Why Do Firms Pay Special Dividends?

This paper investigates a puzzle with respect to equity distributions. Firms returning cash to shareholders have two main ways of doing so: cash dividends and share repurchases. The focus of this paper is an alternative equity (cash) distribution, the special dividend. The paper examines two main research questions. First, why would a firm issue a special dividend. The decision to pay a special dividend is most appropriately compared to the decision to repurchase shares. Alternatively, dividend paying firms might increase the regular dividend (or initiate a dividend if not currently paying one). Based on both theory and empirical evidence, it is difficult to specify circumstances under which a special dividend would dominate the alternatives for shareholder distributions. Second, what are the valuation implications of a special dividend? Do investors react positively, negatively, or not at all, to the announcement of the special dividend and/or to its payment? What explains the reaction or lack of reaction? I also examine two related research questions: 1) what are the implications of the special dividend for the firm and investors, including an analysis of firm characteristics and of investor perceptions; 2) what accounting considerations influence the decision to issue special dividends. The sample consists of large special dividends (as a percentage of market capitalization) for the period 1995 to 2005.