Flexibility and dividends

We develop a model of corporate dividend policy based on the idea that management values operating flexibility. By reducing dividends and conserving cash, management increases its flexibility. This improves its ability to invest in projects that it believes are good for the shareholders in the long run but which shareholders would not provide the capital for because they think the projects are value reducing. However, the cost of not paying dividends is a reduction in the current stock price. Management trades off these two aspects of dividends. Flexibility considerations help us understand various dimensions of dividend policy that existing theories do not explain. Our theory generates numerous testable predictions that we confront with the data. The evidence is supportive of the model.