HIAS-E-20

Does Better Corporate Governance Encourage
Higher Payout?
Risk, Agency Cost, and Dividend Policy
Debarati Bhattacharya
Paulumbo Dohahue School of Business, Duquesne University, USA

Wei-Hsien Li
Department of Finance, National Central University, Taiwan

S. Ghon Rhee
Shidler College of Business, University of Hawaii at Manoa, USA
Hitotsubashi Institute for Advanced Study, Hitotsubashi University, Japan

March 16, 2016

Hitotsubashi Institute for Advanced Study, Hitotsubashi University
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Does Better Corporate Governance Encourage Higher Payout?
Risk, Agency Cost, and Dividend Policy
Debarati Bhattacharya
Palumbo Donahue School of Business, Duquesne University, USA
Wei-Hsien Li
Department of Finance, National Central University, Taiwan
S. Ghon Rhee
Shidler College of Business, University of Hawaii at Manoa, USA
Hitotsubashi Institute for Advanced Study, Hitotsubashi University, Japan

We investigate whether corporate governance complements or substitutes for payout
policy as an effective method of reducing agency cost through its interplay with theidiosyncratic risk of the firm. Corporate governance acts as a substitute for [complement to]
the firm’s dividend policy when its idiosyncratic risk is high [low]. Our empiricalinvestigation reveals that moving from the weakest to the strongest quintile of corporate
governance increases the predicted probability of dividend payout by 28% when the firm’s
idiosyncratic risk is at its lowest quintile. On the other hand, when the idiosyncratic risk is at
its highest quintile, moving from the weakest to the strongest quintiles of corporate
governance decreases the predicted probability of dividend payout by 32%. We also observethat the interplay of governance and idiosyncratic risk considerations shapes up managerial
decisions for share repurchase, total payout, and dividend initiation.

JEL Classification: G10, G30
Keywords: Dividend policy; Idiosyncratic risk; Corporate governance; Stock repurchase;
Dividend initiation; Agency costs

11. Introduction
The current literature offers two competing views on the relation between corporate
governance and dividend payout: (i) one view suggests that they are complements; and (ii)the other view suggests that they are substitutes. We reconcile the two competing views by
capturing the impact of idiosyncratic risk.
Strong governance may enforce a payout policy that reduces free cash flow which would
have been at the disposal of managers, making corporate governance and dividend policy
complement each other. On the contrary, other governance mechanisms may be employed toeffectively control the behavior of managers, in which case corporate governance cansubstitute for the dividend policy. La Porta et al. (2000), Michaely and Roberts (2012), andGrullon and Michaely (2014) find evidence in support of corporate governance acting as acomplement to dividend policy, while Hu and Kumar (2004), Officer (2011), and John,
Knyazeva and Knyazeva (2015) report just the opposite. In a recent review, Farre-Mensa,
Michaely, and Schmalz (2014) observe that “…There are still significant disagreements inthe literature regarding how corporate governance affects payout policy.”
In this paper, we highlight this debate by studying how corporate governance influences
the payout policy under different levels of idiosyncratic risk, a key variable highlighted by
Hoberg and Prabhala (2009) in dividend payout decision. Jensen (1986) suggests free cash
flow leads to an overinvestment problem. To mitigate such an agency cost, good corporate
governance should encourage dividend payout. However, when the idiosyncratic riskincreases, underinvestment becomes a concern. DeMarzo, Fishman, He, and Wang (2012)
and Panousi and Papanikolaou (2012) both develop theoretical models that predict
decreasing investment with rising idiosyncratic risk under the assumption of managerial risk

2

aversion. Panousi and Papanikolaou (2012) further establish that the above mentioned effectis mitigated if managers are compensated with options or are under strict monitoring ofinstitutional investors. Building on these arguments, we hypothesize that when the cost ofoverinvestment is high (proxied by lower idiosyncratic risk), good governance would
encourage payout to reduce cash in the hands of the managers who might engage in valuedestroying investments. On the other hand as the cost of underinvestment rises withincreasing idiosyncratic risk, good governance would discourage payout to preserve cash for
future value-increasing investments. The main prediction of our paper is: corporate
governance will either complement or substitute dividend policy depending on the level ofidiosyncratic risk of the firm. 1
We investigate the relation between governance and dividend policy at varying levels of
idiosyncratic risk. Due to the unavailability of consistent corporate governance rankings from
Risk Metrics/Institutional Investors Services (ISS), a large number of cross-sectional
observations for a total of 4,028 firms is utilized to compensate the seven-year time-series
data. 2 In the robustness tests, however, we extend study periods depending on alternative
proxy measures of corporate governance introduced: (i) board independence (1996-2010);(ii) pay-performance sensitivity (1992-2010); (iii) big4 auditor (1999-2010); and (iv)blockholders (1986-2010).
We begin by investigating whether corporate governance matters in the dividend payout
decision. In a simple univariate set up, we find that the dividend payers’ median governancemeasure is 18% higher than that of the non-payers, suggesting that better governed firms are
1
Systematic risk is much less of a concern for two reasons: (i) managers can hedge away exposure to systematic risk
(Knopf, Nam, and Thornton, 2002); and (ii) the impact of systematic risk on investment is economically muchsmaller than that of idiosyncratic risk (Panousi and Papanikolauou, 2012).
2
Subsequent to 2009, Risk Metrics/ISS has implemented major restructuring in the way the governance variables
are constructed.

3

motivated to return money to investors. However, the idiosyncratic risks of the payers are
significantly lower than the non-payers. Next, we examine our main premise of anasymmetric effect of corporate governance on dividend payout decisions hinged on the levelof idiosyncratic risk faced by the firm. Consistent with this idea, we report that the interplayof governance and idiosyncratic risk is indeed a significant determinant of propensity to pay
dividends. We find that moving from the weakest to the strongest quintile of corporate
governance increases the predicted propensity of dividend payout by 28% when the firm’s
idiosyncratic risk is at its lowest quintile. On the other hand, when the idiosyncratic risk is at
its highest quintile, moving from the weakest to the strongest quintiles of corporate
governance decreases the predicted propensity of dividend payout by 32%. Our results
remain robust to alternative measures of idiosyncratic risk and corporate governance and anumber of variations of the baseline model.
Further, we test the joint effect of governance and idiosyncratic risk on the propensity of
dividend payout in an enhanced model that controls explicitly for free cash flow and financial
constraint. The empirical evidence supporting the asymmetric effect of corporate governanceon dividend payout decisions is strengthened for firms susceptible to higher free cash flow
problems and facing greater financial constraints.
We then extend our investigation to other related aspects of payout policy decisions:repurchase; total payout; and dividend initiation. We find that good governance discourages(encourages) share repurchase and total payout for firms with higher (lower) idiosyncraticrisk similar to the dividend payout results. These results suggest that share repurchase may
substitute for dividends as a disciplining mechanism. The intensity of this effect, however, islower compared to dividend payout which is supported by the empirical evidence from the4

payout literature that dividends are much stickier than repurchase and therefore a morecredible monitoring mechanism. Also, we find that firms with stronger corporate governanceare less inclined to initiate dividends when their idiosyncratic volatility is high compared tofirms with weaker governance. 3 In addition, we find that dividend initiation events are more
often attributed to firms with stronger governance and lower idiosyncratic risk. These firms
are also less likely to cut or omit dividends in the next five years compared to theircounterparts with weaker governance and higher idiosyncratic risk. These results support theidea that firms with better governance exhibit greater prudence in shaping their dividend
policy. They are less likely to initiate when the idiosyncratic risk is high, and if they do
initiate, they are more likely to keep the promise. In sum, all of the above findings also
support the earlier prediction of the asymmetric role of corporate governance in payout
decisions under different level of idiosyncratic risk which is instrumental in reconciling thecomplement and substitute debate.
Our study makes several contributions. First, our findings add a new dimension of thejoint effect of governance and idiosyncratic risk on payout propensity to the extensive
literature on payout policy which helps in reconciling the complement and substitute debate.
The most recent studies have focused primarily on disappearing dividends and offer several
explanations of the phenomenon, such as substitution of dividends by share repurchase,changes in dividend tax, catering theory, failure of younger firms to initiate dividends, andfinally risk (Grullon and Michaely, 2002; Chetty and Shaez, 2005; Baker and Wurgler, 2004;
Denis and Osobov, 2008; Chay and Suh, 2009; Hoberg and Prabhala, 2009). There also
exists an extensive literature studying the relation between governance quality and dividend

3

We employ a propensity score-based weighting approach in our model of propensity to initiate dividends to ensurethat our dividend initiation evidence is not driven by omitted variables.

5policy through the ambit of agency conflicts. As discussed earlier, the evidence is fairly
mixed. Our results reveal that idiosyncratic risk not only continues to be an importantconsideration in regard to making payout decisions but when interacted with corporate
governance it sheds a new light on the complement and substitution effect. Second, we add tothe dividend literature by extending our study to include share repurchase, a payout methodthat has grown in popularity since 1983. We find that despite the joint effect of governanceand idiosyncratic risk remaining negative and significant it is smaller in magnitude than its
effect on dividend payout propensity. This is consistent with the notion that repurchase is not
as effective a disciplining tool as dividends. We also include dividend initiation in our study,a major corporate event with important consequences in the short and long terms. We
conclude that the interplay of governance and idiosyncratic risk shapes the decision to initiate
dividends as well. Firms with better governance are more conservative in making dividend
initiation decisions when idiosyncratic risk is high, and when they do, they are also lesslikely to omit or cut dividends in the years following initiation.
The rest of the paper is organized as follows. Section 2 reviews related literature anddevelops our hypotheses. Section 3 describes the data and provides summary statistics.
Section 4 examines the joint effect of governance and idiosyncratic risk on the propensity to
pay dividends and provides robustness analyses of our main results. Section 5 examines thejoint effect of governance and idiosyncratic risk on the propensity to repurchase shares, total
payout, and initiate dividends. It also documents whether or not governance and idiosyncraticrisk jointly affect the likelihood of firms keeping up with a steady dividend payment in theyears following initiation. Section 6 presents the conclusions.
2. Literature review and hypothesis development
6

