dividen policy dan free cash flow.pdf

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Managerial FinanceVol. 36 No. 5, 2010pp. 394-413# Emerald Group Publishing Limited

0307-4358DOI 10.1108/03074351011039427

Dividend policy, signalling andfree cash flow: an integrated

approachRichard Fairchild

School of Management, University of Bath, Bath, UK

Abstract

Purpose Scholars have examined the importance of a firms dividend policy through two competingparadigms: the signalling hypothesis and the free cash-flow hypothesis. It has been argued that ourunderstanding of dividend policy is hindered by the lack of a model that integrates the two hypotheses.The purpose of this paper is to address this by developing a theoretical dividend model that combinesthe signalling and free cash-flow motives. The objective of the analysis is to shed light on the complexrelationship between dividend policy, managerial incentives and firm value.Design/methodology/approach In order to consider the complex nature of dividend policy, adividend signalling game is developed, in which managers possess more information than investorsabout the quality of the firm (asymmetric information), and may invest in value-reducing projects(moral hazard). Hence, the model combines signalling and free cash-flow motives for dividends.Furthermore, managerial communication and reputation effects are incorporated into the model.Findings Of particular interest is the case where a firm may need to cut dividends in order to investin a new value-creating project, but where the firm will be punished by the market, since investors arebehaviourally conditioned to believe that dividend cuts are bad news. This may result in firms refusingto cut dividends, hence passing up good projects. This paper demonstrates that managerialcommunication to investors about the reasons for the dividend cut, supported by managerial reputationeffects, may mitigate this problem. Real world examples are provided to illustrate the complexity ofdividend policy.Originality/value This work has been inspired by, and develops that of Fuller and Thakor, andFuller and Blau, which considers the signalling and free cash-flow motives for dividends. Whereas

those authors consider the case where firms only have new negative net present value (NPV) projectsavailable (so that dividend increases provide unambiguously positive signals to the market in both thesignalling and free cash-flow cases), in this papers model, the signals may be ambiguous, since firmsmay need to cut dividends to take positive NPV projects. Hence, the model assists in understanding thecomplexity of dividend policy.

Keywords Dividends, Corporate finances, Cash flow

Paper type Research paper

1. IntroductionNearly 50 years after Miller and Modiglianis (1961) famous dividend irrelevancetheorem, academics and practitioners still have little understanding of dividend policyand its effect on firm value. Indeed, Black (1976) observed, The harder we look at thedividend picture, the more it seems like a puzzle, with pieces that just dont fit

together. In this paper, we develop a dividend signalling model that attempts toanalyse the various factors that affect dividend policy and firm value.

According to Miller and Modiglianis (1961) theorem, the value of the firm isunaffected by its dividend policy in a world of perfect market conditions. Two majorassumptions driving the MM irrelevance theorem were that:

(1) A firms management is purely interested in maximizing share-holder value(there are no agency problems).

(2) Corporate insiders and outsiders share the same information about the firmsoperations and prospects (the symmetric information assumption).

The current issue and full text archive of this journal is available at

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Subsequent theoretical research has analysed the effects of incorporating asymmetricinformation and agency problems into the firms dividend decision. This resulted intwo competing approaches; the dividend signalling hypothesis, and the excess cash

hypothesis. Our dividend model incorporates both approaches.The signalling hypothesis states that under asymmetric information betweenmanagers and investors, dividend policy may provide signals regarding the firmscurrent performance and future prospects[1]. The free cash-flow hypothesis (alsoknown as the excess-cash hypothesis) states that dividend policies address agencyproblems between managers and outside investors (for example Easterbrook, 1984;

Jensen, 1986; Fluck, 1995). In particular, the agency problem in Jensens (1986) analysisarises from an empire building managers incentives to invest in negative net presentvalue (NPV) projects. Dividends alleviate this problem by reducing the free cash flowavailable to the manager. As noted by Fuller and Thakor (2002), both of thesehypotheses (signalling and free cash flow) support much (but not all) of the empiricalevidence that dividend increases (decreases) are good (bad) news, causing stock price

increases (decreases).Perhaps the reason why a solution to Blacks (1976) dividend puzzle remains so

elusive is that we lack an integrated theory that incorporates both the signalling andfree cash-flow motivations for dividends (Fuller and Thakor 2002; Fuller and Blau,2010). Fuller and Thakor (2002) sketch the first such integrated model. We build ontheir work by developing a dividend model that incorporates both asymmetricinformation and free cash-flow problems. Particularly, we consider a dual role fordividends. Dividends may provide a signal of current income to investors (hence themanager is motivated to choose a high dividend to provide a positive signal). However,in our analysis, a new project is available to the firm. If the firm wishes to invest in thisproject, it must get the funds from current income. Hence, in addition to the currentincome-signalling role, the level of dividends may also affect the managers ability to

invest in the new project. Hence, the manager may wish to cut dividends (to take agood, value-adding project), or he may wish to payout high dividends (to reduce thefree cash flow in order to commit not to take a bad, value-reducing project).

Our model contributes to Fuller and Thakors (FT 2002) analysis in the following ways.First, we develop the analysis, and derive the equilibria of the dividend game, in a formaland rigorous manner[2]. Second, FT only consider the possibility that a negative NPVproject exists. Hence, they focus on Jensens (1986) free cash-flow problem. In contrast, weconsider the possibility that the project may have a negativeorpositiveNPV. This enablesus to consider the following under-researched area. Although the majority of theoreticaland empirical work suggests that the relationship between dividends and share price ispositive (dividend increases are good news), Wooldridge and Ghosh (1998) have

suggested that, when a firm has strong growth opportunities available, dividend cuts maynot always be bad news. Conversely, dividend increases may be bad news. For example,Allen and Michaely (2002) argue, However, we note that with asymmetric information,dividends can also be viewed as bad news. Firms that pay dividends are the ones thathave no positive NPV projects in which to invest, and according to Black (1976), Perhapsa corporation that pays no dividends is demonstrating confidence that it has attractiveinvestment opportunities that might be missed if it paid dividends.

