How Stock Prices React To Dividend Announcements Finance Essay

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Main objective of the corporate finance is to maximize the value of the shareholders in firm. This is objective is achieved through investment and financing decisions. Investments decisions involve the selection of positive net present value projects while financing decisions involve the selection of capital structure that minimize the cost of capital of the firm. Apart from these decisions, managers need to decide on regular basis to payout the earnings to shareholders, reducing the agency problem (Jenson and Meckling, 1976).

However question remains whether paying out of earnings would essentially create value for the shareholders or not. This decision constitutes the dividend policy behaviour of a firm. In modern finance, dividend decisions have attracted more attention.

Dividend policy is considered one of the most crucial issues for management decision today, because it serves as a communication tool between management and investors. Dividend signals lot of information to investors as they do involve cash and cash cannot be easily manipulated. This is known as the information contents of dividends. (Arab, Sedrine and Karaa, 2004).

A greater amount of researchers have examined the impact of dividend announcements on share price from a variety of different perspectives and in a selection of different circumstances. Dividend policy behaviour of corporations operating in emerging markets is significantly different from the widely accepted dividend policy behaviour of corporations operating in developed markets. There has been a lot of research on various stock exchanges in developed markets worldwide on this topic, but there has been only a small amount of research in emerging markets like India.

Research Question

The guiding principle and underlying theme of my research is as follow:

How does Stock Prices react to dividend announcements in emerging markets?

In order to reach most accurate conclusion, I have divided above question into four sub questions or issues:

· Do dividend announcements really convey any information to investors? If yes,

· What type of information they convey?

· What could be the informational effect of these announcements?

· How do stock prices actually react to this information and under what circumstances?

The purpose of the study

Focussing mainly on companies listed on Bombay Stock Exchange, main purpose of the study is to investigate whether dividend announcements have any effect on share prices or not. Under the preview of market efficiency, an in depth understanding of widely accepted dividend policy practices of corporations in India would be made.

To observe the effect of dividend announcements on stock prices, the relationship between dividend announcements and stock prices would be explored by applying some statistical models and techniques. In the light of these findings, informational effect of dividend announcements would be evaluated.

Hypothesis development

Stock prices reaction to dividend announcements would be tested to check whether this is consistent with the signalling theory. A market reaction in the same direction as the dividend changes suggests that dividend announcements convey information to the market about the future prospects of the firm and vice-versa.

The following hypotheses would be tested:

H0: Dividend announcements do not provide information to the market, i.e. there is no stock prices reaction to the dividend announcements.

H1: Dividend announcements provide information to the market, i.e. there is stock prices reaction to the dividend announcements.

Study outline

After having deeply studied the concerned literature and following an exhaustive search of databases and journals, focus of analysis will be exploring the evidence of relationship between divided announcements and stock prices behaviour of selected companies on Bombay Stock Exchange. For this quantitative data would used for both the variables collected with some specified criteria. For the dividend announcements, first, companies would be separated where the announcement is significantly different from what is being forecast: positive and negative surprises, based on the information contents of the news, identified as good and bad. For stock prices, monthly data would not be considered because there can be many surprises in a month besides the dividend announcement effect being studied. To be precise on testing the market efficiency, it is important to measure the impact of the announcement using the smallest feasible interval. That is why; daily data would be taken for some specified time period interval.

2. Literature Review

There is an extensive literature that investigates the informational content of market announcements such as dividends. The influential paper by Ball and Brown (1968) was followed by many others in this field, such as those by Aharony and Swary (1980) and Sant and Cowan (1994) and Arab, Sedrine and Karaa, (2004). This paper would be carried out within the framework of market efficiency and literature analyzing informational content of dividend announcements.

Market Efficiency

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security. Some of the most interesting and important academic research during the past 20 years has analyzed whether our capital markets are efficient. This extensive research is important because its results have significant real-world implications for investors and portfolio managers. In addition, the question of whether capital markets are efficient is one of

the most controversial areas in investment research. Recently, a new dimension has been added to the controversy because of the rapidly expanding research in behavioral finance that likewise has major implications regarding the concept of efficient capital markets. (Reilly and Brown, 2006). Because of its importance and controversy, there is need to understand the meaning of the terms efficient capital markets and the efficient market hypothesis (EMH).

