Why Do Firms Pay Dividends? International Evidence on the Determinants of Dividend Policy*

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Why Do Firms Pay Dividends? International Evidence on the Determinants of Dividend Policy*

DAVID J. DENIS** Krannert School of Management Purdue University West Lafayette, IN 47907 djdenis@purdue.edu

IGOR OSOBOV Georgia State University Department of Finance Atlanta, GA 30303 iosobov@gsu.edu

May, 2007

We thank Yakov Amihud, Harry DeAngelo, Linda DeAngelo, Diane Denis, Jim Hsieh, Omesh Kini, Erik Lie, John McConnell, Lalitha Naveen, Raghu Rau, Steve Smith, Jeff Wurgler, an anonymous referee, and seminar participants at Colorado, Georgia State, and Purdue for helpful comments. **

*

Corresponding author.

Electronic copy available at: http://ssrn.com/abstract=887643

Why do Firms Pay Dividends? International Evidence on the Determinants of Dividend Policy

Abstract In the U.S., Canada, U.K., Germany, France, and Japan, the propensity to pay dividends is higher among larger, more profitable firms, and those for which retained earnings comprise a large fraction of total equity. Although there are hints of reductions in the propensity to pay dividends in most of the sample countries over the 1994 to 2002 period, they are driven by a failure of newly listed firms to initiate dividends when expected to do so. Dividend abandonment and the failure to initiate by existing nonpayers are economically unimportant except in Japan. Moreover, in each country, aggregate dividends have not declined and are concentrated among the largest, most profitable firms. Finally, outside of the U.S. there is little evidence of a systematic positive relation between relative prices of dividend paying and non-paying firms and the propensity to pay dividends. Overall, these findings cast doubt on signaling, clientele, and catering explanations for dividends, but support agency cost-based lifecycle theories.

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Electronic copy available at: http://ssrn.com/abstract=887643

Why do Firms Pay Dividends? International Evidence on the Determinants of Dividend Policy

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Introduction Why do some firms pay dividends while others do not? Since the publication of the

original Miller and Modigliani (1961) irrelevance propositions, this question has puzzled financial economists. Traditionally, finance scholars have emphasized explanations for

dividends that are based on the desire to communicate information to shareholders or to satisfy the demand for payouts from heterogeneous dividend clienteles [see Allen and Michaely’s (2003) survey]. Recently, however, DeAngelo, DeAngelo, and Skinner (2004) cast doubt on signaling and clientele considerations as first-order determinants of dividend policy by reporting that dividends in the U.S. are increasingly concentrated among a small number of large payers. An alternative view of dividends, proposed by DeAngelo and DeAngelo (2006), is that optimal payout policy is driven by the need to distribute the firm’s free cash flow. They propose a life-cycle theory that combines elements of Jensen’s (1986) agency theory with evolution in the firm’s investment opportunity set of the type discussed in Fama and French (2001) and Grullon, Michaely, and Swaminathan (2002). In this theory, firms optimally alter dividends through time in response to the evolution of their opportunity set. The theory predicts that in their early years, firms pay few dividends because their investment opportunities exceed their internally generated capital. In later years, internal funds exceed investment opportunities so firms optimally pay out the excess funds in order to mitigate the possibility that the free cash flows will be wasted. Consistent with this life-cycle view, DeAngelo, DeAngelo, and Stulz (2006) find that the propensity to pay dividends is positively related to the ratio of retained earnings to total equity, their proxy for the firm’s life-cycle stage.

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Yet a further wrinkle in the ‘dividend puzzle’ literature is presented in Fama and French (2001). Fama and French report a substantial decline...
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