Description
The purpose of this article is to empirically explore the sensitivity of payouts to cash flows
and the other financing decisions, such as debt and investment, of firms.
Design/methodology/approach – Using panel regressions based on COMPUSTAT
Journal of Financial Economic Policy
The sensitivity of payouts to corporate financing decisions
Edward C. Hoang Indrit Hoxha
Article information:
To cite this document:
Edward C. Hoang Indrit Hoxha , (2015),"The sensitivity of payouts to corporate financing decisions",
J ournal of Financial Economic Policy, Vol. 7 Iss 4 pp. 290 - 300
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The sensitivity of payouts to
corporate fnancing decisions
Edward C. Hoang
University of Colorado Colorado Springs Colorado Springs,
Colorado, USA, and
Indrit Hoxha
Pennsylvania State University, Middletown, Pennsylvania, USA
Abstract
Purpose – The purpose of this article is to empirically explore the sensitivity of payouts to cash fows
and the other fnancing decisions, such as debt and investment, of frms.
Design/methodology/approach – Using panel regressions based on COMPUSTAT data for 7,544
public frms during the period 1973–2013, we estimate the sensitivity of total payouts. Specifcally,
following the theory presented in Lambrecht and Myers (2012), we test the interdependent fnancing
decisions of the frm. First, we compute total payout as the sum of cash dividends and net stock
repurchases; second, we examine the sensitivity of total payouts to changes in the frm’s net income,
debt and investment. Furthermore, we present several tests to demonstrate the robustness of our
results.
Findings – We suggest evidence in support of the theory in Lambrecht and Myers (2012) showing that
there is a negative relationship between total payouts and investment. Furthermore, we fnd that total
payouts are positively associated with net income and debt of the frm.
Originality/value – Previous research has shown howcash fows affect different fnancing decisions,
but it is not clear howtotal payouts are sensitive to other fnancing decisions. The focus of this paper is
the response of total payouts to investment policy, debt fnancing policy and changes in cash fows.
Keywords Investment, Debt
Paper type Research paper
1. Introduction
Much of the literature on corporate payouts has examined the determinants of payouts
separate from other fnancing decisions. Specifcally, fnancial economists have long
argued that managers set policies for investment, debt and payouts that are independent
of one another. In contrast, recent work has challenged this assumption by exploring the
joint dynamics of investment, debt and payouts; this suggests that the various corporate
fnancial decisions are intertwined, and, hence, payouts may be affected by investment
and debt fnancing policies. In light of these fndings, we extend the literature on
corporate payouts by studying the sensitivity of payouts in an empirical model
incorporating both investment and debt policies, and cash fow.
According to Lambrecht and Myers (2012), investment, debt and payout policies may
adjust to balance the frm’s cash fow. The behavior of frms is formalized by the
following intertemporal budget constraint:
?Debt
t
? Net Income
t
? Investment
t
? Payout
t
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
JFEP
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Received8 January2015
Revised23 April 2015
28 April 2015
Accepted28 April 2015
Journal of Financial Economic
Policy
Vol. 7 No. 4, 2015
pp. 290-300
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-01-2015-0005
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Based on the above equation, Lambrecht and Myers (2012) provide a key prediction for
payout policy. They argue that managers have a preference to keep payouts less
variable in order to smooth their own compensation. As a result, if there is a shock to net
income, debt policy and investment may adjust to keep the budget constraint balanced
and, hence, payouts smoothed. We extend their analysis by investigating the dynamics
of payout policy to changes in net income, debt policy and investment.
The analysis presented in this paper shows that payout policy responds to changes in
the sources and uses of cash for the frm, such as net income, debt policy and investment.
Prior research exploring payout behavior has overlooked the frm’s budget constraint in
their work, as Lambrecht and Myers (2012) point out “corporate fnance theories tend to
ignore the budget constraint […] [and] the constraint is essential to understand the
dynamics of payout.” Ultimately, if the frm desires to balance the budget constraint,
payout policy can be predicted since the frm’s sources and uses of cash should match
over the course of the frm’s life cycle.
For example, if the frm accumulates more debt without any changes to net income
and investment policy, then the extra cash created must be distributed to fnancing
payouts. While holding net income and investment constant, the effect of debt policy on
payouts corresponds with the predicted adjustment made in the budget constraint.
Specifcally, an increase in debt is associated with an increase in payouts.
In addition, according to the budget constraint, if net income and debt policy are held
constant, there is a tradeoff between investment and payouts. Lambrecht and Myers
(2012) argue that if debt policy is held fxed and there is no change to the frm’s cash fow,
then payouts will have to be cut back in order to fnance investment. Finally, if net
income increases, while holding investment and debt policy decisions fxed, then payout
is predicted to increase to keep the budget constraint balanced. We fnd empirically that
an increase in net income is associated with an increase in payout. In their survey of
managers, Brav et al. (2005) fnd that an increase in cash fowwill motivate managers to
issue more payouts to reduce excess cash holdings driven by increases in frmearnings.
Using panel regressions based on Compustat data for 7,544 public frms during the
period 1973–2013, we estimate the sensitivity of total payouts. Our methodology is
straightforward: On a frm-level basis, we compute total payouts as the sum of
dividends and net stock repurchases and examine whether payouts have systematic
relationships with investment, debt and net income predicted by the LM budget
constraint. We fnd that a negative relationship exists between payout and investment.
Furthermore, net income and debt are each positively associated with payouts. Overall,
our empirical fndings, which measure the response of payouts and provide the direction
of that response, support the theoretical implications of the LM budget constraint.
We provide several robustness tests of our results. First, we look at frms in sectors
that are independent or dependent on external fnancing. Then our next tests partition
frms into young and old frms, and small and large frms. Finally, we explore the
response of payouts during different time periods. Our main results are unaffected by
performing these robustness tests. Collectively, these results reinforce the notion that
payouts are affected by other corporate fnancing decisions.
Our fndings contribute to the growing empirical literature exploring the
interrelationship between different corporate fnancing decisions. More recently,
Gatchev et al. (2010), Ostergaard et al. (2011) and Chang et al. (2014) use accounting
identities to describe cash fow, and measure the sensitivity of various cash fow items.
