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Unformatted text preview: money makers? There is incomplete information about the investment opportunities, the cash flow and risks associated with them Leading to high agency costs. We can understand why investors would refuse to believe a firm’s reported earnings unless they were backed by an appropriate dividend policy. The Information in Dividends 15 Bhattacharya (1979): dividends are a signal of firm quality. Low quality firms can cheat in the short run by scrapping up enough cash flows to pay generous dividends, but they will not be able to sustain this in the long run. Low quality firms will have to reduce investment or resort to raising more cash by turning towards debt and equity holders. Managers won’t increase dividends until they are confident that they have sufficient cash flows to sustain them. A high quality firm will provide dividends just sufficient enough to deter ‘cheating’ by low quality firms. 16 The Information in Dividends: Empirical evidence Benartzi, Michealy and Thaler (1997) found that dividend increases generally followed a couple of years of unusual earnings growth Healy and Palepu (1988) focused on first time dividend paying firms. On average earnings increased by 43% in the years that dividends were paid Over th...
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