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MF 36,5

Dividend policy, signalling and free cash flow: an integrated approach
Richard Fairchild
School of Management, University of Bath, Bath, UK
Abstract
Purpose – Scholars have examined the importance of a firm’s dividend policy through two competing paradigms: the signalling hypothesis and the free cash-flow hypothesis. It has been argued that our understanding 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 combines the signalling and free cash-flow motives. The objective of the analysis is to shed light on the complex relationship between dividend policy, managerial incentives and firm value. Design/methodology/approach – In order to consider the complex nature of dividend policy, a dividend signalling game is developed, in which managers possess more information than investors about 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 invest in a new value-creating project, but where the firm will be punished by the market, since investors are behaviourally conditioned to believe that dividend cuts are bad news. This may result in firms refusing to cut dividends, hence passing up good projects. This paper demonstrates that managerial communication to investors about the reasons for the dividend cut, supported by managerial reputation effects, may mitigate this problem. Real world examples are provided to illustrate the complexity of dividend policy. Originality/value – This work has been inspired by, and develops that of Fuller and Thakor, and Fuller 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) projects available (so that dividend increases provide unambiguously positive signals to the market in both the signalling and free cash-flow cases), in this paper’s model, the signals may be ambiguous, since firms may need to cut dividends to take positive NPV projects. Hence, the model assists in understanding the complexity of dividend policy. Keywords Dividends, Corporate finances, Cash flow Paper type Research paper

394

1. Introduction Nearly 50 years after Miller and Modigliani’s (1961) famous dividend irrelevance theorem, academics and practitioners still have little understanding of dividend policy and its effect on firm value. Indeed, Black (1976) observed, ‘‘The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together’’. In this paper, we develop a dividend signalling model that attempts to analyse the various factors that affect dividend policy and firm value. According to Miller and Modigliani’s (1961) theorem, the value of the firm is unaffected by its dividend policy in a world of perfect market conditions. Two major assumptions driving the MM irrelevance theorem were that:
Managerial Finance Vol. 36 No. 5, 2010 pp. 394-413 # Emerald Group Publishing Limited 0307-4358 DOI 10.1108/03074351011039427

(1) A firm’s 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 firm’s operations and prospects (the ‘‘symmetric information’’ assumption).

Subsequent theoretical research has analysed the effects of incorporating asymmetric information and agency problems into the firm’s dividend decision. This resulted in two 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 between managers and investors, dividend policy may provide signals regarding the firm’s current performance and future prospects[1]. The free cash-flow hypothesis (also known as the excess-cash hypothesis) states that dividend policies address agency problems between managers and outside investors (for example Easterbrook, 1984; Jensen, 1986; Fluck, 1995). In particular, the agency problem in Jensen’s (1986) analysis arises from an empire building manager’s incentives to invest in negative net present value (NPV) projects. Dividends alleviate this problem by reducing the free cash flow available to the manager. As noted by Fuller and Thakor (2002), both of these hypotheses (signalling and free cash flow) support much (but not all) of the empirical evidence that dividend increases (decreases) are good (bad) news, causing stock price increases (decreases). Perhaps the reason why a solution to Black’s (1976) dividend puzzle remains so elusive is that ‘‘we lack an integrated theory that incorporates both the signalling and free 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 on their work by developing a dividend model that incorporates both asymmetric information and free cash-flow problems. Particularly, we consider a dual role for dividends. Dividends may provide a signal of current income to investors (hence the manager 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 this project, it must get the funds from current income. Hence, in addition to the current income-signalling role, the level of dividends may also affect the manager’s ability to invest in the new project. Hence, the manager may wish to cut dividends (to take a good, value-adding project), or he may wish to payout high dividends (to reduce the free cash flow in order to commit not to take a bad, value-reducing project). Our model contributes to Fuller and Thakor’s (FT 2002) analysis in the following ways. First, we develop the analysis, and derive the equilibria of the dividend game, in a formal and rigorous manner[2]. Second, FT only consider the possibility that a negative NPV project exists. Hence, they focus on Jensen’s (1986) free cash-flow problem. In contrast, we consider the possibility that the project may have a negative or positive NPV. This enables us to consider the following under-researched area. Although the majority of theoretical and empirical work suggests that the relationship between dividends and share price is positive (dividend increases are ‘‘good news’’), Wooldridge and Ghosh (1998) have suggested that, when a firm has strong growth opportunities available, dividend cuts may not 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 that have no positive NPV projects in which to invest’’, and according to Black (1976), ‘‘Perhaps a corporation that pays no dividends is demonstrating confidence that it has attractive investment opportunities that might be missed if it paid dividends’’. Hence, the relationship between dividends and firm value is complex. The market 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

Dividend policy, signalling and free cash flow 395

since the market then mistakenly values this firm as low quality)[6]. hence passing up a positive NPV project[4]. we consider investors who have been conditioned to believe that high dividends signal high quality[5]. we consider the role of managerial reputation in allowing a firm to communicate that it is cutting the dividend in order to invest in a new value-adding project. and consider the role of communication and reputation. In contrast. . (2008). In section 2.1.MF 36. In our first case. Section 5 concludes. . Frankfurter and Wood (2002) observe that. The remainder of the paper is organized as follows. However. As an extension to our second case. while a dividend cut may be seen as a positive signal (the firm has significant growth opportunities available). Cohen and Yagil (2006) identify ‘‘a new type of agency cost of dividend: the sum of positive NPV projects that are abandoned in order to pay dividends’’.2. Indeed. Secondly. Firstly. In section 2. a dividend increase may be seen as a negative signal (the firm lacks growth opportunities). we present our model. the reputation mechanism is such that the market punishes a firm that chooses a high dividend (in order to ‘‘fool’’ the market that it is a high-income firm). we consider some anecdotal evidence demonstrating the complexities surrounding dividend policy. in the light of our model.5 396 mitigating free cash-flow problems (that is dividends reduce agency problems). The role of reputation in dividend policy has been explored by Brucato and Smith (1997) and Gillet et al. In Brucato and Smith. we analyse a moral hazard problem in which empire-building managers may cut dividends in order to invest in a negative (value-reducing) NPV project due to managerial private benefits.. including these influences in modeling efforts can enrich the development of a theory to explain the endurance of corporate dividend policy. Similarly. That is. as the high-quality firm can separate from the low-quality firm by paying a high dividend. In section 4. these beliefs drive the adverse selection problem (the high-quality firm is unwilling to reduce the dividend below that of the low-quality firm. However. whereby managers may refuse to cut dividends.]. Investor behavior is substantially influenced by societal norms and attitudes [. in addition to analysing the effects of agency and asymmetric information problems on dividend policy. we consider an adverse selection problem. we consider whether the adverse selection problem can be mitigated by communication to investors. Our integrated signalling/excess cash-flow model of dividends attempts to analyse all of these affects. Wooldridge and Ghosh (1998) argue that firms may be able to avoid a negative market reaction by communicating to investors that the reason for dividend cuts is to invest in future growth opportunities. Indeed. Our third contribution is to consider two types of inefficiency (or agency problem) relating to managerial incentives regarding dividend policy[3]. we consider our adverse selection case. In section 2. Our fourth contribution is that we include a behavioural dimension in our model. It may be argued that this may be cheap-talk. Furthermore. in Gillet et al. a reputable dividend signal is one where an unexpected dividend increase is confirmed by a subsequent unexpected earnings increase. In the second case. researchers are beginning to consider behavioural models. but subsequently reports low profitability. we consider our free cash-flow case. reinforced by managerial reputation effects. in our model. According to Shiller (1989). the investors’ beliefs are indeed correct. Wooldridge and Ghosh argue that managerial reputation may provide an important mechanism for providing credibility to corporate finance decisions. we discuss practical and managerial implications of our model. They observe that. .