There is an extensive literature studying the relation between governance quality anddividend policy through the ambit of agency conflicts. A firm ideally retains its free cash forprecautionary needs or pay out to shareholders in the absence of profitable real investment
opportunities in the near future. The empirical evidence suggests a positive relation between
governance, cash reserves, and its utilization. Harford, Mansi, Maxwell (2008) find that firms
with weaker corporate governance structures have smaller cash reserves. Dittmar and MahrtSmith (2007) also document that poorly governed firms have a lower value of cash holding.
Both studies find that poorly governed firms tend to spend cash quickly, rather than hoard it.
Firms could also invest their cash into risky financial assets. Duchin, Gilbert, Harford, andHrdlicka (2015) document that U.S. industrial firms invest heavily in non-cash, risky
financial assets, and those investments are undertaken by poorly-governed firms. Thus,
despite the firm’s need to save cash for precautionary motive, poorly governed firms would
suffer from lower value of cash-holding and they tend to have lower returns in their financial
investments. However, whether weakly governed firms are more inclined to pay dividends inorder to reduce the sub-optimality of their cash-holding and financial investments is muchdebated. La Porta et al. (2000) arguably open the complement versus substitute debate
between corporate governance mechanisms and dividend policy in disciplining managers.
They propose and test the “outcome model” and “substitute model” of dividends. In theiroutcome model, minority shareholder rights are associated with higher dividend payout,which implies corporate governance complements dividend policy. Dividend payout can be
the result of effective governance where strong governance forces management to payout tomitigate free cash flow problems, making corporate governance and dividend payout
complement each other. On the contrary, other governance mechanisms may be employed to7effectively control the behavior of managers, in which case, corporate governance cansubstitute for dividend payout. The substitute argument predicts that dividend payout isnegatively related to the quality of corporate governance, while the complement argument
predicts a positive relation. Evidence on the relation between dividend payout andgovernance mechanisms is mixed. A well-known result in corporate finance literature is thatof free cash flow leading to an overinvestment problem documented by Jensen (1986). To
mitigate such an agency cost, ceteris paribus, good corporate governance encourages
dividend payout. La Porta et al. (2000), Michaely and Roberts (2012), and Grullon andMichaely (2014) find that firms with stronger governance indeed make larger dividend
payments in order to reduce agency conflicts, supporting the view that corporate governanceis a complement to dividend policy. In contrast, Hu and Kumar (2004), Officer (2011), John,
Knyazeva, and Knyazeva (2015) report the opposite, supporting the view that corporate
governance is a substitute to dividend policy.
In this paper, we reconcile these competing views by highlighting the impact ofidiosyncratic risk on the relation between corporate governance and dividend policy. The
importance of idiosyncratic risk on payout policy is well-known. Hoberg and Prabhala (2009)
report that idiosyncratic risk alone explains 40% of the disappearing dividends phenomenon
in the United States. Chay and Suh (2009) document that cash flow uncertainty proxied bystock return volatility is negatively related to the decision of paying dividends using
international data. DeMarzo, Fishman, He, and Wang (2012) and Panousi and Papanikolaou(2012) both develop theoretical models that assume managerial risk aversion and predict
decreasing investment with rising idiosyncratic risk. Moreover, the tradeoff between
investment and dividend is a fairly well-established view in both the capital structure and8dividend payout literature. Fama and French (2002) document that firms with larger
investments relative to earnings have lower long term dividend payments because there isless need to discipline mangers under these circumstances. Grullon et al. (2002), DeAngelo
and DeAngelo (2006), and DeAngelo et al. (2006) advance the life-cycle theory by observing
a negative association between dividend payouts and investment opportunities. As a result,when the cost of underinvestment rises with increasing idiosyncratic risk, good governanceshould discourage payout to preserve funding for future value-enhancing investment. On theother hand, when the cost of overinvestment rises with decreasing idiosyncratic risk, good
governance should encourage payout to reduce free cash flow problems. Therefore, we
believe that the effect of governance on the dividend policy hinges upon the idiosyncraticrisk of the firm. To be specific, we argue that the relation between corporate governance anddividend payout propensity is positive when the idiosyncratic risk is low but becomes lesspositive or even negative as the idiosyncratic risk increases.
The main prediction of our paper is that quality of corporate governance will bothcomplement and substitute for dividend policy depending on the level of the idiosyncraticrisk of the firm. Empirically, we predict that the relation between governance and dividend
payout propensity is positive when the idiosyncratic risk is low and becomes negative as theidiosyncratic risk increases. Hence, our main testable hypothesis is as follows:
The firm with better governance is more likely to pay dividends when the idiosyncraticrisk is low and less likely to pay dividends when the idiosyncratic risk is high.
The key role played by corporate governance in dividend policy, as reflected in theempirical results is fairly intuitive. After all, corporate governance is not only about “howinvestors get the managers to give them back their money” (Shleifer & Vishny, 1997) but

9also about accountability to providers of capital, which would imply that an important
corporate policy decision such as dividend payout will be closely monitored within a stronger
corporate governance environment.
We relate payout policy to the firm’s effort in balancing the overinvestment andunderinvestment problem based on its quality of corporate governance. Further, we expectthat the negative effect of the interaction term between governance and idiosyncratic risk on
dividend payout policy would be magnified in the presence of excess free cash flow. In
addition, prior studies document the importance of costly external finance on the cash policy.
For example, Almeida, Campello, and Weisbach (2004) find that firms exhibit a greater
propensity to save cash from their cash flow when they face higher costs of external finance.
Faulkender and Wang (2006) report that the marginal value of cash is greater in firms withlimited access to external capital markets than in firms that are less financially constrained.
As Denis and Sibilkov (2010) noted, the findings on cash policy have implication on payout
policy as well. That is, payout policy is relevant to shareholders through its impact on
investment in the presence of costly external finance. Thus, we expect that our main finding
is not only robust when controlled for free cash flow and financial constraint but is alsostronger when larger free cash flow and financial constraint are presented. The first testablecorollary of our hypothesis is as follows:
Corollary 1: The negative effect of the interaction between corporate governance andidiosyncratic risk on dividend payout propensity is stronger when the firm’s free cash
flow is large and for the firm facing financial constraint.
Allen and Michaely (2003) note the growing importance of repurchases since 1983.
However, while it is not very clear to what extent the alternative form of payout, share10repurchase, plays a role in disciplining managers given that dividends are arguably a better
controlling tool than repurchases (see Jagannathan, Stephens, and Weisbach, 2000; and Guayand Harford, 2000). Skinner (2008) documents that the positive relation between earningsand dividend payout observed in the past is now also observed for total payout defined as
dividend plus repurchase as well, which suggests that firms consider both dividend andrepurchase are effective ways of paying out earnings. We extend our study by investigating
whether our earlier finding that governance either complements or substitutes for dividend
policy based on the level of idiosyncratic risk of the firm is corroborated by models
predicting the probability of both repurchase and total payout. Our second testable corollaryis:Corollary 2: The interaction between corporate governance and idiosyncratic risk isnegatively related to repurchase propensity and total payout propensity.
Dividend initiation is considered to be a major corporate event in the life of a firm. Not
only is it closely related to most financial and investment decisions of the firm but it also
involves a long term commitment of a payment substantial amount of money on a repeatedbasis. Allen and Michaely (2003) document that corporations smooth dividends and rarely
cut them. In the same literature review, they summarize studies on payout policy by Healy
and Palepu (1988), Michaely, Thaler and Womack (1995), Barberis, Shleifer, and Vishny(1998), which show that initiations, on average, have positive announcement returns ofapproximately 3%, while omissions have negative announcement returns of approximately
7%. Clearly, from market reactions, managers are motivated to announce dividend initiations
and avoid dividend cuts or omissions whenever possible. Therefore, it is reasonable to expectthat the interplay of governance and idiosyncratic risk consideration is likely to affect the11decision of initiating dividend in a manner similar to paying dividends. Our last testablecorollary is as follows:
Corollary 3: The interaction between corporate governance and idiosyncratic risk isnegatively related to dividend initiation propensity and total payout propensity.
3.

Data and Summary Statistics

3.1. Sample selection
We analyze the dividend decisions of firms from 2003-2009. Our sample period ends in2009 due to the unavailability of a consistent Industry Corporate Governance Quotients(ICGQs), the primary governance rank measure used in this study. ISS has implemented
major restructuring in the way the governance variables are constructed after 2009. The
sample consists of the firms for which ISS collects data on governance standards and also forwhich security market and accounting data are available in the Center for Research in Security
Prices (CRSP) and Standard & Poor’s COMPUSTAT databases. To ensure that the firms are
publicly traded, we include firms with CRSP share codes of 10 or 11. We require that the
sample firms have price and shares outstanding available for December of year t and at least
100 trading days for estimating the risk measure for the same calendar year, t. We exclude
utilities (SIC Codes 4900-4949) and financial firms (SIC Code 6000-6999). We also requirethat the firms have the accounting data in COMPUSTAT for fiscal year t that are used toconstruct the variables for our analyses.
Part A of the Appendix describes definitions of key measure of governance index, risk
measures, and dividend decision variables and Part B presents the definitions of control
variables and other relevant variables. RiskMetrics/ISS provides ICGQs that measure sample
firms’ percentile positions within their Global Industry Classification Standard (GICS)

12

industry groups. 4 ICGQs are the most discernable commercial governance ratings based on
64 governance variables constructed from several dimensions of board structure(composition, independence), executive and director compensation, ownership, corporate
audit, charter, bylaw provision, takeover defenses, progressive practices (performance
reviews and succession plans), and director education. ISS covers a vast majority of publicly
traded firms, approximately 5,000 firms every year in our data period. This makes ICGQ themost comprehensive corporate governance measure available for a boarder set of firms
compared to several academic governance measures that cover only the S&P1500 companies.
Moreover, it is important to note that this rating adjust for industry and size and its algorithm
also accounts for broader changes in market condition. This clearly provides ICGQ with anadvantage over some of the check-and-sum academic measures that disregard the variation ingovernance standards and practices across industries or any time-varying market changes. 5
The governance rank for a firm in year t is the ICGQ as reported in December of that year.
The final sample in the payout propensity analysis consists of 18,037 firm-years over the
study period.
3.2. Variable definitions and summary statistics
Idiosyncratic risk of a firm is measured by the standard deviation of residuals from a
regression of its daily excess stock returns on the market risk premium, following Hoberg

