The Hidden Cost of Volatility Drag

That said, the recent trend in share repurchases has been a significant departure from the traditional dividend payout model that has dominated corporate finance for decades.

On one hand, the growth of share repurchase activity can be attributed to the increasing demand for capital by companies seeking to maintain liquidity and manage their capital structure. According to aggregate data from Compustat, expenditures on share repurchase programs have increased dramatically over the last 20 years or so, rising from 4.8 percent in 1980 to 41.8 percent in 2000.

Furthermore, while dividend payments have grown at an average annual rate of 6.8 percent, share repurchase expenditures have averaged a much higher 26.1 percent annually over the same period. This significant difference highlights the shift in corporate payout policy, where companies are increasingly resorting to share repurchases rather than cash dividends.

That said, it's essential to understand whether corporations are using share repurchases as a substitute for dividends. We directly investigated this question by analyzing the number and dollar amount of share repurchases initiated by firms relative to total earnings. Our results show that while large, established firms have generally not cut or reduced their dividend payments, they do exhibit a higher propensity to pay out cash through repurchases.

On the flip side, our analysis also reveals that young firms have experienced an extraordinary growth in share repurchase activity over the last 15 years or so, with expenditures increasing from 4.8 percent in 1980 to 41.8 percent in 2000. This significant increase is particularly notable in industrial firms, where they spent more money on share repurchases than on dividend payments in 1999 and 2000.

What's interesting is that this shift in corporate payout policy has not been driven by a desire to cut dividends, but rather by the increased availability of capital from share repurchases. As we explore further, it becomes clear that corporations are leveraging share repurchases as a way to manage their cash flow, maintain liquidity, and respond to market conditions.

That said, it's essential to consider the tax implications of this shift. The Tax Reform Act of 1986 greatly reduced the relative tax advantage of capital gains over ordinary income, making capital gains more attractive for corporations seeking to minimize taxes. Furthermore, share repurchases offer investors a way to postpone the realization of capital gains and thus the payment of taxes.

As we delve deeper into the implications of this shift in corporate payout policy, it becomes clear that managers are taking their shareholders' tax status into account when deciding on a payout method. This insight has significant implications for our understanding of corporate payout theories and the role of tax considerations in investment decisions.

That said, the data suggests that corporations view dividends and share repurchases as interchangeable payout methods, which would have important implications for many of the traditional payout theories. However, this is an area where more research is needed to fully understand the underlying motivations behind this shift.

In conclusion, the analysis of share repurchase activity reveals a significant departure from the traditional dividend payout model that has dominated corporate finance for decades. As we explore further, it becomes clear that corporations are leveraging share repurchases as a way to manage their cash flow and respond to market conditions. However, more research is needed to fully understand the underlying motivations behind this shift in corporate payout policy.