Introduction

In financial year ending June 2024, Commonwealth Bank of Australia (CBA) distributed a total dividend of $4.65 per share, reaffirming its reputation as one of Australia’s most consistent dividend payers. [Footnote 1] This decision not only rewarded shareholders but also reinforced investor confidence in the bank’s financial stability and future earnings potential. Such corporate actions highlight the significance of payout policy, a critical component of financial management that dictates how a company distributes its profits to shareholders.

When companies generate profits, they must decide whether to distribute profits to shareholders, if so what form the payout would take. Each of these decisions comes with its own financial and strategic implications. For example, paying a high dividend will provide an immediate return to shareholders but limit the capital that can be used to invest for future growth. In markets like Australia, where the franking credit system incentivizes dividends, payout decisions also carry tax implications that influence investor preferences.

Companies that regularly increase dividends demonstrate confidence in their earnings stability, whereas reductions in payouts may signal financial distress or a shift in capital priorities. Similarly, share buybacks can indicate management’s belief that the company’s stock is undervalued. The challenge lies in striking the right balance—ensuring investors are rewarded while maintaining sufficient capital for future growth and servicing debt obligations.

Understanding payout policy is crucial for financial professionals, investors, and corporate managers, as it influences investment decisions, stock valuation, and long-term corporate sustainability. By examining different payout mechanisms, the factors influencing payout decisions, and real-world corporate strategies, we gain deeper insight into how firms navigate this essential aspect of financial management.

The key learning objectives for this topic include:

1. Understand the Nature of Payout Policy in Corporate Finance: Explain what the payout policy entails and assess the impact of payout policy on corporate growth and stock market perception.

2. Analyze Different Payout Methods and Their Financial Implications: Compare and contrast dividends and share buybacks as key forms of profit distribution in different corporate and market settings.

3. Examine the Key Factors Influencing Payout Policy Decisions: Identify and analyze the internal and external factors that shape a company’s payout policy, including macroeconomic conditions, industry influence and firm specific factors.

4. Apply Payout Theories to Explain Corporate Payout Strategies: Explore key theories of payout policy, including Dividend Irrelevance Theory, Agency Cost Theory and Life Cycle Theory and assess real-world corporate payout decisions.

Learning Objective 1: The role and importance of payout policy

Payout policy refers to a company’s approach to distributing profits to its shareholders, determining how much of its earnings should be paid out and in what form. Companies can choose to return cash to shareholders through dividends, where investors receive periodic payments, or through share buybacks, where the company repurchases its own stock to reduce the number of outstanding shares. Alternatively, firms may decide to retained earnings, reinvesting profits into the business for future growth, expansion, or debt reduction.

The decision on how much profit to distribute versus reinvest affects corporate growth, stock market perception, and the firm’s long-term sustainability.

1.1 Payout Policy and Corporate Growth

From a corporate decision-making perspective, payout policy determines how a company manages its earnings to balance shareholder return with investing for future growth. Firms must assess whether distributing dividends or repurchasing shares will benefit investors more than reinvesting profits in expansion, acquisitions, or debt reduction.

A low or conservative payout policy, where a company retains a significant portion of its earnings, can support future growth through reinvestment. Companies that operate in high-growth industries, such as technology, biotech, or renewable energy, often choose to reinvest earnings into research and development (R&D), acquisitions, new market expansion, or debt reduction. By prioritizing growth investments over immediate shareholder distributions, these firms can enhance their competitive advantage, increase market share, and generate higher future cash flows, ultimately leading to capital appreciation for investors. For example, Atlassian, an Australian software company, reinvests its earnings into product development and expansion rather than paying dividends, enabling it to scale globally and sustain high revenue growth.

Conversely, a high payout policy, where a company distributes most of its earnings through dividends or share buybacks, may limit future growth opportunities by reducing funds available for internal investment. Firms in mature, low-growth industries, such as utilities, banking, and consumer staples, tend to follow this strategy because their markets are well established, and reinvestment opportunities are relatively limited. For instance, Commonwealth Bank of Australia (CBA) regularly pays out 70-80% of its earnings as dividends, reflecting its strong cash flow generation and lower need for aggressive expansion. While this approach attracts income-focused investors, it may constrain the firm’s ability to pursue new business ventures or respond to changing market dynamics.

