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What do capital structure models tell us about the payout policy?

by Dr Shiqi Chen, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance

Graph showing variations in payout policy with arrows indicator upward pressure.

At the beginning of the COVID-19 (coronavirus) crisis, a massive drop in global dividends occurred as firms struggled to preserve cash in this unprecedented world health crisis. While Royal Dutch Shell and British Petroleum cut their dividend for the first time since the Second World War and the 2010 Deepwater Horizon Disaster, respectively, Exxon continued its thirty-seventh increase in the dividend. The CEO of Chevron, Michael Wirth, said that “the dividend is our number one priority and it is very secure. We’re taking actions to preserve cash. It will have some impact on production in the near term, but we’ve stayed with our financial priorities, which include protecting the dividend.” Eighteen months since the outbreak of the pandemic in March 2020, firms now are on track to recover dividends. Shell’s dividend now stands at 24 cents, which has increased by 50% compared to 16 cents since the first cut in 2020. The global dividend is forecast to bounce back to the pre-coronavirus level as early as this year.

Shiqi Chen.
Dr Shiqi Chen

This event highlights the already well-documented fact of firms’ payout policy: dividend smoothing, that is, once dividend is in place, firms are reluctant to cut it. Brav et al. (2001) conduct a survey on 384 financial executives and in-depth interviews with another 23, and conclude that “maintaining the dividend level is a priority on par with investment decisions. Managers express a strong desire to avoid dividend cuts, except in extraordinary circumstances”. Skinner (2008) includes repurchases and shows that the aggregate payout is also smooth. However, the payout policy is not determined in isolation. Indeed, a firm’s investment, financing and payout decisions are interdependent through the sources and uses of funds constraints. The constraint reduces the degree of freedom in the decision-making process. This implies that managing payout is going to have a ripple effect on the other two policies. In turn, if a firm adheres to a leverage target, shocks are absorbed by payout and investment, making payout smoothing hard to achieve. Thus, interesting questions arise – whether the existing capital structure models can be reconciled with payout smoothing? What are the implications for financing and investment decisions when firms stick with a particular payout policy and vice versa?

Chen and Lambrecht (2021) develop a framework to examine the dynamic interactions of the three corporate policies. More specifically, rather than deriving the firm’s optimal policies, this paper takes the selected payout or financing policy as exogenously given and examines the resultant implications on the remaining policy through the sources and uses of funds constraint, and the balance sheet identity. With this simple approach, the paper discovers interesting results and generates empirical predictions that can be brought to the data directly.

The paper shows that a positive (negative) net debt ratio (NDR) target can amplify (dampens) the influence of income shocks. First, if payout is given, positive (negative) gearing requires the firm to rebalance by investing (disinvesting) after positive income shocks, implying a procyclical (countercyclical) investment strategy. Second, suppose investment is fixed, a firm with a positive (negative) NDR target displaces a procyclical (countercyclical) payout policy. Both results suggest that a very negative NDR is less empirically plausible. While payout smoothing is hard to achieve under a very negative leverage target, the paper shows that it can be achieved if the investment policy is positively correlated with net income. Furthermore, the paper shows that a Lintner-style payout smoothing can be reconciled with a leverage target if the firm only partially adjusts toward the target. The maximum level of payout smoothing is achieved if the speed of adjustment is between zero and one-half. On the contrary, if the firm adopts a pecking-order style financing strategy, payout smoothing is easy to accomplish as long as the debt capacity is not yet reached. Under such circumstances, the incomes shocks are completely absorbed by changes in net debt, indicating that the greater degree of payout smoothing, the stronger negative relation between net incomes and variations in net debt.

Based on the analysis, the paper categorises firms into different types.

  1. It predicts that firms with a significant positive net debt ratio target often have a stable, high net income and easy access to the capital market as a frequent rebalancing of the capital structure is required. In addition, these firms’ risky assets should be either very liquid to enable asset sales or tangible to serve as collateral.
  2. Mature, stable and lack of growth opportunities firms are more likely to adopt a net debt ratio target around zero. These firms maintain payout levels by adopting a procyclical investment policy. Investment and payout are financed via retained income.
  3. The paper conjectures that firms with a significant negative net debt ratio target are rare because a very negative NDR implies empirically implausible features.
  4. Young and private firms that are not yet at their stationary states are candidates for a pecking-order style capital structure. With a pecking-order preference, the firm’s NDR can be changed freely in response to heavy investment needs and income shocks. Firms that have just reached maturity are also candidates for pecking-order financing. They sit on a pile of cumulated debt and start paying down the debt, thereby reducing NDR to a long-run optimal NDR target.

All these results suggest that firms can switch between different capital structure regimes during their life cycle.


Brav, A., Graham, J.R., Harvey, C.R. and Michaely, R. (2005) “Payout policy in the 21st century.” Journal of Financial Economics, 77(3): 483-527

Chen, S. and Lambrecht, B.M. (2021) “Do capital structure models square with the dynamics of payout?” Social Science Research Network Paper

Oliver, J. (2021) “UK dividends recovery lags behind other markets.” Financial Times, 30 July 2021

Sheppard, D. (2021) “Shell raises dividend and launches share buybacks after oil prices jump.” Financial Times, 29 July 2021

Skinner, D.J. (2008) “The evolving relation between earnings, dividends, and stock repurchases.” Journal of Financial Economics, 87(3): 582-609

Stevens, P. (2020) “Chevron CEO says the dividend is the company’s No. 1 priority and is ‘very secure’.” CNBC, 24 March 2020