Dividend Increases and Initiations, Debt Policy and Default Risk in Equity Returns

Abstract

This paper documents that dividend initiations and increases are associated with reductions in default risk (DR). Using a sample of 6,336 U.S. firm-year observations that either increased or initiated cash dividend payments during the 20 year period 1986-2005, we find that DR is significantly reduced the year prior to the dividend increase and initiation announcements, and that this reduction explains the dividend payment decision beyond profitability and the Fama and French (1993) risk measures. Additionally, our results support that the reduction in DR is a priced risk factor. Specifically, we show that a) the dividend initiation and increase firms exhibit a decrease in the DR factor loading by augmenting the Fama-French three-factor model, and b) the reduction in DR significantly explains the positive market reaction upon dividend increases and initiations. Our results also suggest that managers utilising on the reduced default risk, increase total debt in order to increase firm's tax benefits. Finally, further analysis reveals that changes in default risk and changes in debt to equity ratio are significant factors in explaining the three year excess returns following dividend increases and initiations (Michaely et al., 1995; Benartzi et al., 1997; Grullon et al., 2002). The results are robust to further controls for profitability, retained earnings, liquidity, growth, size, special items, and systematic risk.