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Dividend Signalling, Stock Prices Volatility and Firms Capital Structure

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1 Table of Contents Introduction ................................................................................................................................. 2 Role of Optimal Capital Structure in Firm Performance ............................................................ 2 Capital Structure Theories and its Impact of Firm Value ........................................................... 3 Contribution of Signaling Theory ............................................................................................... 4 Signaling theory and Asymmetric Information .......................................................................... 4 Dividend signaling and Risk Management ................................................................................. 4 Dividend and Stock Market Performance ................................................................................... 5 Support of Empirical Evidence ................................................................................................... 5 Conclusion .................................................................................................................................. 6 References ................................................................................................................................... 6

2 Introduction Imperfect market is a place where there is different information to buyers and sellers. In this situation signaling theory plays the important role in determining the behavior of the market. Firm while investing or announcing the dividend policy communicates its future prospects to their investors, creditors, clients and their rivals about the firm growth. On the other hand when information is communicated, the main questions arise that how it would be interpreted by buyers and how they react to this information? Reactions of investors create some activity in the market. The market is growing and there is immense competition in the market signaling theory has gained much popularity and momentum (Connelly et al., 2011). Asymmetric information determines the relevance of signaling theory. As investors or creditors do not have full access to the firms operational information, a little fact can change their investment decisions. Newly established firms hired some good names as their directors to signal the potential investors that the firm contains strong values and involve in legitimate business (Certo, 2003). This clearly indicates that one party can make changes to affect other party decision. Firms change their capital structures to give a positive signal to potential investors. There is a lot more clientele effect involved. If the firm is dealing with the investors who are like to invest for long term and prefer dividend payments then firms who pay regular dividends are more likely to succeed. On the other hand if there is strong equity market and investors in it are more risk takers prefer capital gains and also get along with an increase in value of stocks. In this situation firms look for investment opportunities and curb the dividend payments to support their investors. Role of Optimal Capital Structure in Firm Performance Whenever the firm decides to achieve the optimal capital structure the main objective for the firms financial manager is to decide whether to go for leverage or issue equity to raise funds. How much to borrow and how to overcome the financial obligation of its creditors? On the other hand how to maximize the shareholders wealth? Many theories in literature which help the financial institutions to fulfill the optimal capital structure needs. In pursuit of the optimal capital structure many models have been formed with the objective of gaining higher returns with low risk involved and achieving the optimum value for the firm. Chen et al. (2009) provided the structural model which states that asset structure, expected growth, profitability,

3 stock returns, volatility, leverage, industry classification, liquidity, value, size, long term momentum and reversals are the main driving forces to determine the optimal capital structure and stock returns. These factors are important but there are many other factors which can play the important role in fulfilling the optimal capital needs of the firms. Capital Structure Theories and its Impact of Firm Value Miller & Modigliani, (1961) provided the dividend irrelevance theory, which states that dividend is not an integral factor in determining the firm value they suggested that firm value is not determined by the dividend policy. On a part of the capital structure Modigliani & Miller, (1958) indicated that firm capital structure whether they go for debt or equity cannot affect the firm value. The assumption behind this theory is the perfect market where there is no information asymmetry. Buyers and sellers have equal access to the market. After capital structure irrelevance theory it is found that there are benefits of debt in the form of tax shield so the firm can employ more debt as compared to equity because the firm can enjoy the benefit of tax shield on debt but they overlooked the cost of debt i.e. financial distress cost. Firm reliance on debt creates a financial obligation and this creates a financial distress situation if the firm is finding it difficult to satisfy its financial obligations. Jensen & Meckling (1976) give the static tradeoff theory of capital structure which states that firm draws a line between cost of debt i.e. financial distress cost and the benefit of debt i.e. tax shield and with the balance in between it can achieve the optimal capital structure. Information asymmetry arises when one party knows better than the other party. Mostly the inside management has better access to the information regarding firm operations than outsiders. Then firm can exploit the rights of outsiders. The pecking order theory, which is proposed by Myers (1984), is the consequence of information asymmetry. The pecking order theory does not follow the objective of optimal capital structure rather it follows the hierarchy of funding needs. In pecking order theory firm first follow retain earnings, then go for debt financing because debt financing reduces the information asymmetry but when cost of debt is more than benefits of debt firm go for equity financing. Another capital structure theory proposed by Jensen & Meckling (1976) states that the optimal capital structure can be achieved by the agency cost of the firm, where the conflict of interest arises among different parties involved in the agreement. These conflicts can be between the management of the company and shareholders. It can be between debt holders and firm

