Dividend Changes and Profitability:

An Empirical Study of Indian Manufacturing Firms

Jijo Lukose P J* and S Narayan Rao**

The study, using a large sample of firms listed on the Bombay Stock Exchange (BSE), examines the stock price reaction
to dividend changes and the relevance of signaling models in explaining the valuation effects associated with dividend
changes. The study finds significant wealth effects around dividend changes as proposed by the signaling models.
There is a strong positive relationship between dividend changes and profitability during the year of dividend change.
Dividend initiating (omitting) firms have large increase (decrease) in earnings in the year of change, compared to the
moderate change in earnings in case of dividend increasing (decreasing) firms. Dividend changes contain no information
about future earnings in the subsequent years.

Introduction
Signaling models have been extensively used to explain the dividend policy of firms.
These models suggest that dividend changes contain information about current and future
earnings. Signaling models have received a great deal of empirical attention and theoretical
support in the US and other developed markets. A major motivation for this study is the
paucity of empirical research on the applicability of signaling models in the Indian context.
The main objective of this study is to examine the market reaction to dividend changes using
Indian data. Thus, this study contributes to the limited work on the market reaction to
corporate announcements using Indian data sets, with a more comprehensive and complete
list of dividend announcements. This assumes importance in the presence of the apparent
difference of institutional background in India compared to that in the developed markets.
Another objective is to provide an empirical testing of the hypothesis that changes in
dividends convey information about future earnings.

Literature Review
Despite their view of dividend irrelevance, Modigliani and Miller (1958) indicate that
dividends may convey information not otherwise known to the market. This argument is
theoretically proposed in a number signaling models by Bhattacharya (1979), John and
Williams (1985), and Miller and Rock (1985). These models reach the same conclusion that
firms pay dividends to convey information to investors that cannot be conveyed through
other credible ways. According to the signaling theory, dividends should reflect managers’
superior inside information about the firms’ earnings prospects. One of the key implications
of signaling models is that dividend changes should be followed by changes in earnings in the
* Associate Professor, Institute for Financial Management and Research, 24, Kothari Road, Nungambakkam,
Chennai 600034, India; and is the corresponding author. E-mail: jijo@ifmr.ac.in
* * Associate Professor, Shailesh J Mehta School of Management, Indian Institute of Technology Bombay, Powai,
Mumbai 400076, India. E-mail: narayan@som.iitb.ac.in

Dividend Changes
© 2010 IUP and Profitability:
. All Rights Reserved. An Empirical Study of Indian Manufacturing Firms 5
same direction. Higher dividends signal better earnings, and therefore, lead to a higher market
value.
The empirical testing of dividend signaling models has focused on two issues. The first
empirical question is whether dividend changes have any impact on share prices. As higher
dividends signal better future earnings, increase in dividends should lead to positive excess
returns and decrease to negative excess returns. Consistent with the signaling argument,
empirical studies document that market reaction is positive (negative) when dividends are
increased (decreased) (see Aharony and Swary, 1980; Asquith and Mullins, 1983; Healy and
Palepu, 1988; and Michaely et al., 1995). The abnormal returns around dividend announcement
are positively related to the sign and degree of the dividend change. It is also observed that
the magnitude of abnormal return is positively related to the degree of unexpected changes
in dividends.
The second relevant question is whether dividend changes contain information about
the future earnings of the firm. The results from studies that examined the relationship
between dividend changes and future earnings are mixed. Healy and Palepu (1988) show that
firms that initiate (omit) dividends have significant increase (decrease) in their annual
earnings for at least one year before and the year of dividend change. Similarly, these firms
have significant increases and decreases in earnings for at least one year after the
announcement. In the case of initiating firms, earnings increase for two years following these
dividend increases. DeAngelo et al. (1996) show that dividend increases are not informative
signals about future earnings and some firms’ favorable dividend actions could likely be
managerial mistakes. Benartzi et al. (1997) find a very strong lagged and contemporaneous
correlation between dividend changes and earnings. But in the two years following the dividend
increase, they find that earnings changes are essentially unrelated to the sign and the magnitude
of the dividend change. Nissim and Ziv (2001) posit that studies like Benartzi et al. (1997) are
misspecified due to the ‘measurement error’ in the dependent variable and the ‘omitted
correlated variable’ problem. After addressing these problems, they found that dividend
changes are positively associated with earnings changes in each of the two years following the
dividend changes. However, Grullon et al. (2005) reexamined the results by using a nonlinear
model for earnings expectations and found that dividend changes contain no information
about the earnings changes.
There is a paucity of empirical studies examining the dividend signaling hypothesis in the
Indian context. Rao (1994) reports a Cumulative Average Abnormal Return (CAAR) of
12.73% (for a 21-day event window) as response to the announcement of dividend increases.
There are studies focusing on testing the dividend theories such as Lintner’s model (Mishra
and Narender, 1996) and examining the determinants of dividend policy (Bhat and Pandey,
1994).

