Firm’s Excess Cash and The Dividend Announcement Effect An Event Study Conducted on NYSE Listed Companies

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Firm’s Excess Cash and

The Dividend Announcement Effect

An Event Study Conducted on NYSE Listed Companies

Name: Izabela Lewińska Student Number: 11622261 Supervisor: Drs. P.V.Trietsch, M.Phil. Program: Economics and Business Economics

Specialization: Finance Date: 12th_{July 2020}

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Statement of Originality

This document is written by Student Izabela Lewińska, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document and original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

This research paper investigates, foremost, the occurrence of dividend announcement effect around the declaration dates for NYSE companies between 1990 and 2019. Moreover, it examines the importance of excess cash and other firm’s characteristics for the magnitude of the effect. Results of the event study suggest significant positive (negative) abnormal returns during the period around the announcement of dividend increases (decreases). In addition, the firm’s size, dividend yield, and percentage change of dividends were found to influence the abnormal performance around the announcement of a dividend increase. Regarding the announcement of dividend decrease, the dividend yield was established to influence the effect. Variable accounting for excess cash was found insignificant in both regressions. Overall, the findings of this paper support the dividend signaling, and clientele hypothesis, but show no compliance to the free cash flow theory.

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1. Introduction

The dividend announcement and its potential effect on changes in the firm’s stock price have been a topic of ongoing discussion among various researchers. On one hand, some of them had advocated for the irrelevance of dividends in determining the price of the company’s securities (Miller & Modigliani, 1961). Others justified the occurrence of abnormal performance around the dividend announcement dates and supported it with diverse theories and rationales (Lintner, 1956; Gordon, 1959).

Pettit (1972), and Aharony and Swary (1980) among others articulated that the excess returns around the declaration of dividend changes are due to investors altering their beliefs about companies expected future cash flows. Moreover, the free cash flow hypothesis expresses another approach to this view, by claiming that the abnormal performance around the announcement is caused by the overinvestment problem (Lang and Litzenberger, 1989).

Furthermore, Galai and Masulis (1976) present support for the wealth redistribution hypothesis, showing that while stockholders benefit from price increase due to the dividend effect, they do it at the expense of bondholders. Lastly, those researchers that address the catering theory of Baker and Wurgler (2004) defend the view that changes in dividend policy are connected to catering investors' incentives.

However, while several researchers have examined the relationship between various firm’s characteristics such as company size, maturity, absolute change in dividends, or debt/equity ratio on the dividend announcement effect (Bajaj and Vijh, 1990; Julio & Ikenberry, 2004), little investigation has been done to study the impact of excess cash on the size of stock’s abnormal performance (Li & Lie, 2006; Lie, 2000). For this reason, the paper will focus on determining the relation between the excess funds of companies, and the positive (negative) excess returns around the declaration of dividend increases (decreases).

Furthermore, since firm’s prospective capital is the main focus of the free cash flow hypothesis, the company’s excess cash seems like a crucial next step to be investigated. Additionally, previous papers have put the majority of their attention on the potential effect of excess funds on special dividend, or tender offers, and not announcements of decreased or increased dividends (Howe, He & Kao 1992; Lie, 2000). What is more, as the average cash to assets ratio has been determined to increase by over 100% among American companies between 1980 and 2004 (Bates, Kahle & Stulz, 2009), it can be said that the importance of this matter in

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2 determining the relation between stock prices and the declaration of changes in dividend policy should not be overlooked.

Therefore, this paper will focus on conducting an event study around the time of the dividend announcements of NYSE companies for a period between 1990 and 2019. To address the issue, the main research question of this paper will be: Does a company’s excess cash influence the

dividend announcement effect?

Moreover, it will be addressed by answering the following sub-questions:

a. What is defined as the dividend announcement effect? b. How is the dividend announcement effect measured?

c. What are the factors influencing the dividend announcement effect?

d. Which theories explain changes in firms’ value after dividend announcement? e. How does a firm’s excess cash influence the dividend announcement effect?

Withal, the remainder of this paper is structured as follows: the second chapter provides the overview of relevant literature. Then, data and methodology are introduced, followed by the result and robustness section. Lastly, the paper will conclude with a discussion and recommendations for further work.

2. Theoretical Framework

This research paper brings attention to the effect of dividend announcements based on the amount of a firm’s excess cash. Hence in this section, the relevant theories and concepts are presented in order to discuss the underlying topic. At first, the idea of a dividend announcement effect is defined as well as the methods of measure and its influencing factors. Secondly, theories that interpret the changes in firms’ value after dividend announcements are discussed, followed by an introduction of excess cash as an additional variable that may influence the magnitude of abnormal performance. Lastly, the theoretical framework will conclude with the development of hypotheses.

Moreover, in order to introduce the theories and their main ideas, a conceptual framework is presented below.

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Figure 1. Conceptual Framework

2.1 Dividend announcement effect

The dividend announcement effect is a phenomenon that constitutes an ongoing topic in various researches and rests upon a notion that prices of firms’ securities change following the declaration of dividend increases or decreases. Moreover, studies throughout the years were arguing whether the effect indeed exists and is significant (Baker, 2009).

On one hand, the dividend irrelevance theory states that the firm’s valuation is independent of the dividend policy adopted by managers and is built solely upon the chosen investment policy. This proposition is based on an assumption of perfect capital markets with no frictions, taxes, transaction costs, and an idea that investors that are homogenous and rational (Miller & Modigliani, 1961). From this point of view, no announcements of dividend should have an impact on the stock price.

On the other hand, as argued by Lintner (1956), and Gordon (1959) among others, reality does indeed deviate from this idealistic concept and the irrelevance assumptions do not hold in their full scope. That is why various empirical studies have tested the pace and accuracy with which stock prices display the effect of dividend announcements. Aharony and Swary (1980) in their event study have identified that shareholders of companies that announced dividend increase (decrease) experience, on average, positive (negative) abnormal returns during the twenty-day event window.