The trade-off between payout policy and future growth also depends on external financing availability. Companies that retain earnings can fund their growth without relying heavily on external debt or issuing new equity, preserving financial flexibility. However, firms with strong access to capital markets may sustain both high payout ratios and growth investments by issuing bonds or shares to finance expansion.

1.2 Payout Policy and Signalling Effect

Payout policy has a signalling effect to the market as investors closely analyse dividend payments, share buybacks, and earnings retention decisions to assess a company’s financial health, future prospects, and management confidence. changes in dividends or repurchase programs can provide implicit insights into management’s view of the company’s earnings stability and growth potential.

A consistent or increasing dividend payout is often interpreted as a positive signal that management is confident in the company’s future earnings and cash flow stability. Investors, particularly those seeking reliable income—such as retirees and institutional funds—view stable dividends as an indication of financial strength, lower risk, and long-term sustainability. In Australia, Commonwealth Bank of Australia (CBA.AX) has historically maintained a high and stable dividend payout, reinforcing investor trust and supporting stock price stability. [Footnote 1] This practice suggests to the market that the bank expects continued profitability, reducing uncertainty and attracting long-term investors.

Conversely, a dividend cut or suspension can send a negative signal to the market, often leading to panic selling and downward pressure on stock prices. Investors may perceive a reduction in dividends as an indication that management anticipates weaker future earnings, cash flow constraints, or financial distress. A well-known example is BHP’s dividend cut in 2016, which was triggered by declining commodity prices. The market reacted negatively, as the reduced payout signalled that the mining giant expected lower profitability and needed to preserve cash, leading to a decline in BHP’s stock price. [Footnote 2]

The signaling effect of share buybacks can also shape stock market perception. When a company repurchases its own shares, it often signals to investors that management believes the stock is undervalued. This can create positive sentiment, leading to an increase in share price. However, if a buyback program is seen as an attempt to artificially inflate earnings per share (EPS) without strong underlying financial performance, investors may view it with scepticism.

Learning Objective 2: Payout Methods

Once a decision is made to distribute profits to shareholders, there are two main channels for distribution: dividend payment and share repurchase. Each payout method has unique financial implications and strategic considerations.

Historically, U.S. companies primarily returned value to shareholders through dividends. However, since the 1980s, there has been a significant rise in the prevalence of share buybacks. Between 2003 and 2012, companies in the S&P 500 allocated approximately 54% of their net income to buybacks, compared to 37% for dividends. This trend continued, and by 2022, U.S. corporations spent over $1 trillion on buybacks. Factors contributing to this shift include favourable tax treatments, flexibility in capital allocation, and the potential to enhance earnings per share by reducing the number of outstanding shares. [Footnote 3]

In contrast, Australian companies have traditionally favoured dividends as the primary method of returning profits to shareholders. This preference is partly due to Australia’s dividend imputation system, which offers tax credits to shareholders, making dividends more attractive. Between the 2010 and 2015 financial years, dividend payments in Australia increased by approximately 40%. [Footnote 4] In recent years, while dividends remain predominant, there has been a gradual increase in share buybacks. For instance, in 2022, Australian companies’ total common dividends reached a record high of AUD 113 billion, reflecting a compound annual growth rate of 6.5% over the past decade. [Footnote 5]

2.1 Dividend Payments

Companies can distribute dividends in different forms, depending on their financial strategy, shareholder preferences, and corporate policies. The most common types of dividends include:

Regular Cash Dividends

A regular cash dividend is the most common type of payout, where companies distribute a fixed amount per share at regular intervals, usually semi-annually in Australia. This provides shareholders with a consistent income stream and signals financial stability and earnings confidence. Commonwealth Bank of Australia (CBA), Westpac (WBC), and BHP are well-known for their reliable cash dividend payments.

Special Dividends

A special dividend is a one-time, non-recurring dividend that companies issue when they have excess profits, surplus cash, or proceeds from asset sales. Unlike regular dividends, these payments are not expected on a recurring basis. For example, BHP declared a record special dividend in 2019 after divesting its U.S. shale assets.

