Overinvestment, corporate governance, and dividend initiations

Micah S. Officer* Marshall School of Business Department of Finance and Business Economics University of Southern California Los Angeles, CA 90089 Phone: 213-740-6519 Email: officer@marshall.usc.edu First draft: January, 2007 This draft: April, 2007

Abstract: Firms with high agency costs of overinvestment have significantly more positive dividend initiation announcement returns than other firms do. This paper presents the results from three experiments consistent with this conclusion: (i) dividend initiation announcement returns are significantly more positive for firms with low Tobins Q and high cash flow; (ii) following an exogenous event (the dividend tax cut of 2003) which changed the equilibrium tradeoff between hoarding cash and paying it out, firms with weak governance (i.e. those that are more likely to overinvest) have significantly more positive initiation announcement returns; and (iii) firms with low Q significantly reduce their cash hoarding in the years following dividend initiations. Combined, these results are consistent with the hypothesis that initiating dividends reduces the agency costs of free cash flow and that the market reaction to dividend initiation announcements rationally anticipates the lower agency costs of free cash flow or overinvestment.

I thank Harry DeAngelo, Linda DeAngelo, Michael Hertzel, Ehud Kamar, Harold Mulherin, Mike Stegemoller, Ralph Walkling, Rong Wang, Mark Weinstein, Mike Weisbach, and seminar participants at the College of William & Mary, Arizona State University, the Pennsylvania State University, and the Universities of Arizona, Georgia, and Southern California for comments, and Jim Linck for providing some of the data.

Overinvestment, corporate governance, and dividend initiations

Abstract: Firms with high agency costs of overinvestment have significantly more positive dividend initiation announcement returns than other firms do. This paper presents the results from three experiments consistent with this conclusion: (i) dividend initiation announcement returns are significantly more positive for firms with low Tobins Q and high cash flow; (ii) following an exogenous event (the dividend tax cut of 2003) which changed the equilibrium tradeoff between hoarding cash and paying it out, firms with weak governance (i.e. those that are more likely to overinvest) have significantly more positive initiation announcement returns; and (iii) firms with low Q significantly reduce their cash hoarding in the years following dividend initiations. Combined, these results are consistent with the hypothesis that initiating dividends reduces the agency costs of free cash flow and that the market reaction to dividend initiation announcements rationally anticipates the lower agency costs of free cash flow or overinvestment.

1. Introduction Dividend initiation announcements are associated with positive stock returns on average. For example, Asquith and Mullins (1983) report abnormal returns of 3.7% around the announcement of dividend initiations, although similar findings persist in studies using longer and more recent sample periods. These returns, along with those associated with announcements of increases in dividend payments, are typically interpreted as implying that dividend initiations (or increases) communicate valuable information to the market. In the existing literature, two main hypotheses (that are not mutually exclusive) have emerged to explain the nature of this information: (i) that dividend initiations signal higher cash-flow/profitability for initiating firms; and (ii) that dividend initiations signal lower agency costs at the initiating firm as managers will have less of their shareholders cash to waste, expropriate, or overinvest in the future. In this paper I test the agency cost hypothesis by examining the relation between dividend initiation announcement returns and proxies for the agency costs of overinvestment or free cash flow. The first proxy I employ is the interaction of Tobins Q and cash flow from operations. Tobins Q has been used in the dividend initiation announcement return literature (e.g. Lang and Litzenberger (1989)) as a proxy for investment opportunities, with the notion that the managers of a firm with poor investment opportunities (low Q) are likely to overinvest or waste their stockholders cash. Paying that cash out by initiating dividend payments reduces the probability that these agency costs are incurred. Using Q as a proxy for overinvestment, Lang and Litzenberger (1989) find that returns around dividend change announcements are significantly more positive for firms with Q less than one than for firms with Q greater than one. However, neither Denis, Denis, and Sarin (1994) nor Yoon and Starks (1995) report similar findings using comparable tests. I demonstrate the importance of conditioning on both cash flow and Q: dividend initiation announcement returns are significantly higher for firms with low Q than for firms with high Q, but the difference is especially pronounced in subsamples of firms with high pre-initiation cash flow. High cash flow 1

combined with poor investment opportunities suggests that managers have both the means and opportunity to waste their shareholders resources, and is therefore indicative of high agency costs of overinvestment. One problem with the agency costs of overinvestment explanation for dividend initiation announcement returns is why managers that are expropriating or wasting their shareholders resources (by overinvesting in pet projects, for example) would choose to initiate dividend payments in the first place. To address this issue, I examine dividend initiations following an exogenous event that increased shareholder demand for dividends and changed the equilibrium tradeoff between hoarding cash and paying it out. Specifically, the Jobs and Growth Tax Relief Reconciliation Act of May, 2003, reduced the maximum statutory income tax rate on dividends from 38% to 15%. The wave of dividend initiations following the passage of the Act suggests that this exogenous shock made hoarding cash more costly at the margin and prompted managers that would otherwise hoard cash to begin to pay it out. I examine whether proxies for governance or the propensity to overinvest explain announcement returns around dividend initiations spawned by the 2003 dividend tax law. Apart from Q, I examine the effect of three governance proxies (whether the board is insider dominated, whether the firms managers are entrenched by anti-takeover provisions, and the ownership stake in the firm held by activist public pension funds who may monitor the firm) on initiation announcement returns in this sample. I find that firms with weak governance or monitoring have significantly more positive dividend initiation announcement returns than other firms do. For example, firms with insider-dominated boards that initiate dividends in the 6 months following the law change have average initiation announcement returns of 6.6%, significantly more positive than the announcement returns for firms that do not have insider-dominated boards (1.3%). This paper concludes by examining one of the important underlying predictions of the agency explanation for dividend initiation announcement returns. Implicit in the agency cost hypothesis is the notion that the returns around dividend initiations reflect reduced agency costs 2

for poorly governed or overinvesting firms because such firms are less likely to hoard cash and expropriate resources from shareholders in the future. I examine cash holdings, and find that firms with low Q prior to initiations reduce their cash holdings to a level that is statistically indistinguishable from the industry median in the five to six years after initiation, while high Q firms do not. This evidence is consistent with the notion that the market adjusts upward its estimate of firm value around initiations by overinvesting firms because these firms are likely to hoard (and potentially waste) less of their shareholders cash in the future. The hypothesis that the payment of dividends reduces the agency costs of free cash flow or overinvestment has its foundation in Rozeff (1982), Easterbrook (1984), and Jensen (1986). Rozeffs (1982) hypothesis is that dividend policy is one part of the optimal portfolio of choices that firms make as bonding commitments to shareholders to reduce agency costs. Easterbrook (1984) argues that a policy of paying dividends reduces agency costs by improving the monitoring and risk-taking incentives of managers. Jensen (1986) suggests that cash payouts reduce the free cash flow under managers control and improve monitoring and investment incentives by curbing the ability to overinvest. Since the reduction in agency costs is the greatest for firms with the highest agency costs of free cash flow, returns around dividend initiation announcements should be significantly more positive for firms that have the potential to overinvest and have more free cash flow to waste than for other firms. This is what I find. There are three ways that this paper contributes to the extant literature on dividend policy and governance. First, while the agency cost hypothesis has long been considered important in the payout literature, there is surprisingly mixed empirical evidence in the existing literature that agency problems influence market returns around dividend policy announcements (e.g. Lang and Litzenberger (1989); Denis, Denis, and Sarin (1994); or Yoon and Starks (1995)), and no evidence (of which I am aware) of a direct relation between the market reaction to dividend policy announcements and proxies for governance and monitoring. This paper fills a gap in this literature by establishing a more robust relation between proxies for overinvestment (Q) and 3

