique angle to confront theories with data

Limitations: • Questions may be misunderstood• Truthful responses?• Non-response bias • Friedman (1953)

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Comparison to archival empirical work Limitations to existing research include• Earnings management and voluntary disclosure hard

to measure• Rank ordering among various motivations difficult• Variable with least measurement error may dominate• Same r.h.s. variables can proxy for different

economic motivations (e.g., size)• Often a narrow focus on one motivation

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Method Survey and Interview Design• Draft survey instrument “refereed” by both finance

and accounting researchers as well as experts in survey design

• Interviewed structured to adhere to best scientific practices of interviews, e.g. Sudman and Bradburn (1983)

• IRB certification for human subject research

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Sample • 401 usable survey responses

– response rate of 10.4%• 25% response rate at a practitioner conference• 8% response rate to Internet survey

• Interview 20 CFOs– 40-90 minutes in length– More give and take than in the survey– Interviewed firms are much larger, more levered and more profitable

than the average Compustat firm.• Relative to Compustat firms

– Surveyed firms are larger, more levered, greater dividend-yield, fewer firms report negative earnings

– Similar B/M and positive P/E

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Sample

Firm characteristics (self reported)• Agency

– CEO age, tenure, education– Inside ownership

• Size– Revenues– Number of employees

• Growth opportunities– P/E– Growth in earnings

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Sample

Firm characteristics (self reported)• Free cash flow effects

– Profitability– Leverage

• Informational effects– Public/private– Which stock exchange

• Industry• Credit rating

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Sample

Firm characteristics (self reported)• Financial reporting practices

– Number of analysts– Do they give “guidance”?

• Ticker symbol!

Demographic correlations in Table 1– Note positive relation between whether you give

guidance and number of analysts (Lang and Lundholm TAR 1996)

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Corporate Financial Reporting

Performance measurements (earnings, cash flows): Sec 3.1,Table 2

Voluntary disclosure

Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:

Why meet benchmarks?Sec 3.3, Table 4

What if miss benchmarks? Sec 3.4, Table 5

How to meet benchmarks: Sec 4.1, Table 6

Value sacrifice to meet benchmarks:Sec 4.2, Table 7

Why smooth earnings?Sec 5.1, Table 8

Value sacrifice for smooth earnings Sec 5.2, Table 9

Why disclose?Sec 6.1,Table 11

Why not disclose?Sec 6.2, Table 12

TimingSec 6.3

Table 13

Fig. 1 Flowchart depicting the outline of the paper

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Graham/Harvey/Rajgopal: Corporate Reporting Motivation

DeGeorge, Patel, Zeckhauser, JB 1999

18

0% 20% 40% 60% 80% 100%

Same quarter last year EPS

Analyst consensus EPS forecast

Reporting a profit (i.e. EPS >0)

Previous quarter EPS

Percent of respondents


Earnings benchmarks

Responses to the question: “How important are following earnings benchmarks?” based on a survey of 401 financial executives.

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Earnings benchmarks

Conditional: Consensus is relatively more important for• Firms with more analysts• Firms that give guidance• Large firms• More levered firms

[Table 3]

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

avoid violating debt-covenants achieve desired credit rating employees achieve bonuses

assures stakeholders business is stable reduce stock price volatility

convey future growth prospects to investors external reputation of management

maintain or increase our stock price build credibility with capital market

Percent agree or strongly agree


Why meet earnings benchmarks?

Responses to the statement: “Meeting earnings benchmarks helps …” based on a survey of 401 financial executives.

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Stock price motivation• 86% of CFOs say “builds credibility”• 80% maintain or increase stock price

23



Stakeholder motivations• Firms enhance reputation with stakeholders, such as

customers, suppliers, creditors• Conditional analysis shows this is important for

small, tech, inside dominated, young and not profitable

24



Employee bonus• Survey evidence not significant• Interviews suggest that internal targets more

important for managers (“stretch” and “budget” greater than consensus)

25



Career concerns• External reputation very important• This motivation was prominent in interviews.

Executive labor market important. Failure to deliver on targets inhibits intra-industry mobility.

