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.

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.

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 same direction. Higher dividends signal better earnings, and therefore, lead to a higher market value.

Applied Finance Journal, Indian Manufacturing Firms, Bombay Stock Exchange, BSE, Signaling models, Centre for Monitoring Indian Economy, CMIE, Financial Data, Capital Markets, Simple Linear Models, Regression Models, Financial Economics, Corporate Financial Policies.