Hence, the relationship between dividends and firm value is complex. The marketmay view an increase in dividends favourably, either as a positive signal of currentincome (that is dividends reduce asymmetric information problems), or as a means of


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mitigating free cash-flow problems (that is dividends reduce agency problems).However, a dividend increase may be seen as a negative signal (the firm lacks growthopportunities), while a dividend cut may be seen as a positive signal (the firm hassignificant growth opportunities available). Our integrated signalling/excess cash-flow

model of dividends attempts to analyse all of these affects.Our third contribution is to consider two types of inefficiency (or agency problem)

relating to managerial incentives regarding dividend policy[3]. Firstly, we analyse amoral hazard problem in which empire-building managers may cut dividends in orderto invest in a negative (value-reducing) NPV project due to managerial private benefits.Secondly, we consider an adverse selection problem, whereby managers may refuse tocut dividends, hence passing up a positive NPV project[4]. Indeed, Cohen and Yagil(2006) identify a new type of agency cost of dividend: the sum of positive NPV projectsthat are abandoned in order to pay dividends.

Frankfurter and Wood (2002) observe that, in addition to analysing the effects ofagency and asymmetric information problems on dividend policy, researchers arebeginning to consider behavioural models. Theyobserve that,

Investor behavior is substantially influenced by societal norms and attitudes [. . .]. Accordingto Shiller (1989), including these influences in modeling efforts can enrich the development ofa theory to explain the endurance of corporate dividend policy.

Our fourth contribution is that we include a behavioural dimension in our model. Thatis, we consider investors who have been conditioned to believe that high dividendssignal high quality[5]. In our first case, the investors beliefs are indeed correct, as thehigh-quality firm can separate from the low-quality firm by paying a high dividend. Inthe second case, these beliefs drive the adverse selection problem (the high-quality firmis unwilling to reduce the dividend below that of the low-quality firm, since the marketthen mistakenly values this firm as low quality)[6].

As an extension to our second case, we consider whether the adverse selectionproblem can be mitigated by communication to investors, reinforced by managerialreputation effects. Indeed, Wooldridge and Ghosh (1998) argue that firms may be ableto avoid a negative market reaction by communicating to investors that the reason fordividend cuts is to invest in future growth opportunities. It may be argued that thismay be cheap-talk. However, Wooldridge and Ghosh argue that managerial reputationmay provide an important mechanism for providing credibility to corporate financedecisions.

The role of reputation in dividend policy has been explored by Brucato and Smith(1997) and Gillet et al. (2008). In Brucato and Smith, a reputable dividend signal is onewhere an unexpected dividend increase is confirmed by a subsequent unexpectedearnings increase. Similarly, in Gillet et al., the reputation mechanism is such that the

market punishes a firm that chooses a high dividend (in order to fool the market that itis a high-income firm), but subsequently reports low profitability. In contrast, in ourmodel, we consider the role of managerial reputation in allowing a firm to communicatethat it is cuttingthe dividend in order to invest in a new value-adding project.

The remainder of the paper is organized as follows. In section 2, we present ourmodel. In section 2.1, we consider our free cash-flow case. In section 2.2, we considerour adverse selection case, and consider the role of communication and reputation. Insection 4, we discuss practical and managerial implications of our model. Furthermore,in the light of our model, we consider some anecdotal evidence demonstrating thecomplexities surrounding dividend policy. Section 5 concludes.


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2. The modelWe consider an economy consisting of two all-equity firms[7] and a capital market.There is universal risk neutrality, and the risk-free rate is zero[8]. Firm i is run bymanager i2 G, B (for good and bad, respectively[9]). The timing of events is as

follows. Each firm enters the game with existing net income ofNi, withNg> Nb > 0.At the start of the game, the market cannot observe managerial type, and, in theabsence of signals, assigns an equal probability to each firm being of each type.

At the end of date 0, firm is net incomeNiis revealed to manageri, but not to theinvestors. The market becomes aware of a future investment opportunity (a newproject, denoted project n). Furthermore, the market knows that this project willachieve a date 2 return on equity.

At date 1, each manager imakes a committed dividend announcement (that is, heannounces a payout ofDi, to which he is committed). The two managers make theseannouncements simultaneously. The announcement has a signalling role (to bedescribed below), which affects firm value. At this stage, the manager receives

monetary compensation, as a fraction 2 [0, 1] of the date 1 firm value V1. Hence,dividend signalling is important to the manager, since it affects date 1 firm value, and,therefore affects managerial compensation.

At date 1.5, each manager pays out the dividend that was announced at date 1. Thesubsequent investment opportunity, project n, requires investment I2 (Nb, Ng]. If amanager has sufficient date 1 cash flow remaining (after paying the dividend), he isable to invest in the new project[10]. Therefore, managerBis unable to invest in projectn, regardless of his level of dividend payout, since Nb < I. ManagerGis able to investin the new project ifNg Dg I>Ng I Dg.

Alternatively, a manager can invest in financial securities at zero NPV.At date 2, if project 2 has been taken, it provides private benefits[11] to the manager of

b > 0, and it achieves net income I(1 ) in date 2. We consider two possibilities;

I(1 ) 0 (project 2 has positive or zero NPV), andI(1) < 0 (project 2 has negativeNPV). All of the date 2 net income is paid out as date 2 dividend, and the game ends.

We note that, since the manager has already received his monetary compensation atdate 1, he will invest in the new project at date 1.5 if he can (regardless of whetherI(1 ) 0 or I(1 ) < 0) in order to obtain the private benefits b > 0. Thisprovides a possiblemoral hazardproblem, and provides a potential role for dividendsas a commitment device not to take negative NPV projects (as in Jensen, 1986).

