Dividend Signalling

Dividend Signalling

Words Count: 2150

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content

1 Introduction - 3 -

1.1 A brief Review of Theoretical Frameworks of signalling models - 3 -

1.2 Structure - 4 -

2 Dividend policy is irrelevant to share price - 5 -

2 Dividends are positively related to share price - 6 -

3 Dividends are negatively related to stock price - 9 -

4 Conclusion - 11 -

5 Recommendation - 11 -

Reference - 12 -

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1 Introduction

Dividend policy, with capital structure and long-term financing, as three main corporate finance policies, has been widely discussed via massive empirical studies. In order to explain the mechanism among dividend payout shareholders' wealth and market expectation of the firm, different schools of theories were developed such as the Miller-Modigliani's irrelevance theory (1961), bird-in-hand theory, agency costs theory, clientele effect, signalling theory.etc. This paper aims at looking into the dividend signalling by reviewing different literatures and real world cases.

1.1 A brief Review of Theoretical Frameworks of signalling models

Miller-Modigliani (hereafter referred to as MM) (1961) assumed that under certain assumption (i.e. in a perfect capital market with free information and rational customers where asymmetric information problems, transaction cost and tax do not exist), the value of a firm is only determined by profitability and managerial level, and thus will not be affected by payout policy. Therefore there is no difference between cash dividend and share repurchase. The MM theory is regarded as the cornerstone of modern capital structure theorem and the foundation of most signalling models.

Lintner (1956) is thought to be the first researcher who undertook empirical study on dividend signalling through questionnaires of financial managers in 600 listed companies in the USA and confirmed the conveying of dividend signal. More scholars including Pettit (1972), Below and Johnson (1996) were also involved in empirical discussion on this subject later.

Based on Spence's job market signalling model (1974), Ross (1977) first introduced asymmetric information to a capital structure signalling model of leverage which is founded on "lower-truncated" cost structure where bankruptcy amercement for managers is applied. Related to the model of Ross (1977), Bhattacharya (1979) developed a signalling model including the discussion of convergence to equilibrium in financial-signalling models and signalling cost structure. However, both researchers did not explain clearly the reason why firms tend to use cash dividend as only signal carrier to the market and the smoothness of dividend payment over time.

Miller and Rock (1985) discovered signalling equilibrium under asymmetric information, indicating the firm may direct the investors currently but cannot "fool" the market in the long run, as when making decision, both shareholders and managers are aware of this mechanism of the market. Miller and Rock (1985) also pointed out "signaling cost" theory which is a trade-off between current and future value. Contractual provisions and other methods are introduced as way solving the problem of asymmetry. In the same year, John and Williams (1985) proposed a signalling equilibrium model where tax, issuing new share, repurchase and investment were identified. Both of the theories above considered the reason why firms take dividend prior to other methods.

To explain the smoothness of dividend, Kumar (1988) proposed "coarse signalling model" which assumes continuity of dividend payment, arguing firms tend to maintain dividend under certain earning level until the earnings go excess of this level. Pettit (1972) also discussed delay of increasing dividend raised by managers' fear of the uncertainty of future cash flow.

John and Lang (1991) believed that increasing in dividend cannot always be seen as good news by introducing a new dividend signalling model where "inside trading" was taken into consideration, which will be further discussed in the sections below.

1.2 Structure

This paper contains three main discussion parts which are in the same order as three positions