A Theory of Dividend Smoothing1

Dividend smoothing remains a puzzle for …nancial economists. We present a model in which smoothing of dividends arises as an equilibrium outcome. A manager who cares about the intrinsic value of the …rm as well as its current stock price has to decide how to allocate earnings between investments and dividends. Since the stock price is determined by uninformed investors, the manager has an incentive to in‡ate dividends and lower investment relative to the …rst best. We show that there is a continuum of equilibria in which the dividend is constant for a range of realized earnings. Compared to the standard separating equilibrium, this partial pooling induces higher …rm value, lower average dividends, and lower deviation from the …rst-best investment. We argue that the previous year’s dividend can serve as a “focal point,”allowing managers and investors to coordinate on just one in a continuum of equilibria. We conclude that dividend smoothing provides a partial remedy to underinvestment resulting from information asymmetries. We also o¤er several new testable predictions relating dividend smoothing to investors’mix, managerial incentives, and investment.