Title: "Is it really the dividend announcement effect?" Subtitle: "An event study for the existence of the dividend announcement effect for companies listed on the DAX and the IBEX-

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Is it really the dividend announcement effect?

An event study for the existence of the dividend announcement effect for companies listed on

the DAX and the IBEX-35

Bachelor Thesis, June 2020

Author: G. Youssef Student Number: 11756020 Supervisor: Drs. P.V.Trietsch, M.Phil Economics and Business Economics: Finance track

ECs: 6

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This document is written by Student Gerges Youssef who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document are 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 paper examines the dividend announcement effect on stock markets in Spain and Germany. Spain and Germany were chosen because of the lack of research in this field regarding European countries. The size of the effect as well as results and patterns will be compared and discussed. The data used is the stock returns and the dividend declarations for firms listed on the DAX and the IBEX-35 in the period 2005 till 2015. The results showed a significant Cumulative Average Abnormal Return of 0.41% for the firms listed on the DAX in Germany and 0.37% for the firms listed on the IBEX-35 Spain which were both consistent with the signalling hypothesis.

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Chapter 1: Introduction

1.1 Motivation and background

A topic discussed in the field of research in finance is whether a dividend payment will increase the shareholder value. What is known and what most papers agree with (table 1) is that share returns tend to be positive at the time of dividend announcement (Gunasekarage & Power, 2006). What is noticeable, however, is the limited research conducted on corporate announcements in more than one country, which is pointed out by MacKinlay (1997). Studies conducted by Zhang (2002), McNally (1999), and Vermaelen (2005) are focused on how the declaration of dividends affects firm value in single countries or stock exchanges, which are all based on US firms.

This paper on the other hand studies whether there is a difference between Spain and

Germany in the announcement effect or not. This is significant to know because it could be that there are country specific unknown factors like economic freedom that influence the stock prices next to dividend announcements. The aim of this paper is, therefore, to compare the stock exchanges of Spain and Germany which would give some insights and (if present) show us the difference between the stock price reactions to dividend announcements in these two countries. To measure the effect of dividend announcements, these two security markets in Europe have been sampled and used for comparison regarding the announcement effect on share prices. The stock indices that represent the samples for Spain and Germany are IBEX-35 and DAX respectively.

1.2 Central Question

the following central question will be stated:

“Does the dividend announcement effect exist in Spain and Germany and are there differences between the countries?”.

1.3 Existing Literature

Research done by Gunasekarage and Power (2006) shows that share returns tend to be positive at the time of dividend announcement. Positive in the sense of making a profit out of the dividend announcement of a firm by holding it before the announcement until after the announcement. They also show that most of the share performance after the time of issuance was attributed to the earnings rather than to the announcement (Gunasekarage & Power, 2006). This main result of investor

behavior on share prices can be explained by theories regarding dividend announcements. The catering theory by Baker and Wurgler (2004), for example, explains the dividend announcement through the demand from investors. When demand for dividend-paying stocks increases, so do the dividend announcements and hence managers “cater” their investors some dividend.

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Moreover, John and Williams (1985) show that dividend announcements are “signals” of a firm’s current and future prosperity. These are the key articles summarizing the existing literature, more will be discussed in the literature review section of this paper.

1.4 Research Questions

the following research questions have been formulated to tackle the central research question: • Why do dividend announcements matter?

• What is the effect of dividend announcements on the stock prices of DAX and IBEX-35? • Are these results consistent with the signaling theory?

• How can we explain the observed market reaction of the DAX and the IBEX-35? • What is the effect of economic freedom on the dividend announcement effect between

countries?

1.5 Data

In this case, we need a sample to represent Spain and a sample to represent Germany. The IBEX-35 (Índice Bursátil Español) was selected for Spain as it consists of the top 35 companies of Spain’s biggest stock exchange, Bolsa de Madrid, in Madrid. For Germany, the DAX was chosen as it represents the top 30 companies listed on the Frankfurt stock exchange. The two stock exchanges contain companies from all types of industries linked in the bibliography of this paper. Furthermore, an event window of -5 days to +5 days encompassing the dividend announcement has been used to measure abnormal returns. Data of the dividend announcements and stock prices are retrieved from Wharton Research Data Services (WRDS). In specific, 229 dividend declaration dates for Germany and 321 dividend declaration dates for Spain.

1.6 Merging Data and Method

The paper makes use of an event study (to determine the size of the announcement effect) with a window size of 10 days. Regression analysis is used to determine the drivers and the size of the dividend announcement effect in the two countries. Moreover, a comparative approach will be achieved to compare the effect of the announcement on stock prices between companies listed on the DAX and the IBEX-35.

1.7 Structure

This paper starts with an overview of the existing literature in chapter 2. Chapter 3, the methodology, describes how the research has been conducted, namely the type of research, collection method, way of analyzing data, etc. Chapter 4 describes the empirical analysis of the data used along with the results of the study. Next, in chapter 5, the meaning and implications of the results will be discussed in relation to the research questions. Finally, chapter 6 gives a conclusion of the thesis.

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Chapter 2: A literature review

This thesis aims to find the dividend announcement effect of Spain and Germany and whether it is consistent with the investor behavior theories that already exist. That is, it will be compared with one of the theories discussed in this chapter, the dividend signaling theory. Initially, the importance of dividends will be discussed more in-depth. Secondly, variables that can determine stock returns and also measure these theories will be evaluated. After discussing the variables, some important terms regarding the dividend announcement will be explained to grasp the timeline in which dividend announcements are made. Subsequently, different views from previous research used and conclusions will be described with the help of a literature table that summarizes the key literature in this field of dividend announcement effects. The hypothesis will also be stated and this chapter ends with a conceptual framework.