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4 Contrarily, some researchers observed opposite outcomes. Among them Watts (1973) who used over 300 companies during a term of 20 years. He was one of the first ones to test whether the subsequent year’s earnings can be explained by current year’s dividends and found that even though the coefficient among firms is positive, it’s not significant. Moreover, no abnormal returns have been found during months around the dividend announcement date. Other research papers that did not find significant changes in security prices due to dividend announcements belong to Black and Scholes (1974), Deangelo, Deangelo, and Skinner (1996) or Grullon et al. (2005).

Furthermore, those researchers that did find a dividend announcement effect often accredit this occurrence to various plausible theories. Among them are dividend signalling hypothesis, free cash flow theory, wealth redistribution, or catering hypothesis and they will be depicted in the upcoming subsections.

2.2 Measures of the dividend announcement effect

Studies on the dividend announcement effect have attempted to measure the occurrence of this phenomenon by calculating companies’ abnormal returns in an event study (Aharony & Swary, 1980; Kale, Kini & Payne, 2012; Lie (2000). In order to assess the abnormal returns, first, a benchmark has to be set as of what constitutes the ‘normal’ ones. Brown and Warner (1980) in their paper describe in detail the three possible measurement techniques: mean-, market-, and market and risk-adjusted returns.

The first model estimates that expected returns for each security are equal to a constant value. Then, the abnormality is calculated by subtracting from actual gain, the predicted one. Such a technique has been used by Handjinicolaou and Kalay (1984) among others. Secondly, the market-adjusted return states that each stocks’ returns are on average equal to those of a market portfolio, as it consists of all available securities. The abnormal gain is then equal to the difference between realized return and the one on the market portfolio. This approach has been widely used by Aharony and Swary (1980), Asquith and Mullins (1983), or Hussin et al. (2010).

The last technique of measuring stock returns mentioned by Brown and Warner (1980) is about market-risk adjustment. This model measures excess returns of a stock and the market as a difference between realized gains and the predicted returns, where the security is characterized by the same volatility as a benchmark portfolio. Other researchers that also articulated for this method are Miller & Scholes (1978).

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5 Moreover, what has been varying between studies is the choice of a frequency of dividend announcements. Pettit (1972), Aharony and Swary (1980), Handjinicolaou and Kalay (1984) use quarterly data to analyse whether the declaration of dividends influence the stock prices by themselves or only because their release date is close to an announcement of current earnings. Contrary, Watts (1973) and Nissim and Ziv (2001) set their research on annual dividends by claiming that they are determined on a yearly basis.

Furthermore, some papers that explored the dividend announcement effect were focusing on shorter time frames, starting with just a few months (Hussin et al., 2010; Pettit, 1972), while others extended, they dataset for observations over decades (Asquith & Mullins, 1983; Grullon et al., 2005).

2.3 Factors influencing the dividend announcement effect

Having examined the occurrence of abnormal returns around the dividend announcement day, several researchers focus on the subsequent investigation of factors that may influence the size of securities’ price reaction. By regressing the cumulative abnormal returns on independent variables, three firms’ characteristics have been found significant in several papers: firm size, the percentage change in dividend per share, and the dividend yield.

It has been researched that the company’s size accounted for as its market value of equity, is negatively related to stock price reaction after dividend announcement. Bajaj and Vijh (1990), as well as Lonie et al. (1996), argue that smaller firms are more likely to experience larger price changes than big companies since there is limited information available about them throughout the non-announcement time. This information asymmetry is due to the fact that these corporations are less likely to draw market participants’ attention and hence experience the so-called ‘small firms’ effect’. Furthermore, this is in line with the dividend signalling hypothesis, as corporations with little information available to the public will use dividend policy to signal changes in the firm to its investors.

Moreover, the percentage change of the dividend per share has been identified to be positively correlated with the magnitude of price reaction. This phenomenon is advocated by the dividend signalling hypothesis which claims that greater alterations of dividends constitute a tool to signal bigger changes in a firm’s upcoming cash flows (Asquith & Mullins, 1983; Yoon & Starks, 1995).

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6 Lastly, the dividend yield, also known as the dividend-share price ratio has been found to also positively affect the share price adjustment to the dividend policy changes (Asquith & Mullins, 1983; Lonie et al., 1996). Bajaj and Vijh (1990) have researched that the dividend yield represents a clientele effect. Therefore, stocks with higher yield are foreseen to react more positively to dividend escalations, and more negatively to their reductions.

2.4 Interpretation of changes in a firm’s value after the dividend announcement

In this section, four theories are introduced to provide a possible explanation of why alterations in stock prices occur when companies announce dividend changes. For each of the concepts, their scope and definition will be presented, as well as researchers that found results in favour and against the underlying hypothesis. The section is concluded with a summary table of the main presented papers.

2.4.1 Dividend Signalling Theory

The dividend signalling theory suggests that changes made in the dividend policy express information about the firm’s future cash flows. It is said that since managers have superior knowledge regarding the company’s profitability than its stockholders, they will increase dividends only when they are certain that sufficient resources are on hand to support this expense. Equivalently, there will be a decrease in dividends only in a situation when managers know that they will not be able to sustain the current dividend payout scheme. For these reasons, investors will adjust their expectations towards a firm’s future cash flows by taking the changes in the dividend policy as either a positive or negative signal (Pettit, 1972).

Researches done by Asquith and Mullins (1983), Bhattacharya (1979), Hussin et al. (2010), or Nissim and Ziv (2001) show support for this hypothesis. Healy and Palepu (1988), controlling for other relevant information in the market around an announcement, found that corporations initiating dividends encounter 3.9% higher returns around the declaration date, while the ones that omit them experience the two-day return of -9.5%. Both results are significant at 1% level. Moreover, Aharony and Swary (1980) similarly found a significant dividend announcement effect for the two days surrounding the declaration date. For increases in dividends, they discovered a significant abnormal return of 1% in that time period, which is separate from the information conditional on earnings estimates.

