Introduction to Corporate Finance

15: Payout Policy

maintain repurchase programs. Figure 15.4 reports CFO responses to a set of questions that address

separate issues related to corporate share repurchase policy. An overwhelming majority of CFOs (87%)

said that they repurchased shares when their shares were good value – when the share price was

relatively low. Similarly, CFOs said they repurchased shares when buying their own shares was a better

investment than other alternatives available to them at the time. But several other factors were important

in repurchase decisions, such as trying to increase EPS, offsetting dilution from share option programs

and having excess cash on the balance sheet.

Repurchase Effects

When a company buys back shares, it reduces the denominator in the earnings per share (EPS)

calculation, and more than 75% of the CFOs reported in Figure 15.4 that raising EPS was an important

part of their thinking on share repurchases. So, does increasing EPS by decreasing shares outstanding

sound like an easy way to create value? After all, won’t shareholders place a higher value on a company’s

shares if its earnings are higher? The answer is no: value will not necessarily increase due solely to an

increase in EPS. Why? Because as the company distributes cash to shareholders, not only does the

number of outstanding shares fall, but the mix of assets held by the company also changes. For simplicity,

assume that a company owns just two kinds of assets, low-risk cash and high-risk plant and equipment.

When the company distributes some of its cash to investors, its subsequent asset mix is riskier than it

was before the repurchase, so shareholders will demand a higher rate of return. Moreover, as equity is

retired through share repurchases, the company’s ratio of debt to equity increases, and so financial risk

increases as well. The effect of increasing the risk borne by shareholders offsets the reduction in shares

outstanding, so even though EPS rises after a share repurchase, that alone does not lead to an increase

in company value, because the earnings are riskier.

Dividend Effects

The evidence presented above indicates that dividend decisions are made very conservatively. That is,

companies are hesitant to start paying dividends (or to increase the amount of dividends they pay) in

FIGURE 15.3 CFOS’ VIEWS ON DIVIDENDS AND REPURCHASES

0102030405060708090

% agree or strongly agree

We make dividend/repurchase decisions

after our investment plans are determined

Dividend/repurchase decisions convey

information about our company to investors

Dividends/repurchases make the stock of

a firm less risky (vs. retaining earnings)

There are negative consequences to reducing

dividends/repurchases

Rather than reducing dividends/repurchases, we

would raise new funds to undertake

a profitable project

Dividends Repurchases

Source: Reprinted from Brav, Graham, Harvey and Michaely, ‘Payout Policy in the 21st Century’, Journal of Financial Economics,

vol. 77, pp. 483–527, © 2005, with permission from Elsevier

Cynthia Lucchese,

Chief Financial Officer,

Hillenbrand Industries

‘We have to decide how

much cash to return as

a dividend versus share

repurchases.’

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