4 management or it can be among the debt holders of the firm and shareholders of the firm. Another theory which is based on signaling of the market provided by Baker & Wurgler (2002) elaborates that fluctuation in the stock market can affect the firms capital structure. It states that when the stock of the firm is overvalued, the firm is going to issue more stock and conversely when the stocks are undervalued than firm starts to buy back its stock. It has been seen that firm capital structure theory is always based on some signal because of the information asymmetry and the imperfect market hypothesis. These theories focus on the optimal capital structure while giving a signal in the market. Firms capital structure decisions always send some signal, whether positive or negative, to its shareholders and creditors regarding firms operations. Contribution of Signaling Theory Information asymmetry has been the main source of describing the signaling theory. And the pecking order theory in which the requirement of funding form a hierarchy. Signaling theory has a significant role in finance but its contribution in other management disciplines has been widely discussed by literature. Signaling theory has an important contribution in literature on entrepreneurship. Where it has a significant contribution in characteristics of the board and management1 and Signaling theory also considered important in human resource management2 where the hiring process of management provide a signaling effect. Signaling theory and Asymmetric Information There is the asymmetric information when the managers do not want to share the inside information of the firm with the outsiders (stakeholders). Whenever firm leaks out any operational news about the firm it creates a positive or negative signal for the outsiders of the firms and they act according to the signal created by the information given by the company. Asymmetric information is the source of creating signal in the market. Dividend signaling and Risk Management Dividend gives the signal for the stable management and profitability of the firm. Managers communicate with the shareholder that there will be a change in future cash flows with
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Certo, (2003) and Lester, Certo, Dalton, Dalton, & Cannella (2006) Suazo, Martinez, & Sandoval (2009)

5 the change in dividend policy. So information asymmetry is positively related to dividend policy, which means that higher the information asymmetry in the market higher will be the sensitivity about the dividend announcement (Miller and Rock, 1985). There are many firm decisions which affect the dividend policy. Dionne & Ouederni (2011) provided in their study that we can reduce the effect and sensitivity of dividend on firm shareholder while hedging our future cash flows. Dividends are the most significant source which help the investors to understand the future earning capabilities of the firm but this effect is reduced by the hedging of future earnings (Dionne & Ouederni, 2011). Dividend and Stock Market Performance Dividends are the source of communication between the firm insiders and outsiders. Making a dividend policy is the important factor which determines the future value of the firm. Shareholders wealth is the main objective of firm financial management and it is linked to the value of the firm. Managers wanted to increase the wealth of shareholders to increase the value of the firm. The optimal dividend policy is the drive force to enhance the firm value (Suwanna, 2012). Theoretically it is argued that with the decrease in dividend policy the stock prices reduce and there is less returns on securities. On the other hand it is observed that the announcement of dividends tends to increase the abnormal returns from stocks. This is due to the asymmetric information between the investor and the managers of the firms. The dividend policy of the firm signals the investor, who doesnt have the complete information about the firm inside affairs, about the future performance of the firm. So the dividend payouts create a signaling effect for the investors about the future prospects of the firm. Support of Empirical Evidence Suwanna (2012) used event study methodology on 60 companies listed in stock exchange of Thailand. His results indicated that the dividend announcement has the significant impact on stock returns. With the event window of 40 days, Suwanna, (2012) proposed that there is a significant increase in stock prices with the announcement of dividends. This indicates that shareholders prefer dividend in Thailand and the announcement of dividend sends a positive signal to shareholders about the performance of the company and its help building trust of the company in the eyes of stakeholders.

