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Signaling Theory Assessment: Dividend and Corporate Risk
Department of Finance Jagannath University 1 | P a g e
Signaling Theory Assessment: Dividend and Corporate Risk -Perspective Bangladesh
Assignment
Date of Submission: 19th July, 2011.
Signaling Theory Assessment: Dividend and Corporate Risk
-Perspective Bangladesh
Submitted To:
Md. Omar Faruque Lecturer Department of Finance Jagannath University, Dhaka.
Submitted By:
Md. Mazharul Islam.Group Representative of Finance InterfaceB.B.A, 3rd Batch (2nd Year, 2nd Semester)Session: 2008-2009
Department of Finance Jagannath University, Dhaka.
Date of Submission: 19th July, 2011.
Department of Finance Jagannath University 2 | P a g e
An Assignment of Financial Management
Course Code: FIN -2206
7
Signaling Theory Assessment: Dividend and Corporate Risk
Group Members of Finance Interface
Sl. No.
Name Roll No. Work Load100%
Total Marks
01. Md. Mazharul Islam. 091541 70%
02. Khadizatuz Zohara. 091526 30%
Department of Finance Jagannath University 3 | P a g e
Signaling Theory Assessment: Dividend and Corporate Risk
Letter of Transmittal19th July, 2011
Md. Omar FaruqueLecturerDepartment of FinanceJagannath University, Dhaka.
Subject: To submit an assignment of “Signaling Theory Assessment: Dividend and Corporate Risk - Perspective Bangladesh”
Dear Sir
This is informed you that we have completed our Assignment on “Signaling Theory
Assessment: Dividend and Corporate Risk - Perspective Bangladesh”. ”. Here we
tried my best to give an overview of signaling theory, types of information, and its
contribution in management decision making and a practical example of it related our
course ‘Financial Management.
In preparing this Assignment we have followed the instruction of yours, we will be
glad to clarify any discrepancy that may arise.
Thank you for your cooperation.
Sincerely,
Md. Mazharul Islam.
On the behalf of the groupFinance InterfaceRoll no: 091541Department of Finance.
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Signaling Theory Assessment: Dividend and Corporate Risk
Jagannath University, Dhaka.Acknowledgement
First of all we would like to thank the almighty for giving us the strength and the
aptitude to complete this report within due time. We are deeply indebted to our
course teacher Md. Omar Faruque for assigning us such an interesting topic named
“Signaling Theory Assessment: Dividend and Corporate Risk”. We also express
the depth of our appreciation to our honorable course teacher for his suggestions and
guidelines, which helped us in completing this report.
Department of Finance Jagannath University 5 | P a g e
Signaling Theory Assessment: Dividend and Corporate Risk
Executive Summary
Signaling theory states that changes in dividend policy convey information about changes in future cash flows. Dividend signaling suggests a positive relation between asymmetry and dividend policy. In other words, the higher the asymmetric information level, the higher is the sensitivity of the dividend to future prospects of the fir. Several empirical studies attempt to test the informational content of dividend changes, yet they disagree about the sign and the significance of information asymmetry on dividend policy.
Dividend theory suggests that dividend is sticky and it can be used to signal quality of the firms. However, empirical evidences do not strongly support the signaling efficiency of dividend to future firms’ performance. Specifically, when dividend surprise is measured in terms of differences from past dividend, empirical research cannot find strong relationship between dividend surprise in current period and future firm performance.
Another strand of literature suggests that corporate risk management alleviates information asymmetry problems and hence positively affects the firm value. Information asymmetry between managers and outside investors is one of the key market imperfections that makes hedging potentially benefit.
In this assignment we exploit the documented interaction between the level of information asymmetry and the dividend policy, along with its interaction with corporate risk management. We argue that risk management alleviates the asymmetric information problem, which is a main determinant of dividend policy.
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Signaling Theory Assessment: Dividend and Corporate Risk
Table of Contents
Name Page No.Acknowledgement 5Executive Summary 6
Part - I
Abstract 81.1 Introduction 81.2 Rationale of the study 81.3 Objective of the report 91.4 Scope of the study 91.5 Methodology of the study 101.6 Limitation of the study 10
Part - II
2.1 Signal and Signaling theory 112.2 Different types of Signaling 12-132.3 Types of Information 132.4 Dividend Signaling 132.5 The main idea of signaling 14
1. Assumptions 152. Example one 173. Example Two 19
Part -III3.1 Conclusion 21Bibliography 22
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Signaling Theory Assessment: Dividend and Corporate Risk
Abstract
Signaling theory is useful for describing behavior when two parties (individuals or organizations) have access to different information. Typically, one party, the sender, must choose whether and how to communicate (or signal) that information, and the other party, the receiver, must choose how to interpret the signal. Accordingly, signaling theory holds a prominent position in a variety of management literatures, including strategic management, entrepreneurship, and human resource management. While the use of signaling theory has gained momentum in recent years, its central tenets have become blurred as it has been applied to organizational concerns. Dividend theory suggests that dividend is sticky and it can be used to signal quality of the firms. However, empirical evidences do not strongly support the signaling efficiency of dividend to future firms’ performance. Specifically, when dividend surprise is measured in terms of differences from past dividend, empirical research cannot find strong relationship between dividend surprise in current period and future firm performance.
