Financing Payouts * †

Joan Farre-Mensa Roni Michaely Harvard Business School Cornell University and IDC

Martin Schmalz University of Michigan

December 8, 2014

* We would like to thank Malcolm Baker, Alexander Ljungqvist, Uday Rajan, Matt Rhodes-Kropf, Jeffrey Zwiebel, and seminar audiences at Harvard Business School. Schmalz is grateful for generous financial support through an NTT Fellowship from the Mitsui Life Financial Center. † Address for correspondence: Harvard Business School, Rock 218, Soldiers Field, Boston, MA, 02163; phone 617-495-6963. E-mails: jfarremensa@hbs.edu (Farre-Mensa); rm34@cornell.edu (Michaely); schmalz@umich.edu (Schmalz).

Financing Payouts

Abstract

Despite the obvious interest in payout policy, no paper to date has systematically analyzed

how payouts are funded, perhaps because the answer might have appeared just too

obvious: payouts are funded with free cash flow—at least over long enough time periods.

In stark contrast to this commonly held view, we find that firms rely on the capital markets

to finance a third of aggregate payouts, mainly with debt but also with equity. Such

“financed payouts” are widespread, persistent, prevalent both among dividend-paying and

repurchasing firms, and large in magnitude. Standard interpretations of agency or signaling

theories are unable to explain this behavior. We argue, however, that our findings are

consistent with a reinterpretation of ideas related to agency conflicts and a holistic view of

corporate financial strategy that examines payout and capital structure decisions jointly.

Key words: Payout policy, financing decisions, debt issues, equity issues, capital structure.

JEL classification: G35; G32.

1

The established conventional wisdom is that firms rely on internally generated funds to fund

their payouts, whether these payouts are motivated by agency, signaling, or other considerations.

For example, Grullon, Michaely, and Swaminathan (2002) and DeAngelo, DeAngelo, and Stulz

(2006) present a lifecycle view of payouts where mature, cash-rich firms distribute excess free

cash flow to their investors while young, growing firms raise but do not pay out capital. Ross,

Westfield, and Jaffe (2013) conclude that “a firm should begin making distributions when it

generates sufficient internal cash flow to fund its investment needs now and into the foreseeable

future.” Accordingly, they recommend managers to set their level of payouts “low enough to

avoid expensive future external financing” (p. 607). While it is a theoretical possibility that firms

could also raise outside funds to finance their payouts, such behavior is costly and thus

considered, at least by some authors, “uneconomic as well as pointless” (Miller and Rock, 1985).

The results in this paper counter this conventional thinking: We find that 42% of firms with

positive payout initiate an equity or net debt issue during the same year; the vast majority of

them, 36% of all payers, could not have funded their payout without the proceeds of these issues.

In addition, we show that 35% of the cash firms raise is paid out by the same firms during the

same year. Our findings thus indicate that a substantial fraction of aggregate payouts is not

funded by internally generated funds but rather is actively financed in the capital markets.

In addition to being widespread, actively financed payouts are also important because of their

dollar magnitude: 32% of the aggregate capital paid out by public U.S. firms is simultaneously

raised by the same payers via firm-initiated equity or net debt issues.1 Most of the capital that

firms simultaneously pay out and actively raise—26% of aggregate payouts—is needed to fill the

gap between the firms’ payouts and the sum of their internal funds and the proceeds of employee

stock option exercises. If we follow a less conservative approach and include employee-initiated

1 Much of the proceeds of gross debt issues are simply used to roll over prior debt. Our conservative focus on net debt issues (i.e., debt issues net of debt repurchases) allows us to capture those proceeds that firms can actually use to fund investment, cash flow shortfalls, or—as it turns outs—payouts.

2

equity issues as a source of payout financing instead of treating them as internal funds, the

percentage of financed payouts increases by nine percentage points: 41% of the aggregate capital

paid out by public firms is simultaneously raised by the same payers via firm- or employee-

initiated security issues.

Financed payouts are markedly pro-cyclical: In 2007, right before the onset of the Great

Recession, industrial public firms in the U.S. actively financed $200 billion of payouts by

simultaneously initiating debt or equity issues. Two years later, in the midst of the recession, the

amount of financed payouts was cut by a factor of four, barely reaching $50 billion. Notably,

though, payout financing is not a transitory phenomenon: All our results remain virtually

unchanged if we measure firms’ sources and uses of funds over four-year intervals. This finding

indicates that the use of external capital to finance payouts is persistent and is not the result of

payout smoothing or, more generally, of time mismatches between free cash flow and payouts.

The frequency, magnitude, and persistence of financed payouts is striking, particularly in

light of the obvious costs associated with this behavior. In addition to direct issuance costs, these

costs include asymmetric information discounts on newly issued securities, due to which

financed payouts are inconsistent with pecking order models (Myers and Majluf, 1984). The

possibility that firms may have to pass up profitable investment opportunities when resorting to

the capital markets to finance payouts instead of investment is another potential cost of financing

payouts (Asker, Farre-Mensa, and Ljungqvist, 2014).

The fact that approximately 40% of all payers finance their payouts implies that there must

be benefits that offset these well-known costs. In order to explore what these benefits are, we

first examine the form of payouts that firms finance. We find that firms are as likely to finance

share repurchases as dividends. Thus, actively financed payouts cannot be simply explained by

firms’ desire to avoid the well-known costs associated with cutting dividends (Linter, 1956;

Brav, Graham, Harvey, and Michaely, 2005). We do observe, however, that in recessionary

3

years, a larger fraction of financed payouts take the form of dividends than repurchases. This

finding is consistent with the notion that the desire to avoid dividend cuts is an important driver

of payout financing behavior in times when access to capital is most limited.

Next, we examine the extent to which firms choose debt or equity issues to actively finance

their payouts. This choice has direct capital structure implications, and thus it points to different

motives for why firms raise and pay out capital at the same time. Our analysis shows that net

debt is by far the most important source of payout financing: up to 30% of aggregate payouts are

financed via simultaneous net debt issues made by the same payers. Conversely, 39% of the

proceeds of net debt issues— $135 billion of the $350 billion of net debt issued by public U.S.

firms in our average sample year—are paid out during the same year by the same issuing firms.

These findings are consistent with firms using financed payouts as a way to adjust their capital

structure without depleting their cash reserves.2

Given that secondary equity offerings (SEOs) and private placements are relatively rare, it is

not surprising that only 3% of aggregate payouts are financed via firm-initiated equity issues.

Yet, when firms do initiate equity issues, they pay out as much as 19% of the proceeds during the

same year. This unexpected finding of ‘equity recycling’ indicates that capital structure

adjustments are an important but not the only reason why firms choose to set payout levels that

they need to finance by actively raising capital.

On the face of it, equity recycling may appear hard to justify due to the obvious costs

associated with equity-financed payouts. It can however be the result of a monitoring strategy in

which boards make firms pay out all their operating cash flow, with the only exception of those

funds required for maintenance-type investments. As a result, managers are forced to raise

2 Such capital structure adjustments can be motivated by agency (Jensen, 1986), taxes (e.g., Modigliani and Miller, 1963), or risk-rebalancing considerations. Debt-financed payouts also allow firms to avoid paying repatriation taxes when their cash is held overseas (Foley, Hartzell, Titman, and Twite, 2007). In addition, in the case of debt-financed repurchases, they can increase earnings-per-share and thus help firms meet or beat analysts’ forecast (Bens, Nagar, Skinner, and Wong, 2003).

4

capital to fund any new investment projects, even those they could have funded internally had

they cut their payouts (Easterbrook, 1984). This monitoring strategy mitigates the agency costs

of free cash flow by allowing shareholders to decide which new projects should be funded; to the

extent that debtholders can exercise a similar monitoring role, it can also motivate debt-financed

payouts. Importantly, though, this monitoring strategy, which results in payouts well in excess of

free cash flow, is very different from the commonly held notion that cash rich firms simply pay

out their free cash flow to mitigate agency problems (Jensen, 1986).

The empirical evidence is consistent with the notion that the desire to prevent wasteful

investment plays a significant role in explaining both equity- and debt-financed payouts: we find

that 30% to 40% of actively financed payouts correspond to firms with unusually high

investment levels. These firms’ internal funds would have been enough to fund their payouts in a

counterfactual scenario in which the firms invested at ‘routine’ levels. Conversely, these firms

would have had to raise less or no capital had their cut their payouts when investment needs

surged. Yet by forcing the firms to maintain their payouts, their boards ensured that managers

had to raise capital and thus had to subject themselves to the scrutiny of the capital markets.

By contrast, it appears unlikely that financed payouts are motivated by signaling

considerations. Financed payouts are inconsistent with well-known payout signaling models such

as Miller and Rock (1985). In other models, such as Bhattacharya (1979), financed dividends can

arise when a firm signals its quality by committing to a dividend level that, ex ante, it expects to

be able to fund internally; yet, ex post, a low-probability cash flow shock forces the firm to raise

funds to finance its dividend. We find that close to 80% of firms that need to finance their

dividends do not have abnormally low profitability levels. In addition, dividend signaling models

such as Bhattacharya’s cannot explain financed repurchases, which are just as prevalent as

financed dividends: Repurchase announcements are typically seen as significantly less binding

5

than dividends (Jagannathan, Stephens, and Weisbach, 2000), and so they can be cancelled

following a negative shock with little signaling cost.

Our paper makes two contributions. First, ours is the first paper to systematically analyze

how firms fund their payouts. The vast literature on payout policy has investigated in detail the

determinants of the form of payouts (dividends or repurchases), their motivations, and the effect

that payout decisions have on equity returns. (See Allen and Michaely (2003), DeAngelo,

DeAngelo, and Skinner (2008), and Farre-Mensa, Michaely, and Schmalz (2014) for recent

reviews.) Yet despite the obvious interest in payouts, no paper to date has analyzed how payouts

are actually funded, perhaps because the answer might have appeared just too obvious: payouts

are funded with free cash flow—at least over long enough time periods.

In fact, we find that firms rely on the capital markets to finance a third of aggregate payouts,

with another nine percentage points of paid-out capital provided by employees through stock

option exercises. While it has long been known that, occasionally, some firms rely on the capital

markets to finance large payouts (Denis and Denis, 1993; Wruck, 1994; Andrade and Kaplan,

1998), the pervasiveness, economic magnitude, and persistence of financed payouts that we

document is unexpected.

Second, our paper enhances our understanding of what firms do with the proceeds of security

issues. As it turns out, in addition to using these proceeds to fund investment, cover cash flow

shortfalls, or build up their cash reserves (e.g., Kim and Weisbach, 2008; Denis and McKeon,

2012), a substantial fraction of the capital firms raise is used to fund payouts. By simultaneously

raising and paying out capital, firms can accomplish a number of objectives, from rebalancing

their capital structure, mitigating the agency costs of free cash flow, or increasing earnings-per-

share. Regardless of the motives at play, a key insight of our paper is that payout and issuance

decisions are intrinsically related, and thus much can be gained by studying them jointly as

interdependent elements of the financial ecosystem.

6

The paper proceeds as follows. Section 1 provides aggregate statistics on payout and capital

raising activity. Section 2 examines simultaneous payouts and security issues. Section 3

investigates whether firms that simultaneously raise and pay out capital could have funded their

payouts without raising capital. Section 4 discusses the costs and benefits of financing payouts

with the goal of shedding light on the motives behind this behavior. Section 5 concludes.