2.1 Why Dividends Announcements Matter

This section will discuss different arguments of why dividend announcements matter wit the help of research already conducted in this study. After discussing the research, the arguments will be further elaborated upon.

Researchers like Asquith and Mullins explain that asymmetric information regarding the market reaction of dividend change on stock price is the dividend announcement effect. Their empirical study showed that stock price is adjusted to the unexpected change in the dividend payout policy. They explained that unexpected dividend changes will result in the same direction as a change in the stock price. Just like Asquith and Mullins, more researchers try to explain the effect of dividend announcements on the share price of a company.

A study conducted by Burkhardt and Whitfield (1991) showed that utility investors, who prefer dividends on their stock, also preferred consistent dividend and dividend growth. It seems that it is to the shareholder's preference to earn a return to their investments which is comprehensible. Michealy, Richard, and Kent (1995) have researched the effect of dividend omission and initiation using the firms listed on the NYSE and the AMEX for their study. They found out that there is a positive relationship between dividend initiations and the stock price. They also found a negative relationship with the dividend omissions. This means that firms with a dividend payout policy are perceived “better” by investors.

This higher perception of dividend-paying stocks has several reasons. One of them is the argument that dividends are an income stream to shareholders (Driver, Grosman, &

Scaramozzino, 2019). The higher the dividend yield, the more attractive the share is, this will be seen through the market reaction on announcement day. Another argument is that dividends are a way to provide an investor with information to assess the company’s prospects. Investors can value a

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all the future dividend income. This might also explain why investors tend to prefer a consistent dividend payout policy. In some cases, the shareholders even try to pressure firms into increasing dividends. They do this through threatening for takeovers, shareholder-oriented corporate governance, and selling the shares (Driver, Grosman, & Scaramozzino, 2019).

All in all, investors know that they will receive a dividend if they own the stock after the dividend announcement date. This means that the demand for stocks will go up and investors are willing to pay a premium for this dividend. According to Dyl and Weigand (1998), dividend announcements matter because the announcement conveys information to the public which changes their view on the firm. Whenever their view changes on the firm as a result of this new “information” the firm valuation will change and so does the stock price (Dyl & Weigand, 1998).

2.2 Investor Behaviour Theories

In the following section different theories that explain the dividend announcement effect are discussed. These theories are the dividend irrelevance theory, dividend signaling theory, catering theory, the efficient market hypothesis, and the agency theory.

2.2.1 Dividend Irrelevance Theory

Assume a world where dividends are irrelevant and where the dividend announcements do not matter. This is a world that Miller and Modigliani (1961) proposed in their dividend irrelevance theory. According to their paper, a firm will not be affected by the selection of its dividend policy in a perfect market. Let us put some emphasis on the Perfect capital market part of their model. A perfect capital market means that there are no corporate taxes, no issuance costs, and transaction costs. A market where firms are predictable in terms of its investment policy and where the value of a firm will not be affected by the choice of dividend policy. For this reason, a company must be indifferent in choosing a payout policy. Hence the model assumes that share repurchases and dividend payments are perfect substitutes.

However, a perfect capital market and a perfect world do not exist. The preference of an investor to a certain payout policy is influenced by the tax rules that concern their capital gains at that moment. When dividends are taxed higher than capital gains resulting from share repurchases, investors will mainly prefer a share repurchase scheme and the same goes for the other way around (Berk & DeMarzo, 2017). Nevertheless, Modigliani and Miller formed the basis of research in the capital market. This means that other researches have built upon their work.

2.2.2 Dividend Signalling Theory

As Miller and Rock (1985) noted, not all information is priced in the stock as there is information symmetry in the market. Managers, therefore, will announce dividends for the stock price to go up to its essential worth (Miller & Rock, 1985). That is, dividends are a way to inform

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shareholders about the future growth potential of a firm. Because there is a so-called ‘separation of ownership’ in a public corporation, there is also a separation of knowledge. Insiders (managers) know more than outsiders (shareholders) and this must be corrected through conveying this missing

information utilizing dividends (Bhattacharya , 1979).

Some research has already been conducted regarding the relationship between the signaling theory and the dividend announcements. Yoon and Starks (1995), for example, compared the signaling theory with the agency theory. They found out that capital expenditures increased after the dividend announcement within three years after the dividend payout. Another stud by Ngo and Verhoeven (2011) concluded that the firms that announce dividends observe a positive and significant cumulative abnormal return. Hence, stock prices increased as a result of dividend announcements in the market validating the signaling theory. Jensen (1986) saw that free cash flows were a big factor that caused an increase or decrease in stock prices after dividend announcements. According to Jensen’s study, the dividend would only be paid out whenever there is an excess of cash in a firm after the necessary investments for firm growth (Jensen, 1986).

2.2.3 Catering Theory

A modern theory developed by Baker and Wurgler (2004) stated that decisions of the board of directors will be based upon the driven demand of investors for the dividend payout. In other words, the investors decide whether to get payed out or not. When the demand for stocks that pay a dividend is high, so will be the number of dividend initiations to ‘cater’ the investors. However, when the demand is low, firms would rather not pay a dividend and use it elsewhere (Baker & Wurgler, 2004).

Baker and Wurgler (2004) are known for the bird-in-hand fallacy and the time-varying risk aversion concept. When an investor has a high risk aversion, the risky investments would be omitted which are mostly linked to dividend-paying stocks. This means that demand for riskless (non-paying) stocks will decrease the desire to have dividend initiations. They also emphasized an investor’s investment horizon. If an investor cares about the long-term of the firm's well-being and growth, he will be much more likely to give up dividend payments because he believes that there will be more profits in the longer term when the dividend proceeds go to reinvestment (Baker & Wurgler, 2004). In 2006, Li and Lie (2006) have gone deeper into the catering theory explaining the strength of the impact of an announcement to the market in case of high demand and case of low demand, saying that the impact will be bigger for dividend-paying stocks when its demand is high.

