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

Increasing the dividend payment beyond what the less-than-quality firm could afford would signal to the market that the quality firm is in a strong financial position and has the ability to invest in high-quality projects while also returning value to its shareholders. This would differentiate it from the less-than-quality firm, which may not be able to afford such a high dividend payment. Option A may not be as effective as it relies on analysts to convey the information to the market, while the dividend payment is a direct signal from the firm itself. Option B may actually signal the opposite as cutting dividends could indicate financial trouble, and may not accurately convey that the firm has quality projects on the horizon. Option D is incorrect as the signaling model of dividends assumes that firms can take actions to signal their quality to the market.

The Fictitious Widget Industry Is Composed of Two Firms