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Dividend policy, systematic liquidity risk, and the cost of equity capital

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Abstract

This paper examines a new channel through which dividend policy can affect firm value. We find that firms that pay dividends exhibit lower systematic liquidity risk than those that do not. We also report a significant negative relationship between dividend payment and systematic liquidity risk. The liquidity improvement associated with dividend payments translates into an economically meaningful reduction in the cost of equity capital. Our results are robust to endogeneity concerns, to alternative measures of liquidity risk and dividend payouts, and to alternative model specifications. Further analysis suggests that the reduction in liquidity risk associated with dividend payouts is more pronounced for weakly governed firms and firms with opaque informational environment. Finally, we find that the recent financial crisis led to a greater increase in systematic liquidity risk for firms with no or low dividend payouts. Overall, our study implies that dividend policy can be used by corporate managers to shape liquidity risk and mitigate the adverse impact of economic downturns on the value of their firms.

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Notes

  1. Earlier studies also find that dividend payments have a positive relationship with stock liquidity, implying that dividend policy is relevant for liquidity (e.g., Howe and Lin 1992; Mitra and Rashid 1997; Gurgul et al. 2003; Dasilas and Leventis 2011).

  2. Although Pastor and Stambaugh’s measure is known to reflect the sensitivity of stock returns to innovations in aggregate liquidity, the measure is designed to capture the illiquidity that relates to the price impact of trades rather than the liquidity risk arising from trading continuity (Lin et al. 2009) and works better for portfolios than individual stocks (Pastor and Stambaugh 2003).

  3. However, our results are still held if we do not winsorize all continuous variables.

  4. See “Appendix” for the definitions of variables.

  5. Acharya and Pedersen (2005) decompose liquidity risk into three components. The first one implies that the expected return is higher for assets with a higher covariance between the liquidity of the stock and the liquidity of the general market \({(\beta }_{1}^{L})\). The second one accounts for the covariance between the return of the stock and the liquidity of the general market \(({\beta }_{2}^{L}\)). The third one considers the covariance between the liquidity of the stock and the return on the general market (\({\beta }_{3}^{L}\)). The estimated 1.1% difference in cost of equity capital is due to the total liquidity risk premium from the three components, out of which the return premium due to the covariance between stock return and market liquidity (\({\beta }_{2}^{L}\)) is 0.16%.

  6. Considering the limited number of the events based on dividend omissions and initiations, we also estimate the impact of the change of dividend payouts on liquidity risk. In untabulated results, we find that the change of dividend payouts also exhibits a significant and negative relationship with liquidity risk, consistent with our baseline results based on the level of dividend payouts.

  7. For example, assuming that a firm has a fiscal year end of December, the firm pays dividends over the period from 2001 January to 2001 December. We estimate the liquidity beta over the pre-treatment period from 2000 January to 2000 December and over the post-treatment period from 2002 January to 2002 December.

  8. We require that a stock must be followed by at least three analysts to be included in the sample for this analysis.

  9. The Management Score measures a company’s commitment and effectiveness towards following best practice corporate governance principles. The Shareholders Score measures a company’s effectiveness towards equal treatment of shareholders and the use of anti-takeover devices. The CSR Strategy Score reflects a company’s practices to communicate that it integrates the economic (financial), social and environmental dimensions into its day-to-day decision-making processes.

  10. Following Sloan (1996), we define accruals as follows. Accruals = ((ΔCA − ΔCash) − (ΔCL − ΔSD − ΔTP) − DP)⁠, where ΔCA is the change in current assets, ΔCash is the change in cash and equivalents, ΔCL is the change in current liabilities, ΔSD is the change in short-term debt included in the current liabilities, ΔTP is the change in income tax payable, and DP denotes depreciation and amortization expenses. All of the numbers are scaled by lagged total assets.

  11. See Amihud (2019) for the details on the construction of ILM. This factor is used by Amihud et al. (2013), Amihud et al., (2015), and Amihud and Noh (2017).

  12. In theory, the decisions to pay dividends or repurchase stocks should convey information about future earnings and profitability to the market (Dittmar 2000; Grullon and Michaely 2004). However, prior empirical studies find mixed results in support for the information based explanation of stock repurchases. For example, Grullon and Michaely (2004) and Wang et al. (2021) find that repurchasing firms experience no significant improvement in long-term performance and analysts do not change their expectations of the repurchasing firms through earnings forecasts. However, Lie (2005) finds that repurchasing firms incur improvements in operating performance following the quarters when the firms actually repurchase the stocks. Therefore, the information channel through which stock repurchases affect liquidity risk is not of a main focus in this section.