Part-I
1.1 Introduction
The signaling theory is very important for today’s competitive business world. Signaling theory states that corporate financial decisions are signals sent by the company's managers to investors in order to shake up these asymmetries. These signals are the cornerstone of financial communications policy. The signaling theory also describes the types of information which is also important for taking investment decision. So managers get consistent, accurate and relevant information and take decision easily which has tremendous impact on organizational effectiveness.
1.2 Rationale of the Study
The assignment is assigned by our course teacher Lecturer MD. Omar Faruque as a part of our course named ‘‘Financial Management”. The topic of the report is ‘‘Signaling Theory Assessment: Dividend and Corporate Risk”. By conducting this assignment, we have known about Signaling Theory, its impact on company’s dividend paid, capital structure and management decision making. This assignment has given us a chance to know about signaling theory which would help us in managing huge information efficiently and effectively and accurately so that by using that information we can take appropriate decision about company’s investment.
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Signaling Theory Assessment: Dividend and Corporate Risk
1.3 Objective of the Report
The main objective of this case study is to earn knowledge about the Signaling Theory and its impact on company’s investment and management decision making.
Primary Objectives:
The main objective of this assignment is to analyze Signaling Theory.
Secondary Objectives:
This assignment has also some other objectives which are as follows:
To know about various information
To know about dividend signaling
To know about its impact on capital structure.
To find out information problems in investment decision making
To suggest for solving this problems.
1.4 Scope of the Study
There were huge scopes to work in the arena of the case. Considering the dead line, the scope and exposure of the paper has been wide-ranging. The study behind “Signaling Theory Assessment: Dividend and Corporate Risk” has covered overall analysis in making investment decision the different information system applied in signaling theory, advantages applying the method and solution are shown in this case. By preparing this report it becomes more understandable about signaling theory
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Signaling Theory Assessment: Dividend and Corporate Risk
1.5 Methodology of the Study
Financial Management: Capital Structure (13th edition) by Scott Besley and Eugene F. Brigham. -
Sources of data
Here the secondary sources of information were used. The secondary sources are:
Web sites
Books
DSE & SEC
Different Business Publication & Notes
1.6 Limitation of the study
As we collected our information through secondary sources, so we have not been able to collect more information which could give us more clear knowledge about the signaling theory. While conducting the case on ‘‘Signaling Theory Assessment: Dividend and Corporate Risk” some limitations was yet present there:
Because of time shortage many related area cannot be focused in depth.
Recent data and information on different activities was unavailable.
Recent fall of share market that implements some information restrictions.
As a case analysis, it has been prepared shortly.
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Signaling Theory Assessment: Dividend and Corporate Risk
Part II
2.1 Signal
An action taken by a firm’s management that provides close to investors about how management views the firm’s prospects is called signal.
Signaling Theory
Signaling theory states that corporate financial decisions are signals sent by the company's managers to investors in order to shake up these asymmetries. These signals are the cornerstone of financial communications policy. In economics, more precisely in contract theory, signaling is the idea that one party conveys some meaningful information about itself to another party.
Signaling theory is concerned with understanding why certain signals are reliable and others are not. It looks at how the signal is related to the quality it represents and what are the elements of the signal or the surrounding community that keep it reliable. It looks at what happens when signals are not entirely reliable – how much unreliability can be tolerated before the signal simply becomes meaningless?
Signaling occurs in competitive environments. The interests of the sender and the receiver seldom align exactly, and often they are quite at odds with each other. Sometimes the competition is fierce and overt, as with prey and predators. Potential prey may signal to predators that they are poisonous or that they can run so fast or fight back so strongly that pursuing them is futile. Potential competitors may signal their strength to each other; if they are unevenly matched, the weaker may acquiesce and actual battle, which is costly for all, can be avoided. Sometimes the competition is subtle, as when the signaling is between seemingly congenial companions. But even within cooperative relationships there are conflicts of interest about how plans and identity are perceived. I wish to present myself in the best possible light while you want to know what I am really thinking and what I really can and will do.
