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Shareholder Heterogeneity, Adverse Selection, and Payout Policy

Published online by Cambridge University Press:  06 April 2009

Deborah J. Lucas  and
Robert L. McDonald
Deborah J. Lucas
Affiliation:
Northwestern University and NBER
Robert L. McDonald
Affiliation:
Northwestern University, J. L. Kellogg Graduate School of Management, Department of Finance, Leverone Hall, Evanson, IL 60208.
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Abstract

When shareholders have different plans to sell their shares, they will, in general, have different preferences concerning the firm's decision to pay out cash using dividends or share repurchase. We illustrate these different preferences and explore a model of payout policy that highlights the adverse selection costs of repurchases when managers have superior information about the value of the firm. We show that, in the absence of fixed costs to repurchasing shares, there is a separating equilibrium in which managers use taxable dividends to signal the quality of the firm, with better firms paying lower dividends, using repurchases for the remainder of the payout. With fixed costs to repurchasing, small payouts are made via dividend and large payouts are divided between repurchases and dividends, as in the no-fixed cost case. In both cases, the percentage of shares repurchased increases with the size of the payout and larger repurchases are better news.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 33 , Issue 2 , June 1998 , pp. 233 - 253
Copyright
Copyright © School of Business Administration, University of Washington 1998

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