MM said that payout policy does not affect shareholder value. Shareholder value is driven by the firm’s investment policy, including its future growth opportunities. Financing policy, including the choice between debt and equity, can also affect value, as we will see in Chapter 18.
In MM’s analysis, payout is a residual, a by-product of other financial policies. The firm should make investment and financing decisions, and then can pay out whatever cash is left over. Therefore, decisions about how much to pay out should change over the life cycle of the firm.
MM assumed a perfect and rational world, but many of the complications discussed in this chapter actually reinforce the life cycle of payout. Let’s review the life-cycle story.
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’ compensation 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 31.
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.
As the nearby box shows, 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 companies 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 primarily 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 economies with good corporate governance. Payout can play a still more important role in countries where corporations are more opaque and governance less effective.
In some countries, you cannot always trust the financial information that companies provide. A passion for secrecy and a tendency to construct multilayered corporate organizations can produce earnings figures that are doubtful and sometimes meaningless. Thanks to creative accounting, the situation is little better for some companies in the United States, although accounting standards have tightened since passage of the Sarbanes-Oxley legislation in 2002.
How does an investor separate the winners and losers when governance is weak and corporations 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 significant 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 governance 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.