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

increases the possibility of lawsuits

outsiders might think firm lacks flexibility

increases scrutiny of all aspects of earnings releases

have to spend time explaining why we missed

outsiders think there are previously unknown problems

creates uncertainty about our future prospects

Graham/Harvey/Rajgopal: Corporate Reporting Consequences of missing benchmarks

Responses to the statement: “Failing to meet benchmarks…” based on a survey of 401 financial executives.

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Consequences of missing benchmarks

Uncertainty• Uncertainty about future prospects is thought to be

priced

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Cockroach problem• “You have to start with the premise that everyone

manages earnings”• If you can’t come up with a few cents, there must be

some previously unknown serious problems at the firm

• “If you see one cockroach, you immediately assume there are hundreds behind the walls, even though you have no proof that this is the case”

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Mitigation of negative reaction• Explain miss is due to specific accounting accrual• Miss quarterly but confirm annual guidance• Nonfinancial indicators suggest good future

performance

Other factors• Conference call becomes negative; investors become

defensive

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Graham/Harvey/Rajgopal: Corporate Reporting Actions taken to meet benchmarks

0% 20% 40% 60% 80% 100%

Decrease discretionary spending (e.g. R&D,advertising, maintenance, etc.)

Delay starting a new project even if this entails asmall sacrifice in value

Book revenues now rather than next quarter (ifjustified in either quarter)

Provide incentives for customers to buy moreproduct this quarter

Draw down on reserves previously set aside

Postpone taking an accounting charge

Sell investments or assets to recognize gains thisquarter

Repurchase common shares

Alter accounting assumptions (e.g. allowances,pensions etc.)

“Near the end of the quarter, it looks like your company might come in below the desired earnings target. Within what is permitted by GAAP, which of the following choices might your company make?”

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Real versus accounting actions• 80% would reduce discretionary spending, R&D,

maintenance, advertising• 55.3% would delay starting a new project even if it

entailed a small sacrifice in value• Not as much support for “accounting actions”

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Real versus accounting actions• Little research on real actions

– Dechow and Sloan (JAE 1991); Bartov (TAR 1993); Bushee (TAR 1998), R&D or asset sales

– Roychowdhury (WP 2003) over produce and sales discounts to meet targets

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Real versus accounting actions• Significantly more likely to say they are taking real

rather than accounting actions• In contrast, most of the work on “earnings

management” has focused on accruals

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Why real versus accounting actions?• Aftermath of Enron-Worldcom along with S-Ox• Any hint of accounting questions could have

devastating effect on stock prices• More willing to admit to real actions• Auditors can’t second guess real actions

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Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value

Hypothetical scenario: Your company’s cost of capital is 12%. Near the end of the quarter, a new opportunity arises that offers a 16% internal rate of return and the same risk as the firm. The analyst consensus EPS estimate is $1.90. What is the probability that your company will pursue this project in each of the following scenarios?

Actual EPS if you do not pursue the project

Actual EPS if you pursue the project

The probability that the project will be pursued in this scenario is …

(check one box per row)

0% 20% 40% 60% 80% 100%

$2.00 $1.90

$1.90 $1.80

$1.80 $1.70

$1.40 $1.30

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Sacrificing long-term value 0% 20% 40% 60% 80% 100%

If you take project, youwill exactly hit consensus

earnings

If you take project, youwill miss consensusearnings by $0.10



Probability of accepting project

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Sacrificing long-term value

Only 45% would take the project for sure – even if they are projected to meet consensus

EPS if you do not pursue

EPS if you

pursue

Average probability of

pursuing 0% 20% 40% 60% 80% 100%

$2.00 $1.90 4% 4% 5% 10% 32% 45%$1.90 $1.80 10% 14% 10% 20% 28% 18%$1.80 $1.70 14% 12% 13% 21% 22% 17%$1.40 $1.30 20% 13% 12% 15% 20% 19%

Probability that the project will be pursued: (Percent of respondents indicating)

[Table 7]

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Reminiscent of Brav, Graham, Harvey and Michaely• Sacrifice positive NPV projects before cutting

dividends

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0% 10% 20% 30% 40% 50% 60% 70% 80%

Percent of CFO's who rate choice as +1 or +2 (on scale of -2 to +2)

6j: M&A strategy7j: M&A strategy

6h: Good alternative investments7h: Good alternative investments

3a: Investment decision made 1st4a: Investment decision made 1st

3e: Fund externally, rather than cut4e: Fund externally, rather than cut

Repurchases Dividends

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Other insights on meeting benchmarks

Interviews• 18/20 interview mentioned trade off of short-run

earnings and long-term optimal decisions• Investment banks offer products that create

accounting income with negative cash flow consequences

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Guidance• Goal of guidance is to meet or exceed consensus

every quarter• Analysts complicit in game of always meeting or

exceeding• Large positive surprises lead to “ratchet-up effect”• Asymmetric

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Break out of the game• Why not declare that you will not play the earnings

management game?