1. Aggregate payout and capital raising activity

1.1 Sample selection

Our baseline sample consists of all public U.S. firms that appear in the Compustat-CRSP

merged files between 1989 and 2012.3 We exclude firms in the year of their IPO because we are

interested in payout and issuance decisions after firms’ initial public offering. We also exclude

financial firms (SIC 6) and utilities (SIC 49). The final sample consists of 10,591 unique firms

and 90,791 firm-year observations.

1.2 Description of aggregate payout and capital raising activity

We start by describing the aggregate payout and capital raising activities of industrial public

U.S. firms during our sample period. Table 1 shows the percentage of firms that pay out or raise

capital for each year in our sample period (Panel A) and the aggregate dollar amount paid out or

raised (Panel B).4 We report annual figures averaged over four-year intervals to conserve space.

To better visualize time trends, Figures 1 and 2 show the underlying annual figures that we have

averaged in Table 1. Importantly, in Table 1 and Figures 1 and 2 there is no link at the firm level

between payouts and security issues, as capital may be paid out and raised by different firms.

Several significant trends emerge from this analysis. Both the percentage of firms with

positive total payout (the sum of dividends and share repurchases) and the dollar amount paid out

have experienced a substantial increase over our sample period. This increase in payouts has

3 We start our sample in 1989 because this is the first full year for which data from the Statement of Cash Flow were standardized following the adoption of Statement of Financial Accounting Standard 95. 4 All dollar figures reported in the paper are in real dollars of year 2012 purchasing power.

7

largely been driven by share repurchases, which have been the most important payout vehicle

since 1997 (with the only exception of 2009). In particular, Figure 1 shows that repurchases

exploded from 2002 to 2007, going up by a factor of almost four, from $143 billion in 2002 to

$562 billion in 2007. They fell back to $150 billion in 2009 and have been recovering since then.

Dividends, on the other hand, have experienced a different dynamic: As noted by Fama and

French (2001), the number of dividend payers declined through the 1990s and reached a low-

point in 2001, when less than a quarter of all public U.S. firms paid a dividend. But dividends

have made a remarkable comeback since then, with the percentage of dividend payers peaking at

39% in 2012, the last year of our sample period.5 At the same time, the aggregate dollar amount

paid out through dividends stayed relatively flat during the 1990s—reflecting the fact that the

firms that stopped paying dividends accounted for a relative small fraction of aggregate

dividends payments (DeAngelo, DeAngelo, and Skinner, 2004)—and has been slowly but

steadily increasing since 2001. Figure 1 also shows that repurchases have been much more

volatile and pro-cyclical than dividends throughout our sample; this is consistent with the well-

known tendency of firms to pay smooth dividends (e.g., Jagannathan et al., 2000; Leary and

Michaely, 2011).

On the securities issuance side, net debt issues, defined as the absolute value of the difference

between the amount of debt issued and the amount repurchased or retired, have been by far the

most important source of external funds for U.S. firms. In the average year in our sample period,

U.S. firms raised $255 billion in net debt, representing over 70% of the capital they raised that

year. Figure 2 shows that the aggregate dollar amount raised via net debt issues has been mostly

pro-cyclical, though it was slow to recover after the 2001 recession, when it continued declining

through 2005. The figure also shows that between 20% and 45% of all firms issued net debt in

5 Farre-Mensa, Michaely, and Schmalz (2014) review the recent payout literature and, in particular, papers that have examined the forces behind this “disappearance and reappearance” of dividends.

8

any given year, a percentage that was also highly pro-cyclical.

In addition to issuing debt, firms can raise capital by issuing equity. We break down equity

issues in firm-initiated issues (SEOs and private placements) and employee-initiated issues—the

latter being mostly the result of employee stock options exercises (McKeon, 2013). Employee-

initiated issues have become increasingly prevalent over the last three decades: In any given year

since 1997, over 60% of all public firms received a cash inflow from employee stock option

exercises. These exercises have become an important—though perhaps unintended—source of

capital for public U.S. firms, with the aggregate proceeds of employee-initiated equity issues

peaking at $100 billion in 2007.

Firm-initiated equity issues, on the other hand, are less frequent: During our sample period,

only between 10% and 20% of all public firms initiated an equity issue in any given year. The

annual proceeds of firm-initiated equity issues averaged $45 billion during our sample, reaching

a peak of $123 billion in 2000 but not surpassing $50 billion since 2002. As a result, employee-

initiated equity issues have been a quantitatively more important source of funds than firm-

initiated issues in every year since 2002, except in 2009 (see Figure 2).

There is a key conceptual difference between a firm that chooses to raise capital by initiating

a debt or an equity issue, and a firm that raises capital as a by-product of its employees’ option

exercises, over which the firm has little direct control.6 Throughout the paper, we therefore

distinguish between i) instances in which firms actively raise capital, either by initiating the

issuance of net debt or equity, and ii) instances in which the capital-raising events are triggered

by actions of the firms’ employees.

6 Firms do control if and when they issue options to their employees, but arguably this decision is motivated by the need to provide incentives and typically takes place several years before the options are exercised. Also, as argued by McKeon (2013), the vast majority of stock option grants are to employees below the top five executives. Even in the case of options exercised by top managers, these exercises are most naturally seen as personal investment decisions rather than as firm-level capital-raising events.

9

To sum up, Table 1 and Figures 1 and 2 show that the aggregate payout and capital raising

activities have both trended upwards over our sample period. The aggregate annual amounts paid

out and raised are positively correlated over time, with a correlation coefficient of 0.58, and their

average values are almost identical ($353.7 billion and $350.4 billion, respectively).

It is important to emphasize that the aggregate statistics presented so far do not imply that

payouts and issuances are related at the firm level: For example, it could be that firms paying out

and raising capital are different firms that find themselves at different stages of their life cycles,

as predicted by standard lifecycle theories (e.g., Grullon et al., 2002; DeAngelo et al., 2006). The

goal of this paper, however, is to understand the extent to which firms rely on the capital they

raise to finance their payouts. To that end, we provide evidence that payouts and issuances are

related at the firm level in the next sections.

2. An upper bound for financed payouts: Simultaneously raising and paying out capital

The following example illustrates the conceptual difficulties of measuring firms’ reliance on

the proceeds of security issues to finance their payouts: Consider the case of a firm that, in a

given year, pays out $50, has free cash flow (operating cash flow net of investment) of $50, and

issues $100 of net debt. Can we say that this firm is using debt to finance its payout? On the one

hand, the firm is simultaneously issuing debt and paying out capital, and so one could argue that

it is; on the other hand, the firm’s free cash flow is enough to fund its payout, and so the firm did

not in fact need to issue debt to finance its payout. These difficulties are, of course, a direct

consequence of the fact that money is fungible.

In this section, we start our analysis of financed payouts by investigating how common it is

for firms to pay out and raise capital simultaneously, i.e., during the same fiscal year. In doing

so, we examine joint payout and issuance decisions at the firm level, in contrast to the aggregate

statistics presented in Section 1. As the previous example illustrates, this will give us an upper

bound of the extent to which firms rely on the proceeds of security issues to finance their

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payouts. The underlying assumption is that issuance proceeds are the source of capital of ‘first

resort’ when funding payouts.7 In Section 3, we will provide a lower bound of how prevalent

financed payouts are by assuming that the proceeds of security issues are the source of capital of

‘last resort’ when it comes to funding payouts.

We report both firm counts (e.g., the percentage of firms that simultaneously raise and pay

out capital) and dollar magnitudes (e.g., the dollar amount of capital that firms simultaneously

raise and pay out). Similarly as Table 1, the tables in this section report annual figures averaged

over four year intervals to conserve space. We supplement the tables with graphs plotting annual

figures to better illustrate time trends.

In Section 2.1., we first examine the prevalence of firms that pay out capital and issue any

type of security during the same year. We then analyze how our findings change if we focus only

on actively issued securities, i.e., instances in which firms initiate a debt or an equity issue, thus

excluding equity issues that are the result of employee stock options exercises. In Section 2.2, we

further disaggregate the securities that are issued simultaneously with payouts into net debt

issues, firm-initiated equity issues, and employee-initiated equity issues.

2.1 All security issues vs. firm-initiated security issues

Table 2, Panel A, provides an upper bound of the extent to which firms finance their payouts

by examining firms that pay out capital and issue any type of security (net debt, firm-initiated

equity, or employee-initiated equity) during the same year. Columns 1, 2, and 3 report the

number of firms that, in any given year, both raise and pay out capital, presented as a fraction of

the whole population of public firms (Column 1), the population of firms that pay out capital

(Column 2), and the population of firms that raise capital (Column 3).

7 The only exception are the proceeds of debt issues: By using net debt in our analysis, we are assuming that debt proceeds are only used to finance payouts after funding debt retirements.

11

The takeaway from these three columns is clear: A substantial fraction of firms raise and pay

out capital during the same year.8 Specifically, Column 1 shows that, in the average year over

our sample period, 40% of all public U.S. firms paid out and raised capital during the same fiscal

year. This percentage has been growing over time, peaking in 2012 at 52%. Relatedly, Column 2

shows that a striking 82% of payout payers raise capital in the same year; Column 3 conditions

the sample on firms that raise capital, showing that over 50% of firms that issue securities also

simultaneously pay out capital.

Taken at face value, these findings may be viewed as surprising: Insofar as information

asymmetries between firms and investors cause a wedge between the costs of external and

internal capital, leading firms’ financial policies to follow a ‘pecking order’ (Myers and Majluf,

1984), firms should cut their payouts before issuing any securities. Similarly, many standard

payout models do not predict the frequent occurrence of simultaneous payouts and security

issues (see, e.g., Miller and Rock, 1985). In what follows, our goal is to better understand why so

many firms appear to find it optimal to simultaneously raise and pay out capital, despite the costs

of such a policy of “financing payouts.”

We start by analyzing the degree to which our findings are driven by employee-initiated

equity issues. Table 1 shows that, in the later years of our sample, over two-thirds of all public

firms experienced such an issue. In light of this, it is all but unavoidable that many payout payers

will simultaneously raise capital. In fact, to the extent that the proceeds from these issues can be

seen as additional free cash flows that firms do not actively seek to raise and may not need, one

might expect firms to pay these proceeds back to their investors.

In order to investigate to which extent our results are driven by such a possibility, Table 2,

Panel B, excludes employee-initiated equity issues from our analysis and focuses only on payout

8 All firm counts we report throughout the paper require variables to be greater than $100,000 to be considered positive. In this section, this ensures that we identify firms that pay out and raise economically meaningful amounts of capital and thus do not pick up rounding errors.

12

payers that actively initiate security issues in the same year. This analysis provides an upper

bound for the degree to which payouts are actively financed—i.e., the degree to which firms

initiate securities issues in order to finance their payouts. Column 1 in Panel B shows that, in the

average sample year, 20% of all public firms simultaneously pay out and actively raise capital by

initiating a net debt or an equity issue. This means that an average of 42% of all payers actively

raise capital during the same year (Column 2); conversely, 46% of all firms that actively raise

capital also pay out capital during the same year (Column 3). Thus, a comparison of Panels A

and B indicates that employee-initiated equity issues make up just under a half of the instances of

firms that simultaneously pay out capital and issue securities.

Figure 3 (top graph) shows that the percentage of public firms that simultaneously pay out

and actively raise capital is highly pro-cyclical:9 It fell from a peak of 26% in 1998 to 13% in

2002 (in the aftermath of the 2001 recession), and then again during the Great Recession, from

22% in 2007 to 12% in 2009, before bouncing back to 25% in 2012. Therefore, it is in years

when capital is arguably easiest to raise that firms choose to actively issue securities and

simultaneously pay out (at least part of) the proceeds. The dotted and dashed lines show similar

time trends when plotting the percentage of firms with simultaneous payouts and firm-initiated

security issues relative to the total number of firms paying out capital and initiating security

issues, respectively.

