Special Dividend Announcements: Signaling or Free Cash Flow Hypothesis‘ Evidence from UK Firms

Abstract

We examine the impact of special dividend announcements for UK firms over the period 1989-2007. We find that the market reacts positively to the announcement of these dividends, but that the reaction is stronger for firms with lower growth opportunities (low Tobin’s q). For lower-growth firms, we do not find any evidence that the firm is using a special dividend to signal future cash flow performance. Rather, it appears that these firms are using a special dividend to distribute cash that is surplus to its needs, consistent with agency theory. For special dividend issuing firms with higher growth opportunities (high Tobin’s q), we find evidence that such firms subsequently enjoy improved cash flow performances (for both the fiscal year-end immediately after, and the fiscal year following, the announcement date), thereby supporting a signaling hypothesis for special dividends. Overall, our findings offer support for both the free cash flow hypothesis and the signaling hypothesis. That is, managers use special dividends to signal future cash flow performance for firms with high growth opportunities, while using special dividend to reduce agency costs for firms with low growth opportunities.