A firm's performance and its dividend policy

Abstract

Dividend smoothing is a well-known empirical phenomenon which is extensively described and analyzed in the financial literature. However, the motivation behind this widespread firm's policy is not totally understood. The signaling approach is one model employed to explain dividend smoothing: managers reduce information asymmetry between firm insiders and other stakeholders by maintaining dividends stable, thus signaling their confidence in the firm's future performance. Nevertheless, results from empirical studies are incomplete and contradictory, and the full extent and implications of dividend smoothing as a signaling approach requires further research. In this regard, firms' performance as a factor that influences dividend smoothing is not commonly studied. The goal of this dissertation is to fulfill this gap, determining the existence of a relationship between firm's performance and dividend smoothing. Additionally, this dissertation also takes business cycle effects into consideration when investigating the association between performance and smoothing. The existing research dealing with business cycle and dividend policy shows that recessions can have an important impact on firms' dividend payout, including dividend smoothing. However, firms' performance as a factor that influences dividend smoothing during recession and recovery is not directly found in the literature. In order to achieve the goals above described, the firms were divided in three performance groups: high, intermediate, and low performance. Employing a database of U.S. firms during the period 1980 to 2014, five distinct sub-periods of recession and recovery were analyzed using the Lintner's smoothing regression, including recent developments in the model. The regression analysis was carried out with a panel data model with fixed-effects. The results contribute to the literature by establishing that firm's performance has indeed an impact on dividend smoothing: intermediate performance firms practice a higher level of dividend smoothing, contrasted to an erratic dividend policy adopted by low and high performance firms. Furthermore, firm's performance has also an impact on dividend smoothing during different phases of the business cycle: compared to low and high performance firms, fewer intermediate performance firms cut dividends during recession. This leads to a higher level of dividend smoothing practiced by intermediate firms, contrasted to a higher variation in dividend policy adopted by low and high performance firms. With these findings, this dissertation sheds light on the relationship between firm's type and dividend policy, particularly in circumstances where external macroeconomic shocks, not under the control of the firm, may affect the firm's value. In practical terms, the ability to determine the firm's true performance by observing its dividend policy, either in recessions or recoveries, improves potential investors' capability to direct investments to their target firms.