Analyzing the Effect of Dividends on Default Probability According to Signaling and Agency Theories

Document Type : Research Paper

Authors

1 Ph. D Candidate, Department of Management, Faculty of Administrative Sciences and Economics, University of Isfahan, Isfahan, Iran.

2 Associate Prof., Department of Management, Faculty of Administrative Sciences and Economics, University of Isfahan, Isfahan, Iran.

3 Assistant Prof., Department of Mathematics, Institute for Advanced Studies in Basic Sciences (IASBS), Zanjan, Iran.

10.22059/frj.2023.352275.1007419

Abstract

Objective
The probability of default is one factor that determines the cost of capital due to its role in credit risk. Dividend as a sign of cash flow or as a sign of ownership of wealth is one of the factors affecting the probability of default. There are two theories of dividend signaling theory and agency theory regarding the effect of dividends on credit risk. The cash profit signaling theory expresses the management’s confidence in the company’s future cash flows and causes market participants to calculate the company’s assets as high and the company’s asset volatility as low, thus reducing information asymmetry, it causes the probability of default calculated by market decreases and there is a negative relationship between dividend and estimated default probability. Conversely, agency theory posits that cash dividends decrease the company’s assets and increase the debt ratio, and this increases the risk of debtholders and the acquisition of their wealth by shareholders, and the conflict of interests between shareholders and debtholders. Therefore, it causes a positive relationship between dividends and estimated default probability. This article aims to examine the relationship between dividends and the probability of default, exploring its alignment with both dividends signaling theory and agency theory.
 
 
 
Methods
In this article, Geske’s method, which is an extension of Merton’s method, is used to calculate the probability of default. Subsequently, an unbalanced nonlinear regression is applied to investigate the quadratic relationship between cash interest and the probability of default during the years 2001-2021. The statistical population comprises companies listed on the Tehran Stock Exchange and the Iran Farabourse, with the exclusion of financial companies, those with more than six months of consecutive trading suspension, and those that have experienced trading suspension for more than twenty percent of their market lifespan. Ultimately, 462 companies meet these criteria and are included in the study.
 
Results
The findings suggest a quadratic U-shaped nonlinear relationship between dividends and the probability of default. Initially, as dividends increase, the probability of default decreases with a diminishing slope. However, beyond a certain threshold of dividend increase, the probability of default starts to rise with an increasing slope.
 
Conclusion
According to the theory of dividend signaling, as dividends increase up to a certain threshold, the company's future earnings outlook is positively evaluated. The market, in turn, assesses the company's assets at a higher value with lower asset volatility. This positive assessment, attributed to the reduction of information asymmetry, leads to a decrease in the market's estimated probability of default. Once the dividend surpasses this threshold, it becomes advantageous for shareholders. This is due to a reduction in the company's assets, an elevation in the debt ratio, an increased risk for debtholders, and the potential transfer of the company's assets, ultimately leading to the appropriation of wealth from debtholders by shareholders. Therefore, the probability of default increases, which is in accordance with the empirical findings of the quadratic U-shaped relationship between dividend and the probability of default.

