Management stock compensation : what is the effect on the dividend payout policy?

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Bachelor thesis

Management stock

compensation

What is the effect on the dividend payout policy?

Name:

Eline Brouwer

Student number:

10415963

Programme:

Economie en Bedrijfskunde

Track:

Financiering en Organisatie

Supervisor:

Dhr. P.V. Trietsch

Date:

25 June 2015

Abstract

This thesis is about the effect of management stock compensation on the dividend payout policy of the company. This effect is measured using data of companies that were in the S&P 500 during the years 2003 – 2007. It appears that management stock compensation leads to a reduction of the dividend payout of the company. This is not in line with the expectation that management stock compensation leads to higher dividends. A possible explanation of the negative effect could be that management stock compensation and dividends could be seen as substitutes to reduce the agency problem. This thesis also includes a discussion about using dividends as a measure of the agency problem.

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Verklaring eigen werk

Hierbij verklaar ik, Eline Brouwer, dat ik deze scriptie zelf geschreven heb en dat ik de volledige verantwoordelijkheid op me neem voor de inhoud ervan.

Ik bevestig dat de tekst en het werk dat in deze scriptie gepresenteerd wordt origineel is en dat ik geen gebruik heb gemaakt van andere bronnen dan die welke in de tekst en in de referenties worden genoemd.

De Faculteit Economie en Bedrijfskunde is alleen

verantwoordelijk voor de begeleiding tot het inleveren van de scriptie, niet voor de inhoud.

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1. Introduction

At large publicly traded companies the ownership and management of the company is mostly separated. This separation of ownership en management gives rise to the so called agency problem (Dyl, 1988). The agency problem is a problem of alignment between the interests of the owners and the management of the company. The managers of the company may pursue their own interest instead of that of the shareholders. This agency problem that many publicly traded firms face could be reduced by compensating the managers with shares of the company, so that the interests of shareholders and managers are better aligned (Fenn & Liang, 2001). Consequently, the question arises what the effects of management stock compensation are. In particular, it is questioned if it has an effect on the dividend payout policy of the firm. The dividend payout of the firm is something that shareholders are concerned about, because dividends increase the wealth of shareholders (Asquith & Mullins Jr., 1983). Also it will be discussed if dividends could be used as a

measure of the agency problem. These are questions that will be investigated in this thesis. There exists a lot of literature about management stock compensation, but there is only one that is in line with the research of this thesis. That is the research of Fenn & Liang (2001). They found that management stock compensation comes together with higher dividend payout at companies that face high agency costs. However, dividend payout and management stock compensation could also be seen as substitutes to reduce the agency problem, as stated by Schooley & Barney Jr. (1994) and Rozeff (1982).

In this thesis the conflicting findings of the existing literature will be taken into account to come to a general conclusion. A new insight will be introduced in this thesis, because there will be a discussion if it is possible to say something about the degree of the agency problem by looking at the effect on the dividend payout policy of the company.

The effect of management stock compensation on the dividend payout policy of the company is investigated in this thesis. The research question that will be answered is: ‘Does

management stock compensation have an effect on the dividend payout policy?’ The

expectation is that management stock compensation comes together with higher dividend payouts, based on the results of the research of Fenn & Liang (2001). Therefore the

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To be able to give an answer to the research question, the following sub questions are formulated:

1) Which other explanatory variables should be included in the research? 2) How is the dividend payout policy of the company measured?

3) How are the other explanatory variables measured?

4) What are the results of the regressions of management stock compensation on the dividend payout?

5) Is it possible to say something about the degree of the agency problem when looking at the effect on the dividend payout policy?

The research question will be answered by doing a multiple regression in Stata. The data consists of dividends and share repurchases from publicly traded companies that were in the S&P 500 during the years 2003 – 2007. This data and the data about the firm

characteristics are retrieved from COMPUSTAT. The data about management stock

compensation is obtained from Execucomp. The data from these two databases is merged, so that it could be used to do a regression in Stata. The remaining sample that is left after deleting the observations that contained missing values, consists of 775 observations.

