Dividend-Reduction Motives Drive Market Reactions and Earnings Performance

Abstract

This paper investigates the cash flows of firms that reduce dividends when earnings decline and those that undertake the same action when earnings increase to shed light of the motives for these dividend reductions. The results show that the former firms experience increases in operating and financing cash flows and their double their investment spending, while the latter firms experience declines in operating and financing cash flows and they reduce investment spending by over a half. The results suggest that dividend reductions in the face of increases in earnings are due to cash pressures to finance investments, while the same reductions in the face of declines in earnings stem from cash pressures caused by earnings difficulties and reduced access to external financing. In line with these motives, the market reacts negatively to dividend reductions when earnings decline but it reacts positively to dividend reductions when earnings increase. Furthermore, consistent with investment behaviors of these firms, the firms that reduce dividends when earnings decline continue to display weak earnings performance, while those that reduce dividends when earnings increase continue to experience strong earnings performance. These results shed new light on the market’s reaction to dividend reductions as well as on the relation between dividend reductions and future earnings performance.