AN EMPIRICAL INVESTIGATION OF ASYMMETRIC BEHAVIOR IN CORPORATE DIVIDEND POLICY

I. INTRODUCTION Among the most enduring concepts regarding corporate dividend policy is that corporate dividends respond asymmetrically to changes in corporate ability to pay. Asymmetric dividend policy would reveal itself in a ratchet effect, with corporations raising dividends more readily than they lower them. The concept first received attention in the pathbreaking work of Lintner [1956] and was addressed in the later works of Fama and Babiak [1968] and Marsh and Merton [1987]. Included as standard material in virtually every corporate finance textbook, the ratchet effect in dividend policy is rationalized on the basis of dividend signaling (whereby dividends embody information regarding the likely path of future earnings), and also upon resistance to dividend reductions by stockholders who rely on dividends as a source of income (known as the clientele effect). However, as we shall argue, the ratchet effect in aggregate dividends can also reflect the fact that, unlike earnings, dividends are bounded by a floor value of zero. The resulting ratchet effect is depicted as a relation quite similar to that propounded by Duesenberry [1948] in relation to consumption behavior. In spite of its importance, this piece of the dividend puzzle continues to lack systematic empirical confirmation. The literature essentially treats the issue of asymmetric dividend behavior as secondary and, contrary to the accepted view, generally dismisses it based upon limited empirical tests. For example, Lintner tests for a possible ratchet effect in dividends by including a constant term in his partial adjustment model but provides no information regarding whether the constant term is statistically significant. Fama and Babiak [1968] and Marsh and Merton [1987] address the issue more explicitly and conclude that there is no ratchet effect. However, given the non-stationarity of the underlying data, the results of these studies, which depend on conventional statistical methods, may not be reliable. In addition, the assumption of a constant long-run dividend payout ratio implies that numerator and denominator of this ratio are cointegrated in the sense defined by Engle and Granger [1987]. Of all the earlier studies on dividend behavior, only the work of Marsh and Merton considers explicitly the nonstationarity of the underlying data. However, Marsh and Merton's study was completed before Engel and Granger demonstrated the appropriate methods of dealing with cointegrated nonstationary time series upon which Marsh and Merton rely. Consequently, their work does not include the cointegration tests we would expect given the current state of the art. The present paper carries the analysis an additional step, utilizing methods now available to place the inferences on a firmer statistical foundation. We do so by performing the multivariate cointegration tests of Johansen and Juselius [1990], which Gonzalo [1994] has demonstrated are more powerful than Engle and Granger's methods. In contrast to the existing literature on dividend behavior, we focus primarily on the ratchet effect. Our statistical results provide evidence of asymmetry in dividend policy and suggest that corporations employ different adjustments in raising the dividend payout than in lowering it. More specifically, our findings suggest that the ratio is increased by adjusting dividend payments and decreased by holding dividends stable while earnings rise. To render our tests robust with respect to the underlying dividend model, we use three alternative measures of corporate ability to pay dividends: current earnings, cash flows, and stock prices. Although we employ each of these alternatives in our tests to demonstrate that the results are not dependent upon our choice of a particular determinant of dividends, we buttress our findings by estimating the explanatory power of the three alternatives and find that current earnings serve as the strongest proxy for ability to pay dividends, thus providing evidence that this model is superior the other two. …