A considerable amount of financial economic research is built on the notion that
company-specific information is costless and equally available to all market
participants, both those inside and outside the firm. But this condition is
rarely met in practice because outside investors typically have imperfect
information about the firm's current and future status. This study was among the
first to use signaling theory to describe how managers can convey information to
investors in a credible manner. Specifically, Bhattacharya demonstrates the
conditions under which dividends can be used to signal future profitability and
why investors might prefer to receive these payments.
A long-standing debate in the academic literature has centered on why corporations pay
dividends. At one extreme, in their seminal analysis of the topic, Modigliani and Miller
argue that dividends are irrelevant because investors can generate their own cash-flow
streams by selling a portion of their share holdings. On the other hand, the so-called
bird-in-the-hand argument holds that shareholders prefer dividends over capital gains
for consumptive and risk-hedging reasons. In this study, Bhattacharya develops a model
in which dividends serve as a signal of the “insider's” anticipation of the
firm's future performance, thereby providing a new rationale for the existence of these
cash emissions.
The author makes several critical assumptions in constructing his model. First and
foremost, he posits that investors are imperfectly informed and have planning horizons
that are shorter than the life of the firm. In his analysis, Bhattacharya allows for the
possibility that investors have both single-period and multiperiod horizons. Second, he
assumes that investors are taxed on dividend income at a higher rate than on capital
gains. Finally, he adopts a framework in which the informational signal must be costly
to be effective, which is known as a dissipative signal. Dividend payments, because of
disadvantageous tax treatment and the fact that they constrain the company's ability to
reinvest past profits to generate future profits, satisfy this restriction.
From this foundation, Bhattacharya creates a model for the discounted expected value
derived by stockholders from a particular level of dividend payments. The model depends
on four distinct factors: the after-tax proportion of the current dividend received by
the shareholder, the liquidation value of the share holding based on a stream of future
dividend payments set at the current level, the benefits of reinvesting any excess cash
flows (i.e., cash generated by the firm but not paid out in dividends) in the firm, and
the expense of having to maintain the present dividend level in the face of an operating
cash-flow shortfall. This last factor, along with the incremental tax burden imposed on
investors, creates the cost necessary to make dividend payments a viable signal of
managers' expectations of future economic conditions.
When this model of expected value is interpreted as the shareholders' objective function,
the study's primary results are achieved by solving for the level of dividend payments
that maximizes the goal. By doing this analysis first for a one-period investment
horizon, the author is able to reach various conclusions from the resulting
“comparative statics.” Chiefly, he demonstrates that the market-signaling
value of the dividend payments survives in equilibrium only if the expectations about
future cash flows that are being signaled are ultimately fulfilled. That is, the
liquidating share value implied by the dividend payments must be the true value of the
firm's future cash flows. Additionally, he shows that the optimal value for the dividend
payment declines with increases in the tax rate and the prevailing interest rate in the
market.
In an effort to make the analysis more realistic, Bhattacharya expands his model to allow
for the possibility that shareholders make multiperiod investments. The major result
that he is able to derive from this extension is that the shorter an investor's time
horizon, the greater the urgency to receive wealth in a consumable form and thus the
greater the equilibrium dividend payout ratio. He observes that this result has the same
ultimate impact as the traditional bird-in-the-hand argument, but it arrives at that
conclusion for a vastly different reason. He also demonstrates that lengthening the
planning horizon reduces the importance of the end-of-period liquidating share value in
the objective function relative to the intrahorizon cash flows.
The author concludes the study by conceding several limitations of the model. First, he
notes that in a multiperiod setting, allowing shareholders to have different planning
horizons results in a failure to reach investor unanimity regarding corporate decision
rules. Second, the objective function he uses depends critically on the existence of
interperiod consumption-loan markets and the assumption of risk neutrality among
investors. Finally, restrictions are placed on the use of corporate debt and the price
at which asset sales are allowed to take place in the secondary market. He suggests that
the basic intuition provided by his analysis should carry over to more elaborate models.