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Accounting and Finance 51 (2011) 869–891

Do dividend changes predict the future


profitability of firms?

Young M. Choia, Hyo K. Jub, Young K. Parkb


a
Cheongju University, Cheongju; and
b
Sungkyunkwan University, Seoul, Korea

Abstract

Many previous studies have been conducted to test whether corporate dividend
changes predict the future profitability of firms. While the debate continues, we
assess the information content of dividends (ICD) hypothesis in the Korean mar-
ket as it provides an interesting experimental setting for testing the hypothesis in
the context of corporate governance. We find that it is difficult to support the
ICD hypothesis if one accepts nonlinear patterns in earnings. However, when we
divide the sample in terms of Chaebol vs. non-Chaebol and high-growth vs. low-
growth firms, we find that the ICD hypothesis becomes valid, especially for non-
Chaebol firms and for low-growth firms. Therefore, we suggest that the validity
of the ICD hypothesis may be dependent on firm characteristics such as the
corporate governance structure and growth stage.

Key words: Dividend changes; Information contents; Corporate earnings;


Return on Assets; Agency problem

JEL classification: G3

doi: 10.1111/j.1467-629X.2010.00379.x

1. Introduction

Many researchers and market practitioners think that dividend changes bear
informational content about the firm’s earnings, ever since Lintner (1956) sug-
gested that firms increase their dividends only if management believes that
earnings have permanently increased, meaning that increased earnings would be

The authors thank an anonymous referee, Ghon S. Rhee, and seminar participants at the
University of Hawaii for their helpful comments and suggestions. Young K. Park would
like to acknowledge the Department of Finance at California State University, Fullerton,
where he was a visiting professor during some of this research.
Received 7 March 2009; accepted 25 August 2010 by Robert Faff (Editor).

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sustained. Miller and Modigliani (1961) develop this idea as a theory referred to
as ‘the information content of dividends (ICD) hypothesis’. This theory states
that dividend changes convey information regarding the firm’s future profitabil-
ity and cash flow. In fact, event studies that assess dividend-change announce-
ments and associated responses in the stock market (Pettit, 1972; Aharony and
Swary, 1980; Asquith and Mullins, 1983; Dielman and Oppenheimer, 1984) show
that dividend increases result in positive abnormal returns in the stock price of
the underlying firm. This implies that the market considers dividend increases as
a positive signal regarding the firm’s future earnings and therefore the value of
the firm’s shares.
However, actual tests of the relationship between dividend changes and future
earnings report differing findings. Watts (1973) initiates the investigation into
the relation between dividend changes and future earnings. He finds a positive
relationship between the two variables, but this is not statistically significant.
Thus, he concludes that the ICD is not economically meaningful. Similarly,
research by Healy and Palepu (1988) and DeAngelo et al. (1996) does not sup-
port the hypothesis that dividend changes can provide information about future
earnings. DeAngelo et al. (1996) interpret these results to mean that manage-
ment tends to increase dividends on the basis of overoptimistic forecasts about
future earnings, and thus the ICD is unreliable. Benartzi et al. (1997) also sup-
port this view, finding that firms that increase dividends experience significant
earnings increases in the year before and in the same year, but not in subsequent
years. Besides, they find that firms that cut dividends, owing to their earnings
decrease in the year prior and in the same year, often show earnings increases in
the following year.
Whereas many papers do not support the ‘the ICD hypothesis’, the study of
Nissim and Ziv (2001), which uses an alternative methodology, shows strong evi-
dence supporting this hypothesis. Their study determines that ‘dividend changes’
and ‘future earnings in the subsequent 2 years are statistically significantly posi-
tively related. They also demonstrate that dividend changes are related positively
to the level of the firm’s future profitability, where profitability is measured by
future earnings and future abnormal earnings. This paper’s finding is crucial, as
it revives the strong possibility that dividend changes contain information
content about future earnings. However, a subsequent paper by Grullon et al.
(2005) objects to Nissim and Ziv’s (2001) finding, accusing the study of the
misuse of the linear regression model, despite the nonlinearity in the earnings
patterns.
Thus, disputes regarding the ICD appear to have resurged, and we believe it
interesting to assess the ICD hypothesis, in other markets, and to evaluate the
hypothesis using Korean market data. It is worthwhile to conduct a test of the
ICD hypothesis using Korean market data because of the following reasons.
First, past research into the ICD hypothesis has been conducted principally in
the US context. Thus, it should prove worthwhile to evaluate this hypothesis in
other markets to determine whether the theory is universally applicable. Second,

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more frequent dividend changes in Korea can provide more opportunities to


observe the meaning of dividend payment changes. In the Korean market, the
dividend payout is conventionally shown in the form of the dividend rate (divi-
dend relative to the par value of the share) rather than the dividend yield (divi-
dend relative to the market price of the share). This practice permits firms to
retain a low amount of cash payments for dividends. As the amount of the divi-
dend payment is rather small in absolute terms, firms tend to increase or decrease
dividends more frequently, depending on their economic conditions, when com-
pared to US firms. Thus, dividend changes in a Korean firm better reflect mana-
gerial perceptions regarding the well-being of the company and provide a better
chance to observe the effects of dividend changes on future earnings. Third,
Korea has a unique governance characteristic. Many firms in Korea belong to
large business groups called Chaebol, and the members in a Chaebol cross-hold
the shares of other firms in the same business group. Owing to these cross-hold-
ings among Chaebol members, an owner can exercise strong control (voting)
rights that far exceed its cash-flow rights (Claessens et al., 2000). This wide gap
between control rights and cash-flow rights can affect the dividend policy in Kor-
ean Chaebol members. As dividend payments reduce the internal resource that is
under the control of the owner, Chaebol member firms can choose to pay lesser
dividends compared to non-Chaebol firms. Therefore, we think it will be interest-
ing to separately test the ICD hypothesis for Chaebol and non-Chaebol firms to
see whether ICD varies depending on the corporate governance characteristics.
Fourth, although the dividend payout policy should be closely related to the
firm’s growth level, La Porta et al. (2000) argued that the policy can vary
depending on the level of minority shareholder rights. Because Korea is one of
the low minority shareholder-rights markets (La Porta et al., 2000), we can also
examine the relationship between the ICD hypothesis and the firm’s growth level
in a low-minority shareholder-rights economy.
Several event studies of the Korean market (Nam and Woo, 1987; Park et al.,
2003) demonstrate that dividend increases result in abnormal returns in the stock
market. Therefore, this paper does not assess the ICD hypothesis with regard to
the relationship between dividend changes and stock market responses. Rather,
in this paper, we directly assess the relationship between dividend changes and
the firm’s earnings and profitability in subsequent years.
We initially conduct the study using the Nissim and Ziv (2001) method. Both
basic regression and Fama and MacBeth (1973) cross-sectional regression of div-
idend changes on earnings changes, after controlling for ROE, show that divi-
dend changes are significantly positively correlated with firm profitability in the
following year. We also run a regression by separating firms with dividend
increases from firms with dividend decreases to avoid a potential mixture of the
relationship in the full-sample analysis. The results demonstrate that only nega-
tive dividend changes can predict changes in the firm’s profitability for the
following year. These findings are similar to those of Nissim and Ziv (2001), in
which they run similar regressions for the US market. However, when we run

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the same cross-sectional regression after controlling for nonlinear earnings pat-
terns, the dividend signalling effect is no longer presented, which is similar to
Grullon et al. (2005).
On the other hand, when we divide Korean firms into Chaebol members and
non-Chaebol members, we find a significant positive relationship between divi-
dend changes and future earnings, which supports the ICD hypothesis, especially
for non-Chaebol members. Similarly, when we divide firms into high-growth and
low-growth firms, we find the same positive significant relationship between divi-
dend changes and future earnings, especially for low-growth firms. Thus, our test
results suggest the possibility that the validity of the ICD hypothesis may depend
on firm characteristics or stage such as the level of corporate governance and
growth stage.

