The study examines the dividend substitution effect of share repurchase decisions of firms in India. According to dividend substitution hypothesis, firms use funds ordinarily meant for dividend payment to buy back shares. The yearwise analysis of dividends reveals that dividends are not lower in the year of buyback declaration in India. The statistical model employed generates a positive relationship between dividend forecast error and repurchase activity, contradicting the dividend substitution hypothesis. The Indian firms pay more dividends for every Rs.1 spent on buyback in the announcement year. The Chief Finance Officers of repurchasing companies disagree to the proposition of dividend substituting effect of repurchases. The high-levered small-sized firms with higher cash balances and lower valuations engage in share repurchase in India but not at the expense of dividends.

Corporations possess a variety of mechanisms to distribute cash to their shareholders (Lee and Rui, 2007). The most common forms of such distributions are cash dividends and share repurchases. For decades, corporations employed cash dividends as a means of cash distribution. The trend was reversed in the 1990s with the increasing popularity of share repurchases, especially the Open Market Repurchases (OMRs) in US. The total amount distributed under repurchase programs exceeded the cash dividends for the first time in 1998 in US (Grullon and Michaely, 2002). The adoption of Rule 10b-18 by SEC¹ encouraged many firms to repurchase their stock and the amount distributed under share repurchase programs increased continuously and was $181.8 bn in 1998 as against $174.1 bn paid through cash dividends (Grullon and Michaely, 2002).

The increasing use of repurchases over dividends has led to a belief that firms substitute dividends by repurchases. Empirical studies in US show evidence for dividend substitution effect (Grullon and Michaely, 2002; and Skinner, 2008), while in non-US countries no such clear evidence is seen. For US firms only, Jagannathan et al. (2000) find contrary evidence that firms use repurchases to pay out temporary or variable sources of cash flows, while dividends are paid out of permanent cash flows, i.e., there is no substitution.

Applied Finance Journal, Are, Share, Repurchases, Substitutes, Dividend, Payments, India.