V1 is the manager’s date 1 monetary compensation. B (for ‘‘good’’ and ‘‘bad’’. project n. 1] represents the manager’s compensation parameter (or equity stake).5 if he can (regardless of whether I(1 þ )  0 or I(1 þ ) < 0) in order to obtain the private benefits b > 0. Furthermore. and the risk-free rate is zero[8]. respectively. and it achieves net income I(1 þ ) in date 2. denoted project n). If a manager has sufficient date 1 cash flow remaining (after paying the dividend). The manager’s objective is to choose dividends to maximize M given the other manager’s choice of dividends. I(1 þ )  0 (project 2 has positive or zero NPV). and (b) Ng À I < Nb (see section 2. 1] of the date 1 firm value V1. At date 1. requires investment I 2 (Nb. Firm i is run by manager i 2 G. but not to the investors.2. We consider two possibilities. since the manager has already received his monetary compensation at date 1. At the start of the game. dividends can solve the asymmetric information problem . The subsequent investment opportunity. and still be able to set a sufficiently low dividend to invest in the new project if it wishes to. the market knows that this project will achieve a date 2 return on equity . therefore affects managerial compensation. We consider two cases. There is universal risk neutrality. Each firm enters the game with existing net income of Ni. and B 2 b. and. he announces a payout of Di. it provides private benefits[11] to the manager of b > 0. since it affects date 1 firm value. Hence. At this stage. dividend signalling is important to the manager. with Ng > Nb > 0. The market becomes aware of a future investment opportunity (a new project. respectively[9]). we consider a situation where the high-quality (highincome) firm can separate from the low-quality (low-income) firm by setting a higher dividend. assigns an equal probability to each firm being of each type. The announcement has a signalling role (to be described below). a manager can invest in financial securities at zero NPV. in the absence of signals. as a fraction 2 [0. All of the date 2 net income is paid out as date 2 dividend.5. We note that. to which he is committed). regardless of his level of dividend payout. 0 are the date 2 private benefits if the manager does or does not take project 2. The manager has a date 1 compensation scheme.2). and provides a potential role for dividends as a commitment device not to take negative NPV projects (as in Jensen. M ¼ V1 þ B ð1Þ Dividend policy. (a) Ng À I > Nb (see section 2. and. The timing of events is as follows.1). each manager pays out the dividend that was announced at date 1. Manager G is able to invest in the new project if Ng À Dg  I ¼>Ng À I  Dg. and I(1 þ ) < 0 (project 2 has negative NPV). manager B is unable to invest in project n. At the end of date 0. This provides a possible moral hazard problem. Therefore. The two managers make these announcements simultaneously. and the game ends. he is able to invest in the new project[10]. In the first case (Ng À I > Nb). the manager receives monetary compensation. At date 2. each manager i makes a committed dividend announcement (that is. since Nb < I. the market cannot observe managerial type. which affects firm value. 1986). if project 2 has been taken. Alternatively. signalling and free cash flow 397 where 2 [0. The model We consider an economy consisting of two all-equity firms[7] and a capital market. Ng]. At date 1. Therefore. firm i’s net income Ni is revealed to manager i. he will invest in the new project at date 1.

or manager G pays a higher dividend than manager B. Ng À I > Nb the highquality firm can separate from the low-quality firm by paying a higher dividend. a separating equilibrium exists where the good manager . we consider the effect of the new project’s return on equity  (which determines whether project 2 has positive or negative NPV) and the manager’s private benefits on the equilibrium dividend policies (we relegate all proofs to the Appendix). and still invest in the new project if it wishes. Ng. and separate from the low-quality firm. they can be used to signal current income). This enables the good manager to separate from the bad manager by paying a higher dividend. If one manager chooses a higher dividend than the other. a separating equilibrium exists where the good manager chooses medium dividend level Dg ¼ Ng À I. and still separate from manager b by choosing a dividend in excess of Nb (which manager b cannot mimic). In the case that the new project has a positive NPV (  0). we consider an adverse selection problem. and is able to invest in the new project. we focus on the role of dividends in mitigating the agency problems of free cash flow. We restrict our attention to the following dividend choices. . while the bad manager chooses low dividend level Db ¼ Nb. and the manager’s compensation plus private benefits from the new project are positive ( I þ b  0).and low-quality firm is sufficiently large (equivalently. P1. That is. Ng À I. If the new project has a negative NPV ( < 0).MF 36. If both managers chose the same dividend. In order to solve for the Bayesian equilibria of the dividend-signalling game. Manager B can only choose[12] Db ¼ Nb. while retaining enough cash to invest in the new project. where the high-quality firm cannot simultaneously cut dividends to invest in a new positive NPV project. P1a. 2. and is unable to invest in the new project. the market believes that the manager who has chosen the higher (lower) dividend is the good (bad) manager[14]. the required investment for the new project is relatively small). In the case that the difference between the high. Manager G can choose a dividend D 2 Nb. We take as given that investors believe that a high/low dividend combination signals a high-/low-quality firm. since Ng À I < Nb. In P1. We specify the following posterior beliefs. By restricting our attention to these choices. manager g is able to invest in the new project. the market cannot update its beliefs.5 398 (that is. In this case. we consider the role of communication and managerial reputation. Note that this case allows us to focus our attention on the role of dividends in mitigating the agency problems of free cash flow.1 Dividends as an unambiguous signal of quality (Ng À I > Nb) Since Ng À I > Nb. we need to specify how the market updates its beliefs upon observing the managers’ dividend choices[13]. manager G pays the same dividend as manager B. manager G pays a higher dividend than manager B. we are able to consider the case where: . the bad firm can mimic the good firm’s dividend if the good firm cuts the dividend to invest in the new project. In the second case (Ng À I < Nb). P1b. In this case. .

