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The study, using a large sample of firms listed on the Bombay Stock Exchange (BSE), examines the stock price reaction
to dividend changes and the relevance of signaling models in explaining the valuation effects associated with dividend
changes. The study finds significant wealth effects around dividend changes as proposed by the signaling models.
There is a strong positive relationship between dividend changes and profitability during the year of dividend change.
Dividend initiating (omitting) firms have large increase (decrease) in earnings in the year of change, compared to the
moderate change in earnings in case of dividend increasing (decreasing) firms. Dividend changes contain no information
about future earnings in the subsequent years.
Introduction
Signaling models have been extensively used to explain the dividend policy of firms.
These models suggest that dividend changes contain information about current and future
earnings. Signaling models have received a great deal of empirical attention and theoretical
support in the US and other developed markets. A major motivation for this study is the
paucity of empirical research on the applicability of signaling models in the Indian context.
The main objective of this study is to examine the market reaction to dividend changes using
Indian data. Thus, this study contributes to the limited work on the market reaction to
corporate announcements using Indian data sets, with a more comprehensive and complete
list of dividend announcements. This assumes importance in the presence of the apparent
difference of institutional background in India compared to that in the developed markets.
Another objective is to provide an empirical testing of the hypothesis that changes in
dividends convey information about future earnings.
Literature Review
Despite their view of dividend irrelevance, Modigliani and Miller (1958) indicate that
dividends may convey information not otherwise known to the market. This argument is
theoretically proposed in a number signaling models by Bhattacharya (1979), John and
Williams (1985), and Miller and Rock (1985). These models reach the same conclusion that
firms pay dividends to convey information to investors that cannot be conveyed through
other credible ways. According to the signaling theory, dividends should reflect managers’
superior inside information about the firms’ earnings prospects. One of the key implications
of signaling models is that dividend changes should be followed by changes in earnings in the
* Associate Professor, Institute for Financial Management and Research, 24, Kothari Road, Nungambakkam,
Chennai 600034, India; and is the corresponding author. E-mail: jijo@ifmr.ac.in
* * Associate Professor, Shailesh J Mehta School of Management, Indian Institute of Technology Bombay, Powai,
Mumbai 400076, India. E-mail: narayan@som.iitb.ac.in
Dividend Changes
© 2010 IUP and Profitability:
. All Rights Reserved. An Empirical Study of Indian Manufacturing Firms 5
same direction. Higher dividends signal better earnings, and therefore, lead to a higher market
value.
The empirical testing of dividend signaling models has focused on two issues. The first
empirical question is whether dividend changes have any impact on share prices. As higher
dividends signal better future earnings, increase in dividends should lead to positive excess
returns and decrease to negative excess returns. Consistent with the signaling argument,
empirical studies document that market reaction is positive (negative) when dividends are
increased (decreased) (see Aharony and Swary, 1980; Asquith and Mullins, 1983; Healy and
Palepu, 1988; and Michaely et al., 1995). The abnormal returns around dividend announcement
are positively related to the sign and degree of the dividend change. It is also observed that
the magnitude of abnormal return is positively related to the degree of unexpected changes
in dividends.
The second relevant question is whether dividend changes contain information about
the future earnings of the firm. The results from studies that examined the relationship
between dividend changes and future earnings are mixed. Healy and Palepu (1988) show that
firms that initiate (omit) dividends have significant increase (decrease) in their annual
earnings for at least one year before and the year of dividend change. Similarly, these firms
have significant increases and decreases in earnings for at least one year after the
announcement. In the case of initiating firms, earnings increase for two years following these
dividend increases. DeAngelo et al. (1996) show that dividend increases are not informative
signals about future earnings and some firms’ favorable dividend actions could likely be
managerial mistakes. Benartzi et al. (1997) find a very strong lagged and contemporaneous
correlation between dividend changes and earnings. But in the two years following the dividend
increase, they find that earnings changes are essentially unrelated to the sign and the magnitude
of the dividend change. Nissim and Ziv (2001) posit that studies like Benartzi et al. (1997) are
misspecified due to the ‘measurement error’ in the dependent variable and the ‘omitted
correlated variable’ problem. After addressing these problems, they found that dividend
changes are positively associated with earnings changes in each of the two years following the
dividend changes. However, Grullon et al. (2005) reexamined the results by using a nonlinear
model for earnings expectations and found that dividend changes contain no information
about the earnings changes.