2.2.4 The Efficient Market Hypothesis

The efficient market hypothesis is explained by Fama (1970) and encompasses the stock reactions on an information announcement. He defined three kinds of market efficiency. The weak form of an efficient market, the semi-strong efficient market, and the strong-form efficient market

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hypothesis. The weak form hypothesis of an efficient market is about the question of whether historical information such as historical prices and historical balances to value a firm’s shares today. In other words, this form suggests that the current stock price reflects all past data on stock prices. This form, therefore, assumes that investors cannot make any more excess returns through technical analysis of patterns on historical data (Fama, 1970).

The semi-strong form hypothesis takes all public information into account and uses it for the calculation of the stock prices. This means that private information is still not priced in and an investor can make a profit out of this kind of information. Public information is information that is free information to the public such as financial statements, announcements, stock splits, etc. Finally, the strong-form hypothesis holds into account all public as well as private information. Share prices, therefore, reflect all public and private information, and no investor could make an excess return nor outperform the market as there is no asymmetry anymore.

2.2.5 Agency Cost theory

Just as the other theories discussed, the agency theory depicts the relationship between dividend policy and the change in the share price. According to Easterbrooks (1984), managers of a firm have different interests than the owners of the firm. Managers would use excess cash for their benefits. Shareholders would not want this as they do not gain anything from a manager’s gains. We are talking here about the typical separation property of a firm. Shareholders want to gain dividends while managers would prefer to buy luxurious goods from investor’s money. This money could have been invested in a positive net present value project and its proceeds could have gone to shareholders in the form of a dividend. These lost dividends or capital gains are often referred to as ‘agency costs’ (Easterbrook, 1984).

Easterbrooks (1984) provided a potential solution for this ‘problem’ which is to mitigate access to the company’s generated funds. This way, a manager can allocate fewer recourses to himself as there is less available. The way to do this is to generally pay dividends to shareholders. Relating this theory to the dividend announcement effect will bring to light the following relationship. When dividend pay-outs decrease, the access to funds increases and so does the agency cost of a company.

2.3 Measurements of Investor Behaviour Theories

This part will describe the determinants of a stock price, which are also used to measure the stock price in lieu of the different investor behavior theories. It closes off with a model that includes three of these factors. This section goes into depth in some variables, the abnormal return and

cumulative abnormal return, the firm size, the earnings volatility, the leverage ratio and the factors of Fama and French three-factor model. Next subchapter will discuss more variable used in previous research but with less depth.

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2.3.1 Abnormal Return and Cumulative Abnormal Returns

A common measure used in most event studies, therefore, is the abnormal return. It is defined as the actual ex-post return of stock minus the normal return of the firm, both over the event window (MacKinlay, 1997). The latter is defined as the expected return unconditioned on the event itself. Abnormal return is the dependent variable in this case as it directly relates to stock prices. In fact, it is calculated using the stock prices and will therefore be an important factor used in most studies which can be seen in table 1. This is because abnormal returns could help identify a firm’s skill on running a business. It renders the excess compensation that an investor receives from investing in a specific firm instead of in the benchmark (e.g. S&P 500). A potential disadvantage of using abnormal return to measure the dividend announcement effect is that the abnormal return can be caused by other factors rather than a dividend announcement, giving it less explanatory power (more on dividend announcements in the next section).

To represent all the stocks in the sample, the cumulative abnormal return is also often calculated. That is, the summation of the individual stock abnormal returns. Subsequently, to get more information out of the abnormal returns, the cumulative average abnormal return (CAAR). The cumulative abnormal return sums up negatives and positives. A disadvantage can be that outliers are taking the results more up or down if one does not remove them. Measuring the CAAR is conducted through using a small window of time (couple of days) because it appears that summing up the daily abnormal returns often creates bias in ones results (Cowan & Sergeant, 1997).

2.3.2 Firm Size

The firm size as defined by Viswanath et al. (2002), is the natural logarithm of the market capitalization. The market capitalization is used as a measurement of the size of a firm. The bigger the firm and the higher the reputation, the more dividends will be paid out and the higher a firms stock price will be (Viswanath, Kim, & Pandit, 2002). Other researchers like Mougoue and Rao (2003) have shown a converse relationship between firm size and the dividend payout ratio of a firm, implying that smaller firms pay out more than larger ones. This can be linked to the abnormal returns, because more dividend payout will mean a higher worth of a company’s stock, increasing the probability of a higher abnormal return (Healy & Palepu, 1988).

According to Dang (2013), firm size can be measured by total assets of a firm, total sales, or market capitalization. The proxy used, however, needs a theoretical and empirical justification because these different measurements will measure different firm size aspects. In fact, Dang (2013) has studied over 87 papers and finds out that none of them have a significant say on which measurement one should use for measuring firm size, the variable that might explain the change of empirical results partly. An advantage of using firm size is that it can be linked to profitability. Vijayakumar and Tamizhselvan (2010) have found in their study that there exist a positive relationship between firm size

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and profitability. Moreover, Lee (2009) used fixed effect panel data on 7000 US publicly-held firms and found the same results. The only difference was that Lee’s research showed that the relationship was non-linear, meaning that the firm size change for larger firms has a weaker effect on profitability than on small firms. This brings the disadvantage of using the firm’s size into light, it is less effective for the measuring of firms that have more or less similar sizes.

