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Article
Publication date: 20 April 2010

Richard Fairchild

Scholars have examined the importance of a firm's dividend policy through two competing paradigms: the signalling hypothesis and the free cash‐flow hypothesis. It has been argued…

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Abstract

Purpose

Scholars have examined the importance of a firm's dividend policy through two competing paradigms: the signalling hypothesis and the free cash‐flow hypothesis. It has been argued that our understanding of dividend policy is hindered by the lack of a model that integrates the two hypotheses. The purpose of this paper is to address this by developing a theoretical dividend model that combines the signalling and free cash‐flow motives. The objective of the analysis is to shed light on the complex relationship between dividend policy, managerial incentives and firm value.

Design/methodology/approach

In order to consider the complex nature of dividend policy, a dividend signalling game is developed, in which managers possess more information than investors about the quality of the firm (asymmetric information), and may invest in value‐reducing projects (moral hazard). Hence, the model combines signalling and free cash‐flow motives for dividends. Furthermore, managerial communication and reputation effects are incorporated into the model.

Findings

Of particular interest is the case where a firm may need to cut dividends in order to invest in a new value‐creating project, but where the firm will be punished by the market, since investors are behaviourally conditioned to believe that dividend cuts are bad news. This may result in firms refusing to cut dividends, hence passing up good projects. This paper demonstrates that managerial communication to investors about the reasons for the dividend cut, supported by managerial reputation effects, may mitigate this problem. Real world examples are provided to illustrate the complexity of dividend policy.

Originality/value

This work has been inspired by, and develops that of Fuller and Thakor, and Fuller and Blau, which considers the signalling and free cash‐flow motives for dividends. Whereas those authors consider the case where firms only have new negative net present value (NPV) projects available (so that dividend increases provide unambiguously positive signals to the market in both the signalling and free cash‐flow cases), in this paper's model, the signals may be ambiguous, since firms may need to cut dividends to take positive NPV projects. Hence, the model assists in understanding the complexity of dividend policy.

Details

Managerial Finance, vol. 36 no. 5
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 3 September 2018

Wasim Khalil Al-Shattarat, Basiem Khalil Al-Shattarat and Ruba Hamed

This study aims to examine the signalling hypothesis of dividends by testing empirically the market reaction to dividends announcements. Furthermore, this study aims to examine…

Abstract

Purpose

This study aims to examine the signalling hypothesis of dividends by testing empirically the market reaction to dividends announcements. Furthermore, this study aims to examine the information content of dividends announcements with respect to future earnings changes for a sample of Jordanian industrial firms over the period 2009 to 2015.

Design/methodology/approach

The authors mainly used the event study methodology to examine the market reaction to dividend release announcements. The market model is used to generate the expected returns. Also, the t-test is used to examine the significance of the mean and cumulative abnormal return. Furthermore, a simultaneous-equation model developed by Nissim and Ziv (2001) and Grullon et al. (2005), applying the two-stage least squares (2SLS), is used to examine the relationship between dividends changes and future earnings changes.

Findings

The results reveal consistency with the limited extant empirical evidence for developing markets and provide some new insights for Jordanian listed firms that support the signalling hypothesis. In applying the event study methodology, the information content of dividends shows that there is a significant positive market reaction to dividends announcements. The study’s findings also present a strong relationship between dividends announcements and profitability in the year of announcements and the subsequent year, whereas this relationship does not exist in the second year. The findings show that there is value-relevance for dividends, suggest that investors recognize the signalling purpose and discern that dividends announcements are useful in predicting favourable and unfavourable future earnings in the short run (the same year and subsequent year) and also show that managers may use dividends to signal earnings prospects in anticipation of expected future market benefits.

Research limitations/implications

The findings of this study could have significant policy implications. The support of a signalling effect implies an existence of information symmetry, at least theoretically, between management and investors. On the other side, this study could not reflect the levels of inside ownership or the existence of signalling substitutes even though these findings could have implications for Jordan’s existing corporate governance practices and firms’ disclosure environment. The results are specific to Jordan, but they do shed light on the generality of the rival models of dividend policy. Many of the structural characteristics of the capital market in Jordan are, however, also present in other emerging markets. The results from this study may, therefore, help provide the basis for comparative research both in the region and in other emerging markets.

Practical implications

The support of the signalling effect implies the existence of information symmetries, at least theoretically, between management and investors. These findings could have implications for Jordan’s existing corporate governance practices and firms’ disclosure environment.

Originality/value

This paper contributes to the literature by providing a workable test for the dividend signalling hypothesis, applying a simultaneous-equation model that incorporates the market reaction to dividends announcements and future earnings changes. Moreover, this paper uses a recent data set of dividends announcements in Jordan. This study provides additional insight to support the signalling hypothesis in emerging markets. Overall, current and previous studies have focused typically on investigating dividend policy in developed markets, especially the US and European markets, although there has been limited analysis of dividends changes on earnings changes for developing markets.

Details

Journal of Financial Reporting and Accounting, vol. 16 no. 3
Type: Research Article
ISSN: 1985-2517

Keywords

Article
Publication date: 1 June 2006

John Goddard, David G. McMillan and John O.S. Wilson

We test for the validity of the smoothing and signalling hypotheses of dividend determination.

