Final answer:
Cash dividends primarily indicate that a firm is profitable and intends to lower agency costs by distributing excess cash to shareholders. The correct signals sent to the market when a firm issues cash dividends are that the firm is profitable and intends to lower agency costs. Hence, the right answer is option (e). I and III only.
Step-by-step explanation:
Cash dividends may send several signals to the market, but primarily, they suggest that the firm is currently and expects to continue to be profitable and that agency costs will be lowered since less cash will be held by the firm.
These signals correspond to how dividends indicate a firm's confidence in its ongoing ability to generate profits and its intent to mitigate potential agency problems by distributing excess cash to shareholders rather than it possibly being invested in suboptimal projects by management.
Therefore, the correct answer to the student's question, 'Cash dividends send which two of the following signals to the market?' is e. I and III only. This corresponds to the statements: I. Agency costs will be lowered since less cash will be held by the firm, and III. The firm is currently and expects to continue to be, profitable.
Note that declaring cash dividends does not inherently signal plans for downsizing or an end to stock repurchases, which are decisions that are influenced by a broad variety of factors beyond dividend payments.