The manager has a date 1 compensation scheme,

MV1 B 1

where2

[0, 1] represents the managers compensation parameter (or equity stake),V1 is the managers date 1 monetary compensation, and B2 b, 0 are the date 2private benefits if the manager does or does not take project 2, respectively.

The managers objective is to choose dividends to maximize M given the othermanagers choice of dividends. We consider two cases; (a)Ng I> Nb(see section 2.1),and (b)Ng I< Nb(see section 2.2).

In the first case (Ng I> Nb), we consider a situation where the high-quality (high-income) firm can separate from the low-quality (low-income) firm by setting a higherdividend, and still be able to set a sufficiently low dividend to invest in the new projectif it wishes to. Therefore, dividends can solve the asymmetric information problem


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(that is, they can be used to signal current income). In this case, we focus on the role ofdividends in mitigating the agency problems of free cash flow.

In the second case (Ng I< Nb), we consider an adverse selection problem, where thehigh-quality firm cannot simultaneously cut dividends to invest in a new positive NPV

project, and separate from the low-quality firm. That is, sinceNg I< Nb, the bad firmcan mimic the good firms dividend if the good firm cuts the dividend to invest in the newproject. In this case, we consider the role of communication and managerial reputation.

2.1 Dividends as an unambiguous signal of quality (Ng I > Nb)SinceNg I> Nb, manager gis able to invest in the new project, and still separatefrom manager b by choosing a dividend in excess ofNb (which manager b cannotmimic). Note that this case allows us to focus our attention on the role of dividends inmitigating the agency problems of free cash flow.

We restrict our attention to the following dividend choices. Manager Bcan onlychoose[12] Db Nb. Manager G can choose a dividend D2 Nb, Ng I, Ng. Byrestricting our attention to these choices, we are able to consider the case where:

. managerGpays the same dividend as managerB;

. managerGpays a higher dividend than manager B, and is able to invest in thenew project; or

. managerGpays a higher dividend than managerB, and is unable to invest in thenew project.

In order to solve for the Bayesian equilibria of the dividend-signalling game, we need tospecify how the market updates its beliefs upon observing the managers dividendchoices[13]. We specify the following posterior beliefs. If both managers chose the samedividend, the market cannot update its beliefs. If one manager chooses a higherdividend than the other, the market believes that the manager who has chosen thehigher (lower) dividend is the good (bad) manager[14].

In P1, we consider the effect of the new projects return on equity (whichdetermines whether project 2 has positive or negative NPV) and the managers privatebenefits on the equilibrium dividend policies (we relegate all proofs to the Appendix).

P1. We take as given that investors believe that a high/low dividend combinationsignals a high-/low-quality firm. In the case that the difference between thehigh- and low-quality firm is sufficiently large (equivalently, the requiredinvestment for the new project is relatively small), Ng I> Nb the high-quality firm can separate from the low-quality firm by paying a higherdividend, and still invest in the new project if it wishes.

P1a. In the case that the new project has a positive NPV ( 0), a separatingequilibrium exists where the good manager chooses medium dividendlevel Dg Ng I, while the bad manager chooses low dividend levelDb Nb. This enables the good manager to separate from the badmanager by paying a higher dividend, while retaining enough cash toinvest in the new project.

P1b. If the new project has a negative NPV ( < 0), and the managerscompensation plus private benefits from the new project are positive(I b 0), a separating equilibrium exists where the good manager


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chooses medium dividend level Dg Ng I, while the bad managerchooses low dividend levelDb Nb. The good manager separates from thebad manager by paying medium dividends, and invests in the negativeNPV project due to managerial private benefits (moral hazard problem).

P1c. If the new project has a negative NPV ( < 0), and the managerscompensation plus private benefits from the new project are negative(I b < 0), a separating equilibrium exists where the good managerchooses high dividend levelDg Ng, while the bad manager chooses lowdividend level Db Nb. The good manager separates from the badmanager by paying high dividends, and commits to the market not toinvest in the negative NPV project (using dividends to mitigate the moralhazard problem).

Proof. See the Appendix.2.1.1 Cross-sectional effect of dividends on firm value.Fuller and Thakor (FT 2002),

and Fuller and Blau (2010), suggest that the cross-sectional relationship (that is acrossfirms) between dividends and firm value may be complex and non-monotonic. In thissection, we demonstrate that the results inP1support FTs hypothesis.

Figure 1 depicts the results inP1.The diagram considers a cross-section of firms, and demonstrates that the

relationship between dividends and firm value may be monotonic, or non-monotonic(as in FT 2002). Interval A represents firms run by B-type managers who pay thelowest dividend, and hence have the lowest firm value. Interval C represents firms runby G type managers, for whom I b < 0; managerial compensation is such thatthese managers choose the highest dividend to a) signal high current income, and b)commit to the market not to invest in the new negative NPV project.

Interval B represents firms run by G type managers, for whom I b 0;

managerial compensation is such that these managers choose a medium level ofdividends in order to invest in the new project. Now, if the new project has negativeNPV, firm value for these firms will be less than those in interval A or C (monotonic

FigureCross-sectio

relationship betwdividends and firm va


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relationship). However, if the new project has a positive NPV, firm value for these firmswill be higher than those in interval A or C (non-monotonic relationship).

2.2 Numerical example

We illustrate this case by way of a numerical example with the following parametervalues:Ng 400,Nb 100 andI 200. SinceNg I> Nb, managerGis able to cutdividends to invest in the new project, and separate from manager Bby paying ahigher dividend. As noted in P1, when the project has positive NPV, manager Gwillpay the medium dividend to invest in the new project while separating from managerB. When the project has negative NPV, manager Gs incentive to pay the mediumdividend (to invest in the new project) or the high dividend (to commit not to take thenew project) depends on his equity compensation and his private benefits. In order toexamine this, we consider the case where the managerial compensation (equity)parameter is 0.5. Furthermore, we consider two possibilities for managerialprivate benefits from investing in the new project; b 2 0.50.

