Academic journal article Financial Management

Do Firms Use Dividends to Signal Large Future Cash Flow Increases?

Academic journal article Financial Management

Do Firms Use Dividends to Signal Large Future Cash Flow Increases?

Article excerpt

A substantial theoretical literature, including Lintner (1956), Bhattacharya (1979), Miller and Rock (1985) and John and Williams (1985), suggests that corporate dividend policy is designed to reveal earnings prospects to investors. For example, Lintner (1956) and Miller (1987) contend that dividend changes disclose information about a firm's permanent income. Dividend signaling models make the more specific predictions that firms raise dividends either prior to earnings increases or to reveal that an increase is permanent.

Existing empirical research looking for evidence of signaling using large samples of dividend changes, however, provides mixed evidence at best. Consistent with dividend signaling, stock returns are positively correlated with dividend changes (Aharony and Swary, 1980; Asquith and Mullins, 1983; and Pettit, 1972; among others). However, Bajaj and Vijh (1990) present evidence that dividend clienteles account for the market reaction to dividend changes. Behavioral models can also explain the relation between dividends and stock returns (e.g., Shefrin and Statman, 1984).

There is evidence that analysts revise their earnings forecasts following dividend changes (e.g., Ofer and Siegel, 1987), but other authors argue that there is no significant effect (e.g., Lang and Litzenberger, 1989). Consistent with signaling, Healy and Palepu (1988), among others, show that firms' earnings tend to increase (drop) after dividends are initiated (omitted). However, Maquieira and Megginson (1994) find that earnings do not surge after newly public firms begin paying dividends. Additionally, Bernartzi, Michaely, and Thaler (1997) find that earnings do not systematically grow following dividend increases. Instead, they find that dividend changes are related to contemporaneous and lagged earnings changes. Clearly, there is no compelling evidence that corporate dividend decisions are made to signal future profitability.

Of course, there is no reason to believe that corporate dividend policy is driven by a single goal. Most practitioners believe that, all else being equal, firms set a target dividend payout ratio (Fama and Babiak, 1968, and Baker, Farrelly, and Edelman, 1985, among others). In addition to investor clienteles and behavioral considerations, there may be an interaction between dividend policy and agency problems (e.g., Jensen and Meckling, 1976, and Easterbrook, 1984). The tax code will also influence dividend decisions (Papaioannou and Savarese, 1994). If dividend changes are driven by more than one factor, cross-sectional studies of dissimilar firms may not have the power to distinguish specific effects, even if they are an important part of corporate dividend policy.(1)

This paper uses a direct, focused test for dividend signaling. We identify a sample of firms that have had four years of stable cash flow but are poised on the threshold of large cash flow increases.(2) These firms have two desirable qualities. First, they all potentially have very positive information that investors are unlikely to possess - they are prime candidates to signal. Second, by requiring four years of stable cash flow, we limit the possibility that dividend changes just before the cash flow shock are caused by contemporaneous or lagged profitability changes.

We examine these firms' dividend decisions prior to their cash flow jump to explore the extent to which they use dividends to signal the impending changes. We compare two extreme groups, 101 companies with permanently elevated cash flow and 45 companies with only temporary cash flow increases, to a third "control" group, 34 firms that experience a continued period of flat cash flow. This configuration allows us to evaluate dividend policy in firms with increased cash flow benchmarked against a sample of firms whose behavior proxies for what would happen if profits remained flat. Additionally, it permits us to compare the influence of permanent and temporary cash flow increases on corporate dividend policy. …

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