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Abstract

Purpose

We test for the validity of the smoothing and signalling hypotheses of dividend determination.

Design/methodology/approach

Using a VAR framework we examine the dynamic behaviour of share prices, dividends and earnings for 137 UK manufacturing and service companies, observed over the period 1970‐2003.

Findings

There is strong evidence of a contemporaneous relationship between prices, dividends and earnings, and little evidence of independence between these variables. Some evidence in favour of both the smoothing and the signalling hypothesis is obtained from causality tests, with perhaps more support for the latter hypothesis. However, there is considerable diversity in the causal relationships between prices, dividends and earnings.

Research limitations/implications

No single hypothesis regarding the determination of dividends, and the predictive power of dividends for earnings and prices appears to dominate.

Originality/value

The results presented here are of interest to markets agents in that while they suggest there is no single transition mechanism linking prices, dividends and earnings, nevertheless these three variables are strongly correlated and exhibit varying degrees of causality.

Details

Managerial Finance, vol. 32 no. 6
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 22 May 2009

Khaled Hussainey and Jinan Aal‐Eisa

The purpose of this paper is to examine whether voluntary disclosure and dividends signal future earnings for decline earnings growth firms. It seeks to inform regulators (and…

2304

Abstract

Purpose

The purpose of this paper is to examine whether voluntary disclosure and dividends signal future earnings for decline earnings growth firms. It seeks to inform regulators (and managers) about the potential benefits of increased disclosure and increased dividends to investors for firms that suffer an earnings decline after a sustained period of annual earnings growth.

Design/methodology/approach

The event study methodology is used to examine the behaviour of 33 non‐financial UK firms after a decline of their sustained earnings growth. It also uses the computerised content analysis to count the number of forward‐looking sentences in the annual report narratives. It calculates changes in disclosure and dividends in the year of earnings growth declines and examine their association with the abnormal future earnings.

Findings

Consistent with prior research, it is found that increasing dividends does not convey value relevant information about future earnings for decline earnings growth firms. However, based on disclosure signalling theory, it is found that increasing levels of forward‐looking information in annual report narratives is an important mechanism for signalling future earnings for these firms.

Practical implications

For an effective communication with the stock market in the years of earnings decline after sustained period of growth, managers should give high priority to developing an appropriate and complete set of forward‐looking information in their annual reports. This will enable investors to better anticipate firms' future prospects. The results suggest that if forward‐looking statements in annual report narratives contain value relevant information for investors, then regulators should consider a compulsory narrative section (i.e. operating and financial review) in the annual report.

Originality/value

This paper is the first to study the value relevance of voluntary disclosure for decline earnings growth firms.

Details

Managerial Auditing Journal, vol. 24 no. 5
Type: Research Article
ISSN: 0268-6902

Keywords

Article
Publication date: 29 July 2014

Reza H. Chowdhury, Min Maung and Jenny Zhang

– The purpose of this paper is to examine the signaling and free cash flow hypotheses of dividends in the context of an emerging financial market.

Abstract

Purpose

The purpose of this paper is to examine the signaling and free cash flow hypotheses of dividends in the context of an emerging financial market.

Design/methodology/approach

The authors use fundamental financial information of Chinese companies listed in the Shenzhen and Shanghai stock exchanges. They examine the impact of cash dividend payments on future profitability of individual firms with and without controlling for non-linearity in their earnings to test the signaling hypothesis. They also determine the characteristics of dividend paying firms to examine the free cash flow hypothesis.

Findings

It was found that while dividend increases by publicly listed Chinese firms are followed by increases in earnings in two subsequent years, such relationship does not exist in the case of dividend decreases. However, under the assumption of non-linearity of earnings, it was found that neither dividend increases nor dividend decreases convey any valuable information about future changes in earnings of Chinese firms. Further, it was found that firms with high cash holdings, large profitability and high managerial efficiency are likely to pay dividends. The authors therefore conclude that announcements of cash dividend payments do not signal future performance but indicate good governance practices of publicly traded firms in China.

Originality/value

This evidence is critical for potential foreign investors in their portfolio investment decisions and for regulators in determining an efficient measure of corporate disclosure in China.

Details

Studies in Economics and Finance, vol. 31 no. 3
Type: Research Article
ISSN: 1086-7376

Keywords

Article
Publication date: 1 March 1996

A.A. Lonie, G. Abeyratna, D.M. Power and C.D. Sinclair

Investigates the stock market response to interactive dividend and earnings announcements by a sample of 620 UK companies over the period January to June 1991. First, examines the…

10710

Abstract

Investigates the stock market response to interactive dividend and earnings announcements by a sample of 620 UK companies over the period January to June 1991. First, examines the possibility that the response to a dividend announcement may be influenced by whether the dividend is being increased, decreased or left unchanged. US studies suggest that this may indeed be the case and acknowledge the role of the dividend as a signal to investors; dividend increases tend to be associated with positive abnormal returns, and dividend decreases tend to be associated with negative abnormal returns around the time of the dividend announcement. Second, recognizes that identifying a unique dividend information announcement effect is particularly difficult in the UK because UK dividends are almost invariably announced simultaneously with information about corporate earnings. Addresses this problem by focusing on those occasions when the signals associated with these announcements conflict with one another ‐ where dividends are increased and earnings decrease or vice versa. The influence of combinations of dividend and earnings news is found to be important in explaining the share price reaction on the announcement day.

