Academic journal article Quarterly Journal of Business and Economics

The Role of Information in Stock Split Announcement Effects

Academic journal article Quarterly Journal of Business and Economics

The Role of Information in Stock Split Announcement Effects

Article excerpt

Introduction

Many researchers have referred (and still refer) to stock splits as financial puzzles. The paradoxical nature of stock splits probably stems from two widely held, but diametric, views:

* Stock splits are merely costly paper shuffling exercises that cannot affect the value of the firm;(1)

* The value of the firm immediately and significantly increases upon the announcement of impending stock splits.

The second view recently has gained credence from studies that carefully document positive valuation effects around the time of stock split announcements. While several reasons for these announcement effects have been offered (including trading range, attention, signaling, and tax), important questions remain unanswered.

The purpose of this study is to determine the role that information plays in stock split announcement effects by examining pure stock split announcements across a range of stocks differing in terms of their information richness. The reason for suspecting that information and split effects are related is found in Merton (1987). He questions the received paradigm that in all cases the complete diffusion of public information occurs instantaneously and that investors process and react to that information immediately. An alternative model is that diffusion takes time; its rate differs across firms; and not all investors react promptly. If the alternative is a reasonable description of real capital markets, then the process by which market prices adjust to the information contained in stock split announcements will differ across firms.

Relevant Literature

Grinblatt, Masulis, and Titman (1984) find that stocks listed on the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) react positively to stock split announcements that are not contaminated by other contemporaneous firm-specific news. Their analysis supports both the trading range and attention hypotheses. Their findings are confirmed by Ball and Torous (1988) using a maximum-likelihood method that incorporates the possibility of a random event date rather than the standard multiday approach. Lakonishok and Lev (1987) find that splits are aimed primarily at restoring stock prices to a normal trading range; however, they also find some support for the signaling-based hypothesis. Further, Liljeblom (1989) confirms the presence of stock split announcement effects for stocks traded on the Stockholm Stock Exchange.

Brennan and Copeland (1988a) assume that managers use stock split announcements to communicate their private information about the firm's prospects to investors. Their signaling model is based on the relation between stock trading costs and stock prices, and they find that it explains a substantial portion of the observed split announcement returns. Conroy, Harris, and Benet (1990) find that bid-ask spreads increase in percentage terms subsequent to splits and impose a liquidity cost on investors; therefore, stock splits act as a valid signal.

Lamoureux and Poon (1987) argue that split announcement effects are due to the increase in the tax-option value of the split. Doran and Nachtmann (1988), Klein and Peterson (1989), and Asquith, Healy, and Palepu (1989) associate positive split announcement effects with favorable earnings forecast revisions and significant postannouncement earnings growth. McNichols and Dravid (1990) find that managers signal their private information about the firm's future earnings by their choice of the split factor.

Brennan and Copeland (1988b) report a temporary increase in the stocks' betas on both the split announcement date and the effective date; moreover, they find a permanent increase in betas following the ex-date. Klein and Peterson (1988) find evidence of increased volatility and market inefficiency in call option prices around the announcement and ex-dates of large stock splits. Foster and Scribner (1991) find announcement effects after controlling for beta nonstationarity. …

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