Payout Policy Design

51 Pages Posted: 21 Jul 2003

See all articles by Ralph Bachmann

Ralph Bachmann

Nanyang Technological University (NTU) - Division of Banking & Finance

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

Date Written: May 27, 2003

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.

Keywords: Payout policy, security design, capital structure choice, cash dividends, asymmetric information, endogenous information acquisition, informed trading, noisy rational expectations

JEL Classification: C72, D82, G31, G35

Suggested Citation

Bachmann, Ralph and Thakor, Anjan V., Payout Policy Design (May 27, 2003). Available at SSRN: https://ssrn.com/abstract=411880 or http://dx.doi.org/10.2139/ssrn.411880

Ralph Bachmann (Contact Author)

Nanyang Technological University (NTU) - Division of Banking & Finance ( email )

Nanyang Avenue, S3-B1A-14
Singapore 639798
Singapore
+65 6790 5000 (Phone)
+65 6794 6321 (Fax)

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Financial Theory Group ( email )

United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street, E62-618
Cambridge, MA 02142
United States

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