2.3.3 Leverage Ratio

Leverage is a financial ratio that measures whether a firm can meet its financial

obligations or not (Berk & DeMarzo, 2017). The leverage ratio can take shape in the form of the debt ratio, debt-to-equity ratio and the interest coverage ratio. Leverage ratios are an important measure for abnormal returns because companies rely on a capital structure with each equity and debt to finance a company’s operations. Knowing the quantities of debt, one could have useful information in

evaluating the ability of a company to pay back debt when due (Berk & DeMarzo, 2017). The debt ratio, for example, explains what percentage of total assets is due in loans. A higher ratio would mean that more obligations must be held into account. Moreover, the interest payed for the debt will also be high and might even increase the company’s probability of default. This all will reduce earnings which could potentially be paid out to shareholders and which could have had any chances of realizing abnormal return.

The leverage ratio is a simply calculated method to quickly assess a company’s leverage and whether a company will most likely default or not. It also gives an oversight of a company’s leverage they can hold and whether it is feasible and smart to increase leverage. A disadvantage of this measure, however, is that there could be firms still paying out dividends even though they have a high leverage ratio. Including such companies in a sample can bias the results, which means that this ratio would not have much explanatory power in this case. Another disadvantage is that the measure is not significantly comparable or comprehensive enough. This is because banks use different

accounting standards. For example, US GAAP rules are less restrictive than IFRS rules which means that companies in countries that use IFRS are not comparable to companies in US that use US GAAP (Lautenschläger, 2013).

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2.3.4 Earnings Volatility

A current study of Rubin and Smith (2009) used the standard deviation of the stock earnings as a measure. They researched firms that tend to distribute income when their net earnings are more volatile. Their reasoning is based on their observations, concluding that firms with low volatility of cash flows are consistently paid out relative to firms with high volatility. Earnings volatility determines the risk of changing income of a company. It helps predict a particular stock’s market price on a certain point in time and monitors the net earnings of companies periodically to determine whether earnings of a company’s stock are stable or not.

Stock performance relies on earnings and inconsistent earnings will subsequently imply a higher risk of holding a specific stock. This can potentially be linked to the abnormal return variable. Whenever a stock’s earnings are unsure and the earnings volatility is high, the abnormal return cannot be easily predicted as with a low earnings volatility. A disadvantage of this method is seasonality. It could be that firms have a negative stock price reaction resulting from seasonality. As a result, the stock earnings will be less in some seasons and will have little movement until ‘good news’. Another disadvantage could be a sudden change in stock prices of a particular sector such as oil. This sudden drop impacts the computation of earnings volatility and will change the results, misleading a

shareholder that looks at this variable (Corporate Finance Institute, 2020).

2.3.5 Three-Factor Model

A controversial model used for event studies is the three-factor model of Fama and French (1993). This model has Sharpe’s market model (1964) as a basis and adds a couple of more risk factors to the formula. Sharpe’s asset pricing model predicts stock returns only on the past sensitivity of individual stock returns to market excess returns. It hence has only one risk factor. Fama and French’s three-factor model expands on Sharpe’s model with two more risk factors, namely Firm size (SMB), and book-to-market ratio (HML).

The SMB of Fama and French (1993) can be defined as the return on a portfolio of small stocks minus the return on a portfolio that consists of large stocks, it means small minus big (SMB) in terms of sizes. SMB shows that small companies tend to outperform large companies. Small firms tend to be bad at attracting funds to stay on their feet and will, therefore, be riskier to invest in (Fama & French, 1993).

Furthermore, the HML factor explains that High book-to-market ratio firms show a high-risk level but have a larger value. That is, value stocks tend to outperform growth stocks. The three-factor model could explain 95 percent of the 5 percent rise in a single portfolio instead of 70 percent explained by the CAPM model. This is because the three-factor model accounts for company size and value and adjusts for the outperformance tendency (Fama & French, 1993).

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2.4 Measuring the Dividend Announcement Effect

In this section the dividend announcement as a whole will be discussed, its variables used in previous research, and the conclusions of the researchers in this field.

2.4.1 Dividend Announcements

Dividend announcements are announcements made to the public to declare the payment of dividends, may it be cash or stock dividends. There are a few terms that need to be discussed

regarding dividend announcements. Before the distribution of dividends, the firm is legally obliged to make an official statement that they will be paying out dividends on a certain date. This date is called the declaration date, the date at which the dividend payout will be announced by the board of directors of a company and which will be referred to as announcement day. Shareholders, however, will not receive the dividend directly at the declaration date. There will always be some period, depending on the company, that passes after the declaration date before the dividend gets paid. This means that shareholders will be able to purchase or sell their stock holdings in the company. Demand for the stocks will, therefore, increase as shareholders would want to have the stock dividend (Berk & DeMarzo, 2017).

Time, however, is limited for investors because they must be listed on the shareholder’s register of a company before a certain date to be entitled to dividend. We call this the record date which again depends on the company. If one wants to redeem the dividend of a stock, he must purchase the stock before the Ex-Dividend date for him to be listed in the company’s record list of shareholders (Berk & DeMarzo, 2017).

2.4.2 Results of Previous research

There are several studies regarding the relationship between dividend announcements and share prices. Most studies out there make use of an event study that measures the firm value impact from a specific event. According to Mackinlay (1997), an event study is useful because it

encompasses the fact that the firm stock price reflects the effect of an event directly. This way of measurement is relatively more time-efficient as it only reviews a small period rather than years of observation (MacKinlay, 1997). The substantial study results of researchers studying the same topic have been presented in table 1.

Table 1: Previous conducted event studies

Author(s) Title Variables Which

firms?

