CHAPTER II LITERATURE REVIEW

The impact of dividend announcements on stock prices has been examined in a wide variety of scenarios.
There is a very rich literature on the information of dividends and the effect of dividend announcements
on the price of common shares. Significant effects surrounding corporate announcements of changing
dividend payouts are confirmed by several studies all over the world. However the number of studies on
the Pakistani stock exchange is found to be relatively small in number.

Aharony and Swary (1980) concluded in their study that the average significant excess returns on the day
of announced dividend changes of +0.36% in case of dividend increases, and –1.13% for dividend
decreases. He used a sample of 384 events for this study.

Dyl and Weigand (1998) add that dividend initiations not only lead to an increase in stock prices, but are
also accompanied by an immediate downward shift in both total and systematic company risk.
Furthermore they report a decline in earnings' volatility in the first years following the dividend initiation.
The authors conclude that a management decision to initiate regular dividend payments brings new
information to investors regarding the risk of a firm.

Dhillon and Johnson (1994) not only find stock prices but also bond prices to change significantly in
reaction to the announcement of changing dividends.

Lonie et al, (1996).used announcement effects for the UK stock market. They find statistically significant
abnormal returns of +2.03% for a two-day window in case of dividend increases and –2.15% in case of
dividend decreases.

For 200 companies listed on the German stock market Amihud and Murgia (1997) investigated the effects
of changing dividends on shareholders' value during the period 1988 to 1992. In line with the studies
mentioned above, they found a statistically significant cumulative abnormal return for the announcement
day and the previous day of +0.96% for dividend increases and –1.73% for dividend decreases.

Gunasekarage (2006) examined the long-run financial and return performance of UK companies which
were grouped according to whether or not they had changed their dividends and earnings. Findings show
that at the time of the announcements, share returns tend to be positive (negative) where companies have
increased (decreased) the dividend and earnings and this phenomenon is also expected for Pakistan’s
stocks market. Author found that the stock market has anticipated some of the news in the preceding 12
months. However, the dividend earnings news does not appear to act as a signal of long-term future
company performance; companies which cut this dividend and reported lower earnings achieved the
largest excess returns over the next five years. A similar mean-revealing pattern existed in the financial
ratios. Finally, most of the future long-term share performance was attributable to the earnings rather than
to the dividend news.

Researchers have examined the impact of dividend announcements on share prices from a variety of
different perspectives and in a selection of different circumstances. The prominent studies on the issue of
long term performance of dividend-changing companies have been conducted using US data and they are
limited to either extreme dividend changes such as dividend initiations and omissions (Healy and Palepu,
1988).

Michaely et al. (1995) observe the announcement behaviour of excess returns for samples of dividend-
initiating and-omitting firms and document evidence of a drift in share returns over the three-year post-
announcement period considered. For the initiating firms, the share prices continued to rise even after the
initial announcement; the average first-year excess return was 7.5 per cent and the mean three-year excess
return was 24.8 per cent. For the dividend-omitting firms, a drift in the opposite direction was observed;
the average first-year excess return was –11.0 percent and the mean three-year excess return was –15.3
percent. Their findings are in agreement with the earnings behavior reported for initiating firms in Healy
and Palepu (1988), but contradict with the mean reverting behaviour of earnings found for omitting
companies.

Woolridge and Ghosh (1985) were perhaps the first to investigate the long run return behavior of
dividend cutting companies. They proposed that if a company has several potentially profitable and non-
postponable investment opportunities but little available cash, and if its cost of external financing is
substantial, the value of that company’s shares may be enhanced by reducing dividends and increasing
investment. In agreement with this argument, the researchers find that all the three dividend-decreasing
groups in their sample: (1) firms which announced a reduction in dividend along with a simultaneous
decline in earnings or a loss; (2) firms which announced news of a dividend cut disclosing details of a fall
in earnings or a loss; and (3) firms which cut their dividend while announcing details of an increase in
capital spending or higher earnings, outperformed the market in the long run by recouping the market
values which were lost during the announcement period. In the year after the dividend cut, the share
prices of the three categories of companies rose by 10.23 per cent, 11.38 per cent and 15.97 per cent
respectively. Similar findings for dividend cutting companies have been documented in De Angelo et al.
(1992) and Jensen and Johnson (1995) who examined the financial performance of such companies
before and after the dividend cut.

