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What Drives Canadian Corporate Dividend Policy: Agency
Cost or Information Asymmetry?
Fodil Adjaoud, University of Ottawa, School of Management
Imed Chkir, University of Ottawa, School of Management
Samir Saadi *, University of Ottawa, School of Management
Abstract
We investigate the reaction of the Canadian market to dividend announcements in order to test the signaling
theory against the agency cost theory. We also introduce the impact of the ownership structure of the companies on
the information content of dividends. Our results show that dividend announcements are followed by significant
abnormal stock returns: positive in case of dividend increases and negative in case of dividend decreases. A more
detailed analysis of these abnormal returns shows that they are more important when the company is of small size and
with the existence of blockholders. These results do not support the agency cost theory in explaining why do firms
pay dividends and rather support the signaling theory.
Introduction
Despite a voluminous amount of theoretical and empirical studies over more than five decades, a lack of
consensus among financial economists on why firms pay dividends still persists. In a perfect and frictionless capital
market, when a firm’s investment policy is held constant, dividend policy is irrelevant because it has no effect on a
firm’s stock price or its cost of capital (Miller and Modigliani, 1961). The highly restrictive assumptions of the
irrelevance theory limit its application to real world situations. For instance, Black (1976) notes that given the
classical tax rate preference for capital gains and deferral of capital gains taxation until the realization “corporation
that pays no dividend will be more attractive to taxable individuals than a similar corporation that pays dividend.”
Yet some companies offered large payouts (e.g. Lintner, 1956). This fact puzzled academia. For example, Brealey
and Myers (2003) consider the dividend policy as one of the “10 unsolved problems in finance.”
The dividend literature offers four standard theories to explain the dividend puzzle: signaling, tax preference
and dividend clientele, agency, and bird-in-the-hand. Until recently, the signaling and agency theories have gained
the most support. The tax clientele view has mixed results while the “bird-in-the-hand” explanation has received
criticism from both empirical and theoretical views and has been labeled a “fallacy.”
Studies supporting the signaling theory posit that a firm uses dividends as a device to convey private
information about its future profitability; thus dividends lessen information asymmetry between management and
shareholders and, in turn, enhance the firm’s value to shareholders (see among others, John and Williams, 1985;
Bhattacharya, 1979; Miller and Rock, 1985). Hence, the signaling theory predicts a positive (negative) stock-price
reaction to the announcement of dividend increases (decreases). This prediction is largely supported by empirical
studies (Adjaoud, 1984; Healy and Palepu, 1988).
More recent studies, however, stipulate that stock market reactions to dividend-change announcement are
not due to a signaling role of dividends but rather to a reduction in agency costs within a dividend-paying firm. For
instance, dividends can mitigate agency costs by forcing firms to seek funds from capital market, in which managers
are subject to additional monitoring at lower cost (Easterbrook, 1984). Moreover, dividends payouts can reduce the
likelihood of managers using excess returns to pursue their own interests and/or investing the firm’s free cash flows
in sub-optimal projects (Jensen, 1986). Recently, some empirical studies cast serious doubt on the dividendsignaling hypothesis discussed above. For instance, Grullon, Michaely, Benartzi, and Thaler (2005) and Grullon,
Michealy and Swaminathan (2002) show that dividend changes do not signal changes in firm’s future profitability.
One would argues however, that if the signaling theory is deemed invalid then why managers are reluctant to
cut dividends, and to increase them if firms cannot sustain such increases in the future? (see for instance, Lintner,
1956; Adjaoud, 1986; Baker, Saadi, Gandhi, and Dutta, 2006).
* Corresponding author. saadi@management.uottawa.ca
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The present study aims to address this luck of consensus in dividend literature on what explanation drives
dividend policy by examining the stock price reactions to dividend announcements within the Canadian stock market.
We conjecture that the recent preference toward the agency theory is due to omission of certain variables that if
controlled for would uncover the signaling role of dividend pay-outs.
While most of the literature predominantly focuses on the US stock market, we chose to examine the
Canadian market as it presents a special case in the study of corporate dividend policy. First, ownership is highly
concentrated in Canadian public firms but widely diffused in U.S. public firms. In Canada, a small group of large
blockholders, or affiliated groups of investors, dominate the ownership scene, where wealthy families maintain some
influence over public officials.1 Secondly, as Cheffins (1999) notes, Canadian public firms operate in a common law
country and are subject to several legal recourses imposed by lawmakers to protect minority shareholders from
corporate expropriation. The presence of high ownership concentration as in Canada is the norm rather than an
exception around the world. While the mechanisms for protecting investors in countries with high ownership
concentration have been questionable, minority shareholders in Canada receive the benefit of strong legal protection.
