In the signaling model of dividend, a firm's dividend policy is hypothesized to convey the information about its future prospects that is privately observed only by insiders (i.e., Miller and Rock (1985), John and Williams (1985), John and Nachman (1987), and etc.). More specifically, if insiders have exclusive access to information about the firm's future performance, then it has been suggested that insiders have an incentive to signal the firm's future performance through dividends to the market place, expecting that the market may revise its existing perception about the firm's future prospects. John and Williams (1985) have demonstrated how dividends can act as a credible signal of the fundamental earnings prospects of the firm. In practice, for dividends to be a credible signal, insider should maintain a systematic relationship between expected earnings and dividends. In this regard, Lintner (1956) found that managers smoothly adjust firms’ dividends with respect to earnings and maintain a long-run target payout ratio. Lintner’s further investigations show that most firms do not make an immediate adjustment to this target payout ratio.
Firms follow a partial adaptation process making a gradual dividend adjustment to the target ratio if current payout is deviated from the target ratio. Both the dividend smoothing and the dividend signaling hypotheses have been confirmed by a number of subsequent studies. Whereas dividend smoothing and dividend signaling are well-established empirical facts, the empirical evidences are based principally on informations collected in the US market. The dividend policies of corporations differ significantly across countries due to a variety of institutional and financial market differences. The principal objective of this study is to assess the dividend policies of firms in Korea. In particular, this study investgates whether Korean firms follow dividend policies as in developed markets in which dividend smoothing and dividend signaling become stylized facts.
A common problem for the researchers studying the dividend signaling hypothesis and the dividend smoothing hypothesis is that most of the studies tend to focus on the signaling model of dividend (e.g. dividend announcement studies) or the smoothing model of dividend separately (e.g. partial adjustment models), but not both. Existing empirical tests cannot help us to distinguish between: (i) dividends are explicit signals of future earnings (the dividend signaling hypothesis) and (ii) dividends are smoothed with respect to earnings to be a credible signal (the dividend smoothing hypothesis). There have been no empirical attempts to estimate and verify the dividend-earnings relation reflecting both hypotheses. Existing empirical tests cannot really identify the types of mechanisms for the dividend-earnings relation (e.g. the joint considerations of signaling and dividend smoothing).
In this study, I propose a cointegration model to test both hypotheses in an integrated framework in order to provide better insight into the dividend and earning relation. This allows us to investigate not only the informational content of dividend but also the underlying factor to make dividend signal to be credible.
The objective of this paper is two fold. First, we test the informational content of dividend. For this purpose, we construct a model to show the predictive relations among dividends and future earnings at the firm level. We are particularly interested in the issue of whether the model can detect a presence of inter-temporal relations between dividends and earnings. Second, we test the dividend smoothing hypothesis using a non-linear framework involving dividends and earnings stream. Tests of the time-series implications of dividend models in a cointegrating framework offer a distinctive approach to examine the ability of each hypothesis to explain corporate dividend behavior and hence, identify the types of mechanisms for the dividend-earnings relation. The most significant use of the cointegration model is that this model is able to identify the long-term equilibrium relationship between dividends and earnings. Because theoretical analysis specifies the long-run equilibrium relationship between the earnings and dividend time series in the presence of information asymmetry, the cointegration model employed in this study is regarded as a more direct test of the theoretical arguments in this area. Also a test is performed to examine the relationship between this derived dividend-setting behavior of a firm and the information environment using both multivariate and univariate techniques. The evidence shows that dividend-earnings relation depends on the degree of information asymmetry and dividend smoothing is an underlying factor to maintain a long-term equilibrium relationship between dividends and earnings. The remainder of this paper is organized as follows. Section II lays out the basic model. Section III describes the data and the methodology employed in this study. Section IV reports the empirical results. Section V summarizes and concludes the study and offers suggestions for future research.
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