The Impact of Dividend Covenants on Investment and
Operating Performance
Boochun Jung†
Woo-Jong Lee††
Yanhua Sunny Yang *
Current version: April 2015
___________________________________________________________________________
ABSTRACT: This paper examines the influence of dividend covenants in corporate bonds
on investment and operating performance. Prior literature analytically demonstrates that by
limiting dividend distribution to shareholders, dividend restrictions effectively place a
minimum on investment expenditures (Smith and Warner, 1979; Kalay, 1982). This suggests
a positive relation between dividend covenants and investment. The literature also
conjectures that the influence of dividend covenants on investment 1) mitigates the underinvestment problem associated with debt financing; or 2) exacerbates over-investment. We
empirically document that the presence of dividend covenants is associated with a higher
level of investment and poorer future performance. Further analyses confirm that the higher
level of investment is consistent with dividend covenants exacerbating over-investment rather
than mitigating under-investment. Our results suggest that dividend covenants could have
unintended consequences to firm stakeholders.
JEL Classification: M41
Keywords: DIVIDEND COVENANTS; INVESTMENT; OPERATING PERFORMANCE
___________________________________________________________________________
*
University of Connecticut, School of Business. Email: [email protected]
University of Hawaii at Manoa, Shidler College of Business. Email: [email protected]
††
Seoul National University, College of Business Administration. Email: [email protected]
†
We thank comments by an anonymous reviewer, Ronan Powell (associate editor), Brian Bolton, Ji-Woong
Chung, Lee-Seok Hwang, Michael Islin, E. Han Kim, Jay Junghun Lee, S. Ghon Rhee, Jongil So, Sooyoung
Song, Logan Steele, Nancy Su, Yong Yu, and participants at the 5th annual conference on Asia-Pacific Financial
Markets, the American Accounting Association 2012 annual meetings, the brown bag at the University of
Connecticut, and the finance seminar at the University of Hawaii at Manoa. Boochun Jung gratefully
acknowledges financial support from the Shidler College of Business. Woo-Jong Lee appreciates financial
support by the Institute of Management Research at Seoul National University.
The Impact of Dividend Covenants on Investment and Operating Performance
1. Introduction
This paper examines the influence of dividend covenants in publicly traded corporate
bonds on firms’ investment behavior and operating performance. Bond issuers include
dividend covenants in bond contracts to limit cash dividends, stock repurchases, and other
forms of distributions to stockholders as one way to mitigate conflicts between stockholders
and debt-holders (e.g., Jensen and Meckling, 1976; Myers, 1977). Based on cash flow
identity, Smith and Warner (1979) and Kalay (1982) analytically show that by placing a
ceiling on dividend distribution, dividend covenants effectively place a floor on investment
expenditure by the debt issuers, which suggests a positive relation between dividend
covenants and investment. 1 Given that a large portion of debt includes dividend covenants,
the influence of dividend covenants on investment and operating performance is likely to be
economically significant. 2 To date, however, there is little empirical evidence on the influence.
This paper attempts to fill this void.
Smith and Warner (1979) and Kalay (1982) also conjecture that additional investment
induced by the presence of dividend covenants could mitigate under-investment or exacerbate
over-investment. On one hand, to the extent that dividend covenants result in cash available
for investment in positive net present value projects, they would mitigate under-investment
and improve future operating performance (Myers, 1977). 3 On the other hand, to the extent
that dividend covenants result in excess cash available to management, they could exacerbate
1
In the framework of Smith and Warner (1979) and Kalay (1982), the influence of dividend payment
restrictions on investment does not require dividend covenants to be binding. When the covenants are not
binding, concerns about violating dividend covenants in the future when performance declines could induce the
firms to distribute less dividends than the allowed amount. Consistent with this argument, Kalay (1982)
documents that his sample firms subject to dividend covenants do not pay out the allowed maximum amount of
dividends.
2
Nikolaev (2010) documents that 40% observations in his sample have dividend covenants in bonds. It is 32%
for our sample.
3
If firms undertake positive NPV projects but with lower returns than previously-funded projects, more
investments could be associated with lower operating performance. Thus, operating performance alone does not
indicate investment efficiency.
1
the free-cash flow problem, leading to more investment in negative net present value projects
and lower future operating performance (Jensen, 1986). Thus, conditional on finding a
positive relation between dividend covenants in bond contracts and subsequent investments,
we further examine whether the increased future investment reflects the exacerbation of overinvestment or the reduction of under-investment and whether firms subject to dividend
covenants report superior or inferior future operating performance.
The relation between dividend covenants and investment is not without tension. The
analytical analyses in Smith and Warner (1979) and Kalay (1982) do not consider other ways
by which management may spend cash restricted by dividend covenants from being paid to
shareholders (e.g., Myers, 1977). As Bates et al. (2009) document, managers could hold a
large amount of cash to protect themselves against future adverse cash flow shocks. In
addition, management could transfer excess cash to non-pecuniary perks rather than invest it
(Jensen, 1986; Chava et al., 2010). It is therefore an open empirical question whether
dividend covenants in bond contracts influence the level of future investment.
Our analyses are based on 6,840 firm-year observations from 1985 to 2010. We
measure investment as the sum of R&D expense, capital expenditure, and acquisition
expenditure less cash receipts from sales of property, plant, and equipment. For firms with
dividend covenants we document that investment as a percentage of total assets is 1.1%
higher than that for firms without dividend covenants. For comparison, the average ratio of
investment to total assets is 10.9% for the total sample. Thus, the influence of dividend
covenants seems to be economically significant. Because an average firm in our sample has
total assets of $2,813 million, the presence of dividend covenants is associated with $31
million more investment on average (= 2,813*1.1%). We also find that the presence of
dividend covenants is associated with a higher likelihood of over-investment, but not
associated with the likelihood of under-investment.
2
In addition, we document a negative relation between dividend covenants and future
operating performance, consistent with the higher likelihood of over-investment associated
with dividend covenants. Overall, we infer that dividend covenants exacerbate the overinvestment problem and lead to poorer future operating performance. Inconsistent with the
theoretical argument in prior literature (e.g., Myers, 1977) that dividend covenants could
mitigate the under-investment problem, we find that dividend covenants are not related to the
likelihood of under-investment.
One concern about our empirical analysis is that unobservable factors could drive
both the inclusion of dividend covenants in bond contracts and the variation in either
investment or performance. To mitigate the concern about the self-selection bias, we reanalyze the impact of dividend covenant on investment and future performance after further
considering whether firms hold excess cash or not. Following Dittmar and Mahrt-Smith
(2007), we measure excess cash as the amount of cash unexplained by common factors
associated with cash holdings. As discussed at the beginning of the introduction, cash holding
competes with investment for cash uses. If the documented positive relation between
dividend covenants and investment is indeed due to dividend covenants, we would observe a
weaker relation between dividend covenants and investment for firms holding excess cash. 4
We find that our results hold only for firms without excess cash, yet are absent for firms with
excess cash. Therefore, unobservable factors are unlikely to explain the positive relation
between dividend covenants and investment. 5 Nonetheless, to further mitigate the concern
about the self-selection bias, we perform two additional tests that are based on propensity
score matching (Becker and Ichino, 2002) and the Heckman’s (1976) two-step estimation
procedure, respectively. All the results are robust to both approaches.
4
In untabulated tests, we find that firms subject to dividend covenants do not hold more excess cash than other
firms. We infer that dividend covenants tend to induce more investment rather than cash accumulation.
5
Results are similar when we classify excess cash holding based on the sample median of excess cash or the
sample median of cash.
3
In addition, we examine whether the influence of dividend covenants on investment
varies with the legal restriction on dividend payout and prior year dividend payout rate. We
find weak evidence consistent with stronger influence of dividend covenants among firms
incorporated in states with less restrictive statute on dividend payout. Regarding dividend
payout rate, the effect of dividend covenants on investment concentrates in firms with lower
payout rate. We interpret the result as consistent with Kalay’s (1982) observation that
dividend covenants induce precautionary use of cash among firms paying less dividends than
the maximum allowed by the covenants.
The positive relation between dividend covenants and investment is robust to the
exclusion of project-financed investment (Esty 2003), four alternative measures of
investment, an alternative measure of the presence of dividend covenants, controls for
corporate governance, and controls for the presence of other commonly-used covenants such
as investment covenants and financing covenants. The four alternative measures of
investment are industry-adjusted investment, investment unpredicted from sales growth
(Biddle et al., 2009), investment unpredicted from previous period investments (Titman et al.,
2004), and acquisition expenditure. The alternative measure of the presence of dividend
covenants is the percentage of bonds that have dividend covenants. This measure considers
the possibility that the influence of dividend covenants is stronger when firms have a higher
proportion of bonds with dividend covenants. These results provide strong support to our
inference that dividend covenants lead to more investment.
This paper makes two contributions. First, we empirically test a longstanding theory
concerning the impact of dividend covenants on investment (Smith and Warner, 1979; Kalay,
1982). Consistent with the theory, we document that dividend covenants are associated with
more investment. We further document that the higher investment associated with dividend
covenants reflects the exacerbation of the over-investment problem and leads to inferior
4
future operating performance. However, dividend covenants do not appear to mitigate the
under-investment problem. Therefore, we infer that dividend covenants could cause costly
unintended consequences for debt-holders and shareholders by exacerbating over-investment
and thus, worsening future operating performance. To the best of our knowledge, this paper is
the first to empirically test firms’ investment activities and future operating performance
associated with dividend covenants. Second, this paper contributes to a growing literature that
examines the effect of debt covenants on management behaviors, including financial
reporting (e.g., Chava and Roberts, 2008; Nini et al., 2009; Nikolaev, 2010). Even though
dividend covenants are present in a significant portion of bonds, with the exception of Healy
and Palepu (1990), little empirical evidence is provided about dividend covenants’ effect on
management behavior and operating performance. Healy and Palepu (1990) examine the
effect of dividend covenants on dividend payments of firms close to violating dividend
covenants, but not the effect of dividend covenants on future investment or operating
performance for a broader sample, which is the focus of our paper.
The rest of this paper proceeds as follows. Section 2 reviews the literature and
develops hypotheses, and Section 3 describes research designs. Section 4 presents the sample
selection procedures, descriptive statistics, and empirical test results. Section 5 contains
robustness analyses. The paper concludes with Section 6.
