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Taxable cash dividends - A money-burning signal

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  • Ken Bechmann
  • Johannes Raaballe

Abstract

Firms pay out cash to shareholders using both dividends and share repurchases despite the fact that dividends are generally taxed more heavily than share repurchases. This paper provides a general explanation for this dividend puzzle by developing a class of signaling models where the most efficient signal for a firm of sufficiently high quality always involves payout of taxable cash dividends. If the high type is not of much higher quality than the low type, the cheapest way to deter imitation from the low type is to increase share repurchases financed by a cut in investments. However, when the high type is of much higher quality than the low type, the cut in investments on the margin becomes more costly to the high type than to the low type. Hence, the most efficient signal becomes a money-burning signal, which is equally costly for both types of firms. The crucial assumption leading to this result is that a marginal cut in investments eventually becomes more costly to the high-quality firm than to the low-quality imitator. Taxable cash dividends financed by the issuance of new shares/reduced share repurchases, which only gives rise to increased taxes, is the money-burning signal.

Suggested Citation

  • Ken Bechmann & Johannes Raaballe, 2010. "Taxable cash dividends - A money-burning signal," The European Journal of Finance, Taylor & Francis Journals, vol. 16(1), pages 1-26.
    • Handle: RePEc:taf:eurjfi:v:16:y:2010:i:1:p:1-26
    DOI: 10.1080/13518470802604432
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    References listed on IDEAS

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    1. Renneboog, L.D.R. & Trojanowski, G., 2005. "Patterns in Payout Policy and Payout Channel Choice of UK Firms in the 1990s," Discussion Paper 2005-22, Tilburg University, Center for Economic Research.
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