Journal of Corporate Finance 17 (2011) 710–724

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Journal of Corporate Finance

j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j c o r p f i n

Overinvestment, corporate governance, and dividend initiations☆

Micah S. Officer ⁎
Loyola Marymount University, College of Business Administration, Hilton Center for Business, 1 LMU Drive, Los Angeles, CA 90045-2659, United States

a r t i c l e i n f o a b s t r a c t

Article history: Firms with low Tobin's Q and high cash flow have significantly more positive dividend
Received 7 April 2009 initiation announcement returns than do other firms. I interpret this result as consistent with
Received in revised form 8 June 2010 the hypothesis that reductions in the agency costs of overinvestment at firms with poor
Accepted 15 June 2010
investment opportunities and ample cash flow are reflected in higher dividend initiation
Available online 1 July 2010
announcement returns. Further tests, such as examining the impact of governance metrics on
initiation announcement returns following the dividend tax cut of 2003 and examining the
JEL classifications: long-run cash-retention policies of dividend-initiating firms, are consistent with this
G35
interpretation. There is also some evidence that is consistent with the cash flow signaling
G34
hypothesis, as dividend-initiating firms with low Tobin's Q and low pre-initiation cash flow
Keywords:
experience substantial revisions in analysts' earnings forecasts and significantly positive
Dividend initiations initiation announcement returns.
Agency costs © 2010 Elsevier B.V. All rights reserved.
Corporate governance

1. Introduction

Dividend initiation announcements are associated with positive stock returns on average. For example, Asquith and Mullins
(1983) report abnormal returns of 3.7% around the announcement of dividend initiations, and similar findings persist in studies
using longer and more recent sample periods. These returns, along with those associated with announcements of increases in
dividend payments, are typically interpreted as implying that dividend initiations (or increases) communicate valuable
information to the market. In the existing literature, two main hypotheses (that are not mutually exclusive) have emerged to
explain the nature of this information: (i) that dividend initiations signal higher expected future cash flow/profitability for
initiating firms; and (ii) that dividend initiations signal lower agency costs at the initiating firm as managers will have less of their
shareholders' cash to waste, expropriate, or overinvest in the future (Rozeff (1982), Easterbrook (1984), and Jensen (1986)).
In this paper I find that dividend initiation announcement abnormal returns average 5.1% (median of 3.2%) for initiators with
Tobin's Q below the industry–year median (“low Q”) and cash flow from operations above the industry–year median (“high cash
flow”), relative to an average of 3.0% (median of 1.7%) for all other dividend-initiating firms. Announcement returns for low Q/high
cash flow dividend initiators are statistically significantly more positive than the returns to other initiating firms, even in
regressions that control for other determinants of initiation announcement abnormal returns.
I interpret this evidence as consistent with the agency cost hypothesis. Tobin's Q has been used in the dividend initiation
announcement return literature (e.g. Lang and Litzenberger (1989)) as a proxy for investment opportunities, with the notion that the
managers of a firm with poor investment opportunities (low Q) and ample resources (high cash flow) are likely to overinvest or waste
their stockholders' cash. Paying that cash out by initiating dividend payments reduces the probability that these agency costs are

☆ I thank Harry DeAngelo, Linda DeAngelo, David Denis (the editor), Michael Hertzel, Ehud Kamar, Harold Mulherin, Mike Stegemoller, Ralph Walkling, Rong
Wang, Mark Weinstein, Mike Weisbach, an anonymous referee, and seminar participants at Arizona State University, the City University of Hong Kong, the College
of William & Mary, the Pennsylvania State University, and the Universities of Arizona, Georgia, and Southern California for comments, and Jim Linck for providing
some of the data.
⁎ Tel.: + 1 310 338 7658.
E-mail address: micah.officer@lmu.edu.

0929-1199/$ – see front matter © 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jcorpfin.2010.06.004
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 711

incurred, and my interpretation of the evidence in this paper is that this reduction in agency costs is reflected in initiation
announcement returns.
There is support in the literature for this interpretation. Using Q as a proxy for overinvestment, Lang and Litzenberger (1989)
find that returns around dividend change announcements are significantly more positive for firms with Q less than one than for
firms with Q greater than one. However, neither Denis et al. (1994) nor Yoon and Starks (1995) report similar findings using
comparable tests. In this paper I demonstrate the importance of conditioning on both Q and cash flow in these tests: dividend
initiation announcement returns are significantly higher for firms with low Q than for firms with high Q (average of 4.5% versus
2.7%; univariate t-statistic for difference in means = 3.6), but the difference is especially pronounced in subsamples of firms with
high pre-initiation cash flow. High cash flow combined with poor investment opportunities suggests that managers have both the
means and opportunity to waste their shareholders' resources, and is therefore indicative of high agency costs of overinvestment.
Because even firms with low pre-initiation Q and cash flow have significantly positive dividend initiation announcement
returns, however, there is also some evidence is this paper that is consistent with the cash flow signaling hypothesis. If this subset
of low Q/low cash flow initiating firms have low pre-initiation future cash flow expectations, the revision in those expectations
could be responsible for this abnormal announcement return pattern. To further test this interpretation, I analyze abnormal
revisions in analysts' earnings forecasts around dividend initiations (similar to Denis et al. (1994)). I find that the most significant
positive revisions in analysts' earnings forecasts between the month before and month after dividend initiations are also for low Q/
low cash flow dividend-initiating firms, as one would expect if the combination of low Q and low pre-initiation cash flow captures
low future cash flow expectations. Combined, these results are consistent with the cash flow signaling hypothesis, although the set
of initiating firms with the strongest evidence of cash flow signaling do not coincide with the set of initiating firms with the most
positive initiation announcement returns.
In summary, this paper presents evidence that dividend initiation announcement returns appear, to some extent, to reflect
both the overinvestment and cash flow signaling hypotheses. The overinvestment hypothesis appears to have a role explaining the
significantly higher returns to initiating firms with low Q and high cash flow. On the other hand, analysts appear to interpret
dividend initiations as signals of higher future cash flow for low Q/low cash flow firms. This “signal” appears to translate into
positive market reactions on average to initiation announcements by such firms, although the announcement returns in this
subset are not as positive as those for initiating firms with low Q and high cash flow.
I conduct several robustness tests to further examine the evidence that supports the overinvestment hypothesis. The agency
cost hypothesis is silent on the issue of why managers that could expropriate or waste their shareholders' resources (by
overinvesting in pet projects, for example) would choose to initiate dividend payments in the first place. Therefore, I examine
dividend initiations following an exogenous event (the Jobs and Growth Tax Relief Reconciliation Act of May, 2003) that increased
shareholder demand for dividends and changed the equilibrium tradeoff between hoarding cash and paying it out. The wave of
dividend initiations following the passage of the Act suggests that this exogenous shock made hoarding cash more costly at the
margin and prompted managers that would otherwise hoard cash to begin to pay it out.1 This exogenous, demand-side shock
affects all firms equally (conditional on the tax rate applicable to the marginal shareholder), and therefore this event should
produce a sample of dividend initiations that is relatively free of any bias driven by the (supply-side) reluctance of “entrenched”
managers to initiate dividend payments.
Since data on governance metrics (other than Q and cash flow) is more readily available for observations in 2003, I can also
examine the effect on initiation announcement returns of alternative proxies for agency costs, such as whether the board is insider
dominated, whether the firm's managers are entrenched by anti-takeover provisions, and the ownership stake in the firm held by
activist public pension funds who may monitor the firm. Consistent with the results in the main sample conditioned on Q and cash
flow, I find that firms with weak governance or monitoring have significantly more positive dividend initiation announcement
returns than other firms do immediately following the passage of the Jobs and Growth Tax Relief Reconciliation Act. For example,
firms with insider-dominated boards that initiate dividends in the 6 months following the law change have average (median)
initiation announcement abnormal returns of 8.6% (10.3%), significantly more positive than the average (median) announcement
returns for firms that do not have insider-dominated boards of 1.3% (2.2%).
I also examine one of the important underlying predictions of the agency explanation for dividend initiation announcement
returns. Implicit in the agency cost hypothesis is the notion that the returns around dividend initiations reflect reduced agency
costs for poorly governed or overinvesting firms because such firms are less likely to hoard cash and overinvest following the
dividend initiations. I examine dividend levels, cash holdings, and investment (capital expenditures plus R&D expenditures), and
find that common dividends amount to about 25% of prior-fiscal-year cash holdings post-initiation for the firms in my sample.
Therefore, post-initiation dividends appear to absorb a meaningful amount of firms' cash that could otherwise be wasted or
expropriated. I also find that firms with low Q/high cash flow prior to initiation reduce their cash holdings to a level that is
statistically indistinguishable from the industry median in the three to five years after initiation, while the other initiating firms in
my sample keep post-initiation cash levels and investment well above the industry median.

