A class of solvable stochastic dividend optimization problems: on the general impact of flexibility on valuation

Summary. We consider the determination of an optimal dividend policy in the presence of cash flow uncertainty and transaction costs. We state a set of weak conditions under which the optimal dividend policy can be explicitly characterized for a broad class of diffusions modelling the underlying cash flow dynamics and demonstrate that increased dividend policy flexibility does not only increase the maximal expected cumulative present value of the future dividends, it also increases the rate at which this value grows (i.e. Tobin’s marginal q). We also prove that increased transaction costs result into larger but less frequent dividend payments.Received: 23 November 2003, Revised: 23 March 2005, JEL Classification Numbers: G35, G31, C44, Q23.Luis H.R. Alvarez: Correspondence toLuis H. R. Alvarez acknowledges the financial support from the Foundation for the Promotion of the Actuarial Profession, the Finnish Insurance Society, the Yrjö Jahnsson Foundation, and the Research Unit of Economic Structures and Growth (RUESG) at the University of Helsinki. The authors are grateful to an anonymous referee for constructive comments and suggested improvements on an earlier version of this study.