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The current paper differs from the aforementioned papers in its focus. While previous
research has shown that cash fow affects corporate fnancing decisions, it is not clear
howsensitive payouts are to other corporate fnancing decisions. In this paper, we focus
on the response of total payouts (dividends ?net stock repurchases) to investment, debt
fnancing policy and cash fow.
The rest of the paper proceeds as follows. In Section 2, we discuss the related
literature. In Section 3, we describe the methodology and data. In Section 4, we present
and discuss the empirical results. We conclude in Section 5.
2. Related literature
In our paper, we empirically examine the response of total payouts to changes in cash
fow, and other corporate fnancing decisions such as debt and investment policies.
Lambrecht and Myers (2012) (referred to as LM hereafter) provide theoretical
predictions for corporate payout behavior. In their theoretical analysis, they conjecture
that managers have a preference to smooth corporate payout, which is the sum of
dividends and net stock repurchases, in order to smooth their own executive
compensation. Based on the intertemporal budget constraint which they formulate as:
?Debt
t
? Net Income
t
? Investment
t
? Payout
t
LM show that debt policy and investment will absorb shocks to net income to keep
payouts smoothed[1]. Their theory of payout smoothing is motivated by Lintner (1956),
which asserts that payouts follow a long-term target set by managers. Although the
Lintner model focuses on dividends, LMinclude stock repurchases along with dividends
as their measure of total payouts. Furthermore, in their analysis, they suggest that
payout will be cut back to fnance investment if there are no changes to net income and
debt policy. However, the predictions of their model are conditional on shocks to net
income, and debt policy and investment will absorb the shocks to keep payouts less
variable.
Brav et al. (2005) conduct a survey that gathers information frommanagers about the
setting of payout policy. Based on the responses of executives, their survey fndings
suggest that managers will distribute more dividends and repurchase more stock if net
income increases. An increase in net income may create excess cash holdings, and frms
will issue more payout to reduce this excess if debt and investment policies are not used
to absorb the extra cash.
Previous literature has examined the effect of cash fow on payout behavior. For
example, Gatchev et al. (2010) and Chang et al. (2014) develop different cash fow
identities to examine the effect of cash fow and its components on payout. However,
they both overlook the idea in their analysis that payout may adjust to balance the
budget constraint over the frm’s lifetime. Furthermore, Ostergaard et al. (2011)
investigate the effect of cash fowon the distribution of dividends without incorporating
the effects of investment and debt policies in their empirical model. Finally, Leary and
Michaely (2011) fnd evidence that frms smooth corporate payout. However, in their
analysis, the authors do not examine the effects of debt and investment policies on
corporate payout smoothing.
Hennessy and Whited (2005, 2007) and DeAngelo et al. (2012) provide theoretical
work exploring the joint dynamics of corporate fnancing policies. In these papers, the
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authors examine the interactions of investment, debt policy and payout in models with
taxes, and transaction and adjustment costs. Hoang and Hoxha (2014) estimate an
empirical model which incorporates the interactions of investment, debt policy and
payout. They fnd that a large fraction of net income shocks will be absorbed by debt
policy and investment to keep payout less variable. Other work on the dynamics of
corporate behavior have overlooked payouts and concentrated on examining the
relationship between capital structure and investment fnancing[2]. In our analysis, we
explore the response of payout to cash fow and other corporate fnancing decisions.
There exists a large literature exploring the determinants of payout behavior. Using
a sample consisting of 1,100 non-fnancial frms during the period 1993–1997, Fenn and
Liang (2001) fnd that frms with lowmarket-to-book ratios issue increase dividends and
repurchases of stock. Skinner (2008) suggests that corporate earnings infuence payout
policy. His results show that relatively larger, more mature and proftable frms pay
both dividends and repurchases. Deshmukh et al. (2013) show that frms managed by
overconfdent executives will decrease both dividends and repurchases because
overconfdent managers exhibit a greater sensitivity in investment to cash fow. In their
analysis of S&P 500 frms during the period 2004–2006, Ben-Rephael et al. (2013)
suggest that small frms repurchase stock less frequently and at a lower price than the
average market price compared to larger frms. Using a more comprehensive sample
based on all USA repurchasing frms during the period 2004–2011, Dittmar and Field
(2015) fnd the price of repurchase is markedly lower than the average market price.
Both papers suggest that frms are able to time the market when they repurchase stock
at relatively lower prices.
In recent work, the response of payout to fnancial settings such as the USAfnancial
crisis has been examined. For example, Campello et al. (2010) fnd that less dividends
were issued during the fnancial crisis because of the negative shock to cash fow.
Hauser (2013) suggests that frms issued less dividends during the period 2008–2009. In
a related paper, Hilliard and Jahera (2014) argue that the cutting of dividends during the
fnancial crisis was intended to signal to investors that the frmwas taking measures to
emerge fromthe crisis by building cash holdings. Also, during the fnancial crisis, Bliss
et al. (2014) fnd that both the issuance of dividends and repurchases of stock declined in
order to fnance investment. Despite fnding that total payout (dividends ? stock
repurchases) have been increasing prior to the fnancial crisis, Floyd et al. (2015) show
that non-fnancial frms reduced stock repurchases but maintained their issuance of
dividends during the crisis.
3. Methodology and data
Our empirical model considers the relationship between payouts (dividends ? stock
repurchases-equity issues) and net income, investment and debt:
?log Payouts
it
? ?log Net Income
it
? ?log Investment
it
? ?log Debt
it
? ?
i
? ?
t
? ?
it
We take the frst difference of the logarithms of our variables. Since the empirical model
is in logarithms, the estimated slope coeffcients can be expressed as elasticities.
Furthermore, to control for the presence of unobservables which may infuence
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corporate payouts, we include frm ( ?
i
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t
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which are estimated using robust standard errors.
To estimate our empirical model, we use data retrieved fromthe Compustat database.
More specifcally, we obtain data on variables such as net income, short-term and
long-term debt, cash balances, cash dividends, stock repurchases and equity issues. In
our panel data, we examine 7,544 frms over the time period 1973–2013. To address the
potential impact of outliers on our estimates, we winsorize the data at the 1st and 99th
percentiles. In addition, we follow the corporate fnance literature by excluding utility
frms with SIC codes between 4,900 and 4,999 and fnancial frms with SIC codes
between 6,000 and 6,999. Following LM, we defne net debt as the difference between
short-term and long-term debt and cash holdings of the company, and construct total
payouts as the sum of dividends ? stock repurchases of stock-equity issues. After
making these adjustments to our data, our baseline specifcation is estimated using an
unbalanced panel including 72,397 observations for public frms that issue cash
dividends and stock repurchases to investors.
