liquidity and dividends

8/6/2019 Liquidity and Dividends

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Stock Market Liquidity and Firm Dividend Policy

Suman BanerjeeA. B. Freeman School of Business

Tulane University7 McAlister Drive

New Orleans, LA [email protected]

(504 ) 865 -5558

Vladimir A. GatchevA. B. Freeman School of Business



(504 ) 865 -5534

Paul A. SpindtA. B. Freeman School of Business



(504 ) 865 -5413

February 2005

JEL classi cation : G35 , G33Keywords : Dividends; Payout policy; Liquidity; Trading friction

Please address correspondence to Vladimir A. Gatchev, A. B. Freeman School of Business, Tulane Uni-versity, 7 McAlister Drive, New Orleans, LA 70118. Tel. (504) 865-5534; E-mail: [email protected].

For helpful discussions and comments we thank Vladimir Atanasov, David Blackwell, Michael Brandt, ValentinDimitrov, Chitru Fernando, John Graham, Joel Horowitz, Kose John, David Lesmond, Neal Maroney, DavidMauer, Tom Noe, Nagpurnanand Prabhala, Michael Rebello, Bill Reese, Ramana Sonti, Venkat Subramaniamand Sheri Tice. The paper has also bene ted from comments by seminar participants at Tulane University,University of New Orleans, Southern Methodist University, Kennesaw State University, University of Mis-souri, Georgia State University, University of Central Florida, Auburn University, University of Cincinnati,University of Oklahoma, the 2003 EFMA meetings, and the 2004 WFA meetings. We would like to thankMichael Lemmon in particular, our discussant at the 2004 WFA meetings, for his comments and insights. Weremain responsible for any errors.


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Stock Market Liquidity and Firm Dividend Policy

ABSTRACT

We provide evidence of a link between rm dividend policy and stock market liquidity. Inthe cross-section, owners of less (more) liquid common stock are more (less) likely to receive

cash dividends. Over time, the notable increase in US stock market liquidity explains most of

the declining propensity of rms to pay dividends documented by Fama and French ( 2001 ).

We further show that past liquidity is an important determinant of dividend initiations and

omissions for individual rms. Extending our analysis, we nd evidence that sensitivity of

rm value to innovations in aggregate liquidity declines after dividend initiations.

JEL classi cation : G35 , G33Keywords : Dividends; Payout policy; Liquidity; Trading friction


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Firms dividend policies continue to puzzle nancial researchers. In this paper, we argue

that investor demand for stocks paying cash dividends is positively related to the trading

friction that investors face when creating homemade dividends. We further hypothesize that

the likelihood a rm will pay cash dividends is positively related to investor demand for

dividend payments and therefore inversely related to the market liquidity of the rms stock.

Examining the empirical evidence, we nd strong support for our hypothesis.

In their seminal work, Miller and Modigliani ( 1961 ) formally developed the dividend

irrelevance hypothesis. In perfect capital markets populated by rational investors, a rms

value is solely a function of the

rms investment opportunities and is independent of the rms payout policy. A large body of theoretical work has tried to evaluate the importance

that managers and investors attach to dividend policy in light of the irrelevance proposition.

The starting point of these studies is to question some of the assumptions that characterize

the perfect capital markets hypothesized by Miller and Modigliani. 1

One notable assumption of the dividend irrelevance proposition, and one central to this

paper, is that trading is frictionless. In perfect markets, investors can instantaneously invest

or liquidate their investment in any stock without incurring any direct or indirect costs of trading and without changing the price of the underlying security. In markets with no trading

friction, rational investors with liquidity needs can create homemade dividends at no cost by

selling an appropriate amount of their holdings in the rm. As a result, they will be indi ff erent

between receiving a dollar of dividend and selling a dollars worth of their investment.

In markets with trading friction, stocks that pay cash dividends allow investors to satisfy

their liquidity needs with little or no trading in the stock and thus enable them to avoid

trading friction. As a result, investors with current or anticipated future liquidity needs

may have a preference for dividend paying stocks. This preference will be positively related

to the level of trading friction so that higher (lower) trading friction will lead to higher

(lower) demand for cash dividends relative to homemade dividends. Dong, Robinson, and1 Allen and Michaely (2001) provide a survey on the literature.

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Veld ( 2003 ) present survey evidence that retail investors want dividends, partly because their

costs of cashing in dividends are lower than the transaction costs involved in selling shares. 2

It is important to address the question of how investor demand for dividends translates

into actual dividend policy. On the one hand, existing literature argues that stock market

liquidity a ff ects the valuation of rms both in the cross-section and through time. 3 In this

literature, stocks with higher liquidity levels (i.e., lower trading friction) trade at a premium

and have lower expected returns relative to stocks with lower liquidity levels (i.e., higher

trading friction). Firms, however, can pay cash dividends, reduce investor dependence on

the liquidity of the market, and therefore raise their valuations an option more valuablefor rms with higher discount rates due to lower liquidity levels. Indeed, Baker and Wurgler

(2004 a, 2004 b) present signi cant evidence that rms consider valuation e ff ects when choosing

a dividend policy. On the other hand, it is also possible that investors directly enforce the

desired dividend policy, as suggested by La Porta, Lopez-de-Silanes, Shleifer, and Vishny

(2000 ).

While the possibility of a link between stock market liquidity and the dividend policy of

the rm dates at least back to Miller and Modigliani ( 1961 ), current literature provides littledirect empirical evidence on that issue. Some indirect evidence, however, is consistent with

our hypothesis. For example, Long ( 1978 ) documents that between 1956 and 1976 the cash

dividend class of shares of Citizens Utilities Company on average sold at a premium to the

stock dividend class. Subsequent work by Poterba ( 1986 ) shows that the two classes of shares

trade at similar prices for the 1976 -1984 period. The disappearing premium on the cash

dividend shares is consistent with an increase in the liquidity of the market in that period.

2 Dividend reinvestment, if needed, can result in additional trading costs for investors. In 1954 NYSEimplemented the Monthly Investment Plan (MIP) that, among other things, allowed reinvestment of dividends.This program was terminated in 1976. Meanwhile, in 1968, Citibank (then First National City Bank of NewYork) introduced the rst dividend reinvestment program (DRIP). DRIPs increased in popularity and sincethe mid-1970s most rms have such programs (see Davey (1976) and Carlson (1996)). One of the majorobjectives of such programs is to allow investors to reinvest dividends.

3 See, for example, Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), Brennan, Chordia,and Subrahmanyam (1998), Amihud (2002), Jones (2002), and Pstor and Stambaugh (2003).

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Nevertheless, the question of whether stock market liquidity has an incremental impact

on the dividend policy of the rm remains largely an empirical one and its investigation is the

focus of the current study. We perform our analysis while taking into consideration rm size,

pro tability, and growth opportunities. The necessity to control for these variables arises for

at least two reasons. First, their use as determinants of dividend policy is consistent with the

role of dividends in controlling the agency costs of free cash ow (Easterbrook, 1984 ; Jensen,

1986 ) and with a pecking-order model where rms avoid issuing securities due to asymmetric

information costs (Myers and Majluf, 1984 ; Myers 1984 ) and other otation costs. The

empirical importance of these variables for the

rms decision to pay dividends is examinedin Fama and French ( 2001 ) and is further con rmed in our study. Second, the liquidity of the

rms common stock can also be related to the size, pro tability, and growth opportunities

of the rm. Therefore, it is important to examine the link between rm dividend policy

and liquidity after controlling for the possibility of such a relation. For the remainder of the

paper, we refer to these variables as rm characteristics and to their collective explanatory

power over the dividend policy of the rm as the rms ability to pay dividends.

The main results of the paper can be summarized as follows. First, we document that rms with less liquid markets (characterized by low trading activity, high proportion of zero

trading days, and high price impact of order- ow) are more likely to pay dividends. These

results persist after we control for the characteristics of the rm discussed above and provide

direct support for our hypothesis. Second, we present evidence that market liquidity and

rm likelihood to pay dividends are negatively related over time. The past four decades are

characterized by declining commission rates, declining bid-ask spreads, and a ten-fold increase

in market activity measures frequently used to quantify the liquidity of the stock market.