A natural question follows: Are simultaneous payouts and security issues economically

important, or are the above results driven by small firms, and therefore the dollar magnitudes are

negligible? Columns 4 through 9 of Table 2 investigate this question. Panel A examines the

dollar amount that firms simultaneously raise and pay out during the same fiscal year, measured

as follows: For each firm-year, we calculate the minimum of the proceeds of its security issues

9 The underlying data are the same as in Column 1 of Table 2, Panel B, but in the figure we can plot each annual percentage instead of averaged over four-year intervals, as we do in Table 2 to conserve space.

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(net debt and equity, denoted SIit) and its total payout (TPit): min{SIit, TPit}. For example, for the

firm in our previous example raising $100 of net debt, paying out $50, and with $50 of free cash

flow, we define the amount that the firm simultaneously raises and pays out to be min{100, 50}

= $50. (Note that this firm increases its cash holdings by $100.)

As explained above, by measuring the capital that firms simultaneously raise and pay out, we

obtain an upper bound of the extent to which firms rely on the proceeds of security issues to

finance their payouts. The firm in our example could in fact have paid out $50 without raising

any capital, and so one can argue that the debt issuance decision was not related to the payout

decision. That said, had the firm not simultaneously issued debt and paid out $50, it could have

reduced the debt it raised by this amount while still achieving the same cash increase.

To get a sense of how large simultaneous payouts and security issues are relative to the total

amount of capital firms pay out and the amount they raise, we construct the following two ratios

for each year in our sample period: min , /t t

TPt it it it

i Pub i Pub

R SI TP TP

and

min , / ,t t

SIt it it it

i Pub i Pub

R SI TP SI

where Pubt denotes the set of all public firms in our sample

in year t. TPtR captures the fraction of aggregate total payouts that is simultaneously raised

through securities issued by the same payers during the same year, while SItR captures the

fraction of aggregate proceeds of security issues that is paid out by the same issuers during the

same year.10

Column 4 in Table 2, Panel A, shows how the annual ratio TPtR (averaged over four-year

intervals to conserve space, as before) has evolved over our sample period: On average, 41% of

the aggregate capital paid out by public U.S. firms was raised during the same year by the same

10 Alternatively, we could construct the ratio min{SIit , TPit}/ TPit for each payout payer, and then average this ratio across all firms paying out capital in any given year (and analogously with the ratio min{SIit , TPit}/ SIit for security

issuers). Doing this yields similar patterns to those we report using TPtR and ,SI

tR respectively.

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firms that made the payouts. This ratio has decreased somewhat in recent years, indicating that

simultaneous payouts and security issues have not kept pace with the payout explosion captured

in Figure 1. This is despite the fact that Column 5 shows that the fraction of aggregate proceeds

of security issues that are simultaneously paid out, SItR , has been growing over time, averaging

39% over our sample and reaching 57% in 2011.

Columns 4 and 5 in Panel B show that the large dollar magnitude of simultaneous payouts

and security issues is not primarily the result of firms paying out the proceeds of employee stock

options exercises. Columns 4 and 5 in Panel B show the analogous versions of the TPtR and SI

tR

ratios with SI substituted by AI, where AI includes only capital actively raised through either net

debt issues or firm-initiated equity issues. Remarkably, we still find that, on average over our

sample period, close to a third (32%) of the aggregate capital paid out by public U.S. firms is

financed through firm-initiated security issues during the same year. The results in Column 5 are

equally if not more surprising: A staggering 34% of the aggregate proceeds of active issuances

are paid out by the same firms during the same fiscal year, a ratio that has increased markedly

since 2003. The bottom graph in Figure 3 shows that simultaneous payouts and firm-initiated

security issues are strongly pro-cyclical, with the aggregate annual sum of simultaneous payouts

and active issues, min ,t

it iti Pub

AI TP , peaking in 2007 at $227 billion.

Taken together, our findings paint a very different picture from the commonly held view that

firms that (actively) raise capital and those that pay out capital are different firms that are at

different stages of their lifecycles and face different growth opportunities (e.g., Grullon,

Michaely, and Swaminathan, 2002; DeAngelo, DeAngelo, and Stulz, 2004). Rather, we have

shown that, on average over our sample period, over 82% of firms that pay out capital also issue

securities in the same year they pay out. Even if we focus only on firm-initiated security issues,

this ratio remains a very substantial 42%. Perhaps even more remarkable, the amount of capital

15

that is actively raised and paid out by these firms represents 32% of the aggregate total payout;

conversely, 34% of the proceeds of security issues initiated by public U.S. firms are paid out to

shareholders during the same year.

We now investigate whether the results are primarily driven by one particular form of

payout. In particular, one might expect that because it is costlier to cut dividends than

repurchases (e.g., Brav et al., 2005), firms might be particularly keen on maintaining dividend

payments, even if doing so requires raising capital. Under this hypothesis, dividends that are

financed through security issues should be more prevalent than financed repurchases. To see

whether this is the case, Columns 6 and 7 in Table 2 perform the same analysis as Columns 4 and

5 but substituting total payouts (TP) with dividend payout (Div); similarly, Columns 8 and 9

substitute total payouts with capital paid out via share repurchases (Rep).

The results in Panel A indicate that firms pay out the proceeds of security issues via

dividends and share repurchases to a similar extent (23% and 24%, respectively).11 When we

restrict the sample to firm-initiated security issues (Panel B), we find very similar results: 21% of

the proceeds of firm-initiated security issues are paid out via dividends and also 21% via

repurchases. If anything, a comparison of Columns 7 and 9 indicates that in recent years, a larger

share of the proceeds of firm-initiated issues has been paid out via share repurchases than via

dividends. The only exception is 2009 (not captured in the table), when 30% of the proceeds of

firm-initiated security issues were paid out via dividends and only 17% via repurchases. (Figure

1 shows that repurchase volume collapsed during the Great Recession.)

Therefore, it appears that a desire to maintain dividends can be the primary motive for

actively financed payouts only in recessionary years (when raising capital is likely costliest). On

the other hand, in expansionary years, particularly in the later years of our sample, over a third of

11 The sum of Columns 7 and 9 does not equal Column 5. To illustrate why, consider the case of a firm that raises $80 of debt, pays out $50 in dividends and another $50 via share repurchases. For this firm, min{SI, TP} = $80 < min{SI, Div} + min{SI, Rep} = $50 + $50 = $100.

16

the capital that firms actively raise is simultaneously paid out via share repurchases. To the

extent that repurchases are typically seen as less sticky than dividends, maintaining repurchase

levels is unlikely to be the motivation for such financed repurchases.

Our findings show that simultaneous payouts and firm-initiated security issues represent a

large fraction of both payout and capital raising activity. The implications of these findings may

critically depend on the type of security issues: For example, as we discuss in Section 4, whether

firms finance their payouts via equity or debt issues has very different capital structure

implications and thus would point to different motives for why firms raise and pay out capital at

the same time. The next section breaks down the role that debt and equity issues play in

explaining our findings.

2.2 Breaking down the role of debt and equity issues

Table 3 examines the extent to which firms simultaneously pay out capital and issue net debt

(Panel A), firm-initiated equity (Panel B), and employee-initiated equity (Panel C), following the

same structure as Table 2. Three results stand out.

First, debt appears to be the dominant form of payout financing: Column 4 indicates that up

to 30% of aggregate payouts are financed via net debt issues (Panel A), while firm- and

employee-initiated equity issues finance at most 3% (Panel B) and 11% (Panel C) of payouts,

respectively. Columns 6 and 8 show that debt dominates the financing of both dividends and

share repurchases.

Second, when examining firm counts, a somewhat different picture emerges: Column 1

shows that the percentage of public firms with a simultaneous payout and net debt issue is a

substantial 18% (Panel A). That said, this fraction is smaller than the 34% of firms with a

simultaneous payout and employee-initiated equity issue (Panel C), reflecting the large

prevalence of firms with capital inflows from employee stock option exercises. On the other

17

hand, simultaneous payouts and firm-initiated equity issues are rare: less than 4% of all public

firms initiate equity issues and pay out capital during the same year (Panel B).12

Third, relative to the total amount of capital firms raise, Column 5 shows that a remarkable

39% of net debt is paid out during the same year (Panel A); this represents $135 billion of the

$350 billion of net debt issued by public U.S. firms in our average sample year. Panel B shows

that an equally remarkable 19% of firm-initiated equity issuance proceeds are also paid out.

Therefore, while the fact that SEOs and private placements are relatively infrequent implies that

they finance only a small fraction of payouts, when firms do actively raise equity, they pay out

close to a fifth of the proceeds during the same year.

As for employee-initiated equity issues, as much as 79% of these proceeds are paid out

(Panel C). This finding is consistent with the notion that for most firms, the cash inflows from

option exercises represent unneeded capital that is a by-product of the firms’ compensation

policies, and so they pay the cash back to their shareholders. At the same time, our results are

also consistent with firms using employees as a source of capital for making payouts to

shareholders.

3. A lower bound for financed payouts: The payout-funding gap

Our analysis of simultaneous payouts and issuances in Section 2 provides an upper bound for

the extent to which firms rely on the capital markets to finance their payouts. In this section, we

provide a lower bound for the prevalence and dollar magnitude of financed payouts by focusing

only on the subset of simultaneous payers and issuers that could not have funded their payouts

without the proceeds of security issues.

12 The fact that some firms simultaneously raise and pay out equity has been noted by Weld (2008) and Grullon, Paye, Underwood, and Weston (2011).

18

3.1 Prevalence and magnitude of payout-funding gaps

In order to identify firms that, ceteris paribus, would have been unable to fund their payouts

without simultaneously raising capital, we need to measure the gap between a firm’s payout and

its free cash flow. To define this gap, it is helpful to consider the following cash flow identity,

which expresses a firm’s total payout in terms of the firm’s potential sources and uses of cash:

Total payout (TPit) = Free cash flow (FCFit) – Change cash (CCit) + Security issues (SIit) (1)

Free cash flow (FCFit) is the sum of operating cash flow (OCFit) and investment cash flow

(ICFit).13 As in Section 2, total payout (TPit) is the sum of dividends and share repurchases, while

security issues (SIit) is the sum of the proceeds of a firm’s debt and equity issues. In addition, we

define a firm’s cash reduction as minus its change in cash holdings if the change in cash is

negative, and zero otherwise (i.e., CRit = – min{CCit, 0} ≥ 0).

It then immediately follows from equation (1) that whenever a firm’s total payout exceeds

the sum of its free cash flow and cash reduction (i.e., TPit > FCFit + CRit), the firm needs to

issue securities to finance (part of) its payout (i.e., SIit > 0). We label such a firm as having a

payout-funding gap, and define its gap as follows:

Payout gap (PGit) ≡ min{max{TPit – (FCFit + CRit), 0}, TPit} (2)

To illustrate our definition of payout gap, consider the following three situations. First, a firm

that pays out $50, has free cash flow of $25 and no changes in cash, has a $25 payout gap.

Second, a firm that pays out $50, has negative free cash flow of –$100 and no changes in cash,

has a $50 payout gap. That is, our definition ensures that a firm’s payout gap is never larger than

the payout itself, even if free cash flow is negative.

