Dividends Policy

A theory suggests that firms can use dividend policy to signal their quality. Why may dividend payments be credible signals of firm quality? What are the predictions of this theory?

Payout ratios (total cash payments/earnings) differ across industries. They are higher in mature industries

and are related to industry growth rate, investment opportunities and the degree of regulation (utility firms have very high payout ratios).

In recent years dividend payments have declined that is partly due to the fact that most recently listed firms are small with high investment opportunities but low profitability and so they are less likely to pay dividends large profitable industrial firms pay higher dividends Stock prices react positively to announcements of dividend increases or share repurchases and negatively to announcements of dividend decreases. Changes in long-run, sustainable earnings are the most important determinant of changes in dividends.

Therefore, firms seem to increase dividends only if they are reasonably sure that they will be able to maintain them permanently at the new level.

MM Proposition (1961): For a given investment schedule, the market value of the firm is independent of

its dividend (payout) policy.

the current firm value is affected positively by the dividends paid out and the firm value next period and negatively by the new capital raised.

Dividends as a Signal of Firm Quality Key Points:

• Good firms cannot credibly signal their quality without incurring a cost. If the signal is costless, the bad firms will always mimic the good ones.

• Dividend payments are costly both for good and bad firms but more so for bad firms.

• By increasing the dividend they promise to pay, good firms can reveal their quality because it is prohibitively costly for bad firms to mimic.

• Good firms are willing to pay high dividends to separate themselves because the benefit of separation

(higher share price) exceeds the cost (of costly outside...