2. Literature review and hypothesis development
The literature argues that debt covenants mitigate the conflicts between debt-holders
and shareholders by restricting managers’ self-serving behaviors (e.g., Jensen and Meckling,
1976; Smith and Warner, 1979). Consistent with this argument, prior studies document that
firms reduce investment subsequent to the violation of a financial covenant (Chava and
Roberts, 2008) or after adding restrictions on capital expenditure in an issuer’s private debt
5
(Nini et al., 2009). These studies conclude that debt covenants constrain investment. Nini et
al. (2009) further conclude that capital expenditure covenants also create positive
externalities that benefit equity holders through reducing investment and improving future
performance. This study expands this literature in two ways. First, unlike the literature that
focuses on scenarios where control right is shifted to creditors, we examine the impact on
management activities of the presence of dividend covenants for an average firm when the
control right is not shifted to creditors. Second, while prior studies focus on covenants that
mitigate the agency problems and benefit both debt-holders and equity holders by
constraining management investment, we examine dividend covenants that can potentially
exacerbate the over-investment problem and thus be costly for both groups of stakeholders.
Dividend covenants are designed to mitigate the conflict between debt-holders and
shareholders regarding dividend distribution. The conflict arises from potential wealth
transfer from debt-holders to shareholders through paying dividends out of cash obtained
from issuing debt, selling assets, or foregoing profitable investment projects. For this purpose,
debt-holders can prohibit borrowing companies from paying out any dividends to
shareholders, or only permit dividend payment out of an inventory of funds defined by the
covenant. Empirical findings in the literature (e.g., Kalay, 1982; Smith and Warner, 1979;
Nikolaev, 2010) are consistent with the latter form of dividend covenants being widely used.
One common form of dividend covenants specifies that the inventory of funds
available for dividend payment accumulates 50% of profit and all proceeds from stock
issuance, and deducts 100% of loss. Thus, when dividend covenants are binding, firms could
boost earnings instead of reducing dividends. The literature provides mixed evidence on this.
Healy and Palepu (1990) document that firms close to violating dividend covenants do not
manage accruals upward, but reduce their dividends. DeAngelo and DeAngelo (1990)
document that for firms experiencing persistent losses, binding dividend covenants seem to
6
be an important contributor to dividend reduction. On the other hand, a more recent study by
Daniel et al. (2008) finds that firms with debt, but not those without debt, manage accruals
upward to maintain existing dividend levels. Daniel et al. (2008) suggest that dividend
covenants in debt contracts could affect the earnings management incentive. Extending this
literature on the influence of dividend covenants on firms’ earnings management and
dividend distribution decisions, this study examines the influence of dividend covenant on
firms’ investment behavior and operating performance.
Smith and Warner (1979) and Kalay (1982) propose that with the cash flow identity,
imposing a maximum amount of dividend payment effectively places a minimum on
investment expenditures, suggesting a larger amount of investment associated with dividend
covenants. The larger amount of investment could come out of two sources. The first source
is cash in excess of the maximum amount allowed by the dividend covenants. The second
source is cash in excess of the affected firms’ actual dividend payment but within the
maximum amount of dividend allowed by dividend covenants. As Kalay (1982) documents,
the affected firms pay less dividends than the allowed amount and maintain a “reservoir” of
funds, likely as a precaution against violating dividend covenants in the future when
operating performance deteriorates. In the paper, we describe both sources as cash restricted
by dividend covenants and do not distinguish them.
More investment could mitigate the under-investment problem associated with debt
financing as discussed by Myers (1977). Thus, dividend covenants could relate to more
investment in value-enhancing or positive net present value projects, and possibly improved
subsequent operating performance. However, as Myers (1977) points out, restricting dividend
payments may not resolve the under-investment problem. For example, when stakeholders
are unable to monitor management’s self-serving activities or when it is too costly to do so,
the management could transfer capital to themselves as non-pecuniary perks. In addition,
7
besides investing in real assets, bond issuers could hoard cash to protect themselves against
adverse cash flow shocks or invest in liquid securities (Bates et al., 2009). The above
discussion suggests that management may not invest cash restricted from dividend payment.
On the other hand, when management chooses to invest in available projects, in the presence
of managerial agency risk that arises from separation of ownership and control, managers
may pursue self-interest policies that do not maximize firm value, such as empire building
(Chava et al., 2010). In this case, management could use dividend covenants as a justification
for not paying out excess cash to shareholders and instead invest it in negative net present
value projects. Thus, dividend restriction could exacerbate the free cash flow problem (Jensen
1986) and potentially lead to over-investment. From the overall discussion, we hypothesize in
H1 below that dividend payment restriction is associated with a higher amount of investment.
H1: Dividend covenants in bond contracts would lead to more investment in future
periods.
The discussion above further suggests that the tendency to invest more could reflect
either the mitigation of under-investment or the exacerbation of over-investment, which has
distinctly different implications for whether and how dividend covenants mitigate the
conflicts of interest among stakeholders. While the mitigation of under-investment is
beneficial for both debt-holders and stockholders, the exacerbation of over-investment
damages the interests of both stakeholders. Thus, conditional on documenting evidence that
supports H1, below with two separate hypotheses, we further examine whether the higher
amount of investment for firms subject to dividend covenant restriction is due to the
mitigation of under-investment or the exacerbation of over-investment, or both.
H1a: Dividend covenants in bond contracts would exacerbate over-investment.
H1b: Dividend covenants in bond contracts would mitigate under-investment.
An investment increase due to dividend covenants also has implications for future
operating performance. Investing more in positive net present value projects mitigates the
8
under-investment problem and could also improve future performance. More investment in
negative net present value projects exacerbates the over-investment problem and leads to
performance deterioration (e.g., Titman et al. 2004). Thus, with H2 below, we examine the
impact of dividend covenant restriction on operating performance. Based on the above
discussion, we leave the prediction for H2 unsigned.
H2: Dividend covenants in bond contracts are significantly associated with future
operating performance.
Results of examining H2 could validate our inference from testing H1a and H1b that
are on firms’ tendency to over-invest or under-invest. For instance, if we document results
consistent with a higher tendency to over-invest for firms subject to dividend covenants,
lower future operating performance would triangulate our inference that dividend covenants
exacerbate the over-investment problem. Similarly, documenting both a lower tendency of
under-investment and higher future operating performance would support our inference that
dividend covenants mitigate the under-investment problem.
3. Research designs
3.1. Research design for H1
To test the first hypothesis, H1 that predicts a positive relation between the presence
of dividend covenants in bond contracts (DR) and future investment, we estimate equation (1)
below. A positive coefficient on DR supports H1, suggesting that the presence of dividend
covenants leads to more future investment.
INVESTit+1 = α0 + α1DRit + α2DIVit + α3AQit + α4SIZEit + α5M/Bit + α6STD(OCF)it +
α7STD(SALES)it + α8STD(INVEST)it + α9ALTMANZit + α10PPEit + α11LEVit +
α12OCFit/SALESit + α13OperCycleit + α14LOSSit + α15AGEit +
Year fixed effect + Industry fixed effect + ε
(1).
where,
INVESTit+1 =
the amount of investment in year t+1 for firm i, defined as the sum of R&D
9
expense (XRD), capital expenditure (CAPX), and acquisition expenditure
(AQC) less cash receipts from sale of property, plant, and equipment
(SPPE), scaled by lagged total assets (AT). 6
DRit =
an indicator variable that equals one if firm i has dividend covenants in any
of its outstanding bond contracts in year t, and zero otherwise. 7 Dividend
covenants refer to covenants that restrict dividends or other forms of
payments, such as stock repurchases, to shareholders.
DIVit =
dividend payment (DVC) in year t divided by lagged total assets.
AQit =
accruals quality based on the Dechow and Dichev (2002) model modified
by McNichols (2002). The model regresses working capital accruals on
lagged, current, and future cash flows (OANCF), change in revenue (SALE),
and property, plant and equipment (PPEGT), where all variables are scaled
by the average of beginning and ending total assets. Working capital
accruals are measured as the sum of the increase in accounts receivable
(RECCH), the increase in inventory (INVCH), the decrease in accounts
payable and accrued liabilities (APALCH), the decrease in taxes accrued
(TXACH), and the increase (decrease) in other assets (liabilities)
(AOLOCH). The model is estimated cross-sectionally for each industry
with at least 20 observations in a given year based on the Fama and French
(1997) 48-industry classification. The standard deviation of the firm-level
residuals from years t-5 to t-1 is defined as AQ. Thus, a higher value of AQ
indicates worse accruals quality. 8
SIZEit =
the natural logarithm of total assets at the end of year t.
M/Bit =
the ratio of the market value (CSHO*PRCC_F) to the book value of equity
(CEQ).
STD(OCF)it =
the standard deviation of cash flows from operations over years t-4 to t,
where cash flows from operations (OANCF) are deflated by the average of
6
Since dividend covenant may influence investment beyond the subsequent year, as a robustness check, we also
examine investment in year t+2 and the average of investment during the subsequent two years. Our results
based on these alternative measures of investment are qualitatively similar.
7
For example, for a bond that is mature in ten years, we code DR at 1 for all ten years the bond is outstanding.
8
The literature documents that accrual quality measure may have severe measurement errors when a firm is
involved in material net external financing (Ball and Shivakumar, 2008; Shan et al., 2013), which likely applies
to our sample. To address this concern, we take two approaches. First, we exclude AQ from the main regression
and re-estimate model (1). Second, we replace AQ with another proxy for financial reporting quality that is less
likely to be distorted by net external financing. Following Li (2008) and Biddle et al. (2009), we use the FOG
index, a measure of financial disclosure transparency for the subsample of 4,958 firm-years with data on FOG.
The main results are robust to the exclusion of AQ or controlling for FOG index instead of AQ.
10
beginning and ending total assets of the corresponding year.
STD(SALES)it = the standard deviation of sales over years t-4 to t, where sales (SALE) are
deflated by the average of beginning and ending total assets of the
corresponding year.
STD(INVEST)it = the standard deviation of total investment over years t-4 to t, where total
investment is deflated by the average of beginning and ending total assets of
the corresponding year.
ALTMANZit =
Altman’s (1968) Z-score, calculated as (1.2*(ACT - LCT) + 1.4*RE +
3.3*(OIADP + NOPI) + SALE)/AT. A higher Altman’s Z-score indicates
lower bankruptcy risk.
