What does the timing of dividend reductions signal?
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What does the timing of dividend reductions signal? Xin Che1 · Kathleen P. Fuller2
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Dividend reduction theory suggests that during an economy-wide shock, a relatively early dividend reduction indicates that a firm reduces its cash outflows to pursue positive net present value projects, whereas a relatively late dividend reduction is due only to cash constraints rather than investment strategies. This paper directly tests the dividend reduction theory. Consistent with the theory, we find that during a recession, early-dividend reducers make 5% more firm investment than late-dividend reducers within the reduction year. Further, the investment levels are not significantly different between early and late reducers outside of recessions. The results also suggest that the signaling effect does not persist, implying that in a recession, the investment opportunities pursued by the early reducers are short-lived. Keywords Dividend reduction · Recession · Timing · Investment JEL Classification G35
1 Introduction Whether dividend policies convey information about a firm’s future profitability has long been debated. Under the assumptions of perfect capital market, rational behavior, and perfect uncertainty, Miller and Modigliani (1961) propose that a firm’s value is independent of its payout policy and solely based on its earning power and investment. Yet, it has been well documented empirically that a change in dividends impacts market value (e.g., Asquith and Mullins 1983; Brickley 1983; Healy and Palepu 1988; Michaely et al. 1995). In an attempt to explain the relation between dividend policy and firm value, many studies have proposed
* Xin Che [email protected] Kathleen P. Fuller [email protected] 1
Department of Finance, California State University, Fullerton, Fullerton, CA, USA
2
Department of Finance, University of Mississippi, University, MS, USA
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dividends as a signal of future firm prospects (e.g., Bhattacharya 1979; John and Williams 1985; Miller and Rock 1985). These theories predict dividend increases (decreases) signal higher (lower) future earnings.1 Intriguingly, Benartzi et al. (1997) show an increase in future earnings is reliably signaled by a dividend reduction instead of a dividend increase. Healy and Palepu (1988), DeAngelo et al. (1992), and Jensen and Johnson (1995) also consistently find that firms that reduced their dividends experienced a subsequent earnings increase. Finally, Grullon et al. (2005) show that dividend changes are negatively correlated with future earnings, implying that dividend cuts are expected to be followed by an earnings increase rather than a decrease. One possible explanation for firms’ earnings increase following dividend reductions is the increased subsequent investment. However, prior literature documents that dividend reductions are associated with a decrease in investment rather than an increase, which runs counter to the intuiti
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