Data Selection, Variables and Methodology

The basic source of data for the study is Prowess database of the Centre for Monitoring Indian
Economy (CMIE). The sample includes all manufacturing firms listed on the Bombay Stock

6 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

Exchange (BSE) with data available in the Prowess database. Indian companies are permitted
to declare dividend out of the current profits, or reserves created out of the past profits.
We used the final dividend for the corresponding year or the sum of the interim dividends as
our variable of interest. This procedure yields similar values reported by Nissim and Ziv
(2001). The final sample included only those firms that increased dividend by at least 10%.
We have defined the dividend decreases as 5% decrease in dividend rate. We excluded firms
that do not have financial data for the previous two years and the subsequent two years. We
also omitted firms that do not have stock price data and firms that declared equity capital
changes during the corresponding financial year. Panel A of Table 1 presents the distribution
of the sample by year. The number of observations ranges from 411 in 1993 to 1,702 in 1998.
The sample contains a total of 9,523 observations, out of which 4,139 are non-change events.
Panel B provides the descriptive statistics of dividend changes. The average (median) increase
in dividends is 34.78% (20.97%), compared with an average (median) decrease in dividends
of nearly 33.24% (31.58%). Negative dividend changes are not frequent compared to positive
dividend changes.
Obtaining the exact dividend announcement date is crucial for measuring the wealth
effects associated with dividend announcement. As per Clause 19 of the Standard Listing
Agreement, the stock exchange on which the shares of the company are listed should be
notified without delay the date of the board meeting at which the recommendation of a
dividend is due to be considered. Similarly, decisions taken regarding dividends should be
intimated to the stock exchanges immediately after the board meetings. To be included in
the event study sample, a dividend announcement must satisfy the following additional
criteria:
• The date of board meeting should be available with The Economic Times daily or the
BSE Bulletin. We used microfilm copies of The Economic Times to identify the event
dates during the period 1990-96. Electronic database of The Economic Times
maintained by The Times of India was used to identify the announcement dates
during the period 1996-2000. The data for the 1996-2000 period was confirmed
with the BSE Bulletin data from the BSE.
• The share return data should be available for the five days surrounding the
announcement date (i.e., from day –2 to day +2).
Panel C of Table 1 reports the distribution of the sample firms by the year of announcements.
As can be observed from the table, more sample firms report positive dividend changes
compared to negative dividend changes. The dividend omission sample comprises only 44
firms due to the nonavailability of share price data.

Market Reaction to Dividend Changes

To examine whether capital market is surprised by the announcement of dividend changes,
we analyzed the stock price reaction around the announcement of dividend changes.
We have defined the event date as the date prior to the day on which the announcement
appears in The Economic Times daily or the date of publication of the BSE Bulletin. We report
Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms 7
8
Table 1: Description of Sample
Panel A: Sample by Year

Year Dividend Dividend Initiations/ Dividend Dividend No Changes Non-Payers Total

Increases Resumptions Decreases Omissions
1991 155 35 24 18 99 92 423
1992 166 33 23 9 101 81 413
1993 127 18 31 22 88 125 411
1994 183 30 11 14 71 163 472
1995 243 39 30 25 78 225 640
1996 340 42 105 107 110 426 1,130
1997 473 43 186 133 51 717 1,603
1998 297 48 184 136 151 886 1,702
1999 339 36 156 117 87 870 1,605
2000 310 40 108 64 48 554 1,124
Total 2,633 364 858 645 884 4,139 9,523
Note: The sample of BSE listed manufacturing firms with financial information available for five years around the event and market value of equity is available at the
beginning of the dividend change year.
Panel B: Descriptive Statistics for Dividend Changes
Dividend Increases Dividend Decreases
Mean 34.78 –33.24
Standard Deviation 43.08 20.50
Quartile 1 10.14 –45.09
Median 20.97 –31.58
Quartile 3 43.30 –18.18
N 2,607 849
Note: Rate of change of dividend (%) is given above. Dividend change is defined as . The data is winsorized at 0.5%
and 99.5% of the empirical distribution.

The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 the abnormal returns during the five days around the
announcement date (i.e., –2 to +2) as a measure of market reaction

Total
180
147
147
44
to dividend announcements. We removed firms with missing
daily returns in any of the five days (–2 to +2). The individual
securities’ abnormal returns are estimated based on the
2000
34
12
32
market-adjusted model (Brown and Warner, 1985) and are

7
aggregated over the days to calculate the Average Abnormal
Return (AAR), i.e.,
1999

N
22
10
29
10 1
AAR t 
N  AR
i 1
it ...(1)
Panel C: Sample Distribution of Dividend Changes for the Event Study

where ARit is the abnormal return on security i.

1998
16
14
39
11

The average abnormal return can then be aggregated over

the event window to calculate the CAAR.
1997

2

 AR
27
22
21
7

CAAR  t ...(2)
t  2

Table 2 reports the market reaction to dividend

1996

announcement.
47
32
10
4
Table 1 (Cont.)

As expected, we observe a positive stock price reaction to

dividend increases and dividend initiations. Interestingly, the
1995

mean CAR for five days around the announcement of dividend

21
17
1
0

decrease is 0.12% (median value of –0.58%) with 48.3% of the

firms reporting positive returns. The model for measuring
unexpected dividend change will have little impact on our
1994

17
6

8
1

analysis for the sample of dividend initiations and dividend

omissions. The dividend initiation sample reports Cumulative
Abnormal Return (CAR) of 6.14% for five days around the
1993

announcement of dividend. A CAR of –6.91% is observed for

14
1

5
2

five days around the announcement of dividend omission.

The median CAR for the five days around the announcement is
1992

–9.34%, with only 25% of the firms having positive abnormal

6
9
2
2

returns. The price reaction to dividend initiations and omissions

is significantly large compared to the dividend increase and
decrease. To check the robustness of the findings of the method
of estimating abnormal return, we replicated the event studies
Dividend Decreases
Dividend Omissions
Dividend Increases
Dividend Initiation

using the market model and mean-adjusted returns. The results

Year

obtained are similar to the reported results.