initiation announcement returns and examining the effect of an exogenous shock that closes the agency model by explaining why poorly governed or overinvesting firms would choose to initiate dividend payments in the first place. Second, the corporate governance literature has blossomed recently, potentially because governance appears to be more important to investors following the meltdowns of Enron, WorldCom, Adelphia, and so on. Extant research establishes a link between proxies for governance and payout/retention policy (Harford, Mansi, and Maxwell (2006), Hu and Kumar (2004), John and Knyazeva (2006), and Pan (2006); also Dittmar, Mahrt-Smith, and Servaes (2003) in the international context), firm value (Bebchuk, Cohen, and Ferrell (2005), Cremers and Nair (2005), and Gompers, Iishi, and Metrick (2003)), board structure (Gillan, Hartzell, and Starks (2006)), and the market for corporate control (Masulis, Wang, and Xie (2006)), amongst other effects. This paper contributes to that literature by demonstrating that poor governance and the potential to overinvest are important as part of an explanation for the market reaction to dividend policy announcements. Third, this paper complements the recent literature examining the relation between governance and the marginal values of retained-cash and dividends. Pinkowitz, Stulz, and Williamson (2006) and Dittmar and Mahrt-Smith (2005) show that cash holdings have lower marginal value for firms with poor governance (Dittmar and Mahrt-Smith) or in countries with poor investor protection (Pinkowitz, Stulz, and Williamson). In particular, Pinkowitz, Stulz, and Williamson (2006) demonstrate the flip-side of the lower value of internally-held cash: higher marginal value of cash paid out as dividends in countries with poor investor protection. If dividends are more valuable (and retained cash less valuable) when investor protection or governance is weak, then dividend initiations should be associated with higher revisions in market values for overinvesting firms (or those with weak governance), as I find. An alternative to the agency hypothesis is the cash-flow signaling hypothesis ((i) above). There is little empirical evidence that changes in dividend policy signal higher current or future 4

operating cash flow or profitability, despite the theoretical popularity of cash flow signaling models. Watts (1973) reports a surprisingly weak relation between current dividends and future earnings, and suggests that any information in current dividends about future earnings is small. DeAngelo, DeAngelo, and Skinner (1996) examine a sample of firms that report earnings declines following a long period of growth, and conclude that dividend decisions provide little information about future earnings. Grullon, Michaely, and Swaminathan (2002) firmly reject the cash-flow signaling hypothesis, concluding that profitability actually decreases on average following dividend increases (and vice versa).1 I find little evidence to support the cash flow signaling model specifically, pre-initiation cash flow (a potential proxy for future cash flow) by itself is only weakly related to initiation announcement returns for firms with high Q, and strongly related to announcement returns only for firms with low Q. High historical (and potentially future) cash flow by itself does not appear to be enough to predict high dividend initiation announcement returns evidence of potential overinvestment or expropriation of that cash flow is also required. I focus on dividend initiations (as opposed to changes) for two reasons. First, dividend initiations are a change in financial policy. If a policy of paying dividends indicates managerial commitment to return cash to stockholders rather than waste resources or overinvest, then such a signal is potentially stronger when a firm decides to start paying dividends for the first time than when managers incrementally change the amount of dividends paid. Second, dividend initiations are likely to be less predictable than dividend changes. Once a firm starts paying dividends, dividend announcement dates are relatively predictable as many accompany earnings announcements. While the amount of a dividend change may be surprising to market participants, a dividend change is more predictable in its timing relative to an initiation. As my objective is to examine market reactions to dividend policy announcements, initiations provide an ideal sample
On the other hand, Denis, Denis, and Sarin (1994) and Yoon and Starks (1995) find that analysts significantly revise earnings forecasts in the direction suggested by cash flow signaling models following dividend change announcements.
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of dramatic and surprising changes in financial policy, the value implications of which should be reflected in the returns around initiation announcements.

2. Dividend initiation announcements I form a sample of dividend initiations from 1963 to 2002 from the CRSP database.2 Specifically, dividend initiation announcements are defined as the first announcement by a firm listed in CRSP of an ordinary, taxable, cash dividend payable at the quarterly, semi-annual, or annual frequency to holders of ordinary common stock (share codes 10 and 11) listed on the NYSE, Nasdaq, or Amex. Each firm is in the sample only once (subsequent dividend initiations following an omission are ignored), and financial (SIC codes 6000 to 6999) and utility (SIC codes 4900 to 4949) firms are discarded. All dividend initiating firms must have a stock price on CRSP 365 calendar days prior to the initiation announcement and be covered by the Compustat database (with no dividends recorded by Compustat in the prior five fiscal years). Table 1 shows the distribution of initiation announcements by year of announcement. There are 1,119 dividend initiation announcements between 1963 and 2002 that meet the criteria described above. The observations are reasonably well distributed over time, with the exception of a distinct spike in initiations in the mid-1970s. The second column in Table 1 contains the percentage of those announcements for which there is a quarterly earnings announcement date within a 21-day window centered on the dividend initiation announcement date.3 27% of the initiation announcements have a quarterly earnings announcement in the preceding or following 10 days, although that fraction is considerably higher nearer the end of the sample period.4 Although not tabulated, the dividend initiations in this sample are reasonably substantial as a fraction of the firms cash balances measured at the end of the fiscal year preceding initiation:
Initiations from 2003 are used later in the paper to measure the response to the exogenous tax-law shock occurring in that year. 3 Compustat begins recording quarterly earnings announcement dates in 1971. 4 Asquith and Mullins (1983) report that 66 of their 160 dividend initiations announcements (41%) from 1963 1980 have an earnings announcement within 10 days.
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dividend initiating firms pay out 23.5% of their pre-initiation cash on average, although the median is 5.3%. Table 2 shows the distribution of dividend initiation announcements by industry, with industries defined using two-digit SIC codes. While the announcements are reasonably well distributed between the industry categories in Table 2, there is some concentration in the Machinery and Equipment, Wholesale Distributors and Retail, and Recreation industries. The second column contains the number of initiations in the industry as a fraction of the total number of firms that report being in that industry in all Decembers between 1963 and 2002. Using this metric, the initiations are very evenly spread across industries, with the only obvious outlier being the Utilities industry (as I exclude regulated firms, and most utilities are regulated). Perhaps surprisingly, there are only 19 dividend initiations over this time period in the Agriculture, Forestry, Fishing, and Mining industry (3.3% of the total firms in the industry) a level approximately equal to the initiation rate in the Telecommunications industry (2.9%), despite the fact that telecommunications is undoubtedly an industry with higher growth opportunities (Smith and Watts (1992)) than agriculture and fishing. The final column shows the number of initiations with proximate earnings announcements, and, aside from the Utilities industry, this measure varies little across industries.

3. Descriptive statistics Table 3 contains descriptive statistics for dividend initiation announcement abnormal returns. Cumulative abnormal dividend initiation announcement returns are the firm-specific sum of abnormal returns during the three-trading-day window centered on the dividend initiation announcement date, and daily abnormal returns are the difference between firm return and the value-weighted market return from CRSP. The two columns in Table 3 show equal- and valueweighted averages of cumulative abnormal announcement returns for various subsamples of the

data, where the value weights are market capitalizations from CRSP three trading-days prior to the dividend initiation announcement date. The first entry in the first column is the usual result for dividend initiation announcement returns (see, for example, Asquith and Mullins (1983)). For the full sample from 1963 2002, three-day equally-weighted average initiation announcement abnormal returns are 3.75%, which is statistically significantly different from zero at the 1% level (median of 2%, also statistically significantly different from zero). The value-weighted average (second column) is 0.55%, suggesting that large firms have lower initiation announcement returns. In the second row, one observation from 2003 is added to the sample Microsofts dividend initiation announcement on January 16th, 2003. The addition of this one observation leaves the equal-weighted average initiation return virtually unchanged, but causes the average value-weighted return to be significantly negative. Microsoft, a large firm by any definition of the word, experienced a cumulative abnormal return of -7% for the three-trading-day period surrounding its initiation announcement. While the full-sample average-return characteristics are consistent with much of the prior literature, it is notable that one observation (Microsoft) has such a dramatic effect on value-weighted average dividend initiation announcement returns. Excluding initiations with a quarterly earnings announcement within 10 days (third row, data on earnings announcement dates is only available after 1971) has little effect on the average initiation announcement returns. Clearly, some of the proximate earnings announcements are good news and some bad news, suggesting that the proximity of earnings announcements does not dramatically change the first moment of the distribution of initiation returns.5 Because the co-incidence of earnings and dividend initiation announcements has almost no perceptible effect on average dividend initiation announcement returns, I use the largest available sample in the remainder of the analysis, without conditioning on the fact that a substantial fraction of dividend initiation announcements are timed with quarterly earnings releases.
5

This result is also documented in Asquith and Mullins (1983).