2. Data

The dataset in this study is composed of firms listed on the Korea Stock
Exchange for the years between 1991 and 2007. We collected financial statement
data from the Korea Information Service, whereas the stock market data were
collected from the Korea Stock Research Institute-Stock Database. The data to
categorize firms into Chaebol and non-Chaebol firms were collected from the
Korea Fair Trade Commission. The following criteria were used for deciding
whether to include a given firm in the study set.

1 The firm had to be nonfinancial.


2 It had to have paid dividends in two consecutive years, thus rendering divi-
dend changes observable.
3 It should not have declared other distribution events such as stock splits,
stock dividends, mergers between the declaration of the previous dividend and
the declaration of the current dividend.
4 It should not have exhibited abnormal dividend changes (over 500 per cent)
owing to the extraordinarily small amount of dividend payments in the previ-
ous year.

Table 1 shows the annual and total number of firms in our study sample. The
total number of observations for dividend increases, dividend decreases and no
changes in dividends during the study period is 1654, 1351 and 800, respectively.
Although the dividend increases outnumber the dividend decreases, as in previ-
ous studies of the US market (Nissim and Ziv, 2001; Grullon et al., 2005), the
significantly smaller number of ‘no dividend changes’ is the most noteworthy fea-
ture in the Korean market’s dividend payments. This demonstrates that while
firms in the US market appear to exert great efforts for stable dividend pay-
ments, the management of a Korean firm can freely change dividends with less
pressure from shareholders and analysts. It has also been demonstrated that the
number of firms with dividend increases fell dramatically in 1997, whereas the

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Table 1
Frequency of firm-year observations with at least one dividend event by fiscal year

Year Dividend increases Dividend decreases No change Total

1992 75 100 64 239


1993 77 79 56 212
1994 86 59 63 208
1995 80 91 50 221
1996 76 104 33 213
1997 35 119 18 172
1998 74 57 30 161
1999 94 45 23 162
2000 74 94 21 189
2001 99 69 43 211
2002 132 62 47 241
2003 126 86 50 262
2004 148 98 53 299
2005 168 86 73 327
2006 136 115 91 342
2007 174 87 85 346
Total 1654 1351 800 3805

This table reports the number of firms that increase, decrease or do not change dividends compared
to the previous year.

number of firms showing dividend decreases surged. This is attributable to the


Asian financial crisis, which also hit the Korean economy heavily. The reverse
phenomenon was observed, namely that many firms increased dividends and
fewer than the normal number of firms decreased dividends in 1998 because of
the dramatic recovery in the Korean economy in the following year. The data
for these 2 years are also included in the study, as the temporary shock is a rela-
tively small part of the large sample period and does not alter the overall result.1
We provide summary statistics for each of the dividend-change groups
(increase, decrease and no change) in panels A, B and C of Table 2. The average
percentage change in dividends, average returns [ROE and Return on Assets
(ROA)] and the average size of firms in each dividend-change percentile group
are also provided. In the table, RDDIV0 refers to the percentage change in divi-
dends and is calculated as shown below:

DIV0  DIV1
RDDIV0 ¼ : ð1Þ
DIV1

In Equation (1), DIV0 means the dividend at year 0 and DIV)1 means the divi-
dend in the year before. The top panel in the table shows that the average change

1
We also conducted the test by excluding the 1997–1998 period, and the overall result
was largely unchanged. The test results are available upon request.

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Table 2
Descriptive statistics for dividend event observations

(%, 100 mil )

Mean Median STD Low 10% 25% 50% 75% 90% High 10%

Panel A. Dividend increases (N = 1654)


RDDIV 41.39 23.46 54.89 0.79 4.17 10.48 18.13 26.33 173.70
ROE 20.93 11.69 38.92 14.04 17.94 18.27 19.56 20.13 27.95
ROA 7.65 6.34 5.98 5.82 6.68 7.25 7.53 7.54 8.63
Mkt.Cap 9121.04 700.54 40,377.95 6770.18 7142.71 7458.82 8639.96 8353.46 15,865.70
Panel B. No change (N = 800)
ROE 16.23 10.77 23.37 – – – – – –
ROA 5.95 5.13 4.97 – – – – – –
Mkt.Cap 2044.66 456.69 9116.16 – – – – – –
Panel C. Dividend decreases (N = 1351)
RDDIV )27.28 )20.04 24.22 )79.26 )62.74 )46.09 )35.55 )30.26 )0.44
ROE 9.81 7.02 30.86 7.90 3.82 7.10 8.05 9.35 14.00
ROA 3.91 2.80 4.92 4.11 2.65 2.90 3.28 3.64 6.35
Mkt.Cap 7138.63 481.29 49,959.80 2590.36 2080.93 3624.33 4121.06 6365.50 14,096.78
Panel D. Whole sample (N = 3805)
RDDIV 8.31 0 49.57 )60.07 )37.16 )19.37 )10.78 )3.68 116.34
ROE 16.00 9.88 33.70 4.31 8.04 12.39 13.64 15.06 24.40
ROA 5.96 4.78 5.66 2.73 3.25 4.42 5.26 5.73 8.11
Mkt.Cap 6927.48 562.5 40,226.86 3452.45 4128.65 5339.63 5725.15 6431.24 11,400.24

This table reports firm characteristics for the sample firms. RDDIV is the annual percentage change
in the cash dividend payment. ROE is equal to the earnings before extraordinary items scaled by the
book value of equity. ROA is equal to the operating income before depreciation scaled by total
assets. Mkt. Cap is the market value of equity. The values of all financial variables are determined at
the beginning of the year of the dividend announcement.

in dividend for the ‘dividend-increase’ group is +41 per cent, which is far larger
than the +16 per cent reported in the US study (Nissim and Ziv, 2001). As Kor-
ean firms generally pay small amounts of dividends, a small increase in dividend
payments results in relatively profound percentile changes. On the other hand,
the average change in dividend for the ‘dividend-decrease’ group is )27 per cent,
as shown in the first column in the third panel, and this is smaller than the aver-
age drop of 43 per cent reported in the US study. The reason that the average
drop in the United States is significantly larger than in Korea is that US firms
attempt to maintain the same level of dividends, even in bad years, whereas Kor-
ean firms are more flexible in terms of their ability to decrease dividends in bad
years. As a result, when US firms fail to maintain their dividends, the average
decrease is far larger than that observed in Korean firms.
We also conduct a comparative analysis for six subgroups formed on the basis
of the percentage of dividend change. In the case of the ‘dividend-increase’ panel
(Panel A), the larger the dividend increase, the higher are the firm ROE and
ROA values. However, in the case of the ‘dividend-decrease’ panel (Panel C), the

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larger the dividend decrease (i.e., the lower percentile group), the lower are the
ROE and ROA values of the firm. These indicate that firms increase dividends
as profits increase and decrease dividends as profits decrease, which is very con-
sistent with our expectations. It is also interesting to note that the market capital
of the ‘dividend-increase’ group is far larger than that of the ‘dividend-decrease’
group, as is the case in the United States.

