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Dividend and signaling Dividend signaling is an important topic because by paying dividends a firm can prove it is able to generate cash, not just accounting profits. In turn, by revealing its profitability in this manner, the firm can be differentiated from less profitable firms. Another reason signaling is important to management is that it has an incentive to perform well enough to maintain its dividend and avoid the adverse consequences of a dividend cut or equity issues to replace funds paid out. Bhattacharya (1979) presents the first major dividend signaling paper. Bhattacharya assumes outside investors have imperfect information about the firm's profitability, and that cash dividends are taxed at a higher rate than capital gains. Under these conditions, dividends function as a signal of expected cash flows. The major disipitative costs that cause dividends to function as signals arise because dividends are taxed at the ordinary income tax rate, whereas capital gains are taxed at a lower rate. Bhattacharya's result concerning the shareholders' planning horizon is that the shorter the horizons over which the shareholders have to realize their wealth, the higher the equilibrium proportion of dividends to expected earnings. In the Bhattacharya (1979) model the announcement effects of dividend increases are positive. Dividend payouts are lower, with larger adverse tax consequences and higher flotation costs of external financing. John and Williams (1985) explain why it may be optimal for a firm to pay cash dividends and raise new equity financing or repurchase stock in the same planning period. In their model, dividends are paid to reduce the underpricing of the securities issued to raise new outside financing. Miller and Rock (1985) examine dividends net of external financing and their analysis focuses on the following key issues: the earnings announcement, the dividend announcement, the financing announcement and the impact of a firm's policies on an optimal investment level. Miller and Rock find that earnings surprises and net dividend surprises convey the same information. The financing announcement effect is merely the dividend announcement effect, but with the sign reversed. An unexpected increase in dividends will increase shareholders' wealth, and an unexpected issue of new equity or debt will be interpreted as bad news about future prospects of the firm. Miller and Rock's signaling approach shows that announcement effects emerge naturally as implications of the basic valuation model rather than as an appendage. Ambarish, John and Williams (1987) construct an efficient signaling equilibrium with dividends and investments identifying its properties. Such a study is an attempt to answer questions such as why do dividends persist despite their dissipative costs; what are the announcement effects in more realistic problems with multiple signals; and why should corporate insiders signal with dividends when less costly mechanisms can convey credible private information to the market. In this somewhat theoretical paper, there are three main results which the authors obtain. First of all, under equilibrium conditions some firms signal with both dividends and investment. Second, when investment is fixed the announcement effects of dividend payments are positive. Finally, if the dividends are fixed, the announcement effect of investment is negative for firms with asymmetric information primarily from assets in place and positive for firms with opportunities to invest.
