Scandinavian Working Papers in Economics

Working Papers,
Copenhagen Business School, Department of Finance

No 2005-4: Taxable Cash Dividends

Ken L. Bechman and Johannes Raaballe
Additional contact information
Ken L. Bechman: Department of Finance, Copenhagen Business School, Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark
Johannes Raaballe: Department of Finance, Copenhagen Business School, Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark

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 “single-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 firm’s high quality. The implications of the models are consistent with several important empirical facts about dividends and share repurchases. Thus, this paper’s 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

JEL-codes: D82; G35

42 pages, June 28, 2006

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