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Smoothing

96.9% and 20/20 interviews prefer smooth earnings over more volatile holding cash flows constant

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Smoothing 0% 20% 40% 60% 80% 100%

Is perceived as less risky by investors

Makes it easier for analysts/investors to predictfuture earnings

Assures customers/suppliers that business is stable

Reduces the return that investors demand (i.e.smaller risk premium)

Promotes a reputation for transparent and accuratereporting

Conveys higher future growth prospects

Achieves or preserves a desired credit rating

Clarifies true economic performance

Increases bonus payments

Responses to the question: “Do the following factors contribute to your company preferring a smooth earnings path?”

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Smoothing

Reasons• Lowers “risk”; increased predictability; lower “risk”

premium• Clear from survey and interviews that CFOs believe

that this risk is priced• Possible link to literature on: estimation error,

disagreement in asset pricing, information risk premium, and behavioral literature on risk versus uncertainty

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Sacrificing value for smoothing 0% 20% 40% 60% 80% 100%

None

Small sacrifice

Moderate sacrifice

Large sacrifice

Responses to the question: “How large a sacrifice in value would your firm make to avoid a bumpy earnings path?”

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Other insights on smoothing

Interviews• Volatile earnings will create trading incentives for

speculators, hedge funds and legal vultures• Volatile earnings mean that you will have a number

of misses – which CFOs want to avoid

Smoothing example

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53%36%

7% 2%2%

Institutions Analysts Individuals Rating Agencies Hedge Funds


Marginal investor

Responses to the statement: “Rank the two most important groups in terms of setting the stock price for your company”

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Graham/Harvey/Rajgopal: Corporate Reporting Marginal investor

Price setters• Institutional investors• Analysts have important short-term impact• Retail investors important because they are potential

customers and are less likely to flip stock

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Graham/Harvey/Rajgopal: Corporate Reporting Marginal investor

Critique of analysts, institutions• Young, do not have sense of history• Contagion: bandwagon effect important given

relative performance measurement• Quantitative hedge funds issue sell signal if you miss

–irrespective of fundamental information

CFOs believe idiosyncratic risk is priced

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Types• Conference calls, meetings, press releases, and

disclosure of more than mandated information in regulatory filings

• Healy and Palepu (2001) say that motivations for voluntary disclosure “important unresolved question for future research”

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Drivers• Information asymmetry• Increased analyst coverage• Corporate control contest• Stock compensation• Management talent• Limitations of mandatory disclosure

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Contraints• Litigation risk• Proprietary costs• Political costs• Agency costs• Setting a precedent that may be hard to maintain

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Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure

0% 20% 40% 60% 80% 100%

promotes a reputation for transparent/accurate reporting

reduces the “information risk” that investors assign toour stock

provides important information to investors that is notincluded in mandatory financial disclosures

increases the predictability of our company’s futureprospects

attracts more financial analysts to follow our stock

corrects an under-valued stock price

increases the overall liquidity of our stock

increases our P/E ratio

reveals to outsiders the skill level of our managers

reduces our cost of capital reduces the risk premium employees demand for

holding stock granted as compensation

Survey responses to the question: Do these statements describe your company's motives for voluntarily communicating financial information?