and commits to the market not to invest in the negative NPV project (using dividends to mitigate the moral hazard problem). If the new project has a negative NPV ( < 0). we demonstrate that the results in P1 support FT’s hypothesis. and Fuller and Blau (2010). while the bad manager chooses low dividend level Db ¼ Nb. Fuller and Thakor (FT 2002).1 Cross-sectional effect of dividends on firm value. P1c. The good manager separates from the bad manager by paying medium dividends.chooses medium dividend level Dg ¼ Ng À I. and invests in the negative NPV project due to managerial private benefits (moral hazard problem). Cross-sectional relationship between dividends and firm value . and demonstrates that the relationship between dividends and firm value may be monotonic. for whom I þ b  0. Interval A represents firms run by B-type managers who pay the lowest dividend. or non-monotonic (as in FT 2002). The good manager separates from the bad manager by paying high dividends. for whom I þ b < 0. Proof. managerial compensation is such that these managers choose a medium level of dividends in order to invest in the new project. managerial compensation is such that these 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. In this section. Interval C represents firms run by G type managers.1. a separating equilibrium exists where the good manager chooses high dividend level Dg ¼ Ng. signalling and free cash flow 399 Figure 1. Interval B represents firms run by G type managers. while the bad manager chooses low dividend level Db ¼ Nb. Figure 1 depicts the results in P1. 2. if the new project has negative NPV. firm value for these firms will be less than those in interval A or C (monotonic Dividend policy. suggest that the cross-sectional relationship (that is across firms) between dividends and firm value may be complex and non-monotonic. See the Appendix. and hence have the lowest firm value. Now. The diagram considers a cross-section of firms. and the manager’s compensation plus private benefits from the new project are negative ( I þ b < 0).

5. and continues to assign an equal probability to the firms being g or b. 400 When the project has a positive NPV. Since Ng À I > Nb. In contrast to the previous case.2 Numerical example We illustrate this case by way of a numerical example with the following parameter values: Ng ¼ 400. we focus on the case where  > 0 (new project has positive NPV).3 Dividends as an ambiguous signal of quality: Ng À I < Nb In our second case. However. the market believes that firm i is the good firm. the market has been conditioned to believe that high dividends signal high quality. If the new project has a negative NPV. Nb. we focus on the agency problems associated with a manager refusing to cut the dividend. Firm value is V ¼ Ng þ I ¼ 400 À 0. As noted in P1. Nb ¼ 100 and I ¼ 200. and firm value is Vb ¼ 100. and B ¼ 0 (the manager has zero private benefits). Furthermore. the market is unable to update its beliefs. That is. P1a revealed that manager G chooses the medium dividend Dg ¼ Ng À I ¼ 200 to invest in the new project. if manager G chooses low dividend Ng À I in order to invest in the new project. If the new project has a negative NPV and b ¼ 0. and firm b is the bad firm.1(200) ¼ 380. manager B can mimic him.1(200) ¼ 420. then manager G pays the high dividend Dg ¼ Ng ¼ 400 to commit not to take the new project (see P1c). manager G is able to cut dividends to invest in the new project. and  ¼ À10 per cent (negative NPV). . If the market observes that Di ¼ Nb. Hence. . Db ¼ Nb ¼ 100. 2. we consider the case where the managerial compensation (equity) parameter is ¼ 0. . Firm value is V ¼ Ng þ I ¼ 400 þ 0. with Dj ¼ Ng À I. This is indeed the case in our example with b ¼ 50. We consider two possibilities for the return on the new project.5 relationship).50. manager G’s incentive to pay the medium dividend (to invest in the new project) or the high dividend (to commit not to take the new project) depends on his equity compensation and his private benefits.MF 36. Ng. . manager G will pay the medium dividend to invest in the new project while separating from manager B. and separate from manager B by paying a higher dividend. b 2 0. If the market observes that both firms have chosen the same dividend level. 2. We specify the following market beliefs: . . In all cases. In order to examine this. thereby passing up a positive NPV project (see Cohen and Yagil. We consider the following possible dividend levels. Firm value is V ¼ Ng ¼ 400. For clarity. P1b revealed that manager G chooses the medium dividend Dg ¼ Ng À I ¼ 200 to invest in the new project if I þ b  0.  ¼ 10 per cent (positive NPV). we consider two possibilities for managerial private benefits from investing in the new project. if the new project has a positive NPV. when the project has positive NPV. Di 2 Ng À I. 2006). firm value for these firms will be higher than those in interval A or C (non-monotonic relationship). When the project has negative NPV. we have inserted these numerical values into Figure 1.

Therefore. signalling and free cash flow 401 Using these beliefs. 2004). We now consider the role of corporate communication and reputation in enabling the good manager to cut the dividend in order to invest in the new project. we focus on P2b. If the new project’s positive NPV exceeds the negative adverse selection effect (I > Ng À Nb). due to the adverse selection effect (manager B would mimic the low dividend).. at the same time. the market is unsure whether this represents the low-income firm. and. Specifically. P2a. . Proof. manager G refuses to cut the dividend to take the new project. If the negative adverse selection effect exceeds the new project’s positive NPV (I < Ng À Nb). the market (correctly) believes that firm i is the good firm (since firm B cannot afford to payout Ng). two equilibria exist: (i) a pooling equilibrium where both managers pay the low dividend. or Dj ¼ Ng À I. First. P2. where investors may irrationally believe that the best firms pay dividends. the manager can communicate (at zero cost) to the market that it is the good firm. Dividend policy. manager G refuses to cut dividends. At this stage. In the case that the difference between the high-quality and low-quality firm is low (equivalently. We now develop the game to incorporate corporate communication and reputation at the date 1 dividend announcement stage. P2b. passing up a positive NPV project. thereby passing up a good positive NPV investment opportunity. thereby passing up a good positive NPV investment opportunity. the high-quality firm cannot cut the dividend to take the new project. For the remainder of this analysis. that is. the required investment for the new project is relatively large). manager G refuses to cut the dividend in order to invest in a positive NPV project. or the high-income firm cutting the dividend in order to invest in the new positive NPV project. if manager i announces a dividend of Di ¼ Ng À I. Manager G refuses to cut the dividend to take the new project. That is. See the Appendix. with Dj ¼ Nb. but is unable to invest in the new project. a separating equilibrium exists where the good manager chooses the high dividend Dg ¼ Ng and the bad manager chooses the medium dividend Db ¼ Nb. We take as given that investors believe that a high/low dividend combination signals a high-/low-quality firm. and firm j is the bad firm. we derive the following equilibria (see the Appendix for the proof). and that he has set the low dividend in order to invest in the new project (and not because it has low current income). the market has been conditioned to believe that higher quality firms pay higher dividends: we could appeal to catering theory (Baker and Wurgler. Manager B mimics manager G’s dividend choice. we note that P2 is supported by irrational/behavioural beliefs. and (ii) a separating equilibrium where the good manager chooses the high dividend Dg ¼ Ng and the bad manager chooses the medium dividend Db ¼ Ng À I. manager G cuts the dividend in order to invest in the new project. If the market observes that Di ¼ Ng. Dg ¼ Db ¼ Ng À I. In (i). In (ii). separate from the low-quality firm by paying a higher dividend. Ng À I < Nb.