Earnings, Profitability and Dividend Changes

Prior studies reported mixed evidence about the operating
performance following dividend changes, though the results on
Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms 9
 Table 2: Market Reaction to Dividend Announcements
Cumulative abnormal return (day –2 to day +2) for the sample firms (Market-adjusted)

Dividend Dividend Dividend Dividend

Increases Initiation Decreases Omissions
Median CAR (%) 0.853 4.592 –0.580 –9.338
Proportion of Positive Returns 0.561 0.687 0.483 0.250
Mean CAR (%) 2.543 6.139 0.117 –6.910
t-value 3.825* 6.006* 0.115 –3.460*
N 180 147 147 44
Note: t-values are calculated using the cross-sectional standard deviation;
* Significant at 1% level.

market reaction to dividend announcements are similar. The second part of the empirical
analysis investigates the behavior of earnings around dividend changes. We use operating
cash profit to measure operating performance and book value of net assets as the scaling
variable. Total assets include the total of fixed assets, investments, and current assets. Table 3
presents the definition of the variables used in the study.
The results of the analysis are organized under three subsections. The first presents the
performance measures around the announcement date. In the second, we compare the
performance of the firms that have announced dividend changes with the performance of
firms that reported no change in dividend. In the last, we examine the relation between
Table 3: Definition of Variables Used in the Study
Variable Prowess Item Definition
Operating cash profit pbdit_nnrt_noi + amortization Earnings before depreciation,
(EBITDA) interest and taxes less extraordinary
income add extraordinary expense
add amortizations
Profit After Tax (PAT)* pat & pat_nnrt_noi Adjusted profit after tax
Total Assets (TA) tot_asset Total assets * less revaluation
reserves less miscellaneous expenses
not written off less advance tax
Net Worth (NW) net_worth-pref_capital Equity share capital add reserves
less revaluation reserves less
miscellaneous expenses not written off
Dividend (D) equity_dividends Equity dividends
Market to book ratio market_cap/ Market value of equity/net worth
(Equity) (net_worth-pref_capital)
Note: * All adjusted figures are adjusted for extraordinary income and expenses.

10 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

dividend changes and future earnings changes using linear as well as nonlinear models of
earnings expectations.

Time Series Pattern of Level of Operating Performance

As a preliminary analysis, we divide our firms into six groups according to the dividend
event. We then calculate the following three ratios to understand the operating performance
of the firms around dividend changes.
• Operating cash profit scaled by total assets (Return on Assets)
• Earnings scaled by net worth (Return on Net Worth)
• Dividend divided by earnings (Dividend Payout Ratio)
Based on the suggestions of Barber and Lyon (1996), we report median ratios around
dividend changes. Dividend initiating (omitting) firms have large increase (decrease) in
profitability in the year of change compared to the modest increase (decrease) in the case of
dividend increasing (decreasing) firms. The magnitude of change is more in the case of
unfavorable dividend changes. The behavior of earnings in Panel B of Table 4 is much more
visible compared to the operating cash profit. In the future years, both variables are not
showing much relationship to the dividend changes. The dividend initiators are showing a
declining trend in return on equity. The non-payers are less profitable compared to other
groups and have reported negative earnings or very low positive earnings. The dividend
omitting firms’ declined profitability is persisting for the two years subsequent to the dividend
omission. The mean reversion of profitability is evident in the highly profitable positive
dividend changing firms. But we cannot find any convincing pattern in the positive dividend
changes group for improvements in profitability following the first year. But, we find that
negative dividend events provide some reliable information about the profitability in the
first year subsequent to dividend change. But thereafter, we cannot find any pattern in the
profitability. We have also examined the pattern of profit margin, assets turnover, growth
rate of assets, and growth rate of sales. For brevity, the results are not reported here.
In general, the growth ratios showed a positive relationship with the dividend changes.

Time Series Pattern of Earnings Changes

Following Benartzi et al. (1997), we report earnings changes deflated by Market Value (MV) of
equity in Panel A of Table 5. In Panel B, we report the values after deflating the same by Book
Value (BV) of equity at the beginning of the year. Both analyses provide almost similar
results. The statistics reported are Z-values based on Mann-Whitney test comparing the
value for the corresponding groups with ‘no change’ category. For the dividend increase
group, we found significant increase in earnings in year –1, 0 and 1. The dividend initiators
show significant change only in year 0. But both these groups show a negative change in
year 2. The dividend decreasing firms show a negative earnings change in all the years. But for
the dividend omitting firms, the change in earnings in year 2 is positive. The conclusions
drawn based on this analysis may be biased, as we have not accounted for the mean reverting
nature of accounting income (Fama and French, 2000). But the data confirms our earlier
observation that there is a positive relationship between dividend changes and concurrent

