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The Marginal Source of Finance

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  • Lindhe, Tobias

    (Department of Economics)

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    Abstract

    This paper addresses the ongoingdebate on which view of equity, traditional or new, that best describes firm behavior. According to the traditional view, the marginal source of finance is new equity, whereas under to the new view, marginal financing comes from retained earnings. In the theoretical part, we set up a model where the firm faces a cost of adjusting the dividend level because of an aggravated free cash flow problem. The existence of such a cost - which has been used in arguing the traditional view - does not invalidate the core of the new view, namely that the marginal investment may be financed with retained earnings. The combination of costly changes in dividends and retained earnings as the marginal source of funds actually defines an extended new view of equity. In the empirical part, we test the implication of the new view that dividends and investments are negatively related. The overall conclusion is that the implication of the new view is supported for traded Swedish firms during 1980-98.

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    Bibliographic Info

    Paper provided by Uppsala University, Department of Economics in its series Working Paper Series with number 2002:9.

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    Length: 24 pages
    Date of creation: 02 May 2002
    Date of revision:
    Handle: RePEc:hhs:uunewp:2002_009

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    Postal: Department of Economics, Uppsala University, P. O. Box 513, SE-751 20 Uppsala, Sweden
    Phone: + 46 18 471 25 00
    Fax: + 46 18 471 14 78
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    Web page: http://www.nek.uu.se/
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    Keywords: The traditional view of equity; the new view of equity; financing policy; payout policy;

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    1. David F. Bradford, 1979. "The Incidence and Allocation Effects of a Tax on Corporate Distributions," NBER Working Papers 0349, National Bureau of Economic Research, Inc.
    2. Auerbach, Alan J. & Hassett, Kevin A., 2003. "On the marginal source of investment funds," Journal of Public Economics, Elsevier, vol. 87(1), pages 205-232, January.
    3. Alan J. Auerbach, 1980. "Share Valuation and Corporate Equity Policy," NBER Working Papers 0255, National Bureau of Economic Research, Inc.
    4. James M. Poterba & Lawrence H. Summers, 1984. "The Economic Effects of Dividend Taxation," Working papers 343, Massachusetts Institute of Technology (MIT), Department of Economics.
    5. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
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