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Motivations for voluntary disclosure

Information asymmetry: Information risk• Diamond Verrecchia (1991) voluntary disclosure

reduces asymmetry between informed and uninformed, increases liquidity.– 81.9% agree – only 4.3% disagree– Related 56.2% agree that predictability of company’s

future prospects is enhanced

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Information asymmetry: Information risk• Interviews distinguish between “information risk”

and “inherent risk”• Believe that both command a risk premium• Releasing bad news quickly can be beneficial in

reducing information risk

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Information asymmetry: Reputation• 92.1% agree with reputational benefit for transparent

reporting (scores the highest)• Interviews:

– Correct investors misperceptions– Create an environment of trust so strategic actions more

easily taken in the future– Trust may be important in gaining access to future capital

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Information asymmetry: Cost of capital• While only 39.3% point to cost of capital, the

information risk is linked to cost of capital• P/E lift 42% might be similar to the cost of capital• Interviews:

– A number mentioned “reducing analysts disagreement” and linked that to cost of capital

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Information asymmetry: Liquidity• Motivation especially for small firms

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Increased analyst coverage:• Bhushan (1989a,b) and Lang and Lundholm (1996)• 50.8% agree• More agreement with small and insider dominated

firms

64



Stock price motivation:• 48.4% use disclosure to try to correct undervalued

stock

65



Stock compensation:• Managers want to reduce contracting costs with

employees where there is information asymmetry, otherwise employees will demand a risk premium

• No support, half disagree

66



Management talent signaling:• Trueman (1986)• More support for small firms plus other questions

suggest that this is important

67



Limitations of mandatory disclosures (new):• 72.1% say that voluntary corrects gaps in mandatory• Interviews:

– Some mandatory “confuse rather than enlighten”– “Some of our own footnotes related to off-balance sheet

items and securitizations are so complex, even I don’t understand them.”

– Quarterly mandatory disclosures lack timeliness– Mandatory ignores intangibles

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Constraints on voluntary disclosure 0% 20% 40% 60% 80% 100%

avoid setting a disclosure precedent that may bedifficult to continue

avoid giving away “company secrets” or otherwiseharming our competitive position

avoid possible lawsuits if future results don’t matchforward-looking disclosures

avoid potential follow-up questions aboutunimportant items

avoid attracting unwanted scrutiny by regulators

avoid attracting unwanted scrutiny by stockholdersand bondholders

Survey responses to the question: Limiting voluntary communication of financial information helps…

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Constraints on voluntary disclosure

Precedent (new)• The most popular response with 69.6% agreeing• Most important for insider dominated firms• Start a practice that you might want to abandon later

70



Litigation costs• Threat of litigation makes managers disclose bad

news quickly• 46.4% agree; especially important for young and tech

71



Proprietary costs• Might jeopardize firm’s competitive position• 58.8% agree• More agreement with small firms and those with few

analysts

72



Agency costs• We know that career concerns and external

reputation important for meeting benchmarks• Information may be limited to reduce the chance of

undue focus by stakeholders• Not much support – for this agency cost angle

73



Political costs• Disclosure may be limited to avoid unwanted

attention of regulators• No support on average – but this question, in

particular, is difficult to interpret

74


Good news versus bad news

Bad news fasterNo differenceGood news faster

Survey responses to the question: Based on your company's experience, is good news or bad news released to the public faster?

75


Good news versus bad news 0% 20% 40% 60% 80% 100%

Disclosing bad news faster enhances our reputationfor transparent and accurate reporting

Disclosing bad news faster reduces our risk ofpotential lawsuits

Good news is released faster because bad newstakes longer to analyze and interpret

Good news is released faster because we try topackage bad news with other disclosures which

can result in a coordination delay

Survey responses to the question: Do the following statements describe your company's motives related to the timing of voluntary disclosures?

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Conclusions

• Consensus earnings factors into decisions• Strong desire to meet benchmarks – cockroach

problem• It is routine to sacrifice long-term value to meet these

benchmarks• Meeting benchmarks is important both for the firm’s

stock price and managers reputation and mobility• Agents optimizing over short-term horizon

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Conclusions

• Having predictable smooth earnings is thought to both reduce the cost of capital and enhance manager reputation

• Voluntary disclosure is an important tool in manager’s arsenal

• Disclosure can potentially reduce information risk and enhance a manager’s reputation

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Graham/Harvey/Rajgopal: Corporate Reporting Future research

Last survey instrument!

• We are thinking of administering the identical survey before it is published to non-management members of Boards of Directors.

