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The Marginal Source of Finance

Author

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  • Lindhe, Tobias

    (Department of Economics)

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.

Suggested Citation

  • Lindhe, Tobias, 2002. "The Marginal Source of Finance," Working Paper Series 2002:9, Uppsala University, Department of Economics.
  • Handle: RePEc:hhs:uunewp:2002_009
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    File URL: http://www.nek.uu.se/pdf/wp2002_9.pdf
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    References listed on IDEAS

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    1. James M. Poterba & Lawrence H. Summers, 1984. "The Economic Effects of Dividend Taxation," Working papers 343, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. Bradford, David F., 1981. "The incidence and allocation effects of a tax on corporate distributions," Journal of Public Economics, Elsevier, vol. 15(1), pages 1-22, February.
    3. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-329, May.
    4. Auerbach, Alan J., 1979. "Share valuation and corporate equity policy," Journal of Public Economics, Elsevier, vol. 11(3), pages 291-305, June.
    5. 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.
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    Cited by:

    1. Dackehag, Margareta & Hansson, Åsa, 2015. "Taxation of Dividend Income and Economic Growth: The Case of Europe," Working Papers 2015:24, Lund University, Department of Economics.

    More about this item

    Keywords

    The traditional view of equity; the new view of equity; financing policy; payout policy;

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy
    • H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm

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