1
It could be argued that the Act actually changed the marginal cost of paying cash out in the form of dividends relative to paying cash out in the form of stock
repurchases. (I thank an anonymous referee for pointing this out). However, existing empirical evidence suggests that dividends and repurchases are used by
firms to disburse very different types of cash flows. Specifically, both Guay and Harford (2000) and Jagannathan et al. (2000) find that firms choose dividend
payments to distribute relatively permanent cash flow increases and stock repurchases to distribute more temporary cash windfalls. Therefore, in terms of the
long-term benefits of reducing the agency costs of overinvestment from long-term (i.e., permanent) high cash flows, this evidence suggests that the relevant
margin that the Act may have altered was the choice between paying cash out in the form of dividends or hoarding it.
712 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

A natural question is what my evidence about the market reaction to dividend initiations tells us about dividend policy choices. The
results in this paper suggest that dividend initiations by low Q/high cash flow firms produce the largest reduction in agency costs, as
reflected in the strong market reaction to dividend initiations by such firms. If firms' financial policies are influenced by concerns about
reducing agency costs, this suggests that low Q/high cash flow firms may be the most likely to initiate the regular payment of
dividends.2 I find that this is the case. Specifically, 32% of firms initiating dividend payments have low pre-initiation Q and high pre-
initiation cash flow while only 25% of industry-, size-, and performance-matched non-initiating, non-paying peers have such
characteristics. While there are other factors that may be equally as important in predicting which firms initiate dividends (such as the
RE/TE ratio described in DeAngelo et al. (2006) and the firm's leverage ratio), a firm's potential for overinvesting, and the means to do
so, is a significant contributor to both the decision to initiate dividend payments and the market reaction to initiations.
This paper contributes to the extant literature on dividend policy and governance in several ways. First, while the agency cost
hypothesis has long been considered important in the payout literature, there is surprisingly mixed empirical evidence in the
existing literature that agency problems influence market returns around dividend policy announcements (e.g. Lang and
Litzenberger (1989); Denis et al. (1994); Yoon and Starks (1995)), and no evidence (of which I am aware) of a direct relation
between the market reaction to dividend policy announcements and proxies for governance and monitoring. Furthermore, several
papers conclude that there is very little signaling content to dividend policy change announcements (Watts (1973); DeAngelo et
al. (1996); Grullon et al. (2002)). In this paper, I report some evidence consistent with the cash flow signaling model (similar to
Denis et al. (1994) and Yoon and Starks (1995)).
Second, extant research establishes a link between proxies for governance and payout/retention policy or the value of retained
cash (Harford et al. (2006), Hu and Kumar (2004), John and Knyazeva (2006), and Pan (2006); also Dittmar et al. (2003), Dittmar
and Mahrt-Smith (2007), and Pinkowitz et al. (2006) in the international context). This paper contributes to that literature by
demonstrating that poor governance and the potential to overinvest are important as part of an explanation for the market
reaction to dividend policy announcements.

2. Dividend initiation announcements

I form a sample of dividend initiations from 1963 to 2008 from the CRSP database. Specifically, dividend initiation
announcements are defined as the first announcement by a firm listed in CRSP of an ordinary, taxable, cash dividend payable at the
quarterly, semi-annual, or annual frequency to holders of ordinary common stock (share codes 10 and 11) listed on the NYSE,
Nasdaq, or Amex. Each firm is in the sample only once (subsequent dividend initiations following an omission are ignored), and
financial (SIC codes 6000 to 6999) and regulated utility (SIC codes 4900 to 4949) firms are discarded. All dividend-initiating firms
must have a stock price on CRSP 365 calendar days prior to the initiation announcement and be covered by the Compustat
database (with no dividends recorded by Compustat in the prior five fiscal years).
I focus on dividend initiations (as opposed to changes) for two reasons. First, dividend initiations are a change in financial
policy. If a policy of paying dividends indicates managerial commitment to return cash to stockholders rather than waste resources
or overinvest, then such a signal is potentially stronger when a firm decides to start paying dividends for the first time than when
managers incrementally change the amount of dividends paid. Second, dividend initiations are likely to be less predictable than
dividend changes. Once a firm starts paying dividends, dividend announcement dates are relatively predictable as many
accompany earnings announcements. While the amount of a dividend change may be surprising to market participants, a dividend
change is more predictable in its timing than an initiation is. As my objective is to examine market reactions to dividend policy
announcements, initiations provide an ideal sample of dramatic and surprising changes in financial policy, the value implications
of which should be reflected in the returns around initiation announcements.
Table 1 shows the distribution of initiation announcements by year of announcement. There are 1283 dividend initiation
announcements between 1963 and 2008 that meet the criteria described above. The observations are reasonably well distributed
over time, with the exception of relatively thin coverage in the early 1960s and a distinct spike in initiations in the mid-1970s
(potentially driven by the introduction of NASDAQ).
The second column in Table 1 contains the percentage of those announcements for which there is a quarterly earnings
announcement date within a 21-day window centered on the dividend initiation announcement date.3 33% of the initiation
announcements have a quarterly earnings announcement in the preceding or following 10 days, although that fraction is considerably
higher nearer the end of the sample period.4 As shown later in this paper, the incidence of an earnings announcement close to a
dividend initiation (typically the same day) has relatively little effect on the average market reaction to the initiation announcement.
The third column in Table 1 shows the number of initiations divided by the number of non-dividend-paying firms in each year
from 1963 to 2008. In other words, this column describes the fraction of the population of potential dividend initiators that make it
into this sample.5 Over the sample period covered in this paper, an average of 1.1% of non-paying firms per year become dividend

2
Although a tendency for firms with characteristics that are associated with the most positive dividend initiation announcement returns to initiate the
payment of dividends could also be consistent with “catering” motives, as in as in Baker and Wurgler (2004).
3
Compustat begins recording quarterly earnings announcement dates in 1971.
4
Asquith and Mullins (1983) report that 66 of their 160 dividend initiations announcements (41%) from 1963–1980 have an earnings announcement
within ± 10 days.
5
Although not all non-dividend-paying firms would make it into this sample if they began paying in a given year, because the sample is only comprised of
first-time initiators.
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 713

Table 1
Dividend initiations by year. This table presents the sample of dividend initiation announcements by industrial (non-financial and non-utility) firms from the CRSP
database by year of announcement from 1963 to 2008. Dividend initiation announcements are defined as the first announcement by a firm listed in CRSP of an
ordinary, taxable, cash dividend payable at the quarterly, semi-annual, or annual frequency to holders of ordinary common stock (share codes 10 and 11) listed on
the NYSE, Nasdaq, or Amex. All dividend initiating firms must have a stock price on CRSP 365 calendar days prior to the initiation announcement, and subsequent
dividend initiations following an omission are omitted from the sample. Firms must also be covered by the Compustat database, and have no dividends recorded
by Compustat in the prior five fiscal years. The second column contains the percent of dividend initiation announcements each year for which there is a quarterly
earnings announcement date for the quarter in the 21 calendar day window centered on the dividend initiation announcement date. Compustat begins recording
quarterly earnings announcement dates in 1971. The third column reports the number of initiations divided by the number of non-payers in the calendar year,
where non-payers are defined as firms in the CRSP database that do not declare an ordinary, taxable, cash dividend payable at the quarterly, semi-annual, or annual
frequency to holders of ordinary common stock (share codes 10 and 11) listed on the NYSE, Nasdaq, or Amex. The fourth column reports the number of dividend
payers divided by the total number of firms in the calendar year, where dividend payers are defined as firms in the CRSP database that declare an ordinary, taxable,
cash dividend payable at the quarterly, semi-annual, or annual frequency to holders of ordinary common stock (share codes 10 and 11) listed on the NYSE, Nasdaq,
or Amex. Both the third and fourth columns are restricted to post-1972 observations because this is the first full year that Nasdaq firms are incorporated into the
CRSP file.

