The complete contracting possibilities specified in Assumption 3 mean that there is no agency problem between managers and security holders,for example.In this case,motivating the decisions of managers is possible through the use of enforceable contracts.Without complete contracting possibilities,dividend policy could,for example,help ensure that managers act in the interest of shareholders.A high payout ratio cause management to be more disciplined in the use of the firm's resources and consequently increase firm value.We cover these issues in sections 6.2 and 7.2. Assumption 4 concerns transaction costs.These come in a variety of forms.For example,firms can distribute cash through dividends and raise capital through equity issues.If flotation costs are significant,then every trip to the capital market will reduce the firm's value. This means changing dividend policy can change the value of the firm.By the same token,when investors sell securities and make decisions about such sales,the transaction costs that investors incur can also result in dividend policy affecting the value of the firm.Section 8 develops several transaction-cost-related theories of dividend policy. Assumption 5 is that markets are complete.To illustrate why this is important,assume that because trading opportunities are limited,there are two groups with different marginal rates of substitution between current and future consumption.By adjusting its dividend policy,a firm might be able to increase its value by appealing to one of these groups.The literature has paid very little attention to explanations such as these for dividend policy.Nevertheless,these explanations could be important if some investors wish to buy stocks with a steady income stream,and markets are incomplete because of high transaction costs.Further analysis in this area might provide some insights into dividend policy 16
The complete contracting possibilities specified in Assumption 3 mean that there is no agency problem between managers and security holders, for example. In this case, motivating the decisions of managers is possible through the use of enforceable contracts. Without complete contracting possibilities, dividend policy could, for example, help ensure that managers act in the interest of shareholders. A high payout ratio cause management to be more disciplined in the use of the firm's resources and consequently increase firm value. We cover these issues in sections 6.2 and 7.2. Assumption 4 concerns transaction costs. These come in a variety of forms. For example, firms can distribute cash through dividends and raise capital through equity issues. If flotation costs are significant, then every trip to the capital market will reduce the firm's value. This means changing dividend policy can change the value of the firm. By the same token, when investors sell securities and make decisions about such sales, the transaction costs that investors incur can also result in dividend policy affecting the value of the firm. Section 8 develops several transaction-cost-related theories of dividend policy. Assumption 5 is that markets are complete. To illustrate why this is important, assume that because trading opportunities are limited, there are two groups with different marginal rates of substitution between current and future consumption. By adjusting its dividend policy, a firm might be able to increase its value by appealing to one of these groups. The literature has paid very little attention to explanations such as these for dividend policy. Nevertheless, these explanations could be important if some investors wish to buy stocks with a steady income stream, and markets are incomplete because of high transaction costs. Further analysis in this area might provide some insights into dividend policy. 16
Another issue that is central to our survey is the form of the payout.One area of significant growth in the literature is related to the role of repurchases as a form of payout,not only because repurchases have become more popular(Table 1),but also because of the research concerning the reasons for repurchases and the interrelation between dividends and repurchases. In section 4 we define corporate payout,both conceptually and empirically.In section 9 we review in detail the recent developments concerning repurchases. 4.How Should We Measure Payout? The Miller and Modigliani framework defines payout policy as the net payout to shareholders.However,most empirical work measures payout only by the amount of dividends the firms pay.Such studies do not consider repurchases.Neither do they factor in either net payout(accounting for capital raising activities)or cash spent on mergers and acquisitions. If we wish to find out how much cash corporations pay out(relative to their earnings)at the aggregate level,we need to consider some of the aggregate measures,such as the one presented in Table 1,namely,aggregate dividends plus aggregate repurchases relative to aggregate earnings.But even this measure is incomplete.First,shareholders also receive cash payouts from corporations through mergers and acquisitions that are accomplished through cash transactions.That is,shareholders of the acquired firms receive a cash payment that can be viewed as a liquidating(or final)dividend. Using data from SDC,Table 4 presents the magnitude of such payments.For each year we calculate the total dollar amount that was paid to U.S.corporations in all cash M&A deals. (Note that this figure is a lower bound,since it does not account for deals in which payment was partially in cash and partially in stocks.)The amount is not trivial and it does vary by year.This 17