  13. The daily Fama–French three factors and the momentum factor are obtained from Xfi Centre for Finance and Accounting, University of Exeter. See http://business-school.exeter.ac.uk/research/centres/xfi/famafrench/files/

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Authors and Affiliations

  1. Cardiff Business School, University of Cardiff, Aberconway Building, Colum Drive, Cardiff, CF10 3EU, UK

    Khelifa Mazouz

  2. School of Management, University of Bradford, Bradford, BD7 1DP, UK

    Yuliang Wu

  3. University of Bahrain, P.O. Box 32038, Sakhir, Kingdom of Bahrain

    Rabab Ebrahim

  4. Huddersfield Business School, University of Huddersfield, Queensgate, Huddersfield, HD1 3DH, UK

    Abhijit Sharma

Authors
  1. Khelifa Mazouz
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  2. Yuliang Wu
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  3. Rabab Ebrahim
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  4. Abhijit Sharma
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Correspondence to Yuliang Wu.

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Appendix: Variable definitions

Appendix: Variable definitions

Variable name

Definition

Source

Panel A: Liquidity risk

Liquidity beta

The coefficient on the liquidity factor of LCAPM (Liu 2006) estimated by a stock’s daily returns over prior 12 months

Datastream

FF_liquidity beta

The coefficient on the illiquidity factor in the model where the LCAPM (Liu 2006) is augmented by the size, value and momentum factors

Datastream and Xfi Centre for Finance and Accounting, University of Exeter*

Amihud_liquidity beta

The coefficient on the illiquidity factor (ILM) constructed by Amihud (2019) in the model which includes ILM, the Fama–French three factors and the momentum factor

Datastream and Xfi Centre for Finance and Accounting, University of Exeter*

Panel B: Dividend measures

DIV

A dummy variable which is equal to one if dividend per share is positive, and zero otherwise

Datastream

DVP

Dividend yield which is defined as dividend per share over a stock’ price at fiscal year end

Datastream

DIV/total asset

The ratio of dividend payout over total assets

Datastream

DIV/sales

The ratio of dividend payout over total sales

Datastream

DIV/net income

The ratio of dividend payout over net incomes

Datastream

DIV/Cash flows

The ratio of dividend payout over operating cash flows

Datastream

Rep

A dummy variable which is equal to one if net repurchases are non-zero, and zero otherwise. Net repurchase are defined as the increase in common treasury stock if treasury stock is not recorded as zero or missing. If treasury stock is recorded as zero in the current and prior year, we measure repurchase as the difference between stock purchases and stock issuances from the statement of cash flows. If either of these amounts is negative, repurchases are set to zero

Datastream

Repv

The ratio of the amount of net repurchases over total assets

Datastream

Panel C: Firm characteristics

LM12

The standardized turnover-adjusted number of days with zero trading volume over prior 12 months

Datastream

TO

The accumulated daily turnover over prior 12 months. The turnover is calculated as a firm’s shares outstanding over the trading volume

Datastream

Profitability

Profitability is the ratio of earnings before interest and taxes to total assets

Datastream

IO

The percentage of institutional holdings over share outstanding

Thomson Reuters’ Eikon

Analyst

The number of analysts following a firm

Thomson Reuters’ Eikon

MTB

The book value of total shareholder equity divided by the market value of equity

Datastream

Past return

A stock’s accumulated monthly returns over prior 12 months

Datastream

Volatility

The standard deviation of a stock’s daily returns in the past 12 months

Datastream

FTSE100

A dummy variable which is equal to one if a firm is included in the FTSE100 index, and zero otherwise

Datastream

R&D

The expenditure of research and development over market capitalization

Datastream

Age

The years since a firm is first recorded in the Datastream

Datastream

Leverage

The sum of current liabilities and long-term debt over total book assets

Datastream

Size

Market capitalization in logarithm

Datastream

Dispersion of earnings forecast

The standard deviation of earnings forecasts for the next fiscal year scaled by the mean value of the earnings forecasts made during the same year

Thomson Reuters’ Eikon

Gov_ score

A weighted average of management, shareholder, and social responsibility scores

Thomson Reuters’ Eikon

The percentage of independent director

The percentage of independent directors on the board

Thomson Reuters’ Eikon

CEO-Chairman

A CEO is also the chairman of the board

Thomson Reuters’ Eikon

  1. *See http://business-school.exeter.ac.uk/research/centres/xfi/famafrench/files/

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Mazouz, K., Wu, Y., Ebrahim, R. et al. Dividend policy, systematic liquidity risk, and the cost of equity capital. Rev Quant Finan Acc 60, 839–876 (2023). https://doi.org/10.1007/s11156-022-01114-3

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