Conclusion (based on CAR)

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Healy & Palepu (1988) Earnings Information Conveyed by Dividend Initiations and Omissions • Stock Price • Dividend initiations • Dividend omissions • Size of the company • Analysts following the

company trade • Number of institutional investors in company’s equity • % equity held by institutional investors NYSE & AMEX

Dividend paying stocks exhibit positive abnormal returns while non-dividend paying stocks show negative announcement effect

Special result: 2nd_{day following} announcement stock return abnormally high

Jin (2000) On the differential market reaction to dividend initiations • Firm size • Earnings volatility • Institutional holdings • Board Ownership • Tobin’s Q ratio • Dividend Yield • Pre-CAR • Earnings Change • Cumulative abnormal return (CAR) • Stock prices • Dividend announcements NYSE & AMEX firms

Companies have negative CAR if dividend announcement benefit is small and positive CAR if the announcement benefit is relatively higher.

Lonie et all. (1996) The stock market reaction to dividend announcements • Stock prices • Dividend announcements • Abnormal return Londen stock exchange Positive dividend announcement leads to immediate share price increase and negative announcement leads to a decrease in stock price. Neutral dividend announcement usually results a significant

positive abnormal return Dehghani & Chun

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The impact of the special dividend announcement on the stock return: the case of Malaysia • Average Abnormal Return • Cumulative abnormal return • Stock prices • Dividend announcements Malaysian stock exchange

Stock returns react positively after dividend announcement.

Owira (2016) The effect of dividend announcements on stock returns of companies listed at the Nairobi Stock Exchange

• Cumulative abnormal return • Abnormal return • Stock prices • Dividend announcements Nairobi Securities exchange

Dividend announcements have no significant effect over stock returns.

Owira’s remark: Dividend information should be made more transparent to avoid agency costs

Table 1 shows research conducted in different continent about the same topic, the dividend announcement effect. In the US, one can generally conclude that Dividend paying stocks exhibit positive abnormal returns while non-dividend paying stocks show a negative announcement effect. In other parts of the world, however, like in Kenia, stock returns are not significantly affected by dividend announcements. Researchers in this field is hence find evidence that support two opposite sides of the dividend announcement effect. One side that believes that a dividend announcement will have significant influence, and the other side that believes that dividend announcements do not have

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any significant explanatory value in the change in stock price. Most of the research in table 1, however, supports the first.

Owira has a different conclusion than the rest of the researchers mentioned in the table. One can see that he used CAR, AR, stock prices and dividend announcements as variables in his research, while other researchers used more variables. He also relates his research to the agency cost theory discussed earlier in this chapter. His remark was that Dividend information should be made more transparent to avoid agency costs. He implies that the little transparency that Kenian companies have can explain his conclusion of no dividend announcement effect (Owira, 2016).

It was deemed interesting to research two other countries not mentioned in the table, Germany and Spain to see which side the two samples will support. It was also interesting to use only the variables used by Owira to see whether the conclusion will be the same as his or more similar to the majority. Table 1 has most papers concluding that there is a significant announcement effect. This paper, therefore, expects that Germany and Spain will have the same conclusion as the majority of table 1. Because they are both within one continent, sharing the same economy in Europe, the expectation will also be that the effect will not differ significantly from one country to the other.

2.5 Hypotheses

The reasoning for the hypotheses is mainly influenced by the world index of economic freedom (Foundation, 2020).

Table 2: World index of economic freedom for Spain and Germany (Foundation, 2020)

As can be seen in table 2, the two countries have similar indexes which indicate that the two countries are comparable. This comparability is needed to reduce outside influences not included in this

research model. The world index takes the following key aspects of a free economy into account: ➢ Property rights ➢ Judicial effectiveness

➢ Government integrity ➢ Tax burden

➢ Government spending ➢ Fiscal health business freedom

➢ Labor freedom ➢ Monetary freedom

➢ Monetary freedom ➢ Trade freedom

➢ Investment freedom ➢ Financial freedom

Keeping these factors into account, the world index is regarded as a reliable source next to the literature and the general theories explained in the last section. Moreover, having discussed the different studies in this field, one could see that most researchers are not denying that there is an effect on share prices resulting from dividend announcements. The general conclusion of these studies is its

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positive effect. On average, the dividend announcements result in a positive effect on share prices. The goal of this paper is to render evidence for the effect in two European countries, namely Spain and Germany.

The similarity in the index of economic freedom together with already discussed literature brings the following two hypotheses in the spotlight:

Hypothesis 1: Dividend announcements will have a positive effect on firm value

Hypothesis 2: The dividend announcement effect will not differ between Germany and Spain

2.6 Conceptual Framework

The conceptual framework will outline the hard-core regarding factors, variables and relationships. Dividends are paid out of earnings of a company and can take shape in the form of stock or cash dividend (Berk & DeMarzo, 2017). According to Laabs (2013), the market reaction after a dividend announcement is mostly positive, meaning that investors’ views change positively when new information enters the stock market (dividend announcements).

Just like the other studies

previously discussed, this paper will make use of the event window and estimation window

rendered below.

Estimation Window Event Window

-120 -5 0 +5

The estimation window of 120 days before the announcement until 5 days before is used to estimate the average stock price, so what is normal. The event window on the other hand, will be used to observe any deviations from this average stock price 5 days before and 5 days after the announcement of dividend payments.

Earlier discussed are some variables researched by others that seem to be affecting the stock prices around the event window as well. Previously discussed variables can be found in table 1 and in section 2.3.

Independent Variables Dependent Variables Dividend Declaration Date Daily Stock Price Firm Size Dividend Announcements Earnings Volatility Leverage Ratio Stock Price Abnormal Return

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This paper will not use all the independent variables, however, it will only use the ones deemed most important, pictured below. The daily stock prices will be determined by the dividend declaration date and compared within the event window to find a relationship between the two variables, just like in previous research such like that of Owira (2016).

Chapter 3: Methodology

This chapter is about the methodology of the research. In the first section, the data and sample will be discussed. Secondly, the overall research approach will be explained for replicability. The chapter closes with a description of the analytical model that will be used.