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2. Related literature

In this chapter a summary will be given about the existing literature on the topics that are related to management stock compensation and dividend policy. The most important research that is taken into account in this thesis is the research of Fenn & Liang (2001). In general, that research is the only one that is in line with the research of this thesis. First, a brief explanation of ways to distribute cash to shareholders is given. Further, the first sub question is answered, by discussing the determinants of the dividend payout policy. Finally, some remarkable results of earlier studies are discussed. These results could have an effect on the research results of this thesis.

2.1 Ways to distribute cash to shareholders

According to Barclay and Smith (1988) the two major ways to distribute cash to shareholders are cash dividends and open market repurchases. Therefore, the dividends that are taken into account in this thesis are cash dividends and share repurchases. Share repurchases could be seen as a form of dividend payout, because it is also a way in which shareholders can earn money on their shares.

In a research of Grullon & Michaely (2002) the substitution from cash dividends to share repurchases is investigated. It appears that share repurchases experienced a major growth since 1980. In 1999 and 2000 industrial companies distributed more cash in the form of share repurchases than cash dividends. The major reason for this substitution is the tax advantage. The capital gains that are earned on share repurchases are taxed more favorable than the income that is earned on cash dividends (Grullon & Michaely, 2002).

2.2 Determinants of dividend payout policy

In this paragraph the determinants of the dividend payout policy of the company are described. These determinants will all be included in the model to predict the dividend payout policy. The main determinant that will be tested in this thesis is management stock compensation. The other variables could be seen as other explanatory variables that probably have an effect on the dividend payout policy.

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2.2.1 Management stock compensation

The research of Fenn & Liang (2001) is about managerial stock incentives and how it affects corporate payout policy. The main findings of the research are that management stock ownership leads to higher total payouts at companies that face high agency costs. Companies that face high agency costs are companies that have low management stock ownership and high free cash flow. However, at companies with low agency costs they did not find a relationship between management stock ownership and the dividend payout of the company.

When looking at the logical effect of management stock compensation, this

expectation also appears. It is reasonable to think that compensating managers with shares leads to higher dividend payouts. When managers have shares in the company, they are shareholders too. In that way, they should behave in line with the interests of shareholders. According to Asquith & Mullins Jr. (1983) dividends lead to an increase in the wealth of shareholders. Dividends could be seen as a signal to investors that the company is doing well, so it could lead to higher share prices (Asquith & Mullins Jr., 1983). Since dividends are valuable for shareholders, it is plausible to assume that managers will raise dividends when they own shares of the company.

2.2.2 Profitability

The first other explanatory variable that is considered is the profitability of the company. Denis and Osobov (2008) investigated the determinants of dividend policy. They found that firms that make high profits pay higher dividends than firms that make low profits. It seems that the profitability of the company is positively related to the dividend payout policy of the company (Denis & Osobov, 2008). The calculation that Denis and Osobov used to measure the profitability of the company is the return on assets.

2.2.3 Amount of debt

The amount of debt can have an effect on the dividend payout policy. When a company has a high amount of debt it faces financial costs like interest and loan repayments. On top of that they may face financial distress costs (Fenn & Liang, 2001). Consequently, when they have to pay high interest and loan repayments they have less cash left to distribute to shareholders. According to Fenn & Liang (2001) that is the reason that companies that have high amounts of debt pay out lower dividends.

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2.2.4 Firm size

According to Hu & Kumar (2004) firm size is a determinant of dividend payout policy. They expect that a greater firm size has a positive effect on the dividend payout of the company. Often, small firms are in a ‘growing phase’, so they invest their cash flow in new projects and do not have much cash left to distribute to shareholders. From the results of Hu & Kumar (2004) it appears that firm size is significant at the 1% level. Firm size has a positive effect on the dividend payout policy of the company. On top of that, Denis & Osobov (2008) also found that firm size is a determinant of dividend payout policy. Their results show that larger companies are more likely to pay high dividends than small companies. Denis & Osobov (2008) used the book value of assets to measure the size of the company. Assets are a good representation of the size of the company, because it includes all the properties and

resources owned to produce value to the company.

