Dividend Policy and Consumption Risk

In this paper, we study the theoretical relationship between dividend policy and risk, in an intertemporal context. We use the fundamental framework of the consumption capital asset pricing model (CCAPM) to demonstrate that the dividend payout ratio of a stock (dividends divided by earnings) is negatively related to its covariance between dividends and consumption, cumulated over many periods. This result is consistent with the long-run definition of consumption risk, recently proposed in the literature. This result also suggests that long-run consumption risk influences dividend policy. In short, our model indicates that the target payout ratio of a firm can be estimated with a simple and easy-to-apply formula.