Cross-Sectional Analyses Of Firms Using Financed Payouts by SSRN
Harvard Business School
Cornell University – Samuel Curtis Johnson Graduate School of Management; Interdisciplinary Center (IDC)
Martin C. Schmalz
University of Michigan, Stephen M. Ross School of Business
May 1, 2015
The established conventional wisdom is that payouts are first and foremost a vehicle to return free cash flow to investors. In stark contrast, we find that 32% of aggregate payouts are simultaneously raised in the capital markets by the same firms, mainly through debt but also through equity. Conversely, issuers pay out 39% of the aggregate proceeds of net debt issues and 19% of the proceeds of firm-initiated equity issues during the same year. Over 42% of payout payers engage in such “payout financing” behavior, which is widespread among both dividend-paying and repurchasing firms. The frequency, magnitude, and persistence of financed payouts are unexpected, particularly in light of the obvious costs associated with this behavior. Cross-sectional analyses suggest that firms use financed payouts to manage their capital structure, monitor managers, engage in market timing, and boost earnings-per-share.
Cross-Sectional Analyses Of Firms Using Financed Payouts
The established conventional wisdom in the finance literature is that firms rely on free cash flow to fund their payouts, whether these payouts are motivated by agency, signaling, or other considerations. For example, Jensen (1986), Grullon, Michaely, and Swaminathan (2002), and DeAngelo, DeAngelo, and Stulz (2006) present a lifecycle view of payouts where mature, cash-rich firms distribute excess free cash flow to their investors while young, growing firms raise but do not pay out capital. Ross, Westfield, and Jaffe (2013) conclude that “a firm should begin making distributions when it generates sufficient internal cash flow to fund its investment needs now and into the foreseeable future.” Accordingly, they recommend managers to set their level of payouts “low enough to avoid expensive future external financing” (p. 607). While it is a theoretical possibility that firms could also raise external funds to finance their payouts, such behavior is costly and thus considered, at least by some authors, “uneconomic as well as pointless” (Miller and Rock, 1985) – which likely explains why this possibility has not been systematically examined until now.
The results in this paper counter this conventional thinking. We find that 42% of industrial public U.S. firms with positive payout initiate an equity or a net debt issue during the same year. The vast majority of them, 36% of all payers, could not have funded their payout without the proceeds of these issues, all else equal. In addition to being widespread, simultaneous payouts and security issues (henceforth, “financed payouts”) are also substantial in dollar magnitude: 32% of the aggregate capital paid out by public U.S. firms is raised by the same payers during the same year via net debt or firm-initiated equity issues.1 If we include as a source of payout financing the proceeds of equity issues initiated via employee stock option exercises, the percentage of financed payouts increases by nine percentage points: 41% of the aggregate capital paid out by public firms is simultaneously raised by the same payers either actively from the capital markets or passively from their employees. Clearly, thus, a big portion of payouts are not funded by free cash flow.
Critically, firms’ reliance on the capital markets to finance their payouts is not a transitory phenomenon: The gap between firms’ payouts and their internally generated funds persists if we aggregate firms’ sources and uses of cash flows over four-year intervals. This finding indicates that the use of external capital to finance payouts is persistent and is not the result of payout smoothing or, more generally, of timing mismatches between free cash flow and payouts.
The frequency, magnitude, and persistence of financed payouts are unexpected, particularly in light of the obvious costs associated with this behavior. In addition to underwriting and other direct issuance expenses, these costs include asymmetric information discounts on newly issued securities (Myers and Majluf, 1984) and passing up profitable investment opportunities as a result of prioritizing payouts over investment (Asker, Farre-Mensa, and Ljungqvist, 2015). In fact, most firms that finance their payouts do not have an investment-grade credit rating or are in the top public-firm size quartile, which suggests that the cost of financing payouts can be substantial for them.
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