Lastly, consider a firm like the one in our example in Section 2 that pays out $50, has free

cash flow of $50, and issues $100 worth of net debt, which it uses to build up its cash reserves

13 The two main components of investment cash flow are capital expenditures and acquisitions, both of which enter the definition of investment cash flow with a negative sign as they represent capital outlays.

19

(i.e., SIit = CCit = $100). This firm pays out and raises capital during the same year, and hence

was captured as such in Section 2 (min{TPit, SIit} = $50). By contrast, according to the “payout

gap” definition introduced in this section, this firm does not have a gap because its free cash flow

is sufficient to fund its payout, i.e., PGit = 0.

This last example illustrates the complementary nature of our analysis in Sections 2 and 3:

Section 2 gave us an upper bound of the extent to which payouts are financed because by

measuring financed payouts as min{TP, SI}, we effectively assumed that the proceeds of security

issues were the source of capital of ‘first resort’ when funding payouts. On the other hand, our

definition of payout gap in equation (2) provides a lower bound for financed payouts by

assuming that security issues are the source of capital of ‘last resort’ for payouts, only being used

after firms exhaust their free cash flow and cash reductions. This allows us to address the

conceptual problem posed by the fungibility of money without making further assumptions.

The first four columns of Table 4, Panel A, examine the prevalence of firms with a payout

gap and the dollar magnitude of their gaps. Columns 1 and 2 show that, in our average sample

year, 22% of all public firms—representing 46% of all firms that pay out capital—have a payout-

funding gap.14 Column 3 shows that, across firms with a payout gap, the ratio of the payout gap

to total payout, PGit / TPit, averages 73%; therefore, conditional on having a gap, payout gaps

are large. Importantly, the magnitude of payout gaps is also substantial at the aggregate level:

Column 4 shows that the annual ratio of the aggregate sum of payout gaps over the aggregate

capital paid out by all public firms, /t t

it iti Pub i Pub

PG TP , averages 30%. This means that, in our

average sample year, $98 billion or 30% of the total capital paid out by public U.S. firms could

not have been funded without the proceeds of security issues. Therefore, our lower bound for

14 Analogously as in the previous tables, we require PGit > $100,000 to classify a firm as having a payout gap.

20

financed payouts indicates that no less than 46% of all payers finance their payouts, with the

dollar amount of financed payouts representing at least 30% of aggregate total payouts.

How do our findings change if we examine only payouts that, ceteris paribus, could not have

been funded without the proceeds of firm-initiated security issues? To investigate this, Columns

5 through 8 in Table 4, Panel A, perform an analysis analogous to that in Columns 1 through 4

but focusing on what we call active payout gaps, defined as follows:

Active payout gap (APGit) ≡ min{max{TPit – (FCFit + CRit + EEit), 0}, TPit} (3)

where EEit captures the proceeds of employee-initiated equity issues and all other variables are

as in equation (2). By adding the proceeds of employee-initiated issues to free cash flow and

cash reductions, this definition allows us to obtain a lower bound for the prevalence and

magnitude of actively financed payouts. 15

Columns 5 and 6 show that a remarkable 36% of all payers—or 17% of all public firms— set

a payout level that forces them to initiate a debt or an equity issue to fund their payout. Column 8

shows that the aggregate magnitude of active payout gaps represents on average 26% of the

aggregate capital annually paid out by public U.S. firms.

Figure 4 shows that both the percentage of firms with an active payout gap and the aggregate

dollar magnitude of these gaps are highly pro-cyclical, declining markedly around the three

recessionary periods in our sample: the early 1990s recession, the early 2000s recession, and the

Great Recession. This suggests that in recessionary years, when it is hardest and costliest to raise

capital (e.g., Campello, Graham, and Harvey, 2010; Erel, Julio, Kim, and Weisbach, 2012), firms

are reluctant to set payout levels that they need to finance by initiating security issues. Yet they

seem to have no problem doing so when the economy appears to be performing well: In 2007,

15 Indeed, it follows from equation (1) that whenever TPit > FCFit + CRit + EEit, then AIit > 0 (where as in Section 2 AIit captures capital that is actively raised through either net debt or firm-initiated equity issues).

21

right before the onset of the Great Recession, close to 40% of all payers had active payout gaps;

they had to raise a combined $190 billion through firm-initiated issues to close their gaps.

We can combine Tables 2 and 4 to determine average ranges for the prevalence and dollar

magnitude of both financed and actively financed payouts. The summary table below does this:

Firm counts Dollar magnitudes

% of payout payers % of aggregate total payouts

Lower bound Upper bound Lower bound Upper bound

(1) (2) (3) (4)

Financed payouts 46.0% 82.4% 30.1% 40.6%

Actively financed payouts 36.1% 42.1% 26.1% 31.8%

Summary table. This table combines the results of Table 2 (Columns 2 and 4; Panels A and B) and Table 4 (Columns 2, 4, 6, and 8; Panel A) to provide lower and upper bounds for the prevalence and dollar magnitude of financed and actively financed payouts. All figures are annual figures averaged over all years in our sample period.

The widest range between the lower and upper bounds obtained in Sections 2 and 3 is in the

percentage of payers that finance their payouts: Between 46% and 82% of payers can be said to

use the proceeds of security issues to finance their payouts, depending on whether we assume

that these proceeds are the source of capital of last or first resort for funding payouts,

respectively. This wide range reflects the fact that among the 82% of payers that simultaneously

issue securities there is a large number of firms with only employee-initiated equity issues that

do not have a payout gap. If we focus on the dollar magnitude of financed payouts, we no longer

find the same wide range between the corresponding lower and upper bounds: Firms finance

between 30% and 41% of aggregate total payouts. This narrower range is consistent with the

notion that the employee-initiated issues that are responsible for the wide range in the percentage

of payers with financed payouts tend to be small in dollar magnitude.

On the other hand, if we focus on actively financed payouts, we find narrow ranges both

when examining firm counts and dollar magnitudes: Between 36% and 42% of payers use the

proceeds of firm-initiated security issues to actively finance their payouts; as a result, between

22

26% and 32% of aggregate total payouts are actively financed. These narrow ranges indicate that

most payers that simultaneously initiate securities issues do so because they need the proceeds of

these issues to close their payout-funding gaps.

Figure 5 combines Figures 3 and 4 to examine how both the percentage of payers with

actively financed payouts and the dollar magnitude of their financed payouts have changed over

time. The figure confirms that actively financed payout gaps are strongly pro-cyclical, consistent

with our prior interpretation that it is primarily in expansionary years when firms set payout

levels that they need to finance by actively raising capital. This finding is consistent with the

evidence in Bliss, Cheng, and Denis (2014) that exogenous shocks to the supply of credit lead

firms to reduce their payouts as a substitute form of financing. Indeed, our results show that

reducing payouts allows firms not just to conserve internal capital, but also to reduce their

external capital needs.

3.2 Are payout gaps the result of timing mismatches between free cash flow and payouts?

The large prevalence and dollar magnitude of both financed and actively financed payouts

raise an important question: Are the gaps on which we base our lower bounds for financed

payouts the result of time mismatches between free cash flow and payouts? This concern is

particularly relevant given that it has long been known that firms tend to smooth their payouts

relative to their free cash flow (Lintner, 1956). In particular, if firms set their payout equal to

their average free cash flow, our analysis will identify a payout gap every year that a firm has

below average free cash flow. Crucially, if time mismatches were driving the gaps we have

identified in Section 3.1, the gaps should all but disappear if we measure firms’ sources and uses

of cash over longer horizons.

We test this hypothesis in Panel B of Table 4, where we define payout-funding gaps over

four-year intervals:

23

3 3 3

4

0 0 0

min max ,0 ,yearit it j it j it j it j

j j j

PG TP FCF CR TP

(4)

and analogously for active payout gaps. Interestingly, both payout gaps and active payout gaps

are somewhat more prevalent and of similar aggregate dollar magnitude when we define them

over four-year intervals than when we define them annually in Panel A.16 Therefore, we find no

support for the notion that our findings are driven by time mismatches between firms’ free cash

flow and payouts.

4. Why do firms choose to finance their payouts?

The summary table in Section 3 indicates that, in the average sample year, between 36% and

42% of payers engage in active payout financing, relying on the proceeds of firm-initiated

security issues to fund their payouts. These actively financed payouts are not just widespread but

they are also economically important, representing between 26% and 32% of the aggregate

capital paid out by public U.S. firms.17

Our goal in this section is to shed light on the motives driving the unexpectedly large

magnitude of financed payouts. This magnitude runs counter to the common notion that payouts

are first and foremost a vehicle to return free cash flow to investors (e.g., Grullon, Michaely, and

Swaminathan, 2002)—whether it is to ensure that the cash is not misspent or to signal the

payers’ quality.

Section 4.1 starts by briefly discussing why actively financed payouts are costly; these costs

are well-known and underscore the surprising nature of our findings. Section 4.2 then turns to

examining the potential benefits of financing payouts and discusses the extent to which these

benefits are likely to explain the striking prevalence of financed payouts observed in the data.

16 This finding is in fact not surprising given that we expect firms that smooth their payout relative to their free cash flow to use their cash holdings to do so. Our baseline definitions of payout gap (equations (2) and (3)) add cash reductions to free cash flow, and so Panel A does not identify such temporal smoothing behavior as having a gap. 17 An additional 4% to 9% of aggregate payouts are financed through employee-initiated equity issues, which play a perhaps less surprising but nevertheless significant role in the funding of payouts.

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4.1 Costs of actively financing payouts

Our discussion of the costs of actively financed payouts focuses on three key costs: the

wedge between a firm’s internal and external costs of funds, the notion that actively financed

payouts can ‘crowd out’ profitable investments, and tax-related costs.

4.1.1 Wedge between the cost of internal and external capital

Perhaps the most notable reason why actively financing payouts is costly stems from the fact

that (virtually) all firms face a wedge between their internal and external costs of funds. Indeed,

any small transaction cost of raising external funds implies that external capital is more costly

than internal capital (see, e.g., Kaplan and Zingales, 1997). In fact, information asymmetry

between firms and investors implies that the wedge between a firm’s cost of internal and external

capital can be much higher than is implied by pure transaction costs (e.g., Myers and Majluf,

1984). In particular, informational frictions can imply that “the cost of new debt and equity may

differ substantially from the opportunity cost of internal finance generated through cash flow and

retained earnings” (Fazzari, Hubbard, and Petersen, 1988, p. 142). It is thus not surprising that

Miller and Rock (1985) point out that “it would be uneconomic as well as pointless” for firms to

pay dividends and raise capital simultaneously (as quoted by Easterbrook, 1984, p. 650).

4.1.2 Underinvestment

To the extent that firms’ ability to raise capital is not unlimited, using actively raised funds to

make payouts can imply that the firms have to pass up profitable investment opportunities. In

line with this notion, Bens, Nagar, and Wong (2002) show that firms that shift resources away

from real investments towards the repurchase of their own shares appear to experience a

subsequent decline in performance. In recent work, Asker, Farre-Mensa, and Ljungqvist (2014)

show that public U.S. firms invest less and are less responsive to investment opportunities than

their privately held counterparts. At the same time, they show that public firms have higher

25

payouts, a finding that they note is consistent with public firms inefficiently prioritizing high

payouts over profitable investments due to short-termist pressures.

4.1.3 Taxes

Our analysis in Tables 2 and 3 indicates that firms finance both their dividends and their

share repurchases. But because dividends are taxed, if a firm raises $1 of capital from investors

and immediately pays it out as a dividend, its shareholders will receive $(1 – τ), where τ is the

dividend tax. This creates an incremental cost for those firms that actively finance their

dividends that needs to be added to the costs discussed above.