Topic of efficient capital markets is being considered at this point for the reason to consider the efficiency of the market in terms of how security prices react to new information. As noted earlier, in an efficient capital market, security prices adjust rapidly to the infusion of new information, and, therefore, current security prices fully reflect all available information. To be absolutely correct, this is referred to as an informationally efficient market (Reilly and Brown, 2006). Although the idea of an efficient capital market is relatively straightforward, it is often failed to consider why capital markets should be efficient. What set of assumptions imply an efficient capital market? An initial and important premise of an efficient market requires that a large number of profit maximizing participants analyze and value securities, each independently of the others.

Second assumption is that new information regarding securities comes to the market in a random fashion, and the timing of one announcement is generally independent of others. Third assumption is especially crucial: profit-maximizing investors adjust security prices rapidly to reflect the effect of new information. Although the price adjustment may be imperfect, it is unbiased. This means that sometimes the market will over adjust and other times it will under adjust, but one cannot predict which will occur at any given time. Security prices adjust rapidly because of the many profit-maximizing investors competing against one another. The combined effect of information coming in a random, independent, unpredictable fashion and numerous competing investors adjusting stock prices rapidly to reflect this new information means that one would expect price changes to be independent and random (Reilly and Brown, 2006). Adjustment process requires a large number of investors following the movements of the security, analyzing the impact of new information on its value, and buying or selling the security until its price adjusts to reflect the new information. This scenario implies that informationally efficient markets require some minimum amount of trading and that more trading by numerous competing investors should cause a faster price adjustment, making the market more efficient. (Reilly and Brown, 2006)

Finally, because security prices adjust to all new information, these security prices should reflect all information that is publicly available at any point in time. Therefore, the security prices that prevail at any time should be an unbiased reflection of all currently available information, including the risk involved in owning the security. Therefore, in an efficient market, the expected returns implicit in the current price of the security should reflect its risk, which means that investors who buy at these informationally efficient prices should receive a rate of return that is consistent with the perceived risk of the stock. Most of the early work related to efficient capital markets was based on the random walk hypothesis, which contended that changes in stock prices occurred randomly. Fama (1991) presented the efficient market theory in terms of a fair game model, contending that investors can be confident that a current market price fully reflects all available information about a security and the expected return based upon this price is consistent with its risk. In his original article, Fama divided the overall efficient market hypothesis (EMH) and the empirical tests of the hypothesis into three sub hypotheses depending on the information set involved: (1) weakform EMH, (2) semi strong-form EMH, and (3) strong-form EMH.

The weak-form EMH assumes that current stock prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information, such as odd-lot transactions, block trades, and transactions by exchange specialists. The semi strong-form EMH asserts that security prices adjust rapidly to the release of all public information; that is, current security prices fully reflect all public information. The semi strong hypothesis encompasses the weak-form hypothesis, because all the market information considered by the weak-form hypothesis, such as stock prices, rates of return, and trading volume is public. The strong-form EMH contends that stock prices fully reflect all information from public and private sources. This means that no group (Reilly and Brown, 2006).

During the last decade, a new branch of financial economics has been developed referred to as behavioral finance, which is concerned with the analysis of various psychological traits of individuals and how these traits affect how they act as investors, analysts, and portfolio managers. As noted by Olsen (1998), behavioral finance recognizes that the standard finance model of rational behavior and profit maximization can be true within specific boundaries, but advocates of behavioral finance assert that this model is incomplete since it does not consider individual behavior. Specifically, behavioral finance seeks to understand and predict systematic financial market implications of psychological decision processes. Behavioral finance is focused on the implication of psychological and economic principles for the improvement of financial decision making.

The results of many studies indicate that the capital markets are efficient as related to numerous sets of information. At the same time, research has uncovered a substantial number of instances where the market fails to adjust prices rapidly to public information. Given these mixed results regarding the existence of efficient capital markets, it is important to consider the implications of market efficiency in emerging markets.

