Payout Policy Franklin Allen University of Pennsylvania (allenf@wharton.upenn.edu) and Roni Michaely Cornell University and IDC (rm34@Cornell.edu) April,2002 Prepared for North-Holland Handbook of Economics edited by George Constantinides,Milton Harris,and Rene Stulz.We are in debt to Gustavo Grullon for his insights and help on this project.We would like to thank Harry DeAngelo,Eric Lie,Rene Stulz and Jeff Wurgler for their comments and suggestions
Payout Policy Franklin Allen University of Pennsylvania (allenf@wharton.upenn.edu) and Roni Michaely Cornell University and IDC (rm34@Cornell.edu) April, 2002 _____________________ Prepared for North-Holland Handbook of Economics edited by George Constantinides, Milton Harris, and Rene Stulz. We are in debt to Gustavo Grullon for his insights and help on this project. We would like to thank Harry DeAngelo, Eric Lie, Rene Stulz and Jeff Wurgler for their comments and suggestions
Abstract This paper surveys the literature on payout policy.We start with a description of the Miller- Modigliani payout irrelevance proposition,and then 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 accumulated evidence indicates that changes in payout policies are not motivated by firms'desire to signal their true worth to the market.Both dividends and repurchases seem to be paid 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 increased overall payout and increased firms'financial flexibility
Abstract This paper surveys the literature on payout policy. We start with a description of the MillerModigliani payout irrelevance proposition, and then 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 accumulated evidence indicates that changes in payout policies are not motivated by firms’ desire to signal their true worth to the market. Both dividends and repurchases seem to be paid 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 increased overall payout and increased firms’ financial flexibility
1.Introduction How much cash should firms give back to their shareholders?And what form should payment take?Should corporations pay their shareholders through dividends or by repurchasing their shares,which is the least costly form of payout from a tax perspective?Firms must make these important decisions over and over again (some must be repeated and some need to be reevaluated each period),on a regular basis. Because these decisions are dynamic they are labeled as payout policy.The word "policy"implies some consistency over time,and that payouts,and dividends in particular,do not simply evolve in an arbitrary and random manner.Much of the literature in the past forty years has attempted to find and explain the pattern in payout policies of corporations. The money involved in these payout decisions is substantial.For example,in 1999 corporations spent more than $350b on dividends and repurchases and over $400b on liquidating dividends in the form of cash spent on mergers and acquisitions. Payout policy is important not only because of the amount of money involved and the repeated nature of the decision,but also because payout policy is closely related to,and interacts with,most of the financial and investment decisions firms make.Management and the board of directors must decide the level of dividends,what repurchases to make (and the mirror image decision of equity issuance),the amount of financial slack the firm carries(which may be a non- trivial amount;for example,at the end of 1999,Microsoft held over $17b in financial slack), investment in real assets,mergers and acquisitions,and debt issuance.Since capital markets are neither perfect nor complete,all of these decisions interact with one another. Understanding payout policy may also help us to better understand the other pieces in this I Data on dividend and repurchases are from CRSP and Compustat.Data on cash M&A activity (for U.S.firms as acquirers only)is from SDC. 3
1. Introduction How much cash should firms give back to their shareholders? And what form should payment take? Should corporations pay their shareholders through dividends or by repurchasing their shares, which is the least costly form of payout from a tax perspective? Firms must make these important decisions over and over again (some must be repeated and some need to be reevaluated each period), on a regular basis. Because these decisions are dynamic they are labeled as payout policy. The word “policy” implies some consistency over time, and that payouts, and dividends in particular, do not simply evolve in an arbitrary and random manner. Much of the literature in the past forty years has attempted to find and explain the pattern in payout policies of corporations. The money involved in these payout decisions is substantial. For example, in 1999 corporations spent more than $350b on dividends and repurchases and over $400b on liquidating dividends in the form of cash spent on mergers and acquisitions.1 Payout policy is important not only because of the amount of money involved and the repeated nature of the decision, but also because payout policy is closely related to, and interacts with, most of the financial and investment decisions firms make. Management and the board of directors must decide the level of dividends, what repurchases to make (and the mirror image decision of equity issuance), the amount of financial slack the firm carries (which may be a nontrivial amount; for example, at the end of 1999, Microsoft held over $17b in financial slack), investment in real assets, mergers and acquisitions, and debt issuance. Since capital markets are neither perfect nor complete, all of these decisions interact with one another. Understanding payout policy may also help us to better understand the other pieces in this 1 Data on dividend and repurchases are from CRSP and Compustat. Data on cash M&A activity (for U.S. firms as acquirers only) is from SDC. 3