4

The definition of the 24 GICS industry groups can be found at http://www.msci.com/products/indexes/sector/gics/.
We acknowledge that the index only reflects the within-industry quality of corporate governance. Thus, it is notnecessarily a fitting indicator of the cross-industry quality of corporate governance. However, under a more realistic
assumption that investment decision and dividend decision are not independent, one could expect an industry effectto exist for dividend decisions. Many studies recognize such an effect, including Lintner (1956), Michel (1979),
Marsh and Merton (1987), Smith and Watts (1992), and Christie (1994). In particular, Smith and Watts (1992) use
industry-level data to test dividend policy. In their survey paper, Brav et al. (2005) report that 38.3% of executives
indicate that the dividend policies of their competitors and other companies in their industries play an important rolein their own dividend decisions. Therefore, we believe that using ICGQ could provide useful insight into how
governance affects dividend decisions. Later in the paper, we also test our main results using different governanceproxies from the literature which are not industry-adjusted and find consistent results.
513

and Prabhala (2009). We also use the idiosyncratic risk estimated using the Fama and French
3-factor and Carhart 4-factor models and the Campbell, Lettau, Malkiel, and Xu (2001)
approach adjusting for market and industry. Our results remain robust with different versionsof idiosyncratic risk.
The control variables used in our main regression models are market-to-book, defined asratio of book value of assets minus book value of equity plus market value of equity, allscaled by book value of assets; asset growth from year t-1 to year t, defined as the ratio ofbook value of assets in year t over book value of assets in year t-1 minus 1; and profitability,
defined as earnings before extraordinary items plus interest expense plus deferred income
taxes, all scaled by book value of assets. All variables are the same as those in Hoberg andPrabhala (2009).
We use NYSE percentile as our firm size proxy. NYSE percentile is the NYSE market
capitalization percentile, i.e., the fraction of NYSE firms having market capitalization equal
or smaller than firm i in year t. In the dividend payout propensity regression, we use the
NYSE percentile as the size proxy to make our results comparable to previous studies on
dividend propensity.
We use two other control variables in our main logit models: RE/TE, measured as a ratioof retained earnings to total common equity, winsorized at the 5th and 95th percentile andTE/TA, measured as a ratio of total common equity to total asset, a variable commonly used
to account for the effect of the firm’s capital structure on dividend policy in the literature.
Both variables are defined for firms with positive total common equity as in DeAngelo,
DeAngelo, and Stulz (2006).

14

Table 1 presents firm characteristics of dividend non-payers and payers sorted by thelevel of idiosyncratic risk. The full sample consists of 18,037 firm-years from 2003 to 2009.
The low (high) idiosyncratic risk subsample consists of observations with idiosyncratic risk
lower (higher) than the sample median in each year. We code the firm-year observation as
dividend payer if the amount of dividend payment is positive in the fiscal year, thereby
segregating the full sample into 4,745 non-payers, 4,273 payers among the firms with low
idiosyncratic risk and 7,994 non-payers, 1,025 payers among the firms with highidiosyncratic risk. The substantially higher (lower) number of non-payers (payers) among thehigh risk firm is consistent with the central idea of Hoberg and Prabhala (2009). We firstexamine the average governance index (ICGQ) of the payers and non-payers among thefirms segregated by idiosyncratic risk. At first glance, the results of difference tests based on
t-tests for equality of means and Wilcoxon test for equality of medians, indicate that thefirms’ governance among the dividend payers is higher than that of the non-payers,
suggesting that better governed firms are motivated to return money to investors, regardlessof the risk category, This supports the theory of governance acting as a complement todividend policy. However, on closer inspection, the difference in median governancebetween payers and non-payers among the firms with lower idiosyncratic risk is 9.5
percentile points, substantially higher than the 3.5 percentile point for firms with higher
idiosyncratic risk. The results are consistent with our empirical prediction that better
governed firms are more inclined to pay dividends when their idiosyncratic risk is low.
Among the high idiosyncratic risk firms the considerably smaller difference of 3.5 percentile
points in median governance quality between the payers and non-payers may be indicative ofgovernance substituting for dividend policy, when idiosyncratic risk is high. Prior dividend

15

literature documents that dividend payers and non-payers fundamentally differ across various
market-based and accounting variables. Other factors deemed critical in the dividend policy
literature, such as market-to-book, asset growth, profitability, size (Fama and French, 2001),
retained earnings-to-total equity and total equity to total asset (DeAngelo, DeAngelo, andStulz, 2006), significantly differ between the payers and non-payers across the idiosyncraticrisk categories, in manners consistent with that literature. The group of dividend payers
comprise of larger and more profitable firms while the non-payers comprise of firms withhigher market-to-book (a commonly used proxy for growth opportunities) and faster rate ofasset growth.
[Insert Table 1]
4. Corporate Governance, Idiosyncratic Risk, and Propensity to Pay Dividends
We conduct pair-wise correlation analysis for all variables that are deployed in most of
our multivariate analysis of dividend propensity. The Pearson correlation coefficients andSpearman rank correlation coefficients are reported in Table 2.
[Insert Table 2]
We inspect the correlation coefficients to ensure that our variables do not suffer from asevere case of multicollinearity that may afflict the validity of our multivariate regression
analyses. Firm size and ICGQ show a moderately high positive correlation at 47.3% which is
not surprising because larger firms, subject to greater market scrutiny, are more likely toadapt better corporate governance practices. However, the other pairwise correlations
coefficients have expected signs but fairly small in size to raise any concern. In particular,
the correlation coefficients between ICGQ and idiosyncratic risk, our main measure ofinterest, range between -25.4% and -33.9%. This suggests that they have relatively close16

association in that better governed firms are less risky in general. However, we find thatcondition index is less than 10 in our diagnostic test, which indicates that multicollinearity is
not severe.
4.1.Baseline ModelIn this section we present evidence supporting our main prediction that corporate
governance and dividend policy are complements or substitutes depending on the levelidiosyncratic risk.
[Insert Table 3]This table reports Fama and MacBeth (1973) style estimates of a logit model with thedependent variable, with the payer indicator equal to one in year t if the firm has a positive
dividend per share by the ex-date in fiscal year t and zero otherwise. One cross-sectionalmodel is estimated per year and standard errors are Newey-West (two lags) adjusted.
In column 1 of Table 3, the governance index predicts higher odds of dividend payout in
absence of firm risk, supporting the complement theory. However, in column 2, when we add
idiosyncratic risk, the governance index demonstrates a marginally significant negative
relation with propensity to payout, evidence that supports the substitute theory, andidiosyncratic risk is significantly negatively related to propensity to payout, supporting thefindings of Hoberg and Prabhala (2009). This also indicates that how governance interacts
with risk in dividend payout decisions merits further exploration. In this specification, we
also add RE/TE, measured as a ratio of retained earnings to total common equity, winsorizedat the 5th and 95th percentile and TE/TA. 6 It is easy to see why RE/TE, which is a ratio of
earned equity would be positively related to payout propensity. This supports the findings of
The results are similar if the RE/TE is winsorized at the 1st and 99th percentile. However, we have a fairly large
number of negative RE/TE observations, which drives the mean to -0.68, significantly lower than the median of 0.23.
This may be responsible for the predicted probability being largely undervalued when every variable is at its mean.
6

17

life cycle theory of DeAngelo, DeAngelo, and Stulz (2006). Finally, in column 3, we test our
premise of the asymmetric likelihood of payout by firms at varied levels of corporate
governance under changing scenario of investment opportunity proxied by the idiosyncraticrisk by adding an interaction term between ICGQ and idiosyncratic risk, and as predicted, thevariable of interest is significantly negative. We work under the notion that lower
idiosyncratic

risk

impliesoverinvestment

andhigheridiosyncratic

risk

implies

underinvestment problem. This is supported by earlier studies, such as DeMarzo, Fishman,
He, and Wang (2012) and Panousi and Papanikolaou (2012). Therefore, when the cost ofunderinvestment rises with increasing idiosyncratic risk, good governance should discourage
payout to preserve funding for future value-enhancing investment. On the other hand, when
the cost of overinvestment rises with decreasing idiosyncratic risk, good governance should
encourage payout to reduce free cash flow problems. As a result, we predict that relation
between corporate governance and dividend payout propensity is positive when theidiosyncratic risk is low but becomes less positive or even negative as the idiosyncratic riskincreases. Our results in Table 3 support this empirical prediction. 7 In addition, similar to theunivariate results, reported in Table 1, larger, more profitable firms with a higher proportionof retained earnings show higher likelihood of paying dividends, while firms with higher
market-to-book (a commonly used proxy for growth opportunities) and faster rate of asset
growth show lower likelihood of paying dividends, evidence consistent with prior literature.
To access the economic significance of our results, we rank each independent variable foreach year, and then partition the resulting ranks into quintiles labeled from 1 (lowest quintile)
to 5 (highest quintile). Then we rerun our propensity to pay dividend regression and report7

We also test our corporate governance, idiosyncratic risk and dividend payout hypothesis using probit and linear
probability models. All results remain consistent with our original findings.

18

the estimates in Panel A of Table 4. The results from these quintile regressions further
confirm that the governance’s impact on dividend payout propensity decreases with theidiosyncratic risk. Moreover, it suggests that our findings are not driven by extreme value of
any independent variable.
[Insert Table 4]
In the first two rows Panel B of Table 4, we present the predicted probabilities ofdividend payout using model as specified in Panel A. They represent the probability of a firmpaying dividend when its corporate governance belongs to the highest and the lowest ICGQ
quintiles for the five idiosyncratic risk categories. The control variables are held constant attheir medians for the purpose of calculating the predicted probabilities. For both the strong
and weak governance firms, we observe that the predicted probability declines withincreasing idiosyncratic volatility. This highlights the importance of idiosyncratic risk onpropensity of dividend payout, consistent with Hoberg and Prabhala (2009).
The third row of Panel B, reports the percentage change in predicted probability of
dividend payment by a firm when it moves from the 1st (weakest) to the 5th (strongest)
quintile of governance ranking (ICGQ) for individual idiosyncratic risk quintile. We find thatwhen the idiosyncratic volatility is at its lowest quintile, moving from the 1st quintile to the
5th quintile of governance increases the predicted probability of dividend payout by 28.04%(=(42.01-32.81)/32.81). On the other hand, when the idiosyncratic volatility is at its highest
quintile, moving from the 1st (weakest) quintile to the 5th (strongest) quintile of governancedecreases the predicted probability of dividend payout by 32.12% (=(5.77-8.50)/8.50).
Collectively, these findings suggest an economically meaningful impact of governance on
dividend payout propensity under low and high level of idiosyncratic risk that support how
19

governance acts both as a complement and substitute of dividend policy for low and highidiosyncratic risk of a firm respectively.
4.2. Robustness Tests
In Table 5, we run additional tests to ensure the robustness of our previously documented
result. First, we investigate whether our results hold up using an alternative proxy of
idiosyncratic risk to address the concern that firm specific risk may be systematicallydifferent across industries. The alternative proxy of idiosyncratic risk is estimated as eachfirm’s residual volatility after accounting for market and industry volatility, in the context of
the Campbell, Lettau, Malkiel and Xu (2001) approach. The interaction term remains
negatively significant suggesting that our results are robust to an alternative idiosyncratic risk
measure. 8 In column 2, to ensure that our results are not driven by smaller firms that are lesslikely to pay dividends, we test our model exclusively on S&P 1500 firms. Our results
remain unchanged. Bliss, Chen, and Denis (2015) find a spike in cash retention by firms in
response to supply of credit during financial crisis. In column 3, we investigate whether our
results merely reflect firms’ reaction to the recent financial crisis in that better governed
firms choose not to pay dividend when risk is high while poorly governed firms simply goout of business. We exclude the observations from 2007 to 2009 and find stronger statisticalsignificance of the interaction term between governance and risk. In column 4, we explore
the impact of the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, which
reduces the maximum tax rate on dividends and therefore makes dividends more attractive toinvestors. Because our data period starts in 2003, we drop 2003 to ensure that our results are8

Our results are similar when idiosyncratic risk is estimated using the multifactor Fama and French model. In
addition, the results are consistent if the industry fixed effect is added to the cross-sectional regressions in the FamaMacBeth procedure.

