DIVIDENDS, DILUTION, AND TAXES: A SIGNALLING EQUILIBRIUM

Abstract

A signalling equilibrium with taxable dividends is identified. In this equilibrium, corporate insiders with more valuable private information optimally distribute larger dividends and receive higher prices for their stock whenever the demand for cash by both their firm and its current stockholders exceeds its internal supply of cash. In equilibrium, many firms distribute dividends and simultaneously issue new stock, while other firms pay no dividends. Because dividends reveal all private information not conveyed by corporate audits, current stockholders capture in equilibrium all economic rents net of dissipative signalling costs. Both the announcement effect and the relationship between dividends and cum-dividend market values are derived explicitly. DIVIDENDS HAVE LONG PERPLEXED financial economists. Despite recent successes in constructing signalling equilibria with dividends, many important questions remain unanswered.' For example, why do corporations declare dividends and simultaneously sell new stock or, alternatively, distribute dividends and not repurchase stock? How do dividends with their dissipative costsprimarily adverse personal taxes-coexist with other presumably less costly technologies for releasing inside information, like audited annual reports? Do plausible signalling equilibria with dividends require transaction costs incurred by either corporations when issuing or retiring stock or investors when trading outstanding shares? Finally, how do the tax rates and demands for liquidity of such investors as widows, senior citizens, and financial institutions influence signalling equilibria? A satisfactory theory of signalling with dividends must also have empirical content. In particular, such a theory should provide empirically testable propositions detailing the effects of announced dividends on stock prices,2 crosssectional connections between dividends and market values, and any resulting relationships between payout ratios and rates of return on stocks.3 In addition,