Introduction to Corporate Finance

15: Payout Policy

Signalling Model

The signalling model of dividends addresses another market imperfection that makes payout policy

relevant: asymmetric information – the situation in which managers of the company have more information

about the company and its prospects than do investors. If managers know that their company is strong

when investors, for some reason, do not know this, then managers can pay dividends (or aggressively

repurchase shares) in hopes of signalling their company’s quality to the marketplace. For a signal to

effectively separate strong companies from weak companies (so that a strong company can signal its type

to the market), it must be costly for a weak company to mimic the action taken by the strong company.

According to the signalling model, it is costly for a company (especially a weak company) to initiate or

increase dividends. For example, a company that pays out will likely face greater scrutiny from the capital

markets if it needs to raise capital in the future, or the company must expect positive internal cash flow in

the near future (as did Starbucks in the chapter-opening ‘What companies do’ feature); in both of these

scenarios, the strong company has an advantage over the weak company.

An alternative signalling story is based on investors having to pay higher taxes on dividend income,

with the weak company being less able to withstand this cost to their investors. Thus, dividends help

investors solve the asymmetric information problem of distinguishing between high-quality and low-

quality companies, because high-quality companies are more able to pay dividends. Like the agency cost

signalling model

Assumes that managers use

dividends to convey positive

information to poorly informed

shareholders

asymmetric information

The situation that exists when

managers of the company

have more information about

the company and its prospects

than do investors

DIVIDENDS AND REPURCHASES IN THE EUROPEAN UNION, 1989–2006
As a percentage of total cash payouts to shareholders, from 1989 through 2006 share repurchases rose relative to
dividends in Europe, just as they did in the United States.

Source: Reprinted from Henk von Eije and William Megginson, ‘Dividends and Share Repurchases in the European Union’,

Journal of Financial Economics 89 (2), pp. 347–374, Copyright © 2008, with permission from Elsevier.

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180 ,000

200,000

198919901991199219931994199519961997

Year

199819992000200120022003200420052006

Millions of euros Cash dividends

Repurchases

Total