Cash flow volatility and dividend policy

CASH FLOW VOLATILITY AND DIVIDEND POLICY

DAI JING
(Bachelor of Finance, Fudan Univ., 2003)

A THESIS SUBMITTED
FOR THE DEGREE OF MASTER OF SCIENCE
DEPARTMENT OF REAL ESTATE
NATIONATIONAL UNIVERSITY OF SINGAPORE
2005


To my supervisor Prof. Ong Seow Eng
Thanks for the great guidance, generous help and continuous encouragement

To Department of Real Estate, National University of Singapore
Thanks for all the supports for my master study

To all my friends and colleges, especially Dr. Andrew C. Spieler
Thanks for the invaluable comments, help and experience in the research work

To my dear parents and fiancé
Thanks for your love, understanding and care

i


Table of Contents
Page

Acknowledge……………………………………………………………..i

Table of Contents………………………………...……………………. ii
Summary……………………………………………………………….. v
List of Tables…………………………………………………...………vii
List of Figures…………………………………………………………viii

Chapter 1: Introduction
1.1 Background ……………………………………………………………………...1
1.2 Research Objectives………………………………………………………...........4
1.3 Data Sample……………………………………………………………………...4
1.4 Research Methodology…………………………………………………………..5
1.5 Hypotheses of Study……………………………………………………………..6
1.6 Organization of Study……………………………………………………………6

Chapter 2: Literature Review
2.1 Cash Flow Volatility and Dividend Payouts…………………………………..…..8
2.2 A Dividend Debate Referring to Cash Flow Volatility…………………………..10
2.3 Information Signaling Theory……………………………………………………10
2.4 Agency Cost Theory…………………………………………………….…..……12
2.5 Summary ………………………………………………………………………...14

ii


Chapter 3: The Dividend Debate in REIT Industry
3.1 REIT: An Interesting Testing Ground for Dividend Policy …………...………...16
3.2 The Dividend Debate between Two Theories ………………………………...…22
3.3 A Better Measurement for REITs’ Dividend Policy……………………………..24
3.3.1 Definition of Excess Dividend …………………………………………….25
3.3.2 Reasons for Excess Dividend ………………. …………………………….26
3.4 Summary ………………...…………………………………………………..…..29

Chapter 4: Research Methodology
4.1 “Wealth Penalty” Caused by Firm Risk………………………………………….31
4.2 Excess Dividend Payout and Cash Flow Volatility……...………………………33
4.2.1 Excess Dividend Equation…...…………………………………………….34
4.2.2 Proxies for Cash Flow Volatility…………………………………………...37
4.2.3 Panel Regression Specifications…………………………..………………..39
4.3 Other Factors to Influence Dividend Payout Behavior……..................................40
4.3.1 Growth Rate of Asset…………………...….................................................40
4.3.2 Return of Asset………………………..........................................................42
4.4 Total Dividend Equation…………………...…………………………………….42
4.5 Impact from Change of Statutory Distribution Rate in 2001…………………….43
4.5.1 Dividend Changes in 2001……………………………………...………….43
4.5.2 Probit Analysis of Information Content of Current Dividend Payouts...…..45
4.6 Summary ………………………………………...……………………………..47

iii


Chapter 5: Data Sample and Descriptive Statistics
5.1 Data Sample ……………………………………………………………………49
5.2 Descriptive Statistics……………………………………………………………49

Chapter 6: Empirical Results
6.1 Excess Dividend Regression………………………………………………….….52
6.2 Excess Dividend and Other Influences…………………………………………..55
6.3 Total Dividend Regression…………………………………………………..…...56
6.3.1 Comparison between Excess Dividend and Total Dividend………………58
6.3.2 Firm Factor Analysis……………………………………………………….59
6.4 Impact from Change of Statutory Distribution Rate in 2001…………………….62

6.5 Summary …………………………………………………….…………………..69

Chapter 7: Summary and Conclusions
7.1 Summary of Main Findings ……………………………………………………...70
7.2 Research Contributions….………………………………………...……………..72
7.3 Follow-Up Research ……………………………………………………………..74

Bibliography
Appendix

iv


Summary

The dividend debate between agency cost theory and information signaling theory
indicates opposite explanations of the relationship between dividend payout and cash
flow volatility.

