Analyzing Cash Returned
to Stockholders
05/28/08
Ch. 11
Dividends and stock buybacks
 The two major means of returning cash to
shareholders is dividends and stock buybacks
 The 1990s and 2000s have seen a dramatic increase
in buybacks in the U.S. as a means for firms to return
cash to stockholders.
 Effects of buybacks:
 Reduces the book value of equity
 Reduces the number of shares outstanding
 Provides cash to stockholders selectively
Methods of repurchasing equity
 Repurchase tender offer
 The price, number of shares and period of time during
which the offer is open is specified by the firm.
 Open market repurchases
 Firms buy back shares at the prevailing market price.
 Privately negotiated repurchases
 Firms buyback shares from a large stockholder at a
negotiated price.
Choosing between dividends and
repurchases
 Sustainability and stability of excess cash
flow
 Stockholder tax preference
 Predictability of future investment needs
 Undervaluation of the stock
 Management compensation
Cash flow approach to analyzing
dividend policy
 Measure cash available to be returned to
stockholders
 Assess project quality
 Evaluate dividend policy
 Examine the relationship between dividend
and debt policies
Cash available to be returned
 The Free Cash Flow to Equity (FCFE) is a measure
of how much cash is left in the business after nonequity claimholders (debt and preferred stock) have
been paid, and after any reinvestment needed to
sustain the firm’s assets and future growth. This is
the cash available for dividend payouts.
Free cash flow to equity = Net Income + Depr&Amort
– Chg in WC – Cap Exp
+ (New Debt Issue – Debt Repay)
– Pref. Dividends
Estimating FCFE when leverage is
stable
Net Income
- (1- ) (Cap Exp - Depr&Amort)
- (1- ) (Change in WC) – Preferred Dividends
= Free Cash flow to Equity
where
 = Debt Ratio
How much of its FCFE is the firm
paying out?
 Payout ratio can be measured as:
CF to stockholders to FCFE Ratio = (Dividends + Buybacks) / FCFE
 If the ratio is:
 Less than 1 (firm paying less than it can afford), it may
be to maintain financial flexibility, because of volatile
earnings, or for managerial objectives such as perks,
empire building, etc.
 NYSE average is around 50%.
The consequences of failing to pay
FCFE
Chrysler: FCFE, Dividends and Cash Balance
$3,000
$9,000
$8,000
$2,500
$7,000
$2,000
$1,500
$5,000
$4,000
$1,000
$3,000
$500
$2,000
$0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
($500)
$1,000
$0
Year
= Free CF to Equity
= Cash to Stockholders
Cumulated Cash
Cash Balance
Cash Flow
$6,000
Dividends with negative FCFE (or
payout ratios greater than 1)
 Some companies maintain payout ratios that
are greater than their available FCFE or
sometimes pay dividends when the company
generates negative FCFE.
 How does a company with negative free cash
flows to equity pay dividends (or buy back
stock)?
 Why might it do so?
Project (or investment) quality
 The alternative to returning cash to stockholders is reinvestment.
 Therefore, the better a firm’s projects, the less a firm should return to
stockholders.
 Measuring Project Quality
 Accounting return measure:


Return on Capital vs. WACC
Stock price performance:


Excess returns, which can be calculated as the actual return on the
stock minus the expected return based on CAPM
In an efficient market, this can be considered to be an evaluation of
whether a firm earn a return on its investments that were greater
than or less than those expected by the market.
Evaluating dividend policy
 Based on FCFE and project quality, we can
determine whether a firm’s current dividend
policy is appropriate.
 We should also consider the amount of cash
the firm has on hand. Decisions to
repurchase shares may be driven by this.
 Four scenarios are possible.
Scenario one
 A firm may have good projects and may be paying
out more than its free cash flow to equity.
 The firm is losing value in two ways.
 It is creating a cash shortfall that has to be met by
issuing more securities.
 Overpaying may create capital rationing constraints; as
a result, the firm may reject good projects it otherwise
would have taken.
 Possible cause for concern if dividends are cut: How
can the firm reduce dividends without having
investors think it is a negative signal?
Scenario two
 A firm may have good projects and may be paying
out less than its free cash flow to equity as a
dividend.
 This firm will accumulate cash, but stockholders are
unlikely to insist that it be paid out because:


It is likely that the excess cash will be used
productively in the long-term.
Stockholders trust the actions of management
Scenarios three
 A firm may have poor projects and may be paying out
less than its free cash flow to equity as a dividend.
 This firm will also accumulate cash, but find itself
under pressure from stockholders to distribute the
cash.
Scenario four
 A firm may have poor projects and may be paying out
more than its free cash flow to equity as a dividend.
 This firm has an investment problem (bad projects) and a
dividend problem (need to raise capital to pay dividends).
 Although dividends should be cut to match the firm’s FCFE, the
firm would be better off being more prudent about their project
selection.
 Improving project returns will increase FCFE, thus allowing for
higher payouts. If FCFE is still insufficient to meet dividends, the
firm should then cut dividends
Relationship between dividend and
debt policies
 Dividend policy analysis is further complicated if a
firm’s debt policy is considered. Is the firm attempting
to move to its optimal debt ratio?
 Increasing dividends (or buybacks) can serve as a
means for a firm to increase its leverage or debt ratio.
 Therefore, if a firm is under-levered (debt ratio <
optimal debt ratio), it may choose to pay out more
than its FCFE as dividends to increase leverage.
 Conversely, an over-levered firm may pay out less
than its FCFE to decrease leverage.
A Practical Framework for
Analyzing Dividend Policy
How much did the firm pay out? How much could it have afforded to pay out?
What it actually paid out
What it could have paid out
Dividends
FCFE
+ Equity Repurchase
Firm pays out too little
FCFE > Dividends
Firm pays out too much
FCFE < Dividends
Do you trust managers in the company with
your cash?
Look at past project choice:
Compare
ROC to WACC
What investment opportunities does the
firm have?
Look at past project choice:
Compare
ROC to WACC
Firm has history of
good project choice
and good projects in
the future
Firm has history
of poor project
choice
Firm has good
projects
Give managers the
flexibility to keep
cash and set
dividends
Force managers to
justify holding cash
or return cash to
stockholders
Firm should
cut dividends
and reinvest
more
Firm has poor
projects
Firm should deal
with its investment
problem first and
then cut dividends