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DIVIDEND ANNOUNCEMENTS;
Cash Flow Signaling vs. Free Cash Flow Hypothes~s?*
Larry H.P. LANG
New York University, New York, N Y 10000, USA
Robert H. LITZENBERGER
University of Pennsytvania" Philadelphia, PA 19104, USA
Received March 1988, final version received December 1988
We test the cash flow signalling and free cash flow/overinvestment explanations of the impact of
dividend announcements on stock prices. We use "robin's Q ratios less than unity ta designate
overinvestors. The average return associated with announcements of large dividend changes is
significantly larger for firms with Q's less than unity than for other firms. This evidence, the
results of further tests involving a finer partition of the data, and an analysis of changes in
analysts' earning forecasts surrounding dividend announcements support the overinves~ment
hypothesis over the cash flow signalling hypothesis.
|. Introduction
The positive association between announcements of dividend changes and
stock-price movements has been documented in several empirical studies.
Fama, Fisher, Jensen, and Roll (1969) find that firms announcing stock splits
accompanied by increases in cash dividends have a statistically significant,
positive mean. risk-adjusted stock return during the announcement months,
and those accompanied by dividend decreases have a significant negative
return. Studies by Pettit (1972) and others find that the mean risk-adjusted
return for firms announcing dividend increases is significantly positive over the
two days surrounding the announcement, and for those announcing dividend
decreases the two-day return is significantly negative. More recently, Aharony
and Swary (~980) report similar results after controlling for contemporaneous
*The authors acknowledge helpful commeats from Yakov Am/hud, Michael Barclay. K.C
Chart, Michael Jensen, Kose John, David Mayers, Richardson Petfit (the referee), Andrei Shleiter,
Cliffo:t Smith (the editor), Rene Stulz, and participants of a seminar at the 1988 American
Finance Association meeting in New York. The data collection, calculation of Tobin's Q~ aL,d
computer erogramming assistance of Anne Cheng ~ e gratefully acknowledged. The research
assistance of C.T. Chen, Jose Puyol, Lin Shaw, and David Sun are case acknowledged. The
gemaining errors are the sole responsibility of the al:thors. The original rifle of this paper was
'What information is contained in dividend annouvcements?'.
0304-405X/89/$3.50~ 198% Elsevier Science Publishers B.V. (Nc,rth-Holland)
182
183
We use the Modigliani and Miller (1966) limited growth model to describe
the ovednvestment hypothesis and the rationale for using Tobin's Q ratio as
an indicator of overinvestment. Using this model the value of firm V is
X
V~
(1)
184
dV
dD-dDt\
-d-i
/K]T,
(2)
where dP/dl < 0 because of decreasing marginal efficiency of capital and the
term in square bracket is the marginal net present value profitability index
(marginal Q less unity). For value-maximizing firms, marginal Q is unity and
the level of investment is independent of the dividend, thus dl/dD = 0 which
imphes t~at dV/dD = 0. For overinvesting firms the marginal Q is less than
unity a n a the level of investment is inversely related to the dividend, i.e.,
dl/dD = - 1 which implies that dV/dD > O.
To obtain the average Tobin's Q ratio, both sides of (1) are divided by the
firm's current capital stock, C:
Uc
K (e-K)r,
(3)
where R = X/C is the average return on the current capital stock. Under
scale-expanding invesu~:~*nt and diminishing marginal efficiency of capital, if
the average return on investmca~, i% is greater than K, then the average return
on the er,dsting capital stock, R, must also be greater than g. and Tobin's Q
will be greater than unity. Conversely, if the average return on the existing
capital stock, R, is less than K, then the average return on investment, P,
must also be less than K and Tobin's Q will be less than unity.
i 85
186
numbers of shares outstanding from the Center for Research in Security Prices
(CRSP) monthly return file. The book value of preferred stock is used as a
surrogate for its market value because pre~er~ed stock is a very small portion
of the sample firms' capital structures. The prices of long-term bonds are
obtained from Moody's Bond Record. If the price of a nonconvertible bond is
not reported, the yield to maturity of, another bond with a similar maturity
and coupon rate issued by the same firm is used to calculate the first bond's
price. Bonds with less than a year remaining to maturity, floating-rate bonds,
convertible debt for which price data are not reported, and debt with an
unknown coupon and/or maturity date are valued at book value. Replacement costs of net plant and equipment and inventories for 1979 to 1984 are
btained from the Financial Accounting Standard Board (FASB) regulation
33 tape edited by Columbia University.
<Our sample includes dividend-change announcements that meet two criteria: (1) the absolute dividend changes by more than 10% and (2) we are able to
calculate +~he average Q's for the firm announcing the change. The daily
returns an_d the date of di'Adend announcements are retrieved from the CRSP
daily return file and master file, respectively. Stocks that have split in the
q,_,arter before the dividend announcements are excluded, as are financial
organizations and public utilities. The final sample consists of 429 dividendchange announcements from 1979 to 1984.
Daily risk adjusted returns are measured as unadjusted returns minus the
product of a Scholes-Williams beta and the equally weighted CRSP index
returns. To test the hypothesized difference in average returns for firms with
average Q's greater than and less than unity, returns associated with announcements of dividend increases greater than 10 percent are averaged with
the negative of returns of firms with dividend decreases greater than 10
percent in absolute value. As shown in table 1, the average returns for firms
with average Q's less than unity is more than three times as large as that for
firms with average Q's greater than unity. The difference is significant at the
1 % 'l 'e q e l .