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 B mimicking. The good manager chooses the low dividend in order to invest in the new project. and the bad manager chooses the medium dividend. Proof. The manager that has communicated and lied (manager b) suffers a reputation loss r. Extension to model: repeated dividend game[17] Thus far in the analysis. P3. we have focused on a static. In this section. Now allow the manager to educate.5 402 At date 2. oneshot.1 Cross-sectional Effect of dividends on firm value The cross-sectional effect of dividends on firm value is demonstrated in Figure 2. Furthermore. the separating equilibrium is Dg* ¼ Ng À I. if manager G can credibly communicate that he has cut the dividend in order to invest in the new project. the bad manager mimics the good manager by choosing Di ¼ Ng À I. and communicate to. 3. Given that r > ðNg þ Nb =2 þ I Þ (the reputation effect is sufficiently strong to prevent the bad manager from mimicking). thereby examining the cross-sectional effect of dividends on valuation cross firms.MF 36. Cross-sectional relationship between dividends and firm value when managerial communication is credible . such that the good manager refuses to cut the dividend to invest in the new project. that is.2. See the Appendix. Figure 2 demonstrates that. For example.2) becomes ÅB ¼ ððNg þ Nb þ I Þ=2Þ À r : That is. the market observes firm type. so that he achieves a ‘‘pooled’’ compensation at date 1. dividend choice. 2. we assume that[16] r > ððNg þ Nb Þ=2Þ þ I Þ: We obtain the following result. Appendix equation (A. and Db* ¼ Nb > Dg*. the cross-sectional relationship between dividends and firm value may be negative. but then suffers a reputation loss r when his type is revealed at date 2[15]. we assume that investors believe that a high/low dividend combination signals a high-/low-quality firm: see P1 and P2). thus altering the market’s posterior beliefs. the market that dividend cuts are to invest in new positive NPV projects. Consider the case where the negative adverse selection effect exceeds the new project’s positive NPV (I < Ng À Nb). we have taken the investors’ beliefs as exogenously given (that is. we consider a repeated dividend game which seeks to explain how investors’ beliefs (that high/low dividends signal high-/low-quality firms) may be Figure 2.

Di 2 Ng. As in our previous analysis. Recall that this means that. in the absence of reputation or communication. we focus on P2b. where I < Ng À Nb). where Ng À I < Nb). it is trivial to note that it is optimal for firm G to choose the high dividend to separate from firm B. To keep the analysis as simple as possible. The managers simultaneously choose dividends Di 2 Nb.2. we can solve stage 1 before considering stage 2[18]. Given the market beliefs that high (low) dividends signal a good (bad) firm. the market observes firm income. the market assigns equal probability to these types.Nb. we solve for stage 1. At the start of stage 1. at stage 1. The market cannot observe these firm types. where the negative adverse selection effect exceeds the new project’s positive NPV (see P2b. in the . Dg ¼ Ng. Nb. then. and good firm chooses Dg ¼ Ng. signalling and free cash flow 403 Since a firm cannot pay more than its current income as dividends. we incorporate the following behavioural factor. and investors receive the first stage dividends. a firm cannot pay more than its stage 1 income (see[10]). Furthermore. This provides the interest in our repeated dividend game. We specify that the market believes that a high/low combination signals a high-/lowquality firm (this is not an assumption: see[13]). In the first stage. the new investment opportunity does not exist (therefore. In the absence of signals.formed over time. if the investors have been conditioned over time to believe that high/low dividends signal high-/low-quality firms. Before considering the second stage of the game. our repeated dividend game consists of two stages.Ng to maximize the managerial payoff: M ¼ V1 ð2Þ Dividend policy. and (2) the good firm pays a higher dividend than the bad firm. Db ¼ Nb. the manager of the good firm will refuse to cut dividends to take the new project. our two firms (high and low quality) achieve a stage 1 income Ng and Nb.Nb. Furthermore. then MG ¼ MB ¼ ðNg þ Nb Þ 2 ð3Þ If the bad firm chooses Db ¼ Nb. The market updates its beliefs about firm type. neither of the firms (or the market) realize that the game will enter a second stage (the managers of the firms suffer from myopia/bounded rationality). who is restricted to the low dividend. At date 1 of stage 1. respectively. we only need to consider two possibilities: (1) both firms pay the same dividend. At date 0 of stage 1. Under this assumption. if both choose Di 2 Nb. Hence. investors are unaware that dividend policy may affect future investment and growth). then MB ¼ Nb MG ¼ N g ð4Þ ð5Þ Comparing (5) and (3). In order to do so. firm G and firm B simultaneously announce whether they will pay a high or low dividend. Furthermore. we focus on dividends as an ambiguous signal of quality (see section 2. Di 2 Nb.

(2000) demonstrate that management understands that high dividends may restrict corporate investment in value-creation: . Finally. However. . . Our model thus emphasized managerial communication/education of investors. . VG ¼ Ng. At this stage. the good manager refuses to cut dividends to invest in growth[19]. dividends have become ‘‘sticky’’. we focus on the adverse selection problem. Practical and managerial implications Our dividend signalling model demonstrates that dividend policy is indeed complex.5 404 (separating) equilibrium. . and the stage 1 firm values become VB ¼ Nb.] Its share price fell. We take these beliefs into the second stage of the game. The market updates its beliefs. . and in reducing the free cash-flow problem (that is. as a means of eliminating this problem. that is. Lease et al. especially if the stock market has been conditioned to believe that high dividends signal a high-quality firm. . We have demonstrated that high dividends may have a positive effect on firm value. At stage 2. We now consider some anecdotal evidence that provides a practical perspective to our theory. and demonstrates the real-world confusion surrounding dividend policy. Since investors have been conditioned. supported by managerial reputation considerations. However. The market forgets which firm is type G or type B (otherwise there is no role for dividend signalling in stage 2). when good positive NPV investment opportunities are available.[.MF 36. Dg ¼ Ng. the temptation for the manager to invest in negative NPV projects due to private benefits).] on the announcement Figgie’s stock price declined. by past performance and past dividend policy.] Wal-Mart’s share price increased. as described below.] Bethlehem Steel Corporation announced that it was omitting its quarterly dividend. the market observes firm G’s and firm B’s income. a high dividend may indeed be value reducing if it prevents firms from being able to make these investments[20]. P and G’s share price increased.] on the announcement.] Procter and Gamble Company announced an annual dividend increase [. . . . and investors’ beliefs (that a high/low dividend combination signals a high-/low-quality firm) are confirmed. the stage 1 dividends are Db ¼ Nb. [. However. at the end of stage 1. where. [.] Wal-Mart Stores announced an increase in its quarterly dividend. . to believe that high dividends signal a high-quality firm. investors have been conditioned to believe that higher dividends signal higher quality). they become aware of the new investment opportunity. 4. 4. Effectively. . . management may refuse to cut dividends. As noted. [. thereby passing up these positive NPV opportunities. both by providing a positive signal of current performance (in terms of current income).1 The ‘‘traditional’’ positive relationship between dividends and firm value Lease et al. at this stage. in the absence of communication or reputation. Stage 2 is identical to the model described at the start of section 2 (the model). but remembers that the better firm paid the higher dividend. the high-quality manager refuses to cut the dividend to take the new project (P2b). . we introduce a further behavioural factor. [. [. reputation and communication become important (as in P3). Furthermore. positively (negatively) to dividend increases (decreases): Figgie International announced a cut in its quarterly dividend. Now. the firms realize that they are operating for a second period. We now enter stage 2 of the game. (2000) provide the following examples where the market reacted in the ‘‘standard’’ way. Investors take this belief into stage 2 (therefore. .

