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Signaling, Free Cash Flow and “Nonmonotonic” Dividends

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  • Kathleen Fuller
  • Benjamin M. Blau

Abstract

Many argue that dividends signal future earnings or dispose of excess cash. Empirical support is inconclusive, potentially because no model combines both rationales. This paper does. Higher quality firms pay dividends to eliminate the free cash‐flow problem, while firms that outsiders perceive as lower quality pay dividends to signal future earnings and reduce the free cash‐flow problem. In equilibrium, dividends are nonmonotonic with respect to the signal observed by outsiders; the highest quality firms pay smaller dividends than lower perceived quality firms. The model reconciles the existing literature and generates new empirical predictions that are tested and supported.

Suggested Citation

  • Kathleen Fuller & Benjamin M. Blau, 2010. "Signaling, Free Cash Flow and “Nonmonotonic” Dividends," The Financial Review, Eastern Finance Association, vol. 45(1), pages 21-56, February.
    • Handle: RePEc:bla:finrev:v:45:y:2010:i:1:p:21-56
    DOI: 10.1111/j.1540-6288.2009.00236.x
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    Cited by:

    1. N. Eriotis & P. Kaldis & E. Poutos & D. Vasiliou, 2014. "The Factors that Affect the Dividend Policy of the Greek Listed Firms Prior to the Economic Crisis: A Comparison to Nyse, Nasdaq, Norwegian and U.K. Firms"," American Journal of Economics and Business Administration, Science Publications, vol. 5(4), pages 139-152, June.
    2. Esqueda, Omar A., 2016. "Signaling, corporate governance, and the equilibrium dividend policy," The Quarterly Review of Economics and Finance, Elsevier, vol. 59(C), pages 186-199.
    3. Blau, Benjamin M. & Fuller, Kathleen P. & Van Ness, Robert A., 2011. "Short selling around dividend announcements and ex-dividend days," Journal of Corporate Finance, Elsevier, vol. 17(3), pages 628-639, June.
    4. Negrea Laura Georgeta & Matis Dumitru & Mustata V. Razvan, 2011. "Free Cash Flow As Part Of Voluntary Reporting. Literature Review," Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 1(2), pages 591-596, December.
    5. Jeffrey Jones & Jenny Gu & Pu Liu, 2014. "Do dividend initiations signal a reduction in risk? Evidence from the option market," Review of Quantitative Finance and Accounting, Springer, vol. 42(1), pages 143-158, January.
    6. Shams Pathan & Robert Faff & Carlos Fernández Méndez & Nicholas Masters, 2016. "Financial constraints and dividend policy," Australian Journal of Management, Australian School of Business, vol. 41(3), pages 484-507, August.

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