Contrarily, some authors did not find any evidence in support of the information content theory, implying that dividend does not transmit any important message to the capital market during its

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7 announcement (Benartzi, Michaely & Thaler, 1997; Deangelo et al., 1996). Grullon et al. (2005) present opposite results to those of Nissim and Ziv (2001) as they argue that the latter’s assumption of linear earnings’ mean reversion is incorrect. Having controlled for patterns in earnings between changing- and constant-dividend firms, they find essentially no significant changes in stock prices after dividend announcements.

Similarly, Watts’ (1973), who was one of the first ones to focus on the relation between dividend policy and price reaction, using over 300 companies, justifies that while the companies’ coefficients are on average positive, their t-test results are insignificant. He concludes that the information content is trivial and does not excel in the transaction cost of obtaining it.

2.4.2 Free Cash Flow Hypothesis - Agency Problem

The free cash flow hypothesis, also known as the overinvestment dilemma, accounts for the agency problem between managers and shareholders. Jensen (1986) who was the first one to uncover this notion articulates that due to the differences in incentives between these two parties, conflicts of interest will arise, as managers not being fully monitored may engage in wasteful investment or empire building. These activities would reduce the overall value of the firm. Hence, one way of aligning both of the interests is for the company to pay higher dividends rather than keeping the retained earnings. It will decrease the number of cash flows in excess to these required for needed corporate operations and thus subsequently increase the firm’s value.

Empirical evidence has been found that advocates for the rightness of the overinvestment hypothesis. Lang and Litzenberger (1989) used Tobin Q as an index for firms’ overinvesting actions, with those overinvesting having Q < 1. They tested the difference in returns deriving from announced rises in dividends for Q’s smaller and greater than unity. Their report states that the average return for corporations with Q < 1 is 300% larger than that for firms with Q > 1. This variation is significant at a 1% level and in line with the idea that investors positively react to the news that dividends are raised and therefore the agency problem is minimized.

Moreover, La Porta et al. (2000) show support for the theory by analysing dividend pay-outs by companies from different legal systems in over 30 countries. They discover that in common law states, hence in those claimed to have greater legal corporate protection, investors are more

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8 effective in obtaining dividends from firms in a situation when alternative investment opportunities are scarce.

Nevertheless, Denis, Denis, and Sarin (1994) employing Tobin Q find contrary results to those of Lang and Litzenberger (1989). Their research concludes that dividend yield and Q ratio are negatively correlated and hence firms with Q < 1 de facto increase their spending following an increase in dividends and cut them after dividend reduction. This counters the free cash flow hypothesis. Lastly, Yoon and Starks’ (1995) paper similarly does not show support for the overinvestment hypothesis. Their study indicates that earnings growth for both high- and low- Q companies do not significantly differ after dividend increases.

2.4.3 Wealth Redistribution Hypothesis

The wealth redistribution hypothesis, as first introduced by Galai and Masulis (1976), advocates that in case of an unforeseen dividend rise, wealth would be reallocated from the firm’s bondholders to its stockholders if the addition was funded by debt. For this reason, the theory supports the idea that the positive price reactions to the announcements of dividends co-occur with negative consequences on prices of bonds and vice versa. Essentially, it presents a perception that stockholders benefiting from price increase due to the dividend effect do it at the expense of those holding bonds.

Dhillon and Johnson (1994), using 131 dividend announcements between 1978 and 1987, conducted research that supports this hypothesis. They identified that during the two days around the declaration of dividend increase excess returns for these companies equal to 0.98%, while the abnormal return on bonds amounts to -0.37%. Correspondingly, when accounting for an announcement of dividend decrease, the abnormal returns on the stock are -2.01%, whereas the matching bond return equals to 0.81%. The t-statistics for both tests are significant at 1% level.

On the other hand, some researchers express contrary results than those of Dhillon and Johnson (1994). Handjinicolaou and Kalay (1984) found that even though stock prices react in a favorable way to the announced larger dividend they do not seem to be altered by a sudden decrease in dividends. The z-statistics for these two tests are 4.62 and 0.45 respectively. The authors also indicate that prices of bonds are not influenced by enlarged dividends, but they do respond adversely to cuts in dividends. Moreover, Woolridge (1983) with his research on 225 NYSE companies over the period of 7 years, as well as Jayaraman and Shastri (1988) using

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9 over 2000 dividend announcements made by 660 firms in the same period found no significant reverse bond price reactions to the announcement of dividends.

2.4.4 Catering Theory

The fourth approach that focuses on interpreting the changes in stock prices after the dividend announcement is the catering theory introduced by Baker and Wurgler (2004). Their proposition states that there are strong ties between the tendency to distribute dividends and catering incentives. As claimed by them, in order to push stock prices over their underlying values, companies favour investors that are irrational and who expect the growth and dividend-paying stocks. In particular, firms that didn’t pay dividends before will initiate one in a situation when the shares of companies distributing dividends trade at a premium. This action seeks to boost the corporation’s market value. Moreover, dividends will be omitted when shares of the dividend-paying companies are valued at a discount and hence the firm’s stock prices will not increase.

Furthermore, through their investigation on United States’ firms and the dividend changes declared between 1963 and 2000, Li and Lie (2006) made Baker and Wurgler's (2004) research more extensive. They also found that the market’s reaction to the changes in dividend is dependent on whether the dividends trade at that time on discount or premium. Their results indicate that firms are more willing to enlarge dividends when the premium is substantial and decrease them when the dividend premium is limited. In a similar manner, Kale, et al. (2012), as well as Ali and Urcan (2012) support the catering theory, when using the methodology of Fama and French (2001) on American companies during the same time period as the hypothesis’ pioneers.

