Capital Structure and Market Reactions to Dividend Initiation

We examine the interaction between capital structure and dividend initiation. Reasons often given for the positive abnormal return when firms initiate dividends are the signaling of asymmetric information and the reductions of agency costs. Theory also suggests that these are reasons for choosing debt in the capital structure. This study finds that the effect of initiating dividends is dampened when there is debt in the capital structure. It also shows that the abnormal return is not always increasing in dividend yield, particularly for highly levered companies. Highly levered companies do benefit from wealth transfers from bondholders when dividends are announced. For these firms, paying dividends increases equity value because shareholders are given priority over bondholders for some of the firm’s cash flows. The results of this paper show that capital structure does matter, in a way that is consistent with both the information signaling hypothesis as well as the agency cost hypothesis. * The Wharton School, University of Pennsylvania. Phone: (215) 898-7617. E-mail: [email protected] I am grateful to Paul Asquith, Mintao Fan, Hayne Leland, Rich Lyons, Terry Marsh, David Tien and Nick Wonder for their comments. Comments and suggestions will be greatly appreciated and can be sent to [email protected]