Capital Markets The analysis of Turkish investment incentives i. Gini coefficient

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1. Introduction

This paper investigates the effects of foreign investors on the relationship between dividend changes and the predictability of future earnings. Because f oreign investors‘ ownership in the Korean market has increased substantially since 1992, many researchers have analyzed the effects of foreign ownership on dividend changes. Most papers, however, have focused on the association between foreign investors and the level of the dividend. The purpose of this paper is twofold. The first one is to test whether dividend changes is useful variable to predict future earnings using modified model following Grullon et al. 2005. The second is to investigate the effect of foreign investors on the predictability of dividend change. Since Lintner 1956 provides important theoretical foundation for the information content of dividends hypothesis, Miller and Modigliani 1961 suggest that dividend changes convey new information about the firms ‘ future profitability. According to dividend signaling theories, dividend increases would present a permanent upward revaluation of the cash flows of firms and a commitment to maintain a higher level of dividends e.g., Bhattacharaya, 1979; Miller and Rock, 1985; John and Williams, 1985. Based on this prediction, the dividend increase is recognized as a positive signal about the firms‘ future earnings and profitability. However, the related studies on the relationship between the dividend changes and future earnings suggest mixed results depending on applied assumptions Watts, 1973; DeAngelo et al., 1996; Benartzi et al., 1997; Nissim and Ziv, 2001; Grullon et al., 2005; Ali and Urcan, 2006. Specifically, Grullon et al. 2005 point out that there is no significant relation between dividend increase and unexpected future earnings changes when they reflect the feature 1325 of the mean reversion phenomenon and autocorrelation of earnings which are non-linear. In this paper, we test the relationship between dividend changes and the predictability of future earnings using Grullon et al. 2005 ‘s method The characteristic of dividend is determined by the dividend policy, and further dividend policy has a close relationship with firm‘s investment decision as well as capital sourcing. Lintner 1956 argued that managers unwilling to change payout ratio without any important change on the firm‘s future performance. Won and Kim 1992 report that managers are more likely to concern about the internal factors such as net income, divisible surplus, predicted future performance, and the shareholders‘ preference for dividend policy. More importantly, several studies suggest that the foreign investors have significant effect on Korean market. Park 2004 reports that foreign investors‘ participation in firms generally pushes up the dividend payments while pulling down investments made in facilities no matter which industry a company is in. Sul and Kim 2006 show that those companies whose majority shareholders are foreign investors tend to pay higher dividends than others whose majority shareholders are domestic investors. In contrast to negative effect of foreign investor, there are empirical studies claiming positive impact of foreign investor in Korean market. Ahn, Shin, and Chang 2005 suggest that foreign investors prefer firms with lower information asymmetry. The study also shows that foreign investors can effectively monitor the management of firm in lessening information asymmetry. Similarly, Park and Lee 2006 suggest that foreign investors ‘ participation in investment of domestic firms can help the firm make more efficient management decision by improving their corporate governance. Thus, Park and 1326 Lee claim that it is problematic to generalize the negative role of foreign investors in Korean market. Based on this argument, we predict that if foreign investors play an effective monitoring role in dividend policy, dividend change for firms with higher level of foreign investors is a good indicator in predicting future earnings than for firms with lower level of foreign investors. However, if foreign investors play a negative role in dividend decision process, predictability of dividend decreases. We test this prediction through the modified partial adjustment model from the Grullon et al. 2005 to consider non- linearity behaviors of earnings. The empirical results suggest that the dividend increases in firms with higher level of foreign investors have positive relationship with future earnings increases for next one year relative to the dividend change year. Specifically, the predictability of dividends for the low dividend policy of 1992-1996 is significantly positive while the predictability of dividend for the later period of 1999-2003 is insignificant. The empirical results from the test of effect of foreign ownership suggest that after the policy change in year 1998, foreign investors have a positive effect on the relationship between dividend increases and future earnings increases. This result is identical even after controlling for the endogeneity problem by Heckman two-stage analysis. This finding implies that foreign investors in Korea play an important role in monitoring the dividend decision management of a firm. The rest of paper is organized as follows. Section 2 provides a literature review of the information content of dividend and foreign investor. Section 3 develops hypotheses. Section 4 presents research design and data description. Section 5 provides empirical 1327 results about the relationship between dividend changes and future earnings regarding foreign ownership. Section 6 conducts additional tests, and Section 7 concludes. 2. Literature review 2.1 The information content of dividends Lintner 1956 suggested that firms increase their dividends when management puts trust on the projection that earnings have consistently increased. Miller and Modigliani 1961 proposed an ―information content of dividend‖ hypothesis that held dividend changes convey new information about a firm ‘s future profitability. John and Williams 1985 suggested that maintaining the level of cash dividends will prevent the devaluation of a firm. Miller and Rock 1985 assumed that managers have internal information about the firm and suggested that managers use dividends as a signal to inform investors about a firm‘s profitability. What dividend signaling theories offers is theoretic frameworks implying a dividend increase can be an indicator for not only a permanent upward revaluation of the cash flow of a firm but also a firm ‘s commitment to maintain a higher level of dividends. This interpretation allows us to hypothesize that a dividend increase is a positive signal about the firm ‘s future earnings and profitability. However, there has not been sufficient empirical evidence supporting these signaling theories. In other words, there are little studies proving a positive relationship between dividends and increase in earnings. One of the earliest studies investigating the relationship between dividend changes and future earnings Watts, 1973, Watts found a positive relationship between the two variables. Yet, the relationship was not statistically 1328 significant. As a result, he concluded that the information content of dividends is not economically meaningful. Another study DeAngelo et al., 1996 was also not able to support the hypothesis that dividend changes can provide information about future earnings. In concluding the study, the researchers interpreted these results as indicating that management tends to increase dividends based on overly optimistic projection about future earnings. This interpretation, thus, implies that there is little reliable information content to be gleaned from dividend changes. Similarly, Benartzi et al. 1997 found that firms that increase dividends experienced significant earnings increases in the year before and the year of the dividend increase but not in subsequent years. Nissim and Ziv 2001 used a different model of earnings expectations to investigate the relationship between dividend changes and future profitability. Upon introducing mean reversion in the earnings expectation model and using a more appropriate deflator, they find that dividend increases and unexpected future earnings changes are positively correlated. In the study, Nissim and Ziv were able to obtain information about ,the level of profitability in subsequent years by looking into dividend changes, which is hardly available from market and accounting data. On the other hand, a follow-up study Grullon et al. 2005 concerns about finding of Nissim and Ziv 2001 by questioning that the linear specification of earnings expectation model used by Nissim and Ziv 2001 was not correct. They brought attention to the point that it is problematic to presume the mean reversion of earnings as a linear processes, which is not. This is because treating linearity when the true functional form is nonlinear would result in the