Another issue that is central to our survey is the form of the payout. One area of significant growth in the literature is related to the role of repurchases as a form of payout, not only because repurchases have become more popular (Table 1), but also because of the research concerning the reasons for repurchases and the interrelation between dividends and repurchases. In section 4 we define corporate payout, both conceptually and empirically. In section 9 we review in detail the recent developments concerning repurchases. 4. How Should We Measure Payout? The Miller and Modigliani framework defines payout policy as the net payout to shareholders. However, most empirical work measures payout only by the amount of dividends the firms pay. Such studies do not consider repurchases. Neither do they factor in either net payout (accounting for capital raising activities) or cash spent on mergers and acquisitions. If we wish to find out how much cash corporations pay out (relative to their earnings) at the aggregate level, we need to consider some of the aggregate measures, such as the one presented in Table 1, namely, aggregate dividends plus aggregate repurchases relative to aggregate earnings. But even this measure is incomplete. First, shareholders also receive cash payouts from corporations through mergers and acquisitions that are accomplished through cash transactions. That is, shareholders of the acquired firms receive a cash payment that can be viewed as a liquidating (or final) dividend. Using data from SDC, Table 4 presents the magnitude of such payments. For each year we calculate the total dollar amount that was paid to U.S. corporations in all cash M&A deals. (Note that this figure is a lower bound, since it does not account for deals in which payment was partially in cash and partially in stocks.) The amount is not trivial and it does vary by year. This 17
type of liquidating dividend seems to have a significant weight in the aggregate payout of U.S. corporations.For example,in 1999,proceeds from cash M&As were more than the combined cash distributed to shareholders through dividends and repurchases combined. Our next measure accounts not only for the outflow of funds from corporations to their shareholders,but also for the inflow of funds.Columns 3 and 4 in Table 4 present the dollar amount of capital raised by U.S.corporations through SEOs and IPOs.Column 5 reports the net amount (cash from M&As minus proceeds from IPOs and SEOs).It is clear that these are significant amounts.When we compare Tables 1 and 4,we see that in the last decade these amounts are as large as the cash payments through dividends and repurchases combined.We are also interested to see its impact on the overall aggregate payout.Clearly,in some years the aggregate payout is higher than after-tax earnings. One can also define the aggregate payout as the total transfer of cash from the corporate sector to the private sector.This definition contains three elements:dividends paid to individual investors,repurchase of shares from individual investors,and net cash M&A activity where the proceeds are going to the private sector. Using this definition and information from the IRS Statistics of Income and the Federal Reserve Flow of Funds publications,we can recalculate a rough measure of the total payout to the private sector over the years.We base this measure on the total dividends,repurchases,and cash M&A activity.We assume that the proportional holdings of each group (individuals, corporations and institutions)is the same for all firms in the economy In Table 2,we calculate the portion of shares held by individual investors (using information from Table L-312 from the Federal Reserve Flow of Funds).Using this ratio,we 3 Total dividends are taken from Table F-7(distribution of national income)of the Flow of Funds Accounts of the U.S.The portion of dividends received by individuals is from Table I of the SOI Bulletin,Winter 1999-2000. 18
type of liquidating dividend seems to have a significant weight in the aggregate payout of U.S. corporations. For example, in 1999, proceeds from cash M&As were more than the combined cash distributed to shareholders through dividends and repurchases combined. Our next measure accounts not only for the outflow of funds from corporations to their shareholders, but also for the inflow of funds. Columns 3 and 4 in Table 4 present the dollar amount of capital raised by U.S. corporations through SEOs and IPOs. Column 5 reports the net amount (cash from M&As minus proceeds from IPOs and SEOs). It is clear that these are significant amounts. When we compare Tables 1 and 4, we see that in the last decade these amounts are as large as the cash payments through dividends and repurchases combined. We are also interested to see its impact on the overall aggregate payout. Clearly, in some years the aggregate payout is higher than after-tax earnings. One can also define the aggregate payout as the total transfer of cash from the corporate sector to the private sector. This definition contains three elements: dividends paid to individual investors, repurchase of shares from individual investors, and net cash M&A activity where the proceeds are going to the private sector. Using this definition and information from the IRS Statistics of Income and the Federal Reserve Flow of Funds publications, we can recalculate a rough measure of the total payout to the private sector over the years. We base this measure on the total dividends, repurchases, and cash M&A activity. We assume that the proportional holdings of each group (individuals, corporations and institutions) is the same for all firms in the economy. In Table 2, we calculate the portion of shares held by individual investors (using information from Table L-312 from the Federal Reserve Flow of Funds).3 Using this ratio, we 3 Total dividends are taken from Table F-7 (distribution of national income) of the Flow of Funds Accounts of the U.S. The portion of dividends received by individuals is from Table 1 of the SOI Bulletin, Winter 1999-2000. 18
can approximate the portion of repurchased shares and net cash M&As that went to the private sector.For example,in 1995,the private sector received $94b in dividends(see Table 2),$82b in cash M&As (57.9%of shares owned by individuals multiplied by $143b of net cash M&As,see Tables 2 and 4),and roughly $50b in repurchases (57.9%of shares owned by individuals multiplied by $72.3b of repurchases;see Tables 1 and 2).We note that out of total cash payments to the private sector of around $219b,less than half is through "formal"dividends. Table 5 presents the cash payout that goes to the private sector(dividends,repurchases,and net cash M&As)for the various years. These issues have not received much attention in the literature.We believe they should. It is difficult to take a position on payout policy before we correctly measure it. An equally interesting issue is to analyze the payout,its components,and the relation between payout and earnings at the firm level.For example,we think it would be interesting to investigate the type of firm that gives its shareholders liquidating dividends,and how such dividends relate to other types of payout.Analyzing the interaction between total payout, dividends,and the recent surge in repurchases would also require information on individual firms'payout policies.But at the firm level,there may be another problem in the definition of payout relative to earnings,since a significant portion of firms have negative earnings.For these firms,it is not possible to define a total payout ratio,a repurchase payout ratio,or a dividend payout ratio. Our discussion highlights several important points.First,in our opinion,the main issue is not whether one measure is better than another.Instead,we ask,what is the question that we are trying to answer?This question in turn should have an impact on which definition of payout we use 19
