A Note on the Information Content of Corporate Dividend Policy

Abstract

This note discusses the significance of the information content of dividends, which is reflected through the market price reactions to a firm’s dividend decisions. Informational asymmetries are the main reason for signaling whereby firm managers are likely to have better information than external participants, implying that their financial decisions will tend to convey the firm’s future prospects to the market. An efficient signaling equilibrium is that optimal combination of signaling costs and agency costs that minimizes any dissipative costs. An important consideration is the preference of the investor for dividend income versus capital gains due to the higher tax differential in the case of dividends. There are two major types of asymmetric information: adverse selection and moral hazard. In adverse selection, the managers of a company have more information on hand relating to the firm’s future prospects and current situation than outsiders or external investors. This may lead them to exploit their advantage at the cost of others. For example, they may choose to manage the amount of information released to investors, thus affecting the latter’s decision to make a certain investment. This can affect investors’ ability to make good investment decisions. Signaling is one mechanism that can be used to resolve the problem of adverse selection. Another mechanism used to control this problem is financial reporting, which credibly converts inside information into public information. The other issue arising from asymmetric information is moral hazard, which is initiated by the separation of ownership and control in most medium and large businesses. Shareholders cannot necessarily observe the extent and quality of top managerial effort made directly on their behalf. Managers may, therefore, take advantage of this and compromise on the quality of their effort.