Dividends, Share Repurchases, and the Substitution Hypothesis

We show that repurchases have not only became an important form of payout for U.S. corporations, but also that firms finance their share repurchases with funds that otherwise would have been used to increase dividends. We find that young firms have a higher propensity to pay cash through repurchases than they did in the past and that repurchases have become the preferred form of initiating a cash payout. Although large, established firms have generally not cut their dividends, they also show a higher propensity to pay out cash through repurchases. These findings indicate that firms have gradually substituted repurchases for dividends. Our results also suggest that before 1983, regulatory constraints inhibited firms from aggressively repurchasing shares. For decades, U.S. corporations have overwhelmingly preferred to pay out cash in the form of dividends rather than share repurchases, despite the relative tax advantage of capital gains over ordinary income. However, over the last 20 years or so, share repurchase activity has experienced an extraordinary growth. According to aggregate data from Compustat, expenditures on share repurchase programs ~relative to total earnings! increased from 4.8 percent in 1980 to 41.8 percent in 2000. Furthermore, while share repurchase expenditures grew at an average annual rate of 26.1 percent over the period 1980 to 2000, dividends only grew at an average annual rate of 6.8 percent. As a consequence of these large differences in growth rates, share repurchases as a percentage of total dividends increased from 13.1 percent in 1980 to 113.1 percent in 2000. In 1999 and 2000, industrial firms spent more money on share repurchases than on dividend payments. That is, for the first time in history, share repurchase programs have become more popular than dividends. What are the reasons for this change in corporate payout policy? Are corporations buying back shares with funds that they would otherwise have used to pay dividends? And if so, why did this process not start much earlier? The answers to these questions are important because they will *Grullon is from Rice University and Michaely is from Cornell University and IDC. We would like to thank Eugene Fama; John Graham; Erik Lie; Maureen O’Hara; Oded Sarig; Robert Swieringa; participants in the 2002 AFA meetings; and seminar participants at Cornell, INSEAD, Norwegian School of Management, Rice, and USC. THE JOURNAL OF FINANCE • VOL. LVII, NO. 4 • AUGUST 2002