Dividend policy puzzle: The information effect and a new version of the signaling theory

Dividends are expensive to pay or to receive. Firms may borrow, cut their investment plans, or jeopardize liquidity level in order to pay dividends; similarly, investors would, before the new tax law in 1986, pay higher tax rates on dividends than on capital gains. However, despite their apparent disadvantages to firms and investors, one can still observe that firms insist on paying them, and some investors still prefer to receive them.;This research tests the existence of a dividend information effect around dividend announcement dates and proposes an explanation to prevailing dividend policies using a new version of the signaling theory. We argue that earning announcements provide incomplete information to the market, and that investors can, after receiving the dividend signals, interpret most of the observed changes in firm activities, as represented by changes in the firm's balance sheet from one period to another period. This complex signal would clarify some or all of the uncertainty about the firm's future, but will not always be as direct as one expects. Dividend signals can be clear, semi-clear, or ambiguous depending on how much information they carry to the market, and on how long it takes investors to interpret them. Based on our results, dividend signals convey information about investment prospects, changes in financing policies, and agency actions depending on the state the firm is in prior to receipt of the signal. We further find that the strength of market reaction to dividend announcements depends on the quality and sign of signals.