same consequences as overlooking relevant independent variables. For this reason, Grullon and his colleagues claimed what Nissm and Ziv found in their study might not be acceptable. In the study 1329 Grullon et al. 2005, the authors addressed the mean reversion and auto-correlation issue by using the modified partial adjustment model proposed by Fama and French 2000. Controlling for the nonlinear patterns in the earnings, the study results Grullon et al., 2005 indicate that the relationship between dividend changes and future earning does not appear statistically significant. Being consistent with the signaling theory of dividends, findings of Ali and Urcan ‘s study 2006 highlight a significantly positive relationship between dividend increases and future earning changes in low dividend premium years. In the high dividend premium years, however, such a relationship does not appear between the two variables. Ali and Urcan interpret the findings that dividend increases in high dividend premium years can possibly occur because managers positively take investors ‘ demands for dividends into account. Won and Kim 1992 showed that managers are mainly concerned about the internal factors, including net income, divisible surplus, predicted future performance, and the shareholders‘ preference for dividend, when determining dividend policy. In sum, these findings indicate that the correlation between dividend changes and unexpected earnings would vary depending on market or management constraint for dividend changes. 2.2 Foreign investors in Korea Foreign investors have been permitted to invest in Korean stock market since 1992, and since that time f oreign investors‘ ownership of stocks has increased sharply, from 4.9 in 1992 to 38 in 2007. As the holdings of foreign investors have grown, researchers have becoming increasingly interested in the impact of foreign investors‘ 1330 ownership. Besides reporting a crucial influence of foreign investors on the dividend policy, Park 2004 demonstrated a positive relationship of foreign investors ‘ ownership with the increase of dividend payments and the decrease of the investment for facilities. Sul and Kim β006 examined the effects of foreign shares on the increases in a firm‘s dividends. Findings of the study indicate that foreign investors who have more than 5 of ownership can exercise their influence on the company ‘s dividend increase. The study also highlights that companies of foreign majority shareholders usually pay higher dividends than companies of domestic majority shareholders. On the other hand, Ahn, Shin, and Chang 2005 found that foreign investors acquire higher ownership for firms that are covered more closely by analysts and that have lower forecast errors and discretionary accruals. They suggested that foreign investors prefer firms with a lower information asymmetry and that these investors serve as an effective external monitoring system that has the result of lessening information asymmetry. Park and Lee 2006 found that the investment of foreign investors for domestic firms tend to improve corporate governance and consequently, to help the management make more efficient decisions. As shown in these studies, the foreign investors ‘ roles in Korea market are controversial and this leaves rooms for further research. 3. Hypotheses To investigate the validity of the information content of dividend hypotheses, Park 2004 tested the relationship between dividend changes and profitability in the fiscal years following those changes with Korean firm samples. He found that when employing the method of Nissim and Ziv 2001, dividend changes can predict earnings for the 1331 following year. By contrast, Grullon et al. 2005 found that the correlation between dividend changes and future earnings disappears after controlling for nonlinear patterns in the behavior of earnings. In this study we revisit the dividend signaling issue by using a model of unexpected earnings that explicitly controls for nonlinear patterns in the behavior of earnings. We check whether the correlation between dividend changes and future profitability of Korean firms stays positive under the method of Grullon et al. 2005. This leads to our first hypothesis: H1. Dividend changes have a positive relationship with future earnings changes. Ali and Urcan 2006 found that there exists a significantly positive correlation between dividend increases and changes in unexpected future earnings in low dividend premium periods. In the high dividend premium periods, however, there is no significant correlation between dividend increases and changes in unexpected future earnings. Moreover, they assume that dividend increases in high dividend premium periods are the consequence of manager‘s concern about the investors‘ demand for dividends. This, in turns, indicates that the relationship between dividend changes and future earnings will depend in part on managers‘ motives in determining dividend policy. Previous researches into the determinants of dividend policy have found that managers take into account various internal constraint s, such as earnings and shareholders‘ preferences about dividends, when they decide the firm‘s dividend policy. Reasoning from the dividend policy researches and the work of Ali and Urcan 2006, we predict 1332 that ownership structure will have an effect on the relationship between dividend changes and future profitability. This prediction is based on the assumption that the ownership structure is an important factor in determining dividend policy,. Over the past 15 years f oreign investors‘ presence in the Korean stock market has increased considerably, to the point where foreign investors owned about 38 of the Korean market in 2007. As these foreign investors‘ holdings have grown, many researchers have analyzed the effects of such foreign ownership. Park 2004 presented that having foreign investors‘ ownership in firms is likely to increase dividend payments while decreasing the amount of investments for facilities. Sul and Kim 2006 found that the influence of the foreign investors in determining a firm‘s dividends increases as the percentage of foreign ownership increases. The study also showed that having more foreign than domestic shareholders are likely to indicate higher payment of dividends. By contrast, Ahn, Shin, and Chang 2005 suggested that foreign investors tend to be inclining toward firms with lower information asymmetry and that these foreign investors can exert their influence in lessening information asymmetry. Park and Lee 2006 propose that foreign investors take an important part in Korean market by making investments in domestic firms. Consequently, this can have positive impacts on corporate governance and therefore more efficient management decisions can be made. In making a conclusion, Park and Lee 2006 point out that due to its complex nature it is not a simple task to generalize the overall impact of foreign investor, although there have been concerns about their negative role in Korea. To sum up, it seems evident that there is a great agreement on a significant impact of foreign investors in Korean market which is shared by both a positive and a negative 1333 point of view toward their roles. However, there are little theoretical and empirical studies on the foreign investors ‘ impact on Korean market. Given these circumstances, we predict that foreign ownership plays an important role in deciding a firm‘s dividend policy and, in particular, that it will have an important effect on the relationship between dividend changes and future profitability. This leads to the following hypothesis: H2. The association between dividend changes and future earnings changes is affected by foreign ownership. 