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.     

Controlling shareholders’ opportunistic use of share repurchases

This study examines how share repurchase and dividend policies are influenced by controlling shareholders in an emerging market. We maintain that the controlling shareholders can utilize share repurchase opportunistically, particularly when they exercise voting rights in excess of cash-flow rights. The evidence of Korean firms suggests that the wedge between the voting rights and cash-flow rights positively affects share repurchases but negatively affects cash dividends. We also find that share repurchases are not always supported by operating performances. The results indicate that firms may utilize share repurchases as a means to pursue private benefits of the controlling shareholders. We also document that share repurchases do not substitute for cash dividends, suggesting that share repurchases are not genuine distributions. Furthermore, we find that the wedge of share repurchases reduces firm value. Overall, our results indicate that the controlling shareholders of Korean firms use share repurchases opportunistically rather than strategically.     

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.     

Social capital and payout policies

In this paper, we investigate the relationship between regional social capital and corporate payout policies. Using a large sample of US data, we find a positive relationship between regional social capital and both the likelihood and the amount of cash dividend payouts. However, we find that social capital has no bearing on the likelihood and amount of stock repurchases. The results from additional analyses show that the relationship between social capital and dividends is more pronounced for less geographically dispersed firms. We also find that the network component of social capital has a greater effect on dividends than the social norm component. Our results are robust to alternative specifications of dividends and social capital and to the use of a two-stage least squares (2SLS) analysis to alleviate endogeneity concerns. Overall, we document that regional social capital plays an important role in influencing cash dividend payout policies.     

Managerial motivation and timing of open market share repurchases

There are two major mechanisms by which managers distribute cash to shareholders: through dividends and share repurchases. Historically, dividends have been the preferred method, but in recent years, share repurchases have become more popular, with more firms using repurchases than dividends to distribute cash. During the sample period of 2004–2006, 6.5 billion shares were repurchased for a total dollar volume amount of $222 billion. Using a unique dataset on actual monthly share repurchases, this paper investigates when and why managers repurchase shares in the open market. The paper finds evidence that firms which make repurchases are jointly timing their repurchases to perceived undervaluation and the presence of discretionary cash flow. In addition, the paper finds evidence which supports that (1) firms in competitive industries tend to repurchase less, (2) firms tend to substitute repurchases for anti-takeover provision adoption, and (3) firms attempt to manage earnings upward through the use of repurchases.     

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.     

The value of financial flexibility and corporate financial policy

We propose a novel approach to measure the value that shareholders assign to financial flexibility. In contrast to existing proxies for financial constraints, our measure is market-based, forward-looking and not directly influenced by past financial decisions. We find that firms for which shareholders consider financial flexibility more valuable have lower dividend payouts, prefer share repurchases to dividends, and exhibit lower leverage ratios. Moreover, these firms tend to accumulate more cash. Our analysis contributes to the growing literature on financial flexibility and indicates that—in line with prior survey evidence—financial flexibility considerations shape corporate financial policy.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses 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 emerged was 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 fl exibility 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 by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility 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 fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

Stock Price Volatility,Ordinary Dividends,and Other Cash Flows to Shareholders

This paper shows that the results of variance-bound tests depend on how cash distributions to shareholders are measured. As in prior studies, we find apparent evidence of excess volatility when a narrow definition of cash flow (dividends only) is applied. However, we are unable to reject the hypothesis of market efficiency when the cash flow measure also includes share repurchases and takeover distributions in addition to ordinary cash dividends.     

Option-Based Compensation,Corporate Investment Policy,and Stock Repurchases

Abstract:

Taking account of the business life cycle, this paper investigates the impact of the proceeds associated with stock option exercises on investment expenditures and stock repurchases. The results reveal that the proceeds associated with option exercises could add internal funds to firms and contribute to investment in research and development and capital expenditures, especially in the growth stage of a firm’s life cycle. This paper also shows the positive relationship between option proceeds and stock repurchases in the stagnant stage of that cycle. The empirical results further suggest that stock repurchases may substitute for dividends. In summary, the paper empirically demonstrates that stock options not only encourage employees to work harder, but also create more funds for the firm.     

