EVIDENCE ON HOW COMPANIES CHOOSE BETWEEN DIVIDENDS AND OPEN‐MARKET STOCK REPURCHASES

Abstract

Dividends and open‐market stock repurchases are by far the two most common mechanisms for distributing excess cash to shareholders. This article identifies and then tests three potentially important factors for the corporate choice between increasing cash dividends and initiating openmarket stock repurchases. More specifically, the authors argue that companies are more likely to distribute cash to investors through open‐market repurchases than through dividend increases when (1) management believes its stock is undervalued, (2) management compensation packages include stock options, and (3) the company's stockholder base is dominated by institutional investors.To test these three explanations, the authors use a matched‐pair design in which each company announcing an open market repurchase program in a given year is matched with a comparable‐size firm from the same industry that increased its cash dividends but did not initiate an open‐market repurchase program. As predicted, the results suggest that equity undervaluation, management compensation, and the level of institutional holdings are all important contributors to corporate choices between dividend increases and open‐market repurchases.