OPTIMAL PAYOUT POLICY UNDER AN INTEGRATED MODEL OF THE FINANCIAL DECISION CALCULUS OF THE CORPORATION

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Abstract

The Dividend Irrelevancy Proposition appears to mean that it is not possible to find an optimal payout ratio.  But there is an important exception.  If the corporation is growing at a constant rate, and the management forswears recourse to external equity finance, its retention ratio will be defined by its optimal investment strategy.  The payout ratio is the complement of the implied optimal retention ratio

The present paper develops a model which maximises market value added by determining an optimal gearing ratio for the corporation, and its optimal periodic capital expenditure outlays.  A steady state growth path is established in accordance with which each of the corporation’s accounting and stock market magnitudes grows at a constant rate, and each of its accounting and stock market ratios, including its payout ratio, remains constant over time.

Although the payout ratio does not have the status of a decision variable of the model, the following claims at least may be made for it:

1. it results from an optimisation process
2. it provides a valid prediction of how the well-managed corporation may be expected to behave in relation to its distribution policy: the corporation simply pays out that portion of its earnings it can afford after prioritising its investment spend each period

The central simulation then shows how the payout ratios of corporations with different growth rates will trace out a U-shaped curve.  The slowest and fastest growing companies will have the highest ratios, including 100% in the case of zero growth, of course.  In between, the payout ratio dips to about one third. 

Generally, the faster the corporation grows, the more it will want to invest, and the greater the proportion of its earnings it will need to retain to finance this process.  However, the fastest growing corporations will trade on very high P-E multiples, and have correspondingly high market capitalisations.  This supports a correspondingly high proportion of debt in the financing mix, which reduces the need for internally generated funds, and this in turn enhances the distribution potential.  The model then demonstrates how the fastest growing companies might indeed be inclined to pay out their earnings in full. 

Each of the corporations in the simulation adopts the same gearing ratio (debt to enterprise value), and is priced by the stock market to generate the same total rate of return: this is the equity cost of capital, which is also an output of the model.