Foster and Vickrey (2005) findings imply that the market, in the aggregate, uses stock dividend
information in setting equilibrium security prices, that much of the market's reaction to such information
occurs no later than the declaration date, and that such information tends to produce positive unexpected
returns. With respect to the second goal, the results imply that the market is not conditioned to react
positively to stock dividends of any size on the ex date.

Chottiner and Young (1971) did not exclude distributions from their sample of significant news
announcements and earnings announcements occurred in close proximity to their ex dates. Their
exclusion criterion for cash dividends is not completely clear, however.

According to Miller and Modigliani (1961) demonstrate that firm value is independent of dividend policy
in a perfect capital market setting, but speculate an information effect of dividend announcements under
information asymmetry. They also proved that certain assumptions about dividend policy should not
matter to the value of a firm and with a good control for profitability. The regressions can measure how
the taxation of dividends affects firm value. Simple tax hypotheses say that value is negatively related to
the value of a firm.

Dmitriy (2006) found about dividend policy that each operating enterprise is interested in running a
profitable business. This might be achieved only by means of exploiting a complex of different factors.
Dividend policy among other factors can be regarded as a cause of variations in firm value

Bhattacharya (1979) proposed a model which included the main elements of the two aforementioned
hypotheses: dividends are taxed more heavily than capital gains, but, at the same time, the payment of
dividends is also used to convey information about the strength of the firm’s future earnings potential. In
such a model, the signal-related value of the dividend can offset the tax-related, and transactional, costs of
paying the dividend. We hypothesize in this paper that an important influence on the relationship between
dividend announcements and stock returns will be the overall climate of trust within financial markets.
That is, we postulate that the signal value of the dividend announcement is a function of investors’
perceptions of the moral hazards in the overall market related to accepting information received from a
firm’s insiders.

Lindhe (2002) define the broad consensus among economists that taxes do affect firm investments and
financial decisions and, from a purely tax-oriented perspective, that debt is the most favorable source of
finance, since interest payments are tax deductible at the firm level and shareholders.

Aharony and Swary (1980) attempts to resolve the empirical issue as to whether quarterly dividend
announcements convey useful information. They examined abnormal stock returns surrounding
contemporaneous earnings and dividend announcements in order to determine whether investors evaluate
the two announcements in relation to each other. Authors find that there is a statistically significant
interaction effect. The abnormal return corresponding to any earnings or dividend announcement depends
upon the value of the other announcement. This evidence suggests the existence of a corroborative
relationship between the two announcements. Investors give more credence to unanticipated dividend
increases or decreases when earnings are also above or below expectations, and vice versa.

Miller and Scholes (1982) in a study focused primarily on dividends and taxes, find significant evidence
of a dividend announcement effect. These studies have for the most part attempted to measure the
separate effects of either dividends or earnings. In general, the effect of the other announcement has been
treated as a statistical nuisance that muddies the waters and introduces methodological complications.
Consequently, these studies necessarily leave unanswered the question of whether investors evaluate
dividend and earnings announcements in relation to each other.

Divecha and Morse (1983) report that the effect of the dividend announcement generally is impounded
into stock prices within the 20-day period surrounding the announcement. However, they found that the
empirical results were unaffected by announcement order.

Kane, Lee, and Marcus (2004) examined abnormal stock returns surrounding contemporaneous earnings
and dividend announcements in order to determine whether investors evaluate the two announcements in
relation to each other. They find that there is a statistically significant interaction effect. The abnormal
return corresponding to any earnings or dividend announcement depends upon the value of the other
announcement. This evidence suggests the existence of a corroborative relationship between the two
announcements. Investors give more credence to unanticipated dividend increases or decreases when
earnings are also above or below expectations, and vice versa.
Jayaraman and Shastri (1993) find that regular dividend increase announcements are not followed by a
significant change in volatility, while ‘labeled’ ones (i.e. those identified as special, one-off dividends)
are followed by a fall in volatility. They take this to indicate that the signal given by a labeled
announcement is clearer than the usual announcement, and therefore reduces uncertainty.

