Chapter 16 Payout Policy 427
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Young growth firms have plenty of profitable investment opportunities. During this time it
is efficient to retain and reinvest all operating cash flow. Why pay out cash to investors if the
firm then has to replace the cash by borrowing or issuing more shares? Retaining cash avoids
costs of issuing securities and minimizes shareholders’ taxes. Investors are not worried about
wasteful overinvestment, because investment opportunities are good, and managers’ compen-
sation is tied to stock price.
As the firm matures, positive-NPV projects become scarcer relative to cash flow. The firm
begins to accumulate cash. Now investors begin to worry about overinvestment or excessive
perks. The investors pressure management to start paying out cash. Sooner or later, managers
comply—otherwise stock price stagnates. The payout may come as share repurchases, but
initiating a regular cash dividend sends a stronger and more reassuring signal of financial
discipline. The commitment to financial discipline can outweigh the tax costs of dividends.
(The middle-of-the-road party argues that the tax costs of paying cash dividends may not be
that large, particularly in recent years, when U.S. personal tax rates on dividends and capital
gains have been low.) Regular dividends may also be attractive to some types of investors, for
example, retirees who depend on dividends for living expenses.
As the firm ages, more and more payout is called for. The payout may come as higher
dividends or larger repurchases. Sometimes the payout comes as the result of a takeover.
Shareholders are bought out, and the firm’s new owners generate cash by selling assets and
restructuring operations. We discuss takeovers in Chapter 32.
The life cycle of the firm is not always predictable. It’s not always obvious when the firm
is “mature” and ready to start paying cash back to shareholders. The following three questions
can help the financial manager decide:
- Is the company generating positive free cash flow after making all investments with
positive NPVs and is the positive free cash flow likely to continue? - Is the firm’s debt ratio prudent?
- Are the company’s holdings of cash a sufficient cushion for unexpected setbacks and a
sufficient war chest for unexpected opportunities?
If the answer to all three questions is yes, then the free cash flow is surplus, and payout is called for.
In March 2012, Apple’s answer to all three questions was “yes.” Yes, it was continuing to
accumulate cash at a rate of $30 billion per year. Yes, because it had no debt to speak of. Yes,
because no conceivable investment or acquisition could soak up its excess cash flow.
Some critics had argued that Apple should pay out the cash because it was earning interest
at less than 1% per year. That was a spurious argument because shareholders had no better
opportunities. Safe interest rates were extremely low, and neither Apple nor investors could
do anything about it.
Note also two further points. First, Apple did not just initiate a cash dividend. It announced
a combination of dividends and repurchases. This two-part payout strategy is now standard
for large, mature corporations. Second, Apple did not initiate repurchases because its stock
was undervalued but because it had surplus cash. You will hear critics who claim that compa-
nies should repurchase shares in bad times, when profits disappoint, and forbear in good times
when profits are high. It is true that repurchases are sometimes triggered by management’s
view that their company’s stock is underappreciated by investors. But repurchases are primar-
ily a device for distributing surplus cash to investors. It’s no surprise that repurchases increase
when profits are high and more surplus cash is available.
Payout and Corporate Governance
Most of this chapter has considered payout policy by public corporations in developed econo-
mies with good corporate governance. Payout can play a still more important role in countries
where corporations are more opaque and governance less effective.