2.2.5 Free cash flow

Free cash flow is the cash flow of the company that is left after the investments with a positive net present value are funded (Jensen, 1986). According to Fenn & Liang (2001) companies that have a high level of free cash flow will have higher dividend payouts than companies that have low levels of free cash flow.

2.3 Management stock options

Compensating managers with options of shares seems to have an opposite effect compared to compensating managers with shares. It appeared there is a negative relationship between management stock options and the dividend payout policy (Fenn & Liang, 2001). The effect of stock options is not something that is considered in this thesis, but it is important to mention it because it can have an opposite effect in comparison to shares. So, the effect of compensating managers with shares does not have the same effect as compensating managers with options of shares. This negative effect of stock option compensation on the dividend payout policy also appeared from the paper of Lambert, Lanen & Larcker (1989). They say that stock option compensation reduces dividends, because options are often not dividend-protected. So the payment of dividends will lead to a reduction of the value of the option. That is not profitable for the manager who is holding the options, so he will decide not to pay out dividends (Lambert, Lanen, & Larcker, 1989).

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2.4 Managerial entrenchment

Another paper that is about the topic of this thesis is from Hu & Kumar (2004). They investigated the effect of various elements of managerial entrenchment on the dividend payout policy of the firm. Managerial entrenchment is the extent to which managers have so much power to make decisions, so that they can pursue their own interests instead of that of shareholders. They do not get enough discipline from the control mechanisms and corporate governance structure to take decisions that are in line with the interests of shareholders (Berger, Ofek, & Yermack, 1997)

From the empirical results of Hu & Kumar (2004) it appears that managerial

entrenchment has a significant effect on the payout policy of the company. They included many explanatory variables in their model, like: firm size, firm age, CEO stock ownership, executive stock options and many more. Berger, Ofek and Yermack (1997) found that managerial entrenchment has a significant effect on the leverage of the firm. Managers rather avoid debt, so that they are imposed to less risk.

2.5 Management stock compensation and dividend policy as substitutes

Dividend payout and management stock compensation could be seen as substitutes to reduce the agency problem. This phenomenon is discussed by Rozeff (1982) and Schooley & Barney Jr. (1994). They state that when CEO ownership is low, an increase in the ownership of shares leads to a reduction of the agency problem. Since the agency problem is reduced by giving shares to the managers, dividends are not needed anymore to reduce the agency problem further. As a consequence dividends decrease (Schooley & Barney Jr., 1994). Dividends could be seen as a way to reduce the agency problem, because to be able to pay larger dividends external equity will have to be raised. When new equity is raised, the managers are monitored by bankers, the securities and exchange commissions and other commissions. Managers will behave more in line with the interests of the shareholders because they are monitored now (Crutchley & Hansen, 1989).

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3. Data description and model setup

In this chapter the second and the third sub question will be answered. First, the data that is used is explained. After that, the measure of the dividend payout policy of the company is discussed. Following, there will be an explanation of the way the other explanatory variables are measured. Finally, the multiple regression models that are used to measure the effect of management stock compensation on the dividend payout policy of the firm are described.

3.1 The data

The data consists of companies that were in the S&P 500 during the years 2003 – 2007. These years are chosen, because this was the period before the financial crisis in 2008. In the financial crisis a lot of companies paid out lower dividends, because of the financial

difficulties during that time. Campello, Graham & Harvey (2010) found economically and statistically significant evidence that companies that were financially constrained paid out lower dividends during the crisis. Since it is not clear to say when the financial crisis was over, the period before the crisis is taken into account in this thesis. In this way, the research results will not be affected by the influence of the crisis.

After deleting all the observations that contained missing values, a sample of 775 observations is left. Many observations were deleted, because a lot of companies did not report the percentage of shares owned by managers. The remaining observations are checked, but there were no strange numbers in the sample (for a scatterplot see the appendix). The sources of the data are COMPUSTAT and Execucomp. The data of these two databases is merged in Excel, so that the data is matched to the corresponding company and year.

