Shareholder wealth, information signaling and the specially designated dividend

Journal of Financial Economics 12 (1983) 187-209. North-Holland

SHAREHOLDER WEALTH, INFORMATION SIGNALING AND THE SPECIALLY DESIGNATED DIVIDEND

An Empirical Study* James A. B R I C K L E Y University of Utah, Salt Lake City, UT 84112, USA

Received June 1982, final version received October 1982 This paper examines common stock returns and dividend and earnings patterns surrounding specially designated dividends labeled by management as 'extra', ~special' or 'year-end' and compares them to those surrounding regular (unlabeled) dividend increases. The results support the notion that management uses the labeling of dividend increases to convey information to the market about the future potential of the firm. Unlabeled increases appear to contain the most positive information. Contrary to the sometimes suggested view, specially designated dividends appear to convey positive information about future dividends and earnings beyond that relating to the current period.

1. Introduction A m a j o r area of controversy a n d interest is the effect of dividend policy on shareholder wealth. While empirical studies generally have supported the hypothesis that dividend changes convey i n f o r m a t i o n to the market a n d affect c o m m o n stock prices, our u n d e r t a n d i n g of dividends as ' i n f o r m a t i o n signaling devices' is limited. Theoretical models for dividend signaling are still in the pioneering stage a n d empirical studies essentially have d o c u m e n t e d only that the market appears to react favorably to dividend increases and negatively to decreases.1 This study examines c o m m o n stock returns a n d dividend a n d earnings patterns s u r r o u n d i n g 'specially designated dividends' (SDDs) labeled by *This paper is based on my Ph.D. dissertation at the University of Oregon. I would like to thank George Racette, my Chairman, and other members of my committee, Larry Dann, Michael Hopewell and Alden Toevs for their support and encouragement. Also, I would like to thank Sanjai Bhagat, Ken Eades, John McConnell, Wayne Mikkelson, Chris Muscarella, Michael Pinegar, James Schallheim, Samuel Stewart and especially Ronald Lease for numerous helpful comments. I have also benefited from the suggestions of Ross Watts, the referee for this journal. All remaining errors are mine. ~Theoretical works on dividend signaling include Bhattacharya (1979, 1980), Eades (19821, Hakansson (1982), and Kalay (1980). Empirical studies include Aharony and Swary (1980), Asquith and Mullins (1982), Charest (1978), Eades (1982), Gonedes (1978), Kalay (1980), Laub (1976), Penman (1980), Pettit (1972, 19761and Watts (1973, 1976). 0304~05x/83/$3.00 © 1983, Elsevier Science Publishers B.V. (North-Holland)

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management as either 'extra', 'special' or "year-end' and compares them to those surrounding regular (unlabeled) dividend increases~ The study is important for at least three reasons. First, the paper improves our understanding of the motivations for dividend changes and the role of these changes as information signaling devices. Second, the paper provides insights into the role of SDDs in corporate finance. Third, the study has broader implications relating to the general topic of financial signaling. There is a growing number of empirical studies which suggest that certain financial decisions may be interpreted by the market as signals about the firm's prospects. 2 While these studies are consistent with an information signaling hypothesis, no direct evidence exists that management consciously uses financial decisions for signaling the firm's outlook, Regular dividend increases and SDDs are both dividend decisions which represent cash disbursements to shareholders with identical tax consequences. Thus regular dividend increases and SDDs provide an opportunity to compare two financial events which differ ostensibly only in the label chosen by management. Any difference in the market reaction to the labeling of a dividend increase presumably is attributable to a difference in the signal or 'message' conveyed by management through the label. Evidence of such a differential market reaction would support the notion that management consciously is aware of the signaling implications of financial decisions (at least for dividend increases). 3 2. Overview of the study and preview of the results Each year there are about 2,000 to 4,000 increases in the quarterly dividend by U.S. firms. 4 Approximately 1,000 of these increases each year are given special labels by management. The most frequent label is the word 'extra' (used about 80~,, of the time). 5 The second most frequent designation is 'special' (about 14~Yo). Occasionally management will label the increase 'year-end' (about 6Vo). In this study all three labels are grouped into the general category of "specially designated dividends'. Some firms such as Dupont, Eastman Kodak and Sears Roebuck declare SDDs in the same quarter almost every year. Other firms declare SDDs on a much less frequent basis, if at all. For example, American Can declared only one SDD in the 15 years from 1966 through 1980. Presumably management's ZRelevant studies include Aharony and Swary (1980), Asquith and Mullins (1982), Dann (1981), Masulis (19801, McConnell and Schlarbaum (1981), Pettit (1972,1976) and Vermaelen (1981). 3A question which immediately arises is: Why would management use financial decisions such as dividend policy to signal the firm's outlook instead of simply making a public announcement of its forecasts? This question is not addressed in this paper. 4Based on Moody's Annual Dividend Record, 1969 1979. 5Percentage figures on the frequency of the various labels come from Brickley (1982).

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intent and the subsequent market reaction to these latter 'infrequent SDDs' may vary from SDDs which are declared routinely. 6 This study focuses on 'infrequent SDDs' (hereafter simply referred to as SDDs). The conventional explanation for the function of SDDs is set in the context of dividend changes conveying information. 7 Traditionally, it is argued that management increases the regular dividend only when it is confident that the new dividend can be maintained over time. Following this argument, the announcement of a regular dividend increase may convey positive information about the firm's prospects. In this setting, an SDD can be viewed as a distribution of cash to shareholders which may not convey as bright a message as an increase in the regular dividend. Sometimes it is suggested that the SDD contains the message that the SDD is a temporary increase in the dividend and will not be repeated. 8 Other times it is claimed that the SDD simply implies that the likelihood of repeating the higher dividend is less than when the regular dividend is increased. 9 While dividend changes have provided the focus for considerable empirical research, the distinction between labeled and unlabeled increases has been ignored. ~° This paper provides empirical evidence relating to three major questions relating to the labeling of dividend increases. These include: (1) (2) (3)

Do SDDs convey information? Are SDDs only temporary dividend increases or do they imply more positive information about future dividends and earnings? Is different information conveyed by SDDs and regular dividend increases?

