Why Do Firms Pay Dividends?

Economists have puzzled for a long time as to why firms pay dividends in a world where taxes penalise dividend payments. In a paper with Qing Ye and Wenwen Zhan, I look at dividend policy in an early and unregulated capital market. In this market, we can ex ante rule out some traditional explanations for dividend policy as there are no taxes, no institutional investors, and no impediments to stock repurchases. In this early capital market, it turns out that firms paid dividends in order to communicate the company's health to investors.  The Review of Finance has recently accepted this paper and it is now available to view on its advance access page.
Here is the paper's abstract:
Why do firms pay dividends? To answer this question, we use a hand-collected dataset of companies traded on the London stock market between 1825 and 1870. As tax rates were effectively zero, the capital market was unregulated, and there were no institutional stockholders, we can rule out these potential determinants ex ante. We find that, even though they were legal, share repurchases were not used by firms to return cash to shareholders. Instead, our evidence provides support for the information communication explanation for dividends, whilst providing little support for agency, illiquidity, catering or behavioural explanations.

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