Thirdly, Canadian equity market is less liquid that the US market where the average size of firms is much greater
(Dutta, Jog, and Saadi 2005). Larger companies have more resources to distribute to their shareholders. In fact,
White (1996) and Fama and French (2001) find that the probability of paying dividends increases with the size of the
firm. Market liquidity may also influence a firm’s dividend payout decision. Lower liquidity leads to information
asymmetry. In order to mitigate the adverse effect of information asymmetry, management might choose to pay
higher dividends.
Using a sample of Canadian firms that report dividend announcements between 1994 and 2000, we show
that dividend announcements are followed by significant abnormal stock returns: positive in case of dividend
increases and negative in case of dividend decreases. A more detailed analysis shows that these abnormal returns are
more important when a company is of small size and are positively related to the existence of blockholders. These
results do not support the agency cost theory explaining why do firms distribute dividends and rather support the
signaling theory.
The remaining of the paper is structured as follows. In Section II, we present a review of the literature on
agency and signaling theories. Section III presents our research methodology. Section IV describes our data while
Section V reports our empirical tests and results. Section VI concludes the paper.
Literature Review
In their seminal work, Miller and Modigliani (1961) show that, in a perfect and frictionless capital market,
when a firm’s investment policy is held constant its dividend policy has no effect on shareholders wealth. Hence,
shareholders should be indifferent between dividend payment and capital gains. However, contrary to this prediction
and despite that dividends are usually more heavily taxed than capital gains, several firms follow extremely
deliberate dividend payout strategies (Lintner, 1956). This fact perplexed financial economists for more than five
decades. Black (1976) once remarked “The harder we look at the dividend picture, the more it seems like a puzzle,
with pieces just don’t fit together.” Almost two decades later Baker, Powell, and Veit (2002) conclude, “Despite a
voluminous amount of research, we still do not have all the answers to the dividend puzzle.”
Endeavor to solve the “dividend puzzle”, the literature proposes several explanations. Of these, most
empirical and theoretical studies favor two explanations usually seen as rival: The signaling theory and agency cost
theory.
Signaling theory
Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985), among others, argue that
dividends mitigate information asymmetry between management and shareholders. These theoretical models propose
that dividend payments convey private information about a firm’s future profitability under the condition that a firm
pays dividends on a regular basis.
Several empirical studies strongly support the signaling explanation including Adjaoud, (1984), Asquith and
Mullins (1983), and Lintner (1956). In particular, Lintner (1956) suggests that past dividends and current earnings
determine current dividends. Asquith and Mullins (1983), and Healy and Palepu (1988) find a positive association
between cash-dividend announcement and firm future profitability. Nissim and Ziv (2001) report a positive
relationship between current dividend changes and future changes in profitability and earnings. Li and Zhao (2005)
find that the propensity to pay or initiate dividends declines with the increase of analyst coverage. Amihud and Li
1
Morck, Stangeland, and Yeung (2000) report that 254 of the 500 largest Canadian companies represent privately
held firms. The remaining 246 are public firms of which only 53 have broad ownership.
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(2006) find that the magnitude of stock price response to dividend changes has diminished since the mid-1970s,
which could make firms less willing to incur costs associated with dividend signaling. Their evidence is consistent
with the disappearing dividend phenomenon documented by Fama and French (2001) and should therefore be
interpreted as supportive of dividend signaling theories.
Other recent studies, however, cast doubt on signaling theory as being inconsistent with the “dividend
disappearance” phenomenon. DeAngelo, DeAngelo, and Skinner (2004) posit that this shift in dividend payers is the
result of a high concentration of dividends among a small number of firms with considerable earnings. Their
evidence challenges the signaling theory as a first-order determinant of payout policy.2 Based on his analysis of six
major international stock markets including the U.S., Osobov (2004) also rejects the signaling argument as an
explanation for the shift of dividend payouts. Grullon, Michaely, and Swaminathan (2002) argue that dividends
convey information about the degree of firm maturity and therefore signal the level of a firm’s risk rather than future
cash flows. On the contrary to the results of Nissim and Ziv (2001), and Grullon et al. (2005) report a negative
correlation between dividend changes and future changes in profitability, and show that models including dividend
changes do not improve out-of-sample earning forecasts. Brav, Graham, Harvey, and Michaely (2005) find that U.S.
managers strongly agree with the notion of dividend signaling but rarely use it consciously to separate their firms
from the competition. Hence, they conclude that management views provide little support for the signaling
hypothesis of payout policy. However, in a recent surveys of executives from Canadian firms listed on the Toronto
Stock Exchange (TSX), Adjaoud and Zeghal (1998), and Baker, Saadi, Gandhi, and Dutta, (2006) find strong
support for a signaling explanation for paying dividends, but not for the agency cost theory.
