Payout Policy Design

Abstract

Payout policy is viewed as a dynamic complement of security design. Security design considerations suggest that firms should optimally use equity to finance assets that are ex ante informationally-sensitive. However, business operations gradually erode the informational sensitivity of a firm's equity by transforming such assets into cash flows that are informationally-insensitive ex post. Cash dividends undo this effect by splitting the firm's stock into an informationally-insensitive cash component, and an ex-dividend stock with increased sensitivity to firm specific information. Maintaining the informational sensitivity of the equity increases the expected equilibrium stock price of an undervalued firm, and it also reduces its marginal cost of outside equity capital. Our analysis explains the documented cross-sectional variation in dividend policies, the dependence of dividends on publicly-observable historical information, and the puzzling practice of firms paying cash dividends regularly, despite occasionally raising external equity to finance projects. In addition, it yields new testable empirical predictions.