MORGAN STANLEY ROUNDTABLE ON Capital Structure and Payout Policy

A group of distinguished finance academics and practitioners discuss a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerges is that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial flexibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value both by reducing taxes and controlling the corporate free cash flow problem. In such cases, both leveraged financing and cash distributions through dividends and stock buybacks signal management's commitment to its shareholders that the firm's excess cash will not be wasted on projects that produce low‐return growth that comes at the expense of profitability. As for the choice between dividends and stock repurchases, dividends provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve more flexibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial flexibility: too little can mean lost investment opportunities, but too much can lead to overinvestment.     

STERN STEWART ROUNDTABLE ON CAPITAL STRUCTURE AND STOCK REPURCHASE

This roundtable brings together a small group of finance theorists and practitioners to discuss two important—and in most companies closely related—financial policy decisions: (1) the optimal mix of debt and equity and (2) the amount (and form) of cash distributions to shareholders. The result is an interesting set of comments and exchanges that show current theory and corporate practice to be consistent in some respects, but at odds in others. In the first part of this two‐part discussion, the University of Rochester's Clifford Smith presents a broad theoretical framework in which companies set leverage targets by weighing tax and other benefits of debt against potential costs of financial distress, particularly in the form of underinvestment. According to this theory, mature companies with stable cash flows and limited investment opportunities should make extensive use of debt, while growth companies should be funded primarily (if not entirely) with equity. But, as becomes clear in the case study of PepsiCo that follows the opening discussion, putting theory into practice is far from straightforward. Consistent with the theory, Pepsi does have a target leverage ratio, and management has attempted to adhere to that target through a policy of regular stock repurchase. But if the company's decision‐making process appears consistent with the framework mentioned above, it also relies on conventional ratingagency criteria to an extent that surprises some of the panelists. Moreover, Pepsi's policy of maintaining a single‐A credit rating sets off an interesting debate about the value of preserving access to capital markets “under all conditions.” In the second part of the discussion, Rice University's David Ikenberry begins by offering four main corporate motives for stock repurchases: (1) to increase (or at least maintain) the target corporate leverage ratio; (2) to distribute excess capital and so prevent managers from destroying value by reinvesting in low‐return projects; (3) to substitute for dividends, thereby providing a more flexible and tax efficient means of distributing excess capital; and (4) to “signal” and, in some cases, profit from undervaluation of the firm's shares. As in the first part of the discussion, the case of Pepsi largely supports the theory. Assistant Treasurer Rick Thevenet notes that, in 2000, the company generated free cash flow of $3 billion, of which $800 million was paid out in dividends and another $1.4 billion in stock buybacks. And each of the four motives cited above appears to have been at work in the design or execution of Pepsi's buyback policy. There is also some discussion of a fifth motive for buybacks—the desire to boost earnings per share. Although this motive is perhaps the most widely cited by corporate managers, the idea that EPS considerations should be driving corporate buyback programs is shown to rest on flawed reasoning. Moreover, questions are raised about what appears to be an EPS‐driven phenomenon: the corporate practice of attempting to buy back as many shares at the lowest price possible—and the lack of disclosure that often surrounds such a practice. In closing, Dennis Soter offers the novel suggestion that corporate buyback policy should not be designed to transfer wealth from selling to remaining shareholders, but rather to “share the gains from value‐creating transactions.” Through more and better disclosure about their repurchase activities (and Pepsi's policy appears to be a model worth emulating), companies are likely to establish greater credibility with investors, thereby increasing the liquidity and long run value of their shares.     

Capital Deployment Roundtable: A Discussion of Corporate Investment and Payout Policy

U.S. companies are now reportedly earning record‐high operating returns on capital while at the same time continuing to set new records both for corporate cash holdings and distributions to investors in the form of dividends and stock repurchases. But are most of these companies really maximizing value? And what role, if any, do these large distributions play in creating value? These are the two main questions that are addressed by a small group that includes two senior corporate executives and two representatives of well‐known activist investors. A number of panelists suggest that many companies, in misguided efforts to maximize returns on capital, have been using hurdle rates that are too high and so sacrificing value‐adding investment opportunities. As evidence for this claim, they cite evidence that, in recent years, the companies that have achieved the highest stock market returns appear to have made conscious decisions to reduce their returns on capital to pursue higher growth. Another increasingly common charge against U.S. companies is their tendency to pay out excessive capital to investors, especially in the form of stock repurchases at prices that turn out to be too high. But this last practice, however widespread, may not be as troubling as it has been made out to be. Although it involves a wealth transfer from existing to selling shareholders, overall investor value is lost only if such buybacks lead to corporate underinvestment. But, as a number of panelists (including the activist investors) point out, such payouts of capital have generally functioned as a demonstration of corporate managers' commitment to investing and operating with the optimal, or value‐maximizing, level of capital—neither too much nor too little.     