6 The price of stocks and the trading volume which affected by the dividend announcements give the brief understanding about the strength of the signals which are communicated by dividend announcement in the market (Karpoff, 1987). Gurgul, Mestel, & Schleicher (2003) analysed the signals created by dividend announcements and their impact on the stock trading volume. They found that around dividend announcement dates there is abnormal access trading in the market. Bozos, Nikolopoulos, & Ramgandhi (2011) studied the dividend signaling effect under stable as well as adverse economic conditions. They conducted a study on London Stock Exchange (LSE) and found that there are positive and significant abnormal returns of stocks around dividends and earnings announcements. They found those dividends are more significant at the time of economic adversity and found to be weak in stable economic conditions. Conclusion It is confirmed from the critical discussion of both theoretical and empirical evidences provided in the previous literature that dividends, stock returns and the signaling theory are closely related. Firms do want to have optimal capital structure and want to communicate a positive signal to their investors when they are deciding to give dividends. The empirical evidences as discussed above show that there is a positive vibe in the market when firm announce the pay dividends to their shareholders and it tends to have a positive impact on stock returns. These findings are in line with the theoretical aspects of this assignment where every decision regarding capital structure made by the firm sends some signal to their investors. dividend signaling helps to reduce information asymmetry, which make the equity market more stable. References Baker, M., & Wurgler, J. (2002). Market timing and capital structure. Journal of Finance, (1), 1 32. Bozos, K., Nikolopoulos, K., & Ramgandhi, G. (2011). International Review of Financial Analysis Dividend signaling under economic adversity: Evidence from the London Stock Exchange . International Review of Financial Analysis, 20(5), 364374. doi:10.1016/j.irfa.2011.07.003

7 Certo, S. T. (2003). Influencing initial public offering investors with prestige: Signaling with board structures. Academy of Management Review, 28, 432446. Chen, Y. C., Cheng, L. F., Xiang, G. yan, & Wen, L. Y. (2009). Co-determination of capital structure and stock return-A LISREL approach an empirical test of Taiwan stock markets. the Quarterly Review of Economics and finance, 50(2), 222233. Connelly, B. L., Certo, S. T., Ireland, R. D., & Reutzel, C. R. (2011). Signaling Theory: A Review and Assessment. doi:10.1177/0149206310388419 Dionne, G., & Ouederni, K. (2011). Corporate risk management and dividend signaling theory. Finance Research Letters, 8(4), 188195. doi:10.1016/j.frl.2011.05.002 Gurgul, H., Mestel, R., & Schleicher, C. (2003). Stock market reactions to dividend announcements: Empirical evidence from the Austrian stock market. Financial Markets and Portfolio Management, 17(3), 332350. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305360. Karpoff, J. M. (1987). The relation between price changes and trading volume: A survey. The Journal of Financial and Quantitative Analysis,, 22(1), 109126. Lester, R. H., Certo, S. T., Dalton, C. M., Dalton, D. R., & Cannella, A. A. (2006). Initial public offering investor valuations: An examination of top management team prestige and environmental uncertainty. Journal of Small Business Management, 44, 126. Miller, M. H., & Modigliani, F. (1961). Dividend Policy, Growth, and The Valuation of Shares. Journal of Business, 34(4), 411433. Miller, M., & Rock, K. (1985). Dividend policy under asymmetric information. The Journal of Finance, 40, 10311051. Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporate finance and the theory of investment. American economic review, 48, 261275. Myers, S. C. (1984). The capital structure puzzle. Journal of Finance, 34(3), 575592.

8 Suazo, M. M., Martinez, P. G., & Sandoval, R. (2009). Creating psychological and legal contracts through human resource practices: A signaling theory perspective. Human Resource Management Review, 19, pp. 154166. Suwanna, T. (2012). Impacts of Dividend Announcement on Stock Return, 40, 721725. doi:10.1016/j.sbspro.2012.03.255