A corporation’s payout policy is the answer to two questions. First, how much cash should the
company pay out to its stockholders? Second, should the cash be distributed by paying cash divi-
dends or by repurchasing shares?
The answer to “How much?” is often zero. Younger companies with profitable growth oppor-
tunities do not pay out cash and rarely repurchase stock. They finance investment as much as
possible with internally generated cash flow. But as they mature, growth opportunities gradually
fade away and surplus cash accumulates. Then investors press for payout because they worry that
managers will overinvest if too much idle cash is lying around.
Cash is surplus when these three criteria are met:
- Free cash flow is reliably positive. Recall that free cash flow is the operating cash flow left
over after the firm has made all positive-NPV investments. - The firm’s debt level is prudent and manageable. Otherwise free cash flow is better used to pay
down debt. - The firm has a sufficient war chest of cash or unused debt capacity to cover unexpected oppor-
tunities or setbacks.
A firm with surplus cash will probably start by repurchasing shares. Repurchases are more flex-
ible than dividends. Once a company announces a regular cash dividend, investors expect the divi-
dend to continue unless the company encounters serious financial trouble. Thus financial managers
do not start or increase a cash dividend unless they are confident that the dividend can be maintained.
Announcements of dividend initiations or increases usually cause a stock price increase, because the
announcements signal managers’ confidence. This is the information content of dividends.
Regular cash dividends are paid by mature, profitable firms. But most firms that pay regular
cash dividends also repurchase shares. If we lived in an ideally simple and perfect world, the
choice between cash dividends and stock repurchase would have no effect on market value. For
example, when a company shifts payout from repurchases to cash dividends, then shareholders’
extra cash is exactly offset by a lower stock price.
● ● ● ● ●SUMMARY
Chapter 16 Payout Policy 429
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How does an investor separate the winners and losers when governance is weak and cor-
porations are opaque? One clue is payout. Investors can’t read managers’ minds, but they can
learn from their actions. They know that a firm that reports good earnings and pays out a sig-
nificant fraction of the earnings is putting its money where its mouth is. We can understand,
therefore, why investors would be skeptical about reported earnings unless they were backed
up by consistent payout policy.
Of course firms can cheat in the short run by overstating earnings and scraping up cash for
payout. But it is hard to cheat in the long run because a firm that is not making money will
not have cash to pay out. If a firm pays a high dividend or commits to substantial repurchases
without generating sufficient cash flow, it will ultimately have to seek additional debt or equity
financing. The requirement for new financing would reveal management’s game to investors.
The implications for payout in developing countries could go either way. On the one hand,
managers who are committed to shareholder value have a stronger motive to pay out cash
when corporate governance is weak and corporate financial statements are opaque. Payout
makes the firm’s reported earnings more credible. On the other hand, weak corporate gov-
ernance may also weaken managers’ commitment to shareholders. In this case they will pay
out less, and instead deploy cash more in their own interests. It turns out that dividend payout
ratios are on average smaller where governance is weak.^32
(^32) See R. LaPorta, F. Lopez de Silanes, A. Shleifer, and R. W. Vishny, “Agency Problems and Dividend Policy around the World,”
Journal of Finance 55 (February 2000), pp. 1–24.