20

free from any effect of the JGTRRA. The interaction between governance and risk remains
significantly negative suggesting that our finding is not affected by the JGTRRA. 9
Furthermore, all variables in our main model belong to the same fiscal year, which makes our
results comparable to those in the current literature. However, it is likely that dividend
payouts affect the firm’s risk as well as its governance. To account for such a concern ofreverse causality, we measure governance and risk in the year prior to dividend distribution
in column 5 and measure every other independent variable in the year prior to dividend
distribution in column 6. Our results remain robust with an even stronger statisticalsignificance than before indicating that they are not driven by reverse causality. The mostnotable result is that in columns 1 through 6, though ICGQ independently has a significantly
positive impact on the propensity to pay dividend, it is subsumed by the interaction term
between ICGQ and idiosyncratic risk. This supports our prediction that the relation between
corporate governance and dividend payout propensity changes from positive to negative as
the idiosyncratic risk increases.
[Insert Table 5]
Academic researchers and industrial experts often find it difficult to agree on the validityof measures of corporate governance (see Gompers, Ishii, and Metric, 2003; Core, Guay, andRusticus, 2006; Bebchuk, Cohen, and Ferrell, 2009; Johnson, Moorman, and Sorescu, 2009;
Daines, Gow, Larcker, 2010). We employ ICGQ, provided by RiskMetric/ISS, which isapparently the most widely accepted governance rating, with roughly 1,700 institutional
clients following. Given the contentious nature of this literature, we next investigate the9

In unreported analyses, we add a dummy equal to 1 if the observation is in 2003 in a panel regression with industry
fixed effects and find the dummy to be significantly positive. This suggests that change in dividend tax has
significant impact on the propensity of paying dividend, yet our results are not affected by it.

21

extent to which our findings are dependent on our choice of corporate governance measure,
ICGQ, or the restricted sample period over which the measure is available. We conduct
further tests in which we use samples collected over extended periods and alternative proxies
of corporate governance borrowed from the prior literature on board structure, executive
compensation, audit quality, and blockholders.
Board independence is measured by independent directors as a percentage of total
number of the directors on board. Rosenstein and Wyatt (1990), Knyazeva, Knyazeva, andMasulis (2013), and Armstrong, Core, and Guay (2014) alongside several others documentthat corporate board independence plays a valuable monitoring role. The board of director
data are obtained from the RiskMetrics Director database from 1996 to 2010. Payperformance sensitivity (Delta), a commonly used construct that measures the degree ofalignment of interest between management and shareholder (see Core, Guay, and Larcker(2003) for a review) is defined as dollar change in CEO’s wealth associated with a 1%change in the firm’s stock price (in $000s) based on the algorithm provided by Coles, Daniel,
Naveen (2013) using the Execucomp database from 1992 to 2010. 10 Big 4 Auditor is adummy that is equal to 1 if the firm uses any of the following auditors:
PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG. The data
are obtained from COMPUSTAT from 1999 to 2010 where the auditor code is available. 11
Blockholder is measured as the percentage of shares held in each firm by the firm's largest
institutional shareholder. Cremer and Nair (2005), Chen, Harford, and Li (2007), and manyothers use this blockholder monitoring measure to proxy for internal governance.

10

We thank Lalitha Naveen for providing the algorithm and data on her website http://sites.temple.edu/lnaveen/data/
DeAngelo (1981) documents the larger auditors are associated with better auditing quality. The Big 4 auditors areoften studied in recent studies like Francis and Yu (2009).
11

22

Blockholder data are obtained from 13-F filings provided by Thomson Reuters from 1986 to
2010. 12
[Insert Table 6]
Column 1 of Table 6 reports the results of the dividend propensity model using board
independence as a proxy for corporate governance. Column 2 reports the same results using
Delta as a proxy for corporate governance. Column 3 reports the results of the dividend
propensity model using Big 4 Auditor as a proxy for corporate governance. Finally, column 4reports the results using Blockholder as a proxy for corporate governance.
To sum up, all four alternative governance proxies show a stronger joint effect ofgovernance and idiosyncratic risk on dividend payout decisions, which suggests that ourearlier findings are not confounded by the use of alternative proxies of corporate governanceover extended sample periods.
4.3. Impact of Free Cash Flow
Prior literature suggests that firms face a trade-off between benefits and costs related to
cash retention. On one hand, the cost of retention rises with excess cash and firms withexcess cash would be more inclined to distribute dividends to reduce the cost of retention
supporting the propositions of Easterbrook (1984) and Jensen (1986). On the other hand, theadvantage of retaining cash grows with level of financial constraint. Firms build cash
reserves as a valuable buffer against shocks to their cash flows or investment opportunities.
Thus, firms tend to hold greater cash balances when they face costlier external finance. 13

12

The results are similar when Blockholder is defined as the percentage of shares held in each firm either by thefirm's top 5 institutional shareholders or by all the firm’s institutional shareholders.
13
In an earlier study, Chae, Kim, and Lee (2009) find that the positive relation between governance, agency conflictand dividend policy changes sign when confronted with external financial constraint. They interpret these findings
as firms facing higher (lower) financial constraint make lower (higher) payouts as their corporate governance23

Almeida, Campello, and Weisbach (2004), Faulkender and Wang (2006), and Denis andSibilkov (2010) report evidence consistent with these predictions.
Therefore, a natural, next step is to test joint effect of governance and idiosyncratic risk
on propensity of dividend payout in an enhanced model that controls explicitly for agency
costs and financial constraints. We introduce the measures of free cash flow (FCF) andfinancial constraint following the past literature. Our first FCF proxy is defined as operating
income minus the total income taxes plus change in deferred taxes minus total interest
expenses all scaled by book value of assets, as defined by Lehn and Poulsen’s (1989). Our
second FCF proxy is the one proposed by Leuz, Triantis, and Wang (2008), industry-adjusted
internally financed growth. It is defined as ROA/(1-ROA) minus the GICS industry groupmedian asset growth. For financial constraint, we employ the KZ-index to proxy as definedby Kaplan and Zingales (1997). We reconstruct the KZ-index for each firm-year using thefollowing equation:
KZ = െ1.002(‫ ܨܥ‬Τܶ‫ )ܣ‬െ 39.368(‫ܸܫܦ‬/ܶ‫ )ܣ‬െ 1.315(‫ܣܥ‬ΤTA) + 3.139‫ ܸܧܮ‬+ 0.283ܳ,
where, &)»TA is the earnings before extraordinary items plus depreciation and amortization
scaled by lagged book value of assets; ‫ ܸܫܦ‬ΤTA is total dividend payments, scaled by lagged
book value of assets; ‫ܣܥ‬ΤTA is cash, scaled by lagged book value of assets; ‫ ܸܧܮ‬is total debt
divided by the sum of total debt and total stockholder equity; and ܳ is the market-to-bookratio. The components of the KZ-index are winsorized at the 1st and 99th percentile before
construction.
Table 7 reports Fama and MacBeth (1973) style estimates of a logit model with thedependent variable, payer indicator, equals to one in year t if the firm has a positive dividend
improves. They use idiosyncratic volatility as a proxy for financial constraint. However, we found that the findingsof Chae et al. (2009) are not robust to alternative proxies of financial constraint.

24

per share by the ex-date in fiscal year t and zero otherwise. The model includes some
additional variables that account for agency costs and financial constraints with 17,275 firmyear observations from 2003 to 2009. Although the study period, between 2003 and 2009, isrelatively short du Although the study period, between 2003 and 2009, is relatively short duee Although the study period, between 2003 and 2009, is relatively short due[Insert Table 7]
Columns (1) and (3) show a positive association between high free cash flow andpropensity to pay dividends, supporting the agency cost propositions. Idiosyncratic risk
negatively predict dividend payout, consistent with Hoberg and Prabhala (2009). Financial
constraint, as documented in the recent literature, notably Denis and Sibilkov (2010) andCampello, Graham, and Harvey (2010), negatively predict dividend payout propensity. Ouroriginal finding of a negative relation between the interaction of governance and risk and thepropensity to pay dividends continues to be robust and the signs on all other variables remainunchanged. Our results are robust to the alternative measures of financial constraint
suggested by Whited and Wu (2006) and Hadlock and Pierce (2010).
In columns (2) and (4), we introduce a three-way interaction term between governance,
idiosyncratic risk and high free cash flow dummy. Our primary hypothesis relates payout
decision to the overinvestment and underinvestment problems, which stem from agency
problem of managerial risk aversion, and that governance complements or substitutes for
dividend payout based on whether the firm faces over or underinvestment problem.
Therefore, we predict that our results should strengthen when explicitly controlled for agency
cost, high free cash flow. Consistent with this prediction, we find that the three-way
interaction term is significantly negative, while the signs on all other variables remain

