Financing Payouts
Joan Farre-Mensa, University of Illinois at Chicago
Roni Michaely, University of Geneva
Martin Schmalz, University of Oxford
Motivation: An untested assumption
Ross, Westerfield, and Jaffe (2013):
•
“A firm should begin making distributions when it generates
sufficient internal cash flow to fund its investment needs now and
into the foreseeable future.”
•
Set level of payouts “low enough to avoid expensive future
external financing.”
Conventional wisdom in payout lit.: payouts funded w/ free cash flow
•
Grullon et al. (2002), DeAngelo et al. (2006): lifecycle view of the firm
–
Young firms raise capital to invest, mature firms pay out excess FCF
•
dividends when cash flow is permanent, share repurchases when it is temporary
 Same firm should not raise and pay out capital at the same time
RQ1: Do managers follow the textbook advice?
 As it turns out, they do not: Financed payouts are prevalent
 43% of payout payers initiate net debt or equity issues in the same year
they pay a dividend or repurchase shares (= “finance” their payouts)
 41% of payout payers do not generate enough profits to maintain their
investment and payout levels without the proceeds of these issues
 The economic magnitude of financed payouts is important
 31% of aggregate payouts are financed with a security issue initiated by
the same firm in the same year; debt is by far the largest financing source
 Conversely, 37% of aggregate proceeds of security issues are paid out
by the same firm in the same year, both via repurchases & dividends
 Financed payouts are persistent
 65% of firms that finance their payouts do it at least once every two years
 The gap between payouts and free cash flow persists—in fact, widens—
over five-year intervals
RQ2: Why do firms finance their payouts?
 A policy of financing payouts is obviously costly—so why do it?
•
Firms face non-trivial fixed and marginal costs of raising external capital (e.g.,
Hennessy and Whited 2007)
 One key reason is firms’ desire to jointly manage their capital
structure and cash holdings (increase leverage w/o depleting cash)

Tax considerations—both the tax deductibility of interest payments
and the avoidance of repatriation taxes—are a key motivating factor
 Other reasons—which we do not directly study—likely also important:

Agency considerations (Easterbrook 1984, Jensen 1986), cross-market
arbitrage (Ma 2019), monetary policy (Acharya and Plantin 2020,
Elgouacem and Zago 2019)
RQ3: What are the consequences of debtfinanced payouts?
•
Debt-financed payouts appear to increase firms’ exposure to negative
shocks, particularly for firms w/o an investment-grade credit rating
–
•
Just 26% of firms that debt-finance their payouts have an investment-grade rating
Debt-financed payouts are associated with:
–
lower investment levels during industry downturns
–
a deeper stock price decline during the COVID-19 crisis
•
Of course, the decision to debt-finance payouts is endogenous, so we
stop short from claiming causality
•
That said, our findings suggest that not all payouts are the same when
thinking about the consequences of payouts on financial fragility
Contributions
1. First systematic analysis of how firms fund their payouts
–
Earlier evidence that some firms occasionally finance payouts
o
E.g., Denis and Denis (1993) investigate 39 leveraged recaps. Similarly, Danis,
Rettl, and Whited (2014) study large debt-financed payouts, which are “not frequent”
o
Fama French (2005) & Grullon et al. (2011): some firms simultaneously raise equity
& pay out
 Turns out much of it is driven by equity issues initiated by employees via stockoption exercises, which we conservatively exclude
 The pervasiveness, magnitude, and persistence of financed payouts that
we document indicates that over 40% of firms do not follow the textbook
advice of funding payouts internally
Contributions
2. Enhance our understanding of motives behind payout policies
─
Firms’ reliance on financed payouts to actively manage capital structure is
consistent w/ trade-off theories of capital structure
─
Evidence does not support Myers’ (1984) pecking-order prediction that “an
unusually profitable firm will end up w/ unusually low debt ratio, and it won’t do
much of anything about it. It won’t go out of its way to issue debt and retire
equity to achieve a more normal debt ratio”
3. The COVID-19 crisis has renewed calls from policy makers and public
commentators to impose restrictions on corporate payouts, in particular
share repurchases (see, e.g., CARES Act, Schumer and Sanders 2019).