Market Efficiency in Emerging Markets

The vast majority of efficient market research to date has focused on the major United States and European securities market. Far fewer have investigated the developing and less developed countries markets. It is usually believed that the markets in developing and less developed countries are not efficient in semi-strong form or strong form. The test of semi strong form and strong form efficiency is very rare in less developed countries because of absence of sufficient data in a convenient form, structural profile, inadequate regulations, lack of supervision and administrative loose in the implication of existing rules. In addition, companies' information are released and circulated before the annual report is officially available; the annual reports of some of the listed companies are mistrusted and is often result of rumors circulation in the market about the companies. The market moved dramatically over a period of time to become a speculation market and then a gamble market. That means there is a trend of market movement and most of the investors in the market become speculators. Moreover, share price indices data are available and reliable to test the weak form efficiency of the market. It is very much convenient to test the weak form efficiency of the market rather than semi-strong form and strong-form efficiency. (Mobarek and Keasey (2005)

The definition of emerging market highlights on the growth potentiality as well as rapid growth of size of the market. However, it is not unlikely that the market participants are not well informed and behaving irrational compare to well organize markets. Samuel's (1981), who asserts the nature of the emerging market in terms of information availability such as follows:

"Prices can not be assumed to fully reflect all available information. It can not be assumed that investors will correctly interpret the information that is released. The corporation has greater potential to influence its own stock market price and there is a greater possibility that its price will move about in a manner not justified by the information available"

According to Fama (1970), EMH can be categorised into three levels based on the definition of the available information set, namely weak form, semi-strong form, and the strong form. Following the work of Fama, the EMH has been widely investigated in both developed and emerging markets. Especially, in emerging stock markets, most empirical studies have focused on the weak form, the lowest level of EMH because if the evidence fails to support the weak-form of market efficiency, it is not necessary to examine the EMH at the stricter levels of semi-strong and strong form (Wong and Kwong, 1984).

But the research findings on the market of developing and less developed countries are controversial. Some of the researcher find evidence of weak form efficiency and can not reject the random-walk hypothesis in emerging markets (For instance; Ojah and Karemera, 1999). Whereas the others find the evidence of non-randomness stock price behavior and reject the weak-form efficiency in the developing and emerging markets (such as; Nourredine Khaba, 1998).

Most of the less developed markets suffer with the problem of thin trading. In addition, in smaller markets, it is easier for large traders to manipulate the market. Though it is generally believed that the emerging markets are less efficient, the empirical evidence does not always support the thought. Nourrrendine Kababa (1998) has examined the behaviour of stock price in the Saudi Financial market seeking evidence that for weak-form efficiency and find that the market is not weak-form efficient. He explained that the inefficiency might be due to delay in operations and high transaction cost, thinness of trading and illiquidity in the market. In short, review of previous studies state that the developed markets are generally weak-form efficient. But the dynamics of emerging market equities requires clarification. Comparison and a needed additional information on equity price dynamics is an important segment of the world's emerging capital markets (Mobarek and Keasey (2005).

Is Bombay Stock Market Efficient?

Bombay Stock Exchange (BSE) has been acclaimed to be the largest out of 22 stock exchanges in India. In 1875, BSE was established as Association of Persons (AOP). Today, it is the oldest and largest stock exchange, not only in the country, but in Asia as well. With over 6,000 stocks listed, this Stock Exchange of Mumbai enumerates for more than two-third of the total trading volume in India. It is also the first stock exchange to be recognized by the Government of India, under the Securities Contracts Act, 1956. (

Since its establishment, Bombay Stock Exchange has played a vital role in the growth of capital markets in India. Another great truth about BSE is that it is the world's fifth largest stock exchange, with a market capitalization of $466 billion. It makes use of BSE SENSEX, which is an index of 30 big and developed stocks. The index provides an evaluation of the comprehensive performance of BSE and is very much tracked throughout the world.


In 1992, Securities and Exchange Board of India (SEBI) was established to reform and regulate the Indian stock market. NSE was set up with tight disclosure norms and disclosures policies. Futures and options of individual stocks commenced from 2000 onwards. This was expected to improve the liquidity and efficiency in the market. The newly created derivatives market turnover now exceeds the cash market and market capitalisation as a ratio of GDP has improved from lows of 10 per cent to around 50 per cent currently. Electronic trading was established. The Depository Act, 1996 paved the way for setting depositories for trading in dematerialised form. The recommendations of the L C Gupta Committee (1996) on derivatives trading was accepted and passed by Parliament in December 1999, which expanded the definition of securities to include derivatives. ( But in spite of these evolutions, India's biggest stock market BSE has not gained informational efficincy.

However factors leading to inefficiency of BSE includes, Gross domestic product per capita which is substantially below the average for developed economies; greater government regulation limiting or banning foreign ownership in domestic companies; a lax and/or corrupt regulatory environment; in efficient back office operations including clearing and settlement capabilities; restrictions on repatriation of initial capital, dividends, interest and capital gains; greater perceived investment risk than in developed markets. (Dan W.Hess 1998).

