The Effect of Future Earnings and Free Cash Flow on Dividend

Abstract

In economics, and more specifically in contract theory, signaling refers to the act in which one party sends some meaningful information about itself to the other party. Signaling derives from the theory of information asymmetry, which implies a conflict of interest between managers and investors, which reduces the moderating role of dividends; because managers have asymmetric information compared to the investors on the earnings and future dividend policies. This study investigates the relationship between dividends paid and future earnings by considering the free cash flow. For this purpose, 82 companies listed on the stock exchange from 2002 to 2014 were examined. Using the simultaneous equation method, this study finds that increasing the rate of change in future earnings will reduce the annual rate of change in dividends paid. It is also found that the effect of changes in future earnings on changes in dividends is not a reason for the effect of changes in the dividend paid on future earnings.

Keywords

• dividend changes
• dividend signaling theory
• free cash flow theory
• future earnings changes