We consider two possibilities for the return on the new project; 10 per cent(positive NPV), and 10 per cent (negative NPV).

. When the project has a positive NPV, P1a revealed that manager Gchooses themedium dividendDg Ng I 200 to invest in the new project. Firm value isV NgI 400 0.1(200) 420.

. If the new project has a negative NPV, P1brevealed that managerGchooses themedium dividend Dg Ng I 200 to invest in the new project ifI b 0. This is indeed the case in our example withb 50. Firm value isV NgI 400 0.1(200) 380.

. If the new project has a negative NPV and b 0, then manager G pays thehigh dividendD

gN

g400 to commit not to take the new project (seeP1c). Firm

value is V Ng 400.

In all cases,Db Nb 100, and firm value isVb 100.For clarity, we have inserted these numerical values into Figure 1.

2.3 Dividends as an ambiguous signal of quality: Ng I < NbIn our second case, we focus on the case where > 0 (new project has positive NPV),andB 0 (the manager has zero private benefits). In contrast to the previous case, wefocus on the agency problems associated with a manager refusing to cut the dividend,thereby passing up a positive NPV project (see Cohen and Yagil, 2006).

We consider the following possible dividend levels; Di2 Ng I, Nb,Ng. That is, if

managerGchooses low dividendNg Iin order to invest in the new project, managerBcan mimic him.We specify the following market beliefs:

. If the market observes that both firms have chosen the same dividend level, themarket is unable to update its beliefs, and continues to assign an equalprobability to the firms beinggor b.

. If the market observes thatDi Nb, withDj Ng I, the market believes thatfirm iis the good firm, and firm b is the bad firm. Hence, the market has beenconditioned to believe that high dividends signal high quality.


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. If the market observes that Di Ng, withDj Nb, orDj Ng I, the market(correctly) believes that firm iis the good firm (since firm Bcannot afford topayoutNg), and firmjis the bad firm.

Using these beliefs, we derive the following equilibria (see the Appendix for the proof).P2. We take as given that investors believe that a high/low dividend combination

signals a high-/low-quality firm. In the case that the difference between thehigh-quality and low-quality firm is low (equivalently, the required investmentfor the new project is relatively large), Ng I< Nb, the high-quality firmcannot cut the dividend to take the new project, and, at the same time, separatefrom the low-quality firm by paying a higher dividend.

P2a. If the new projects positive NPV exceeds the negative adverse selectioneffect (I> Ng Nb), two equilibria exist: (i) a pooling equilibrium whereboth managers pay the low dividend; Dg Db Ng I, and (ii) aseparating equilibrium where the good manager chooses the high

dividendDg Ngand the bad manager chooses the medium dividendDb Ng I. In (i), manager G cuts the dividend in order to invest in thenew project. Manager B mimics manager Gs dividend choice, but isunable to invest in the new project. In (ii), manager G refuses to cut thedividend to take the new project, thereby passing up a good positive NPVinvestment opportunity.

P2b. If the negative adverse selection effect exceeds the new projects positiveNPV (I< Ng Nb), a separating equilibrium exists where the goodmanager chooses the high dividend Dg Ng and the bad managerchooses the medium dividend Db Nb. Manager G refuses to cut thedividend to take the new project, thereby passing up a good positive NPV

investment opportunity.

Proof. See the Appendix.For the remainder of this analysis, we focus onP2b; that is, managerGrefuses to cut

the dividend in order to invest in a positive NPV project, due to the adverse selectioneffect (manager B would mimic the low dividend). We now consider the role ofcorporate communication and reputation in enabling the good manager to cut thedividend in order to invest in the new project.

First, we note that P2is supported by irrational/behavioural beliefs. That is, themarket has been conditioned to believe that higher quality firms pay higher dividends:we could appeal to catering theory (Baker and Wurgler, 2004), where investors mayirrationally believe that the best firms pay dividends. Therefore, manager Grefuses tocut dividends, passing up a positive NPV project.

We now develop the game to incorporate corporate communication and reputationat the date 1 dividend announcement stage. Specifically, if manager iannounces adividend ofDi Ng I, the market is unsure whether this represents the low-incomefirm, or the high-income firm cutting the dividend in order to invest in the new positiveNPV project.

At this stage, the manager can communicate (at zero cost) to the market that it is thegood firm, and that he has set the low dividend in order to invest in the new project(and not because it has low current income).


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At date 2, the market observes firm type. The manager that has communicated andlied (manager b) suffers a reputation loss r. For example, Appendix equation (A.2)becomes B Ng Nb I=2 r:That is, the bad manager mimics the goodmanager by choosing Di Ng I, so that he achieves a pooled compensation at

date 1, but then suffers a reputation lossrwhen his type is revealed at date 2[15].We focus on the case where the reputation effect is strong enough for the good

manager to be able to cut the dividend without fear of manager Bmimicking; that is,we assume that[16] r> Ng Nb=2 I :We obtain the following result.

P3. Consider the case where the negative adverse selection effect exceeds the newprojects positive NPV (I< Ng Nb), such that the good manager refuses to cutthe dividend to invest in the new project. Now allow the manager to educate, andcommunicate to, the market that dividend cuts are to invest in new positive NPVprojects, thus altering the markets posterior beliefs. Given thatr> Ng Nb=2 I (the reputation effect is sufficiently strong to prevent thebad manager from mimicking), the separating equilibrium isDg* Ng I, and

Db* Nb > Dg*. The good manager chooses the low dividend in order to investin the new project, and the bad manager chooses the medium dividend.

