Payout Policy and the Cost of Capital

In this paper we examine the impact of payout policy on cost of capital. Using forward-looking implied cost of capital as a measure of expected returns, we examine the cross-sectional relation between cost of capital and (a) the level of payout and (b) the distribution policy choice between dividends and repurchases. We initially find that the cost of capital is decreasing in the level of payout, consistent with the maturity hypothesis but once we control for direct measures of risk the result reverses. We further find that, in general, the higher the dividend intensity in the payout the lower the cost of capital despite the tax disadvantage of dividends. To counter the off-setting effects of the various alternative hypotheses in the overall sample, we conduct further analysis of the distribution policy across sub-samples based on growth, leverage, analyst coverage, size, earnings volatility, and institutional ownership. We find no support for the tax hypothesis that predicts cost of capital should be increasing in dividend intensity. We however find that firms use dividends to successfully mitigate the agency costs of free cash flows consistent with the agency hypothesis. The evidence regarding the information hypothesis, that dividends are preferred under asymmetric information, is mixed.