There is a paucity of empirical studies examining the dividend signaling hypothesis in the
Indian context. Rao (1994) reports a Cumulative Average Abnormal Return (CAAR) of
12.73% (for a 21-day event window) as response to the announcement of dividend increases.
There are studies focusing on testing the dividend theories such as Lintner’s model (Mishra
and Narender, 1996) and examining the determinants of dividend policy (Bhat and Pandey,
1994).
Total
180
147
147
44
to dividend announcements. We removed firms with missing
daily returns in any of the five days (–2 to +2). The individual
securities’ abnormal returns are estimated based on the
2000
34
12
32
market-adjusted model (Brown and Warner, 1985) and are
7
aggregated over the days to calculate the Average Abnormal
Return (AAR), i.e.,
1999
N
22
10
29
10 1
AAR t
N AR
i 1
it ...(1)
Panel C: Sample Distribution of Dividend Changes for the Event Study
2
AR
27
22
21
7
CAAR t ...(2)
t 2
announcement.
47
32
10
4
Table 1 (Cont.)
17
6
8
1
5
2
market reaction to dividend announcements are similar. The second part of the empirical
analysis investigates the behavior of earnings around dividend changes. We use operating
cash profit to measure operating performance and book value of net assets as the scaling
variable. Total assets include the total of fixed assets, investments, and current assets. Table 3
presents the definition of the variables used in the study.
The results of the analysis are organized under three subsections. The first presents the
performance measures around the announcement date. In the second, we compare the
performance of the firms that have announced dividend changes with the performance of
firms that reported no change in dividend. In the last, we examine the relation between
Table 3: Definition of Variables Used in the Study
Variable Prowess Item Definition
Operating cash profit pbdit_nnrt_noi + amortization Earnings before depreciation,
(EBITDA) interest and taxes less extraordinary
income add extraordinary expense
add amortizations
Profit After Tax (PAT)* pat & pat_nnrt_noi Adjusted profit after tax
Total Assets (TA) tot_asset Total assets * less revaluation
reserves less miscellaneous expenses
not written off less advance tax
Net Worth (NW) net_worth-pref_capital Equity share capital add reserves
less revaluation reserves less
miscellaneous expenses not written off
Dividend (D) equity_dividends Equity dividends
Market to book ratio market_cap/ Market value of equity/net worth
(Equity) (net_worth-pref_capital)
Note: * All adjusted figures are adjusted for extraordinary income and expenses.
Panel A: Raw Earnings Change (%) Deflated by MV of Equity at the End of Year –1
–1 0 1 2 N
Dividend Increase 1.20 (2.75)** 1.94 (12.97)** 0.32 (2.71)** –0.26 (–3.076)** 2,633
Dividend Initiation 1.54 (1.33) 8.94 (14.55)** 0.30 (1.52) –1.18 (–2.90)** 364
Dividend Decrease –0.10 (–4.20)** –4.98 (–16.18)** –1.28 (–2.75)** 0.00 (–2.18)* 858
Dividend Omission –1.62 (–6.45)** –11.89 (–20.4)** –2.68 (–4.01)** 0.65 (0.54) 645
Panel B: Raw Earnings Changes (%) Deflated by BV of Equity at the End of Year –1
Dividend Increase 2.54 (3.93)** 3.78 (15.06)** 0.80 (2.95)** –0.43 (–2.99)** 2,633
Dividend Initiation 2.71 (1.48) 10.62 (14.48)** 0.60 (1.52) –1.20 (–2.77)** 364
Dividend Decrease –0.19 (–3.87)** –5.44 (–13.19)** –1.66 (–3.15)** –0.05 (–2.27)* 858
Dividend Omission –1.27 (–6.18)** –10.03 (–17.9)** –2.00 (–3.61)** 0.64 (–0.26) 645
Note: We have defined raw earnings change as the annual change in earnings before extraordinary items deflated by the beginning of year 0 market value of equity.