25unchanged. This implies that the joint effect of governance and idiosyncratic risk on dividend
payout propensity is stronger for firms with high FCF. Our conclusion is that the main
findings are strengthened in the presence of agency problems.
5. Stock Repurchase, Total Payout, and Dividend Initiation
5.1. Stock Repurchase
Skinner (2008) documents that the positive relation between earnings and dividend
payout observed in the past is now true for total payout defined as dividend plus repurchaseas well, suggesting that firms consider both dividend and repurchase as effective ways ofpaying out earnings. We investigate whether our earlier findings on dividend payout arecorroborated by models predicting the probability to repurchase or total payout.
Table 8 presents Fama and MacBeth (1973) style estimates of a logit model with NeweyWest (two lags) adjusted standard deviation. The dependent variable is equal to one for share
repurchasing firms, large share repurchasing firms, and total payout (dividend and stock
repurchase combined) firms in columns (1), (2), and (3), respectively, and zero otherwise. In
column (1), we find that the coefficient of the interaction term between governance andidiosyncratic risk remains negative and significant but with a lower magnitude. This isconsistent with the prediction that the level of idiosyncratic risk remains an important
determinant in repurchase decisions even though its magnitude is smaller than the case ofdividend payment propensity. The coefficient is larger for large repurchases, supporting thatlarge scale repurchase is potentially a stronger disciplining tool. The propensity of the total
payout model (3) shows that the magnitude of the interaction is now close to what we foundfor dividend paying propensity alone. We rerun the regressions using a subsample of nondividend payers to ensure that our results are not driven by the firms that simultaneously pay

26dividends and repurchase. The results are reported in columns (4) and (5). We again find thatthe interaction between governance and idiosyncratic risk is negative and significant,suggesting the robustness of our findings on repurchase. 14 The results indicate that both in
the full sample as well as the subsample of non-dividend payers, corporate governancecomplements (substitutes for) share repurchase and total payout policy when theidiosyncratic risk of the firm is low (high).
[Insert Table 8]
5.2. Dividend Initiation
Dividend initiation is not only closely related to most financial and investment
decisions of the firm but also involves a long-term commitment of paying a substantial
amount of earnings on a repeated basis. Prior studies (see, Healy and Palepu (1988),
Michaely, Thaler and Womack (1995), Barberis, Shleifer, and Vishny (1998)) show that
initiations, on average, have positive announcement returns of approximately 3%, whileomissions have negative announcement returns of approximately 7%. Clearly, from themarket reactions, managers are motivated to announce dividend initiations and avoid
dividend cuts or omissions whenever possible. Therefore, it is reasonable to expect that theinterplay of governance and risk consideration is likely to affect the decision of initiating
dividend in a manner similar to paying dividends. We test this empirical prediction in a
multivariate logit model.
Table 9 reports the results of logit regression that analyzes the decision to initiate
dividend payments. The regression uses an initiation indicator as the dependent variable thattakes on the value of one if the firm was not a payer for the last five calendar years and has a
14

We define the repurchase as in Grullon and Michaely (2002). Our results are robust to the alternative definition of
repurchase (net repurchase) as in Skinner (2008).

27

regular cash dividend announcement (CRSP DISTCD 1220-1259) in the current calendar
year (event date is obtained from CRSP DCLRDT) and zero otherwise. 15 The sample
consists of 6,704 firm-years, from 2003-2009. We identify the initiators in year t as thosefirms that have positive earnings in the previous fiscal year and have not paid dividends inthe years (t-5, t-1).
We find that the two-way interaction between governance and idiosyncratic risk isnegative as shown in columns (1), (2), and (3). This is consistent with our prediction on theasymmetric impact of governance on dividend initiation based on the firm’s idiosyncratic
risk, in that better governed firms are more likely to initiate dividends when idiosyncratic risk
is low and less likely to do so when idiosyncratic risk is high. Payout policy, similar toseveral other corporate decisions is widely known to be vary across industries. It could also
be influenced by unobservable firm characteristics. The results reported in columns (2) and(3) mitigate concerns that our findings are either an artifact of deviations across industry or
missing firm characteristics by adding industry- and firm-fixed effects to the initiation
regression reported in column (1). The asymmetric impact of governance on dividend
initiation based on firm risk, is strengthened after the variations between industries and firms
are controlled for.
[Insert Table 9]5.2.1. Dividend initiation event and firm behavior in the post-event period
In this section we study the 223 dividend initiation events (every initiation event islinked to a unique firm) that occurred during the period 2003-2009 by 1,898 unique firmsthat constitute our original sample of 6,704 firm-years in the dividend initiation analysis.
15

Initiators are identified following the procedure in DeAngelo, DeAngelo, and Stulz (2006).

28

Given our earlier findings, we anticipate a substantially large number of initiators among thefirms with stronger governance and lower risk. We also investigate how the dividend policyof these firms shape up over the next five years. We choose a fixed window in accordancewith the corporate finance literature and considering that our sample period ends in 2009, a
five year post-event window seems to be a reasonable choice. 16 We find that roughly 47% of
the 223 dividend initiation events are attributed to firms with stronger corporate governanceand lower idiosyncratic risk. These firms are also 28% less likely to cut or omit dividends inthe next five years compared to their counterparts with weaker governance and higher risk.
These results support our claim that governance and risk jointly affect the dividend policy.
Figure 1 depicts the dividend initiating firms' mean (the solid line) and median (thedash line) idiosyncratic risk five years prior to the dividend initiation. The sample consist of
214 dividend initiation events from 2003 to 2009 of firms for which return data (used inmeasuring idiosyncratic risk) are available for all five years prior to the event. Year t is theyear of initiation, year t-1 is the year immediately prior, and so on. The chart helps tocorroborate the idea that risk is an important component in determining dividend policy, andthe firms that initiate dividends indeed experience a decline in their risk in the five years
prior.
[Insert Figure 1]
Figure 2 depicts the number of firm-initiation events, and their probabilities of omitting
or cutting dividend within five years after initiation for the 223 dividend initiation eventsfrom 2003 to 2009 for which data are available from Risk Metrics/ISS Governance Rating,
CRSP, and Standard and Poor's COMPUSTAT. The four subgroups are created on the basis

16

For example, Lehn and Zhao (2006) check whether CEOs who oversee bad M&As are fired within a five year
window after the acquisition.

29

of idiosyncratic risk (high and low) and corporate governance (strong and weak). We use themedian values of idiosyncratic volatility and governance index within each industry year for
the full sample of 18,037 firm-years. Among the firms with low idiosyncratic risk, 105
dividend initiation events are attributed to firms with strong governance, compared to 51
such events for weak governance firms. Even though the number of firms initiating dividends
are not different across the two governance categories for firms with high idiosyncratic risk,
the probability of omission or cut is substantially lower for strong governance firms that may
be indicative of positive information about future firm performance, available to the
management, despite the underinvestment problem among high risk firms. We also conduct
Wilcoxon two-sample tests of number of initiations and probability of dividend omission/cut
for the four categories of firms described in Figure 2. 17 The pairwise comparisons of the
before mentioned statistics support our earlier conjectures in that, when segregated amongfour groups of stronger (weaker) governance and high (low) risk, we find that approximately
47% of the 223 dividend initiation events are attributed to firms with stronger governanceand lower risk. These firms are also 28% less likely to cut or omit dividends in the next five
years compared to their counterparts with weaker governance and higher risk. It is interesting
to note, that the probability of dividend omission or cut seem to matter statistically whencompared across different categories of firms by risk while keeping the governance invariant.
[Insert Figure 2]
6. Conclusion
A familiar and well explored question in the dividend payout literature is whether
investors prefer dividend paying firms and should firms cater to such preference. The market

17

Results not tabulated.

30

participants are as divided on this question as academics. Don Kilbride, who has managed the$24.6 billion Vanguard Dividend Growth Fund since 2006, believes that “dividend growth is
the most important arrow in a stock investor’s quiver”. 18 In contrast, Warren Buffett prefers
to use Berkshire Hathaway’s huge cash pile to buy companies rather than pay dividends toinvestors. 19
The other interesting question, which is the focus of this study is if the goal of good
corporate governance is to monitor managers while they make critical decisions that impact
firm value, should it encourage or discourage dividend payouts. Since the work by La Portaet al. (2000), an extensive literature has developed studying the relation between governancequality and dividend policy through the ambit of agency conflicts and is divided on whether
governance complements or substitutes for dividend policy in disciplining managers. Whilesome studies find that firms with stronger governance make larger dividend payments inorder to reduce agency conflicts, supporting corporate governance as a complement todividend policy theory, others report just the opposite, supporting corporate governance as a
substitute for dividend policy.
In this paper, we reconcile these two opposing strands of literature by investigating how
corporate governance influences dividend payout policy under different level of idiosyncraticrisk. While better corporate governance encourages dividend payout to reduce free cash flow,
when idiosyncratic risk, a proxy for the cost of underinvestment is low, it discourages payout
to preserve funding for value-increasing investment, when idiosyncratic risk and as a result
18

Jen Wieczner of Fortune Magazine reports that since the beginning of 1999, the S&P 500 Dividend Aristocrats
index which is made up of companies that have increased their dividends for at least 25 consecutive years has
returned 314%, more than double the broader market. Please refer to http://fortune.com/2015/04/27/dividend-stocksshelter-in-bear-market/.
19David Gelles of New York Times reports that the Berkshire board regularly considers returning to capital
programs but decides against it. Please refer to http://dealbook.nytimes.com/2014/03/14/berkshire-hathaway-boardrecommends-shareholders-vote-against-dividend/.

31the cost of underinvestment rises. Thus, we argue that the relation between corporate
governance and dividend payout propensity is positive when the idiosyncratic risk is low, andbecomes less positive or even negative as the idiosyncratic risk increases. We report that theinterplay of governance and idiosyncratic risk is indeed a significant determinant ofpropensity to pay dividends as well as repurchase and total payout. We also find that firms
with stronger corporate governance are less inclined to initiate dividends when their residual
volatility is high compared to firms with weaker governance. In addition, we find that firms
with stronger governance and lower idiosyncratic risk are significantly less likely to cut oromit dividends in the next five years after initiation, compared to their counterparts withweaker governance and higher idiosyncratic risk. All of the above findings support the earlier
prediction of the asymmetric role of corporate governance in payout decisions which helps inreconciling the complement and substitute debate.
Finally, in unreported analyses, we investigate whether our results on dividend paying
propensity can be extended to the level of dividend payment. We run Tobit regressions on the
DV/A (Dividend amount/Book value of asset) for all firms and OLS regressions for dividend
payers. We obtain results consistent with our main findings when we use alternative
measures of governance, board independence, pay-for-performance, takeover defenses, andblockholders. These results suggest that governance and idiosyncratic risk jointly determine
not only the propensity of the dividend payment but also the level of the dividend payment. 20

20

The reason that we cannot find results in the ICGQ sample can be attributed to the impact of the recent financial
crisis in which some firms, even with good governance and low idiosyncratic risk might have reduced the level ofdividend payment or even stopped payment due to the severe credit shock. Bliss, Cheng, and Denis (2015)
document that 9.12% and 14.98% of firms reduced dividend payment in 2008 and 2009, while 10.47% of firms
eliminated dividend payment in 2009. (these numbers are around 3% before the crisis). The relatively short timespan of the ICGQ sample (2003-2009) compared to that of the samples for which the alternative governance proxies
are available makes it more likely that the results were affected by om the shock.