The remainder of this section describes the organization of the paper and previews the results of the empirical analysis. After the sample design is described in section 3, section 4 examines the common stock returns around the announcements of SDDs and compares them to the returns surrounding regular dividend increases. To focus on 'infrequent SDDs' only SDDs which are the first SDDs to be announced in at least two years by the firms in question are used in the analysis. A significant positive market reaction to the announcements of SDDs suggests that these announcements convey new positive information to the market. The size of the SDD compared to the magnitude of the announcement period common stock return indicates that SDDs convey information beyond that relating to the immediate higher dividend. The comparative 6For example, Van Horne (1977, p. 303) writes: 'As soon as a certain level of dividends is recurrent, investors begin to expect that level regardless of the distinction between 'regular" and 'extra' dividends.' 7Found in most managerial finance textbooks. aSee, for example, Archer et al. (1979, p. 275). 9See, for example, Brealey and Myers (1981, p. 325-326). 1°See footnote 1 for citation of the relevant studies.

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market reactions to SDDs and regular dividend increases indicates that regular dividend increases convey more positive information than do SDDs. In section 5 we examine dividend payouts in the year following the announcements of SDDs and regular dividend increases. The purpose of this analysis is to determine if these payouts support the conclusions made in section 4 about the informational content of labeled and unlabeled dividend increases. Assuming that the market does not change its assessment of the risk of a firm when a firm declares an SDD or increases its regular dividend, the positive market reactions found in section 4 should relate to an altering of expectations about future dividends and earnings. Further, the differential market reactions to SDDs and regular dividend increases implies that the market expectations about future dividends and earnings depend on the label attached to a dividend increase. First, we compare tha dividend payouts following SDDs to the payouts following decisions not to change the dividend. Consistent with the conclusion in section 4 that SDDs are more than a transitory increase in the dividend, we find that the payout following an SDD is "above average' when compared to firms which do not change their dividend. Second, we compare dividend payouts following SDDs with payouts following regular dividend increases. Consistent with the differential market reactions to SDDs and regular dividend increases, dividend payouts following regular dividend increases are shown to be larger than the payo'uts following SDDs. Section 6 examines earnings patterns around SDDs and compares them to the earnings patterns around regular dividend increases. The examination reveals that both regular dividend increases and SDDs tend to be declared by firms experiencing good earnings over the previous year. Further there is no significant difference in the earnings performances in this prior year between firms declaring SDDs and firms increasing their regular dividend. However, consistent with the notion that the labeling of a dividend increase conveys information about the future potential of the firm, the firms declaring regular dividend increases have statistically significant larger earnings changes in the year after the dividend increase than the firms declaring SDDs. Section 7 summarizes the study, 3. Data sources and sample design Three samples are utilized in the empirical analysis. These include a sample of firms announcing SDDs and two control samples consisting.of firms announcing regular dividend increases and firms announcing no change in the dividend, respectively. To minimize the likelihood that the common stock price impacts on the dividend announcement date are confounded with other contemporaneous firm-specific events, the samples are limited to firms with no other firm-specific announcements reported in the Wall Street

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Journal

within five trading days (plus or minus) of the dividend announcement. This section describes each sample and the data sources.

3.1. Sample of SDDs The basic sample used in this study consists of 165 SDDs declared from 1969 through 1979 on common stock listed on the New York or American Stock Exchange. The sample is designed to contain SDDs of firms which do not declare them on a routine basis. To qualify for inclusion in the sample: (1) (2) (3)

the dividend must be reported in Moody's Annual Dividend Record as an SDD; the S D D must be the first S D D declared by the firm in at least a twoyear period; and the S D D must not be a resumption of interrupted dividends, i.e., the firm must have paid a dividend the quarter before.

3.2. Control sample of regular increases To compare market reactions and subsequent dividend and earnings performance for SDDs and regular dividend increases, it is necessary to develop a control sample of firms announcing increases in their regular dividends. To meet ceteris paribus conditions, it is desirable to try to match as closely as possible the characteristics of the control sample with the sample of SDDs. Obviously, it is impossible to develop a control sample which is identical to the sample of SDDs in all aspects except for the designation of the increased dividend (e.g. timing, amount, type of industry, and type of firm). In this analysis, timing is viewed as of primary importance for three reasons. First, in analyzing dividend and earnings patterns after a dividend announcement, timing is extremely important. As the strength of the national economy is likely to affect a firm's ability to generate earnings and to pay dividends and as this strength varies over time, biases could be imparted if the control sample observations occur at different times than the sample SDDs. Second, it is possible that the market may react differently to dividend changes during certain subperiods of the overall sample period, or during different times during the year. Third, if the control observations and the sample SDDs are declared on the same day, market effects can be controlled easily. 11 l l F o r instance, a difference of means test for paired observations involves subtracting the return of one member of the pair from the other. As both members are for the same dates, the market effect is taken into account. Note that this is based on the presumption that any differences in the betas and thus expected returns of the control firms and SDD firms given