Dividends and share repurchases in the European Union

We examine cash dividends and share repurchases from 1989 to 2005 in the 15 nations that were members of the European Union before May 2004. As in the United States, the fraction of European firms paying dividends declines, while total real dividends paid increase and share repurchases surge. We also show that financial reporting frequency is associated with higher payout, and that privatized companies account for almost one-quarter of total cash dividends and share repurchases. Our regression analyses indicate that increasing fractions of retained earnings to equity do not increase the likelihood of cash payouts, whereas company age does.     

Expropriation of minority shareholders and payout policy

This paper studies the payout policy of Italian firms controlled by large majority shareholders (controlled firms). The paper reports that a firm's share of dividends in total payout (dividends plus repurchases) is negatively related to the size of the cash flow stake of the firm's controlling shareholder and positively associated with the wedge between the controlling shareholder's control rights and cash flow rights. These findings are consistent with the substitute model of payout. One of the implications of this model is that controlled firms with weak corporate governance set-ups, in which controlling shareholders have strong incentives to expropriate minority shareholders, tend to prefer dividends over repurchases when disgorging cash.     

Excess Cash and Shareholder Payout Strategies

On March 19, 2012, Apple announced a program to distribute its “excess” cash to shareholders in the form of dividends and share buybacks. This announcement followed a pattern that is remarkably similar to the one leading up to Microsoft's announcement in 2004. Likewise IBM, the bluest of blue chips, made a path‐breaking decision to initiate share buybacks in the 1980s. And as recently as April 2012, IBM, along with many other large corporations, announced yet another major share buyback program together with an increase in its dividend. These actions underscore the reality that senior management's main job is to allocate capital efficiently—and that efficient allocation of capital means distributing it when necessary. In light of these events, and the demand from shareholders that appears to be driving them, this paper explores analytical and empirical issues related to excess cash and corporate payout policy. In so doing, it provides the outline of an analytical framework for executives when thinking about the allocation of excess cash among competing uses, including deleveraging, growth, special and regular dividends, and share buybacks. The essence of the framework is this: Once companies satisfy their demands for cash based on their expected financial transactions, their targeted capital structure, and prospective investment (mergers and acquisitions) considerations, management should turn its attention to capital structure and shareholder payout decisions. Assuming that the company's capital structure is reasonably close to its target, and that its rating agencies are supportive, management should aim to pay a level of dividends that (1) reflects the underlying strength and stability of their projected earnings streams and that (2) satisfies the expectations of its core shareholders while positioning itself for the future. For more cyclical and otherwise riskier companies, management should also consider the use of stock buybacks or special dividends as a way of paying out the more variable, or unexpected, part of their expected earnings stream.     

CEO inside debt holdings and risk-shifting: Evidence from bank payout policies

Bank payouts divert cash to shareholders, while leaving behind riskier and less liquid assets to repay debt holders in the future. Bank payouts, therefore, constitute a type of risk-shifting that benefits equity holders at the expense of debt holders. In this paper, we provide insights on how CEO incentives stemming from inside debt (primarily defined benefit pensions and deferred compensation) impact bank payout policy in a manner that protects debt holder interests. We show that CEOs with higher inside debt relative to inside equity are associated with more conservative bank payout policies. Specifically, CEOs paid with more inside debt are more likely to cut payouts and to cut payouts by a larger amount. Reductions in payouts occur through a decrease in both dividends and repurchases. Our results also hold over a subsample of TARP banks where we expect the link between risk-shifting and payouts to be of particular relevance because it involves wealth transfers from the taxpayer to equity holders. We conclude that inside debt can help in addressing risk-shifting concerns by aligning the interests of CEOs with those of creditors, regulators, and in the case of TARP banks, the taxpayer.     