Year # of dividend % of initiations with earnings Initiating firms as Payers as a % of total

initiations announcement +/− 10 days % of non-payers number of firms

1963 2
1964 4
1965 7
1966 5
1967 5
1968 6
1969 5
1970 5
1971 9 0.0%
1972 14 21.4% 0.6% 35.1%
1973 50 30.0% 2.7% 51.0%
1974 72 26.4% 4.8% 55.8%
1975 110 22.7% 7.9% 57.1%
1976 110 30.0% 8.0% 57.9%
1977 94 16.0% 7.2% 59.4%
1978 48 16.7% 3.7% 58.6%
1979 28 17.9% 2.1% 57.1%
1980 18 27.8% 1.1% 52.0%
1981 20 25.0% 1.0% 45.0%
1982 11 54.5% 0.5% 41.9%
1983 8 25.0% 0.3% 35.4%
1984 20 25.0% 0.7% 33.4%
1985 15 40.0% 0.5% 31.4%
1986 17 23.5% 0.5% 27.9%
1987 24 45.8% 0.7% 26.3%
1988 38 34.2% 1.2% 25.4%
1989 38 55.3% 1.2% 25.4%
1990 34 47.1% 1.1% 24.5%
1991 22 36.4% 0.7% 23.3%
1992 26 34.6% 0.8% 23.2%
1993 23 43.5% 0.7% 21.9%
1994 27 29.6% 0.7% 20.7%
1995 33 45.5% 0.8% 19.6%
1996 12 50.0% 0.3% 17.8%
1997 17 41.2% 0.4% 17.0%
1998 9 0.0% 0.2% 16.5%
1999 16 12.5% 0.4% 16.3%
2000 10 30.0% 0.2% 15.2%
2001 9 55.6% 0.2% 15.7%
2002 13 46.2% 0.4% 16.3%
2003 89 55.1% 3.0% 17.8%
2004 59 50.8% 2.1% 19.1%
2005 45 46.7% 1.6% 19.9%
2006 26 53.8% 1.0% 19.7%
2007 18 27.8% 0.7% 19.5%
2008 12 75.0% 0.5% 19.5%
Total 1283 33.0% 1.1% 29.1%

payers through (first-time) initiations, although there are local peaks in this conversion ratio in the mid-1970s and mid-2000s. For
example, the 89 initiating firms in 2003 comprise about 3% of the non-paying population of firms. The fourth column in Table 1
displays dividends payers each year as a fraction of the total number of firms listed in the CRSP database. Evidence of the temporal
decline in the propensity-to-pay (Fama and French (2001); DeAngelo et al. (2004)) is clearly visible in the table, although the
714 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

trend appears to reverse in recent years (partly driven by the jump in the number of initiations in the mid-2000s seen in columns 1
and 3).
Although not tabulated, the initiation announcements are reasonably well distributed amongst industries, with some
concentration in the Machinery and Equipment, Wholesale Distributors and Retail, and Recreation industries. The only obvious
outliers are the utilities and financial services industries, which contains very few observations since I exclude financial and
regulated firms from the sample (and most, but not all, utilities are regulated).

3. Descriptive statistics

Table 2 contains descriptive statistics for dividend initiation announcement abnormal returns. Cumulative abnormal dividend
initiation announcement returns are the firm-specific sum of abnormal returns during the three-trading-day window centered on
the dividend initiation announcement date, and daily abnormal returns are the difference between firm return and the value-
weighted market return from CRSP. The two columns in Table 2 show equal- and value-weighted averages of cumulative abnormal
announcement returns for various subsamples of the data, where the value weights are market capitalizations from CRSP three
trading days prior to the dividend initiation announcement date.
The first entry in the first column is the usual result for dividend initiation announcement returns (see, for example, Asquith
and Mullins (1983)). For the full sample from 1963 to 2008, three-day equally-weighted average initiation announcement
abnormal returns are 3.5%, which is statistically significantly different from zero at the 1% level (median of 1.9%, also statistically
significantly different from zero). The value-weighted average (second column) is statistically significant and negative (− 1.1%),
suggesting that large firms have substantially lower initiation announcement returns.
In the second row, however, removing just one observation from 2003 – Microsoft's dividend initiation announcement on
January 16th, 2003 – barely changes the equal-weighted average but causes the average value-weighted return to be significantly
positive (0.8%). Microsoft, a large firm by any definition of the word, experienced a cumulative abnormal return of −7% for the
three-trading-day period surrounding its initiation announcement. While the full-sample average-return characteristics are
consistent with much of the prior literature, it is notable that one observation (Microsoft) has such a dramatic effect on value-
weighted average dividend initiation announcement returns. For this reason, the Microsoft initiation is excluded from the
remainder of the tests reported in this paper (including the remainder of the rows in Table 2).
Excluding initiations with a quarterly earnings announcement within ±10 days (third row, data on earnings announcement
dates is only available after 1971) has little effect on average initiation announcement returns. Clearly, some of the proximate

Table 2
Cumulative abnormal dividend initiation announcement returns. This table presents descriptive statistics for cumulative abnormal announcement returns for the
dividend initiations described in Table 1. Cumulative abnormal announcement returns are the firm-specific sum of abnormal returns during the three-trading-day
window centered on the dividend initiation announcement date. Daily abnormal returns are the difference between firm daily return and the daily value-weighted
market return from CRSP. The value weights for firm-specific returns are market capitalizations from CRSP three trading days prior to the dividend initiation
announcement date. Compustat begins recording quarterly earnings announcement dates in 1971. In the first column the top number is the equal-weighted mean,
the number in brackets is the median, and the number of observations is in parentheses. In the second column the top number is the value-weighted mean and the
number of observations is in parentheses. ⁎⁎⁎ or ⁎⁎ indicates that the mean or median is significantly different from zero (using a cross-sectional test) at the 1% or
5% level (respectively).

Equal-weighted Value-weighted

Dividend initiation announcement cumulative abnormal returns, 1963–2008 3.50%⁎⁎⁎ − 1.07%⁎⁎⁎

[1.93%]⁎⁎⁎ (1282)
(1282)
Dividend initiation announcement cumulative abnormal returns, 1963–2008 3.51%⁎⁎⁎ 0.84%⁎⁎⁎
excluding the Microsoft initiation (1/16/2003) [1.94%]⁎⁎⁎ (1281)
(1281)
Dividend initiation announcement cumulative abnormal returns, 1971–2008 3.63%⁎⁎⁎ 1.14%⁎⁎⁎
excluding initiations with earnings announcement ± 10 days [1.81%]⁎⁎⁎ (858)
(858)
Average dividend initiation announcement cumulative abnormal return, by 1960s 2.46%⁎⁎ 0.69%
decade: [2.37%]⁎⁎ (34)
(34)
1970s 4.37%⁎⁎⁎ 1.96%⁎⁎⁎
[2.72%]⁎⁎⁎ (539)
(539)
1980s 2.78%⁎⁎⁎ 2.02%⁎⁎⁎
[1.21%]⁎⁎⁎ (209)
(209)
1990s 3.55%⁎⁎⁎ − 0.86%⁎⁎⁎
[1.52%]⁎⁎⁎ (219)
(219)
2000s 2.51%⁎⁎⁎ 1.18%⁎⁎⁎
[1.78%]⁎⁎⁎ (280)
(280)
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 715

Table 3
Dividend initiation announcement returns, Q, and cash flow from operations. This table presents equal-weighted averages of cumulative abnormal dividend
initiation announcement returns for subsamples divided by Q and pre-initiation cash flow from operations, calculated using Compustat data for the fiscal year
ending immediately prior to the dividend initiation announcement date for all dividend initiating firms with positive book equity. Q is total assets (annual data
item #6) plus fiscal-year-end market value of equity (annual data item #25 multiplied by annual data item #199) minus book value of equity (annual data item
#60) minus balance sheet deferred taxes (annual data item #74), all divided by total assets (as in Kaplan and Zingales (1997)). Cash flow from operations is
defined as in Bushman et al. (2008) as earnings before extraordinary items (annual data item #18) plus depreciation and amortization (annual data item #14)
minus working capital accruals, all scaled by total assets. Working capital accruals are defined as the change in current assets (annual data item #4) minus the
change in cash holdings (annual data item #1) minus the change in current liabilities (annual data item #5) plus the change in short-term debt (annual data item
#34) plus the change in tax payable (annual data item #71). In Panel A, the four subsamples are split based on initiating-firm Q compared to 1 and cash flow from
operations compared to the median in the same industry in the same fiscal year. Industry definitions are from Fama and French (1997) and assignment to industry
uses Compustat SIC codes. In Panel B, the four subsamples are split based on initiating-firm Q and cash flow from operations compared to the median in the same
industry in the same year prior. In all cases, there is no comparative median if there are fewer than five firms in the industry in the year prior to initiation. The
number of observations in each cell is in parentheses. ⁎⁎⁎ indicates that the average cumulative abnormal dividend initiation announcement return is statistically
significantly different from zero at the 1% level.