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A n o t h e r aspect which we c o n s i d e r i m p o r t a n t to c o n t r o l is the size of the d i v i d e n d increase. T h e size m e a s u r e used for c o n t r o l p u r p o s e s is the S D D or d i v i d e n d increase expressed as a percentage of the regular d i v i d e n d p a i d p r i o r to the increase. This m e a s u r e we refer to as 'relative size'. Evidence p r e s e n t e d by Pettit (1972) s u p p o r t s the belief that 'relative size' is i m p o r t a n t in e x p l a i n i n g r e a c t i o n s to regular d i v i d e n d increases. Also, evidence presented below suggests that this variable is i m p o r t a n t in explaining m a r k e t reactions to S D D s . The selected c o n t r o l s a m p l e consists of 100 o b s e r v a t i o n s where the regular d i v i d e n d is increased from the p r e v i o u s q u a r t e r by a firm listed on either the N e w Y o r k or A m e r i c a n Stock Exchange. t2 T o be included in the sample, a firm m u s t not have d e c l a r e d an S D D in the year p r i o r to the decision to increase the r e g u l a r dividend. C o n t r o l o b s e r v a t i o n s are chosen to m a t c h as closely as possible the t i m i n g a n d s e c o n d a r i l y the 'relative size' of 100 S D D s selected from the s a m p l e of 165. This process yields a p a i r e d c o m p a r i s o n s a m p l e of S D D s a n d r e g u l a r d i v i d e n d increases of 100 observations.13 T h e S D D s used in the p a i r e d c o m p a r i s o n are chosen so that the d i s t r i b u t i o n for this s u b s a m p l e in terms of year a n d m o n t h d e c l a r e d is r e p r e s e n t a t i v e of the d i s t r i b u t i o n for the overall s a m p l e of 165 S D D s . As 100 represents 60~o of 165, the 100 S D D s are chosen by selecting r a n d o m l y 60'~,o of the o b s e r v a t i o n s within each m o n t h of each year from the larger sample, This p r o c e d u r e yields a s u b s a m p l e of S D D s with a very similar d i s t r i b u t i o n of the d a t e s d e c l a r e d as that of the larger sample. In d e v e l o p i n g the p a i r e d sample, when possible a r e g u l a r d i v i d e n d increase o c c u r r i n g on the same d a t e as its p a i r e d S D D is chosen (possible in 68 cases). W h e n this is not possible an o b s e r v a t i o n is selected from the next business d a y c o n t a i n i n g an a p p r o p r i a t e o b s e r v a t i o n . ~4 W h e n choices are available, the regular d i v i d e n d increase with the 'relative size' closest to the p a i r e d S D D is selected. market returns are offset through the averaging process. It is important to note also that the advantage of controlling for market effects is viewed as only of secondary importance. As the events are not clustered in calendar time, it is unlikely that the adjustment of raw returns for market effects will alter the results materially. See Brown and Warner (1980), Dann (1981), and Kraus and Stoll (1972). ~2The definition of a dividend increase as an increase in the dividend from the previous quarter is used by Pettit (1972) and Aharony and Swary (1980). Both studies found informational content in dividend changes. t3A paired sample of 1130(instead of 1651 was chosen in light of the tradeoff between the cost of collecting control observations and the desire to have a large sample. ~41n 20 of the 32 cases where it was not possible to obtain a paired observation on the same date, it was possible to obtain one on the next day. In 12 cases, it was necessary to obtain observations from days beyond the day following the announcement of the SDD. In cases where the next day is used, common market effects are likely to exist for the increased regular and its paired comparison. First, as two-day returns are used, these observations share one day in common. Second, researchers have found some serial correlation in daily stock returns. See Fama (1976).

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Unfortunately, given the timing constraints, it is not possible in most cases to match closely the size of the regular increase in the dividend with that of the SDD. SDDs tend to be large both in dollar size and 'relative size' compared to regular dividend increases. It is common for an SDD to equal or even exceed the regular quarterly dividend. It is very uncommon for a regular dividend to be doubled. Tables 1 and 2 compare the distributions of the control observations and their paired SDDs in terms of dollar size and 'relative size'. The SDDs clearly dominate in size using either measure. Fortunately, it is possible to control for size using various statistical techniques employed below. Table 1 Distribution by dollar size; Regular dividend increases and SDDs in the paired sample (100 paired observations; sample period 1969-1979).

Dollar size 0-1 cent 2-5 cents 6-10 cents > 10 cents Total

Number of regular increases 30 64 6 0

Number of paired SDDs 5 36 32 27

100

100

Median size 2.5 cents Range 1//3-10 cents

9.5 cents 1 cent-S1.00

Table 2 Distribution by 'relative size';~ regular dividend increases and SDDs in the paired sample (100 paired observation's; sample period 1969-1979). Number of Relative size regular increases 0Yoo-5% 6~o-10~o 11~o-19~o 20~-39~ 40% -99~

100~0--200~0

1

> 200~o

0

0 0 17 20 27 23 13

100

100

Total

16 16 27 26 14

Number of paired SDDs

Median size 15~ Range 2.9Yo-100~o

56~ 10.8yo-1200Yoo

aRelative size is defined as the SDD or regular dividend increase expressed as a percentage of the regular dividend paid prior to the increase.

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J.A. Brickley, Specially designated dividends and signaling

3.3. Control sample of.firms announcing no change in the dividend To compare dividend payouts following SDDs and decisions not to change the dividend, a control sample of 100 firms not changing their quarterly dividend is developed. The 100 SDDs used to obtain the paired comparison sample of SDDs and increased regular dividends are used to develop a paired comparison sample of firms announcing SDDs and firms announcing no change in the dividend. For each announcement date for the SDDs in the comparison sample, an observation of a firm not changing its quarterly dividend is selected randomly from The Wall Street Journal. To be included, a control firm must not have declared an SDD in the year prior to the decision not to change the dividend. It was possible in all cases to match exactly the date of the no change in the dividend with the date of its paired SDD. 4. Common stock returns around the announcements of S D D s and regular dividend increases This section examines common stock returns surrounding the announcements of SDDs and regular dividend increases. The purposes of this analysis are: (1) to investigate if SDDs disclose information to the market; (2) to examine the nature of this information (if any), and (3) to investigate whether SDDs and regular dividend increases convey different information. First, the common stock returns surrounding SDDs are analyzed. Second, the magnitude of the c o m m o n stock return surrounding the announcement of an SDD is compared to the size of the SDD. Third, lhe common stock returns around the announcement of SDDs are compared to the common stock returns around the announcements of regular dividend increases. 4.1. Market reactions to SDDs A time series of daily c o m m o n stock returns for 121 trading days centered around the declaration date of the S D D is taken from the CRSP Daily Returns File for each of the 165 SDDs. Average returns for each of the 121 trading days relative to the declaration day (day 0) are calculated as the arithmetic mean of the individual securities" raw returns on their c o m m o n dates in event time. For example, the average return on day 0 is the arithmetic mean of the daily returns on the date of the SDD announcement for the 164 observations in our sample which have returns on CRSP for that day. Like other recent event studies using daily returns, raw returns rather than market- or risk-adjusted returns are used in the analysis. Table 3 presents the time series of average returns for the 121 trading days. Column 1 shows the trading day relative to the declaration date Iday 0). Column 2 presents the average daily return on each of these days. The

