'Preparing' the Equity Market for Adverse Corporate Events: A Theoretical Analysis of Firms Cutting Dividends

Abstract

This paper presents the first theoretical analysis of the choice of firms between preparing and not preparing the equity market in advance of a possible dividend cut. In our model, a firm has assets in place that will generate an intermediate cash flow, and a growth opportunity. Firm insiders have private information about the intermediate cash flow as well as about the net present value of its growth opportunity. We characterize the firm’s equilibrium choice between preparing and not preparing the market, as well as dividend-cut decision (subsequent to the realization of its intermediate cash flow). In equilibrium, firms in temporary financial difficulties but good long-term growth prospects are more likely to prepare the market in advance of dividend cuts, while those with permanently declining earnings are less likely to prepare the market. Our analysis generates several testable predictions, not only for the propensity of firms to prepare the market prior to dividend cuts, but also for the announcement effect (on the market preparation day, the dividend cut day, and the combined announcement effect over both days) as well as for the long-run operating, dividend payment, and stock return performance of prepared versus non-prepared dividend cutting firms.

Keywords: Market Preparation, Dividend Cuts, Asymetric Information

JEL Classification: G35, M41