On the other hand, Sharma (1983) examined the efficiency of Bombay Stock Market and the randomness of stock price behavior on BSE. Data for 23 companies was used for this purpose. He concluded that price change behavior on BSE was similar to those in developed economies. Results indicated that stock price changes followed a general random walk behavior, which means weak form efficiency.

Prior Research in BSE

There is not too much research in Indian market about its efficiency. Bhatacharya and Mukherjee (2002) concluded that stock market in India is still in a transitory phase. If this result is also arrived at for subsequent periods, then it may be concluded that Indian stock market is approaching towards informational efficiency at least with respect to three macroeconomic variables, viz. exchange rate, foreign exchange reserves and trade balance.

Poshakwale (1996) has presented evidence concentrating on the weak form efficiency and on the day of week effect in the Bombay Stock Exchange under the consideration that variance is time dependent. Moving from its traditional functioning to that required by the opening of the capital markets, the BSE has presented different patterns of stock returns and supports the validity of day of the week effect. The frequency distribution of the prices in BSE does not follow a normal or uniform distribution

Wickremasinghe and Cooray (2005) have examined weak form efficiency in the stock markets of India, Sri Lanka, Pakistan and Bangladesh and the degree of linkage between these markets. The classical unit root tests support weak form efficiency for all four countries. Hence, the post-deregulation stock markets of South Asia appear in general to be efficient except in the case of Bangladesh for which the results are mixed.

Ahmed and Ashraf (2006) rejected the random walk hypothesis for NSE Nifty (National Stock Exchange of India) and BSE Sensex stock indices. According to them, both the stock markets are relatively more inefficient in the second period. There is high and increasing volatility in both the stock indices. The results seem to go against the efforts towards improving the functioning and transparency of the stock market. It seems certain anomalies still exist which may be making the stock market inefficient. These could be the dissemination of information regarding equity holdings and FII (Foreign Institutional Investors) trades. The level of disclosures about equity holdings is fuzzy at times.

Dividend as Signals

The usefulness and the justification of the dividend policy constitute on of the most controversial topic of the financial theory. For Black (1976), "the harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just do not fit together".

Dividend Puzzle

THE SO-CALLED DIVIDEND puzzle (Black 1976) has been the focus of finance economists at least since Modigliani and Miller's seminal work (1958,1961). This work established that, in a frictionless world, when the investment policy of a firm is constant, its dividend payout policy is irrelevant meaning that it has no consequences for the shareholder's wealth. Dividend irrelevance is also supported by the empirical work of Black and Scholes (1974), where they argue that there is no significant relationship between dividend yields and stock returns. Higher dividend payout leads to lower retained earnings and capital gains, and vice versa, it leaves total wealth of the shareholders unchanged.

Prior Research

Prior empirical research, generally focused on firms listed in developed stock markets, suggests that the announcement of dividend (cash or stock) increases is associated with significantly positive stock market excess returns. However, emerging markets add more to the "dividend puzzle", and recently, attracted researchers trying to explain the dividend policy ehavior and its reaction in the market. Empirical studies showed mixed evidence on stock return due to dividend announcement. A number of studies (Michaely et al., 1995) found that there is a positive market reaction to dividend increases (good news announcements) and a negative market reaction to dividend cuts (bad news announcements). Same positive relationship also had been revealed by the works of Gordon (1959), Ogden (1994) and Stevens and Jose (1992). Two main theoretical arguments have been proposed to justify the market response to dividend announcements observed in the above studies. First, in a world of information asymmetry, where managers have access to detailed internal reports with data relating to the profitability of the firm, alterations in dividend policy convey managerial assessments of future profitability/cash flows of the firms to the outside investors (Bhattacharya, 1979,1980; John and Williams, 1985). This argument was recognized by Miller and Modigliani (1961) as early as 1961 even though they proposed that no relationship should exist between the dividend policy and the market value of the firm; they admitted that "where a firm has adopted a policy of dividend stabilization with a long-established and generally appreciated target payout ratio, investors are likely to (and hence have good reason to) interpret a change in the dividend rate as a change in the management's view of the future profit prospects of the firm" (Miller and Modigliani, 1961, p. 293). In this context, dividend increases (decreases) convey favourable (unfavourable) information about current and future profitability of firms to the outside investment community.