4. a dissident member of the family that controls Dow Jones and Co. Wooldridge and Ghosh (1998) emphasize the importance of corporate communication and managerial reputation when cutting dividends to invest in growth. then they should continue with the normal dividend plan and postpone the investment opportunity.25 to $19. UK. ‘‘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 improve their networks and diversify at home and abroad’’.. Cohen and Yagil’s (2006) international survey of CFOs of major companies in USA. supported by positive communication to the market. consider two examples of firms changing their dividend policy. they state: If the managers believe that the reason for the dividend cut can be effectively communicated to investors in such a manner that it would not result in a dramatic stock price decrease. announced that it . Dividend policy. the dividend cut. Indeed. contending that Dow Jones has increased its dividends at the expense of re-investing its earnings to fuel future growth. if they believe that a drastic decline in the stock price may occur. especially when a firm has significant growth opportunities available. The authors argue that managers should consider two factors when deciding whether to cut dividends: (1) How sensitive is the stock price to dividend changes (the adverse selection problem)? (2) To what extent can managers transfer information (that is communicate) about the profitable investment opportunity so that investors will understand the reason for the dividend increase? Indeed. Canada and Japan reveals that this agency problem exists. However. Our model suggested that the problem may be mitigated if managers can communicate the reasons for dividend cuts (to invest in new value-adding projects). following a ‘‘re-evaluation of its dividend policy in light of the Company’s strategic repositioning for growth and the resulting cash requirement’’. and Compaq Computer Corporation. raises questions about its dividend policy. On the other hand. Germany. Compaq Computer Corporation paid a dividend for the first time in 1997. supported by managerial reputation effects. was seen as good news). This suggests that investors may understand that dividends may need to be cut to invest in company growth. Windermere-Durable Holdings. we demonstrated that managers may refuse to cut dividends for fear of negative market reaction (which may be driven by investors being behaviourally conditioned to believe that dividend cuts are bad news). but they still demand dividends. Inc. They compare the cases of Gould Inc. In 1983.Elisabeth Goth. However. then they should prefer investing over paying the full amount of the dividend.2 Dividend cuts are not always bad news! Our analysis revealed that dividend cuts are not always bad news. On the release of the dividend-cut announcement. the firm’s share price increased from $18. causing its share price to fall (a dividend initiation was seen as a ‘‘bad news’’ signal that the company had run out of good investment opportunities). signalling and free cash flow 405 Lease et al. and ITT. The ‘‘flow of information’’ factor should be derived from the structural investors’ relations networks and from past experience. announced that it was cutting the dividend in order to re-invest all earnings into the business. WindermereDurable Holdings. Gould Inc. In contrast..00 (hence. Inc..

and consider real-world examples. the manager may cut dividends in order to invest in a negative NPV project. Second. due to private benefits. This adverse selection problem is similar to that analysed by Myers and Majluf (1984). They signalled current income. we make the standard assumption .5 406 was cutting its quarterly dividend in order to ‘‘conserve cash that can be used to finance the growth of its electronic businesses [. We suggested that the latter problem may be mitigated by communication to investors. See. We demonstrated that the relationship between managerial incentives. Miller and Rock (1985). ITT’s share price fell[21]. dividends served a dual purpose. Hence. Bhattacharya (1979). 6. reinforced by managerial reputation effects. hence passing up a good investment opportunity. We do not model this behavioural factor in any deep way. we consider these two agency problems as separate cases within the framework of our model. the adverse selection problem relates to a manager of a good firm refusing to issue undervalued equity.MF 36. for example. Note that we discuss the refusal to cut dividends in more depth. Conclusion We have developed a dividend-signalling model that begins to address Fisher Black’s (1976) dividend puzzle. In their analysis. for the sake of clarity and tractability. in section 3. holding other decisions constant. In this paper. either as a positive signal of current income (that is dividends reduce asymmetric information problems). In contrast.] the board set the new dividend in the light of the company’s transition to a high-technology firm’’. Models that consider psychological underpinnings are Baker and Wurgler 2004 (dividend catering). Our model identified two potential agency problems associated with dividend policy. We therefore argued that dividends may provide confusing signals to investors. while a dividend cut may be seen as a positive signal (the firm has significant growth opportunities available). the manager may be unwilling to reduce dividends to take a positive NPV project. It is common in theoretical analysis of corporate finance policy to focus on one decision. On the day of the announcement. 5. . and Shefrin and Statman 1984 (self-control). However. ITT announced a 64 per cent cut in its dividend payment. We believe that our integrated model has provided a springboard for future theoretical and empirical research into the complex nature of corporate dividend policy. its share price increased. 2. We note that Fuller and Blau (2010) also developed a formal and rigorous integrated model. dividend policy and firm value is indeed complex. (1987). we wish to focus on the dividend decision. 3. our model has several differences compared with theirs. 5. Our model is integrated in the sense that it combines both the signalling and free cashflow effects of dividend policy. However. John and Williams (1985) and Ambarish et al. and they affected the firm’s ability to invest in new projects. Notes 1. . since he is concerned with the negative signal of current income. independently of ours (we became aware of their paper as we were completing ours). who may view an increase in dividends favourably. In our model. 7. First. as outlined below. a dividend increase may be seen as a negative signal (the firm lacks growth opportunities). explaining that its dividend level had ‘‘become inconsistent with the intensely competitive hightechnology environment’’. 4. without the complication of capital structure. or as a means of mitigating free-cash-flow problems (that is dividends reduce agency problems). However.