4.2 Benefits of actively financing payouts

Why do well over a third of all payers choose to finance their payouts, despite the seemingly

large costs associated with doing so? In this section, we discuss four potential benefits of

financing payouts: adjusting a firm’s capital structure, mitigating the agency costs of free cash

flow, signaling the firm’s quality, and increasing earnings-per-share.18 Our results suggest that

three of these four benefits play an important role in explaining the widespread payout-financing

behavior we observe in the data (the exception is signaling).

While our discussion of the potential benefits of financing payouts shows that this behavior is

consistent with some classic payout theories, financed payouts have generally received little

attention in the more recent literature (e.g., see the surveys by DeAngelo et al. (2008) and Farre-

Mensa et al. (2014)).19 The striking prevalence of financed payouts suggests that the benefits of

financing payouts might be more important than it is often assumed—while, at the same time,

the costs associated with financing payouts might be less important.

18 Our discussion of the benefits of actively financed payouts does not aim to be exhaustive. A fifth potential benefit that we do not discuss is market timing, which might prompt firms to raise debt when they believe their equity is undervalued and use the issuance proceeds to repurchase their shares. 19 The only exception are leveraged recapitalizations, but these are rare (Denis and McKeon, 2012) and thus do not drive our findings.

26

4.2.1 Capital structure adjustments

A key potential benefit of actively financed payouts, specifically in the case of debt-financed

payouts, is that they allow firms to increase their leverage. These capital structure adjustments

can be motivated by at least three reasons. First, as pointed out by Jensen (1986), “debt creation,

without retention of the proceeds of the issue, enables managers to effectively bond their promise

to pay out future cash flows. (…) Issuing large amounts of debt to buy back stock also sets up the

required organizational incentives to motivate managers and to help them overcome normal

organizational resistance to retrenchment which the payout of free cash flow often requires” (p.

324). Second, as noted by Easterbrook (1984), “financing projects out of retained earnings—if

unanticipated by bondholders—transfers wealth from shareholders to debtholders” by decreasing

the risk of the already-issued debt (p. 653). Debt-financed payouts can reverse these leverage

decreases, while still preserving the cash the firm needs to fund its investments. Third, debt-

financed payouts can also be motivated by a desire to increase leverage in order to optimize the

tax-efficiency of a firm’s capital structure without depleting its cash reserves (as would happen if

the firm paid out its internal funds). Consistent with this argument, Heider and Ljungqvist (2014)

show that firms affected by state corporate income tax rises increase their debt holdings without

changing their asset base, implying that firms swap debt for equity by paying out the debt

issuance proceeds.20

Our analysis in Table 3 shows that the vast majority of actively-financed payouts are

financed through debt issues rather than via firm-initiated equity issues: In our average sample

year, 90% of firms that simultaneously pay out and actively raise capital do so by issuing net

debt. In terms of dollar magnitudes, the difference is even more stark: 95% of the capital that is

20 In addition to allowing firms to adjust their capital structure without using internal funds that the firms may need to invest or may wish to conserve for precautionary reasons, there is an additional reason why some firms prefer to finance their payouts by issuing debt. This is the case of firms whose cash is overseas and would be subject to repatriation taxes if it were brought back to the U.S. to fund the firms’ payouts.

27

paid out and actively raised during the same year by the same firms is raised via net debt issues.

This is consistent with the notion that capital structure adjustments motivated by agency, risk-

rebalancing, or tax considerations play a key role in explaining the striking prevalence of

actively financed payouts we observe in the data.

4.2.2 Mitigating agency costs of free cash flow

Recall that Table 3, Panel B, shows that as much as 19% of the proceeds of firm-initiated

equity issues are paid out by the same issuing firms during the same year. Needless to say, these

equity-financed payouts have no effect on a firm’s capital structure, and so they cannot be

motivated by the capital structure adjustments discussed in the prior section. How can we explain

this behavior?

Easterbrook (1984) notes that payouts can mitigate agency problems by “compelling firms to

raise new money in order to carry out their activities” (p. 655), thereby subjecting managerial

decisions to the scrutiny of the capital markets. Boards can exercise this monitoring by setting

payouts at a level such that firms pay out all their operating cash flow, with the only exception of

those funds required for routine, maintenance-type investments. By doing so, they force

managers to raise capital to fund any new investment projects (even those that could have been

funded using the firms’ internal funds had these funds not been paid out), thus allowing investors

to decide whether the projects should be funded. This monitoring strategy naturally results in

equity-financed payouts. In fact, to the extent that the monitoring can also be exercised by debt

investors, this strategy can also motivate debt-financed payouts.

To what extent are the actively financed payouts we observe in the data driven by firms with

unusually high levels of investment (and thus unusually low levels of free cash flow) that are

likely undertaking new investment projects? To answer this question, we need to define

“unusually high levels of investment” by establishing a benchmark for the expected level of

routine investment. In Table 5, we use two different approaches to capture a firm’s expected

28

investment. This allows us to examine how the prevalence and economic magnitude of active

payout gaps (our lower bound for actively financed payouts) change if we assume that no firm

invests more than its expected level.

First, in Columns 1 through 4, we follow Daniel, Denis, and Naveen (2010) and measure a

firm’s expected investment as the median ratio of (CAPEX + acquisitions)/ lagged assets of the

firm’s industry in that year multiplied by the firm’s lagged assets. We can then define a firm’s

industry-counterfactual active payout gap, ,IndIitAPG analogously as in equation (3) but

substituting the firm’s free cash flow by the free cash flow it would have if it invested no more

than the median firm in its industry.21 Second, Columns 5 through 8 report an analogous analysis

but in this case our counterfactual gap measure, ,LagIitAPG assumes that no firm invests more

than it did in the previous year. (Analogously as with ,IndIitAPG we do allow firms to invest less

than they did in the previous year.) Finally, for ease of comparison, Columns 9 through 12 of

Table 5 reproduce our active payout gap baseline results from Table 4, which use a firm’s actual

level of investment.

A comparison of the average percentage of payers with an industry-counterfactual gap

(Column 2) to the actual percentage (Column 10) reveals that 61% of payers with an active gap

still have a gap when assuming that they invest no more than their industry median (22.1/36.1 =

61.3). If instead we compare Columns 6 and 10, the percentage of firms that still have a gap

when we assume that no firm invests more than it did the prior year is somewhat larger, at 71%.

In terms of dollar magnitudes, the aggregate sum of counterfactual gaps represent 60% (Column

4; industry-median counterfactual) and 69% (Column 8; prior-year counterfactual) of the actual

dollar magnitude of active payout gaps (Column 12).

21 If a firm invests less than the median firm in its industry, no substitution is made and active payout gap is defined using the firm’s actual investment rather than the higher investment level of its industry peers. This ensures that a firm’s counterfactual gap is always smaller than its actual gap.

29

Taken together, the results in Table 5 indicate that approximately 30% to 40% of the active

payout gaps identified in Table 4 are instances of firms with unusually high investment; these

firms would have no gap if they had just ‘routine’ investment levels. Conversely, had these firms

paid out no capital, they would now need to raise less (or no) capital to fund their investment

surge. However, their boards chose to set payout levels that ensured that they had to raise capital

for any non-routine investment projects rather than being able to use their internal funds to fund

these projects. This allows the boards to mitigate the agency costs of free cash flow.

We can perform an analogous analysis to the one in Table 5 but assuming that no firm

invests less than the median firm in its industry or than it did in the previous year. Table IA.1 in

the Internet Appendix shows the results of this analysis. In this case, the counterfactual

prevalence of active payout gaps increases by between 12 and 14 percentage points, respectively,

relative to its actual value in Table 4. Although these results are only suggestive, they indicate

that between 12% and 14% of payers might be underinvesting in order to avoid having to

actively raise capital to fund their payouts. Importantly, this does not include those payers whose

payout level does force them to actively raise capital and by doing so are shifting away resources

from profitable investments (see Section 4.1.2).

4.2.3 Signaling

Firms might also benefit from actively financing their payouts due to signaling motives. In a

number of payout models, payouts (typically dividends) are used to signal a firm’s quality. Our

goal here is not to discuss all these models; rather, we will examine the extent to which actively

financed payouts arise as a natural prediction of two of the most well-known payout signaling

models: Bhattacharya (1979) and Miller and Rock (1985).

In Bhattacharya’s (1979) model, “a firm ‘should’ be able to meet its dividend commitment

without recourse to extra, ‘unanticipated’ new financing;” however, in states of the world in

which the firm suffers a negative cash flow shock, the dividend “is still paid, and it is assumed

30

that making up the ‘shortfall’ results in [financing] costs to current shareholders” (p.262).

Therefore, in Bhattacharya’s model, financed dividends can arise in the (low probability) event

that a firm is hit by a negative cash flow shock. (To the extent that dividends represent a stronger

commitment than share repurchases (Jagannathan et al., 2000), this model has a harder time

explaining financed repurchases. Indeed, any announced repurchase plans could be cancelled in

the face of a negative shock with little signaling cost.)

Table 6 examines the extent to which actively financed dividends can be explained as

instances of firms that decide to maintain their dividends in the face of negative cash flow

shocks, as in Bhattacharya’s model. To do so, we start by defining a firm’s active dividend gap,

ADGit, similarly as we define its active payout gap, substituting the firm’s total payout in

equation (3) by its dividend payout. This allows us to identify those firms for which the sum of

their free cash flow, cash reduction, and proceeds of employee-initiated equity issues are not

enough to fund their dividend, and thus they have to actively raise capital to close their dividend

gap—in addition to having to close any additional gap created by share repurchases.

Columns 1 through 4 show the prevalence and dollar magnitude of active dividend gaps

throughout our sample period. In addition, Columns 5 through 8 explore how the prevalence and

magnitude of active dividend gaps change if we assume that no firm is less profitable than the

median firm in its industry, following an analogous approach to that used in Table 5. Similarly,

Columns 9 through 12 examine counterfactual active dividend gaps under the assumption that no

firm is less profitable than it was in the previous year.

Two results stand out from Table 6. First, a comparison of Columns 1 through 4 in Table 6 to

our baseline active payout gap results in Table 4, Panel A, reveals that active dividend gaps are

substantially less prevalent than active payout gaps: In our average sample year, less than 10% of

all public firms have an active dividend gap (Column 1 in Table 6) while over 17% of firms have

an active payout gap (Column 5 in Table 4, Panel A). In terms of dollar magnitudes, the

31

aggregate sum of active dividend gaps represents 11% of aggregate payouts (Column 3 in Table

6), while the aggregate sum of active payout gaps represents 26% of aggregate payouts (Column

8 in Table 4, Panel A). Therefore, and consistent with our evidence in Tables 2 and 3, it is not the

case that firms only finance their dividends. Instead, much of payout financing activity

corresponds to share repurchases and thus cannot be explained by Bhattacharya’s signaling

model—or, more generally, by any theory that relies on the notion that cutting dividends is

costly due to signaling or other considerations.

Second, a comparison of the dividend gaps in Columns 1 through 4 to the counterfactual gaps

in Columns 5 through 12 indicates that 78% of firms with a gap would still have a gap if they

had been at least as profitable as their industry peers or as they themselves were in the previous

year. This suggests that most of the dividend gaps we observe in the data do not conform to the

prediction of Bhattacharya’s model that dividend gaps are the result of firms deciding to

maintain their dividend after suffering a negative cash flow shock.

Actively financed payouts—particularly over four-year intervals as we found in Table 4,

Panel B—are not a natural prediction of Miller and Rock’s (1985) signaling model either.