4. Research design and data description 4.1 The relation between dividend changes and future earnings changes Our first step is to reexamine the relationship between dividend changes and future profitability in the Korean market. We use both the method of Nissim and Ziv 2001 and the method of Grullon et al. 2005. Our basic strategy will be to test the ‗information content of dividend‘ hypothesis by using a regression analysis with dividend changes R△DIV as an independent variable and future earnings changes as a dependent variable. Nissim and Ziv 2001 apply the following equation: Eτ – Eτ -1 B -1 = 0 + 1DPC×R△DIV + 2DNC×R△DIV 1 + 3ROEτ-1 + 4 E – E -1 B -1 + ετ where, Eτ = earnings before extra ordinary items in year τ, relative to the dividend event year 0 1334 B -1 = the book value of equity at the beginning of the dividend event year Eτ – Eτ -1 B -1 = earnings change from year τ -1 to year τ deflated by the book value of the firm‘s equity at the beginning of the dividend event year. R△DIV = the rate of change in the cash dividend per share relative to the previous year DIV = dividend at year 0, and DIV -1 = dividend at the year before. DPC DNC = 1 when the dividend increases decreases and 0 otherwise ROEτ -1 = net income in year 0 scaled by the book value of the equity at the year 0 Nissim and Ziv 2001 included ROEτ -1 as an explanatory variable, accounting for the tendency of ROE to revert to the mean. Freeman, Ohlson, and Penman 1982, and Fama and French 2000 found that the return on equity, which is positively correlated with current earnings, has a negative relationship with future earnings. This inverse relationship is due to the fact that ROE tends to revert to the mean: a high ROE implies an expected decrease in earnings, and vice versa. Nissim and Ziv also included E – E - 1 B -1 as an additional control variable. Dividend changes are highly correlated with contemporaneous earnings changes, so the positive correlation between dividend changes and earnings changes in the two subsequent years may be due to autocorrelation in the earnings change series. Thus Nissim and Ziv include E – E -1 B -1 in order to examine whether dividend changes contain information on future earnings changes, in addition to what can be predicted directly from the earnings change in the dividend change year. We R△DIV = DIV – DIV -1 DIV -1 1335 run the regression models annually and analyze the significance of the means of the coefficients using Fama-MacBeth statistics. Grullon et al.2005 use the equation: Eτ – Eτ -1 B -1 = 0 + 1DPC ×R△DIV + 2DNC × R△DIV + 1 + 2NDFED + 3NDFED×DFE + 4PDFED×DFE×DFE + λ1 + λ2NCED + λ3NCED×CE + λ4PCED×CE×CE + ετ, 2 where DFE = ROE – E[ROE ], ROE = return on equity in year 0 E[ROE ] is the fitted value calculated from the cross-sectional regression of ROE on the logarithm of total assets in year -1, the logarithm of the ratio of market equity to book equity in year -1, and ROE -1 . NDFED PDFED = 1 when DFE is negative positive and 0 otherwise CE = E –E -1 B -1 . NCED PCED = 1 when CE is negative positive and 0 otherwise. We use a modified partial adjustment model the Grullon et al.2005 method to control for the nonlinear relationship between future earnings changes and past earnings levels and changes. As discussed in Fama and French 2000, the dummy variables and the squared terms are expected to capture the nonlinearity of the reversion to the mean and the earnings autocorrelation. The coefficient on 1 expresses the reversion to the mean when profitability is greater than expected, while 2 expresses the reversion to the mean when the profitability is less than expected. When profitability is much greater or 1336 much less than expected, we use quadratic terms to express the reversion to the mean: γ for a large negative deviation, and 4 for a large positive deviation of profitability. Similarly, λ1, λ2, λ3, and λ4 are used to express the non-linearity in the autocorrelation of changes in profitability. 4.2 Dividend changes and future earnings changes conditional on foreign ownership We examine the correlation between dividend increases and unexpected changes in future earnings while varying the level of foreign ownership. In particular, we analyze the following model: Eτ – Eτ -1 B -1 = 0 + 1DPC ×R△DIV + 2DNC × R△DIV + 3FOR + 4DPC×R△DIV ×FOR + 5DNC×R△DIV ×FOR + 1 + 2NDFED + 3NDFED×DFE + 4PDFED×DFE×DFE + λ1 + λ2NCED + λ3NCED×CE + λ4PCED×CE×CE + ετ, 3 where FOR is the percentage of a firm‘s total stock value that is held by foreign investors. The purpose of this variable is to capture the impact of foreign ownership on firms. The term DPC × R△DIV0 expresses the effect of the signaling role played by dividend increases in firms without foreign ownership. The decisions on dividend policy by managers in firms without foreign investors are clearly not affected by foreign investors, while in firms with foreign ownership, the term DPC × R△DIV0× FOR captures the effect of the signaling role of dividend increases. If foreign investors press managers to increase dividend without improvement in firm‘s performance and managers have to 1337 meet the demand, the coefficient for DPC × R△DIV0× FOR is negative. On the other hand, if foreign investors behave in a positive way, for example, by monitoring the managers and improving the firm‘s performance, the coefficient would be positive. 4.3 Sample selection and descriptive statistics The sample selection procedure for this study was similar to that of Park 2004. The sample included firms in the KSE Korea Stock Exchange and KOSDAQ Korea Securities Dealers Automated Quotation from the years 1992 through 2003. Financial statement data were collected from KIS-Value, and the stock market data were obtained from the KSRI Korea Stock Research Institute Stock Database. We restrict observations to those firms that satisfied three conditions: 1 the dividend change was observable, 2 the firm was not a financial firm, and 3 the dividend change was less than 500. INSERT TABLE1 HERE Table 1 shows the annual number of dividend changes for the firms in our sample. The total number of observations of a dividend increase, a dividend decrease, and no dividend change during the sample period was 1,834, 1,839, and 624, respectively. In 1997 and 1998, the total number of dividend increases and dividend decreases was dramatically different from other years. This aberration was caused by the Asian financial crisis, which had a huge impact on Korean economy. Because including data from that period could distort the result of the analysis, the data for these two years were excluded from the sample. INSERT TABLE2 HERE 1338 Table 2 provides descriptive statistics for the three dividend change groups increase, decrease, and no change. Panel A shows the average amount of dividend change for the dividend increase group, which is 59.2. Panel C shows the average amount of dividend change for the dividend decrease group, which is -31.1. For the entire sample the average amount of dividend change is 13.2. The ROE for each group increases in proportion to the R△DIV of the group, from 0.067 to 0.107. The percentage of ownership by foreign investors FOR also increases as R△DIV increases, from 5.5 to 8.01. INSERT TABLE3 HERE Table 3 contains Spearman correlation coefficients for dividend increases below the diagonal and for dividend decreases above the diagonal. Foreign ownership is positively correlated with future earnings change. Foreign ownership is also positively and significantly correlated with dividend changes. ROE and future earnings change have a significant negative relationship, which reflects the reversion to the mean discussed above.

5. Results

5.1 Dividend changes and Future earnings changes Table 4 shows the results of the regression analysis based on equation 1. To alleviate the bias in the regression test statistics due to the cross-sectional correlation in the error term, we use the Fama-MacBeth 1973 procedure to estimate the regression coefficients. First we estimate the cross-sectional regression coefficients for each year 1339 using all the observations in that year. Then we calculate the time-series means and the corresponding t-statistics of the cross-sectional regression coefficients. INSERT TABLE4 HERE Previous studies have found that the relationship between dividend changes and future earning changes is not symmetric between dividend increases and dividend decreases DeAngelo and DeAngelo, 1990; Benartzi et al., 1997; Nissim and Ziv, 2001. We thus allow the coefficients for dividend increase and dividend decrease to be different. DPC is a dummy variable that equals one in the case of dividend increases and zero otherwise, while DNC is a dummy variable that equals one whenever the dividend increases and zero otherwise. Both are multiplied by R△DIV , with 1 the regression coefficient for dividend increases and 2 the regression coefficient for dividend decreases. Table 4 displays the regression results from equation 1. For τ=1, the coefficient of dividend increase is positive and significant at 10 level, while the coefficient of dividend decrease is positive but not statistically significant. The coefficient for ROE is significant and negative, demonstrating a pattern of reversion to the mean for ROE. For τ=β the coefficient of dividend decrease is positive and significant at 5 level, implying that a dividend decrease in year 0 is positively correlated with a decrease in future earnings. Grullon et al. 2005 noted that results from prior studies were based on the assumption that the rate of reversion to the mean and the level of autocorrelation are uniform across all observations. Therefore, to examine the relationship between dividend changes and future earnings changes we use the method of Grullon et al. 2005 which estimates regression through the modified partial adjustment model proposed by Fama 1340 and French 2000. This method allows for nonlinearity in the reversion to the mean and in the autocorrelation process of earnings. Table 5 shows the regression results from the estimating equation 2. For τ=1, the coefficient of dividend increase is positive and significant at 10 level, while the coefficient of dividend decrease is negative but is not statistically significant. This result is different from the result of Grullon et al. 2005. It seems likely that the difference is due to the low dividend policy that predominated among Korean firms in the period 1992 –1996. 