Do Dividends Predict Future Firm Performance?...Theoretical Foundations One of the first scholars who contributed to the theoretical foundation of the signalling hypothesis was Sudipto

Stian Abrahamsen Tobias W. Balchen

BI Norwegian School of Management Master Thesis

Do Dividends Predict Future Firm Performance?

Exam code and name: GRA 1903 Master Thesis

Hand in date: 01.09.2010

Program: Master of Science in Business and Economics

Major in Finance

The thesis is part of the MSc programme at BI Norwegian School of Management. The school takes no responsibility for the methods used, result found and conclusions drawn.

BI Norwegian School of Management – Thesis 01.09.2010

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Content

ACKNOWLEDGEMENTS ......................................................................................................... II

ABSTRACT ................................................................................................................................ III

INTRODUCTION ........................................................................................................................1 LITERATURE REVIEW................................................................................................................................ 2 Theoretical Foundations................................................................................................................... 3 Empirical Findings............................................................................................................................... 5 Private vs. Public Firms and Dividend Policy ........................................................................... 7 The Norwegian 2006 Dividend Tax Reform ............................................................................. 8

DATA.............................................................................................................................................9 FILTERING.................................................................................................................................................10 DATA DESCRIPTION AND DESCRIPTIVE STATISTICS.........................................................................11

PRELIMINARY FINDINGS .................................................................................................... 17 PAYOUT RATIOS .......................................................................................................................................17 Preliminary conclusions ..................................................................................................................23

METHODOLOGY ..................................................................................................................... 23 HYPOTHESES ............................................................................................................................................24 CONTROL VARIABLES..............................................................................................................................25

EMPIRICAL FINDINGS: ......................................................................................................... 26

CONCLUSION ........................................................................................................................... 31

LIMITATIONS AND FURTHER RESEARCH...................................................................... 32

REFERENCES: .......................................................................................................................... 33

APPENDIX; PRELIMINARY THESIS: ................................................................................. 36


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Acknowledgements

We would like to express our gratitude towards our supervisor Bogdan Stacescu

for excellent supervision, time and inspiration. We would also thank him for being

flexible and helpful during our stay abroad. We would also like to thank the

Centre for Corporate Governance Research for providing us with the data.


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Abstract

In this paper the effect of changes in dividend policy on future firm performance

for non-listed firms are analyzed. Our study is on small and medium sized unlisted

Norwegian firms. First we establish that these firms are highly flexible in setting

their dividend policy, changing it frequently. Further with univariate analysis we

find some support for the Lintner view, were the management only increase the

dividends when earnings are expected to increase permanently. With multivariate

regression analysis we find a strong relationship between a dividend increase and

an increase in the earnings. However, we are unable to find support when future

earnings are investigated; hence the information content of the dividends

hypothesis is rejected.


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Introduction

Stock markets and investor behaviour suggest that dividends have information

content. When dividends are increased a firm’s stock price tends to increase and

vice versa when dividends are cut (e.g. Grullon et al., 2002). In the literature

regarding dividend payout policy this notion of information content is supported.

Many theories suggest that changes in dividends contain some information

regarding the future profitability and earnings of the firm. More precisely many of

these theories predict that dividends are positively correlated with future

profitability and earnings. One such theory is the signalling hypothesis, which is

based on information asymmetry between managers and investors (e.g

Bhattacharya,1979, and Miller and Rock, 1985). With this asymmetry they claim

that dividends are used as explicit signals about future earnings, which the

management sends out intentionally and at some cost to the investors. According

to Bhattacharya (1979) the signalling cost stems from the fact that dividends are

taxed at a higher rate than capital gains (Bhattacharya 1979). Miller and Rock

(1985), however, view the loss of funds to use in investments as the major

signalling cost.

A prediction of the dividend signalling hypothesis is that dividend changes are

positively correlated with future changes in profitability and earnings, hence the

share price movements discussed above are observed. According to Grullon et al.

(2005) this is one of the most important issues in corporate finance; hence it is of

interest to investigate these theories more thoroughly. This is a task that has been

pursued by many scholars; however so far no definite agreement has been

reached.

The signalling hypothesis have been widely researched, however, as stated above,

there are contradictory findings in the literature. Some studies give support for the

signalling hypothesis (Nissim and Ziv 2001, Bhattacharya 1979), while others

finds no or limited support for it (Grullon et al. 2005, Benartzi et al. 1997). Our

research will give indications on whether the theory is supported for Norwegian

non-listed firms.


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Most of the research on this subject has employed data from listed firms. In this

paper, however, the relationship between dividends and future firm performance

for private firms in Norway will be investigated. With this approach we have most

of the framework available in prior work, but the research will be done on data

that has not been researched extensively. This analysis can yield interesting results

and possibly add new insights to the debate about the relationship between

dividends and future earnings.

A standard assumption is that information asymmetries are a larger issue for small

and unlisted firms, which can imply support for the signalling hypothesis.

Nevertheless it can be tempting to believe that there is no strong correlation

between the change in dividends and the change in future earnings for private

firms. A first argument is the Modigliani and Miller irrelevance theorem (kilde?),

which states that firm value is independent of finance structure. From this it

follows that investors are indifferent to whether dividends are paid out or if

earnings are reinvested profitably. Another argument is that the management in

private firms in many cases is the actual shareholders, and in the cases with

outside shareholders they are often very “close” to the management. The fact that

to use dividends as a signalling-strategy is costly could then induce the

management of private firms to choose another strategy. In the cases were the

insiders and outsiders are the same individuals there is indeed no need to send a

signal. Our research will therefore give us an interesting, and useful, indication on

how private firms use dividends, and which of the theories we find support for.

The rest of the paper is organized as follows. First we introduce the relevant

theories on dividends, and how dividends can be used as a signal about the future

performance of a given firm. In addition to this the most important empirical

findings to date are presented. Section two outlines the set-up of our data and

methodology, and defines the different measures and variable used in this paper.

In section three we run multivariate regressions while controlling for several firm

specific variables, before concluding in the last section.

Literature review

The dividend signalling theory is highly disputed; there are several scholars who


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have theoretically documented that the dividend signalling theory should hold.

However in the empirical literature there are contradicting findings, some scholars

have found evidence supporting the hypothesis, e.g. Nissim and Ziv (2001)

whereas others have not, e.g. Benartzi, Michaely and Thaler (1997)

Theoretical Foundations

One of the first scholars who contributed to the theoretical foundation of the

signalling hypothesis was Sudipto Bhattacharay. In the paper “Imperfect

Information, Dividend Policy, and “The Bird in the Hand” Fallacy” (1979) he

develops a theoretical model in which dividends function as a costly signal for

expected future cash flows. Hence changes in dividends should convey

information about future cash flows. It follows that dividend decreases are bad

news (lower future cash flow) and dividend increases are good news (higher

future cash flow). The author develops these results by assuming that outside

investors have imperfect information about firm’s profitability and that cash

dividends are taxed at a higher rate than capital gains. The fact that dividends are

taxed at a higher rate is the major cost that leads dividends to function as a costly

signal.

In the model of Bhattacharya outside investors cannot distinguish the profitability

of productive assets held by firms, and existing shareholders care about the market

value assigned by outsiders. Investors ignore other sources of information than

dividends “on the ground, taken by themselves, that they are fundamentally

unreliable screening mechanisms because of the moral hazard involved in

communicating profitability” (Bhattacharay, 1979, 260). From this it follows that

the communication of even ex post cash flows from existing assets is costly,

because only dividends can convey this information and dividends are taxed

higher than capital gains.

In conclusion Bhattacharya develops a model where dividends can function as

explicit signals about future earnings, sent intentionally and at some cost by

management to the firm and its stockholders.

Merton Miller and Kevin Rock (1985) analyzed dividend policy of firms when


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information is asymmetric. When there exists asymmetric information the state of

information with respect to earnings, investment and net dividends at the time of

the dividend announcement is different for firm insiders and outsiders. For an

outsider an important and easily available component of public information is the

dividends, hence dividends are critical for the market valuation of the firm. An

insider, however, also has information on unannounced earnings; this will

naturally lead to a difference in the perceived value of the firm. The model, which

is developed in this paper, proposes therefore dividends as a signal to outsiders on

how insiders view the economic future of the firm. For the firm, this is a costly

way of communicating. This is in accordance with Bhattacharya (1979), however

Miller and Rock view the major signalling cost as the loss of funds to use in

investments, and not the higher tax rate dividends faces. Due to this cost,

signalling with dividends only makes sense for the good-news firms, and not the

bad-news firms. It is only for the good-news firm that the cost may be worth

bearing in order to avoid giving the market a false impression that earnings were

not high enough to justify a dividend.