3. Empirical analysis

3.1. Basic analysis

The initial analysis in our study involves regression, using dividend changes
(RDDIV0) as an independent variable and earnings changes as the dependent
variable, to assess the ICD hypothesis. We use earnings before extraordinary
items to calculate the earnings changes. The basic specification used in Nissim
and Ziv (2001) is Equation (2), in which Et denotes the earnings in year t, B)1 is
the book value of equity at the beginning of the year (or the end of the previous
year), ROEt)1 is the return on the book value of equity at t ) 1, and RDDIV0 is
the rate of dividend change in the year of dividend change calculated from Equa-
tion (1). We employ ROE as the control variable in this equation as Freeman
et al. (1982) report that the return on the book value of equity (ROE = E/B) is
a significant predictor of the change in earnings.

ðEt  Et1 Þ=B1 ¼ a0 þ a1 RDDIV0 þ a2 ROEt1 þ et : ð2Þ

We measure abnormal earnings in the dependent variable with the realized


earnings, Et, in year t. This implicitly assumes that earnings follow a random
walk, and therefore the change in earnings in the above equation measures the
unexpected profitability. As we test the ICD hypothesis using data collected
between 1991 and 2007, the dependent variable of the regression is derived from
the earnings from 1992 to 2007 for t = 0, from 1993 to 2007 for t = 1 and from
1994 to 2007 for t = 2. For example, if the year 1995 is set as t = 0, the rate of
dividend change is calculated from RDDIV0 = (DIV95 ) DIV94)/(DIV94) and
the dependent variable becomes (E95 ) E94)/P94 for t = 0, (E96 ) E95)/P94 for
t = 1, and (E97 ) E96)/P94 for t = 2.2
Table 3 reports the results from this regression analysis that employs the
denominator of the dependent variable as the book value (B)1) and includes
ROE as the control variable. It has been demonstrated that the regression
coefficient (a1) is positive and statistically significant for t = 1 at the 10 per cent

2
Throughout this paper, the fixed-number subscripts/indices, 0 (base year) and )1 (previ-
ous year), do not change, whereas t and t)1 can be either 1 or 2 to forecast either future
year 1 or future year 2. This notation is widely used in the prior literature (see for instance
Nissim and Ziv, 2001; Grullon et al., 2005).

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Table 3
Regression of the future earnings change, deflated by the book value, on the dividend change and
control variables

(Et ) Et)1)/B)1 = a0 + a1RDDIV0 + a2ROEt)1 + et

t a0 a1 a2 R2 N

1 0.0869 (2.11)** 0.1291 (1.68)* )0.7335 ()6.92)*** 0.0151 3149


2 )0.0219 ()0.47) )0.1513 ()1.62) )0.1141 ()14.19)*** 0.0725 2620

This table reports estimates of regressions relating raw earnings changes to dividend changes. Et is
the earnings before extraordinary items in year t (year 0 is the event year). B)1 is the book value of
equity at the end of year )1. RDDIV0 is the annual percentage change in the cash dividend payment
in year 0. ROEt)1 is equal to the earnings before extraordinary items in year t = 1 scaled by the
book value of equity at the end of year t = 1. *, ** and *** denote significant difference from zero
at the 1%, 5% and 10% levels, respectively.

level. On the other hand, the regression coefficient (a1) for t = 2 is negative and
not statistically significant. According to this initial test result, we can state that
as the dividend increases (decreases), the future earnings tend to increase
(decrease) for the next year, thus suggesting that dividend changes may provide
useful information regarding future earnings for at least a year in the Korean
market. These results do not change when the test period excludes the period
during which the Asian financial crisis occurred.

3.2. Cross-sectional analysis

The aforementioned result bolsters the ICD hypothesis that dividend changes
can predict future earnings. However, we also conduct cross-sectional regression
analysis using the method developed by Fama and MacBeth (1973) to assess the
relationship between dividend changes and the level of profits in each year,
because this reduces the problem associated with residual cross-correlations in
Equation (2). Prior to running the cross-sectional regression, we attempt to
model the residual term in Equation (2) as a white-noise process, as this is a
time-series with autoregression, and the regression coefficient may be time-vari-
ant. The best way to handle this problem is to add lagged variables of the depen-
dent variable, (E0 ) E)1)/B)1, as additional independent parameters in the
equation. Thus, Equation (2) is transformed to the following equation:

ðEt  Et1 Þ=B1 ¼ a0 þ a1 RDDIV0 þ a2 ROEt1 þ a3 RDDIV1


ð3Þ
þ a4 ROEt2 þ a5 ðE0  E1 Þ=B1 þ tt :

This is a dynamic equation form and is more appropriate to explain the direct
linkage between dividend changes and future earnings changes. The results of
cross-sectional regression based on Equation (3) are shown in Table 4. The

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Table 4
Fama–MacBeth cross-sectional regression of the future earnings change, deflated by the book value,
on the dividend change and control variables

ðEt  Et1 Þ=B1 ¼ a0 þ a1 RDDIV0 þ a2 ROEt1 þ a3 RDDIV1


þ a4 ROEt2 þ a5 ðE0  E1 Þ=B1 þ tt

t a0 a1 a2 a3 R2

Panel A. Whole sample


1 0.1381 (1.92)* 0.3721 (3.44)*** )1.0775 ()2.30)** )0.0017 ()0.13) 0.2421
2 0.0775 (0.77) 0.0041 (0.06) )0.6318 ()2.11)* )0.0729 ()1.64) 0.3005
Panel B. Chaebol
1 0.0287 (3.83)*** 0.0457 (1.32) )0.5565 ()1.15) 0.0071 (0.60) 0.3241
2 )0.0442 ()0.82) 0.1822 (1.48) )0.7458 ()2.67)** 0.0041 (0.14) 0.3654
Panel C. Non-Chaebol
1 0.0026 (0.21) 0.0369 (4.97)*** 0.3746 (1.48) )0.007 ()2.34)** 0.1586
2 0.0017 (0.08) )0.0354 ()1.32) 0.0953 (0.72) )0.0145 ()1.22) 0.2374
Panel D. High-growth firms
1 0.0049 (0.53) 0.0208 (0.74) 0.2363 (2.09)* )0.0082 ()2.19)** 0.1494
2 0.0062 (0.30) )0.0355 ()0.98) 0.1203 (1.16) )0.0187 ()1.59) 0.2226
Panel E. Low-growth firms
1 0.0083 (0.70) 0.0397 (4.93)*** 0.7277 (1.51) 0.0006 (0.18) 0.1905
2 )0.0256 ()0.71) 0.0123 (0.50) )0.2721 ()1.23) )0.0113 ()1.52) 0.2237

This table reports estimates of regressions relating raw earnings changes to dividend changes. Et is
the earnings before extraordinary items in year t (year 0 is the event year). B)1 is the book value of
equity at the end of year )1. RDDIV0 is the annual percentage change in the cash dividend payment
in year 0. ROEt is equal to the earnings before extraordinary items in year t scaled by the book value
of equity at the end of year t. We use the Fama and MacBeth (1973) procedure to estimate the
regression coefficients. In the first stage, we estimate cross-sectional regression coefficients each year
using all the observations in that year. In the second stage, we compute the time-series means of the
cross-sectional regression coefficients. The standard deviations for these averages are estimated using
the Hansen and Hodrick (1980) standard error correction method. The average adj. R2 is the average
(adjusted) R2 of the cross-sectional regressions. Chaebol and non-Chaebol firms are categorized
according to the Korea Fair Trade Commission. ‘High-growth’ firms (resp., ‘Low-growth’ firms) are
identified depending on whether their book-to-market (B/M) ratio is lower than (resp., at least) 50%.
*, ** and *** denote significant difference from zero at the 1%, 5% and 10% levels, respectively.

regression coefficients in the table are the time-series averages of the cross-sec-
tional regression coefficients calculated each year. The standard deviations for
these averages are estimated via the Hansen and Hodrick (1980) error correction
method, and the t-statistics are provided in parentheses. The R2 in the final col-
umn is the average regression coefficient of determination. Prior to conducting
the regression analysis, we first attempt to determine whether the residual terms
follow an AR (1) process for t = 1, using the Breusch–Godfrey test. The null
hypothesis that there is no auto-regression is rejected for Equation (2), with a
p-value of 0.0410, but supported for Equation (3), which includes the time-lagged
variables (p-value = 0.9743).

