<<

. 3
( 10 .)



>>

2003 $1,267.00 $1,077.00 $1,049.00 ($264.00) $1,559.00 ($1,145.00) $414.00
Average $1,208.55 $2,553.33 $2,769.96 $22.54 $969.38 $676.03 $1,645.41
The depreciation numbers also include amortization and the capital expenditures include
acquisitions; the acquisition of Capital Cities/ABC is reflected in the large jump in capital
expenditures in 1996 and in depreciation in the years after as goodwill was amortized.
Increases in non-cash working capital, shown as positive numbers, represent a drain on
the cash. In 1994, for example, non-cash working capital increased by $ 654.10 million,
reducing the cash available for stockholders in that year by the same amount. Finally, the


14
15

net cashflow from debt is the cash generated by the issuance of new debt, netted out
against the cash outflow from the repayment of old debt. Again, using 1994 as an
example, Disney issued $ 551.10 million more in new debt than it paid off on old debt,
and this represents a cash inflow in that year.
We have computed two measures of free cashflow to equity, one before the net
debt cashflow and one after. Using 1994 as an illustration, we compute each as follows:
FCFE before net Debt CF = Net Income + Depreciation “ Capital Expenditures “
Change in non-cash Working Capital = 1110.40 + 1608.30 “ 1026.11 -654.10 = $
1038.49 million
FCFE after net Debt CF = FCFE before net Debt CF + Net Debt Cashflow =
1038.49 + 551.10 = $1589.59 million
As Table 11.4 indicates, Disney had negative free cash flows to equity in 2 of the 10
years, in 1996 because of the Capital Cities acquisition and in 2001 because they reported
a loss. The average annual FCFE before net debt issues over the period was $968 million
and the average net debt issued over the period was $676 million, resulting in an annual
FCFE after net debt issues of $1,645 million.
A similar estimation of FCFE was done for Aracruz from 1998 to 2003 in table
11.5, again using historical information:
Table 11.5: FCFE for Aracruz in US$ from 1998 to 2003
Change in FCFE FCFE
Net Capital non-cash (before net Net Debt (after net
Year Income Depreciation Expenditures WC Debt CF) Cashflow Debt CF)
1998 $3.45 $152.80 $88.31 $76.06 ($8.11) $174.27 $166.16
1999 $90.77 $158.83 $56.47 $2.18 $190.95 ($604.48) ($413.53)
2000 $201.71 $167.96 $219.37 $12.30 $138.00 ($292.07) ($154.07)
2001 $18.11 $162.57 $421.49 ($56.76) ($184.06) $318.24 $134.19
2002 $111.91 $171.50 $260.70 ($5.63) $28.34 $36.35 $64.69
2003 $148.09 $162.57 $421.49 ($7.47) ($103.37) $531.20 $427.83
Average $95.67 $162.70 $244.64 $3.45 $10.29 $27.25 $37.54
Between 1998 and 2003, Aracruz had big swings in net income and corresponding
swings in FCFE, with FCFE being negative in 3 of the 6 years. The average annual FCFE
before net debt cashflows was approximately 10 million dollars. The cashflows from debt
add to the volatility, since Aracruz paid off large amounts of debt in 1999 and 2000 and




15
16

raised large amounts of debt in 1998, 2001 and 2003. The average annual FCFE after net
debt cashflows changes relatively little to 37.54 million dollars.
We can compute Aracruz™s FCFE each year, using the approximation that we
described in the last section. To do this, we first have to compute the net debt cashflows
as percent of reinvestment needs over this period. Using the average values for debt
cashflows, capital expenditures, depreciation and changes in non-cash working capital:
Average Debt Ratio = Net Debt Cashflow/ (Capital expenditures “ Depreciation +
Change in non-cash Working capital) = 27.25/(244.64-162.70+3.45) = 31.92%
The FCFE each year can then be estimated using the average debt ratio, instead of the
actual net debt cashflows. Table 11.6 contains the estimates of FCFE each year using this
approach for Aracruz:

Table 11.6: Approximate FCFE for Aracruz from 1998 to 2003
(Capital Expenditures - Change in non-cash WC (1-
Year Net Income Depreciation)*(1-DR) DR) FCFE
1998 $3.45 -$43.91 $51.78 -$4.42
1999 $90.77 -$69.69 $1.48 $158.98
2000 $201.71 $35.00 $8.38 $158.34
2001 $18.11 $176.28 -$38.64 -$119.53
2002 $111.91 $60.73 -$3.83 $55.02
2003 $148.09 $176.28 -$5.09 -$23.11
Average $95.67 $55.78 $2.35 $37.54
Note that the average FCFE between 1998 and 2003 remains the same at 37.54 million
dollars a year when we use the approximation. The FCFE in each year is different,
though, from the estimates in table 11.5, because we are smoothing out the effects of the
cashflows from debt.
To estimate the FCFE for Deutsche Bank, we used the categories developed
earlier for banks - net interest income, arbitrage income and advisory and fee income
from providing financial advice and services to firms. To estimate the net investment
made in 2003 for each source of income, and ignoring training expenses, we used the
balance sheet numbers for 2002 and 2003. Table 11.7 reports these numbers.
Table 11.7: Deutsche Bank: 2002 and 2003 Financials
2002 2003 Change
Interbank Assets ‚¬ 25,691.00 ‚¬ 14,649.00 -‚¬ 11,042.00
Net Loans ‚¬ 167,303.00 ‚¬ 144,946.00 -‚¬ 22,357.00