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms 11

 Table 4: Operating Performance Around Dividend Changes
Year Relative to Dividend Announcement
–2 –1 0 1 2 N
Panel A: Operating Cash Profit Deflated by the Same Year Asset Value (%)
Dividend Initiation 11.14 12.57 15.69 14.39 12.96 364
Dividend Increase 15.24 15.25 16.26 15.05 13.72 2,633
No Change 15.37 15.34 14.50 13.53 12.70 884
Dividend Decrease 14.79 14.30 11.52 10.53 10.51 858
Dividend Omission 12.98 11.78 7.83 6.92 6.70 645
Non-Payers 6.41 5.77 5.68 5.51 5.01 4,139
Panel B: Return on Equity (%)
Dividend Initiation 1.91 4.53 14.10 11.15 7.78 364
Dividend Increase 11.91 11.32 13.13 10.48 8.29 2,633
No Change 11.46 11.37 8.96 7.11 6.33 884
Dividend Decrease 12.35 9.71 3.56 1.82 2.11 858
Dividend Omission 10.41 6.61 –2.76 –4.13 –1.89 645
Non-Payers 0.00 –0.97 –0.65 0.78 2.35 4,139
Panel C: Dividend Payout Ratio (%)
Dividend Initiation 0 0 32.58 28.07 22.39 364
Dividend Increase 32.06 37.69 38.87 33.51 30.33 2,633
No Change 33.56 37.93 38.54 31.80 25.42 884
Dividend Decrease 33.94 38.13 29.78 13.34 0 858
Dividend Omission 32.28 40.00 0 0 0 645
Non-Payers 0 0 0 0 0 4,139
earnings changes. Moreover, dividend changes contain moderate information about earnings
changes in year 1. But as argued by Benartzi et al. (1997) and Grullon et al. (2005), limited
information about earnings in year 1 is available at the time of the dividend announcement.
Further, we found that dividend changes contain little information about earnings changes
in year 2. In general, our results support the argument that dividend changes are reactions to
the current and past earnings changes. If dividend changes contain any information about
future, it may not be about earnings, but may be about firm risk or other firm characteristics
(Grullon et al., 2002).

Regression Analysis—Dividend Changes and Earnings Changes

In this segment, we investigate the relationship between dividend changes and future earnings
changes. We have used simple linear model proposed by Nissim and Ziv (2001) as well as

12 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 Table 5: Dividend Changes and Raw Earnings Changes

Panel A: Raw Earnings Change (%) Deflated by MV of Equity at the End of Year –1

–1 0 1 2 N

Dividend Increase 1.20 (2.75)** 1.94 (12.97)** 0.32 (2.71)** –0.26 (–3.076)** 2,633

Dividend Initiation 1.54 (1.33) 8.94 (14.55)** 0.30 (1.52) –1.18 (–2.90)** 364

Dividend Decrease –0.10 (–4.20)** –4.98 (–16.18)** –1.28 (–2.75)** 0.00 (–2.18)* 858

Dividend Omission –1.62 (–6.45)** –11.89 (–20.4)** –2.68 (–4.01)** 0.65 (0.54) 645

No Change 0.61 –0.21 –0.12 0.56 884

Non-Payers –2.75 –0.76 0.63 0.60 4,139

Panel B: Raw Earnings Changes (%) Deflated by BV of Equity at the End of Year –1

Dividend Increase 2.54 (3.93)** 3.78 (15.06)** 0.80 (2.95)** –0.43 (–2.99)** 2,633

Dividend Initiation 2.71 (1.48) 10.62 (14.48)** 0.60 (1.52) –1.20 (–2.77)** 364

Dividend Decrease –0.19 (–3.87)** –5.44 (–13.19)** –1.66 (–3.15)** –0.05 (–2.27)* 858

Dividend Omission –1.27 (–6.18)** –10.03 (–17.9)** –2.00 (–3.61)** 0.64 (–0.26) 645

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms

No Change 1.40 –0.42 –0.24 1.35 884

Non-Payers –1.85 –1.28 0.00 0.10 4,139

Note: We have defined raw earnings change as the annual change in earnings before extraordinary items deflated by the beginning of year 0 market value of equity.
The figures in parentheses are Z-values based on Mann-Whitney Test where dividend changing firms are compared with ‘no change’ firms;
* Significant at 5% level; and ** Significant at 1% level.

13
nonlinear model suggested by Fama and French (2000) to estimate the expected earnings. We
have excluded cases involving dividend initiations, dividend omissions, no dividends
(non-payers), and firms with market value of equity less than Rs. 10 mn at the beginning of
the year. Table 6 reports the summary statistics for the sample. The values reported are for the
year immediately preceding the year of dividend change.
Table 6: Summary Statistics
Panel A: Dividend Increases
RDIV (%) MKT M/B ROA (%) ROE (%)
Mean 35.77 299.85 2.43 16.37 12.36
Standard Deviation 45.60 1,338.97 2.70 7.26 12.45
Quartile 1 10.09 12.15 0.79 11.33 4.93
Quartile 2 20.93 36.55 1.54 15.25 11.31
Quartile 3 43.99 136.25 2.86 20.53 19.05
N 2,614 2,614 2,614 2,614 2,614
Panel B: Dividend Decreases
Mean –33.22 164.27 1.58 15.00 10.47
Standard Deviation 20.65 719.54 2.11 7.04 11.91
Quartile 1 –45.14 9.94 0.50 10.45 3.82
Quartile 2 –31.51 27.51 0.88 14.30 9.71
Quartile 3 –18.04 88.13 1.80 18.46 16.52
N 858 858 858 858 858
Panel C: No Changes
Mean 0 137.17 2.46 16.09 11.63
Standard Deviation 0 382.19 2.44 7.06 13.04
Quartile 1 0 8.89 0.85 11.33 4.66
Quartile 2 0 25.16 1.67 15.34 11.36
Quartile 3 0 81.48 3.12 20.00 18.89
N 867 867 867 867 867
Note: This table reports the characteristics of the sample used for the regression analysis. RDIV is the rate of
change of cash dividend in year 0 compared to year –1. All other variables are for the end of year –1. All
variables, except MKT, have been winsorized at 0.5% and 99.5% of the empirical distribution. MKT is the
market capitalization of the firm in rupees crores.

Table 7 presents the results of regression analysis of raw earnings changes on dividend
changes. The dependent variable in the regressions is change in earnings in year 0, 1 or 2
deflated with the market value at the beginning of the year 0 (Benartzi et al., 1997).

