Specially Designated Dividends: Signalling or Free Cash Flow?

Abstract

This study jointly examines the signalling and free cash flow hypotheses as applied to announcement-period reactions around specially designated dividend (SDD) announcements. Results support the presence of both theories in the most recent era: 1990–2006. Specifically, significant positive relationships between returns and earnings changes for the year of SDD announcements and the year immediately following them are found. Separation based on proximity to regular dividend payments suggests the signalling strength is weak for SDDs paid in isolation, stronger when paid with a regular dividend and stronger again for those paid with a regular dividend increase. Signalling strength is also shown to be dominant within firms with a low Tobin’s Q, consistent in part with the conditional signalling hypothesis. Analysis also suggests that the market’s response is consistent with SDDs’ function as a tool for the mitigation of potential agency problems. Larger market reactions are found for firms with poor investment opportunities (low Tobin’s Q) coupled with large amounts of free cash flow.