16
17

Security Purchases/Resell ‚¬ 155,258.00 ‚¬ 185,215.00 ‚¬ 29,957.00
ST Investments ‚¬ 318,681.00 ‚¬ 370,002.00 ‚¬ 51,321.00
LT Investments ‚¬ 4,729.00 ‚¬ 2,569.00 -‚¬ 2,160.00
Net Fixed Assets ‚¬ 8,883.00 ‚¬ 5,786.00 -‚¬ 3,097.00
Other Assets ‚¬ 68,732.00 ‚¬ 73,751.00 ‚¬ 5,019.00
Total Non-Cash Assets ‚¬ 749,277.00 ‚¬ 796,918.00 ‚¬ 47,641.00

Total Deposits ‚¬ 327,625.00 ‚¬ 306,154.00 -‚¬ 21,471.00
ST Borrowings ‚¬ 125,842.00 ‚¬ 155,002.00 ‚¬ 29,160.00
LT Borrowing ‚¬ 92,388.00 ‚¬ 82,018.00 -‚¬ 10,370.00
ST Liabilities ‚¬ 172,379.00 ‚¬ 222,838.00 ‚¬ 50,459.00
LT Liabilities ‚¬ 10,130.00 ‚¬ 9,400.00 -‚¬ 730.00
Liabilities ‚¬ 728,364.00 ‚¬ 775,412.00 ‚¬ 47,048.00

We then categorized these changes into the “interest income” investments, “arbitrage
income” investments and “other” investments, considering interbank investments as
interest income investments.
Interest Income Investments = (Net Loans + Interbank Investments - Deposits)2003
- (Net Loans + Interbank Investments - Deposits)2002
Arbitrage Investments = (Short Term and Long Term Investments + Security
Purchases - ST Borrowings - LT Borrowings - ST Liabilities - LT Liabilities)2003
- (Short Term and Long Term Investments - ST Borrowings - LT Borrowings -
ST Liabilities - LT Liabilities)2002
Other Investments = (Net Fixed Assets + Other Assets)2003 - (Net Fixed Assets +
Other Assets)2002
With these definitions, and based upon Deutsche™s Bank™s net income of 1,365 million
Euro in 2003, we estimated the FCFE :
Net Income = 1365
- Interest Income Investments -(-‚¬ 11,928.00)
- Arbitrage Investments - ‚¬ 10,599.00
- Other Investments - ‚¬ 1,922.00
FCFE = ‚¬ 772.00
This analysis would suggest that Deutsche Bank had 772 million Euros available to be
returned to stockholders in 2003.


11.2. ˜: Defining Free Cash Flows to Equity




17
18

The reason that the net income is not the amount that a company can afford to pay out in
dividends is because
a. Earnings are not cash flows
b. Some of the earnings have to be reinvested back in the firm to create growth
c. There may be cash inflows or outflows associated with the use of debt
d. All of the above
Explain.

Measuring the Payout Ratio
The conventional measure of dividend policy ““ the dividend payout ratio ““
gives us the value of dividends as a proportion of earnings. In contrast, our approach
measures the total cash returned to stockholders as a proportion of the free cash flow to
equity:
Dividend Payout Ratio = Dividends / Earnings
Cash to Stockholders to FCFE Ratio = (Dividends + Equity Repurchases) / FCFE
The ratio of cash returned to stockholders to FCFE shows how much of the cash available
to be paid out to stockholders is actually returned to them in the form of dividends and
stock buybacks. If this ratio, over time, is equal or close to 100%, the firm is paying out
all that it can to its stockholders. If it is significantly less than 100%, the firm is paying
out less than it can afford to and is using the difference to increase its cash balance or to
invest in marketable securities. If it is significantly over 100%, the firm is paying out
more than it can afford and is either drawing on an existing cash balance or issuing new
securities (stocks or bonds).

Illustration 11.3: Comparing Dividend Payout Ratios to FCFE Payout Ratios: Disney
and Aracruz
In the following analysis, we compare the dividend payout ratios to the cash to
stockholders as a percent of FCFE for Disney and Aracruz. Table 11.8 shows both
numbers for Disney from 1994 to 2003.

