1. Introduction

As we have seen in the introductory section, firms over the last few years have substantially increased the amount of capital that they return to shareholders. Some commentators argue that firms are in fact obsessed with payouts and that returning so much capital to shareholders is bad for the economy. The reason for this potentially negative effect is twofold:

  • Because of excessive payouts, firms do not have sufficient funds to finance their valuable investment projects. Therefore, firms forego valuable investment opportunities; they underinvest.
  • Moreover, many firms take on too much debt to finance cash distributions to shareholders. 

 

These are crucially important issues, which go to the heart of the corporate financial policies. In this section, we take a closer look at the first argument. We investigate under which scenarios payouts harm shareholders because of underinvestment and we ask whether there is empirical evidence that firms, on average, actually forego valuable investment opportunities to return money to shareholders.

 

The second argument is an argument about optimal debt levels and the trade-offs between the costs and benefits of debt financing. The module Capital Structure Decisions deals extensively with this question. Put very simply, debt financing has some tax benefits over equity financing (interest payments are tax deductible whereas payouts to shareholders are not) but it also brings about distress costs (the more debt a firm has, the higher the probability of default). Please refer to the module Capital Structure Decisions for a detailed discussion of these issues.