The figures in parentheses are Z-values based on Mann-Whitney Test where dividend changing firms are compared with ‘no change’ firms;
* Significant at 5% level; and ** Significant at 1% level.
13
nonlinear model suggested by Fama and French (2000) to estimate the expected earnings. We
have excluded cases involving dividend initiations, dividend omissions, no dividends
(non-payers), and firms with market value of equity less than Rs. 10 mn at the beginning of
the year. Table 6 reports the summary statistics for the sample. The values reported are for the
year immediately preceding the year of dividend change.
Table 6: Summary Statistics
Panel A: Dividend Increases
RDIV (%) MKT M/B ROA (%) ROE (%)
Mean 35.77 299.85 2.43 16.37 12.36
Standard Deviation 45.60 1,338.97 2.70 7.26 12.45
Quartile 1 10.09 12.15 0.79 11.33 4.93
Quartile 2 20.93 36.55 1.54 15.25 11.31
Quartile 3 43.99 136.25 2.86 20.53 19.05
N 2,614 2,614 2,614 2,614 2,614
Panel B: Dividend Decreases
Mean –33.22 164.27 1.58 15.00 10.47
Standard Deviation 20.65 719.54 2.11 7.04 11.91
Quartile 1 –45.14 9.94 0.50 10.45 3.82
Quartile 2 –31.51 27.51 0.88 14.30 9.71
Quartile 3 –18.04 88.13 1.80 18.46 16.52
N 858 858 858 858 858
Panel C: No Changes
Mean 0 137.17 2.46 16.09 11.63
Standard Deviation 0 382.19 2.44 7.06 13.04
Quartile 1 0 8.89 0.85 11.33 4.66
Quartile 2 0 25.16 1.67 15.34 11.36
Quartile 3 0 81.48 3.12 20.00 18.89
N 867 867 867 867 867
Note: This table reports the characteristics of the sample used for the regression analysis. RDIV is the rate of
change of cash dividend in year 0 compared to year –1. All other variables are for the end of year –1. All
variables, except MKT, have been winsorized at 0.5% and 99.5% of the empirical distribution. MKT is the
market capitalization of the firm in rupees crores.
Table 7 presents the results of regression analysis of raw earnings changes on dividend
changes. The dependent variable in the regressions is change in earnings in year 0, 1 or 2
deflated with the market value at the beginning of the year 0 (Benartzi et al., 1997).
0 1 R2
0 Coefficient –0.005 0.097 0.122
t-value –2.44* 24.59**
1 Coefficient –0.024 0.037 0.008
t-value –7.83** 5.94**
2 Coefficient –0.025 –0.011 0
t-value –6.57** –1.470
Note: denotes the year relative to the dividend change year (year 0). P–1 is market value of equity at the end
of year –1. RDIV0 is the rate of change in dividend. For each year, the first row reports the coefficient
and the second raw reports t-value. All the variables have been winsorized at 0.5% and 99.5% of the
empirical distribution;
* Significant at 5% level; and ** Significant at 1% level.
The independent variable in each regression is the rate of change of dividend in year 0.
Our results confirm the earlier patterns that have been established with categorical analysis.
The regression for the year 0 provides evidence for the positive relation between earnings
changes and dividend changes. Similarly, we found a positive relationship in year 1 also.
But the relation in year 2 is insignificant. This provides evidence that dividend changes may
have some information about the change in earnings in year 1. But this may be due to the fact
that mangers already have some information about the earnings in the year 1 while they take
a decision about the dividend for the year 0 (see Grullon et al., 2005).