The first column of Table 4 contains averages of financial variables for the sample of dividend initiating firms, measured using Compustat data from the fiscal year prior to the initiation announcement. Q is computed as in Kaplan and Zingales (1997), as the market value of assets (the book value of assets plus the market value of common equity minus the book value of common equity minus balance sheet deferred taxes) divided by the book value of assets. Cash flow from operations is defined as in Bushman, Smith, and Zhang (2006) and is scaled by total assets (as is the cash balance), and leverage is the book value of long-term debt divided by total assets. Firm size is measured as the fiscal-year-end market value of equity scaled by the fiscalyear-end level of the S&P 500 index (as in Lie (2000)), and RE/TE is the ratio of retained earnings to total equity from DeAngelo, DeAngelo, and Stulz (2006). Sales growth is the annual percent change in sales from the prior year, and Age is the number of years that the firm has appeared in Compustat.6 For each dividend initiating firm, I form a portfolio of all non-financial and non-utility firms in Compustat that do not pay a dividend in the initiating year and have the same fiscal year end date as the initiating firm, and compute equal-weighted averages of each characteristic in the year prior to initiation for this comparison portfolio. The second column in Table 4 contains the average difference between the initiating-firm financial variable and the comparative average. Relative to comparable non-payers at the same point in time, initiating firms, on average, are significantly more profitable, larger, older, and have a higher earned-to-contributed capital mix (RE/TE). These characteristics of dividend paying firms are consistent with the results in Fama and French (2001) and DeAngelo, DeAngelo, and Stulz (2006), suggesting that firms initiate the payment of dividends at a point in their life cycle when the firm is large, profitable, and generating large amounts of free cash flow. While initiating firms have substantially greater cash flow than non-payers on average, their cash balances are not significantly different. Initiating

Although this is clearly different from the number of years since incorporation, it should be a reasonable proxy for the number of years a firm has been publicly traded.

firms also have significantly lower Q than comparable non-payers, despite having slightly higher sales growth on average firms initiating the payment of dividends appear to have significantly worse investment opportunities than non-payers and therefore choose to begin returning excess cash to stockholders. The next section of this paper demonstrates that within the sample of initiating firms, those with the lowest Q and the highest pre-initiation cash flow (i.e. those firms with the greatest agency costs of overinvestment or free cash flow) have the highest dividend initiation announcement returns, consistent with the greatest reduction in the potential agency costs of overinvestment.

4. The relation between dividend initiation returns and the agency costs of overinvestment If initiating a policy of paying dividends reduces the agency costs of overinvestment, I expect to observe significantly more positive announcement returns for initiating firms with high agency costs of overinvestment than for other initiating firms. In Table 5, I divide the sample into four groups based on Q and cash flow, and examine whether there are significant differences in average initiation announcement returns between these subsamples of initiating firms. In Panel A, firms are split based on whether pre-initiation Q is greater or less than (or equal to) one, as in Lang and Litzenberger (1989), and whether pre-initiation cash flow from operations (scaled by total assets) is greater or less than (or equal to) the industry median in the year prior to initiation. Lang and Litzenberger (1989) show theoretically that overinvesting firms will have Q less than one, and the split based on pre-initiation cash flow is consistent with the free cash flow arguments in Jensen (1986). Q and cash flow from operations are measured in the fiscal year prior to the initiation announcement (as in Table 4), and industry definitions are from Fama and French (1997). The lowest dividend initiation announcement returns in Panel A are for firms with Q greater than one (i.e. not likely to be overinvesting) and greater than industry median cash flow (2.4%). The highest initiation announcement abnormal returns in Panel A are for firms with Q 10

lower than one (i.e. are likely to be overinvesting) and high cash flow (6.8%), and the initiation returns to high cash flow firms with Q greater than one and firms with Q less than one are different from one another with a high degree of statistical significance (p-value = 0.00). Furthermore, among overinvesting initiating firms (Q less than or equal to one), those with higher than industry median cash flow (i.e. more resources to overinvest) have significantly higher initiation announcement returns than those with low cash flow. Although a cutoff of one for Tobins Q is theoretically appealing (Lang and Litzenberger (1989)) and used in may other studies as a benchmark for good investment opportunities or overinvesting in different contexts (e.g. Lang, Stulz, and Walkling (1991)), several prior studies have employed alternate cutoffs because of the concern that the median Q may be different from one. Specifically, Yoon and Starks (1995) (a comparable study of dividend initiation announcement returns) and Servaes (1991) (a study of the gains from takeovers) both employ a relative Q cutoff. In this spirit, Panel B of Table 5 replicates Panel A using a relative cutoff for Q. In Panel B, firms are considered to have high Q if their Q in the year prior to the dividend initiation announcement is above the industry median in that year (matching the cutoff for preinitiation cash flow from operations). The key results in Panel B are similar to those in Panel A. Specifically, the highest initiation announcement abnormal returns in Panel B are again for the 281 initiating firms with low Q and high cash flow (5.6%), and, among initiating firms with high cash flow, initiation announcement returns for those with low Q (likely to be overinvesting with ample resources to do so) are significantly different from the returns to those with high Q (pvalue = 0.00). These results are consistent with the overinvestment / agency cost hypothesis the highest initiation announcement returns appear to be associated with overinvesting firms with large amount of cash flow relative to industry peers, and, among firms with high cash flows, those that are less likely to have productive investment opportunities in the future have significantly higher initiation announcement abnormal returns. The latter result seems particularly 11

pertinent for firms with cash flows higher than the industry median, and therefore much of their shareholders resources to either waste on negative NPV investments or invest profitably, those firms that likely have the worst investment opportunity set (low Q), but choose to initiate dividends anyway, have the highest dividend initiation announcement returns. The univariate results in Table 5 do not control for other, potentially important, determinants of dividend initiation announcement returns. Therefore, Table 6 contains OLS regressions explaining cumulative abnormal dividend initiation announcement returns, controlling for firm characteristics that may be associated with either the propensity to initiate dividends or the market reaction to initiation announcements. The control variables include dividend yield, based on the initial dividend, to control for the magnitude of the dividend surprise (as in Denis, Denis, and Sarin (1994), Yoon and Starks (1995), and Lie (2000)). Dividend initiations may be less surprising, and associated with weaker wealth effects, if the firm has already begun to pay out cash to stockholders in a form other than dividends, and so the regressions contain an indicator variable equal to one if the firm has repurchased stock in the five years preceding the initiation announcement.7 As seen in Table 4, dividend initiating firms have some distinct characteristics for example, initiating firms are larger, more profitable, and have higher earned-to-total capital ratios than non-payers. If initiations by firms with these characteristics are less surprising, then such initiations will generate a lower market reaction in absolute terms. Therefore the regressions contain these variables as controls for the propensity to initiate. Also, Grullon, Michaely, and Swaminathan (2002) demonstrate that firms that increase dividends payments experience a substantial decline in systematic risk, and that the returns around dividend change announcements are significantly associated with the magnitude of the reduction in risk premium. The change in the risk premium after the announcement of a dividend initiation (RISK) is included in the regressions, and is estimated as in Grullon, Michaely, and
7

Stock repurchases are measured as in Fama and French (2001).