When we apply our 1963 -1977 estimates to predict the proportion of dividend payers in more

recent years, we nd that increased market liquidity explains most of the lower propensity of

rms to pay dividends documented by Fama and French ( 2001 ). Furthermore, the predictive

accuracy of a model that controls for stock market liquidity, versus a model that does not, is

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more pronounced for rms more likely to pay dividends based on their size, pro tability, and

growth opportunities (i.e., rms with higher ability to pay) and for rms with more liquid

stocks. 4

We further address the question of whether dividend policy determines stock market

liquidity and not vice versa. We now perform our analysis conditional on the past dividend

policy of rms while at the same time we use a historic measure of liquidity rather than a

contemporaneous one. We nd that past year market liquidity is an important determinant of

dividend initiations and of dividend omissions. Less (more) liquid rms that have never paid

dividends are more (less) likely to initiate dividend payments. Similarly, less (more) liquid rms that have paid dividends for the past ve years are more (less) likely to continue paying

dividends in the future. For dividend initiations, the predictive accuracy of a model that

controls for market liquidity, versus a model that does not, is higher and the improvement

is comparable to our results for all rms. For dividend omissions, stock market liquidity

has no economic power in explaining the dividend omission rates of rms. In fact, we do

not nd lower propensity to pay dividends for rms with long history of dividend payments.

Models based on rms ability to pay dividends and models based on ability and stock marketliquidity equally well explain more recent dividend omission rates of rms. In other words,

we do not observe lower propensity to pay (i.e., higher propensity to omit dividends) for

dividend paying rms.

Up to this point of our discussion we have focused on the relation between dividend

policy and liquidity at the rm level. Recent studies, however, present evidence of a common

liquidity factor across rms. Chordia, Roll, and Subrahmanyam ( 2000 ), for example, nd that

several measures of liquidity co-move with market- and industry-wide liquidity. Pstor and4 DeAngelo, DeAngelo, and Skinner ( 2004 ) nd that the reduction in payers documented by Fama and

French ( 2001 ) occurs almost entirely among rms that paid or would have paid very small dividends. Thisevidence is consistent with our hypothesis since in more liquid markets investors can hold portfolios with morestocks and replicate small dividend payouts by combining rms with high payouts and rms with no payoutsin their portfolios. This would e ff ecively reduce the demand for low dividend payout stocks.

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Stambaugh ( 2003 ) propose that assets with high positive sensitivity of returns to aggregate

liquidity result in disproportionate decrease of investor welfare when aggregate liquidity is

low. They nd signi cant evidence that investors price this liquidity risk so that stocks with

high sensitivities of returns to aggregate liquidity have higher expected returns than stocks

with low or negative sensitivities.

Extending our previous arguments, we now suggest that the demand of investors for

dividend paying stocks, and thus the value of such stocks relative to non-paying stocks, is

higher in states characterized by low aggregate liquidity. We therefore expect that dividend

initiating

rms will reduce their return sensitivity to innovations in aggregate liquidity. Webuild upon the work of Pstor and Stambaugh ( 2003 ) and indeed nd that, after rms

initiate dividend payments, their stock returns become less sensitive to aggregate liquidity.

This result further suggests that investors, when valuing rms, view cash dividends and stock

market liquidity as substitutes.

The rest of the paper is organized as follows. Section I describes the data and the variables

of this study. Section II provides our cross-sectional results. Section III outlines the changes

in the qualities of US security markets for the period of 1963 -2003 and the changes in rmdividend policy. Section IV investigates the e ff ectiveness of liquidity in explaining the changes

in rm dividend policy over time. Section V reports separate results for past payers and past

non-payers. Section VI describes our robustness tests. Section VII examines the changes in

systematic liquidity risk around dividend initiations, and Section VIII concludes.

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I. Sample and Variables

A. Sample

Our study covers NYSE and AMEX rms for the years from 1963 to 2003 .5 We gather data

from the COMPUSTAT annual les, and the Center for Research in Security Prices (CRSP)

monthly and daily les. We exclude rms with CRSP Standard Industrial Classi cation

(SIC) codes between 6000 -6999 ( nancials) and between 4900 -4949 (utilities) and restrict our

main sample to rms with publicly traded common stock with CRSP share codes of 10 or 11 .

Our main sample consists of all rms for which we can obtain the earnings-to-assets ratio,

the market capitalization, the market-to-book ratio, the growth in assets from the previous

year, and share turnover. Data requirements on additional variables used in some of the tests

dictate the actual sample sizes of these tests.

B. Variables

In this section we present and motivate the variables that we use in our empirical tests.

The precise computation of these variables is outlined in Table I.

A rm is de ned as a dividend payer in year t whenever COMPUSTAT reports positive

dividends per share for scal year t . Our results, however, do not change if we use CRSP

data to identify dividend-paying rms by comparing returns including distributions to returns

excluding distributions.

The rst set of variables that we use to explain the dividend decision of rms is based

on the size, pro tability, and growth opportunities of the rm. We construct these variables

as in Fama and French ( 2001 ). For a given year t and for every rm i the measure of rm

size is equal to the percentage of NYSE rms with market capitalization lower than the

market capitalization of rm i . The rms market capitalization for year t is equal to the5 Nasdaq trading volume is overstated relative to NYSE and AMEX trading volume and this does not allow

us to use all rms. However, we have performed our analysis also separately for Nasdaq stocks and obtainsimilar results, which are available on request.

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product of its share price and shares outstanding for June of year t as reported in the CRSP

monthly les. This measure of rm size is constructed under the assumption that the NYSE

market capitalization percentiles have constant implications for the dividend policy of the

rm throughout the examined period. The pro tability and growth opportunities proxies are

calculated using COMPUSTAT data for scal year t . Firm pro tability for year t we measure

as earnings divided by assets for that year (E t /A t ). To proxy for growth opportunities we

use the value-to-assets ratio of the rm for year t (V t /A t ) and the proportionate change in

assets for year t (dA t /A t ).

The second set of variables that we use to explain the dividend decision of

rms is aimed atcapturing the market liquidity of the rms common stock. It is unlikely that a single empirical

measure can capture all aspects of market liquidity. Therefore, in our cross-sectional analysis

we use several proxies for stock market liquidity. Three of the proxies are directly related

to the trading activity in a rms common stock, and one is related to the price impact of

trades.

The trading activity in the stock of the rm has both theoretical as well as empirical appeal

as a measure of liquidity. Constantinides ( 1986 ) shows that larger xed transaction costsbroaden the region of no transaction while Amihud and Mendelson ( 1986 ) develop a model

where assets with higher bid-ask spreads have longer holding periods, thus lower trading

activity. Atkins and Dyl ( 1997 ) provide empirical support for these models. Additionally,

the combined evidence of Stoll ( 1978 ) and Stoll ( 2000 ) suggests that a measure of trading

activity plays an important role in explaining the cross-sectional variation in bid-ask spreads

both in historic and current data. Trading activity also has implications for the execution

risk of an investor where rms with higher trading activity have lower execution risk, all else

equal. Finally, trading activity may also have a more direct impact on investor demand for

cash dividends. When there are economies of scale in trading, the marginal cost of creating

homemade dividends is lower when investor trading activity is higher. As a result, investor

demand for cash dividend paying stocks should decline when trading activity is high. Our rst

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measure of trading activity is the annual share turnover the ratio of shares traded to shares

outstanding for calendar year t from COMPUSTAT (TURN t ).6 Existing research has widely

used share turnover as a proxy for liquidity (see, for example, Datar, Naik, and Radcli ff e

(1998 ) and Chordia, Subrahmanyam, and Anshuman ( 2001 )). Because of its theoretical and

empirical appeal, we use share turnover to proxy for liquidity when we analyze the relation

between liquidity and dividend payers over time. In these tests we assume that share turnover

has relatively constant implications for the dividend policy of rms over time. We construct

two additional proxies for the trading activity in a stock using the annual traded dollar

volume in the stock (DVOL t ) (Brennan, Chordia, and Subrahmanyam (1998

) and Chordia,Subrahmanyam, and Anshuman ( 2001 )) and the proportion of days with zero traded volume

as an inverse measure of trading activity (NOTRD t ) (Glosten and Milgrom ( 1985 ), Kyle

(1985 ), Constantinides ( 1986 ), Dumas and Luciano ( 1991 )).