232 INSERT TABLE5 HERE INSERT TABLE6 HERE In Table 6 we test this inference by separating the sample period of 1992-1996 from the later period 1999 –2003. The coefficient of dividend increase for the earlier period is positive and significant, while the coefficient of dividend increase for the later period is positive but not significant. This result may be caused by the difference in dividend policy between the two periods. 5.2 Dividend changes and future earnings changes conditional on foreign ownership In this section, we examine the relationship between dividend increases and unexpected changes in future earnings as the level of foreign ownership varies. The regression estimates for equation 3 are provided in Table 7. Neither the coefficients of 232 In the early period 1992-1996 firms had a low dividend policy. The average dividend rate during the preceding period was 9.3, while the average dividend rate during the following period was 17. 1341 dividend changes nor the interaction term for dividend changes and foreign ownership are significant for τ=1 and τ=β. The only statistically significant term is the coefficient of foreign ownership, which is positive. This result could be interpreted as implying that foreign ownership does not have a significant effect on the relationship between dividend changes and future earnings changes. However, there was an important policy change in 1998. Up to that point foreign investors could not acquire more than 50 of a Korean firm‘s outstanding shares, but the rule was repealed in 1998. The average amount of foreign ownership among the 25 of firms with the greatest percentage of foreign ownership was 15.6 during the period 1992 –1996 but grew to 25.3 in 1999–2003, the four years following the repeal of the rule. Therefore it is possible that the effect of foreign ownership on Korean firms was different during those two periods. INSERT TABLE7 HERE INSERT TABLE8 HERE In Table 8, we test for an effect of this change in policy by comparing the coefficients calculated separately for these two sample periods, 1992 –1996 and 1999–2003. For the earlier period the coefficient on the interaction term for dividend changes versus foreign ownership is negative and not significant, but for the later period the interaction term is positive and significant at 5 level. After the policy change, foreign ownership had a positive effect on the relationship between dividend increases and future earnings increase for the year following the dividend increase year. 5.3 Endogeneity problem 1342 5.3.1 Heckman two-stage analysis If one examines only the main independent variable, the interaction term between dividend increase and foreign ownership, it is not possible to eliminate selection bias as a potential explanation for the result. That is, if foreign investors choose to invest in performing companies that perform well and if those companies would exhibit a positive correlation between dividend changes and changes in future earnings even without the presence of the foreign investors, the result from the analysis would be same; in this situation the interpretation that foreign investors have a positive effect on the relationship between dividend changes and future earnings changes would be wrong. To address this endogeneity issue, we employ Heckmans‘ two-stage approach. Because there is no well- accepted evidence to guide the selection of explanatory variables for the probit foreign ownership model, we choose to include six explanatory variables that were identified by Kim et al 2008. First, we perform a regression on the following equation using data from our population of Korean firms: FH = α LEVERAGE + α 1 MTB + α 2 CFO + α 3 SIZE + α 4 SALES + α 5 ROE + 4 Where, FH =1 when foreign investors are participated in the firm, 0 otherwise MTB = market-to-book ratio CFO = cash flow from operations book value of equity SIZE = total asset book value of equity SALES = total sales book value of equity 1343 All other variables are as defined in previous tables. In the second stage, we incorporate the inverse εill‘s ratio and year dummy variables into equation 3 and re-estimate it. The results, displayed in Table 9, are similar to those in Table 7. The coefficient of the interaction term between dividend increase and foreign ownership is still positive and significant after controlling for the endogeneity problem. This suggests that foreign ownership does have an effect on the relationship between dividend changes and future earnings changes. INSERT TABLE9 HERE 5.3.2 The effect of foreign ownership on the likelihood and magnitude of dividend changes In this section we examine how foreign ownership affects dividend policy, specifically, how it affects the likelihood and the amount of dividend changes. We use logistic models, given in equation 6, to estimate the effect of foreign ownership on the likelihood of dividend changes, and we use the Fama-MacBeth 1973 approach to estimate the effect of foreign ownership on the magnitude of dividend changes, as shown in equation 7. In the Fama-MacBeth approach, one first computes cross-sectional regression coefficients for each year using all of the observations from that year. After that, one calculates the time-series means and the standard deviations of the coefficients. Panel A in Table 10 shows the results of the regression calculation from the estimating equation 6. The coefficient of foreign ownership is positive when the dependent variable is DPC, suggesting that firms with a larger percentage of foreign ownership are more likely to increase dividends. Panel B displays the results on the effect of foreign ownership on the magnitude of dividend increases. The coefficient of foreign 1344 ownership is positive when the dependent variable is DPC× R△DIV0, suggesting that firms with a larger percentage of foreign ownership have a higher relative amount of dividend increases than firms with less foreign ownership. INSERT TABLE10 HERE 6. Additional test 6.1 Institutional ownership We examined the effects of institutional ownership by replacing foreign ownership with institutional ownership and doing a similar analysis. Institutional ownership refers to ownership by financial firms, security corporations, and insurance companies. For the period 1999-2003, the regression analysis for the estimating equation 3 with institutional ownership results in a positive but not significant coefficient. 6.2 Sample selection The sample used in this study consisted of firms in the KSE Korea Stock Exchange and the KOSDAQ Korea Securities Dealers Automated Quotation. The intention was to use data from all Korean firms as the data set for this study. However, it has been suggested that firms in the KSE and in the KOSDAQ may differ in certain characteristics. KOSDAQ firms are perceived as less predictable, for example, and the regulations for listing are different for KSE firms versus KOSDAQ firms. Therefore we retested equation 3 using only firms in KSE for the period after the 1998 policy change. Table 11 reports the regression results from the estimating equation 3 using only the firms in the KSE. The coefficient on the interaction term of dividend increase versus 1345 foreign ownership is positive and more significant than the previous result shown in Table 8. The result suggests that the positive relation between dividend changes and future earnings changes is stronger in KSE firms with high levels of foreign ownership. Furthermore, we checked this result with the Heckman two-stage analysis, and the results from that analysis also support this conclusion. INSERT TABLE11 HERE 6.3 Alternative variables We test profitability in the future as a dependent variable. In untabulated results, we find that the effect of foreign investors in the later period, 1999-2003, is still significant. This result suggests that foreign investors play a positive role in determining dividend policy. We further examine the effect of foreign investor on the relationship between the dividend changes and future earnings by using alternative variables: total dividend cash + stock dividend change and dividend rate cash dividend divided by total assets. The results are identical to the previous results.

7. Conclusion