Table 3 C o m m o n s t o c k r a t e s of r e t u r n o v e r 1 2 1 - d a y p e r i o d a r o u n d a n n o u n c e m e n t specially d e s i g n a t e d d i v i d e n d s (165 events; s a m p l e p e r i o d 1969-1979). (1) Trading day -60 50 40 -- 30 - 25 - 20 - 19 18 - 17 - 16 15 - 14 13 - 12 - I1 - 10 -9 - 8 - 7 - 6 - 5 -4 - 3 -2 - 1 -

-

-

-

-

(2) Mean rate of r e t u r n (°,(,t 0.291 - 0.208 0.162 - 0.014 - 0.346 0.148 0.033 0.087 -0.044 0.227 -0.014 0.585 -0.224 0.172 0.041 0.147 0.046 0.184 0.335 - 0.077 0.I 93 -0.014 - 0.082 0.551 0.213

U .211_.] 2 3 4 5 6 7 8 9 10 11 12 l3 14 15 16 17 1 8

1 9

20 25 30 40 50 60

0.421 0.066 0.335 0.293 -0.102 0.462 0.078 -- 0.002 O. 172 -0.281 0.214 0.096 0.043 - 0.004 - 0.076 0.413 O. 102 O. 175 0.064 O. 186 0.286 -- 0.088 O. 119 0.248 -

-

(3) Sample size

(4)

162 162 164 164 164 164 163 164 164 164 164 163 164 163 163 163 164 164 163 164 164 164 162 163 164

61:56:45 56:76:30 58:63:43 70:60:34 54:78:32 63:70:3 [ 59:62:42 59:65:40 61:72:31 59:71:34 61:74:29 66:57:40 46:70:48 65:56:42 61:71:31 67:66:30 61:68:35 69:65:30 68:55:40 67:65:32 63:62:39 66:61:37 53:78:31 77:59:27 63:66:35

b164_.] 164 164 163 164 164 164 164 164 164 164 165 165 164 165 165 165 165 ! 65 164 164 165 164 164 165

of

# Positive: # Negative: # Z e r o

[.93:39:32_] 68:57:39 69:58:37 67:62:34 70:61:33 61:75:28 72:56:36 70:63:31 62:73:29 64:64:36 57:76:31 63:69:33 57:70:38 63:59:42 62:71:32 57:78:30 69:54:42 68:66:31 64:67:34 67:64:33 62:60:42 64:64:37 57:65:42 72:58:34 73:60:32

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J.A. Brickley, Specially designated dividends and signaling

last two columns report the number of valid returns contained on CRSP for each of the trading days and the number of those returns which are positive, negative and zero. x5 Day 0 and day + 1 are designated as the 'announcement period'. 16 The day 0 average return is 0.91% and the day +1 return is 1.2!3o. In contrast, the average return for the 50-day period beginning 60 days prior to the announcement period and ending on day - 1 1 is 0.05')o. This period which we designate as the 'pre-announcement comparison period' is used as a standard to judge whether the announcement period returns are 'abnormal'. 17 The statistical significance of the two-day announcement period average common stock return is tested formally by a t-test. The null hypothesis is that the two-day announcement period average return (/~2,) equals the mean of the non-overlapping two-day average returns from the comparison period (/~2,). The t-statistic is given by t = ( R 2 a - R 2 c ) / ( s \ / 1 + l/N),

C1)

where the estimate of the standard deviation 1~) of two-day portfolio returns is obtained from the time series of comparison period two-day portfolio resturns. 18 Given that /~2~=2.113~,, /~2~.=0.10.°o, g=0.34°/,~ and N = 2 5 , the tvalue for the difference in two-day returns is 5.9 (24 degrees of freedom), and the null hypothesis can be rejected at the 0.01 level of significance. Additional evidence on the abnormality of the announcement period returns is contained in the signs of the individual two-day security returns during the announcement period. The number of positive two-day returns during the announcement period is larger than for any of the nonoverlapping two-day intervals in the comparison period. One hundred-ten of the two-day returns for the announcement period are positive, compared to 54 which are either negative or zero. The number of positive two-day returns in the comparison period ranges from a low of 63 to a high of 93. If we assume independence, the probability is only 0.04 that the largest number of positive returns will occur in the announcement period given both periods have the same return distribution. Therefore, based on the signs of the ~The number of "valid returns' may vary because of missing values on the CRSP tapes. ~rFor some firms, the announcement of the S D D may occur too late in the day to affect the day 0 stock return, but instead will be impounded in the day I stock return. Day 1 is the date the event is reported in the Wall Street Journal. ~7This period is chosen for comparison because it is close to the announcement period, but enough before it to enhance the probability that security returns in the comparison period are not contaminated by leakages relating to the forthcoming dividend announcement. It is desirable to have a comparison period close to the announcement period to minimize the probability that there are significant differences in the firm's economic characteristics between the two periods. fSThis test assumes normality and equal variances for the distributions generating announcement period and comparison period two-day portfolio returns.