According to information signaling theory, managers will lower the dividend in case
the firm can not distribute the announced amount when the future cash flow is
uncertain. Managers will choose a dividend policy where announced dividend is less
than expected income in order to avoid the potential “wealth penalties”1. The more
volatile future cash flow means higher risk related to the future earning. Thus, the
information signaling theory predicts that dividend payout should be lower when
future cash flows are more volatile.

Grounded in the agency cost theory, an increase in dividends will result in a reduction
in free cash flow which will generate agency costs. The larger the cash flow variance,
the greater potential agency costs will exist. Higher dividend payout can be used

against non-value maximizing investments for firms with greater cash flow
uncertainty. Thus, agency cost theory predicts that firms with more volatile cash flows
would distribute a greater proportion of their cash flows as dividends.

This empirical study tests the two theories above, with a sample of 135 public equity
US REIT firms from 1985 to 2003. It explores the role of expected cash flow
volatility as a determinant of dividend policy for REIT industry.
1

A stock price drop is usually associated with cutting dividends, which is also known as “wealth
penalty” for shareholders.
v


The study constructs both excess dividend and total dividend panel regression models,
which are based on the model from Bradley, Capozza and Seguin (1998) and the
concept of excess dividend equation proposed by in Lu and Shen (2003). Our results
show strong evidence that REIT firms pay out substantial excess dividends to avoid
agency problem when the future cash flows are volatile. The information signaling
theory plays a relatively minor role in REIT firms’ dividend policy.

The statutory distribution of dividend is one special characteristic of REIT industry.
This ratio was reduced from 95% to 90% in 2001. Our sample shows that most REIT
firms were reluctant to reduce the dividend payout in spite of this regulation change.
In addition, REIT firms also maintained the dividend payouts even when they have
lower earnings. This dividend maintenance behavior over 2001 may provide a
significant signal to the market. However, the results from the probit analysis do not
show that the dividend changes in 2001 can be considered as accurate signals for
future dividend or cash flow changes.

vi


List of Tables
Page
Table 3-1

Definition of Excess Dividend

25

Table 3-2:

Summary of Excess Dividend Payout

27

Table 3-3:

Summary of Excess Dividend Payout when EPS < 0

28

Table 4-1:

Comparison between Agency Cost Theory and
Information Signaling Theory

39

Table 4-2:

Effect from Change of Statutory Distributed Rate
from 95% to 90%

43

Table 5-1:

Summary of Statistics

50

Table 6-1:

Excess Dividend Regression

53

Table 6-2:

Excess Dividend and Other Influences Regression

55

Table 6-3:

Total Dividend Regression

57

Table 6-4:

Excess Dividend Regression for Big Firm Subgroup

61

Table 6-5:

Excess Dividend Regression for Small Firm
Subgroup

61

Table 6-6:

Probit Analysis of Current Dividend and Future
Dividend Changes in 2001

62

Table 6-7:

Probit Analysis of Current Dividend and Future
Dividend Changes in 2001

64

Table 6-8:

Probit Analysis of Current Dividend and Future Cash
Flow Changes in 2001

65

Table 6-9:

Probit Analysis of Current Dividend and Future
Dividend Changes in 2001 (Robust Test)

67

Table 6-10:

Probit Analysis of Current Dividend and Future Cash
Flow Changes in 2001 (Robust Test)

68

vii


List of Figures

Page
Figures 3-1:

U.S. REITs Number from 1980 to 2003

19

Figures 3-2:

U.S. REITs Capitalization from 1980 to 2003

19

viii


Chapter 2

Chapter 1
Introduction

1.1 Background

Dividends are payments made to the firm’s shareholders, which are based on the
firm’s underlying earnings. The determination of the proportion of profits 2
periodically paid out to shareholders is called “dividend policy”. Firms usually follow
deliberate dividend payout strategies that can be driven by several goals. This raises
several interesting questions: how do the firms choose their dividend policies? What
is the optimal proportion of the earning to be paid out as cash dividend? These
questions are considered as a puzzle related to the dividend policy determination
process.