Monetary policy and regional availability of debt financing

The relative availability of bond and bank financing should affect the firm's external financing and investment decisions. We define a measure that proxies for the regional borrowing inflexibility to substitute between bank and bond financing: “debt inflexibility”. Debt inflexibility tilts the firm's financial structure towards equity and reduces investment. The impact is stronger during the period of tight monetary policy, particularly for smaller firms and firms without banking relationships. Debt inflexibility increases the sensitivity of cash holdings to cash flows, reduces the likelihood of dividend payment and makes the firm more likely to pay equity in mergers and acquisitions.     

Corporate Cash Policy and How to Manage it with Stock Repurchases

At the end of 2004 total U.S. corporate cash holdings reached an all‐time high of just under $2 trillion—an amount equal to roughly 15% of the total U.S. GDP. And during the past 25 years, average cash holdings have jumped from 10% to 23% of total corporate assets. But at the same time their levels of cash have risen, U.S. companies have paid out dramatically increasing amounts of cash to buy back shares. This article addresses the following questions: What accounts for the dramatic increase in the average level of corporate cash holdings since 1980? And why do some companies keep so much cash (with one fourth of U.S. firms holding cash amounting to at least 36% of total assets) while others have so little (with another quarter having less than 3%)? Why do companies pay out excess cash in the form of stock repurchases (rather than, say, dividends), and what explains the significant increase in repurchases (both in absolute terms and relative to dividends) over time? The author begins by arguing that cash reserves provide companies with a buffer against possible shortfalls in operating profits—one that, especially during periods of financial trouble, can be used to avoid financial distress or provide funding for promising projects that might otherwise have to be put off. Such buffers are particularly valuable in the case of smaller, riskier companies with lots of growth opportunities and limited access to capital markets. And the dramatic increase in corporate cash holdings between 1980 and the present can be attributed mainly to an increase in the risk of publicly traded companies—an increase in risk that reflects in part a general increase in competition, but also a notable change over time in the kinds of companies (smaller, newer, less profitable, non‐dividend paying firms) that have chosen to go public. At the other end of the corporate spectrum are large, relatively mature companies with limited growth opportunities. Although such companies tend to produce considerable free cash flow, they also tend to retain relatively small amounts of cash (as a percentage of total assets), in part because of shareholder concern about the corporate “free cash flow problem”—the well‐documented tendency of such companies to destroy value through overpriced (often diversifying) acquisitions and other misguided attempts to pursue growth at the expense of profitability. For companies with highly predictable earnings and investment plans, dividends provide one means of addressing the free cash flow problem. But for companies with more variable earnings and less predictable reinvestment, open‐market stock repurchases provide a more flexible means of distributing cash to shareholders. Unlike the corporate “commitment” implied by dividend payments, an open market stock repurchase program creates what amounts to an option but not an obligation to distribute funds. The value of such flexibility, which increases during periods of increased risk and uncertainty, explains much of the apparent substitution of repurchases for dividends in recent years.     

WHAT DO WE KNOW ABOUT STOCK REPURCHASES?

Stock repurchases by U.S. companies experienced a remarkable surge in the 1980s and ‘90s. Indeed, in 1998, the total value of all stock repurchased by U.S. companies exceeded for the first time the total amount paid out as cash dividends. And the U.S. repurchase movement has gone global in the past few years, spreading not only to Canada and the U.K., but also to countries like Japan and Germany, where such transactions were prohibited until recently. Why are companies buying back their stock in such amounts? After dismissing the popular argument that stock repurchases boost earnings per share, the authors argue that repurchases serve to add value in two main ways: (1) they provide managers with a tax‐efficient means of returning excess capital to shareholders and (2) they allow managers to “signal” to investors their view that the firm is undervalued. Returning excess capital is value‐adding for two reasons: First, it helps prevent companies from pursuing growth and size at the expense of profitability and value. Second, by returning capital to investors, repurchases (like dividends) play the critically important economic function of allowing investors to channel their investment from mature or declining sectors of the economy to more promising ones. But if stock repurchases and dividends serve the same basic economic function, why are repurchases growing more rapidly? Part of the explanation is that, because repurchases are taxed as capital gains and dividends as ordinary income, repurchases are a more tax‐efficient way of distributing excess capital. But perhaps even more important than their tax treatment is the flexibility that (at least) open market repurchases provide corporate managers‐flexibility to make small adjustments in capital structure, to exploit (or correct) perceived undervaluation of the firm's shares, and possibly even to increase the liquidity of the stock, which could be particularly valuable in bear markets. For U.S. regulators, the growth in open market stock repurchases raises some interesting issues. Perhaps most important, companies are not required to (and rarely do) furnish their investors with details about a given program's structure, execution method, number of shares repurchased, or even its duration. Policy regulators (and corporate executives as well) should consider some of the benefits provided by other systems, notably Canada's, which provide greater transparency and more guidelines for the repurchase process.     

