Chapter 7. Payout Policy

This paper surveys the literature on payout policy. We start out by discussing several stylized facts that are important to the development of any comprehensive payout policy framework. We then describe the Miller and Modigliani (1961) payout irrelevance proposition, and consider the effect of relaxing the assumptions on which it is based. We consider the role of taxes, asymmetric information, incomplete contracting possibilities, and transaction costs. The tax-related literature on dividends explores the implications of differential taxes on dividends and capital gains on stocks’ valuation and firms’ propensity to pay out cash in the form of dividends. The issues investigated in this literature are of central importance to corporate finance and asset pricing. It is important to understand the degree to which investor taxes are impounded into security prices, which in turn can affect investment returns, the cost of capital, capital structure, investment spending, and governmental revenue collection. The overall empirical evidence on this issue appears to indicate that from a tax perspective, dividends should be minimized. We review the theoretical as well as empirical literature on Signaling/Adverse Selection models and Agency models. The accumulated evidence indicates that changes in payout policies are not motivated by firms’ desire to signal their true worth to the market. There is no evidence that firms that increase their dividends experience an unexpectedly high earnings or cash flow in subsequent periods. The literature does point out however, that changes in cash payments are negatively associated with firms’ risk profile. This and other evidence seem to be consistent with the notion that both dividends and repurchases are paid when firms have excess cash flows in order to reduce potential overinvestment by management. We also review the issue of the form of payout and the increased tendency to use open market share repurchases. Evidence suggests that the rise in the popularity of repurchases increases overall payout and increases firms’ financial flexibility. It seems that young, risky firms prefer to use repurchases rather then dividends. We also observe that many large, established firms and those with more volatile earnings substitute repurchases for dividends. We believe that the choice of payout method and how payout policy interacts with capital-structure decisions (such as debt and equity issuance) are important questions and a promising field for further research.