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Panel A in Table 4 shows that a1 is positive for t = 1 and t = 2 and statisti-


cally significant for t = 1. Therefore, this result supports the hypothesis that div-
idend changes can predict future corporate earnings for the next period. Our
result is virtually identical to the test results reported by Nissim and Ziv (2001),
and the only difference is that the relationship is significant only for t = 1 in the
Korean market, whereas it lasts until t = 2 in the US market.
Then, Panels B and C show the regression results after the entire sample is
divided into Chaebol and non-Chaebol firms. For non-Chaebol firms, a1 is posi-
tive for t = 1, which is the same as the result in Panel A. However, for Chaebol
firms, the coefficients are not significant; this indicates the absence of a significant
relationship between dividend changes and future earnings. Thus, there are two
different results for Chaebol and non-Chaebol firms: one rejects and the other
supports the ICD hypothesis. We would interpret these results as follows.

(1) Chaebol owners have more control power over member firms as Claessens
et al. (2000) report. Therefore, they are more reluctant to raise the dividend
payment because they can use the internally available resources under their
own control. Therefore, Chaebol firms do not promptly change dividends in
response to an increase in the corporate profit level; hence, their dividend
changes contain less information about corporate earnings changes. On the
other hand, non-Chaebol firms, which exhibit a smaller discrepancy between
cash-flow rights and voting rights, face strong demands from better diversi-
fied shareholders to distribute the earnings as dividends. Therefore, they are
more prompt to change dividends as the corporate profit changes, and the
ICD hypothesis is more valid for these firms.
(2) Chaebol member firms are larger in size and internationally better known.
Also, a large portion of their shares are held by international investors,3 espe-
cially US and European institutional investors. As a consequence, their divi-
dend policy is affected by these foreign shareholders. As it is US and western
practice that dividend payments be maintained once they are increased, firms
with large numbers of US and western shareholders should be more reluctant
to change dividends. Therefore, this conservative attitude to dividend changes
on the part of Chaebol firms makes the ICD hypothesis less valid for Chaebol
firms, whereas non-Chaebol firms are more flexible in changing dividends.

In addition, we also divide the Korean firms into ‘high-growth’ firms and ‘low-
growth’ firms depending on whether the book-to-market (B/M) ratio is lower
than 50 per cent or higher than 50 per cent. The regression results for high-
growth firms and low-growth firms are reported in Panels D and E, respectively,
in Table 4. The results show that the relationship between dividend changes and

3
For example, in the most well-recognized Korean Chaebol, viz., the Samsung group, the
firms are 26 per cent owned by foreign shareholders on average, and the foreign share of
Samsung Electronics is as much as 49 per cent (as of June 2010).

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future earnings is positively significant for low-growth firms, but not for high-
growth firms. This is not surprising. It is well known that high-growth firms tend
to retain and reinvest their earnings for further growth, whereas low-growth
firms have fewer opportunities to reinvest their earnings and therefore tend to
distribute them. Therefore, low-growth firms tend to change dividends more
responsively as their current and future earnings prospects change. Furthermore,
in Korea, low-growth firms have better minority shareholder rights than high-
growth firms. Many firms that were privatized in the 1990s are low-growth firms
in mature industries such as utilities (electric power, gas, etc.), banks and
tobacco. Because their shares are well distributed from the government to institu-
tional and individual shareholders, there is no single owner (government still can
insist on being the largest shareholder), and therefore shareholder rights are bet-
ter respected. Besides, low-growth firms usually are older firms, and as time goes
by, their shares are distributed to more individuals (e.g., Black and Gilson,
1998).4 Therefore, we would say that low-growth firms change dividends more
promptly not only because they have fewer opportunities to reinvest, but also
because minority shareholder rights are better respected. As a result, we would
say that dividends have more significant informational content in low-growth
firms in the Korean economy (i.e., a low-minority shareholder-right economy).

3.3. Cross-sectional analysis for asymmetric dividend changes

We conjecture that the relationship between dividend changes and future earn-
ings changes may not be symmetrical between dividend increases and dividend
decreases. We have already seen from Table 2 that the magnitudes of dividend
increases and dividend decreases differ significantly. Therefore, it is worthwhile
to run separate analyses for the dividend-increase group and the dividend-
decrease group, as in Equation (4). We again include the lagged variable of the
dependent variable in the equation to accommodate the autoregressive character-
istics of earnings changes.

ðEt  Et1 Þ=B1 ¼ a0 þ a1 DPCðRDDIV0 Þ þ a2 DNCðRDDIV0 Þ


ð4Þ
þ a3 ROEt1 þ a4 ðE0  E1 Þ=B1 þ et :

In the above equation, DPC (DNC) is a dummy variable, which takes the
numeric value of 1 when the dividend change is positive (negative) and 0 other-
wise; either variable is to be multiplied with RDDIV0. As a result, a1 becomes the
regression coefficient for the positive dividend-change group, and a2 becomes the
regression coefficient for the negative dividend-change group.

4
This comparison is between the low-growth group and the high-growth group. There-
fore, it is different from Claessens et al.’s (2000) study that runs a linear regression
between the concentration of control and company age with a sample of 345 firms (a large
portion of this sample already comprises of Chaebol members).

Ó 2010 The Authors


Accounting and Finance Ó 2010 AFAANZ
880 Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

Panel A in Table 5 shows the positive a1 and a2, but only a2 is statistically sig-
nificant for t = 1; both are insignificant for t = 2. This indicates that negative
dividend changes may be predictive of future earnings decreases at least for the
next year, whereas positive dividend changes cannot predict future earnings
increases. When we divide the entire sample into Chaebol and non-Chaebol
firms, the results are more favourable for the ICD hypothesis, as we can see in
Panels B and C. As in the case of Table 4, non-Chaebol firms show positive and
significant values with respect to both a1 and a2 for t = 1. This result again sup-
ports the ICD hypothesis for non-Chaebol firms. On the other hand, for Chae-
bol firms, only a2 for t = 2 is statistically significant, which is rather weak
support of the ICD hypothesis. The results for high-growth firms and low-
growth firms are also similar. Both a1 and a2 for t = 1 are positively significant
for low-growth firms, whereas only a2 for t = 1 is positively significant in the
case of high-growth firms. Therefore, we find again that the ICD hypothesis is
better supported when we distinguish firms in terms of firm-specific characteris-
tics such as the corporate governance level or the growth level. In addition, we
can say that negative dividend changes provide somewhat more information
about future earnings than positive dividend changes.
Overall, the cross-sectional analysis with Equations (3) and (4), assuming the
linear model of earnings expectation, shows that dividend changes provide useful
information for future earnings changes. This ICD effect is clearer and more sig-
nificant for non-Chaebol firms or low-growth firms perhaps because of the ratio-
nales that we have provided in the previous section.

