Dividends as a signaling device and the disappearing dividend puzzle

• Develop a signaling model of dividends with loss averse shareholders.
• Relate riskiness of future earnings to the likelihood of dividend initiation.
• Link between managerial sensitivity to short-term capital gains to dividend policy.
• Model the effect of investors preferences on firms’ payout policy.
• Relate the model's predictions to the disappearing dividend puzzle.

In this paper we develop a generalization of the Baker and Wurgler (2012) signaling model where investors are loss-averse to dividend cuts. We apply our framework to study how a firm's characteristics and manager's incentives affect payout policy properties. In equilibrium firms with riskier earnings are less likely to pay dividends, however, those that pay, payout more. Similarly, firms whose managers have a higher share of stock options in their compensation package are less likely to pay positive dividends. There is a clientele effect. Investors’ preferences and choices affect the payout policy and two otherwise identical firms can greatly differ in how they pay dividends. Finally, we relate our model's predictions to the disappearing dividend puzzle.