Proof. See the Appendix.2.2.1 Cross-sectional Effect of dividends on firm valueThe cross-sectional effect of

dividends on firm value is demonstrated in Figure 2.Figure 2 demonstrates that, if manager Gcan credibly communicate that he has cut

the dividend in order to invest in the new project, the cross-sectional relationshipbetween dividends and firm value may be negative.

3. Extension to model: repeated dividend game[17]Thus far in the analysis, we have taken the investors beliefs as exogenously given(that is, we assume that investors believe that a high/low dividend combination signalsa high-/low-quality firm: seeP1andP2). Furthermore, we have focused on a static, one-shot, dividend choice, thereby examining the cross-sectional effect of dividends onvaluation cross firms.

In this section, we consider a repeated dividend game which seeks to explain howinvestors beliefs (that high/low dividends signal high-/low-quality firms) may be

Figure 2.Cross-sectionalrelationship betweendividends and firm valuewhen managerialcommunication is credible


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formed over time. In order to do so, we focus on dividends as an ambiguous signal ofquality (see section 2.2, whereNg I< Nb). Furthermore, we focus onP2b, where thenegative adverse selection effect exceeds the new projects positive NPV (see P2b,where I< Ng Nb). Recall that this means that, if the investors have been

conditioned over time to believe that high/low dividends signal high-/low-qualityfirms, then, in the absence of reputation or communication, the manager of the goodfirm will refuse to cut dividends to take the new project. This provides the interest inour repeated dividend game.To keep the analysis as simple as possible, our repeated dividend game consists of twostages. Furthermore, we incorporate the following behavioural factor. At the start ofstage 1, neither of the firms (or the market) realize that the game will enter a secondstage (the managers of the firms suffer from myopia/bounded rationality). Under thisassumption, we can solve stage 1 before considering stage 2[18]. Furthermore, atstage 1, the new investment opportunity does not exist (therefore, investors areunaware that dividend policy may affect future investment and growth).

In the first stage, our two firms (high and low quality) achieve a stage 1 income Ngand Nb, respectively. The market cannot observe these firm types. In the absence of

signals, the market assigns equal probability to these types.At date 0 of stage 1, firmGand firmBsimultaneously announce whether they will

pay a high or low dividend;Di2 Ng,Nb. As in our previous analysis, a firm cannot paymore than its stage 1 income (see[10]). The market updates its beliefs about firm type.We specify that the market believes that a high/low combination signals a high-/low-quality firm (this isnotan assumption: see[13]).

At date 1 of stage 1, the market observes firm income, and investors receive the firststage dividends.

Before considering the second stage of the game, we solve for stage 1. The managerssimultaneously choose dividendsDi2 Nb,Ngto maximize the managerial payoff:

MV1 2

Since a firm cannot pay more than its current income as dividends, we only need toconsider two possibilities:

(1) both firms pay the same dividend;Di2 Nb,Nb; and

(2) the good firm pays a higher dividend than the bad firm;Db Nb,Dg Ng.

Given the market beliefs that high (low) dividends signal a good (bad) firm, if bothchooseDi2 Nb,Nb, then

MGMBNg Nb

2 3

If the bad firm choosesDb Nb, and good firm choosesDg Ng, then

MBNb 4

MGNg 5

Comparing (5) and (3), it is trivial to note that it is optimal for firmGto choose the highdividend to separate from firm B, who is restricted to the low dividend. Hence, in the


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(separating) equilibrium, the stage 1 dividends are Db Nb, Dg Ng. The marketupdates its beliefs, and the stage 1 firm values becomeVB Nb, VG Ng.

Finally, at the end of stage 1, the market observes firm Gs and firmBs income, andinvestors beliefs (that a high/low dividend combination signals a high-/low-quality

firm) are confirmed. We take these beliefs into the second stage of the game, asdescribed below.

We now enter stage 2 of the game. Stage 2 is identical to the model described at thestart of section 2 (the model). At stage 2, the firms realize that they are operating for asecond period. Furthermore, at this stage, they become aware of the new investmentopportunity.

At this stage, we introduce a further behavioural factor. The market forgets which firmis type Gor type B(otherwise there is no role for dividend signalling in stage 2), butremembers that the better firm paid the higher dividend. Investors take this belief intostage 2 (therefore, investors have beenconditionedto believe that higher dividends signalhigher quality). As noted, we focus on the adverse selection problem, where, in the absenceof communication or reputation, the high-quality manager refuses to cut the dividend totake the new project (P2b). Effectively, dividends have become sticky. Since investorshave been conditioned, by past performance and past dividend policy, to believe that highdividends signal a high-quality firm, the good manager refuses to cut dividends to investin growth[19]. Now, reputation and communication become important (as inP3).

4. Practical and managerial implicationsOur dividend signalling model demonstrates that dividend policy is indeed complex.We have demonstrated that high dividends may have a positive effect on firm value,both by providing a positive signal of current performance (in terms of currentincome), and in reducing the free cash-flow problem (that is, the temptation for themanager to invest in negative NPV projects due to private benefits). However, when

good positive NPV investment opportunities are available, a high dividend may indeedbe value reducing if it prevents firms from being able to make these investments[20].However, management may refuse to cut dividends, thereby passing up these

positive NPV opportunities, especially if the stock market has been conditioned tobelieve that high dividends signal a high-quality firm. Our model thus emphasizedmanagerial communication/education of investors, supported by managerialreputation considerations, as a means of eliminating this problem.

We now consider some anecdotal evidence that provides a practical perspective toour theory, and demonstrates the real-world confusion surrounding dividend policy.