3.4. Nonlinear model analysis

Although Nissim and Ziv (2001) demonstrate that the relationship between
dividend changes and future earnings is positive and significant, their model
assumes that earnings are a uniform mean reversion process and their autocorre-
lation is linear. However, many previous studies, including those of Elgers and
Lo (1994) and Fama and French (2000), have shown that the mean reversion
process and the level of autocorrelation in the earnings process are nonlinear.
They demonstrate that mean reversion is faster for large changes than for small
changes and faster for negative changes than for positive changes in earnings.
Therefore, Grullon et al. (2005) suggest an alternative specification to control for
the potential nonlinearity in the earnings process, as shown in Equation (5).
ðEt  Et1 Þ=B1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0
þ ðc1 þ c2 NDFED0 þ c3 NDFED0  DFE0
ð5Þ
þ c4 PDFED0  DFE0 Þ  DFE0 þ ðk1 þ k2 NCED0
þ k3 NCED0  CE0 þ k4 PCED  CE0 Þ  CE0 þ et :

In this equation, DFE0 refers to ROE0 ) E [ROE0]. Then, NDFED0 repre-


sents a dummy variable that assumes the value of 1 if DFE0 is negative and 0

Ó 2010 The Authors


Accounting and Finance Ó 2010 AFAANZ
Table 5
Cross-sectional regression of the future earnings change, deflated by the book value, on the asymmetric dividend change and control variables

ðEt  Et1 Þ=B1 ¼ a0 þ a1 DPCðRDDIV0 Þ þ a2 DNCðRDDIV0 Þ þ a3 ROEt1 þ a4 ðE0  E1 Þ=B1 þ et

t a0 a1 a2 a3 a4 R2

Panel A. Whole sample

Ó 2010 The Authors


1 0.1589 (2.12)* 0.1660 (1.16) 0.4385 (3.13)*** )0.9623 ()2.69)** )0.1698 ()2.36)** 0.2206
2 0.0684 (0.85) )0.1255 ()1.60) 0.0331 (0.19) )0.5884 ()2.53)** )0.1439 ()1.49) 0.2799
Panel B. Chaebol
1 0.0015 (0.16) )0.0712 ()0.67) )0.0729 ()1.76) )0.1221 ()1.13) 0.2343 (0.90) 0.2546
2 0.0630 (3.27)*** )0.0602 ()0.73) 0.3356 (2.60)** )0.4542 ()2.51)** )0.0613 ()0.20) 0.3068
Panel C. Non-Chaebol
1 0.0110 (1.34) 0.0408 (2.48)** 0.0939 (3.48)*** )0.1939 ()5.18)*** )0.3369 ()6.33)*** 0.1630
2 )0.0136 ()0.63) )0.0389 ()1.61) )0.0539 ()1.64) )0.0492 ()0.62) )0.3708 ()3.61)*** 0.2067

Accounting and Finance Ó 2010 AFAANZ


Panel D. High-growth firms
1 0.0080 (0.83) 0.0248 (1.13) 0.0887 (2.28)** )0.1853 ()1.69) )0.2898 ()4.2)*** 0.1561
2 )0.0016 ()0.19) )0.0558 ()1.02) )0.0372 ()1.02) )0.0693 ()1.74) )0.287 ()3.08)** 0.1915
Panel E. Low-growth firms
1 0.0185 (2.40)** 0.0398 (3.07)*** 0.0692 (2.49)** )0.2338 ()5.77)*** )0.2351 ()5.06)*** 0.1639
2 0.0020 (0.08) )0.0298 ()1.99)* 0.0696 (1.07) )0.1353 ()1.44) )0.2376 ()2.86)** 0.1970

This table reports estimates of regressions relating raw earnings changes to dividend changes. Et is the earnings before extraordinary items in year t (year 0 is
the event year). B)1 is the book value of equity at the end of year )1. RDDIV0 is the annual percentage change in the cash dividend payment in year 0. DPC
(DNC) is a dummy variable that takes the value of 1 for dividend increases (decreases) and 0 otherwise. ROEt is equal to the earnings before extraordinary
items in year t scaled by the book value of equity at the end of year t. We use the Fama and MacBeth (1973) procedure to estimate the regression coefficients.
In the first stage, we estimate the cross-sectional regression coefficients each year by using all the observations in that year. In the second stage, we compute the
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

time-series means of the cross-sectional regression coefficients. The standard deviations for these averages are estimated using the Hansen and Hodrick (1980)
standard error correction method. The average adj. R2 is the average (adjusted) R2 of the cross-sectional regressions. Chaebol and non-Chaebol firms are cate-
gorized according to the Korea Fair Trade Commission. ‘High-growth’ firms (resp., ‘Low-growth’ firms) are identified depending on whether their book-
to-market (B/M) ratio is lower than (resp., at least) 50%. *, ** and *** denote significant difference from zero at the 1%, 5% and 10% levels, respectively.
881
882 Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

otherwise. By the same token, PDFED0 is a dummy variable that assumes the
value of 1 if DFE0 is positive and 0 otherwise. Similarly, CE0 means that
(E0 ) E)1)/B)1. NCED0 is also a dummy variable that takes the value of 1 if
CE0 is negative and 0 otherwise, whereas PCED0 is a dummy variable that takes
the value of 1 if CE0 is positive and 0 otherwise. These dummy variables, as well
as the squared terms of NDFED0, PDFED0, NCED0 and PCED0, are inserted
in the equation to capture the nonlinearity in the earnings process.
Panel A in Table 6 shows the results of cross-sectional regression for Equation
(5). The regression coefficient for positive changes (a1) is close to 0 (0.0375) and
is not at all statistically significant. Although the regression coefficient for nega-
tive changes (a2) is somewhat larger (0.3069), it is not yet statistically significant.
Thus, the results shown in Panel A do not support the ICD hypothesis. How-
ever, when we divide that sample into Chaebol and non-Chaebol firms, both a1
and a2 for t = 1 become positively significant for non-Chaebol firms. For Chae-
bol firms, only a2 for t = 2 is significant. This result indicates that the ICD
hypothesis becomes valid if we divide the firms by corporate governance charac-
teristics, especially for non-Chaebol firms. Panels D and E also provide
the results for high-growth firms and low-growth firms, respectively. As in the
previous section, we find positively significant a1 and a2 for t = 1 in the case of
low-growth firms, which supports the ICD hypothesis, but not in the case of
high-growth firms. Therefore, we can still argue that the ICD hypothesis is valid
for non-Chaebol and low-growth firms even after we apply the nonlinearity in
the earnings process.

