signaling theory assessment dividend and corporate risk prespective bangladesh(4th semester)

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.


-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.


An Assignment of Financial Management

Course Code: FIN -2206

7


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%



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.



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.



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.



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



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.


http://www.vernimmen.com/html/glossary/definition_signal.html

http://www.vernimmen.com/html/glossary/definition_investors.html

http://www.vernimmen.com/html/glossary/definition_signal.html

http://www.vernimmen.com/html/glossary/definition_signalling_theory.html

http://www.vernimmen.com/html/glossary/definition_signalling_theory.html


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



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.



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



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,



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.



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)



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)



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



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



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.



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:



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.



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.



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


signaling theory assessment dividend and corporate risk prespective bangladesh(4th semester)

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