Researchers have proposed a number of explanations about this dividend puzzle. A
substantial theoretical literature, including Bhattacharya (1979), Kose and Joseph
(1985), Miller and Rock (1985), indicates that dividend payout is designed to reveal
future earnings’ prospects to the outside shareholders. However, recent results are

more mixed, because the firms’ current dividend payouts do not actually reflect the
changes of firms’ future earnings. Agency problems between corporate insiders
(managers) and outside shareholders are greatly related to the dividend policies
(Easterbrook 1984, Jensen1986, Myers 1998).

2

The percentage of earnings paid to shareholders in dividends is called as “dividend payout ratio”.
1


Chapter 2

Cash flow3 is usually considered as an important indicator of a firm's financial health.
The high volatility of cash flow is associated with greater market risks and higher
operation costs. The cash flow volatility not only increases the likelihood that a firm
will need to access capital markets, it also increases the costs of doing so. The
manager’s dividend policy should consider the expected cash flow and its volatility,
which indicate the ability of a firm to pay out current or future dividends. Two
theories have been advocated to explain the relationship between expected cash flow
volatility and dividend payout: information signaling theory and agency cost theory.

There is usually a discrete stock price drop or shareholder “wealth penalty” associated
with cutting dividends. Under the information signaling theory, managers will choose
a dividend policy where announced dividends are less than expected income in order
to avoid the penalty. This policy allows managers to maintain announced dividends
even if subsequent cash flows are lower than anticipation. Thus, the information
signaling theory predicts that dividend payout should be lower when future cash flow
is more volatile.

The agency cost theory suggests that an increase in dividends will result in a reduction
in free cash flow thus multiplying agency cost. The larger the cash flow variance, the
greater the potential agency costs and the more reliance on dividend distribution to
avoid this agency cost. The dividend payout to guard against non-value maximizing
investments should be greatest for the firms with highest cash flow uncertainty. Thus
the agency cost theory predicts that firms with more volatile cash flows would pay out
a greater proportion of their cash flows as dividends. Empirical evidence supporting
3

Cash Flow equals to cash receipts minus cash payments over a given period of time. More detailed
discussion about cash flow will be included in Chapter 2.
2


Chapter 2

the agency cost explanations can be found from Rozeff (1982), Dempsey and Laber
(1992), and Wang, Erickson and Gau (1993).

The information signaling theory and agency cost theory provide contrasting
explanations between dividend payout and future cash flow volatility. According to
information signaling theory, the managers will lower the dividend in case the firm
can not distribute the announced amount when the future cash flow is uncertain.
While the agency cost theory supports that the greater dividend payout can be used
against non-value maximizing investments for firms with greater cash flow
uncertainty.

Real Estate Investment Trust (REIT) is a corporation or trust which uses the pooled
capital of many investors to purchase and manage income property (equity REIT)
and/or mortgage loans (mortgage REIT). It is an organization similar to an investment

company in some respects but concentrating its holdings in real estate investments.
More and more researches have been done about the dividend policy in REIT industry.
The debate between the information signaling theory and agency cost theory has
continuously been heated in this area.

In this study, the relationship between dividend policy and cash flow volatility will be
examined by employing a sample from REITs industry. Two important financial
variables, dividend and cash flow, will be jointly analyzed in one theoretical
framework regarding to the dividend debate. The special characteristics4 in REITs
industry offer several benefits to overcome some of the obstacles that complicate

4

The details will be discussed in Chapter 3.
3


Chapter 2

previous studies in the dividend policy. REIT industry is considered as a good testing
ground for the dividend policy, which can contribute5 to further understandings about
different factors related to the dividend policy.