Like it nor not, we all use signaling in our day-to-day lives. It is used probably at every moment and with everyone. For example:
a. Business: Suppose you come up with a product – let’s say ‘Ketchup’. This Ketchup might be the best ketchup available in the country, if not the entire world. However, shouting-from-rooftops about this ketchup being the best in the world in various advertisements wouldn’t help much, since the Ketchup marketplace is already a crowded one. ‘Tastier than Heinz’ is one approach – relative comparison which customers will
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Signaling Theory Assessment: Dividend and Corporate Risk
quickly catch on to – that’s one type of signaling. The second type of signaling might involve money back guarantees, public tasting guarantees or tying up with a food chain and offering your ketchup as a free add-on. Positive signaling to increase your business.
b. Corporations: This theory works very well during or near Quarter result declarations. Statements like ‘Retail sales are holding’; ‘Economy has been weak’ implies that earnings would not meet expectations. As also, is the case with dividends (giving out dividends consistently may be taken as stable company but no growth prospects), insider buying (when management of the company starts buying shares, it is usually a signal that the company is and will be doing well in the foreseeable future), insider selling (opposite of the previous item) and various other corporate actions – each signaling or telling us what is about to come. They may not be 100% reliable, but works most of the time.
c. Money: How do you let the world know that you are rich? One way, although incredibly crazy would be to print out your bank statements and put it up on a billboard. More often than not, in this case, you are sending out a positive signal for kidnappers! On a serious note, flaunting a Louis Vuitton bag, driving a Porsche car, building a huge house etc. are signals to indicate you are rich. You need not say anything, but your actions speak for it. That’s signaling.
d. At work: ‘Pretending to be busy’, ‘Blocking calendars’ and ‘looking perturbed and disturbed’ are all classic signals to indicate that you are someone important, your time is important and you deal with multiple issues in the corporation, even though you might not be. Trying to hang out with superiors is also a classic signal that you intend to move up the ladder. There are about a million examples of Signaling theory at work.
e. Relationships: Last but not the least, signaling theory works brilliantly in relationships. Does ‘Silence’ ring a bell? ‘What happened dear?’ might be a question posed to you. If you are silent or even worse, say ‘nothing’, then it’s a classic signal that you are pissed off at something he/she had done. I presume almost everyone in a relationship would have a gone through this exact example. That’s signaling at work – indicating to him/her that he/she better not repeat the act again.
2.2 Different Types of Signaling
Some signals are inherently reliable. Here, the cost of simply producing the signal is prohibitive to one who does not have the quality that the signal is advertising. These are called,
1. Assessment signals because the form of the signal itself allows the receiver to assess its reliability.
There are also many signals, especially in human communication, that are not inherently reliable. These are called,
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Signaling Theory Assessment: Dividend and Corporate Risk
2. Conventional signals because it is convention, rather than the any essential characteristic of the signal, that connects its form to its meaning. The reliability of these signals is externally maintained through the actions of the community: producing the signal is not itself costly, but a costly penalty is incurred if one is caught signaling deceptively.
2.3 Types of Information
There are two kinds of management information and they are:
1. Symmetric information
Symmetric information is the situation in which investors and managers have identical information about the firm’s prospects.
2. Asymmetric information
Asymmetric information is the situation in which managers have different information about their firm’s prospects then they do outside investors.
2.4 Dividend Signaling
A theory that suggests company announcements of an increase in dividend payouts act as an indicator of the firm possessing strong future prospects. The rationale behind dividend signaling models stems from game theory. A manager who has good investment opportunities is more likely to "signal" than one who doesn't because it is in his or her best interest to do so.
Over the years the concept that dividend signaling can predict positive future performance has been a hotly contested subject. Many studies have been done to see if the market’s reaction to a "signal" is significant enough to support this theory. For the most part, the tests have shown that dividend signaling does occur when companies either increase or decrease the amount of dividends they will be paying out. The theory of dividend signaling is also a key concept used by proponents of inefficient markets.
Dividend theory suggests that dividend is sticky and it can be used to signal quality of the firms. However, empirical evidences do not strongly support the signaling efficiency of dividend to future firms’ performance. Specifically, when dividend surprise is measured in terms of differences from past dividend, empirical research cannot find strong relationship between dividend surprise in current period and future firm performance.