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Swaminathan (2002).8 Finally, Baker and Wurgler (2004) show that firms are more likely to initiate dividends when the demand for dividends, measured by the dividend premium, is high. Dividend initiations are, therefore, likely to be less surprising when the dividend premium is high, and the dividend premium is included as an explanatory variable in Table 6. Regression (1) in Table 6 contains a baseline regression including only an indicator variable for low Q (as in Panel B of Table 5) and the continuous measure of the initiating firms pre-initiation cash flow from operations (scaled by total assets). As in Table 5, dividend initiation announcement returns are significantly higher for firms with the worst investment opportunities (low Q), with the point estimate equal suggesting that initiation announcement returns are 2.4% higher for firms with low Q (significantly different from zero at the 1% level). Pre-initiation cash flow from operations is significantly positive at the 10% level in this baseline specification. Regression (2) replaces the low Q indicator variable with the continuous measure of firm Q and contains an interaction term of pre-initiation cash flow from operations multiplied by the low Q indicator variable. In this specification, the effect of the interaction of pre-initiation cash flow and Q is particularly apparent. Q is still significantly negative (higher dividend initiation announcement returns for firms with poor investment opportunities), but the effect is greatly magnified by high pre-initiation cash flow from operations. Specifically, the coefficient on the interaction of the low Q indicator variable and pre-initiation cash flow is significantly positive at the 5% level, and the magnitude of the coefficient suggests that, in economic terms, a one

Grullon, Michaely, and Swaminathan (2002) specifically exclude dividend initiations from their sample, however almost all of the risk parameter changes around dividend initiations are similar on average to those reported in that paper. For example, I find average changes in the loadings on the market, SMB, and HML factors of -0.10, -0.17, and 0.00, while Grullon, Michaely, and Swaminathan reported average changes in factor loadings around dividend change announcements of -0.08, -0.10, and -0.06 (Grullon, Michaely, and Swaminathan (2002); Table 5, Panel B). Grullon, Michaely, and Swaminathan report an average risk premium reduction of 0.085% per month for their sample of dividend change announcements, while I find an average risk premium reduction around dividend initiations of approximately 0.14% per month.

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standard deviation increase in pre-initiation cash flow is associated with 1.6% higher dividend initiation announcement returns for initiating firms with low Q.9 The significantly positive effect of the interaction of pre-initiation cash flow from operations and low Q on dividend initiation announcement returns is consistent with the agency costs of overinvestment hypothesis, as such agency costs will be highest for firms with high preinitiation cash flow combined with poor investment opportunities. This suggests that the abnormal returns associated with initiating a policy of paying dividends reflect an anticipated reduction in the agency costs of overinvestment given ample free cash flow to overinvest.10 Most of the control variables included in regression (3) are robustly associated with dividend initiation announcement returns in the expected direction. Initiation announcement returns are lower for large firms, potentially because initiation are less surprising for large firms, and negatively associated with the change in risk premiums (as in Grullon, Michaely, and Swaminathan (2002)). Larger dividend initiations, measured by dividend yield, also appear to generate significantly larger market price responses. Regression (4) introduces the remaining control variables, and none of these are significantly associated with initiation announcement returns. Notably, dividend initiation announcement returns do not appear to be affected by prior repurchase activity or the level of the dividend premium. The sign and significance of coefficient on the interaction of cash flow and low Q is unaffected by the introduction of any of these control variables, although its magnitude is slightly reduced. One especially important advantage to using Q (interacted with pre-initiation cash flow) as a proxy for the agency costs of overinvestment is that Q is exogenous. Q is a function of market prices, and as such is not self-selected by the firm, or classes of investors in the firm, as other proxies for governance or agency costs, such as entrenchment indices or block ownership,
9

The in-sample standard deviation of cash flow from operations scaled by total assets is 10.8%. 0.108*0.1459 (from Table 6) = 1.57%. 10 The regressions reported in Table 6 are similar to those contained in Table 4 of Denis, Denis, and Sarin (1994). Denis, Denis, and Sarin do not, however, find a significant relation between the absolute value of initiation announcement returns and the interaction of Q and pre-initiation cash flow.

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are. However, one problem with interpreting the results in Table 6 as consistent with the agency cost hypothesis is the issue of why firms with high agency costs (i.e. those that have the potential to overinvest) would choose to return cash to stockholders in the first place. In other words, if Q is really capturing the degree to which managers of a firm are likely to waste their shareholders resources on inefficient investments, why would those managers suddenly decide to give up the benefits of overinvesting (in pet or scale-expanding projects) by initiating dividend payments? The agency explanation for initiation returns requires an exogenous event that closes the model by explaining the initiation decision, and I use the tax law change of 2003 as such an event in Section 5.

5. Robustness tests 5.1. The Jobs and Growth Tax Relief Reconciliation Act and alternate proxies for agency costs One problem with the traditional agency hypothesis for the monitoring and disciplinary role of dividends (Easterbrook (1984) and Jensen (1986)) is that dividend payments are voluntary. The theory relies on the premise that managers that are wasting or expropriating wealth from stockholders suddenly decide to begin paying dividends and returning cash to stockholders that could otherwise be invested (wasted) in pet or scale-expanding projects. What is needed to close the agency model is an exogenous shock to the equilibrium that determines whether a firm is a dividend payer or not. Governance shocks (such as the adoption of state or federal governance rules) are one possibility, as governance shocks may compel managers to adopt a financial policy (paying dividends) that is in the best interests of their shareholders. However, governance shocks simultaneously make dividend payments more likely and the payment of dividends less valuable to stockholders (because underlying governance has already improved due to the governance shock). In this section I examine a shock to the demand for dividends that is unrelated to governance or agency costs. The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) was 15

signed into law on May 28th of 2003, and reduced the maximum statutory income tax rate on dividends from 38% to 15%. By dramatically lowering the federal tax rate payable on dividend income, the JGTRRA altered the equilibrium demand for dividends and potentially increased the number of firms supplying dividends in this equilibrium. In the context of the agency cost hypothesis, the JGTRRA altered the demand for dividends in a way that could prompt firms with high agency costs (e.g. those with poor investment opportunities and ample cash) to begin paying dividends for the first time. The JGTRRA contributed to a spike in dividend initiations in 2003. Figure 1 shows the time series of the number of dividend initiations per month from 1990 to 2004. Between 1990 and 2002, the number of initiations averages approximately two per month, with a maximum of eight in May 1990. The dashed line in Figure 1 shows the timing of the JGTRRA, with a distinct and considerable spike in the number of initiations following, and for a few months after, May of 2003. The JGTRRA clearly prompted a historically unusual increase in dividend initiation activity,11 and would appear to provide exactly the kind of shock to the demand for dividends that will help close the agency model. In other words, I hypothesize that a non-dividend-paying firm with ample cash flow at the end of 2002 would be compelled to consider a change in dividend policy in 2003 given the change in tax law, and, consistent with the agency hypothesis, that such demand-induced initiations will have greater valuation effects for those firms that are poorly governed or have high agency costs. The number of dividend initiations per month from May to December of 2003 is in the first column of Table 7. Dividend initiations, presumably at least partly in response to the tax law change, spiked in July and, to a lesser extent, August of that year. The last two rows of Table 7 show that there were 79 initiations in the May December period of 2003, compared to only 14 during the same period of 2002, so the unusual number of initiations in the last half of 2003 is
11

This conclusion is consistent with the findings in Chetty and Saez (2005). However, for survey evidence on the opinion of CFOs about the relation between the 2003 JGTRRA and the decision to pay dividends see Brav, Graham, Harvey, and Michaely (2007).

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unlikely to be driven by seasonality. To maximize the sample size for analysis of the response to this exogenous shock to dividend policy choice, I use all initiations between May and December of 2003. The second column of Table 7 shows that dividend initiation announcements during this time period are still surprising to the market, despite the obvious implications of the tax law change, generating statistically significant average abnormal announcement returns of 2.96%, comparable to the full sample from 1963 2002 (Table 3) but slightly lower than the average returns for the 14 initiations in 2002. Because additional data is available for observations from 2003 that is not available for the full sample, I employ several alternate proxies of governance or agency costs in this sample (in addition to the measures of Q and cash flow from operations employed in Section 4). These alternate measures capture characteristics that could be expected to entrench managers and isolate them from shareholder monitoring. In other words, these measures are empirical proxies for the degree of the agency problem at publicly traded corporations, and, if the agency hypothesis has predictive power in this sample of tax-law-induced dividend policy changes, I expect firms with weak governance or monitoring (high agency costs) to have significantly more positive initiation announcement returns than firms with strong governance. I employ three governance proxies: Board is insider dominated (an indicator variable equal to one if the percent of executive directors on the board of directors is greater than 50%, and zero otherwise); percent ownership by public pension funds (the percent of the firms shares owned by the public pension funds collectively identified in three recent studies of the impact of public pension fund holdings on stock returns (Cremers and Nair (2005), Dittmar and MahrtSmith (2006), and Larcker, Richardson, and Tuna (2005)); and Managerial entrenchment (BCF) (an indicator variable equal to one if the entrenchment index from Bebchuk, Cohen, and Ferrell (2005) is greater than two (the pooled time-series and cross-sectional median), and zero otherwise).