32

Appendix: Variable definitions
Variable
Definitions
Panel A: ISS Governance Indices, Risk Measures, and Dividend Decision Variables
ICGQ
The industry ranking based on the Institutional Shareholder
Services (ISS)’s Corporate Governance Quotient (CGQ) rating,which is a firm’s percentile within its GICS industry group. The
definition of the 24 GICS industry group can be found from thefollowing website:
http://www.msci.com/products/indexes/sector/gics/
Idiosyncratic Risk
The standard deviation of residuals from a regression of its daily
excess stock returns on the market risk premium. Following
Hoberg and Prabhala (2009), we use the firm-specific daily stock
return from one calendar year to compute idiosyncratic risk foreach firm-year observation.
Systematic Risk
The standard deviation of the predicted value from the above
regression which defined idiosyncratic risk.
Payer Indicator
Dummy: 1 if the firm has positive dividend per share by the exdate (Compustat item #26) in the fiscal year that ends in calendar
year t.
Initiator Indicator
Dummy: 1 if the firm was not a payer for the last five calendar
years and have a regular cash dividend announcement (CRSPDISTCD 1220-1259) in current calendar year where the event
date can be identified from CRSP DCLRDT)Omission&cut
Omission&cut equals to 1 if the firm omit the payment or cut theregular cash dividend payment within five years after the
initiation and 0 otherwise.
Repurchase Indicator
Dummy: 1 if the firm has positive $ amount of share repurchasewhich is defined as purchase of common and preferred stock(Compustat item#115) minus the reduction in the value ofpreferred stock outstanding (Compustat item #56) following
Grullon and Michaely (2002).
Large Repurchase
Dummy: 1 if the firm has $ amount of share repurchase greater
Indicator
than 1% of its book assets.
Total Payout Indicator
Dummy: 1 if the firm has positive total payout which is definedas the dividend payment plus the $ amount of share repurchase.
Panel B: Control Variables and other variables
Market-to-bookMarket-to-book ratio of asset. Book value of assets (Compustat
item #6) minus the book value of equity plus the market value ofequity (fiscal year closing price times shares outstanding) all
scaled by book value of assets.
The book value of assets is defined as Stockholder’s Equity
minus Preferred Stock plus Deferred Taxes and Investment Tax
Credit (Compustat item #35) minus Postretirement Benefit Asset(Compustat item #330)
The Stockholder’s Equity is Compustat item #216. If the data
item is not available, it is replaced by either Common/Ordinary33

Appendix: Variable definitions
Variable
Definitions
Equity (Compustat item #60) plus Preferred Stock Par Value(Compustat item #130) or Book value of assets minus Total
Liabilities (Compustat item #181)
The Preferred Stock is Preferred Stock Liquidating Value(Compustat item #10), or Preferred Stock Redemption Value(Compustat item #56), or Preferred Stock Par Value (Compustat
item #130).
The definitions are from Hoberg and Prabhala (2009).
Asset Growth
The year t-1 to year t growth of book value of assets scaled by
the book value of asset at year t-1
Profitability
Earnings before extraordinary items (Compustat item #18) plus
Interest expense (Compustat item #15) plus Deferred income
taxes (Compustat item #50) all scaled by book value of assets.
NYSE Percentile
NYSE Percentile is the NYSE market capitalization percentile,
Book value of assets
i.e., the fraction of NYSE firms having market capitalization
equal or smaller than firm i in year t.
RE/TE
The ratio of earned equity to total common equity from
DeAngelo, DeAngelo, and Stulz (2006). Retained Earnings(Compustat item #36) divided by the The Stockholder’s Equity
defined above. RE/TE is winsorized at the 5th and 95th percentile.
TE/TA
The Stockholder’s Equity divided by book value of total asset.
High FCF
High FCF is a dummy variable that equals 1 if the firm’s FCF
proxy is higher than the sample median for that year, or 0
otherwise.
FCF proxy 1
FCF proxy 1 is defined as: Operating Income (Compustat
item#13) minus the total income taxes (Compustat item #16) pluschange in deferred taxes (Compustat item #35) from the previous
year to the current year minus total interest expenses (Compustat
item #15) all scaled by book value of assets. This free cash flow
measure follows Lehn and Poulsen (1989) that ignores dividends.
FCF proxy 2
FCF proxy 2 is defined as (Maximum internally financed growth)– (GICS industry group median asset growth), where maximum
internally financed growth = ROA/(1-ROA), ROA is income
before extraordinary item (Compustat item #18) scaled by lagged
book value of asset (Compustat item #6). This is the free cash
flow problem measure employed by Leuz, Triantis, and Wang(2008)
Financial Constraint
Financial Constraint is a dummy variable that equals 1 if the KZindex of a firm is in the top tercile for that year following
Lamont, Polk, and Saa-Requejo. (2001), or 0 otherwise.
KZ-index
KZ-index is Kaplan and Zingales (1997)’s financial constraintindex. We construct the KZ-index for each firm-year as
KZ = െ1.002(‫ ܨܥ‬Τܶ‫ )ܣ‬െ 39.368(‫ ܸܫܦ‬Τܶ‫ )ܣ‬െ 1.315(‫ܣܥ‬Τܶ‫)ܣ‬+ 3.139‫ ܸܧܮ‬+ 0.283
34Appendix: Variable definitions
Variable
Definitions
where &)»TA is the Earnings before extraordinary items plus
Depreciation and Amortization (Compustat item #14) scaled bylagged book value of assets (Compustat item #6), ‫ ܸܫܦ‬Τܶ‫ ܣ‬istotal dividend payments (Compustat item #19 and #21) scaled bylagged book value of assets, ‫ܣܥ‬Τܶ‫ ܣ‬is cash (Compustat item #1)
scaled by lagged book value of assets, ‫ܸܧܮ‬, leverage, is total debt
(Compustat iem#34 and item#9) divided by the sum of total debt
and total stock holder equity (Compustat item #216), ܳ is themarket-to-book ratio. The components of KZ-index are
winsorized at the 1st and 99th percentile before construction.
Board Independence
The percentage of the number of independent director to the total
number of the director on the board. The board of director data is
obtained from RiskMetrics Director and Governance
Delta
Pay-performance sensitivity: Dollar change in wealth associatedwith a 1% change in the firm’s stock price (in $000s). It is
calculated based on Coles, Daniel, Naveen (2013) algorithm
using data from Execucomp.
Big 4 Auditor
A dummy equals to 1 if the firm use the following auditors: EY,
PwC, Deloitte Touche Tohmatsu, and KPMG.
Blockholder
The percentage of shares held in each firm by the firm's largest
institutional blockholders. (Cremer and Nair (2005))

35

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39

Table 1
Summary Statistics
This table shows the firm characteristics by dividend nonpayers and payers for subsamples of firms differentiated by theiridiosyncratick risk. The sample consists of 18,037 firm-years from 2003 - 2009 where data available from RiskMetrics/ISS GovernanceRating, CRSP, and Standard and Poor's COMPUSTAT. The low (high) idiosyncratic risk subsample consists of observations with
idiosyncratic risk lower (higher) than the sample median in each year. A firm-year observation is identified as dividend payer if
amount of dividend paid is positive by the firm for that fiscal year. The difference tests are t-tests for equality of means andWilcoxon-test for equality of medians. Median values are in brackets. Variables are defined in the appendix. ***, **, * denotestatistical significance between nonpayers and payers at the 1%, 5%, and 10% level, respectively.

N
ICGQ
Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile
BV Asset
RE/TE
TE/TA

Low Idiosyncratick Risk
NonPayer
Payer
4,745
4,273
62.09
[66.80]0.02[0.02]
0.01[0.01]
1.96[1.57]
0.15[0.08]
0.05[0.06]
0.37[0.32]
2408.21[766.72]-0.04[0.31]
0.58[0.59]

69.16[76.30]0.02[0.02]
0.01[0.01]
1.84[1.55]
0.08[0.05]
0.08[0.08]
0.52[0.53]
9301.98[1972.96]
0.63[0.73]
0.54[0.54]High Idiosyncratick Risk
NonPayer
Payer
7,994
1,025

Diff
-7.07
[-9.50]0.00[0.00]
0.00[0.00]
0.12[0.02]
0.06[0.03]-0.03[-0.02]-0.15[-0.21]-6893.77[-1206.24]-0.67[-0.42]0.04[0.05]

40

***
***
***
***
*
***
***
*
***
***
***
***
***
***
***
***
***
***
***
***

48.64
[48.00]0.05[0.04]
0.01[0.01]
2.12[1.55]
0.15[0.03]-0.10[-0.01]
0.11[0.05]
514.55[120.57]-1.90[-0.58]0.57[0.60]

51.82[51.50]0.04[0.03]
0.01[0.01]
1.62[1.28]
0.07[0.02]
0.04[0.06]
0.16[0.09]
1077.06[286.10]0.30[0.54]
0.56[0.57]

Diff-3.18[-3.50]0.01[0.01]
0.00[0.00]
0.50[0.26]
0.08[0.01]-0.14[-0.07]-0.05[-0.04]-562.51[-165.53]-2.19[-1.13]0.01[0.03]

***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
**

Table 2
Correlation Matrix
This table shows pairwise correlations between select variables. The upper traiangle of this matrix reports the Pearson correlation coefficients and the lower
triangle reports the Spearman rank correlation coefficients. P-values are reported below each coefficient. Variables are defined in the appendix.