can approximate the portion of repurchased shares and net cash M&As that went to the private sector. For example, in 1995, the private sector received $94b in dividends (see Table 2), $82b in cash M&As (57.9% of shares owned by individuals multiplied by $143b of net cash M&As, see Tables 2 and 4), and roughly $50b in repurchases (57.9% of shares owned by individuals multiplied by $72.3b of repurchases; see Tables 1 and 2). We note that out of total cash payments to the private sector of around $219b, less than half is through “formal” dividends. Table 5 presents the cash payout that goes to the private sector (dividends, repurchases, and net cash M&As) for the various years. These issues have not received much attention in the literature. We believe they should. It is difficult to take a position on payout policy before we correctly measure it. An equally interesting issue is to analyze the payout, its components, and the relation between payout and earnings at the firm level. For example, we think it would be interesting to investigate the type of firm that gives its shareholders liquidating dividends, and how such dividends relate to other types of payout. Analyzing the interaction between total payout, dividends, and the recent surge in repurchases would also require information on individual firms’ payout policies. But at the firm level, there may be another problem in the definition of payout relative to earnings, since a significant portion of firms have negative earnings. For these firms, it is not possible to define a total payout ratio, a repurchase payout ratio, or a dividend payout ratio. Our discussion highlights several important points. First, in our opinion, the main issue is not whether one measure is better than another. Instead, we ask, what is the question that we are trying to answer? This question in turn should have an impact on which definition of payout we use. 19
The issue of how to define payout is also very relevant to the excess volatility literature. For example,Ackert and Smith(1993)showed that the results of variance-bound tests depend on how we measure cash distributions to shareholders.When they used only stated dividends,they found evidence of excess volatility.When the payout measure included share repurchase and takeover distributions as well,they did not find evidence of excess volatility.It is likely that using the net total payout to investors will add some variability to cash flows.It may also reduce even further the discrepancy between cash flow volatility and price volatility.In our opinion,this issue is worthy of further research. Second,it is clear that most of the finance literature has analyzed the payout policy question using only the very narrow definition of dividend payout.Some studies have attempted to analyze repurchase payout.But with only a few exceptions,the literature does not cover the issue of total payout,its composition,and determination.This lacuna is understandable,given the fact that over many years,dividends were the most prominent form of payout.But this is not so anymore.Thus,to a great extent our review article reflects the current literature.We devote more space and put more emphasis on dividends relative to the other forms of payouts.We hope future research will explore the other aspects of payout policy and their implications. 5.Taxes Much of the literature on payout policy focuses on the importance of taxes,and tries to reconcile several of the empirical observations discussed in our introduction.Firms pay out a large part of their earnings as dividends;many of the recipients are in high tax brackets.Firms did not traditionally use repurchases as a method of payout.The basic aim of the tax-related 20
The issue of how to define payout is also very relevant to the excess volatility literature. For example, Ackert and Smith (1993) showed that the results of variance-bound tests depend on how we measure cash distributions to shareholders. When they used only stated dividends, they found evidence of excess volatility. When the payout measure included share repurchase and takeover distributions as well, they did not find evidence of excess volatility. It is likely that using the net total payout to investors will add some variability to cash flows. It may also reduce even further the discrepancy between cash flow volatility and price volatility. In our opinion, this issue is worthy of further research. Second, it is clear that most of the finance literature has analyzed the payout policy question using only the very narrow definition of dividend payout. Some studies have attempted to analyze repurchase payout. But with only a few exceptions, the literature does not cover the issue of total payout, its composition, and determination. This lacuna is understandable, given the fact that over many years, dividends were the most prominent form of payout. But this is not so anymore. Thus, to a great extent our review article reflects the current literature. We devote more space and put more emphasis on dividends relative to the other forms of payouts. We hope future research will explore the other aspects of payout policy and their implications. 5. Taxes Much of the literature on payout policy focuses on the importance of taxes, and tries to reconcile several of the empirical observations discussed in our introduction. Firms pay out a large part of their earnings as dividends; many of the recipients are in high tax brackets. Firms did not traditionally use repurchases as a method of payout. The basic aim of the tax-related 20