Seasoned equity offerings and corporate financial management

We assume executives managing corporate financial policy consider the firm's current and target leverage, investment plans, anticipated cash flows, and consequences of alternative sequences of financing transactions, operating within efficient markets. Our analysis yields time-series and cross-sectional predictions for management of investment spending and leverage; use of maturity, priority, and convertibility covenants; and management of dividends, share repurchases, cash balances, and credit lines. Our evidence from 8608 SEOs covering 1970–2015 is consistent with implications of our theory, helps to resolve an array of issues in corporate finance, and offers a step toward a more unified analysis of rational corporate financial management.     

Corporate payout policy in dual-class firms

We examine corporate payout policy in dual-class firms. The expropriation hypothesis predicts that dual-class firms pay out less to shareholders because entrenched managers want to maximize the value of assets under control and the associated private benefits. The pre-commitment hypothesis predicts that dual-class firms pay out more to shareholders because firms use corporate payouts as a pre-commitment device to mitigate agency costs. Our results support the pre-commitment hypothesis. Dual-class firms have higher cash dividend payments and total payouts, and they use more regular cash dividends rather than special dividends or repurchases, compared to their propensity-matched single-class firms. Dual-class firms with severe free cash flow-related agency problems and few growth opportunities rely even more on corporate payouts as a pre-commitment mechanism. We also rule out the alternative explanation that dual-class firms pay out more because super-voting shareholders lack the ability to generate home-made dividends by selling shares since super-voting shares are often non-tradable or very illiquid.     

The Effects of Cash,Debt, and Insiders on Open Market Share Repurchases

The findings of the authors' recent study suggest, on balance, that stock repurchases function much like tax‐efficient special dividends, increasing when free cash flow is large and when debt levels are low, but not replacing regularly scheduled dividends. Repurchasing companies experience median event returns of about 2% around the repurchase announcements, with a related mean effect of roughly 3%. Companies with greater free cash flow and less debt are more likely than otherwise comparable companies to repurchase their shares. Furthermore, repurchasing companies that exhibit substandard preannouncement stock price returns and seek to buy back higher percentages of shares tend to elicit more positive stock price reactions. At the same time, the study provides some evidence that corporate managers attempt to use their inside information to profit from buybacks. For example, managing insiders in repurchasing firms decrease their selling activity and increase their buying activity two weeks before repurchase announcements to a greater extent than non‐managing insiders. But perhaps the most remarkable finding from this part of the study is how little insiders as a group seem to profit from their short‐term trading behavior—a finding that suggests that the market appears to anticipate much of this behavior.     

Payout flexibility and capital expenditure

Over the past two decades or so, repurchases have become an appealing method for disbursing cash to shareholders compared to the traditional dividends. Managerial perception as well as empirical evidence suggests that repurchases are inherently more flexible than dividends, which may account for their increasing popularity. The rigidity of dividends and the apparent flexibility of share repurchases could impact firm investments. Firms may forego profitable investment opportunities to maintain their dividend levels, while repurchases could be easily scaled back to fund profitable investment projects without fear of an adverse market reaction. We test the flexibility hypothesis of repurchases by regressing capital expenditures on repurchases and dividends in addition to other control variables. Consistent with our hypotheses, we find an inverse relationship between capital expenditures and repurchases but an insignificant relationship with dividends. Further, we find that the flexibility associated with repurchases is especially evident for firms that are financially constrained, and during the recent financial crisis period when external capital constraints were severe. Finally, we find that flexibility of repurchases with respect to capital expenditures is stronger in the more recent time period during which regulatory changes made repurchases more attractive as a mechanism to disburse cash back to shareholders.     

