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Market Reaction To Dividend Announcement-An Event Study Analysis

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Market efficiency hypothesis states that stock prices should reflect to the all-available information in the market. Hence, stock prices must change only to the releasing events by the companies on the announcement date. Therfore any reactions before and after the announcement date indicate symptoms of inefficiency of the market. The average magnitude of stock prices changes to the events, it depends on the type of the information that releasing by the firms. For instance, according to the lemon " s principle, stock prices react negatively to the equity issuing events. The aim of this study is to investigate reactions of stock prices due to the dividend announcements. Managers increase dividend only they perceive sustainable increasing expected future earnings. Signaling theory states that firms by increasing dividends send a positive signal to the investors, which can afford more paying out dividends. Also investors receive negative signals while, firms decrease its dividend. This study used Event-study methodology with considering fifty companies to test the reactions of stock prices due to the dividend announcements. In addition, it related the results to the signaling hypothesis theory and dividend smoothing. However, this study finds neither significant support for increasing value of firms around the announcement date or inefficiency of the market.
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Market Reaction To Dividend Announcement-An Event Study Analysis
ALIREZA ATHARI
Department of Banking and Finance
Eastern Mediterranean University
Mersin 10, Famagusta, North Cypru
Country: IRAN
Abstract: Market efficiency hypothesis states that stock prices should reflect to the all-available
information in the market. Hence, stock prices must change only to the releasing events by the companies on
the announcement date. Therfore any reactions before and after the announcement date indicate symptoms of
inefficiency of the market. The average magnitude of stock prices changes to the events, it depends on the
type of the information that releasing by the firms. For instance, according to the lemon‟s principle, stock
prices react negatively to the equity issuing events. The aim of this study is to investigate reactions of stock
prices due to the dividend announcements. Managers increase dividend only they perceive sustainable
increasing expected future earnings. Signaling theory states that firms by increasing dividends send a
positive signal to the investors, which can afford more paying out dividends. Also investors receive negative
signals while, firms decrease its dividend. This study used Event-study methodology with considering fifty
companies to test the reactions of stock prices due to the dividend announcements. In addition, it related the
results to the signaling hypothesis theory and dividend smoothing. However, this study finds neither
significant support for increasing value of firms around the announcement date or inefficiency of the market.
Key-words: Market efficiency, Dividend, Firm value, Signaling theory, Smoothing theory
1 Introduction
Many studies have been conducted to monitor the
reactions of market to the dividend announcements.
Behavior of market around announcement dates gives
this ability to categorize efficiency of the market. There
are three forms of market efficiency. These forms are as
follows: Weak form, semi-strong form and strong form.
Weak-form efficiency states that changes in stock
prices will reflect to the all past and historical
information. Therefore there will be a temporary
benefits for investors to achieve substantial profits, with
applying technical analysis. But this situation will not
prolong for a long-term . Hence technical analysis will
not help to the investors for earning substantial profits.
Second type is a semi-strong efficiency. This form
proposes that current stock prices will reflect to the all-
historical and public
fundamental information about the firms. Fundamental
analysis at this type of the efficiency, will not find any
specific trend for investors to earn profits for a long-
term horizon. Most Investigations in terms of event
study follow this model. Although its worth noting to
say,in presence of positive correlationsamonghistorical
data‟s‟(momentum effects) in intermediate term and
negative correlation among historical data‟s‟ (reverse
effects)in longterm, these opportunities enable investors
to utilize temporarily from such effects. In a
efficient market, technical analysis and fundamental
analysis will not be able to generate profits for
investors in the longterm. In addition, any existence of
abnormality of stock returns per-event and post- event
on the announcement date will contradict directly with
efficient market hypothesis. In other words, both
abnormal average returns and cumulative abnormal
average returns in the event window should be
statistically zero. Third type of the efficiency refers to
the strong-efficiency form, which prices included all
historical information, public or fundamental
information and private information. There are several
relevant theories that justifying the movement of stock
prices around the announcement date. Miller (1980)
suggests that unexpected changes in dividends provide
information about future expected earnings prospects.
Furthermore, Bensh, Keown and Pinkerton (1984)
found investors have more reactions to cutting
dividends in comparison of increasing dividends.
However, Miller and Modigliani (1961) proposed that
in perfect capital market, in the absent of transaction
costs and no taxes, payout policy are irrelevant to
investors and value of firms.