Cash flow from operations (pre-initiation) p-value for difference in columns

≤industry/year median Nindustry/year median

Panel A. Q greater than/less than 1

≤1 4.31%⁎⁎⁎ 6.87%⁎⁎⁎ 0.02
(160) (203)
Q
N1 2.44%⁎⁎⁎ 2.63%⁎⁎⁎ 0.74
(215) (470)
p-value for difference in rows 0.03 0.00

Panel B. Q greater than/less than industry/year median

≤industry/year median 3.84%⁎⁎⁎ 5.13%⁎⁎⁎ 0.14
(196) (314)
Q
N industry/year median 2.58%⁎⁎⁎ 2.84%⁎⁎⁎ 0.70
(179) (359)
p-value for difference in rows 0.14 0.00

earnings announcements are “good news” and some “bad news,” suggesting that the proximity of earnings announcements does
not dramatically change the first moment of the distribution of initiation returns.6 Because the co-incidence of earnings and
dividend initiation announcements has almost no perceptible effect on average dividend initiation announcement returns, I use
the largest available sample in the remainder of the analysis, without conditioning on the fact that a substantial fraction of
dividend initiation announcements are timed with quarterly earnings releases.
The final five rows in Table 2 document average dividend initiation announcement abnormal returns for the five decades
covered by this study, to examine whether there is systematic variation in the market reaction to dividend initiations across time
(as there is systematic variation in the number of initiations and propensity to pay dividends). Dividend initiations are generally
associated with significantly positive market reactions on average across all the decades represented in Table 2, although there are
two notable results. First, dividend initiations in the 1970s appear to be particularly well-received by the market on average, and
the value-weighted average return for the 1990s is significantly negative (suggesting that some initiations by very large firms in
the 1990s are accompanied by negative announcement returns7).

4. Dividend initiation announcement returns and the agency costs of overinvestment

If initiating a policy of paying dividends reduces the agency costs of overinvestment, I expect to observe significantly more
positive announcement returns for initiating firms with high agency costs of overinvestment than for other initiating firms. In
Table 3, I divide the sample into four groups based on Tobin's Q and cash flow, and examine whether there are significant
differences in average initiation announcement returns between these subsamples of initiating firms.8 I measure Q and cash flow
from operations using Compustat data from the fiscal year prior to the initiation announcement. Q is computed as in Kaplan and
Zingales (1997), as the market value of assets (the book value of assets plus the market value of common equity minus the book
value of common equity minus balance sheet deferred taxes) divided by the book value of assets. Cash flow from operations is
defined as in Bushman et al. (2008) and is scaled by total assets.

6
This result is also documented in Asquith and Mullins (1983).
7
This result is principally driven by Compaq Computer Corp. and Waste Management Inc., two very large companies (market capitalizations three days prior
to initiation of $57.4 billion and $27.2 billion, respectively) that initiated dividend payments in the late 1990s (October 1997 and September 1998, respectively)
and experienced negative cumulative initiation announcement abnormal returns (− 2.7% and − 2.6%, respectively). Omitting those observations results in a
positive value-weighted average initiation return for the 1990s which is only slightly lower (0.79%) than that for the other decades in Table 2.
8
Qualitatively similar results are obtained by dividing the sample based on Q and cash levels. These results are available from the author by request.
716 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

In Panel A, firms are split based on whether pre-initiation Q is greater or less than (or equal to) one, as in Lang and Litzenberger
(1989), and whether pre-initiation cash flow from operations (scaled by total assets) is greater or less than (or equal to) the
industry median in the year prior to initiation. Industries are defined as in Fama and French (1997). Lang and Litzenberger (1989)
show theoretically that overinvesting firms will have Q less than one, and the split based on pre-initiation cash flow is consistent
with the free cash flow arguments in Jensen (1986).
The lowest average dividend initiation announcement returns in Panel A are for firms with Q greater than one (i.e. firms that
are not likely to be overinvesting). The highest average initiation announcement abnormal returns in Panel A are for firms with Q
lower than one (i.e. firms that are likely to be overinvesting) and high cash flow (6.9%), and the average initiation returns to high
cash flow firms with Q greater than one and firms with Q less than one are different from one another with a high degree of
statistical significance (p-value = 0.00). Furthermore, among overinvesting initiating firms (Q less than or equal to one), those
with higher than industry median cash flow (i.e. more resources to overinvest) have significantly higher average initiation
announcement returns (6.9%) than those with low cash flow (4.3%).
Although a cutoff of one for Tobin's Q is theoretically appealing (Lang and Litzenberger (1989)) and used in many other studies
as a benchmark for good investment opportunities or overinvesting in different contexts (e.g. Lang et al. (1991)), several prior
studies have employed alternate cutoffs because of the concern that the median Q may be different from one. Specifically, Yoon
and Starks (1995) (a comparable study of dividend initiation announcement returns) and Servaes (1991) (a study of the gains
from takeovers) both employ a relative Q cutoff.
In this spirit, Panel B of Table 3 replicates Panel A using a relative cutoff for Q. In Panel B, firms are considered to have high Q if
their Q in the year prior to the dividend initiation announcement is above the industry median in that year (matching the cutoff for
pre-initiation cash flow from operations). The key results in Panel B are similar to those in Panel A. Specifically, the highest average
initiation announcement abnormal returns in Panel B are again for the 314 low Q/high cash flow initiating firms (5.1%), and,
among initiating firms with high cash flow, average initiation announcement returns for those with low Q (likely to be
overinvesting with ample resources to do so) are significantly more positive than the average abnormal returns to those with high
Q (2.8%).
These results are consistent with the overinvestment (agency cost) hypothesis — low Q firms have the highest average
initiation announcement returns, and, among firms with high cash flows, those firms that are less likely to have productive
investment opportunities in the future accrue significantly higher abnormal returns around the announcement that they intend to
begin returning cash to shareholders in the form of a dividend for the first time.
There is, however, also evidence in Table 3 that is consistent with the cash flow signaling hypothesis. While the initiation
announcement returns in Table 3 are the highest for firms for which overinvestment appears to be of concern, all subsets of firms
represented in Table 3 experience significantly positive initiation announcement abnormal returns. Even firms with high Q have
cumulative abnormal returns that average around 2.5%, and those returns do not appear to be affected by the division into high
and low cash flow subsamples. Furthermore, even firms with low pre-initiation Q and cash flow have significantly positive
dividend initiation announcement returns (of around 4% on average). Since it would be difficult to conclude that high-Q or low-
cash-flow initiating firms face high agency costs of overinvestment, the market reaction to dividend initiations does appear, to
some extent, to reflect the cash flow signaling hypothesis.
The univariate results in Table 3 do not control for other, potentially important, determinants of dividend initiation
announcement returns. Therefore, Table 4 contains OLS regressions explaining cumulative abnormal dividend initiation
announcement returns, controlling for firm characteristics that may be associated with either the propensity to initiate dividends
or the market reaction to initiation announcements. The control variables include the initial dividend yield (to control for the
magnitude of the dividend surprise, as in Denis et al. (1994), Yoon and Starks (1995), and Lie (2000)), an indicator variable for
whether the firm has repurchased stock9 in the five years preceding the initiation announcement (initiations may be associated
with weaker wealth effects if the firm has already paid out cash to stockholders in a form other than dividends), firm size
(measured as the fiscal-year-end market value of equity scaled by the fiscal-year-end level of the S&P 500 index, as in Lie (2000)),
and the RE/TE ratio of retained earnings to total equity from DeAngelo et al. (2006).
Grullon et al. (2002) demonstrate that firms that increase dividends payments experience a substantial decline in systematic
risk, and that the returns around dividend change announcements are significantly associated with the magnitude of the reduction
in risk premium. The change in the risk premium after the announcement of a dividend initiation (ΔRisk) is also included in the
regressions in Table 4, and is estimated as in Grullon et al. (2002).10
Regression (1) in Table 4 contains a baseline regression including only an indicator variable for Q lower than the industry/year
median (as in Panel B of Table 3) and the initiating firm's industry-adjusted pre-initiation cash flow from operations (scaled by
total assets). I industry-adjust operating cash flow by subtracting the industry/year median (as in Table 3). Consistent with the
univariate results, dividend initiation announcement returns are significantly higher for firms with the worst investment
opportunities (low Q), with the point estimate suggesting that initiation announcement returns are 2.0% higher for firms with low
Q (significantly different from zero at the 1% level). The coefficient on industry-adjusted pre-initiation cash flow from operations is
significantly positive at the 10% level in this baseline specification.