4.1 The traditional positive relationship between dividends and firm valueLease et al. (2000) provide the following examples where the market reacted in the

standard way, that is, positively (negatively) to dividend increases (decreases):

Figgie International announced a cut in its quarterly dividend. [. . .] on the announcementFiggies stock price declined. [. . .] Bethlehem Steel Corporation announced that it wasomitting its quarterly dividend. [. . .] Its share price fell.[. . .] Wal-Mart Stores announced anincrease in its quarterly dividend. [. . .] Wal-Marts share price increased. [. . .] Procter andGamble Company announced an annual dividend increase [. . .] on the announcement, P andGs share price increased.

However, Lease et al. (2000) demonstrate that management understands that highdividends may restrict corporate investment in value-creation:


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Elisabeth Goth, a dissident member of the family that controls Dow Jones and Co., raisesquestions about its dividend policy, contending that Dow Jones has increased its dividends atthe expense of re-investing its earnings to fuel future growth.

However, shareholders who enjoyed stock run-ups and rising dividends in the 1980s

are unhappy that Bell CEOs want to curb dividend growth and use profits to improvetheir networks and diversify at home and abroad. This suggests that investors mayunderstand that dividends may need to be cut to invest in company growth, but theystill demand dividends.

4.2 Dividend cuts are not always bad news!Our analysis revealed that dividend cuts are not always bad news, especially when afirm has significant growth opportunities available. However, we demonstrated thatmanagers may refuse to cut dividends for fear of negative market reaction (which maybe driven by investors being behaviourally conditioned to believe that dividend cutsare bad news). Our model suggested that the problem may be mitigated if managers

can communicate the reasons for dividend cuts (to invest in new value-addingprojects), supported by managerial reputation effects. Indeed, Cohen and Yagils (2006)international survey of CFOs of major companies in USA, UK, Germany, Canada and

Japan reveals that this agency problem exists. The authors argue that managersshould consider two factors when deciding whether to cut dividends:

(1) How sensitive is the stock price to dividend changes (the adverse selectionproblem)?

(2) To what extent can managers transfer information (that is communicate) aboutthe profitable investment opportunity so that investors will understand thereason for the dividend increase?

Indeed, they state:

If the managers believe that the reason for the dividend cut can be effectively communicatedto investors in such a manner that it would not result in a dramatic stock price decrease, thenthey should prefer investing over paying the full amount of the dividend. On the other hand, ifthey believe that a drastic decline in the stock price may occur, then they should continue withthe normal dividend plan and postpone the investment opportunity. The flow ofinformation factor should be derived from the structural investors relations networks andfrom past experience.

Leaseet al.consider two examples of firms changing their dividend policy; Windermere-Durable Holdings, Inc., and Compaq Computer Corporation. Windermere-DurableHoldings, Inc., announced that it was cutting the dividend in order to re-invest allearnings into the business, following a re-evaluation of its dividend policy in light of the

Companys strategic repositioning for growth and the resulting cash requirement.On the release of the dividend-cut announcement, the firms share price increasedfrom $18.25 to $19.00 (hence, the dividend cut, supported by positive communication tothe market, was seen as good news). In contrast, Compaq Computer Corporation paid adividend for the first time in 1997, causing its share price to fall (a dividend initiationwas seen as a bad news signal that the company had run out of good investmentopportunities).

Wooldridge and Ghosh (1998) emphasize the importance of corporatecommunication and managerial reputation when cutting dividends to invest in growth.They compare the cases of Gould Inc. and ITT. In 1983, Gould Inc. announced that it


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was cutting its quarterly dividend in order to conserve cash that can be used tofinance the growth of its electronic businesses [. . .] the board set the new dividend inthe light of the companys transition to a high-technology firm. On the day of theannouncement, its share price increased.

In contrast, ITT announced a 64 per cent cut in its dividend payment, explainingthat its dividend level had become inconsistent with the intensely competitive high-technology environment. ITTs share price fell[21].

5. ConclusionWe have developed a dividend-signalling model that begins to address Fisher Blacks(1976) dividend puzzle. We demonstrated that the relationship between managerialincentives, dividend policy and firm value is indeed complex. In our model, dividendsserved a dual purpose. They signalled current income, and they affected the firmsability to invest in new projects. We therefore argued that dividends may provideconfusing signals to investors, who may view an increase in dividends favourably,either as a positive signal of current income (that is dividends reduce asymmetric

information problems), or as a means of mitigating free-cash-flow problems (that isdividends reduce agency problems). However, a dividend increase may be seen as anegative signal (the firm lacks growth opportunities), while a dividend cut may be seenas a positive signal (the firm has significant growth opportunities available).

Our model identified two potential agency problems associated with dividendpolicy. First, the manager may cut dividends in order to invest in a negative NPVproject, due to private benefits. Second, the manager may be unwilling to reducedividends to take a positive NPV project, since he is concerned with the negative signalof current income. We suggested that the latter problem may be mitigated bycommunication to investors, reinforced by managerial reputation effects.

We believe that our integrated model has provided a springboard for futuretheoretical and empirical research into the complex nature of corporate dividend policy.

Notes

1. See, for example, Bhattacharya (1979), Miller and Rock (1985), John and Williams (1985)and Ambarish et al. (1987).

2. We note that Fuller and Blau (2010) also developed a formal and rigorous integratedmodel, independently of ours (we became aware of their paper as we were completingours). However, our model has several differences compared with theirs, as outlined below.

3. Our model is integrated in the sense that it combines both the signalling and free cash-flow effects of dividend policy. However, for the sake of clarity and tractability, weconsider these two agency problems as separate cases within the framework of our model.

4. This adverse selection problem is similar to that analysed by Myers and Majluf (1984).

In their analysis, the adverse selection problem relates to a manager of a good firmrefusing to issue undervalued equity, hence passing up a good investment opportunity.

5. We do not model this behavioural factor in any deep way. Models that considerpsychological underpinnings are Baker and Wurgler 2004 (dividend catering), andShefrin and Statman 1984 (self-control).