Nonetheless, Renneboog and Trojanowski (2005) are one of the researchers that’s work does not advocate for the catering theory. Through their analysis of dividend policy changes made by British companies around the 1990s, they find negative results for dividend premiums. Hence they advocate against the notion that firms' value will increase when shares are valued at a premium and there is an increase in dividends. Lastly, similar conclusions are drawn by Julio and Ikenberry (2004) whose empirical research demonstrates that after controlling for a firm’s size and maturity, the effect of catering irrational investors disappears.

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2.4.5 Summary table of literature

The summary table below presents two researchers from each theory evaluated in the chapter above, with its key concepts, results, and other study characteristics specified.

Authors & Title Countries, Years

Variables, Methodology

Findings

Aharony & Swary (1980). Dividends and earnings announcements and stockholders’ returns. USA, 1963 - 1976 - calculating CAR around dividend announcements - normal stock returns based on market model

- in favour of the dividend signalling hypothesis - significant positive AR of 1% around dividend increase announcement, separate from the information conditional on earnings estimates. - significant negative AR for decreased dividends of -2.8% around the event date

Watts (1973). The Information Content of Dividends. Global, 1945 - 1968 - current earnings - Abnormal Performance Index (API)

- against the dividend signalling hypothesis - information content of dividends is trivial

- cumulative monthly returns of only 0.5% which is insufficient to cover the transaction costs of obtaining the information content of dividends

Lang & Litzenberger (1989). Dividend announcements: Cash flow signalling vs. FCF hypothesis? Global, 1982 - 1984

- Tobin’s Q ratio - in favour of FCF hypothesis

- firms subject to overinvestment activities (Q<1) experience greater market reaction to dividend increases than those with positive NPV projects (Q>1)

- the significant difference in absolute terms between these two groups of 0.019

Yoon & Starks (1995). Signaling, investment opportunities, and dividend announcements. USA, 1969 –1988 - firms size - % change in dividends - dividend yield - Tobin’s Q ratio

- against the FCF hypothesis

- companies, disregarding investment opportunities, raise (lessen) their expenditures after an increase (decrease) in dividends for 3 years after dividend policy change

Dhillon & Johnson (1994). The Effect

of Dividend Changes on Stock and Bond Prices.

USA, 1978 - 1987 - use of Handjinicolaou and Kalay (1984) methodology

- in favour of wealth redistribution hypothesis - around the declaration of dividend increase (decrease) excess returns equal to 0.98% (-2.01%), while the return on bonds amounts to -0.37% (0.81%). Handjinicolaou & Kalay (1984). Wealth redistributions or changes in firm value. USA, 1975 - 1976 - level of debt - market value of equity

- against the wealth redistribution hypothesis - bond prices are not influenced by the dividend increases (z-statistics of 0.015), although they respond negatively to dividend decreases (z-statistics of - 3.70)

Baker & Wurgler (2004). A catering theory of dividends. USA, 1963 - 2000 - dividend premium - asset growth - profitability - after-tax income

- in favour of catering theory

- high premium as a sign of investors being attracted to dividend-paying firms,

- for positive (negative) divided premium, rate of dividend initiation is 11% (3.1%)

Julio & Ikenberry (2004). Reappearing dividends. USA, 1984 –2004 - firm size - firm age

- use of Baker and Wurgler’s dividend premium criteria

- against the catering theory

- reversal in propensity to pay dividends over time - little evidence for the catering theory when accounting for the size and maturity of a firm - even with increases in dividend premiums, the number of dividend-paying companies do not expand Table 1. Summary table of literature

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2.4.6 Relevance of firm’s excess cash for dividend announcement effect

This subsection is devoted to evaluating the relevance of excess cash as a factor potentially determining the magnitude of the dividend announcement effect. First of all, what can be said to constitute excess cash are the company’s resources over and above those needed to carry out its day-to-day activities. They can be accounted for as current assets such as cash, cash equivalents, and short-term investments less total current liabilities of the corporation (Bates et al., 2009).

Moreover, as Jensen’s (1986) hypothesis predicts, large excess cash holdings may influence a manager’s decisions to engage in needless spending and empire building. Hence, investors may react differently to dividend decrease or increase announcements depending on the amount of excess funds that a company has as it may indicate a possibility of future overinvestment. Nevertheless, so far little research has been done to analyze whether the firms’ excess cash has a significant influence on the dividend announcement effect. Thus, it can be said that this aspect is of significant importance, especially when firms have been found to increase their cash holdings significantly since 1980 (Bates et al., 2009).

Furthermore, as noticed by Lie (2000) earlier studies didn’t put much attention on considering the aspect of accumulated cash when accounting for the dividend effect. Thus, in his research, he incorporates cash to test whether it significantly influences the excess returns around the announcement for common dividend increases, one-time special dividend, and tender offers. Furthermore, his findings indicate that the abnormal returns around the declaration of special dividend are positively related to the firm’s cash levels (p < 0.01). Regarding the increase in the regular dividend, excess returns are identified to be significant but smaller than for the special one-time payment, and unrelated to the degree of cash holdings. Lie argues that these differences in significance may be due to the relatively smaller outlay of money belonging to the dividend increase as to the special dividend.

Nevertheless, as noted by Bates et al. (2009) average cash ratio for dividend-paying corporations has increased by over 30% between 1990 and 2000. Keeping in mind the objectives of the agency problem theorem, it may be worth further investigation to test whether there is a substantial change in the extent of abnormal returns around an announcement of dividend changes. Finally, a different measure that Lie’s (2000) of companies’ excess cash would be vital to account for this aspect. Such a method would ensure greater reliability of the

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12 test on the effect of excess cash on encountered abnormal returns around the dividend announcement date.

2.5 Hypotheses

In order to address the central question of this paper, two primary hypotheses are being drawn, followed by three secondary hypotheses. This subsection introduces them and provides the argumentation for their relevance. At the end of the chapter, a table summarizing all included hypotheses is presented.