This paper examines the relationship between dividend changes and future earnings changes among Korean firms and investigates whether ownership by foreign investors has an influence on this relationship. Given the nonlinearity that appears in the reversion- to-the-mean phenomenon, we tested the relationship between dividend changes and 1346 future earnings changes by using the modified partial adjustment model from the Grullon et al. 2005. The model controls for nonlinear relationships between changes in future earnings and past earnings levels and changes. We found that the predictability of dividends is significant in the case of dividend increases, but for dividend decreases it is not statistically significant. We hypothesize that this result reflects the low dividend policy prevalent in the period 1992 –1996. Consistent with this prediction, the predictability of dividends for this period is positive and significant while the predictability of dividends for the later period, 1999 –2003, is positive but not significant. Based on this result, we conclude that the relationship between dividend changes and future profitability was likely changed by the change in the dividend policy. In analyzing the effect of foreign ownership on predictability of dividend for the entire period, 1992 –2003, we found that the coefficient of dividend change and the interaction term between dividend changes and foreign ownership were not significant for τ=1 and τ=β. This result could be interpreted as implying that the relation between dividend changes and future earnings changes does not depend significantly on the level of foreign ownership. However, there was an important policy change in year 1998, when a rule restricting ownership by foreign investors to a maximum of 50 was repealed. Therefore we check the effect of this change in policy by comparing the period 1992 – 1996 with the period 1999 –2003. We found that after the policy change ownership by foreign investors had a positive effect on the relationship between dividend increase and future earnings increase in the year following the dividend increase year. This result is the same even after using Heckman two-stage analysis to control for the endogeneity problem. 1347 In this study, we found that dividend changes in firms with higher foreign ownership have a positive relationship with future earnings changes in the year following the dividend change year. We further found that the result is pronounced for firms with a dividend increase. This study suggests that foreign investors in Korea play an important role in monitoring a firm‘s dividend decisions. As a result, news that a firm will increase its dividend implies that the firm is more likely to have positive future earnings. REFERENCES Aharony, J., and I. 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Watts, R., ―The Information Content of Dividends‖, Journal of Business, Vol. 461973, pp. 191- 211. 1350 Table 1 Annual number of dividend changes Year Dividend increases Dividend decreases No change Total 1992 94 151 60 305 1993 110 128 48 286 1994 126 112 64 302 1995 133 136 52 321 1996 130 158 39 327 1997 69 186 22 277 1998 114 105 33 252 1999 152 88 26 266 2000 139 148 25 312 2001 224 184 80 488 2002 255 199 84 538 2003 288 244 91 623 Total 1,834 1,839 624 4,297 This table reports the number of observations over time for dividend increases, decreases, and no change. 1351 Table 2 Descriptive Statistics for Dividend Event Observations from 1992 to 2003 97,98 excluded Mean STD 10 25 Median 75 90 Panel A. Dividend increases N = 1,651 R△DIV 0.592 0.776 0.026 0.13 0.281 0.672 1.54 ROE 0.107 0.079 0.025 0.0502 0.093 0.147 0.211 ROA 0.055 0.047 0.008 0.019 0.042 0.079 0.11 FOR 8.01 11.86 0.08 2.86 10.28 25.28 PAYOUT 0.372 0.436 0.102 0.169 0.277 0.445 0.664 Panel B. No change N = 569 ROE 0.088 0.067 0.015 0.043 0.079 0.126 0.17 ROA 0.044 0.038 0.006 0.016 0.037 0.064 0.092 FOR 6.21 10.77 1.07 8.14 19.48 PAYOUT 0.372 0.441 0.106 0.156 0.268 0.436 0.676 Panel C. Dividend decreases N = 1,548 R△DIV -0.311 0.279 -0.8 -0.5 -0.22 -0.069 -0.016 ROE 0.067 0.068 0.005 0.024 0.056 0.099 0.154 ROA 0.034 0.04 0.001 0.009 0.023 0.052 0.088 FOR 5.5 8.93 0.03 1.58 7.6 15.59 PAYOUT 0.527 1.107 0.114 0.197 0.345 0.558 0.903 Panel D. All dividend events N = 3,768 R△DIV 0.132 0.687 -0.5 -0.165 0.236 0.771 ROE 0.088 0.075 0.014 0.037 0.074 0.127 0.188 ROA 0.045 0.044 0.005 0.014 0.033 0.067 0.103 FOR 6.71 10.64 0.00 0.04 1.93 8.96 20.42 PAYOUT 0.432 0.770 0.108 0.179 0.300 0.482 0.750 This table reports descriptive statistics for dividend event observations. R△DIV = the rate of change in cash dividend per share relative to the previous year. ROEτ -1 = net income in year 0 scaled by book value of equity at the year 0. FOR = level of foreign ownership 1352 Table 3 Spearman correlation coefficients for dividend increasesdecreases belowabove the diagonalp-values below coefficients E τ – E τ- 1 B - R△DIV- FOR SIZE MTB INVEST ROE E τ – E τ- 1 B - 1 -0.01146 0.05411 -0.00938 -0.02825 -0.10596 -0.1501 0.482 0.0009 0.5647 0.0829 .0001 .0001 R△DIV+ 0.01636 0.66757 0.07559 -0.02947 0.00373 0.07858 0.21406 0.3154 .0001 .0001 0.0705 0.8192 .0001 .0001 FOR 0.05411 0.06128 1 0.03493 0.25153 0.04956 0.17075 0.0009 0.0002 0.032 .0001 0.0023 .0001 SIZE -0.00938 -0.0221 0.03493 1 0.27001 -0.17972 -0.11779 0.5647 0.175 0.032 .0001 .0001 .0001 MTB -0.02825 -0.01412 0.25153 0.27001 1 -0.05489 0.2632 0.0829 0.3862 .0001 .0001 0.0007 .0001 INVEST -0.10596 0.01731 0.04956 -0.17972 -0.05489 1 0.08538 .0001 0.2882 0.0023 .0001 0.0007 .0001 ROE -0.1501 0.2644 0.17075 -0.11779 0.2632 0.08538 1 .0001 .0001 .0001 .0001 .0001 .0001 This table reports correlation among variables. The bold values are significant at the 1percent level. E – E -1 B -1 = earnings change in the event year 0 related to the earnings of year -1. R△DIV = the rate of change in cash dividend per share relative to the previous year. FOR = level of foreign ownership. SIZE = total asset book value of equity. MTB = Market-to-book ratio. INVEST = Capital expenditureTotal asset. ROEτ -1 = net income in year 0 scaled by book value of equity at the year 0. Table 4 Regressions of Future Earning Changes on Dividend Changes Using the Nissim and Ziv2001 Method 92~03 E τ – E τ-1 B -1 = α0 + α1DPC ×R△DIV + αβDNC ×R△DIV +αγ ROE τ-1 + α4 E – E -1 B -1 + τ 1 DEP = E τ – E τ-1 B -1 , τ=1 DEP = E τ – E τ-1 B -1 , τ=β Variables Coefficient t- statistics Coefficient t- statistics Intercept 0.001 0.23 0.001 0.13 DPC×R△DIV 0.075 2.08 -0.001 -0.2 DNC×R△DIV 0.0006 0.65 0.019 2.38 ROE τ-1 -0.269 -6.2 -0.245 -4.5 E – E -1 B -1 -0.052 -1.21 -0.1 -2.28 Adj. R 2 0.049 0.059 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports estimates of regression relating future earnings changes to current dividend changes. The sample consists of 3,768 observations for the year 1992 to 2003. Regression is estimated on the based on the Nissim and Ziv method. This model controls for uniform mean reverting and earnings autocorrelation by using linear model of earnings expectations. We use Fama-MacBeth 1973 approach to estimate the regression coefficients. Eτ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 1353 otherwise. DNC = 1 when dividend decreases and 0 otherwise. ROEτ -1 = net income in year 0 scaled by book value of equity at the year 0. E – E -1 B -1 = earnings change in the event year 0 related to the earnings of year -1. Table 5 Regressions of Future Earning Changes on Dividend Changes Using the Grullon et al2005 Method 92~03 E τ – E τ-1 B -1 = α0 + α1DPC × R△DIV0 + αβDNC × R△DIV0 + 1 + βNDFED + γNDFED×DFE + 4PDFED×DFE × DFE + 1 + 2NCED + γNCED×CE + 4PCED×CE × CE + τ 2 DEP = E τ – E τ-1 B -1 , τ=1 DEP = E τ – E τ-1 B -1 , τ=β Variables Coefficient t- statistics Coefficient t- statistics Intercept -0.15 -2.09 -0.025 -2.29 DPC×R△DIV 0.008 2.27 -0.002 -0.62 DNC×R△DIV -0.007 -0.74 0.015 1.68 DFE -0.056 -0.21 0.033 0.16 DFE ×NDFED 0.45 1.07 -0.14 -0.3 DFE 2 ×NDFED 4.26 2.28 0.001 DFE 2 ×PDFED -3.6 -1.25 -3.28 -1.87 CE 0.269 1.6 0.3 0.91 CE ×NCED -0.461 -1.78 -0.66 -1.17 CE 2 ×NCED -1.16 -2.16 -0.67 -0.68 CE 2 ×PCED -1.17 -1.04 -0.57 -0.76 Adj. R 2 0.108 0.054 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports estimates of regression relating future earnings changes to current dividend changes. The sample consists of 3,768 observations for the year 1992 to 2003. Regression is estimated on the based on the Grullon et al method. This regression use the modified partial adjustment model proposed by Fama and French 2000 to control for the non – linearities in the relation between future earnings changes and lagged earnings level and changes. We use Fama-MacBeth 1973 approach to estimate the regression coefficients. Eτ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 otherwise. DNC = 1 when dividend decreases and 0 otherwise. DFE = ROE – E[ROE ], ROE = return on equity in year 0. E[ROE ] is the fitted value from the cross-sectional regression of ROE on logarithm of total assets in year -1, the logarithm of market to book ratio of equity in year -1, and ROE -1 . NDFED = 1 when DFE is negative and 0 otherwise. PDFED = 1 when DFE is positive and 0 otherwise CE = E –E -1 B -1 . NCED = 1 when CE is negative and 0 otherwise. PCED = 1 when CE is positive and 0 otherwise. 