But Nissim and Ziv (2001) argued that the insignificant relations in the future years may
be due to the incorrect specification of the model and the measurement error in the dependent
variable. They argued that there should be a control variable in the model, as return on equity
is mean reverting. To remove the error in the dependent variable one has to use the book
value of common equity for deflating earnings changes. Specifically, we estimated the following
regression model, suggested by Nissiom and Ziv (2001).
Interestingly, the results presented in Panel A of Table 8 are similar to the previous model,
except for the fact that dividend changes are giving a significant negative coefficient in
year 2. To account for the heteroskedasticity and autocorrelation in the regression residual,
we have used Fama and MacBeth (1973) procedure along with the pooled OLS estimations.
The reported values are the average slopes and t-statistics based on time series standard
errors of the average slopes. But there are two problems with this estimation. One, the
relatively small number of annual observations will reduce the power of the tests.
The results of the regression analysis, reported in Panel B of Table 8, are also similar to our
previous results.
It is interesting to note that in all the regressions, firms that have increased dividend
report a negative relationship with the earnings change in year 2. We have checked the
robustness of the results by including additional control variables. The coefficient of the
dividend decrease group is significant in year 1. In year 2, the coefficient is positive for the
dividend decrease group in 4 out of 10 years that we have examined, compared to 2 out of 10
for the dividend increase group. Firms that have decreased dividend showed a strong positive
relationship with the future earnings change in year +1, as compared to dividend increase
group.
But Fama and French (2000) report that mean reversion of profitability is highly nonlinear.
Grullon et al. (2005) argue that assuming linearity when the true functional form is nonlinear
may have the same consequence as leaving out the relevant independent variables.
Therefore, following them, we have also used the partial adjustment model of Fama and
French (2000) to control for the nonlinearity in the relation between future earnings changes
and lagged earnings levels and changes. Specifically, we have adopted the model from Grullon
et al. (2005), which is given below:
0 1 2 R2
=1
Pooled –0.009 (–2.63)** 0.041 (7.04)** –0.065 (–2.97)** 0.011
CS –0.004 (–0.40) 0.034 (3.63)** –0.033 (–0.68) 0.021
Prop+ 0.3 0.9 0.6 –
=2
Pooled –0.008 (–2.13)* –0.018 (–2.35)** –0.027 (–1.32) 0.002
CS 0.005 (0.37) –0.020 (–1.51) –0.048 (–1.08) 0.017
Prop+ 0.4 0.2 0.4 –
Panel B: Regression of Earnings Changes Deflated by Book Value on Dividend Changes and Control Variables
0 1P 1N 2 3 R2
=1
Pooled 0.005 (1.21) 0.021 (3.05)** 0.115 (6.72)** –0.12 (–4.53)** 0.065 (2.37)** 0.018
CS 0.006 (0.69) 0.020 (2.15)* 0.113 (4.04)** –0.071 (–1.41) 0.053 (1.51) 0.030
Prop+ 0.5 0.8 0.9 0.5 0.6 –
=2
17
In this model, DFE0 = ROE0 – E(ROE0), where E(ROE0) is the fitted value of ROE0 from
the cross-sectional regression of ROE on the logarithm of total assets in year –1 ( ln(TA–1)),
logarithm of the market-to-book ratio of equity in year –1(ln(MBVE–1)) and return on equity
in year –1 (ROE–1). We have estimated the error from cross-sectional regression in each year.
CE0 is equal to (E0 – E–1)/B–1. NDFED0 (PDFED0) is a dummy variable that takes the value of
1 if DFE0 is negative (positive) and 0 otherwise. Similarly, NCED0 (PCED0) is a dummy
variable that takes the value of 1 if CE0 is negative (positive) and 0 otherwise. As pointed out
by Fama and French (2000), the terms included are meant to capture the nonlinearities in
the mean reversion and autocorrelation in earnings.
