Dividend Policy and Investment Incentives

The argument in the last subsection assumed that investors could correctly infer the firm's investment expenditures even though the investments are not directly observable. This assumption requires that investors understand the investment opportunities of the firm as well as the degree of emphasis that managers place on maximizing the firm's current share price versus maximizing the firm's intrinsic value. If investors know management's incentives and understand the firm's investment opportunities, they can accurately infer how much the firm will invest. The only unobservable factor in the all-equity firm's sources and uses of funds equation would then be operating cash flow, which can be inferred from the observed dividends and changes in equity financing. (For firms with debt and equity financing, operating cash flow could be inferred by additionally observing interest payments and changes in debt financing.)

In reality, investors and analysts are usually unable to make accurate inferences about a firm's investment opportunities or how much managers want to invest. As a result, the dividend choice conveys information about both the opportunities and incentives to invest as well as the firm's operating cash flows. This implies that a firm's unanticipated dividend cut could provide a mixed signal. A dividend cut could mean that the firm was less profitable; alternatively, the cut could mean that the firm had good opportunities and planned on investing more than investors had previously anticipated.

Can Dividend Cuts Signal Improved Investment Opportunities? A dividend cut that is interpreted to mean that the firm has increased investment expenditures can be either good news or bad news, depending on whether investors believe that the firm will be investing in positive or negative net present value projects. Woolridge and Ghosh (1985) argued that if firms can effectively communicate to investors that an announced dividend cut is motivated by a desire to conserve cash to fund good investments, their stock prices will react favorably. To illustrate this point, the authors highlighted the April 11, 1975, announcement by Ford Motor Company of a cut in its quarterly dividend from $0.80 to $0.60 per share. This announcement, accompanied by a statement by Henry Ford II that the cut would "conserve sufficient cash to finance products that can add to profitability in future years," generated a 1.9 percent increase in Ford's stock price. However, as our chapter's opening vignette on ITT's dividend cut indicates, investors are often skeptical about such statements. As a result, stock prices usually fall when firms announce dividend cuts.

Dividend Cuts and the Incentive to Overinvest. Arguing that a dividend cut is made to increase funds for investment will of course elicit a favorable price response only if shareholders believe the firm will invest the money in positive net present value projects. As Chapter 18 noted, managers may overinvest because they prefer to see their firms grow. Thus, a signal indicating that management plans to increase investment can be considered both bad news and good news. As a result, stock price responses to dividend increases and decreases should depend on the investment opportunities available to the firm. Investors would thus view a dividend increase more favorably when firms have poorer investment opportunities.

Result 19.7 A dividend increase or decrease can provide information to investors about:

• Management's investment intentions.

In the latter case, if investors believe that an increased level of investment associated with a dividend cut is motivated by improved prospects, they will view the dividend cut favorably. However, if investors believe that managers will make negative net present value investments, they will interpret a dividend cut as bad news.

The findings in Lang and Litzenberger (1989) support the hypothesis that investors view dividend cuts more favorably when firms have better investment prospects and view dividend increases more favorably when investment prospects are poorer.6 They examined the stock price reactions to announced dividend increases and decreases for stocks that differed according to the relation between their market values (MV) and their book values (BV). Firms with market values that exceed their book values are believed to have favorable investment opportunities while those with market values that are less than their book values are believed to have unfavorable investment opportunities.

Lang and Litzenberger's sample was divided into four groups.

1. Firms with MV > BV with dividend increases.

2. Firms with MV > BV with dividend decreases.

3. Firms with MV < BV with dividend increases.

4. Firms with MV < BV with dividend decreases.

As Exhibit 19.2 shows, a dividend increase created only a slight stock price increase for firms believed to have favorable investment opportunities (that is, MV > BV). Likewise, a dividend decrease generated only a slight stock price decrease

6Litzenberger and Lang's sample of daily returns consisted of 429 dividend change announcements that met two criteria: (1) The absolute value of the percentage dividend change was greater than 10 percent; and (2) data on market and book values were available.

Exhibit 19.2 Average Daily Returns on Dividend Announcement Days, 1979-84

Dividend Increase

Dividend Decrease

Difference in Absolute Values for Increases and Decreases

MV > BV

0.003a

-0.003

0.000

MV < BV

0.008a

—0.027a

0.019a

Difference (Row 2 — 1)

0.005a

—0.024a

0.019a

Statistically different from zero. Source: Lang and Litzenberger (1989).

Statistically different from zero. Source: Lang and Litzenberger (1989).

for these firms. In contrast, dividend increases and decreases resulted in much larger stock price responses for firms believed to have unfavorable investment opportunities (that is, MV < BV). This evidence suggests that dividend changes are viewed as signals of the firm's level of future investment.

Denis, Denis, and Sarin (1994) provided an alternative interpretation of the observed differences in the stock price reaction of high and low MV/BV firms to dividend changes. They pointed out that high MV/BV firms generally have lower dividend yields and greater growth potential, which implies two things:

1. Increases in the dividends of high MV/BV firms are less likely to be viewed as a surprise.

2. High MV/BV firms are likely to attract investors who are less interested in dividends.

To understand the first point, recall from Chapter 11 that the Gordon Growth Model version of the dividend discount equation can be rearranged to show that the cost of capital is the sum of (1) the dividend yield and (2) the dividend growth rate. Hence, holding the risk of the firm (and thus the cost of capital) constant, low dividend yields imply high dividend growth rates and vice versa. The second point is an implication of dividend clienteles, discussed in Chapter 15. Both of these factors suggest that high MV/BV firms will react less to dividend increases than low MV/BV firms even in the absence of the incentive problems discussed by Lang and Litzenberger.

Denis, Denis, and Sarin demonstrated that after accounting for differences in dividend yields and the size of the dividend change, high and low MV/BV firms react similarly to dividend changes. In addition, they found that following dividend increases, stock market analysts increase their earnings forecasts more for low MV/BV firms than for high MV/BV firms. Based on this evidence, they concluded that stock prices respond to dividend changes because of the information the announcements convey about the firm's future earnings. Their evidence does not support the idea that stock prices respond because dividend changes provide information about the firms' future investment choices.

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