Another signalling equilibrium model is proposed by John Kose and Joseph

Williams in the article “Dividends, Dilution and Taxes: A Signalling Equilibrium”

(1985). The intuition of their model is that a firm must either retire fewer

outstanding shares or issue new shares in order to raise funds for investments. As

firms, current stockholders have to sell existing shares to raise cash on personal

account. If either of this happens, then current stockholders will suffer some

dilution in their fractional ownership of the firm. When inside information is

favourable, the reduction of this dilution is valuable for the current stockholders.

As a consequence insiders, acting in the interest of their current stockholders, may

distribute a taxable dividend if outsiders recognize this relationship, bid up the

price of the stock, and thereby reduce the dilution of current stockholders. Insiders

will therefore control dividends optimally and outsiders pay the correct price for

the firms’ stock. In equilibrium insiders with truly more valuable future cash flow

will distribute larger dividends and receive higher prices for their stock, whenever

the demand for cash by both the firm and its current stockholders exceeds its

internal supply of cash. Thus in Kose and Williams (1985) model there should be,

at least in theory, a positive relationship between an increase in dividends and

future cash inflow.


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Empirical Findings

There are many scholars who have tried to empirically document a relation

between dividend changes and future firm performance, for instance Benartzi,

Michaely and Thaler in their article “Do Changes in Dividends Signal the Future

or the Past” (1997). In this article the authors utilize a large number of firms and

events and they control for many factors that can create spurious relationship

between dividends and subsequent earnings changes. Their results, both by

utilizing categorical analyses and regression analyses, indicate a very strong

correlation between dividend changes and both lagged and contemporaneous

earnings. However, they are unable to find much evidence of a positive

relationship between dividend changes and future earnings changes.

Because of their findings the authors ask if dividend changes can be a signal of

something else than the expected value of future earnings. One possibility is that

dividend increases are a signal of a permanent shift in earnings (as Linter (1956)

suggests). They do indeed find some support for Lintner’s view. Nevertheless,

their results indicate,

that if firms are sending a signal, (a) it is not a signal about future earnings

growth and (b) the market doesn’t “get it”. Why firms would burn money to send

a signal that is not received is, indeed, a mystery (Benartzi et.al. 1997, 1009).

Unlike Benartzi et al. (1997) Nissim and Ziv (2001) present the “information

content of dividend hypothesis”, which states that dividend changes trigger stock

returns because they convey new information about the firms’ profitability. Doron

Nissim and Amir Ziv (2001) investigate this hypothesis and they find a positive

relationship between dividend changes and future earnings changes, future

earnings and future abnormal earnings. Further they find that dividend increases

are positively related to earnings in each of the four subsequent years, but that a

dividend decrease is not related to future earnings.

As they explain in their paper, the lack of correlation between dividend decreases

and future earnings does not necessarily imply that dividend decreases are not


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informative about future earnings. Actually, when current year earnings are

omitted, the coefficient on dividend decreases becomes positive and significant.

This, they claim, can be explained by accounting practices. Losses should be

recognized in earnings when anticipated whereas profits should be recognized

only when earned. As a result, current year earnings cannot contain the future

implications of the good news that caused management to increase dividends. On

the other hand, future implications of the bad news that triggered the dividend

decrease should be reflected in current earnings.

In response to the article by Nissim and Ziv (2001) Gustavo Grullon, Roni

Michaely, Shlomo Benartzi and Richard Thaler presented the article “Dividend

Changes Do Not Signal Changes in Future Profitability” (2005), where the

signalling hypothesis is rejected. In this paper the authors claim that Nissim and

Ziv’s assumption of linear mean reversion in earnings is inappropriate. From

econometrics it is known that assuming linearity when the true functional from is

nonlinear has the same consequences as omitted variable bias. Hence the Nissim

and Ziv results may be biased.

The authors therefore employ a model that assumes that the rate of mean reversion

and the coefficient of autocorrelation are highly nonlinear. With this approach the

relation between dividend changes and future earnings disappears. Overall no

evidence is found supporting the idea that dividend increases signal better

prospects for future firm profitability. Further it is also shown that out of sample

forecasts are generally better without using dividend changes as an independent

variable.

Given the evidence presented in this article and others it is sensible to conclude

that changes in dividends are not useful in predicting future changes in earnings.

However the authors do not rule out that dividend increases signal something, but

that something is not an abnormal increase in future earnings or future

profitability.

The literature proceeds in order to try to establish exactly what dividends are a

sign of. In the article “Are Dividend Changes a sign of Firm Maturity” Grullon,

Michaely and Swaminathan (2002) try to answer this question. From this article


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and others there are indications that dividends contain information from market

reactions. Further, by definition fundamental news about a firm has to be either

about its cash flows or its discount rate. The authors claim that since it is not news

about cash flows it must be about the discount rate. They document, by using data

on US stocks, that firms which increase (decrease) dividends experience a

significant decline (increase) in their systematic risk, i.e. a reduction in the

discount rate. On the basis of their findings the develop a new hypothesis, the

maturity hypothesis, which states that dividends contain information about firms

transitions in life cycles to a more mature phase. As firms become more mature

they tend to increase their payouts due to less positive NPV opportunities. Hence

we should expect dividend increases to be associated with subsequent declining

profitability, risk and return on investments that lead to lower capital expenditures

(capex). This hypotheses is related to the free cash flow hypotheses developed by

Jensen (1986), however the free cash flow hypothesis does not contain any

explicit prediction concerning changes in risk, hence it cannot be the complete

story.

To formally test the maturity hypothesis the authors investigates different aspects

of firm performance employing various techniques. Amongst other they analyze

changes in Return on Assets (ROA) and dividend payout ratios. Dividend payout

ratios are interesting because if cash flow signalling models are correct the payout

ratio of a dividend-increasing firm should increase temporarily, and then decline

gradually over time as earnings start to catch up with the increased dividends.

Finally the development in capex and excess cash are investigated. The free cash

flow hypothesis suggests that dividend-increasing firms ought to decrease (at least

keep it constant) their capex. In addition one) would expect to see their cash

balances decline. Their findings support the notion of the maturity hypothesis and

fills in the pieces providing more content to the free cash flow hypothesis.

Private vs. Public Firms and Dividend Policy

The research in this paper deals with private firms, unlike most of the previously

done research on the area. Michaely and Roberts (2007) compare the different

dividend policies between public and private firms, and try to explain why private

firms may have a different dividend policy than public firms. In this paper, the


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authors divide their data sample of UK-firms in three distinct groups; wholly

owned firms, private dispersed firms and public firms.

As stated by Michaely and Roberts (2007), an important difference between a

private- and a public-firm is the ownership structure. Some private firms exhibit

little, if any, separation between control and ownership. If there should exist

outside shareholders, then they are often close family members, or informed and

active monitors, such as corporation with close ties to the firm. This can affect the

dividend policy of the firm. Some private firms may for instance increase

dividend payments not as a signal to shareholders, but maybe because of tax

reasons or instead of wages, although the paper by Michaely and Roberts (2007)

do not find evidence of this.

The authors present three hypotheses in their paper. The most interesting

hypothesis for our work is as follows:

Hypothesis 3: Following dividend increases, operating performance should

improve for Private Dispersed firms and Public firms, but there should be little or

no relation between dividend increases and operating performance for Wholly

Owned firms (Michaely and Roberts 2007, 25).

The hypothesis suggests that the firms that increase their dividends are those who

are undervalued by the market. When they test this hypothesis they come up with

two conclusions. Under symmetric information, firms will not try to signal future

change in earnings with an increase in dividends. This is intuitive since outsiders

have the same information as insiders. But, when information is asymmetric, they

also find no evidence for firms trying to signal higher future earnings with an

increase in dividends. Hence, they do not find evidence of a positive relationship

between high future earnings and increase in dividends, as Nissim and Ziv (2001)

did.