Lyroudi1 et al (2007), examine the stock price reaction to interim dividend announcements of Greek
firms listed on the Athens Stock Exchange (ASE) under the special legal framework of pertinent dividend
policy that holds in Greece and differs from the one in the other developed economies. Authors’ results
confirm the “information content of dividends hypothesis” which predicts positive market reaction on the
announcement date. However, the magnitude of the price reaction initiated by the final dividend
announcement seems to be higher than the one by the interim dividend announcement, in contrast to the
known literature, due to the special legislation that characterizes dividend policy in the Greek market.

Balachandran et al. (1999) found that the magnitude of price reactions to interim dividend reductions is
statistically significantly related to the size of the dividend reduction, the gearing ratio, the industrial
classification, the incidence of a prior dividend cut and the actual change in interim earnings.

Balachandran (2003) investigated the impacts of initial interim dividend reductions and initial final
reductions upon stock prices for UK firms that had not reduced their dividends in the previous three-year
period. His empirical results supported the contention that interim dividend reductions conveyed a
stronger signal to the market than the one conveyed by final dividend reductions, resulting in a stronger
negative reaction as opposed to the final dividend reductions. Although the market reacts negatively
around final dividend cut announcements it bounces back to its prior level within 13 days of
announcements.

Liu and Szewczyk (2000), investigates the long-run stock performance following dividend omissions and
reductions, and looks for answers for three questions: 1) Does the market under react to announcement of
dividend omissions and reductions? 2) if the market does, how long does it take for the market to correct
this under reaction, and 3) are there any factors that influence the long-run underperformance? They
found a significantly negative long-run abnormal stock returns for up to five years after announcement.
The results are robust across time periods and methodologies. However, they find the horizon of long-run
post announcement abnormal returns might be overstated in prior literature.
On the long-run anomaly following dividend initiations and omissions documented by Michaely, Thaler
and Womack (1995) in their 1964-1988 sampling period, Fama suggests that changing the authors’
matching criteria might tell a different story. Fama calls for an out of sample test before drawing any
inferences about long-term returns following changes in dividends.

In their seminar paper, Miller and Modigliani (1961) first present the argument that dividend policy is
irrelevant to the value of a firm if some well-defined conditions are met. These conditions require a
perfect world where there are no differential tax rates between capital gain and dividends, no information
asymmetries between insiders and outsiders, no conflicts of interest between managers and shareholders,
and no transaction costs or flotation costs.

Fama (1998) questions Michaely’s results because the negative three-year abnormal returns following
omissions are largely concentrated in the second half of their 1964 - 88 sample period and because
abnormal return documented by Michaely et al (1995) disappears when matching criteria is altered. Fama
calls for an out-of-sample test before drawing any inferences about long-term returns following changes
in dividends.

Boehme and Sorescu (2002) study long-term stock performance following dividend initiations and
resumptions from 1927 to 1998. Although they find that post-announcement abnormal returns are
significantly positive, the abnormal performance is confined to the smaller firms and not robust across
sub-samples.

Barber and Lyon (1997) suggest a control firm approach by matching an event firm with a non-event firm
with the similar sizes and book-to-market ratios. However, Fama (1998) notices that matching on one
criterion can produce much different abnormal returns than matching on another criteria, and both size
and book-to-market ratios do not capture all relevant cross-firm variation in average returns.

The use of time series regression is common in the research on dividend announcements. For example
Agrawal et al (1992) regresses the monthly excess return (actual return minus the equal weighted average
return on the control portfolio in the same size deciles as the event firm) of an event firm on market risk
premium in the same month. The most commonly used asset pricing model in time-series regression is
Fama-French three-factor-model. The post-event monthly excess return for firm j is regressed on a market
factor, a size factor, and a book-to-market factor. One-month Treasury bill rate is usually used as risk free
rate. Market factor is the return on a value-weighted market index minus risk free rate. Similarly Boehme
and Sorescu (2002) also regresses calendar-time portfolio excess returns. We will also develop our study
using the OLS regression technique (defined in chapter 3).