E  E 1  P1   0  1 RDIV0    ...(3)

14 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 Table 7: Regression of Raw Earnings Changes on Dividend Changes (N = 4,399)

E  E 1  P1   0  1RDIV  

0

 0 1 R2
0 Coefficient –0.005 0.097 0.122
t-value –2.44* 24.59**
1 Coefficient –0.024 0.037 0.008
t-value –7.83** 5.94**
2 Coefficient –0.025 –0.011 0
t-value –6.57** –1.470
Note: denotes the year relative to the dividend change year (year 0). P–1 is market value of equity at the end
of year –1. RDIV0 is the rate of change in dividend. For each year, the first row reports the coefficient
and the second raw reports t-value. All the variables have been winsorized at 0.5% and 99.5% of the
empirical distribution;
* Significant at 5% level; and ** Significant at 1% level.

The independent variable in each regression is the rate of change of dividend in year 0.
Our results confirm the earlier patterns that have been established with categorical analysis.
The regression for the year 0 provides evidence for the positive relation between earnings
changes and dividend changes. Similarly, we found a positive relationship in year 1 also.
But the relation in year 2 is insignificant. This provides evidence that dividend changes may
have some information about the change in earnings in year 1. But this may be due to the fact
that mangers already have some information about the earnings in the year 1 while they take
a decision about the dividend for the year 0 (see Grullon et al., 2005).
But Nissim and Ziv (2001) argued that the insignificant relations in the future years may
be due to the incorrect specification of the model and the measurement error in the dependent
variable. They argued that there should be a control variable in the model, as return on equity
is mean reverting. To remove the error in the dependent variable one has to use the book
value of common equity for deflating earnings changes. Specifically, we estimated the following
regression model, suggested by Nissiom and Ziv (2001).

E  E 1  B1   0   1RDIV0   2 ROE 1    ...(4)

Interestingly, the results presented in Panel A of Table 8 are similar to the previous model,
except for the fact that dividend changes are giving a significant negative coefficient in
year 2. To account for the heteroskedasticity and autocorrelation in the regression residual,
we have used Fama and MacBeth (1973) procedure along with the pooled OLS estimations.
The reported values are the average slopes and t-statistics based on time series standard
errors of the average slopes. But there are two problems with this estimation. One, the
relatively small number of annual observations will reduce the power of the tests.

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms 15

Secondly, the autocorrelation in the slopes from the year-by-year regressions may also create
problems. There are a number of approaches used to account for the autocorrelation. Fama
and French (2000) used an estimate of first-order autocorrelation to arrive at the correct
standard errors. Another approach is to include the previous year’s dependent and
independent variables as additional explanatory variables. Grullon et al. (2005) used Hansen
and Hodrick (1980) standard error correction method. As we have not adjusted the reported
t-values, the marginal values should be explained with caution. A comparison with the
results of Nissim and Ziv (2001) and Grullon et al. (2005) shows that the positive relation
between year 1 earnings change and dividend change is more evident in the Indian data. But
the relation with the control variable is not significant in our data. Further, in Panel B, we
estimate regressions that allow for different coefficients for dividend increases and dividend
decreases. Here, we include the earnings change in the year 0 as an additional control variable.
The regression model in Equation (5) allows for asymmetric reactions to dividend increases
and decreases and controls for uniform mean reversion and momentum in earnings:

E  E 1  B1   0  1P DPC0  RDIV0

 1 N DNC0  RDIV0  2 ROE 1   3 E0  E 1  B1    ...(5)

The results of the regression analysis, reported in Panel B of Table 8, are also similar to our
previous results.
It is interesting to note that in all the regressions, firms that have increased dividend
report a negative relationship with the earnings change in year 2. We have checked the
robustness of the results by including additional control variables. The coefficient of the
dividend decrease group is significant in year 1. In year 2, the coefficient is positive for the
dividend decrease group in 4 out of 10 years that we have examined, compared to 2 out of 10
for the dividend increase group. Firms that have decreased dividend showed a strong positive
relationship with the future earnings change in year +1, as compared to dividend increase
group.
But Fama and French (2000) report that mean reversion of profitability is highly nonlinear.
Grullon et al. (2005) argue that assuming linearity when the true functional form is nonlinear
may have the same consequence as leaving out the relevant independent variables.
Therefore, following them, we have also used the partial adjustment model of Fama and
French (2000) to control for the nonlinearity in the relation between future earnings changes
and lagged earnings levels and changes. Specifically, we have adopted the model from Grullon
et al. (2005), which is given below:

E  E 1  B1   0  1P DPC 0  RDIV0  1 N DNC 0  RDIV0

  1   2 NDFED 0   3 NDFED 0  DFE0
  4 PDFED0  DFE0   DFE0
 1  2 NCED 0  3 NCED 0  CE 0
 4 PCED 0  CE 0   CE 0    ...(6)

16 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 Table 8: Regression of Earnings Changes Deflated by Book Value on Dividend Changes and Control Variables (N = 4,339)
Panel A: Regression of Earnings Changes Deflated by Book Value on Dividend Changes and Control Variables

0 1 2 R2
=1
Pooled –0.009 (–2.63)** 0.041 (7.04)** –0.065 (–2.97)** 0.011
CS –0.004 (–0.40) 0.034 (3.63)** –0.033 (–0.68) 0.021
Prop+ 0.3 0.9 0.6 –
=2
Pooled –0.008 (–2.13)* –0.018 (–2.35)** –0.027 (–1.32) 0.002
CS 0.005 (0.37) –0.020 (–1.51) –0.048 (–1.08) 0.017
Prop+ 0.4 0.2 0.4 –
Panel B: Regression of Earnings Changes Deflated by Book Value on Dividend Changes and Control Variables