Keywords

Main Subjects

References

 
Acharya, V.V. & Carpenter, J. N. (2002). Corporate bond valuation and hedging with stochastic interest rates and endogenous bankruptcy. The Review of Financial Studies, 15(5), 1355-1383.
Acharya, V.V., Gujral, I., Kulkarni, N. & Shin, H. S. (2011). Dividends and bank capital in the financial crisis of 2007-2009. Working Paper, No. 16896. National Bureau of Economic Research.
Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609.
Avramov, D., Jostova, G., & Philipov, A. (2007). Understanding changes in corporate credit spreads. Financial Analysts Journal, 63(2), 90-105.
Bhattacharya, S. (1979). Imperfect information, dividend policy, and "the bird in the hand" fallacy. The Bell Journal of Economics, 259-270.
Black, F. (1976). The dividend puzzles. The Journal of Portfolio Management, 2(2), 5-8.
Collin-Dufresn, P., Goldstein, R. S. & Martin, J. S. (2001). The determinants of credit spread changes. The Journal of Finance, 56(6), 2177-2207.
Delianedis, G. & Geske, R. (2001). The components of corporate credit spreads: Default, recovery, tax, jumps, liquidity, and market factors. Working Paper, UCLA.
Dhillon, U. S. & Johnson, H. (1994). The effect of dividend changes on stock and bond prices. The Journal of finance, 49(1), 281-289.
Durand, D. (1959). The cost of capital, corporation finance, and the theory of investment: comment. The American Economic Review, 49(4), 639-655.
Elton, E. J., Gruber, M. J., Agrawal, D. & Mann, C. (2001). Explaining the rate spread on corporate bonds. The Journal of Finance, 56(1), 247-277.
Floyd, E., Li, N. & Skinner, D. J. (2015). Payout policy through the financial crisis: The growth of repurchases and the resilience of dividends. Journal of Financial Economics, 118(2), 299-316.
Geske, R. (1977). The valuation of corporate liabilities as compound options. Journal of Financial and Quantitative Analysis, 12(4), 541-552.
Geske, R. (1979). The valuation of compound options. Journal of Financial Economics, 7(1), 63-81.
Hersugondo, H., Handriani, E. & Imam Ghozali, D. (2021) Investment and Leverage Policy Based on Agency Theory in Indonesia Manufacturing Companies, International Journal of Management, 11(12).
Handjinicolaou, G. & Kalay, A. (1984). Wealth redistributions or changes in firm value: An analysis of returns to bondholders and stockholders around dividend announcements. Journal of Financial Economics, 13(1), 35-63.
Hussain, A. & Akbar, M. (2022). Dividend policy and earnings management: Do agency problem and financing constraints matter? Borsa Istanbul Review, 22(5), 839-853.
Jayaraman, N. & Shastri, K. (1988). The valuation impacts of specially designated dividends. Journal of Financial and Quantitative Analysis, 23(3), 301-312.
Jensen, M. C., & Meckling, W. H. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305-360.
John, K. & Williams, J. (1985). Dividends, dilution, and taxes: A signalling equilibrium. The Journal of Finance, 40(4), 1053-1070.
Kaplan, Z., & Pérez-Cavazos, G. (2022). Investment as the opportunity cost of dividend signaling. The Accounting Review, 97(3), 279-308.
Kim, I. J., Ramaswamy, K. & Sundaresan, S. (1993). Does default risk in coupons affect the valuation of corporate bonds? Contingent claims model. Financial management, 117-131.
Litterman, R. & Scheinkman, J. (1991). Common factors affecting bond returns. Journal of Fixed Income, 1(1), 54-61.
Longstaff, F. A. & Schwartz, E. S. (1995). A simple approach to valuing risky fixed and floating rate debt. The Journal of Finance, 50(3), 789-819.
Mathur, I., Singh, M., Nejadmalayeri, A. & Jiraporn, P. (2013). How do bond investors perceive dividend payouts. Research in International Business and Finance, 27(1), 92-105.
Merton, R. C. (1974). On the pricing of corporate debt: The risk structure of interest rates. The Journal of finance, 29(2), 449-470.
Miller, M. H., & Rock, K. (1985). Dividend policy under asymmetric information. The Journal of finance, 40(4), 1031-1051.
Modigliani, F. & Miller, M. H. (1963). Corporate income taxes and the cost of capital: a correction. The American economic review, 53(3), 433-443.
Mohammadzadeh, P., Jalili Marand, A. (2012). Prediction of Bankruptcy Using Mixed Logit Model. Journal of Economic Modeling Research, 2(8), 1-21. (in Persian)
Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147-175.
Nie, J. & Yin, L. (2022). Do dividends signal safety? Evidence from China. International Review of Financial Analysis, 82, 102123.
Ogden, J. P., Jen, F. C. & O'Connor, P. F. (2003). Advanced Corporate Finance: Policies and Strategies. Pearson College Division.
Scholes, M., & Black, F. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81(3), 637-654
Shan, Y. G., Wu, W., & Zhang, L. (2022). Do Overpaid Dividends Drive Stock Price Crash Risk? Evidence from China. SSRN, Available at: https://papers.ssrn.com/sol3/Delivery.cfm/98f93201-d7c2-44ef-b964-e2c996b068c9-MECA.pdf?abstractid=4149258&mirid=1
Stockhammer, E. (2010). Financialization and the global economy. Political Economy Research Institute Working Paper, 242(40), 1-17.
Wang, G., Wang, Y., Yang, D., & Cheng, L. (2022). Dividend commitment and bond yields: An examination of wealth transfer effects. Finance Research Letters, 102719.
Wei, X., Truong, C. & Do, V. (2020). When are dividend increases bad for corporate bonds. Accounting & Finance, 60(2), 1295-1326.
Woolridge, J. R. (1983). Dividend changes and security prices. The Journal of Finance, 38(5), 1607-1615.
Financial Research Journal
Volume 26, Issue 1
2024
Pages 26-53

Files

Share

How to cite

Statistics