A Growth Type Explanation for Persistence in Retained Earnings and Propensity to Pay
40 Pages Posted: 2 Apr 2009
Date Written: March 9, 2009
Recent research has found a positive relationship between firm propensity to pay (PTP) and retained-earnings-to-total-equity ratio (RE/TE). Motivated by a lifecycle theory of dividends, researchers have interpreted RE/TE as a proxy for firm maturity stage. This paper shows that the RE/TE ratios are surprisingly persistent. Consequently, while high-RE/TE firms always have a high PTP, low-RE/TE firms (more than 40% of all firms actually start with a negative RE/TE) always have a low PTP and typically do not pay dividends. We present a growth type explanation for this cross-sectional persistence. Firms with low RE/TE ratios tend to be high growth firms; low (and especially negative) RE/TE ratios reflect persistently heavy issues of new equity and large R&D investments that pay off slowly-a phenomenon related to high growth-type, consistent with the prediction by a generalized Myers-Majluf model. We postulate that low-RE/TE firms, if they start paying dividends, may confuse the market and be pooled with low-growth firms that usually pay dividends. Thus, the absence of dividend paying is consistent with high growth-type and does not hinder the investment plans of low-RE/TE or high-growth-type firms. We conclude that it is growth type and not lifecycle that best explains PTP persistence.
Keywords: Dividends, Propensity to Pay, Retained Earnings, Growth Type, Persistence
JEL Classification: G32, G35
Suggested Citation: Suggested Citation