PPEit =
the ratio of property, plant and equipment (PPENT) to lagged total assets.
LEVit =
the ratio of long-term debt (DLTT) to the sum of long-term debt and the
market value of equity (DLTT + CSHO*PRCC_F).
OCFit/SALESit-1 = cash flows from operations (OANCF) scaled by lagged sales (SALE).
OperCycleit =
the logarithm of the sum of the ratio of accounts receivables to sales
(RECT/SALE) and the ratio of inventory to cost of goods sold
(INVT/COGS). Both ratios are multiplied by 360.
LOSSit =
an indicator variable that equals one if net income before extraordinary
items (IB) is negative, and zero otherwise.
AGEit =
the logarithm of the number of years a firm’s stock data have been recorded
in CRSP.
Motivated by the literature on investment behavior (e.g., Richardson, 2006; Biddle et
al., 2009; Cella 2013), in equation (1), we include various control variables that may affect
the level of investment. Survey evidence in Brav et al. (2005) and empirical evidence in
Daniel et al. (2010) indicate that managers may forgo investment to maintain the dividend
level, suggesting a negative relation between dividend payment and investment. Thus,
equation (1) includes the amount of dividend payment (DIV). We expect a larger amount of
investment when firms have more investment opportunities (M/B), are financially healthier
(ALTMANZ), and do not experience losses (LOSS). In addition, since long-term debt (LEV) is
positively correlated with bankruptcy risk (Jensen and Meckling, 1976; Myers, 1977), the
11
debt overhang issue is more likely for firms with a higher proportion of long-term debt. We
expect lower investment for such firms. We also account for the possible variation of
investment with firm size (SIZE) and age (AGE). Biddle et al. (2009) document that cash
flow
volatility (STD(OCF)),
sales
volatility
(STD(SALES)),
investment
volatility
(STD(INVEST)), asset tangibility (PPE), cash flows as a percentage of sales (OCF/SALES),
operating cycle (OperCycle), and accruals quality (AQ) significantly influence investment.
Finally, equation (1) includes year and industry fixed effects to control for the variation in
investment over time and across industry. 9 Standard errors are adjusted for firm clustering to
address the within-firm correlation in the standard errors (Petersen, 2009).
3.2. Research design for H1a and H1b
We use a logistic regression below to test H1a (H1b) that predicts a positive
(negative) relation between the presence of dividend covenants in bond contracts and the
likelihood of future over-investment (under-investment).
OVERit+1 (or UNDERit+1) = α0 + α1DRit + α2DIVit + α3AQit + α4SIZEit + α5M/Bit +
α6STD(OCF)it + α7STD(SALES)it + α8STD(INVEST)it +
α9ALTMANZit + α10PPEit + α11LEVit + α12OCFit/SALESit +
α13OperCycleit + α14LOSSit + α15AGEit +
Year fixed effect + Industry fixed effect + ε
(2).
Where,
OVERit+1 =
1 when firm i’s investment in year t+1 (i.e., INVESTt+1) is in the top quartile
among all firms in the same year, and 0 if INVEST is in the middle two
quartiles.
UNDERit+1 = 1 when firm i’s investment in year t+1 is in the bottom quartile among all
firms in the same year, and 0 if INVEST is in the middle two quartiles.
The definitions of OVER and UNDER follow Biddle et al. (2009). All other variables
are as defined in equation (1). When estimating the likelihood of over-investment (under-
9
Following Fama and French (1997), we classify our sample firms into 48 industry categories.
12
investment), we exclude all observations with UNDERit+1 (OVERit+1) at 1. Thus, by definition,
the average values of OVERit+1 and UNDERit+1 are 33%.
When OVER (UNDER) is the dependent variable, a positive (negative) coefficient on
DR supports H1a (H1b). For the same reason as described for equation (1), equation (2) also
includes various control variables.
3.3. Research design for H2
We test H2 with regression (3) below.
ROAit+τ = α0 + α1DRit + α2DIVit + α3ROAit + α4PPEit + α5SIZEit + α6M/Bit + α7LEVit +
α8AGEit + Year fixed effect + Industry fixed effect + ε
(3).
where,
ROAt+τ = net income (NI) for year t + τ (τ = 1 or 2) divided by the average of beginning and
ending total assets (AT) at year t+τ.
ROAt = net income (NI) for year t divided by the average of beginning and ending total assets
(AT) at year t. All other variables are as defined for regressions (1) and (2).
A negative coefficient on DR indicates lower profitability associated with dividend
covenants. In the context of more investment by firms subject to dividend covenants, the
lower profitability is more likely to reflect over-investment than the mitigation of underinvestment. On the other hand, a positive coefficient on DR indicates higher profitability
related to dividend covenants and is more consistent with the mitigation of under-investment
than over-investment. Because investment could have a long-term effect on operating
performance, we investigate ROA over the future two years. Following Dittmar and MarhtSmith (2007), we control for firm size (SIZE), asset structure (PPE), and lagged ROA. We
further include dividend payment (DIV), market-to-book ratio (M/B), leverage (LEV), and
firm age (AGE). These variables potentially influence both the inclusion of dividend
covenants in debt contracts and future operating performance.
3.4. Hypothesis tests conditional on excess cash
13
As described in the introduction, a positive relation between dividend covenants and
investment could be driven by self-selection bias. To examine this possibility, we perform all
the previous analyses after adding a dummy variable, POS_EXCASH, that indicates whether a
firm holds excess cash, and its interaction with DR. Since holding cash (including liquid
securities) competes with investment for cash restricted by dividend covenants, we expect the
relation between dividend covenants and future investments to be more pronounced among
firms that do not hold excess cash. 10 However, as long as self-selection does not vary with
excess cash, the relation between dividend covenants and investment should not vary with
excess cash. For the same reason, we expect the positive relation between dividend covenants
and the tendency to over-invest to concentrate in firms that do not hold excess cash. Similarly,
we also examine future operating performance by adding POS_EXCH and its interaction with
DR.
We follow Dittmar and Mahrt-Smith (2007) and compute excess cash as the residual
from estimating regression (4) below for each year. POS_EXCASH equals 1 for positive
residuals and 0 otherwise.
Ln(CASHit/NAit) = α0 + α1LnNAit + α2FCFit/NAit + α3NWCit/NAit + α4IND_Sigma +
α5MVit/NAit + α6RDit/NAit + Year fixed effect + Firm fixed effect + ε
(4).
where:
CASHit =
Cash and cash equivalent (CHE) at the end of year t.
NAit =
Net assets at the end of year t, measured as total assets (AT) minus cash and
cash equivalent (CHE). It proxies for access to financial markets and cash
demand from day-to-day operations.
FCFit =
Cash flows from operating activities (OANCF) minus interest and taxes over
year t. It measures internal financing.
NWCit =
Current assets (ACT) minus current liabilities (LCT) and cash (CHE). It
measures potential cash substitute.
10
This argument implicitly assumes that when firms have extra cash, those subject to dividend covenants are
less likely to distribute it to shareholders. Our untabulated results confirm this conjecture. Firms subject to
dividend covenants have significantly lower frequency of increase in cash dividends or stock repurchases.
14
IND_Sigmait = Industry average of the standard deviation of FCF/NA in the prior ten years.
MVit =
Market value of equity, calculated as the product of stock price and the
number of common shares (CSHO*PRCC_F) plus total liabilities (LT).
RDit =
Research and development expense (XRD). We set it to zero if missing.
4. Sample selection, descriptive statistics, and empirical results
4.1. Sample selection and descriptive statistics
Our primary data sources are the Mergent FISD (Fixed Investment Securities
Database) for bond issuance and covenant usage data, the Compustat for financial
information, and the CRSP for firm age. The FISD contains detailed information about bonds
at the time of issuance, such as offering yield, offering amount, call and put features, and
comprehensive information about all covenants included in bonds. Because the FISD
includes only bonds that mature after 1989 (Billett et al., 2007, p. 704) our sample periods
cover 1988 to 2010. Following prior studies (e.g., Chava et al., 2010), we consider only
bonds issued by U.S.-domiciled non-financial firms that have required data from the
databases listed above. We include rule-144a privately placed bonds, which are allowed by
the SEC to be publicly traded once certain conditions are met. We exclude Yankee, Canadian,
and foreign currency bonds. Furthermore, the bonds must be corporate debentures with
covenant information available in the FISD. 11 These requirements yield 6,840 firm-year
observations for 897 unique firms. 12 As described in the research designs, we adjust standard
errors by firm clustering to mitigate the concern about within-firm correlation in standard
errors. We winsorize all continuous variables at the 1% and 99% levels to minimize the
influence of outliers on the results.
Table 1 presents descriptive statistics for the main variables for the whole sample and
11
Medium-term notes are excluded because the FISD does not record covenant information for them.
Out of 6,840 firm-year observations, 257 adopted DR and 64 terminated DR during the sample period. The
rest did not change their DR status. Since no firm has experienced the change in DR status more than once in
our sample period, the changes were for 257 and 64 unique firms, respectively.
12
15
the subsamples classified based on the presence of dividend covenants in bond contracts.
About 32% of the entire sample has dividend covenants in bond contracts (hereafter DR
firms). Table 1 shows that relative to firms without dividend covenants (hereafter NON-DR
firms), the DR firms are smaller, younger, less profitable, financially less healthy, more
leveraged, have lower market-to-book ratios, and pay lower amount of dividends. All other
variables except investment (INVEST) and the binary variable of the likelihood of overinvestment (OVER) differ significantly between the two subgroups. The significant
differences in various firm characteristics between DR firms and NON-DR firms suggest the
importance of controlling for these variables when estimating the relation between dividend
covenants and future investment. As discussed in the introduction, the differences in firm
characteristics between DR firms and NON-DR firms also raise concerns about the selfselection issue, which we further verify with tests described in Section 3.4 and later also treat
with propensity score matching and Heckman’s (1976) two-step estimation procedures.
Table 2 reports correlations among the main variables. Inferences from the
correlations between dividend covenants (DR) and other variables are generally similar to
those from Table 1. DR is positively correlated with leverage (LEV) and loss occurrence
(LOSS) and negatively correlated with firms size (SIZE), growth opportunities (M/B),
financial health (ALTMANZ), and firm age (AGE). Correlation coefficients among other
variables are also largely consistent with the literature. For example, consistent with Biddle et
al. (2009), investment is positively correlated with growth opportunities (M/B), investment
volatility (STD(INVEST)), and asset tangibility (PPE) and negatively correlated with loss
occurrence (LOSS) and firm age (AGE). Table 2 shows that dividend covenants are not
correlated with investment or the likelihood of over-investment. Below we examine the
relation between investment and dividend covenants with multivariate tests.