Descriptive statistics for the variables used in the estimations are reported in Table I.
Each of the variables is defated using the Gross Domestic Product (GDP) price defator,
which is obtained fromthe Bureau of Labor Statistics (BLS). In the descriptive statistics
table, we report the means, standard deviations, and medians for total payout (the sum
of dividends and net repurchases of stock), net income, debt, and investment.
4. Results
We report our baseline specifcation results in Table II. We fnd that a 10 per cent
increase in net income is associated with a 0.3 per cent increase in payout. Furthermore,
a 0.1 per cent increase in payout is associated with a 10 per cent increase in debt, and
payouts decrease by 0.8 per cent when investment increases by 10 per cent. These
results are statistically signifcant at the 1 per cent level, and the observed correlation
Table I.
Descriptive statistics
Variable Mean SD Median
In millions
Total payout 126.03 942.52 6.44
Dividends ? net repurchases
Net income 206.02 1,037.35 20.79
Debt 727.14 5,168.08 42.77
Investment 2,780.43 9,954.58 266.85
Table II.
Baseline results
Variable Total payout
Net Income 0.03*** (12.45)
Debt 0.01*** (3.43)
Investment ?0.08*** (?3.51)
Observations 72,397
Adj. R-squared 0.09
Note: We report t-statistics in parentheses; signifcance level: ***1 per cent
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between payouts and cash fow, investment, and debt fnancing are consistent with the
theoretical predictions of the LM budget constraint. Additionally, these fndings
support the survey results in Brav et al. (2005). For example, they fnd that an increase
in net income is associated with an increase in payout. Apotential reason for this is that
managers may prefer to reduce excess cash holdings, which is induced by a positive
shock to net income, by issuing more payout.
Furthermore, we fnd that frms issue more payout if there is an increase in debt. A
reason for this fnding is that if there is no increase in net income and investment policy
is held fxed, then the newly created cash generated by corporate debt must be used to
fnance payout if the frmis motivated to manage their intertemporal budget constraint.
We fnd a negative effect of investment policy on payout, which is supported by LM. In
their paper, payout must be cut back in order to manage the budget constraint when
there is no change in net income, debt policy is held fxed, and investment increases.
In Table III, we explore payout policy for frms that are independent and dependent
on external fnancing. If frms depend on external funds to fnance debt and investment
policies, payout policy may be different for dependent frms compared to independent
frms. For example, frms dependent on external fnancing may be able to raise external
funds to fnance investment without having to cut back on payout. Therefore, being
either dependent or independent of external fnancing may infuence payout policy.
To explore the effect of dependency on external funds, we followthe methodology in
Rajan and Zingales (1998). Specifcally, we rank frms in the manufacturing sector based
on their external fnancing dependency. The frms in the top 50 per cent of the ranking
are considered in the dependent on external fnance category, and the other half in the
bottom of the ranking are considered independent from external fnance.
The estimates for independent frms display the same patterns as the baseline
results. Specifcally, payouts increase by 0.3 per cent in response to a 10 per cent increase
in net income. In addition, payouts increase by 0.2 per cent when there is a 10 per cent
increase in debt, and payouts fall by 1.8 per cent when investment increases by 10 per
cent. These results suggest that for frms that can raise internal funds, payout will
accordingly adjust to manage the budget constraint when net income, and debt and
investment policies change.
For frms that are dependent on external fnancing, debt and investment policies
have no statistical effects on payout. Because these frms rely on external fnancing, they
can use external funds to manage the budget constraint without altering payout policy
when debt and investment policies change. Therefore, changes in debt and investment
may not have an effect on payout for frms dependent on external fnancing.
Table III.
Externally
independent versus
externally dependent
frms
Variable Independent Dependent
Net income 0.03*** (4.93) 0.02*** (5.04)
Debt 0.02*** (2.82) 0.01 (1.35)
Investment ?0.18*** (?2.81) ?0.06 (?1.49)
Observations 15,084 26,168
Adj. R-squared 0.06 0.08
Note: We report t-statistics in parentheses; signifcance level: ***1 per cent
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However, the effect of net income on payout behavior is statistically signifcant for
dependent frms. Specifcally, a 10 per cent increase in net income is associated with 0.2
per cent increase in payout. This fnding suggests that a positive shock to net income
induces excess cash holdings, and, therefore, frms will distribute more payout to reduce
this excess.
Payout policy may differ for small frms compared to large frms. Small frms may
try to attract investors by issuing more payout, and large frms may have less
investment opportunities, which in turn may affect their payout policy. Therefore, we
extend our baseline model by disaggregating our sample of frms into small and large
categories to explore the effects of small and large frm sizes on payout policy.
In Table IV, we split the sample into two distinct groups based on the assets of the
frms. The small frms represent the frms with the lowest 50 per cent with regard to
average assets, while the large frms are the frms with the top 50 per cent of average
assets. For small frms, we fnd that increases in net income and debt policy are
associated with an increase in payout. The coeffcient on net income is larger for small
frms compared to large frms showing they pass on more of net income to shareholders
to potentially attract more investors. However, investment policy does not have a
statistically signifcant effect on payout policy. This suggests that investment policy
does not follow the prediction set forth by the budget constraint formulated in LM. A
possible reason for this fnding is that small frms may be fnancing investment
opportunities in order to grow and are reluctant to cut back on payout to attract
investors.
The estimates for large frms are consistent with the baseline results. For example,
Brav et al. (2005) and LM suggest that increases in net income and debt are associated
with an increase in payout. We fnd that, for large frms, a 10 per cent increase in net
income is associated with a 0.3 per cent increase in payout, and a 10 per cent increase in
debt is associated with a 0.1 per cent increase in payout. In addition, as predicted by LM,
since net income and debt policy are unchanged, an increase in investment will be
associated with a reduction in payout for large frms.
In Table V, we explore the effect of frmage on payout policy. LMdevelop the budget
constraint in their analysis of mature frms. Therefore, the predictions underlying the
budget constraint may not apply to young frms. We explore whether there are
differences in the response of payout for young and mature frms. Our sample is
constructed as the following: if the frm has been publicly traded for ten years or fewer,
we classify that frm as being young; otherwise, the frm is classifed as mature.