3.5. Robustness check with ROA

The ICD hypothesis suggests that dividend changes hold information regard-
ing a firm’s future earnings but does not necessarily specify which earnings mea-
surement information it holds. Therefore, it is meaningful to test the ICD
hypothesis with different earnings measurements variables, aside from the
accounting earnings utilized in the previous relevant literature. Return on Assets,
which is calculated by dividing earnings by total assets, is not only legitimate but
also a very appropriate dependent variable to test the ICD hypothesis. Because,
while earnings changes primarily show the ‘earnings growth’ when compared to
the previous year, the change in ROA shows the ‘profitability growth’ of the
firm. When we consider the fact that the total assets of a firm change according
to changes in the amount of debt or capital loss, ROA that takes the change in
assets into account should be a more adequate variable for the measurement of
a firm’s performance.5 Therefore, we first replace the dependent variable in
Equation (4) with the change in ROA (ROAt ) ROAt)1) to obtain the following

5
See Fama and French (2000) for a detailed explanation.

Ó 2010 The Authors


Accounting and Finance Ó 2010 AFAANZ
Table 6
Cross-sectional regression of earnings changes on dividend changes using the nonlinear model approach

ðEt  Et1 Þ=B1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0 þ ðc1 þ c2 NDFED0 þ c3 NDFED0  DFE0 þ c4 PDFED0  DFE0 Þ
 DFE0 þ ðk1 þ k2 NCED0 þ k3 NCED0  CE0 þ k4 PCED  CE0 Þ  CE0 þ et

Ó 2010 The Authors


t a0 a1 a2 c1 c2 c3 c4 k1 k2 k3 k4 R2

Panel A. Whole sample


1 0.0779 0.0375 0.3069 )0.6716 1.3662 3.1096 0.7142 )0.1265 )0.3329 )0.0997 0.0415 0.3654
(1.15) (0.31) (1.46) ()1.99)* (1.57) (1.81)* (1.33) ()0.91) ()0.82) ()0.91) (1.58)
2 )0.1052 )0.1745 )0.0701 0.7522 )2.7556 )5.1284 )1.4460 )0.1002 0.0892 0.0521 0.0518 0.2646
()0.92) ()1.52) ()0.26) (1.41) ()1.81)* ()2.26)** ()1.14) ()0.36) (0.20) (0.62) (0.43)

Accounting and Finance Ó 2010 AFAANZ


Panel B. Chaebol
1 )0.0167 0.0051 )0.0371 0.0261 0.2200 2.1625 )1.7255 0.0734 )1.1023 )7.3266 1.936 0.4644
()1.66) (0.13) ()1.00) (0.12) (1.04) (1.28) ()0.9) (0.3) ()2.63)** ()2.52)** (1.03)
2 )0.1209 2.0272 0.2059 1.1784 )2.532 )31.8241 )5.8496 3.1663 )6.0842 )11.1579 )18.4039 0.4402
()1.12) (1.18) (2.47)** (1.62) ()1.40) ()1.07) ()0.88) (1.74) ()1.46) ()1.16) ()2.16)*
Panel C. Non-Chaebol
1 )0.0352 0.0292 0.0689 0.0190 )0.4118 )2.6379 0.1394 )0.2263 )0.0572 )0.0604 )0.4792 0.2325
()1.39) (2.19)** (1.84)* (0.36) ()0.92) ()0.96) (0.58) ()1.77) ()0.19) ()0.10) ()0.67)
2 )0.0161 )0.0817 )0.0903 0.1143 )0.1414 )1.0503 )0.9062 1.0872 )1.7627 )4.7177 )2.5469 0.0811
()0.58) ()1.51) ()2.06)* (0.51) ()0.34) ()1.32) ()1.18) (1.48) ()1.62) ()1.43) ()2.06)*
Panel D. High-growth firms
1 )0.0592 )0.0208 0.0273 0.2057 )1.0802 )7.9808 )0.6073 )0.7361 0.5512 )0.0928 3.6536 0.2654
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

()1.55) ()0.44) (0.82) (1.26) ()0.96) ()0.91) ()1.15) ()1.11) (0.74) ()0.10) (0.87)
2 0.0546 )0.0124 )0.0880 )0.3589 1.3158 1.2644 0.7703 1.3182 )1.7961 )6.7993 )15.9929 0.1550
(1.56) ()0.27) ()1.90)* ()0.98) (0.62) (0.07) (0.50) (1.17) ()1.35) ()1.60) ()1.30)
883
884

Table 6 (continued)

ðEt  Et1 Þ=B1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0 þ ðc1 þ c2 NDFED0 þ c3 NDFED0  DFE0 þ c4 PDFED0  DFE0 Þ
 DFE0 þ ðk1 þ k2 NCED0 þ k3 NCED0  CE0 þ k4 PCED  CE0 Þ  CE0 þ et

Ó 2010 The Authors


t a0 a1 a2 c1 c2 c3 c4 k1 k2 k3 k4 R2

Panel E. Low-growth firms


1 0.0061 0.0305 0.0398 )0.0196 )0.1348 )1.2936 0.2124 )0.3021 0.2987 0.5128 0.0194 0.2341
(0.82) (3.52)*** (2.50)** ()0.16) ()0.39) ()0.71) (0.50) ()1.86)* (1.48) (1.20) (0.03)
2 )0.1066 )0.0575 0.0630 0.6373 )1.6014 )3.7247 )1.1031 0.9136 )1.6139 )1.1837 )3.2055 0.0950
()1.59) ()2.36)** (0.94) (1.10) ()1.56) ()1.59) ()0.86) (2.15)* ()1.93)* ()1.28) ()2.97)**

Accounting and Finance Ó 2010 AFAANZ


This table reports estimates of regressions relating raw earnings changes to dividend changes. Et is the earnings before extraordinary items in year t (year 0 is
the event year). B)1 is the book value of equity at the end of year )1. RDDIV0 is the annual percentage change in the cash dividend payment in year 0. DPC
(DNC) is a dummy variable that takes the value of 1 for dividend increases (decreases) and 0 otherwise. ROEt is equal to the earnings before extraordinary
items in year t scaled by the book value of equity at the end of year t. DFE0 is equal to ROE0 ) E [ROE0], where E [ROE0] is the fitted value from the cross-
sectional regression of ROE0 on the logarithm of the total assets in year )1, the logarithm of the market-to-book ratio of equity in year )1, and ROE)1. CE0
is equal to (E0)E)1)/B)1. NDFED0 is a dummy variable that takes the value of 1 if DFE0 is negative; it is 0 otherwise. PDFED0 is a dummy variable that
takes the value of 1 if DFE0 is positive and 0 otherwise. NCED0 is a dummy variable that takes the value of 1 if CE0 is negative and 0 otherwise. PCED0 is a
dummy variable that takes the value of 1 if CE0 is positive and 0 otherwise. We use the Fama and MacBeth (1973) procedure to estimate the regression coef-
ficients. In the first stage, we estimate the cross-sectional regression coefficients each year by using all the observations in that year. In the second stage, we
compute the time-series means of the cross-sectional regression coefficients. The standard deviations for these averages are estimated using the Hansen and
Hodrick (1980) standard error correction method. The average adj. R2 is the average (adjusted) R2 of the cross-sectional regressions. Chaebol and non-Chae-
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

bol firms are categorized according to the Korea Fair Trade Commission. ‘High-growth’ firms (resp., ‘Low-growth’ firms) are identified depending on
whether their book-to-market (B/M) ratio is lower than (resp., at least) 50%. *, ** and *** denote significant difference from zero at the 1%, 5% and 10%
levels, respectively.
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891 885

linear equation.6 We replace ROE in the right-hand side of Equation (4) with
ROA, and this also allows us to maintain consistency with the change in the left-
hand-side variable from earnings to ROA.

