Essays in finance

In Essay one I demonstrate that the optimal dividend policy depends on the effect of personal taxes on firms' equilibrium return on retained earnings. This study assumes that capital gains are taxed upon realization and that the only way firms can distribute cash to shareholders is by paying dividends. If the inter-corporation dividends are not taxed, no equilibrium exists with positive payouts. When inter-corporations dividends are taxed, however, and firms pay a premium for high stakes in others firms, equilibrium exists where firms pay positive dividends.;In Essay two I examine the cost of retained earnings and the cost of contributed capital in a world with personal taxes and how they depend on the payout method. If the holding period of investors is more than a year, then the cost of retained earnings is lower than the cost of contributed capital, both for the firm that pays dividends and the one that repurchases shares. The cost of retained earnings is lower for the dividend-paying firm while the cost of contributed capital is lower for the firm that repurchases shares. The retention rate of earnings has more affect on the cost of retained earnings for the dividend-paying firm. I derive the value of a firm that pays out cash by repurchasing shares, under the assumption that the holding period of investors is finite.;In the third essay (joint with Alok Khare) we examines whether prices of firms violate the variance bounds implied by the present value relation. The value of a firm is the discounted present value of future net cash flows, which consists of dividends and repurchases net of share issues. We employ the variance bound test derived by West (1988) on data using all cash flows between firms and shareholders. Our result is that prices are not excessively volatile when compared to subsequent total net cash flows to shareholders. The data consist of all firms in the DJIA from 1983 to 2005.