ICGQ
ICGQ
Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile
BV Asset
RE/TE
TE/TA

1
-0.339(<.001)0.179(<.001)0.064(<.001)
0.003(0.661)0.161(<.001)0.484(<.001)0.473(<.001)0.202(<.001)-0.135(<.001)

Idio. Risk Sys. Risk
-0.2540.141(<.001)(<.001)0
0.198(<.001)0.159
1(<.001)-0.143-0.008(<.001)(0.301)-0.199-0.039(<.001)(<.001)-0.455-0.008(<.001)(0.256)-0.6190.392(<.001)(<.001)-0.6150.358(<.001)(<.001)-0.5440.014(<.001)(0.058)0.018-0.036(0.014)(<.001)

M/B
0.001(0.917)-0.017(0.024)-0.077(<.001)1
0.326(<.001)0.258(<.001)0.267(<.001)-0.081(<.001)-0.066(<.001)0.179(<.001)

Growth Profitability NYSE % BV Asset-0.043
0.128
0.473
0.223
(<.001)(<.001)(<.001)(<.001)-0.044-0.412-0.434-0.161(<.001)(<.001)(<.001)(<.001)-0.051-0.0300.180
0.025(<.001)(<.001)(<.001)(<.001)
0.191-0.1290.120-0.039(<.001)(<.001)(<.001)(<.001)
1
0.169
0.056
0.000
(<.001)(<.001)(0.966)
0.401
1
0.309
0.092
(<.001)(<.001)(<.001)
0.219
0.409
1
0.453
(<.001)(<.001)(<.001)
0.116
0.333
0.894
1
(<.001)(<.001)(<.001)
0.148
0.542
0.397
0.430
(<.001)(<.001)(<.001)(<.001)0.075
0.053-0.109-0.300(<.001)(<.001)(<.001)(<.001)

41

RE/TE
0.140
(<.001)-0.438(<.001)
0.010(0.160)-0.248(<.001)0.063(<.001)0.618(<.001)0.312(<.001)0.102(<.001)1
0.058(<.001)

TE/TA-0.115(<.001)-0.066(<.001)-0.085(<.001)0.162(<.001)0.050(<.001)0.036(<.001)-0.124(<.001)-0.088(<.001)
0.195(<.001)1.000

Table 3
Governance-Risk Relation and Propensity to Pay Dividends
This table reports Fama and MacBeth (1973) style estimates of a logit modelwith Newey-West (two lags) adjusted standard deviation. One cross-sectionalmodel is estimated per year. The dependent variable Payer Indicator is equal to
one for dividend-paying firms and zero otherwise. The sample consists of
18,037 firm-years from 2003 – 2009 for which data are available in
RiskMetrics/ISS Governance Rating, CRSP, and Standard and Poor's
COMPUSTAT. P-values are reported in parentheses below each coefficient.
The R-square reported is the average R-square from the cross-sectional
regressions. Variables are defined in the appendix. ***, **, * denote statisticalsignificance at the 1%, 5%, and 10% level, respectively.

Dependent Variable
ICGQ
Idiosyncratic Risk

Payer Indicator(1)(2)
0.002 ***
-0.001 *(0.030)(0.066)-54.836 ***(0.001)0.550(0.974)-0.193 ***(<.001)-1.354 ***(0.003)2.995 ***
(0.001)1.075 ***(<.001)1.309 ***(<.001)-0.994 ***(0.010)(3)0.010 *
(0.054)-32.213 ***(0.002)-0.486 **(0.033)5.741(0.717)-0.191 ***(<.001)-1.345 ***(0.003)
2.976 ***
(0.001)
0.944 ***(<.001)1.299 ***(<.001)-0.963 **(0.014)

18,0370.320

18,0370.322

ICGQ*Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile-0.409 ***(<.001)-1.506 ***(<.001)
7.665 ***(<.001)2.551 ***(<.001)

RE/TE
TE/TA
# observations
2
R

18,0370.218

42

Table 4
Economic Impact of Governance on Propensity to Pay Dividends under Different Levels of Risk
Panel A of this table reports Fama and MacBeth (1973) style estimates of a logit model with Newey-West (two lags) adjusted standard deviation. One cross-sectional model is estimated per year. The dependent
variable Payer Indicator is equal to one for dividend-paying firms and zero otherwise. The independent variables are measured in quintiles. The sample consists of 18,037 firm-years from 2003 – 2009 for which data
are available in RiskMetrics/ISS Governance Rating, CRSP, and Standard and Poor's COMPUSTAT. P-values are reported in parentheses below each coefficient. The R-square reported is the average R-squarefrom the cross-sectional regressions. Variables are defined in the appendix. ***, **, * denote statistical significance at the 1%, 5%, and 10% level, respectively. The first two rows of Panel B report the predictedprobability of dividend payout using model as specified in Panel A, ICGQ at the highest quintile and at the lowest quintile across idiosyncratic risk quintiles, while fixing the controls variables at their medians. The
third row of Panel B reports the proportion change in the predicted probability between the ICGQ at the highest quintile and at the lowest quintile.

Panel A: Propensity to pay dividend regression where all independent variables are measured in quintiles
ICGQ*
Idiosyncratic
Systematic Market-toVariables
ICGQ
Idiosyncratic
Risk
Risk
book
Risk
0.063***(0.005)-0.195***(<.001)-0.014***(0.004)0.032(0.286)-0.097***(<.001)Asset
GrowthProfitability

NYSE
Percentile

RE/TE

TE/TA

# obs/R2-0.138***(0.002)0.130***(<.001)

0.053**(0.012)0.397***(<.001)-0.068**(0.022)

18,037
0.336

Panel B: Predicted probability where control variables are at their median
1st (lowest) quintile
Idiosyncratic Risk at

2nd quintile

3rd quitile

4th quintile

5th (highest) quintile

Predicted Probability ICGQ at highest quintile

42.01%

28.08%

17.39%

10.19%

5.77%

Predicted Probability ICGQ at lowest quintile

32.81%

24.38%

17.55%

12.33%

8.50%% Change in probability(highest - lowest)/lowest

28.04%

15.19%-0.92%-17.30%-32.12%43

Table 5
Governance-Risk Relation and Propensity to Pay Dividends – Robustness Analysis
This table reports Fama and MacBeth (1973) style estimates of a logit model with Newey-West (two lags) adjusted standard deviation.
One cross-sectional model is estimated per year. The dependent variable Payer Indicator is equal to one for dividend-paying firms andzero otherwise. The sample consists of 18,037 firm-years from 2003 - 2009 for which data are available in RiskMetrics/ISS GovernanceRating, CRSP, and Standard and Poor's COMPUSTAT. Column 1 reports the results using alternative proxy of idiosyncratic risk
estimated as each firm's residual volatility after accounting for market and industry volatility, in the spirit of Campbell, Lettau, Malkiel andXu (2001). Column 2 reports the result with the subsample consists of S&P 1500 firms. Column 3 reports the results with the subsample
excluding year 2007-2009. Column 4 reports the result the results with the subsample excluding year 2003. Column 5 reports the resultswith Governance and Risk proxies are measured at the year prior to the dividend distribution. Column 6 reports the results with all
independent variables are measured at the year prior to the dividend distribution. P-values are reported in parentheses below eachcoefficient. The R-square reported is the average R-square from the cross-sectional regressions. Variables are defined in the appendix.
***, **, * denote statistical significance at the 1%, 5%, and 10% level, respectively.

Dependent Variable

ICGQ
Idiosyncratic Risk
ICGQ*Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile
RE/TE
TE/TA
# observations
R2

(1)

(2)

(3)

Payer Indicator(4)

Alternative
Risk Proxies

S&P1500
Subsample

Excluding2007-2009

Excluding
2003

0.010 **
(0.029)-30.833 ***(0.004)-0.485 **(0.024)-6.773(0.679)-0.178 ***(<.001)-1.345 ***(0.003)2.820 ***
(0.001)0.861 ***
(0.001)1.304 ***(<.001)-0.993 **(0.015)0.005 *
(0.068)-69.068 ***(<.001)-0.349 **(0.036)48.745 *(0.058)-0.260 ***(0.001)-1.143 ***(0.002)
1.548 ***
(0.002)1.305 ***(<.001)1.396 ***(<.001)-1.431 ***(0.001)0.014 **
(0.025)-36.153 **(0.030)-0.688 **(0.017)-10.189(0.538)-0.229 ***(<.001)-0.963 ***(0.002)
3.628 ***
(0.010)0.941 ***
(0.008)1.470 ***(<.001)-0.572 **(0.040)0.011 *
(0.068)-25.469 ***(<.001)-0.562 **(0.048)13.923(0.273)-0.185 ***(0.001)-1.347 **(0.010)3.203 ***
(0.002)0.855 ***(<.001)1.264 ***
(0.001)-1.042 **(0.013)0.014 *
(0.008)-41.769 ***(0.016)-0.706 **(0.007)0.040(0.998)-0.182 ***(0.001)-1.324 **(0.002)
3.287 ***
(0.001)0.717 ***
(0.004)
1.159 ***(<.001)-0.842 **(0.004)0.013 ***
(0.009)-39.042 **(0.028)-0.664 ***(0.006)
1.158(0.948)-0.269 ***(<.001)-0.948 ***(0.001)4.520 ***
(0.003)0.960 ***
(0.001)1.181 ***(<.001)-0.599 ***(0.006)18,035
0.321

6,788
0.276

11,3330.340

15,1070.319

14,5640.339

14,564
0.347

44

(5)

(6)

All
Governanceindependent
and Risk at t-1
variables at t-1

Table 6
Corporate Governance, Risk, and Propensity to Pay Dividends - Alternative Governance Proxies
This table reports Fama and MacBeth (1973) style estimates of a logit model with Newey-West (two lags) adjusted
standard deviation One cross-sectional model is estimated per year. The dependent variable Payer Indicator is equal to one
for dividend-paying firms and zero otherwise. Column 1 reports the results using a sample of 15,474 firm-years from 1996 2010 for which data are available in RiskMetrics Director, CRSP, and Standard and Poor's COMPUSTAT. Column 2 reports
the result using the sample of 17,684 firm-years from 1992 - 2010 for which data is available in Execucomp, CRSP, andStandard and Poor's COMPUSTAT. Column 3 reports the result using the sample consists of 36,961 firm-years from 1999 2010 where data available from CRSP, and Standard and Poor's COMPUSTAT with auditor code available. Column 4reports the result using the sample consists of 80,830 firm-years from 1986 - 2010 where data available from ThomsonReuters Institutional Ownership, CRSP, and Standard and Poor's COMPUSTAT. P-values are reported in parentheses
below each coefficient. The R-square reported is the average R-square from the cross-sectional regressions. Variables aredefined in the appendix. ***, **, * denote statistical significance at the 1%, 5%, and 10% level, respectively.

