Financing Payouts

Joan Farre-Mensa | Roni Michaely | Martin Schmalz

Apr 2, 2026

Key Takeaways

Research Question: How common, large, and persistent are externally financed payouts, and what motives drive firms to finance their payouts?
Data and Method: The study analyzes 11,557 U.S. public firms from 1989 to 2019, combining descriptive statistics with probit models and difference-in-differences designs that exploit tax shocks to assess the prevalence and drivers of externally financed payouts.
Findings
- Forty-three percent of firms that pay out also initiate a net debt or an equity issue during the same year, resulting in 31% of aggregate payouts being externally financed.
- Twenty-five percent of aggregate payouts could not have been paid without the firms simultaneously raising capital.
- Over 83% of firms that finance their payouts would be unable to sustain their payout and investment levels without raising capital, because their payouts surpass their internal funds (free cash flow, cash reductions, and employee-initiated equity issues).
- These payout gaps persist over multi-year horizons; when measured over five-year intervals, their prevalence increases and their annualized aggregate magnitude remains unchanged, indicating a persistent pattern rather than short-term payout smoothing.
- Debt dominates as the financing vehicle: firms finance 30% of aggregate payouts via net debt issues, whereas firm-initiated equity issues finance less than 3% of aggregate payouts.
- Profitable firms with moderate growth use debt-financed payouts to jointly manage their leverage and cash.
- Tax incentives, specifically the tax deductibility of interest payments and the avoidance of pre-TCJA (Tax Cuts and Jobs Act) repatriation taxes on foreign earnings, play a causal role in driving debt-financed payouts.
Implication: Externally financed payouts are not simply distributions of excess cash; they are deliberate tools for jointly managing leverage and cash. Investors and policymakers should view the funding source of payouts as an important component of a firm’s strategic capital structure and liquidity management.

Source Publication:

Farre-Mensa, Joan, Roni Michaely, and Martin Schmalz (2025). Financing Payouts. Journal of Financial and Quantitative Analysis, 60(4), 1586–1624. This paper received the 2026 Journal of Financial and Quantitative Analysis Sharpe Award for the best paper published in 2025.

Background and Research Questions

Whereas foundational frameworks treat payouts as a residual decision made only after funding investment needs, modern corporate finance theories recognize that agency frictions and information asymmetries provide active, strategic motivations for firms to distribute cash. However, a common assumption across much of this literature is that firms rely on internal free cash flow to fund these distributions, whether motivated by agency considerations, signaling, or otherwise. Yet, firms, in practice, often pay out while simultaneously raising external capital—a practice that Easterbrook (1984) describes as “downright inexplicable.” Still, standard text books continue to assume payouts rely primarily on internal cash. This study challenges that assumption by asking how prevalent and persistent externally financed payouts are and what motives, in addition to cross-market arbitrage, drive firms to finance them strategically. Rather than viewing payouts as passive outcomes of cash flows, the authors show they are deliberate financial decisions integrated within a firm’s broader capital structure and liquidity management strategy.

Data and Methodology

The study examines 11,557 U.S. public firms from 1989 to 2019, excluding financial firms, utilities, and firms in the year of their IPO, producing 106,407 firm-year observations. Payouts are broken down into regular dividends and share repurchases plus special dividends. External financing is measured through net debt issues and firm-initiated equity issues, distinguishing them from employee-initiated equity issues such as stock option exercises.

To analyze which firms use external capital to fund payouts, the authors first calculate descriptive statistics to quantify the prevalence and magnitude of externally financed distributions. They then employ probit models to estimate the likelihood that a firm will fund payouts externally, conditioning on firm characteristics such as growth opportunities, cash holdings, and leverage.

To identify causal mechanisms, the study leverages exogenous variation in tax incentives. It uses two quasi-natural experiments: staggered state-level corporate tax changes and the 2017 Tax Cuts and Jobs Act (TCJA). These shocks affect the value of interest tax deductions and the incentives to defer paying taxes on foreign earnings, allowing the authors to distinguish whether firms’ use of debt for payouts responds to tax considerations.