Hypothesis 1a, (1b): Firms announcing an increase (decrease) in cash dividend experience an

increase (decrease) in stock price.

The first hypothesis aims on assessing the direction and magnitude of a dividend effect on stock price changes. It regards whether firms announcing a dividend increase (decrease) encounter an increase (decrease) in their stock prices. Moreover, having examined previous work in this field, it can be seen that researchers who found the presence of dividend announcement effect articulate that prices react positively to announced dividend increases, and negatively to their declared cuts (Bhattacharya, 1979; Aharony & Swary, 1980; Lang and Litzenberger, 1989).

Nevertheless, others have detected the abovementioned results only for dividend increase (Handjinicolaou & Kalay, 1984), or their results even though support for the hypothesis were insignificant (Watts, 1973). Therefore, the result of this analysis will contribute new insight into the study of dividend announcements as the used database includes more recent years than those of previous researches.

Hypothesis 2a, (2b): Firms with higher levels of excess cash experience a greater increase

(decrease) in their stock price due to the announcement of increased (decreased) dividend compared to firms with low excess cash holdings.

The last primary hypothesis addresses the main regard for this paper. It examines whether the amount of a company’s excess cash influences the magnitude of stock price reaction to dividend announcement. As firms are said to be holding increasingly more cash on their balance sheets (Bates et al., 2009) this factor constitutes the main focus of this research.

Hypothesis 3a, (3b): Firms with a higher percentage change in dividend per share between

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of increased (decreased) cash dividend compared to firms with the lower percentage change in dividend per share.

Hypothesis 4a, (4b): Firms with a higher dividend yield experience a greater increase

(decrease) in their stock price due to the announcement of increased (decreased) cash dividend compared to firms with low dividend yield.

Hypothesis 5a, (5b): Smaller firms experience a greater increase (decrease) in their stock price

due to the announcement of increased (decreased) cash dividend compared to larger firms.

These three secondary hypotheses aim at testing whether this study finds a firm’s size, dividend yield, and percentage change in dividend per share relevant when determining the size of the dividend announcement effect. As discussed in earlier papers, several researchers found these factors significant while regressing the cumulative abnormal returns on various company’s characteristics (Asquith & Mullins, 1983; Bajaj and Vijh, 1990; Lonie et al., 1996). Therefore, as this study accounts for a larger and more recent time period, and simultaneously adds the new factor of excess funds, addressing these hypotheses ought to bring new insight into the study on abnormal performance around the dividend announcement dates.

Table 2. Summary of hypotheses with their specified variables, methods for testing and coefficients found in previous researches.

3. Data and Methodology

This section describes the data that has been used to test the abovementioned hypotheses. Moreover, the methodology is subsequently presented that was adopted to analyse the cumulative abnormal returns and the multivariate regression model.

Tested Variable Method Dividend Increase Announcement Dividend Decrease Announcement

CAR Event Study Positive Negative

ECASH Multivariate

Regression Model Positive Negative

CHANGE Multivariate

YIELD Multivariate

LOG(SIZE) Multivariate

Regression Model Negative Positive

Sign of Coefficient Found in Previous Literature

H1: Dividend Announcement ➝ Stock Price

H2: Excess Cash ➝ Dividend Announcement Effect

H3: Size of Dividend Change ➝ Dividend Announcement Effect

H4: Dividend Yield ➝ Dividend Announcement Effect

Hypothesis

H5: Firm's Size ➝ Dividend Announcement Effect

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3.1 Sample Selection

The information on the dividend announcements and firms’ daily returns have been collected from the Daily Stock File of the Center for Research in Security Prices (CRSP). Gathered information contains a dataset for a period of 30 years, between 1st of January 1990 and 31st of December 2019 for the New York Stock Exchange (NYSE) listed companies. Moreover, the following criteria have been used for the selection of the sample:

1. Firms from the financial sector, as well as utilities, have been excluded. The reason for the former is that these corporations are said to be characterized by higher leverage than the rest of the market, while the latter may be subject to additional state regulations. This is in line with Fama and French (1992) reasoning.

2. As suggested by Yoon and Starks (1995), as well as Lang and Litzenberger (1989) to assure a significance of the analysis only announcements of quarterly dividend changes equal or larger than 10% as compared to the previous quarter are treated.

3. Data on the treated firms’, accounted as excess cash, cash equivalents, and short-term investments less total current liabilities had to be available in Quarterly Fundamentals in the Compustat database.

863 announcements of a dividend increase and 515 of dividend declines satisfy the criteria. The majority of the decline in the initial sample of 8358 announcements is an outcome of the benchmark of minimum 10% quarterly change in the dividend. The below table visualizes the fracture of observations and presents variables essential for this study.

Number of observations

Percent of

cases Min. Max. Mean

Full sample 8358 100% - - - Dividends increased 1875 22% - - - Dividends unchanged 5676 68% - - - Dividends decreased 807 10% - - - Stock price - - 0,3 101,4 34,8 Dividend amount - - 0,0 0,9 0,2 Stock return - - -7,82% 5,21% 0,05% Market return - - -8,93% 5,42% 0,03%

Table 3. Summary statistics.

3.2 Methodology

In the following two subsections the methodology for an event study conducted in this research, as well as the regression model employed to test the second hypothesis are presented.

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3.2.1 Event Study

Since this research is aimed at testing the dividend announcement effect on the reaction of stock prices, an event study is undertaken as proposed by McKinlay (1997) and widely used in previous studies (Bhattacharya, 1979; Pettit, 1972; Watts, 1973). What is more, as established by previous studies on changes in dividend policy, an event window of 10 days – 5 days prior and 4 days after the announcement – is tested (Hussin et al., 2010). Besides, the adopted estimation window amounts to 100 days before the event window.