Corporate governance and firm cash holdings in the US

Using governance metrics based on antitakeover provisions and inside ownership, we find that firms with weaker corporate governance structures actually have smaller cash reserves. When distributing cash to shareholders, firms with weaker governance structures choose to repurchase instead of increasing dividends, avoiding future payout commitments. The combination of excess cash and weak shareholder rights leads to increases in capital expenditures and acquisitions. Firms with low shareholder rights and excess cash have lower profitability and valuations. However, there is only limited evidence that the presence of excess cash alters the overall relation between governance and profitability. In the US, weakly controlled managers choose to spend cash quickly on acquisitions and capital expenditures, rather than hoard it.     

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.     

Payout policy in the 21st century

We survey 384 financial executives and conduct in-depth interviews with an additional 23 to determine the factors that drive dividend and share repurchase decisions. Our findings indicate that maintaining the dividend level is on par with investment decisions, while repurchases are made out of the residual cash flow after investment spending. Perceived stability of future earnings still affects dividend policy as in Lintner (1956. American Economic Review 46, 97–113). However, 50 years later, we find that the link between dividends and earnings has weakened. Many managers now favor repurchases because they are viewed as being more flexible than dividends and can be used in an attempt to time the equity market or to increase earnings per share. Executives believe that institutions are indifferent between dividends and repurchases and that payout policies have little impact on their investor clientele. In general, management views provide little support for agency, signaling, and clientele hypotheses of payout policy. Tax considerations play a secondary role.     

Unconventional monetary policy and stock repurchases: Firm-level evidence from a comparison between the United States and Japan

This paper is the first comparative study examining the determinants of stock repurchases during the period of unconventional monetary policy. By constructing a vast firm-level dataset of the U.S. and Japan and conducting multivariate Tobit and probit analyses, this paper presents evidence that during the period of unconventional monetary policy, in both the U.S. and Japan, firms with more free cash flow and lower borrowing costs are more likely to repurchase stock, firms with higher financial leverage are more likely to abstain from stock repurchases, and firms coordinate dividends and stock repurchases to please shareholders. I also find striking contrasts between the results of U.S. and Japanese firms, and show the importance of financial structure in explaining the contrasting results. From a micro perspective, this paper provides new insight and evidence to support the view that financial structure should be thought of as an important factor determining the effects of unconventional monetary policy.     

Does geography matter? Firm location and corporate payout policy

We investigate the impact of geography on agency costs and firm dividend policies. We argue that remote firm location increases the cost of shareholder oversight of managerial investment decisions. We hypothesize that remotely located firms facing free cash flow problems precommit to higher dividends to mitigate agency conflicts. We find that remotely located firms pay higher dividends. As expected, the effect of geography on dividends is most pronounced for firms with severe free cash flow problems. Further, remotely located firms rely more on regular dividends instead of special dividends or share repurchases and decrease dividends less often.     

Capital Allocation: Evidence,Analytical Methods,and Assessment Guidance

Capital allocation is one of top management's primary responsibilities. Although always important, it is critical today because corporate operating returns on invested capital are at an all‐time high, while recent growth and investment have been modest, and corporate balance sheets in the U.S. have substantial cash. Yet few senior executives are sufficiently well‐versed in finance theory and methods to allocate capital as effectively as possible. Further, incentive programs that focus on meeting earnings per share often encourage behavior that is not in the best interests of long‐term shareholders. In this report, the authors begin with the premise that the goal of corporate capital allocation is to build long‐term value per share; and with that view in mind, they examine the main sources and uses of capital by the largest 1,500 U.S. companies during the last 30 years. More specifically, the authors identify the amounts of capital allocated to each of seven important alternatives, including major uses of capital such as M&Amp;A, capital expenditures, R&D, and distributions of capital to investors such as dividends and stock repurchases. And after reviewing the past allocations of capital to each of these alternatives, the authors summarize the academic research on the effects on corporate values of each of these uses of capital. The authors report that U.S. corporations fund most of their investments internally, and that M&Amp;A and capital expenditures have long been, and continue to be, the largest operating uses of capital, though both capital expenditures and growth in assets have fallen in recent years. At the same time, both corporate cash holdings and distributions to shareholders in the form of dividends and stock buybacks are at record levels. But even with such high payouts, R&D spending as a percentage of revenue by U.S. companies has remained high, and actually increased during the past decade. Finally, the authors provide a framework that can be used either internally or by outsiders to evaluate the capital allocation practices and effectiveness of a management team. This framework asks management to assess its past performance, provide realistic projections of future returns on invested capital, and evaluate their own incentive programs—all while renewing their commitment to the five principles of thoughtful capital allocation: (1) zero‐based capital allocation; (2) funding of strategies, not projects; (3) no capital rationing; (4) zero tolerance for bad growth; and (5) continuous monitoring of the value of all assets and business, and willingness to take action if and when such values are larger outside than inside the firm.     