Agency Theory
The potential agency costs associated with the separation of management and ownership induce a conflictmitigation role for dividend payments. Jensen and Meckling (1976), Jensen (1986), and Lang and Litzenberger
(1989) argue that dividends reduce the cash flow that managers have at their discretion. The agency theory stipulates
that dividend payouts signal reduction in agency costs rather than future profitability.
Several other empirical studies including Moh’d, Perry and Rimbey (1995) and Osobov (2004) show
support for the agency explanation for dividends. For instance, Osobov (2004) argues “dividends disappearance” is
consistent with the agency explanation given the recent improvements in international corporate governance.
Easterbrook (1984) and Rozeff (1982) suggest that dividend payments force companies to go to equity
markets in order to raise additional capital, thus reducing agency costs as a result of the increased scrutiny the capital
market places on the firm. This gives outside shareholders the opportunity to exercise some control. Most of the
literature on relation between dividends and agency costs employ Tobin’s Q, measured by the asset market-to-book
ratio, as a proxy for the quality of a firm’s investment opportunity set and management’s inclination to invest in nonprofitable projects. Based on the signaling explanation, Tobin’s Q is an indication of investors’ expectation of a
firm’s growth prospects or investment opportunities: A firm with a high Q ratio (i.e. Q>1) should exhibit higher
abnormal returns following dividends announcement than a firm with low Q ratio (i.e. Q<1) since it is perceived by
investors as having higher growth opportunities. Easterbrook (1984) and Rozeff (1982) use Tobin’s Q and find
opposite results than those expected under signaling theory, which they interpret as evidence for dividend as an
agency-cost-reducing mechanism rather than being a signaling tool.
We contend that the results reported by Easterbrook (1984) and Rozeff (1982) are not necessarily
inconsistent with the signaling explanation. Nevertheless, they could even be evidence for a signaling role of
dividend policies if the above studies had controlled for the following factors:
First, several studies find a positive association between Q ratio and firm size. For instance, Fama and
French (1996), and Chan and Chen (1996) report that small firms display, in average, lower Q ratios than large firms.
Secondly, others studies show that large firms are more widely covered by business press and followed by
larger financial analysts than small firms. In fact, Atiase (1985) shows that the business press publish fewer items for
small firms than for large firms. Based on Atiase’s (1980, 1985) differential information hypothesis, dividend
announcements hold more surprise for small firms than large ones, thereby causing greater market reactions in terms
of abnormal returns for small firms than for large firms. Freeman (1983) and Richardson (1984) report supporting
evidence to the Atiase’s firm size hypothesis.
If we take these two factors into consideration, reporting higher abnormal returns for firms with lower
growth opportunities does not necessarily contradict the signaling explanation, but could back it since dividend
announcements tend to exhibit more surprise for small firms. Accordingly, we would expect significantly higher
stock-price reaction to dividend announcements for small firm compared to large ones.
2
Some may argue that the discussion in DeAngelo, DeAngelo, and Skinner (2004) based on the concentration of
dividends among few large firms is qualitative and so insufficient to reject signaling theories.
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Research on dividend policy has taken an interesting twist since the publication of Fama and French (2001).
Their evidence shows that in the past two decades the number and proportion of U.S. dividend-paying firms have
dropped radically. Specifically, the proportion of dividend-paying firms fell from 67% to 21% between 1978 and
1999. Fama and French (2001) conclude that the drastic decline in dividend propensity over the last two decades is
mainly due to changes in firm characteristics. They find that dividend-paying firms are those with high profitability
and low growth, while non-paying firms tend to exhibit low profitability and high growth. Evidence by Grullon,
Michealy and Swaminathan (2002) as well as DeAngelo and DeAngelo (2006) support this lifecycle-based
explanation. This shows that, in the American context, dividend payout policies depend on three major factors
namely profitability, size and growth opportunity.
