The paper “ Agency Cost Hypothesis, Clientele Effect, Reasons for Companies to Choose Repurchases rather Dividends under a Classical Tax System” is a good example of an assignment on finance & accounting. There exist a strong relationship between dividends and share price. Research studies have demonstrated that the market usually reacts positively to the increases in dividends and vice versa. The signaling hypothesis is one of the hypotheses that have received the strongest support in explaining this relationship. This hypothesis puts forward that the announcement of a special dividend transmits new information to a market marked by asymmetric information (Balachandran and Nguyen 2004).
The signaling hypothesis is founded on the idea that managers of companies have better information about the company’ s earnings perspective than do analysts and shareholders. Hence, to maximize investors’ wealth, managers have to disclose this information to the market by performing certain observable company achievements, for example paying special dividends. Consequently, the market uses such information to update prospects about the company’ s earnings potential. A new stock price is determined as an effect of this process (Woolridge 1982). The announcement of special dividends is associated with positive period returns as these announcements convey positive information about the firm’ s expectations to a less informed market (DeAngelo et al.
2000). The relative size of the special dividends is associated with the announcement period returns. The larger the relative size of a special dividend, the greater the content of the information transmitted (Gombola and Liu 1999). The announcements of initial special dividends have a greater positive abnormal price reaction than the announcement of subsequent special dividends. This is because the market will have already incorporated the initial innovation signaled in the initial special dividends into prospects.
Hence, the next special dividend will not be a greater surprise with a consequent diminution of the price reaction (Grullon and Michaely 2002).
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