Event studies are one of the methods and contribute significantly to the literature regarding the impact of corporate announcements. That is why, in this case, an event study would be a proper fit to assess whether corporate announcements such as dividend announcements, create abnormal stock returns. The event that interests this paper is the announcement day of the dividend policy change of a company. On this day, market prices will change as a result of the release of this ‘new’ information. An event study can only be conducted when the market did not expect this change.

3.1 Sample and Data collection

The objective of the event study is to see if the information release (dividend announcement) will provide coherent information to the market. In this case, there should be a relationship between the observed change of the market value of a company and the information that is released before this change in value. This paper will use the information of the 35 listed companies listed on the IBEX-35 and the 30 companies listed on the DAX who had dividend announcements between 2005 and 2015. The 10-year period deemed sufficient enough to research potential relationships of stock prices and dividend announcements. This relationship will be researched through an explanatory research approach.

The dividend announcements link to the daily stock prices on the exchange. Germany consists of a sample of 30 firms which includes a sample of 229 dividend announcements in total and Spain consists of a sample of 35 firms consisting of 321 dividend announcements. The data used was secondary data collected from CRSP daily stock through the Wharton Research Database (WRDS). The data consists of the announcement date, also called ‘the declaration date’, and the daily average stock prices of the firms listed on DAX and IBEX-35 for Germany and Spain respectively. Table 2 shows summary statistics.

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Announcements

Companies

Period

Spain

321

35 2005-2015

Germany

229

30 2005-2015

Table 2: Announcements

3.2 Overall Research Approach (design)

The literature discussed in the previous chapter shows that shareholders prefer and expect a consistent dividend payout. A common measure used in most event studies is, therefore, the abnormal return. It is defined as the actual ex-post return of stock minus the normal return of the firm, both over the event window (MacKinlay, 1997). The latter is defined as the expected return unconditioned on the event itself. This paper examines the abnormal returns surrounding the dividend announcement with the assumption that stock returns are predictable which is mostly not the case in real life.

After defining the abnormal return, one needs to know how to calculate the normal return of a given stock. There are several ways to do that. According to Mackinlay (1997), a market model is one of the common ways to conduct an event study. This model checks for the actual returns of a reference market and tracks its correlation with the individual firm. The market model describes the impact on a company after dividend announcements as the difference between the stock’s return on announcement day and average return. The normal return can be measured in two common ways. One way is using the constant mean return model which has the 𝑋𝑡 variable as a constant. This model

assumes that the mean return of a security is constant over time. The other alternative is using the market model in which 𝑋𝑡 is the market return. This model assumes a linear relationship between security and

market return and can also be transformed into the multifactor market model which holds more risk factors into account.

3.3 Data Analysis & Analytical Model

In this paper, the market model will be made use of, a one-factor model. Other multifactor models could also have been used such as the three-factor model of Fama and French (1993). This model has Sharpe’s market model (1964) as a basis and adds a couple of more risk factors to the formula. Sharpe’s asset pricing model predicts stock returns only on the past sensitivity of individual stock returns to market excess returns. It hence has only one risk factor. Fama and French’s three-factor model expands on Sharpe’s model with two more risk factors, namely Firm size, and book-to-market ratio. However, an important thing to note is that multifactor models do not add much significant explanatory value in the case of an event study, which is why the paper prefers the one-factor model (MacKinlay, 1997). The event window used in this paper is 5 days before the dividend announcement until 5 days

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after (-5, 5), which is a proper event window according to MacKinlay (1997). He also states that a proper estimation window for an event is 120 days before it (MacKinlay, 1997). That is why the estimation window will be 125 days before the announcement to 5 days before the announcements. The market model is defined in the following way:

𝑅𝑖𝑡 = 𝑎𝑖+ 𝛽1(𝑅𝑚𝑡− 𝑟𝑓𝑡)

Where:

𝑅

𝑖𝑡 = Return of company i on day t

𝑟

_𝑓𝑡 = The Risk-free rate

α = Alpha (Portfolio actual return – benchmark actual return)

𝛽

_𝑖 = Coefficients determined by OLS regression 𝑅𝑖𝑡 − 𝑟𝑓𝑡 = The excess market return

The random error term will be expected to be 0 with a variance 𝜎𝜀2.

To represent all the stocks in the sample, the cumulative abnormal return must be calculated. That is, the summation of the individual stock abnormal returns. Subsequently, to get more information out of the abnormal returns, the cumulative average abnormal return (CAAR) between -5 and +5 days circumventing the announcement day must be calculated using the 𝐶𝐴𝑅𝑖 to obtain the effect of the

dividend announcements.

Having the variables AAR and CAAR, a t-test has to be conducted in order to find a shift in the stock price after announcements and whether this is significant or not. It will be conducted with:

Null Hypothesis: E(CAAR) = 0 Alternative Hypothesis: E(CAAR) ≠ 0

Test statistic

𝑡 = 𝐶𝐴𝐴𝑅𝑖,(𝑡1,𝑡2)

√𝑣𝑎𝑟(𝐶𝐴𝐴𝑅𝑖,(𝑡1,𝑡2))

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Chapter 4: Results (Empirical data analysis)

In this section, the empirical findings obtained from the processing of the data discussed in chapter 3 will be presented and discussed. The dividend announcement effect on stock returns for firms listed on the DAX and IBEX-35 will be further described and linked to the dividend signaling effect. The event study methodology was used and deemed appropriate for the assessment for the dividend announcement effect. Microsoft Excel and Stata 16 were used for analyzing data.

4.1 Reaction on Spanish and German stocks

The question of whether the reaction of Spanish stocks on dividend announcement will differ from German stocks or not will be discussed in this section. Table 1 will be used to describe the difference between the two samples and Figure 1 will be used to describe the pattern and the results coming from the two samples.