Second, managers may disclose information about their policy for financing investments to the market through dividend decisions (Keane, 1974,1985); according to this view, a high dividend payout policy is associated with new equity/debt financing while a low dividend payout policy is associated with the financing of capital expenditure through retained earnings (Fazzari et al., 1988 and Lonie et al., 1990). Investors may prefer the former combination because a large quantity of information is usually disclosed about the proposed investment in the share prospectus; uncertainty is reduced in comparison to the situation where most of the information about the investment remains undisclosed.

According to these two explanations, dividend changes either convey managerial assessments

about the current and future performances of firms to outside investors or deal with wasteful managerial behaviour by eliminating discretionary cash flows available to corporate managers. In this context, it is reasonable to hypothesize that companies which disclose increases in their current dividend payments should experience an improvement in their current and future performances while companies which announce decreases in their current dividend payments should experience a deterioration in their current and future firm performance while the companies who pay the same dividend as before shall only achieve normal performance. These explanations are particularly interesting for this research work.

Application of Signaling Theory

Applications of signaling theory in the area of corporate payout policy have become increasingly common. The best known signaling models (asymmetric information models) are Bhattacharya (1979) and Hakansson (1982).Yet few authors have provided explanations for the practice of signaling with dividends rather than repurchases of shares (John and Williams, 1985). The information content hypothesis states that dividend announcements are used by managers as a way to signal shareholders in respect of future prospects of the firm.

Additionally, it has been found that signal strength is a function of the amount of information transmitted and large dividend changes are stronger signals than smaller dividend changes (Asquith and Mullins, 1983). As a result the magnitude of information effects of dividends has increased the need for prediction of dividend changes.

In fact a fundamental question in corporate finance has been whether changes in dividend policy convey information about the firm's performance to capital markets. Not only are there well documented price reactions to announcements of changes in dividend policy, but dividends have also been established as a mechanism whereby information related to the operations and future plans of a firm can be communicated (Benartzi, Michaely and Thaler, 1997).

The dividend information hypothesis postulates that cash dividend carries information regarding the future cash flows of firm that is to be reflected in the market price of stock after announcement of dividend, particularly when dividend increases (Bhattacharya (1979) and Bar-Yosef and Huffman (1986)).

Academics have also considered the consequences of a dividend announcement on trading volume patterns (Richardson et al, 1986), share price volatility (Venkatesh, 1989), the revision of analysts' forecasts (Ofer and Seigel, 1987) and the speed of any associated price adjustment (Patell and Wolfson, 1984).

Venkatesh (1989) argues that stock return volatility should decrease after firms begin paying dividends because investors will focus more on the information content of dividend announcements and less on other news events, such as earnings announcements. He maintain that dividends convey information about lower risk more directly to markets, as managers decide to initiate or increase dividends when they believe the firm's earnings stream is not only permanently higher, but more stable and predictable as well. He argues that fundamental news about a firm is either about its cash flows or discount rate, and the lack of support for cash flow signaling implies the market response to positive dividend events must be a reaction to an expected change in risk.

Bernheim (1991) also provided a theory of dividends in which signaling occurs because dividends are taxed more heavily than repurchases. In his model, the firm controls the amount of taxes paid by varying the proportion of the total payout that is in the form of dividends, rather than repurchases. A good firm can choose the optimal amount of taxes to provide the signal. As with the John and William's model, Bernheim's model does not provide a good explanation of dividend smoothing.

Recent Studies

DeAngelo and DeAngelo (2006) present a critique of Miller and Modigliani's (1961) proof that dividends do not affect the value of the firm in perfect markets. They claim the finding of dividend irrelevance obtains because Miller and Modigliani's framework supports 100% payouts, and when this assumption is relaxed, payout policy affects value in the same manner as investment policy. DeAngelo and DeAngelo argue that the irrelevance result is essentially hardwired into Miller and Modigliani's assumptions, which makes their proof nothing more than an elegant tautology. DeAngelo and DeAngelo have a few unkind words for Black (1976) as well, declaring his dividend puzzle to be a "non-puzzle," as it is based on Miller and Modigliani's conclusions. They assert that Miller and Modigliani and Black have limited our vision about the importance of payout policy and sent researchers off searching for frictions that would make payout policy matter, while it has mattered all along.