the monetary benefits. Indeed. In case 2 below. hence reducing agency problems by subjecting itself to market scrutiny. simply by borrowing or issuing equity. Hence. we consider how investors. given these beliefs. Agrawal and Nagarajan (1990) and Agrawal and Jayaraman (1994) empirically examine all-equity US firms. Finally. 11. we will demonstrate that investors are correct in this belief. such as equity stakes. so that: (i) firms prefer an all-equity structure to one including debt. our firms could alleviate the free cash-flow problem by issuing debt rather than paying dividends. He therefore has the choice of investing his cash flow Nb in the financial markets or as a dividend. agents are only concerned with expected cash flows (and not the associated variance). 14. if we allow firms to re-visit the capital market. but are carefully considered and thought through by the modeller. Note that this essentially is the approach adopted by Miller and Rock (1985). in addition to. We leave analysis of this for future research. Note that if we do not make this assumption regarding the reputation parameter. Furthermore. We then consider the effects of communication and reputation. Furthermore. A commonly analysed agency problem is that of managers receiving private benefits from running a project. the managers’ behaviour is consistent with the beliefs (see Appendix A. Note that these beliefs are not ‘‘assumptions’’. Agrawal and Mandelker (1987). Jensen (1986) discusses how managers might waste free cash flows on large. When solving a Bayesian dividend-signalling game. and we need to demonstrate that. 15. empire-building. We assume that he pays it all as dividend. Easterbrook (1984) discusses a firm’s simultaneous decision to finance increased dividends by re-visiting the capital market. 10. Rasmusen argues that the skill of the modeller of a signalling game lies in specifying beliefs that are consistent with the equilibrium of the game. It is worth noting that some scholars have considered the dividend and debt/equity decision jointly. Throughout the analysis. even though these projects may be value reducing. 9. In this paper. projects. and (ii) firms must use internally generated cash to pay dividends and/or invest in future projects. signalling and free cash flow 407 . and to focus on dividend policy. conditioned to believe that high dividends signal high quality. and suggest that these firms have higher dividends than those with debt. Jensen (1986) considers the role of dividends and debt as substitutes for each other in controlling managerial free cash-flow problems (whereas we focus on dividends). They argue that this supports Jensen’s (1986) argument that these firms are substituting dividends for debt. then our dividend signalling model would break down. Indeed. and independently of. Recall that manager B is unable to invest in the new project. where the high-quality firm refuses to cut dividends to take the positive NPV project.2 for a worked example).8. For instance. we implicitly assume that visits to the capital market are prohibitively costly (see[10]). Dividend policy. the game becomes much more complex. and the market discounts future cash flows at a zero discount rate. due to the private benefits that they obtain. 13. Please see the appendix for all of the payoffs for the various dividend combinations. 12. It is assumed that the manager is unable to return to the capital market to raise the required funds for the new project. we need to work out how the managers’ choice of dividends will affect their payoffs. in equilibrium. In order to keep the analysis ‘‘clean’’. we refer to the firm run by the good manager as ‘‘high quality’’ and the firm run by the bad manager as ‘‘low quality’’. we need to consider each manager’s ‘‘best response’’ to the other’s strategies. as the bad firm could pay more dividends than income. 16. lead to an adverse selection model. In this case. the steps are as follows: we need to specify how the market updates its beliefs upon observing the firms’ simultaneous dividend choices. that firms are all equity.

if manager G was choosing between Dg ¼ Nb and Dg ¼ Ng À I. 21. thereby eschewing profitable investments. 18. ‘‘I think Microsoft is sending a message to shareholders that the story has changed from one of a high-growth company to a mature company [. Lintner (1956) was the first to identify this feature. In order to avoid this strange outcome. 20. Stern argues for cutting the dividend. academics and practitioners discuss whether firms should pay a high level of dividends when they have significant growth opportunities. so I will respond to Z by doing. The general academic view is that dividends should be cut. Now. if Assumption 1 was violated. there is never an incentive for firms to pay high dividends that lead to a reduction in value. firm B asks itself. An equilibrium does exist where firms refuse to cut dividends to take a value-adding project. Therefore. each player cannot observe the other player’s decision when making its own choice. a normal form game is a table that represents the interaction of simultaneous strategic decisions by two players. 24. the practitioner view is that the firm should cater to investors with high dividends.2). Recall that if manager G can invest in the new project. and emphasizes the role of communication and reputation. and seeing firm value fall: e. . For an interesting discussion on dividend policy. Interestingly. Therefore.] The day Microsoft declares a cash dividend is the day people no longer think of it as a growth stock’’. the new project would have such a large negative NPV that. and its share price fell dramatically. Each firm makes such calculation for each of the other firm’s choices. The top row represents the dividend choices of firm B. there are cases of firms increasing dividends. There is considerable evidence that dividends are sticky. and the cell numbers represent the subsequent payoff equations from the combination of the two firms’ choices.1) would exceed (A. The firms make their choices simultaneously.g. both players are optimizing. which he termed dividend smoothing. In the Appendix table. he will do Z. and the payoffs associated with those choices. and so must attempt to ‘‘second-guess’’ what the other player will do. high dividends are not actually value reducing in our model. This leads to an iterative process of expectations and counter-expectations (if I expect my opponent to do X. we maintain Assumption 1. . ‘‘If I expect firm G to choose Dg ¼ Ng À I. Helen Jung. which involves backward 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 the game to the end of stage 2).5 408 17. that is. This is in contrast to the normal procedure for solving games. Note that. . since that player will then be worse off. they find it difficult to cut them again. We are grateful to an anonymous referee for suggesting this interesting extension to the model. even when they need to do so to invest in new projects. the left-hand column represents the dividend choices of firm G. Microsoft paid a dividend for the first time in 2003. In a Nash equilibrium. . then (A. once firms have increased dividends. . If he is expecting me to respond to X by doing Y. 20 January 2003). but they mean that firms are foregoing value creation. see ‘‘A Discussion of Corporate Dividend Policy’’ in ‘‘Six Roundtable Discussions of Corporate Finance’’. what is it optimal for me to do’’. 19. it is best for me to do Y. and the trade-off between paying dividends and investing for growth. In game theory. 23. In this chapter. given this iterative process. he will. and there is no incentive for either player to unilaterally deviate from the equilibrium strategies. We solve such games by considering each players’ best response to each of the other player’s choices (for example. since they are passing up positive NPV projects.).MF 36. he would prefer to choose Dg ¼ Nb to mimic the bad manager (in order to reduce the market’s assessment that he will be able to take the new project). edited by Joel Stern. In reality. (web source: ‘‘Microsoft’s Dividend Signals a New Era for Company’’. 22. In our models.