Table 9 reports the results of the analysis. As documented by Grullon et al. (2005), we
found that the improved model establishes that there is no significant relation between
dividend changes and future earnings. The only significant positive relationship between
dividend changes and future earnings is in the case of dividend decrease group. Out of the 10
cross-sectional regressions for year 1, the coefficient of dividend increase (dividend decrease)
is significant at 10% level only for four (seven) years. For year 2, it is significant only for one
(zero) year out of ten years. In general, our results did not support the signaling/information
content hypotheses.
The results of the analysis are presented in Table 10. We found significant positive relation
only in year 1 for the dividend decrease group. For the US firms, Nissim and Ziv (2001) and
Grullon et al. (2005) report positive relationship both in year 1 and 2. In the nonlinear model
also we found similar results, whereas Grullon et al. (2005) report that after controlling for
0 1P 1N 1 2 3 4 1 2 3 4 R2
= 1
Pooled –0.009 0.016 0.115 –0.509 0.503 1.554 3 0.281 –0.170 –0.096 –0.768 0.023
t-stat –1.690 2.28* 6.56** –2.71** 1.715 2.25* 3.33** 2.59** –0.875 –0.239 –3.04** –
Cross-Sectional
Mean 0.003 0.013 0.143 0.213 –0.216 1.891 –1.999 –0.196 0.509 0.498 1.191 0.083
t-stat 0.240 1.500 4.02** 0.530 –0.480 1.500 –0.810 –0.680 1.460 0.710 1.240 –
Prop+ 0.500 0.700 0.90 0.600 0.500 0.600 0.300 0.500 0.700 0.600 0.600 –
= 2
Pooled –0.01 –0.025 0.038 0.172 –0.468 0.188 –0.13 –0.027 0.155 –0.124 –0.376 0.007
t-stat –1.39 –2.64** 1.660 0.690 –1.200 0.210 –0.11 –0.190 0.600 –0.230 –1.120 –
Cross-Sectional
Mean –0.003 –0.028 –0.009 –0.144 –0.527 –1.266 1.175 0.302 0.271 1.592 –1.130 0.06
t-stat –0.220 –1.750 –0.320 –0.380 –0.990 –1.090 0.480 1.080 0.710 1.350 –2.26* –
19
the nonlinear patterns in earnings, dividend changes do not contain information about the
future level of ROE.
and
where DFY0 = ROA0 – E(ROA0), where E(ROA0) is the fitted value of ROA0 from the
cross-sectional regression of ROA on the logarithm of total assets in year –1 ( ln(TA–1)) ,
logarithm of the market-to-book ratio of equity in year –1(ln(MBVE–1)) and return on equity
in year –1 (ROA–1). We have estimated the error from cross-sectional regression in each year.
CY0 is equal to (ROA0 – ROA–1)/TA–1. NDFYD0 (PDFYD0) is a dummy variable that takes the
value of 1 if DFY0 is negative (positive) and 0 otherwise. Similarly, NCY0 (PCY0) is a dummy
variable that takes the value of 1 if CY0 is negative (positive) and 0 otherwise. In this model,
we have replaced the independent values for ROE with relevant values for ROA. The results
are given in Table 11. With the simple linear model, we found a significant positive relationship
between dividend changes and ROA changes in year 1. Grullon et al. (2005) report insignificant
relationship between dividend changes and ROA changes in year 1. But for year 2, our models
report either insignificant relationship or a wrong coefficient. The results are same when we
used a nonlinear model.
0 1P 1N 2 3 4 5 R2
= 1
Cross-Sectional
= 2
21
22
Table 10 (Cont.)