In order to subsequently assess the abnormal returns around the declaration date, firstly a model for normal performance needs to be estimated. Normal returns are defined as returns on the firm’s stock when it does not announce any changes in its dividend policy. In this research, similarly to some earlier studies, they will be predicted through the market model (Aharony & Swary, 1980; Asquith & Mullins, 1983; Hussin et al., 2010). To acquire the estimates for α and 𝛽, the ordinary least squares regression is performed over the 100-day estimation window:

_{𝑅𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖𝑅𝑚𝑡 + 𝜀𝑖𝑡 (1)}

where _{𝑅𝑖𝑡 and 𝑅𝑚𝑡 are subsequently the stock’s i and the market portfolio return at time t. 𝛼𝑖} is the stock’s i excess return relative to the benchmark, 𝛽𝑖 shows stock’s i sensitivity to market risk, and 𝜀𝑖𝑡 is the error term for firm-specific events with a mean of zero.

Moreover, the abnormal returns are calculated as the difference between actualized returns and those anticipated by the aforementioned model for each event day and each stock. Hence, abnormal returns are constructed as follows:

_{𝐴𝑅𝑖𝑡 = 𝑅𝑖𝑡 – Rmt (2)}

where abnormal returns for stock i are represented by _{𝐴𝑅𝑖𝑡, Rit stands for stock’s i return on} day t, and Rmt for market return on day t and is approximated by returns on S&P500 Index.

Then, in order to draw conclusions from the event study on the dividend announcement effect, the cumulative average abnormal returns are calculated for all stocks in the examined portfolio during the 10 days of the event window. As the last step, a t-test is carried out to check for their significance (McKinlay, 1997).

3.2.2 Regression Model

To facilitate an investigation on excess cash as a factor influencing the market reaction to the announcement of dividend changes, the following multiple regression analysis is determined.

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16 It aims at regressing cumulative abnormal returns as the dependent variable on independent variables containing relevant firm characteristics and constitutes an extended version of a regression used by Yoon & Starks (1995).

CARi = α + 1ECASHi + 2CHANGEi + 3YIELDi + 4LOG(SIZE)i + _i₍₃₎ where CARi is the cumulative abnormal return for stock i, α is a regression’s intercept, i stand for coefficients of the independent variables, and i is a zero-mean error term.

ECASHi represents the firm’s excess cash, determined as cash, its equivalents, and short-term investments less total current liabilities at the previous quarter-end. As stated by Lie (2000), shareholders of companies with a larger amount of excess cash along with little investment opportunities are going to gain significantly more from a dividend increase, since according to the free cash flow hypothesis, it can serve as an indication of lowered overinvestment opportunities (Bhattacharya, 1979). Thus, a coefficient for ECASHi in that scenario is expected to be positive. In the situation of an announcement of a dividend decrease, the coefficient is anticipated to be negative, as it could be a signal that the corporation’s manager may engage in empire-building and excessive spending (Li & Lie, 2006).

CHANGEi is a variable representing a percentage change in dividend per share between quarters. It has been implied by the dividend signaling theory which states that larger modification in dividends expresses anticipation of greater changes in future cash flows. Therefore, it is expected that the coefficient of this variable will be positive (negative) when testing announcements of dividend increases (decreases). Moreover, this independent variable was previously used for testing CARs by Ghosh and Woolridge (1988), Lonie et al. (1996), Woolridge (1983), and Yoon & Starks (1995) among others.

YIELDi stands for the dividend-share price ratio, calculated as the newly announced dividend less the former quarterly amount and divided by the company’s stock price at the previous quarter-end. As established by Bajaj and Vijh (1990), this independent variable ought to serve as a representation of the clientele effect. Their study suggests that stocks with higher yield should react more positively to a declaration of dividend rise, and considerably more negative to dividend declines. This is consistent with an analysis made by Lonie et al. (1996), Li and Lie (2006), as well as Asquith and Mullins (1983).

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17 LOG(SIZE)i is an independent variable that accounts for the size of a company that announces the dividend change. It is calculated as a natural logarithm of the market value of the firm’s equity at the end of the month preceding the declaration of dividend. It accounts for the notion of information asymmetry between small and large corporations. As Yoon & Starks (1995) report that abnormal returns arising from dividend increase announcements are superior for smaller firms. Hence, it is anticipated that the coefficient of LOG(SIZE)i will be negative for dividend increases, and positive for announcements of their decreases (Ghosh & Woolridge, 1988; Lonie et al., 1996).

Table 4 shows the specific firm characteristics particular to observations of a dividend increase and decrease announcements of this paper.

Dividend increases Dividend decreases

Min. Max. Mean Min. Max. Mean

ECASH 0 63051 883,72 0 59309 750,34

CHANGE -2,24 20 0,73 -1,53 0,70 -0,52

YIELD -0,05 1,87 0,02 -0,93 0,05 -0,03

LOG(SIZE) 10,24 20,06 15,08 8,35 17,99 13,57

Table 4. Descriptive statistics of observations for both dividends increase and decrease announcements. CHANGE represents the percentage change in dividend per share between quarters. YIELD is the dividend-share price ratio, calculated as the newly announced dividend less the former quarterly amount and divided by the company’s stock price at the previous quarter-end.LOG(SIZE) is calculated as a natural logarithm of the market value of the firm’s equity at the end of the month preceding the declaration of dividend. ECASH represents the firm’s excess cash, determined as cash, cash equivalents, and short-term investments less total current liabilities. To reduce the effect of outliers, all four variables are winsorized at the 1% and 99% of the empirical distribution.

4. Empirical Analysis

In this section results of the empirical analysis of the event study and the regression model are presented. Furthermore, for both subsections, descriptive statistics and implications of the results are provided.

4.1 Dividend Announcement Effect

This subsection is dedicated to testing the first hypothesis and hence analysing the announcement effect of both dividends decreases and increases. For this reason, the cumulative abnormal returns are estimated during the event window of 10 days around the declaration date.

