Dividend Signaling: Non-Cooperative Game Theory
In all public companies, the manager of the firm, whether it be the Board of Directors, or a sole CEO of the company must define and determine its dividend policy. There are two methods managers can return value back to their shareholders: by buying back shares or distributing dividends, each with different tax policies and timelines. We will examine the decision making behind distributing dividends and how game theory is applied to such decisions. This presents a game with two players: the managers giving out the dividends and the shareholders receiving the dividends.
Miller and Modigliani(1961) in their original papers first suggest that dividend policy can be used to signal the firm’s health. It was until Bhattacharya(1979)’s paper that utilized game theory to describe his model of dividends as signal. The manager has two stage choices: first, is the decision to give out dividends, and the second is by how much. This is where game theory plays a part. In this game, only one player has all the information and the other has little information. Bhattacharya demonstrates that the managers have full information regarding the true value of the firm while the shareholders can only guess. This is a perfect example of information asymmetry. Based on the decision of the manager to raise or lower dividends, assuming that they do give out dividends, the shareholders can respond to keep or sell or buy additional shares by maximizing their expected utility from the shares. The interesting deviation from the game theory we learned in class is that dividend signaling matters who moves first. Bhattacharya argues that dividend signals the profitability of the firm, like a peacock flaunting its colors for its mate. Just like these peacocks mate dances, paying dividends is the way firms try to convince other investors that the firm is so good it has profits to spare hoping to raise their stock price. However, if they raise dividends too high and are unable to pay for it, it could lose by having to fund for their dividends through other means leading to deadweight transactional costs. Like the peacock, flaunting its colors too much could hurt the firm as the peacock could easily become victim to preys out in the wild.
Bhattacharya demonstrates that if information was shared, that all information known to both the insiders of the company and the public, then the market would be strong form efficient. Investors will be able to make the most optimal decision, as it will have knowledge of the company’s true intrinsic price. And managers will have a less of an incentive to dole out these costly dividend signals in order to buff up their stock price.
http://www.jstor.org/stable/pdf/3666098.pdf
https://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/Bhattacharya%201979.pdf