3.2 The dividend payout variables

The dividend payout variables are the dependent variables in this research. The effect of the other variables on the dividend payout of the firm is measured. For the cash dividends the item cash dividends (cash flow) is used from COMPUSTAT for the years 2003 – 2007. The companies that have missing values for cash dividends were deleted from the sample. The measure of the cash dividend payout is calculated using the following formula:

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( )

The market value of stock is also obtained from COMPUSTAT, but this variable is not available for all the observations. That is why the market value of stock is computed using the formula below.

( ) ( )

By comparing the calculated market value of stock with the market value of stock that is available from COMPUSTAT it appears these two variables are nearly the same. The

observations with missing values for the close price or shares outstanding are deleted from the sample. It appears the average cash dividend payout of the companies in the sample is 1.25%.

For the open market repurchases the item purchase of common and preferred stock from COMPUSTAT is used. Just like the cash dividend payout, the share repurchase payout is measured by dividing the total amount of share repurchases by the market value of stock. It is measured this way, so that it easily could be compared to the cash dividend payout. The calculation is shown in formula three.

( )

The average share repurchase payout is 3.53%. Finally, the total payout of the company is measured by adding the percentage share repurchase payout to the percentage cash dividend payout. The average total payout is 4.78%.

3.3 The management stock compensation variable

The most important independent variable of this research is the amount of stock held by the management of the firm. The data about management stock compensation is obtained from Execucomp, because this data is not available on COMPUSTAT. Because there are two different databases used, the data of Execucomp is merged with the data of COMPUSTAT. In

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that way the percentage of stock held by the managers is added to the corresponding company. From Execucomp the item percentage of total shares owned (options excluded) is used. Execucomp includes the shares owned by 9 executives per company per year. The number of executives differed per company. Most companies reported 5 managers that own shares. All the percentages of shares owned by managers per company per year are added up. All the managers that were reported are taken into account, so not only the CEO, because they all make important decisions for the company. There were a lot of missing values, it could be that these values were not registered properly by the company. That is why all the observations that contained missing values are deleted from the sample.

The expectation is that compensating the managers of a firm with shares has a positive effect on the dividend payout policy of the firm. This expectation is based on the outcome of the research of Fenn & Liang (2001). They found that compensating managers with shares comes together with higher dividends at companies that face high agency costs. Both cash dividend payout and share repurchase payout should be positively influenced by management stock compensation.

From these expectations based on the literature and logic, explained in the previous chapter, the hypotheses are:

These hypotheses are tested by looking at the effect on the total dividend payout of the company. The separate effects of cash dividend and share repurchase payout are only used to see if there is difference between them.

3.4 The other explanatory variables

The third sub question is ‘How are the other explanatory variables measured?’ This will be answered in this paragraph. The dividend payout policy of a company is not only determined by the amount of management stock compensation. There are other variables as well that will have an effect on the dividend payout policy. These variables should be included in the model, so that the model will give a realistic result.

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3.4.1 Profitability

To measure the profitability of the company the return on assets is used. Denis and Osobov also used this measure to calculate the profitability of the company. The way the return on assets is calculated is shown in formula four.

( ) ( )

( )

The total assets and the earnings before interest and taxes (EBIT) are obtained from COMPUSTAT. These variables did have a few missing values, so these observations are deleted from the sample. As mentioned earlier, Denis and Osobov (2008) found that companies that make higher profits pay out higher dividends. This is plausible to assume, because companies that make more profits have more money to spend, so this money could be used to distribute to shareholders. So the hypotheses for the profitability of the company are:

3.4.2 Amount of debt

The second other explanatory variable that is considered is the amount of debt that the company has. The degree of debt is measured using the debt ratio, which is shown below.