Table 11.8: Disney: Dividends as Percentage of Earnings and Cash Returned as
Percentage of FCFE


18
19

Cash returned
Payout to Cash
Year Net Income Dividends Ratio FCFE Stockholders Returned/FCFE
1994 $1,110.40 $153.20 13.80% $1,589.59 $723.90 45.54%
1995 $1,380.10 $180.00 13.04% $2,621.50 $528.70 20.17%
1996 $1,214.00 $271.00 22.32% ($235.00) $733.00 NA
1997 $1,966.00 $342.00 17.40% $3,535.00 $975.00 27.58%
1998 $1,850.00 $412.00 22.27% $2,538.00 $442.00 17.42%
1999 $1,300.00 $0.00 0.00% $3,132.00 $19.00 0.61%
2000 $920.00 $434.00 47.17% $168.00 $600.00 357.14%
2001 ($158.00) $438.00 NA ($366.00) $1,511.00 NA
2002 $1,236.00 $428.00 34.63% $3,057.00 $428.00 14.00%
2003 $1,267.00 $429.00 33.86% $414.00 $429.00 103.62%
1994-
$12,085.50 $3,087.20 25.54% $16,454.09 $6,389.60 38.83%
2003

As you can see, Disney paid out 25.54% of its aggregate earnings as dividends over this
period.6 Over the same period, it returned 38.83% of its FCFE to its stockholders in the
form of dividends and stock buybacks. Though the payout ratio gives us little information
about the company, the cash returned as a percent of FCFE suggests that Disney
accumulated cash during this period. Even if we ignore the cashflows generated by debt
in estimating FCFE, Disney returned only 65.91% of its FCFE to its stockholders in the
form of dividends and stock buybacks.
Table 11.9 shows dividend payout ratios and cash returned to stockholders as a
percent of FCFE for Aracruz from 1998 to 2003.
Table 11.9: Aracruz “ Dividends as Percentage of Earnings and Cash Returned as
Percent of FCFE
Year Net Income Dividends Payout Ratio FCFE Cash Cash
returned to Returned/FCFE
Stockholders
1998 $3.45 $24.39 707.51% $166.16 $50.79 30.57%
1999 $90.77 $18.20 20.05% ($413.53) $18.20 NA
2000 $201.71 $57.96 28.74% ($154.07) $80.68 NA
2001 $18.11 $63.17 348.87% $134.19 $63.17 47.08%
2002 $111.91 $73.80 65.94% $64.69 $75.98 117.45%
2003 $148.09 $109.31 73.81% $427.83 $112.31 26.25%
1998- $574.04 $346.83 60.42% $225.27 $401.12 178.07%



6 To compute the payout ratio over the entire period, we first aggregated earnings and dividends over the
entire period and then divided the aggregate dividends by the aggregate earnings. This avoids the problems
created by averaging ratios where outliers (very high ratios) are common.


19
20

2003
As with Disney, the payout ratio and the cash returned as a percent of FCFE tell you
different stories. While Aracruz paid out 60.42% of its aggregate earnings over the period
as dividends, the total cash returned as a percent of aggregate FCFE was in excess of
100%. Some of the dividends were clearly funded using cash accumulated at the start of
the period.

dividends.xls: This spreadsheet allows you to estimate the free cash flow to equity
and the cash returned to stockholders for a period of up to 10 years.



divfcfe.xls: There is a dataset on the web that summarizes dividends, cash
returned to stockholders and free cash flows to equity, by sector, in the United States.

Why Firms may pay out less than is available
For several reasons, many firms pay out less to stockholders, in the form of
dividends and stock buybacks, than they have available in free cash flows to equity. The
reasons vary from firm to firm and we list some below “
The managers of a firm may gain by retaining cash rather than paying it out as a

dividend. The desire for empire building may make increasing the size of the firm an
objective on its own. Or, management may feel the need to build up a cash cushion to
tide over periods when earnings may dip; in such periods, the cash cushion may
reduce or obscure the earnings drop and may allow managers to remain in control.
The firm may be unsure about its future financing needs and may choose to retain

some cash to take on unexpected investments or meet unanticipated needs.
The firm may have volatile earnings and may retain cash to help smooth out

dividends over time.
Bondholders may impose restrictions on cash payments to stockholders, which may

prevent the firm from returning available cash flows to its stockholders.


11.3. ˜: What happens to the FCFE that are not paid out?




20
21

In 2003, Microsoft had free cash flows to equity of roughly $ 9 billion, paid no dividends
and bought back no stock. Where would you expect to see the difference of $ 9 billion
show up in Microsoft™s financials?

<<

. 3
( 10 .)



>>