Indeed, these authors write that “because a signaling equilibrium is fully revealing, the model

here presented provides no support, of course, for a policy of sustaining dividends in the face of

earnings disasters” (p. 1045). All in all, we find little support for the notion that an important

driving force behind actively financed payouts is firms’ desire to signal their quality to the

capital markets or, more generally, to avoid dividend cuts at all costs.

4.2.4 Increasing earnings-per-share

There is ample evidence in the literature that (at least some) public-firm managers are

concerned about meeting or beating earnings forecasts (see, e.g., Graham, Harvey, and Rajgopal

(2005) for survey evidence, and Bartov, Givoly, and Hayn (2002) and Bhojraj, Hribar, Picconi,

and McInnis (2009) for empirical evidence). Analysts’ forecasts are typically expressed in terms

32

of earnings-per-share (EPS), and the evidence in Bens, Nagar, Skinner, and Wong (2003)

indicates that one way how firms try to increase EPS is by repurchasing shares.22

To what extent are financed repurchases motivated by firms’ desire to increase EPS?

(Clearly, this motivation plays no role in the case of financed dividends.) Table 3, Panel C,

shows that firms pay out the vast majority of the proceeds of their employee-initiated equity

issues via share repurchases, particularly in recent years. This finding is consistent with the

notion that firms are concerned about the dilutive effect of these issues and aim to undo this

dilution by repurchasing shares. Importantly, though, the fact that stock options are exercised at

below a firm’s stock market price implies that using the proceeds of option exercises to

repurchase shares is generally not enough to undo the dilutive effect of the exercises. As a result,

firms need to fund part of their repurchases by issuing debt or by using internal funds if they

want to repurchase as many shares as options have been exercised.

Almeida, Fos, and Kronlund (2013) find that firms raise their debt levels in order to finance

so-called “EPS-motivated repurchases.” This suggests that the desire to increase EPS may play a

significant role in explaining the striking prevalence of debt-financed repurchases that we

observe in the data.

5. Conclusions

This paper is the first to systematically study the extent to which industrial public firms in the

U.S. rely on the proceeds of security issues to fund their payouts. Our analysis indicates that 42%

of payout payers simultaneously raise funds in the capital markets. At least 30% of aggregate

payouts are not funded with free cash flow but with security issues, and over a third of the

proceeds of firm-initiated debt and equity issues are paid out in the same year. We show that

financed payouts are pro-cyclical, take the form of both dividends and share repurchases, and are

persistent in time—in fact, our findings remain virtually unchanged if we measure firms’ sources 22 This is not to say that all share repurchases are EPS increasing; see Bens et al. (2003) for details.

33

and uses of funds over four-intervals. Our results thus paint a very different picture from the

commonly held view that payouts are first and foremost a vehicle to return free cash flow to

investors (e.g., Grullon, Michaely, and Swaminathan, 2002), except in the rare instances when

firms carry out a leveraged recapitalization (Denis and McKeon, 2012).

While, at first glance, financed payouts may appear “uneconomic as well as pointless”

(Miller and Rock, 1985) and have received little attention in the literature (see the recent surveys

by DeAngelo et al. (2008) and Farre-Mensa et al. (2014)), we show that they are in fact

consistent with some classic payout theories. In particular, we find most support for the notion

that firms use financed payouts to minimize the agency costs of free cash flow (Easterbrook,

1984) and to gradually adjust their capital structures. By contrast, it appears unlikely that payout

financing is motivated by signaling considerations or, more generally, by a desire to avoid costly

dividend cuts—except during recessions. The pervasiveness, economic magnitude, and

persistence of financed payouts suggest that the benefits associated with this behavior might be

more important than it is often assumed.

Our findings suggest that firms’ payout and issuance decisions are intrinsically related, and

thus much can be gained by studying them jointly as interdependent elements of the financial

ecosystem. For instance, how does the source of payout funding affect investors’ reaction to

payout announcements? And, conversely, how does payout financing behavior affect firms’

access and cost of capital? We leave the exploration of these and related questions for future

research.

34

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37

Figure 1. Aggregate payout activity. For each year from 1989 to 2012, the top graph shows the percentage of all public U.S. firms that are payout payers (i.e., pay dividends or repurchase shares), pay a dividend, or repurchase shares during that year. The bottom graph shows the aggregate total payout (the sum of dividends and share repurchases) paid by all public U.S. firms each year, as well as the aggregate dividends and share repurchases. Dollar magnitudes are in billions of dollars of 2012 purchasing power.

0%

20%

40%

60%

80%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Firm counts (% of all public firms)

Payout payers Dividend payers Share repurchasers

0

100

200

300

400

500

600

700

800

900

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Dollar magnitudes (billions of 2012 $)

Total payout Dividends Share repurchases

38

Figure 2. Aggregate capital raising activity. For each year from 1989 to 2012, the top graph shows the percentage of firms with net debt issues (debt issues net of debt repurchases), firm-initiated equity issues, and employee-initiated equity issues. The bottom graph shows the aggregate dollar amount raised via net debt issues, firm-initiated equity issues, and employee-initiated equity issues by all public U.S. firms each year. Dollar magnitudes are in billions of dollars of 2012 purchasing power.

0%

20%

40%

60%

80%

100%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Firm counts (% of all public firms)

Net debt issuers Firm-initiated equity issuers Employee-initiated equity issuers

0

50

100

150

200

250

300

350

400

450

500

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Dollar magnitudes (billions of 2012 $)

Net debt issues Firm-initiated equity issues Employee-initiated equity issues

39

Figure 3. Simultaneous payouts and firm-initiated security issues. For each year from 1989 to 2012, the solid line in the top graph plots the percentage of all public firms that pay out capital and initiate security issues during the same year; the dotted line plots the percentage of all payout payers that initiate security issues during the same year; and the dashed line plots the percentage of all firms initiating security issues that pay out capital during the same year. The bottom graph plots, for each year t, the aggregate magnitude of the simultaneous payouts and firm-initiated security issues of all public U.S. firms (i.e., the sum of min{AIit, TPit} across all public firms, where AI captures the proceeds of firm-initiated security issues and TP is total payout). Dollar magnitudes are in billions of dollars of 2012 purchasing power.

0%

20%

40%

60%

80%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Simultaneous payouts and firm-initiated issues (firm counts)

% of all public firms that pay out capital and initiate securities issues

% of all payout payers that initiate securities issues

% of all firms initiating securities issues that pay out capital

0

50

100

150

200

250

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Simultaneous payouts and firm-initiated issues (dollar magnitude in billions of 2012 $)

Aggregate sum of simultaneous payouts and firm-initiated securities issues

40

Figure 4. Can firms fund their payouts without actively raising capital? For each year from 1989 to 2012, the solid line in the top graph plots the percentage of all public firms that have an active payout gap, i.e., firms with APGit ≡ min{max{TPit – (FCFit + CRit + EEit), 0}, TPit} > $100,000; these firms require the proceeds of firm-initiated security issues to fund their payouts. (TP is total payout; FCF is free cash flow, the sum of operating cash flow and investment cash flow; CR is cash reduction; and EE captures the proceeds of employee-initiated equity issues.) The dotted line in the top graph plots the percentage of all payout payers that have an active payout gap. The bottom graph plots, for each year t, the aggregate magnitude of the combined active payout gaps of all public U.S. firms (i.e., the sum of APGit across all public firms). Dollar magnitudes are in billions of dollars of 2012 purchasing power.

0%

20%

40%

60%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Active payout gap (firm counts)

% of all public firms that have an active payout gap

% of all payout payers that have an active payout gap

0

50

100

150

200

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Active payout gap (dollar magnitude in billions of 2012 $)

Aggregate sum of active payout gaps

41

Figure 5. Actively financed payouts over time. For each year from 1989 to 2012, the top graph plots the upper and lower bounds of the percentage of payers with actively financed payouts; the bottom graph plots the upper and lower bounds of the aggregate magnitude of the combined actively financed payouts paid by all public U.S. firms. (Dollar magnitudes are in billions of dollars of 2012 purchasing power.) As discussed in Section 3.2, we define the upper bound of a firms’ actively financed payout as the amount of capital that the firm simultaneously raises and pays out (see Figure 3); the lower bound is defined as the firm’s active payout gap (see Figure 4).

0%

20%

40%

60%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Actively financed payouts (firm counts - % of all payers)

Actively financed payouts - upper bound Actively financed payouts - lower bound

0

50

100

150

200

250

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Actively financed payouts (dollar magnitude in billions of 2012 $)

Actively financed payouts - upper bound Actively financed payouts - lower bound

42

Table 1. Aggregate payout out and capital raising activity. Panel A shows the percentage of all public U.S. firms that pay out capital (columns 1 through 3), and the percentage of firms that raise capital (columns 4 through 8). Specifically, for each column, we compute the relevant annual percentage of firms that pay out or raise capital each year in our sample period, and then report these annual percentages averaged over four-year intervals to conserve space. Analogously, Panel B shows the aggregate annual dollar amount (in billions of dollars of 2012 purchasing power) paid out or raised by all public U.S. firms, also averaged over four-year intervals to conserve space. Financial firms and utilities are excluded throughout the paper. Panel A. Firm counts.

Annual percentage of all public firms that …

pay out capital via … raise capital via …

No. public firms

dividends or share repur-chases

dividends share repur-chases

any security

issue

any firm-initiated

issue net debt

firm-initiated equity

employee-initiated

equity Annual figures

averaged over … (1) (2) (3) (4) (5) (6) (7) (8)

1989-1992 3,626 45.6% 36.3% 24.5% 66.6% 45.7% 36.7% 13.8% 41.1%

1993-1996 4,314 42.6% 32.3% 23.5% 78.0% 51.6% 40.3% 18.1% 54.9%

1997-2000 4,537 47.0% 27.1% 35.7% 83.1% 52.8% 42.7% 16.7% 64.0%

2001-2004 3,602 45.8% 26.5% 32.7% 83.5% 37.7% 27.8% 14.3% 72.5%

2005-2008 3,109 52.9% 32.1% 40.3% 88.0% 41.5% 33.5% 11.9% 77.7%

2009-2012 2,627 57.1% 34.3% 42.7% 79.9% 37.2% 28.4% 12.1% 67.2%

all years 3,636 48.5% 31.4% 33.2% 79.8% 44.4% 34.9% 14.5% 62.9%

Panel B. Dollar magnitudes.

Aggregate annual dollar amount (in billions of 2012 dollars) that is …

paid out via … raised via …

dividends or share repur-chases

dividends share repur-chases

any security

issue

any firm-initiated

issue net debt

firm-initiated equity

employee-initiated equity

Annual figures

averaged over … (1) (2) (3) (4) (5) (6) (7) (8)

1989-1992 159.6 107.8 51.8 206.9 189.7 155.9 33.7 17.2

1993-1996 191.4 115.8 75.6 266.9 239.4 193.0 46.4 27.4

1997-2000 315.9 128.7 187.2 502.8 445.9 374.4 71.4 56.9

2001-2004 308.7 134.9 173.8 352.4 292.6 245.6 47.0 59.8

2005-2008 628.3 194.9 433.4 443.8 362.1 321.4 40.7 81.7

2009-2012 518.5 218.0 300.5 329.7 270.9 238.0 32.9 58.8

all years 353.7 150.0 203.7 350.4 300.1 254.7 45.4 50.3

43

Table 2. Simultaneous payouts and security issues. This table examines the extent to which firms simultaneously pay out and raise capital during the same fiscal year. In Panel A, we consider all security issues; specifically, SI is the sum of the proceeds of positive net debt issues (i.e., max{debt issued – debt repurchased, 0}), firm-initiated equity issues, and employee-initiated equity issues. In Panel B, we focus only on instances in which firms actively raise capital by considering only firm-initiated security issues; AI is thus defined as the sum of the proceeds of positive net debt issues and firm-initiated equity issues. On the payout side, Columns 1 through 5 examine total payout (TP) without distinguishing between dividends and share repurchases; Columns 6 and 7 focus on dividends only (Div); and Columns 8 and 9 focus on share repurchases (with Rep denoting the dollar amount of shares repurchased).