9
Stock repurchases are measured as in Fama and French (2001).
10
Grullon et al. (2002) specifically exclude dividend initiations from their sample, however almost all of the risk parameter changes around dividend initiations
are similar on average to those reported in that paper for dividend changes.
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 717

Table 4
The relation between dividend initiation announcement returns and overinvestment. This table presents results from OLS regressions explaining cumulative
abnormal dividend initiation announcement returns. The dependent variable (cumulative abnormal announcement returns) is defined in Table 2. Low Q is an
indicator variable equal to one if the initiating firm's Q is less than or equal to the industry/year median (as in Table 3, Panel B), and zero otherwise. Cash flow from
operations (industry adjusted) is cash flow from operation (as in Table 3) minus the industry/year median. Industry definitions are from Fama and French (1997).
Size is the market value of equity (in billions) scaled by the level of the S&P 500 index at the end of the fiscal year immediately prior to the dividend initiation
announcement date. Dividend yield is the amount of the initial dividend divided by the stock price three trading days prior to the dividend initiation
announcement date. ΔRisk is the change in the risk premium after the announcement of a dividend initiation, computed as in Grullon et al. (2002). Prior
repurchases is an indicator variable equal to one if the initiating firm repurchases stock in the five years prior to the dividend initiation, and zero otherwise. ROA is
income before extraordinary items (annual data item #14) plus interest expense (annual data item #15) and income statement deferred taxes (annual data item
#50) (if available) all divided by total assets (annual data item #6). RE/TE is retained earnings (annual data item #36) divided by book value of equity (annual data
item #60) and is Winsorized at the 5th and 95th percentiles. All other independent variables are defined in previous tables. White-corrected standard errors are in
parentheses. ⁎⁎⁎,⁎⁎, or ⁎ indicates that the regression coefficient is significantly different from zero at the 1%, 5%, or 10% level (respectively).

(1) (2) (3) (4)

Intercept 0.0247⁎⁎⁎ 0.0508⁎⁎⁎ − 0.0676⁎⁎⁎ − 0.0637⁎⁎⁎

(0.0036) (0.0047) (0.0154) (0.0178)
Q − 0.0105⁎⁎⁎ − 0.0022 − 0.0031
(0.0023) (0.0021) (0.0026)
Low Q 0.0201⁎⁎⁎
(0.0054)
Cash flow from operations (industry adjusted) 0.0668⁎ 0.0248 0.0206 − 0.0101
(0.0356) (0.0374) (0.0408) (0.0449)
Low Q * Cash flow from operations (industry adjusted) 0.1229⁎ 0.1509⁎⁎ 0.1244⁎⁎
(0.0668) (0.0666) (0.0635)
Log(Size) − 0.0120⁎⁎⁎ −0.0107⁎⁎⁎
(0.0018) (0.0019)
Dividend yield 0.3648⁎⁎ 0.4569⁎⁎
(0.1719) (0.1912)
ΔRisk − 0.4014⁎⁎ − 0.3882⁎⁎
(0.1876) (0.1928)
Prior repurchases − 0.0037
(0.0059)
ROA 0.0814
(0.0778)
RE/TE 0.0009
(0.0075)
Number of observations 1048 1048 996 923
Adjusted R2 0.02 0.03 0.14 0.14

Regression (2) replaces the low Q indicator variable with the continuous measure of firm Q and contains an interaction term of
pre-initiation cash flow from operations multiplied by the low Q indicator variable. In this specification, the importance of the
interaction of pre-initiation cash flow and Q is apparent. Specifically, the coefficient on the interaction of the low Q indicator
variable and pre-initiation cash flow is significantly positive (at the 10% level), and the magnitude of the coefficient suggests that,
in economic terms, a one standard deviation increase in pre-initiation cash flow is associated with incremental 1.3% higher
dividend initiation announcement returns for initiating firms with low Q.11 The significantly positive effect of the interaction of
pre-initiation cash flow from operations and low Q on dividend initiation announcement returns is persistent throughout the
remaining specifications in Table 4.12
Most of the control variables included in regression (3) are robustly associated with dividend initiation announcement returns
in the expected direction. Initiation announcement returns are lower for large firms, potentially because initiation are less
surprising for large firms, and negatively associated with the change in risk premiums (as in Grullon et al. (2002)). Larger dividend
initiations, measured by dividend yield, also appear to generate significantly larger market price responses. Regression (4)
introduces the remaining control variables. While none of these additional control variables are significantly associated with
initiation announcement returns, the sign and significance of coefficient on the interaction of cash flow and low Q is not affected by
their introduction into the regression.

5. Robustness tests and further evidence

5.1. The size of dividend initiations and constraint on investment

To believe that the results in Tables 3 and 4 are consistent with the overinvestment hypothesis, one must believe that the
dividend initiations in this sample are substantial enough to have a meaningful impact on the ability of the initiating firms to

11
The in-sample standard deviation of industry-adjusted cash flow from operations scaled by total assets is 10.6%. 0.106 * 0.1229 = 1.3%.
12
The regressions reported in Table 4 are similar to those in Table 4 of Denis et al. (1994). Denis et al. (1994) do not, however, find a significant relation
between initiation announcement returns and the interaction of Q and pre-initiation cash flow.
718 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

Fig. 1. Dividends as a proportion of cash holdings, cash flow, and investment. This figure shows the average ratio of common dividends to cash holdings, cash flow
from operations, and investment for firms initiating dividends between 1962 and 2003. Year 0 is the year containing the dividend initiation date. All accounting
data are from Compustat, the ratios are Winsorized at the 5th/95th percentiles, and the sample contains the initiations from Table 1 with contiguous observations
in Compustat throughout the event period. Cash holdings are from the end of the prior fiscal year, cash flow from operations is defined in Table 3, and investment is
capital expenditure plus research and development expenditure.

overinvest. Fig. 1 presents the average ratios of (i) common dividends to cash holdings at the end of the prior fiscal year;
(ii) common dividends to cash flow from operations in the same fiscal year; and (iii) common dividends to investment (capital
expenditure plus research and development expenditure) in the same fiscal year. These averages are presented for event years −2
through +5 (year 0 is the year containing the dividend initiation date). The sample used for the figure contains initiators with
contiguous observations from Compustat throughout this event period to ensure that the sample size is constant in the different
event years (i.e., dividend initiations after 2003 are excluded).
By construction, the average of all these ratios is zero for the pre-initiation years, but after initiation dividends consume about
25% of prior-fiscal-year-end cash holdings, or 13–15% of current-year cash flow. Dividends are about 20% of actual investment
levels (capital expenditures plus R&D). These ratios are not economically different for low Q/high cash flow firms compared to all
other initiating firms. For example, in the post-initiations years (1–5) the ratio of dividends paid to cash flow from operations
averages 12.9% for low Q/high cash flow firms and14.3% for all other initiators.
Ratios of the magnitudes depicted in Fig. 1 certainly appear substantial enough to reduce managers' ability to waste (or steal)
the firms' resources, and therefore reduce agency costs. In particular, absent the dividend initiated in year 0, an overinvesting firm
could have “wasted” about 20% more on capital expenditures or R&D than the actual investment level observed in the data.