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returns, we can reject the hypothesis that the return distributions are identical for the comparison and announcement periods at the 4% level. 19 The evidence in this section of abnormal positive returns around the announcement of SDDs is consistent with the hypothesis that SDDs convey positive information to the market. It is not possible to tell from this analysis whether the SDD is simply a temporary but unanticipated dividend or whether SDDs convey a more positive message. We address this issue in the next section which compares the size of the SDD with the size of the accompanying common stock return. 4.2. A comparison between the size of the SDD and the size of the announcement period stock return If the SDD is simply a temporary but unanticipated increased payout, one would expect (ceteris paribus) that the common stock return accompanying the announcement of an SDD would be approximately equal to the SDD expressed as a percentage of the common stock price. This measure of an SDD we call 'percentage size'. For example, if a stock is selling for $30 and it is announced by declaring an SDD that the stockholders are to receive an unanticipated, but one time increased payout of 10¢ in the near future, stock price would be expected to increase approximately 0.3% (the 'percentage size'). On the other hand, if the announcement of an SDD conveys additional positive information, one would expect a larger common stock return than the 'percentage size' of the SDD. In this section we test formally whether there is a significant difference between the magnitude of the announcement period common stock return and the 'percentage size' of the SDD. The closing price of the common stock on the Friday before the announcement of the SDD is used for calculating the 'percentage size'. The t-statistic for testing the null hypothesis that the announcement period return is equal to the percentage size of the SDD is given by T = Ma/(Sa ] x/~-),

(2)

where M n is the mean for our sample of the 'percentage size' of the SDD subtracted from the accompanying announcement period return, Sa is the estimated cross-sectional standard deviation of this difference and N is the sample size. Given values of 1.2%, 4.2% and 164 for Md, Sn and N, respectively, the t-value is 3.65. This t-value allows us to reject the null hypothesis at the 1% level. The positive sign of Md and the results of the statistical test are consistent with the notion that the SDD is more than a 19The test procedure used here is the same as a M a n n - W h i t n e y test.

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temporary increase in the dividend. The average market reaction is too large to be explained by the immediate higher dividend represented by the SDD. This issue is examined in more detail later in the paper. 4.3. A comparison of common stock returns surrounding SDDs and regular dividend increases The conventional view of the SDD is that more positive information is disclosed to the market by regular dividend increases than by SDDs (ceteris paribus). This view implies that the common stock return accompanying a regular dividend increase will be larger than the return accompanying the announcement of an SDD (ceteris paribus). In this section we compare the stock returns around these two types of dividend announcements. J'he first test of differential market reactions to SDDs and regular dividend increases does not control for the size of the dividend increase. The test consists of a standard difference in means t-test for paired comparisons (see eq. 2). The null hypothesis is that the mean of the announcement period return for an SDD subtracted from the announcement period return for its companion regular dividend increase is zero. This test produces a t-value of - 1 . 9 4 . This t-value is n o t only insignificant at the 5'7o level but the sign is opposite that predicted by conventional wisdom. The p-value of 0.06, if anything, suggests that the market reaction to an SDD dominates the reaction to a regular increase. However, this result may be misleading in the absence of any control for size. The result may simply suggest that the market prefers a larger SDD to a small regular dividend increase. To control for size, the following regression model is used: R E T 2 D =-60 + 6z R E G I N C + f l S Z R E L + u,

(31

where RET2D is the announcement period return relative, R E G I N C = 1 if the observation is a regular dividend increase, 0 if it is an SDD, S Z R E L is the SDD or regular dividend increase divided by the regular dividend declared in the previous quarter ('relative size') and u is a random error term. 20 Because the relative sizes (SZREL) of the SDDs and the control observations are so radically different, the regression model is estimated using only observations that have a 'relative size' of at least 20Yo and less 2°With this formulation the observations are no longer paired, but are simply single observations in a larger sample. The correlation between the two-day returns for the control sample and the paired comparison sample is very low and is unlikely to cause any statistical problems. The square of the estimated correlation coefficient (R 2) between the two-day returns of the control sample and their paired SDDs is only 0.028 (p-value of 0.10 for the standard F-test). This result suggests no significant linear dependence.

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than 100%. The use of this criterion has the advantage of limiting the focus of analysis to a size range in which observations from both categories exist. The criterion further screens out small dividend increases which are more likely than larger increases to have any information disseminated swamped by random error. As the observations are no longer treated as paired comparisons, it is not necessary to limit the observations to SDDs contained in the paired comparison sample. Therefore, any SDD in the larger sample of 165 that meets the size criterion is used. Using the 40 control observations and 65 SDDs that meet the size criterion, the estimated model using ordinary least squares (OLS) is •R E T 2 D = 0 , 9 9 + O . O 1 6 R E G I N C + O . 0 4 8 S Z R E L , (79.0) (1.9") (2.0*)

RZ=0.05.

(4)

where the asterisks indicate a one-tailed p-value of 3% (102 degrees of freedom). The positive sign on the coefficient for R E G I N C and the t-value of 1.9 allow us to reject at the 3% level the null hypothesis that the market reaction to SDDs is greater than or equal to the market reactions to regular dividend increases of similar 'relative size'. 21 This result is consistent with the traditional notion that regular dividend increases convey more positive information than SDDs (ceteris paribus). The plots of residuals from this regression indicate the error term is not of constant variance. Given this violation of OLS assumptions, the resulting estimates are unbiased, but are not minimum variance. To correct for this problem, we re-estimate the parameters of the model using weighted least squares. The technique used requires dividing each variable in the regression by S Z R E L and then re-estimating the model with OLS. 22 The resulting coefficient for R E G I N C is again 0.016, but its one-tail p-value is lower at 1.25% (increased significance). Plots of the residuals from this regression showed no evidence of heteroscedasticity. The results in this section support the contention that the labeling of a dividend increase conveys information to the market. Apparently, the market perceives that an unlabeled dividend increase conveys more positive information than an S D D of similar relative size. 21One must be cautioned that the error term of this regression does not appear to be normally distributed. Using the Kolmogorov-Smirnov test, the hypothesis that the error term is normally distributed can be rejected at the 1% level. However, statistical tests of the type used are generally quite robust to departures from normality with samples of our size. See Box and Anderson (1955), Hotelling (1961), Kendall and Stuart (1973) and Box and Watson (1962). 22This model assumes that the standard deviation of the error term is directly proportional to SZREL.