Our paper suggests that not all payouts are created equal when it comes
to their impact on financial fragility—the source of payout financing
matters
Sample and data
•
•
Sample: Public firms incorporated and located in the U.S., 1989-2019
•
exclude financial firms and utilities
•
exclude firms in year of their IPO
Main variables from the statement of cash flows in Compustat
–
Free cash flow: operating CF + investment CF
•
investment CF = – capex – acquis + sale PPE
–
Net debt issues: max {debt issues – debt repurchases, 0}
–
Equity issues; follow McKeon (2015) and break down in
•
firm-initiated issues (SEOs and private placements)
•
employee-initiated issues (employee stock option exercises,
warrant exercises)
 Focus only on “actively financed payouts”: payouts financed
with simultaneous net debt or firm-initiated equity issues
Payouts and security issues
Dollar magnitudes (billions of 2012 $)
1,200
1,000
800
600
400
200
0
1989
1991
1993
1995
Total payout
1997
1999
2001
2003
2005
2007
Repurchases & special dividends
2009
2011
2013
2015
2017
2019
Regular dividends
•
We aggregate repurchases and special dividends as they are both part of the discretionary
component of payouts (they can be cut w/ little consequence)
• Repurchases account for over 97% of repurchases + special dividends
• For brevity, sometimes we write “repurchases” to refer to repurch. + spec. dividends
•
By contrast, cutting (or even failing to increase) regular dividends tends to be perceived as
costly (e.g., Brav et al. 2005)
Payouts and security issues
Dollar magnitudes (billions of 2012 $)
1,200
1,000
800
600
400
200
0
1989
1991
1993
1995
1997
Total payout
1999
2001
2003
2005
2007
Repurchases & special dividends
2009
2011
2013
2015
2017
2019
2009 2011 2013 2015 2017
Employee-initiated equity issues
2019
Regular dividends
Dollar magnitudes (billions of 2012 $)
700
600
500
400
300
200
100
0
1989
1991 1993 1995
Net debt issues
1997
1999 2001 2003 2005
Firm-initiated equity issues
2007
To what extent do the same firms
simultaneously (in the same year) raise and
pay out capital?
Amount of payout that is financed (FP it) =
min { Payout it, Firm-initiated issuance proceeds it }
•
Firm counts
•
Dollar magnitudes
Simultaneous payouts and issues (counts)
60%
% of all payout payers that simultaneously
raise capital (avg. = 43%)
40%
20%
% of all public firms that simultaneously
raise and pay out capital (avg. = 22%)
0%
1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
Simultaneous payouts and issues ($)
Dollar magnitudes (billions of 2012 $)
350
300
250
200
150
100
50
0
1989
1991
1993
1995
1997
1999
2001
Total payouts financed by net debt issues
Reg. dividends financed by net debt issues
2003
2005
2007
2009
2011
2013
2015
2017
2019
Repurchases & spec. div. financed by net debt issues
Total payouts financed by firm-initiated equity issues
• On average, 31% of aggregate payouts are simultaneously raised in capital markets
• Financed reps are more common than financed divs, particularly in recent years
• Debt is by far the most common source of payout financing
Simultaneous payouts and security issues are
-
prevalent (43% of all payout payers)
-
economically large (31% of aggregate payouts)
-
strongly procyclical (at least until 2015)
 55% are share repurchases & special dividends,
45% are regular dividends
 They are financed mostly with debt

Not surprising: SEOs and private placements are small
relative to net debt issues

Still, 17% of firm-initiated equity issues are
simultaneously paid out vs. 41% of net debt issues
o
81% of employee-initiated equity issues are paid out
Do firms that finance their payouts need to raise
external capital to be able to pay out as much as they
do, given their profit and investment levels?