This study constructs both excess dividend and total dividend panel regression models,
which are based on the model from Bradley, Capozza and Seguin (1998) and the
concept of excess dividend equation proposed by in Lu and Shen (2003). Our results
show strong evidence that REIT firms pay out substantial excess dividends to avoid
agency problem when the future cash flows are volatile. The information signaling
theory plays a relatively minor role in REITs’ dividend policy. In addition, a group of
probit models has been employed and results show that the dividend changes in 2001

can not be considered as accurate signals for future dividend or cash flow changes.

1.2 Research Objectives

There are two main objectives in this study: firstly, it investigates the role of expected
cash flow and its volatility as determinants of dividend policy. Which theory
dominates the explanations for dividend payout behaviors? Secondly, it focuses on the
extent to which the different factors associated with cash flow volatility will influence
dividend policy.

1.3 Data Sample

The data in this study is collected from Compustat database and CRSP (Centre for

5

The contributions of this study will be summarized in Chapter 7.
4


Chapter 2

Research in Security Prices). The sample contains a sample of 135 public equity US
Real Estate Investment Trusts (REITs) from 1985 to 2003. The database focuses on
equity REITs and excludes all mortgage REITs and hybrid REITs due to their
different business characteristics and asset structure. REITs that are not traded on the
NYSE, AMEX or NASDAQ are also excluded from our sample.

1.4 Research Methodology

This study considers excess dividend as a better measurement for REITs’ dividend
policy. Based on Bradley, Capozza and Seguin (1998) and Lu and Shen (2003), an
excess dividend panel regression model is constructed to test the relationship between
dividend payout and cash flow volatility. Three kinds of Panel regressions are
included in the empirical process: OLS, fixed effect and random effect. In addition to
the variables associated with cash flow volatility, firm growth rate and return rate are
also discussed in the regression models.

The total dividend regression model is conducted as a robust test for excess dividend
regression model. Covering the same firm and same time period, the comparison
between excess dividend payout and total dividend payout will help the investors have
a better understanding of REITs’ dividend payout strategies and make a more accurate
expectation of future cash flow volume and its volatility.

The statutory distribution in REIT dividend was reduced from 95% to 90% in 2001.
However, most of REITs in our sample were reluctant to reduce the dividend payouts
in spite of the regulation change or lower earnings. This dividend maintenance

5


Chapter 2

behavior in 2001 provided a significant signal to the market. A probit analysis is
employed to explore the relationship between the current/future dividend changes and
cash flow changes.

1.5 Hypotheses of Study

According to the research objectives and methodology, following hypotheses are

formulated in this study:

(1) According to information signaling theory, the managers will lower the excess
dividend payouts when the future cash flow is uncertain. If the future earning is
unexpected low, the REITs may not distribute the announced amount of dividend
and a “wealth penalty” may happen. As a result, the higher future cash flow
volatility, the fewer dividends will be paid out.
(2) According to the agency cost theory, greater excess dividend payout can be used
against non-value maximizing investments for firms with greater cash flow
uncertainty in the future. The higher future cash flow volatility, the more
dividends will be distributed to shareholders.

These two theories give totally opposite predictions on the relationship between
dividend payout and future cash flow volatility.

1.6 Organization of Study

The study is organized into seven chapters. The structure is listed as follows:

6


Chapter 2

Chapter 1 provides an introduction comprising the background, objectives, data
sample, methodology and main hypotheses of this study.

Chapter 2 provides a brief review of the dividend debate between information
signaling theory and agency cost theory.

Chapter 3 begins with an introduction about the characteristics of REITs. The
following is a review of literature on the divided debate in REITs industry. Then the
reasons to choose excess dividend as a better measurement are discussed.