The Norwegian 2006 Dividend Tax Reform

A final aspect that may prove important for our research is the announced

Norwegian tax reform in 2006, i.e. the shareholder income tax. This reform


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increased top marginal tax rates on individual dividend income and capital gain

from zero to 28 percent. Prior to the reform there was a large difference in

marginal tax rates on labour and capital income for medium and high-income

classes. This provided incentives for business owners to re-classify labour income

as capital income, in order to minimize the tax bill.

Since the tax rate currently is positive, the timing of capital gains or dividend

distributions are important. Further since capital gains can be deferred these are

slightly preferred by investors over dividends. This is also discussed by

Alstadsæter and Fjærli (2009) were they show that both the new and old tax

regimes are neutral, and thus the tax reform should have no other effect than on

the timing of dividends. Neutrality implies that the tax is “neutral with respect to

timing of dividends and capital structure of the firm…, and investment decisions

and risk taking”.

Alstadsætar and Fjærli (2009) document a strong timing effect on dividend

payments as a consequence of the tax reform, aggregate proposed dividends

increased by 82 percent the last year before the reform (2005) and dropped by 41

percent in the year thereafter. These tax motivated dividend payments may have

additional costs by reducing the cash holding of firms, thus reduce their

investment capabilities for the future. Finally, they find that the increased

dividend payments increase the firm’s debt to equity ratios. As the findings in

their paper indicate, the tax reform distorted the number of dividend payments

prior to the reform. This may have weakened the relationship between dividends

and earnings, for some time surrounding the tax reform. I.e. firm’s may want to

extract as much as possibly through dividends prior to the tax reform regardless of

earnings.

Data

The data have been provided by the Center for Corporate Governance Research

(CCGR). The CCGR have a special focus on non-listed firms and family firms in

particular, and are thus able to deliver high-quality data on variables that

otherwise would be difficult to obtain. From their extensive database we have

obtained data on 20 variables for non-listed firms. These data are un-consolidated


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account data and also data concerning ownership control. The sample period

ranges from ’94 until ’08, and is on long-panel form. This dataset will allow us to

investigate relationships between dividends and different factors of firm

performance such as return on assets and equity, and changes in earnings. Our

entire sample contains 2 304 743 firm-years, but different filters are applied, to be

explained in the next section, and the final sample consists of 423 392 firm-years.

Filtering

In order to reduce the possibility of including erroneous observations and inactive

shell firms in the sample, a number of different criteria for an observation to be

included are employed. A shell firm is a corporation without active business or

significant assets; in addition “shells tend to be conduits or holding companies

and are generally included in the description of special purpose entities” (OECD

Benchmark Definition of Foreign Direct Investments 2008, 101). For this reason

shell firms are sought excluded from the analysis.

Firms with negative dividends, cash, assets, investments, revenue, bonds and debt

observations were deleted in order to remove possible erroneous observations.

Further the most important criteria in order to exclude shell firms are that all

observations for which a firm has zero employees and observations for which a

firm has zero in revenue are taken out of the sample (please refer to table 1).

For the revenue variable there are no observations for the period ’94 to ’96 and

only a very few for ’97 and ‘98, which implies that with this filter the first four

years of our dataset is lost. However this is also necessary for another reason,

namely that revenue will be used as a scaling factor for certain variables in


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analysis to come. With this as zero or missing the scaling will not work according

to our intentions. We also rule out firms from the sample that over the entire

period do not pay dividends at all.

Further since the dataset is on un-consolidated basis we remove all firms that are

not independent according to the dummy variable “independent”. We face a

challenge in doing this because prior to 2000 there are no observations regarding

firms’ independence. In order to circumvent this problem independence is

extrapolated from 2000 until 1999. This is done on the basis that ownership

structure is quite stable over time; thus extrapolating independence gives more

information, and outweighs the negative effects added by the extra uncertainty

that follows from the extrapolation. After this process is completed we remove all

dependent firms from the sample. After the filtering process our final sample size

consists of 423 392 firm-years covering the time period 1999 to 2008.

Data Description and Descriptive Statistics

Before the first descriptive statistics are reported the variables employed in this

section of the paper will be defined. The dividend variable in our sample is

dividends payable in t+1, i.e. dividends for 2000 are dividend payable for year

2001. Further the dividend change variable is defined as the dividend in year t

minus the dividend in the previous year, scaled on the dividend in the previous

year.

As a measure of profitability we use the Return on Assets (ROA). This is defined

as operating result scaled by total assets:

The change in ROA for firm i is given by:


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Another performance measure we will employ in our analysis is Return on Equity

(ROE), calculated as result scaled by the book value of equity.

In addition we have two alternative measures of the change in result, one where

last years earnings scale the change in result, and one where the change is scaled

on the book value of equity last year.

Finally the payout ratio of a firm is defined as the ratio of dividends to operating

result, and size is defined as the logarithm of revenue:

The dataset included several extreme values, for example the maximum dividend

change was about 1356 percent. In order to reduce the effect of such observations

on the results, these variables have been winsorized at the 1 percent and 99

percent level of the empirical distribution. Some variables, however, are bounded

on one side, e.g. dividend increases at 0, and these are therefore winsorized on the

non-bounded side only. The winsorization procedure follows that which others

have done in this field of research (e.g. Grullon et. al. 2005, Nissim and Ziv

2001).


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With the dataset complete we report the first descriptive statistics. In table 2 an

overview of the types of dividend events by year is presented. The dividend

events are separated in five groups; initiations, i.e. the first year a company pays

out a dividend after a zero dividend year, dividend increases, no change events,

dividend decreases and finally omissions in which dividends are cut to zero.

In table 2 we notice some first signs of difference between private and public

firms. A pattern that can be found in the literature for public firms is that dividend

decreases are much less common than dividend increases. In the article by Grullon

et. al. (2005) the ratio of dividend increasing firms to decreasing is about 24, i.e.

for each firm that reduces dividends there are 24 which increases. The same ratio

for the sample used by Nissim and Ziv (2001) is slightly lower at 16,2, however,

this is still much higher than the ratio in our sample as can be inferred from table

2, which is as low as 1,4. Finally we also notice that initiations and omissions are

almost as common as dividend increases and decreases. This is also quite different

from the data on listed firms, where dividend initiations are much less frequent

than increases in dividends. These findings indicate that the private firms in our

sample are quite flexible and change their dividend policy frequently.

From the table we also observe that the numbers of increases and decreases in

dividends vary somewhat from year to year, while the number of no-change

events is rather stable, although it increases (permanently) in 2006 to above 20

000 observations. In 2005 we observe that most firms (68%) decrease their

dividends, while in 2004 most firms increased their dividends (38%). These

effects are most likely due to the tax reform implemented by the Norwegian

government January 1, 2006, which introduced a positive tax (28 %) on

dividends. The reader must remember that the 2005 dividends are proposed

dividends for 2006. In the years leading up to the reform firms would pay out as

much as possible and then when the tax is introduced dividends are reduced or

even cut to zero in order to minimize the tax bill over time. This also explains the

very high number of omissions in 2005 (23 814) compared to the other years.


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The hypothesis of the tax reform being the main reason for the change in

dividends is strengthened when we analyze the mean operating result scaled by

equity. We find that this variable seems to be relative stable; hence a change in

firms’ results is not likely to be the reason for the change in dividend policy.

When analyzing the absolute value of total dividends paid we can also observe a

drop after the implementation of the tax reform (see figure 1). As explained by

Annette Alstadsæter and Erik Fjærli in their paper “Neutral Taxation of

Shareholder Income” (2009) this can be explained by two factors:

“One is the pure timing effect, as the corporations accelerate their dividend

payments prior to the reform. This is only a transitory effect. The other reason is

that closely held corporations either find substitutes for dividend payments such

as hiding consumption expenditures into the operating expenses of their firm or

that they believe that tax rates will drop again in the future. In the meanwile, the

corporation is used more or less as a savings box. This is a more permanent

effect”. (2009, 26)

.

