Value of dividend signaling in uncertain times

• Published date: 01 December 2021
• Author: Hayley Baker,Millicent Chang,Choy Yeing (Chloe) Ho
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/irfi.12334

ORIGINAL ARTICLE

Value of dividend signaling in uncertain times

Hayley Baker

1

| Millicent Chang

2

| Choy Yeing (Chloe) Ho

1

1

Department of Accounting and Finance,

University of Western Australia, Crawley,

Western Australia, Australia

2

School of Accounting, Economics and

Finance, University of Wollongong,

Wollongong, New South Wales, Australia

Correspondence

Choy Yeing (Chloe) Ho, Department of

Accounting and Finance, University of

Western Australia, 35 Stirling Highway,

Crawley, WA 6009, Australia.

Email: chloe.ho@uwa.edu.au

Abstract

When investors are uncertain about firm value, they collect

private information and contemplate the decisions made by

management before trading. In this study, we examine the

effects of policy uncertainty on managers' payout decisions

and investors' reactions to these decisions. We show that

managers tend to increase dividend payouts when uncer-

tainty surrounding government policies is high. This rela-

tionship is particularly evident among better performing

firms. Investors also respond more favorably to dividend

increases in times of uncertainty. As a result, we conclude

that policy uncertainty affects the firm's information envi-

ronment owing to which managers respond to investor

demand for information by paying dividends to signal firm

quality.

KEYWORDS

abnormal return, announcement reaction, dividend, policy

uncertainty, signaling

JEL CLASSIFICATION

G32; G35; G38

1|INTRODUCTION

Heightened government policy uncertainty in recent years has caused significant losses to the economy, promoting

insecurity among investors.

1

Policy uncertainty in the United States reached several peaks due to the government's

inability to raise the federal debt-ceiling in August 2011, the fiscal cliff crisis at the end of 2012, the government

shutdown in October 2013, and the Trump election at the end of 2016.

2

It is not surprising that policy makers and

researchersemphasize the importance of understanding its impacton financial markets and corporatedecision-making.

Although a growingliterature has examined theimpact of policy uncertaintyon corporate decisions such as investment

Received: 23 January 2020 Revised: 30 July 2020 Accepted: 21 August 2020

DOI: 10.1111/irfi.12334

© 2020 International Review of Finance Ltd. 2020

International Review of Finance. 2021;21:1419–1440. wileyonlinelibrary.com/journal/irfi 1419

levels, acquisitions, innovations, and cash holdings, research on the link between policy uncertainty and dividend

payout is sparse. To better understand managerial actions in these situations, we pose two questions. First, does

policy uncertainty affect payout decisions? And second, do investors value dividends more when uncertainty is

higher?

Two streams of literature lend support to the notion that firms increase payouts when policy uncertainty is high.

During economic downturns, the difficulty of predicting asset returns increases due to larger variation in future firm

outcomes (Bloom, 2009). This in turns increases the importance of high-quality firms to differentiate themselves

from other firms. Building on the seminal work of Lintner (1956) that managers adopt sticky dividend policy and

avoid cutting dividends to maximize firm value, subsequent research has shown that dividends are a salient mecha-

nism to signal better future performance and alleviate information asymmetry, especially in incomplete markets

(Bhattacharya, 1979; John & Williams, 1985; Miller & Modigliani, 1958; Miller & Rock, 1985; Nissim & Ziv, 2001).

The other strand of literature highlights the importance of information to investors in uncertain times.

Kacperczyk and Seru (2007) show that investors rely more on public information rather than private information

when the latter is less precise. Given greater macroeconomic uncertainty creates higher variation in future outcomes,

we expect that investors will rely more on public information to evaluate the impact of uncertainty that poses high

systematic risks. Loh and Stulz (2018) find that the value of analysts' forecasts increases during economic crises and

report that the price impact of earnings forecast revisions and recommendations are greater, indicating that investors

rely more on public information through analysts. In the same way, given dividend announcements contain informa-

tion about firms' future prospects, these announcements will be more impactful when uncertainty is high. Therefore,

in times of higher uncertainty, investors are expected to react more favorably to dividend announcements. However,

it is possible that managers may refrain from disbursing cash in order to accumulate precautionary savings, as docu-

mented in Duong, Nguyen, Nguyen, and Rhee (2020). Therefore, whether managers increase dividends or not during

uncertain times is an empirical question.

Our sample comprises 429,763 firm-quarter observations of 12,381 unique firms from 1986 to 2017. We use

Baker, Bloom, and Davis' (BBD, 2016) Economic Policy Uncertainty (EPU) Index, which measures policy-related eco-

nomic uncertainty from newspaper articles, tax code provisions, and forecasters' surveys. We begin by testing how

EPU affects dividend increase decisions, employing payout models commonly used in the literature to control for

factors associated with payout, such as leverage, cash holdings, and growth opportunities. Our results strongly indi-

cate that policy uncertainty is associated with a higher likelihood of increased dividends in the subsequent quarter.

To alleviate the concern of omitted variable bias that could stem from policy uncertainty capturing other macroeco-

nomic conditions, we control for several macroeconomic measures of uncertainty, as proposed by Bloom (2009), and

proxy for future economic conditions (investment opportunities) using principal component analysis. Second, policy

uncertainty and payout policies can be jointly correlated with unobservable variables, such as investment opportuni-

ties, which raises endogeneity concerns. We use the instrumental variable (IV) analysis to address such concern and

find that our results are robust to endogeneity correction. Further results show that firms with better prior stock

returns are more inclined to increase dividends.

The next set of analyses examines whether the signaling value of a dividend increase is greater when policy

uncertainty is high. We find that investors value dividend increases more when policy uncertainty is high, supporting

the notion that signals regarding the firm's current and future performance are more important in uncertain times.

While increasing dividend is costly in times of high uncertainty, our findings indicate that the marginal benefits of sig-

naling outweigh the costs. In multinomial logit regressions, we show a positive association between policy uncer-

tainty and dividend increase and a negative association with stock repurchases. The fact that the likelihood of

repurchases reduces when uncertainty is high is consistent with prior literature that repurchase activities declined

during the 2008 financial crisis (Iyer & Rao, 2017).

Our study makes two main contributions to the literature. First, our results are in contrast to conservative man-

agement during uncertainty, whereby firms have been found to reduce investment expenditure and increase cash

holdings (Duong et al., 2020; Gulen & Ion, 2015; Julio & Yook, 2012). These studies indicate that managers prepare

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