Payout Composition and Investors' Reaction to Dividend and Stock Repurchase Announcements

Abstract

This study investigates the relative magnitude of the market reactions to dividend and stock repurchase announcements. Prior studies motivate conflicting predictions as to how investors perceive dividend distributions versus stock repurchase announcements as signals about future cash flows. Lucas and McDonald (1998) predict that firms with more favorable private information will pay less dividends and repurchase more shares. Other studies (Brickley [1983], Jagannathan et al. [1999]) argue that an increase in the regular dividend, because it entails an implicit commitment to maintain the higher payout level in future periods, represents a more positive signal about future cash flows. These studies predict that firms anticipating a more permanent increase in cash flows are more likely to distribute dividends than stock repurchases. I test these competing hypotheses by investigating how the market reaction to an announced distribution is affected by the composition of the firm's total (year-to-date) announced cash payout during the fiscal year. Lucas and McDonald (1998) argue that firms employ a combination of dividends and stock repurchases to minimize their total signaling costs and the market reaction to an announced cash distribution depends on the composition of the total payout (the proportion of the announced stock repurchase program to the sum of the announced value of the stock repurchase program and the dividend increase). I find that after controlling for the magnitude of the distribution and the information environment, the market reaction is more favorable when regular (but not one-time) dividends comprise a larger proportion of the total payout. My findings suggest that regular dividends are a more positive signal about future cash flows and elicit a more favorable market reaction than stock repurchases. Key Words: Corporate signaling; Dividends; Stock repurchases