Dividends, Share Repurchases, and the Substitution Hypothesis

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Abstract
Over the past 20 years share repurchase programs have become an important payout method for US firms. Are these repurchases substitute for dividends? And if so, why has it taken so long to start to pay shareholders in a way that reduces their tax liability? Analyzing this trend we show that, unlike in the past, young firms have a strong tendency to pay cash through repurchases rather than dividends and that repurchases have become the preferred form of payout among firms initiating cash distributions to their equityholders. Large-established firms also show a higher propensity to payout cash through repurchases. Although we do not find that these firms have been cutting dividends, it seems that they have been financing their repurchase programs with funds that otherwise would have been used to increase dividends. These findings indicate that large-established firms have been gradually substituting repurchases for dividends. We also find evidence that suggests that investors view dividends and share repurchases as substitute payout methods. Specifically, we show that (1) the market reaction to dividend cuts is not significantly different from zero for repurchasing firms and (2) the market reaction surrounding share repurchase announcements is significantly more positive during periods where the benefit of substituting share repurchases for dividends is relatively large. Finally we address the question of why corporations have been waiting for so long to substitute repurchases for dividends. We present evidence consistent with the notion that regulatory constraints inhibited firms from aggressively repurchasing shares until 1982. Our findings may provide a partial explanation for the dividend puzzle.

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