A Liquidity-based Resolution to the Dividend Puzzle

Contrary to the renowned irrelevance theory proposed by Modigliani and Miller in 1961, empirical evidence suggests that assets that pay dividends command a price premium, despite the fact that dividend payments are generally taxed more heavily than capital gains. In this paper, I use a monetary-search model and propose a new resolution to this puzzle, based on the idea that the price premium of dividend assets arises due to the superior liquidity role played by dividends compared to returns in the form of capital gain. As dividend is virtually identical to money in facilitating transactions, it helps stockholders avoid selling their assets at an undesirable price in financial markets with frictions and trading delays. The paper provides a number of theoretical results that find support in the data. I also study firms’ optimal decision to pay dividends, and show that an increase in the interest rate can hurt the economy not only through the traditional channel, i.e., reduction in real money holdings, but also through the reduction in aggregate R&D activities.