( )

For total debt the item total long-term debt from COMPUSTAT is used. For these variables there were no missing values. The expectation, based on the results of the research of Fenn & Liang (2001), is that a higher amount of debt leads to a lower dividend payout. The hypotheses for the amount of debt are:

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3.4.3 Firm size

The third other explanatory variable is firm size. In this thesis firm size is measured using the amount of assets of the company, just like Denis and Osobov did. Based on the results of the researches of Hu & Kumar (2004) and Denis & Osobov (2008), the expectation is that a greater firm size leads to higher dividend payouts. The hypotheses for firm size are:

3.4.4 Free cash flow

The fourth and last other explanatory variable is free cash flow. Free cash flow is measured using the items net cash flow from operating activities and capital expenditures from COMPUSTAT. The following formula is used to calculate free cash flow:

( )

The expectation is that a higher level of free cash flow leads to higher dividend payouts, based on the results of Fenn & Liang (2001). Therefore, the hypotheses for free cash flow are:

The expected effects of all the variables are summarized in the figure below.

Figure 1: Expected effects of the variables

Variable Expected effect on dividend payout

Shares owned by managers ↑

Profitability ↑

Amount of debt ↓

Firm size ↑

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3.5 The multiple regression models

The effect of management stock compensation on cash dividends and share repurchases will be measured separately and in total. So there will be three regressions. One regression on the effect on cash dividends, one on the effect on share repurchases and one on the total effect of cash dividends plus share repurchases. In this way it possible to compare these effects and see if there is a difference between them. The hypotheses will be tested using the regression on the total dividend payout of the company, because this includes both dividend payout methods. The three regressions are shown below.

These three regressions are carried out in Stata, using a sample of 775 observations. The results are discussed in the chapter results and analysis.

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4. Results and analysis

In this chapter the results of the regression analysis are discussed. The fourth sub question will be answered: ‘What are the results of the regressions of management stock

compensation on the dividend payout?’ The answer will be formulated by looking at the

results of the regression on the total payout, cash payout and repurchase payout. First the summary statistics of the research will be given. Followed by a discussion of the correlation between the explanatory variables. Then the effect on the total payout of the company will be discussed. After that the effect on cash dividend payout and share repurchase payout will be discussed separately. Also, there will be a discussion about the unexpected negative effect of management stock compensation. Finally, the last sub question will be answered:

‘Is it possible to say something about the degree of the agency problem when looking at the effect on the dividend payout policy?’

4.1 Summary statistics

The sample that is left after deleting all the missing values consists of 775 observations. In table 1 the summary statistics are given for all the variables that are measured. The average total dividend payout for the companies in the sample is 4.78%. For cash dividend payout and share repurchase payout the averages are 1.25% and 3.53%. On average, the companies in the sample pay out more dividends in the form of share repurchases than in the form of cash dividends. This result is in line with the research results of Grullon & Michealy (2002), as discussed in the literature chapter. The dividend payouts are shown in the chart below.

Chart 1: Dividend payout percentages

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% Percentage cash dividend payout Percentage share repurchase payout Percentage total dividend payout

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The average percentage shares owned by managers is 4.23%. The percentages vary between 0.014% to 59.7%.

From table 1 it appears that the companies in the sample are very different in size and debt ratio. The size of the companies varies between 285 million to 1,060,505 million. The debt ratio varies between 0% to 96%. Because companies of different sizes and different amounts of debt are in the sample the results could be generalized to companies of all sizes. The same applies to the free cash flow of the companies.

Table 1: Summary statistics

Variable Mean Standard

deviation

Minimum Maximum Number of

observations Dependent variables

Percentage total dividend payout

4.782% 4.612% 0.005% 28.335% 775

Percentage cash dividend payout 1.252% 1.540% 0% 11.505% 775 Percentage share repurchase payout 3.530% 4.408% 0% 28.051% 775 Independent variables

Shares owned by managers 4.230% 6.714% 0.014% 59.7% 775

Return on assets (ROA) 11.174% 8.112% -30.368% 58.800% 775

Debt ratio 17.526% 15.861% 0% 96.284% 775

Firm size 22,869 72,494 286 1,060,505 775

Free cash flow (FCF) 562 3,344 -46,561 29,529 775

The numbers for firm size and free cash flow are in millions.