Panel B: NL Model
0 1P 1N 1 2 3 4 1 2 3 4 1 2 R2
= 1
Pooled 0 0.01 0.12 0.82 –0.11 –0.45 –0.32 –0.03 0.14 0.39 –0.08 0.01 0
0.352
t-stat 0.48 2.50** 7.96** 15.70** –1.91 –3.26** –2.08* –0.49 1.11 1.50 –0.46 4.73** –0.69
Cross-Sectional
Mean 0.01 0.01 0.16 0.84 –0.10 –0.23 –0.31 –0.10 0.29 0.95 0.18 0.01 0
t-stat 1.22 0.83 3.45** 9.46** –0.92 –1.16 –1.31 –1.09 2.22* 5.41** 0.53 4.50** –1.53 0.396
Prop+ 0.60 0.80 0.90 1.00 0.40 0.30 0.20 0.40 0.80 1 0.40 0.90 0.40
= 2
Pooled –0.01 –0.02 0.12 0.93 –0.29 –0.60 –1.21 –0.28 0.41 0.19 0.59 0.02 0
0.084
t-stat –0.34 –1.42 3.68** 8.25** –2.36* –1.97* –3.56** –1.82 1.48 0.34 1.62 4.85** –0.64
Cross-Sectional
Mean 0 –0.01 0.06 1.01 –0.27 –0.66 –1.29 –0.36 0.51 1.21 0.47 0.03 0
t-stat –0.13 –0.22 1.72 5.59** –1.18 –1.40 –2.60** –1.29 0.69 0.64 0.62 4.71** –1.47 0.136
Prop+ 0.40 0.40 0.70 1.00 0.30 0.20 0.10 0.40 0.40 0.50 0.50 0.90 0.30
Note: The first row (pooled) reports the results based on pooled OLS regression and in CS we use the Fama-MacBeth (1973) procedure to estimate the regression
coefficients. All the variables have been winsorized at 0.5% and 99.5% of the empirical distribution. DPC (DNC) is a dummy variable that equals 1 for dividend
increases (decreases) and 0 otherwise. The R2 in CS is the average (adjusted) R2 of the cross-sectional regressions.
* Significant at 5% level, ** Significant at 1% level.
0 1P 1N 2 3 R2
= 1
Cross-Sectional
= 2
23
24
Table 11 (Cont.)
Panel B: Nonlinear Model
0 1P 1N 1 2 3 4 1 2 3 4 R2
= 1
Pooled –0.008 0.006 0.019 –0.557 0.132 3.992 –1.085 0.398 0.128 –0.145 –0.584
0.076
t-stat –4.49** 2.98** 3.61** –4.76** 0.680 3.02** –0.96 3.49** 0.780 –0.21 –0.560
Cross-Sectional
Mean –0.006 0.007 0.021 –0.652 0.205 4.329 –2.103 0.428 0.158 –0.018 1.184
t-stat –2.51* 3.17** 1.97* –3.88** 1.710 3.19* –1.730 2.97** 1.070 –0.020 0.970 0.120
Prop+ 0.10 0.80 0.80 0 0.800 0.80 0.300 1 0.700 0.500 0.600
= 2
Pooled –0.012 –0.007 –0.001 –0.381 0.081 1.392 –0.617 0.386 –0.36 –1.854 –2.697
0.055
t-stat –6.03** –3.20** –0.155 –3.01* 0.38 0.98 –0.5 3.13** –2.02* –2.43* –2.39*
Cross-Sectional
Mean –0.011 –0.005 –0.019 –0.477 0.20 1.821 –0.174 0.44 –0.442 –2.202 –3.004
t-stat –4.22** –0.920 –1.900 –2.83** 0.86 1.02 –0.08 4.55** –3.32** –2.17* –4.23** 0.105
Prop+ 0.10 0.200 0.400 0.20 0.60 0.70 0.40 0.90 0.20 0.10 0.20
Note: The first row (pooled) reports the results based on pooled OLS regression and in CS we use the Fama-MacBeth (1973) procedure to estimate the regression
coefficients. All the variables have been winsorized at 0.5% and 99.5% of the empirical distribution. DPC (DNC) is a dummy variable that equals 1 for dividend
increases (decreases) and 0 otherwise. The R2 in CS is the average (adjusted) R2 of the cross-sectional regressions.
* Significant at 5% level; ** Significant at 1% level.
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Reference # 01J-2010-01-01-01