Dependent Variable
Board Independence
Board Independence*Idiosyncratic Risk

(1)
0.022 ***(<.001)-0.703 ***(0.009)Delta
Delta*Idiosyncratic Risk

Payer Indicator(2)(3)

0.418 *
(0.068)-21.322 **(0.026)

Big 4 Auditor
Big 4 Auditor*Idiosyncratic Risk

0.480 *
(0.095)-21.533 **(0.034)Blockholder-52.496 ***(0.001)-25.984(0.493)-0.188 ***(0.001)-0.791 ***(<.001)0.848(0.149)1.261 ***(<.001)1.089 ***(<.001)-1.166 ***(<.001)-93.512 ***(<.001)-55.684(0.179)-0.176 ***(<.001)-0.868 ***(<.001)0.619(0.440)1.851 ***(<.001)
1.327 ***(<.001)-1.311 ***(<.001)-49.294 ***(<.001)-15.154(0.438)-0.226 ***(<.001)-1.123 ***(<.001)2.443 **
(0.010)1.400 ***
(0.001)
1.123 ***(<.001)-0.845 ***(<.001)

0.772(0.583)-94.064 **(0.018)-50.665 ***(<.001)-79.243 ***(0.002)-0.259 ***(<.001)-1.097 ***(<.001)2.040 ***(<.001)2.606 ***(<.001)1.385 ***(<.001)-0.404 **(0.037)

15,4740.316

17,6840.360

36,9610.323

80,8300.374

Blockholder*Idiosyncratic Risk
Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile
RE/TE
TE/TA
# of observations
R2

(4)

45

Table 7
Corporate Governance, Risk and Propensity to Pay Dividends With Explicit Control
for Agency Cost
This table reports Fama and MacBeth (1973) style estimates of a logit model with Newey-West (two lags)
adjusted standard deviation. One cross-sectional model is estimated per year. The dependent variable Payer
Indicator is equal to one for dividend-paying firms and zero otherwise. High FCF is a dummy variable equals
to 1 if FCF proxy is higher than median of the year. Financial Constraint is a dummy variable equals to 1 if
the KZ-index is in the top tercile of the year. In column (1) and (2), the proxy of free cash flow (FCF) per thedefinition in Lehn and Poulsen (1989) without considering the dividends. The sample consists of 17,275 firmyears from 2003-2009 for which data are available in RiskMetrics/ISS Governance Rating, CRSP, andStandard and Poor's COMPUSTAT. In column (3) and (4), the proxy of free cash flow (FCF) is per thedefinition in Leuz et al. (2008). The sample consists of 18,037 firm-years from 2003-2009 for which data are
available in RiskMetrics/ISS Governance Rating, CRSP, and Standard and Poor's COMPUSTAT. P-values
are reported in parentheses below each coefficient. The R-square reported is the average R-square from thecross-sectional regressions. Variables are defined in the appendix. ***, **, * denote statistical significanceat the 1%, 5%, and 10% level, respectively.

Dependent Variables
Free Cash Flow measure
ICGQ
ICGQ*Idiosyncratic Risk
ICGQ*Idiosyncratic Risk*High FCF
High FCF
Financial Constraint (FC)
Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile
RE/TE
TE/TA
# of observations
R2

Payer
FCF proxy 1
FCF proxy 2
(1)
(2)
(3)
(4)
0.007
0.008
0.006
0.007 *
(0.203)(0.154)(0.259)(0.095)-0.439 *-0.411-0.402 *-0.322(0.079)(0.103)(0.073)(0.109)-0.089 **-0.240 ***(0.018)(0.002)0.204 *** 0.345 *** 0.118 *
0.472 ***(<.001)(0.001)(0.051)(0.001)-1.482 *** -1.483 *** -1.426 *** -1.427 ***(<.001)(<.001)(<.001)(<.001)-35.919 *** -35.224 *** -38.328 *** -36.059 ***(0.001)(0.001)(0.001)(0.001)
5.870
6.078
5.610
6.369
(0.738)(0.731)(0.748)(0.717)-0.222 *** -0.223 *** -0.203 *** -0.204 ***(<.001)(<.001)(<.001)(<.001)-1.483 *** -1.476 *** -1.410 *** -1.402 ***(0.005)(0.005)(0.004)(0.005)2.548 *** 2.564 *** 2.588 *** 2.669 ***(<.001)(<.001)(0.001)(<.001)
0.992 *** 0.976 *** 0.986 *** 0.947 ***(<.001)(<.001)(<.001)(<.001)
1.171 *** 1.170 *** 1.194 *** 1.190 ***(<.001)(<.001)(<.001)(<.001)-3.075 *** -3.068 *** -3.027 *** -3.029 ***(<.001)(<.001)(<.001)(<.001)
17,2750.347

46

17,2750.347

18,0370.347

18,0370.348

Table 8
Corporate Governance, Risk, and Propensity to Repurchase or Total Payout
This table reports Fama and MacBeth (1973) style estimates of a logit model with Newey-West (two lags) adjusted
standard deviation. One cross-sectional model is estimated per year. The dependent variable is equal to one for share
repurchasing firms, large share repurchasing firms and dividend-paying and/or share repurchasing firm in models (1),(2), and (3) respectively and zero otherwise. The full sample used in models (1), (2), and (3) consists of 18,037 firmyears from 2003 - 2009, while the sub sample of non-dividend payers consists of for 12,739 firm-yeras from 2003-2009
for which data are available in RiskMetrics/ISS Governance Rating, CRSP, and Standard and Poor's COMPUSTAT. Pvalues are reported in parentheses below each coefficient. The R-square reported is the average R-square from thecross-sectional regressions. Variables are defined in the appendix. ***, **, * denote statistical significance at the 1%,5%, and 10% level, respectively.

(1)
Dependent Variable
ICGQ
Idiosyncratic Risk
ICGQ*Idiosyncratic Risk
Systematic Risk
Market-to-book
Asset GrowthProfitability
NYSE Percentile
RE/TE
TE/TA
# observations
R2

Full Sample
(2)

(3)

Non-dividend Payers(4)(5)

Repurchase
Indicator

Large
Repurchase
Indicator

Total Payout
Indicator

Repurchase
Indicator

Large
Repurchase
Indicator

0.010 ***
(0.003)-19.589 ***(0.003)-0.253 **(0.036)-13.721 **(0.030)0.011(0.486)-0.877 ***(<.001)
1.399 ***
(0.009)1.147 ***(<.001)0.129 ***(<.001)
0.632 ***
(0.003)0.017 ***(<.001)-19.809 ***(<.001)-0.409 ***(0.007)-11.633 *(0.084)0.162 ***(<.001)-1.748 ***(<.001)2.836 ***
(0.002)
1.042 ***(<.001)0.128 ***(<.001)0.928 ***
(0.001)0.015 ***
(0.002)-23.001 ***(<.001)-0.438 **(0.017)-13.237(0.181)-0.038 **(0.019)-0.994 ***(<.001)
1.527 ***
(0.008)1.086 ***(<.001)0.231 ***(<.001)0.235(0.310)0.011 ***
(0.001)-19.398 ***(0.009)-0.255 **(0.026)-11.576 **(0.019)-0.034 *(0.085)-0.677 ***(<.001)
1.170 **
(0.029)0.985 ***(<.001)
0.094 ***
(0.003)0.748 ***
(0.002)0.017 ***(<.001)-26.127 ***(<.001)-0.424 ***(0.004)-10.081(0.145)0.077 ***(<.001)-1.266 ***(<.001)2.292 ***
(0.004)0.866 ***(<.001)0.090 ***
(0.002)
1.041 ***(<.001)

18,0370.181

18,0370.202

18,0370.257

12,7390.136

12,7390.151

47

Table 9
Governance-Risk Relation and Propensity to Initiate DividendThis table reports the logit regression results on whether or not a firm initiates
dividend. The dependent variable Initiator is equal to one for dividend-initiating
firms and zero otherwise. The sample consists of 6,704 firm-years where the firm is
not a payer in the last five calendar years and has positve earnings. We require
the data being available from RiskMetrics/ISS Governance Rating, CRSP,Standard and Poor's COMPUSTAT and Thomson-Reuters Institutional
Ownership. Column (1), (2), and (3) reports the results with year fixed effect, withindustry-year fixed effect and with firm-fixed effect correspondingly. P-values arereported in parentheses below each coefficient. Variables are defined in the
appendix. ***, **, * denote statistical significance at the 1%, 5%, and 10% level,
respectively.

Dependent Variable
ICGQ
Idiosyncratic Risk
ICGQ*Idiosyncratic Risk
Systematic Risk

(1)

(2)

(3)

0.008

0.012

0.031 *

(0.258)(0.130)(0.063)-20.256-13.398

1.646(0.172)(0.363)(0.963)-0.577 **-0.595 **-1.408 **(0.037)(0.032)(0.027)

0.428-16.735

44.397(0.978)Market-to-book-0.257(0.339)***(0.002)
Asset GrowthProfitability
NYSE Percentile(0.486)-0.3000.077(0.067)(0.276)(0.849)6.255 ***

5.397 ***

-1.609(<.001)(0.001)(0.702)-0.5271.161
0.258(0.021)

TE/TA-0.179(0.037)****(0.002)
RE/TE-0.176(0.155)
**

1.414

***

(<.001)**0.233-0.906(0.699)**(0.039)5.567 ***(<.001)

**

0.290

0.162

0.856

(0.671)(0.036)(0.904)

Fixed Effects

Year

Ind&Year

Firm

N

6,704

6,704

6,704

2

0.088

0.095

0.179

R

48

Figure 1
Idiosyncratic Risk of Firms Leading up to the Initiation Event
This chart depicts the dividend initiating firms' mean (the solid line) and median (the dashline) idiosyncractic risk five years prior to the dividend initiation. The sample consist of 214
dividend initiation events from 2003 to 2009 of firms for which return data (used in measuringidiosyncratic risk) is available for all five years prior to the event and for which data is alsoavailable from RiskMetrics/ISS Governance Rating, CRSP, and Standard and Poor's
COMPUSTAT. Year t is the year of initiation, year t-1 is the year immediately prior, and so on.
median Idiosyncratic Risk

mean Idiosyncratic Risk
4.00%
3.50%
3.00%
2.50%
Idiosyncratic
2.00%
Risk
1.50%
1.00%
0.50%
0.00%
t-5

t-4

t-3

49

t-2

t-1

t

Figure 2
Dividend Initiation Event and Its AftermathThis bar chart depicts the numbers of dividend initiation and probabilities of omitting or cutting
dividend within five years after the initiation separately for subsamples of firms categorised bydiffering levels idiosyncratic risk and governance index. There are 223 dividend initiation eventsfrom 2003 to 2009 for which data is available from RiskMetrics/ISS Governance Rating, CRSP,and Standard and Poor's COMPUSTAT. The four subsamples have above and below medianvalues of idiosyncratic volatility and governance index within each industry year for the full sample
of 18,047 firm-years.
# of initiation
120

Prob. Omission or cut
45%

42%

105

40%

100
31%
80
60
40

35%
30%
25%

51
15%

20%
14%

34

33

15%
10%

20

5%

0

0%
Low Risk & Weak
GovernanceHigh Risk & Weak
Governance

Low Risk & Strong
Governance

50

High Risk & Strong
Governance