Finally, counterfactual simulations and textual evidence from SEC debt prospectuses complement the analysis. Simulations quantify how debt-financed payouts influence leverage and cash holdings, whereas prospectuses confirm that firms often explicitly state in their public debt prospectuses their intention to use proceeds to finance payouts.

Findings

The analysis shows externally financed payouts are both widespread and substantial in dollar magnitude. Over the sample period, 43% of firms that pay out also initiate a net debt or an equity issue during that same year, resulting in 31% of aggregate payouts being externally financed. Firms could not have paid 25% of aggregate payouts without the simultaneously raising capital.

Most financed payouts exceed the firm’s internal funds (including free cash flow, cash reductions, and employee-initiated equity issues). When measured over five-year intervals, payout gaps become more prevalent and their annualized aggregate magnitude remains unchanged, indicating a persistent pattern of firms setting payouts above the level they can fund internally without raising capital. Sixty-four percent of firms that finance their payouts do so at least every two years.

Debt is by far the most important source of payout financing. Net debt issuance finances 30% of aggregate payouts, whereas firm-initiated equity issuance accounts for less than 3%. Firms devote a larger fraction of raised capital to financing share repurchases than to regular dividends, particularly since the mid-2000s. Prospectus evidence supports this pattern: among the debt-financed payouts with available prospectuses, 73% mention stock buybacks and/or dividend payments as intended uses of debt proceeds.

The underlying motivation for debt-financed payouts is the joint management of leverage and cash. Profitable firms with moderate growth use debt-financed payouts to fund investment while maintaining leverage and preserving cash reserves. In the sample, the median firm conducting debt-financed repurchases starts with leverage 5.0 percentage points below target; following the debt-financed repurchase, its leverage increases to just above target. Counterfactual simulations show 81.3% of firms with debt-financed repurchases would have had negative cash holdings in year t=0 if they had tried to achieve the same leverage adjustment using only repurchases without issuing debt. By contrast, a fast-growing firm with negative free cash flow can simply use the right mix of debt and equity issues instead of debt-financed payouts to manage both its leverage and cash holdings, and a profitable firm without good investment opportunities can use internally funded repurchases to keep both its leverage and cash stable.

Tax considerations further shape firms’ use of debt-financed payouts. Firms facing higher state corporate taxes increase debt-financed repurchases, reflecting the benefits of interest deductibility. Before the 2017 TCJA, profitable U.S. multinationals also used debt-financed payouts to offset the leverage reductions induced by their retained foreign earnings while avoiding repatriation taxes. The TCJA moved the U.S. toward a territorial tax system, removing the avoidance of repatriation taxes as a motive for debt-financing payouts.

Finally, investors react less positively to announcements of higher payouts when firms have a persistent history of debt-financing them. However, the average announcement return for such firms is still positive, suggesting investors view debt-financed payouts as positive events, perhaps because they allow firms to jointly manage their leverage and cash holdings.

Implications

The study highlights that externally financed payouts are widespread, economically large, and persistent. For investors, understanding the funding source is important, because debt-financed payouts indicate firms are jointly managing their leverage and cash holdings, rather than simply distributing excess cash.

For corporate managers, the findings illustrate that debt-financed payouts allow profitable, moderately growing firms to sustain investment, leverage, and internal liquidity simultaneously.

From a broader perspective, the results underscore that any evaluation of the welfare costs and benefits of taxes or other restrictions on payouts—such as the Inflation Reduction Act’s 1% excise tax on repurchases—should account for how payouts are financed. More generally, the study emphasizes that the relationship between payouts, capital structure, and cash should be studied jointly as interdependent elements of corporate financial management.

References:

Easterbrook, F. H. “Two Agency-Cost Explanations of Dividends.” American Economic Review, 74 (1984), 650–659.