4.2 Correlation between explanatory variables

In table 2 the correlation matrix is shown. There is no high degree of multicollinearity between the explanatory variables, because the largest correlation that appears from the table is -0.2026 between firm size and return on assets. This correlation is not that large, since it is closer to zero than to one. This means that these two variables are not highly

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correlated. A possible explanation for the little correlation between firm size and return on assets could be that assets are used to measure firm size and it is also used to calculate return on assets. All the other variables are less correlated than firm size and assets, so multicollinearity does not seem to be problem.

Table 2: Correlation matrix

Correlation Shares owned (%)

Return on assets (ROA)

Debt ratio Firm size Free cash flow (FCF)

Shares owned (%) 1.0000

Return on assets (ROA) -0.0843 1.0000

Debt ratio -0.0109 -0.1828 1.0000

Firm size -0.0254 -0.2026 -0.0060 1.0000

Free cash flow (FCF) 0.0139 0.0223 -0.0731 0.0571 1.0000

4.3 Effect on the total payout of the company

In table 3 (see page 18) the results are shown of the linear regression on the total dividend

payout of the company, including all the explanatory variables. It appears the = 0.0365 is

low, so maybe the explanatory variables are not good in explaining the dependent variable. The percentage of total shares owned by the managers seems to be significant at the 10% level. So at the 10% level the percentage total shares owned by the managers of the firm has an effect on the total dividend payout of the company. However, the expectation that the dividend payout will rise is not true. The coefficient is negative, so management stock compensation comes together with a lower level of total dividend payout.

The debt ratio is significant at the 1% level, so it does have an effect on the dividend payout policy of the company. Again the expectation stated earlier is not true. The debt ratio appears to have a positive effect on the dividend payout as compared to the expectation that it would have a negative effect on the dividend policy. This is a surprising result. Firm size is significant at the 5% level, so this variable also has an effect on the dividend policy. The hypothesis that a greater firm size leads to a higher dividend payout seems to be true, because the coefficient has a positive value. However, firm size does not have a great impact on the dividend payout policy, because the coefficient is 0.0000000552 which is low. In this

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regression, free cash flow is not significant at all the significance levels. The same applies to the return on assets.

4.4 Effect on the cash dividend payout of the company

The results of the regression on cash dividend payout are also shown in table 3. These results are different from the results of the effect on the total dividend payout. The return on assets and the debt ratio are both statistically significant at the 1% level, but the

hypotheses for both these variables are not true. Debt ratio has a positive effect on cash dividend and return on assets has a negative effect on cash dividend. The expectations are the other way around. Firm size, free cash flow and total shares owned by the managers are

all not statistically significant. However, the = 0.1988 which means that this model is

better at explaining the dependent variable than the model on the total payout of the company.

4.5 Effect on the share repurchase payout of the company

In table 3 the results of the effect on the share repurchase payout are also shown. The =

0.0205 is again low. When the results of the effect on share repurchases are compared to cash dividends, it appears that the variables are better in explaining cash dividends than

share repurchases. That is because the for cash dividends is higher than for share

repurchases. Another difference is the significance of the shares owned by the managers. From table 3 we see that the percentage total shares owned by managers is significant at the 5% level. As with the effect on total payout, it is not in line with the hypotheses that are formulated. The variable has a negative effect on share repurchase payout. Firm size and return on assets are both significant at the 5% level. The results are both in line with the hypotheses about these variables, since both variables have a positive effect on share repurchase payout. Debt ratio and free cash flow are both not significant, so they do not have an effect on the repurchase payout of the company.