puzzle.Theories of capital structure,mergers and acquisitions,asset pricing,and capital budgeting all rely on a view of how and why firms pay out cash. Six empirical observations play an important role in discussions of payout policies: 1. Large,established corporations typically pay out a significant percentage of their earnings in the form of dividends and repurchases. 2. Historically,dividends have been the predominant form of payout.Share repurchases were relatively unimportant until the mid-1980s,but since then have become an important form of payment. 3. Among firms traded on organized exchanges in the U.S.,the proportion of dividend-paying firms has been steadily declining.Since the beginning of the 1980s,most firms have initiated their cash payment to shareholders in the form of repurchases rather than dividends. 4. Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts of taxes on these dividends. 5. Corporations smooth dividends relative to earnings.Repurchases are more volatile than dividends 6 The market reacts positively to announcements of repurchase and dividend increases,and negatively to announcements of dividend decreases. The challenge to financial economists has been to develop a payout policy framework where firms maximize shareholders'wealth and investors maximize utility.In such a framework payout policy would function in a way that is consistent with these observations and is not rejected by empirical tests
puzzle. Theories of capital structure, mergers and acquisitions, asset pricing, and capital budgeting all rely on a view of how and why firms pay out cash. Six empirical observations play an important role in discussions of payout policies: 1. Large, established corporations typically pay out a significant percentage of their earnings in the form of dividends and repurchases. 2. Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid-1980s, but since then have become an important form of payment. 3. Among firms traded on organized exchanges in the U.S., the proportion of dividend-paying firms has been steadily declining. Since the beginning of the 1980s, most firms have initiated their cash payment to shareholders in the form of repurchases rather than dividends. 4. Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts of taxes on these dividends. 5. Corporations smooth dividends relative to earnings. Repurchases are more volatile than dividends. 6. The market reacts positively to announcements of repurchase and dividend increases, and negatively to announcements of dividend decreases. The challenge to financial economists has been to develop a payout policy framework where firms maximize shareholders’ wealth and investors maximize utility. In such a framework payout policy would function in a way that is consistent with these observations and is not rejected by empirical tests. 4
The seminal contribution to research on dividend policy is that of Miller and Modigliani (1961).Prior to their paper,most economists believed hat the more dividends a firm paid,the more valuable the firm would be.This view was derived from an extension of the discounted dividends approach to firm valuation,which says that the value Vo of the firm at date 0,if the first dividends are paid one period from now at date 1,is given by the formula: Vo=D (1) 名(1+r) where D,=the dividends paid by the firm at the end of period t r=the investors'opportunity cost of capital for period t Gordon(1959)argued that investors'required rate of return rt would increase with retention of earnings and increased investment.Although the future dividend stream would presumably be larger as a result of the increase in investment (i.e.,Dt would grow faster),Gordon felt that higher rt would overshadow this effect.The reason for the increase in r would be the greater uncertainty associated with the increased investment relative to the safety of the dividend. Miller and Modigliani(1961)pointed out that this view of dividend policy incomplete and they developed a rigorous framework for analyzing payout policy.They show that what really counts is the firm's investment policy.As long as investment policy doesn't change, altering the mix of retained earnings and payout will not affect firm's value.The Miller and Modigliani framework has formed the foundation of subsequent work on dividends and payout policy in general.It is important to note that their framework is rich enough to encompass both dividends and repurchases,as the only determinant of a firm's value is its investment policy. The payout literature that followed the Miller and Modigliani article attempted to reconcile the indisputable logic of their dividend irrelevance theorem with the notion that both 5
The seminal contribution to research on dividend policy is that of Miller and Modigliani (1961). Prior to their paper, most economists believed hat the more dividends a firm paid, the more valuable the firm would be. This view was derived from an extension of the discounted dividends approach to firm valuation, which says that the value V0 of the firm at date 0, if the first dividends are paid one period from now at date 1, is given by the formula: (1+ r ) D = t t t t=1 0 ∑ ∞ V (1) where Dt = the dividends paid by the firm at the end of period t rt = the investors' opportunity cost of capital for period t Gordon (1959) argued that investors’ required rate of return rt would increase with retention of earnings and increased investment. Although the future dividend stream would presumably be larger as a result of the increase in investment (i.e., Dt would grow faster), Gordon felt that higher rt would overshadow this effect. The reason for the increase in rt would be the greater uncertainty associated with the increased investment relative to the safety of the dividend. Miller and Modigliani (1961) pointed out that this view of dividend policy incomplete and they developed a rigorous framework for analyzing payout policy. They show that what really counts is the firm’s investment policy. As long as investment policy doesn’t change, altering the mix of retained earnings and payout will not affect firm’s value. The Miller and Modigliani framework has formed the foundation of subsequent work on dividends and payout policy in general. It is important to note that their framework is rich enough to encompass both dividends and repurchases, as the only determinant of a firm’s value is its investment policy. The payout literature that followed the Miller and Modigliani article attempted to reconcile the indisputable logic of their dividend irrelevance theorem with the notion that both 5