1. Introduction

After having discussed the various forms of payout, this section takes a step back and looks at some important determinants of payout decisions. 

We do so in a very stylized environment by looking at a firm that only lives 1 year. This simplified setting allows us to illustrate the key considerations surrounding the firm's payout policy. It is important to note that these considerations also apply when we make the firm more realistic---they simply become more complicated to illustrate.

 

The firm in question expects to earn a cash flow of 100 today and 110 in one year. Thereafter, the firm ceases to exist. The firm is fully equity financed and has 10 shares of common stock outstanding. Its overall cost of capital (the so-called costs of assets or unlevered cost of capital) is 10%.

For the moment, we also assume the following, though we will drop these assumptions later on to better understand when and how payout decisions matter:

  • There are no corporate taxes
  • There are no personal taxes
  • The firm and the shareholders have the same investment opportunities. Put differently, they can both invest in projects that have the same risk as the firm and promise to generate a rate of return of 10%.
  • There are no transaction costs. In particular, paying out or raising capital is free of charge.
  • There are no information asymmetries. In particular, investors have the same information as the firm.

 

In this setting, we first consider various payout alternatives, namely:

  • Dividend payments equal to the cash flows
  • Initial dividend smaller than cash flow
  • Initial dividend larger than cash flow.