A payout policy is the way a firm chooses between the alternative ways to pay cash out to shareholders. When a firm generates a profit, the managers have a choice with what they would like to do with the excess funds. They have several options and each choice has advantages and disadvantages, which I will try and explain. The diagram shows the options available to a firm once all debts have been serviced.
If a firm is presented with a profitable investment opportunity it can choose to reinvest the cash and increase the value of the firm. Many young, rapidly growing firms choose to reinvest all of their cash flows this way. By successfully investing the cash the firm would increase the value of the shares for the shareholders.
Choosing to retain all of the profit to increase cash reserves is not a particularly common choice. Often firms choose to retain a small percentage to 'top up' their cash reserves but distribute the rest. If firms retain cash reserves that are too high there is no benefit to shareholders. Some make the arguement that by having excessive cash reserves it can encourage managers to inefficiently allocate the funds. However, by increasing cash reserves the company can be confident that they will have sufficient funds to invest in a future project. Possibly avoiding the often costly process of raising capital in either equity or debt markets.