Two other important determinants of dividend policy which have received only limited attention until
recently are ownership structure and shareholders legal protection. Several studies have introduced firm ownership
structure to explain some aspect of the finance theory (Ang, Cole and Lin, 2000; Gugler and Yurtoglu, 2003a; Jensen
and Meckling, 1976; Morck, Shleifer and Vishny, 1988). Some studies shed light on the role of ownership structure
in mitigating agency cost given its influential role in internal monitoring effort (Denis, Denis, and Sarin, 1997).
Jensen and Meckling (1976), for instance, show that management stock ownership can reduce agency costs by
aligning the interests of a firm's management with its shareholders. Ang, Cole, and Lin (2000) use asset turnover
ratios to measure agency costs between managers and shareholders in closely held corporations, which the finance
literature refers to vertical governance problem (Roe, 2004).3 They report significant inverse relation between agency
cost and managerial shareholdings, thus providing a strong empirical support to theoretical work by Jensen and
Meckling (1976). They also find that the agency cost increases with the number of non-managerial shareholders.
More recent studies pay particular attention to the presence of blockholders and report that they have an important
influence on monitoring firms. For example, Bhagat, Black, and Blair (2001) find that during the period 1987-1990
firms with large blockholdings exhibit superior performance than their peers.
Several studies including Allen, Bernardo, and Welch (2000), Grinstein and Michaely (2003), Gugler and
Yurtoglu (2003b), and Rozeff (1982), document an explicit relation between ownership structure and corporate
dividend policy. For instance, Allen, Bernardo, and Welch (2000) and Grinstein and Michaely (2003) show that
firm’s dividend decisions are related to the desirability of having institutional investors among their shareholders. 4
Amihud and Li (2006) partly attribute the decline in the information content of dividend announcements to the rise in
stock ownership by institutional investors who are more sophisticated and informed. Rozeff (1982) reports a positive
relation between dividend payout and the fraction of equity owned by managers and a negative relation with high
dispersion of ownership measured by the number of stockholders of a firm. In the same vein, Noronha, Shome and
Morgan (1996) find a positive relation between dividend payout ratio and the existence of blockholders.
Recent studies further refine the dividend puzzle by providing evidence supporting the influence of
shareholders legal protection on dividend decisions consistent with the agency theory (La Porta Lopez-De-Salinas,
Shleifer, and Vishny 2000; Faccio, Lang, and Young 2001). For instance, La Porta et al. (2000) show that
corporations operating in countries with strong legal protection of minority shareholders (i.e. common law countries)
pay higher dividends than firms in countries with weak legal protection (i.e. civil law countries). They also find that
high growth firms in common law countries pay lower dividends than low growth firms. This observation however
was not reported for firms in civil law countries.
Given the high ownership concentration of Canadian firms and the strong legal protection that minority
shareholders benefit in Canada, we expect that the agency problem is not severe, and thus market reaction to
dividends change should mainly reflect an information effect about firm’s future profitability.
Research Methodology
To examine shareholders reactions to dividend announcements, we use both univariate and multivariate
analysis. The univariate analysis consists of an event study by which we aim to, first, examine stock price reaction to
dividend announcements, and second, determine how this market reaction is affected by firm size and growth
opportunity. Accordingly, at a first stage, we endeavor to test the following hypotheses:
Hypothesis 1: Dividend announcements induce abnormal returns that are significantly different from zero.
Hypothesis 2: Abnormal returns would be higher for firms with low growth opportunity (i.e. Q<1) than for
firms with high growth opportunity (i.e. Q>1).
3
The second agency problem proposed by the finance literature is the governance problem between majority and
minority shareholders labeled by Roe (2004) as horizontal governance problem.
4
Allen, Bernardo, and Welch (2000) argue that some firms prefer to be monitored by institutions in order to increase
value. Given that institutions prefer dividends, these firms tend to attract them by paying higher dividends. Gillan and
Starks (2000), and Hartzell and Starks (2003) report supporting evidence to the monitoring role of institutions.
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Hypothesis 3: Firms with Q<1 would be of small size, while those with Q>1 would be of large size.
At a second stage, we employ a multivariate analysis where we seek to examine the influence of several
variables on the informational content of dividend announcements.
To examine stock price reaction to dividend announcements, we compute the abnormal returns using the
Market Adjusted Model. The model defines abnormal returns as the excess return on a security, adjusted for the
return on the market index over the same period of time. The equation for market adjusted abnormal returns is as
follows:
ARi ,t  Ri ,t  Rm ,t
(1)
Where:
ARi ,t is the market adjusted abnormal return on security i over time t.
