Expectations and the Cross-section of Dividend Announcement Eeects 2 Interpreting Dividend Announcement Eeects 2.1.2 an Information Signalling" Reinterpretation 2.2 Tobin's Q : Free-cashhow or Information Signalling? 2.2.1 the Free Cashhow Evidence 2.2.2 an Information Signalling" Interpretation

Recent literature documents that Tobin's Q and dividend yield explain the cross-section of dividend announcement e ects. These results have been interpreted as evidence of agency costs of free cashow and/or the existence of dividend clientele. In this paper, we argue that these interpretations are potentially inconsistent with rational expectations nancial markets, and we provide alternate economic interpretations of the cross-sectional relationships. Speci cally, we propose that the explanatory power of yield and Tobin's Q manifests information e ects arising out of a signalling equilibrium, in which rms signal their growth prospects through dividends. We demonstrate the validity of our interpretation in two ways. One, we re-examine the free cash ow/clientele evidence, and show that the same evidence is consistent with the interpretation we are proposing. Second, we implement a formal econometric model of the signalling hypothesis, and show that the cross-section of dividend announcement e ects is consistent with the speci cation that results. This analysis leads to an explicit empirical characterization of the signalling equilibrium underlying dividend announcements, and we obtain new and economically interesting results in this context. Our results reconcile the cross-sectional variation in dividend announcement e ects with theories of dividend signalling, and we discuss their broader economic implications for cross-sectional analyses in event-studies. Stock-price changes around dividend announcements are usually explained in terms of a \signalling" hypothesis. Firms raise dividends when earnings are expected to increase, and cut dividends when earnings are likely to decline. Recognizing this relationship, stock markets respond to dividend announcements in the direction of the dividend change. This view is consistent with much empirical and anecdotal evidence, as well as several theoretical models of dividend signalling.1 However, recent literature [Lang & Litzenberger (1989), Bajaj & Vijh (1990), Denis, Denis & Sarin (1994)] suggests that changes in rm value around dividend announcements are at least partially due to economic phenomena other than dividend signalling. Speci cally, this literature documents that the cross-section of dividend announcement e ects are explained by a set of four variables : dividend yield, Tobin's Q, rm size, and the price of a rm's stock. That yield explains dividend announcement e ects has been attributed to the existence of dividend clientele investors with varying marginal preferences for dividend income relative to capital gains. On the other hand, the explanatory power of Tobin's Q has been interpreted as evidence of the free cash ow theory proposed by Jensen (1986). Firm size and stock price have been included essentially as controls for inferences in multivariate settings. In particular, it has not been clear as to why the price of a rm's stock should determine how markets react to its dividend announcements, and this nding has been posed as a empirical puzzle. The free cash ow and clientele interpretations are somewhat surprising, from an economic viewpoint. Dividends are viewed as being weak mechanisms by which to resolve free cash ow problems. It is odd, therefore, that free cash ow e ects should show up in stock-price reactions to dividend changes. On the other hand, the existence of dividend clientele and their impact on asset prices have been extensively debated in the asset pricing literature for over two decades. This literature has not reached any de nite conclusion.2 Thus, it is puzzling that clientele e ects should be so prominently manifest in short-term price reactions to dividend announcements. A more serious issue relates to the rational expectations content of these interpretations. Following an established norm, the literature mentioned above assumes that dividend changes are exogenous events that are not anticipated by nancial markets. All empirical tests in the literature, as well as their economic interpretation, rest on this premise. Recent empirical evidence relating dividends to subsequent earnings/analyst earnings forecasts includes Healy and Palepu (1988) and Ofer and Siegel (1987); dividend signalling models are developed in Bhattacharya (1979), John and Williams (1985), Miller and Rock (1985). See Black and Scholes (1974), Litzenberger and Ramaswamy (1979), Miller and Scholes (1982) for representative arguments on both sides. More recently, Kalay and Michaely (1993) cast fresh doubt on the clientele hypothesis.