Also…• “Detection of Financial Earnings Management”• “Detection of Real Earnings Management”We have the tickers for 107 firms many of which admit to both

financial and real earnings management

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Payout Policy in the 21Payout Policy in the 21stst Century CenturyAlon Brav

Duke University, Durham, NC USA

John R. GrahamDuke University, Durham, NC USA

Campbell R. HarveyDuke University, Durham, NC USA

National Bureau of Economic Research, Cambridge, MA USA

Roni MichaelyCornell University, Ithaca, NY USA

IDC, Israel

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Brav/Graham/Harvey/Michaely: Payout Policy

Introduction • In 1956, John Lintner laid the foundation for the modern

understanding of dividend policy • He conducted detailed interviews with 28 companies• His research helped set the agenda for theoretical and empirical

research on dividend policy

• Much has changed in the last 50 years. – Possibly different payout policy goals– Repurchases– More insights from theory that may help direct the spotlight in the right

direction

• We revisit this path-breaking study at the beginning of the 21st century

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Introduction

• We survey 384 financial executives with an instrument that focuses on both dividends and repurchases– 256 public, 128 private– Most presented results are based on the public firms

• We conduct one-on-one interviews with 23 CFOs or Treasurers of prominent corporations– Interviews last between 40 minutes and two hours

82


Methodology

Survey and Interview Design• Draft survey instrument “refereed” by both finance

researchers and experts in survey design• Interviewed structured to adhere to best scientific

practices of interviews, e.g. Sudman and Bradburn (1983)

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Methodology

Survey Delivery• Survey CFOs, Treasurers, Finance VPs• Primarily members of Financial Executives International• Two $500 random winners• Three surveys

– FEI CFO Forum (April 23, 2002, Co. Springs CO)– Dave Ikenberry NFCF (May 1, 2002, Houston TX)– Mass emailing to 2200 FEI members– Overall ~16% response rate

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Goals of Treasury department:• Fund investment

– M&M• Liquidity and possible contingencies• Payout decisions are second-order

Except...• DO NOT CUT DIVIDENDS ranks equal to or

above all of these items


How are payout decisions made?

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Brav/Graham/Harvey/Michaely: Payout Policy Payout vs. Investment Decisions

0% 10% 20% 30% 40% 50% 60% 70% 80%


6j: M&A strategy7j: M&A strategy

6h: Good alternative investments7h: Good alternative investments

3a: Investment decision made 1st4a: Investment decision made 1st

3e: Fund externally, rather than cut4e: Fund externally, rather than cut


86


Dividends vs. Repurchases (Fig. 2)

0% 10% 20% 30% 40% 50% 60% 70% 80%

Other

Retain as cash

Invest more

Mergers/Acquisitions

Repurchase shares

Pay down debt

Fig. 2A: Of funds that are used to pay dividends, what is their most likely alternative use? (Current dividendpayers only). For each response we report the percentage of respondents who answer 1 or 2 on a scale from -2 to+2.

0% 10% 20% 30% 40% 50% 60% 70% 80%

Other

Pay more dividends

Retain as cash

Invest more

Mergers/Acquisitions

Pay down debt

Fig. 2B: Of funds that are used to repurchase shares, what is their most likely alternative use? (Current sharerepurchasers only). For each response we report the percentage of respondents who answer 1 or 2 on a scalefrom -2 to +2.

87


Complements or Substitutes?

• Level of dividend fixed• Substitute repurchases for change in dividends

– One way substitution• Would use even more repurchases if they were

free of constraint of dividend history

88


Lintner (1956)

Three main points• Target payout ratio (dividend/earnings)• Dividend policy set conservatively

– “partial adjustment” to target payout– smooth through time– sticky (history important)

• Level given, focus on changes– tied to long-run sustainable earnings– do not increase now if you might have to cut later

• No repurchases

89


Compare to Lintner (1956)

Dividend policy still “conservative”?• Yes• Perceived big penalty for cut, small reward for

increase– So, smooth, to avoid future cuts

• Path dependence of dividend policy• BUT

– stealth dividend cut if possible– holding dividend constant OK

90

Brav/Graham/Harvey/Michaely: Payout Policy Payout Decisions Still Made Conservatively? vs. Lintner (1956)

Repurchases: No, flexible Dividends: Yes, still conservative

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%


5c: smooth from year to year5j: not want to cut in future

5b: change in div what matters

6L: Maintain historic policy7L: Maintain historic policy

3d: Neg. consequence to cutting4d: Neg. consequence to cutting

5d: Try to avoid cutting6d: Try to avoid cutting

91

Brav/Graham/Harvey/Michaely: Payout Policy Conservatively increase payout? Similar to Lintner (1956)?