0  1P  1N 2 3 R2
=1
Pooled 0.005 (1.21) 0.021 (3.05)** 0.115 (6.72)** –0.12 (–4.53)** 0.065 (2.37)** 0.018
CS 0.006 (0.69) 0.020 (2.15)* 0.113 (4.04)** –0.071 (–1.41) 0.053 (1.51) 0.030
Prop+ 0.5 0.8 0.9 0.5 0.6 –
=2

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms

Pooled –0.002 (–0.36) –0.024 (–2.64)** 0.044 (1.93)* –0.025 (–1.16) –0.066 (–2.09)* 0.005
CS 0.012 (0.77) –0.024 (–1.54) 0.006 (0.19) –0.048 (–1.28) –0.027 (–0.38) 0.029
Prop+ 0.4 0.2 0.4 0.4 0.4 –
Note: ROEt is calculated as Et/Bt . For each year, the first row (Pooled) reports the results based on pooled OLS regression; the second row (CS) reports regression
coefficients using the Fama-MacBeth (1973) procedure. ‘Prop+’ means the proportion of regressions in which the coefficient is positive. All the variables have been
winsorized at 0.5% and 99.5% of the empirical distribution. DPC (DNC) is a dummy variable that equals 1 for dividend increases (decreases) and 0 otherwise. The
R2 in CS is the average (adjusted) R2 of the cross-sectional regressions; * Significant at 5% level; ** Significant at 1% level.

17
 In this model, DFE0 = ROE0 – E(ROE0), where E(ROE0) is the fitted value of ROE0 from
the cross-sectional regression of ROE on the logarithm of total assets in year –1 ( ln(TA–1)),
logarithm of the market-to-book ratio of equity in year –1(ln(MBVE–1)) and return on equity
in year –1 (ROE–1). We have estimated the error from cross-sectional regression in each year.
CE0 is equal to (E0 – E–1)/B–1. NDFED0 (PDFED0) is a dummy variable that takes the value of
1 if DFE0 is negative (positive) and 0 otherwise. Similarly, NCED0 (PCED0) is a dummy
variable that takes the value of 1 if CE0 is negative (positive) and 0 otherwise. As pointed out
by Fama and French (2000), the terms included are meant to capture the nonlinearities in
the mean reversion and autocorrelation in earnings.
Table 9 reports the results of the analysis. As documented by Grullon et al. (2005), we
found that the improved model establishes that there is no significant relation between
dividend changes and future earnings. The only significant positive relationship between
dividend changes and future earnings is in the case of dividend decrease group. Out of the 10
cross-sectional regressions for year 1, the coefficient of dividend increase (dividend decrease)
is significant at 10% level only for four (seven) years. For year 2, it is significant only for one
(zero) year out of ten years. In general, our results did not support the signaling/information
content hypotheses.

Regression Analysis—Dividend Changes and the Level of Future Earnings

Nissim and Ziv (2001) argue that an analysis of the relationship between dividend changes
and future level of earnings is desirable from the perspective of information content of
dividend hypothesis. In this segment, we have used the model proposed by Nissim and Ziv
(2001) and modified by Grullon et al. (2005). In the modified model, Grullon et al. (2005) used
the ROE of the previous year, rather than the ROE in the year –1, as a control variable.

ROE   0  1P DPC0  RDIV0  1N DNC0  RDIV0   2 ROE 1

  3 ROE0  ROE 1    4 MB1   5SIZE 1    ...(7)

The study has also included a nonlinear model as given below:

ROE   0  1P DPC0  RDIV0  1N DNC0  RDIV0

  1   2 NDFED0   3 DFED0  ROE0   4 PDFED0  ROE0 
 ROE0  1  2 NCED0  3 NCED0  CE0  4 PCED0  CE0 
 CE0  1 MB1   2SIZE 1    ...(8)

The results of the analysis are presented in Table 10. We found significant positive relation
only in year 1 for the dividend decrease group. For the US firms, Nissim and Ziv (2001) and
Grullon et al. (2005) report positive relationship both in year 1 and 2. In the nonlinear model
also we found similar results, whereas Grullon et al. (2005) report that after controlling for

18 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 Table 9: Regressions of Raw Earnings Change on Dividend Changes Using Fama and French (2000)
Nonlinear Model to Predict Expected Earnings

0  1P  1N 1 2 3 4 1 2 3 4 R2
 = 1
Pooled –0.009 0.016 0.115 –0.509 0.503 1.554 3 0.281 –0.170 –0.096 –0.768 0.023
t-stat –1.690 2.28* 6.56** –2.71** 1.715 2.25* 3.33** 2.59** –0.875 –0.239 –3.04** –
Cross-Sectional
Mean 0.003 0.013 0.143 0.213 –0.216 1.891 –1.999 –0.196 0.509 0.498 1.191 0.083
t-stat 0.240 1.500 4.02** 0.530 –0.480 1.500 –0.810 –0.680 1.460 0.710 1.240 –
Prop+ 0.500 0.700 0.90 0.600 0.500 0.600 0.300 0.500 0.700 0.600 0.600 –
 = 2
Pooled –0.01 –0.025 0.038 0.172 –0.468 0.188 –0.13 –0.027 0.155 –0.124 –0.376 0.007
t-stat –1.39 –2.64** 1.660 0.690 –1.200 0.210 –0.11 –0.190 0.600 –0.230 –1.120 –
Cross-Sectional
Mean –0.003 –0.028 –0.009 –0.144 –0.527 –1.266 1.175 0.302 0.271 1.592 –1.130 0.06
t-stat –0.220 –1.750 –0.320 –0.380 –0.990 –1.090 0.480 1.080 0.710 1.350 –2.26* –

