Arab Journal of Administration المجلة العربية للإدارة


Several theories have been forwarded to explain firms’ payout behavior and the ‘abnormal’ positive effect of dividend initiations/increases and repurchases on stock prices. This paper theoretically develops a strand of thought that has awkwardly introduced itself in the literature, namely: the avoidance of overinvestment, into an alternative theory. Mature firms with limited growth potential avoid undertaking negative net present value projects by paying out the majority of their earnings; these firms may even reduce their equity base through stock repurchases. When such firms announce that they will initiate dividends the downward pressure on their valuation, due to the market forecasts of overinvestment, is relieved leading to abnormal positive returns. The relative relevance of one or the other of the theories of dividend policy depends on the relative prevalence of the conditions assumed under each. In their seminal paper Miller & Modigliani (1961) show that, in a world described by perfect markets and rational behavior, dividend policy is irrelevant. Two understated assumptions underlie their conclusion. First, that future dividend policy of a firm “… is independent of the actual dividend decision in t.” This implies that dividend policy need not be stable. This is a view opposed and evidence against reported by many researchers, e.g. (Lintner, 1956), (Fama & Babiak, 1968), and (Brav et. al., 200)). From a complementary view point DeAngelo et al (1992: 1838) find that persistent losses are “… essentially a necessary, but not sufficient, condition for dividend reductions in firms with established earnings and dividend records.” Jensen & Johnson (1995) indicate that firms that drop dividends cannot escape from this fate because they suffer from chronic problems that continue to linger after the drop and which force them to restructure. In similar vein, Brav et. al. (2005) argue that the inflexibility of dividends acts as a strong deterrent to dividend initiation and that management tends to raise external funds before cutting dividends. They also explain why repurchases are not perfect substitutes for dividend payments. Repurchases are made out of residual volatile cash flow, are more flexible than dividends, can be used to time the equity market, to increase earnings per share, or to offset stock-option dilution.The second understated assumption is that firms can offset any effect of their dividend decisions on the amount of internal financing available for their ‘given’ investment opportunities by obtaining additional external equity financing. However, many researchers have found that firms prefer internal financing and use external equity financing only as a last resort. The reason is that a new equity issuance might convey the perception that the firm is taking advantage of the overpricing of its stock and/or that the firm wants new investors to carry the burden of an unpromising future with current investors. Asquith & Mullins (1986: 38), for example, find that in a sample of 128 offerings of new equity issues 80% “…experienced price reductions associated with the equity issue announcement.” Also, new equity issuances entail considerable floatation costs. Thus, eliminating or reducing payouts can be used in lieu of external financing to avoid underinvestment (Deshmukh, 2003).