Introduction to Corporate Finance

15: Payout Policy

A company’s payout policy describes the choices

its managers make about distributing cash to

shareholders. These choices include whether to

pay shareholders a regular (recurring) dividend or a

one-time ‘special’ dividend, whether to repurchase

outstanding shares and what size the cash distribution

should be. In companies with a history of paying

dividends, managers must decide if the company

should maintain its current payouts or change them.

Managers tend to increase regular dividends only

when they expect that future cash flow will be sufficient

to pay the dividends and to meet their company’s

other financial needs. Companies must also weigh

the share market’s reaction to changes in dividend

policy. Influencing that reaction are factors such as the

current level of a company’s dividends, the volatility of

the dividend stream over time and the income taxes

investors must pay when they receive dividends. As

you can see, the many dimensions of this problem can

make payout policy decisions quite difficult.

In recent years, phenomenal growth has

been observed in both the number of companies

implementing share repurchase programs and

the total value of these programs. Companies that

announce a share repurchase program state that they

will buy some of their own shares over a period of

time. Companies usually repurchase shares through

purchases on the open market, though targeted

repurchases directly from large shareholders are also

possible. In executing a repurchase program, companies

distribute some of the cash they have accumulated

to investors who want to sell their shares. Therefore,

dividends and share repurchases are alternative means

by which companies pay out cash to investors.

It is important to keep in mind that a company’s

dividend policy is not independent from its other

financing and investment decisions. For example,

for a company that has at least some debt, paying

a dividend decreases the company’s equity, and

therefore raises its debt ratio. A company that decides

to distribute cash to shareholders via a dividend or

share repurchase may increase the likelihood that it

will have to raise external financing in the future. In

fact, it is not unusual for the same company to pay a

dividend, repurchase shares, borrow money and issue

new ordinary shares all in the same year. It should be

no surprise, then, that some of the same issues that

arise when we think about capital structure decisions

are also important in setting dividend policy.

Our objective in this chapter is to answer two

basic questions. First, does payout policy matter?

(Can managers increase or decrease the total

market value of a company’s securities by changing

its payouts?) Second, if payout policy does matter,

how should managers set payouts to maximise the

company’s value? Before attacking these questions,

in Section 15-1 we provide a brief overview of payout

policy fundamentals, and in Section 15-2 we discuss

the factors affecting dividend and share repurchase

decisions. Section 15-3 shows that payouts are

irrelevant in a world of perfect (frictionless) capital

markets, which suggests that dividends and share

repurchases exist because of some imperfection in

markets or human nature. Section 15-4 describes

various real-world market imperfections that affect

actual payout policy decisions. Finally, Section 15-5

presents a payout policy checklist and summarises

key payout policy lessons.

payout policy

The choices managers make

about distributing a company’s

cash, including whether to

pay shareholders a regular or

a ‘special’ dividend, whether

to repurchase shares and

what size the cash distribution

should be

share repurchase

programs

Programs in which companies

will buy some of their own

shares over a period of time,

usually on the open market

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

discuss the fundamentals of payout

policy, including cash dividend payment

procedures, types of policies and share

repurchases

describe some of the key factors affecting

dividend and share repurchase decisions

understand why payout policy is irrelevant

in a world with perfect capital markets

review the arguments for dividend

relevance in the imperfect (real) world,

including agency and signalling models

review real-world influences on payout

policy such as taxes, transactions costs and

uncertainty

summarise key lessons regarding payout

policy.

LO15.1

LO15.2

LO15.3

LO15.4

LO15.5

LO15.6

What happens to a company’s

dividend yield as its share price

declines?

t hinking cap

question