5.2. The decision to initiate dividends

What can the evidence about the market reaction to dividend initiations tells us about why some firms choose to initiate
dividends while other firms do not? In Table 5 I examine univariate differences in firm characteristics, including Q and cash flow
from operations, for the dividend-initiating firms in my sample and a matched sample of non-initiating, non-dividend-paying
firms. The matched sample is formed by finding non-dividend-paying firms in the same industry as a dividend initiating firm, and
with total assets and ROA within ±25% of the values for the dividend initiating firm in the fiscal year ending immediately prior to
the dividend initiation announcement date. If this results in multiple matches for any dividend initiating firm, the match with
closest RE/TE is chosen. Therefore, there is one matched firm for every dividend initiating firm in the sample.
Dividend initiating firms and the matched sample have approximately the same market value of equity and Q on average (first
two rows of Table 5), but dividend initiating firms have significantly higher cash flow from operations and cash holdings (as a
fraction of total assets) than the matched non-initiating, non-paying firms do (both on average and at the median). 32% of
dividend initiating firms can be classified as low Q/high cash flow firms (fourth row of Table 5) compared to only 25% of the
matched firms. This difference is statistically significant at the 5% level.
Relative to matched non-initiating, non-paying firms, dividend initiating firms appear to have higher RE/TE (despite the fact
that RE/TE is one of the match criteria) and lower leverage. There is also (slightly weaker) evidence that dividend initiating firms
have lower sales growth than the matched firms do, and that dividend initiating firms are slightly older (at least at the median).13

13
Although the number of years that the firm has appeared in Compustat is clearly different from the number of years since incorporation, it should be a
reasonable proxy for the number of years a firm has been publicly traded.
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 719

Table 5
Dividend initiating firms compared to non-payers: why do firms initiate? This table presents descriptive statistics for the sample of dividend initiating firms
described in Table 1 and for a matched sample of non-initiating, non-dividend-paying firms. The matched sample of non-initiating, non-dividend-paying firms is
formed by finding non-dividend-paying firms in the same industry as a dividend initiating firm, and with total assets and ROA within ± 25% of the values for the
dividend initiating firm in the fiscal year ending immediately prior to the dividend initiation announcement date. If this results in multiple matches for any
dividend initiating firm, the match with closest RE/TE is chosen. Therefore, there is one matched firm for every dividend initiating firm in the sample. The top
number in the table is the mean, the number in brackets is the median, and the number of observations is in parentheses. All variables are from Compustat data for
the fiscal year ending immediately prior to the dividend initiation announcement date for firms with positive book equity. Size is the fiscal-year-end market value
of equity scaled by the fiscal-year-end level of the S&P 500 index, and Low Q/High cash flow from operations is an indicator variable equal to one if the firm's cash
flow from operations (scaled by total assets) is greater than the industry/year median and the firm's Q is less than or equal to the industry/year median (as in
Table 3, Panel B). Cash is cash holdings divided by total assets, Leverage is the book value of long-term debt (annual data item #9) divided by total assets, and Sales
growth is the percent change in sales (annual data item #12) from the prior fiscal year (Winsorized at the 5th and 95th percentiles). Age is the number of years
since the firm first appeared in Compustat. All other variables are defined in previous tables. ⁎⁎⁎ indicates that the mean or median is significantly different from
zero at the 1% level, and a or b indicates that the mean or median for dividend initiating firms is statistically significantly different from the mean or median for
matched non-initiating, non-dividend paying firms at the 1% or 5% level (respectively).

Dividend initiating firms Matched non-initiating, non-dividend-paying firms

Size 0.0006⁎⁎⁎ 0.0005⁎⁎⁎

[0.0002] ⁎⁎⁎ [0.0001] ⁎⁎⁎
(676) (582)
Q 1.535⁎⁎⁎ 1.594⁎⁎⁎
[1.153] ⁎⁎⁎ [1.204] ⁎⁎⁎
(676) (582)
Cash flow from operations 0.0931⁎⁎⁎ a 0.0651⁎⁎⁎
[0.0931] ⁎⁎⁎ a [0.0688] ⁎⁎⁎
(648) (600)
Low Q/High cash flow from operations 0.320⁎⁎⁎ b 0.253⁎⁎⁎
(631) (525)
Cash 0.153⁎⁎⁎ a 0.119⁎⁎⁎
[0.093] ⁎⁎⁎ a [0.066] ⁎⁎⁎
(700) (700)
RE/TE 0.558⁎⁎⁎ a 0.501⁎⁎⁎
[0.592] ⁎⁎⁎ a [0.545] ⁎⁎⁎
(700) (700)
Leverage 0.162⁎⁎⁎ a 0.193⁎⁎⁎
[0.137] ⁎⁎⁎ a [0.167] ⁎⁎⁎
(699) (699)
Sales growth 0.192⁎⁎⁎ b 0.225⁎⁎⁎
[0.162] ⁎⁎⁎ [0.172] ⁎⁎⁎
(665) (624)
Age 9.503⁎⁎⁎ 9.590⁎⁎⁎
[8.000] ⁎⁎⁎ b [7.000] ⁎⁎⁎
(700) (700)

These characteristics of dividend initiating firms (relative to matched non-initiating, non-paying peers) are consistent with the
results in Fama and French (2001) and DeAngelo et al. (2006), suggesting that firms initiate the payment of dividends at a point in
their life cycle when the firm is experiencing slower sales growth and generating large amounts of free cash flow.
Importantly for the current paper, the same characteristics that are associated with the most positive market reactions to
dividend initiations (low Q/high cash flow) are also more prevalent in dividend initiating firms than in matched non-initiating,
non-paying industry peers. In other words, a firm's potential for overinvesting appears to be a significant contributor to both the
decision to initiate dividend payments and the market reaction to dividend initiations.

5.3. The jobs and growth tax relief reconciliation act and alternate proxies for agency costs

One problem with the traditional agency hypothesis for the monitoring and disciplinary role of dividends is that dividend
payments are voluntary. The theory relies on the premise that managers that are wasting or expropriating wealth from
stockholders suddenly decide to begin paying dividends and returning cash to stockholders that could otherwise be invested
(wasted) in pet or scale-expanding projects. What is needed to “close” the agency model is an exogenous shock to the equilibrium
that determines whether a firm is a dividend payer or not.
Governance shocks (such as the adoption of state or federal governance rules) are one possibility, as governance shocks may
compel managers to adopt a financial policy (paying dividends) that is in the best interests of their shareholders. However,
governance shocks simultaneously make dividend payments more likely and the payment of dividends less valuable to
stockholders, because underlying governance has already improved due to the governance shock.
Rather than employ such a supply-side shock, in this section I examine a demand-side shock that is unrelated to governance or
agency costs but that affects shareholders' demand for dividends. The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) was
signed into law on May 28th of 2003, and reduced the maximum statutory income tax rate on dividends from 38% to 15%. By
dramatically lowering the federal tax rate payable on dividend income, the JGTRRA made hoarding cash more costly at the margin
720 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

Fig. 2. Number of dividend initiations, per month 1990–2008. The solid line in this figure shows the number of dividend initiations per month from 1990 to 2008.
Dividend initiations are defined in Table 1. The dashed line in the figure represents May, 2003, when the Jobs and Growth Tax Relief Reconciliation Act was signed
into law.

and potentially prompted managers that would otherwise hoard cash to begin to pay it out. This exogenous, demand-side shock
affects all firms equally, and therefore this event should produce a sample of dividend initiations that is relatively free of any bias
driven by the (supply-side) reluctance of “entrenched” managers to initiate dividend payments.
The JGTRRA contributed to a spike in dividend initiations in 2003. Fig. 2 shows the time series of the number of dividend
initiations per month from 1990 to 2008. Between 1990 and 2002, the number of initiations averages approximately two per
month, with a maximum of eight in May 1990. The dashed line in Fig. 2 shows the timing of the JGTRRA, with a distinct and
considerable spike in the number of initiations following, and for a few months after, May of 2003.14 There were 77 initiations in
the May–December period of 2003 (an average of 9.6 per month). This compares to only 12 during the same period of 2002, so the
unusual number of initiations in the last half of 2003 is unlikely to be driven by seasonality. To maximize the sample size for
analysis of the response to this exogenous shock to dividend policy choice, I use all initiations between May and December of 2003.
The dividend initiation announcements during this time period are still surprising to the market, despite the obvious implications
of the tax law change: cumulative abnormal announcement returns average 2.47% for this subsample, approximately equal to the
average initiation announcement return in the 2000s reported in Table 2 (2.51%).
Almost 90% (69) of these 77 initiating firms used stock repurchases in the five years prior to initiating dividends, where the
repurchases were presumably intended to distribute temporary cash flows (Guay and Harford (2000) and Jagannathan et al.
(2000)). While this might suggest that the Act changed the form of distributions (from repurchases to dividends), this is not the
case: of these 69 firms, 55 (80%) continue to repurchase stock in the five years after dividend initiation, and the average repurchase
per firm-year increases (from $15.1 m to $65.0 m; although the median is essentially unchanged).
I hypothesize that a non-dividend-paying firm with ample cash flow at the end of 2002 would be compelled to consider a
change in dividend policy in 2003 given the change in tax law, and, consistent with the overinvestment hypothesis, that such
demand-induced initiations will have greater valuation effects for those firms that have high agency costs of overinvestment or are
poorly governed.
Because additional data are available for observations from 2003 that are not available for the full sample, I employ three
alternate proxies for governance: Board is insider dominated (an indicator variable equal to one if the percent of executive
directors on the board of directors is greater than 50%, and zero otherwise); percent ownership by public pension funds (the
percent of the firm's shares owned by the public pension funds collectively identified in three recent studies of the impact of public
pension fund holdings on stock returns (Cremers and Nair (2005), Dittmar and Mahrt-Smith (2007), and Larcker et al. (2005));
and a managerial entrenchment index based on anti-takeover provisions (an indicator variable equal to one if the entrenchment
index from Bebchuk et al. (2009) is greater than two (the pooled time-series and cross-sectional median), and zero otherwise).
Dividend initiating firms are considered to have weak governance if the board is insider dominated (Weisbach (1988) and Brickley
et al. (1994)), if the Bebchuk et al. (2009) entrenchment index indicates managerial entrenchment (i.e., is greater than two), or if
the percent ownership by public pension funds is below the median for all firms at the same quarterly reporting date (Brickley et
al. (1988), Barclay and Holderness (1991), Smith (1996), Wahal (1996), and Del Guercio and Hawkins (1999)).
All data for initiating firms are from the period immediately preceding the initiation, which in most instances equates to data
from 2002. Data on board composition are from the sample in Linck et al. (2008).15 The percent ownership by public pension funds

