Earnings information and the determination of dividend policy

A multiperiod model is presented that explains why corporations persist in paying dividends according to some relatively stable payout ratios. In this model, accounting information (earnings reports) and dividends are two main sources of information to investors concerning future cash flows (CF). Managers and investors differ in their expectations of future CF. Because of moral hazard reasons managers cannot communicate their private information directly to investors, and therefore do so via the dividends decision. Investors who believe that managers on average pay dividends proportional to CF revise their expectations when observing the dividends paid. Managers who strive to maximize the value of the firm must balance between the positive effect of dividends on expectations and their negative effects on after-tax value. It is shown that the maximization process yields dividends that are proportional to CF. This reinforces and then perpetuates investors' beliefs of the proportional relation between dividends and CF. It is further shown that a behavior of dividends according to Lintner's model can also be explained by the present model.