Optimal Payout Ratio under Uncertainty and the Flexibility Hypothesis: Theory, Empirical Evidence, and Implications

Cheng Few Lee, Manak C. Gupta, Hong-Yi Chen and Alice C. Lee

Chapter 111 in Handbook of Investment Analysis, Portfolio Management, and Financial Derivatives:In 4 Volumes, 2024, pp 3681-3731 from World Scientific Publishing Co. Pte. Ltd.

Abstract: Following the dividend flexibility hypothesis used by DeAngelo and DeAngelo (2006), Blau and Fuller (2008), and others, we theoretically extend the proposition of DeAngelo and DeAngelo’s (2006) optimal payout policy in terms of the flexibility dividend hypothesis. We also introduce growth rate, systematic risk, and total risk variables into the theoretical model. In addition, based upon Lee and Alice (2021), we discuss the implication of the existence of optimal payout ratio in financial analysis and decision for a company.To test the theoretical results derived in this chapter, we use data collected in the US from 1969 to 2009 to investigate the impact of growth rate, systematic risk, and total risk on the optimal payout ratio in terms of the fixed-effect model. We find that based on flexibility considerations, a company will reduce its payout when the growth rate increases. In addition, we find that a nonlinear relationship exists between the payout ratio and the risk. In other words, the relationship between the payout ratio and risk is negative (or positive) when the growth rate is higher (or lower) than the rate of return on total assets. Our theoretical model and empirical results can therefore be used to identify whether flexibility or the free cash flow hypothesis should be used to determine the dividend policy.

Keywords: Financial Accounting; Financial Auditing; Mutual Funds; Hedge Funds; Asset Pricing; Options; Portfolio Analysis; Risk Management; Investment Analysis; Momentum Analysis; Behavior Analysis; Futures; Index Futures; CDCs; Financial Econometrics; Statistics; Financial Derivatives; Financial Accounting (search for similar items in EconPapers)
JEL-codes: G1 G11 G12 G3 M41 M42 (search for similar items in EconPapers)
Date: 2024
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