Executive Summary — Payout policy is at the core of many key questions in corporate finance. In a world in which financial markets are not frictionless, how much firms pay out and which vehicle they choose to distribute cash to their shareholders may affect their valuation, has a potential impact on how much taxes investors pay, may affect management's investment decisions, and may inform the market about how good the firm is relative to its peers. In this paper the authors review the academic literature on payout policy, with a particular emphasis on developments in the past two decades. Scholarship on payout policy has made significant advancements in the last 20 years, and we now know much more about the importance of taxes, agency, and signaling motives for payout policy. Perhaps the most important change in corporate payout policy in the last two decades has been the secular increase of stock repurchases and the apparent triumph of buybacks over dividends as the dominant form of corporate payouts. Looking at the bigger picture, the authors observe that, until recently, most scholarship has analyzed payout policy in isolation. An important recent development in the payout literature has been to consider the interaction between payout and other corporate policies, such as compensation or investment. The fact that payouts are not simply residual free cash flows underlines the importance of taking seriously the interdependence of financing, investment, and payout decisions. Key concepts include:
- Studies centered on the 2003 dividend tax cut confirm that differences in the taxation of dividends and capital gains have only a second order impact on payout policy. Signaling theories have found only weak support, both empirically and in survey evidence, which likely explains why the notion of dividends as costly signals of firm quality to the market has become less popular. Agency has often prevailed as the alternative explanation in the horse race against signaling theories.
- A number of factors other than the level of free cash flow determine the level and form of payouts. More research is needed to understand even the basic elements of the corporate financial 'ecosystem', which includes financing, investment, and payout policies. Analyzing these interactions can play a key role in advancing the payout literature in the years to come.
We survey the literature on payout policy, with a particular emphasis on developments in the last two decades. Of the traditional motives of why firms pay out (agency, signaling, and taxes), the cross-sectional empirical evidence is most persuasive in favor of agency considerations. Studies centered on the May 2003 dividend tax cut confirm that differences in the taxation of dividends and capital gains have only a second-order impact on setting payout policy. None of the three traditional explanations can account for secular changes in how payouts are made over the last 30 years, during which repurchases have replaced dividends as the prime vehicle for corporate payouts. Other payout motives such as changes in compensation practices and management incentives are better able to explain the observed variation in payout patterns over time than the traditional motives. The most recent evidence suggests that further insights can be gained from viewing payout decisions as an integral part of a firm's larger financial ecosystem, with important implications for financing, investment, and risk management.