Our nal proxy for liquidity is the illiquidity ratio (ILLIQ t ). This measure, or its inverse

(the Amivest measure of liquidity), is used in existing research to proxy for the depth of

the market and the impact of order- ow on stock prices as analyzed by Kyle ( 1985 ).7 It is

calculated as the average ratio of absolute daily return to daily dollar volume using data fromthe CRSP daily les.

In order to ensure that outliers do not drive our results, we winsorize all variables based on

their annual 0 .5th and 99 .5th percentiles, excluding the proxy for size, which by construction

is bounded between 0 .00 and 1 .00 .

[Insert Table I about Here]

6 Using CRSP data gives similar results.7 See, for example, Amihud, Mendelson, and Lauterbach ( 1997 ), Amihud ( 2002 ), and the references therein.

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II. Empirical Evidence in the Cross-section

In this section we rst perform annual cross-sectional logistic regressions between 1963 and2003 to explain the dividend policy of the rm. We report the average coe ffi cient estimates

for several time periods to assess the importance of the variables and their robustness over

time.

In Table II we present the average coe ffi cient estimates for di ff erent speci cations for three

sub-periods ( 1963 -1977 , 1978 -1992 , and 1993 -2003 ).

Panel A of Table II uses only share turnover to predict the probability of dividends. The

results suggest that there is a signi cant negative relation between a rms stock market

liquidity and its likelihood to pay dividends. This relationship is signi cant at the 0 .01 level

for all examined sub-periods. Further investigation reveals that the impact of liquidity on

dividends is nontrivial. The likelihood of a dividend for the average rm for the 1963 -1977

period is 71 .50 percent. Our estimates suggest that one standard deviation increase (decrease)

in liquidity leads to a decrease (increase) in this probability to 59 .55 (81 .04 ) percent. The

additional analyses for 1978 -1992 and for 1993 -2003 also reveal signi cant sensitivities of

dividends to the liquidity of the rms stock. Using the estimates for 1993 -2003 we nd that

one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in the

average probability of 48 .12 to 41 .84 (54 .46 ) percent.

We now turn to multivariate tests where we also control for several rm characteristics

that existing research relates to rm dividend policy. As explanatory variables, we rst use

proxies for rm size, rm pro tability, and rm growth opportunities. Results are presented

in Panel B of Table II, columns ( 1), (4) and ( 7). The estimates are similar to the ones

reported by Fama and French ( 2001 ). Larger and more pro table rms are more likely to

pay dividends, while rms with higher growth opportunities are less likely to do so.

We also add several measures of liquidity to the set of explanatory variables. The results

with share turnover are presented in Panel B while the results with all other measures are

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presented in Panel C of Table II. Columns ( 2), (5), and ( 8) of Panel B, Table II show that

share turnover is again negatively and signi cantly (at the 0 .01 level) related to the likelihood

of dividends for the three examined sub-periods. The 1963 -1977 coeffi cient estimate suggests

that one standard deviation increase (decrease) in liquidity leads to a decrease (increase) in

rm probability to pay dividends from 71 .49 percent to 58 .60 (81 .64 ) percent. The results

for 1963 -1977 are very similar to the univariate results presented in Panel A. In later periods,

however, the impact of liquidity on the likelihood of dividends is more signi cant when we

control for the rm characteristics discussed above. For 1993 -2003 , for example, one standard

deviation increase (decrease) in liquidity leads to a decrease (increase) in the probability of dividends from 48 .12 percent to 30 .04 (66 .70 ) percent. The increased importance of liquidity,

after controlling for the growth opportunities of the rm, is not consistent with the idea that

the impact of liquidity on rm dividend policy is mainly driven by a possible positive link

between liquidity and growth opportunities in the cross-section.

The tests that we perform above assume that liquidity has the same impact on the divi-

dend decision of rms regardless of their characteristics. In general, this need not be the case.

In particular, liquidity should be more relevant for the dividend decision of rms with higherability to pay dividends (i.e., large, pro table rms and rms with low growth opportuni-

ties) since such rms have more exibility in their decision to pay or not to pay dividends.

Alternatively, if it is prohibitively costly for the rm to provide dividends (e.g., small rms

with no pro t and high growth opportunities), then stock market liquidity may have little

or no eff ect on the dividend policy of the rm. To analyze whether liquidity has di ff erential

impact on the dividend policy of rms depending on their rm characteristics, we allow for

diff erent coeffi cient estimates of share turnover for two portfolios of rms. The rst portfolio

consists of rms that are less likely to pay dividends (probability less than 70 percent) based

on rm characteristics while the second portfolio consists of rms that are more likely (prob-

ability more than 70 percent) to pay dividends based on rm characteristics. The estimates

are given in columns ( 3), (6), and ( 9). We nd that the probability of dividend payments

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is more sensitive to liquidity for the portfolio of rms that are more likely to pay based on

rm characteristics. For 1963 -1977 , one percentage point increase in share turnover results

in approximately 0 .33 percentage points decrease in the likelihood of dividend payments for

rms that are less likely to pay based on rm characteristics. In contrast, one percentage

point increase in share turnover for rms that are more likely to pay, based on their charac-

teristics, results in a decrease in the likelihood to pay dividends by 0 .41 percentage points.

This evidence is consistent with the notion that liquidity is more relevant for the dividend

policy of rms with lower costs of issuing dividends.

The rest of our liquidity measures are also related to the likelihood of dividends in linewith our hypothesis. Columns ( 1), (4), and ( 7) of Panel C, Table II show that rms with

higher illiquidity ratios are more likely to pay dividends. Similarly, rms with lower trading

volume and rms with higher proportion of days with no trading are also more likely to pay

dividends. All of the examined relations are signi cant at the 0 .01 level for all sub-periods

except the illiquidity ratio in the 1993 -2003 sub-period when it is signi cant at the 0 .05 level.

We also analyze the impact of one standard deviation change in the di ff erent liquidity

measures on the probability of dividends. In 1963 -1977 , for example, one standard deviationdecrease in the illiquidity ratio (i.e., increase in liquidity) results in a decline in the probability

of dividends from 71 .41 percent to 38 .02 percent. In the same period, one standard deviation

increase in dollar volume results in a decline in the probability of dividends from 71 .49 percent

to 59 .61 percent while one standard deviation decrease in the proportion of days with no

trading leads to a decline in the probability to pay from 71 .40 percent to 58 .44 percent.

While all liquidity variables have a nontrivial impact on the probability of dividends, the

illiquidity ratio (for the rst two periods) and share turnover (for the last period) have the

most notable impact on the estimated probability of dividends.

[Insert Table II about Here]

In additional tests we have investigated the possibility that measurement error in value-

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to-assets is driving our cross-sectional results (Erickson and Whited ( 2000 )). We have used

an instrumental variable approach where as instruments for the value-to-assets of the rm we

use research and development expense divided by assets and our results remain unchanged.

Further, we have examined whether share turnover is capturing rm growth rather than

liquidity. When we regress each year share turnover on value-to-assets, change in assets,

and research and development to assets, the R 2 of the regression is around 5% and rarely

above 10% . Further, we have also included additional proxies for growth to explain the rms

decision to pay dividends in the attempt to better control for growth. These proxies include

research and development-to-assets, change in assets in year t+1

, and change in assets in yeart+ 2. The qualitative as well as the quantitative results pertaining to liquidity are robust to

these tests and the magnitude of the coe ffi cients and the predictive ability are insensitive to

these inclusions. Thus, even though we cannot rule out the above-mentioned problems, we

do not nd any evidence that such problems are responsible for our ndings.

The evidence presented in this section provides signi cant direct support for our hypoth-

esis. After controlling for the impact of rm characteristics on rm dividend policy, we nd

that holders of common stock with less liquid market are also more likely to receive dividends.This link is robust across the 41 years of data we have gathered and across di ff erent measures

of market liquidity.

