The fictitious widget industry is composed of two firms.One firm is a quality firm and the other is a less-than-quality firm.Given the signaling model of dividends,how might the quality firm convey to the market that it is the quality firm?

Question

Quizplus · Accepted Answer

The signaling model of dividends suggests that a firm can convey information about its quality to the market by changing its dividend policy. In this case, the quality firm can increase its dividend payment beyond what the less-than-quality firm could afford, as this would signal to the market that it is financially healthy and confident about its future prospects. Cutting the dividend payment could be interpreted as a sign of financial distress, and telling the market directly that it is the quality firm might not be credible. Therefore, increasing the dividend payment is the best option for the quality firm to signal its quality. Option D is incorrect because there are actions the firm can take to signal its quality.

The Fictitious Widget Industry Is Composed of Two Firms