DeAngelo and DeAngelo's critique suggests two distinct perspectives regarding dividends and valuation. The first perspective, widely-held before Miller and Modigliani (1961), is propounded by Lintner (1956) and Gordon (1959). The idea is simple: investors like dividends, and the bigger the better. More formally, dividends are the stream of expected future cash flows that give stocks their "intrinsic value." The second perspective, which prevails following Miller and Modigliani (1961), is defined by researchers' quest for the reasons - all due to market imperfections - firms would engage in the undesirable practice of regular cash payouts.

DeAngelo and DeAngelo (2006) show the probability a firm will pay dividends increases when there is more retained equity in its capital structure, which is typical of older, more established firms. They hypothesize that increases in dividends convey information about firms' transition from a faster growth phase to a slower growth, mature phase.

Fargher and Weigand (2006) contend this life cycle hypothesis is even more applicable to the case of first-time dividend initiators than to firms increasing dividends. Successful ividendpaying firms increase dividends regularly, in some cases every year for periods lasting

several decades. Any change in life cycle signaled by a dividend increase is likely to be incremental compared with the signal of changing firm maturity conveyed by a first-time dividend. They argue that dividend signaling theories are incompatible with Linter's (1956) view of dividends, which Benartzi, Michaely and Thaler (1997) call "the best description of the dividend setting process available".

Lintner describes how managers conservatively smooth past and current earnings changes into the level of the firm's dividend. His findings indicate managers believe dividends should be uninterrupted, related to permanent (rather than temporary) increases in profits, and increased only when the level and stability of earnings make it likely dividends will not have to be reduced in the future. The general consensus among more recent studies of dividends and earnings is that the decision to initiate or raise the firm's dividend is based on past and current earnings growth, not expected growth in future earnings. This does not mean that dividend payouts do not communicate information to markets; it rather means the information may be more corroborative, confirming that recent earnings changes are permanent, rather than predictive of future earnings changes, as suggested by earnings signaling models.

Brav, Graham, Harvey and Michaely (2005) indicate a potential misalignment between signaling theory and managers' attitudes. Although 80% of managers believe dividends convey information to investors, only 25% of respondents indicated they use dividends to look better than their competitors, and less than 5% said they deliberately incur the costs associated with raising external funds and foregoing new investments to distinguish their firm from its rivals.

Allen and Michaely (2003) also supported that using the sources and uses of funds identity, and assuming the firm's investment is known, dividend announcements may convey information about current earnings (and maybe even about future earnings, if earnings are serially correlated) even in the absence of any signaling motive. Since investment is known, dividends are then the residual. Thus, the larger-than expected dividends imply higher earnings. Since the market does not know the current level of earnings, higher- than anticipated earnings would lead to a positive stock price increase. A rise in dividends typically signals that the firm will do better, and a decrease suggests that it will do worse. These theories may explain why firms pay out so much of their earnings as dividends. The managers can signal that the firm's project is good by committing to a large dividend at time. If a firm does indeed have a good project, it will usually be able to pay the dividend without resorting to outside financing and therefore will not have to bear the associated transaction costs.

Allen and Michaely (2003) further raised some questions. For example, why would a management care so much about the stock price next period? Why is its horizon so short that it is willing to burn money (in the form of a payout) just to increase the value of the firm now, especially when the true value will be revealed next period? It is also not clear why firms smooth dividends. Finally, why should a firm use dividends (or repurchases) to signal? It would be more dramatic to burn the money in the middle of Wall Street, and it might even be cheaper.

Miller and Rock (1985) also constructed a two-period model. In their model, at time zero firms invest in a project, the profitability of which cannot be observed by investors. At time 1, the project produces earnings and the firm uses these to finance its dividend payment and its new investment. Investors cannot observe either earnings or the new level of investment. An important assumption in the Miller and Rock model is that some shareholders want to sell their holdings in the firm at time 1, and that this factor enters manager's investment and payout decisions. At time 2, the firm's investments again produce earnings. A critical assumption of the model is that the firm's earnings are correlated through time. This setting implies that the firm has an incentive to make shareholders believe that the earnings at time 1 are high so that the shareholders who sell will receive a high price. Since both earnings and investment are unobservable, a bad firm can pretend to have high earnings by cutting its investment and paying out high dividends instead. A good firm must pay a level of dividends that is sufficiently high to make it unattractive for bad firms to reduce their investment enough to achieve the same level.