14
This conclusion is consistent with the findings in Chetty and Saez (2005). However, for survey evidence on the opinion of CFOs about the relation between
the 2003 JGTRRA and the decision to pay dividends see Brav et al. (2008). The spike in initiating can also be seen in the time series in Table 1, as a fraction of the
number of non-paying firms. In 2003, the number of initiators jumps to 3.0% of the non-paying population of firms, relative to just 0.4% in 2002.
15
I thank Jim Linck for allowing me to use these data.
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 721

is derived from CDA/Spectrum (13F) data, and is measured at the quarterly reporting date no more than 90 days prior to the
dividend initiation announcement date (i.e. sometimes in 2003, but prior to the initiation). I use 2002 data from the Investor
Responsibility Research Center (IRRC) database of corporate charter provisions to measure the entrenchment index as in Bebchuk
et al. (2009). Because of data limitations, there is some variation in the number of initiations between May and December of 2003
can be matched to the data sources described for these governance proxies. The weakest matching is to IRRC data on anti-takeover
charter provisions, with only 38 (out of 77) initiating firms during this period being matched to these data.
Table 6 contains means and medians for abnormal dividend initiation announcement returns for subsamples split based on
these governance proxies. The results show that for firms initiating dividends after the tax law change, those with weak pre-
initiation governance (insider dominated boards, entrenched managers, or below-median ownership by public pension funds)
have significantly more positive average dividend initiation announcement returns than those with strong governance do. This
conclusion holds regardless of whether one considers the mean or median. Furthermore, the differences are economically
meaningful. For example, the 12 initiating firms in this sample with insider dominated boards have average dividend initiation
announcement returns of 8.6% (median of 10.3%), substantially greater than the average initiation announcement return of 1.3%
(median of 2.2%) for the 48 firms without insider dominated boards. For firms initiating dividends immediately after The Jobs and
Growth Tax Relief Reconciliation Act was signed into law in May 2003, those with weak governance (i.e., the potential to waste or
expropriate shareholders' resources) have significantly (and substantially) more positive initiation announcement returns than
those with strong governance do.
I also replicate Table 3, Panel B for this subsample of 77 firms. The most powerful result in Table 3 is that, amongst firms with
higher-than-median cash flow from operations, low Q firms have significantly and substantially higher average initiation
announcement returns than high Q firms. Results for the subsample of 77 firms initiating dividends immediately after The Jobs and
Growth Tax Relief Reconciliation Act was signed into law are consistent with the results in the full sample. Specifically, low Q/high
cash flow initiating firms (defined as in Table 3, Panel B) have median initiation announcement returns of 3.1% (significant at the
10% level) whereas high Q/high cash flow initiating firms have median initiation announcement returns of 0.9% (statistically
insignificant). The same pattern holds for the means. However, the median (or mean) initiation announcement returns are not
statistically different in these two subsamples: the p-value for a Wilcoxon signed-rank test of difference in the medians is 0.24.

5.4. Cash flow signaling and analysts' earnings estimates

The fact that I observe high announcement returns around dividend initiations for low Q firms could be consistent with the
cash flow signaling hypothesis if low pre-initiation Q is indicative of low pre-initiation future cash flow expectations (and hence
greater revisions in those expectations around financial policy signals, such as a dividend initiation).
I attempt to provide some evidence about this alternative using the method outlined in Denis et al. (1994), which involves
analyzing unexpected revisions in analysts' earnings forecasts around dividend initiations. Specifically, I obtain analysts forecasts
of one-year-ahead earnings-per-share (EPS) from the IBES database and measure the change in the median analyst's EPS forecast
from one month prior to one month after dividend initiations (holding the forecast period constant). As described in detail in Denis
et al. (1994) (p.581), I scale each change in the median forecast by the initiating firm's stock price two days prior to initiation and
compute unexpected (or abnormal) standardized forecast revisions (where the expected, or normal, forecast revision accounts for
the upward bias in analysts' forecasts and the serial correlation in forecast revisions induced by infrequent updating).
Table 7 reports median standardized unexpected forecast revisions for the full sample (Panel A) and for various subsamples
conditioned on Q and cash flow from operations (as in Table 3, Panel B). I employ medians rather than means because of the small
sample sizes that result after matching dividend initiating firms to IBES (although Denis et al. (1994) also report medians despite
having a much larger sample of dividend changes). The median forecast revision for the full sample of dividend initiating firms in

Table 6
Dividend initiation announcement returns (5/2003 to 12/2003) and governance proxies. This table presents equal-weighted averages and medians (in brackets) of
cumulative abnormal dividend in the months immediately after The Jobs and Growth Tax Relief Reconciliation Act was signed into law. The number of
observations is in parentheses. In each row, “Weak” governance is defined as: Board is insider dominated = 1; Managerial entrenchment = 1; or Percent
ownership by public pension funds less than or equal to the median for all firms for which CDA/Spectrum reports ownership data at the same quarterly reporting
date. All dividend initiating firms that are not defined as having “Weak” governance (in each row) are defined as having “Strong” governance. ⁎⁎⁎ or ⁎⁎ indicates
that the mean or median is significantly different from zero (using a cross-sectional test) at the 1% or 5% level (respectively) using a t-test or Wilcoxon signed-rank
test (respectively). a, b, or c indicates that the “Weak” governance mean (or median) is statistically significantly different from the “Strong” governance mean (or
median) at the 1%, 5%, or 10% level (respectively) using a t-test (or a Wilcoxon test).

“Weak” governance “Strong” governance

Board is insider dominated 8.64%⁎⁎⁎ a 1.29%

[10.33%]⁎⁎ b [2.18%]⁎⁎
(12) (48)
Managerial entrenchment 4.35%⁎⁎⁎ a − 0.56%
[4.93%]⁎⁎ a [− 0.09%]
(13) (25)
Percent ownership by public pension funds 3.46%⁎⁎ c 0.58%
[3.32%]⁎⁎ c [0.39%]
(23) (33)
722 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

Table 7
Changes in analyst earnings forecasts around dividend initiation announcements. This table presents median standardized unexpected analysts' forecast revisions
for the full sample of dividend initiating firms (Panel A) and for various subsamples conditioned on Q and cash flow from operations (Panels B and C). Analysts'
forecasts are of one-year-ahead earnings-per-share (EPS) from the IBES database, and revisions are calculated as the change in the median analyst's EPS forecast
from one month prior to one month after dividend initiations (holding the forecast period constant). Each change in the median forecast is scaled by the initiating
firm's stock price two days prior to initiation and standardized unexpected forecast revisions are calculated as the standardized forecast revision minus the
expected standardized forecast revision (which is described in detail in Denis et al. (1994), and accounts for the upward bias in analysts' forecasts and the serial
correlation in forecast revisions induced by infrequent updating). The number of observations in each cell is in parentheses. All other variables are defined in
previous tables. ⁎⁎⁎, ⁎⁎, or ⁎ indicates that the median standardized unexpected revision in forecasts of EPS is statistically significantly different from zero at the 1%,
5%, or 10% level (respectively) using a Wilcoxon signed-rank test. The p-values for differences in columns are from Wilcoxon tests for differences in medians.