17

Following prior literature, dividend initiating firms are considered to have weak governance if the board is insider dominated (Weisbach (1988) and Brickley, Coles, and Terry (1994)), if the Bebchuk, Cohen, and Ferrell entrenchment index indicates managerial entrenchment, or if the percent ownership by public pension funds is below the median for all firms at the same quarterly reporting date. Large institutional investors (particularly public pension funds) act as external monitors forcing firms in their portfolios to improve decisionmaking and control (Barclay and Holderness (1991)). Furthermore, Brickley, Lease, and Smith (1988), Smith (1996), Wahal (1996), and Del Guercio and Hawkins (1999) all argue that public pension funds are the most activist institutional monitors of firms. By comparing pubic pension fund ownership to the contemporaneous median, I am assuming that the incentive to monitor (i.e. to reduce agency costs) is increasing in the stake held in the firm by public pension funds. All data for initiating firms are from the period immediately preceding the initiation, which in most instances equates to data from 2002. Data on board composition are from the sample in Linck, Netter, and Yang (2006).12 The percent ownership by public pension funds is derived from CDA/Spectrum (13F) data, and is measured at the quarterly reporting date no more than 90 days prior to the dividend initiation announcement date (i.e. sometimes in 2003, but prior to the initiation). I use 2002 data from the Investor Responsibility Research Center (IRRC) database of corporate charter provisions to measure the entrenchment index as in Bebchuk, Cohen, and Ferrell (2005). This index is the sum of six indicator variables that capture whether a firm has a staggered board, limits to amend the bylaws or charter, supermajority-voting provisions, golden parachutes, or a poison pill, and takes values from 0 to 6 (increasing in the number of anti-takeover charter provisions that a firm has). The last 3 columns of Table 7 document how many of the 79 initiations between May and December of 2003 can be matched to the data sources described above for these additional governance or agency cost proxies. The weakest matching is to IRRC data on anti-takeover
12

I thank Jim Linck for allowing me to use these data.

18

charter provisions, with only 38 of the initiating firms during this period being matched to the data. However, 62 initiating firms are matched to data on board composition, and 59 to data on ownership by public pension funds. Within the sample of initiating firms, 18% (11 out of 62) have insider dominated boards and 34% (13 out of 38) have entrenched managers (Bebchuk, Cohen, and Ferrell entrenchment index greater than two). The average fraction of shares owned by public pension funds is 2.78%, and for 41% of the initiating firms (24 out of 59) the fraction of shares owned by public pension funds is below the median fraction of ownership for all firms in the 13F data at the same quarterly reporting date. Data from Compustat on cash flow and Q from the fiscal year prior to initiation (as in Section 4) is available for 74 of the 79 initiating firms. One disadvantage to using these additional agency cost proxies is that they are potentially endogenous firms choose the composition of their board and whether to have certain types of anti-takeover protection, and public pension fund investors choose which firms to invest in (a decision which, for tax reasons, may be associated with the firms propensity to pay dividends). Furthermore, the small sample sizes involved make robust empirical techniques for dealing with endogeneity practically impossible to implement here. However, the use of these proxies offers several advantages over splitting the sample based on pre-initiation Q and cash flow (as in Section 4). While Q is a commonly-employed market-based proxy for investment opportunities, these additional proxies directly measure elements of a firms governance or monitoring system (for example, whether managers are entrenched by anti-takeover provisions and whether a powerful external monitor owns a large stake in the firm). While these additional proxies are undoubtedly related to the market-based metric, Q (for example, Table 9 in Cremers and Nair (2005)), they have the potential to offer complementary evidence to the main tests discussed in Section 4 by capturing whether the governance of managers is weak enough that they have the opportunity to overinvest in negative NPV projects given the resources to do so. Table 8 contains abnormal dividend initiation announcement returns for subsamples split based on these additional governance proxies. The results show that for firms initiating after the 19

demand-inducing tax law change, those with weak pre-initiation governance (insider dominated boards, entrenched managers, or below-median ownership by public pension funds) have significantly more positive average dividend initiation announcement returns than those with strong governance. For example, the 11 initiating firms in this sample with insider dominated boards have average dividend initiation announcement returns of 6.6%, which is significantly greater (at the 5% level) than the average initiation announcement returns of 1.3% for firms without insider dominated boards. The same pattern is evident when the sample is split based on the indicator of managerial entrenchment (4.7% announcement returns to initiating firms with entrenched managers versus -0.3% returns to firms without entrenched managers), with slightly stronger statistical significance. The results in the subsamples based on public pension fund ownership go in the same direction (significantly positive returns to firms with low ownership by important external monitors, insignificant returns to firms with high ownership), but the two averages are not statistically different at conventional levels (p-value = 0.11). Although not tabulated, returns for subsamples split based on Q and cash flow show similar patterns to those evident in Table 5. Specifically, initiating firms in this sample from 2003 with low pre-initiation Q and high pre-initiation cash flow from operations (both relative to the industry median at the same point in time) have initiation announcement returns of 5.7% (significantly positive), while high Q / high cash flow firms have returns of 1.37% (insignificantly different from zero). The difference in these averages is significantly different from zero with a pvalue of 0.11. In sum, in this section I condition on an exogenous event that closes the agency hypothesis by providing impetus for firms with weak governance or monitoring (and likely to be overinvesting in negative NPV projects) to initiate the payment of dividends. I find similar results as those reported in the main tests. For firms initiating immediately after The Jobs and Growth Tax Relief Reconciliation Act was signed into law, a law change that demonstrably changed the equilibrium retain versus pay-out decision, those with weak governance (or evidence of 20

overinvestment) have significantly more positive initiation announcement returns than those with strong governance. This evidence supports the agency cost explanation for initiation announcement returns, as it appears that the market reaction to initiation announcements reflects anticipated lower agency costs of free cash flow for initiations immediately after an exogenous shock that would have caused overinvesting managers to reconsider their firms payout policy.

5.2. Dividend initiations and cash hoarding The agency hypothesis for dividend initiation announcement returns is predicated upon a specific premise: that the market response to a dividend initiation reflects a lower probability of future overinvestment or hoarding of free cash flow. Another way to test the agency hypothesis, therefore, is to provide direct evidence on this underlying prediction. Rational expectations would suggest that if markets respond more positively to dividend initiations by firms with poor investment opportunities and ample cash to waste, such firms should, on average, exhibit less hoarding of cash and wasting of resources in the future. Wasting of resources is a particularly difficult construct to measure. For example, both Denis, Denis, and Sarin (1994) and Yoon and Starks (1995) find that low Q firms that increase dividends also increase capital expenditures in the following years, contrary to the simple prediction under the agency/overinvestment hypothesis that dividend increases (with positive returns to overinvesting firms) should be followed by less investment. However, capital expenditures are only one of many different ways that the managers of a firm can waste or expropriate resources. A long literature in finance argues, for example, that value-destroying acquisitions are a prominent way that managers can spend their stockholders cash rather than pay it out (see, for example, Jensen (1986)). Furthermore, capital expenditures, even those by low Q firms, may not be wasteful. As a final piece of evidence in favor of the agency hypothesis, I take a different approach. Instead of measuring the use of cash and attempting to designate some, or all, of it as wasteful, 21