Panel A. All security issues.

  Firm counts Dollar magnitudes

% public firms

that raise & pay

out capital

% payout payers

that also raise

capital

% firms raising capital

that also pay out capital

Aggregate sum of min{SI, TP} over …

Aggregate sum of min{SI, Div} over …

Aggregate sum of min{SI, Rep} over …

Annual figures

averaged over … 

aggregate sum of

TP

aggregate sum of SI

aggregate sum of

Div

aggregate sum of SI

aggregate sum of

Rep

aggregate sum of SI

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1989-1992 32.9% 72.2% 49.5% 51.4% 39.7% 56.6% 29.8% 62.5% 15.6%

1993-1996 33.7% 79.2% 43.3% 41.8% 29.9% 48.4% 21.3% 49.6% 13.7%

1997-2000 39.4% 83.8% 47.4% 48.5% 30.9% 62.3% 16.2% 53.9% 20.4%

2001-2004 39.3% 85.7% 47.1% 36.3% 32.2% 50.8% 19.9% 40.4% 20.3%

2005-2008 47.6% 90.2% 54.2% 33.9% 48.5% 51.9% 23.3% 39.6% 38.9%

2009-2012 47.5% 83.1% 59.4% 31.8% 50.0% 44.3% 29.6% 40.8% 36.9%

all years 40.1% 82.4% 50.1% 40.6% 38.5% 52.4% 23.3% 47.8% 24.3%

Panel B. Only firm-initiated security issues (net debt and firm-initiated equity).

  Firm counts Dollar magnitudes

% public firms that

actively raise & pay out capital

% payout payers

that also actively

raise capital

% firms actively raising capital

that also pay out capital

Aggregate sum of min{AI, TP} over …

Aggregate sum of min{AI, Div} over …

Aggregate sum of min{AI, Rep} over …

Annual figures

averaged over … 

aggregate sum of

TP

aggregate sum of AI

aggregate sum of

Div

aggregate sum of AI

aggregate sum of

Rep

aggregate sum of AI

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1989-1992 21.1% 46.3% 46.2% 45.7% 38.5% 50.5% 29.0% 53.2% 14.6%

1993-1996 20.6% 48.4% 40.0% 34.3% 27.4% 39.1% 19.2% 39.0% 12.0%

1997-2000 23.8% 50.7% 45.1% 38.9% 27.9% 51.1% 14.9% 41.3% 17.6%

2001-2004 15.5% 33.7% 40.9% 24.9% 26.6% 35.8% 16.8% 24.1% 14.6%

2005-2008 20.7% 39.1% 49.8% 24.1% 42.0% 36.1% 19.8% 26.7% 32.2%

2009-2012 19.8% 34.1% 52.2% 23.1% 44.3% 32.5% 26.4% 28.7% 32.2%

all years 20.2% 42.1% 45.7% 31.8% 34.5% 40.9% 21.0% 35.5% 20.5%

44

Table 3. Simultaneous payouts and security issues – the role of debt and equity. This table examines which securities firms issue when they simultaneously pay out and raise capital during the same year. Panel A focuses on net debt issues, with ND denoting the proceeds of positive net debt issues (i.e., max{debt issued – debt repurchased, 0}). Panel B examines firm-initiated equity issues, with FE denoting the proceeds of firm-initiated equity issues, while Panel C does the same for employee-initiated equity issues, with EE denoting the proceeds of these issues. Columns 1 through 5 focus on total payout (TP) without distinguishing between dividends and share repurchases, columns 6 and 7 focus on dividends (Div), and columns 8 and 9 on share repurchases (Rep). Panel A. Net debt issues.

  Firm counts Dollar magnitudes

% public firms that

issue net debt & pay out capital

% payout payers

that also issue net

debt

% firms issuing net debt that also pay out capital

Aggregate sum of min{ND, TP} over …

Aggregate sum of min{ND, Div} over …

Aggregate sum of min{ND, Rep} over …

Annual figures

averaged over … 

aggregate sum of

TP

aggregate sum of

ND

aggregate sum of

Div

aggregate sum of

ND

aggregate sum of

Rep

aggregate sum of

ND

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1989-1992 18.6% 40.7% 50.5% 39.5% 41.0% 44.2% 31.4% 46.8% 15.5%

1993-1996 18.3% 43.0% 45.5% 31.6% 31.6% 36.7% 22.5% 36.2% 13.8%

1997-2000 21.5% 45.7% 50.4% 38.1% 32.4% 50.7% 17.5% 40.2% 20.3%

2001-2004 13.4% 29.2% 48.1% 22.6% 28.9% 33.1% 18.7% 21.8% 15.8%

2005-2008 19.3% 36.4% 57.4% 23.7% 46.9% 35.8% 22.3% 26.3% 36.0%

2009-2012 17.9% 30.8% 61.8% 22.7% 50.4% 31.8% 30.3% 28.4% 36.2%

all years 18.2% 37.6% 52.3% 29.7% 38.5% 38.7% 23.8% 33.3% 22.9%

Panel B. Firm-initiated equity issues.

  Firm counts Dollar magnitudes

% public firms that issue

firm-init. equity & pay out capital

% payout payers

that also issue firm-

initiated equity

% firms issuing firm-

initiated equity

that also pay out capital

Aggregate sum of min{FE, TP} over …

Aggregate sum of min{FE, Div} over …

Aggregate sum of min{FE, Rep} over …

Annual figures

averaged over … 

aggregate sum of

TP

aggregate sum of FE

aggregate sum of

Div

aggregate sum of FE

aggregate sum of

Rep

aggregate sum of FE

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1989-1992 4.3% 9.4% 30.7% 8.2% 40.6% 8.7% 28.6% 10.0% 18.7%

1993-1996 4.2% 9.8% 22.9% 3.6% 14.2% 3.9% 9.7% 3.4% 5.9%

1997-2000 4.2% 9.0% 25.4% 2.2% 10.1% 2.5% 4.2% 2.3% 6.8%

2001-2004 3.3% 7.3% 23.4% 3.1% 18.2% 3.3% 8.7% 3.2% 10.6%

2005-2008 2.6% 4.9% 22.1% 1.3% 18.2% 2.7% 12.1% 0.6% 6.3%

2009-2012 2.9% 5.2% 24.0% 0.7% 11.0% 1.2% 8.7% 0.4% 5.2%

all years 3.6% 7.6% 24.7% 3.2% 18.7% 3.7% 12.0% 3.3% 9.0%

45

Panel C. Employee-initiated equity issues.

  Firm counts Dollar magnitudes

% public firms that

issue emp.-init. equity & pay out capital

% payout payers that also issue employee- initiated equity

% firms issuing

employee- initiated equity

that also pay out capital

Aggregate sum of min{EE, TP} over …

Aggregate sum of min{EE, Div} over …

Aggregate sum of min{EE, Rep} over …

Annual figures

averaged over … 

aggregate sum of

TP

aggregate sum of

EE

aggregate sum of

Div

aggregate sum of

EE

aggregate sum of

Rep

aggregate sum of

EE

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1989-1992 22.9% 50.4% 56.1% 9.1% 83.5% 11.7% 74.1% 16.5% 48.2%

1993-1996 25.8% 60.7% 47.2% 11.0% 76.6% 15.4% 65.6% 16.5% 43.6%

1997-2000 31.6% 67.4% 49.5% 12.1% 68.1% 18.7% 43.2% 16.8% 56.1%

2001-2004 35.7% 77.9% 49.3% 13.9% 72.7% 20.6% 46.5% 19.2% 56.2%

2005-2008 43.8% 83.0% 56.7% 11.1% 85.9% 23.2% 55.4% 15.0% 79.7%

2009-2012 42.3% 74.1% 62.9% 9.8% 85.9% 17.3% 64.3% 15.2% 74.6%

all years 33.7% 68.9% 53.6% 11.2% 78.8% 17.8% 58.2% 16.6% 59.7%

46

Table 4. Can firms fund their payouts without raising capital? This table examines whether firms with simultaneous payouts and security issues could have funded their payouts without the proceeds of these issues. To do so, Columns 1 and 2 examine the prevalence of firms with a payout gap, i.e., firms with PGit ≡ min{max{TPit – (FCFit + CRit), 0}, TPit} > $100,000 (denoted PGit >> 0), while columns 3 and 4 examine the dollar magnitude of these gaps relative to total payouts. Columns 5 and 6 examine the prevalence of firms with an active payout gap, i.e., firms with APGit ≡ min{max{TPit – (FCFit + CRit + EEit), 0}, TPit} >> 0, while columns 7 and 8 examine the dollar magnitude of these active gaps relative to total payouts. (TP is total payout; FCF is free cash flow, the sum of operating cash flow and investment cash flow; CR is cash reduction; and EE captures the proceeds of employee-initiated equity issues.) In Panel A, PG and APG are defined annually and, similarly as in Tables 1 through 3, we report annual counts or magnitudes averaged over four years to conserve space. In contrast, in Panel B, we define gaps (and also total payouts) over four-year intervals, as follows:

3 3 3

3

0 0 0

min max ,0 , 0tit it j it j it j it j

j j j

PG TP FCF CR TP

(and analogously for active gaps).

Payout gaps (PG) (i.e., firms that cannot fund their payout

without raising capital)

Active payout gaps (APG) (i.e., firms that cannot fund their payout

without actively raising capital)

Firm counts Dollar magnitudes Firm counts Dollar magnitudes

% of public

firms with a payout

gap

% of payout payers with a payout

gap

Average of the ratio

PG /TP across all firms with

a gap

Aggregate sum of PG

over aggregate sum of TP paid by all

public firms

% of public

firms with an active payout

gap

% of payout payers with an active payout

gap

Average of the ratio

APG /TP across all firms with an active

gap

Aggregate sum of APG

over aggregate sum of TP paid by all

public firms

(1) (2) (3) (4) (5) (6) (7) (8)

Panel A. Gap defined annually (we report annual figures averaged over four-year intervals)

1989-1992 20.3% 44.6% 80.7% 41.0% 18.3% 40.1% 83.5% 38.0%

1993-1996 21.4% 50.4% 81.3% 32.7% 18.6% 43.7% 85.0% 29.8%

1997-2000 26.1% 55.6% 80.0% 40.5% 21.9% 46.5% 84.3% 35.6%

2001-2004 17.9% 39.1% 71.1% 22.2% 12.2% 26.7% 81.2% 18.2%

2005-2008 25.9% 49.0% 62.3% 24.6% 17.7% 33.5% 74.1% 19.6%

2009-2012 21.6% 37.2% 61.5% 19.6% 15.1% 25.9% 73.6% 15.3%

average of all years 22.2% 46.0% 72.8% 30.1% 17.3% 36.1% 80.3% 26.1%

Panel B. Gap defined over four-year intervals (sources and uses of capital aggregated over four years)