Chapter 4 discusses the research methodology: excess dividend regression, total
dividend regression and other influences including the influences from regulation
changes.

Chapter 5 presents a detailed description of the dataset used in this study.

Chapter 6 presents the empirical results and makes a discussion based on them.

Chapter 7 summarizes the findings from the empirical analysis, gets main conclusions
and points the contributions of this study. Finally, it also indicates important directions
for further research.

7


Chapter 2

Chapter 2
Literature Review

This chapter focuses on the debate on the relationship between cash flow volatility
and dividend policy in a general financial concept. A literature review shows that
information signaling theory and agency cost theory have given opposite explanations
on this topic. The first part will review the important basic concepts of cash flow
volatility and dividend payout. The following parts seek to summarize the main
findings on the relationship between cash flows and dividends, which will show us a

picture of the dividend debate based on different theories6.

2.1 Cash Flow Volatility and Dividend Payout

Cash flow equals cash receipts minus cash payments over a given period of time. We
can also calculate cash flow, equivalently, by adding amounts charged off for
depreciation, depletion, and amortization to net profit.7 A complete statement of cash
flows includes three parts: cash flow from operation (CFO), cash flow from investing
activities (CFI) and cash flow form financing activities (CFF). The analysis on cash
flows provides information not only about the cash receipts and cash payments during
an accounting period, but also about the firm’s operating, investing, and financing
activities. Therefore, cash flow is usually considered as a measurement of a firm's
financial health.

6

This chapter focuses on the literature review of the dividend debate in general financial area. The literature
review about REITs will be discussed in details in next chapter.

7

The two ways mentioned about the cash flow calculation are described orderly as “direct way” and
“indirect way”.
8


Chapter 2

Volatility measures the change in value of a financial instrument with a specific time
horizon, and quantifies the risk of the instrument over that time period. The volatility

of cash flow not only increases the likelihood that a firm will need to access capital
markets, it also increases the costs of doing so. Therefore, the cash flow volatility in
the future reflects the potential risk in future operating, investing, and financing
activities of a firm.

Dividends are a portion of profits distributed by a firm to its shareholders based on the
firm’s underlying earnings, the type of stock and number of shares owned by the
shareholders. Dividends are usually paid in cash, though they may also be paid in the
form of additional shares of stock or other properties. The amount of a dividend
determined by the inside management of the firm, usually called as “dividend policy”,
is restricted by the amount of cash owned by the firm. In a real world with taxes and
transaction costs, the dividends will greatly influence the firm value. There is a
tradeoff for managers between retained earnings on one hand, and dividend
distributions to shareholders on the other.

The expected cash flow and its volatility reflect the potential business risk of a firm,
which also indicate the ability of a firm to pay out dividend. Cash flow and dividend
should be jointly analyzed in a consolidated framework, as the firm’s management
always considers cash flow factors into the dividend policy determination process.

9


Chapter 2

2.2 A Dividend Debate Referring to Cash Flow Volatility

How do firms choose their dividend policy? How do managers determine the optimal
payout ratio? From cash flow’s aspect, two theories have been advocated: information
signaling theory and agency cost theory. These two theories offer opposite

explanations about the relationship between expected cash flow volatility and
dividend payout.

Under the information signaling theory, there is a discrete stock price or shareholder
wealth “penalty” associated with cutting dividends. In order to avoid these penalties,
managers will choose a dividend policy where announced dividends are less than
expected income. Thus, dividend payout should be lower when future cash flows are
more volatile.

The agency cost theory argues that an increase in dividends will result in a reduction
in free cash flow 8 where the agency problem may exist. The dividend payout
investments should be greatest for the firms with highest cash flow uncertainty to
avoid non-value maximizing investment activities. Thus, firms with more volatile
cash flows would pay out a greater proportion of their cash flows as dividends.