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms

Prop+ 0.400 0.200 0.400 0.500 0.500 0.400 0.400 0.800 0.500 0.600 0.30 –
Note: For each year, the first row (pooled) reports the results based on pooled OLS regression; the row ‘CS’ reports average regression coefficients using the Fama-MacBeth
(1973) procedure. ‘Prop+’ means the proportion of regressions in which the coefficient is positive. All the variables have been winsorized at 0.5% and 99.5% of the
empirical distribution. DPC (DNC) is a dummy variable that equals 1 for dividend increases (decreases) and 0 otherwise. The R2 in CS is the average (adjusted)
R2 of the cross-sectional regressions.
* Significant at 5% level; ** Significant at 1% level.

19
the nonlinear patterns in earnings, dividend changes do not contain information about the
future level of ROE.

Regression Analysis—Dividend Changes and Profitability

One of the major performance metrics used to measure firm performance is the Return on
Assets (ROA). Barber and Lyon (1996) provide theoretical justification for using the operating
performance over the earnings while measuring firm performance. Further, they report that
change models always dominate level models with better statistical properties. So, to
complement our earlier analysis, we have examined the relationship between dividend changes
and changes in future profitability. We have defined ROA as the Operating Income Before
Depreciation and Amortization (EBITDA) scaled by the book value of total assets. Being a
cleaner measure, relatively free from accounting manipulations and capital structure changes
this provides a better understanding of the relationship between dividend changes and
profitability. In the following linear and nonlinear regression models, we replicate all of the
previous analyses by replacing earnings with ROAt as the dependent variable.

ROA  ROA 1   0  1P DPC 0  RDIV0  1N DNC 0  RDIV0

  2 ROA 1   3 ROA 0  ROA 1     ...(9)

and

ROA  ROA 1   0  1P DPC0  DIV0  1N DNC0  RDIV0

  1   2 NDFYD0   3 NDFYD0  DFY0
  4 PDFYD0  DFY0   DFY0  1  2 NCY0
 3 NCY0  CY0  4 PCY0  CY0   CY0    ...(10)

where DFY0 = ROA0 – E(ROA0), where E(ROA0) is the fitted value of ROA0 from the
cross-sectional regression of ROA on the logarithm of total assets in year –1 ( ln(TA–1)) ,
logarithm of the market-to-book ratio of equity in year –1(ln(MBVE–1)) and return on equity
in year –1 (ROA–1). We have estimated the error from cross-sectional regression in each year.
CY0 is equal to (ROA0 – ROA–1)/TA–1. NDFYD0 (PDFYD0) is a dummy variable that takes the
value of 1 if DFY0 is negative (positive) and 0 otherwise. Similarly, NCY0 (PCY0) is a dummy
variable that takes the value of 1 if CY0 is negative (positive) and 0 otherwise. In this model,
we have replaced the independent values for ROE with relevant values for ROA. The results
are given in Table 11. With the simple linear model, we found a significant positive relationship
between dividend changes and ROA changes in year 1. Grullon et al. (2005) report insignificant
relationship between dividend changes and ROA changes in year 1. But for year 2, our models
report either insignificant relationship or a wrong coefficient. The results are same when we
used a nonlinear model.

20 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 Table 10: Earnings Level and Dividend Changes

Panel A: Linear Model (N = 4,339)