Lintner (1956) suggested that firm‟s management is
reluctant to change dividends frequently (dividend
smoothing). Managers prefer to stable dividends with
sustainable growth rather than volatilities of the
dividends. Bhattacharya (1979) implied there exists
asymmetric information between a firm‟s management
and investors. Miller and Rock (1985) and John and
Williams (1985) supported the signaling theory. This
theory implies investors receive positive signals while a
firm increasing dividend and receiving negative signals,
when a firm decides to decrease the dividend. This
dividend changes contain a series of information about
future expected earnings. Black (1976) and Easterbrook
(1984) proposed that dividends play a critical role in
agency costs between management and
shareholders. Free cash flow hypothesis implies that, in
spite of being more costly to retain free cash in terms of
agency costs and taxations, however Managers often
decide to payout dividends to alleviate agency costs
among managers and shareholders. Dividend Payout is
not desirable behavior for managements. Gordon
(1959) and Lee (1995) suggested there are positive
abnormal returns due to the dividend payment
announcements. Dividend signaling hypothesis that
formalized by Williams (1985) and Millier and Rock
reflected to the mangers‟ views about future earnings
prospects. Williams and
Millier and Rock believed that increasing of dividends
indicate managers have higher level of expectations
about future earnings of the firms and more likely
enable to payout higher dividends. In addition, cutting
dividends show managers have given up hopes that
earnings will cover in the near term. Future earnings
and dividends relationship supported by Fama,
Babiak(1968), Pettit(1972),Venkatesh(1989) also,
Jensen and Johnson(1995). They figured out dividend
changes convey specific future earnings of a firm to the
market. Although, cutting the dividends is costly for
managers in terms of reputation and the reaction of
investors. However it is not as costly as failing to make
debt payments. Therefor dividend changes to be
relatively weaker signal than leverage changes.
Empirical
evidence shows that when companies initiate
dividends, stock prices increasing by average 4%, in
while omitting their dividends, stock prices
decreasing by average 7% abnormal returns.
Increasing or decreasing of dividends
on the announcement date would end up to increasing
by average 2% and decreasing by average 5%
respectfully. This study is mainly focus to test
whether there exists significant average abnormal
returns and cumulative abnormal returns on the
announcement date or not. After that, it is possible to
assess the level of the efficiency of the market. In
order to test the following hypothesis, it should apply
event-study analysis with using market model. First
step in quantitative analysis is to determine null and
alternative hypothesis as follows: H0: There are zero
statistically significant abnormal average returns due
to dividend announcement. HA:There are statistically
significant abnormal l r e turns due to dividend
announcement. In order to run a test, it will consider
fifty companies in the United States.
2 DATA & METHODOLOGY
Event study is a statistical method to evaluate
thevalue of a firm upon event announcement. The
point is to find out the abnormal returns, which
attributed to the dividend event. This methodology
can be used to see the effects of any event in both
direction and magnitude. Event study
proposed by MacKinlay (1997) or Mitchell and Netter
(1994). It is notable to say event study methodology
in short-horizon is much accurate and reliable than the
long-horizon event studies. However, this
methodology
improved by Kothari and Warner which enable
researchers to use for long-term. The aim of this
article is what‟s happening for returns of fifty
companies ten days before and ten days after
announcing of studied event. Estimation period for
group case study is {-10,10} and use {-191, -21},
range for estimation of parameters. This study uses
the market model in estimating the market
reaction to the dividend announcement with
estimation period from -199 prior days of the event.
Furthermore using s&p500 index as a proxy for
finding market prices. After that, it should compute
abnormal and cumulative
returns for discrete returns. It used following formulas
for calculation of discrete returns and expected
returns. To compute the expected returns, it should
regress stock returns and index returns to find out
intercept and slope of the market model.
(1) Rit= (Pit-Pit-1+Dit)/pit-1
(2) Rt=a+b*(RMt) +Ut, t=1, 2 ...T
In the last part, abnormal returns are equal to the
difference between actual stock returns and estimated
returns that derived from the market model.
(3) ARit=Rit-(a+b*RMt)
Cumulative abnormal returns are equal to the
summation of abnormal returns in a length of times.
T = t2
(4) CAR (t1, t2)=Σ (ARt)
T = t1
T-statistic test is an indicator to show whether market
reactions on the announcement date affect a firm‟s
value or not. In this order, it should test abnormal
returns and cumulative returns.
(5) T-test=AR/s.dev
(6) t-test=CAR(t1,t2)/ [(T) ^0.5]*(s.dev)
3 EMPIRICAL RESULTS
(Table 1), demonstrates the results of comprehensive
analysis. It shows average abnormal returns and
average cumulative abnormal returns during
estimation window from (-10 to +10). It uses t-test to
test whether average abnormal returns and average
cumulative abnormal returns are significant or not.
The results show that except period {-4}, which
average abnormal return (-0.43%) is statistically
significant at
10%, the rest are insignificant. In addition, average
cumulative abnormal returns
between periods of {0,5}, {0,10} and {2,10}
at 5% and 10% are significant.