4.2. Empirical results
16
4.2.1. Results for the tests of H1
Table 3, Panel A presents the results of estimating model (1). Results in Panel B are
based on the model (1) after further considering whether a firm has excess cash or not. Panel
A shows that, consistent with H1, the coefficient on DR is positive and significant at the 1%
level. The coefficient is also economically significant. The magnitude of 0.011 suggests that
relative to NON-DR firms, a DR firm of average total assets invests $30.9 million more (=
$2,812 million*0.011). As compared to the average ratio of investment to total assets at
10.9%, the results suggest that dividend covenants could be associated with a 10% increase in
investment (= 0.011/0.109) for an average firm. Turning to control variables, we document
negative coefficients on firm size, dividend payment, long-term debt ratio, and loss
occurrence, and positive coefficients on the market-to-book ratio, investment volatility, and
asset tangibility, generally consistent with the literature (e.g., Biddle et al. 2009).
Panel B shows that the relation between dividend covenants in the current year and
future investment is significantly positive for firms not having excess cash, but not for firms
holding excess cash. To the extent that the factors associated with dividend covenant
inclusion do not explain excess cash holding, the differential relation between dividend
covenants and investment for firms holding excess versus those not holding excess cash is
inconsistent with self-selection driving the results on investment. Overall, consistent with H1,
we document that dividend covenants are positively related to future investment of the
affected firms. The positive relation concentrates in firms that do not hold excess cash, for
which extra cash is more likely to be directed to investment.
4.2.2. Results for the tests of H1a and H1b
Table 4 reports the estimation results of equation (2), which tests hypotheses H1a and
H1b. The first two columns of Panel A present results supporting H1a that predicts a positive
relation between dividend covenants and the likelihood of over-investment. The coefficient
17
on DR is significantly positive (coefficient = 0.231; p-value = 0.02), suggesting that dividend
covenants positively influence the likelihood of over-investment. The coefficient on DR is
also economically significant. When the other independent variables take their respective
mean values, the presence of dividend covenants increases the likelihood of over-investment
by 4.9%. Considering the mean value of OVER at 33.3%, which is determined by research
design, a change of 4.9% appears economically significant. As shown in the last two columns
of Panel A, the coefficient on DR is insignificant (p-value = 0.47), not supporting H1b that
predicts a negative relation between dividend covenants and the likelihood of underinvestment. We thus conclude that dividend covenants are correlated with a higher likelihood
of over-investment, but are not correlated with the likelihood of under-investment.
Similar to Panel B of Table 3, we estimate regression (2) conditional on whether a
firm has excess cash or not. Panel B shows that when the dependent variable is the likelihood
of over-investment, the coefficient on DR is positive and significant while the sum of the
coefficient on DR and the coefficient on DR*POS_EXCASH is insignificant, indicating that
the positive relation between dividend covenants and the likelihood of over-investment is
driven by the sub-sample of firms not having excess cash. The overall results in Table 4
suggest that the positive relation between dividend covenants and future investment reported
in Table 3 is more likely to reflect the exacerbation of over-investment rather than the
mitigation of under-investment.
4.2.3. Results for the tests of H2
Table 5 reports the results of testing H2 that dividend covenants affect future
operating performance. The left side columns of Table 5 examine ROA for the year
subsequent to the year DR is measured (i.e., ROAt+1). The coefficient on DR is -0.007 and
significant, suggesting that dividend covenants negatively influence future operating
performance. The magnitude of the coefficient on DR is about 17% of the sample average of
18
ROA (= -0.007/0.042), which seems economically significant. The right side columns
examine ROA in the second year subsequent to the year DR is measured (i.e., ROAt+2).
Results are consistent with those with ROAt+1. The coefficient on DR is -0.009 and significant.
Overall, the results suggest that dividend covenants negatively affect future operating
performance. Combining this result with those in tables 3 and 4, we infer that dividend
covenants exacerbate over-investment and worsen future operating performance. Regarding
the control variables, we find that ROA is higher for firms with larger dividend payout, a
higher ROA in the previous year, more growth opportunities, lower leverage, and older age.
In Panel B, we also examine the relation between dividend covenants and future ROA
conditional on whether a firm has excess cash. When the dependent variable is ROAt+1, both
the coefficient on DR and the sum of it with the coefficient on DR*POS_EXCH are
significantly negative, suggesting that the negative association of dividend covenants with
future operating performance exists in all firms irrespective of their excess cash holding.
Results are qualitatively similar when the dependent variable is ROAt+2.
5. Robustness tests
5.1. Results based on propensity score matching
As we describe in the introduction, it is plausible that the inclusion of dividend
covenants in bond contracts is subject to the self-selection bias, i.e., firms with certain
characteristics (uncontrolled in the regressions) may select to include these covenants and
also invest more. Although the insignificant relation between investment and dividend
covenants among firms holding excess cash contradicts this argument, we apply propensity
score matching (Rosenbaum and Rubin, 1983) to further account for the potential selfselection bias.
For each DR observation, i.e., a firm with dividend covenant, we match it with a
19
NON-DR observation that has the closest propensity score within the radius of 0.001 of the
DR observation’s propensity score. The propensity score (PSCORE) is estimated based on
regression (5) below, which estimates the likelihood of including dividend covenants in bond
contracts. We follow prior literature to include in equation (5) factors that could influence the
inclusion of dividend covenants in bond contracts. 13
Prob (DRit+1) = α0 + α1DIV_DECILEi + α2CURRENT RATIOit + α3DEBT/EBITDAit +
α4PPEit + α5SIZEit + α6AGEit + α7ROAit + α8M/Bit + α9LEVit +
Year fixed effect + Industry fixed effect + ε
(5)
where,
DIV_DECILEi =
the decile rank of dividend payment by firm i in the earliest year
recorded in Compustat, scaled to fall between 0 and 1. If a firm has not
paid any dividend during the sample period, it is coded as zero.
CURRENT RATIOit = the ratio of current assets (ACT) to current liabilities (LCT).
DEBT/EBITDAit =
the ratio of total debt (DLC+DLTT) to EBITDA (EBITDA).
All other variables are as defined in equation (1).
Equation (5) includes the decile rank of dividend payout in the earliest year recorded
in Compustat (DIV_DECILE) to account for the influence of dividend payment on the
inclusion of dividend covenants. We measure dividend payment in the earliest year because it
is unlikely to affect the amount of investment. Firms with a long history of paying out
dividends have strong incentives to exclude dividend covenants from bond contracts because
dividend restriction could prevent the firm from maintaining a stable dividend policy and
even result in dividend reduction that is costly for stockholders. DeAngelo et al. (2004)
document that during 1978−2000, top dividend payers in earlier years increase dividends in
later years while firms that pay very small dividends tend to stop paying dividends in later
years. Thus, we expect the sample firms that paid out a large amount of dividends in earlier
periods to continue to pay out dividends and exclude dividend covenants from bond contracts.
13
Equation (5) includes only variables prior literature documents as affecting the inclusion of dividend
covenants. Alternatively, in equation (5) we include all of the independent variables from equation (1). Results
(untabulated) based on 1,763 matched pairs of observations are qualitatively similar to those in Table 6.
20
We expect the opposite for firms paying out a small amount of dividends in earlier periods.
On the other hand, bondholders may demand dividend covenants for firms paying out a larger
amount of dividends to protect themselves from wealth transfer to shareholders through
excessive dividend payment. In summary, we expect dividend payment in the earliest year in
Compustat to be significantly correlated with dividend covenant inclusion (or exclusion).
Chava et al. (2010), Sunder et al. (2010) and Nikolaev (2010) document that firm size
(SIZE), profitability (ROA), market-to-book ratio (M/B), asset tangibility (PPE), and
leverage (LEV) are correlated with the inclusion of dividend covenants in bond contracts. We
also include CURRENT RATIO, AGE and DEBT/EBITDA as other factors influencing the
inclusion of dividend covenants. As dividend covenant restricts cash usage, we expect more
liquid assets, such as current assets, to influence the decision of dividend covenant inclusion.
Covenant based on DEBT/EBITDA is one of the most commonly used covenants (Demiroglu
and James, 2010; Dichev and Skinner, 2002). To the extent that the inclusion of dividend
covenant is correlated with other types of covenants, we expect DEBT/EBITDA to affect the
inclusion of dividend covenant. We control for firm age as it could be negatively related to
the inclusion of debt covenants (Demerjian, 2013). Equation (5) also includes year dummies
and industry dummies to account for the variation of dividend covenant inclusion over time
and across industry. Untabulated results of estimating regression (5) show that signs of the
coefficients on the independent variables are consistent with those documented by prior
literature. Specifically, firms that have been paying a smaller amount of dividends, and have a
larger amount of debt relative to earnings, lower tangibility, smaller size, younger age, lower
profitability, fewer growth opportunities, and higher leverage are more likely to include
dividend covenants in bond contracts.
The matching procedure yields 1,850 pairs of observations. The propensity score is
not significantly different between the treatment group and the control group (p-value = 0.99),
21
suggesting that the matching process is reasonable. Table 6 presents results based on the
matched sample. Our inferences from these results are consistent with those from the results
based on the full sample. Specifically, Panel A1 of Table 6 shows that within the matched
sample, dividend covenants are significantly positively related to future investments (p-value
= 0.05). The coefficient on DR is 0.010, similar to 0.011 in Table 3. Consistent with results in
Table 4, Panel A2 of Table 6 presents a positive relation between dividend covenants and the
likelihood of over-investment, and an insignificant relation for the likelihood of underinvestment. Panel B further shows that the positive relations between dividend covenants and
investment and the likelihood of over-investment exist only for firms not having excess cash.
Finally, Panel C shows that for the matched sample, dividend covenants are negatively
related to future operating performance. In sum, the results mitigate the concern about the
self-selection bias driving our findings.