1354 Table 6 Regressions of Future Earning Changes on Dividend Changes Using the Grullon et al2005 Method E τ – E τ-1 B- 1 = α0 + α1DPC × R△DIV0 + αβDNC × R△DIV0 + 1 + βNDFED + γNDFED×DFE + 4PDFED×DFE × DFE + 1 + 2NCED + γNCED×CE + 4PCED×CE × CE + τ 2 DEP = E τ – E τ-1 B -1 , τ=1 92~96 DEP = E τ – E τ-1 B -1 , τ=1 99~03 Variables Coefficient t- statistics Coefficient t- statistics Intercept -0.034 -2.31 -0.007 -2.13 DPC×R△DIV 0.006 2.47 0.01 1.58 DNC×R△DIV -0.026 -2.19 0.009 0.63 DFE 0.582 1.66 -0.557 -3.28 DFE ×NDFED -0.174 -0.31 0.7 1.92 DFE 2 ×NDFED 5.614 1.56 1.95 1.15 DFE 2 ×PDFED -9.288 -2.56 2.61 3.37 CE 0.316 0.99 0.32 3.03 CE ×NCED -0.737 -1.5 -0.33 -2.18 CE 2 ×NCED -2.390 -2.84 -0.16 -0.27 CE 2 ×PCED -1.135 -0.51 -1.95 -5.06 Adj. R 2 0.169 0.045 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports estimates of regression relating future earnings changes to current dividend changes. Regression is estimated on the based on the Grullon et al method. This regression use the modified partial adjustment model proposed by Fama and French 2000 to control for the non – linearities in the relation between future earnings changes and lagged earnings level and changes. We use Fama- MacBeth 1973 approach to estimate the regression coefficients. In this table, we compare two periods from 1992 to 1996 and from 1999 to 2003 by using equation 2 Eτ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 otherwise. DNC = 1 when dividend decreases and 0 otherwise. DFE = ROE – E[ROE ], ROE = return on equity in year 0. E[ROE ] is the fitted value from the cross-sectional regression of ROE on logarithm of total assets in year -1, the logarithm of market to book ratio of equity in year -1, and ROE -1 . NDFED = 1 when DFE is negative and 0 otherwise. PDFED = 1 when DFE is positive and 0 otherwise CE = E –E -1 B -1 . NCED = 1 when CE is negative and 0 otherwise. PCED = 1 when CE is positive and 0 otherwise. 1355 Table 7 Regressions of Future Earning Changes on Dividend Changes and Interactions of Foreign Ownership 92~03 E τ – E τ-1 B- 1 = α0 + α1DPC × R△DIV0 + αβDNC × R△DIV0 + αγFOR + α4DPC × R△DIV0× FOR + α5DNC × R△DIV0 × FOR + 1 + βNDFED + γNDFED×DFE + 4PDFED×DFE × DFE + 1 + 2NCED + γNCED×CE + 4PCED×CE × CE + τ 3 DEP = E τ – E τ-1 B -1 , τ=1 DEP = E τ – E τ-1 B -1 , τ=β Variables Coefficie nt t- statistic s Coefficie nt t- statistics Intercept -0.2 -2.67 -0.03 -2.4 DPC×R△DIV 0.005 1.06 -0.002 -0.33 DNC×R△DIV -0.003 -0.26 0.008 0.4 FOR 0.0007 3.84 0.0006 1.93 DPC ×R△DIV×F OR 0.0005 1.02 -0.001 -0.72 DNC ×R△DIV× FOR -0.0009 -0.47 0.0006 0.23 DFE -0.086 -0.31 -0.02 -0.1 DFE ×NDFED 0.47 1.1 -0.113 -0.25 DFE 2 ×NDFED 4.41 2.5 -0.138 -0.07 DFE 2 ×PDFED -3.48 -1.22 -3.09 -1.81 CE 0.29 1.76 0.308 0.91 CE ×NCED -0.48 -1.87 -0.644 -1.15 CE 2 ×NCED -1.25 -2.3 -0.617 -0.63 CE 2 ×PCED -1.27 -1.14 -0.573 -0.78 Adj. R 2 0.129 0.07 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports estimates of regression relating future earnings changes to current dividend changes and interaction of foreign ownership. The sample consists of 3,768 observations for the year 1992 to 2003. This regression use the modified partial adjustment model proposed by Fama and French 2000 to control for the non – linearities in the relation between future earnings changes and lagged earnings level and changes. We use Fama-MacBeth 1973 approach to estimate the regression coefficients. Eτ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 otherwise. DNC = 1 when dividend decreases and 0 otherwise. FOR = level of foreign ownership. DFE = ROE – E[ROE ], ROE = return on equity in year 0. E[ROE ] is the fitted value from the cross-sectional regression of ROE on logarithm of total assets in year - 1, the logarithm of market to book ratio of equity in year -1, and ROE -1 . NDFED = 1 when DFE is negative and 0 otherwise. PDFED = 1 when DFE is positive and 0 otherwise CE = E –E -1 B -1 . NCED = 1 when CE is negative and 0 otherwise. PCED = 1 when CE is positive and 0 otherwise. 1356 Table 8 Regressions of Future Earning Changes on Dividend Changes and Interactions of Foreign Ownership E τ – E τ-1 B- 1 = α0 + α1DPC × R△DIV0 + αβDNC × R△DIV0 + αγFOR + α4DPC × R△DIV0× FOR + α5DNC × R△DIV0 × FOR + 1 + βNDFED + γNDFED×DFE + 4PDFED×DFE × DFE + 1 + 2NCED + γNCED×CE + 4PCED×CE × CE + τ 3 DEP = E τ – E τ-1 B -1 , τ=1 92~96 DEP = E τ – E τ-1 B -1 , τ=1 99~03 Variables Coefficien t t- statistic s Coefficien t t- statistic s Intercept -0.038 -2.61 -0.009 -3.94 DPC×R△DIV 0.008 1.50 0.003 0.41 DNC×R△DIV -0.013 -0.75 0.007 0.53 FOR 0.0009 2.53 0.0005 1.86 DPC×R△DIV×FOR -0.0003 -0.31 0.0008 2.76 DNC×R△DIV×FO R -0.002 -0.7 0.0004 0.4 DFE 0.506 1.46 -0.609 -3.21 DFE×NDFED -0.139 -0.24 0.808 2.21 DFE 2 ×NDFED 5.56 1.59 2.49 1.45 DFE 2 ×PDFED -8.81 -2.41 2.74 3.38 CE 0.326 1.03 0.365 3.42 CE×NCED -0.722 -1.43 -0.39 -3.51 CE 2 ×NCED -2.473 -2.92 -0.29 -0.45 CE 2 ×PCED -1.129 -0.52 -2.1 -6.34 Adj. R 2 0.19 0.064 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports estimates of regression relating future earnings changes to current dividend changes and interaction of foreign ownership. This regression use the modified partial adjustment model proposed by Fama and French 2000 to control for the non – linearities in the relation between future earnings changes and lagged earnings level and changes. We use Fama-MacBeth 1973 approach to estimate the regression coefficients. In this table we compare two periods from 1992 to 1996 and from 1999 to 2003 by using equation 3 E τ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 otherwise. DNC = 1 when dividend decreases and 0 otherwise. FOR = level of foreign ownership. DFE = ROE – E[ROE ], ROE = return on equity in year 0. E[ROE ] is the fitted value from the cross-sectional regression of ROE on logarithm of total assets in year - 1, the logarithm of market to book ratio of equity in year -1, and ROE -1 . NDFED = 1 when DFE is negative and 0 otherwise. PDFED = 1 when DFE is positive and 0 otherwise CE = E –E -1 B -1 . NCED = 1 when CE is negative and 0 otherwise. PCED = 1 when CE is positive and 0 otherwise. 1357 Table 9 Heckman two-stage regression 1 st stageμ FH = α δEVERAGE + α 1 εTB + α 2 CFO + α 3 SIZE + α 4 SAδES + α 5 ROE + 4 2 nd stage: E τ – E τ-1 B- 1 = α0 + α1DPC × R△DIV0 + αβDNC × R△DIV0 + αγFOR + α4DPC × R△DIV0× FOR + α5DNC × R△DIV0 × FOR + 1 + βNDFED + γNDFED×DFE + 4PDFED×DFE × DFE + 1 + βNCED + γNCED×CE + 4PCED×CE × CE + 1YEAR + 1IεR + τ 5 DEP = E τ – E τ-1 B -1 , τ=1 Variables Coefficient t-statistics Intercept 0.004 0.32 DPC×R△DIV -0.009 -1.38 DNC×R△DIV 0.015 0.92 FOR 0.0003 1.08 DPC×R△DIV×FOR 0.001 2.88 DNC×R△DIV×FOR -0.0004 -0.45 DFE -0.5002 -2.18 DFE×NDFED 0.581 1.44 DFE 2 ×NDFED 1.976 1.22 DFE 2 ×PDFED 0.375 0.26 CE 0.415 2.81 CE×NCED -0.235 -0.96 CE 2 ×NCED 0.655 1.16 CE 2 ×PCED -1.708 -3.23 Lamda -0.031 -1.64 Adj. R 2 0.043 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports the second-stage pooled regression results of the Heckman two-stage analysis. In the first stage, we perform the probit regression using the following equation 4 with the population. In the second stage, we add the inverse εills‘ ratio to Equation 3 and re-estimate it. FH =1 when foreign investors are participated in the firm, 0 otherwise. MTB = market-to-book ratio. CFO = cash flow from operations book value of equity. SIZE = total asset book value of equity. SALES = total sales book value of equity Eτ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 otherwise. DNC = 1 when dividend decreases and 0 otherwise. FOR = level of foreign ownership. DFE = ROE – E[ROE ], ROE = return on equity in year 0. E[ROE ] is the fitted value from the cross-sectional regression of ROE on logarithm of total assets in year - 1, the logarithm of market to book ratio of equity in year -1, and ROE -1 . NDFED = 1 when DFE is negative and 0 otherwise. PDFED = 1 when DFE is positive and 0 otherwise CE = E –E -1 B -1 . NCED = 1 when CE is negative and 0 otherwise. PCED = 1 when CE is positive and 0 otherwise. 1358 Table 10 The effect of foreign ownership on the likelihood and magnitude of dividend changes DPC = α0 + α1FOR + αβδEVERAGE +αγεTB + α4TASSET + α5PROFIT +α6YEAR + α7CHA_ASSET + α8CAP_ INVEST + αλTANGIBδE + τ 6 DPC × R△DIV0 = α0 + α1FOR + αβδEVERAGE +αγεTB + α4TASSET + α5PROFIT +α6YEAR + α7CHA_ASSET + α8CAP_ INVEST + αλTANGIBδE + τ 7 Model 6 DEP = DPC Model 7 DEP = DPC× R△DIV0 Variables Coefficie nt Pr Chisq Coefficie nt t-statistics Intercept -1.17 .0001 0.001 0.33 FOR 0.007 0.033 0.0001 2.74 LEVERAG E 0.538 0.016 -0.005 -1.54 MTB -0.065 0.276 0.004 2.39 TASSET 0.0005 0.005 0.0001 0.26 PROFIT 6.508 .0001 0.104 7.53 CHA_ASSE T -0.0002 0.331 0.0001 0.84 CAP_INVE ST 0.007 0.943 0.007 1.08 TANGIBLE 0.29 0.174 0.008 3.02 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. We use logistic models to estimate the effect of foreign ownership on the likelihood of dividend changes. To estimate the effect of foreign ownership on the magnitude of dividend changes, we use Fama-MacBeth 1973 approach. The first stage computes cross-sectional regression coefficients each year using all the observations in that year. In the second stage, the time- series means and standard deviations of coefficients are calculated. The adjusted R 2 is the average adjusted R 2 of the cross-sectional regressions. Regressions are run separately for dividend increase events and dividend decrease events, respectively. DPC= 1 for positive dividend changes and 0 otherwise. R△DIV = the rate of change in cash dividend per share relative to the previous year. LEVERAGE = Leverage ratio. MTB = Market-to-book ratio. PROFITABILITY = ROE ratio. CHA_ASSET = Change in total assets. CAP_INVEST = Capital expenditureTotal asset. TANGIBLE = Tangible asset Total asset. All other variables are defined in previous tables. 