Question

How can dividend policy reduce information asymmetry problems in a firm?

Answer 1

How can dividend policy reduce information asymmetry problems in a firm?

First, let's define what's an information asymmetry means. It means that the managers (agents) of the firm has more information than the shareholders (owners) and the managers may not always act in the best interest of the shareholders.

Now, the dividend policy can reduce information asymmetry to an extent. The management cannot manupulate the cash the company is generating. In order to pay dividend, the company must be generating free cash flows. A dividend policy which incorporates a growth in dividends suggests that the company's free cash flow is growing. On the other hand, if the dividend policy is changed to decrease the amount of dividend paid to the shareholders, then it signals that the company is struggling to genereate free cash flows.

So, the dividend policy reduce information asymmetry problem.