The Importance of Being Prudent: Leverage and the Informational Content of Dividends

Abstract

This paper studies how the informational content of dividends is affected by leverage. While higher dividends convey good news at low levels of leverage, dividends become a bad signal when leverage is high. Quantitatively, a dividend increase is predicted to have a positive stock price reaction for the median public U.S. firm, but the effect is reversed at higher levels of leverage. The same switch occurs for other corporate actions, including debt buybacks, debt issuance and risk taking. The results highlight the importance of studying the various determinants of firms’ financial decisions jointly.

Keywords: Signaling, dividends, agency costs of debt, banks

JEL Classification: D82, G21, G35