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A great deal of literature exists to propose, explain, and reinforce or negate theoretical conceptualisations of the relationship between dividend announcement content and market reaction(s). This chapter is comprised of a review of that theoretical and empirical literature in a discussion of Dividend Signalling Theory, the Dividend Effect, and the Efficient Market Hypothesis.

2.1 Dividend Signalling Theory and Dividend Effect Literature

Several authorities have forwarded dividend signalling theory and have included discussions on the dividend effect, starting with the work of Asquith and Mullins (1972) and extending in the work of Gonedes (1978), John and Williams (1985), Lang and Litzenberger (1989), Dennis, Dennis, and Sarin (1994), and DeAngelo, DeAngelo and Skinner (1996).

Paul Asquith and David W. Mullins (1972) furthered the theory by way of studies not only on dividend impacts but on dividend initiation times and their effect on market prices. The authors examine and report on the phenomenon as it positively influences market prices, contributing positively to abnormal returns in the long run.

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Nicholas J. Gonedes (1978) breaks from the consensus on information content and the dividend effect and challenges the information content hypothesis with the evidenced suggestion that “Dividend-change announcements reflect information available to management, but not to investors in general” (1978, p. 26). According to Al-yahyaee, this goes counter to the traditional theory that “…annual dividend signals reflect information beyond that reflected in contemporaneous annual income signals” (2006, p. 120).

Kose John and Joseph Williams (1985), while working specifically with taxable dividends, also further dividend signalling theory by supporting the free cash flow hypothesis and in turn by identifying a “signalling equilibrium” (1985, p. 1053) in which “…corporate insiders with more valuable private information optimally distribute larger dividends and receive higher prices for their stock whenever the demand for cash by both their firm and its current stockholders exceeds its internal supply of cash (p. 1053).

Larry Lang and Robert Litzenberger (1989) put forth the theory regarding why companies pay dividends to begin with, suggesting that the overinvestment hypothesis provides the best explanation. While not of focus in this study, the overinvestment hypothesis proposes that companies pay dividends due to the financial rewards doing so brings to them through the market.

David J. Dennis, Diane K. Dennis, and Atulya Sarin (1994) also furthered dividend signalling theory as it supports conceptualisations of dividend announcement content (regarding dividend change as well as dividend yield) as it favourably influences excess returns; and the authors also evidence the influence of dividend change announcements on the revising processes of earnings forecast analysts.

And Harry DeAngelo, Linda DeAngelo and Douglas J. Skinner (2008) furthered dividend signalling theory by way of the free cash flow hypothesis, among others. They speak to the fundamentals of necessarily distributing free cash flow, and also elaborate not on the influence of dividend payouts or dividend payout announcements on the market but vice versa: the authors conclude that managerial signaling motives, clientele demands, tax deferral benefits, investors' behavioral heuristics, and investor sentiment have at best minor influences on payout policy, but that behavioral biases at the managerial level (e.g., over-confidence) and the idiosyncratic preferences of controlling stockholders plausibly have a first-order impact (2008, p. 95).

2.2 Past Dividend Signalling Theory and Dividend Effect Studies

A great deal of literature exists reporting on empirical studies aligned with dividend signalling theory and dividend effect.

Yoon and Stark sought to investigate the effects of dividend change announcements from the perspective of signalling theory in general and the free cash flow hypothesis in particular. Studying dividend increase and dividend decrease announcements from the New York Stock Exchange from 1969 to 1988, the researchers found that in the event period, at announcement time, new information specific to management investment policies is not disclosed. The researchers also found that there is a parallel between dividend changes (increases/decreases) and capital expenditure changes for a period of three years after the dividend change.

Benartzi, Michaely, and & Thaler conducted basic investigations into whether dividend announcements conveyed future or past information. Motivated by theories that hold that dividend change announcements convey information about the future, the researchers tested the theory by sampling all companies trading on the New York Stock Exchange using both a categorical analysis and a regression analysis. They concluded that future information content of dividend announcements was limited: more specifically, they note, they found no support for the assumption that dividends changes will provide information content regarding/to inform future earnings changes. Thus, the authors conclude, “While there is a strong past and concurrent link between earnings and dividend changes, the predictive value of changes in dividends seems minimal” (1997, p. 1031).

Aharony and Swary conducted a study at the New York Stock Exchange purposed toward discovering whether quarterly dividend changes convey additional information not conveyed by quarterly earnings numbers. Using the dividend expectation model and taking into consideration dividend announcement and quarterly earning announcement timing, the researchers find that “…stockholders of companies that did not change their dividends, earned, on average, only normal returns (as predicted from the market model); …stockholders of companies that announced dividend increases realized, on average, positive abnormal returns over the twenty days surrounding announcement dates; [and] …stockholders of companies that reduced their dividends sustained, on average, negative abnormal returns during the twenty days surrounding announcement dates” (1990, p. 6). The findings point to an affirmation of their hypothesis, the authors conclude, that “…changes in quarterly cash dividends provide useful information beyond that provided by corresponding quarterly earnings numbers” (p. 11).

