Information Signaling Effect Theory

Advanced via Stephen Ross in year 1977, He argued such in an inefficient market; management can utilize dividend policy to signal significant information to the market that is only known to them.

Example - If the management pays high dividends, it signals high expected profits in future to keep the high dividend level. This would rises the share price/value and vice versa.

MM attacked this position and suggested that the change in share price following the change in dividend amount is because of informational content of dividend policy quite than dividend policy itself. Consequently, dividends are irrelevant if information can be specified to the market to all players.

Dividend decisions are relevant in an inefficient market and the dividends the higher, the higher the value of the firm. The theory is based upon the following four suppositions:

1. The sending of signals with the management must be cost effective.

2. The signals must be correlated to observable events as general trend in the market.

3. No company can imitate its competitors in transfer the signals.

4. The managers can only sent true signals even if they are bad signals. A transfer untrue signal is financially disastrous to the survival of the firm.