I examine the hoarding of cash by dividend initiating firms. The essence of the agency hypothesis is that managers have the means and opportunity to waste their stockholders cash assuming that the opportunities are present, examining cash hoarding tests whether firms reduce the means by which they could overinvest following dividend initiations. Evidence of reduced cash hoarding following initiations would therefore be consistent with the premise of the agency hypothesis that the market reaction to dividend initiations reflects lower agency costs of overinvestment. The principal concern with measuring cash balances after dividend initiations is that there will be a mechanical relation, as cash dividend payments naturally reduce a firms cash balance. I control for this possibility in two ways. First, I analyze abnormal cash holdings, defined as the difference between a firms cash holdings (scaled by total assets) and the median cash holdings (scaled by total assets) in that firms industry (Fama and French (1997)) in the same fiscal year. Therefore, I measure cash hoarding relative to industry peers, not in absolute terms. Second, I split the sample of dividend initiating firms into two groups based on pre-initiation Q (as in Table 5, Panel B), and examine whether low Q firms (those with the worst investment opportunities and, hence, likely to be overinvesting) exhibit different cash hoarding behavior after initiation than high Q firms do. The results are presented in Figure 2, which shows abnormal (difference from industry/year median) cash holdings scaled by total assets for a 21-year window centered on the fiscal year containing the dividend initiation (year 0). The sample is restricted to dividend initiations prior to 1996, to ensure that 10 years of post-initiation accounting data are available (although qualitatively similar results are found in an unrestricted sample). The sample is also split based on Q in the year prior to initiation, as in Table 5 (above/below the industry median). In the fiscal year prior to initiating dividends, firms hold high cash balances relative to industry peers on average firms with good investment opportunities (high Q) hold cash balances as a percent of total assets that are 8.4% higher than the industry median, and overinvesting firms (low Q) hold 3.6% more of their assets in the form of cash than the industry median. Both these 22

averages are statistically significantly different from zero using a traditional t-test for significance of means, with test statistics greater than seven. As can be seen in Figure 2, both of these percentages are also relatively high compared to recent history for initiating firms, consistent with the notion that firms initiate dividend payments when their cash balances (as a fraction of total assets and compared to the median firm in the industry) have increased markedly. The more interesting differences in cash hoarding, however, occur in the post-dividendinitiation years. Firms with poor pre-initiation investment opportunities (low Q) reduce their abnormal cash hoarding relative to industry peers considerably, to the point where six years after initiation the average dividend initiating firm with low pre-initiation Q has a cash balance that is statistically indistinguishable from the median firm in that industry in that year (t-statistic for significance of the mean abnormal cash holding scaled by total assets = 1.90). Furthermore, this elimination of hoarding behavior continues in the following 4 years on average, abnormal cash holdings continue to diminish for this group and stay statistically insignificantly different from zero for the remainder of the event period. The same is not true for firms with the best investment opportunities. High Q firms continue to hoard cash relative to industry peers well after initiating dividend payments. 10 years after initiation, firms with high pre-initiation Q hold 4.9% more cash as a fraction of total assets than the median firm in their industry, and this is statistically different from zero with a t-statistic of 4.5. This is not necessarily indicative of an inappropriate financial policy on average high Q firms are, after all, likely to be those with the best investment opportunities in their industry and therefore the greatest need for liquidity. However, the difference between high Q and low Q firms is striking, and suggests that low Q firms deliver on the promise of less cash hoarding (and potentially wasteful use of that cash) in the years following initiation. The findings in this section suggest that firms with the worst investment opportunities (Q below industry median before initiation) reduce their hoarding of cash (and the amount of resources available to managers to overinvest) in the years after initiating dividends, relative to 23

both industry peers and initiating firms with the best investment opportunities. This is consistent with the finding that the market reaction to dividend initiation announcements is significantly more positive for firms with ample free cash flow and poor investment opportunities (Section 4) or poor governance/monitoring (Section 5.1). The markets reaction appears to rationally anticipate lower agency costs as evidenced by the reduced future hoarding of cash for firms with poor pre-initiation investment opportunities.

6. Conclusion This paper provides evidence that corporate governance and firms potential to overinvest affect the market reaction to dividend initiation announcements. Overinvesting firms with high cash flow, and those with characteristics that are thought to proxy for weak governance or monitoring (insider dominated boards, entrenched managers, and low ownership by activist public pension funds), experience significantly more positive stock price reactions to dividend initiation announcements than other firms do. These results suggest that firms use dividend policy as a substitute for other control mechanisms in the equilibrium monitoring/bonding package chosen by firms (Rozeff (1982) and Jensen (1986)), and that the market values the anticipated reduction in agency costs resulting from the choice by a potentially overinvesting firm to initiate regular cash dividend payments. These results also hold following an exogenous event that appears to have changed the equilibrium tradeoff between hoarding cash and paying it out, which is important because such an exogenous event is necessary to close the agency model by explaining why overinvesting or poorly governed managers choose to make dividend payments in the first place. Post-initiation cash holding patterns are also consistent with the markets reaction to dividend initiation announcements: firms with weak investment opportunities (and significantly higher dividend initiation announcement returns) substantially reduce their average abnormal hoarding of shareholders cash in the five to six years following a dividend initiation. 24

The results in this paper suggest avenues for future research. While initiation announcement returns are significantly more positive for overinvesting firms, or those with weak governance, initiation returns are significantly positive even for firms that traditional proxies suggest have strong investment opportunities or governance mechanisms. Given that much of the empirical evidence in the literature does not support the cash-flow signaling hypothesis (Watts (1973), DeAngelo, DeAngelo, and Skinner (1996), and Grullon, Michaely, and Swaminathan (2002)), a more thorough analysis of dividend initiation announcement returns appears warranted. One possibility, consistent with the results in Grullon, Michaely, and Swaminathan (2002), is that dividend initiations may signal operating (as well as financial) maturity, and an analysis of how operating maturity interacts with the governance implications of dividend initiations has the potential to significantly expand our understanding of the market reaction to substantial dividend policy changes.

25

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Del Guercio, D., Hawkins, J., 1999. The motivation and impact of pension fund activism. Journal of Financial Economics 52, 293-340. Denis, D., Denis, D., Sarin, A., 1994. The information content of dividend changes: Cash flow signaling, overinvestment, and dividend clienteles. Journal of Financial and Quantitative Analysis 29, 567-587. Dittmar, A. Mahrt-Smith, J., 2005. Corporate governance and the value of cash holdings. Journal of Financial Economics, forthcoming. Dittmar, A., Mahrt-Smith, J., Servaes, H., 2003. International corporate governance and corporate cash holdings. Journal of Financial and Quantitative Analysis 38, 111-133. Easterbrook, F., 1984. Two agency-cost explanations of dividends. American Economic Review 74, 650-659. Fama, E., French, K., 1997. Industry costs of equity. Journal of Financial Economics 43, 153193. Fama, E., French, K., 2001. Disappearing dividends: changing firm characteristics or lower propensity to pay? Journal of Financial Economics 60, 3-43. Gillan, S., Hartzell, J., Starks, L., 2006. Tradeoffs in corporate governance: Evidence from board structures and charter provisions. Working paper, University of Texas at Austin. Gompers, P., Iishi, J., Metrick, A., 2003. Corporate governance and equity prices. Quarterly Journal of Economics 118, 107-155. Grullon, G., Michaely, R., Swaminathan, B., 2002. Are dividend changes a sign of firm maturity? Journal of Business 75, 387-424. Harford, J., Mansi, S., Maxwell, W., 2006. Corporate governance and a firms cash holdings. Working paper, University of Washington. Hu, A., Kumar, P., 2004. Managerial entrenchment and payout policy. Journal of Financial and Quantitative Analysis 39, 759-790.

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Jensen, M., 1986. Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, 323-329. John. K., Knyazeva, A., 2006. Payout policy agency conflicts, and corporate governance. Working paper, New York University. Kaplan, S., Zingales, L., 1997. Do investment-cash flow sensitivities provide useful measures of financing constraints? Quarterly Journal of Economics 112, 169-215. Lang, L., Litzenberger, R., 1989. Dividend announcements: Cash flow signaling vs. free cash flow hypothesis. Journal of Financial Economics 24, 181-191. Lang, L., Stulz, R., Walkling, R., 1991. A test of the free cash flow hypothesis: The case of bidder returns. Journal of Financial Economics 29, 315-335. Larcker, D., Richardson, S., Tuna, A., 2005. How important is corporate governance? Working paper, University of Pennsylvania. Lie, E., 2000. Excess funds and agency problems: An empirical study of incremental cash disbursements. Review of Financial Studies 13, 219-248. Linck, J., Netter, J., Yang, T., 2006. The determinants of board structure. Journal of Financial Economics, forthcoming. Masulis, R., Wang, C., Xie, F., 2006. Corporate governance and acquirer returns. Forthcoming, Journal of Finance. Pan, C., 2006. Why are firms with entrenched managers more likely to pay dividends? Working paper, Ohio State University. Pinkowitz, L., Stulz, R., Williamson, R., 2006. Does the contribution of corporate cash holdings and dividends to firm value depend on governance? A cross-country analysis. Journal of Finance 61, 2725-2751. Rozeff, M., 1982. Growth, beta, and agency costs as determinants of dividend payout ratios. Journal of Financial Research 5, 249-259.