5.2. Results based on the Heckman’s two-step procedure
In this section, we employ the Heckman’s (1976) two-step estimation procedure to
further account for the potential self-selection bias. 14 In the first step, we estimate equation
(5) to calculate the inverse Mill’s ratio. In the second step, we re-estimate equations (1), (2),
and (3) after additionally controlling for the inverse Mill’s ratio. Among the independent
variables used in equation (5), we expect three of them (DIV_DECILE, CURRENT RATIO,
and DEBT/EBITDA) to influence the inclusion of dividend covenants but not subsequent
year investment or operating performance. We thus exclude them from the second step
regressions. 15 Inferences from estimation results (untabulated) of regressions (1) though (3)
are robust to the Heckman’s two-step approach. We still find that dividend covenants are
positively related to investment and the likelihood of over-investment in the subsequent year,
14
As Tucker (2010) and Lennox et al. (2012) point out, propensity score matching mitigates selection bias due
to observables, while the Heckman’s procedure mitigates selection bias due to unobservables. We thus
implement both procedures.
15
Coefficients on the inverse Mill’s ratio in equations (1) and (2) are significantly negative, consistent with the
presence of self-selection in our sample.
22
and negatively related to ROA in both the first and the second subsequent years. These results
increase our confidence that dividend covenants, rather than unobservable factors explain our
empirical findings.
5.3. The restrictiveness of dividend covenants and their effect on investment
In this section, we re-examine the influence of dividend covenants on investment after
additionally considering the restrictiveness of dividend covenants. We use two proxies for the
restrictiveness. The first proxy is based on the restrictiveness of state laws on dividend payout.
If firms are incorporated in states with more restrictive statutes on dividend payout, the effect
of dividend covenants on investment is likely incremental to such statutes, and thus, weaker
than the covenants for firms incorporated in states with less restrictive statute on dividend
payout. The second proxy is based on each firm’s dividend as a rate of retained earnings. We
consider dividend covenants as being more restrictive for firms with a higher payout rate.
Following Mansi et al. (2009) we identify Delaware, Kansas, Maine, Oklahoma, and
South Dakota as having less restrictive payout statues. Among 6,819 firm-year observations
with incorporation information available, we identify 299 firm-year observations
incorporated in these states and consider them as facing weaker state restrictions on dividend
payment. Results presented in Panel A of Table 7 show that for both groups, consistent with
the results based on the entire sample, dividend covenant (DR) is significantly related to
future investment. As expected, the magnitude of the coefficient on DR is larger for the group
of firms located in states with less restrictive laws on dividend payout, at 0.064 and 0.010,
respectively. However, the difference in the coefficients on DR is insignificant (p-value =
0.24), possibly due to the small sample size for firms in states with weaker legal restrictions
on dividend payment.
Our second proxy follows Healy and Palepu (1990). We add up retained earnings at
year end, common and preferred cash dividends paid and stock repurchases during the year,
23
and then divide the sum by previous year cash dividends. The ratio approximates the number
of years that a firm can maintain its current level of dividends without additional future
earnings or stock issuance. For a firm that has dividend covenants, a higher payout rate
suggests that the firm is closer to the dividend constraint. We re-estimate the relation between
DR and future investment separately for firms with a higher payout rate and those with a
lower payout rate, categorized based on the median of the ratio defined above. Results in
Table 7, Panel B show that the coefficient on DR is significantly positive for lower dividend
payout group and insignificant for higher dividend payout group, with the coefficient
significantly larger for the former group than for the latter group (p-value = 0.02). The results
suggest that relative to firms without dividend covenants, firms with the covenants invest
extra cash rather than increase dividends when the covenants are not binding. This is
consistent with Kalay’s (1982) observation that dividend covenants induce precautionary
behaviors in cash use, rather than lead to an increase in dividend payout. When dividend
covenants are likely binding, DR firms do not seem to invest more than other firms. 16
5.4. Robustness of the results to considering project-financed investment
This section investigates whether our main results on investment are driven by
project-financed investment. According to Esty (2003), the amount of project financing in the
U.S. has grown from less than $10 billion per year in the late 1980s to almost $220 billion in
2001. Since project financing obviously leads to more investment in subsequent periods, if
the project finance arrangement includes a dividend constraint to protect the lenders, our
documented relation between dividend covenants and investment may be driven by project-
16
In the hypothesis development section, we posit that the larger amount of investment by firms subject to
dividend covenants could be from two sources of cash. The first source is cash in excess of the maximum
amount allowed by the dividend covenants, which is likely the case when the dividend covenants are binding.
The second source is cash in excess of the affected firms’ actual dividend payment that is below the maximum
amount of dividend allowed by dividend covenants, which is likely the case when dividend covenants are not
binding. The second source is similar to what Kalay (1982) describes as a “reservoir” of funds, cash saved as a
precaution against violating dividend covenants in the future when operating performance deteriorates. We
interpret the results in Panel B of Table 7 as consistent with DR firms’ use of the second source of cash.
24
financed investment.
We use two approaches to address this concern. First, we exclude firms involved in
project financing from the sample. We collect information on all project-specific financing
with debt from the SDC platinum for our sample period. Out of 178 such financing
transactions between 1998 (the year SDC started coverage of project financing) and 2010, our
sample contains 12 cases. Eliminating the 12 cases does not affect the tenor of our results.
Panel A of Table 8 indicates that the magnitude and significance of the coefficient on DR are
not affected by the exclusion of the 12 observations. Second and more conservatively, we
eliminate from the sample industries that are the most likely to engage in project financing.
Based on project financing information in the SDC platinum between 1998 and 2010, we find
that project financing is concentrated in the following three industries: Power, Oil & Gas, and
Transportation, which is also consistent with Esty’s (2003) claim that that project financing is
an important financing vehicle for investment in the natural resource and infrastructure
sectors. The three industries account for more than 80% of project financing in terms of both
the frequency and the amount of the financing (untabulated). We exclude 1,517 firm-year
observations (or about 22% of our sample) in Power, Oil & Gas, and Transportation
industries (SIC 1300-1399, 4000-4999) from the sample and then re-estimate the relation
between dividend covenant and future investment. Panel B shows that the positive relation
between DR and investment still holds with this reduced sample, albeit weaker (p-value =
0.08).
5.5. Alternative measures of investment
Our main analyses use total raw amount of investment. This section examines the
robustness of the positive relation between dividend covenants and future investment to four
alternative measures of investment. First, we use the industry-adjusted investment, measured
as firm-level investment minus industry median investment. This alternative measure
25
implicitly perceives industry median as the norm and considers total raw investment greater
than the industry median as over-investment (Jung et al., 2014). We then re-estimate equation
(1) by replacing total investment with the industry-adjusted investment. The results in Panel
A of Table 9 show that dividend covenant is still positively associated with future investment
after accounting for industry norm. In addition, both the magnitude and the significance of
the coefficient are similar to those in Panel A of Table 3, at 0.015 (p= 0.01) versus 0.011 (p =
0.01), respectively.
The second measure of investment is the extent of deviation of investment from the
level expected from a firm’s growth opportunities, which is estimated by regressing firmlevel total investment on lagged sales growth for each industry-year (Biddle et al., 2009). We
then re-estimate equation (1) by replacing total investment with the residual investment.
Panel B of Table 9 presents the results. The coefficient on DR is positive and significant (at
0.009; p-value = 0.02), suggesting that firms deviate more from the expected level of
investment when firms have dividend covenants. The third measure of investment is the
extent of deviation of investment from the average investment for the same firm in the past
three years (Titman et al., 2004). Results based on this measure are presented in Panel C. The
coefficient on DR is still significantly positive (at 0.004; p-value = 0.05). Our fourth
alternative measure of investment is acquisition expenditure. Prior literature views
acquisition as a common form of empire-building (e.g., Stein, 2003; Nguyen et al., 2012).
Thus, a positive relation between dividend covenants and acquisition expenditure will
triangulate our inference that dividend covenant is related to a larger extent of overinvestment. We re-estimate equation (1) by measuring investment with acquisition
expenditure. Results (untabulated) show a significantly positive coefficient on DR, at 0.004
26
with a p-value of 0.02. 17
In addition, based on two of three alternative measures of investment, we continue to
document that dividend covenants are positively related to the likelihood of over-investment
and not significantly related to the likelihood of under-investment (untabulated). Overall,
results from the alternative measures of investment support a positive relation between
dividend covenants and future investment, which is consistent with exacerbation of overinvestment rather than mitigation of under-investment.
5.6. An alternative measure of the presence of dividend covenants
Our main tests are based on a dummy variable for the presence of dividend covenants
in bond contracts, which captures the average influence of dividend covenants on future
investment and operating performance. It is possible that the influence of dividend covenants
is stronger when a higher percentage of bonds include the covenants, the case for which
creditor monitoring is likely more intense. We therefore use %DR, measured as the
percentage of bonds that have dividend covenants for each firm-year as an alternative
measure of DR and re-estimate regressions (1) through (3). All results based on %DR are
consistent with those based on DR. Specifically, results (untabulated) show positive relations
between %DR and both investment and the likelihood of over-investment and a negative
relation between %DR and ROA in future two years. These results support the variation of
the influence of dividend covenants on investment with the percentage of bond contracts that
include dividend covenants and triangulate our main results.
5.7. Controlling for corporate governance measures
17
In untabulated tests we also separately examine R&D and capital expenditure. We find that the results based
on capital expenditure are consistent with our main results while the results based on R&D are not. Specifically,
we document a negative coefficient on DR (-0.002, p = 0.06) for R&D. One plausible explanation for the
negative coefficient is that the success of R&D investment is highly unpredictable and uncertain. In addition, the
uncertain benefits associated with the R&D, if any, will take a long time to materialize (e.g., Kothari et al.,
2002; Amir et al. 2007). In the context we examine, if DR firms are concerned about violating dividend
covenants in the future when operating performance deteriorates (Kalay, 1982), they may be precautionary in
their investment choices and prefer projects that are more certain and take less time to materialize.
27
To account for the effect of corporate governance on managers’ investment decision,
we include the following three variables in regressions (1) to (3): institutional shareholdings
from Thomson Reuters’ CDA/Spectrum database, analyst coverage from the I/B/E/S, and the
G-index from the IRRC database. Institutional shareholders are more capable of monitoring
managers’ investment decision (Bushee, 1998; 2001) and thus, firms with higher institutional
shareholdings tend to have a less extent of over- or under-investment problem (Cella, 2013).
