The free cash flow hypothesis implies that the overinvestment problem is more prevalent in firms characterized by low growth opportunities. Accordingly, when low growth opportunity firms increase dividends, the market should respond accordingly due to the reduced probability of imminent suboptimal investment (Lang and Litzenberger, 1989). However, when high growth opportunity firms change dividends, no significant market reaction is expected because the dividend change does not affect the market's evaluation of management's investment policies (Yoon and Starks, 1995). In contrast, the signaling theory predicts market responses to dividend changes relative to the firm's level of information asymmetry (Miller and Rock, 1985). Prior literature contains evidence in support of both the free cash flow and signaling hypotheses.
The purpose of this paper is to examine if share price reactions to large dividend change announcements differ by the firm's level of growth opportunities and excess cash by drawing on the predictions of signaling theory and agency theory. We find that the firm's level of growth opportunities and excess cash have a significant impact on excess abnormal returns around the announcement. Stock price reactions are larger for firms with low growth opportunities that significantly increase or decrease dividends, especially when accompanied by large changes in cash balances. In addition, markets do not immediately reflect all publicly available information. We find it takes 15 days for excess cumulative abnormal stock returns to disappear after significant dividend change announcements.
According to signaling theory, firms with high levels of growth opportunities face more information asymmetries (Miller and Rock, 1985). Therefore, high growth opportunity firms have an incentive to use permanent positive cash flow shocks to increase dividends and signal higher expected earnings. An alternative view to the signaling theory is the agency costs of free cash flow theory. The agency costs of free cash flow theory suggest that managers will not invest to maximize shareholder wealth (Jensen, 1986). Thus, a dividend increase can limit possible future suboptimal investments, especially for low-growth opportunity firms, which have fewer positive net present value (NPV) projects. Low-growth, high-excess cash firms that increase dividends should experience positive abnormal returns. On the other hand, high-growth firms have more available positive NPV projects, regardless of excess cash levels. A dividend increase in this case will be met with a less favorable market response because the firm can earn more by investing in the positive NPV projects than investors can earn by investing their dividend proceeds.
The remainder of the paper is organized as follows. Section 2 reviews the relevant literature. Section 3 describes the sample selection criteria and characteristics. Section 4 discusses the methodology and market reaction expectations. Section 5 discusses and interprets the paper's results. Finally, Section VI provides conclusions.
The literature documenting the positive relationship between dividend changes and stock market reactions is quite large (Pettit, 1972; Aharony and Swary, 1980; Asquith and Mullins, 1983; Brook, Charlton and Hendershott, 1998; and Arnott and Asness, 2003; Grullon, Michaely, and Swaminathan, 2002). Even after controlling for dividend change size, a significant positive (negative) association exists between dividend increases (decreases) and yield (Fehrs, Benesh, and Peterson, 1988). Also, there is a direct relationship between negative stock returns caused by dividend decreases and the magnitude of the dividend decrease, prior stock performance, and risk and size of the firm (Ghosh and Woolridge, 1988). Significant positive excess returns are found for dividend initiations and significant negative returns for omissions (Michaely, Thaler and Womack, 1995). There is a positive relationship between average announcement price effect and number of shares repurchased (Ikenberry, Lakonishok and Vermaelen, 1995). Additionally, stock prices decline when the firm needs cash inflows either in the form of decreased dividends or issuance of stock (Asquith and Mullins, 1983). Overall, the market rewards dividend increases and repurchases, and disciplines dividend decreases.
Excess liquidity can alleviate the effects of information asymmetry. In fact, the choice to use a specific form of payout may be related to the permanence of the cash flow shock and, therefore, to the market reaction. Jagannathan, Stephens, and Weisbach (2000) find that firms increase dividends to signal permanently increased cash flows and increase share repurchases to signal temporary cash flow shocks. Guay and Harford (2000) find a relationship between the market's expectations concerning the permanence of cash flow shocks, the firm's choice between dividend increases or share repurchases, and stock price reactions. Positive stock returns occur when the market assesses a recent temporary cash flow shock and the firm chooses to increase dividends. On the other hand, negative stock returns occur when the market estimates a recent permanent cash flow shock and the firm chooses to repurchase shares.
However, excess liquidity can also exacerbate any existing agency problems. The belief that managers might use excess cash to make suboptimal investments at the expense of shareholders is derived from Jensen's (1986) free cash flow theory. Several studies have documented support for the free cash flow theory. Harford (1999) shows that cash rich firms have more agency conflicts (measured by % insider ownership) and are more likely to make value-decreasing diversifying acquisitions. Additional support is found in a sample of firms that are awarded large cash settlements from lawsuits (Blanchard, Lopez-deSilanes, and Shleifer, 1994). These firms reduce debt and make diversifying acquisitions that benefit management. Lamont (1997) examines oil companies whose cash levels were detrimentally affected by the 1986 oil shock and shows that these firms significantly decreased their non-oil investments. This evidence implies that, prior to 1986, the non-oil investments were suboptimal. After the 1986 oil shock, decreased cash flows forced management to end the wasteful spending. Lie (2000) finds that firms defined as having excess cash relative to their industry reduce agency problems by increasing dividends or repurchasing shares. In this case, only special dividend announcements, not regular dividend increases, cause stock price reactions.
Other studies segregate firms based upon Tobin's q (1) to link market reactions to underlying agency problems for firms of differing quality. Although these studies acknowledge the free cash flow problem, no actual calculation of excess cash is linked to the results. Lang and Litzenberger (1989) find that when a firm with free cash flow problems increases its dividend, the market responds favorably due to the reduced possibility of investment in negative NPV projects. In particular, there are greater information effects for low Tobin's q firms than for high Tobin's q firms. This type of dividend policy may be seen by stockholders as a way to diminish agency costs by reducing the free cash flow accessible to managers. Large dividends require more external financing...
Liquidity shock induced dividend change: market reaction by firm quality.
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