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.