1359 Table 11 Regressions of Future Earning Changes on Dividend Changes and Interactions of Foreign Ownership 99~03, KSE E τ – E τ-1 B- 1 = α0 + α1DPC × R△DIV0 + αβDNC × R△DIV0 + αγFOR + α4DPC × R△DIV0× FOR + α5DNC × R△DIV0 × FOR + 1 + βNDFED + γNDFED×DFE + 4PDFED×DFE × DFE + 1 + 2NCED + γNCED×CE + 4PCED×CE × CE + τ 3 DEP = E τ – E τ-1 B -1 , τ=1 DEP = E τ – E τ-1 B -1 , τ=β Variables Coefficien t t- statistic s Coefficien t t- statistic s Intercept -0.01 -2.06 0.0009 0.08 DPC×R△DIV 0.0002 0.02 -0.001 -0.11 DNC×R△DIV -0.001 -0.09 -0.015 -0.71 FOR 0.0003 2.28 0.0006 2.13 DPC×R△DIV×FOR 0.0009 3.02 -0.0004 -0.61 DNC×R△DIV×FO R -0.0001 -0.11 0.001 0.83 DFE -0.488 -2.06 -0.925 -2.68 DFE×NDFED 0.524 1.01 1.18 2.57 DFE 2 ×NDFED 2.63 1.33 3.20 3.73 DFE 2 ×PDFED 2.68 1.48 4.54 1.91 CE 0.46 2.27 0.31 10.29 CE×NCED -0.317 -1.10 -0.33 -1.55 CE 2 ×NCED 0.738 0.87 -0.30 -0.32 CE 2 ×PCED -2.89 -2.60 -0.9 -1.63 Adj. R 2 0.117 0.077 , , , Indicate two-tailed significance at the 10, 5, and 1 percent levels, respectively. This table reports estimates of regression relating future earnings changes to current dividend changes and interaction of foreign ownership. The sample consists of 1,528 observations for the year 1999 to 2003. This regression use the modified partial adjustment model proposed by Fama and French 2000 to control for the non – linearities in the relation between future earnings changes and lagged earnings level and changes. We use Fama-MacBeth 1973 approach to estimate the regression coefficients. Eτ – Eτ -1 B -1 = earnings change in year τ from year τ -1 deflated by the book value of equity at the beginning of the dividend event year. R△DIV = the rate of change in cash dividend per share relative to the previous year. DPC = 1 when dividend increases and 0 otherwise. DNC = 1 when dividend decreases and 0 otherwise. FOR = level of foreign ownership. DFE = ROE – E[ROE ], ROE = return on equity in year 0. E[ROE ] is the fitted value from the cross-sectional regression of ROE on logarithm of total assets in year - 1, the logarithm of market to book ratio of equity in year -1, and ROE -1 . NDFED = 1 when DFE is negative and 0 otherwise. PDFED = 1 when DFE is positive and 0 otherwise CE = E –E -1 B -1 . NCED = 1 when CE is negative and 0 otherwise. PCED = 1 when CE is positive and 0 otherwise. 1360 THE IMPACT OF BLOCK-HOLDER OWNERSHIP, FIRM SIZE AND LEVEL OF COMPETITION ON FINANCIAL DISCLOSURE OF MANUFACTURING COMPANIES LISTED IN THE INDONESIA STOCK EXCHANGE Thomas D. Susmantoro, Cynthia Afriani Utama University of Indonesia Abstract The purpose of this study is to investigate whether the extent of company disclosure in Indonesia are affected by internal factors and external factor. Many previous studies related to disclosure conducted in Indonesia only focus to the internal factors, e.g. firm size and ownership structure blockholder ownership. Unlike previous studies, we address the impact of competition as an external factor to company disclosure level. This study employs Botosan Index and Herfindahl Index HI as a proxy for the extent of disclosure and competition. The result shows that total asset as a proxy for firm size, blockholder ownership and level of competition have positive influence on company disclosure level Keywords: Competition, Herfindahl Index, Financial Disclosure, Firm Size, Ownership structure I. BACKGROUND The Agency Theory suggests that there is asymmetric information 233 between management as the agent and the principal i.e., owner of capital. According to Jensen and Meckling 1976, agency problem occurs when manager hides some information to the principal and diverts the company ‘s asset to maximize hisher utility. As consequences, the agency problem can have a detrimental effect on shareholder value. Lang and Lundholm 1996 state a company can minimize asymmetric information between manager and shareholder by increasing a company ‘s disclosure. Disclosure can be improved by providing not simply mandatory information mandated disclosure but additional information voluntary disclosure as well. The advantages of higher disclosure are: 1 Higher disclosure reduces the cost of equity Botosan 1997; Welker 1995; Marquardt and Wiedman 1998; Leuz and Verrechia 2000; Bloomfield and Wilks 2000; and Hail 2001, Tjakradinata 2000; 233 According to Scott 2000, there are two impacts of asymmetric information: adverse selection and moral hazard. The adverse selection refers to the willingness of the investor who has less information to buy the company stock with the lower price to compensate the agency problem caused by the manager in the future. Moral hazard problem occurs when manager acts inappropriately to the principal who has less information and cannot perfectly monitor the manager. 1361 Sitanggang 2002; Adhariani2004; and Budiarti 2007; 2 Higher disclosure reduces the cost of debt Sengupta, 1998. Higher disclosure improves the lender perception related to default risk of the company. Furthermore, the credit analysts will have more information regarding firm strategy and its ability to repay debt. Some studies show that large shareholders blockholders have a positive relationship with company disclosure Healy, Hutton and Palepu 1999; Jiambalvo, Rajgopal and Mitchell, Chia and Loh 1995; Aitken, Hooper and Pickering 1997; and Venkatachalam 2002. The blockholders 234 control the company decision making including the decision related to the company disclosure. The blockholders have a greater willingness to discipline poorly performing management and more incentive to intervene and exercise ‗voice‘ εayer 1997, Schmalensee and Willig 1989; and Tirole 1990. Other studies find that firm size, which is proxied by value of total assets, has a positive relationship with the extent of company disclosure Arber, Carvell and Strebel 1983; Merton 1985; Chow and Wong-Boren 1987; King, Pownal and Waymire 1990; Bradbury 1991; Bradburyy 1992; Skinerr 1992; McKinnon and Dalimunthe 1993; and Berger and Hann 2002. Bradbury 1991 states that firms with higher value of total assets but not followed proportionally by a higher disclosure level will suffer a greater potential loss relative to firms with small assets. Consequently, shareholders tend to increase monitoring and implementation of high disclosure policy for larger firms. Furthermore, Singhvi 1971 states that large firms necessarily implement a high disclosure policy to obtain easier access to financing and to increase stock liquidity. Previous studies show the influence of blokholders and firm size on the extent of company disclosure. On the other hand, Bilson, Smith and Whaley 2006 stress the influence of competition level as an external factor to the extent of company disclosure. There is a trade-off to implement a higher disclosure. In industry with highly competitive environment, providing more voluntary disclosure in company annual report will have more advantage than industry with less competitive environment. Voluntary disclosure should provide more information about business strategy and their competitive advantage to the investor. I nvestor‘s positive perception on company stock would be beneficial to 234 Beside percentage of ownership large block holder, Singhvi 1971 uses the other proxy for ownership by using the number of shareholder 1362 the existing stockholder. Verrecchia 2001 explains that in the industry with highly competitive environment, the potential loss caused by new entrants and existing competitors is relatively lower than the industry with low competitive environment. For a company that operates in low competitive environment, voluntary disclosure in the annual report results in more disadvantage than a potential loss caused by increasing competition from new entrants and existing competitors Darrough and Stoughton 1990; Dye 2001; and Verrecchia 2001. Furthermore, Dye 2001 states that in industry with low competitive environment, increasing level of company disclosure would cause a potential loss of company cash flow because the competitors reduce the company market share. Therefore, the empirical studies show that competition as an external factor affects a company disclosure level. Based on previous studies, we can summarize that both firm size and ownership structure as internal factors and competition level as an external factor have a positive influence on company disclosure level. Therefore, the objective of this study is to investigate the influence of large shareholders, firm size and competition level on disclosure level of publicly listed companies in the Indonesia Stock Exchange. We include sample from manufacturing companies due to these companies tend to disclose more items compared to non-manufacture companies Lincoln and Kalleberg 1990; Cooke 1989; Choi and Hiramatshu 1987; and Stanga 1976. The remainder of this paper is organized as follows. The second section provides literature review and hypothesis development. The third section describes research methodology meanwhile the fourth section explains empirical results. The final section provides conclusion and implication.