6. Note that we discuss the refusal to cut dividends in more depth, and consider real-worldexamples, in section 3.

7. It is common in theoretical analysis of corporate finance policy to focus on one decision,holding other decisions constant. In this paper, we wish to focus on the dividend decision,without the complication of capital structure. Hence, we make the standard assumption


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that firms are all equity. It is worth noting that some scholars have considered thedividend and debt/equity decision jointly. For instance, Jensen (1986) considers the role ofdividends and debt as substitutes for each other in controlling managerial free cash-flowproblems (whereas we focus on dividends). Furthermore, Easterbrook (1984) discusses a

firms simultaneous decision to finance increased dividends by re-visiting the capitalmarket, hence reducing agency problems by subjecting itself to market scrutiny. Finally,Agrawal and Mandelker (1987), Agrawal and Nagarajan (1990) and Agrawal and

Jayaraman (1994) empirically examine all-equity US firms, and suggest that these firmshave higher dividends than those with debt. They argue that this supports Jensens (1986)argument that these firms are substituting dividends for debt.

In this paper, if we allow firms to re-visit the capital market, then our dividendsignalling model would break down, as the bad firm could pay more dividends thanincome, simply by borrowing or issuing equity. Furthermore, our firms could alleviatethe free cash-flow problem by issuing debt rather than paying dividends. In order to keepthe analysis clean, and to focus on dividend policy, we implicitly assume that visits tothe capital market are prohibitively costly (see[10]), so that: (i) firms prefer an all-equitystructure to one including debt, and (ii) firms must use internally generated cash to pay

dividends and/or invest in future projects. Note that this essentially is the approachadopted by Miller and Rock (1985).

8. Hence, agents are only concerned with expected cash flows (and not the associatedvariance), and the market discounts future cash flows at a zero discount rate.

9. Throughout the analysis, we refer to the firm run by the good manager as highquality and the firm run by the bad manager as low quality.

10. It is assumed that the manager is unable to return to the capital market to raise therequired funds for the new project.

11. A commonly analysed agency problem is that of managers receiving private benefitsfrom running a project, in addition to, and independently of, the monetary benefits,such as equity stakes. Indeed, Jensen (1986) discusses how managers might waste freecash flows on large, empire-building, projects, due to the private benefits that they

obtain, even though these projects may be value reducing.12. Recall that managerBis unable to invest in the new project. He therefore has the choice

of investing his cash flow Nbin the financial markets or as a dividend. We assume thathe pays it all as dividend.

13. When solving a Bayesian dividend-signalling game, the steps are as follows: we needto specify how the market updates its beliefs upon observing the firms simultaneousdividend choices; given these beliefs, we need to work out how the managers choice ofdividends will affect their payoffs; we need to consider each managers best responseto the others strategies; and we need to demonstrate that, in equilibrium, the managersbehaviour is consistent with the beliefs (see Appendix A.2 for a worked example). Notethat these beliefs are not assumptions, but are carefully considered and thoughtthrough by the modeller. Indeed, Rasmusen argues that the skill of the modeller of a

signalling game lies in specifying beliefs that are consistent with the equilibrium of thegame.

14. In this case, we will demonstrate that investors are correct in this belief. In case 2below, we consider how investors, conditioned to believe that high dividends signalhigh quality, lead to an adverse selection model, where the high-quality firm refuses tocut dividends to take the positive NPV project. We then consider the effects ofcommunication and reputation.

15. Please see the appendix for all of the payoffs for the various dividend combinations.

16. Note that if we do not make this assumption regarding the reputation parameter, thegame becomes much more complex. We leave analysis of this for future research.


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17. We are grateful to an anonymous referee for suggesting this interesting extension to themodel.

18. This is in contrast to the normal procedure for solving games, which involvesbackward induction from the very end of the game (we would have had to employ this

method if the firms and the investors had perfect foresight from the beginning of thegame to the end of stage 2).

19. There is considerable evidence that dividends are sticky; that is, once firms haveincreased dividends, they find it difficult to cut them again, even when they need to doso to invest in new projects. Lintner (1956) was the first to identify this feature, whichhe termed dividend smoothing.

20. In our models, there is never an incentive for firms to pay high dividends that lead to areduction in value. An equilibrium does exist where firms refuse to cut dividends totake a value-adding project. Therefore, high dividends are not actually value reducingin our model, but they mean that firms are foregoing value creation, since they arepassing up positive NPV projects. In reality, there are cases of firms increasingdividends, and seeing firm value fall: e.g. Microsoft paid a dividend for the first time in2003, and its share price fell dramatically. I think Microsoft is sending a message toshareholders that the story has changed from one of a high-growth company to amature company [. . .] The day Microsoft declares a cash dividend is the day people nolonger think of it as a growth stock. (web source: Microsofts Dividend Signals a NewEra for Company. Helen Jung, 20 January 2003).

21. For an interesting discussion on dividend policy, and the trade-off between payingdividends and investing for growth, see A Discussion of Corporate Dividend Policy inSix Roundtable Discussions of Corporate Finance, edited by Joel Stern. In thischapter, academics and practitioners discuss whether firms should pay a high level ofdividends when they have significant growth opportunities. The general academicview is that dividends should be cut. Interestingly, the practitioner view is that the firmshould cater to investors with high dividends, thereby eschewing profitableinvestments. Stern argues for cutting the dividend, and emphasizes the role of

communication and reputation.22. Recall that if managerGcan invest in the new project, he will.

23. Note that, if Assumption 1 was violated, then (A.1) would exceed (A.2). Now, the newproject would have such a large negative NPV that, if manager G was choosingbetweenDg Nb and Dg Ng I, he would prefer to choose Dg Nb to mimic thebad manager (in order to reduce the markets assessment that he will be able to take thenew project). In order to avoid this strange outcome, we maintain Assumption 1.