This paper evaluated daily stock returns for the DAX and IBEX-35 who declared

dividends for the event window of 11 days consisting of 5 days before the event and 5 days after. The data between 2005 and 2015 was used for this analysis. The abnormal returns were computed by subtracting expected return, taking the average of returns in the estimation window of 125 days before the event, from the daily actual return including the dividends. To render a pattern, the cumulative abnormal returns for each company were calculated through adding the abnormal returns of each day in the event window which include the pre-event window of -5 days and the post-event window of +5 days. The following two graphs depict the cumulative average abnormal returns for Spain and

Germany. The dividend announcements were announcements of a change in dividend policy in a firm, including both increases and decreases of dividend payout.

Event Day CAAR Spain (IBEX-35) CAAR Germany (DAX) Difference of CAAR

-5 0.00307716 0.000221525 0.003298685 -4 0.016939654 -0.00447295 0.012466704 -3 0.026623147 0.002433575 0.029056722 -2 0.025662974 0.0047301 0.030393074 -1 0.032581801 0.014471625 0.047053426 0 0.040940961 0.01929415 0.060235111 1 0.038884121 0.020503675 0.059387796 2 0.030692281 0.0213932 0.052085481 3 0.051639441 0.019495725 0.071135166 4 0.043769601 0.01231425 0.056083851

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5 0.043970761 0.017809775 0.061780536 Table 3: CAAR for Spain and Germany samples

In table 3, one can see that there is a difference in every event day between the CAAR of

Germany and the CAAR of Spain. Hypothesis 2 stated an expectation that there will be a difference between Germany and Spain. In table 3 the hypothesis looks like it does not hold as the differences are expected to be significant but the table says otherwise. In the next section, evidence will be given and will show whether there is a significant difference or not for the second hypothesis. The table also shows an increase in the difference from day -1 to day 0 and a decrease from 0 to +1.

Figure 1: The CAAR based on the DAX listed companies

Starting with Spain, one could see that the returns show little movements in the pre-event window as it is exhibiting a mainly positive effect. The returns increase until the event day and decrease thereafter immediately, however, increasing again 2 days after the announcement. The graph shows a trend, almost all the returns on the IBEX stocks are increasing before the announcement and decreasing the first 2 days after the announcement. Nevertheless, it does increase again from day 2 onwards which implies that the effect was delayed with 2 days but overall the stock return and price increased after the announcement. Further research could be done in this area of 0 to +2 days and will tell us more. For Germany, one can see a consistent increase with small changes from day -4 today +2. It thereafter decreases again till day +4 in which it increases again after day 4. There could also be seen that the stock returns already showed an increasing pattern before the event that could imply a leakage of information. More will be discussed in the next section.

-0,01 0 0,01 0,02 0,03 0,04 0,05 0,06 -5 -4 -3 -2 -1 0 1 2 3 4 5 CA AR % Event Day

Share Price Reaction

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4.2 Data Analysis

In this part, a further elaboration on the CAR used in both samples will be discussed. Different event windows will be rendered as well as a discussion on the significance of the results. This section will close off with a comparison of the results.

4.2.1 Computation of the CAR

First, robustness needs to be discussed as it is used in most of studies. Robust statistic, which is what is aimed for in this paper, are statistics that yield representable results, and which are resistant to errors in the result. This paper, therefore, uses multiple event windows to check for robustness. The main event window of -5 and +5 is used for explanation and description, however, other windows should have the same results. The statistics for different event windows are presented in the tables below.

Index CAAR Standard Error P-value Event window

DAX 0.003625 0.013008 ***0.0000276495 [-10; +10] IBEX-35 0.003596 0.011005 ***0.000024842253 [-10; +10] DAX 0.004175015 0.000698822 ***0.000208976 [-5; +5] IBEX-35 0.003665433 0.000674744 ***0.000415108 [-5; +5] DAX 0.002816 0.008906 *0.0675998 [-2; +2] IBEX 0.001839 0.006476 **0.0435308 [-2; +2]

Table 3: *, **, *** Significantly different from zero on a 10%, 5%, or 1% level respectively

The cumulative average abnormal returns are computed by summing up the abnormal

returns and subsequently take the average for every event day. Table 3 renders the significance of the CAAR for different event windows. In bold, the statistics that are used for the figure 1 which are the statistics that lead this research. The rest of the statistics are used for robustness of the study. One could see that the the 5 days event window has the lowest CAAR, which also the one less significant than the other windows. For both the IBEX-35 and DAX, the highest CAAR has an event window of [-5, +5] assigned to it. This CAAR, however, does not differ much from the other windows and is, therefore, deemed a proper event window for this study.

4.2.2 Significance & Comparison

In this section, the dividend signaling theory will be used for comparison. The signaling hypothesis states that dividends are a way to inform shareholders about the future growth potential of a firm. The theory cannot be fully substantiated by the results of this graph for Spain. A possible explanation could be the investor pressure on firms discussed in chapter 2 which states that investors prefer dividend-paying stocks over non paying stocks. The pressure could result in a firm paying out dividends even though it is better for the firm not to. It might be that there are positive NPV projects in which the firm is not able to invest in because of the tendency to pay out dividends (Driver,

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Grosman, & Scaramozzino, 2019). DAX firms, on the other hand, are consistent with the dividend signaling hypothesis.

Looking at Germany, the dividend signaling hypothesis also has an explanation for the trend. Share dividend announcements have sent a signal to the stock market that the price is undervalued. In this case, one then assumes that a dividend-paying firm does well and the market then has an

opportunity to respond to this information and subsequently bring up the share price to the true value. There could also be seen that the stock returns already showed an increasing pattern before the event that could imply a leakage of information. It could be that insiders already knew and acted upon the illegal information. Further research can be done in this area of insider trading in Germany.

