A Catering Model of Dividends and Share Repurchases

This paper develops a theoretical model to demonstrate that the firm’s payout/investment decision may be affected

by the relative magnitude of dividend and repurchasing premia. The model shows that the manager of high-quality

firm may pass up a positive NPV project in order to cater to investors’ demand for dividends or share repurchases

(adverse selection problem) if the catering premia are substantial. On the other hand, the manager of low-quality

firm may have strong incentives to return free cash flows to shareholders if the catering premia are higher than the

private benefits from investing in a negative NPV project. Under this case, the agency costs of free cash flows are mitigated.

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