Figure 1 illustrates the amount of total dividends paid out yearly from 1998 to

2008. As we can see the total dividends paid out increased the first years, and

peaked in 2004. The only decrease during this period came around 2000, which

may be explained by the burst of the dot-com bubble in the end of 2000 and a

temporary tax reform in 2001. After the peak in 2004 dividend payments we can

see a vast drop in dividends, followed by an increase in 2006 before we again


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experience a major decline. The reduction of dividends in 2005 can be explained

by the tax reform as discussed above. Overall the firms in the sample seem to be

affected rather strongly by tax consideration when they pay dividends. The reader

needs to keep this in mind when interpreting the results to come in later sections.

Table 3 contains descriptive statistics on dividend change, ROE and ROA for the

five different dividend event groups.

In table 3 we notice further signs of differences between private and public firms.

For public firms a pattern often emerges in which dividend increases are less in

magnitude than dividend decreases (e.g. Grullon et. al. 2005, Nissim and Ziv


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2001), however the opposite holds in our sample as is clear from the table. The

dividend-increasing group on average increases their dividend with 172 percent

whereas those firms who cut on average do so with 43 percent. However the

reader should keep in mind that that a dividend decrease is bounded at 100

percent.

The total number of firm-years is 423 392, whereof 155 872 are no-change events.

The mean ROE ranges from 13,22 percent for the dividend increases group to

1,51 percent for the no change group, we notice a similar pattern for the ROA

which ranges from 12,73 percent for the increasing group to 1,55 percent for the

no change group. An interesting first finding is that the two groups with positive

dividend events (initiations and increases) seem to have better performance

measured by either ROE or ROA, than the firms with negative dividend events

(omissions or decreases). This finding is consistent with previous literature on

public firms. However the worst performing group is the no-change groups, with a

ROE (ROA) of 1,51 percent (1,55 %), we also note the large size of the no change

group. In order to see whether this group differ in size and ownership structure,

these variables are also reported. As we notice from the table, the no-change

group does not deviate significantly from the others, even though its size on

average is smaller.

Preliminary Findings

Payout ratios

In table 4, panel a, the mean payout ratio per year for the firms that do not change

their dividend (no-change group) is presented. Due to the size of this group and

also its poor performance, measured by ROE and ROA document in table 3, it is

of interest to analyse the group further, especially the mean payout ratio. Until

2005 the mean was around 10 percent, but the last three years the mean payout

ratio has dropped, and been barely 1 percent. In light of the tax reform a possible

reason for this is that owners may decrease the payout ratio because of higher

taxation. Their reason is that they need the money to pay wealth tax, and the table

gives us some indication of this story being true.


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In the same panel we also present the mean dividend paid out for the no change

group. We can see some of the same patterns here; in 2005 the mean dividend was

significantly reduced, at least economically. Further in 2007 and 2008 the total

dividends paid out from this group of firms are only around 20 percent of what

was paid out the year before. The reason for the drop in the payout ratio in 2005

till 2008 is a combination of a decrease in the dividends paid out and the fact that

firms experienced an increase in operational results in this period.

In panel b the mean payout ratio and the mean dividends paid out for the firms

that increases their dividends are presented. We note that on average the firms


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tend to pay out as much in dividends as they have in operating result. Additionally

the mean dividends paid is high, and is almost in all years around 1 000 000

Norwegian kroner. The story of the dividend decreasing firms is presented in

panel c. Also for these firms the payout ratio is relatively high. The mean

dividends paid out are beneath the dividends paid out from the dividend increase

firms, but still relatively high.

Table 5 below illustrate how the changes in earnings behave for firms that

increase and decrease their dividends, and in addition how the earnings behave for

firms that does not change their dividends. In panel a we analyze at the percentage

change in earnings, while we in panel b analyse at the change in earnings scaled

on the book value of equity.

In panel a we note that when dividends are decreased the mean change in earnings

is negative with 14 percent. The change in earnings is also negative (-38%) when

a firm does not change their dividends, and positive (93%) when a firm increases

their dividends. For the “no-change” firms the same pattern emerges in the

subsequent years; i.e. changes in earnings are still negative. For the firms that

decrease their dividends, we observe that the sign changes; hence when firms

decrease their dividends firms tend to do better in terms of changes in earnings in

the subsequent years. Also the firms that increase their dividends in year 0, has a

positive change in earnings in the next two years. One more interesting conclusion

one can draw from this panel is how flexible the firms seem to be. If the firms


Page 20

have more money, they pay out more, and the opposite if the firms have less

money.

In panel b we have scaled the change in earnings on the book value of equity. The

firms that do not change their dividends in year 0 have a positive change in

earnings in the dividend change year of 3 percent, and experience an increase in

earnings in the two years after the dividend change year. Dividend decreasing

firms tend to have a decline in earnings in year 0, but a positive change in

earnings in the two subsequent years. Finally we observe that firms that increase

their dividends experience an increase in earnings in the same year, but in the two

subsequent years they experience respectively -1 percent change and +1 percent

change.

A second analysis that can shed light on the future performance of firms after a

dividend change is done by measuring the changes in ROA for the 3 years prior

and the 3 years after the dividend change year (year 0). We would expect to see

average yearly change in ROA in the period 1 to 3 (lead) to be higher than for the

period -1 to -3 (lagged), if future performance improves after a dividend increase.

In table 6, panel a, dividend increases are analysed and in panel b dividend

decreases.


Page 21

The mean firm which increases its dividends experiences a yearly average drop of

1,32 percent in the three years following a dividend increase, whereas prior the

change they experience a yearly average increase of 0,68 percent. The lead minus

lagged ratio is at -1,98 percent, and is significant at the 1 percent level. This

confirms the results that future performance seems to be declining for dividend

increasing firm. For dividend decreasing firms a similar pattern emerges, i.e.

changes in ROA are positive prior to the dividend decrease, then performance

drops and ROA is decreased. By analysing the lead minus lag ratio at -1,56

percent, which is significant at the 1 percent level, the declining performance is

documented.

According to Altstadsæter and Fjærli (2009) the signalling view on dividend

originated with Lintner (1956). Lintner surveyed management of corporations and

his results indicates that management only increase dividends if they are sure they

are able to sustain them at the new and higher level. Grullon, Michaely and

Swaminathan (2002) note that a firm can have permanently higher ROA after the

dividend increase, as predicted by Lintner (1965), and at the same time they

experience “a decline in ROA during years +1 to +3 if the ROA in year 0

temporarily overshoots its higher permanent level” (2002, 397). In order to

analyse if this property holds in our sample, and thus drives the results in table 6

we analyse the level of ROA in the three years prior to the dividend change and

the three years after the dividend change directly. The theory predicts that the

ROA in the three years after the dividend change should be significantly higher

that the ROA in the three years prior to the dividend change.


Page 22

In table 7 the results from this analysis are presented. In panel a the result for the

dividend increasing firms are presented. Here a pattern emerges in most of the

years in which ROA first increase from year -3 until year 0, and then is reduced as

time goes by emerges. However the reduction in the years afterwards is not as

large as the increase in the years prior to the change. This is confirmed by

analyzing the three-year average lead group minus the three-year average lag

group; which leads to a value of 0,55 percent indicating that on average a firm has

0,55 percent higher ROA after a dividend change. This value is statistical

significant at the 1 percent level. In conclusion the firms that increases their

dividends do seem to have a permanently higher level of ROA.

In panel b the analysis is repeated for the group of firms that decrease their

dividends. The pattern that emerges here is quite different, and confirms the

results from table 7 panel b. First the ROA seems to be increasing in the years -3

to -1, but then sustains a rather sharp drop before it remains fairly stable in the

years 1 to 3. By analysing the lead minus lag ROA we confirm that these firms

seem to be experiencing a permanent drop in their ROA of 1,33 percent on

average, again this value is significant at the 1 percent level.


Page 23

Preliminary conclusions

The results from the preliminary analysis are mixed; from the descriptive statistics

it seems that the firms with positive dividends events are the one with best future

performance. This picture is confirmed by analyzing the changes and levels of

ROA in the 6 years surrounding the dividend change, where we found evidence to

support the hypothesis that managers only increase dividends if they believe that

they do not have to reduce them in the near future. In the same analysis it seems

that the firms that decrease their dividends experience a significant lower

permanent ROA. However when analyzing the changes in results as defined by

our two measures we find a reversal effect for the dividend-decreasing group, i.e.

in the dividend decrease year the result is reduced but in the two subsequent years

results are increasing.

