Payout Policy under Heterogeneous Beliefs: A Theory of Dividends versus Stock Repurchases, Price Impact, and Long-Run Stock Returns

Abstract

We analyze a firm’s choice between dividends and stock repurchases in an environment of heterogeneous beliefs and short sale constraints. We study a setting in which the insiders of a firm, owning a certain fraction of its equity and having a certain amount of cash to distribute to shareholders, choose between paying out cash dividends and buying back equity to shareholders, as well as the scale of investment in their firm’s new project. Outside equity holders in the firm have heterogeneous beliefs about the probability of success of the firm’s project and therefore its long-run prospects; they may also disagree with firm insiders about this probability. We show that, depending on the beliefs of firm insiders versus outsiders, the firm may distribute value through cash dividends alone; through a repurchase alone; or through a combination of a cash dividend and a stock repurchase. We also show that, in many situations, it is optimal for firm insiders to underinvest in the firm’s positive net present value project and undertake a stock repurchase with the amount of cash saved by underinvesting. We then analyze the price impact of a cash dividend versus a share repurchase, where the price impact is defined as the abnormal return to the firm’s equity upon the actual payment of a cash dividend or the implementation of a share repurchase respectively (rather than upon the announcement of these events). Finally, we analyze the long-run returns to a firm’s equity following dividend payments and stock repurchases. Our model generates a number of testable predictions different from asymmetric information models of a firm’s choice between dividends versus stock repurchases.