200

J.A. Brickley, Specially designated dividends and signaling

5. Dividend performance following an SDD The evidence reported in section 4 suggests that the announcement of an SDD conveys positive information about the firm beyond that relating to an unanticipated but only temporary increase in cash to shareholders. The evidence further indicates that this information is less positive than that conveyed by a regular dividend increase of similar magnitude. Assuming that the market does not change its assessment of the risk of a firm when a firm increases its dividend, the information conveyed by SDDs and regular dividend increases presumably relates to future dividends and earnings. In this section we examine dividend patterns following the announcements of SDDs. In section 6 we examine the earnings patterns around SDDs. In this section we first present descriptive data on the dividend actions taken in the year following the announcement of the SDD. The dividend payouts following SDDs are then compared to the payouts for firms not changing their dividend. The purpose of this analysis is to examine if dividend payouts following SDDs are 'above average' as suggested by section 4. The dividend payouts following SDDs are then compared to those patterns observed for firms with regular dividend increases. The common stock returns reported in section 4 suggest that payouts following regular dividend increases will be larger than those following SDDs. 5.1. Descriptive overview of the dividend performance Jbllowing an SOD

Table 4 summarizes by quarter the dividend actions taken by the sample SDD firms in the year following the announcement of the initial SDD. One striking feature is that very few of the firms lowered their regular dividend (from the previous quarter) during the year. Only one percent of the sample firms decreased their regular dividend in any given quarter. On the other hand, in each quarter at least 20 percent of the firms made larger dividend payouts than their regular dividend in the previous quarter. In the anniversary quarter of the SDD, 66 percent of the firms took such action. Forty-one percent of the firms in the anniversary quarter declared another SDD. While the sample firms tended to increase their dividends in the year after the SDD, it is not possible to discern from this data alone whether these firms had 'above average' dividend performance. The reason for this is that firms in general appear to be reluctant to lower their regular dividend and so one would expect more dividend increases than decreases for any randomly selected group of firms./a The issue of whether or not the average dividend performance following an SDD is abnormally positive is addressed in the following section. 23Lintner (1956) and Fama and Babiak (1968) provide evidence on the managerial reluctance to cut dividends.

J.A. Brickley, Specially designated dividends and signaling

201

Table 4 Dividend actions taken in the four quarters following the announcement quarter of the specially designated dividend (SDD) (% of sample firms taking the action)? Quarter 1 Quarter 2 Quarter 3 Quarter 4 1. Increased regular dividend from the previous quarter 2. Declared the same regular dividend as in the previous quarter plus paid an SDD 3. Increased the regular dividend from the previous quarter and declared an SDD Larger payout than the previous quarter's regular dividend (sum of #'s 1, 2, 3) Same payout as the previous quarter's regular dividend Lower payout than the previous quarter's regular dividend Average total payout as a percent of the regular dividend paid prior to the initial SDD

24~0

17%

13,%

15j°~i

5~

1%

7°/0

32°/0

0%

2°/,~

1%

97o

29°~

20~,

21%

66~o

70%

79~o

78%

43~o

1,°/0

17o

1%

1%

109%

116~o

124~,

168~

aThis table is based on the full sample of 165 firms declaring SDDs in 196%1979. Sample size may vary slightly from quarter to quarter as firms merge with other firms and so have no dividend records.

5.2. Dividend payouts following SDDs vs. decisions not to change the dividend At least two alternative m e t h o d o l o g i e s exist that could be used to e x a m i n e w h e t h e r or n o t d i v i d e n d p a y o u t s following S D D s are a b n o r m a l l y positive. O n e is a time series a p p r o a c h in which trends of d i v i d e n d p a y o u t s for firms declaring S D D s are e x a m i n e d for possible shifts after the SDDs. Alternatively, d i v i d e n d p a y o u t s following S D D s can be c o m p a r e d to the d i v i d e n d p a y o u t s following decisions by o t h e r firms not to increase their dividends. This cross-sectional a p p r o a c h assumes the average trend in d i v i d e n d p a y o u t s for the 'no c h a n g e ' firms is the same as the trend for the c o m p a r i s o n firms p r i o r to their declaring SDDs. G i v e n this a s s u m p t i o n , one can test whether the d i v i d e n d p e r f o r m a n c e following an S D D is ' a b o v e average'. In this s t u d y we e m p l o y this cross-sectional a p p r o a c h . F o r the analysis the c o n t r o l s a m p l e of 100 no change firms described in section 3 is used. T h r e e measures of subsequent d i v i d e n d p a y o u t per share are used in this study. All m e a s u r e s are adjusted for stock splits a n d stock dividends. All the

202

J.A. Brickley, Specially designated dividends and signaling

measures are relative measures, i.e., total payout per share for a given time period divided by some base payout. Relative measures make it possible to compare dividend performance of firms which start with different dollar amounts per share being paid as dividends. The measures include:

Following quarter measure (FQM) The total dividend payment per share (regular and SDD) declared in the quarter after the announcement quarter (of the SDD, regular dividend increase or no change in the dividend) divided by the regular quarterly dividend declared in the quarter prior to the announcement quarter. This measures the relative dividend level in the quarter immediately following the announcement of the SDD, regular dividend increase, or no change in the dividend. Anniversary quarter measure (AQM) The total dividend declared in the anniversary quarter of the initial announcement divided by the regular quarterly dividend declared in the quarter before the initial announcement. This measures the relative dividend level in the anniversary quarter of the SDD, regular dividend increase, or no change in the dividend. Following year measure (FY M) The total dividends declared in announcement divided by four declared in the quarter prior relative dividend level over the announcement.

the four quarters following the initial times the regular quarterly dividend to announcement. This measures the 12-month period following the initial

Table 5 displays the means for each dividend performance measure for the S D D firms and no change firms in the comparison sample. The table also includes the results for each performance measure of a standard difference in means t-test for paired comparisons. 24 The firms in both groups, on the average, increased their dividend payouts over their previous regular dividend during the year after the initial dividend announcement. However, the mean for all performance measures is larger for the SDD group. The results of the t-test support the hypothesis that dividend performance following an SDD dominates that following a decision not to change the dividend. The null hypothesis that the dividend payout following an S D D is the same or worse than following a decision not to change the dividend is rejected at the 53/0 level (or better) for all three measures. 24See eq. (2) for a specification of the test. Also, note that the sample size is 90 instead of 100. This is because l0 out of the 200 firms merged with other firms and so did not have complete dividend records for the full year.