ROAt  ROAt1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0


ð6Þ
þ a3 ROAt1 þ a4 ðROA0  ROA1 Þ þ e:

Here, ROAt is Et/At, where At indicates the total assets at time t. Table 7 sum-
marizes the regression results for Equation (6). This shows that a1 is not statisti-
cally significant for both t = 1 and t = 2. However, a2 is statistically significant
for t = 1, but not for t = 2. This result suggests that dividend changes have
some information regarding a firm’s future profitability only when there is a neg-
ative change in dividends. The results in Panels B and C are not much different.
As in the case of the entire sample, only a2 is significant for t = 1 in the case of
non-Chaebol firms, whereas a1 and a2 are significant for t = 2 in the case of
Chaebols (we guess that Chaebols are less prompt in changing dividends as the
profit changes, and therefore the time lag of ICD is greater). This weakly sup-
ports the ICD hypothesis even after we change the dependent variable from
earnings to ROA. For high-growth firms and low-growth firms, we again find
that the ICD hypothesis is well supported in the case of low-growth firms as both
a1 and a2 are positively significant for t = 1, whereas it is weakly supported for
high-growth firms (only a2 for t = 1 is positively significant).
We also run a cross-sectional regression of future ROA changes with the non-
linear model of Grullon et al. (2005) by using Equation (7).

ROAt  ROAt1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0


þ ðc1 þ c2 NDFED0 þ c3 NDFED0  DFE0
ð7Þ
þ c4 PDFED0  DFE0 Þ  DFE0 þ ðk1 þ k2 NCED0
þ k3 NCED0  CE0 þ k4 PCED  CE0 Þ  CE0 þ et :

In this equation, all the variables are defined the same as in Equations (4)–(6).
The regression results are reported in Table 8. Panel A in Table 8 shows that a1
is not statistically significant for both t = 1 and t = 2, thereby indicating that
positive dividend changes are not predictive of future changes in firm profitabil-
ity. For negative dividend changes, a2 is not significant for t = 1 and incorrectly
negative for t = 2. Therefore, the nonlinear model with ROA changes as the
independent variable rejects the ICD hypothesis. On the other hand, the results

6
Although we have independently developed this idea of using ROA as an alternative
dependent variable to measure the future profitability in related to dividend changes,
Grullon et al. happen to have used the same method in their study (2005, Journal of
Business).

Ó 2010 The Authors


Accounting and Finance Ó 2010 AFAANZ
Table 7
886

Linear cross-sectional regression of the future ROA change on the asymmetric dividend change and control variables

ROAt  ROAt1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0 þ a3 ROAt1 þ a4 ðROA0  ROA1 Þ þ e

t a0 a1 a2 a3 a4 R2

Panel A. Whole sample

Ó 2010 The Authors


1 0.0031 (1.19) 0.0050 (0.78) 0.0268 (2.46)** )0.2015 ()3.44)*** )0.0341 ()0.23) 0.1353
2 0.0077 (1.73) 0.0001 (0.01) )0.0076 ()0.51) )0.4145 ()5.89)*** 0.1033 (1.78)* 0.1747
Panel B. Chaebol
1 0.0026 (1.01) )0.0001 ()0.01) )0.0125 ()1.05) )0.1446 ()3.02)** )0.0116 ()0.08) 0.2866
2 0.0079 (0.77) 0.0373 (1.82)* 0.0616 (3.23)*** )0.1909 ()1.40) )0.4928 ()1.44) 0.2701
Panel C. Non-Chaebol
1 0.0048 (1.45) 0.0017 (0.25) 0.0385 (2.20)** )0.2157 ()3.91)*** 0.0064 (0.05) 0.1579
2 0.0099 (1.93)* )0.0089 ()1.08) 0.0016 (0.17) )0.366 ()7.52)*** 0.1449 (1.44) 0.1941

Accounting and Finance Ó 2010 AFAANZ


Panel D. High-growth firms
1 )0.0037 ()0.68) )0.0211 ()1.25) 0.0422 (2.43)** )0.1212 ()1.10) )0.0414 ()0.25) 0.1685
2 0.0115 (2.62)** )0.0065 ()0.34) 0.0252 (0.91) )0.367 ()4.11)*** 0.0921 (1.08) 0.1936
Panel E. Low-growth firms
1 0.0107 (3.02)** 0.0136 (4.85)*** 0.0198 (2.73)** )0.3295 ()15.56)*** )0.1587 ()4.74)*** 0.1977
2 0.0097 (1.19) )0.0061 ()1.34) 0.0089 (1.02) )0.2985 ()3.01)** 0.0582 (1.93)* 0.1691

This table reports estimates of regressions relating changes in ROA to dividend changes. ROAt is equal to the operating income before depreciation in year t
scaled by the total assets at the end of year t. RDDIV0 is the annual percentage change in the cash dividend payment in year 0. DPC (DNC) is a dummy var-
iable that takes the value of 1 for dividend increases (decreases) and 0 otherwise. We use the Fama and MacBeth (1973) procedure to estimate the regression
coefficients. In the first stage, we estimate the cross-sectional regression coefficients each year by using all the observations in that year. In the second stage,
we compute the time-series means of the cross-sectional regression coefficients. The standard deviations for these averages are estimated using the Hansen
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

and Hodrick (1980) standard error correction method. The average adj. R2 is the average (adjusted) R2 of the cross-sectional regressions. Chaebol and non-
Chaebol firms are categorized according to the Korea Fair Trade Commission. ‘High-growth’ firms (resp., ‘Low-growth’ firms) are identified depending on
whether their book-to-market (B/M) ratio is lower than (resp., at least) 50%. *, ** and *** denote significant difference from zero at the 1%, 5% and 10%
levels, respectively.
Table 8
Nonlinear cross-sectional regression of the future ROA change on the asymmetric dividend change and control variables

ROAt  ROAt1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0 þ ðc1 þ c2 NDFED0 þ c3 NDFED0  DFE0 þ c4 PDFED0  DFE0 Þ
 DFE0 þ ðk1 þ k2 NCED0 þ k3 NCED0  CE0 þ k4 PCED  CE0 Þ  CE0 þ et

Ó 2010 The Authors


t a0 a1 a2 c1 c2 c3 c4 k1 k2 k3 k4 R2

Panel A. Whole sample


1 )0.0030 0.0058 0.0254 )0.0136 0.0608 0.1683 )0.0226 )0.0145 )0.0049 )0.0056 0.0003 0.1259
()0.59) (1.22) (1.19) ()1.56) (1.79)* (1.92)* ()1.10) ()2.33)** (0.26) ()1.47) (0.25)
2 )0.0258 )0.0072 )0.0241 0.0204 0.0419 0.2341 )0.0222 0.0079 )0.0022 0.0076 )0.0027 0.0619
()1.81)* ()0.89) ()1.81)* (2.87)** (0.32) (0.75) ()1.60) (0.63) ()0.10) (0.79) ()0.61)

Accounting and Finance Ó 2010 AFAANZ


Panel B. Chaebol
1 )0.0114 0.0435 )0.0353 )0.1149 0.3987 0.7643 0.0057 0.3903 )0.4740 1.4750 )0.2504 0.4699
()3.06)*** (1.65) ()1.48) ()2.05)* (1.63) (1.39) (0.02) (1.36) ()2.71)** (0.83) ()0.35)
2 )0.4237 0.6099 0.6521 3.5998 )7.6492 27.718 )4.4297 )2.9596 )9.2965 )73.4229 )5.3206 0.4192
()1.23) (1.36) (1.27) (1.27) ()1.22) (1.25) ()1.47) ()1.14) ()1.24) ()1.23) ()1.41)
Panel C. Non-Chaebol
1 )0.0137 0.0092 0.0340 )0.0214 )0.0193 )0.1301 0.0381 )0.0802 )0.1824 )0.7194 )0.1952 0.2190
()1.97)* (1.79)* (2.22)** ()0.45) ()0.41) ()0.41) (0.22) ()1.92)* ()1.19) ()1.47) ()1.10)
2 )0.0034 )0.0248 )0.0463 0.0264 )0.0761 )0.9749 )0.3032 0.3267 )0.5027 )2.3391 )0.5853 0.1208
()0.43) ()1.28) ()2.17)** (0.36) ()0.52) ()1.14) ()1.09) (1.36) ()1.45) ()1.37) ()2.35)**
Panel D. High-growth firms
1 )0.0192 )0.0154 0.0478 0.0300 )0.3088 )1.9758 )0.1287 )0.4202 0.2719 0.0514 2.1963 0.2784
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