III. Stock Market Liquidity and Dividend Payers over Time

A. Changes in Market Liquidity from 1963 to 2003

In this section we brie y outline the signi cant changes in the features of US stock mar-

kets between 1963 and 2003 . Prior to 1975 the cartel on NYSE was characterized by xed

commission rates, limited entry, and rules that prohibited price-cutting and that limited bro-

kerage services per seat. Potential competition from other exchanges in the trading of NYSE

listed stocks was reduced through additional regulations.

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The Securities Acts Amendments of 1975 and Rule 19 b-3 became eff ective on May 1 ,

1975 . These amendments resulted in the abolition of xed commission rates and mandated

a national market system for securities in which competitive forces would play a much more

signi cant role. The deregulation of the industry was accompanied by the emergence and

expansion of discount brokers. In more recent years, the emergence of Internet brokers has

led to even higher competition in the industry.

By the rst quarter of 1976 , commissions of institutional rms have declined by 31 .6%

(see Stoll ( 1979 )). The decline in overall commission rates continued for the remainder of the

century. Evidence in Jones (2002

) shows a steady decline of average commission rates fromaround 0 .80% in the 1960 -1980 period to around 0 .10% in 2000 . Furthermore, Jones ( 2002 )

nds that the average proportionate quoted bid-ask spread for the 30 Dow Jones Industrial

Average (DJIA) stocks has declined from around 0 .60% in the 1960 -1980 period to around

0 .20% by the end of the 1990 s. Combining commissions and bid-ask spread costs, Jones

(2002 ) argues that total one-way costs have decreased from around 1 .30% in the 1960 -1980

period to around 0 .20% in 2000 . The above outlined changes in the competitive environment

of US security markets and the direct costs of trading were accompanied by a dramaticincrease in trading activity. Average (median) annual share turnover has increased from

approximately 25% (17% ) in 1963 to around 101% (82% ) in 2000 . The decline in trading

costs and the increase in trading activity suggest that the liquidity of the stock market has

improved signi cantly over time.

[Insert Figure I about Here]

B. Stock Market Liquidity and Dividend Payers a Graphic Interpretation

In this section we look at the time trends in stock market liquidity, measured by the

average share turnover, and the proportion of dividend paying rms. Figure II shows that

the steady increase in liquidity after 1978 is accompanied by a steady decline in the proportion

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of dividend payers. We further nd that improved liquidity in the late 1960 s is also followed

by a decline in the proportion of dividend payers.

[Insert Figure II about Here]

To further investigate this issue, we examine dividend decisions of rms based on their

past dividend policies. Figure III, Panel A examines rms that did not pay dividends in

year t -1 and reveals that dividend initiation (and resumption) rates are negatively related

to the liquidity of the stock market. We also observe that changes in stock market liquidity

and dividend initiation rates are closely aligned over time. When we analyze the dividend

decisions of rms that pay dividends in year t -1 (Panel B), we see that dividend omission

rates are higher after 1978 . However, this result does not seem to be as pronounced as the

decline in dividend initiation rates for the sample of non-payers and former payers.

[Insert Figure III about Here]

Baker and Wurgler ( 2004 a) document that rms cater to the preferences of investors so

that when dividend payers sell at a premium (discount) more

rms tend to pay (not pay)dividends. Baker and Wurgler ( 2004 b) further use the catering theory to explain the declining

propensity of rms to pay dividends. Our paper provides one possible explanation for the

variation in the dividend premium over time - namely changes in the liquidity of the stock

market. We use the dividend premium reported by Baker and Wurgler ( 2004 a) to compare

its variation to the variation in stock market liquidity over time. Figure IV suggests that

when liquidity levels are high dividend payers tend to sell at a discount while the opposite

is true for low levels of liquidity. Also, we nd that the standardized returns to dividendinitiation announcements (again obtained from Baker and Wurgler ( 2004 a)) are low when

stock market liquidity is high and vice versa. This evidence is consistent with our hypothesis

that rms cater (possibly through market valuation) to the liquidity preferences of investors.

[Insert Figure IV about Here]

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The initial results of this section are consistent with the notion that stock market liquidity

is related to the proportion of dividend payers over time and suggest that the declining

proportion of dividend payers is related to improved market liquidity. The link seems to be

more pronounced for rms that do not pay dividends in year t -1, i.e. those rms that are the

main source of the decline of dividend payers.

IV. Predicting Dividend Payers over Time

A. The Predictive Ability of Liquidity

In this section we further extend the tests of our hypothesis by analyzing the ability

of improved market liquidity to predict the proportion of dividend payers for the period of

1978 -2003 . In the base model we use the estimated coe ffi cients from column ( 1) of Table II,

Panel B to predict the proportion of dividend payers based on the ability of the rm to pay

dividends. In the second model we add share turnover as an explanatory variable so that we

use the estimated coe ffi cients from column ( 2) of Table II, Panel B to predict the proportion

of dividend payers. In the third model we use the coe ffi cient estimates from column ( 3) of Table II, Panel B where we allow for di ff erential impact of market liquidity on rms that are

less able and rms that are more able to pay based on their size, pro tability and growth

opportunities. The actual and the predicted proportions of dividend payers for the three

models are presented in Table III. 8

[Insert Table III about Here]

When we analyze the predictive ability of the three models we see that the model that

takes into account market liquidity signi cantly decreases the di ff erence between the predicted

payers estimated from the base model and the actual payers. In 1998 -2003 , for example, the8 We have also used variability in earnings as another predictor of the probability to pay dividends. While

the results in terms of prediction of payers over time improve, lower propensity of rms to pay is still evidentand liquidity still explains most of it.

15


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diff erence between predicted and actual payers is 22 .20 percentage points using the original

model based only on rm characteristics. This di ff erence declines to 6 .36 percentage points

when liquidity is taken into account. There is even further improvement in predictive ability

when we allow for diff erential impact of liquidity on the portfolios of rms with higher ability

to pay and for rms with lower ability to pay - the predictive error in 1998 -2003 is reduced

to 4 .69 percentage points.

The results in this section provide evidence over time consistent with our hypothesis that

the likelihood of dividend payments is negatively related to the liquidity of common stocks.

Improved liquidity is one of the reasons (though not the only one) for the decline in dividendpaying rms for the past quarter century. In more recent work, Julio and Ikenberry ( 2004 )

nd that during 2003 and 2004 the propensity of rms to pay dividends has increased. They

attribute this increase to the maturing of rms, the desire of rms to signal con dence in the

wake of corporate governance scandals, and the dividend tax cut of 2003 . It is important to

note that our hypothesis and the hypotheses advanced by Julio and Ikenberry ( 2004 ) are not

mutually exclusive. As a result, the evidence in Julio and Ikenberry ( 2004 ) is not inconsistent

with our hypothesis.

B. The Predictive Ability of Liquidity for Several Portfolios

In this section we rst analyze the predictive ability of the di ff erent models for two portfo-

lios based on the market liquidity of the rms common stock. We then analyze the predictive

ability of the di ff erent models for two portfolios based on the likelihood of dividend payments

as predicted only by rm characteristics. We expect that improved market liquidity should

explain the declining propensity of rms to pay dividends better for more liquid rms and

for rms with higher ability to pay dividends.

In Panel A of Table IV we create two portfolios based on the median share turnover

for the 1963 -2003 period. The sample size of rms with low share turnover decreases over

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time due to the increase in share turnover for the average rm. The model based only on

rm characteristics (model ( 1) of Table II, Panel B) results in higher prediction error for the

portfolio of high turnover stocks. For the six-year period of 1998 -2003 the average predictive

error for the low turnover stocks is 14 .53 percentage points while the average error for the high

turnover stocks is 25 .97 percentage points. When we add share turnover as an explanatory

variable (model ( 2) of Table II, Panel B) we see that the predictive ability improves mostly

for the portfolio of more liquid (high turnover) stocks. More important, there is a reversal in

the predictive error the predictive error now is lower for the portfolio of stocks with higher

share turnover (0

.98

percentage points) as opposed to the portfolio with low share turnover(16 .83 percentage points).

