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Excerpt from Corporate Financial Decisions and Future Earnings Performance: The Case of Initiating Dividends
Dividend policy has several attractive aspects as an information transmission mechanism. Unlike the detailed focus of other announcements, dividends can be used as a simple, comprehensive signal of management's interpretation of the firm's recent performance and its future prospects. Unlike most announcements, dividend announcements must be backed with hard cold cash. The firm must either generate this cash or convince the capital markets to supply it. In addition to the credibility of cash signals, dividends are also highly visible compared with other announcements. (p.9é) A second dividend hypothesis proposed in the literature competes with the information signaling hypothesis and also predicts a positive stock price reaction to dividend announcements. Graham and Dodd Gordon and Gordon and Bradford suggest that the investors prefer returns in the form of dividends, possibly because of institutional constraints. This proposition is consistent with a positive wealth impact of dividend announcements and with the results of Long's (1978) examination of the returns on the dual series common stock of a single firm. A key distinction between the information signaling hypothesis and this other explanation of the dividend announcement effect is that, while the signaling hypothesis explicitly links the announcement of dividends and the firm's current and future performance, no such link is implied by the competing explanation.
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