Academic journal article Quarterly Journal of Business and Economics

The Effect of Asymmetric Information on Dividend Policy

Academic journal article Quarterly Journal of Business and Economics

The Effect of Asymmetric Information on Dividend Policy

Article excerpt

Introduction

In spite of extensive empirical research on dividend policy, we know little about how firms set these policies. Several theories exist on why firms pay dividends. These theories can be categorized based on the market imperfection invoked to provide a rationale for dividends. The various explanations of dividend policy can be classified into at least three categories of market imperfections: agency costs, asymmetric information, and transaction costs. (1)

For instance, Rozeff (1982) and Easterbrook (1984) argue that dividend payments may serve as a mechanism to reduce agency costs of external equity. The agency costs arise from costs associated with monitoring managers and/or from risk-aversion on the part of managers. (2) There is an extensive theoretical literature on asymmetric information that provides a signaling rationale for dividends (Bhattacharya, 1979; Miller and Rock, 1985; and John and Williams, 1985, among others). The signaling literature suggests that dividends convey information about current and future earnings. Several empirical studies have focused on the impact of dividend change announcements on share prices to analyze the information content of dividend changes. The evidence indicates a positive relation between the stock price response and the sign of the announced dividend change (Aharony and Swary, 1980; Asquith and Mullins, 1983, among others). The overall empirical evidence with respect to the signaling theory appears to be mixed. (3) The residual theory suggests that a firm can minimize transaction or issue costs associated with new capital issues by restricting dividends to funds not required for investment purposes (Higgins, 1972). (4)

In this paper, we empirically examine an alternative explanation of dividend policy based on asymmetric information. This alternative explanation is based on the implications of the pecking order theory (Myers, 1984; Myers and Majluf, 1984). The pecking order theory also provides implications for a firm's dividend policy which have been largely ignored in the empirical literature on dividend policy. Myers and Majluf (1984) argue that in the presence of asymmetric information, the firm may underinvest in certain states of nature. The underinvestment arises when the firm has inadequate funds for investment purposes and does not want to bear the lemons-premium associated with new capital issues. They suggest that a firm can reduce underinvestment by financing investments with slack that can be accumulated through retention (or by decreasing dividends). Their analysis implies that, other things equal, the need for slack increases with the level of asymmetric information between the firm and its outside investors. This reasoning suggests that the higher the level of asymmetric information, the lower the dividends. This prediction of the pecking order theory contrasts with that provided by the signaling models. For instance, Miller and Rock (1985) develop a model in which higher dividends are associated with higher earnings. Their model implies that, other things equal, the value of dividend payments as a signal increases with the level of asymmetric information between the firm and its investors. Thus, the prediction of the pecking order theory, with respect to the level of asymmetric information, is opposite to that provided by the dividend-signaling framework of Miller and Rock (1985) and thus provides a basis to distinguish between them.

Our second contribution stems from our inclusion of both dividend-paying and non-dividend-paying firms in our empirical analysis. Most empirical studies on dividend policy have ignored non-dividend-paying firms. If firms find it optimal not to pay dividends, their exclusion from any empirical analysis may create a selection bias in the sample resulting in biased and inconsistent estimates of the underlying parameters. In such cases, generalizations about corporate dividend policy may be inappropriate. …

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