Dividend Catering Theory Case Study

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2.1.4 Dividend catering theory
Investor’s preferences can change over time. Firms frequently cater to the investors’ dynamic preferences of dividends in order to provide incentives to the investors in accordance with their wants and needs is what the dividend catering theory proposed by Baker and Wurgle (2004a) implies. According to their study, investors’ demand for dividends is not consistent but varies over time and firms respond to investors’ demand accordingly. When investors’ demand is high, non-dividend firms initiate dividend distribution; otherwise, dividend paying firms omit it when investors’ demand is low.
“Dividend premium” is an indicator designed by Wurgler and Baker (2004a) to measure the average differential of a firm’s
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The agency cost theory proposed by Easterbrook (1984) and Rozeff (1982) implies that payment of dividends plays the role of keeping cash away from managers, thus reducing the agency costs for the company. The potential agency cost in association with the separation of ownership and management induce a conflict-mitigation role for dividend payments. Meckling and Jensen (1976), and Jensen (1986) find that paying dividends reduces the free cash flow under the discretion of management and dividend payouts play the role of signaling the agency costs reduction rather than profitability in the future. Rozeff (1982) and Easterbrook (1984) argue that dividend payouts force companies to enter the equity markets so as to raise additional capital, reducing the agency costs as a consequence of the increased scrutiny the capital market places on company, thus providing the outside shareholders with chance to exercise their …show more content…
Signaling can be defined as one agent conveys its information to another agent through an action. It stems from the asymmetric information problem. Under this circumstance, managers know more than investors, thus investors tend to seek "signals" from managers' actions in order to have clues about firm’s performance. Being aware of the signaling effect of dividends, firms try not to send a negative signal so as to avoid making their stock price down. Management of a firm that is suspected to face solvency issues may distribute dividends as a signal of financial strength within the company. Bhattacharya (1979), John and Williams (1985) argue that dividends mitigate asymmetric information problem between shareholders and management. Their studies indicate that dividend payments convey information about future profitability of firm only if firm pays dividends on a regular

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