Conroy, Eades, and Harris, in a location-specific study of Japan—“…where managers simultaneously announce the current year’s dividends and earnings as well as forecasts of next year’s dividends and earnings (2002, p. 1199)—studied the dividend effect as well as the earnings “surprises” they define as “…deviations from analysts’ forecasts” (p. 1199). Using X to investigate Japanese companies listed on one section of the Tokyo Stock Exchange (TSE), the researchers found that comparatively, while earnings surprises have a significant impact on market reactions, the information content of dividends have a minimal impact on share prices, findings the authors contend are consistent with Modigliani and Miller’s dividend irrelevance theory.

Koch and Shenoy revisit dividend signalling agency theory in conjunction with the free cash flow hypothesis, which they conclude implies overinvesting and underinvesting firms produce a stronger information effect than do value-maximising firms. Also proposing GFM (Geweke Feedback Measures) measurement strategy is more effective than the traditional F Wald statistic, the researchers examine free cash flow, leverage, and prediction values of both in relation to dividends and their information content. Consistent with the free cash flow hypothesis, they conclude that “…dividends and capital structure policies provide more predictive information for over- and underinvesting firms than for value-maximizing firms” (1999, p. 33).

And with a location-specific study focussed on dividend signalling theory in general (and the substitution hypothesis in particular), Latif, & Mohd investigate managerial motives for share repurchase in Malaysia by way of Tobit regression analysis. The researchers find that signaling hypothesis is supported: whereby of all of the listed companies on the Bursa Malaysia Main Market that repurchased shares from 1999 to April 2006, the majority do so “…partly to signal undervaluation and better operating performance” (2013, p. 99), but not to substitute dividend payments.

2.3 Efficient Market Hypothesis Literature

Several authorities have forwarded dividend signalling theory and have included discussions on the dividend effect, originating with Fama (1970) and developed further by Keim (1983), Reinganum (1983), and DeBondt and Thaler (1990).

The originator of the efficient market hypothesis, Eugene Fama put forth the assumption that markets are information-capable, or, information-efficient and that therefore, “at any given time and in a liquid market, security prices fully reflect all available information” (1970, p. 1575). Elaborating on the hypothesis in his 1970 article, Fama also introduces three models to guide studies with the expected returns model (aka, the fair game model), the random walk model, and the submartingale model. Yet, the author concludes, the market efficiency model is accompanied by ample evidence in support of it over the others. As Strom writes, offering critique of the same, the efficient market hypothesis has come to provide a valid and substantive way for financial research in general and for event studies in particular.

Donald B. Keim (1983) furthered the efficient market hypothesis in efforts toward identifying a tax effect characterised by the linkage of long-run dividend yield and stock returns and the finding that this linkage is not motivated by any ttax treatments of dividends and tax treatment of capital gains differences.

And DeBondt and Thaler (1990) furthered the efficient market hypothesis as they identified market overreaction anomalies: their premise begins with the assertion that investors tend to overreact to dividend announcements, which the authors propose in turn sends the market toward inflation. This suggests a cause-effect trend that in turn instigates a second cause-effect trend.

2.4 Past Efficient Market Hypothesis Studies

A great deal of literature exists reporting on empirical studies informed by the Efficient Market Hypothesis.

Studying location-specific cause-effect regarding dividend decisions and dividend announcement content in Jordan at the Amman Stock Exchange, Khalaf (2012) evidences support for the efficient market hypothesis and at the same time not only finds that dividend change/announcements do impact market prices but finds that several determinants and variables also account for impacts on share value. Using OLS, Tobit, and Heckman’s simultaneous estimation techniques, the researcher found that there is little effect of a firm’s ownership structure on corporate dividend decisions; there is moderate impact by growth, profitability, size, and leverage on some dividend decisions; and at the same time, there is no correlation between dividend, growth opportunities, and leverage of companies.

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Ambarish and Williams (1987) conducted studies investigating what goes into efficient signalling and arrived at conclusions that include that dividends positively impact market prices, but “By contrast, the announcement effect of new stock is negative for firms with private information primarily about assets in place and positive for firms with inside information mainly about opportunities to invest” (1987, p. 321).

And Kadioglu (2008) investigated whether dividend announcement content impacted cumulative abnormal returns around the time of the announcement date in the Turkish Capital Market. Using traditional event study methodology, the researcher found a negative association between cash dividends per share and abnormal returns after the announcement date. The author adds, “Even the cash dividends and other announcements are separated; the cash dividends have a significant effect on the share price individually. In the event study, only the announcement of cash dividends decrease results in a significant positive abnormal return in the event after the announcement day” (2008, p. 47)

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