What Do Dividend Reductions Signal?

Posted: 25 May 2011

See all articles by Gerald R. Jensen

Gerald R. Jensen

Northern Illinois University

Leonard L. Lundstrum

Northern Illinois University

Robert E. Miller

affiliation not provided to SSRN

Date Written: December 1, 2010

Abstract

Dividend reductions have long been considered a "last resort" action for firm managers. Managerial reluctance to reduce dividends emanates from the view that dividend drops signal managerial pessimism regarding future earnings. Contrary to expectations, studies show that earnings rebound significantly following a dividend reduction; yet investors react negatively to the dividend-drop announcement. We present an explanation for the anomalous behavior of earnings and returns around the time of a dividend drop. Our evidence suggests that a reduction in a firm's established dividend coincides with a decrease in the value of the firm's real options. Earnings rebound following the dividend reduction due to the savings that result as the firm allows growth options to expire; however, announcement period returns suggest that investors recognize the lost value associated with the forthcoming expiration of growth options.

Keywords: Dividends, Dividend changes, Signaling, Real options

JEL Classification: G35, G32, G31, G14, G34

Suggested Citation

Jensen, Gerald and Lundstrum, Leonard L. and Miller, Robert E., What Do Dividend Reductions Signal? (December 1, 2010). Journal of Corporate Finance, Vol. 16, No. 5, 2010, Available at SSRN: https://ssrn.com/abstract=1850844

Gerald Jensen

Northern Illinois University ( email )

Barsema Hall
Finance Department
DeKalb, IL 60115
United States
815-753-6399 (Phone)

Leonard L. Lundstrum (Contact Author)

Northern Illinois University ( email )

Wirtz Hall
DeKalb, IL 60115
United States
815 753 0317 (Phone)
815 753 0504 (Fax)

Robert E. Miller

affiliation not provided to SSRN

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