J.A. Brickley, Specially designated dividends and signaling

203

Table 5 Mean dividend performance measures for the paired comparison sample of firms not changing their dividend and firms declaring specially designated dividends and a /-test for paired comparisons for each measure (sample period 1969- 1979).

Mean for SDDs Mean for no changes Mean difference d Sample size Standard error of mean t-value for difference of means test

FQM ~

AQM b

FYM c

1.07 1.02 0.056 90

1.50 1.10 0.407 90

1.23 1.06 0.182 90

0.0297

0.0869

0.0468

1.88°

4.68 ~

3.89 f

"FQM is the total dividend per share declared in the quarter following the SDD or no change in the dividend divided by the regular dividend declared prior to the SDD or no change in the dividend. bAQM is the total dividend per share declared in the anniversary quarter of the SDD or no change in the dividend divided by the regular dividend declared prior to the SDD or no change in the dividend. CFYM is the total dividend per share declared in the year after the SDD or no change in the dividend divided by four times the regular dividend declared prior to the SDD or no change in the dividend. 'JThe reported number is the mean difference of the performance measure for each no change observation subtracted from the performance measure for the paired SDD. The null hypothesis of the t-tests is that this mean difference is less than or equal to zero, cOne-tailed p-value of 0.04. tOne-tailed p-value of less than 0,01.

Two possible biases may exist in the above analysis. First, the no change firms may include firms which are reluctant to increase their dividend and have a long history of paying the same dividend. The S D D firms, on the other hand, may be less likely to follow such a conservative policy as they have demonstrated a willingness to increase their payout. Second, as shown in section 6, firms tend to declare SDDs after periods of good earnings performances. The control sample of no change firms contains firms with both positive and negative earnings performances. As firms which experienced earnings decreases may be less likely to increase their dividend in the future than those experiencing earnings increases, a bias may exist in the above analysis, making rejection of the null hypothesis more likely. To help correct for these possible biases, we examine a subsample of 36 no change firms which had earnings increases and which also increased their dividend

204

J.A. Brickley, Specially designated dividends and signaling

sometime in the two-year period before the announcement date of their decision not to change the dividend. A no change firm is classified as having an earnings increase if the earnings reported during the announcement quarter are greater than the earnings reported four quarters before (adjusted for stock splits and stock dividends). 25 If any bias existed in the original specification, use of this subsample should reduce the mean difference in the performance measures and make acceptance of the null hypothesis more likely. The results of the paired comparison t-tests for this subsample of 36 no change firms are very similar to those for the entire sample. The t-values of 3.37 and 2.50 for the measures A Q M and F Y M allow us to reject the null hypothesis at the 1% level. The t-value of 2,04 allows us to reject the null hypothesis at the 2.5'~ level of significance, using the measure F Q M . The results of this section support the notion that the SDD is more than a temporary increase in the dividend. The evidence supports the contention that firms declaring SDDs are likely to experience superior dividend performance in the future relative to a firm which does not increase its dividend. The next section compares the dividend payouts following SDDs with those following regular dividend increases.

5.2. Dividend payouts,following SDDs vs. regular dividend increases Table 6 presents an analysis of variance for each of the performance measures classified by SDD or regular dividend increase. Consistent with section 4 only observations having a relative size between 20 °j~,, and 100'~o are used. The statistical results support the hypothesis that the dividend performance following a regular dividend increase dominates that following an SDD. The F-tests for each dividend measure are significant at the 2°;; level or better (one-tailed test). Further, three additional non-parametric tests are performed for each measure and all tests are significant at the l°~, levelfl 6 These results are consistent with the evidence presented above that the stock price response to regular dividend increases is more positive than to SDDs. 6. E a r n i n g s p e r f o r m a n c e s u r r o u n d i n g S D D s

The c o m m o n stock returns reported in section 4 are consistent with the hypothesis that management uses the labeling of dividend increases to 2SThe method of choosing the subsample yielded paired observations with approximately equivalent earnings changes from the previous year. The mean change in earnings from the corresponding quarter in the previous year is 55 percent for the SDD observations compared to 47 percent for the paired no change observations. A standard difference in means t-test for paired comparisons does not allow us to reject the null hypothesis that the mean difference in the percentage earnings changes for the paired observations is equal to zero. 26Tests for each measure include the Wilcoxon test, the Median test for two samples and the

Van der Waerden test.