We now create two portfolios of rms based on the predicted probability of dividend

payment using only rm characteristics. Firms that are more likely to pay dividends (a

predicted probability above 70% ), based on rm characteristics and average estimates from

the 1963 -1977 period enter into the rst portfolio. The second portfolio consists of rms

that are less likely to pay dividends (a predicted probability below 70% ) based on rm

characteristics. In the tests to follow, we allow stock market liquidity to di ff erentially in uencethe dividend choice of rms in the two portfolios. The results are presented in Panel B of

Table IV.

Trying to predict dividend payers based only on rm characteristics (model ( 1) of Table

II, Panel B) results in higher predictive error for the portfolio of rms that are more likely to

pay - larger, more pro table rms, and rms with fewer growth opportunities. The predictive

error for such rms is 28 .76 percentage points as opposed to a predictive error of 13 .04 for

rms with the characteristics of non-payers. This result is to be expected in view of the

ndings of Fama and French ( 2001 ) that rms with the characteristics of payers are less

inclined to pay dividends in more recent years. Adding share turnover as an explanatory

variable (Model ( 3) of Table II, Panel B) produces a reversal in predictive ability so that now

the predictive error is lower for the portfolio of rms that are more likely to pay based on

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rm characteristics. The reduction in the predictive error for the portfolio of rms more able

to pay dividends based on their characteristics is noteworthy. In the 1998 -2003 period, for

example, the predictive error when we control for liquidity declines to 3 .27 percentage points.

For the portfolio of rms that are less able to pay dividends the predictive error declines to

6 .60 percentage points.

[Insert Table IV about Here]

We summarize the above discussion by concluding that a model that attempts to predict

dividend payers based on

rm characteristics fails to perfectly predict the proportion of dividend payers in more recent years. Further examination shows that such a model is

less accurate when applied to rms that have more liquid stock markets and rms with

higher ability to pay dividends. Controlling for stock market liquidity improves the overall

predictability of the model. The predictability improves more signi cantly for rms with more

liquid stock markets and rms that, for a given level of stock market liquidity, are more able

to pay dividends. These ndings further support our hypothesis that stock market liquidity

is relevant for rm dividend policy and that improved market liquidity has in uenced rms

with the characteristics of dividends payers to not pay dividends in more recent years. 9

V. Dividend Initiations and Omissions

Existing research has found that the dividend decisions of rms that do not pay dividends

are not the same as the dividend decisions of rms that already do. To address this issue we

perform our tests separately for past payers and past non-payers.Furthermore, di ff erences in the present and past dividend policy across rms may lead to

diff erential trading of investors in those rms. In other words, there is a possibility that our9 When we use the portfolio approach of Fama and French (2001) we obtain similar patterns in the overall

predictive ability of the two models under consideration. The overall di ff erence between predicted and actualpayers, however, is larger than in the logistic predictive model.

18


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22/47

characteristics makes an error of 4 .5 percentage points while including share turnover reduces

the error to 1 .75 percentage points.

[Insert Table VI about Here]

The evidence presented in this section is consistent with our hypothesis that stock market

liquidity is an important (although not the only) determinant of the rms decision to pay

or not pay dividends. The results further show that liquidity is an economically important

variable for dividend initiations but not for dividend omissions.

VI. Robustness Analyses 10

A. Share Repurchases

Since the mid- 1980 s the share repurchase activity of rms, especially open market share

repurchase activity, has increased signi cantly (see, for example, Jagannathan, Stephens,

and Weisbach ( 2000 ) and Grullon and Michaely ( 2002 )). Share repurchases constitute an

alternative means through which rms can distribute cash to shareholders and rms that

repurchase shares may have lower ability to also pay dividends. Furthermore, share turnover,as a measure of liquidity, can be a ff ected by open market share repurchases performed by the

rm. We address these issues in the current section.

Before we continue, it is important to note that dividends and share repurchases are not

necessarily perfect substitutes. On the one hand, dividends are usually taxed at higher rates

than capital gains and they are less exible as a payout policy (see Jagannathan, Stephens and

Weisbach ( 2000 )). On the other hand, repurchases can impose additional costs on investors

(see Barclay and Smith ( 1988 ), Brennan and Thakor ( 1990 ), and Chowdhry and Nanda

(1994 )) because they can lead to transfer of wealth among investors. Finally, open market

repurchases do not lead to investor avoidance of trading friction since investors still have to

trade in order to create homemade dividends.10 For the sake of brevity we do not tabulate the results of this section. All tables are available upon request.

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Fama and French ( 2001 ) show that share repurchases are largely performed by dividend

paying rms and that repurchases do not account for the declining propensity of rms to

pay dividends. In this section, we argue that our own results are not driven by the increased

share repurchase activity of rms.

First, we nd that stock market liquidity is negatively related to the dividend policy of the

rm in the cross-section for a portfolio of rms that do not repurchase shares. This relation

is signi cant at the 0 .01 level in all the sub-periods and is economically important. When we

predict the proportion of dividend payers for 1993 -2003 , a model based only on rm ability

to pay makes a predictive error of 23

.26

percentage points while a model including liquidityreduces the error to 11 .73 percentage points.

Second, to take into account the e ff ect of share repurchases on the ability of the rm to

pay dividends we subtract the repurchased amounts from the earnings available to common

shareholders and use this adjusted measure of pro tability to predict dividend payers. We

additionally adjust share turnover for the impact that open market share repurchases may

have on it from the traded shares in a given year we subtract the repurchase dollar amounts

divided by the share price of the rm. Since we use total repurchases and not only openmarket repurchases, this adjustment overestimates the total number of repurchased shares.

However, the error should be smaller in the 1970 s11 when rms rarely repurchased shares and

for the end of our sample when most of the share repurchases are open market repurchases

(Stephens and Weisbach ( 1998 ); Jagannathan, Stephens, and Weisbach ( 2000 )). As a result,

our predictions for later years based on 1963 -1978 estimates should be relatively una ff ected. 12

We nd that the coe ffi cients on the adjusted share turnover are very similar to the coe ffi cients

on the unadjusted share turnover presented in Table II, Panel B. We also nd that, based on

rm characteristics, there is a lower propensity of rms to pay dividends over time. Including11 COMPUSTAT has repurchase data from 1971, so we do not adjust values prior to that year. Using only

years for which we have share repurchase data (1971 to 1978) as the estimation period leads to similar results.12 We calculate share repurchase amounts as in Grullon and Michaely (2002). Their measure is similar to

the one used by Jagannathan, Stephens, and Weisbach (2000). Using change in treasury stock as in Fama andFrench (2001) gives similar results.

21


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adjusted share turnover as a predictor again decreases the predictive error signi cantly. In

the 1998 -2003 period, for example, the model based on rm characteristics has a predictive

error of 21 .91 percent on average. Including share turnover reduces that error to 5 .93 percent.

The overall results exhibit little di ff erences from our previous ndings.

B. Institutional Clienteles

It is possible that changes in institutional clienteles have resulted in changes in the div-

idend policies of rms. In this section we control for institutional ownership. We collect

institutional ownership data from SDC Thomson Financial and we create a variable that

is equal to the proportion of rm shares held by institutional investors. We then use this

variable as another predictor of rm dividend policy.

We nd that the estimated coe ffi cients for share turnover, after controlling for institutional

ownership, are still signi cantly negative (at the 0 .01 level) and even larger in magnitude.

For 1993 -2003 , for example, the coe ffi cient for share turnover is 1 .15 as opposed to 1 .00

when we do not control for institutional ownership. Therefore, even after we control for

institutional ownership, we still nd that stock market liquidity is negatively related to the

probability of dividend payments.

C. Stock Option Compensation

The past two decades have also witnessed a signi cant growth in stock option compensa-

tion to rm top management. Since managerial stock options are not protected for dividend

payments, they may provide incentives to managers to not pay cash dividends.

We collect data from COMPUSTAT on shares reserved for conversion for the exercise of

stock options (data item 215 ) and on total shares reserved for conversion (data item 40 ). We

express these variables as a proportion of total shares outstanding and use them as additional

control variables in our cross-sectional regressions.