We fnd that a 10 per cent increase in net income is associated with a 0.3 per cent
increase in payout. This fnding is consistent with the conjecture that if debt and
Table IV.
Small versus large
frms
Variable Small Firms Large Firms
Net Income 0.05*** (11.34) 0.03*** (9.93)
Debt 0.02*** (3.89) 0.01*** (2.71)
Investment ?0.01 (?0.41) ?0.13*** (?3.91)
Observations 15,084 50,814
Adj. R-squared 0.23 0.07
Note: We report t-statistics in parentheses; signifcance level: ***1 per cent
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investment policies are fxed and excess cash holding is created by a positive shock to
net income, payout will increase to reduce this excess. In addition, the slope coeffcient
on investment suggests that a 10 per cent increase in investment is associated with a 1.7
per cent decrease in payout. According to the budget constraint formulated by LM, if net
income and debt policy are unchanged, then payout must decrease to accommodate the
increase in investment. Finally, for young frms, we do not fnd a statistically signifcant
effect of debt policy on payout. A potential reason for this fnding is that an increase in
debt may create cash, which may be used by young frms to fnance future investment
projects. Therefore, payout may not respond to changes in debt policy to allow the frm
to potentially fnance future investment opportunities.
The response of payout may vary during different time periods. For example, periods
of economic recessions and expansions, fnancial crises, and strict and lax regulation
periods may have impacted the distribution of corporate payout. In Table VI, we explore
payout behavior during three different time periods: 1973-1987, 1988-2006 and
2007-2013.
During the period 1973–1987, we fnd the responses of payout to be similar to the
baseline results. Specifcally, we fnd that a 10 per cent increase in net income is
associated with a 0.4 per cent increase in payout, and payout increases by 0.1 per cent
when debt increases by 10 per cent. Payout declines by 1 per cent when investment
increases by 10 per cent. Also, the responses of payout during the period 1988–2006 are
consistent with the baseline results. However, in the period 1988–2006, the response of
payout to changes in net income is half the size of the payout response during the period
1973–1987. In addition, the response of payout to investment, in the period 1988–2006,
is twice as large as that reported in the period 1973–1987. Overall, we fnd that for both
time periods, frms will increase payout when net income increases to potentially reduce
excess cash holdings; payout will increase when debt increases, and payout will
decrease when investment increases.
Table V.
Young versus mature
frms
Variable Young frms Mature frms
Net income 0.03*** (3.61) 0.03*** (11.29)
Debt ?0.01 (?1.21) 0.01*** (4.59)
Investment ?0.17** (?2.54) ?0.11*** (?4.34)
Observations 7,440 63,412
Adj. R-squared 0.31 0.06
Notes: We report t-statistics in parentheses; signifcance level: ***1 per cent, **5 per cent
Table VI.
Different periods
Variable 1973–1987 1988–2006 2007–2013
Net income 0.04*** (9.19) 0.02*** (6.28) 0.01*** (2.61)
Debt 0.01** (2.51) 0.01** (2.13) 0.01 (0.95)
Investment ?0.10** (?2.49) ?0.19*** (?5.02) 0.07 (1.12)
Observations 34,039 29,391 8,967
Adj. R-squared 0.09 0.12 0.30
Notes: We report t-statistics in parentheses; signifcance level: ***1 per cent, **5 per cent
297
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We fnd the responses of payout during and in the aftermaths of the fnancial crisis and
the Great Recession in the USA are markedly different compared to the other time
periods. The slope coeffcient on net income is statistically signifcant which indicates a
1 per cent increase in payout is associated with a 10 per cent increase in net income. This
implies that managers distributed some of the increase in frm income to investors.
However, the effects of debt and investment policies are found to have no effect on
payout. If a frmgenerated cash through the creation of debt, managers may be reluctant
to distribute more payout. Following a fnancial strategy of using the newly created
funds to fnance future investment projects may help frms survive and emerge fromthe
fnancial crisis. Therefore, payout policy may have been unresponsive to changes in
debt policy.
Furthermore, our result for investment suggests that payout did not decline when
investment increased. LM conjecture that payout is expected to decrease in response to
an increase in investment while net income and debt policy are held fxed. But during the
period 2007–2013, Bliss et al. (2014) suggest that the cost of external fnancing may have
been relatively high, and, therefore, the cost of reducing payout to fnance investment
may have been costlier than the cost of obtaining external fnancing to fund investment.
Therefore, payout policy might not respond to changes in investment policy.
Overall, we fnd that the slope coeffcients on net income are statistically signifcant
but the magnitudes decrease as the time period changes. Additionally, in the last time
period (2007–2013), payout is unresponsive to changes in debt and investment policies.
Hauser (2013) and Hilliard and Jahera (2014) suggest that frms distributed less payout,
particularly dividends, in response to the fnancial crisis in order to weather the crisis
and its aftermath. Because of the fall in payout, this may potentially explain why the
response of payout to net income is relatively small, and changes in debt and investment
policies have no effect on payout policy.
5. Conclusion
In the paper, we use frm-level data to estimate the responses of corporate payout policy
to changes in net income, debt policy and investment. Previous work had documented
the effect of cash fowon corporate fnancing decisions. We take a different approach by
focusing on payout policy and evaluating its response to not only cash fow, but also
investment and debt fnancing. We fnd that total payouts (dividends plus net stock
repurchases) are strongly and positively associated with increases in net income and the
accumulation of debt. Also, we fnd an increase in investment is associated with a
decrease in payouts. These fndings are consistent with the idea that payout policy may
adjust to manage the budget constraint over the frm’s lifetime. We believe our fndings
open an avenue for further work exploring corporate policy in the context of the joint
determination of investment, debt fnancing, cash fow and payout.
Notes
1. In Lambrecht and Myers (2014), the budget constraint is modifed to incorporate managerial
rent. The predictions from this budget constraint in Lambrecht and Myers (2014) are
consistent with those in Lambrecht and Myers (2012), but rent is explicitly considered to
suggest that managers smooth payout to keep their own rents smooth.