AAR
AAR
T -TEST
ACAR
CAAR
T -
TEST
PERI
OD
0.001
0.46896
0.001
CAR(-10,-1)
0.5083
-10
0.002
0.82747
0.003
CAR(-5,-1)
-0.04
-9
0.001
0.30067
0.003
CAR(0,1)
-1.348
-8
0
-0.0255
0.003
CAR(0,5)
-2.218
-7
0
0.12534
0.004
CAR(0,10)
-2.565
-6
0.002
0.94475
0.006
CAR(2,10)
-2.201
-5
0.004
-2.0194
0.001
CAR(-1,1)
-0.612
-4
0.001
0.28503
0.002
CAR(-6,-3)
-0.3321
-3
0
-0.1465
0.002
-2
0.002
0.84663
0.003
-1
0.003
-1.3982
0
0
0.001
-0.5077
-0.001
1
0.002
-0.8559
-0.002
2
0.003
-1.2109
-0.005
3
0.003
-1.3892
-0.008
4
0
-0.0723
-0.008
5
0
0.0501
-0.008
6
0.002
-1.0456
-0.01
7
0
-1.0787
-0.013
8
0.001
-0.6315
-0.014
9
0.001
-0.3684
-0.015
10
Table 1: Market reaction to dividend announcement
(Graph1,2), demonstrate graphically the market
reactions to the dividend announcements in estimation
periods {-10,10}. The market reaction on the
announcement date is (-0.29%) and gradually after
announcement date the magnitude of market reactions
will become more negative. although there are some
fluctuations before announcement date, but these
reactions are not significant and it doesn‟t suffice
evidence to prove for inefficiency. Average abnormal
returns are around zero and in overall not significant.
However, in contradicted of the average abnormal
returns, the cumulative average abnormal returns after
the announcement in the periods of {0,10} are
statistically significant.
GRAPH 1: Average abnormal returns and average
cumulative abnormal returns-line graph (Graph 2)
shows that after the announcement date, the average
cumulative abnormal returns have negative trend.
Moreover, the magnitude of this trend in absolute-
term has been increased.
GRAPH 2: Average abnormal returns and average
cumulative abnormal returns-column graph
average cumulative of abnormal dividend in
estimation periods with considering such internal and
external factors. In the last quarter of 2012 and first
quarter of 2013 ,which most companies announced
the dividends, surplus of earnings equal to zero.
Therefore average abnormal earnings were not
sustainable and significant that could influence to
increase of dividends.
GRAPH 3: Average abnormal earning,average
dividend and average actual earning
External factors explain that the growth of GDP in the
first quartet of 2013 has decreased in compared to the
last quarter of 2012. It means, the lowering growth of
GDP may lead to companies decision makers‟ to
decide more retaining of earnings in the less
favorable market and changing their decisions to
decrease their payout policy.
GRAPH 4: Average inflation and growth of GDP
4 Conclusion
Managers will decide to change dividends only when
they perceive a sustainable future earnings growth.
Also they are reluctant to change dividends payout
policy frequently.
Hence, according to the (graph 3), the average of
dividends payout are nearly constant that is exactly
accorded to the dividend smoothing. The results in
(graph 3) show that except quarter 3 in 2011 that there
was a significant average abnormal earning, the
averages of actual earnings have mostly constant
growth. Moreover, based on information theory,
announcement of dividends send positive and
negative signals to investors. It means that positive
signals receive by investors with increasing dividends
and negative signals send to
investors when companies‟ managers decide cutting
dividends. Meanwhile, it seems at this article external
factors are dominated internal factors to impact
changing behavior of the market reactions. Lowering
prosperity of the market is very important factor that
directly effect decision makers‟ minds to retain more
earnings to prevent companies from financial distress
and agency costs. Managers at the less favorable
market behave more wisely and replacing retaining of
earnings policy with paying out policy. So it can
explain why the market reactions after dividend
announcement has a negative trend. It is worth to note
that, in evaluation of the reactions of the market to the
dividend announcement in the pre-event and post
event (graph 1, 2), average abnormal returns are not
statistically significant. This means that dividend
announcements by the selected companies is not
substantially significant to affect the value of firms.
The reactions of the market due to the dividend
announcement is a function of magnitude of the
dividend changes. As results, companies will change
dividends, so that they will assure about future
sustainable earning growth, and preventing companies
from financial distress and agency costs with
considering market conditions or market timing.
Refrences:
Bhattacharya, S. (1979). Imperfect Information,
Dividend Policy, and „The Bird in the Hand‟ Fallacy.
The Bell Journal of Economics, 10, 259- 270.
Black, F. (1976). The Dividend Puzzle.
Journal of Portfolio Management, 2, 5-8.
Easterbrook, H. (1984). Two Agency Cost
Explanations of Dividends. The American
Economic Review, 74, 650-659.
Fama, E. (1965). The Behavior of Stock
Market Prices. Journal of Business, 38,
34-105.
Gordon, M. (1959). Dividend, Earning, and
Stock Prices. The Review of Economics and
Statistics, 41, 99-105.
John, K., and Williams, J. (1985). Dividends,
Dilution and Taxes: A Signaling Equilibrium.
Journal of Finance, 40, 1053-1070.
Lee, B. (1995). The Response of Stock Prices
to Permanent and Temporary Shocks to
Dividends. Journal of Financial and
Quantitative Analysis, 30, 1-22.
Lintner, J. (1964). Optimal Dividends and
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MacKinlay, A. C. “Event Studies in
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