Stock (Bonus) Dividends

Instead of cash, companies may issue additional shares to existing shareholders, typically at no extra cost. This preserves cash while rewarding investors, though it dilutes share ownership. Fortescue Metals Group (FMG) has used stock dividends as part of its payout strategy.

Dividend Reinvestment Plans (DRPs)

A dividend reinvestment plan (DRP) allows shareholders to automatically reinvest their dividends in additional company shares instead of receiving cash. This is beneficial for long-term investors as it enables compounding of returns. Many Australian companies, including Telstra (TLS) and Woolworths (WOW), offer DRPs to shareholders.

In Australia, the imputation tax system is designed to eliminate double taxation on corporate profits distributed as dividends. Under this system, when a company pays cash dividends to shareholders, it also passes on franking credits, which represent the corporate tax already paid on those earnings. Shareholders can then use these franking credits to offset their personal tax liabilities, reducing the overall tax burden on dividend income.

For example, if a company has already paid 30% corporate tax on its earnings and distributes a fully franked dividend, shareholders receive a tax credit for the 30% already paid. If the shareholder’s marginal tax rate is lower than 30%, they may receive a refund for the excess credits, making dividends highly tax-efficient, particularly for retirees and superannuation funds, which often pay little to no tax.

This system explains why dividends remain the preferred payout method in Australia, unlike in the U.S., where share buybacks dominate due to capital gains tax advantages. Australian companies, especially in sectors like banking (CBA, Westpac) and mining (BHP, Rio Tinto), prioritize high and consistent dividend payouts to maximize shareholder benefits under the imputation system.

Special dividends can come with franking credits, but it depends on the company’s franking account balance and tax status. If a company has sufficient franking credits from previously paid corporate tax, it may fully or partially frank the special dividend, just like regular cash dividends.

Stock dividends (or bonus shares) do not come with franking credits because they do not represent a taxable distribution of corporate profits. Instead, stock dividends increase the shareholder’s number of shares, but their value is typically not treated as taxable income at the time of issuance.

2.2 Cash Dividend Payment Process 

In Australia, the dividend payment process follows a structured timeline to ensure transparency and compliance with regulatory requirements. The key steps in the cash dividend payment process are:

• Dividend Declaration: The company’s Board of Directors announces the dividend amount, payment date, and record date. The announcement is made via the Australian Securities Exchange (ASX) and company investor reports. For example, CBA declares its interim and final dividends in February and August each year.
• Ex-Dividend Date: The ex-dividend date is the cut-off date for investors to be eligible to receive the dividend. Investors who buy shares on or after this date will not receive the upcoming dividend, while those holding shares before this date will qualify. For this reason, the share price typically falls by the value of the dividend on this date. 
• Record Date: On the record date, the company finalizes the list of shareholders entitled to receive the dividend. It typically falls one business day after the ex-dividend date.
• Payment Date: On the payment date, the company distributes the dividend to eligible shareholders via direct deposit or mailed cheques. In Australia, this process is facilitated through the ASX and share registries like Computershare and Link Market Services.

2.3 Stock Repurchase

A share buyback (or stock repurchase) occurs when a company repurchases its own shares from the market or shareholders, reducing the number of outstanding shares. This process can be conducted through different mechanisms as outlined below.

On-Market Buybacks

In an on-market buyback, the company purchases its shares through a stock exchange (e.g., the ASX) at prevailing market prices. The company announces the buyback plan and repurchases shares gradually over time, following regulatory limits on the volume of shares repurchased per day. The buyback reduces the total number of shares, increasing earnings per share (EPS) and potentially boosting stock prices.

Off-Market Buybacks

An off-market buyback occurs when a company repurchases shares directly from shareholders, often at a predetermined price. This method is usually conducted via a tender offer, where shareholders can voluntarily sell their shares back to the company, often at a discount but with tax benefits. Commonwealth Bank of Australia (CBA.AX) conducted a $2 billion off-market buyback in 2021, offering shareholders a tax-effective way to sell shares with a portion classified as a fully franked dividend. This method of buyback can be more tax-efficient for shareholders, especially in Australia due to franking credits, and allows companies to target specific shareholder groups.