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18 The table below summarizes the magnitude of the cumulative abnormal performance found around 851 announcements of dividend increase and 504 of dividend decrease during the period from 1990 to 2019. It can be seen that for firms announcing a dividend increase, their shareholders gained, on average, positive abnormal returns of 0,50% during the event window around the declaration. Its corresponding t-value is 6,55. Moreover, the majority of statistically significant excess returns were obtained throughout the two days around the announcement. They amounted to 0,62% with a t-value of 11,89.

Considering dividend decrease declarations, during the 10-day event window, the corresponding stock price return amounted to -0,62%, while the two-days CAR is -0,15%. T-values for these results are -9,79 and -5,58 respectively. It means that shareholders of companies that declared a decrease of quarterly dividend earned, on average, negative abnormal returns around the corresponding date. Moreover, whereas all the findings are significant at a 1% level, they have been identified to be of a smaller magnitude than previous papers.

Event and event window n CAR T-value

Dividend increase (-5, 5) 851 0,50% 6,55*** Dividend increase (-1, 1) 851 0,62% 11,89*** Dividend decrease (-5, 5) 504 -0,62% -9,79*** Dividend decrease (-1, 1) 504 -0,15% -5.58***

Table 5. Descriptive statistics for announcements of dividend increases and decreases. T-values obtained by testing CAR to be different from zero. ***, **, * mean significance at 1%, 5%, and 10% level respectively.

It can be seen that the results are in line with previous studies that articulate the presence of positive (negative) stock price reaction to a declaration of dividend increase (decreases) (Asquith & Mullins, 1983; Healy & Palepu, 1988; Hussin et al., 2010). Therefore, it can be stated that the findings of this research uphold the notion that the market reacts to announcements of changes in quarterly dividends.

Furthermore, in line with the paper of Aharony and Swary (1980), abnormal returns for the declaration of dividend increases sustain the semi-strong version of the hypothesis on the efficient capital market. Since most of the stock price reaction happens around two days surrounding the event, it can be said that the market adapts in an efficient way to the new information on the firm’s dividend policy. Nevertheless, for the announcements of dividend reductions, the semi-strong form of efficient market hypothesis does not seem to hold. One of

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19 the possible reasons for such a situation is that inside information was made use of already a few days prior to the event itself.

Lastly, as mentioned by Dhillon & Johnson (1994), and Aharony and Swary (1980) among others, the magnitude of securities’ price reaction to the declaration of reduced dividends is larger than those to dividends increases. This is consistent with the findings presented above when accounting for a full ten-day event window.

4.2 Effect of Firms’ Excess Cash

This subsection is devoted to testing the second primary hypothesis on the significance of excess cash as a variable influencing the dividend announcement effect. Moreover, to simultaneously analyse the impact of other firm’s characteristics from the secondary hypotheses, a model specified in equation (3) is initiated to draw the necessary conclusions.

Table 6 summarizes the main findings of this study with regards to four company’s characteristics as the potentially relevant variables that influence the magnitude of cumulative abnormal returns during the 10-day event window around the declaration date.

Table 6. OLS regression for two types of dividend announcements – increases and decreases. The dependent variable is CAR during the ten-day event window. The independent variables are the percentage change in dividend per share, the dividend-share price ratio, the natural logarithm of the market value of the firm’s equity, and excess cash. ***, **, * mean significance at 1%, 5%, and 10% level respectively.

First of all, variable essential for testing the second primary hypothesis – ECASHi has been found to have the same sign as previously particularized by Lie (2000), Bajaj and Vijh (1990),

Estimated coefficients and t-statistics

Dividend increase Dividend decrease

Intercept 0,0201 -0,011 1,69* -2,33** Excess cash 0,0010 -0,0012 0,68 -0,59 Change 0,0059 -0,0015 1,67* -0,88 Yield 0,0108 -0,0326 2,51** -1,8* Log(Size) -0,009 0,0005 -2,01** 1,18 Number of observations 851 504 R-squared 0,03 0,02

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20 and Denis et al. (1994). It has a negative coefficient of -0,0012 for dividend decreases and a positive of 0,0010 for announcements of enlarged dividends. Nevertheless, due to its insignificance for both regressions, it can provide only inconclusive inferences for the central question and does not show the support to the free cash flow hypothesis.

Secondly, it can be observed that the coefficient of variable CHANGEi is positive and significant at a 10% level for CAR around an announcement of dividend increases. It amounts to 0,0059 and is aligned with findings of Lonie et al. (1996), and Ghosh and Woolridge (1988). Hence, an interpretation can be drawn that larger modification in dividend policy expresses that greater future cash flows are expected, which is in line with the notion of the dividend signaling hypothesis. For the abnormal performance around the announcement of dividend decreases, the coefficient of CHANGEi is negative as predicted by Yoon & Starks (1995) but insignificant, equalling to -0,0015 with a t-value of -0,88. Therefore, regarding the announcement of lowered dividends, it can be said that they provide only ambiguous evidence in favour of the dividend signalling theorem.

Regarding the variable YIELDi, its coefficient is significant for both dividends increases and decreases at 5% and 10% level, respectively. Moreover, the sign of it is as predicted by the clientele hypothesis of Bajaj and Vijh (1990) and totals 0,0108, and -0,0326, accordingly. Such a situation is an indicator that stocks with relatively higher yield react more positively (negatively) to a declaration of enlarged dividends increases (decreases) (Lonie et al., 1996; Li & Lie (2006).

Lastly, the results of the regression provide partial empirical evidence for the dividend signalling hypothesis. The coefficients of LOG(SIZE)_I have the same sign as predicted by Yoon & Starks (1995) for dividend increases and decreases, amounting to -0,009, and 0,0005, respectively. Nevertheless, the results are only significant for the regression of CAR around announcements of dividend increases. Thus, it can be concluded that there seems to be a fragmentary trend similar to that found by Ghosh and Woolridge (1988), or Lonie et al. (1996) among others.