Our ndings suggest that rms with more shares reserved for conversion (either for the

exercise of stock option of for other reasons) are less likely to pay dividends. We further nd

22


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that the coe ffi cient estimates of share turnover are mostly una ff ected by the inclusion of these

new control variables. For the 1963 -1977 period for example the coe fficient estimate of share

turnover is 1 .63 when we control for total shares reserved for conversion. This estimate is

very close to our previous estimate of 1 .74 when we do not control for shares reserved for

conversion.

From 1996 onward COMPUSTAT stopped reporting the number of shares reserved for

conversion. Therefore our last predicted proportion of dividend payers based on a model that

controls for shares reserved for conversion is for 1995 . The evidence suggests that, even after

we control for shares reserved fro conversion, there is a lower propensity to pay dividends inmore recent year. Furthermore, including share turnover again explains most of this lower

propensity to pay. 13

VII. Dividend Policy and Liquidity Risk

In this section we deviate from our previous framework. Until now we have focused our

analysis on the relation between dividend policy and liquidity at the rm level. At this

point we address the possibility of a link between dividend policy and aggregate liquidity.

Pstor and Stambaugh ( 2003 ) propose that assets with high positive sensitivity of returns

to aggregate liquidity result in disproportionate decline of investor welfare when aggregate

liquidity is low. This is because liquidation is costlier when liquidity is lower and because

investors have higher marginal utility of wealth when their wealth declines.

Extending our arguments presented in the previous sections of the paper, we argue that

investor demand for dividend paying stocks, and therefore the value of such stocks relative

to non-paying stocks, is higher in states characterized by low aggregate liquidity. One impli-cation of our argument is that dividend initiations will lead to a reduction in the sensitivity

of stock returns to aggregate liquidity.13 In unreported results we also control for the potential impact of dividend taxation relative to the taxation

of capital gains, the debt level of rms, and the Nixon era. The qualitative results of the paper pertaining toliquidity persist in all of our robustness tests. The results are available on request.

23


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In order to test the above implication, we identify a sample of rms that initiate divi-

dend payments and analyze the changes in sensitivity of their returns to aggregate liquidity.

Our methodology for estimating sensitivities to aggregate liquidity is based on Pstor and

Stambaugh ( 2003 ).

We collect a sample of rms that initiate dividends between 1966 and 1999 and use only

rms that do not pay dividends in years t -3 , t-2, and t -1 and pay dividends in years t+ 1, t+ 2 ,

and t+ 3. We then create two value-weighted portfolios. 14 The rst portfolio includes rms in

the three years prior to dividend initiation. The second portfolio consists of the same rms

but after dividend initiation. For example, the post-dividend portfolio in1985

consists of all rms that initiated dividend payments in 1982 , 1983 , or 1984 . The pre-dividend portfolio in

1985 consists of all rms that initiated dividends in 1986 , 1987 , or 1988 . As a result of our

sample selection methodology, the post-dividend portfolio in 1989 contains the same rms as

the pre-dividend portfolio in 1985 .

We then estimate the market model, the three-factor model of Fama and French ( 1993 ),

and the four-factor model (the three Fama-French factors plus a momentum factor) for each

portfolio while also including the market-wide liquidity factor of Pstor and Stambaugh(2003 ). The three-factor model includes the market factor, the size factor, and the book-

to-market factor. The market factor is the return of the value-weighted CRSP portfolio

minus the risk-free rate, the size factor is the di ff erence in returns between small and large

stocks, and the book-to-market factor is the di ff erence in returns between stocks with high

and low book-to-market ratios. We use the momentum factor to account for the evidence

presented by Jegadeesh and Titman ( 1993 ) that past performance is positively related to

future performance. 15 The liquidity factor of Pstor and Stambaugh ( 2003 ) is based on the

idea that order ow induces greater return reversals when liquidity is lower. The construction14 Pstor and Stambaugh (2003) show that estimates of the liquidity beta are highly imprecise for small

stocks and that the problem is mitigated in value-weighted portfolios.15 We obtain the monthly Fama-French factors and the momentum factor from the Web site of Kenneth

French (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/).

24


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of the liquidity factor is outlined in the Appendix of the paper.

The pre-dividend portfolio has 444 monthly returns and extends from 1963 to 1999 .

The post-dividend portfolio includes the same rms as the pre-dividend one but covers 444

monthly returns from 1967 to 2002 . Both portfolios have a minimum of 10 stocks and a

maximum of 88 stocks.

Panel A of Table VII reports the estimated pre-dividend and post-dividend liquidity betas

for each of the speci cations. We nd that the pre-dividend liquidity beta is equal to 3 .49 in

the four-factor model while the post-dividend liquidity beta for the same portfolio declines to

3.35

. These two estimates are statistically diff

erent (at the0

.10

level) under the assumptionof independence. Pstor and Stambaugh ( 2003 ) report that, for individual stocks, liquidity

betas are signi cantly and positively correlated over time. Positive serial correlation of the

liquidity beta of our portfolio will lead to higher than reported signi cance levels of the

estimated di ff erence. Using the distribution of liquidity betas for the ten portfolios reported

by Pstor and Stambaugh ( 2003 ), our results suggest that dividend-initiating rms move

from the highest liquidity beta portfolio (ten) to liquidity beta portfolio four (see their Table

3). This leads to a reduction in the expected rate of return of the rm of 3 .12 percentagepoints per annum (see their Table 4).

We further investigate the possibility that a similar trend is also observed for rms that

do not initiate dividends. If we indeed observe such a trend, this would suggest that our

results are not related to the dividend initiation decision of rms. Panel B replicates the

analysis for rms that do not pay dividends in any year between year minus three to year

plus three. The portfolios of non-initiating rms include signi cantly more stocks with a

minimum of 152 and a maximum of 2 , 157 stocks per month. We nd that both before and

after the measurement year this portfolio has negative liquidity betas that are relatively high

in magnitude. Prior to the selection year this portfolio of dividend non-payers has a liquidity

beta of 2 .64 while after the selection year the portfolios liquidity beta is 3 .13 and the two

betas are indistinguishable from each other. We conclude that the results reported in Panel

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A are speci c to dividend initiating rms.

[Insert Table VII about Here]

In summary, this section provides preliminary evidence that sensitivity of stock returns

to aggregate liquidity declines after dividend initiations. One possible interpretation of this

result is that, after dividend initiations, the value of the rm increases in states characterized

by low aggregate liquidity and high marginal utility of wealth. Combined with existing

evidence by Pstor and Stambaugh ( 2003 ), the results further suggest that reduced liquidity

risk lowers expected returns by economically signi

cant amounts. The overall results areconsistent with the idea that stock market liquidity and cash dividends act as substitutes

from the perspective of investors.

VIII. Conclusion

We hypothesize that, all else equal, the payout policy of the rm is related to the liquidity

of its common stock. In illiquid markets investors will have greater demand for cash dividends

from the stocks they hold. In highly liquid markets, however, investors can cheaply create

homemade dividends. As a result, rms with more (less) liquid stock markets will have lower

(higher) incentives to distribute cash dividends to their shareholders.

We nd a strong empirical relation between the dividend policy of the rm and the

liquidity of its common stock. These results are prevalent throughout the analyzed period and

remain after we control for the ability of rms to pay dividends. The documented declining

propensity of rms to pay dividends over time is signi cantly related to the signi cant changesin the liquidity of US security markets. A period of fewer dividend payers is characterized

by lower trading costs and increased market activity. We further present evidence that our

results are more relevant for more liquid rms and rms that have the ability to pay cash

dividends to their shareholders.

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In this paper we take the repurchase policy of the rm as given and we show that, while

share repurchases consume cash that can otherwise be distributed as dividends, our results

are not driven by the increased popularity of open market share repurchases. It is also

possible, however, that the proliferation of market share repurchase programs is, at least to

some extend, stimulated by the improved liquidity of the stock markets over time.

We additionally nd that liquidity is a signi cant determinant of dividend initiations and

dividend omissions. Our results suggest that rms with less (more) liquid stocks are more

(less) likely to initiate dividend payments. Similar to our overall results, improvements in

stock market liquidity over time account for most the declining propensity of

rms to initiatedividends as well.