In order to establish clearer results we will in the next section proceed with a

multivariate regression analysis with changes in results as the dependent variable

and dividend groups as explanatory variables.

Methodology

As is clear from the previous section the results regarding future profitability for

dividend changing firms are mixed. In this section we will employ multivariate

regression analyses in order to analyse the relationship more thoroughly. The

regressions employed in this paper are inspired by those of Nissim and Ziv (2001)

however extra control variables are added and the equations are modified slightly

in order to be compatible with data on private non-listed firms.

The scope of this paper is to analyse the effect of a dividend change on concurrent

and future earnings, for this reason the no-change group is not included in the

regressions. In addition the initiation and omission groups are excluded from the

sample, this is in line with other research in the field. For instance Nissim and Ziv

(2001), and Grullon, Michaely and Swaminathan (2002) both exclude initiations

and omissions from their sample. With only increases and decreases the focus is

on the dividend events that are most relevant for the typical firm, and thus the

sample size is 96 206 firm-years. Dividend omissions and initiations are discussed

in separate papers; see for example Michaely, Thaler and Womack (1995) or


Page 24

Healy and Palepu (1988). These papers often apply strict criteria in order for a

dividend event to be included as an initiation or omission. For instance Haely and

Palepu (1988) define a dividend initation as “the first dividend in a firm’s history

or the resumption of a dividend after a hiatus of at least ten years” (1988, 152)

and a dividend event as an omission if “they omit dividends for the first time in

their history or after paying dividends continuously for at least ten years”. (1988,

153) Applying such filters to the data used in this paper is not possible due to our

limited sample length.

The regressions used are:

For

t=0: Rest - Rest−1

B−1

= α0 + β1Div0DPC0 + β2Div0DNC + β3ROEt−1 + β4Sizet−1 + β5Leveraget−1 + β6Casht−1 +

β7GrowthOptt−1 + β8PctEquityLargestOwnert + β9FractionEquityPersOwnert + εt

For t>0: Rest - Rest−1

B−1

= α0 + β1Div0DPC0 + β2Div0DNC + β3ROEt−1 + β4Sizet−1 + β5Leveraget−1 + β6Casht−1 +

β7GrowthOptt−1 + β8Res0 - Res−1

B−1

+ β9PctEquityLargestOwnert + β10FractionEquityPersOwnert + εt

Hypotheses

In order to test the information content of dividend hypothesis we analyse the

results from the two regressions above. The information content of dividends

hypothesis states that dividend changes trigger stock returns because they contain

new information about future earnings of firms. With our sample of non-listed

firm it is impossible to test the effect of dividend changes on stock returns, but we

can test directly for its effect on future earnings changes. Whit the regressions

presented above, the hypotheses are:


Page 25

The first hypothesis states that dividend increases should be accompanied by

positive result changes in the dividend change year and the two following years.

The second hypothesis states that for dividend decreases negative changes in

results in the dividend change year and the two following years should occur. The

regressions are done for t=0, t=1 and t=2, were year 0 is the dividend change year.

With the results from these regressions it is possible to get a stronger indication of

how much a dividend change in year 0 can explain the change in results in the

same year, as well as the two subsequent years.

Control variables

Since it is likely that others factors than dividends have an effect on the change in

results of a given firm we include several control variables. First the return on

equity is included, since it has been shown by Freeman, Ohlson, and Penman

(1982) to be an important predictor of the changes in earnings. As Nissim and Ziv

(2001) explains in their article:

…they show that since ROE is mean reverting, high (low) ROE implies an

expected decrease (increase) in earnings. Since dividend changes are positively

correlated with current ROE, the expected change in earnings is likely to be

negatively correlated with the dividend change. Hence, a lack of correlation

between earnings changes and dividend changes would actually indicate that

dividend changes are informative about future earnings (Nissim and Ziv 2001,

2117).

In addition to this we also control for firm size, defined as the logarithm of

revenues. Many scholars find that firm size have an effect on firm performance,

both negative (Haines 1970, and Evans 1987) and positive (Gale 1972, and

Shepherd 1972), hence we control for this variable in order to isolate its effect on

firm performance. Further corporate governance theory predicts that degree of

leverage influences firm performance through its effect on agency costs (Berger,


Page 26

di Patti 2002), thus we control for this and are able to isolate the change in firm

result due to degree of leverage. Leverage is defined as a firm’s debt-to-equity

ratio. Finally a measure of how much cash a firm has and a measure of growth

options are included. It is possible that both growth options and the amount of

cash can affect the results, hence we control for these effects.

The variables are defined as follows:

Empirical Findings:

In this section we will present (please refer to table 8) the results from the two

regressions presented above. In table 8 the results for t=0 (panel a), t=1 (panel b)

and t=2 (panel c) are presented. In order to correct for possible heteroskedasticity

we use White robust standard errors (White 1980). Since the White robust

standard errors will be approximately equal to the “normal” standard errors in the

absence of heteroskedasticity (White 1980), we employ these in our analysis.

After using the White robust standard errors we can, with higher certainty, state

that our regression estimators are reliable in the presence of outliers.

In panel a we observe the results when t=0. In the dividend change year the

dividend increase variable has a significant and positive impact on changes in

revenues for all the years. This strong concurrent effect between dividend changes

and result changes are consistent with other findings. The dividend decrease


Page 27

variable, on the other hand, varies from being significant and insignificant, and

between having a positive and a negative sign. From these results it is difficult to

draw valid inferences. Moving to panel b, and t=1, we can note the number of

years in which the variable dividend increase is significant is reduced to only 5

years. In addition to this the sign is negative in three out of the five years.

Investigating the dividend decrease variable leaves us with even less significant

results. Only in 4 years the variable is significant, and in only two of these the

variable has a negative sign. Based on these results it is again difficult to draw

valid inferences regarding both the dividend increase and the dividend decrease

variable.

Finally in panel c the results when t=2 are presented. The results turn more

significant for both the dividend increase and the dividend decrease variable. In

five out of nine years the dividend increase variable is both significant and

positive. When it comes to the dividend decrease variable, the variable is

significant in seven out of nine years, and only one out of these seven has a

positive sign. From this panel it seem to be a positive correlation between a

dividend increase and changes in earnings two years into the future, and a

negative correlation between an dividend decrease and changes in earnings two

years into the future.

One important factor to keep in mind when interpreting these results is the

temporary tax reform of 2001 and the permanent reform of 2006. In the year for

which these reforms increase the tax on dividends, i.e. 2001 (temporary) and 2006

(permanent), we would expect to see a reduction in dividends; hence the results

for the decrease group in 2000 and 2005 can at least partly be driven by tax

considerations. The reform of 2001 was not announced so its effect on dividend

changes prior to 2001 should be zero. The 2006 reform, however, was announced.

As discussed this can have weakened the relationship between dividends and

earnings in the year leading up to the reform.

From table 8 we can also analyze the effect from the other control variables on the

dependent variable, change in earnings. Leverage seem to have a negative impact

on future earnings changes, meaning that when a firm increases its leverage future


Page 28

earnings should decrease. Cash do also seem to have a significant effect on future

earnings. But when it comes to cash, the effect seems to be positive; hence higher

relative cash holding is positive correlated with a future increase in earnings. The

variable Size seems to be more ambiguous when it comes to its effect on future

earnings. Our results give us both negative and positive coefficient values, and in

addition the coefficients are both significant and insignificant. The return on

equity is significant and negative in almost all years and in when t is zero, one and

two. This is consistent with the results in Nissim and Ziv (2001) and their mean

reversion story. The variable controlling for growth options is also significant and

positive in almost all years, when t is zero, one and two. We also controlled for

earnings change in the dividend change year, which is significant and negative

when t=1. But when t=2 the results gets more ambiguous; hence it is difficult to

draw valid inferences from these results.

Finally we also control for the different ownership structures of the firms. As we

can see from table 8, the variable percentage equity of the largest owner seems to

have a negative impact on the future change in earnings. The other ownership

variable, fraction of equity held by personal owner is only significant in a few

years for all t values. The results are therefore ambiguous when it comes to this

variable; hence it is difficult to draw valid inferences regarding the impact from

the ownership structure on the change in earnings.


