Aurora Borealis
1 June 2017 CFA Institute Journal Review

When Cutting Dividends Is Not Bad News: The Case of Optional Stock Dividends (Digest Summary)

  1. Vassilis Efthymiou, CFA

Optional stock dividends (OSDs) are a novel dividend payout mechanism that induces shareholders to voluntarily choose stock over a cash dividend, saving the firm from having to pay valuable cash reserves without this move being perceived as negative news.

How Is This Research Useful to Practitioners?

Dividend smoothing has been a longtime pursuit of corporate managers who want to accommodate shareholders’ appetite for systematic dividend payouts and their aversion to dividend cuts. Yet, it constitutes a major challenge for cash-strapped firms or firms with significant outflows for debt servicing. For such firms, optional stock dividends (OSDs) are a preferable alternative to dividend cuts and/or seasoned equity offerings (SEOs).
Although OSDs are similar to dividend reinvestment plans, OSDs offer a significant discount on the new stock issued as a dividend payment, which essentially constitutes the intrinsic value of the warrant-like OSD. From the point of view of option valuation, the higher the discount on the issued stock and the longer the conversion period, the higher the OSDs will be valued.
The authors attempt to answer several important questions about OSDs: (1) What types of firms are more inclined to use OSDs than the less attractive option of cash dividend cuts? (2) Under what market conditions are OSDs preferable to paying cash dividends funded by SEOs? (3) What is the market reaction to corporate announcements of OSDs compared with dividend cuts? (4) What are the determinants of shareholders’ taking up OSDs?
Large, mature firms committed to high dividend yields are more likely to offer OSDs than to cut dividends when they lack cash and equity. In terms of market conditions, OSDs seem to accelerate during recessions, when SEOs are more expensive and banks are unwilling to assume the risk of underwriting them.
The authors’ empirical evidence shows that the market reaction to OSD announcements is positive, similar to the market reaction to cash dividends, in contrast to the negative news conveyed by cash dividend cuts or imperative new equity offerings. This finding implies that investors regard an OSD as a temporary alternative to regular cash dividends, which does not negate the firm’s favorable future prospects. Finally, firms in which institutional investors have considerable holdings tend to use more OSDs and to exhibit higher OSD participation rates than firms with more dispersed ownership. The reason is that institutional investors are considered better informed about whether exercising the OSD option will bring more shareholder value than the cash dividend option.

How Did the Authors Conduct This Research?

To find the significant determinants of a firm’s probability of choosing an OSD over a dividend cut, the authors run multivariate logistic regressions on a sample of 2,033 dividend payments (of which 168 are OSDs) made by 287 French firms listed on the CAC All-Tradable Index from 2003 through 2012. The sample is restricted to French firms because of the identical tax treatment of cash and stock dividends in France, thereby removing any tax considerations from the analysis.
The authors regress a dummy variable that indicates whether an OSD was applied on a series of independent factors: cash availability, debt, size, market value to book value, variability of past net income, institutional ownership, and extent of block shareholdings.
Moreover, to evaluate market reactions to OSDs, the authors regress abnormal stock returns (market model adjusted) on the day of the OSD announcement against the OSD dummy and several other control variables, including market value to book value, EBITDA/assets, size, and year/industry. To account for the possibility of endogeneity of the market reaction, they also use two-stage least-squares regressions to check for model misspecification, with the results remaining essentially the same. Finally, the authors check for robustness by verifying that the intensity and magnitude of share repurchases do not change their initial conclusions and by performing the logistic regressions on restricted samples matched on the basis of size, industry, and year of payment.

Abstractor’s Viewpoint

The authors’ main contribution is disentangling OSDs from other actions firms take to preserve their capital position when in need of cash and equity—for example, dividend cuts and SEOs’ funding the non-interruption of cash dividend payouts. The perceived benefits of OSDs compared with those of other options—including a discount on the stock dividend, the positive market reaction to the announcement, and the cost savings from avoiding SEOs—are all consistent with the authors’ empirical results and are corroborated by several facts: Shareholders of OSD-paying firms clearly favor OSDs, because their votes in favor of receiving OSDs during general meetings amount to 97.5% and their observed choosing of OSDs varies between 55% and 65%, depending on the discount level.
One limitation of this study is that it does not include “pure” stock dividends in the evaluation of OSDs. Thus, future research should juxtapose OSDs with stock dividends in addition to cash dividends. One would expect OSDs to share characteristics of both dividend types. Assuming perfect capital markets and tax indifference between the two, an OSD option exercised by shareholders would be equivalent to the firm’s option to switch from cash to stock dividends with a view toward maximizing shareholder value, thereby suggesting an “OSD irrelevance” hypothesis.

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