Returns for Dividend-Paying and Non Dividend Paying Firms

ABSTRACTIn this paper, we compare the equity returns of dividend-paying and non-dividend paying firms. We find no unconditional return difference even though non-dividend paying firms have many characteristics that suggest high risk. Equivalently, because non-dividend paying firms have high risk-metrics, their returns are abnormally low compared with dividend-paying firms. The reason for these anomalies is that a larger fraction of non-dividend paying firms are in financial distress and, despite high distress-risk and high growth-leverage, firms in financial distress have low returns from high volatility that decreases the options-leverage of equity. Removing firms in financial distress, returns for non-dividend paying firms increase relative to dividend-paying firms and abnormal returns disappear. We argue that part of the reason that firms in financial-distress have high volatility that leads to low returns is managerial risk-shifting that takes form as unexpectedly high capital expenditure rates.JEL: G12, G32, G33, G35KEYWORDS: Equity Returns, Dividends, Financial Distress, Volatility, Growth(ProQuest: ... denotes formulae omitted.)INTRODUCTIONIn perfect capital markets, Miller and Modigliani (1961) show the wealth of a firm's shareholders is invariant to corporate dividend policy. Across firms, returns for dividend-paying and non-dividend paying firms can differ if their corporate financial characteristics differ. The financial literature identifies several differences between dividend-paying and non-dividend paying firms. Pastor and Veronesi (2003) report that non-dividend paying firms have high profit volatility, high return volatility, and high market/book ratios. Fama and French (2001) find that non-dividend paying firms are smaller and less profitable but have better growth opportunities. Rubin and Smith (2009) characterize non-dividend paying firms as younger, smaller, and more levered. DeAngelo, DeAngelo and Stulz (2006) find that firms pay dividends when retained earnings are a large fraction of book-equity, which means that dividend-paying firms are more profitable. Fuller and Goldstein (2011) report that non-dividend paying firms have higher returns in advancing markets (and conversely), which means higher leverage. Blazenko and Fu (2010,2013) find a positive value-premium for dividend-paying firms but a negative value-premium for non-dividend paying firms. Investors might reasonably conclude from these differences that non-dividend paying firms are riskier than dividend-paying firms.However, Fuller and Goldstein (2011) report that dividend-paying firms have returns that exceed non-dividend paying firms. We find no statistical difference between the unconditional returns of dividendpaying and non-dividend paying firms but standard risk-metrics are higher for non-dividend paying firms and, thus, they have abnormally low returns compared with dividend-paying firms. We argue that standard risk-metrics overstate risk for non-dividend paying firms because they fail to capture relations between volatility, risk, and expected return. A larger fraction of non-dividend paying firms compared with dividend-paying firms are in financial distress (IFD) and IFD firms have low returns from high volatility that decreases the options-leverage of equity. Excluding firms in financial distress, returns for non-dividend paying firms increase relative to dividend-paying firms and abnormal returns disappear.Our contribution to the literature on dividend-paying and non-dividend paying firms is to explain why returns on non-dividend paying firms are no greater than dividend paying firms despite high risk metrics. Section 2 reviews the literature on dividend and non-dividend paying firms and discusses our contribution to it. Section 3 presents preliminary results on returns of dividend-paying, non-dividend paying, and IFD firms. In section 4, we present evidence that high-profitability firms have high returns because of high growth-leverage despite high volatility and evidence that volatility accounts for low returns for IFD firms despite high growth-leverage. …