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Signaling Theory Assessment: Dividend and Corporate Risk
Assumption
Signaling theory is based on the assumption that information is not equally available to all parties at the same time, and that information asymmetry is the rule. Information asymmetries can result in very low valuations or a sub-optimum investment policy
The main idea of signaling theory
Signaling theory is an idea of decision making of a firm’s financing. So the main idea of signaling theory is given below:
1) Firm will finance from its own fund that means from internal source;2) Internal sources are Retained Earnings, Reserve Fund, and Accumulated Fund etc.3) Financing from internal sources are more secured than external because cost of
capital in internal source is less than external;4) If financing is not possible from internal source than it will be collected from
external.
MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued. Sell bonds if stock is undervalued.
And investors understand this, so view new stock sales as a negative signal.
In this topic, we briefly discuss signaling theory. But, before we begin our discussion of
signaling theory, why would a firm be interesting in signaling? In general, a firm’s
managers use signals to reveal information to the public about firm value. Managers have
the incentive to signal if:
1) They have private information about firm value and the public does not (i.e.,
information asymmetry)
2) The private information is “good” news (therefore, the signal will reveal this good
news to the public)
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Signaling Theory Assessment: Dividend and Corporate Risk
3) Bad firms can’t (won’t) imitate
4) Managers cannot credibly disclose the positive information without the signal (i.e.,
they can’t simply hold a news conference).
In corporate finance, signaling models have been used (as the textbook describes) to
explain the level of investment by an entrepreneur in a firm, debt versus equity choices, the
size of dividends, and stock splits. The textbook splits its discussion between “costly” (with
exogenous costs) and “costless” signals (with endogenous costs). With either type, the
signal is meant to separate good firms from bad firms.
Our discussion centers on one of the foundational papers in “costly” signaling theory:
Spence, Michael, “Job market signaling,” Quarterly Journal of Economics 87 (1973), 355-
374. In the Spence model, hiring an employee is viewed as an investment decision with
uncertainty concerning the employee’s value. The cost to the firm is the wages paid. The
value to the firm is the employee’s marginal product (i.e., marginal contribution) to the
firm.
Assumptions:
1) Employer cannot directly observe the potential employee’s (i.e., applicant’s)
marginal product
2) Employer can observe the attributes of the applicant that are related to his/her
marginal product (education, work experience, age, sex, race, height, etc.)
3) Some attributes are fixed (age, sex, race, height), some are not (education,
work experience)
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Signaling Theory Assessment: Dividend and Corporate Risk
4) Fixed attributes are termed “indices,” those subject to change by the applicant
are termed “signals”
5) Signals are costly and are negatively correlated with the applicant’s productive
capability. That is, the signal is less costly for applicants with greater
productive capabilities.
6) Employer uses indices and signals to determine the wage rate
7) Employers are risk neutral who offer wages equal to the applicant’s expected
marginal product
8) Employer beliefs about the value implied by the indices and signals can
change through time as new data is received
Since the applicant can’t alter indices, the only thing they can do to affect the wage
rate is to alter their signals. (Spence focuses on the education signal.) The amount of
education acquired by applicant is the amount that maximizes the difference between
the offered wages and the cost of education (the signaling cost). Education costs
include dollars (tuition), time, mental strain, etc.
Assumption 5 is critical to an effective signal. What would happen if the signal
was equally costly to all applicants?
Information feedback loop
1) Employers have conditional probabilistic beliefs about the relation between
indices / signals and applicants’ marginal product
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Signaling Theory Assessment: Dividend and Corporate Risk
2) Employer offers wage schedule (a function of indices and signals)
3) Signaling decisions are made by applicants (taking into account signaling
costs)
4) Employer hires applicant, observes relation between indices/signals and
marginal product and updates beliefs
Spence (1973) describes a signaling equilibrium in which new incoming data is self-
confirming (so no update in beliefs). That is, employers set the wage schedule that
induces applicant signaling decisions. Employers then hire and the marginal product
of the employees is as expected.
Example one:
1) One employer
2) Two types of applicants: Type one have low marginal product (= $1), the other
have high marginal product (= $2).
3) Proportion of group one: q, proportion of group two: 1-q
4) Signal = education. Signaling costs:
Group one: cost of education of level y = y
Group two: cost of education of level y = y/2
5) Education does not change the applicant’s marginal product
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Signaling Theory Assessment: Dividend and Corporate Risk
To find equilibrium, set initial probabilistic beliefs, then determine if they are
confirmed. For example, assume that the employer’s probabilistic beliefs are:
6) If y < y*, then productivity = $1 (with probability 1), if y y*, then
productivity = $2 (with probability 1). So the employer offers wages of $1 to
applicants with y < y* and wages of $2 to applicants with y y*
7) Applicants will respond by either obtaining education level 0 or y* (why only
these two levels?)