Rm ,t is the time t return on the market index.
Ri ,t is the time t return (including dividends) on security i.
The literature of event study analysis proposes other models to estimate the abnormal returns, such as the
Market Model. Nonetheless, several empirical studies show that Market Adjusted Model provides similar results to
those of more sophisticated models (Brown and Warner, 1985). In addition the Market Adjusted Model has other
advantages such as simplicity in implementation and interpretation.
We measure the abnormal wealth effects by computing the average 10-day cumulative abnormal return
across events:
CARt  5 AARt
4
AARt   ARi ,t N and
where
(2)
N is the number of events.
We compute and test for the statistical significance of the average cumulative abnormal return for dividend
surprise in both directions: dividend increases of at least 10% and dividend decreases of at least 10%. The choice of
the percentage change of 10% is consistent with recent empirical studies dealing with the information content of
dividends changes (see, for example, Denis, Denis and Sarin, 1994; Yoon and Starks, 1995; and Lie, 2000).
We use the following regression model to examine the determinants of market reactions to dividend
announcements:
CARi   0  1 SIZEi   2 GROWTH i   3 BlockHolde rsi   4 CFi   i
(3)
Where:
CAR
SIZE
GROWTH
is the average cumulative abnormal return over (-1, +1) around the dividend announcements
estimated using the Market Adjusted Model. We use a three-day window across announcement
day following previous empirical studies such as of Yoon and Starks (1995).
is the firm size measured by the natural logarithm of the market value of outstanding common
stock. Based on Atiase’s (1980, 1985) differential information hypothesis, we expect the firm
size’s coefficient to be negative since the informational content for small firm is greater than
for large firms.
is the growth opportunity measured by Tobin’s Q ratio (which is computed as market value of
asset / book value of asset). We include Q ratio in our model in order to test for the dividend
informational content hypothesis. If dividend announcements convey positive signal about firm
future profitability, then we expect more positive stock price reactions, on average, for firms
that have high growth opportunity than firms with low growth opportunity (Lang and
Litzenberger, 1989).
BlockHolders is an indicator of the level of ownership concentration and refers to the percentage of equity
interest held as a group by the directors of the company and by other individuals or companies
that own more than 10% of the equity shares of the company. Ang, Cole, and Lin (2000) report
significant inverse relation between agency cost and managerial shareholdings. Rozeff (1982)
reports a positive relation between dividend payout and the fraction of equity owned by
managers and a negative relation with high dispersion of ownership measured by the number of
stockholders of a firm. In the same vein, Noronha, Shome and Morgan (1996) find a positive
relation between dividend payout ratio and the existence of blockholders. Given that Canada is
a common low country where most of the firms are closely held agency problem between
managers and shareholders should low, thus we expect the coefficient of “BlockHolders”
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FC
ISBN : 0-9742114-6-X
variable to be negative.5
are the free operating cash flows. According to agency theory, dividends payouts lessen agency
problems between corporate insiders and outside shareholders by reducing the amount of free
cash flows that could be invested in unprofitable projects or diverted by insiders for personal
use (Jensen, 1986; Lang and Litzenberger, 1989). Consequently, stock price reactions should
increase with the level of free cash flow. Hence, we expect the coefficient of the free cash flow
variable to be positive.
Data
Our initial sample includes all dividend-paying stocks listed on the Toronto Stock Exchange (TSX) between
January 1, 1994 and December 31, 2000. The dividend announcement dates are obtained from “Bloomberg”
database. Our initial sample consists of 10,784 dividend announcement for 1,879 firms. For each announcement date
we have its corresponding firm’s name, dividend type, record date, ex-dividend date and pay date. We exclude
special dividends, dividend announcements by foreign corporations and dividends labeled in foreign currencies.
Further, we use TSX Daily Record review to check for any major event relative to each firm within 10-day period
across each announcement date. We eliminate observations where a major event is identified and deemed important
enough to induce a contamination effect to the dividend announcement event. Our final sample consists of 2,130
announcements for the entire period. Their corresponding daily closing stock prices are obtained from the Canadian
Financial Markets Research Centre Database CD (TSX-CFMRC). Data on stock prices are used to compute the daily
returns and daily abnormal returns. Accounting data are provided in StockGuide database.
To be consistent with previous studies dealing with dividend announcements and to ensure that potential
signals announcements are significant, we classify the number of announcements in our sample as follows:
 Dividend increase: The percentage increase in dividends over the previous dividend should be at least 10%.
