Can Disclosure Quality Explain Dividend Payouts?

Dan Lin,Lie-Huey Wang,Hsien-Chang Kuo

doi:10.5539/ibr.v7n7p10

Abstract

This study investigates how a firm’s disclosure quality affects its dividend policy. Using a sample of Canadian firms with disclosure data from The Globe and Mail, we empirically test the outcome hypothesis and the substitution hypothesis. The outcome hypothesis posits that dividends are an outcome of an effective governance regime and complements other governance mechanisms while the substitution hypothesis argues that dividend payout is a substitute for other forms of governance. Since disclosure quality can reflect the severeness of agency problems between outsiders and insiders, the outcome hypothesis predicts that higher disclosure quality would lead to higher dividend payouts while the substitution hypothesis predicts that lower disclosure quality is associated with higher payouts. This study contributes to the ongoing debate on the relationship between disclosure quality and dividend policy. Our results provide support for the outcome hypothesis; specifically, better disclosure quality is associated with both a stronger propensity to pay dividends and among dividend payers, with larger dividends.

Highlights

The agency theory proposed by Jensen (1986) argues that firms’ dividend policies are affected by agency costs
Inconsistent with the prediction, the results suggest that leverage is not a substitute governance mechanism for reducing the agency costs of free cash flow
The results indicate that firms are likely to raise debt in order to maintain its dividend level, reflecting the “stickiness” in dividend payouts that have been discussed in previous literature (Guttman et al, 2010; Twu, 2010)

Summary

Introduction

The agency theory proposed by Jensen (1986) argues that firms’ dividend policies are affected by agency costs. Managers are less likely to use the free cash flow for their private benefits (DeAngelo et al, 2006) or to spend the free cash flow on negative net present value investments. The latter is referred to as the agency costs of free cash flow (Jensen, 1986). After dividend payouts, when firms have capital needs, they will need to issue new equity or debt. Firms are exposed to more frequent monitoring by the primary capital markets (Easterbrook, 1984)

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Conclusion