8) For employer beliefs to be confirmed, then all applicants from group one must
obtain education level 0 and all applicants from group two must obtain
education level y*
9) Each groups sets y to maximize the difference between wage and signal cost –
diagramed in figure 2
10) Education selected by applicants is self confirming if:
For group one: $1 > $2 - y*
For group two: $2 - y* / 2 > $1
11) Putting these two conditions together: $1 < y* < $2. Note – any y* in that
range is in equilibrium, but not equivalent in terms of welfare. For example,
how do members of group one and two think about increasing y*?
12) Proportion of individuals in each group does not affect the equilibrium.
13) If signaling is not allowed, then wage rate for all applicants is: $1q +
$2(1 - q) = $2 – q. For example, if q = 0.4, then wage rate = $1.6.
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Signaling Theory Assessment: Dividend and Corporate Risk
a. Group one prefers no signaling.
b. Group two prefers signaling or no signaling depending on the values for
y* and q. Remember, groups two’s net return is $2 - y* / 2. Also
remember that $1 < y* < $2. So, if q 0.5, then group two is worse off
by signaling.
14) In general, if y* < 2q, then group two is better off in a signaling
environment. So, higher q increases benefit to signal for group two, higher y*
decreases the benefit from signaling.
15) Even more in general, if a1y is the signaling cost for group one and a2y is
the signaling cost for group two, then: group two is better off in a signaling
environment if q > a2 / a1.
Example two:
1) Employer beliefs are:
If y < y*, then group one (productivity $1) with probability q and group two
(productivity $2) with probability 1-q.
If y y*, then group two (productivity = $2) with probability 1
2) Levels of y selected are still either 0 or y*.
3) Wage rate is set at $2 – q for y = 0 and $2 for y = y*.
4) Assume y* set greater than 2q. Then both groups select y = 0.
Group one:
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Signaling Theory Assessment: Dividend and Corporate Risk
y = 0, then net wage = $2 – q (select this)
y = y*, then net wage = $2 – y*
Group two:
y = 0, then net wage = $2 – q (select this)
y = y*, then net wage = $2 – y*/2
5) This is “in equilibrium” because employer’s beliefs are confirmed (i.e., the
wage paid for y = 0 is equal to the marginal product, on average). That is, once
this wage schedule is set, no new data will be released to alter the employer
beliefs.
6) Yet, no information is provided in this equilibrium.
Example three:
1) There is also a signaling equilibrium in which all participants pick y = y*. To
get this equilibrium, employers believe:
If y < y*, then group one (productivity $1) with probability 1.
If y y*, then group one (productivity $1) with probability q and group two
(productivity $2) with probability 1-q.
2) Wage rate is set at $1 for y = 0 and $2 – q for y = y*.
3) These beliefs are self confirming if y* set less than $1 – q.
4) In this equilibrium, everyone gets educated to improve their wage rate, but
education provides no information about productivity.
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Signaling Theory Assessment: Dividend and Corporate Risk
Some closing observations and conclusions:
1) A negative correlation between signal cost and productivity (or value) is a
necessary condition for a signal.
2) However, simply having a negative correlation between signal cost and
productivity doesn’t imply that people will signal (e.g., if education can only
be acquired at levels 1 and 3). Thus, there has to be a sufficient number of
possible signals across the cost range.
3) Multiple equilibrium are possible, with some inferior to others (e.g., setting y*
greater than a bit over 1 in example 1)
4) Sometimes everyone loses with signaling. Sometimes some people win and
others lose.
Conclusion
The findings of this assignment reconcile dividend signaling theory with risk management theory. We contribute to the dividend signaling literature by emphasizing the interaction between corporate risk management policy and dividend policy. The interaction between these two corporate policies has received less attention in the literature despite their common link to information asymmetry.
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Signaling Theory Assessment: Dividend and Corporate Risk
Bibliography
a Book:
Essentials of Managerial Finance, Scott Besley and Eugene F. Brigham.
Asquith, P., and D. Mullins, (1983) \The Impact of Initiating Dividend Payments on Shareholders ‘Wealth" Journal of Business 56: 77-96.
Charest, G., (1978) \Dividend Information, Stock Returns and Market E_ciency - II." Journal of Financial Economics 6: 297-330.
a Website:
http://www.swlearnig.com http://en.wikipedia.com/signaling_theory http://www.ask.com/ signaling theory http://www.investopedia.com
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