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The lowdown


Dynamic interaction

New research by Professor Bart Lambrecht of Cambridge Judge examines the interaction of investment, payout and debt – and the key role of managerial preferences on a firm’s capital structure.

Hand pointing to data chart.

A new research paper co-authored by Bart Lambrecht, Professor of Finance at Cambridge Judge Business School, examines the interaction between investment, payout, and debt at public companies.

Professor Bart Lambrecht

Professor Bart Lambrecht

The paper looks at how this interaction can “change dramatically” depending on managers’ preferences regarding “intertemporal consumption” (also known as the “utility function”). These preferences determine, for example, whether managers adopt a target debt-to-asset ratio. The research develops a model that encapsulates both “trade-off” and “pecking-order” theories of financing.

Here’s a closer look at the ideas explored in the paper – “The dynamics of investment, payout and debt” – co-authored by Professor Bart Lambrecht of Cambridge Judge Business School and Professor Stewart Myers of MIT Sloan School of Management. The paper is forthcoming in the Review of Financial Studies.

Why is it important to consider the investment, financing and payout policies jointly, and what are the basic rules on how these decisions interact?

Finance textbooks often treat these three key policies separately and sequentially, but it’s important to look at them in interaction because that’s the way corporations are effectively managed. In simple terms, each dollar or pound held by a corporation can be invested, saved or paid out, so these three policies are inextricably linked. Sources of funds (meaning income and net borrowing) must equal a company’s use of its funds (in the form of capital expenditure and payouts, such as dividends, bonuses or share repurchases) because funds cannot be created out of thin air, nor should they vanish in thin air. This fundamental equality implies that the firm’s financing, investment and payout policies are linked. Changing one of the three policies has implications for the other two. For example, if corporations want to keep payout smooth then this has implications for borrowing, saving and investment.

Who sets the key corporate policies relating to these factors in public corporations?

In the typical Anglo-Saxon firm with dispersed shareholders, these policies are determined by the top management team – but shareholders can intervene if they don’t like how managers run the corporation. Such intervention is costly, creating some space for managers to extract “rents” (including their salaries, bonuses, pensions and other monetary benefits) – but for managers the threat of being sacked forces rents to move in lockstep with payout to shareholders – for example, managers who seek to raise their own compensation may have to increase the dividend to keep shareholders at bay. The threat of collective action by shareholders creates a link between payout and managerial compensation – and perceived breach of such a link can result in highly publicised shareholder revolts against large CEO payouts.

Why do managers seek to smooth payout?

Managers are risk averse and want their compensation to be smooth (and uncut) over time. But payout (in terms of dividend or share repurchases) and managerial rents move in lockstep, so payout ends up being smoothed too – generating a steady or rising dividend to shareholders. Payout and rents are usually linked to the firm’s long-run sustainable income (known as “permanent” income), with transitory income shocks such as a one-time windfall or foreign currency shift having very little effect on payout and compensation.

How can payout smoothing be achieved given that income is volatile?

Primarily through borrowing and saving. Money is set aside in good times to save for a rainy day, and extra borrowing may be needed if savings are depleted.

What are the implications of payout smoothing for investment and capital structure, and how can large capital expenditure be achieved without cuts in payout?

As long as investments have a positive net present value (the difference between the present value of net cash inflows and outflows), it should be possible for the firm to borrow against the investment’s future net cash flows and finance the investment without having to cut payout. This assumes the company has easy access to capital markets, which may not be the case in some developing markets or for distressed firms.

The paper discusses how a firm’s capital structure depend on managers’ preferences, modelled through the so-called “utility function”, how does this work in practice?

For certain preference structures, managers adopt a constant net debt-to-asset ratio. If a company experiences a positive income shock, a manager who prefers such a constant ratio invests more and finances the investment by extra borrowing to keep the leverage ratio on target; similarly, after a negative income shock this manager sells assets (disinvestment) and uses the proceeds to reduce debt in order to get the leverage ratio back on target. The leverage ratio depends on managers’ degree of risk aversion: highly risk-averse managers may decide not to take on any debt; such a firm may be all equity financed and the firm’s assets may include some cash, causing the firm to have a negative net debt level. For other types of preferences, managers do not maintain a constant debt-to-asset ratio, but keep the capital invested in risky projects constant. Debt becomes a shock absorber: a good income shock does not increase investment but reduces net debt, whereas a bad income shock leads to more borrowing. Profitable firms therefore turn into cash cows, whereas unprofitable firms become heavily indebted and may go out of business.

How does your research paper’s model reconcile different theories of capital structure?

The model in effect incorporates both the “trade-off theory” of capital structure (which says companies choose an optimal leverage target determined by the costs and benefits of debt) and the “pecking-order theory” of financing (in which companies typically use first internal funds, followed by debt, followed by equity). The model in this research paper can generate optimal target leverage ratios, as well as pecking order style financing, depending on managers’ preferences (utility function).