2. For a review, see Strebulaev and Whited (2012).
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Floyd, E., Li, N. and Skinner, D.J. (2015), “Payout policy through the fnancial crisis: the growth of
repurchases and the resilience of dividends”, Working Paper No. 12-01, 1 March, University
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sensitivities, and bank-fnance shocks in nonlisted frms”, Working Paper No. DP8278,
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Corresponding author
Indrit Hoxha can be contacted at: [email protected]
For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
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doc_201584731.pdf
The purpose of this article is to empirically explore the sensitivity of payouts to cash flows
and the other financing decisions, such as debt and investment, of firms.
Design/methodology/approach – Using panel regressions based on COMPUSTAT
Journal of Financial Economic Policy
The sensitivity of payouts to corporate financing decisions
Edward C. Hoang Indrit Hoxha
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The sensitivity of payouts to
corporate fnancing decisions
Edward C. Hoang
University of Colorado Colorado Springs Colorado Springs,
Colorado, USA, and
Indrit Hoxha
Pennsylvania State University, Middletown, Pennsylvania, USA
Abstract
Purpose – The purpose of this article is to empirically explore the sensitivity of payouts to cash fows
and the other fnancing decisions, such as debt and investment, of frms.
Design/methodology/approach – Using panel regressions based on COMPUSTAT data for 7,544
public frms during the period 1973–2013, we estimate the sensitivity of total payouts. Specifcally,
following the theory presented in Lambrecht and Myers (2012), we test the interdependent fnancing
decisions of the frm. First, we compute total payout as the sum of cash dividends and net stock
repurchases; second, we examine the sensitivity of total payouts to changes in the frm’s net income,
debt and investment. Furthermore, we present several tests to demonstrate the robustness of our
results.
Findings – We suggest evidence in support of the theory in Lambrecht and Myers (2012) showing that
there is a negative relationship between total payouts and investment. Furthermore, we fnd that total
payouts are positively associated with net income and debt of the frm.
Originality/value – Previous research has shown howcash fows affect different fnancing decisions,
but it is not clear howtotal payouts are sensitive to other fnancing decisions. The focus of this paper is
the response of total payouts to investment policy, debt fnancing policy and changes in cash fows.
Keywords Investment, Debt
Paper type Research paper
1. Introduction
Much of the literature on corporate payouts has examined the determinants of payouts
separate from other fnancing decisions. Specifcally, fnancial economists have long
argued that managers set policies for investment, debt and payouts that are independent
of one another. In contrast, recent work has challenged this assumption by exploring the
joint dynamics of investment, debt and payouts; this suggests that the various corporate
fnancial decisions are intertwined, and, hence, payouts may be affected by investment
and debt fnancing policies. In light of these fndings, we extend the literature on
corporate payouts by studying the sensitivity of payouts in an empirical model
incorporating both investment and debt policies, and cash fow.
According to Lambrecht and Myers (2012), investment, debt and payout policies may
adjust to balance the frm’s cash fow. The behavior of frms is formalized by the
following intertemporal budget constraint:
?Debt
t
? Net Income
t
? Investment
t
? Payout
t
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
JFEP
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Received8 January2015
Revised23 April 2015
28 April 2015
Accepted28 April 2015
Journal of Financial Economic
Policy
Vol. 7 No. 4, 2015
pp. 290-300
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-01-2015-0005
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Based on the above equation, Lambrecht and Myers (2012) provide a key prediction for
payout policy. They argue that managers have a preference to keep payouts less
variable in order to smooth their own compensation. As a result, if there is a shock to net
income, debt policy and investment may adjust to keep the budget constraint balanced
and, hence, payouts smoothed. We extend their analysis by investigating the dynamics
of payout policy to changes in net income, debt policy and investment.
The analysis presented in this paper shows that payout policy responds to changes in
the sources and uses of cash for the frm, such as net income, debt policy and investment.
Prior research exploring payout behavior has overlooked the frm’s budget constraint in
their work, as Lambrecht and Myers (2012) point out “corporate fnance theories tend to
ignore the budget constraint […] [and] the constraint is essential to understand the
dynamics of payout.” Ultimately, if the frm desires to balance the budget constraint,
payout policy can be predicted since the frm’s sources and uses of cash should match
over the course of the frm’s life cycle.
For example, if the frm accumulates more debt without any changes to net income
and investment policy, then the extra cash created must be distributed to fnancing
payouts. While holding net income and investment constant, the effect of debt policy on
payouts corresponds with the predicted adjustment made in the budget constraint.
Specifcally, an increase in debt is associated with an increase in payouts.
In addition, according to the budget constraint, if net income and debt policy are held
constant, there is a tradeoff between investment and payouts. Lambrecht and Myers
(2012) argue that if debt policy is held fxed and there is no change to the frm’s cash fow,
then payouts will have to be cut back in order to fnance investment. Finally, if net
income increases, while holding investment and debt policy decisions fxed, then payout
is predicted to increase to keep the budget constraint balanced. We fnd empirically that
an increase in net income is associated with an increase in payout. In their survey of
managers, Brav et al. (2005) fnd that an increase in cash fowwill motivate managers to
issue more payouts to reduce excess cash holdings driven by increases in frmearnings.
Using panel regressions based on Compustat data for 7,544 public frms during the
period 1973–2013, we estimate the sensitivity of total payouts. Our methodology is
straightforward: On a frm-level basis, we compute total payouts as the sum of
dividends and net stock repurchases and examine whether payouts have systematic
relationships with investment, debt and net income predicted by the LM budget
constraint. We fnd that a negative relationship exists between payout and investment.
Furthermore, net income and debt are each positively associated with payouts. Overall,
our empirical fndings, which measure the response of payouts and provide the direction
of that response, support the theoretical implications of the LM budget constraint.
We provide several robustness tests of our results. First, we look at frms in sectors
that are independent or dependent on external fnancing. Then our next tests partition
frms into young and old frms, and small and large frms. Finally, we explore the
response of payouts during different time periods. Our main results are unaffected by
performing these robustness tests. Collectively, these results reinforce the notion that
payouts are affected by other corporate fnancing decisions.
Our fndings contribute to the growing empirical literature exploring the
interrelationship between different corporate fnancing decisions. More recently,
Gatchev et al. (2010), Ostergaard et al. (2011) and Chang et al. (2014) use accounting
identities to describe cash fow, and measure the sensitivity of various cash fow items.