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Smith, C., Watts, R., 1992. The investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Financial Economics 32, 263-292. Smith, M., 1996. Shareholder activism by institutional investors: Evidence for CalPERS. Journal of Finance 51, 227-252. Wahal, S., 1996. Pension fund activism and firm performance. Journal of Financial and Quantitative Analysis 31, 1-23. Watts, R., 1973. The information content of dividends. Journal of Business 46, 191-211. Weisbach, M., 1988. Outside directors and CEO turnover. Journal of Financial Economics 20, 431-460. Yoon, P., Starks, L., 1995. Signaling, investment opportunities, and dividend announcements. Review of Financial Studies 8, 995-1018.

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Table 1. Dividend initiations by year This table presents the sample of dividend initiation announcements by industrial (non-financial and non-utility) firms from the CRSP database by year of announcement from 1963 2002. Dividend initiation announcements are defined as the first announcement by a firm listed in CRSP of an ordinary, taxable, cash dividend payable at the quarterly, semi-annual, or annual frequency to holders of ordinary common stock (share codes 10 and 11) listed on the NYSE, Nasdaq, or Amex. All dividend initiating firms must have a stock price on CRSP 365 calendar days prior to the initiation announcement, and subsequent dividend initiations following an omission are omitted from the sample. Firms must also be covered by the Compustat database, and have no dividends recorded by Compustat in the prior five fiscal years. The second column contains the percent of dividend initiation announcements each year for which there is a quarterly earnings announcement date for the quarter in the 21 calendar day window centered on the dividend initiation announcement date. Compustat begins recording quarterly earnings announcement dates in 1971. Year 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total # of dividend initiations 14 18 21 5 5 8 7 5 11 20 54 76 113 112 94 49 27 19 20 16 11 22 20 16 25 36 36 32 26 26 21 26 33 13 18 12 18 10 10 14 1,119 % of initiations with earnings announcement +/- 10 days

9.1% 30.0% 24.1% 23.7% 21.2% 28.6% 17.0% 14.3% 18.5% 26.3% 25.0% 25.0% 27.3% 27.3% 35.0% 31.3% 60.0% 41.7% 47.2% 50.0% 34.6% 30.8% 47.6% 30.8% 45.5% 46.2% 44.4% 8.3% 11.1% 30.0% 60.0% 42.9% 27.0%

Table 2. Dividend initiations by industry This table presents the sample of dividend initiation announcements by industrial (non-financial and non-utility) firms from the CRSP database from 1963 2002 by industry. Industries are defined using two-digit SIC codes. Five observations are missing from the table due to missing or unclassifiable SIC codes. The sample of dividend initiation announcements is defined in Table 1. The second column contains the number of initiations in the industry divided by the total number of firms in CRSP that report being in that industry in Decembers between 1963 and 2002. Initiations as % of CRSP firms in same industry 3.3% 9.7% 7.4% 8.9% 7.0% 5.1% 6.2% 7.6% 2.9% 1.3% 7.8% 4.3% 4.6% % of initiations with earnings announcement +/- 10 days 15.8% 27.7% 21.1% 26.7% 33.3% 26.1% 27.4% 29.2% 27.3% 0.0% 26.5% 28.9% 27.1%

Industry Agriculture, Forestry, Fishing, and Mining Construction and Basic Materials Food and Tobacco Textiles, Clothing, and Consumer Products Logging, Paper, Printing, and Publishing Chemicals and Petroleum Machinery and Equipment (incl. Computers) Transportation Telecommunications Utilities (unregulated) Wholesale Distributors and Retail Recreation, Entertainment, Services, and Conglomerates Total

# of dividend initiations 19 130 38 75 42 115 237 72 22 6 185 173 1,114

Table 3. Cumulative abnormal dividend initiation announcement returns This table presents descriptive statistics for cumulative abnormal announcement returns for the dividend initiations described in Table 1. Cumulative abnormal announcement returns are the firm-specific sum of abnormal returns during the three-trading-day window centered on the dividend initiation announcement date. Daily abnormal returns are the difference between firm daily return and the daily value-weighted market return from CRSP. The value weights for firm-specific returns are market capitalizations from CRSP three trading days prior to the dividend initiation announcement date. Compustat begins recording quarterly earnings announcement dates in 1971. The top number is the mean, the number in brackets is the median, and the number of observations is in parentheses. *** indicates that the mean or median is significantly different from zero (using a cross-sectional test) at the 1% level. Equal-weighted Average dividend initiation announcement cumulative abnormal return, 1963 2002 Average dividend initiation announcement cumulative abnormal return including the Microsoft initiation (1/16/2003) Average dividend initiation announcement cumulative abnormal return, 1971 2002, excluding initiations with earnings announcement 10 days 3.75%*** [2.08%]*** (1,105) 3.74%*** [2.08%]*** (1,106) 3.93%*** [1.83%]*** (724) Value-weighted 0.55%*** (1,105) -3.23%*** (1,106) 0.86%*** (724)

Table 4. Descriptive statistics for dividend initiating firms This table presents average financial characteristics for the sample of dividend initiating firms described in Table 1. The number of observations is in parentheses. All variables are constructed from Compustat data for the fiscal year ending immediately prior to the dividend initiation announcement date for all dividend initiating firms with positive book equity. Q is total assets (annual data item #6) plus fiscal-year-end market value of equity (annual data item #25 multiplied by annual data item #199) minus book value of equity (annual data item #60) minus balance sheet deferred taxes (annual data item #74), all divided by total assets (as in Kaplan and Zingales (1997)). Cash flow from operations is defined as in Bushman, Smith, and Zhang (2006) as earnings before extraordinary items (annual data item #18) plus depreciation and amortization (annual data item #14) minus working capital accruals, all scaled by total assets. Working capital accruals are defined as the change in current assets (annual data item #4) minus the change in cash holdings (annual data item #1) minus the change in current liabilities (annual data item #5) plus the change in short-term debt (annual data item #34) plus the change in tax payable (annual data item #71). Leverage is the book value of long-term debt (annual data item #9) divided by total assets, ROA is income before extraordinary items (annual data item #14) plus interest expense (annual data item #15) and income statement deferred taxes (annual data item #50) (if available) all divided by total assets. Size is fiscal-year-end market value of equity scaled by the fiscal-year-end level of the S&P 500 index, RE/TE is retained earnings (annual data item #36) divided by book value of equity (winsorized at the 5th and 95th percentiles), Sales growth is the percent change in sales (annual data item #12) from the prior fiscal year (winsorized at the 5th and 95th percentiles). Cash is cash holdings divided by total assets. Age is the number of years since the firm first appeared in Compustat. The final column contains the average difference between the initiating-firm characteristic and the average in the fiscal year prior to initiation for all non-financial and non-utility firms (minimum of 5) that do not pay a dividend in the initiating year. ***, **, or * indicates that the average difference between initiating firms and non-payers is statistically significantly different from zero at the 1%, 5%, or 10% level (respectively). Average for dividend initiating firms Q Cash flow from operations Leverage ROA Size RE/TE Sales growth Cash Age 1.40 (987) 0.09 (950) 0.18 (1,049) 0.10 (1,007) 0.0006 (1,008) 0.48 (1,019) 0.21 (997) 0.13 (1,050) 19.64 (1,050) Average difference from non-payers -0.34*** (984) 0.08*** (950) -0.01 (1,047) 0.09*** (1,005) 0.0003*** (1,004) 0.23*** (1,018) 0.02* (996) -0.00 (1,048) 2.20*** (1,048)