The accounting treatment of repurchased shares depends on whether the company cancels or holds them as treasury shares. In Australia, bought-back shares are typically cancelled rather than held as treasury shares. In some countries like the US, companies can hold repurchased shares as treasury shares which can be reissued in the future, rather than cancelling them.

Learning Objective 3: Factors Influencing Payout Policy

A company’s payout policy is influenced by multiple factors, both internal and external. Some key factors are discussed below.

Profitability and Cash Flow Availability

One of the most critical factors influencing payout policy is a company’s profitability and ability to generate stable cash flows. Firms with strong and consistent earnings are more likely to pay higher dividends or conduct share buybacks. In contrast, companies with volatile or unpredictable cash flows may prefer to retain earnings to manage financial uncertainty. This is particularly important as companies with highly volatile cash flows often face greater difficulty accessing capital markets due to the higher risk perception among investors and lenders. These companies face expensive financing and, in some cases, external financing is entirely inaccessible.

Growth Opportunities and Reinvestment Needs

Companies with high growth potential and significant investment opportunities often prefer to retain earnings rather than distribute them to shareholders. Retained earnings can be used for business expansion, research and development (R&D), acquisitions, or debt reduction. For example, Atlassian, an Australian tech firm, does not pay dividends because it reinvests profits into innovation and global expansion. In contrast, established, low-growth firms like Telstra (TLS) or Woolworths (WOW) pay higher dividends because they have fewer reinvestment needs.

Taxation and the Imputation System

As explained above, in Australia, dividend payout policies are heavily influenced by the franking credit system, which allows companies to distribute fully or partially franked dividends that give shareholders tax credits for corporate taxes already paid. This makes dividends more attractive than buybacks for Australian investors, especially retirees and superannuation funds. Companies usually prefer buyback as a form of payout as it’s more flexible and it’s not an expectation from the market that the company carries out a buyback on an annual basis. This explains the popularity of share buybacks as a form of payout in the US.

Shareholder Preferences and Investor Base

A company’s payout policy is influenced by the preferences of its major investors. Different types of investors have different expectations:

• Income-focused investors (e.g., retirees, superannuation funds) prefer high dividend payouts for stable income.

• Growth-focused investors favour low or no dividends, expecting capital appreciation instead.

Learning Objective 4: Payout Theories and Corporate Payout Strategies

Several financial theories attempt to explain why companies choose different payout policies and how these decisions impact shareholder value. Collectively, they partially explain corporate payout strategies observed in practice.

4.1 Dividend Irrelevance Theory 

This theory, developed by Miller and Modigliani (1961) [Footnote 6], posits that dividend policy does not affect a company under the assumption of a perfect capital market characterised by no taxes, no transaction costs, and efficient markets, where all investors have the same information. This is because investors are indifferent between receiving dividends or capital gains because they can sell shares to generate income if needed. Therefore, companies should focus on investment and capital structure decisions, not dividends, since payout policy does not create value.

However, real-world factors like taxes, transaction costs, and investor preferences make dividends relevant. For example, taxation treatment such as the franking credit system makes dividends attractive, challenging the theory’s assumption that investors are indifferent between dividends and capital gains. Changes in dividend payment levels can also affect stock prices leading to a direct change in the firm value. Many firms therefore carefully manage dividends and buybacks to align with investor expectations and market conditions.

4.2 Agency Theory 

Agency Theory, developed by Jensen and Meckling (1976) [Footnote 7], explains how conflicts of interest between shareholders (principals) and company managers (agents) influence corporate financial decisions, including payout policy. The central idea is that managers, who control company resources, may prioritize their own interests rather than maximizing shareholder value. Corporate payout policy, through dividends or share buybacks, can serve as a mechanism to mitigate agency problems and align managerial actions with shareholder interests.