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The current paper differs from the aforementioned papers in its focus. While previous
research has shown that cash fow affects corporate fnancing decisions, it is not clear
howsensitive payouts are to other corporate fnancing decisions. In this paper, we focus
on the response of total payouts (dividends ?net stock repurchases) to investment, debt
fnancing policy and cash fow.
The rest of the paper proceeds as follows. In Section 2, we discuss the related
literature. In Section 3, we describe the methodology and data. In Section 4, we present
and discuss the empirical results. We conclude in Section 5.
2. Related literature
In our paper, we empirically examine the response of total payouts to changes in cash
fow, and other corporate fnancing decisions such as debt and investment policies.
Lambrecht and Myers (2012) (referred to as LM hereafter) provide theoretical
predictions for corporate payout behavior. In their theoretical analysis, they conjecture
that managers have a preference to smooth corporate payout, which is the sum of
dividends and net stock repurchases, in order to smooth their own executive
compensation. Based on the intertemporal budget constraint which they formulate as:
?Debt
t
? Net Income
t
? Investment
t
? Payout
t
LM show that debt policy and investment will absorb shocks to net income to keep
payouts smoothed[1]. Their theory of payout smoothing is motivated by Lintner (1956),
which asserts that payouts follow a long-term target set by managers. Although the
Lintner model focuses on dividends, LMinclude stock repurchases along with dividends
as their measure of total payouts. Furthermore, in their analysis, they suggest that
payout will be cut back to fnance investment if there are no changes to net income and
debt policy. However, the predictions of their model are conditional on shocks to net
income, and debt policy and investment will absorb the shocks to keep payouts less
variable.
Brav et al. (2005) conduct a survey that gathers information frommanagers about the
setting of payout policy. Based on the responses of executives, their survey fndings
suggest that managers will distribute more dividends and repurchase more stock if net
income increases. An increase in net income may create excess cash holdings, and frms
will issue more payout to reduce this excess if debt and investment policies are not used
to absorb the extra cash.
Previous literature has examined the effect of cash fow on payout behavior. For
example, Gatchev et al. (2010) and Chang et al. (2014) develop different cash fow
identities to examine the effect of cash fow and its components on payout. However,
they both overlook the idea in their analysis that payout may adjust to balance the
budget constraint over the frm’s lifetime. Furthermore, Ostergaard et al. (2011)
investigate the effect of cash fowon the distribution of dividends without incorporating
the effects of investment and debt policies in their empirical model. Finally, Leary and
Michaely (2011) fnd evidence that frms smooth corporate payout. However, in their
analysis, the authors do not examine the effects of debt and investment policies on
corporate payout smoothing.
Hennessy and Whited (2005, 2007) and DeAngelo et al. (2012) provide theoretical
work exploring the joint dynamics of corporate fnancing policies. In these papers, the
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authors examine the interactions of investment, debt policy and payout in models with
taxes, and transaction and adjustment costs. Hoang and Hoxha (2014) estimate an
empirical model which incorporates the interactions of investment, debt policy and
payout. They fnd that a large fraction of net income shocks will be absorbed by debt
policy and investment to keep payout less variable. Other work on the dynamics of
corporate behavior have overlooked payouts and concentrated on examining the
relationship between capital structure and investment fnancing[2]. In our analysis, we
explore the response of payout to cash fow and other corporate fnancing decisions.
There exists a large literature exploring the determinants of payout behavior. Using
a sample consisting of 1,100 non-fnancial frms during the period 1993–1997, Fenn and
Liang (2001) fnd that frms with lowmarket-to-book ratios issue increase dividends and
repurchases of stock. Skinner (2008) suggests that corporate earnings infuence payout
policy. His results show that relatively larger, more mature and proftable frms pay
both dividends and repurchases. Deshmukh et al. (2013) show that frms managed by
overconfdent executives will decrease both dividends and repurchases because
overconfdent managers exhibit a greater sensitivity in investment to cash fow. In their
analysis of S&P 500 frms during the period 2004–2006, Ben-Rephael et al. (2013)
suggest that small frms repurchase stock less frequently and at a lower price than the
average market price compared to larger frms. Using a more comprehensive sample
based on all USA repurchasing frms during the period 2004–2011, Dittmar and Field
(2015) fnd the price of repurchase is markedly lower than the average market price.
Both papers suggest that frms are able to time the market when they repurchase stock
at relatively lower prices.
In recent work, the response of payout to fnancial settings such as the USAfnancial
crisis has been examined. For example, Campello et al. (2010) fnd that less dividends
were issued during the fnancial crisis because of the negative shock to cash fow.
Hauser (2013) suggests that frms issued less dividends during the period 2008–2009. In
a related paper, Hilliard and Jahera (2014) argue that the cutting of dividends during the
fnancial crisis was intended to signal to investors that the frmwas taking measures to
emerge fromthe crisis by building cash holdings. Also, during the fnancial crisis, Bliss
et al. (2014) fnd that both the issuance of dividends and repurchases of stock declined in
order to fnance investment. Despite fnding that total payout (dividends ? stock
repurchases) have been increasing prior to the fnancial crisis, Floyd et al. (2015) show
that non-fnancial frms reduced stock repurchases but maintained their issuance of
dividends during the crisis.
3. Methodology and data
Our empirical model considers the relationship between payouts (dividends ? stock
repurchases-equity issues) and net income, investment and debt:
?log Payouts
it
? ?log Net Income
it
? ?log Investment
it
? ?log Debt
it
? ?
i
? ?
t
? ?
it
We take the frst difference of the logarithms of our variables. Since the empirical model
is in logarithms, the estimated slope coeffcients can be expressed as elasticities.
Furthermore, to control for the presence of unobservables which may infuence
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corporate payouts, we include frm ( ?
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which are estimated using robust standard errors.
To estimate our empirical model, we use data retrieved fromthe Compustat database.
More specifcally, we obtain data on variables such as net income, short-term and
long-term debt, cash balances, cash dividends, stock repurchases and equity issues. In
our panel data, we examine 7,544 frms over the time period 1973–2013. To address the
potential impact of outliers on our estimates, we winsorize the data at the 1st and 99th
percentiles. In addition, we follow the corporate fnance literature by excluding utility
frms with SIC codes between 4,900 and 4,999 and fnancial frms with SIC codes
between 6,000 and 6,999. Following LM, we defne net debt as the difference between
short-term and long-term debt and cash holdings of the company, and construct total
payouts as the sum of dividends ? stock repurchases of stock-equity issues. After
making these adjustments to our data, our baseline specifcation is estimated using an
unbalanced panel including 72,397 observations for public frms that issue cash
dividends and stock repurchases to investors.