P. R. pp. (1995). Lintner. Vol. 6. John. and Yagil. pp. 4. K. Vol. M. signalling and free cash flow 409 . P. 40. MA. K. ‘‘Signaling. Fuller. A. F. and ‘nonmonotonic’ dividends’’. (1985). (2002). Easterbrook. pp. and Sarig. Journal of Business. Vol. pp. (2000). pp. ‘‘The dividend puzzle’’. 11. ‘‘Dividend policy under asymmetric information’’. Journal of Portfolio Management. Vol. ‘‘The optimality of debt versus outside equity’’. (1997). Vol. 1031-51. J. Black. regardless of his opponent’s choice of strategy. ‘‘A catering theory of dividends’’. Vol. F. Lease. and Williams. Agrawal. B. and ‘nonmonotonic’ dividends’’.25. ‘‘Dividend policy and reputation’’. Loewenstein. University of Pennsylvania. pp. Lapointe.. growth. ‘‘A multinational study of agency costs of dividends’’. 323-39. ‘‘Corporate capital structure. Journal of Finance. The Quarterly Review of Economics and Finance. U. and Williams. Brucato. and Mandelker. Philadelphia. John. agency costs and ownership control: the case of all-equity firms’’. (1986). mimeo. (2010). corporate finance and takeovers’’. 178-83.. Bell Journal of Economics. free cash flow. ‘‘Dividend policy. pp. Vol.com/abstract¼343980 Gillet. 4. G. ‘‘Agency costs of free cash flow. 59 No. ‘‘Efficient signalling with dividends and investments’’.. and Nagarajan. Fluck. ‘‘Payout policy’’. pp. 3. CFI Working Paper No. 823-37. NY. ‘‘An analysis of the role of firm reputation in the market’s reaction to corporate dividends’’. (2008). Z. available at: http://ssrn. and taxes: a signaling equilibrium’’. A. (1984). (1961). (1990).M. pp. Journal of Finance. J. 37 No 3.. (1987). N. (1985). 111-38. Vol. ‘‘Signaling. pp. 40. retained earnings and taxes’’. 10. Managerial and Decision Economics. and Blau. John. K. International Review of Financial Analysis.J. Vol. 321-44. G. R. M. 21-56. (1994). Fuller. ‘‘Distribution of Incomes of Corporations among dividends. 35 Nos 3/4. Wharton School Center for Financial Institutions. and Modigliani. and Thakor. Its Impact on Firm Value. 139-48. A player has a dominant strategy if it is his optimal strategy. S. Miller. K. F. K. A. pp. and Rock. M. 650-9. ‘‘Imperfect information. Dividend Policy.. free cash flow. The Journal of Finance. PA. Vol. Dividend policy. and Wood. 97-113. 01-21. Kalay. (2004). American Economic Review. SSRN working paper. pp. 76. Vol. Jensen. 42 No. R. 647-65. 34. Vol. Cohen. 411-33. ‘‘Managerial incentives and corporate investment and financing decisions’’. G. Journal of Finance. 45. J. Vol. Vol. Harvard Business School Press. A. and Smith. (1987). J. M. NYU. pp. 5-8. 42. (2006). 2. Finance and Accounting. Vol. The Journal of Finance. 45. dilution. dividend policy. B. References Agrawal. The Journal of Finance. Bhattacharya. N. and ‘the bird in the hand fallacy’’’. ‘‘The dividend policies of all-equity firms: a direct test of the free cash flow theory’’. ‘‘Dividends. Baker. 1053-70. Journal of Business. and the valuation of shares’’. pp. ‘‘Dividend policy theories and their empirical tests’’. 1125-65. and Michaely. Frankfurter. 516-40. Allen. Miller. A. Boston. Vol. (1976). ‘‘Two agency-cost explanations of dividends’’. 259-70. pp. (2002). American Economic Review. pp. The Financial Review. New York. and Jayaraman. and Raimbourg. and Wurgler. (1956). F. American Economic Review. J. 15. Vol. K. 1325-32. M. R. D. (2002). Agrawal. 74 No. (1979). pp. pp. O. Ambarish. International Journal of Finance and Economics.

H. and Statman. Blackwell Publishers.3). This assumption sets a lower limit for the possible negative value of the new project. S. MA. I > Nb À Ng. ‘‘Dividend cuts: do they always signal bad news?’’. 2. the market updates its beliefs to (correctly) assess him as manager G. the market updates its beliefs to (correctly) assess him as manager G. and Majluf. the market is unable to update its beliefs (continuing to assign equal probability to each manager being of each type. and Stern. In contrast to above. J. M.1).R. Further reading Chew. Shefrin. Manager G prefers to choose Dg ¼ Ng À I (in order to separate from manager B and be able to take the new project) if (A.2) > (A. Manager G chooses a dividend from Dg 2 Nb. ‘‘Corporate financing and investment decisions when firms have information that investors do not have’’. 143-50. ensures that (A. The Revolution in Corporate Finance. Ng. ‘‘Explaining investor preference for cash dividends’’. He prefers to choose Dg ¼ Ng (in order to separate from . manager G’s payoff is now Y ¼ Ng ðA:3Þ G Assumption 1. the date 1 market value of each firm is determined by the market beliefs that there is an equal probability of each firm having current cash flow of Ng or Nb. we only need to compare (A. given the market’s posterior beliefs (upon observing the two managers’ dividend choices). Jr (Ed. Consider manager G’s best response to Db ¼ Nb. G or B).H.2) > (A. he will prefer to choose Dg ¼ Ng À I to separate from the bad manager (so that the market will be aware that his firm has high current income and will be able to invest in the new project)[23]. C. N. and ensures that.2) and (A.5 410 Myers. Journal of Financial Economics. 253-82. Furthermore. Wooldridge. again.M.3) ¼> I þ b > 0. the manager is now unable to invest in the new project (and the market is aware of this). manager G’s payoff is Y ¼ ðNg þ I Þ þ b ðA:2Þ G If the manager separates from manager B by choosing Dg ¼ Ng. and Ghosh. the manager is able to invest in the new project (which the market incorporates into its date 1 valuation). D. If manager G pools with manager B by choosing Dg ¼ Nb (such that manager G is able to invest in the new project[22]). Vol. J. therefore manager G’s date 1 payoff is   Y Ng þ Nb þ I þb ðA:1Þ ¼ V þ b ¼ 1 G 2 If manager G separates from manager B by choosing Dg ¼ Ng À I. Quorum Books. Manager G and manager B choose their dividend levels simultaneously. H. (Eds).MF 36. Ng À I.5 of each firm being able to invest in the new project. (1998). Journal of Financial Economics. 13. Therefore. (1984).) (1986). Since (A.S. 3rd ed. NY.. if manager G is choosing between Dg ¼ Nb and Dg ¼ Ng À I.1). Since manager G has chosen. New York. Appendix Proof of P1 Manager B must choose Db ¼ Nb. Vol. Six Roundtable Discussions of Corporate Finance with Joel Stern. and a probability of 0.2) > (A. in Chew. 187-221. pp. pp. (1984). Therefore. D. Malden. 13 No. pp. Therefore.

