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Figure 11.5 illustrates the possible combinations of cash payout and project quality.

Figure 11.5: Analyzing Dividend Policy
Poor Projects Good Projects

Increase payout
Flexibility to
Reduce Investment
Cash Returned < FCFE Microsoft


Cash Returned > FCFE

Cut payout Cut payout
Reduce Investment Invest in Projects

ROE - Cost of Equity

In this matrix, Aracruz, with its superior (albeit barely) project returns and its history of
paying out more in dividends than it has available in free cash flows to equity falls in the
quadrant where cutting dividends and redirecting the cash to projects seems to make the
most sense. Disney, on the other hand, which pays less in dividends than it has available
in free cash flows to equity and has a recent history of poor project returns, clearly will
come under pressure to return more cash to its stockholders.
Note, though, that the pressure to pay dividends comes from the lack of trust in
Disney™s management rather than any greed on the part of stockholders. For a contrast,
consider Microsoft, which had $11.175 billion in free cashflows to equity inn 2003 and
returned only $857 million in dividends. The company™s high return on equity (>25%)
and superior stock price performance earned it the flexibility to pay out far less in cash
than it generated, with little protest from stockholders.


While we might obtain estimates of return on equity and free cash flow to equity
by looking at past data, the entire analysis should be forward looking. The objective is
not to estimate return on equity on past projects, but to forecast expected returns on future
investments. Only to the degree that past information is useful in making these forecasts
is it an integral part of the analysis.

Consequences of Payout not matching FCFE
The consequences of the cash payout to stockholders not matching the free cash
flows to equity can vary depending upon the quality of a firm™s projects. In this section,
we examine the consequences of paying out too little or too much for firms with good
projects and for firms with bad projects. We also look at how managers in these firms
may justify their payout policy, and how stockholders are likely to react to the

A. Poor Projects and Low Payout
There are firms that invest in poor projects and accumulate cash by not returning
the cash they have available to stockholders. We discuss stockholder reaction and
management response to the dividend policy.
Consequences of Low Payout
When a firm pays out less than it can afford to in dividends, it accumulates cash.
If a firm does not have good projects in which to invest this cash, it faces several
possibilities: In the most benign case, the cash accumulates in the firm and is invested in
financial assets. Assuming that these financial assets are fairly priced, the investments are
zero net present value projects and should not negatively affect firm value. There is the
possibility, however, that the firm may find itself the target of an acquisition, financed in
part by its large holdings of liquid assets.
In the more damaging scenario, as the cash in the firm accumulates, the managers
may be tempted to invest in projects that do not meet their hurdle rates, either to reduce
the likelihood of a takeover or to earn higher returns than they would on financial assets.8

8This is especially likely if the cash is invested in treasury bills or other low-risk low-return investments.
On the surface, it may seem better for the firm to take on risky projects that earn, say 7%, than invest in
T.Bills and make 3%, though this clearly does not make sense after adjusting for the risk.


These actions will lower the value of the firm. Another possibility is that the management
may decide to use the cash to finance an acquisition. This hurts stockholders in the firm
because some of their wealth is transferred to the stockholders of the acquired firms. The
managers will claim that such acquisitions have strategic and synergistic benefits. The
evidence9 indicates, however, that most firms that have financed takeovers with large
cash balances, acquired over years of paying low dividends while generating high free
cash flows to equity, have reduced stockholder value.
Stockholder Reaction
Because of the negative consequences of building large cash balances,
stockholders of firms that pay insufficient dividends and do not have “good” projects
pressure managers to return more of the cash back to them. This is the basis for the free
cash flow hypothesis, where dividends serve to reduce free cash flows available to
managers and, by doing so, reduce the losses management actions can create for
Management™s Defense
Not surprisingly, managers of firms that pay out less in dividends than they can
afford view this policy as being in the best long-term interests of the firm. They maintain
that while the current project returns may be poor, future projects will both be more
plentiful and have higher returns. Such arguments may be believable initially, but they
become more difficult to sustain if the firm continues to earn poor returns on its projects.
Managers may also claim that the cash accumulation is needed to meet demands arising
from future contingencies. For instance, cyclical firms will often state that large cash
balances are needed to tide them over the next recession. Again, while there is some truth
to this view, the reasonableness of the cash balance must be compared to the experience
of the firm in terms of cash requirements in prior recessions.
Finally, in some cases, managers will justify a firm™s cash accumulation and low
dividend payout based upon the behavior of comparable firms. Thus, a firm may claim
that it is essentially matching the dividend policy of its closest competitors and that it has

9 See chapter 26.


to continue to do so to remain competitive. The argument that “every one else does it”
cannot be used to justify a bad dividend policy, however.
Although all these justifications seem consistent with stockholder wealth
maximization or the best long-term interests of the firm, they may really be smoke
screens designed to hide the fact that this dividend policy serves managerial rather than
stockholder interests. Maintaining large cash balances and low dividends provides
managers with two advantages: it increases the funds that are directly under their control
and thus increases their power to direct future investments; and it increases their margin
for safety stabilizing earnings and protecting their jobs.