– Alternatively, it may be that firms are simply raising capital (while
generating enough FCF to fund their payouts) to boost their cash reserves
Payout gap (PG it) =
min { max {TP it – “internal funds” it , 0}, TP it }
where “internal funds” =
free cash flow + cash reduction + proceeds of employeeinitiated equity issues
Dollar magnitudes (billions of 2012 $)
350
300
250
200
150
100
50
0
1989
1991
1993
1995
1997
1999
2001
2003
Simultaneous payouts and security issues
2005
2007
2009
2011
2013
2015
2017
2019
Aggregate sum of total payout gaps
 80% of firms that simultaneously raise and pay out capital have a payout
gap, i.e., they could not have funded their payouts using their internal
funds
•
Payout gaps are largely repurchase gaps—firms that repurchase more
than they can fund with their internal funds, after paying their dividends
Dollar magnitudes (billions of 2012 $)
140
120
100
80
60
40
20
0
1989
1991
1993
1995
1997
1999
2001
2003
Repurchase & special dividend gap
2005
2007
2009
2011
2013
Regular dividend gap
2015
2017
2019
Payout gaps are not the result of timing mismatches
between payouts and free cash flow (e.g., due to
payout smoothing)
 Prevalence and magnitude of payout gaps increases if
we measure gaps over 5-year intervals  payouts
gaps are persistent!
Why do firms set payout levels above their internal funds,
which they need to finance by simultaneously raising
costly external capital?
– The costs of doing so can be substantial. Hennessy and Whited
(2007): “for large (small) firms, estimated marginal equity
flotation costs start at 5.0% (10.7%) and [deadweight]
bankruptcy costs equal to 8.4% (15.1%) of capital.”
 Just 26% of firms that debt-finance payouts have investment-grade rating
 Thus, there must be some offsetting benefit
• We begin by examining the characteristics of firms that finance
their payouts
 Focus on firms that finance their repurchases with debt 
Decision cannot be explained by reluctance to cut dividends,
debt is by far the largest source of payout financing
Estimate probit model, show marginal effects
Firms with high
leverage and high
cash are less likely to
finance their payouts
with debt
Combining payouts
with debt issues
allows firms to
increase their (net)
leverage without
depleting their cash
reserves (or incurring
repatriation taxes)
Note: If the firm is investing and
growing, leverage will not
explode!
Regressions include industry and year FE
Evolution of median target leverage deviation with and
without debt-financed discretionary payouts
2%
0%
-1
0
1
2
3
4
-2%
-4%
-6%
-8%
Actual target leverage deviation for firms that debt-finance their repurchases
Counterfactual target leverage deviation if debt-financed repurchases were set to zero
In counterfactual exercise, for debt-financed repurchases, we set
– net debt issues (ND) = ND – min{Rep, ND}
– repurchases (Rep) = Rep – min{Rep, ND}
5
Evolution of mean target leverage deviation with and
without debt-financed discretionary payouts
6%
4%
2%
0%
-1
0
1
2
3
4
-2%
-4%
-6%
Actual target leverage deviation for firms that debt-finance their repurchases
Counterfactual target leverage deviation if debt-financed repurchases were set to zero
In counterfactual exercise, for debt-financed repurchases, we set
– net debt issues (ND) = ND – min{Rep, ND}
– repurchases (Rep) = Rep – min{Rep, ND}
5
What if firms tried to achieve same leverage increase by
simply increasing their repurchases, without
simultaneously raising debt?
10%
0%
-1
0
1
2
3
4
5
-10%
-20%
-30%
-40%
-50%
Actual cash over actual assets for firms that debt-finance their repurchases
Counterfactual cash over actual assets if firms tried to attain the same leverage increases by only
repurchasing more without raising any net debt
–
Plot shows the median; mean is even starker
 81% of firms do not have enough cash to achieve the same leverage
increase exclusively through payout increases!
What motivates firms’ attempts to jointly manage their
capital structure and their cash holdings?
 Corporate income taxes
 Repatriation taxes
State-level tax increases as exogenous shocks to the
demand for leverage
•
Following Heider and Ljungqvist (2015), we exploit staggered changes in
state corporate income taxes as plausibly exogenous shocks to the value
of interest tax deductions using a diff-in-diff approach
─
Issuing debt allows firms to minimize their tax bill because interest is tax
deductible
─
Paying out the debt ensures that tax savings are not offset by the new taxable
interest income that would be generated if firms retained the proceeds as cash
•
Tax increases play a significant role in explaining debt-financed payouts,
but (as expected) only for firms w/ profits to shield from tax
Did the 2017 TCJA decrease firms’ incentives to use debtfinanced payouts to avoid paying repatriation taxes?
