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CMA Intermediate · Financial Management and Business Data Analytics · Dividend Decisions and Dividend Theories

According to the signalling (information content) theory of dividends, a sudden and unexpected increase in the dividend per share by a listed Indian company is most likely to be interpreted by investors as:

Signalling theory holds that managers have inside information and use dividend changes to convey it. An unexpected dividend increase is read as confidence in higher sustainable future earnings, so the share price usually rises. It is not read as evidence of exhausted projects or lower risk.

  1. AA signal that management expects higher sustainable future earnings, so the share price tends to riseCorrect
  2. BA signal that the firm has run out of profitable investment projects and its price should fall
  3. CA sign that the firm's cost of equity has fallen because of lower business risk
  4. DAn indication that the firm will now issue bonus shares in place of cash dividends

Explanation

Under signalling theory, managers know more than outsiders and dividend changes convey that private information. A dividend rise is read as confidence in future earnings, so the price tends to rise. The 'no projects' reading is the free-cash-flow/agency view, not the signalling theory's main message.

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