Details

Journal of Economic Studies, vol. 23 no. 1
Type: Research Article
ISSN: 0144-3585

Keywords

Article
Publication date: 1 August 2000

James Forjan, David Durr and John Thesis

It is well established in academic literature that self‐tender offers and corporate dividends can be used independently to effectively signal firm value. It is unclear, however…

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Abstract

It is well established in academic literature that self‐tender offers and corporate dividends can be used independently to effectively signal firm value. It is unclear, however, whether these two forms of earnings distributions can be used simultaneously. This paper is an empirical examination of the relationship between dutch auction repurchases and corporate dividend policy. This research indicates that a substantial number of firms choose to repurchase their shares in the form of dutch auctions between dividend payments. Because signalling is a likely motivation for both repurchases and cash dividends, these two events may not be independent of each other. The results of this study confirm positive stock market reaction to repurchase announcements and that firm prediction errors are significantly related to signaling variables.

Details

Managerial Finance, vol. 26 no. 8
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 4 July 2020

Bipin Kumar Dixit, Nilesh Gupta and Suman Saurabh

The purpose of this paper is to examine the dividend payout behavior of Indian firms and test whether the three prominent dividend policy theories (signaling, life-cycle and…

Abstract

Purpose

The purpose of this paper is to examine the dividend payout behavior of Indian firms and test whether the three prominent dividend policy theories (signaling, life-cycle and catering) explain the dividend policy of Indian firms.

Design/methodology/approach

The authors test the three theories using the methodology based on the studies of Nissim and Ziv (2001), DeAngelo et al. (2006) and Baker and Wurgler (2004). For testing the signaling theory, the authors regress the change in earnings on the rate of change in dividends using the pooled and Fama–Macbeth regressions. The life cycle theory is tested by running a logistic regression of the dividend payment decision on two proxies of life-cycle measured by the ratio of earned to total equity. Finally, the catering theory tests the relationship between the decision to pay a dividend and the dividend premium.

Findings

The results based on a sample of Indian firms from 1992 to 2017 show that the dividend policy of Indian firms can be explained using the life-cycle theory. However, there is no evidence in support of the signaling and catering theories.

Originality/value

It provides insights into the dividend policy of Indian firms. Though there have been a few studies examining the dividend payout in India, none of the existing studies tests these theories of dividend payout. The existing research using the Indian data provides indirect evidence about the life-cycle theory. This study is the first one to test the application of these theories for Indian firms.

Details

Managerial Finance, vol. 46 no. 11
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 1 December 2003

Richard John Fairchild

Lintner’s (1956) survey revealed that managers are concerned about dividend signalling over time, and adopt a smoothing policy. In addition to signalling, dividend policy may…

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Abstract

Lintner’s (1956) survey revealed that managers are concerned about dividend signalling over time, and adopt a smoothing policy. In addition to signalling, dividend policy may affect a firm’s re‐investment opportunities, particularly if it is capital constrained. In this paper, we examine the interaction between dividend smoothing/signalling and optimal re‐investment. We develop a dividend policy model that considers both an optimal level of dividends (and re‐investment) at each point in time, and optimal smoothing over time. Our model provides both theoretical insights, and provides a practical management tool for dividend policy.

Details

Managerial Finance, vol. 29 no. 11
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 13 September 2011

Hardjo Koerniadi and Alireza Tourani‐Rad

The purpose of this paper is to examine whether managers deliberately use accruals to convey information regarding firm future profitability.

Abstract

Purpose

The purpose of this paper is to examine whether managers deliberately use accruals to convey information regarding firm future profitability.

Design/methodology/approach

The paper uses contemporaneous earnings and dividend increase announcements in New Zealand as the research setting. This setting reduces the possibility of opportunistic income smoothing by managers and, hence, increases the validity of the inference on the accrual signaling hypothesis. The paper employs a refined accrual model that controls the performance effects in estimating the part of accruals subject to managerial discretion.

Findings

The paper finds evidence consistent with managers using both accruals and changes in dividends to communicate private information regarding firm future profitability to the market. In particular, dividend‐increasing firms are observed to report positive accruals that are correlated with the positive market reaction to dividend increase announcements and future profitability. These findings are robust to performance, growth, and post‐earnings announcement drift effects.

Originality/value

This paper provides evidence that managers use accruals in conjunction with a corporate event to convey their private information regarding firm profitability. The results of the study are expected to shed more light on signaling aspects of accruals and to some degree alleviate the negative perception of managerial discretions over accruals vastly documented in the earnings management literature. This will hopefully add supporting evidence to the signaling hypothesis of accruals, which has so far received limited attention in the literature.

Details

Journal of Applied Accounting Research, vol. 12 no. 2
Type: Research Article
ISSN: 0967-5426

Keywords

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