Are Dividends All for Rewarding Investors? Evidence from Payouts Induced by Return on Equity Targets

Abstract

ABSTRACT Dividends have long been perceived as a way for firms to reward investors. However, managers are likely to inflate return on equity (ROE) by paying out dividends because doing so reduces owners’ equity. We utilise performance-vesting equity incentive plans that adopt ROE as the performance measure to examine this possibility. We find that firms with pre-dividend ROE slightly below the vesting target are more likely to pay dividends and are associated with larger payout ratios than others. Because weighted average ROE’s computation assigns more weight to earlier paid dividends, we also find that these firms are more likely to pay dividends earlier and have larger time-weighted payout ratios. Further investigations show that dividends substitute for accrual and real earnings management in inflating ROE. Finally, we obtain evidence that ROE-induced dividends reduce firm value in the long run. Overall, our evidence reveals that dividends may be induced by managers’ incentives to meet ROE targets. This phenomenon deserves more attention, as nowadays regulators often take an exclusively positive view of dividends.