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  • 1. Journal of Financial Economics 24 (1989) 181-191. North-HollandDIVIDEND ANNOUNCEMENTS;Cash Flow Signaling vs. Free Cash Flow Hypothes~s?*Larry H.P. LANGNew York University, New York, N Y 10000, USARobert H. LITZENBERGERUniversity of Pennsytvania" Philadelphia, PA 19104, USAReceived March 1988, final version received December 1988We test the cash flow signalling and free cash flow/overinvestment explanations of the impact ofdividend announcements on stock prices. We use "robins Q ratios less than unity ta designateoverinvestors. The average return associated with announcements of large dividend changes issignificantly larger for firms with Qs less than unity than for other firms. This evidence, theresults of further tests involving a finer partition of the data, and an analysis of changes inanalysts earning forecasts surrounding dividend announcements support the overinves~menthypothesis over the cash flow signalling hypothesis.|. IntroductionThe positive association between announcements of dividend changes andstock-price movements has been documented in several empirical studies.Fama, Fisher, Jensen, and Roll (1969) find that firms announcing stock splitsaccompanied by increases in cash dividends have a statistically significant,positive mean. risk-adjusted stock return during the announcement months,and those accompanied by dividend decreases have a significant negativereturn. Studies by Pettit (1972) and others find that the mean risk-adjustedreturn for firms announcing dividend increases is significantly positive over thetwo days surrounding the announcement, and for those announcing dividenddecreases the two-day return is significantly negative. More recently, Aharonyand Swary (~980) report similar results after controlling for contemporaneous*The authors acknowledge helpful commeats from Yakov Am/hud, Michael Barclay. K.CChart, Michael Jensen, Kose John, David Mayers, Richardson Petfit (the referee), Andrei Shleiter,Cliffo:t Smith (the editor), Rene Stulz, and participants of a seminar at the 1988 AmericanFinance Association meeting in New York. The data collection, calculation of Tobins Q~ aL,dcomputer erogramming assistance of Anne Cheng ~e gratefully acknowledged. The researchassistance of C.T. Chen, Jose Puyol, Lin Shaw, and David Sun are case acknowledged. Thegemaining errors are the sole responsibility of the al:thors. The original rifle of this paper wasWhat information is contained in dividend annouvcements?.0304-405X/89/$3.50~ 198% Elsevier Science Publishers B.V. (Nc,rth-Holland)
  • 2. 182 L.H.P. Lang and R.H. Litzenberger, Dividend ,r :nouncementsquarterly earnings reports. These studies indicate that announcements ofdividend changes do convey information to the market. However, the question~Wnat info~lnatioa is contained in dividend announcements? has not beenfully resolved.Lintner 0958) and Fama and Babiak (1968) find a times-series relationbetween annual dividends and earnings that is consistent with the view thatdividend-paying firms increase their dividends only when management isrelatively confident that the higher vayments can be maintained. If managershave information about future and/or current cash flows that investors do nothave, investors will interpret a dividend increase as a signal that managementanticipates permanently higher cash flows, and a dividend decrease as a signalthat management expects permanently lower cash flows. The dividend sig-nalling models developed by Battacharya (1979), John and Williams ,laoexand Miller and Rock (1985) predict that dividend ~anouncements conveyinformation about future and/or current cash flows. However, this pt~Jictionis not supported by the empirical studies of Watts (1973) and Gonedes (1978),who are unable to find an economically significant relationship betweendividends and subsequent earnings. Further, they find that current and pastdividends forecast future earr&ngs no more r.ccurately than do current andpast earnings. A more recent study by Ofer and Siegel (1987), in contrast, findsthat knowledge of dividend announcements does improve the accuracy of theaverage analysts preannouncement forecasts of future earnings.In a recent article extending the work of Berle and Means (1932) on theseparation of ownership from control, Jensen (1986) argues that a firm witho,,~-~~"-:"o~,o.,,,a~free cash flows will have a tendency to overinvest by acceptingmarginal investment projects with negative net present values. If managers areoverinvesting, an increase in the dividend will, all else being equal, reduce theextent of overinvestment and increase the market value of the firm, and adecrease in the dividend will have the opposite result. Jensen views theempirical evidence of a positive association between dividend-change an-nouncements and stock-price movements as supporting the free cash flowhypothesis.In an attempt to distinguish between the predictions of the cash flowsignalhng hypothesis and the free cash flow hypothesis, the present study usesempirical estimates of T(;bins Q ratio to determine a group of overinvestingfirr,~. If it is assumed that a fi_~s iavestments are scale-expanding and exhibitdecreasing marginal effici~encyof capital, an average Q less than unity impliesovefinvestment, if a firm is underta~ng the value-maximizing level of invest-ment, its average Q will exceed unity. The overinvestment hypothesis predictsthat the average return in response to announcements of sizable dividendchanges is larger for ovefinvesting firms than for value maximizers.We find that the avera~,e return associated with announcements of sizabledividend changes is significantly hJghe~ for firms with average Qs less thanumty than for those with average Qs greater than unity.