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21

Table 7. Summary of hypothesis and results. ***, **, * mean significance of coefficients at 1%, 5%, and 10% level respectively.

5. Robustness

This chapter focuses on the robustness of the abovementioned results. To address the reliability of this paper’s findings, multicollinearity has been analysed using Pearson’s Correlation in order to measure the size of association among the independent variables. Furthermore, while regressing CAR around the dividend increase announcements, substantially strong correlation has been found between variables CHANGE and YIELD. To address this issue, two separate models have been deployed.

CARi = α + 1ECASHi + 2CHANGEi + 3LOG(SIZE)i + _i₍₄₎ CARi = α + 1ECASHi + 2YIELDi + 3LOG(SIZE)i + i (5) Nevertheless, the results of these two models are in line with previous findings. The coefficients of equation (4) and (5) do not vary greatly from those found in the earlier multivariate regression model. Therefore, the results and inferences drawn in the previous chapter are still adequate and credible.

6. Conclusion

In the last chapter the concluding remarks are mentioned regarding the central question and the hypotheses of this paper. Secondly, the limitations of this research with suggestions for future work are specified.

6.1 General Conclusions

This research paper aimed at connecting the amount of a company’s excess cash and other firm’s characteristics to the magnitude of the cumulative abnormal returns around the announcement of dividend changes. In order to investigate the hypothesis on excess funds, 851

Hypothesis Tested Variable Coefficient Result Coefficient Result

H1: Dividend Announcement ➝ Stock Price CAR 0,0050*** Supported -0,0062*** Supported H2: Excess Cash ➝ Dividend Announcement

Effect ECASH 0,0010 Not Supported -0,0012 Not Supported

H3: Size of Div. Change ➝ Dividend

Announcement Effect CHANGE 0,0059* Supported -0,0015 Not Supported

H4: Dividend Yield ➝ Dividend

Announcement Effect YIELD 0,0108** Supported -0,0326* Supported

H5: Firm's Size ➝ Dividend Announcement

Effect LOG(SIZE) -0,009** Supported 0,0005 Not Supported

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22 announcements of dividend increase, and 504 of dividend decrease are used from NYSE firms between 1990 and 2020.

First of all, the study found a positive and significant cumulative abnormal performance of 0,5% during the ten-day event window around the declaration date. These results are in conformation with previous researches of Pettit (1972), Hussin et al. (2010), Asquith and Mullins (1983), or Nissim and Ziv (2001) among others. Moreover, having found the majority of market reaction happen throughout the two-day period around the announcement is aligned with Aharony and Swary‘s (1980) findings and suggests that the market rather efficiently assimilates the newly released information. This is in line with the semi-efficient capital market hypothesis.

Besides, the significant and negative cumulative abnormal returns established in this paper around the declaration of dividend decreases are of a larger absolute magnitude than those for dividend increase announcements. This reaffirms the results established by Dhillon & Johnson (1994). Consequently, the first hypothesis that articulates the occurrence of positive (negative) excess returns around the announcement of dividends increase (decrease) can be confirmed.

Moreover, the second primary hypothesis cannot be supported. Even though the coefficients were found to be of the same sign as in Lie’s (2000) study, both of them are insignificant. Hence, the research does not support the free cash flow theory, as the levels of excess cash that the company has before the announcement of dividend changes seem not to have an impact on the abnormal returns. These results are in line with Howe et al. (1992), who also found no approval for the importance of Jensen’s (1986) theory regarding abnormal returns around the announcement dates.

What is more, the results of this paper are consistent with the implications of the dividend signalling, as the coefficients for CHANGE and LOG(SIZE) were found to be significant when regressing cumulative abnormal returns for the dividend increase announcements. Hence, Hypothesis 3a and 5a are supported and an interpretation can be drawn that the greater the size of a firm and the percentage change in dividend per share, the larger are the abnormal returns around the dividend increase announcement.

Nevertheless, these two coefficients were found insignificant for CAR around the dividend decrease announcement, meaning that they do not determine the magnitude of abnormal performance around this event. Such a conclusion was also drawn by Deangelo et al. (1996) among others. Thus, Hypothesis 3b and 5b have to be rejected.

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23 Lastly, as coefficient accounting for dividend yield is significant for both regressions and its sign is in line with previous studies (Bajaj and Vijh, 1990) Hypothesis 4 is supported. Therefore, it can be said that this paper supports the clientele effect theory as stocks with higher yield experience higher excess returns after a declaration of dividend rise, and considerably more negative after announcements of dividend declines. This reaffirms conclusions drawn by Lonie et al. (1996), or Asquith and Mullins (1983) among others.

6.2 Limitations and Further Work

Even though this paper aims at showing the potential connection between excess cash and the size of the dividend announcement effect, it does not produce a definitive answer to the main research question. Nevertheless, it constitutes a possible basis for the outset of further studies regarding this matter.

Firstly, as stated by Lie (2000), the measurement of excess funds is prone to several causes of noises, as the reasons for companies to hold more cash can vary considerably due to different investment opportunities, bankruptcy costs, or industry competition. Hence, it might be beneficial in subsequent research to use a different measure of excess cash to identify if the coefficient for this regressor becomes significant. Moreover, in Lie’s (2000) paper the cross-sectional regressions disclose a significant relationship between investment opportunities and the abnormal performance, thus an interaction term of excess cash and Tobin Q ratio could be included to account for this effect.

What is more, further studies should include the information on earnings announcements when investigating the dividend announcement effect as both events often occur around a similar date (Asquith & Mullins, 1983; Aharony & Swary, 1980). Therefore, in order to ensure that the effect of a dividend announcement is separated from other declarations, no earnings announcement should occur throughout the 10-day event window. Lastly, even with this additional criterion, it is essential to have a large enough sample of dividend announcements to draw significant conclusions.

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24

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Firm’s Excess Cash and The Dividend Announcement Effect An Event Study Conducted on NYSE Listed Companies