 Dividend decrease: The percentage decrease in dividends over the previous dividend should be at least
10%.
 Stable dividend: The percentage change in dividends over the previous dividend is less than 10%.
Table 1 presents the partition of dividend announcements for each year by type dividend change. Two
observations can be drawn about our sample. First, the number of dividend announcements increase over the period
of study. Second, most of the announcements belong to the category of stable dividend, while there is much less
dividend decreases than dividend increases.
Insert Table 1 about here
Empirical Results
Table 2 reports abnormal returns and cumulative abnormal returns for 10 days across dividend
announcement date. Some interesting observations emerge. First, announcements of dividend increase generate
positive and significant abnormal returns. Indeed, the cumulative abnormal return for day -1 through day +1 is
1.26%. Second, when it comes to announcements of dividend decrease, however, the abnormal returns are negative
and significantly different from zero. In fact, the cumulative abnormal return for day -1 through day +1 is -1.18%.
Interestingly, results in Table 2 show no significant abnormal returns for announcement of stable dividends.
Taken altogether, the results reported in Table 2 support hypothesis 1 showing that dividend announcements
induce abnormal returns that are significantly different from zero: positive in the case of substantial dividend increase
and negative in substantial dividend decrease. This has been said, however, the present results can be explained by
either the signaling theory or agency theory. Therefore, further analyses are indeed necessary in order to identify
what explanation drives the dividend policy in the Canadian stock market.
Insert Table 2 about here
Table 3 presents cross-sectional descriptive summaries between dividend announcement and the sign of the
cumulative abnormal returns for day -1 through day +1. The results show that in the case of stable dividend,
abnormal returns are equally distributed between positive returns (56.5%) and negative returns (43.5%). When
dividends increase substantially, 79% of the abnormal returns are positive, while 81% are negative when dividends
5
It is noteworthy that the “BlockHolders” variable includes both inside blockholders (directors and managers) and
outside blockholders (institutional and outside investors) ownership.
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decrease by at least 10%. The value of test of independence (χ 2 = 19.34) is significantly different from zero at 1%
level, which supports the existence of strong association between abnormal returns and the type of dividend
announcement.
Insert Table 3 about here
Results reported in Table 4 show that, in the case of dividend increase, the abnormal returns of day -1 to day
+1 are significantly for firms with lower Q ratio, and inversely in the case of dividend decrease. For dividend
decreases, the same pattern is observed: the abnormal returns for lower Q firms are lower than abnormal returns of
higher Q firms. Based on t-test and z-test, the abnormal returns for the two groups of firms are significantly different.
Though supporting hypothesis 2, these results may appear surprising if dividend changes are seen as signaling
information about changes in future profitability. Based on this prediction, previous studies reject the signaling
theory. However, and as stated in hypothesis 3, it is important to note that firms with low Tobin’s Q ratio are also of
small size. In fact, as it can be observed from Table 4, there is reliable and strong evidence showing that the average
size of firms with Q<1 is almost the half of the average size of firms with Q>1 and this for both dividend increase (ttest =-3.77) and dividend decrease (t-test = -3.13). If, as suggested by the differential information hypothesis, small
firms are much less followed by financial analysts than large firms, then dividend announcements for small firm will
cause greater market reactions in terms of abnormal returns. Consequently, further analyses are required before a
conclusion could be reached on which of the two theories holds in explaining the Canadian corporate dividend
policies.
Insert Table 4 about here
As suggested by Lie (2000), we use ordinary least squares regression to further examine the market
reactions to dividend announcement. Table 5 presents the results of estimating model 3. The results show that there is
reliable evidence of negative relation between firm size (SIZE) and abnormal returns across dividend announcement
date (p-value 0.024). This provides supporting evidence to the differential information hypothesis, where dividend
announcements for small firm cause greater market reactions than for large firms, as shown by Atiase (1985) and Li
and Zhao(2005).
