Question

1. What is the information content of dividend policy? Given this information content concept, what is the market's typical reaction to a firm's reduction in their dividend (i.e. what happens to the stock's price)?

Answer 1

The information content of dividend policy states that a Firm's managers use dividend distribution to signal assymetric information with regards to the Firm's future earnings. A Firm distributes its a part of its residual earnings (profit after operating expenses, interest and taxes) among its shareholders as dividend. The remaining part is utilized for financing growth opportunities.

An increase in the dividend payout of a Firm generally sparks a good image and future prospect of the Firm in the eyes of the investors thus leading to steady stock price levels or even increase in the stock prices. Accordingly, decreasing dividend payout will lead to a negative future earning capability of the Firm. Whereas the truth might be that the Firm is employing more earnings into growth opportunities. However, market perceives a negative conotation regarding decrease in dividend. In that case, some investors might be skeptical of investing in the stock leading to decrease in demand and hence a fall in stock price.