Growth Opportunities, Corporate Governance and Payout Policy: The Case of the U.S. Defense Industry

Abstract

The financial fortunes of large U.S. defense contractors are affected significantly by changes in defense contracts they receive from the Pentagon. Significant shifts in the volume of government purchases are entirely exogenous events and hence provide a natural experiment for examining how changes in growth opportunities can affect corporate payout decisions. The growth opportunities of the U.S. defense firms, compared with other firms, increased substantially during the Reagan defense buildup of the early 1980s but then declined significantly with the end of the Cold War and the associated defense budget cuts in 1989. I examine how the level and structure of dividends, share repurchases and total payout changed for a sample of 57 defense firms and a benchmark sample of 57 manufacturing firms during the 1990–1995 period, the low-growth phase following a period of sustained growth. I aim to answer two main questions: (1) is corporate payout policy affected by the investment opportunity set? and (2) is the strength of corporate governance a determinant of payout policy? Using panel data over the 1990–1995 period, I regress payout on a growth proxy along with various control variables. A significant contribution of my research is a finding of a negative relationship between growth opportunities and payout policy in a sample that is free from the endogeneity problem which has clogged previous studies. In particular, I find that when growth options for U.S. defense firms deteriorate, defense firms increase their total payout levels. There is significant evidence that this was done through repurchasing shares as opposed to going through the dividend route. When governance quality is incorporated, there is evidence supporting the agency costs theory of free cash flow. In the presence of fewer investment opportunities, defense firms with weak external governance are associated with a smaller increase in share repurchases in particular and total cash distributions in general than the rest of the sample firms. In addition, when growth opportunities declined, the weak internal governance firms that could not afford to increase payouts chose to alter the structure of payouts. Specifically, they increased the proportion of dividends at the expense of repurchases. Overall, the findings in this research demonstrate the existence of a causal link where exogenous shocks to growth opportunities affect corporate payout policy and also supports the role of (1) internal governance in payout policy design where entrenched managers should pre-commit to higher dividends, and (2) external governance as a corporate governance device where firms with effective external governance are associated with higher payout.