Dean Crawford
SUNY at Oswego
Diana R Franz
University of Toledo
Gerald J Lobo
Syracuse University
Abstract: The retained earnings hypothesis predicts that stock distributions accounted for by reducing retained earnings are a more credible signal of managerial optimism than stock distributions that do not reduce retained earnings. This study examines the costs of false signaling that are a necessary precondition for the hypothesis and finds them to be very small or nonexistent, except for a narrowly defined set of firms. The absence of the requisite costs of false signaling calls the validity of the hypothesis into question for most firms. However, prior studies have reported broad-based market evidence consistent with the retained earnings hypothesis. To resolve this apparent inconsistency, this study replicates and extends tests of the retained earnings hypothesis contained in three prior studies. It shows that the findings in support of the retained earnings hypothesis are due to errors in inference resulting from specification errors that bias the results in favor of the hypothesis. The retained earnings hypothesis is generally not supported when the source of the bias is removed.
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