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Table 3: Results of the regressions

Dependent variable Percentage total

dividend payout = 0.0365 Percentage cash dividend payout = 0.1988 Percentage share repurchase payout = 0.0205 Independent variables

Shares owned by managers -0.046 0.024 (0.063)* Expectation: positive effect 0.007 0.007 (0.317) -0.053 0.023 (0.025)**

Return on assets (ROA) 0.019 0.021 (0.374) Expectation: positive effect -0.024 0.006 (0.000)*** 0.042 0.020 (0.037)** Debt ratio 0.046 0.011 (0.000)*** Expectation: negative effect 0.039 0.003 (0.000)*** 0.007 0.010 (0.519) Firm size 0.000 0.000 (0.017)** Expectation: positive effect -0.000 0.000 (0.730) 0.000 0.000 (0.010)**

Free cash flow (FCF) -0.000 0.000 (0.507) Expectation: positive effect 0.000 0.000 (0.756) -0.000 0.000 (0.432)

The first number represents the coefficient. The second number is the standard error. The number in parentheses is the p-value.

* statistically significant at the 10% level ** statistically significant at the 5% level *** statistically significant at the 1% level

The regression on the percentage total dividend payout is used to test the hypotheses of this research, because it includes both dividend methods.

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4.6 Negative effect of management stock compensation

When the expectation of the effect of total shares owned on the dividend payout policy of the firm is compared to the results, it appears they are not the same. The hypotheses mentioned earlier are:

For the effect on total dividend payout, management stock compensation is significant at the 10% level, but is has a negative effect. The cause of this negative effect could be that management stock compensation and dividends could be seen as substitutes, as mentioned in the chapter related literature (Schooley & Barney Jr., 1994). As this substitution

phenomenon holds, management stock compensation comes together with lower dividend payout. This is because management stock compensation already reduced the agency problem, so dividends are not needed anymore to reduce the agency problem. When focusing on the research results of this regression, it could be stated that this gives some evidence that the substitution phenomenon holds.

4.7 Dividends as a measure of the agency problem

There is no general measure to measure the degree of the agency problem of a company. In the last sub question is it questioned if dividends could be used as a measure of the agency problem. A possible explanation for using dividends as a measure could be the following. The dividend payout policy of the company is something that shareholders are concerned about. As mentioned earlier, dividends lead to an increase in the wealth of shareholders (Asquith & Mullins Jr., 1983). When managers are compensated with shares, they are not only managers anymore, but they also are owner/shareholders of the company. Because the managers are shareholders too now, it is straightforward that they want the same thing as the other shareholders. A plausible result would be that the managers use the companies’ cash flow to pay dividends to the shareholders, instead of using it in a way it is only in the interests of the manager. If giving shares to managers leads to higher dividend payouts, then the agency problem is reduced because the interests of shareholders and managers are better aligned. In this way it seems plausible to use the dividend payout to measure the agency problem of the company.

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However, the substitution phenomenon could also play a role (Schooley & Barney Jr., 1994). When management stock compensation and dividends are indeed substitutes, then the dividend payout does not seem to be a good way to measure the agency problem. That is because dividend is a tool to reduce the agency problem, so it is not possible to measure the agency problem with that tool. From this point of view, it is not plausible to use the dividend payout as a measure of the agency problem.

Since the answer to the last sub question seems to be no, there has to be another measure to accurately measure the agency problem. This topic should be further

investigated, so that a variable or a measure could be formulated that accurately measures the degree of the agency problem of the company.

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5. Conclusion

Management stock compensation is a way to reduce the agency problem of a company. However, management stock compensation could also have other effects on the policies of a company. This research focused on the effect of management stock compensation on the dividend payout policy. The main hypothesis that is tested in this thesis is: management stock compensation has a positive effect on the dividend payout policy of the company. On top of that, it is discussed whether dividends can be used to measure the agency problem of a company. According to Fenn & Liang (2001) management stock compensation comes together with higher dividend payouts at companies that face high agency costs.

The first other explanatory variable that is taken into account is profitability, which is measured by the return on assets. Second, the amount of debt is measured by calculating the debt ratio of the company. On top of that, firm size is taken into account by including the amount of assets in the model. The final other explanatory variable that is measured is free cash flow.