0% 10% 20% 30% 40% 50% 60% 70% 80%


6a: Temporary increase in earnings7a: Temporary increase in earnings

6d: Excess cash on balance sheet7d: Excess cash on balance sheet

6b: Sustainable change in earnings7b: Sustainable change in earnings

6c: Stability of future earnings7c: Stability of future earnings

RepurchasesDividends

92


Payout ratio still target? vs. Lintner (1956)

0% 10% 20% 30% 40% 50% 60%

Other

Do not target at all

Dividend yield

Growth in dividends per share

Dividend as a % of earnings

Level of dividends per share

For those that paid dividends within the past 3 years, what do you target when you make your dividend decisions?

93


Payout ratio still target? vs. Lintner (1956)

0% 10% 20% 30% 40% 50% 60%

A strict goal

Not really a goal

A somewhat strict goal

A flexible goal

For those that paid dividends within the past 3 years, is the target part of a strict goal or a flexible goal?

94


Payout ratio still target? vs. Lintner (1956)Extension of Fama-Babiak (1968), Choe (1990)

• The SOA= and TP= . • Both SOA and TP have declined through time using

both matching sample to our survey and broader Compustat sample

.21,1, uEDD ititiiiti

1̂ 12 ˆ/ˆ

95


Summary vs. Lintner (1956)

• Dividend policy still very conservative• Modern cash cows live in (close to) Lintner

world• Repurchase policy is not (i.e., it is more flexible)

• Payout ratio no longer target• Targets very flexible

• Repurchases now very important

96


Miller and Modigliani (1961)

• Payout Policy irrelevant if capital markets perfect

• Imperfections that could explain payout policy– Taxes– Managerial agency conflict– Information/signaling – Other factors (EPS, float, credit ratings, etc)

• Clienteles could result from imperfections

97


A. Taxes

• Theory: At least for individual investors, dividends are taxed move heavily than capital gains.

• Therefore:– Firms should consider investors’ taxation when

deciding about payout policy – Relative taxation should affect the amount of

dividends they pay

98


A. Taxes• Interviews: repurchases are “efficient way to return capital”

– taxes (2nd order) important• Surveys: modest support

0% 10% 20% 30% 40% 50% 60% 70% 80%


8a: Investor taxes lower vs. dividends

6g: Investor taxes

7g: Investor taxes


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B. Clienteles• Investors that pay (relatively) more taxes on

dividends should hold stocks that pay out through repurchases.– Translation: Individual investors should have

an aversion to dividend paying stocks. By implications, institutions should be more attracted to such stocks.

• Prudent man• Institutions as monitors

100


B. Clienteles

• Retail investors– Prefer dividends, in spite of tax disadvantage– Firms like because loyal

• Institutions– If anything, prefer repurchases– Some can not invest in zero dividend stocks

• 42% say pay dividends because of prudent man rules– Tax advantage not an issue to institutions– Firms like because they “have the money”

101


B. Clienteles• Companies do not think that dividends attract institutions more so than do

repurchases• Companies do not use dividends or repurchases attract institutions to

monitor• Inconsistent with Allen, Bernardo, and Welch (2000) idea that firms use

dividends to attract institutional investors

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


6n: Attract retail investors7n: Attract retail investors6i: Influence of institutions7i: Influence of institutions

6p: Attract inst. bc they monitor7p: Attract inst. bc they monitor

6o: Attract institutions7o: Attract institutions


102


C. Agency Stories

• Firms pay dividends to impose discipline on managers

103


C: Free Cash Flow

• Interviews: some say: “money can burn hole in pocket”– But payout not the way to fix the problem

• Surveys: (1) no support in general, (2) repurchases work as well as dividends but (3) Cash cows are much more likely to pay; more reluctant to cut; more likely to keep dividend growth as earnings growth

0% 10% 20% 30% 40% 50% 60% 70% 80%


6f: Disciplinary role

7f: Disciplinary role


104


D. Asymmetric Information

• Conveying information

• Costly self-imposed action—Signaling

• Adverse selection – Do informed investors benefit from repurchase programs,

at expense of uninformed?