The contribution of stock repurchases to the value of the firm and cash holdings around the world

Using corporate payout data from 33 economies, this study investigates the contribution of stock repurchases to the value of the firm and cash holdings in different country-level investor protection environments. We find that stock repurchases contribute more to firm value in countries with strong investor protection than in countries with weak investor protection. We also report that dividends contribute approximately 60% more to firm value than repurchases in countries with weak investor protection. Furthermore, as the proportion of repurchases in total payouts increases, the marginal value of cash increases in countries with strong investor protection, whereas it declines in countries with weak investor protection. In a poor investor protection environment, the marginal value of cash for a firm that makes 100% of its payouts via repurchases is 12 cents lower than that for a firm that distributes 100% of its payouts via dividends. Overall, our findings highlight that stock repurchases are less effective than dividends in mitigating agency problems associated with free cash flow in countries with poor investor protection.     

Trading restrictions and firm dividends: The share lockup expiration experience in China

Chinese firms experienced a substantial reduction in nontradable shares following the Split-Share Structure Reform that began in 2005. The decrease in nontradable shares, or increase in share tradability, is associated with a decline in the firms’ cash dividend payouts. The positive association is attenuated in firms with fewer financial constraints, only weakly affected by firm governance, and not affected by investment opportunities or controlling shareholder type. The results highlight the fact that firms disgorge cash to compensate shareholders for trading restrictions and conclude that dividends persist when firms have easier access to external financing. These findings are robust to alternative definitions of nontradable shares, after controlling for firm fixed effects and omitted changing firm characteristics.     

Corporate payout policy in Australia and a test of the life‐cycle theory

We provide evidence on the frequency and size of payouts by Australian firms, and test whether the life‐cycle theory explains Australian corporate payout policies. Regular dividends remain the most popular mechanism for distributing cash to shareholders, despite a slight decline in the proportion of dividend payers since the relaxation of buyback regulations in 1998. Off‐market share buybacks return the largest amount of cash to shareholders. Dividend paying firms are larger, more profitable and have less growth options that nondividend paying firms. Consistent with the life‐cycle theory, we observe a highly significant relation between the decision to pay regular dividends and the proportion of shareholders’ equity that is earned rather than contributed.     

Maintaining a Flexible Payout Policy in a Mature Industry: The Case of Crown Cork and Seal in the Connelly Era

This case study suggests that the payment of cash dividends may not be essential to the long-run success of even mature companies. A mature company in a mature industry, the Crown Cork and Seal Company did not pay any common dividends during John Connelly's 33-year tenure as chairman and CEO. During that period (from 1957 to 1990), the company used stock repurchases along with a compensation policy featuring low executive salaries and generous executive stock options to motivate and execute a focused business strategy. Under the leadership of Connelly, Crown was rescued from what appeared to be certain bankruptcy to become one of the most profitable firms in its industry. Debt was immediately paid down, preferred stock was retired, and the firm's operations were revamped and streamlined. Instead of following the diversification strategies of larger industry peers, Crown's strategy was focused and driven by profit margin and customer service. This strategy eventually led Crown to invest internationally and acquire one of its major rivals. In addition to significant equity ownership by Crown's management and board members, the company's board had a remarkable number of “outsiders” and representatives from international operations, creating a culture that was outward-looking as well as cohesive. And without paying a dollar of dividends—a practice that many finance scholars believe imposes a necessary discipline on mature companies—Crown both preserved its financing flexibility and produced a remarkable record of increases in both profits and market value.     

Why companies do not pay cash dividends: The Turkish experience

This study uses a survey approach to examine the views of corporate managers of non-dividend-paying firms listed on the Borsa Istanbul (BIST) in order to identify the factors leading to the decision not to pay cash dividends in Turkey. Our survey results show that cash constraints, growth opportunities, low profitability and earnings, and the cost of raising external funds (debt) are the major reasons inducing BIST firms not to pay dividends. Additionally, non-dividend-paying firms consider their shareholder preferences when setting a policy of paying no cash dividends. Yet, they neither view taxes as an important factor for paying no dividends nor perceive that stock repurchases are substitutes for cash dividends. Statistical analysis using secondary data of publicly-traded BIST firms reveals whether the actual corporate actions are consistent with the managerial views revealed by our survey research. These tests show that growth opportunities and debt level have a negative effect on the dividend payment decisions of BIST firms. Also, large blockholders and the existence of multiple large shareholders reduce the likelihood and intensity of paying a cash dividend in the Turkish market. Overall, the evidence suggests that non-dividend-paying companies are likely to be smaller in size, relatively younger (in the earlier stage of their life cycle) with high-growth opportunities or with a low level of profitability (or even loss) and small (negative) earnings. By contrast, highly-profitable, mature and large-size corporations are more likely to pay cash dividends.