Descriptive statistics for the variables used in the estimations are reported in Table I.
Each of the variables is defated using the Gross Domestic Product (GDP) price defator,
which is obtained fromthe Bureau of Labor Statistics (BLS). In the descriptive statistics
table, we report the means, standard deviations, and medians for total payout (the sum
of dividends and net repurchases of stock), net income, debt, and investment.
4. Results
We report our baseline specifcation results in Table II. We fnd that a 10 per cent
increase in net income is associated with a 0.3 per cent increase in payout. Furthermore,
a 0.1 per cent increase in payout is associated with a 10 per cent increase in debt, and
payouts decrease by 0.8 per cent when investment increases by 10 per cent. These
results are statistically signifcant at the 1 per cent level, and the observed correlation
Table I.
Descriptive statistics
Variable Mean SD Median
In millions
Total payout 126.03 942.52 6.44
Dividends ? net repurchases
Net income 206.02 1,037.35 20.79
Debt 727.14 5,168.08 42.77
Investment 2,780.43 9,954.58 266.85
Table II.
Baseline results
Variable Total payout
Net Income 0.03*** (12.45)
Debt 0.01*** (3.43)
Investment ?0.08*** (?3.51)
Observations 72,397
Adj. R-squared 0.09
Note: We report t-statistics in parentheses; signifcance level: ***1 per cent
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between payouts and cash fow, investment, and debt fnancing are consistent with the
theoretical predictions of the LM budget constraint. Additionally, these fndings
support the survey results in Brav et al. (2005). For example, they fnd that an increase
in net income is associated with an increase in payout. Apotential reason for this is that
managers may prefer to reduce excess cash holdings, which is induced by a positive
shock to net income, by issuing more payout.
Furthermore, we fnd that frms issue more payout if there is an increase in debt. A
reason for this fnding is that if there is no increase in net income and investment policy
is held fxed, then the newly created cash generated by corporate debt must be used to
fnance payout if the frmis motivated to manage their intertemporal budget constraint.
We fnd a negative effect of investment policy on payout, which is supported by LM. In
their paper, payout must be cut back in order to manage the budget constraint when
there is no change in net income, debt policy is held fxed, and investment increases.
In Table III, we explore payout policy for frms that are independent and dependent
on external fnancing. If frms depend on external funds to fnance debt and investment
policies, payout policy may be different for dependent frms compared to independent
frms. For example, frms dependent on external fnancing may be able to raise external
funds to fnance investment without having to cut back on payout. Therefore, being
either dependent or independent of external fnancing may infuence payout policy.
To explore the effect of dependency on external funds, we followthe methodology in
Rajan and Zingales (1998). Specifcally, we rank frms in the manufacturing sector based
on their external fnancing dependency. The frms in the top 50 per cent of the ranking
are considered in the dependent on external fnance category, and the other half in the
bottom of the ranking are considered independent from external fnance.
The estimates for independent frms display the same patterns as the baseline
results. Specifcally, payouts increase by 0.3 per cent in response to a 10 per cent increase
in net income. In addition, payouts increase by 0.2 per cent when there is a 10 per cent
increase in debt, and payouts fall by 1.8 per cent when investment increases by 10 per
cent. These results suggest that for frms that can raise internal funds, payout will
accordingly adjust to manage the budget constraint when net income, and debt and
investment policies change.
For frms that are dependent on external fnancing, debt and investment policies
have no statistical effects on payout. Because these frms rely on external fnancing, they
can use external funds to manage the budget constraint without altering payout policy
when debt and investment policies change. Therefore, changes in debt and investment
may not have an effect on payout for frms dependent on external fnancing.
Table III.
Externally
independent versus
externally dependent
frms
Variable Independent Dependent
Net income 0.03*** (4.93) 0.02*** (5.04)
Debt 0.02*** (2.82) 0.01 (1.35)
Investment ?0.18*** (?2.81) ?0.06 (?1.49)
Observations 15,084 26,168
Adj. R-squared 0.06 0.08
Note: We report t-statistics in parentheses; signifcance level: ***1 per cent
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However, the effect of net income on payout behavior is statistically signifcant for
dependent frms. Specifcally, a 10 per cent increase in net income is associated with 0.2
per cent increase in payout. This fnding suggests that a positive shock to net income
induces excess cash holdings, and, therefore, frms will distribute more payout to reduce
this excess.
Payout policy may differ for small frms compared to large frms. Small frms may
try to attract investors by issuing more payout, and large frms may have less
investment opportunities, which in turn may affect their payout policy. Therefore, we
extend our baseline model by disaggregating our sample of frms into small and large
categories to explore the effects of small and large frm sizes on payout policy.
In Table IV, we split the sample into two distinct groups based on the assets of the
frms. The small frms represent the frms with the lowest 50 per cent with regard to
average assets, while the large frms are the frms with the top 50 per cent of average
assets. For small frms, we fnd that increases in net income and debt policy are
associated with an increase in payout. The coeffcient on net income is larger for small
frms compared to large frms showing they pass on more of net income to shareholders
to potentially attract more investors. However, investment policy does not have a
statistically signifcant effect on payout policy. This suggests that investment policy
does not follow the prediction set forth by the budget constraint formulated in LM. A
possible reason for this fnding is that small frms may be fnancing investment
opportunities in order to grow and are reluctant to cut back on payout to attract
investors.
The estimates for large frms are consistent with the baseline results. For example,
Brav et al. (2005) and LM suggest that increases in net income and debt are associated
with an increase in payout. We fnd that, for large frms, a 10 per cent increase in net
income is associated with a 0.3 per cent increase in payout, and a 10 per cent increase in
debt is associated with a 0.1 per cent increase in payout. In addition, as predicted by LM,
since net income and debt policy are unchanged, an increase in investment will be
associated with a reduction in payout for large frms.
In Table V, we explore the effect of frmage on payout policy. LMdevelop the budget
constraint in their analysis of mature frms. Therefore, the predictions underlying the
budget constraint may not apply to young frms. We explore whether there are
differences in the response of payout for young and mature frms. Our sample is
constructed as the following: if the frm has been publicly traded for ten years or fewer,
we classify that frm as being young; otherwise, the frm is classifed as mature.
