In this paper, I study how corporate payout policies and debt can be interchangeably used as substitutes in controlling free cash flow problems. I disentangle the substitution effect derived from free cash flow concerns from other reasons such as signaling. I
consider retained earnings/total equity (RE/TE) and various risk measures, such as equity beta, cash flow beta, and volatility to investigate how these variables affect the choice of different payout policies. I also study the relative importance of these variables on corporate payout policy in terms of their quantitative impact.
Evidence suggests that firms with lower debt tend to payout more to control for free cash flow problems, and this relation is mainly driven by dividends, suggesting that dividends are more direct substitute to debt in controlling FCF problems. Also, my results support the finding of DeAngelo, DeAngelo, and Stulz (2006) that RE/TE is positively related with dividends, but I don’t find any evidence that RE/TE has greater impact than free cash flow problems on dividend payments. The substitution effect induced by FCF
problems is unaffected by the inclusion of RE/TE in the analysis, and when leverage is considered, the effect of FCF problem on dividends dominates the effect of RE/TE. Therefore, FCF problem is still very important in explaining firm’s payouts. Also while equity beta and RE/TE have symmetric effects on dividends and repurchases, cash flow beta and volatility have asymmetric effects. Cash flow risks weaken the degree of substitution between dividends and leverage in favor of repurchases. Even after controlling for RE/TE, size and equity beta, cash flow beta has a significant explanatory power for a firm’s dividend payments.