II. HYPOTHESIS DEVELOPMENT

Healy, Hutton and Palepu 1999; Jiambalvo, Rajgopal and Mitchell, Chia and Loh 1995; Aitken, Hooper and Pickering 1997; and Venkatachalam 2002 show that institutional ownership is positively correlated with company disclosure level. Their studies find that institutional ownership plays an active role in the monitoring and control 1363 of the firm. As a result, they assure that management action align with shareholders‘ objective. Mayer 1997, Schmalensee and Willig 1989; and Tirole 1990 state that institutional ownership is able to enforce management to increase voluntary disclosure and finally reduces information asymmetry between management and shareholders. Institutional investors with a greater ownership concentration and higher voting right exert their control over management by using incentives for examples: reward decision i.e., giving more incentive or bonus to management or punishment i.e., to fire and replace the management or no-bonus to management. This finding is affirmed by Michell, Chia dan Loh 1995 dan Aitken, Hooper dan Pickering 1997 as well. They contend that higher dispersed ownership structure is associated with lower level of company disclosure. Birt, Bilson, Smith and Whaley 2006 conclude that large shareholders e.g. blockholder exert control to company decision including disclosure policy. Birt, Bilson, Smith and Whaley 2006 also argue that blockholders would motivate company to increase disclosure in order to mitigate not only interest between shareholder and management but also among shareholders. Their study finds a positive relationship between ownership concentration and disclosure level. Therefore, the first hypothesis is: H1: Ownership by large shareholders is positively correlated with company disclosure level Large firms tend to increase their disclosure level. Large firms will maintain their assets to prevent decrease or even loss due to improper policy or management frauds. Bradbury 1991 argues that a company with large assets but does not implement high disclosure level will suffer more potential loss than a company with small assets. Furthermore, Foster 1986; McKinnon and Dalimunthe 1993; Bradbury 1992; and Berger and Hann 2002 explain that a company with large assets will implement high disclosure policy to mitigate the agency problem between management and shareholders. Singvhi 1971 argues that large firm will implement high disclosure policy because the advantage of easier access to get external financing and increasing the stock 1364 liquidity. Meanwhile, Sengupta 1998 explains that large firms tend to disclose more because information about their assets is ‘good news‘ to investors. Information on large assets will show that a company has a good reputation and ability to repay its loan or credit. As a result, the creditor will charge a lower cost of debt. The positive impact of firm size to company disclosure is supported by Birt, Bilson, Smith and Whaley 2006 as well. Buzby 1975 also asserts that a company with large assets will have sufficient resources and information system to help the company in collecting and providing information. Based on previous studies, the second hypothesis is: H 2: Level of assets has a positive relationship with company disclosure level Dye 2001 argues that if disclosure is not mandatory, a company only provides favorable information to the stakeholders. The cost occurred due to disclosing unfavorable information is called proprietary cost Verrecchia 2001. Proprietary cost is a trade-off between incentive and disincentive resulting from implementing high disclosure policy. The incentive is to increase the stock price meanwhile the disincentive is a loss of market share Verrecchia 2001. Verrecchia 2001 investigates the role of proprietary cost in order to explain why companies act reluctantly to disclose additional information voluntary disclosure. Verrecchia 2001 argues that companies operate in a low-competitive environment has disincentive to reveal voluntary disclosure. They assume that voluntary disclosure will disclose too much information to their competitor and reduce their market share. Conversely, companies that operate in a highly competitive environment will have a greater incentive to disclose because the potential loss of market share is relatively lower than low competitive environment. Releasing additional information could be beneficial to the company because it could reduce asymmetric information between management and the shareholders Hayes Lundholm 1996; Harris 1998; Botosan and Stanford 2005, Harris 1998. Therefore, the third hypothesis is: H3: The level of competition is positively correlated with company disclosure level 1365

III. RESEARCH METHODOLOGY

3.1. Variable Measurement

In measuring a company disclosure level, it is common to use a score or index that can be calculated based on disclosure items in a company annual report. In US and European countries there is a rating for disclosure level which is published by Association for Investment Management and Research AIMR. This rating can be used as a reference to investors to evaluate adisclosure level of listed companies. In addition to rating released by AIMR, several studies like Cerf 1961; Mautz and May 1978; Fith 1979; Nair and Frank 1980; Lee and Twedie 1981; Gray, Sweeney and Shaw 1984; Gray and Robertson 1989; and Cooke 1988, 1992 introduce several indexes as alternative measures of disclosure. A disclosure index can be used to measure the level of compliance to government or stock exchange regulation. This index could be used as an indicator of mandatory disclosure andor voluntary disclosure. It is counted based on the explanation in the annual report regarding company financial status and its performance. All of information must be revealed, in qualitative or quantitative, in order to help stakeholders in making decision Siegel and Shim 1994. Cerf 1961 employs a disclosure index that consists of several disclosure items. These items are constructed after studying investment decision-making process, by exploring how decisions are made by conducting some interview with security analysts and conducting some tests on reports produced by analysts. Another study, Cooke 1992 utilizes 165 disclosure items that include mandatory and voluntary disclosure items. His research constitutes further evidence on Shingvi and Desai 1971 empirical research. Botosan 1997 employs disclosure quality with the use of an index calculated based on information provided in the annual report. Botosan 1997 demonstrates that annual report can be used to measure quality of disclosure. Lang and Lundholm 1993 in Botosan 1997 state that there is a positive relationship between annual report and other company‘s publications the correlation coefficient is 0.62 and between annual report and AIMR disclosure rating a correlation coefficient of 0.41. Thus, Botosan 1997 argues that disclosure on company annual report could be a good proxy of company disclosure. 1366 Disclosure index developed by Botosan 1997 is classified into the following five categories: background information, summary of historical financial statistics, key non- financial statistics, projected information and management discussion and analysis. Each category has total score that is measured by using several disclosure items. The score depends on the level of information provided in annual report. In measuring each item, Botosan 1997 provides the list of disclosure items with explanation and guidance anchor to define the score so it is useful to minimize subjectivity in determining the score. In contrast to US and Europe, Indonesia has no institution that provides disclosure index. Furthermore, most studies related to disclosure level in Indonesia employ Botosan Index Tjakradinata 2000; Adhariani 2004; and Budiarti 2007. As mentioned above, Botosan index could minimize subjectivity in measuring company disclosure. In measuring disclosure level, it is necessary to understand the style and format of annual report of listed companies. In Indonesia, Badan Pengawas Pasar Modal Bapepam and Lembaga Keuangan as a regulator to monitor stock exchange in Indonesia has released a decree No: KEP-134BL2006 Regulation No X.K.6 that state there is obligation for publicly listed companies to publish an annual report. The decree also provides a guidance of the style and content of annual report that is mandatory to be informed to the public. According to that decree, companies have to explain significant changes compared to the last annual report. The decree also requires certain information to be disclosed in the annual report, i.e., important financial summary, commissioner ‘s report, 235 Board of Director BOD report, company profile, management discussion and analysis, report on corporate governance, responsibility of BOD on annual report, and audited financial report. Specifically on management discussion and analysis, a company has to explain the following information: review on operation of each segment of business, financial performance analysis, discussion and analysis on business condition, significant changes, impact to the company, prospect and achievement and also explanation about major accounting policies being used. The company can provide additional information 235 Indonesian companies apply a two-tier board, i.e., the supervisory board or the board of commissioner and the management board or the board of directors.