Page 29


Page 30


Page 31

Conclusion

In this paper the effect of changes in dividend policy on future firm performance

for non-listed firms is analyzed. As discussed in the literature review there are

many different findings and theories on this area. The main aim of this paper has

been to replicate the findings of Nissim and Ziv (2002), in which “strong evidence

in support of the information content of dividends hypothesis” (pp. 2131) is

presented, for non-listed firms. Based on their research we would expect to see

some of the same patterns in our research.

In order to establish some basic knowledge regarding the relationship in this

sample univariate analysis is employed. The measures of performance used in this

analysis are return on assets, return on equity and changes in results. With this

analysis we find some evidence for the Lintner hypothesis, in which firms

increase their dividends only when earnings are expected to increase permanently.

Further the findings in this section indicate that listed and non-listed firms are

different when it comes to dividend policy. We have been able to establish that

non-listed firms are highly flexible in their dividend policy, changing it rather

frequently. This is consistent with other findings on non-listed firms. Listed firms

tend to engage in smoothing of their dividends, at least partly due to the scrutiny

of public capital markets (Michaely and Roberts 2006). For non-listed firms this

scrutiny does not exist and higher flexibility is possible.

Finally the information content of dividends hypothesis is investigated, over the

time period 2000 till 2008, through multivariate regression analysis. This

hypothesis states that dividend changes trigger stock returns because dividends

contain new information about firm’s future profitability. In order to test this we

have done some alternations to the regressions, but the main elements are the

same. Our results, however, do not lend much support for the information content

of dividends hypothesis. The multivariate regressions give mixed evidence,

especially for the first year after the dividend change. In the second year after a

dividend increase (decrease) the results indicate that firms experience positive


Page 32

(negative) changes in earnings. After employing different techniques and

variables in our analysis the result are found to be robust.

Limitations and Further Research

An important limitation to this paper is the period for which the data is sampled.

First the sample horizon is rather short, compared to other samples in the

literature, with 8 years of data. Second and most importantly there have, as

discussed, been two tax reforms during the sample period, one that introduced

dividend taxation only for a year (2001) and a permanent shift to taxation of

dividends in 2006. These reforms will, as discussed, have affected our results,

possibly weakening the relationship between dividends and earnings, thus our

results may be constricted to be valid only within its period and may possibly not

be generalized. More research is therefore needed on “normal” times without

major reforms in taxations of firms in order to be able to present firm conclusions

regarding the signalling hypothesis.


Page 33

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Income? Corporate Responses to an Announced Dividend Tax” CESifo Working

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Dividends Signal the Future or the Past?” The journal of Finance, 52(3): 1007-

1034.

Berger, Allen N. and di Patti Bonaccorsi Emilia. 2006. “Capital Structure and

Firm Performance: A New Approach to Testing Agency Theory and an

Application to the Banking Industry”. Journal of Banking and Finance, 30(4):

1065 - 1102.

Bhattacharya, Sudipto. 1979. “Imperfect Information, Dividend Policy, and "the

Bird in the Hand” Fallacy” The Bell Journal of Economics, 10(1): 259-270.

Evans, David S. 1987. “The Relationship Between Firm Growth, Size and Age:

Estimates for 100 Manufacturing Industries”, Journal of Industrial Economics,

35(4): 567-582

Fama, Eugene F. and James D. MacBeth. 1973. “Risk, Return and Equilibrium:

Empirical tests”. The Journal of Political Economy, 81(3): 607-636.

Freeman, Robert N., James A. Ohlson, and Stephen H. Penman. 1982. “Book

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Page 36

Appendix; Preliminary thesis:

I. Introduction

In the literature regarding dividend payout policy many theories suggests that

changes in dividends contain some information regarding the future profitability

and earnings of the firm. More precisely many of these theories predict that

dividends are positively correlated with future profitability and earnings. One such

theory is the signalling hypothesis, which is based on information asymmetry

between managers and investors (e.g Bhattacharya 1979, and Miller and Rock

1985). With this asymmetry they claim that dividends are used as explicit signals

about future earnings which the management sends out intentionally and at some

cost to the investors. According to Bhattacharya (1979) the signalling cost stems

from the fact that dividends are taxed at a higher rate than capital gains

(Bhattacharya 1979). Miller and Rock (1985), however, views the loss of funds to

use in investments as the major signalling cost.

Kose John and Joseph Williams (1985) also identifies a signalling equilibrium

were private information is revealed by taxable dividends. In their model insiders

distribute larger dividends when their information is more valuable. According to

the authors this will push up the price of the stock when the demand for cash by

their current stockholders and the firm exceeds its internal supply for cash.

The signalling hypothesis have been widely researched, however there are

contradictory findings in the literature. Some studies give support for the

signalling hypothesis (Nissim and Ziv 2001, Bhattacharya 1979), while others

finds no or limited support for it (Grullon et al. 2005, Benartzi et al. 1997).

This preliminary thesis report is set up as follows; first a section on motivation of

the subject and intentions with the research, then a literature review before we

continue with our planned methodology and a brief description of the data.


Page 37

II. Motivation and intentions

Stock markets and investor behaviour suggests that dividends have information

content. When dividends are increased a firm’s stock price tends to increase and

vice versa when dividends are cut (e.g. Grullon et al. 2002). A prediction of the

dividend signalling hypothesis is that dividend changes are positively correlated

with future changes in profitability and earnings, hence these share price

movements are observed. According to Grullon et al. (2005) this is one of the

most important issues in corporate finance, hence it is of interest to investigate the

information content of dividends. This is a task which has been pursued by many

scholars; and so far no definite agreement has been reached.

Most of the research which has been done on this subject so far has employed data

from listed companies. We, however, will investigate the relationship between

dividends and future firm performance for private companies in Norway. In this

way we have most of the framework in prior work, but the research will be done

on data that has not been researched extensively. This research can yield

interesting results and possibly add new insights to the debate about the

relationship between dividends and future earnings.

We have chosen to define the scope of the research problem broader than just

dividend changes effect on future earnings, and instead focus on firm performance

in a wider sense. This allows us to asses if dividends have an effect beyond just

earnings. We can therefore analyze the effect of dividend changes on investments,

return on assets, cash flow, research and development and so forth.

A normal assumption is that information asymmetries are a bigger problem for

small and unlisted firms, which can imply support for the signaling hypothesis.

However it can also be tempting to believe that there is no strong correlation

between the change in dividends and the change in future earnings for private

firms. A first argument is the Modligiani and Miller irrelevance theorem which

states that firm value is independent of finance structure, from which it follows

that investors are indifferent to if dividends are paid out or if earnings are

reinvested profitably. Another argument could be that the management in many


Page 38

cases is the actual shareholders, but in the cases with outside shareholders they are

often very “close” to the management. The fact that to use dividends is a costly

signaling-strategy could induce the management of private firms to choose

another strategy. In fact, in many cases they do not need to signal since insiders

and outsiders are the same persons. Our research will therefore give us an

interesting, and useful, indication on how firms use dividends, and which of the

two stories we gain support for.

III. Literature review

There exists an extensive literature on this field, and we will in the following

review some of the most important papers. One of the first classical signaling

paper is “Imperfect Information, Dividend Policy, and “The Bird in the Hand”

Fallacy” from 1979 by Sudipto Bhattacharya. The paper develops a theoretical

model in which dividends function as a costly signal for expected future cash

flows. Hence changes in dividends should convey information about future cash

flows. It follows that dividend decreases are bad news (lower future cash flows)

and dividend increases are good news (higher future cash flows). The author

develops these results by assuming that outside investors have imperfect

information about firm’s profitability, and that cash dividends are taxed at a

higher rate than capital gains. The fact that dividends are taxed at a higher rate is

the major signaling cost which leads dividends to function as a signal.

In the model outside investors cannot distinguish the profitability of productive

assets held by firms, and existing shareholders care about the market value of the

firm assigned by outsiders. Investors ignore other sources of information than

dividends on the ground that they are “fundamentally unreliable screening

mechanisms because of the moral hazard involved in communicating

profitability” (Bhattachary, 1979: 260). It follows that the communication of even

ex post cash flows from existing assets is costly, because only dividends can

convey this information and dividends are taxed higher than capital gains. From

this Bhattacharya concludes that dividends can function as an explicit signal about

future earnings, sent intentionally and at some cost by the management to the firm

and its stockholders.