• Stock undervaluation

105


D: Do payout decisions convey information? • Interviews: Yes, punctuation mark at end of sentence

– Need to be consistent with other forms of communication– Repurchases convey as much as dividends

• Surveys: Yes, convey info in general

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


6m: Running low on investments?

7m: Running low on investments?

3b: Convey information?

4b: Convey information?


106

Brav/Graham/Harvey/Michaely: Payout Policy Information: Signaling

0% 10% 20% 30% 40% 50% 60% 70% 80%


5g: bear external financing cost

5h: investor bear dividend tax

5i: pass up good investments

3i: Show we can bear costs

4i: Show we can bear costs

3h: Look better than competitors?

4h: Look better than competitors?


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D. Information: Signaling• Surveys

– No supporting evidence – Scores are even lower for growth/risky firms– 39% (16%) say keep div (repurchase) policy of peers

• Interviews– Spent hours on this issue– Generally try to group selves with peers (not separate)– No evidence of

• increasing dividend to show market that firm is strong• viewing dividend as self-imposed cost

– Avoiding dividend cut• Possibly a signal (costly for bad firms, separate from bad)• Cuts are rare – can’t explain dividend policy for most firms• Does not explain why firms pay dividends in the first place

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D. Information: Stock Price• Interviews: Would like to buy when price low, but

– often want to maintain liquidity at this time– do not want credit rating downgrade– So, it’s a conditional objective

• Surveys: repurchases, stock good investment

0% 10% 20% 30% 40% 50% 60% 70% 80%


6q: Stock price low

7q: Stock price low


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E. Other factors: EPS• Interviews: managers are concerned about EPS

– Some think it’s automatic that repurchases increase EPS– Other believe that it depends on alternative use of funds

• Surveys: EPS important

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


8g: Options not dividend protected

8f: Offset stock option dilution

8b: Increase EPS

Repurchase questions

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E. Other factors: Float and credit ratings• Interviews: Float very important

– Execs think they need to have a large number of shareholders

• Interviews: credit rating important– Hoard cash to improve rating– Especially for financial firms or firms with financial divisions


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Initiate with repurchases or dividends?

0% 10% 20% 30% 40% 50% 60% 70%

some combination ofdividends andrepurchases

dividends only

share repurchases only

Fig. 6D: What would your first payout be if you were hypothetically deciding to pay out capital for the first time. (For

neither dividend payers nor share repurchasers only.)

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Brav/Graham/Harvey/Michaely: Payout Policy Why initiate payout?

0% 10% 20% 30% 40% 50% 60% 70% 80%


9L: Offset stock option dilution9j: Increase EPS

9n: Float/liquidity improves

10c: Extra cash9c: Extra cash

10L: convey info bc undervalued9m: convey info bc undervalued

10i: stock undervalued9i: stock undervalued


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Conclusions

• Payout policy is not first-order important* (M&M)

• Repurchases: decided de novo• Dividends: level very important• Managers prefer repurchases over dividends

because they are more flexible. – Not because of taxes.

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Conclusions

• According to managers, payout– convey information – NOT being used as a costly signal– NOT being used to attract institutions

• Managers do not use dividends over repurchases to attract institutions

• Institutions do not push for more dividends

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Conclusions

• Managers of cash cows believe more strongly that– Dividends should be stable– Keeping dividend growth rate with earnings

growth• But all managers reject the notion that they

need dividends so that they will not spend cash unwisely.

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Rules of the Game: How payout policies are determined

• Make investment plans first*

• Take care of cash/liquidity needs

• *BUT, remember, level of dividends fixed• Only reduce dividends in extraordinary

circumstances• Severe penalty for cutting dividend because the market

believes that “cuts precede bad news”• So, don’t ever cut dividends

• unless you have an amazing investment opportunity• smaller penalty if competitors cut

• Think very carefully before initiating dividends

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Rules of the Game

• Desire to maintain the level of dividend “at any cost” consistent with findings in Graham, Harvey and Rajgopal, 2004, “The Economic Implications of Corporate Financial Reporting”• Here managers desire to hit consensus EPS “at any cost”• 55% would knowingly sacrifice value (not pursue a very

positive NPV project) if it would cause the firm to miss next quarter’s target!

• 78% would knowingly sacrifice value to smooth earnings

Documents

The Economic Implications of Corporate Financial Reporting