LA COMUNICACIÓN DEL MINISTERIO DE RELACIONES

One of the key assumptions of the dividend irrelevance theory is that information about firms is available to everyone. This assumption has been criticised widely due to the fact that asymmetries of information exist to some degree in financial markets. Firms’ managers often possess superior information about their firms relative to outsiders, therefore a change in dividends may convey valuable information to the market. In other words, changes in dividends may act as a signal of firms’ future prospects.

Dividend signalling theory is based on market imperfection due to information asymmetry. In the presence of information asymmetry in the market, firms pay dividends to signal the state of affairs of the business, earnings growth, and future prospects of the firm. This theory argues that an announcement of an increase in dividend payout is an indication of positive future prospects while a decrease in dividend payout tends to portend negative future performance by the firm. A number of dividend signalling models are developed based on dividend signalling theory (Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985)). The central theme of all of these models is that firms’ managers have private information about future prospects of their firms and specify a dividend level to signal that information. Frankfurter and Wood (2002) confirm that the mitigation of information

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asymmetry between managers and shareholders via unexpected changes in dividend policies is the cornerstone of dividend signalling models.

There is an extensive literature on the use of dividends to signal information to investors. One strand of the literature examines the information content of dividends by investigating how stock prices respond to the announcement of dividend changes. The consensus in the literature is that stock prices move in the same direction as dividend changes; an increase (decrease) in dividends is associated with an increase (decrease) in stock prices. The literature concludes that dividend announcements provide the market with useful information about the future performance of firms. Pettit (1972) illustrates that stock prices react significantly to dividend announcements. Laub (1976), Pettit (1976), and Aharony and Swary (1980) suggest that dividends convey valuable information to the market beyond that provided by earnings. Charest (1978), Eades (1982), Woolridge (1982), and Denis, Denis, and Sarin (1994) provide evidence that abnormal stock returns are positively associated with dividend changes. Divecha and Morse (1983) illustrate that the announcement of a dividend increase is associated with an increase in stock prices. Yoon and Starks (1995) show that the stock price reaction to the announcement of large dividend changes is consistent with the prediction of the signalling hypothesis.

Further studies investigate the impact of a major change in firms’ dividend policies such as dividend initiation or dividend omission on the market. Asquith and Mullins (1983) examine the effect of initial dividend payments and the initiation of dividends after a 10-year hiatus. They report positive excess stock returns on the announcement of a dividend payment. Similarly, Richardson, Sefcik, and Thompson (1986) documents an increase in firm value around the announcement of first-time dividends. Benesh, Keown, and Pinkerton

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(1984) analyse the aggregate market response to announcements of substantial shift in firms’ dividend policies and illustrate that announcements of initial dividend payments, dividend omissions, and large decreases in dividends have a significant impact on stock prices. Healy and Palepu (1988) illustrate a positive relationship between dividend initiation (omission) announcements and subsequent earnings changes. They suggest that dividend initiations and omissions are interpreted as managers’ forecasts of future earnings changes. Michaely, Thaler, and Womack (1995) document a significant price impact of dividend omissions and initiations and Kaestner and Liu (1998) report a positive stock price response to dividend initiations and specially designated dividend payments. Finally, Ryan, Besley, and Lee (2000) document positive (negative) stock price reactions to dividend initiations (omissions).

A number of studies however argue that the information content of dividends can only be trivial. Watts (1973) suggests that the relationship between dividend changes and future earnings changes is weak. Gonedes (1978) argues that dividends do not reflect information beyond that reflected in income. Benartzi, Michaely, and Thaler (1997) find only limited support for the notion that dividend changes have information content about firms’ future earnings.

A further strand of research investigates the interaction effect of dividend and earnings announcements on stock prices. Firms may make earnings and dividend announcements within a few days of one another. Therefore, it is critical to understand the individual and joint effects of dividend and earnings announcements on stock prices. Kane, Lee, and Marcus (1984) examine stock returns surrounding contemporaneous earnings and dividend announcements and show that abnormal returns corresponding to any earnings or dividend announcements depend upon the value of the other announcement. Their results

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suggest a corroborative relationship between earnings and dividend announcements. Eddy and Seifert (1992) investigate stock price reactions to contemporaneous and non- contemporaneous dividend and earnings announcements and illustrate that the reaction to joint announcements is significantly greater than the reaction to one announcement. Their results indicate that there is information content from two signals being given at the same time and that the two announcements are not perfect substitutes. Considering these findings, it can be argued that when dividend and earnings announcements occur simultaneously, stock price reactions are not solely attributable to the dividend announcement. A number of studies on this subject eliminate the confounding effect of earnings announcements by excluding dividend announcements that are made within a specified number of days of earnings announcements. For example, Aharony and Swary (1980) isolate dividend effects from those of earnings by investigating only dividend and earnings announcements conveyed to the public on different dates. Tsai and Wu (2015) exclude dividend announcements that are made within three days of earnings announcements from their sample.