Tests of Dividend Signaling Using the Marsh-Merton Model: A Generalized Friction Approach

This article extends the Marsh-Merton (1987) model to test the information effects of dividends. A generalized friction method provides for more reliable estimates of the relationship between dividends and the firm's permanent earnings by resolving the estimation problems caused by the dividend 'stickiness.' Results show that dividend changes not only signal significant changes in the firm's future earnings prospects but also reflect the well-known practice of dividend smoothing. After resolving the estimation problem, a positive relation between unexpected changes in dividends and permanent earnings is found, and this relation appears to be correlated with certain firm attributes.