The Miller and Rock theory has a number of attractive features. The basic story, that firms shave investment to make dividends higher and signal high earnings, is entirely plausible. Unlike the Bhattacharya (1979) model, the Miller and rock theory does not rely on assumptions that are difficult to interpret, such as firms being able to commit to a dividend level. What are its weaknesses? According to Allen and Michaely (2003), It is vulnerable to the standard criticism of signaling models. It is not clear that if taxes are introduced, dividends remain the best form of signal. It appears that share repurchases could again achieve the same objective, but at a lower cost. In Bhattacharya (1979), the dissipative cost that allowed signaling to occur was the transaction cost of having to resort to outside financing. In Miller and Rock (1985), the dissipative costs arise from the distortion in the firm's investment decision. John and Williams (1985) present a model in which taxes are the dissipative cost. The theory thus meets the criticism that the same signal could be achieved at a lower cost if the firm were to repurchase shares instead.

So while the Miller and Rock and the Bhattacharya models imply that dividends and repurchases are perfect substitutes, the John and Williams model implies that dividends and repurchases are not at all related. A firm cannot achieve its objective of higher valuation by substituting a dollar of dividends for a dollar of capital gains. What is the reasoning behind this result? Like other models, John and Williams's starting point is the assumption that shareholders in a firm have liquidity needs that they must meet by selling some of their shares. The firm's managers act in the interest of the original shareholders and know the true value of the firm. Outside investors do not. If the firm is undervalued when the shareholders must meet their liquidity needs, then these shareholders would be selling at a price below the true value. However, suppose the firm pays a dividend, which is taxed. If outside investors take this as a good signal, then the share price will rise. Shareholders will have to sell less equity to meet their liquidity needs and will maintain a higher proportionate share in the firm. Why is it that bad firms do not find it worthwhile to imitate good ones? When dividends are paid, it is costly to shareholders because they must pay taxes on them. But there are two benefits. First, shareholders receive a higher price for the shares that are sold. Second, and more importantly, these shareholders retain a higher proportionate share in the firm. According to Allen and Michaely (2003), if the firm is actually undervalued, this higher proportionate share is valuable to the shareholder. If the manager's information is bad and the firm is overvalued, the opposite is true. It is this difference that allows separation. If dividends are costly enough, only firms that are actually good will benefit enough from the higher proportionate share to make it worthwhile bearing the cost of the taxes on the dividends.

Allen, Bernardo, and Welch (2000) took a different approach to dividend signaling. As in the previous models, dividends are a signal of good news (i.e., undervaluation). However, in their model firms pay dividends because they are interested in attracting a better-informed clientele. Untaxed institutions such as pension funds and mutual funds are the primary holders of dividend-paying stocks because they are a tax-disadvantaged payout method for other potential stockholders. Another reason for institutions to hold dividend-paying stocks is the restrictions in institutional charters, such as the prudent man rules that make it more difficult for many institutions to purchase stocks that pay either no dividends or low dividends.

According to Allen, Bernardo and Welsh (2000), the reason good firms like institutions to hold their stock is that these stockholders are better informed and have a relative advantage in detecting high firm quality. Low-quality firms do not have the incentive to mimic, since they do not wish their true worth to be revealed. Thus, taxable dividends are desirable because they allow firm's management to signal the good quality of their firms. Paying dividends increases the chance that institutions will detect the firm's quality.

Another interesting feature of the Allen, Bernardo, and Welch model is that it does accommodate dividend smoothing. Firms that pay dividends are unlikely to reduce the amount of the dividend, because their clientele (institutions) are precisely the kind of investors that will punish them for it. Thus, they keep dividends relatively smooth.

As in the John and William's model, the Allen, Bernardo, and Welch model involves a different role for dividends and repurchases. They are not substitutes. In fact, firms with more asymmetric information and firms with more severe agency problems will use dividends rather than repurchases.


From an assessment of literature, it shows that empirical test provide great support in favour of signaling theory of dividends. In signaling models, managers choose to pay dividends, in spite of their being costly, in order to signal unobservable firm value. Although the earlier evidence was interpreted as supporting the dividend signaling hypothesis, some later studies have called the theory into question. The theoretical literature on dividend effects has been well developed. Researchers largely accepted that dividend per-se has no impact on the shareholders' value in an ideal economy. However, in a real world, dividend announcement is important to the shareholders because of its tax effect and information content. In this study, examination has been made about the dividends effect on shareholders' prices in Bombay Stock Market with a sample of 30 companies who announced dividend over a period from September 2009 and July 2010.