Dividend Changes and Leverage

Abstract

We document a strong and previously unreported link between changes in dividend policy and subsequent changes in leverage ratios. Large dividend increases and dividend initiations predict significant increases in both book and market leverage ratios over the subsequent five years. However, large dividend decreases do not predict reductions in leverage. The result is robust to many controls, including trade-off variables, reversion of leverage to target, profitability, risk, financing deficits, and firm maturity. The effect is stronger for large firms than for small and medium firms. The results have important implications for tests of pecking order and trade-off theories of leverage, and for dynamic theories of capital structure.