The Information Content of Dividend Actions: Signaling

Modigliani and Miller assumed that both inside and outside investors have similar information about a company. However, in reality, outside investors have less detailed information about a company relative to the managers. Outsiders may use dividend signals to get more information about a company’s prospects. For a signal to be effective, it must be difficult for another company to mimic. It is difficult and costly for one entity to mimic the dividend signals because it does not expect its cash flows to increase and will not maintain consistently high dividends in the long run. Dividend reductions are associated with future earning problems, while dividend increases are related to future earnings growth.

Research has shown that dividend increase is associated with share price increases. Managers are rewarded for increasing the company’s dividend if they believe its price is undervalued because increased scrutiny will lead to a positive price adjustment. Increasing dividends is an important tool to convey information to existing and potential shareholders, especially when a company’s earnings and cash flow outlook continues to be positive. Characteristics of companies that consistently increase their dividends are:

• Relatively low debt ratios.
• High returns on assets.
• Dominant in their industry.
• Global operations.
• Less volatile earnings.

Management can attempt to send a positive signal by cutting the dividend. However, it isn’t easy to implement. Many technology companies pay low dividends because many of their retained earnings are spent on research and development. The business risk of these firms also affects the dividend payout as unforeseen advancements in technology change their operations and products. 

Question

What is the most likely signal that a company will send to its outside investors by increasing dividend payouts?

1. They will not pay bondholders.
2. The company is growing, and its share price will increase.
3. The company is under financial distress and is liquidating.

Solution

The correct answer is B.

An increase in cash is interpreted as a sign of increased profitability.

A is incorrect.  Bond indentures have covenants that ensure that dividends are paid from earnings and not a debt to reduce the risk of default. Thus, dividend payouts will not affect the payout to bondholders.

C is incorrect. A company under financial distress cannot increase dividends due to constrained cash flows.

Reading 18: Analysis of Dividends and Share Repurchases

LOS 18 (c) Describe the types of information(signals) that dividend initiations, increases, decreases, and omissions may convey.