J.A. Brickley, Specially designated dividena~ ad signaling

205

Table 6 Analysis of variance; dividend performance measures classified by specially designated dividend (SDD) and regular dividend increase (20% < SZREL < 100%))

(1) FQM ° SDD Regular dividend increase (2) AQM e SDD Regular dividend increase (3) F Y M ' SDD Regular dividend increase

Nb

Mean

F-value

P-value c

65

1.06

45.82

0.0001

40

1.40

63

1.39

5.22

0.0250

35

1.75

63

1.20

13.84

0.0003

35

1.52

aSZREL is defined as the SDD or regular dividend increase divided by the regular dividend paid prior to the dividend increase. bSample size may vary as firms merge into other firms after the announcement date. CThe appropriate p-value for testing the null hypothesis that a dividend performance measure for the SDD group is greater than that for the regular dividend increase group is this value divided by two. dFQM is the total dividend per share declared in the quarter following the SDD or regular dividend increase divided by the regular dividend declared prior to the increase. CAQM is the total dividend per share declared in the anniversary quarter of the SDD or regular dividend increase divided by the regular dividend declared prior to the increase. f F Y M is the total dividend per share declared in the year after the SDD or regular dividend increase divided by four times the regular dividend declared prior to the dividend increase.

convey information about future dividends and earnings. In section 5 dividend payouts following SDDs and regular dividend increases were found to be consistent with this hypothesis. In this section we examine earnings patterns surrounding SDDs and regular dividend increases. First we compare the S D D and regular dividend increase firms based on the change in earnings per share between the fiscal year prior to the dividend increase (FY - 1) and the fiscal year of the increase (FY0). To the extent that the two groups cannot be distinguished based on their earnings changes over this period, the potential for dividend labeling to convey new information is increased. If the two groups have substantially different earnings changes between F Y - I and FY0, information about differences in future earnings (and dividends) of the two groups may in part be conveyed by earnings

206

J.A. Brickley, Specially designated dividends and signaling

announcements over this period instead of being conveyed primarily through the dividend label. Second we compare the two groups based on the earnings change between the fiscal year of announcement and the following fiscal year (FY + 1). The evidence in section 4 and 5 suggests that the regular dividend increase group would have a more positive earnings change over this period than the SDD group.

6.1. Earnings changes from the fiscal )'ear prior to announcement to the fiscal year of announcement Table 7 presents an analysis of variance for the change in earnings per share (adjusted for stock splits and stock dividends) between F Y - 1 and F Y 0 classified by SDD or regular dividend increase. Consistent with the earlier analysis only observations having a ~relative size' between 20')o and 100'!; are included. The table indicates that both groups on the average experienced relatively large increases in earnings per share during the year (580o for the SDD group and 51!;,0 for the regular dividend increase group). Over 90~o of the firms in each group had non-negative earnings changes. The low F-value of 0.078 does not allow us to reject the null hypothesis that the average earnings change over this period is the same for both groups. 27 As the two groups have indistinguishable earnings changes from the year prior to the dividend increase to the year of the increase, the potential for dividend signaling is enhanced. Table 7 Analysis of variance: percentage change in earnings per share from the fiscal year before the dividend increase to the fiscal year of the increase (20?/ _
Specially designated dividend Regular dividend increase

N

Mean % non-negative

F-value

63

58~!~,

92'!i;

0.078

35

51~4,

94°;

"SZREL is the SDD or regular dividend increase divided by the regular dividend paid prior to the increase. 6.2. Earnings changes from the fiscal year of announcement to the fiscal year after the announcement Table 8 presents an analysis of variance for the cMnge in earnings per share between F Y 0 and FY +1 classified by SDD and regular dividend 2"The Wilcoxon test, the Median test for two samples and the Van der Waerden test also do not allow rejection of the null hypothesis.

J.A. Brickley, Specially designated dividends and signaling

207

Table 8 Analysis of variance; percentage change in earnings per share (EPS) from the fiscal year of the dividend increase to the following fiscal year (20~/o< SZREL < 100°/)." N Specially designated dividend

63

Mean ~ non-negative - I~o

66~o

F-value 2.89 b

Regular dividend

increase

35

30~,,, 77V,,,

aSZREL is the SDD or regular dividend increase divided by the regular dividend paid prior to the increase. bOne-tail p-value of 0.0462. Null hypothesis is that the percentage increase in EPS from the fiscal year of announcement to the following fiscal year is the same between groups or greater for the SDD group.

increase. The table indicates that the earnings for the SDD group did not tend to fall back to the pre-SDD level. The average change in earnings for this group is -l°Jo compared to the 58~o average increase for the previous year. Sixty-six percent of the SDD firms had non-negative earnings changes between F Y 0 and FY + l . This data is consistent with the evidence presented previously, suggesting that the SDD represents more than a transitory increase in the earnings and dividend potential of the firm. On the average the regular dividend increase group faired better between F Y 0 and FY + ! than the SDD group. The regular dividend increase group averaged a 30% increase in earnings over this year with 77~o of the firms having non-negative earnings changes. The F-value of 2.89 allows us to reject the null hypothesis that the earnings change between FY 0 and FY + 1 is the same or greater for the SDD group than for the regular dividend increase group at the 5% level of significance (one-tailed p-value of 0.046.) 2s This result is consistent with the evidence presented previously that a regular dividend increase conveys more positive information than an SDD of similar magnitude.

7. Summary Common stock returns around the announcements of specially designated dividends (SDDs) and regular (unlabeled) dividend increases support the notion that management uses the labeling of dividend increases to convey information to the market about future dividends and earnings. Both SDDs and regular dividend increases appear to convey positive information with the regular dividend increase providing a more positive message. 28The Wilcoxon test, the Median test for two samples and the Van der Waerden test also all allow us to reject the null hypothesis with p-values (one-tailed) of less than 5°,~,.

208

J.A. Brickley, Specially designated dividends and signaling

A comparison of the size of the market reaction to the size of the S D D suggests, contrary to the sometimes stated view, that the S D D represents more than a transitory increase in dividends and earnings. An analysis of dividend payouts and earnings in the year following the announcement of the S D D supports this conclusion. The notion that a regular dividend increase conveys more positive information than an S D D is reinforced by the dividend payouts in the year following the dividend increases. Payouts following regular dividend increases are shown to be significantly larger than those following SDDs. The notion of differential information between labeled and unlabeled increases also is supported by the earnings performances of the two groups. Both SDDs and regular dividend increases tend to be declared after a period of good earnings. Further there is no significant difference between the two groups based on earnings changes between the fiscal year of declaration and the prior fiscal year. However, consistent with the signaling notion, the regular dividend increase group has statistically larger earnings changes in the fiscal year after the dividend announcement.

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