We fnd that a 10 per cent increase in net income is associated with a 0.3 per cent
increase in payout. This fnding is consistent with the conjecture that if debt and
Table IV.
Small versus large
frms
Variable Small Firms Large Firms
Net Income 0.05*** (11.34) 0.03*** (9.93)
Debt 0.02*** (3.89) 0.01*** (2.71)
Investment ?0.01 (?0.41) ?0.13*** (?3.91)
Observations 15,084 50,814
Adj. R-squared 0.23 0.07
Note: We report t-statistics in parentheses; signifcance level: ***1 per cent
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investment policies are fxed and excess cash holding is created by a positive shock to
net income, payout will increase to reduce this excess. In addition, the slope coeffcient
on investment suggests that a 10 per cent increase in investment is associated with a 1.7
per cent decrease in payout. According to the budget constraint formulated by LM, if net
income and debt policy are unchanged, then payout must decrease to accommodate the
increase in investment. Finally, for young frms, we do not fnd a statistically signifcant
effect of debt policy on payout. A potential reason for this fnding is that an increase in
debt may create cash, which may be used by young frms to fnance future investment
projects. Therefore, payout may not respond to changes in debt policy to allow the frm
to potentially fnance future investment opportunities.
The response of payout may vary during different time periods. For example, periods
of economic recessions and expansions, fnancial crises, and strict and lax regulation
periods may have impacted the distribution of corporate payout. In Table VI, we explore
payout behavior during three different time periods: 1973-1987, 1988-2006 and
2007-2013.
During the period 1973–1987, we fnd the responses of payout to be similar to the
baseline results. Specifcally, we fnd that a 10 per cent increase in net income is
associated with a 0.4 per cent increase in payout, and payout increases by 0.1 per cent
when debt increases by 10 per cent. Payout declines by 1 per cent when investment
increases by 10 per cent. Also, the responses of payout during the period 1988–2006 are
consistent with the baseline results. However, in the period 1988–2006, the response of
payout to changes in net income is half the size of the payout response during the period
1973–1987. In addition, the response of payout to investment, in the period 1988–2006,
is twice as large as that reported in the period 1973–1987. Overall, we fnd that for both
time periods, frms will increase payout when net income increases to potentially reduce
excess cash holdings; payout will increase when debt increases, and payout will
decrease when investment increases.
Table V.
Young versus mature
frms
Variable Young frms Mature frms
Net income 0.03*** (3.61) 0.03*** (11.29)
Debt ?0.01 (?1.21) 0.01*** (4.59)
Investment ?0.17** (?2.54) ?0.11*** (?4.34)
Observations 7,440 63,412
Adj. R-squared 0.31 0.06
Notes: We report t-statistics in parentheses; signifcance level: ***1 per cent, **5 per cent
Table VI.
Different periods
Variable 1973–1987 1988–2006 2007–2013
Net income 0.04*** (9.19) 0.02*** (6.28) 0.01*** (2.61)
Debt 0.01** (2.51) 0.01** (2.13) 0.01 (0.95)
Investment ?0.10** (?2.49) ?0.19*** (?5.02) 0.07 (1.12)
Observations 34,039 29,391 8,967
Adj. R-squared 0.09 0.12 0.30
Notes: We report t-statistics in parentheses; signifcance level: ***1 per cent, **5 per cent
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We fnd the responses of payout during and in the aftermaths of the fnancial crisis and
the Great Recession in the USA are markedly different compared to the other time
periods. The slope coeffcient on net income is statistically signifcant which indicates a
1 per cent increase in payout is associated with a 10 per cent increase in net income. This
implies that managers distributed some of the increase in frm income to investors.
However, the effects of debt and investment policies are found to have no effect on
payout. If a frmgenerated cash through the creation of debt, managers may be reluctant
to distribute more payout. Following a fnancial strategy of using the newly created
funds to fnance future investment projects may help frms survive and emerge fromthe
fnancial crisis. Therefore, payout policy may have been unresponsive to changes in
debt policy.
Furthermore, our result for investment suggests that payout did not decline when
investment increased. LM conjecture that payout is expected to decrease in response to
an increase in investment while net income and debt policy are held fxed. But during the
period 2007–2013, Bliss et al. (2014) suggest that the cost of external fnancing may have
been relatively high, and, therefore, the cost of reducing payout to fnance investment
may have been costlier than the cost of obtaining external fnancing to fund investment.
Therefore, payout policy might not respond to changes in investment policy.
Overall, we fnd that the slope coeffcients on net income are statistically signifcant
but the magnitudes decrease as the time period changes. Additionally, in the last time
period (2007–2013), payout is unresponsive to changes in debt and investment policies.
Hauser (2013) and Hilliard and Jahera (2014) suggest that frms distributed less payout,
particularly dividends, in response to the fnancial crisis in order to weather the crisis
and its aftermath. Because of the fall in payout, this may potentially explain why the
response of payout to net income is relatively small, and changes in debt and investment
policies have no effect on payout policy.
5. Conclusion
In the paper, we use frm-level data to estimate the responses of corporate payout policy
to changes in net income, debt policy and investment. Previous work had documented
the effect of cash fowon corporate fnancing decisions. We take a different approach by
focusing on payout policy and evaluating its response to not only cash fow, but also
investment and debt fnancing. We fnd that total payouts (dividends plus net stock
repurchases) are strongly and positively associated with increases in net income and the
accumulation of debt. Also, we fnd an increase in investment is associated with a
decrease in payouts. These fndings are consistent with the idea that payout policy may
adjust to manage the budget constraint over the frm’s lifetime. We believe our fndings
open an avenue for further work exploring corporate policy in the context of the joint
determination of investment, debt fnancing, cash fow and payout.
Notes
1. In Lambrecht and Myers (2014), the budget constraint is modifed to incorporate managerial
rent. The predictions from this budget constraint in Lambrecht and Myers (2014) are
consistent with those in Lambrecht and Myers (2012), but rent is explicitly considered to
suggest that managers smooth payout to keep their own rents smooth.
2. For a review, see Strebulaev and Whited (2012).
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Corresponding author
Indrit Hoxha can be contacted at: [email protected]
For instructions on how to order reprints of this article, please visit our website:
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