Table 3 renders the significance of CAAR’s of the two countries. The computations show positive CAAR’s in both cases. For the DAX listed stocks, there is a positive CAAR of 0.42% over the event window [-5; +5] which is significant on a 1% level. In the case of the IBEX-35, CAAR is also positive with 0.37% and also shows a significant level of 1%. These statistics are consistent with the signaling hypothesis, it shows that on average, there is an abnormal return on the day of a

dividend announcement.

DAX IBEX-35 Difference P-value

0.42% 0.37% 0.05% ***0.000571

Table 4: *, **, *** Significantly different from zero on a 10%, 5%, or 1% level respectively

Looking at the size of the effect we see that Germany has a higher CAAR than listed companies in Spain. To show whether it is a significant change or not, a t-test has been conducted on the difference between the two CAR’s. This test gave a p-value of 0.000571 which means that the difference is significant on a 1% level.

Furthermore, though both being positive, the size of the effect in Germany is bigger with 0.000024078 relative to Spain. This could have multiple reasons. One of them is because of the economy of Germany is ‘freer’ than Spain’s economy as shown in table 2. The Spanish economy has rated to be moderately free, however, there are some obstacles. They are the lack of labor freedom and the abundance of government spending. The socialist government in Spain has been spending a lot making their intervention costly for economic freedom (Foundation, 2020).

4.2.3 Hypotheses and Results

The results should help now to confirm (or not) the hypotheses stated in chapter 2. This section discusses the hypotheses in lieu with the results and summarizes them in table 5.

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The first hypothesis stated that the dividend announcement will have a significant effect on firm value for both countries. The results do support the hypotheses as the p-values were significant on a 1%-level as shown in table 3.

Hypotheses Result

Hypothesis 1: Dividend announcements will have a positive effect on firm value Supported Hypothesis 2: The dividend announcement effect will not differ between

Germany and Spain

Not Supported

Table 5: Hypotheses conclusion

Hypothesis 1 is hence supported as there is enough statistical evidence to conclude that there is a positive effect on firm value in both countries which are represented by the IBEX-35 for Spain and DAX for Germany. The second hypothesis, however, is not supported by the results as there is a significant difference shown in table 4 between the two dividend announcement effects.

Chapter 5: Conclusion and Discussion

Approaching the final chapter of this paper, the conclusion and discussion will be summarized. In 5.2 the limitations and suggestions for future research will be argued which are based on the findings of this paper.

5.1 Conclusion and Discussion

This paper aimed to research the effect of dividend announcements on Spanish firms listed on the IBEX-35 and German firms listed on the DAX. The paper has discussed different investor perspectives to dividend announcements which were also discussed and compared to other researchers in the field. This also showed the importance of dividends to investors. The paper showed that the Spanish and German stock market responded positively to dividend announcements and made them in lieu of the dividend signaling theory. The Cumulative abnormal returns were deemed significant on a 1% level. For this reason, the first two hypotheses are in line with the results. The third hypothesis regarding the size of the effect has been explained in the results chapter and showed that the effect in Germany was higher than the effect in Spain.

The fact that many studies examined a link between the declaration date and the

fluctuation in a firm’s share price in big countries like the US does not mean that their results are valid for other countries like Spain and Germany. That is why this study was conducted, to generalize the results in this field to European countries. It looks like the effect however is higher in a country that has a higher world index of economic freedom, Germany in this case.

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5.2 Limitations and Further Research Suggestions

This research assumed that dividend reactions will be the same in different states of the economy. Having this in mind, the findings are similar to recent studies in this field, however, some limitations should be noted.

The period of 2005 till 2015 has financial crises in it. It could mean that this factor affected the reaction to be lower or higher overall. Furthermore, only the top companies in Germany and Spain were used. That is, the IBEX-35 and the DAX represent only the public companies that are performing well. There might be different results if different companies were used. Moreover, one should be careful with choosing an event window. Multiple things should be considered when the analysis includes more than one country such as country-specific unaccounted events.

Another limitation is the sample size. Sample size helps making statistical inferences about the population, in this case Spain stock market and German stock market reactions. In this research, only 35 companies were sampled from the IBEX-35 and 30 companies for DAX. If the samples were bigger, one could have had other results and more representability for the two countries’ stock markets.

Moreover, other factors could have had an impact in explaining stock returns for firms listed at the DAX and IBEX-35 meaning that dividend announcements are not fully explaining the share price changes. The way the data was analysed have limited the thorough analysis of results as only one variable (CAAR) was used for the analysis. More significant variables could have changed the results and conclusions. An exaggeration of ‘significant’ should be stated as insignificant variables only bias results and they do not add much significant explanatory value in the case of an event study (MacKinlay, 1997).

Nevertheless, the limitations of the study have made clear in which areas further research could be conducted. For instance, there should be more research conducted in the field of Spain and Germany but with bigger samples. The question as to why the second hypothesis of this paper ‘The dividend announcement effect will not differ between Germany and Spain’ does not hold can be further elaborated and researched upon. There could also be stated that the stock returns in both countries already showed an increasing pattern before the event that could imply a leakage of information. Further research can be done in this area of insider trading in Germany and Spain because this might have explanatory power in explaining the dividend announcement effect. Finally, future research can be based on re-assessing the theory and framework of this paper to find out new effects of specific events such as financial crises on the dividend announcement effect. An interesting topic would be the current COVID-19 pandemic that is currently going on. How will this affect market? More specifically, how will the ongoing pandemic that, according to Google

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Statistics (2020), killed over tens of thousands of people worldwide affect the stock market reaction on a dividend announcement?

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