2.3 Information Signaling Theory

A substantial theoretical literature suggests that corporate dividend policy is designed
8

Free cash flow represents the cash that a company is able to generate after laying out the money
required to maintain or expand the company's asset base. Free cash flow can be a source of
principal-agent conflict between shareholders and managers, since shareholders would probably want it
paid out in some form to them, and managers might want to control it.
10


Chapter 2

to reveal earnings prospects and other useful related information to investors. Lintner

(1956) first proposed that dividend changes should convey useful information about
future earnings. Miller and Mogigliani (1961) advanced this reasoning by proposing
that the information content of dividends could be valuable to investors when markets
are incomplete. Miller (1987) also contended that dividend changes disclosed
information about a firm’s permanent income. Dividend signaling models make the
more specific predictions that firms raise dividends either prior to earnings increases
or to reveal that an increase is permanent. Several former papers, including
Bhattacharya (1979), Miller and Rock (1985), and Kose and Joseph (1985), argue that
managers use dividends to signal the changes of future earnings to investors.

The cash flow volatility is usually considered as a good proxy for the future earning.
The following papers discuss the relation between dividend distribution and cash flow
volatilities: Eades (1982), Kale and Noe (1990), and Bradley, Capozza and Seguin
(1998). All assume either explicitly or implicitly that the managers are perfectly
aligned with current shareholders. Under this assumption, the market can infer firms’
private information from their managers’ actions. However, in reality, the managers
may not be able to communicate credible signals to the market. Managers in the firms
that are not effectively monitored may be more likely to maximize their own wealth
instead of the shareholders’ wealth compared to managers in effectively monitored
firms.

Benartzi, Michaely, and Thaler (1997) examine cash flow changes around large
samples of dividend changes, and argue that dividend increases are not credible
signals of future performance. They find that dividends are related to past earnings but

11


Chapter 2

not future earnings. Their results seriously challenge information signaling as an
important component of dividend policy.

Dividend policy can also be evaluated based on how dividends evolve before and
after large cash flow changes. DeAngelo and Skinner (1996) find that dividend
changes lag earning changes in a sample of 145 firms that suffer decreased earnings
after ten straight years of rising earnings. Only in two cases, firms cut dividends
before the earnings drop. They conclude that managers do not signal the negative
information with dividends and the small cash obligations associated with increasing
dividends reduce the reliability of dividends as a signaling mechanism.

2.4 Agency Cost Theory

Agency problem comes from the conflicts of interest among the outside stockholders
and the inside managers. The incremental costs of having an agent (manager) to make
decisions for a principal (shareholder) are known as “agency cost”. According to
Jensen’s (1986) free cash flow hypothesis, the management has an incentive to
maximize the free cash flows at his discretion by distributing minimum dividends.
The excess cash flow is wasted on value-destroying spending. This suggests a policy
of encouraging cash-flow payout to minimize inefficient investment spending. The
dividend payout to shareholders is considered as a disciplinary mechanism, reducing
the agency cost associated with the free cash flow and overinvestment.

Rozeff (1982) indicates that paying dividends will reduce the resources under
mangers’ control, and thus make firms issue new securities resulting in capital market

12


Chapter 2

monitoring, thereby reducing agency costs. Several other studies have also presented
empirical evidence supporting the agency cost explanation as Dempsey and Laber
(1992), and Wang, Erickson and Gau (1993). In addition, the evidence also shows that
those explanations based on agency cost theory are applicable over different
economic conditions (Dempsey and Laber, 1992).

The dividend policy can also be explained from other aspects in an agency problem
framework. Myers (1984) advocates the pecking order theory that firms prefer
retained earnings as their main source of funds for investment9. Therefore a growth
firm tends to have a lower payout ratio and preserve more cash for expansion. The
firm will try to restrain itself from the debt also because: first, to avoid any material
costs of financial distress; and second, to reserve the borrowing power for future
expansion. Thus, the growth opportunity of a firm will influence the consideration of
dividend policy, which is also linked to the investment and financing decisions.