The coefficient of the variable GROWTH is negative and significant at 1% level. This result corroborates
the one reported in Table 4. As discussed above, based on results similar to ours, previous studies have rejected the
signaling explanation in favor of agency cost theory. Moreover, our regression results show that there is reliable
evidence of a positive association between level ownership concentration (BlockHolders) and abnormal returns (pvalue 0.032). This result is inconsistent with the view that dividend is a device that reduces agency costs between
managers and shareholders (Jensen and Meckling, 1976; Easterbrook, 1984; Rozeff, 1982). As stated above the
variable “BlockHolders” includes both inside blockholders (directors and managers) and outside blockholders
(institutional and outside investors) ownership. As Morck, Shleifer, and Vishny (1988), and Byrd, Parrino, and Pritch
(1998) report, the impact of internal and external ownership on a firm’s decision-making process and performance
could differ markedly. In other words, the preference of blockholders are not homogenous and as results the sign of
the coefficient will be the net results of these competing preferences. Hence, the sign of the bockholders coefficient
may reflect the nature of the influence of ownership structure in Canada on setting dividend policies. In fact, a
positive sign shows that the resulting effect on corporate payout policies is a preference for dividends.
Finally, the results reported in Table 5 suggest that the variable free cash flow (FC) has no significant
influence on abnormal returns, which in turn present further evidence against the agency cost explanation. It
noteworthy that our results are consistent with the survey results of Baker et al.(2006) where authors find that
Canadian managers to express support for a signaling explanation for paying dividends, but not for the agency cost.
Insert Table 5 about here
Conclusion
Black (1976) once remarked, “The harder we look at the dividend picture, the more it seems like a puzzle,
with pieces just don’t fit together.” Attempting to solve this puzzle, the overwhelming volume of studies on dividend
policy offer several explanations, where two of them have gained most of the support on the empirical ground: the
signaling theory and agency cost theory. Recently, however, a growing number of studies, mainly in the U.S. context,
report mixed results on what of the two theories explains the dividend policies.
In an attempt to help solve this luck of consensus, we investigate the reaction of the Canadian market to
dividend announcements, where firms exhibit a high level of ownership concentration and operate in environment
where minority shareholders are highly protected. Our results show that dividend announcements are followed by
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significant abnormal stock returns: positive in case of dividend increases and negative in case of dividend decreases.
A more detailed analysis shows that the abnormal returns are greater when the company is of small size and with the
existence of blockholders. These results do not support the agency cost theory in explaining why do firms pay
dividends and rather support the signaling theory.
Based on the above results, it will be interesting to test, in subsequent years, whether a firm future profitability is
consistent with its corresponding signals conveyed by dividend announcements. Another avenue for future research is
to replicate the present study in countries with different legal protection and ownership concentration than in Canada,
and see how these factors would affect our results. Moreoever, since the coefficient of the variable “BlockHolders”
reflects the resulting preference of different type of blockholders, future research can also look at the effect of each
type of blockholders: outside block holders and inside blockholders for both dividend announcement increases and
decreases. A particular attention should also be paid to the presence of institutional blockholders. This would provide
a better understanding of the stock market reaction to dividend announcements.
OCTOBER 15-17, 2006
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6th Global Conference on Business & Economics
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6th Global Conference on Business & Economics
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OCTOBER 15-17, 2006
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Table 1: Sample Partition by Year and by Type of Dividend Change for Firms listed
on Toronto Stock Exchange over the Period 1994-2000.
Table 1 presents a classification of the number of announcements in our sample by year and by type of dividend
changes: Dividend increase: The percentage increase in dividends over the previous dividend should be at least
10%. Dividend decrease: The percentage decrease in dividends over the previous dividend should be at least
10%. Stable dividend: The percentage change in dividends over the previous dividend is less than 10%. The
announcement date (day 0) is the dividend declaration date, provided in “Bloomberg”.
1994
1995
1996
1997
1998
1999
2000
Total
Dividend Increase
56
54
64
72
137
149
104
636
Stable Dividend
124
162
164
188
46
99
290
1073
Dividend Decrease
19
25
28
33
121
159
36
421
Total
199
241
256
293
304
407
430
2130
Table 2: Abnormal Returns & Cumulative Abnormal Returns
Table 2 reports the average abnormal returns (AAR) and average cumulative abnormal returns (CAR) for day -5
through day 4, for each of the three dividend change categories: Dividend increase: The percentage increase in
dividends over the previous dividend should be at least 10%. Dividend decrease: The percentage decrease in
dividends over the previous dividend should be at least 10%. Stable dividend: The percentage change in
dividends over the previous dividend is less than 10%. The announcement date (day 0) is the dividend
declaration date, provided in “Bloomberg”. Abnormal returns are computed using the Market Adjusted Model.
