Signaling, Free Cash Flow, and 'Nonmonotonic' Dividends
37 Pages Posted: 30 Nov 2002
Date Written: June 2002
It has long been argued that dividends are used as a signal of future earnings or as a means of distributing excess cash. However, the empirical tests of these two hypotheses have generated inconclusive results. One reason for these inconclusive results is that no model combines both the signaling and cash-flow-distribution aspects of dividends. This paper develops a framework in which firms have an incentive to pay dividends to both signal and distribute free cash flows. High-quality observationally-distinct firms pay dividends to eliminate the free-cash-flow problem, while high-quality observationally-similar firms that the market perceives as intermediate quality pay dividends to both signal future earnings and reduce the free-cash-flow problem. The equilibrium entails a nonmonotonicity in dividend payments with respect to the signal observed by the market at the interim date; the highest quality firms pay lower dividends than those of intermediate quality. Our theoretical argument helps reconcile the existing inconclusive empirical findings and also generates new empirical predictions that are then tested. The evidence supports these predictions.
JEL Classification: G35
Suggested Citation: Suggested Citation