The G-index indicates the number of anti-takeover provisions in a firm’s charter and in the
legal code of the state in which the firm is incorporated (Gompers et al., 2003). Thus, firms
with a lower G-index have a higher level of shareholder right and thus, the management is
more constrained in firm-value destroying activities, such as over-investing. The data
requirement of the above three variables significantly reduces the sample by about 79% to
1,438 firm year observations, mainly because IRRC covers the G-index only for the period of
1990 to 2006 and for large firms.
We continue to document a significantly positive relation between dividend covenants
and future investment (coefficient on DR = 0.004; p-value = 0.01), and a significantly
negative relation between dividend covenants and returns on assets in subsequent years.
However, the relation between dividend covenants and the likelihood of over-investment
becomes insignificant (p-value = 0.22), which could be due to the reduced power of the test
based on a significantly reduced sample of large firms.
5.8. Controlling for investment restriction and financing restriction covenants
Besides dividend covenants, bond contracts also include covenants restricting
investment and subsequent financing activities, which can also directly or indirectly affect
investment (Chava and Roberts, 2008; Nini et al., 2009). To account for the possibility that
the other types of covenants are correlated omitted variables, in regressions (1) through (3),
we further include two dummy variables that indicate whether a firm’s bond contracts also
28
include investment restriction covenants and subsequent financing restriction covenants,
respectively. More than 90% of firm-year observations in our sample have both types of
covenants. The low variation in the presence of the two types of covenants could reduce the
power of tests on the relation between these covenants and future investment. Untabulated
results show that including the two additional control variables does not change the main
results. The coefficients for the investment covenants and financing covenants are both
insignificant in all three regressions.
6. Conclusion
Motivated by the theoretical argument in prior literature, this paper empirically
examines whether dividend covenants in bond contracts are associated with higher future
investment and lower future operating performance. More important, we examine whether
more investment reflects exacerbation of over-investment or mitigation of under-investment.
We document that dividend covenants are positively related to future investment and firms’
tendency to over-invest, but not significantly related to firms’ tendency to under-invest. Firms
subject to dividend covenant restrictions also experience poorer operating performance in
subsequent periods, consistent with the influence of dividend covenants on firms’ overinvestment tendency.
We apply three approaches to mitigate concerns about the self-section bias driving the
main results. First, we condition the analyses on whether firms hold excess cash or not. The
positive relations between dividend covenants and both investment and the likelihood of
over-investment exist only among firms not holding excess cash. Second and third, the main
results are robust to propensity score matching and Heckman’s (1976) two-step estimation
procedures. Although we cannot completely rule out self-selection as a potential factor
explaining our main results, the overall results are inconsistent with this claim.
29
The main results are robust to alternative measures of investment and the presence of
dividend covenants, accounting for project-financed investment, and additional controls for
corporate governance and for the presence of investment and subsequent financing covenants
in bond contracts. In additional analyses, we find that the influence of dividend covenants on
future investment is incremental to state laws on dividend payout. We also find that the
influence concentrates in firms with a lower dividend payout ratio, for which dividend
covenants are unlikely binding, suggesting that dividend covenants induce precautionary cash
use rather than maximizing dividend payment (Kalay 1982).
To our knowledge, this paper is the first that empirically examines the relation
between dividend covenants and future investment as well as operating performance.
Empirical evidence in this paper supports the conjecture in prior literature that dividend
covenants could lead to over-investment and does not support the conjecture that dividend
covenants could mitigate under-investment. The results suggest that including dividend
covenants can be costly to stakeholders by exacerbating over-investment. Thus, the findings
also have important implications for both shareholders and bondholders in their decisions for
dividend covenant inclusion in bond contracts.
30
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34
Table 1
Summary statistics for main variables
Variable
PPE
SIZE
AGE
ROA
M/B
DIV
INVEST
AQ
STD(OCF)
STD(SALES)
STD(INVEST)
ALTMANZ
LEV
OCF/SALES
OperCycle
LOSS
OVER
UNDER
EXCESS_CASH
Full sample (N = 6,840)
Non-DR firms (N = 4,663)
DR firms (N = 2,177)
Mean
0.756
7.942
32.577
0.042
2.812
0.014
0.109
0.030
0.054
0.134
0.065
1.831
0.300
0.119
4.540
0.154
0.234
0.235
-0.261
Mean
0.750
8.280
37.443
0.052
3.186
0.018
0.108
0.029
0.049
0.124
0.053
1.975
0.244
0.120
4.587
0.105
0.241
0.213
-0.158
Mean
0.769
7.219
22.154
0.020
2.009
0.005
0.111
0.034
0.064
0.155
0.091
1.521
0.420
0.116
4.439
0.260
0.221
0.282
-0.481
Median
0.694
7.930
28.500
0.044
2.104
0.010
0.079
0.024
0.040
0.096
0.041
1.796
0.257
0.098
4.620
0.000
0.000
0.000
-0.160
Std Dev
0.435
1.424
21.526
0.065
3.723
0.016
0.103
0.023
0.044
0.120
0.069
1.063
0.213
0.110
0.616
0.361
0.424
0.424
1.341
Median
0.697
8.302
34.000
0.052
2.333
0.015
0.085
0.023
0.037
0.091
0.036
1.951
0.201
0.103
4.664
0.000
0.000
0.000
-0.110
Std Dev
0.393
1.398
21.183
0.060
3.721
0.017
0.091
0.021
0.039
0.109
0.053
0.977
0.183
0.096
0.589
0.306
0.428
0.410
1.301
Median
0.683
7.117
15.000
0.028
1.699
0.000
0.067
0.027
0.049
0.111
0.057
1.391
0.391
0.083
4.488
0.000
0.000
0.000
-0.311
Std Dev
0.514
1.190
18.316
0.070
3.598
0.011
0.125
0.025
0.050
0.140
0.090
1.170
0.224
0.134
0.661
0.439
0.415
0.450
1.399
Mean difference between DR
and NON-DR firms
Diff
p-value
0.019
<0.01
-1.061
<0.01
-15.290
<0.01
-0.032
<0.01
-1.177
<0.01
-0.013
<0.01
0.002
0.45
0.006
<0.01
0.015
<0.01
0.031
<0.01
0.038
<0.01
-0.454
<0.01
0.176
<0.01
-0.004
<0.01
-0.148
<0.01
0.155
<0.01
-0.020
0.11
0.069
<0.01
-0.323
<0.01
Notes. This table provides summary statistics for the main variables used in the analyses.
DRit
PPEit
SIZEit
AGEit
ROAit
M/Bit
DIVit
= an indicator variable that equals one if firm i has dividend covenants in any of its outstanding bond contracts in year t, and zero otherwise. Dividend
covenants refer to covenants that restrict dividends or other forms of payments, such as stock repurchases, to shareholders.
= the ratio of property, plant and equipment (PPENT) to lagged total assets (AT).
= the natural logarithm of total assets (AT) in year t.
= the logarithm of the number of years a firm’s stock data has been recorded in CRSP.
= net income (NI) for year t divided by the average of beginning and ending total assets (AT) at year t.
= the ratio of the market value of equity (CSHO*PRCC_F) to the book value of equity (CEQ).
= the amount of dividend payment (DVC) in year t divided by lagged total assets (AT).
35
Table 1 (continued)
INVESTit+1
AQit
STD(OCF)it
STD(SALES)it
STD(INVEST)it
ALTMANZit
LEVit
OCFit/SALESit-1
OperCycleit
LOSSit
OVERit
UNDERit
EXCESS_CASHit
= the amount of investment at year t+1 for firm i, defined as the sum of research and development expense (XRD), capital expenditure (CAPX), and
acquisition expenditure (AQC) less cash receipts from sale of property, plant, and equipment (SPPE), scaled by lagged total assets (AT).
= accruals quality, estimated from the Dechow and Dichev (2002) model modified by McNichols (2002). The model regresses working capital accruals
on lagged, current, and future cash flows (OANCF), change in revenue (SALE), and property, plant and equipment (PPEGT), where all variables are
scaled by the average of beginning and ending total assets (AT). Working capital accruals are measured as the sum of the increase in accounts
receivable (RECCH), the increase in inventory (INVCH),the decrease in accounts payable and accrued liabilities (APALCH), the decrease in taxes
accrued (TXACH), and the increase (decrease) in other assets (liabilities) (AOLOCH). AQ is estimated cross-sectionally for each industry with at
least 20 observations in a given year based on the Fama and French (1997) 48-industry classification. The standard deviation of the firm-level
residuals from years t -5 to t-1 is defined as AQ. Thus, a higher value of AQ indicates worse accruals quality.
= the standard deviation of cash flows from operations over years t-4 to t, where cash flows from operations (OANCF) are deflated by the average of
beginning and ending total assets (AT).
= the standard deviation of sales over years t-4 to t, where sales (SALE) are deflated by the average of beginning and ending total assets (AT).
= the standard deviation of total investment over years t-4 to t, where investment is deflated by the average of beginning and ending total assets (AT).
= Altman’s (1968) Z-score, calculated as (1.2*(ACT-LCT) + 1.4*RE + 3.3*(OIADP+NOPI) + SALE) / AT.
= the ratio of long-term debt (DLTT) to the sum of long-term debt and the market value of equity (DLTT + CSHO*PRCC_F).
= cash flows from operations (OANCF) scaled by lagged sales (SALE)
= the logarithm of the sum of the ratio of accounts receivables to sales (RECT/SALE) and the ratio of inventory to cost of goods sold (INVT/COGS).
Both ratios are multiplied by 360.
= an indicator variable that equals one if net income before extraordinary items (IB) is negative, and zero otherwise.
= 1 when a firm’s investment (i.e., INVEST) is in the top quartile among all firms in the same year, and 0 otherwise.
= 1 when a firm’s investment (i.e., INVEST) is in the bottom quartile among all firms in the same year, and 0 otherwise.
= excess cash estimated as residuals from the following equation from Dittmar and Mahrt-Smith (2007):
Ln(CASHit/NAit) = α0 + α1LnNAit + α2FCFit/NAit + α3NWCit/NAit + α4IND_Sigma + α5MVit/NAit + α6RDit/NAit + Year fixed effect + Firm fixed effect + ε.
Where:
= Cash and cash equivalent (CHE) at the end of year t.
CASHit
NAit
= Net assets at the end of year t, measured as total assets (AT) minus cash and cash equivalent (CHE). It proxies for access to
financial markets and cash demand from day-to-day operations.
FCFit
= Cash flows from operating activities (OANCF) minus interest and taxes over year t. It measures internal financing.
