Working Paper: NBER ID: w18242
Authors: Malcolm Baker; Jeffrey Wurgler
Abstract: We outline a dividend signaling approach in which rational managers signal firm strength to investors who are loss averse to reductions in dividends relative to the reference point set by prior dividends. Managers with strong but unobservable cash earnings separate themselves by paying high dividends but retain enough earnings to be likely not to fall short of the same level next period. The model is consistent with several features of the data, including equilibrium dividend policies similar to a Lintner partial-adjustment model; modal dividend changes of zero; stronger market reactions to dividend cuts than increases; relative infrequency and irregularity of repurchases versus dividends; and a core mechanism that does not center on public destruction of value, a notion that managers reject in surveys. Supportive new tests involve nominal levels and changes of dividends per share, announcement effects, and reference point currencies of ADR dividends.
Keywords: dividends; behavioral finance; signaling; prospect theory
JEL Codes: D03; D82; G35
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high dividends (G35) | investor perception of firm strength (G32) |
| dividend cuts (G35) | stronger market reaction (G19) |
| historical reference points (N00) | evaluation of current dividends (G35) |
| modal dividend change is zero (C69) | conservative approach among managers (G31) |
| dividends clustering around round numbers (G35) | investor behavior (G41) |