SHAREHOLDER HETEROGENEITY, ADVERSE SELECTION, AND PAYOUT POLICY

When shareholders have different plans to sell their shares, they will , in general, have different preferences concerning the firm's decisio n to pay out cash using dividends or share repurchase. We illustrate t hese different preferences and explore a model of payout policy that h ighlights the adverse selection costs of repurchases when managers hav e superior information about the value of the firm. We show that, in t he absence of fixed costs to repurchasing shares, there is a separatin g equilibrium in which managers use taxable dividends to signal the qu ality of the firm, with better firms paying lower dividends, using rep urchases for the remainder of the payout. With fixed costs to repurcha sing, small payouts are made via dividend and large payouts are divide d between repurchases and dividends, as in the no-fixed cost case. In both cases, the percentage of shares repurchased increases with the si ze of the payout and larger repurchases are better news.