Table 5. Dividend initiation announcement returns and governance measures This table presents equal-weighted averages of cumulative abnormal dividend initiation announcement returns for subsamples divided by Q and pre-initiation cash flow from operations. In Panel A, the four subsamples are split based on initiating-firm Q (measured in the fiscal year prior to initiation) compared to 1 and cash flow from operations (measured in the fiscal year prior to initiation) compared to the median in the same industry in the same fiscal year. Industry definitions are from Fama and French (1997) and assignment to industry uses Compustat SIC codes. In Panel B, the four subsamples are split based on initiating-firm Q and cash flow from operations (both measured in the fiscal year prior to initiation) compared to the median in the same industry in the same year prior. In all cases, there is no comparative median if there are fewer than 5 firms in the industry in the year prior to initiation. The number of observations in each cell is in parentheses. All variables are defined in previous tables. *** indicates that the average cumulative abnormal dividend initiation announcement return is statistically significantly different from zero at the 1% level. Panel A. Q greater than / less than 1 Cash flow from operations (pre-initiation) <= industry/year median <=1 Q >1 p-value for difference in rows 2.85%*** (172) 0.04 2.38%*** (339) 0.00 0.45 4.68% (169)
***

p-value for difference in columns

> industry/year median 6.76%*** (208) 0.05

Panel B. Q greater than / less than industry / year median Cash flow from operations (pre-initiation) <= industry/year median <= industry/year median Q > industry/year median p-value for difference in rows 3.25%*** (162) 0.28 2.42%*** (266) 0.00 0.22 4.22%*** (179) > industry/year median 5.58%*** (281) 0.15 p-value for difference in columns

Table 6: The relation between dividend initiation announcement returns and governance measures This table presents results from OLS regressions explaining cumulative abnormal dividend initiation announcement returns. The dependent variable (cumulative abnormal announcement returns) is defined in Table 3. Low Q is an indicator variable equal to one if the initiating-firms Q is less than or equal to the industry/year median (as in Table 5, Panel B), and zero otherwise. Size is the market value of equity (in billions) scaled by the level of the S&P 500 index three trading days prior to the dividend initiation announcement date. Dividend yield is the amount of the initial dividend divided by the stock price three trading days prior to the dividend initiation announcement date. RISK is the change in the risk premium after the announcement of a dividend initiation, computed as in Grullon, Michaely, and Swaminathan (2002). Prior repurchases is an indicator variable equal to one if the initiating firm repurchases stock in the five years prior to the dividend initiation, and zero otherwise. Dividend premium is the difference in the logs of the value-weighted average market-to-book ratios for dividend payers and non-payers in the initiation year (as in Baker and Wurgler (2004)). All other independent variables are defined in previous tables. White-corrected standard errors are in parentheses. ***,**, or * indicates that the regression coefficient is significantly different from zero at the 1%, 5%, or 10% level (respectively). (1) Intercept Q Low Q Cash flow from operations Low Q * Cash flow from operations Log(Size) Dividend yield Risk Prior repurchases ROA RE/TE Dividend premium Number of observations Adjusted R2 893 0.02 893 0.04 854 0.16 0.0240*** (0.0057) 0.0759* (0.0391) 0.0199 (0.0314) 0.1459** (0.0582) 0.0574* (0.0309) 0.1203** (0.0566) -0.0107*** (0.0021) 0.4071** (0.2031) -0.5011** (0.2082) 0.0246 (0.0323) 0.1004** (0.0490) -0.0108*** (0.0021) 0.4552** (0.2015) -0.4991** (0.2121) -0.0017 (0.0071) 0.0735 (0.0782) 0.0009 (0.0089) 0.0241 (0.0264) 805 0.14 0.0203*** (0.0053) (2) 0.0464*** (0.0060) -0.0107*** (0.0027) (3) -0.0626*** (0.0182) -0.0045** (0.0023) (4) -0.0675*** (0.0186) -0.0044* (0.0026)

Table 7. Dividend initiations from May 2002 to December 2003 This table presents dividend initiation announcements by industrial (non-financial and non-utility) firms from the CRSP database by month of announcement from May, 2003 December, 2003. The Jobs and Growth Tax Relief Reconciliation Act was signed into law on May 28th of 2003. Dividend initiations are defined in Table 1. The final three columns indicate how many of the initiating firms from May, 2003, to December, 2003 have data on various governance proxies. Board is insider dominated is an indicator variable equal to one if the % of executive directors on the board is greater than 50%, and zero otherwise. Board composition data is from the Compact Disclosure data used in Linck, Netter, and Yang (2006) for 2002. Managerial entrenchment is an indicator variable generated from Investor Responsibility Research Center (IRRC) data for 2002, and is equal to one if the entrenchment index (Bebchuk, Cohen, and Ferrell (2005)) is greater than the cross-sectional median (two), and zero otherwise. % ownership by public pension funds is derived from CDA/Spectrum data, and is the percent of the firms shares owned by public pension funds as defined in Cremers and Nair (2005), Dittmar and Mahrt-Smith (2006), and Larker, Richardson, and Tuna (2005) at the quarterly reporting date no more than 90 days prior to the dividend initiation announcement date (i.e. end of March, June, or September, 2003). In the first column, ***,**, or * indicates that the equalweighted average abnormal dividend initiation announcement return (defined in Table 3) is significantly different from zero at the 1%, 5%, or 10% level (respectively).

Month May June July August September October November December, 2003 May December, 2003 May December, 2002

# of dividend initiations 5 10 22 12 5 7 13 5 79 14

Average abnormal dividend initiation announcement return 0.82% 4.58%** 2.82% 2.21% 8.05% 1.90% 3.18%*** 0.00% 2.96%*** 4.74%***

# of dividend initiating firms with 2002/2003 data on: Board is insider dominated 2 7 19 11 4 6 9 4 62 Managerial entrenchment 3 7 10 5 2 5 5 1 38 % ownership by public pension funds 3 9 19 6 3 6 10 3 59

Table 8. Dividend initiation announcement returns (5/2003 to 12/2003) and governance proxies This table presents equal-weighted averages of cumulative abnormal dividend initiation announcement returns for the sample defined in Table 7. The sample is split using the governance variables defined in Table 7. In each row, Weak governance is defined as: Board is insider dominated = 1; Managerial entrenchment (BCF) = 1; or Percent ownership by public pension funds less than or equal to the median for all firms for which CDA/Spectrum reports ownership data at the same quarterly reporting date. All dividend initiating firms that are not defined as having Weak governance (in each row) are defined as having Strong governance. ***, **, or * indicates that the equalweighted mean is statistically significantly different from zero at the 1%, 5%, or 10% level (respectively). a, b, or c indicates that the Weak governance equal-weighted mean is statistically significantly different from the Strong governance equal-weighted mean at the 1%, 5%, or 10% level (respectively). Weak governance Board is insider dominated Managerial entrenchment (BCF) Percent ownership by public pension funds 6.58%* b (11) 4.65%*** a (13) 3.40%** (24) Strong governance 1.26% (51) -0.28% (25) 0.76% (35)

Figure 1. Number of dividend initiations per month, 1990 - 2004 This figure shows the number of dividend initiations per month from 1990 to 2004. Dividend initiations are defined in Table 1. The dashed line in the figure represents May, 2003, when the Jobs and Growth Tax Relief Reconciliation Act was signed into law.
25

20

Number of initiations

15

10

0
,2 00 3 M ay 19 90 20 00 19 95

Figure 2. Abnormal cash holdings for firms initiating dividends This figure shows the average abnormal cash holdings by year relative to the initiation year for firms initiating dividends between 1962 and 1995. The sample is split based on whether the firms Q is greater or less than (or equal to) the industry/year median in the fiscal year prior to initiation (as in Table 5, Panel B). Abnormal cash holdings are cash holdings (Compustat annual data item #1) scaled by total assets minus the median cash holdings scaled by total assets for all firms in the same industry as the initiating firm in the same fiscal year.
Abnormal cash holdings
0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 Q > median 3 4 5 6 7 8 9 10

Q <= median