EVIDENCE ON HOW COMPANIES CHOOSE BETWEEN DIVIDENDS AND OPEN-MARKET STOCK REPURCHASES

Dividends and open-market stock repurchases are by far the two most common mechanisms for distributing excess cash to shareholders. This article identifies and then tests three potentially important factors for the corporate choice between increasing cash dividends and initiating openmarket stock repurchases. More specifically, the authors argue that companies are more likely to distribute cash to investors through open-market repurchases than through dividend increases when (1) management believes its stock is undervalued, (2) management compensation packages include stock options, and (3) the company's stockholder base is dominated by institutional investors.
To test these three explanations, the authors use a matched-pair design in which each company announcing an open market repurchase program in a given year is matched with a comparable-size firm from the same industry that increased its cash dividends but did not initiate an open-market repurchase program. As predicted, the results suggest that equity undervaluation, management compensation, and the level of institutional holdings are all important contributors to corporate choices between dividend increases and open-market repurchases.     

Cash holdings and share repurchases: International evidence

In this study, we examine the patterns and determinants of share repurchases using firm-level data from seven major countries—Australia, Canada, France, Germany, Japan, the U.K., and the U.S.—over the period 1998–2006. We find that while non-U.S. firms do not repurchase shares as much as U.S. firms do, both U.S. and non-U.S. firms display a common set of share repurchase behaviors. For example, across countries, firms use share repurchases as a flexible means of distributing cash. More importantly, large cash holdings are significantly associated with the amount of share repurchases in all countries. There is evidence that large cash holdings held by repurchasing firms represent excess cash. Firms tend to experience substantial increases in cash holdings prior to share repurchase as a result of reductions in capital expenditures. Overall, our evidence lends support to two hypotheses: (i) firms discharge excess capital to reduce agency conflicts and (ii) firms use repurchases to distribute temporary cash flows.     

Dividends, Share Repurchases, and the Substitution Hypothesis

We show that repurchases have not only became an important form of payout for U.S. corporations, but also that firms finance their share repurchases with funds that otherwise would have been used to increase dividends. We find that young firms have a higher propensity to pay cash through repurchases than they did in the past and that repurchases have become the preferred form of initiating a cash payout. Although large, established firms have generally not cut their dividends, they also show a higher propensity to pay out cash through repurchases. These findings indicate that firms have gradually substituted repurchases for dividends. Our results also suggest that before 1983, regulatory constraints inhibited firms from aggressively repurchasing shares.     

Dividends versus Share Repurchases Evidence from Canada: 1985–2003

This paper provides out-of-sample evidence on the payout policy in Canada during the 1985–2003 period. First, we show that the proportion of nonfinancial firms paying dividends has decreased, while the proportion initiating repurchase programs has increased. We also show that Canadian firms paying dividends and repurchasing shares are extremely concentrated. Second, we focus on the factors that could affect the choice between repurchases and dividends. We find that dividends and repurchases are used by different types of firms. While we do not confirm the financial flexibility hypothesis, our results are consistent with the substitution hypothesis after controlling for selection bias and endogeneity.