8À 11þ. the market is unable to update its beliefs (and. This proves P1. 12À Dividend policy.manager B.3) > (A. 10À Db ¼ Nb 3. the market’s updated beliefs. þ represents manager G’s best responses. 2 5. 6 9. which are invariant to the parameters of the model). Given that each manager receives a fraction 2 [0. Given these beliefs. G\ B Dg ¼ Ng À I Dg ¼ Nb Dg ¼ Ng Db ¼ NgÀI 1. therefore. and the second number in each cell represents manager B’s payoff.2) ¼> I þ b < 0. If the market observes different dividend choices. 4 7. the market believes that the manager G pays the higher dividend. we have only demonstrated the ‘‘definite’’ best responses (see[24]). and commit to the market not to take the new project) if (A. If the market observes that both managers choose the same dividend. continues to assign equal probability to each manager being of each type). 1] of the updated market value. the payoffs are as follows (where (T1) refers to ‘‘table payoff 1’’):   Y Ng þ Nb þ I ðT1Þ ¼ G 2 Y B   Ng þ Nb þ I ¼ 2 Y G ðT2Þ ¼ Nb ¼ NG ¼ NG ¼ NB ðT3Þ Y B ðT4Þ Y G ðT5Þ Y B ðT6Þ Y G   Ng þ Nb ¼ 2   Ng þ Nb ¼ 2 ðT7Þ Y B ðT8Þ . having observed the two firms’ dividend decisions). signalling and free cash flow 411 We assume the following regarding the market’s posterior beliefs (that is. Proof of P2 We solve the following normal form[24] game (the first number in each cell represents manager G’s payoff. the market valuation of the two firms is updated. In this table. – represents manager B’s best responses.

manager G’s best response is to choose Dg ¼ Ng for sure. We assume that. consider manager G’s best responses to each of manager B’s choices. Db ¼ Nb. we combine the two managers’ best responses. thereby passing up the positive NPV project. since (T11) > (T7) > (T3). since NG À NB < I ¼> (T2) > (T4). where NG À NB < I. We now incorporate the following two steps. If manager G chooses Dg ¼ Nb. with Dj ¼ Nb. If manager B chooses Db ¼ Ng À I. manager G chooses Dg ¼ Ng À I. In order to obtain the Nash equilibrium of the game (see[24] for an explanation). manager B is indifferent between choosing Db ¼ Ng À I and Db ¼ Nb. manager B chooses Db ¼ Ng À I for sure. since (T10) ¼ (T12). Therefore the equilibrium is Db* ¼ Nb. Second. This proves P2b. or DG ¼ Nb. for sure. the market to change market beliefs. it cannot update its beliefs. If manager G chooses Dg ¼ Ng. manager B’s dominant strategy[25] is to choose Db ¼ Nb. the manager chooses Db ¼ Nb. We assume that. then. Dg* ¼ Ng. Consider manager B’s best (optimal) responses to each of manager G’s decisions (see[22] for an explanation of this process). since (T8) > (T6). manager B chooses Db ¼ Nb for sure. Therefore. since NG À NB > I ¼> (T4) > (T2).5 Y G ¼ NG ðT9. Thus. Next. we prove P2b. The equilibrium strategies occur where each manager’s best response appears in the same ‘‘box’’ of the table (that is. where NG À NB > I. is choosing the lower dividend Di ¼ Ng À I (in order to invest in the new project). and educate. If the market observes Dg ¼ Db ¼ Ng À I. the manager chooses Db ¼ Nb. If manager G chooses Dg ¼ Ng À I. Consider manager B’s best responses to each of manager G’s decisions. Dg* ¼ Ng. when type is revealed at date 2. If manager B chooses Db ¼ Nb. manager B chooses Db ¼ Nb for sure. This proves P2a). the market believes that the highquality firm. manager B suffers a reputation cost r for ‘‘lying’’. such that. we prove P2a. If manager G chooses Dg ¼ Ng À I. Db* ¼ Nb. with manager G either choosing DG ¼ Ng À I. our second step is to consider a reputation stage as follows. the managers communicate to. If manager G chooses Dg ¼ Nb. manager B is indifferent between choosing Db ¼ Ng À I and Db ¼ Nb. we obtain the multiple equilibria Dg* ¼ Ng À I. in the case NG À NB > I. In the absence of reputation considerations. Steps (1) and (2) together affect payoffs (T2)-(T6) as follows (all of the other payoffs remain as in the proof for P2): . where the þ and À appear together). that is. but knows that one firm is able to invest in the new project. at the time of the dividend announcement. the good manager refuses to cut the dividend. manager G chooses Dg ¼ Ng for sure. the equilibrium is Db* ¼ Nb. manager B chooses Db ¼ Nb for sure. firm G.MF 36. Proof of P3 We focus on the case where NG À NB > I (the adverse selection effect dominates the new project’s positive NPV). If manager G chooses Dg ¼ Ng. since (T11) > (T7) > (T3). in the case of indifference. If manager B chooses Db ¼ Ng À I. since (T8) > (T6). Db* ¼ Ng À I and Dg* ¼ Ng. T12Þ 412 First. Given manager B’s dominant strategy. if the market observes Di ¼ Ng À I. in the case of indifference. since (T10) ¼ (T12). since (T1) > (T5) ¼ (T9) when NG À NB < I. Firstly. T11Þ Y B ¼ NB ðT10. Since manager B can mimic manager G’s dividend Di ¼ Ng À I.

signalling and free cash flow 413 ¼ ðNg þ I Þ ðT30 Þ ðT40 Þ ðT50 Þ ðT60 Þ Y B ¼ Nb ¼ Nb Y G Y B ¼ ðNg þ I Þ À r Under the assumption that r > ðððNg À Nb Þ=2Þ þ I Þ.) Given this dominant strategy.com/reprints .uk To purchase reprints of this article please e-mail: reprints@emeraldinsight.Y B   N g þ N b þ I Àr ¼ 2 Y G ðT20 Þ Dividend policy.com Or visit our web site for further details: www. Therefore. the reputation effect is strong enough to prevent him from mimicking manager G. manager G’s best response is to choose DG ¼ Ng À I. This proves P3. Db* ¼ Nb.ac. it can be demonstrated that manager B’s dominant strategy is to choose Db ¼ Nb.emeraldinsight. the equilibrium is DG* ¼ Ng À I. (In particular. Corresponding author Richard Fairchild can be contacted at: mnsrf@bath.

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