Working Paper Series,
Uppsala University, Department of Economics

Abstract: This paper addresses the ongoingdebate on which view of equity, traditional or new, that best describes firm behavior. According to the traditional view, the marginal source of finance is new equity, whereas under to the new view, marginal financing comes from retained earnings. In the theoretical part, we set up a model where the firm faces a cost of adjusting the dividend level because of an aggravated free cash flow problem. The existence of such a cost - which has been used in arguing the traditional view - does not invalidate the core of the new view, namely that the marginal investment may be financed with retained earnings. The combination of costly changes in dividends and retained earnings as the marginal source of funds actually defines an extended new view of equity. In the empirical part, we test the implication of the new view that dividends and investments are negatively related. The overall conclusion is that the implication of the new view is supported for traded Swedish firms during 1980-98.

Keywords: The traditional view of equity; the new view of equity; financing policy; payout policy

JEL-codes: G32; G35; H32

24 pages, May 2, 2002

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