Page 39

Merton Miller and Kevin Rock wrote a paper in 1985 where they looked at the

dividend policy of a firm when information is asymmetric. We know that when

there exists asymmetric information the state of the information with respect to

earnings, investment and net dividends are different for insiders and outsiders.

For an outsider the most important piece of public information is the dividends,

hence this is very important when it comes to the valuation of a firm. Since an

insider has information about unannounced earnings, this will lead to a difference

in the perceived value of the firm. The model, which is developed in this paper,

therefore proposes dividends as a signal to outsiders on how insiders view the

economic future of the firm. For the firm, this is a costly way of communicating.

This is in accordance with Bhattacharya (1979); however Miller and Rock view

the major signaling cost as the loss of funds to use in investments. Because of this

cost, this kind of signaling only makes sense for the good-news firms, and not the

bad-news firms. It is only for the good-news firms that the cost may be worth

bearing to avoid giving the market a false impression that earnings were not high

enough to justify a dividend.

Kose John and Joseph Williams (1985) propose a signaling equilibrium which

actually has a very simple intuition. A firm must either retire fewer outstanding

shares or issue new shares in order to raise funds for investments. As firms,

current stockholders have to sell existing shares to raise cash on personal account.

If either of these events occurs current stockholders will suffer some dilution in

their fractional ownership of the firm. When inside information is more favorable,

the reduction of this dilution is more valuable for the current stockholders.

“Consequently, insiders, acting in the interests of their current stockholders, may

distribute a taxable dividend if outsiders recognize this relationship, bid up the

stock price, and thereby reduce current stockholders' dilution. In the resulting

signalling equilibrium, insiders control dividends optimally, while outsiders pay

the correct price for the firm's stock.” (Kose John and Joseph Williams, 1985:

1054). In this equilibrium, insiders with truly more valuable future cash flow will

distribute larger dividends and receive higher prices for their stock, whenever the

demand for cash by both the firm and its current stockholders exceeds its internal

supply of cash. Thus, John and Williams (1985) develops a model were there


Page 40

should be, at least in theory, a positive relationship between an increase in

dividends and future cash inflow.

There are many scholars who have tried to empirically document a correlation

between dividend changes and future firm performance, e.g. the signaling

hypothesis. Shlomo Benartzi, Roni Michaely and Richard Thaler analyses this in

their article “Do Changes in Dividends Signal the Future or the Past” (1997). In

their article the authors utilize a large number of firms and events and they control

for many factors that possibly could create a spurious relationship between

dividends and subsequent earning changes. Their results, both by utilizing

categorical analyses and regression analyses, indicate a very strong correlation

between dividend changes and lagged and contemporaneous earnings. However,

they are unable to find much evidence of a positive relationship between dividend

changes and future earnings changes.

Because of their findings the authors ask if dividend changes signal something

else than the expected value of future earnings. One possibility is that dividend

increases are a signal about a permanent shift in earnings (as Lintner (1956)

suggests). They do indeed find some support for Lintner’s view. Nevertheless,

their results lead them to conclude that “if firms are sending a signal, (a) it is not

a signal about future earnings growth and (b) the market doesn’t “get it”. Why

firms would burn money to send a signal that is not received is, indeed, a

mystery.” (Benartzi et al, 1997; 1009).

Unlike Benartzi et al. (1997) Nissim and Ziv (2001) present the “information

content of dividend hypothesis”, which they claim tell us that dividend changes

trigger stock returns because dividends convey new information about the firms’

profitability. Investigating this hypothesis Nissim and Ziv (2001) find a positive

relationship between dividend changes and future earning changes, future

earnings and future abnormal earnings. Further they find that dividend increases

are positively related to earnings in each of the four subsequent years, but that a

dividend decrease is not related to future earnings.

As they explain in their paper, the lack of correlation between dividend decreases

and future earnings does not necessarily imply that dividend decreases are not


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informative about future earnings. Actually, when they omit current year earnings,

the coefficient on dividend decreases becomes positive and significant. This can

be explained by accounting practices. Losses should be recognized in earnings

when anticipated whereas profits should be included only when earned. As a

result, current year earnings cannot contain the future implications of the good

news that caused management to increase dividend. On the other hand, future

implications of the bad news that triggered the dividend decrease should be

reflected in current earnings.

In another article “Dividend changes Do Not Signal Changes in Future

Profitability” by Gustavo Grullon, Roni Michaely, Shlomo Benartzi and Richard

Thaler (2005), the signaling hypothesis is rejected. In this paper the authors claim

that Nissim and Ziv’s (2001) assumption of linear mean reversion in earnings is

inappropriate. From econometrics we know that assuming linearity when the true

functional from is nonlinear has the same consequences as omitted variable bias.

Hence they argue that the Nissim and Ziv results may be biased.

The authors therefore employ a model which assumes that the rate of mean

reversion and the coefficient of autocorrelation are highly nonlinear. With this

approach the relation between dividend changes and future earnings disappears.

Overall they find no evidence supporting the idea that dividend increases signal

better prospects for firm profitability. They also show that out of sample forecasts

are generally better without using dividend changes as an independent variable.

They claim that given the evidence presented in their article and others it is

sensible to conclude that changes in dividends are not useful in predicting future

changes in earnings. However they do not rule out that dividend increases signal

something, “but that something is neither abnormal increases in future earnings

nor abnormal increases in future profitability” (Grullon et al, 2005: 1681).

The literature continues to try to establish what exactly dividends are a signal of.

In the article “Are Dividend Changes a sign of Firm Maturity” by Grullon, Roni

Michaely and Bhaskaran Swaminathan (2002) they try to answer this question.

From this article and others we have indications that dividends contain

information (market reactions). Further, by definition fundamental news about a


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firm has to be either about its cash flows or its discount rate. The authors claim

that since it is not news about cash flows it must be about the discount rate. They

document by using data on US stocks that firms which increase (decrease)

dividends experience a significant decline (increase) in their systematic risk, i.e. a

reduction in the discount rate.

On the basis of their findings the develop a new hypothesis, the Maturity

Hypothesis which states that dividends contain information about firms transitions

in life cycles to a more mature phase. As firms become more mature they tend to

increase their payouts due to less positive net present value opportunities. Hence

we should expect dividend increases to be associated with a subsequent declining

profitability, risk and return on investments which will lead to lower capital

expenditures. This hypotheses is connected with the Free Cash Flow hypotheses

developed by Jensen (1986), however the Free Cash Flow hypotheses does not

contain any explicit prediction concerning changes in risk, hence it cannot be the

complete story.

In order to test this hypothesis the authors investigates different aspects of firm

performance employing various techniques we also can use. First they analyze the

changes in Return on Assets (ROA) and dividend payout ratios. Dividend payout

ratios are interesting because “if cash flow signaling models are correct, the

payout ratio of a dividend increasing firm should increase temporarily at first and

then decline gradually over time as earnings start to catch up with the increased

dividends” (Grullon et al. 2002; 402). Two final variables they investigate are

capital expenditure and excess cash. The free cash flow hypothesis suggests that

dividend increasing firms ought to decrease (at least keep constant) their capital

expenditures. In addition we would expect to see their cash balances decline. This

is something we can analyze and see whether this hypothesis holds in our sample.

Overall their findings support the Maturity Hypothesis and fills in the pieces

providing more content to the Free Cash Flow hypothesis.

In our paper, the data is on private firms, unlike most of the research done on the

area. Michaely and Roberts (2007) compare the different dividend policies

between public and private firms, and try to explain why private firms may have a

different dividend policy than public firms. In this paper, the authors divide their


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data sample of UK-firms in three distinct groups; wholly owned firms, private

dispersed firms and public firms.

As stated by Michaely and Roberts (2007), an important difference between a

private- and a public-firm is the ownership structure. Some private firms exhibit

little, if any, separation between control and ownership. If there should exist

outside shareholders, then they are often close family members, or informed and

active monitors, such as corporation with close ties to the firm. This will affect the

dividend policy of the firm. Some private firms may for instance increase

dividend payments not as a signal to shareholders, but maybe instead of wages

due to tax reasons, although the paper by Michaely and Roberts (2007) do not find

evidence of this in their data.