1989-1992 36.2% 52.6% 78.3% 41.0% 32.8% 47.6% 80.0% 36.3%

1993-1996 40.8% 62.3% 82.4% 33.2% 36.6% 55.9% 83.4% 28.0%

1997-2000 52.7% 71.6% 82.4% 43.2% 46.4% 63.0% 83.9% 37.0%

2001-2004 33.0% 47.4% 77.4% 19.9% 25.1% 36.1% 79.6% 15.1%

2005-2008 46.3% 62.1% 66.0% 28.2% 36.6% 49.1% 68.6% 20.6%

2009-2012 35.7% 47.4% 64.3% 20.5% 27.5% 36.5% 71.7% 14.5%

average of all four-year intervals 40.8% 57.2% 75.1% 31.0% 34.2% 48.0% 77.9% 25.3%

47

Table 5. The role of investment in explaining active payout gaps. This table examines the extent to which the active payout gaps identified in Table 4 are the result of firms with unusually high levels of investment. Specifically, the panel replicates the analysis shown in Columns 5 through 8 of Table 4, Panel A, but using two modified definitions of active payout gap. In Columns 1 through 4, we assume that no firm invests more than the median firm in its industry, thus defining a firm’s modified active payout gap as follows: IndI

itAPG ≡

min{max{TPit – (OCFit + max{ICFit, Industry median ICFit}+ CRit + EEit), 0}, TPit}, where in Industry median ICFit we substitute CAPEX and acquisitions (both of which enter the definition of investment cash flow, ICFit, with a negative sign) by the median ratio of (CAPEX + acquisitions)/lagged assets of the firm’s industry in that year multiplied by the firm’s lagged assets. (TP is total payout; OCF is operating cash flow; CR is cash reduction; and EE captures the proceeds of employee-initiated equity issues. Industry is defined at the 2-digit SIC level.) In Columns 5 through 8, we do the same but in this case we assume that no firm invests more than it did in the previous year; our modified definition of active payout gap is then: LagI

itAPG ≡ min{max{TPit – (OCFit + max{ICFit, Lagged

ICFit}+ CRit + EEit), 0}, TPit}, where in Lagged ICFit we substitute CAPEX and acquisitions by their lagged values. For ease of comparison, Columns 9 through 12 reproduce the baseline active payout gaps results we show in Columns 5 through 8 of Table 4, Panel A, which use a firm’s actual level of investment.

Active payout gaps

We assume that no firm invests more than the median firm in its industry

   We assume that no firm invests more than it did in the previous year

  Actual level of investment

Counts Dollar magnitudes Counts Dollar magnitudes Counts Dollar magnitudes

% of public firms

with an active payout

gap

% of payout payers with an active payout

gap

Average across all

firms with a

modified active

gap of the ratio

APGIndI over TP

Aggregate sum of APGIndI

over aggregate

sum of TP

% of public firms

with an active payout

gap

% of payout payers with an active payout

gap

Average across all

firms with a

modified active

gap of the ratio

APGLagI over TP

Aggregate sum of APGLagI

over aggregate

sum of TP

% of public firms

with an active payout

gap

% of payout payers with an active payout

gap

Average across all

firms with an active

gap of the ratio APG over TP

Aggregate sum of

APG over aggregate

sum of TP

   

Annual figures

averaged over … (1) (2) (3) (4) (5) (6) (7) (8)    (9) (10) (11) (12)

1989-1992 11.3% 24.8% 77.8% 21.9% 14.0% 30.6% 79.4% 28.4% 18.3% 40.1% 83.5% 38.0%

1993-1996 12.1% 28.5% 80.5% 19.4% 13.2% 31.0% 81.7% 20.4% 18.6% 43.7% 85.0% 29.8%

1997-2000 14.5% 30.8% 78.8% 22.2% 16.3% 34.7% 81.0% 24.6% 21.9% 46.5% 84.3% 35.6%

2001-2004 6.8% 14.8% 75.7% 9.6% 8.2% 17.8% 75.5% 11.8% 12.2% 26.7% 81.2% 18.2%

2005-2008 10.3% 19.5% 65.6% 12.4% 12.0% 22.6% 68.0% 13.5% 17.7% 33.5% 74.1% 19.6%

2009-2012 8.3% 14.2% 66.0% 7.9% 9.6% 16.5% 67.1% 9.5% 15.1% 25.9% 73.6% 15.3%

all years 10.6% 22.1% 74.1% 15.5% 12.2% 25.5% 75.4% 18.0% 17.3% 36.1% 80.3% 26.1%

48

Table 6. The role of negative cash flow shocks in explaining active dividend gaps. This table examines the prevalence and economic magnitude of active dividend gaps and the extent to which these are the result of firms deciding to maintain their dividends in the face of negative cash flow shocks. First, in Columns 1 through 4, we define a firm’s dividend gap, ADGit, analogously to the way we define its active payout gap: ADGit ≡ min{max{Divit – (FCFit + CRit + EEit), 0}, Divit}. (Div is dividend payout; FCF is free cash flow; CR is cash reduction; EE captures the proceeds of employee-initiated equity issues; and TP is total payout.) Next, in Columns 5 through 8, we use a modified version of a firm’s active dividend gap that assumes that no firm is less profitable than the median firm in its industry: IndO

itADG ≡ min{max{Divit – (max{OCFit, Industry median OCFit}

+ ICFit + CRit + EEit), 0}, Divit}, where Industry median OCFit is defined as the median ratio of operating cash flow/lagged assets of the firm’s industry in that year multiplied by the firm’s lagged assets. (Industry is defined at the 2-digit SIC level.) Similarly, in Columns 9 through 12, we assume that no firm is less profitable than it was in the previous year; our modified definition of active dividend gap is then: LagO

itADG ≡ min{max{Divit – (max{OCFit, OCFit-1} + ICFit +

CRit + EEit), 0}, Divit}.

Active dividend gaps

Actual level of profitability    We assume that no firm is less profitable than the

median firm in its industry    We assume that no firm is less profitable than it

was in the previous year

Counts Dollar magnitudes Counts Dollar magnitudes Counts Dollar magnitudes

% of public firms

with an active

dividend gap

% of dividend payers with an active

dividend gap

Aggregate sum of

ADG over aggregate sum of TP

Aggregate sum of

ADG over aggregate

sum of Div

% of public firms

with an active

dividend gap

% of dividend payers with an active

dividend gap

Aggregate sum of

ADGIndO over

aggregate sum of TP

Aggregate sum of

ADGIndO over

aggregate sum of

Div

% of public firms

with an active

dividend gap

% of dividend payers with an active

dividend gap

Aggregate sum of

ADGLagO over

aggregate sum of TP

Aggregate sum of

ADGLagO over

aggregate sum of

Div Annual figures

averaged over … (1) (2) (3) (4) (5) (6) (7) (8)    (9) (10) (11) (12)

1989-1992 13.1% 36.1% 22.5% 33.4% 10.3% 28.4% 19.8% 29.4% 10.3% 28.2% 18.0% 26.7%

1993-1996 12.8% 39.8% 16.1% 26.1% 10.3% 32.0% 13.7% 22.3% 10.4% 32.2% 13.6% 22.1%

1997-2000 10.9% 40.1% 13.2% 32.5% 8.9% 32.7% 12.1% 29.9% 8.8% 32.4% 10.9% 26.8%

2001-2004 5.9% 22.5% 7.5% 17.2% 4.2% 15.9% 6.9% 15.6% 4.3% 16.2% 6.6% 15.0%

2005-2008 7.9% 24.7% 4.3% 14.3% 5.9% 18.5% 3.8% 12.6% 6.3% 19.5% 3.8% 12.6%

2009-2012 6.7% 19.3% 4.4% 9.6% 5.1% 14.4% 4.0% 8.7% 5.1% 14.5% 3.7% 8.0%

all years 9.6% 30.4% 11.4% 22.2% 7.4% 23.6% 10.1% 19.8% 7.5% 23.8% 9.4% 18.6%

INTERNET APPENDIX

(NOT INTENDED FOR PUBLICATION)

Table IA.1. Avoiding active payout gaps by underinvesting? This table examines whether the prevalence and economic magnitude of active payout gaps identified in Table 4 would be greater if firms invested in line with their industry or what they invested in the previous year. Specifically, the panel replicates the analysis shown in Columns 5 through 8 of Table 4, Panel A, but using two modified definitions of active payout gap. In Columns 1 through 4, we assume that no firm invests less than the median firm in its industry, thus defining a firm’s modified active payout gap as follows: IndI

itAPG ≡ min{max{TPit – (OCFit + min{ICFit, Industry median ICFit}+ CRit + EEit), 0}, TPit}, where

in Industry median ICFit we substitute CAPEX and acquisitions (both of which enter the definition of investment cash flow, ICFit, with a negative sign) by the median ratio of (CAPEX + acquisitions)/lagged assets of the firm’s industry in that year multiplied by the firm’s lagged assets. (TP is total payout; OCF is operating cash flow; CR is cash reduction; and EE captures the proceeds of employee-initiated equity issues. Industry is defined at the 2-digit SIC level.) In Columns 5 through 8, we do the same but in this case we assume that no firm invests more than it did in the previous year; our modified definition of active payout gap is then: LagI

itAPG ≡ min{max{TPit – (OCFit + min{ICFit, Lagged ICFit}+ CRit + EEit), 0}, TPit}, where in Lagged ICFit we substitute CAPEX and

acquisitions by their lagged values. For ease of comparison, Columns 9 through 12 reproduce the baseline active payout gaps results we show in Columns 5 through 8 of Table 4, Panel A, which use a firm’s actual level of investment when defining its active payout gap.

Active payout gaps

We assume that no firm invests less than the median firm in its industry

   We assume that no firm invests less than it did last year

  Actual level of investment

Counts Dollar magnitudes Counts Dollar magnitudes Counts Dollar magnitudes

% of public firms

with an active payout

gap

% of payout payers with an active payout

gap

Average across all

firms with an active

gap of the ratio

APGIndI+ over TP

Aggregate sum of

APGIndI+ over

aggregate sum of

TP

% of public firms

with an active payout

gap

% of payout payers with an active payout

gap

Average across all

firms with an active

gap of the ratio

APGLagI+ over TP

Aggregate sum of

APGLagI+ over

aggregate sum of

TP

% of public firms

with an active payout

gap

% of payout payers with an active payout

gap

Average across all

firms with an active

gap of the ratio APG over TP

Aggregate sum of

APG over aggregate

sum of TP Annual

figures averaged over … (1) (2) (3) (4) (5) (6) (7) (8)    (9) (10) (11) (12)

1989-1992 22.9% 50.1% 82.2% 42.4% 24.2% 53.1% 84.8% 45.4% 18.3% 40.1% 83.5% 38.0%

1993-1996 23.8% 55.8% 84.2% 37.5% 23.2% 54.5% 85.5% 35.4% 18.6% 43.7% 85.0% 29.8%

1997-2000 28.2% 60.0% 83.5% 42.9% 28.2% 59.9% 86.1% 42.1% 21.9% 46.5% 84.3% 35.6%

2001-2004 17.1% 37.4% 78.8% 22.9% 19.3% 42.1% 81.6% 26.4% 12.2% 26.7% 81.2% 18.2%

2005-2008 24.9% 47.1% 70.1% 25.7% 25.9% 48.8% 75.8% 26.4% 17.7% 33.5% 74.1% 19.6%

2009-2012 21.2% 36.5% 70.8% 20.2% 23.8% 41.3% 75.3% 23.1% 15.1% 25.9% 73.6% 15.3%

all years 23.0% 47.8% 78.3% 31.9% 24.1% 50.0% 81.5% 33.1% 17.3% 36.1% 80.3% 26.1%