Da~ly returns are influenced by information other than dividend announcement. To reduce the impact of other information, we examine mtraday
returns. Because of the data availability, the sample of in)raday returns
consists of 76 dividend-change announcements over the period 19o2-1984.
The exact minute of dividend announcement is obtained from the Dow Jones
News. Service. To a~oid mixing intraday and overnight returns, in our intraday
anal)sis we use only announcements that occur within the trading day. The
intraday stock price data are obtained from the Fitch tapes.
Intvaday returns are measured over the period one hour before to two hours
after dividend announcements, beginning with the first trade price of the
onehow preannouncemen~ period and ending with the last trade of the
187
Table 1
Average daily returns on dividend announcement days for firms with average Q's less tl,,~ unity
and for firms with average Q's greater than unity over the period 1979-1984.
Our sample of daily returns consists of 429 dividend-change announcements that meet two
criteria: (1) th~ absolute value of the percentage dividend change is greater than 10% and (2) we
are able to calculate the average Q ratio for the firm announcing the change. We divide the sample
into two groups using a cut-off point of Tobin's Q = 1. Returns for dividend increases are
averaged with the negative of returns of firms for dividend decreases.
Average return
p-valuea
Q> 1
Q< I
~Q< 1 ) - ( Q > 1)
0k03
(0.02i)
0.011
(0.000)
0.008
(0.000)
a The p-values based on a conventior,.al t-test and those based on a bootstrap procedure [see
Barclay and Litzenberger (1988)] are identical to three decimal places.
Table 2
Average intraday returns on dividend announcement day for firms with average Q's less than
unity and for firms with average Q's greater than unity over the period 1982-1984.
Our sample of intraday returns consists oi 76 dividend-change announcements that meet three
criteria: (1) the absolute value of the percentage dividend change is greater than 109~, (2) we are
able to calculate the average Q ratio for the firm announcing the change, and (3) we are able to
retrieve the exact announcement time from the Dow Jones News Service. Intraday returns are
measured over the period one hour before to two hours after dividend announcements, be#nning
with the first trade price of the one-hour preannouncement period and ending with the last trade
of the two-hour postannouncement period. We divide the sa__mpleinto two groups using a cut-off
point of Tobin's Q = 1. Returns for dividend increases are averaged with the negative returns for
firms for dividend decreases.
Average return
Bootstrap p-value a
Q> 1
Q< 1
( Q < 1 ) - ( Q > 1)
- 0.0001
(0.595)
0.0178
(0.007)
0.0179
(0.012)
188
189
Table 3
Average daily returns on &vidend announcement day for each group over the period 1979-1984.
Our sample of daily returns consists of 429 dividend change announcements :.hat meet t~o
criteria: (1) the absolute value of the percentage dividend change is greater than 10% and (2) we
axe able to calculate the average Q ratio for the firm. We divide the sample into ~our groups:
(1) Tobin's Q > 1 with dividend increase, (2) Tobin's Q > 1 with dividend decrease (3) "robin's
Q < 1 with dividend increase, and (4) Tobi~'s Q < 1 with dividend decrease.
Dividend
increase
Dividend
decrease
Difference in absolute
values for increases
and d~~:reases
Q > 1.0
t-test p-value
0.003
(0.016)
- 0.003
(0.371)
(0.5C0)
Q < 1.0
t-test p-value
0.008
(0.000)
- 0.027
(0.000
(0.005)
0.005
(0.008)
-0.024
(0.027)
(Q< :)-(Q>
t-test p-value
1)
0.000
0.019
J.F.E.--G
190
Medians of elasticity of the average of analysts' earnings forecasts with respect to dividend-change
announcements over the period 1979-1984.
Our sample of analysts forecasts consists of 429 current year's earnings per share (EPS) forecasts
that meet two criteria: (1) the absolute value of the percentage dividend change is greater than
10% and (2) we are able to cMculate the average Q ratio for the firm aanouncing the dividend
change. We divide the sample into four groups: (1) Tobin's Q > 1 vdth dividend increase,
(2) Tobin's Q > 1 with dividend decrease, (3) "i'obin's Q < 1 with db, idend increase, and (4)
Tobin's Q < 1 with dividend decrease.
Dividend increase
Current-year EPS
Dividend decrease
Current-year EPS
Q > 1.0
l~ootstrap p-value
"0.0053
(0.544)
- 0.0483
(0.406)
Q < 1.0
Bootstrap p-value
0.0993
(0.375)
-0.3685
(0.298)
Bootstrap p-value
of(Q < 1 ) - (Q > 1)
(0.370)
(0.329)
5. Conclusion
This paper investigates the informational content of dividends in the frame,
work of the principal-agent conflict model developed by Berle and Means and
extended by Jensen. If managers are overinvesting, an increase in the divMend
will reduce the overinvestment and increase the market value of the firm.
Similarly, a dividend decrease signals that more aegati,~e-net-present-value
projects will be undertaken. For value-maximizing firms the level of investment is theorized to be independent of dividends. -Fhe present study divides
firms into overinvestors and a mixed group of value maximizers and marginal
overinvestors on the basis of Tobin's Q. The average ~etarn for firms with
average Q's less than unity is significantly larger than :::~ firms with average
191
Q's greater than unity. This evidence is consistent with the hypothesis that
dividend changes for overinvesting firms signal information about investment
policies. It is also consistent with the conditional cash flow signalling hypothesis if investors anticipate large dividend increases for firms with average Q's
greater than unity. Further test involving a finer partition of the data and
changes in analysts' forecasts fail to reject the overinvestment hypothesis in
favor of the conditional cash flow signalling hypothesis.
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