Finally, we investigate one possible extension of our analysis. Our ndings suggest that

cash dividends and stock market liquidity act as substitutes from investors standpoint. Firms

that initiate dividend payments reduce the sensitivity of their returns to aggregate liquidity,

possibly because they lower investor exposure to systematic liquidity risk. This link is im-

portant since it further suggests that dividend policy can have an impact on rm value due

to market imperfections.

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Appendix

For each rm i , for a given month t we estimate the regression:

r ei,d +1 ,t = i,t + i,d,t + i,t sign r ei,d,t i,d,t + i,d +1 ,t , d = 1 ,...,D, (1)where r i,d,t is the return of stock i on day d in month t , r ei,d,t is r i,d,t minus the CRSP

value-weighted market return, and sign r ei,d,t i,d,t is the signed dollar volume for stocki on day d in month t in millions of dollars. We use only common shares with at least 15

daily returns ( D > 15 ), that are listed on NYSE or AMEX at the end of year t -1 , that arepriced between $5 and $1000 at the end of the previous month, and for which t is not the

rst or the last month of listing. Using the estimates of i,t for all rms in a given month

that satisfy these conditions, we compute their equally-weighted average as b t =1N

N

Pi =1 b i,t .We then de ne:4

b t = m tm 1 1N N

Pi =1

b i,t

b i,t 1

, (2)

where m t is the market value of all rms used in the estimation for month t and m t

corresponds to August of 1962 .

Finally, we estimate:

4 b t = a + b4 b t 1 + cm t 1m 1 b t 1 + u t , (3)

and set our measure of aggregate liquidity equal to

L t =1

100 bu t . (4)

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1.50%

1.00%

0.50%

0.00%

2.00%

2.50%

1963 1968 1973 1978 1983 1988 1993 1998 20030%

40%

80%

120%

160%

200%

Figure 1. NYSE Commission Rates and Stock Market Activity. Annual commission revenues of NYSEmembers and annual dollar volume on the exchange between 1966 and 2003 are obtained from theNYSE Fact Book. The annual NYSE commission rate (dashed line; left axis) is equal to total

commission revenues divided by total dollar volume on NYSE for a given year. The sample used tocalculate the average share turnover (solid line; right axis) consists of all firms with publicly tradedcommon stock on NYSE with available information in the CRSP monthly files and the COMPUSTATannual files. Share turnover is the ratio of shares traded to shares outstanding for calendar year t .

33


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0%

20%

40%

60%

80%

100%

1963 1968 1973 1978 1983 1988 1993 1998 20030%

40%

80%

120%

160%

200%

Figure 2. Dividend Payers and Stock Market Liquidity. The sample consists of all firms with publiclytraded common stock on NYSE or AMEX with available information in the CRSP monthly files andthe COMPUSTAT annual files. Dividend payers (%) is the proportion of firms that paid dividends infiscal year t (bars; left axis). Average share turnover (%) is the average percentage ratio of shares

traded to shares outstanding for calendar year t (line; right axis).

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Panel A. Dividend initiations (bars) and share turnover (solid line)

0%

4%

8%

12%

16%

20%

1963 1968 1973 1978 1983 1988 1993 1998 20030%

40%

80%

120%

160%

200%

Panel B. Dividend omissions (bars) and share turnover (solid line)

0%

2%

4%

6%

8%

10%

1963 1968 1973 1978 1983 1988 1993 1998 20030%

20%

40%

60%

80%

100%

Figure 3. Dividend Payers and Stock Market Liquidity Conditional on Dividend Policy in Year t -1. The sample consists of all firms with publicly traded common stock on NYSE or AMEX with availableinformation in the CRSP monthly files and the COMPUSTAT annual files. Panel A uses firms thatdid not pay dividends in fiscal year t -1. The figure plots the proportion of firms that pay dividends inyear t (bars; left axis) and the average percentage ratio of shares traded to shares outstanding for thesample for calendar year t (solid; right axis). Panel B uses firms that paid dividends in fiscal year t -1.The figure plots the proportion of firms that do not pay dividends in year t (bars; left axis) and theaverage percentage ratio of shares traded to shares outstanding for the sample for calendar year t (line; right axis).

information in the CRSP monthly files and the COMPUSTAT annual files. Panel A uses firms thatdid not pay dividends in fiscal year t -1. The figure plots the proportion of firms that pay dividends inyear t (bars; left axis) and the average percentage ratio of shares traded to shares outstanding for thesample for calendar year t (solid; right axis). Panel B uses firms that paid dividends in fiscal year t -1.The figure plots the proportion of firms that do not pay dividends in year t (bars; left axis) and theaverage percentage ratio of shares traded to shares outstanding for the sample for calendar year t (line; right axis).

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0%

50%

36

Figure 4. Stock Market Liquidity and the Relative Valuation of Non-Payers. The sample consists of allfirms with publicly traded common stock on NYSE, AMEX, or Nasdaq with available information inthe CRSP monthly files and the COMPUSTAT annual files. The figure plots the average percentageratio of shares traded to shares outstanding for calendar year t (bold solid; left axis), the valuation of non-payers relative to dividend payers (solid; left axis), and the average price reaction to dividendinitiations (dash; right axis). Share turnover for Nasdaq firms is scaled by 50%. The valuation of non-

payers relative to payers for year t is equal to the exponent of the negative value-weighted dividendpremium for year t reported by Baker and Wurgler (2004). The average price reaction to dividendinitiations for year t is equal to the standardized announcement returns reported by Baker andWurgler (2004) and averaged over years t -1, t , and t +1.

100%

%

%

1963 1968 1973 1978 1983 1988 1993 1998-0.50%

0.00%

0.50%

1.00%

1.50%200

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Table IVariable Definitions

We gather all data from the COMPUSTAT annual files except where indicated. COMPUSTAT itemnumbers are presented in parenthesis. For COMPUSTAT variables, t refers to fiscal year t of the firm.

Variable Definition

Dividend

Payer

A firm is defined as a dividend payer in year t whenever COMPUSTAT reportspositive Dividends per Share (26) for fiscal year t . Otherwise a firm is defined as anon-payer.

NYP tThe proportion (in %) of NYSE firms with lower market capitalization of commonstock in June of year t . Share price and number of shares outstanding for June of year t are obtained from the CRSP monthly files.

E t/A t[Earnings before Extraordinary Items (18) + Interest Expense (15) + IncomeStatement Deferred Taxes (50) if available] divided by Assets (6).

PreferredStock

Preferred Stock Liquidating Value (10) [or Preferred Stock Redemption Value (56), orPreferred Stock Par Value (130)].

BookEquity

Stockholder s Equity (216) [or Common Equity (60) + Preferred Stock Par Value(130), or Assets (6) Liabilities (181)] Preferred Stock + Balance Sheet DeferredTaxes and Investment Tax Credit (35) if available Post Retirement Assets (330) if available.

Vt/A t[Assets (6) - Book Equity + Stock Price (199) times Common Shares Outstanding(25)] divided by Assets (6).

dA t/A t [Assets t (6) Assets t-1 (6)] divided by Assets t (6).

TURNt

Common Shares Traded (28) divided by Common Shares Outstanding (25).

DVOL tNatural logarithm of [1.00 + Share Price (24) times Common Shares Traded (28)divided by the 1996 Consumer Price Index].

ILLIQ t

We use the CRSP daily files. For every trading day in year t , we divide the absolutereturn by the dollar volume. Dollar volume is expressed in 1996 US dollars using theConsumer Price Index. We then create the illiquidity variable by averaging the dailyestimates over all trading days of year t and then taking natural logarithm. If thereare less than 30 daily observations for a given year this variable is missing.

NOTRD tThis variable is equal to the proportion of days with no trading volume on the CRSPdaily files for year t . The variable is missing if there are fewer than 30 dailyobservations.