The paper presents three hypotheses, where the last hypothesis possibly is the

most interesting for our work. This hypothesis is as follows:

“Hypothesis 3: Following dividend increases, operating performance should

improve for Private Dispersed firms and Public firms, but there should be little or

no relation between dividend increases and operating performance for Wholly

Owned firms.” (Roni Michaely and Michael Roberts; 2007; 25).

For our work this is very interesting. What the hypothesis suggests is that the

firms which increase their dividends are those that are undervalued by the market.

When they test this hypothesis they come up with two conclusions. Under

symmetric information, firms will not try to signal future change in earnings with

an increase in dividends. This is of course natural since outsiders have the same

information as insiders. But, even when information is asymmetric, they find no

evidence that firms try to signal higher future earnings with an increase in

dividends. Hence, they reject the signaling hypotheses in contrast to Nissim and

Ziv (2001). As explained, the empirical work on the area is highly debated.


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IV. Methodology and Data

As the previous sections shows there exists an extensive literature on this field of

research, with different methodologies and conclusions. We will pursue some of

the methodology used by the authors mentioned in the literature review. However

since we use a different data set, and most importantly that we do not possess data

on market values and stock prices due to our interest in private firms, we will have

to adjust the previously employed methods.

A large part of our methodology is based on the work by Nissim and Ziv (2001).

One of the first regressions we will apply on our data is the following:

Where

- Et: Earnings in year t.

- B-1: Book value of equity at the end of the previous year prior to the

dividend change.

- RDIV0: The annual percentage change in the cash dividend payment in

year 0.

- ROEt-1: Earnings in year t-1 scaled on the book value of equity at the

end of year t-1.

The result from this regression will indicate whether dividend changes are

informative about future earnings changes or not. If dividends contain any

information about future earnings, we expect α1 to be significant.

To examine whether dividend changes contain information of future earning

changes, incremental to the earning changes in the year of the dividend change,

we include, as done by Nissim and Ziv, an additional control variable;

, hence regressing the following model (were DPC (NPC) is a

dummy variable that equals one for dividend increases (decreases) and zero

otherwise):


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We would expect that if a change in dividends conveys some information about

future change in earnings then β1P and β1N would be significantly different from

zero.

To ensure the robustness of our results we will include some additional control

variables to the original equations of Nissim and Ziv. Such controls can be year

and industry effects. In addition we would like to control for financial constraints,

but because of endogeneity problems with financial constraints we will have to

measure it by a proxy, e.g. leverage.

As Nissim and Ziv we now want to extend our analysis, and examine the relation

between dividend changes and the level of earnings in the years following the

dividend change year. To investigate the relationship between a dividend change

and both future earnings and future abnormal earnings (AE) can for us as well be

informative. Because of this we want to examine the following two regressions:

Nissim and Ziv have included the market value of equity, denoted as P-1 in the

regressions above. For us this is obviously impossible to get hold of, so if we are

going to employ this methodology we have two options, either regress the

equations without controlling for this, or we could see if we can find a proxy for

the market value of equity. The reason why Nissim and Ziv include this factor is

to control for information of future profitability. Therefore we do not need to find

a proxy for the market value of the equity per se, but a proxy for the information

of future profitability. A proxy for this could be future growth opportunities

measured by lagged sales over assets.

As an alternative to the pooled regression done by Nissim and Ziv we can do

yearly regressions and average the coefficients to see if the results differ


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substantially. This methodology was originated in Fama and Macbeth (1973) and

has also been used with success in the dividend literature.

Another way to analyze the effect of changes in dividends on future earnings is to

tabulate the earning surprise in year 0,1 and 2 following a change in dividends;

this methodology is used by Benartzi et. al. (1997). In order to employ this

method we have chosen three different measures of earnings surprise.

1) To establish a baseline we will use a simple measure of earnings

surprise:

2) Annual percentage change in earnings (Benartzi et al. 1997), scaled by

book value of equity.

3) Comparison of the dividend changing firms with the non-dividend

changing firms in the same industry (Benartzi et al. 1997):

Where n=1, 2,…,N are the firms that did not change their dividends in

year t and are in the same industry.

We can then follow the evolution for earnings of groups of dividend decreasing,

no-change and increasing firms for the different measures of earnings surprise,

and analyze if there is any systematic pattern in the development of these.

As a final approach we will investigate the connection between dividend changes

and other measures of firm performance such as return on assets (ROA), capital

expenditures and cash holdings, and payout ratios. This is done by Grullon et al.

(2002), and the analyses discussed below draws heavily on that paper.


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First we can compare the average changes in ROA, defined as operating income at

time t on total assets at time t, for the years -3 to -1, 0, and 1 to 3. Then analyze

the average return for the years 1 – 3 minus the average return for the period -3 to

-1, and finally the average return for the years 1 – 3 minus the return in year 0. It

is also possible to correct for industry specific factors and previous performance

and then analyze the results. All these analyses are done for different quintiles of

dividend changing firms, and again if dividends contain information about future

ROA we would expect a significant positive correlation between ROA and

dividend changes. It could be that a dividend signals a permanent increase in

current ROA instead of an increase in future ROA. This would then suggest that

future ROA should be higher than past ROA, at the same time there could be a

decline in years 1 to 3 if the ROA in year 0 temporarily overshoots its higher

permanent level. To ensure that the changes in ROA are not driven by this effect

we must also analyze the level of ROA.

Another factor which will be interesting to analyze is dividend payout ratios,

defined as dividends paid over net income. If cash flow signaling models are

correct, the payout ratio of firms which increases its dividend should increase

temporarily before it gradually declines as earnings increase. Finally the Free

Cash Flow hypothesis states that firms which increase their dividends should

decrease (or at least not increase) their capital expenditures. We will also expect

that their cash balances decline since they have chosen to pay out their excess

cash as dividends.

IV.I. Data

We have gained access to the Centre for Corporate Governance Research database

(CCGR) and have obtained a host of different corporate variables for Norwegian

private firms. Specifically we have data on 20 variables mostly consolidated

account data but also data concerning ownership control and industry codes. For a

description of the different variables included in the dataset please see appendix I.

The data is on a yearly basis from 1994 until 2007, further it is on panel form with

one firm for the entire time period, then the next firm for the entire period and so

forth. This dataset will allow us to investigate relationships between different

factors of firm performance such as return on assets, earnings, capital

expenditures, amount of cash and dividends.


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V. References:

Benartzi, Shlomo; Roni Michaely and Richard Thaler. 1997. “Do changes in

dividends signal the Future or the Past?” The journal of Finance, 52(3): 1007-

1034.

Bhattacharya, Sudipto. 1979. “Imperfect information, dividend policy, and "the

bird in the hand” fallacy” The Bell Journal of Economics, 10(1): 259-270.

Fama, Eugene F. and James D. MacBeth. 1973. “Risk, Return and Equilibrium:

Empirical tests”. The Journal of Political Economy, 81(3): 607-636.

Grullon, Gustavo; Roni Michaely and Bhaskaran Swaminathan. 2002. “ Are

Dividend Changes a Sign of Firm Maturity?” The Journal of Business, 75(3): 387-

424.

Grullon, Gustavo; Roni Michaely; Shlomo Benartzi and Richad Thaler. 2005.

“Dividend Changes Do Not Signal Changes In Future Profitability” Journal of

Business, 78(5): 1659-1682.

Jensen, Michael C. 1986. “Agency Costs of Free Cash Flow, Corporate

Finance,and Takeovers” The American Economic Review, 76(2): 323-329

Kose, John and Joseph Williams. 1985. “Dividends, Dilution, and Taxes: A

signaling equilibrium” The Journal of Finance, 40(4): 1053-1070.

Lintner, John. 1956. “Distribution of incomes of corporations among dividends,

retained earnings, and taxes”. American Economic Review, 46:91-113

Michaely, Roni; and Michael R. Roberts. 2007. “Corporate Dividend Policies:

Lessons From Private Firms”

Miller, H. Merton and Kevin Rock. 1985. “Dividend Policy under Asymmetric

Information” The Journal of Finance, 40(4): 1031-1051.


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Nissim, Doron and Amir Ziv. 2001. “Dividend changes and future profitability.”

Journal of Finance, 56(6): 2111–2133.


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Appendix I

Documents

Do Dividends Predict Future Firm Performance?...Theoretical Foundations One of the first scholars who contributed to the theoretical foundation of the signalling hypothesis was Sudipto