The Impact of a Firm's Payout Policy on Stock Prices and Shareholders' Wealth in an Inefficient Market

Abstract

Recent literature has almost exclusively focused on the announcement effects of payout policy. However, in an inefficient stock market payout policy may not only affect stock prices at the announcement date but also at the payment date. Our theoretical approach is based on the rational demand of risk averse investors and passive investors holding shares in a firm which may or may not pay out free cash flow. The joint existence of both investor types in an inefficient market may lead to a positive impact at the payment date. We predict a positive effect for a share buyback and a dividend payment that is associated with reinvestment, e.g. via a dividend reinvestment plan (DRIP). This price impact affects shareholders' current and long run net wealth. Both buyback and divi-dend with DRIP cause a wealth transfer between smart and passive investors in the long run, with the direction of the wealth transfer depending on the level of the firm's market valuation relatively to expected future value.