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Published in: Review of Quantitative Finance and Accounting 3/2017

30-09-2016 | Original Research

Payout flexibility and capital expenditure

Authors: Subramanian Rama Iyer, Harry Feng, Ramesh P. Rao

Published in: Review of Quantitative Finance and Accounting | Issue 3/2017

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Abstract

Over the past two decades or so, repurchases have become an appealing method for disbursing cash to shareholders compared to the traditional dividends. Managerial perception as well as empirical evidence suggests that repurchases are inherently more flexible than dividends, which may account for their increasing popularity. The rigidity of dividends and the apparent flexibility of share repurchases could impact firm investments. Firms may forego profitable investment opportunities to maintain their dividend levels, while repurchases could be easily scaled back to fund profitable investment projects without fear of an adverse market reaction. We test the flexibility hypothesis of repurchases by regressing capital expenditures on repurchases and dividends in addition to other control variables. Consistent with our hypotheses, we find an inverse relationship between capital expenditures and repurchases but an insignificant relationship with dividends. Further, we find that the flexibility associated with repurchases is especially evident for firms that are financially constrained, and during the recent financial crisis period when external capital constraints were severe. Finally, we find that flexibility of repurchases with respect to capital expenditures is stronger in the more recent time period during which regulatory changes made repurchases more attractive as a mechanism to disburse cash back to shareholders.

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Appendix
Available only for authorised users
Footnotes
1
Financial flexibility is more common in recent literature (Arslan-Ayaydin et al. 2014). In this paper we focus on the flexibility of share repurchases.
 
2
Not everyone agrees with the interpretation that higher sensitivity of investments to internal cash flows is associated with higher constraints. Kaplan and Zingales (1997) find that the least constrained firms exhibit higher investment-cash flow sensitivity than firms that are classified as more financially constrained. They state that cash flow may act as a proxy for investment opportunities and the presence of outliers may explain the conflicting results found by Fazzari et al. (1988). Classifying firms a priori into different groups by size, Kadapakkam et al. (1998) use an international sample and find that investment-cash flow sensitivity is lowest in the small firm group and highest among the large firms, which is also confirmed by Cleary (1999). On the other hand, Allayannis and Mozumdar (2004) show that the Kaplan and Zingales (1997) results may have been influenced by possible outliers and by firms that face financial distress. Using negative cash flows as proxy for financial constraints and by removing some of the outliers in the Kaplan and Zingales (1997) study, Allayannis and Mozumdar (2004) find results that are more in line with Fazzari et al. (1988). Using simulated data, Alti (2003) demonstrates that investment and cash flow can be closely related even when financing is frictionless. While these studies question the interpretation of the sensitivity of investments to cash flow as an indication of the impact of financial constraints on investments, they do not suggest that financial constraints do not impact investments.
 
3
Figure 1 includes all repurchases, including open market, Dutch auction, and tender-offer repurchases, though the vast majority are of the open market type.
 
4
For the sake of brevity, we omitted the correlation statistics for the subgroups but they are available from the authors upon request.
 
5
Strictly speaking, this is not entirely true as the restricted sample of repurchases also include firms that engage in repurchases only and do not follow a dual repurchase-dividend policy.
 
6
There are other options that firms may avail, including asset sales, alliances, etc.; but these may take more time to implement.
 
7
We thank an anonymous reviewer for suggesting these additional robustness tests.
 
Literature
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Metadata
Title
Payout flexibility and capital expenditure
Authors
Subramanian Rama Iyer
Harry Feng
Ramesh P. Rao
Publication date
30-09-2016
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting / Issue 3/2017
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-016-0603-z

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