The Implications of Retained Earning, Leverage

Mimicking Portfolios on Dividend Reputation

and Stock Returns

Elsa Vinancia Sinambela

Department of Accounting, University of North Sumatra, Medan, Indonesia

1. Introduction
Leverage is an important risk factor that is overlooked in the asset pricing literature. In
finance, leverage (or gearing in the United Kingdom and Australia) is any technique
involving using debt (borrowed funds) rather than fresh equity (value of owned assets
minus liabilities) in the purchase of an asset, with the expectation that the after-tax profit
to equity holders from the transaction will exceed the borrowing cost, frequently by several
multiples ⁠— hence the provenance of the word from the effect of a lever in physics, a
simple machine which amplifies the application of a comparatively small input force into
a correspondingly greater output force.

The main objective of this paper is to explore the effect of portfolio leverage imitation
factors on dividend reputation and stock returns. Following Fama and France's (FF, 1993)
procedure in shaping book-to-market mimic size and portfolios, I form leverage mimicking
factor portfolios to explain the returns.

Sloan (2006), in a Seminal Paper ) shows that investors tend to over accrual (cash flow)
when making profit expectations only systematically and feel surprised when accruals
turned out to be less persistent than cash flows, especially around announcement of future
earnings. As a result, firms with low accruals earn higher abnormal earnings than firms
with high accruals.
Further research is continued by breaking down accruals into different components, while
trying to provide some explanations about accrual anomalies. In addition, this study
expands the asset price literature in two ways, namely, it provides the first comprehensive
study of the influence of portfolio leverage imitation factors in explaining variations in
stock returns. I expanded the set of variables used to explain returns to include leverage, a
factor with strong theoretical appeal (Modigliani and Miller, 1958).

The capital asset pricing model (CAPM) (Sharpe, 1972; Lintner, 1965; Black et al., 1972)
uses market risk; Fama and French (1992) used size and book-to-market, incremental
factors and Carhart (1997) used momentum as a risk factor. There is a section list to include
leverage which is a source of financial risk but has been largely ignored in the asset pricing
literature. Then, I consider to use the original idea in Modigliani and Miller (1958) that
capital structure varies in different industries as asset structure and production processes
vary and conduct our empirical analysis in different industries.

Xie (2001) interpreted Sloan's (1996) results as evidence of earnings manipulation, with
the implicit assumption that managers exploit discretionary accruals to manipulate earnings
[1]. Fairfield et al. (2003a) show that accruals relating to net non-current operating assets
are mispriced in a similar manner to accruals relating to net current operating assets.

Based on these findings, Fairfield et al. (2003a) argued that the accrual anomaly
documented by Sloan (1996) is part of greater growth (in net operating assets) and
suggested that it arises from diminishing marginal returns to new investment and/or
overinvestment [2]. In a follow-up study, Dechow et al. (2008) focus on cash flow and
show that stock prices act as if investors overestimate (correctly anticipate) what is in cash
flow (distribution of cash to providers of capital).

In this paper, I attempt to expand the existing literature by simultaneously investigating the
persistence and price components of accruals considered by Fairfield et al. (2003a) and the
cash flow component considered by Dechow et al. (2008). Specifically, revenue will be
decomposed into current operating accruals, non-current operating accruals, retained cash
flows, cash flows distributed to debt holders (debt payments minus debt issues) and cash
flows distributed to equity holders (dividends plus share repurchases minus issuance of
shares).

Recognizing that the first three components represent profitability related to retained
capital and the last two components represent those related to distributed capital, I also
consider the decomposition of retained and distributed earnings. Retained earnings relate
to changes in net return on investment, while distributed income relates to cash flows with
external financing activities. Using this decomposition, we can examine possible
relationships between the implications of various components of earnings for dividend
reputation and stock returns and gain a deeper understanding of the underlying causes.

This paper is structured as follows: section 2 provides a detailed description of the research
design. In section 3, the data, sample formation and variable measurement, while in section
4, I provide empirical results. Section 5 is summary and conclusion.