Dividend Policy and Share Repurchases: Signaling, Agency, and Tax Effects

Abstract

Dividend policy—the decision of how much of earnings to distribute to shareholders versus retain for reinvestment—presents one of corporate finance’s enduring puzzles. Miller and Modigliani (1961) demonstrated that in perfect markets, dividend policy is irrelevant to firm value: investors who prefer income can create ‘homemade dividends’ by selling shares, while those who prefer capital gains can reinvest dividends, so the form of return is irrelevant to total return. Yet firms invest substantial managerial attention in dividend decisions, investors appear to react significantly to dividend changes, and dividends create tax disadvantages in many jurisdictions relative to share repurchases. This paper reviews the dividend irrelevance theorem and its assumptions, the signaling theory of dividends (Bhattacharya, 1979; Miller and Rock, 1985), the agency theory of dividends (Jensen, 1986), tax clientele effects, and the shift from dividends to share repurchases as the dominant form of cash distribution over the past three decades.