NWCit
= Current assets (ACT) minus current liabilities (LCT) and cash (CHE). It measures potential cash substitute.
= Industry average of the standard deviation of FCF/NA in the prior ten years.
IND_Sigmait
MVit
= Firm market value, calculated as the product of stock price and the number of common shares (CSHO*PRCC_F) plus total
liabilities (LT).
RDit
= Research and development expense (XRD). We set it to zero if missing.
36
Table 2
Spearman correlation coefficients among the main variables
DR
(1)
PPE
(2)
SIZE
(3)
AGE
(4)
ROA
(5)
M/B
(6)
DIV
(7)
INVEST
(8)
AQ
(9)
STD(OCF)
(10)
STD(SALES)
(11)
STD(INVEST)
(12)
ALTMANZ
(13)
LEV
(14)
OCF/SALES
(15)
OperCycle
(16)
LOSS
(17)
OVER
(18)
UNDER
(19)
EXCESS_CASH
(20)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
(14)
(15)
(16)
(17)
(18)
(19)
(20)
0.02
-0.35
-0.33
-0.23
-0.15
-0.38
0.01
0.11
0.16
0.12
0.26
-0.20
0.39
-0.02
-0.11
0.20
-0.02
0.08
-0.11
-0.04
0.00
-0.03
-0.07
0.03
0.27
-0.24
-0.12
-0.16
-0.04
-0.28
0.13
0.44
-0.30
0.00
0.14
-0.13
-0.24
0.43
0.17
0.16
0.26
-0.02
-0.29
-0.29
-0.14
-0.18
0.05
-0.31
0.11
0.01
-0.17
-0.03
-0.02
0.13
0.13
0.10
0.38
-0.04
-0.11
-0.15
-0.08
-0.25
0.10
-0.21
-0.06
0.21
-0.11
-0.02
-0.07
0.13
0.29
0.38
0.10
-0.12
-0.15
-0.04
-0.15
0.39
-0.49
0.17
0.03
-0.43
0.09
-0.07
0.05
0.31
0.10
-0.06
-0.09
-0.06
-0.06
0.18
-0.31
0.08
0.06
-0.14
0.06
-0.03
0.04
0.03
-0.19
-0.22
-0.16
-0.23
0.25
-0.40
0.11
0.13
-0.24
0.01
-0.08
0.00
-0.03
-0.01
-0.05
0.07
0.01
-0.23
0.29
-0.01
-0.12
0.62
-0.25
0.01
0.67
0.32
0.12
0.00
0.09
-0.20
0.21
0.21
-0.04
0.11
0.17
0.33
0.19
-0.13
0.15
-0.11
0.12
0.26
-0.03
0.10
0.15
0.20
0.24
0.08
-0.26
-0.08
0.07
-0.02
0.03
0.09
-0.20
0.24
0.09
-0.08
0.13
0.02
0.07
-0.13
-0.44
-0.28
0.01
-0.33
0.09
-0.16
0.12
-0.15
-0.14
0.39
-0.16
0.10
-0.20
-0.09
-0.17
0.09
0.02
-0.13
0.01
-0.07
0.07
0.06
-0.10
0.13
0.06
-0.31
0.01
0.07
Notes. Bold numbers indicate that the correlation coefficients are significant at the 5% level or lower. See Table 1 for variable definitions.
37
Table 3
The relation between the presence of dividend covenants in the current year and investment in the
subsequent year
Panel A: The relation
between dividend covenants
and investment
Panel B: The relation between
dividend covenants and investment
conditional on excess cash
Coeff.
p-value
Coeff.
p-value
-0.007
0.011
0.83
0.01
-0.013
0.016
0.67
<0.01
POS_EXCASH
0.010
<0.01
DR* POS_EXCASH
-0.012
0.07
Dependent
INVESTt+1
variable
=
Intercept
DR
DIV
-0.660
<0.01
-0.650
<0.01
AQ
0.060
0.49
0.057
0.51
SIZE
-0.003
0.06
-0.003
0.04
M/B
0.019
<0.01
0.019
<0.01
STD(OCF)
0.031
0.54
0.024
0.63
STD(SALES)
-0.007
0.65
-0.007
0.64
STD(INVEST)
0.105
<0.01
0.109
<0.01
ALTMANZ
0.005
0.07
0.005
0.08
PPE
0.106
<0.01
0.110
<0.01
LEV
-0.102
<0.01
-0.101
<0.01
OCF/SALES
0.115
<0.01
0.114
<0.01
OperCycle
-0.004
0.23
-0.004
0.26
LOSS
-0.012
<0.01
-0.012
<0.01
AGE
-0.006
0.45
-0.007
0.41
Year and industry fixed effects
YES
YES
N
6,840
6,840
Adj.R2
26.10%
26.20%
DR + DR* POS_EXCASH
0.31
Notes. This table presents the results of estimating the relation between investment in the subsequent year and
the presence of dividend covenants in bond contracts. POS_EXCASH =1 for positive excess cash
(EXCESS_CASH), and 0 otherwise. The standard errors are adjusted for firm level clustering. All other variables
are as defined in Table 1.
38
Table 4
The relation between the presence of dividend covenants in the current year and the likelihood of overand under-investment in the subsequent year
Panel A: The relation between the presence of dividend covenants in the current year and the likelihood of overand under-investment in the subsequent year
Dependent variable =
OVERt+1
UNDERt+1
Coeff
p-value
Coeff
p-value
Intercept
-3.210
0.06
2.937
<0.01
DR
0.231
0.02
0.040
0.47
DIV
-23.175
<0.01
2.452
0.28
AQ
-3.177
0.18
-0.814
0.54
SIZE
-0.166
<0.01
-0.101
<0.01
M/B
0.459
<0.01
-0.295
<0.01
STD(OCF)
1.431
0.26
0.114
0.86
STD(SALES)
0.095
0.82
0.596
<0.01
STD(INVEST)
1.604
0.01
-0.727
0.03
ALTMANZ
0.210
<0.01
-0.115
<0.01
PPE
2.469
<0.01
-2.411
<0.01
LEV
-2.770
<0.01
1.407
<0.01
OCF/SALES
2.378
<0.01
-0.219
0.53
OperCycle
-0.032
0.74
0.043
0.43
LOSS
0.034
0.79
0.325
<0.01
AGE
-0.260
0.21
-0.066
0.57
Year and industry fixed effect YES
YES
N
5,130
5,130
Pseudo R2
20.2%
26.0%
Panel B: The influence of dividend covenant on the likelihood of over-investment and under-investment
conditional on whether a firm has excess cash
Dependent Variable =
OVERt+1
UNDERt+1
Coeff.
p-value
Coeff.
p-value
Intercept
-1.011
0.51
4.712
<0.01
DR
0.382
<0.01
-0.019
0.91
POS_EXCASH
0.254
<0.01
-0.107
0.36
DR* POS_EXCASH
-0.321
0.04
0.162
0.41
DIV
-21.203
<0.01
3.366
0.50
AQ
-1.705
0.46
-2.636
0.37
SIZE
-0.162
<0.01
-0.202
<0.01
M/B
0.514
<0.01
-0.483
<0.01
STD(OCF)
0.420
0.74
0.285
0.85
STD(SALES)
0.119
0.76
0.845
0.06
STD(INVEST)
1.518
0.01
-1.228
0.12
ALTMANZ
0.172
0.01
-0.246
<0.01
PPE
2.274
<0.01
-4.052
<0.01
LEV
-2.377
<0.01
2.219
<0.01
OCF/SALES
2.181
<0.01
-0.219
0.75
OperCycle
-0.086
0.37
0.128
0.33
LOSS
0.021
0.86
0.511
<0.01
AGE
-0.159
0.43
-0.238
0.45
Year and industry fixed effects
YES
Yes
N
5,130
5,130
Pseudo R2
18.6%
23.6%
0.63
0.24
DR + DR* POS_EXCASH
Notes. OVERit+1 = 1 when a firm’s investment (i.e., INVESTt+1) is in the top quartile among all firms in the same
year, and 0 if INVEST is in the middle two quartiles. UNDERit+1 = 1 when a firm’s investment is in the bottom
quartile among all firms in the same year, and 0 if INVEST is in the middle two quartiles. POS_EXCASH =1 for
positive excess cash (EXCESS_CASH), and 0 otherwise. The standard errors are adjusted for firm level
clustering. All other variables are as defined in Table 1.
39
Table 5
The relation between dividend covenants and future period return on assets (ROA)
Panel A: The relation between dividend covenants and future period return on assets (ROA)
Dependent variable =
Intercept
DR
DIV
ROA
PPE
SIZE
M/B
LEV
AGE
Year fixed effect
Industry fixed effect
Adj. R2
N
ROAt+1
Coeff.
0.006
-0.007
0.613
0.504
0.000
-0.001
0.002
-0.017
-0.006
YES
YES
43.6%
6840
p-value
0.75
<0.01
<0.01
<0.01
0.97
0.11
<0.01
<0.01
0.07
ROAt+2
Coeff.
0.038
-0.009
0.825
0.310
-0.001
0.000
0.001
-0.017
-0.008
YES
YES
29.5%
6840
p-value
0.07
<0.01
<0.01
<0.01
0.71
0.93
<0.01
<0.01
0.12
Panel B: The influence of dividend covenant on ROA conditional on whether a firm has excess cash
Dependent variable =
Intercept
DR
POS_EXCASH
DR* POS_EXCASH
DIV
ROA
PPE
SIZE
M/B
LEV
AGE
Year fixed effect
Industry fixed effect
Adj. R2
N
DR + DR* POS_EXCASH
ROAt+1
Coeff.
-0.004
-0.006
0.001
-0.002
0.616
0.478
0.000
-0.001
0.001
-0.016
-0.004
YES
YES
42.6%
6,840
p-value
0.78
<0.01
0.38
0.55
<0.01
<0.01
0.96
0.35
<0.01
<0.01
0.23
<0.01
ROAt+2
Coeff.
0.028
-0.009
0.001
-0.001
0.817
0.296
-0.001
0.000
0.001
-0.016
-0.006
YES
YES
28.8%
6,840
p-value
0.15
<0.01
0.71
0.72
<0.01
<0.01
0.75
0.69
<0.01
<0.01
0.26
<0.01
Notes. This table presents the results of estimating the relation between dividend covenants and future period
ROA. ROAt+τ = net income (NI) for year t + τ (τ = 1 or 2) divided by the average of beginning and ending total
assets (AT) at year t + τ. POS_EXCASH =1 for positive excess cash (EXCESS_CASH), and 0 otherwise.