When a company retains excess cash, managers may have more discretion to invest in unprofitable projects, take excessive risks, or increase personal perks. Paying higher dividends forces managers to distribute excess cash to shareholders, reducing the funds available for misuse or inefficient investments. A disciplined payout policy ensures that managers remain accountable and focus on value-generating projects. Empirical evidence confirmed that firms with high free cash flows, but poor investment opportunities tend to pay higher dividends to avoid agency conflicts. Decline in investment opportunities also appear to increase dividends and share repurchases. [Footnote 8]

As an extension, Jensen (1986) [Footnote 9] introduced the Free Cash Flow Hypothesis, which states that companies with high free cash flow, but limited investment opportunities face a risk of wasteful spending by managers. Instead of letting excess cash sit idle or be misallocated, firms can return capital to shareholders through share buybacks, reducing agency conflicts. Buybacks also increase earnings per share (EPS), benefiting remaining shareholders.

4.3 Life Cycle Theory of Payout Policy

This theory suggests that a company’s dividend and share buyback decisions evolve as it progresses through different stages of its corporate life cycle. [Footnote 10] According to this theory, firms adjust their payout policies based on profitability, investment opportunities, and financial constraints, leading to low payouts in early stages and higher payouts in maturity when reinvestment opportunities decline.

The theory aligns with the idea that young, high-growth firms prioritize reinvestment, while mature firms return excess cash to shareholders when growth slows.

The table below outlines the key characteristics of each stage in a company’s life.

This framework helps investors understand why firms adjust their payout policies over time based on their financial position and growth prospects.

Summary – Key Concepts in this Topic

1. The Nature and Importance of Payout Policy

Payout policy refers to a company’s approach to distributing profits to shareholders through dividends, share buybacks, or retained earnings. It plays a crucial role in corporate finance, influencing stock market perception, and shareholder value. A well-managed payout policy balances rewarding investors with financial stability and reinvestment for future growth. In Australia, the franking credit system makes dividend payments particularly attractive to investors, shaping corporate payout decisions.

2. Different Payout Methods

Companies return cash to shareholders through dividend payments or stock repurchases. Dividends include cash and stock dividends, and some companies might conduct both forms of payout.

Both dividend payments and stock repurchase have different characteristics that companies need to consider in making the payout decision.

3. Key Determining Factors of Payout Policy

Several factors influence corporate payout decisions, including:

• Profitability and Cash Flow: Higher earnings support regular dividends and buybacks.
• Growth Opportunities: High-growth firms retain earnings for expansion, while mature firms return cash to shareholders.
• Tax Considerations: The imputation system in Australia encourages dividend payments due to franking credits.
• Investor Preferences: Income-focused investors prefer dividends, while growth investors favour retained earnings.

4. Payout Policy Theories

Various financial theories were developed to explain why companies adopt different payout policies. The most prominent ones include:

• Dividend Irrelevance Theory: Under the assumption of a perfect capital market, payout policy does not affect firm value; investment decisions matter more in value creation.
• Agency Theory: Dividends and buybacks reduce excess cash, limiting managerial discretion and reducing agency costs.
• Life Cycle Theory: The payout policy changes as a firm goes through its life cycle. Young firms reinvest earnings, while mature firms distribute excess cash as dividends or buybacks.

Footnotes

1. For more information, see Dividend information – CommBank
2. For more information, see BHP Billiton Slashes Its Dividend – WSJ
3. For more information, see How the U.S. Taxes Stock Buybacks and Dividends | Bipartisan Policy Center
4. For more information, see The Rise in Dividend Payments | Bulletin – March 2016 | RBA
5. For more information, see Analyzing High Dividend Yield Strategies in Australia
6. Modigliani, F. and Miller, M. 1961. “Dividend Policy, Growth and the Valuation of Shares”, The Journal of Business, 34, 411-433.
7. Jensen, M. and Meckling, W. 1976. “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure”, Journal of Financial Economics, 3, 305-360.
8. See Lang and Litzenberger (1989) and Grullon and Michaely (2002).
9. Jensen, M. 1986. “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers”, The American Economic Review, 76, 323-329.
10. The life cycle theory of payout policy is collective work between Fama and French (2001), Grullon, Michaely and Swaminathan (2002) and DeAngelo, DeAngelo and Stulz (2006).