Dividend Increase
Stable Dividend
Dividend Decrease
(N = 636)
Day (t)
AAR
CAR
(%)
(%)
(N = 1073)
t-test
AAR
CAR
(%)
(%)
(N = 421)
t-test
AAR
CAR
(%)
(%)
t-test
-5
0.11
0.11
0.46
0.005
0.005
0.01
0.03
0.03
0.49
-4
0.16
0.27
0.98
0.01
0.01
0.05
-0.24
-0.20
-1.05
-3
0.16
0.43
1.02
0.16
0.17
0.89
-0.19
-0.40
-1.58
-2
0.25
0.67
1.08
0.06
0.23
0.28
-0.02
-0.42
-1.61
-1
0.37
1.04
2.21**
-0.02
0.21
-0.09
-0.32
-0.73
-1.92**
0
0.46
1.50
2.67***
-0.04
0.17
-0.21
-0.51
-1.24
-2.44***
1
0.43
1.93
2.15**
0.05
0.22
0.29
-0.35
-1.59
-1.94**
2
0.36
2.29
1.59
-0.05
0.17
-0.27
-0.52
-2.11
-1.98**
3
0.30
2.59
1.20
-0.16
0.01
-0.91
-0.31
-2.42
-1.07
4
0.21
2.80
1.13
0.33
0.34
1.18
-0.08
-2.50
-0.86
*** Significant at 1%; ** Significant at 5%; * Significant at 10 %.
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Table 3: Test of Independence
Table 3 presents cross-sectional descriptive summaries between dividend announcement and the sign of the
cumulative abnormal returns for day -1 through day +1. Figures in parentheses are t-statistics. The
announcement date (day 0) is the dividend declaration date, provided in “Bloomberg”.
Dividend Announcement
Type
Positive Cumulative Abnormal
Return
Increase
Stable
Decrease
Negative Cumulative
Abnormal Return
Total
502 (79%)
134 (21%)
636
606 (56.5%)
467 (43.5%)
1073
80 (19%)
341 (81%)
421
1 188
942
2 130
Total
χ = 19.34, significant at 1%.
2
Table 4: Rank by Tobin’s Q Ratio
Panel A. Dividend Increase
The present table presents descriptive statistics for dividend increase. N is the number of observation, Q is
market value of assets / book value of assets. AAR0 is the average abnormal returns on the dividend
announcement day.
Q<1
Q≥1
t-test
z-test
(N = 234)
(N = 148)
Tobin’s Q ratio
0.48
2.10
-11.54***
AAR -1
0.38
0.24
1.65**
-1.72**
AAR0
0.47
0.25
1.83**
-1.78**
AAR1
0.59
0.31
2.04**
-1.83**
10,900
26,644
-3.77***
-6.22***
Total Asset (in M$)
-16.36***
Panel B. Dividend Decrease
The present table presents descriptive statistics for dividend increase. N is the number of observation, Q is
market value of assets / book value of assets. AAR0 is the average abnormal returns on the dividend
announcement day.
Q<1
Q≥1
t-test
z-test
(N = 199)
(N = 103)
Tobin’s Q ratio
0.47
2.05
-9.11***
-14.24***
AAR -1
-0.33
-0.21
-1.42*
-1.69**
AAR0
-0.78
-0.49
-2.09**
-3.31***
AAR1
-0.57
-0.47
-1.34*
-1.62**
19,534
32,751
-3.13***
-4.17***
Total Asset (in M$)
*** Significant at 1%; ** Significant at 5%; * Significant at 10 %.
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Table 5: Multivariate Analysis
Table 5 present the results of estimating the following model:
CARi   0  1 SIZE i   2 GROWTH i   3 BlockHolders i   4 FCi   i ; where CAR is the cumulative
abnormal return over (-1, +1) around the dividend announcements estimated using the Market Adjusted Model,
SIZE is the firm size measured by the natural logarithm of the market value of outstanding common stock.,
GROWTH is the growth opportunity measured as market value of asset / book value of asset, BlockHolders is
an indicator of the level of ownership concentration and refers to the percentage of equity interest held as a
group by the directors of the company and by other individuals or companies that own more than 10% of the
equity shares of the company, FC are the free operating cash flows.
Coefficient
t-test
p-value
Intercept
SIZE
GROWTH
BlockHolders
FC
0.0634
-0.0033
-0.003
0.01
0.0001
3.0972***
-2.2572**
-2.8703***
2.1482**
0.4632
0.002
0.024
0.0042
0.032
0.30
*** Significant at 1%; ** Significant at 5%; * Significant at 10 %.
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