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Table IIEstimates from Logistic Regressions to Explain Dividend Payers

For each year t between 1963 and 2003 we estimate logistic regressions to explain whether a firm paysdividends in year t . The sample contains all NYSE/AMEX firms with available information. Panel Auses only share turnover (TURN t) as an explanatory variable. As explanatory variables for the rest of the models we use the proportion of NYSE firms with lower market capitalization (NYP t), theearnings-to-assets ratio (E t/A t), the market-to-book ratio (V t/A t), and the growth rate of assets(dA t/A t). We refer to these four variables as firm characteristics. We then add several variables thatproxy for the market liquidity of the firm s stock. In Panel B we add share turnover (TURN t). Wealso allow for different coefficients of share turnover for firms that are less likely (TURN _Lt) and forfirms that are more likely (TURN _Mt) to pay dividends based on firm characteristics. Firms that havean estimated probability below 70% (the average proportion of payers for 1963-1977) to pay, based ontheir firm characteristics and the average coefficient estimates from the 1963-1977 period, are classifiedas less likely to pay. Firms for which this probability is above 70%, are classified as more likely to pay.In Panel C we further use the illiquidity ratio (ILLIQ t), the traded dollar volume (DVOL t), and theproportion of non-trading days (NOTRD t) as explanatory variables. When we use the illiquidity ratiowe also include the natural log of the monthly average of the share price for year t as a control formicrostructure effects resulting from minimum tick size rules. The table reports the average estimatedcoefficient for a given period and the t -statistic of whether the average estimate is significantlydifferent from zero. Firms is the average number of firms used in the regressions. Payers is the averagepercent of payers for a given period. Payers (+) is the estimated percent of payers if the examinedliquidity measure improves by one standard deviation while Payers ( ) is the estimated percent of payers if the examined liquidity measure deteriorates by one standard deviation. The effects of

liquidity changes on the percent of payers are examined at the presented average percent of payers.a, b,

c indicate significance respectively at the 1%, 5%, and 10% levels from a two-tailed t -test.

Panel A. Dependent variable is whether a firm pays dividends in year t 1963-1977 1978-1992 1993-2003

(1) (2) (3)

Intercept 1.60 a 1.00a 0.18b

(10.28) (6.23) (2.40)

TURN t 1.62a 0.50a 0.33a

( 5.93) ( 3.66) ( 5.53)

Firms 1,374 1,389 1,432Payers 71.50 67.06 48.12Payers (+) 59.55 62.29 41.84Payers ( ) 81.04 71.51 54.46


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Panel B. Dependent variable is whether a firm pays dividends in year t

1963-1977 1978-1992 1993-2003(1) (2) (3) (4) (5) (6) (7) (8) (9)

Intercept 0.22 0.33c 0.28 0.18 0.29 0.24 1.03a 0.58a 0.62a

( 1.62) (1.99) (1.70) ( 0.91) ( 1.47) (1.24) ( 15.33) ( 7.91) ( 8.70) NYP t 4.17a 4.13a 4.40a 4.28a 5.08a 5.26a 3.19a 4.17a 4.30a

(32.11) (18.71) (22.16) (73.06) (42.67) (48.79) (25.68) (34.36) (32.20) Vt/A t 0.84a 0.74a 0.79a 0.73a 0.66a 0.70a 0.34a 0.35a 0.37a

( 9.44) ( 8.90) ( 10.02) ( 6.35) ( 7.29) ( 7.21) ( 10.54) ( 12.28) ( 13.08) dA t/A t 0.54 0.05 0.09 0.66a 0.34b 0.39b 1.32a 1.05a 1.07a

( 1.25) ( 0.13) ( 0.22) ( 4.21) ( 2.24) ( 2.62) ( 7.31) ( 5.08) ( 5.18)

E t/A t 16.57a 15.87a 16.56a 8.18a 7.97a 8.58a 5.11a 4.72a 5.16a(13.10) (14.62) (14.40) (11.61) (10.77) (10.36) (27.73) (23.85) (24.05)

TURN t 1.74a 1.45a 1.00a

( 14.91) ( 23.42) ( 12.21)

TURN _Lt 1.59a 1.26a 0.87a

( 9.50) ( 24.09) ( 10.96) TURN _Mt 1.99a 1.56a 1.05a

( 15.22) ( 20.27) ( 11.94)

Firms 1,374 1,389 1,433Payers 71.49 67.06 48.12Payers (+) 58.60 52.61 30.04Payers ( ) 81.64 78.88 66.70


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Table IIIActual and Predicted Percent of Dividend Payers Using Average Logistic Regression Estimates from

1963-1977For each year between 1963 and 1977 we estimate logistic regressions to explain whether a firm paysdividends in year t . As explanatory variables in model (1) we use the proportion of NYSE firms withlower market capitalization (NYP t), the earnings-to-assets ratio (E t/A t), the market-to-book ratio(V t/A t), and the growth rate of assets (dA t/A t). We refer to these four variables as firmcharacteristics. In Model (2) we add share turnover (TURN t) as an explanatory variable. In Model

(3) we estimate different slope coefficients for share turnover for firms that are less likely (TURN_

Lt)and for firms that are more likely (TURN _Mt) to pay dividends based on firm characteristics. Firmsthat have an estimated probability below 70% (the average proportion of payers for 1963-1977) to pay,based on their firm characteristics and the average coefficient estimates from the 1963-1977 period, areclassified as less likely to pay. Firms for which this probability is above 70%, are classified as morelikely to pay. Firms is the number of firms for a given year. Actual Percent is the average actualpercent of payers in a given period. For each model, we estimate the individual firm s probability topay dividends using the average coefficients from 1963-1977 and the values of the explanatoryvariables for year t in the logistic regression. We then average these probabilities across firms toestimate the Predicted Percent of payers in a given year t . Finally, we average our annual predictionsfor a given period.

(1) (2) (3)

Actual Predicted Predicted Predicted Predicted Predicted PredictedFirms Percent Percent Actual Percent Actual Percent Actual

1978-1982 1,545 77.24 76.27 0.97 73.76 3.48 73.31 3.92

1983-1987 1,338 65.97 69.69 3.72 64.42 1.55 63.82 2.14

1988-1992 1,283 57.98 68.58 10.60 64.26 6.28 63.62 5.65

1993-1997 1,485 51.16 67.36 16.20 59.50 8.34 58.63 7.47

1998-2003 1,390 45.58 67.78 22.20 51.95 6.36 50.27 4.69


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Table IVActual and Predicted Percent of Dividend Payers for Different Portfolios Using Average Logistic

Regression Estimates from 1963-1977For each year between 1963 and 1977 we estimate a logistic regression to explain whether a firm paysdividends in year t . We present the actual proportion of payers and the difference between thepredicted and the actual proportion of payers for several periods. As explanatory variables in Models(1) and (3) we use the proportion of NYSE firms with lower market capitalization (NYP t), theearnings-to-assets ratio (E t/A t), the market-to-book ratio (V t/A t), and the growth rate of assets(dA t/A t). We refer to these four variables as firm characteristics. In Models (2) and (4) we also addshare turnover for year t (TURN t) as an explanatory variable. In Panel A we create two portfoliosbased on share turnover (TURN t) using the average of its 50 th percentile for the 1978-2003 period. InPanel B we create two portfolios based on the predicted probability of dividend payment. Firms withan estimated probability below 70% (the average proportion of payers for 1963-1977) to pay, based ontheir firm characteristics and the average coefficient estimates from the 1963-1977 period (Table I,Panel B, model 1), are classified as less able to pay while firms, for which this probability is above70%, are classified as more able to pay dividends. In models (2) and (4) of Panel B, we estimatedifferent slope coefficients for share turnover for firms that are less likely (TURN Lt) and for firms thatare more likely (TURN Mt) to pay dividends based on the above classification (Table II, Panel B,model 3). Firms is the average number of firms in a portfolio for a given period. Actual Percent is theaverage percent of payers in a given portfolio for a given period. We estimate the individual firm sprobability to pay dividends using the average coefficients from 1963-1977 and the values of theexplanatory variables for year t in the logistic model. We then average these probabilities across thefirms in a given portfolio for a given year t to estimate the Predicted Percent of payers for thatportfolio in that year and then obtain the value of Predicted minus Actual payers. For each period,the table presents the averages of the annual values.

Actual Predicted Predicted Actual Predicted PredictedFirms Percent Actual Actual Firms Percent Actual Actual

(1) (2) (3) (4)

Panel A

Less liquid (low share turnover) More liquid (high share turnover)

1978-198

liquidity and dividends

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