•
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated US multinational
firms’ incentives to hoard cash overseas to avoid repatriation taxes
–
Before the TCJA, US corporations were taxed on worldwide income. However,
a US corporation could defer foreign income by retaining earnings through a
foreign subsidiary
–
The US corporation would pay US tax on the foreign earnings only when they
were repatriated. Upon repatriation, the earnings would be subject to US
taxation at a rate up to 35%, with a credit for foreign taxes paid
•
The repatriation typically resulted in a net US tax obligation because the US tax rate
was usually higher than the foreign tax rate
–
Debt-financed payouts allowed firms to ensure that their net leverage would
not fall despite the cash held overseas. Firms could then wait for a repatriation
tax holiday (like the one in 2004) to bring back foreign cash and repay debt
–
Pursuant to the TCJA, the US now exempts from taxation the earnings of a
US firm from active foreign subsidiaries, even if the earnings are repatriated
•
After the TCJA came into effect in 2018, the tax cost of repatriating foreign
earnings is no longer associated w/ a higher likelihood to debt-finance payouts
•
Dynamic results are consistent w/ the parallel trends assumption
What are the consequences of debt-financed payouts?
 Investment reaction to industry downturns
 Stock price reaction to COVID-19 crisis
If anything,
repurchasing firms
tend to invest more,
even during periods of
industry distress
Regressions include firm and year FE
If anything,
repurchasing firms
tend to invest more,
even during periods of
industry distress
The same is not true
for firms whose
repurchases are debtfinanced
Regressions include firm and year FE
If anything,
repurchasing firms
tend to invest more,
even during periods of
industry distress
The same is not true
for firms whose
repurchases are debtfinanced
Debt-financed
repurchases lead to
−0.6 p.p. less
investment following
periods of industry
distress
Regressions include firm and year FE
If anything,
repurchasing firms
tend to invest more,
even during periods of
industry distress
The same is not true
for firms whose
repurchases are debtfinanced
Debt-financed
repurchases lead to
−0.6 p.p. less
investment following
periods of industry
distress
No significant effect for
firms w/ an
investment-grade
rating
Debt-financed
repurchases are
associated w/ a
deeper stock price
decline during the
COVID-19 crisis
This finding is
exclusive to debtfinanced repurchases.
Cash-flow financed
repurchases are not
associated w/ deeper
stock declines. This
likely explains the
insignificant findings
found by Fahlenbrach,
Rageth, and Stulz
(2020)
Debt-financed
repurchases are
associated w/ a
deeper stock price
decline during the
COVID-19 crisis
This finding is
exclusive to debtfinanced repurchases.
Cash-flow financed
repurchases are not
associated w/ deeper
stock declines. This
likely explains the
insignificant findings
found by Fahlenbrach,
Rageth, and Stulz
(2020)
Again, no significant
effect for firms w/ an
investment-grade
rating
Conclusions
•
The commonly held view in the payout literature that payouts are first and
foremost a vehicle to returns free cash flow to investors
payouts should be set “low enough to avoid expensive future external financing”
(Ross et al. 2013)
is incomplete
•
•
Payouts that are financed with simultaneous debt or equity issues are
–
prevalent: 43% of payout payers do so
–
large in magnitude: 31% of aggregate payouts are financed
–
persistent
–
take the form of both repurchases (55%) and dividends (45%)
Payout financing is an important use of the capital firms raise:
–
41% of aggregate proceeds of net debt issues
–
17% of aggregate proceeds of firm-initiated equity issues
are simultaneously paid out
Conclusions
•
We show that firms use debt-financed payouts to jointly manage their
capital structure and cash holdings, motivated, in particular, by tax
considerations
•
We show that not all payouts are created equal when it comes to their
impact on financial fragility—the source of payout financing matters
 Our findings highlight that firms’ liquidity, capital structure, and payout
policies are closely related
 Important to study them jointly!