With all these variables in the model, it appears that management stock

compensation has a significant effect (10% level) on the total dividend payout policy of the company. However, it does not have the expected positive effect. Management stock compensation has a negative effect on the total dividend payout. A possible solution for this unexpected result is that management stock compensation and dividend payout could be seen as substitutes to reduce the agency problem, as stated by Schooley and Barney Jr. (1994). So when managers are compensated with shares, the agency problem is already reduced so that dividends are not needed anymore to serve as a tool to further reduce the agency problem. Because of this substitution problem, it can be stated that dividends are not a reliable tool to measure the agency problem. That is because dividends itself are a tool to reduce the agency problem, so that it cannot be used to measure the agency problem. However, there should be more research to investigate if the substitution phenomenon really holds.

A weakness of this research that should be mentioned is that the is low, so the

variables included in this research are probably not good at explaining the variation in the dividends of the company. This should be kept in mind when reading the results, because it

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could be that they are not that reliable. The negative effect of management stock

compensation and the positive effect of the amount of debt could be influenced by that. However, a strength of the research is that different points of view of earlier studies are taken into account, to come to a general conclusion.

From the conclusion of this research a recommendation for future research could be formulated. In future research a measure or a variable should be formulated, so that the degree of the agency problem could accurately be measured. That is because the agency problem is a serious problem that many companies face. There is no general measure yet to measure this problem, so it is hard to measure the degree of the agency problem.

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6. Bibliography

Asquith, P., & Mullins Jr., D. (1983). The Impact of Initiating Dividend Payments on Shareholders' Wealth. The Journal of Business(Vol. 56, No. 1), 77-96.

Barclay, M., & Smith Jr., C. (1988). Cash Dividends versus Open-Market Repurchases. Journal

of Financial Economies(22), 61-82.

Berger, P., Ofek, E., & Yermack, D. (1997). Managerial Entrenchment and Capital Structure Decisions. The Journal of Finance(Vol. 52, No. 4), 1411-1438.

Campello, M., Graham, J., & Harvey, C. (2010). The real effects of financial constraints: Evidence from a financial crisis. Journal of Financial Economics, 470-487.

Crutchley, C., & Hansen, R. (1989). A Test of the Agency Theory of Managerial Ownership, Corporate Leverage, and Corporate Dividends. Financial Management(Vol. 18, No. 4), 36-46.

Denis, D., & Osobov, I. (2008). Why do firms pay dividends? International evidence on the determinants of dividend policy. Journal of Financial Economics(89), 62-82.

Dyl, E. (1988). Corporate Control and Management Compensation: Evidence on the Agency Problem. Managerial and Decision Economics(Vol. 9, No. 1), 21-25.

Fenn, G., & Liang, N. (2001). Corporate payout policy and managerial stock incentives.

Journal of Financial Economies(60), 45-72.

Grullon, G., & Michaely, R. (2002). Dividends, Share Repurchases, and the Substitution Hypothesis. The Journal of Finance(Vol. 57, No. 4), 1649-1684.

Hu, A., & Kumar, P. (2004). Managerial Entrenchment and Payout Policy. Journal of Financial

and Quantitative Analysis(Vol. 39, No. 4), 759-790.

Jensen, M. (1986). Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.

American Economic Review(Vol. 76, No. 2), 323-329.

Lambert, R., Lanen, W., & Larcker, D. (1989). Executive Stock Option Plans and Corporate Dividend Policy. The Journal of Financial and Quantitative Analysis(Vol. 24, No. 4), 409-425.

Rozeff, M. (1982). Growth, beta and agency costs as determinants of dividend payout ratios.

The Journal of Financial Research(Vol. 5, No. 3), 249-259.

Schooley, D., & Barney Jr., L. (1994). Using dividend policy and managerial ownership to reduce agency costs. The Journal of Financial Research(Vol.17, No. 3), 363-373.

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7. Appendix

Scatterplot 0 .1 .2 .3 Pe rce n ta g e t o ta l p a yo u t 0 .2 .4 .6

Management stock compensation : what is the effect on the dividend payout policy?

Bachelor thesis