| Summary: | This model explains dividend policy as a component of a screening contract
set up by an uninformed principal. Our model assumes that the manager wants
to maximize his net wealth and the principal recognizes this and sets up a
screening contract to utilize the skill of the agent in the productive enterprise.This
model deals simultaneously with moral hazard and hidden information.
We model hidden information in two ways-hidden information about the
productivity of agent and hidden information about the initial cash endowment
of the agent.
We find that when hidden information is about the productivity of the agent
then, contrary to the findings of the dividend models based on the signaling
paradigm, dividend - conditional on cash availability - bears an inverse
relationship to managerial type. That is, for a given level of available cash, the x
lower type manager declares a higher dividend than that declared by a manager
with higher productivity. Still this particular model can be used to explain many
of the empirical findings obtained by other researchers. An interesting corollary
of our model is that with costly effort and differences in productivity, the
relationship between dividend and managerial type flips from being monotone
increasing to monotone decreasing; this corollary extends the result obtained by
Miller and Rock (1985). Another interesting implication of this dissertation is that
dividends can be shown to be relevant in the presence of moral hazard and
hidden information, even when the agency contract is chosen optimally .
When the hidden information is about the initial cash endowment of the
agent then however we find that the agent with greater cash endowment declares
higher dividend. We can therefore see that the nature of the hidden information
plays a critical role in determining the relationship between dividends and agent
type. When cash available is common knowledge and the asymmetric information
is about the productivity of agent then higher dividend -conditioned on cash
availability- is an indication of lower agent type. However when productivity of
agent is common knowledge and the asymmetric information is about the initial
cash endowment of the-agent then higher dividend is an indication of higher
agent type. We may note here that the outcome of the model in the second case
is in line with the outcome of the signalling models and the free cash flow
conjectures by Easterbrook (1984) and Jensen(1986).
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