The standard errors are adjusted for firm level clustering. All other variables are as defined in Table 1.
40
Table 6
Results for the sample matched on propensity score
Panel A: The relation between the presence of dividend covenants in the current year and investment and the
likelihood of over- and under-investment in the subsequent year
Dependent variable =
Intercept
DR
DIV
AQ
SIZE
M/B
STD(OCF)
STD(SALES)
STD(INVEST)
ALTMANZ
PPE
LEV
OCF/SALES
OperCycle
LOSS
AGE
Year and industry fixed effect
Adj. R2
N
Panel A2:
OVER t+1
Panel A1:
INVESTt+1
Coeff
-0.050
0.010
-0.759
-0.117
-0.002
0.028
0.140
-0.011
0.063
0.000
0.098
-0.086
0.109
-0.008
-0.023
-0.017
YES
26.5%
3,700
p-value
0.47
0.05
<0.01
0.43
0.31
<0.01
0.09
0.60
0.12
0.98
<0.01
<0.01
0.03
0.12
<0.01
0.29
Coeff
0.002
0.140
-13.825
-1.810
-0.111
0.298
1.199
0.170
0.295
0.055
1.364
-1.258
0.641
-0.085
-0.367
-0.158
YES
18.8%
2,775
Panel A3:
UNDER t+1
p-value
0.99
0.02
<0.01
0.31
<0.01
<0.01
0.18
0.53
0.48
0.27
<0.01
<0.01
0.06
0.20
<0.01
0.37
Coeff
-4.719
0.083
3.946
3.088
-0.138
-0.248
-1.680
0.991
-0.656
-0.099
-1.943
0.771
-0.095
-0.023
0.314
0.075
YES
29.1%
2,775
Panel B: The influence of dividend covenant on the amount of investment, the likelihood
and the likelihood of under-investment conditional on whether a firm has excess cash
Panel B1:
Panel B2:
Dependent Variable =
INVESTt+1
OVERt+1
Coeff.
p-value
Coeff.
p-value
DR
0.018
<0.01
0.244
0.05
POS_EXCASH
0.012
0.02
0.294
0.06
DR* POS_EXCASH
-0.013
0.05
-0.336
0.07
Intercept and other control variables
YES
YES
Year and industry fixed effects
YES
YES
N
3,526
2,638
Pseudo R2
26.2%
22.4%
0.38
0.83
DR + DR* POS_EXCASH
p-value
<0.01
0.18
0.16
0.07
<0.01
0.00
0.06
<0.01
0.12
0.03
<0.01
<0.01
0.78
0.75
<0.01
0.67
of over-investment,
Panel B3:
UNDERt+1
Coeff.
p-value
0.013
0.87
-0.086
0.35
-0.049
0.69
YES
YES
2,638
23.4%
0.81
Panel C: The relation between dividend covenants and future ROA
Dependent variable
ROAt+1
ROAt+2
Independent variables
Coeff.
p-value
Coeff.
p-value
Intercept
-0.016
0.80
0.011
0.90
DR
-0.011
<0.01
-0.013
<0.01
DIV
0.460
<0.01
0.435
<0.01
ROA
0.497
<0.01
0.329
<0.01
PPE
-0.004
0.42
-0.010
0.17
SIZE
0.000
0.99
0.000
0.95
M/B
0.001
0.07
0.001
0.13
LEV
-0.012
0.24
-0.007
0.61
AGE
-0.010
0.20
-0.011
0.35
Year and industry fixed effect
YES
YES
Adj. R2
35.1%
22.6%
N
3,700
3,700
Notes. The standard errors are adjusted for firm level clustering. All other variables are as defined in Table 1.
41
Table 7
The effect of dividend covenants on future investment by the restrictiveness of dividend covenants
Panel A: The effect of dividend covenants on investment by the restrictiveness of payout statues
Dependent Variable = INVESTt+1
Intercept
DR
DIV
AQ
SIZE
M/B
STD(OCF)
STD(SALES)
STD(INVEST)
ALTMANZ
PPE
LEV
OCF/SALES
OperCycle
LOSS
AGE
Year and industry fixed effects
N
Adj. R2
Firms located in states with
more restrictive payout statute
Coeff.
0.000
0.010
-0.637
0.068
-0.003
0.020
0.029
-0.009
0.112
0.005
0.104
-0.101
0.109
-0.005
-0.012
-0.009
YES
6,520
26.3%
p-value
0.99
0.02
<0.01
0.45
0.05
<0.01
0.56
0.56
<0.01
0.04
<0.01
<0.01
<0.01
0.17
<0.01
0.29
Firms located in states with less
restrictive payout statute
Coeff.
-0.071
0.064
-1.734
-0.103
-0.010
0.044
0.220
-0.017
-0.201
-0.015
0.155
-0.183
0.135
0.035
-0.017
0.188
Yes
299
29.3%
p-value
0.56
0.01
0.10
0.83
0.18
0.02
0.47
0.85
0.10
0.39
<0.01
0.01
0.17
0.12
0.32
<0.01
Panel B: The effect of dividend covenants on investment by high and low dividend payout
Dependent Variable = INVESTt+1
Intercept
DR
DIV
AQ
SIZE
M/B
STD(OCF)
STD(SALES)
STD(INVEST)
ALTMANZ
PPE
LEV
OCF/SALES
OperCycle
LOSS
AGE
Year and industry fixed effects
N
Adj. R2
Firms with lower dividend
payout
Coeff.
-0.001
0.018
-0.596
-0.013
-0.002
0.024
0.048
-0.005
0.102
0.000
0.116
-0.107
0.102
-0.004
-0.019
-0.021
YES
3,415
28.0%
p-value
0.98
<0.01
0.07
0.91
0.46
<0.01
0.45
0.85
0.01
0.98
<0.01
<0.01
<0.01
0.42
<0.01
0.09
Firms with
payout
Coeff.
-0.041
-0.001
-0.453
0.248
-0.002
0.009
-0.039
0.007
0.062
0.015
0.094
-0.092
0.135
-0.005
-0.004
0.002
Yes
3,425
24.0%
higher
dividend
p-value
0.26
0.87
0.01
0.04
0.20
0.03
0.51
0.70
0.06
<0.01
<0.01
<0.01
<0.01
0.40
0.37
0.86
Notes.
The standard errors are adjusted for firm level clustering. All variables are as defined in Table 1.
42
Table 8
The relation between dividend covenants and future investment after excluding project-financed
investment
Dependent Variable = INVESTt+1
Intercept
DR
DIV
AQ
SIZE
M/B
STD(OCF)
STD(SALES)
STD(INVEST)
ALTMANZ
PPE
LEV
OCF/SALES
OperCycle
LOSS
AGE
Year and industry fixed effects
N
Adj. R2
Panel A: After deleting 12
observations
involved
in
project financing
Coeff.
p-value
-0.006
0.011
-0.649
0.063
-0.003
0.019
0.031
-0.006
0.103
0.005
0.107
-0.102
0.114
-0.005
-0.011
-0.005
Yes
6,828
26.2%
0.86
0.01
<0.01
0.47
0.04
<0.01
0.54
0.68
<0.01
0.07
<0.01
<0.01
<0.01
0.22
<0.01
0.52
Panel B: After deleting firms in
Power, Oil & Gas, and
Transportation industries
Coeff.
p-value
0.028
0.006
-0.389
0.092
-0.003
0.015
0.011
-0.016
0.103
0.006
0.090
-0.098
0.071
-0.009
-0.017
-0.004
Yes
5,323
21.9%
0.37
0.08
<0.01
0.25
0.02
<0.01
0.79
0.27
<0.01
<0.01
<0.01
<0.01
<0.01
<0.01
<0.01
0.54
Notes.
Panel B excludes observations in Power, Oil & Gas, and Transportation industries because project financing
data in the SDC platinum between 1998 and 2010 indicates that project financing concentrates in the three
industries. The standard errors are adjusted for firm level clustering. All variables are as defined in Table 1.
43
Table 9
Robustness of the positive relation between dividend covenants and future investment to alternative measures of investment
Dependent Variable =
Intercept
DR
DIV
AQ
SIZE
M/B
STD(OCF)
STD(SALES)
STD(INVEST)
ALTMANZ
PPE
LEV
OCF/SALES
OperCycle
LOSS
AGE
Year and industry fixed effects
N
Adj.R2
Panel A:
Industry-adjusted investment
Panel B:
Investment unpredicted from sales growth
Coeff.
0.151
0.015
-0.599
0.115
-0.004
0.021
0.124
-0.023
0.115
0.002
0.107
-0.125
0.085
-0.011
-0.015
-0.010
Yes
6,840
9.6%
Coeff.
0.030
0.009
-0.434
0.014
-0.003
0.016
0.046
-0.016
0.089
0.003
0.098
-0.095
0.096
-0.008
-0.007
-0.007
Yes
6,840
19.3%
p-value
0.20
0.01
0.01
0.48
0.05
<0.01
0.24
0.30
0.01
0.60
<0.01
<0.01
0.02
0.04
0.01
0.33
p-value
0.29
0.02
<0.01
0.88
0.03
<0.01
0.34
0.27
<0.01
0.28
<0.01
<0.01
<0.01
0.03
0.05
0.35
Panel C:
Investment unpredicted from
past years’ investment levels
Coeff.
p-value
0.049
0.03
0.004
0.05
-0.127
0.08
-0.027
0.72
-0.010
<0.01
0.006
<0.01
-0.061
0.19
-0.013
0.33
-0.272
<0.01
0.004
0.04
0.008
0.33
-0.058
<0.01
-0.016
0.28
-0.007
<0.01
-0.005
0.24
0.024
<0.01
Yes
6,840
10.4%
Notes. Industry-adjusted investment is measured as each firm’s total investment minus industry median investment. Investment unpredicted from sales growth is the deviation
of investment from the level expected based on a firm’s growth opportunities. The expected investment is estimated by regressing firm-level total investment on lagged sales
growth for each industry-year (Biddle et al., 2009). The investment unpredicted from past years’ investment is the difference between current year investment and the average
investment for the same firm in the past three years (Titman et al., 2004). The standard errors are adjusted for firm level clustering. All other variables are as defined in Table
1.
44