Panel A. Full sample

Median standardized unexpected revision in forecasts of EPS 0.0303⁎⁎⁎

(191)

Panel B. Q greater than/less than industry/year median

≤industry/year median N industry/year median p-value for difference in columns

Median standardized unexpected revision in forecasts of EPS 0.0342 0.0243⁎⁎ 0.95

(60) (110)

Panel C. Q less than industry/year median, bisected by (pre-initiation) cash flow from operations

Cash flow from operations (pre-initiation)

≤industry/year median Nindustry/year median p-value for difference in columns

Median standardized unexpected revision in forecasts of EPS 0.1872⁎⁎ 0.0296 0.11

(22) (33)

Panel A (0.030, significantly different from zero at the 1% level) is slightly higher than the full-sample median revision reported by
Denis et al. (1994) for dividend changes (0.024, also significantly different from zero at the 1% level), perhaps indicating that
dividend initiations contain slightly more positive news about future earnings (cash flows) than dividend changes do.
Conditioning on Q being greater than or less than the industry/year median (Panel B) does not produce significant differences
in forecast revisions (p-value for difference in revisions between high and low Q firms = 0.95), although the point estimates go in
the same direction reported in Denis et al. (1994) (more positive revisions for low Q firms; Denis et al. (1994) condition on Q N 1
and Q b 1). Restricting the analysis to low Q firms only (Panel C), however, produces a notable result. Specifically, forecast revisions
for low Q/low cash flow initiating firms are extremely positive at the median (0.187) — this is significantly different from zero and
substantially higher than the median revision for low Q/high cash flow initiators (0.030). The p-value for the difference in these
medians is 0.11, although given the small sample sizes involved this is a relatively high level of statistical significance.
In summary, I find the most significant positive revisions in analysts' earnings forecasts around dividend initiations for low Q/
low cash flow dividend initiating firms. This is consistent with the notion that the combination of low Q and low pre-initiation cash
flow captures low future cash flow expectations (which analysts revise upwards considerably following initiations). While this
evidence is consistent with the cash flow signaling hypothesis, it is puzzling that the initiating firms that have the most positive
initiation announcement returns (low Q/high cash flow) are not the same firms for which analysts appear to interpret dividend
initiations as implying the strongest signal of higher future earnings.

5.5. Cash hoarding and investment by firms initiating dividends

The overinvestment hypothesis for dividend initiation announcement returns implies that the market response to a dividend
initiation reflects a lower probability of future hoarding of free cash flow and overinvestment. Rational expectations would suggest
that if markets respond more positively to dividend initiations by firms with poor investment opportunities and ample cash to
waste, such firms should, on average, exhibit less hoarding of cash and wasting of resources in the future.
I examine post-initiation cash holding patterns for dividend initiating firms. This exercise is similar to the tests reported in
Grullon et al. (2002) for dividend changes. I analyze abnormal cash holdings (scaled by total assets), where abnormal means the
difference between an observation for an initiating firm and the industry/year median (industries are defined as in Fama and
French (1997)). Therefore, I measure cash hoarding relative to industry peers (not in absolute terms).
Fig. 3 shows equal-weighted averages of abnormal cash holdings over the event window from year − 5 (relative to the year
containing the initiation announcement date) to year +5. Like Fig. 1, the sample contains initiators with contiguous observations
from Compustat throughout this event period to ensure that the sample size is constant in the different event years (i.e., dividend
initiations after 2003 are excluded). The figure presents equal-weighted averages separately for low Q/high cash flow firms (143
observations in each year) and for all other initiators in the sample (313 observations in each year).
In the years prior to initiating dividends, firms hold high cash balances relative to industry peers on average — approximately
4–6% higher cash balances (as a percent of total assets) than the industry median, with low Q/high cash flow firms generally at the
lower end of that range (but still statistically significantly different from zero at better than the 1% level). Cash holdings (relative to
 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724 723

Fig. 3. Abnormal cash holdings for firms initiating dividends. This figure shows average abnormal cash holdings by year relative to the initiation year for firms
initiating dividends between 1962 and 2003. Year 0 is the year containing the dividend initiation date. The sample is split into two subsamples: initiating firms
with low Q/high cash flow, and all other initiating firms. Abnormal cash holdings are cash holdings scaled by total assets minus median cash holdings scaled by
total assets for all firms in the same industry as the initiating firm in the same fiscal year. All accounting data is from Compustat, cash holdings scaled by total assets
is Winsorized at the 5th/95th percentiles, and the sample contains the initiations from Table 1 with contiguous observations in Compustat throughout the event
period.

industry peers) appear to peak just before the initiation announcement year, consistent with the notion that firms initiate
dividend payments when their cash balances have increased markedly.
After the dividend initiation year, however, differences begin to emerge between low Q/high cash flow initiating firms and all
other initiators. While all initiating firms reduce cash balances considerably, the biggest reduction is by low Q/high cash flow firms.
In fact, low Q/high cash flow firms reduce abnormal cash hoarding relative to industry peers to the point where three years after
initiation the average cash balance for low Q/high cash flow initiating firms is statistically indistinguishable from the industry/year
median (t-statistic for significance of the mean abnormal cash holding scaled by total assets in year 3 = 1.8). Furthermore,
abnormal cash holdings for this group stay statistically insignificantly different from zero for the remainder of the event period (t-
statistic for significance of the mean abnormal cash holding scaled by total assets in year 5 = 0.9).
The same is not true for all other initiating firms, as they continue to hoard cash relative to industry peers well after initiating
dividend payments. Five years after initiation, all other initiating firms hold 3.0% more cash as a fraction of total assets than the
median firm in their industry, and this is statistically different from zero with a t-statistic of 3.9.
I also examine abnormal investment over the same event window, where investment is defined as capital expenditure plus
research and development expenditure scaled by total assets (i.e., aggregates hard (capital expenditures) and soft (R&D) forms of
investment). There is a substantial reduction in abnormal investment around the dividend initiation year for low Q/high cash flow
initiators. However, this reduction in (over)investment for low Q/high cash flow initiating firms begins in about year −3. In other
words, the decision to reduce investment (to the industry/year median) appears to pre-date the dividend initiation decision.

6. Conclusion

The central finding in this paper is that firms with low Tobin's Q and high cash flow have significantly more positive dividend
initiation announcement returns than other firms do. Much of the analysis in this paper is designed to provide evidence about
potential explanations for this finding. Specifically, initiations immediately following the passage of The Jobs and Growth Tax
Relief Reconciliation Act in 2003 show evidence of significantly higher initiation announcement returns for firms with weak
governance (or monitoring) than for firms with strong governance, and after initiation low Q/high cash flow firms reduce cash
hoarding to the level of the median firm in their industry while other initiating firms do not.
Combined, these results suggest that the agency cost (overinvestment) hypothesis provides a plausible explanation for the
initiation announcement return patterns that I observe. Paying cash out by initiating dividend payments reduces the probability
that the managers of a firm with poor investment opportunities (low Q) and ample resources (high cash flow) are likely to
overinvest or waste their stockholders' cash, and this reduction in the agency costs of overinvestment appears to be priced via
higher dividend initiation announcement returns.
The results in this paper also offer some support for the cash flow signaling hypothesis.16 In my analysis of revisions in one-
period-ahead EPS forecasts I find that analysts appear to interpret dividend initiations as very positive signals about the future
earnings potential of low Q/low cash flow initiating firms. Furthermore, such firms have positive initiation announcement returns
(although not the most positive of the subsets examined here). Although much of the empirical evidence in the literature does not

16
The cash flow signaling and agency cost hypotheses are not mutually exclusive.
724 M.S. Officer / Journal of Corporate Finance 17 (2011) 710–724

support the direct implications of the cash flow signaling hypothesis (Watts (1973), DeAngelo et al. (1996), and Grullon et al.
(2002)), the results in this paper suggests that both the overinvestment and cash flow signaling hypotheses appear to have a role
in explaining the market reaction to dividend initiation announcements.

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