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Department of Finance, Copenhagen Business School Working Paper Series, Department of Finance, Copenhagen Business School

No 2005-4:
Taxable Cash Dividends

Ken L. Bechman and Johannes Raaballe

Abstract: Firms pay out cash using both dividends and share repurchases. In many aspects these two means are similar, but one important difference is that dividends are generally taxed more heavily than share repurchases. Nevertheless firms persist in paying out large amounts in dividends. This paper provides an explanation for this dividend puzzle by developing a class of signaling models violating the ďsingle-crossing property in which information about the quality of the firm is asymmetric between the management and the shareholders. In these models a high-quality firm can always signal its quality by using share repurchases only. However, in certain cases share repurchases become costlier on the margin for a high-quality firm than for a low-quality imitator. In such cases, the high-quality firm signals most cost efficiently by means of a combination of share repurchases and taxable cash dividends financed by the issuance of new shares. Taxable cash dividends financed by the issuance of new shares then can be considered a positive kind of money burning whose role is to signal a firmís high quality. The implications of the models are consistent with several important empirical facts about dividends and share repurchases. Thus, this paperís main contribution is to examine a range of new signaling models that provides a role for taxable cash dividends and share repurchases and to derive their empirical implications.

Keywords: Dividends; Share Repurchases; Signaling; Single-Crossing Property; Money Burning; (follow links to similar papers)

JEL-Codes: D82; G35; (follow links to similar papers)

42 pages, June 28, 2006

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