The Shareholder Base and Payout Policy

The following post comes to us from Andriy Bodnaruk of the Finance Department at the University of Notre Dame and Per Östberg of the Swiss Finance Institute.

In our paper, The Shareholder Base and Payout Policy, forthcoming in the Journal of Financial and Quantitative Analysis, we examine the relation between the shareholder base and payout policy. Finance practitioners acknowledge that having a broad shareholder base is an important factor for many corporate decisions. For example, in a recent study of firm payout policy, Brav, Graham, Harvey, and Michaely (2005) survey financial executives and conclude that “With respect to payout policy, the rules of the game include … [to] have a broad and diverse investor base…” Despite the apparent importance of the shareholder base there is little academic evidence relating shareholder base to corporate decisions. In this paper we investigate the effect of the shareholder base on the level and method of payout.

Shareholder base and payout policy of the firm are linked through a firm’s cost of capital. There are at least two reasons to expect that companies with a smaller shareholder base would have a higher cost of capital and, hence, be less flexible in their choice and size of payout. First, having a large shareholder base may reduce asymmetric information between insiders and outsiders through more information production. Second, the shareholder base may be related to the recognition of the firm and hence the availability of external financing. For example, Merton (1987) states that “an increase in the relative size of the firm’s investor base will reduce the firm’s cost of capital and increase the market value of the firm.”

We explore the relation between the shareholder base and payout policy using a sample of firms on NYSE, NASDAQ, and AMEX between 1984 and 2004. First, we find that small shareholder base firms have lower payout levels and larger cash reserves. We corroborate these results in an experimental setting by considering the introduction of decimal quotes on U.S. stock exchanges in 2001. Decimalization significantly lowered trading costs and thereby raised the demand for shares by retail investors and resulted in larger shareholder bases. This increase in the shareholder base is associated with increased payout and decreased cash holdings.

Second, given that there is a relation between the shareholder base and the cost of external financing, this has a potential implication for the method of payout. A firm considering making a special distribution can do it either in the form of a share repurchase or through a special dividend. However, an open market repurchase program may result in a smaller shareholder base if some shareholders tender all of their shares. We verify this conjecture by demonstrating that a share repurchase program reduces the shareholder base of the firm by at least 3.70% over the year of repurchase and the subsequent year. In contrast, non-repurchasing firms experience, on average, a 3.69% increase in the shareholder base over a two-year period. Hence, while repurchases are more tax efficient, they come at a cost of reduction in the shareholder base and therefore higher costs of external financing.

Third, given that a repurchase reduces the size of the shareholder base, we examine whether firms with already limited shareholder bases are less likely to use a repurchase as a payout method and thereby reduce the size of the shareholder base even further. We find that the shareholder base significantly affects the decision to undertake one-time distributions to shareholders and the method of distribution (special dividend or share repurchase). Small shareholder base companies are more likely to pay special dividends. Conditional on undertaking a special distribution, companies with small shareholder bases choose to use a special dividend (rather than repurchase stock) in 9.05% of cases while 6:49% of special distributions of large shareholder base firms are special dividends.

Overall, the findings of this paper suggest that the shareholder base not only affects firm valuation, but is also an important consideration for payout policy.

The full paper is available for download here.

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