24. In game theory, a normal form game is a table that represents the interaction ofsimultaneous strategic decisions by two players, and the payoffs associated with thosechoices. In the Appendix table, the left-hand column represents the dividend choices offirm G. The top row represents the dividend choices of firm B, and the cell numbersrepresent the subsequent payoff equations from the combination of the two firms

choices. The firms make their choices simultaneously. Therefore, each player cannotobserve the other players decision when making its own choice, and so must attempt tosecond-guess what the other player will do. We solve such games by considering eachplayers best response to each of the other players choices (for example, firm Basksitself, If I expect firmGto choose Dg Ng I, what is it optimal for me to do. Eachfirm makes such calculation for each of the other firms choices. This leads to an iterativeprocess of expectations and counter-expectations (if I expect my opponent to do X, it isbest for me to do Y. If he is expecting me to respond to X by doing Y, he will do Z, so Iwill respond to Z by doing. . .). In a Nash equilibrium, both players are optimizing, giventhis iterative process, and there is no incentive for either player to unilaterally deviatefrom the equilibrium strategies, since that player will then be worse off.


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Myers, S. and Majluf, N.S. (1984), Corporate financing and investment decisions when firmshave information that investors do not have,Journal of Financial Economics, Vol. 13 No. 2,pp. 187-221.

Shefrin, H. and Statman, M. (1984), Explaining investor preference for cash dividends, Journal

of Financial Economics, Vol. 13, pp. 253-82.Wooldridge, J.R. and Ghosh, C. (1998), Dividend cuts: do they always signal bad news?, in Chew,

D.H. and Stern, J.M. (Eds), The Revolution in Corporate Finance, 3rd ed., BlackwellPublishers, Malden, MA, pp. 143-50.

Further reading

Chew, D.H. Jr (Ed.) (1986), Six Roundtable Discussions of Corporate Finance with Joel Stern,Quorum Books, New York, NY.

Appendix

Proof of P1Manager Bmust choose Db Nb. Manager G chooses a dividend from Dg2 Nb, Ng I, Ng.ManagerGand managerBchoose their dividend levels simultaneously.

Consider manager Gs best response to Db Nb, given the markets posterior beliefs (uponobserving the two managers dividend choices). If managerGpools with managerBby choosing

Dg Nb(such that managerGis able to invest in the new project[22]), the market is unable toupdate its beliefs (continuing to assign equal probability to each manager being of each type, Gor B). Therefore, the date 1 market value of each firm is determined by the market beliefs thatthere is an equal probability of each firm having current cash flow ofNgor Nb, and a probabilityof 0.5 of each firm being able to invest in the new project. Since managerGhas chosen, thereforemanagerGs date 1 payoff is

YG

V1 b Ng Nb I

2

b A:1

If managerGseparates from managerBby choosingDg Ng I, the market updates its beliefsto (correctly) assess him as manager G. Furthermore, the manager is able to invest in the newproject (which the market incorporates into its date 1 valuation). Therefore, managerGs payoff is

YG

Ng I b A:2

If the manager separates from manager Bby choosing Dg Ng, again, the market updates itsbeliefs to (correctly) assess him as managerG. In contrast to above, the manager is nowunable toinvest in the new project (and the market is aware of this). Therefore, managerGs payoff is now

YG

Ng A:3

Assumption 1. I > Nb Ng, ensures that (A.2) > (A.1). This assumption sets alower limit for the possible negative value of the new project, andensures that, if manager G is choosing between Dg Nb andDg Ng I, he will prefer to chooseDg Ng Ito separate fromthe bad manager (so that the market will be aware that his firm hashigh current income and will be able to invest in the new project)[23].

Since (A.2) > (A.1), we only need to compare (A.2) and (A.3). Manager Gprefers to chooseDg Ng I (in order to separate from manager Band be able to take the new project) if(A.2) > (A.3) > I b > 0. He prefers to choose Dg Ng (in order to separate from


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manager B, and commit to the market not to take the new project) if (A.3) > (A.2) >I b < 0. This provesP1.

Proof of P2

We solve the following normal form[24] game (the first number in each cell represents managerGs payoff, and the second number in each cell represents manager Bs payoff. representsmanagerGs best responses, represents managerBs best responses. In this table, we have onlydemonstrated the definite best responses (see[24]), which are invariant to the parameters of themodel).

We assume the following regarding the markets posterior beliefs (that is, the markets updatedbeliefs, having observed the two firms dividend decisions). If the market observes that bothmanagers choose the same dividend, the market is unable to update its beliefs (and, therefore,continues to assign equal probability to each manager being of each type). If the market observesdifferent dividend choices, the market believes that the manager Gpays the higher dividend.Given these beliefs, the market valuation of the two firms is updated. Given that each managerreceives a fraction 2 [0, 1] of the updated market value, the payoffs are as follows (where (T1)refers to table payoff 1):

YG

Ng Nb I

2

T1

YB

Ng Nb I

2

T2

YG

Nb T3

YB

NG T4

YG

NG T5

YB

NB T6

YG

Ng Nb

2

T7

YB

Ng Nb

2

T8

G\B Db NgI Db Nb

Dg Ng I 1, 2 3, 4DgNb 5, 6 7, 8DgNg 9, 10 11, 12


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YB

Ng Nb I

2

r T20

YG Ng I T3

0

YB

Nb T40

YG

Nb T50

YB

Ng I r T60

Under the assumption that r> Ng Nb=2 I , it can be demonstrated that managerBsdominant strategy is to chooseDb Nb. (In particular, the reputation effect is strong enough toprevent him from mimicking manager G.) Given this dominant strategy, manager Gs bestresponse is to chooseDG Ng I. Therefore, the equilibrium isDG* Ng I.Db* Nb.

This provesP3.

Corresponding authorRichard Fairchild can be contacted at: [email protected]

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