Document Type

Article

Publication Date

5-2019

Abstract

There is an observed positive correlation between the size of firms’ dividends and the amount of cash they keep on hand. We specify a new channel of precautionary cash holdings as related to dividend-smoothing, which predicts that increased dividends should cause firms to keep more cash on hand. In the reverse direction, theory’s predictions depend on the source of the increased cash on hand. General dividend smoothing theory predicts that temporary increases in cash due to natural market fluctuations should not affect dividends. If the increased cash is due to a permanent increase in profitability, both the marginal benefit and the marginal cost of paying dividends also increase, and the net effect is unclear. Theory’s predictions of causality cannot be tested empirically using observed firm data, however, due to an underlying endogeneity issue. We instead turn to a laboratory experiment to determine causality. In the lab, we separately and exogenously vary each relevant variable to test each theoretical hypothesis. Increased dividends lead to increased cash on hand. One-time increases in firms’ cash on hand, representing natural market fluctuations, do not affect firms’ dividends. Increases in cash on hand due to a permanent increase in firm profitability, however, cause dividends to decrease.

Publication Title

SSRN Electronic Journal/Journal of Behavioral and Experimental Economics

ISSN

1556-5068/2214-8051

Publisher

Social Science Research Network/Elsevier

Volume

83

Issue

101458

First Page

1

Last Page

10

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