Financial Flexibility and the Choice Between Dividends and Stock Repurchases

This paper measures the growth in open market stock repurchases and the manner in which stock

repurchases and dividends are used in U.S. corporations. Stock repurchases and dividends are used at

different times from one another, by different kinds of firms. Stock repurchases are very pro-cyclical,

while dividends increase steadily over time. Dividends are paid by firms with higher "permanent"

operating cash flows, while repurchases are used by firms with higher "temporary", non-operating cash

flows. Repurchasing firms also have much more volatile cash flows and distributions. Finally, firms

repurchase stock following poor stock market performance and increase dividends following good

performance. These results are consistent with the view that the flexibility inherent in repurchase

programs is one reason why they are sometimes used instead of dividends.

1. Introduction

One of the most significant trends in corporate finance during the 1990s is the increasing

popularity of open market stock repurchase programs. Between 1985 and 1996, the number of

open market repurchase program announcements by U.S. industrial firms has increased 650%

from 115 to 755, and their announced value has increased 750% from $15.4 billion to $113

billion. Correspondingly, dividends have only risen by a factor of just over two during the same

period; aggregate dividends for all industrial firms listed on Compustat have risen from $67.6

billion to $141.7 billion. Repurchases are clearly an increasingly important method of paying

out cash to shareholders.

In this paper, we examine firms' decisions to distribute cash flows and their choices

between paying out cash flows in the form of dividends or stock repurchases. Our goal is to

assess the increasing importance of repurchases in payout decisions and to isolate factors that

affect the choice between repurchases and dividends. Our primary hypothesis is that dividends

represent an ongoing commitment and are used to distribute permanent cash flows, while

repurchases are used to pay out cash flows that are potentially temporary. Repurchases thus

preserve financial flexibility relative to dividends because they do not implicitly commit the firm

to future payouts.

At least since Lintner (1956), firms have been reluctant to cut dividends and have been

greeted