Signaling theory Flashcards
(11 cards)
What is the core idea of signaling theory in corporate finance?
That managers use financial decisions (like dividends) to send signals to investors about the firm’s private information, especially future earnings.
Why would a firm increase its dividend under signaling theory?
To signal confidence in future profitability and cash flows.
What does a dividend cut typically signal in signaling theory?
That the firm expects weaker earnings or is facing financial trouble.
What assumption does signaling theory rely on?
That there is asymmetric information — managers know more than outside investors.
What makes a dividend a credible signal?
Because firms avoid cutting dividends, so raising them implies strong confidence in future performance.
What is a major criticism of signaling theory?
Empirical evidence shows that dividend increases don’t always lead to future earnings growth, making the signal less reliable.
What is the key idea of the life cycle theory of dividends?
That dividend policy depends on the firm’s stage in its life cycle — mature firms pay dividends, while young growth firms don’t.
When should a firm pay dividends according to the life cycle theory?
When it reaches maturity, has excess cash, and lacks high-return investment opportunities.
What determines the optimal payout ratio in life cycle theory?
The comparison between the expected ROE on new projects and the cost of capital (k).
If ROE > k → reinvest;
If ROE < k → pay dividends.
How does life cycle theory interpret a dividend increase?
As a signal that the firm is maturing and has fewer profitable investment opportunities.
What is the main difference between signaling theory and life cycle theory?
Signaling theory sees dividend changes as a message about future prospects;
Life cycle theory sees them as a result of the firm’s current internal situation (maturity and cash surplus).