  • 3. L.H.P. Lang and R.H. Litzenberger, Dividend announcements 183Although t~s empirical evidence is consistent with the overinvestmenthypothesis, J~ is also consistent with the cash flow signalling hypothesis ifinvestors anticipate large dividend increases for firras with average Qs greaterthan unity. Further tests involving a finer partition of the data and the relationbetween announcement of dividend changes and subsequent changes in ana-lysts earnings forecasts support the overinvestment hypothesis over the cashflow signalling hypothesis.Section 2 describes the theoretical basis of the subsequent tests. Section 3describes the data and provides evidence tb.at is consistent with both ovefin-vestment and cash flow signalling hypotheses. Section 4 presents a test thatattempts to distinguish between the two hypotheses, and section 5 summarizesthe implications of the study for interpreting the information in dividendannouncements.2. gob|ns Q ratio as an indicator of overinvestmentWe use the Modigliani and Miller (1966) limited growth model to describethe ovednvestment hypothesis and the rationale for using Tobins Q ratio asan indicator of overinvestment. Using this model the value of firm V isV~IXK T (1)where X is expected earnings from existing assets, / is the cost of capital, Pis the average rate of return on investment, I is the anticipated level of currentinvestment, and T ~s the firms finite growth horizon. The first term in squarebrackets is the contributiov of the firms ,~xistingassets to its market value andthe second is the net present value of future investmem opportunities. Theterm (P-K)/K is the average net present vame profitability index (netpresent value per dollar of investment) for the firms investments when theyare made. The cash flow sitgaalling hypothesis predicts that announcemems ofdividend increases vail signal higher cash flows or earnings X from currentassets, and vice versa, i.e., dV/dD=(dX/dD)/K> O, but ~he net presentvalue of future investments is assumed to be unaffected.As suggested by Easterbrook (1984, p. 655), capital markets serve a monitor-ing function when management raises capital through security offerings. In-vestment bankers and other financial intermediaries evaluate proposedprojects and put their reputations on the line by implicitly certifying that thenew securities are backed by the represented earrfi~-~ potential. As pointedout by Jensen (1986, p. 324)~value-maximizing firms with their P > K are ableto withstand capital markets monitoring, whose investment is carried to thepoint where the marginal Q (present value of mar~nal investment) is unity,whether m:arginal investment is financed internally or externally. Announce-
  • 4. 184 L.H.P. Lang and R.H. Litzenberger, Dividendannouncementsments of dividend changes by value-maximizing firms, therefore, will have noimpact on investors expectations about investment policies, and should onaverage have no effect on the firms stock prices.Jensen (1986) argues that firms with substantial free cash flow have atendency to overinvest by accepting marginal investment projects that havenegative net present values. Those firms will be reluctant to subject negative-net-prescott-value projects to the monitoring associated with external financing.Furthermore, the fixed interest obligation associated with debt issues providesan additional disincentive to finance negative-net-present-value projects withdebt. Announcements of dividend changes by overinvesting firms will changeinvestors expectations about the size of the firms future investment innegative-net-present-value projects. An increase in the dividend will, all elsebeing equal, lessen the overinvestment and increase the market value of thefirm, and vice versa for dividend decrease. We call this extended form of thefree cash flow hypothesis the overinve-:,:ment hypothesis.Under the overinvestment hypothesis, the impact of a dividend changeann~,


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