Easterbrook (2001) discusses whether dividend distribution is a method of aligning
managers’ interests with those of investors. He suggests that the monitoring of
managers in open capital market is available at low cost. Dividend distribution can
reduce the internal funds and keep firms in the capital market. This can used to
explain why firms simultaneously pay out dividends and raise new funds in the capital
market. The internal monitoring costs can be reduced by distributing dividend and
using external financing.

9

Firms prefer the internal funds to external funds, and debt to equity if the external funds are needed.
The firm will choose a dividend payout ratio which can meet the required rate of return of equity
investment by internally generated funds.

13


Chapter 2

Grounded in agency cost theory, substitution concept10 is raised by some researchers.
Easterbrook’s (1984) rationale of substitution among agency cost control devices
suggests the agency cost explanations are only valid for firms that are not effectively
monitored. Noronha, Shome, and Morgan (1996) show that dividends as an agency
cost control device are effective only for firms with low growth opportunity or
without the presence of alternative no-dividend monitoring devices. Filbeck and
Millineaux (1999) also produce evidence consistent with the substitution concept.
Some researchers connect the substitution hypothesis with the shareholder rights in
the discussion of dividend policy. La Porta et al (2000) examine dividend policies of
firms in 33 countries and argue that firms with weak shareholder rights pay dividends
more generously than do firms with strong shareholder rights. Gompers, Ishii, and
Metrick (2003) investigate how the market for corporate control (external governance)
and shareholder activism (internal governance) interact. Agency costs can influence
dividend payouts on one hand; one the other hand, they are related to the strength of
internal governance. Therefore, the dividend payouts should be linked to the strength
of internal governance. Dividends play the role as a substitute for internal governance.

2.5 Summary

This chapter analyses the relationship between dividend payouts and cash flow
volatility. Cash flow volatility reflects the business risk of a firm and its ability to
distribute dividends. When managers determine the payout proportion, cash flow and
its volatility always play important roles.

10

The dividend policy is only a substitution for other monitoring devices to avoid the agency cost.
14


Chapter 2

How do cash flows affect the dividend policy? There are two leading theories related
to this dividend debate: information signaling theory and agency cost theory. The first
idea argues that dividend policy is designed to reveal earnings prospects and other
useful related information to investors. The managers will lower the dividend in case
the firm can not distribute the announced amount when the future cash flow is more
volatile. While the agency cost theory supports that the greater dividends should be
paid out for firms with greater cash flow uncertainty against non-value maximizing
investments.

Main findings about the two theories from literature are summarized in this section.
This dividend debate related to the cash flow volatility raises many interesting
questions. However, the results seem to be more mixed recently.

15


Chapter 3

Chapter 3

The Dividend Debate in REIT Industry

This chapter introduces the characteristics of Real Estate Investment Trust. The

reasons and advantages to choose REIT data in this study are discussed based on these
characteristics in this industry. The following part is the literature review about the
dividend debate in REIT industry. The definition of excess dividend is advocated in
the third section. This study argues that excess dividend is a better measurement for
REIT industry compared to total dividend and three main reasons are proposed in the
discussion.

3.1 REIT: An Interesting Testing Ground for Dividend Policy

The majority of dividend policy literature uses data from a wide variety of industries
in their investigation. The use of multiple industry firm data may be advantageous in
testing theory, as different business natures of firms in the sample will provide
sufficient cross sectional variations. However, the same factor may carry different
weights in the decision-making process for firms in different industries. It will be
difficult to distinguish the effects between industry factors and the factors directly
related to dividend policy. The dividend policy and related important variables will
vary from industry to industry, because asset risk, asset type and requirement for
funds (internal or external) also vary by industry (Myers 1984).

In other words,

wide differences in firms’ business nature will complicate the situation. This study
chooses a single industry as the sample, which will eliminate the industry effects and
highlight the importance of firm-specific volatility.
16