0  1P  1N 2 3 4 5 R2

 = 1

Pooled 0 0.012 0.128 0.699 0.008 0.009 0 0.3470

t-stat –0.06 2.05* 8.98** 35.32** 0.330 3.99** –0.131 –

Cross-Sectional

Mean 0.005 0.008 0.169 0.725 –0.012 0.011 –0.002 0.3720

t-stat 0.510 0.900 4.08** 20.52** –0.350 3.87** –0.800

Prop+ 0.700 0.700 1 1 0.400 0.9 0.400

 = 2

Pooled –0.007 –0.034 0.053 0.732 0.032 0.016 –0.001 0.1762

t-stat –0.470 –2.92** 1.800 26.57** 0.670 3.47** –0.250

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms

Cross-Sectional

Mean –0.006 –0.024 0.006 0.706 0.008 0.021 –0.002 0.2120

t-stat –0.310 –1.140 0.190 8.07** 0.140 4.82** –0.780

Prop+ 0.400 0.200 0.400 1 0.600 1 0.300

21
22
Table 10 (Cont.)
Panel B: NL Model

0  1P  1N 1 2 3 4 1 2 3 4 1 2 R2

 = 1
Pooled 0 0.01 0.12 0.82 –0.11 –0.45 –0.32 –0.03 0.14 0.39 –0.08 0.01 0
0.352
t-stat 0.48 2.50** 7.96** 15.70** –1.91 –3.26** –2.08* –0.49 1.11 1.50 –0.46 4.73** –0.69
Cross-Sectional
Mean 0.01 0.01 0.16 0.84 –0.10 –0.23 –0.31 –0.10 0.29 0.95 0.18 0.01 0
t-stat 1.22 0.83 3.45** 9.46** –0.92 –1.16 –1.31 –1.09 2.22* 5.41** 0.53 4.50** –1.53 0.396
Prop+ 0.60 0.80 0.90 1.00 0.40 0.30 0.20 0.40 0.80 1 0.40 0.90 0.40
 = 2
Pooled –0.01 –0.02 0.12 0.93 –0.29 –0.60 –1.21 –0.28 0.41 0.19 0.59 0.02 0
0.084
t-stat –0.34 –1.42 3.68** 8.25** –2.36* –1.97* –3.56** –1.82 1.48 0.34 1.62 4.85** –0.64
Cross-Sectional
Mean 0 –0.01 0.06 1.01 –0.27 –0.66 –1.29 –0.36 0.51 1.21 0.47 0.03 0
t-stat –0.13 –0.22 1.72 5.59** –1.18 –1.40 –2.60** –1.29 0.69 0.64 0.62 4.71** –1.47 0.136
Prop+ 0.40 0.40 0.70 1.00 0.30 0.20 0.10 0.40 0.40 0.50 0.50 0.90 0.30
Note: The first row (pooled) reports the results based on pooled OLS regression and in CS we use the Fama-MacBeth (1973) procedure to estimate the regression
coefficients. All the variables have been winsorized at 0.5% and 99.5% of the empirical distribution. DPC (DNC) is a dummy variable that equals 1 for dividend
increases (decreases) and 0 otherwise. The R2 in CS is the average (adjusted) R2 of the cross-sectional regressions.
* Significant at 5% level, ** Significant at 1% level.

The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

 Table 11: Regression of Changes in ROA on Dividend Changes (N = 4,339)

Panel A: Linear Model

0  1P  1N 2 3 R2

 = 1

Pooled 0.024 0.007 0.03 –0.225 –0.002

0.086
t-stat 11.10** 3.48** 5.83** –19.38** –0.120

Cross-Sectional

Mean 0.027 0.007 0.027 –0.237 0.006

t-stat 6.67** 3.53** 2.37** –11.71** 0.240 0.104

Prop+ 1 0.80 0.80 0 0.500

 = 2

Pooled 0.012 –0.007 0.01 –0.166 –0.091

0.072
t-stat 6.18** –3.16** 1.88 –14.63** –5.09**

Dividend Changes and Profitability: An Empirical Study of Indian Manufacturing Firms

Cross-Sectional

Mean 0.017 –0.007 –0.01 –0.185 –0.087

t-stat 3.85** –1.360 –1.17 –8.74** –4.61** 0.107

Prop+ 0.80 0.200 0.40 0 0.10

23
24
Table 11 (Cont.)
Panel B: Nonlinear Model

0  1P  1N 1 2 3 4 1 2 3 4 R2

 = 1
Pooled –0.008 0.006 0.019 –0.557 0.132 3.992 –1.085 0.398 0.128 –0.145 –0.584
0.076
t-stat –4.49** 2.98** 3.61** –4.76** 0.680 3.02** –0.96 3.49** 0.780 –0.21 –0.560
Cross-Sectional
Mean –0.006 0.007 0.021 –0.652 0.205 4.329 –2.103 0.428 0.158 –0.018 1.184
t-stat –2.51* 3.17** 1.97* –3.88** 1.710 3.19* –1.730 2.97** 1.070 –0.020 0.970 0.120
Prop+ 0.10 0.80 0.80 0 0.800 0.80 0.300 1 0.700 0.500 0.600
 = 2
Pooled –0.012 –0.007 –0.001 –0.381 0.081 1.392 –0.617 0.386 –0.36 –1.854 –2.697
0.055
t-stat –6.03** –3.20** –0.155 –3.01* 0.38 0.98 –0.5 3.13** –2.02* –2.43* –2.39*
Cross-Sectional
Mean –0.011 –0.005 –0.019 –0.477 0.20 1.821 –0.174 0.44 –0.442 –2.202 –3.004
t-stat –4.22** –0.920 –1.900 –2.83** 0.86 1.02 –0.08 4.55** –3.32** –2.17* –4.23** 0.105
Prop+ 0.10 0.200 0.400 0.20 0.60 0.70 0.40 0.90 0.20 0.10 0.20
Note: The first row (pooled) reports the results based on pooled OLS regression and in CS we use the Fama-MacBeth (1973) procedure to estimate the regression
coefficients. All the variables have been winsorized at 0.5% and 99.5% of the empirical distribution. DPC (DNC) is a dummy variable that equals 1 for dividend
increases (decreases) and 0 otherwise. The R2 in CS is the average (adjusted) R2 of the cross-sectional regressions.
* Significant at 5% level; ** Significant at 1% level.

The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

Conclusion
Signaling models propose that dividend changes convey information about future changes in
earnings. Though positive (negative) changes in dividends are associated with positive
(negative) reaction from the stock market, researchers have found little evidence supporting
the relationship between dividend changes and future changes in earnings or profitability.
This study examined the dividend behavior of Indian firms and found that market reacts
favorably to dividend increases and initiations. Dividend initiating (omitting) firms have
large increase (decrease) in profitability in the year of change as compared to dividend
increasing (decreasing) firms. In the future years, both profitability and earnings might not
show any relationship to the dividend changes. We found that dividend changes are highly
correlated with the earnings change in the current year. Dividend changes contain moderate
information about earnings and profitability in the first year after the dividend announcement,
but no relationship with earnings from the second year onwards. Our evidence does not
support the argument that dividend changes contain information about future profitability.
Acknowledgment: The authors acknowledge the helpful comments received from the conference participants
at IIM Lucknow and the Asian Finance Association annual conference.

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26 The IUP Journal of Applied Finance, Vol. 16, No. 1, 2010

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