()1.50) ()0.70) (2.17)** (0.83) ()1.04) ()0.95) ()1.75) ()1.37) (0.67) (0.08) (1.05)
2 0.0046 )0.0029 )0.0511 0.0266 )0.3017 )5.4125 )0.1733 0.4718 )0.5650 )2.1331 )7.3267 0.1798
(0.38) ()0.19) ()2.55)** (0.30) ()0.45) ()0.72) ()1.06) (1.06) ()1.39) ()2.39)** ()1.26)
887
888

Table 8 (continued)

ROAt  ROAt1 ¼ a0 þ a1 DPC0  RDDIV0 þ a2 DNC  RDDIV0 þ ðc1 þ c2 NDFED0 þ c3 NDFED0  DFE0 þ c4 PDFED0  DFE0 Þ
 DFE0 þ ðk1 þ k2 NCED0 þ k3 NCED0  CE0 þ k4 PCED  CE0 Þ  CE0 þ et

Ó 2010 The Authors


t a0 a1 a2 c1 c2 c3 c4 k1 k2 k3 k4 R2

Panel E. Low-growth firms


1 )0.0018 0.0136 0.0001 0.0016 0.0293 0.2233 )0.1971 )0.1021 0.0125 0.0927 0.0016 0.2123
()1.07) (6.76)*** (0.01) (0.05) (0.27) (0.71) ()1.61) ()1.13) (0.09) (0.39) (0.01)
2 )0.069 0.0055 )0.0712 0.4052 )0.7688 )0.1406 )0.3857 )0.0862 0.0515 0.7463 )0.3606 0.0986
()1.37) (0.35) ()1.40) (1.14) ()1.12) ()0.14) ()1.04) ()0.40) (0.28) (1.04) ()1.03)

Accounting and Finance Ó 2010 AFAANZ


This table reports estimates of regressions relating changes in ROA to dividend changes. ROAt is equal to the operating income before depreciation in year t
scaled by the total assets at the end of year t. RDDIV0 is the annual percentage change in the cash dividend payment in year 0. DPC (DNC) is a dummy var-
iable that takes the value of 1 for dividend increases (decreases) and 0 otherwise. DFE0 is equal to ROA0 ) E [ROA0], where E [ROA0] is the fitted value
from the cross-sectional regression of ROE0 on the logarithm of the total assets in year )1, the logarithm of the market-to-book ratio of equity in year )1,
and ROA)1. CE0 is equal to ROA0 ) ROA)1. NDFED0 is a dummy variable that takes the value of 1 if DFE0 is negative and 0 otherwise. PDFED0 is a
dummy variable that takes the value of 1 if DFE0 is positive and 0 otherwise. NCED0 is a dummy variable that takes the value of 1 if CE0 is negative and 0
otherwise. PCED0 is a dummy variable that takes the value of 1 if CE0 is positive and 0 otherwise. We use the Fama and MacBeth (1973) procedure to esti-
mate the regression coefficients. In the first stage, we estimate the cross-sectional regression coefficients for each year by using all the observations in that
year. In the second stage, we compute the time-series means of the cross-sectional regression coefficients. The standard deviations for these averages are esti-
mated using the Hansen and Hodrick (1980) standard error correction method. The average adj. R2 is the average (adjusted) R2 of the cross-sectional regres-
sions. Chaebol and non-Chaebol firms are categorized according to the Korea Fair Trade Commission. ‘High-growth’ firms (resp., ‘Low-growth’ firms) are
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

identified depending on whether their book-to-market (B/M) ratio is lower than (resp., at least) 50%. *, ** and *** denote significant difference from zero at
the 1%, 5% and 10% levels, respectively.
Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891 889

in Panel C (non-Chaebol panel) show that both a1 and a2 are significant for
t = 1, which supports the ICD hypothesis, whereas Panel B (the Chaebol panel)
does not support the hypothesis. Therefore, we can confirm our previous result
and argue that the ICD hypothesis is valid for non-Chaebol firms even under the
nonlinear model with ROA changes as the dependent variable. Regarding high-
growth firms and low-growth firms, a2 is significant for t = 1 in the case of
high-growth firms, whereas a1 is significant for t = 1 regarding low-growth
firms. Therefore, the ICD hypothesis becomes weakly supported when we divide
firms into high- and low-growth firms. In sum, we would still argue that dividend
changes can (except for Chaebol firms) be predictive of future changes in profit-
ability (ROA) even in the case of nonlinear cross-sectional regression analysis if
we distinguish firms according to their corporate governance or growth stage
characteristics.

4. Conclusions

This study investigates the validity of the ICD hypothesis for Korean firms by
testing the relationship between dividend changes and profitability in the fiscal
years following the dividend changes. We employ the methods of both Nissim
and Ziv (2001) and Grullon et al. (2005) to compare the outcome with that of
the US market.
For the entire sample, we determine that dividend changes can predict future
earnings changes for the following one year in simple and cross-sectional regres-
sion analyses in the Korean market, which supports Nissim and Ziv (2001) and
the ICD hypothesis. On the other hand, using the Grullon et al. (2005) nonlinear
cross-sectional regression method, we find that dividend changes are not predic-
tive of future changes in earnings. Thus, we can surmise that both the findings of
Nissim and Ziv (2001) and Grullon et al. (2005) are universally valid. Then, the
bottom line becomes whether one believes that mean reversion and autocorrela-
tion in earnings are linear or nonlinear. As the previous literature largely corrob-
orates the nonlinear nature of the earnings process, it will be difficult to support
the ICD hypothesis on the basis of the empirical analysis conducted in the Uni-
ted States (Grullon et al., 2005) as well as this study.
However, when we divide the firms into Chaebol and non-Chaebol firms, divi-
dend changes provide some information for future earnings, especially for non-
Chaebol firms, under both linear and nonlinear methods. Similarly, when we
divide firms into high-growth and low-growth firms, dividend changes seem to
have some information about future earnings, especially for low-growth firms in
both the linear and nonlinear models. These results are consistent whether
we use earnings or ROA as the dependent variable to represent the firm’s future
performance.
Therefore, we propose an important idea from our test results, namely the
validity of the ICD hypothesis can be dependent on firm-specific characteristics,
such as the corporate governance level or the firm’s growth level. We would

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Accounting and Finance Ó 2010 AFAANZ
890 Y. M. Choi et al./Accounting and Finance 51 (2011) 869–891

rationalize this proposition by suggesting that companies with better (worse)


minority shareholder rights can distribute (retain) profits more promptly as
forced by shareholders; therefore, dividends bear more (less) direct information
for the firm’s profitability. Similarly, as is recognized in the prior literature, low-
growth firms can distribute the profit more promptly to shareholders, while
high-growth firms reinvest the resources for further growth. Therefore, the ICD
can change depending on the firm’s corporate governance or growth characteris-
tics. This sheds new light on investigating the ICD hypothesis in the light of
firm-specific conditions and therefore can be a valuable new contribution to the
study of corporate dividends.

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