B. Good Projects and Low Payout
While the outcomes for stockholders in firms with poor projects and low dividend
payout ratios range from neutral to terrible, the results may be more positive for firms
that have a better selection of projects, and whose management have had a history of
earning high returns for stockholders.
Consequences of Low Payout
The immediate consequence of paying out less in dividends than is available in
free cash flow to equity is the same for firms with good projects as it is for firms with
poor projects: the cash balance of the firm increases to reflect the cash surplus. The long
term effects of cash accumulation are generally much less negative for these firms,
however, for the following reasons:
These firms have projects that earn returns greater than the hurdle rate, and it likely

that the cash will be used productively in the long term.
The high returns earned on internal projects reduces both the pressure and the

incentive to invest the cash in poor projects or in acquisitions.
Firms that earn high returns on their projects are much less likely to be targets of

takeovers, reducing the threat of hostile acquisitions.
To summarize, firms that have a history of investing in good projects and that expect to
continue to have such projects in the future may be able to sustain a policy of retaining
cash rather than paying out dividends. In fact, they can actually create value in the long
term by using this cash productively.


Stockholders Reaction
Stockholders are much less likely to feel a threat to their wealth in firms that have
historically shown good judgment in picking projects. Consequently, they are more likely
to agree when managers in those firms withhold cash rather than pay it out. While there is
a solid basis for arguing that managers cannot be trusted with large cash balances, this
proposition does not apply equally across all firms. The managers of some firms earn the
trust of their stockholders because of their capacity to deliver extraordinary returns on
both their projects and their stock over long periods of time. These managers will be
generally have much more flexibility in determining dividend policy.
The notion that greedy stockholders force firms with great investments to return
too much cash too quickly is not based in fact. Rather, stockholder pressure for dividends
or stock repurchases is greatest in firms whose projects yield marginal or poor returns,
and least in firms whose projects have high returns.
Management Responses
Managers in firms that have posted stellar records in project and stock returns
clearly have a much easier time convincing stockholders of the desirability of
withholding cash rather than paying it out. The most convincing argument for retaining
funds for reinvestment is that the cash will be used productively in the future and earn
excess returns for the stockholders. Not all stockholders will agree with this view,
especially if they feel that future projects will be less attractive than past projects, as may
occur if the industry in which the firm operates is maturing. For example, many specialty
retail firms, such as the Limited, found themselves under pressure to return more cash to
stockholders in the early 1990s as margins and growth rates in the business declined.

C. Poor Projects and High Payout
In many ways, the most troublesome combination of circumstances occurs when
firms pay out much more in dividends than they can afford, and at the same time earn
disappointing returns on their projects. These firms have problems with both their
investment and their dividend policies, and the latter cannot be solved adequately without
addressing the former.


Consequences of High Payout
When a firm pays out more in dividends than it has available in free cash flows to
equity, it is creating a cash deficit that has to be funded by drawing on the firm™s cash
balance, by issuing stock to cover the shortfall, or by borrowing money to fund its
dividends. If the firm uses its cash reserves, it will reduce equity and raise its debt ratio. If
it issues new equity, the drawback is the issuance cost of the stock. By borrowing money,
the firm increases its debt, while reducing equity and increasing its debt ratio.
Since the free cash flows to equity are after capital expenditures, this firm™s real
problem is not that it pays out too much in dividends, but that it invests too heavily in bad
projects. Cutting back on these projects would therefore increase the free cash flow to
equity and might eliminate the cash shortfall created by paying dividends.
Stockholder Reaction
The stockholders of a firm that pays more in dividends than it has available in free
cash flow to equity faces a dilemma: On the one hand, they may want the firm to reduce
its dividends to eliminate the need for additional borrowing or equity issues each year.
On the other hand, the management™s record in picking projects does not evoke much
trust that the firm is using funds wisely, and it is likely that the funds saved by not paying
the dividends will be used on other poor projects. Consequently, these firms will first
have to solve their investment problems and then cut back on poor projects, which, in
turn, will increase the free cash flow to equity. If the cash shortfall persists, the firm
should then cut back on dividends.
It is therefore entirely possible, especially if the firm is underleveraged to begin
with, that the stockholders will not push for lower dividends but will try to convince
managers to improve project choice instead. It is also possible that they will encourage
the firm to eliminate enough poor projects so that the free cash flow to equity covers the
expected dividend payment.
Management Responses
The managers of firms with poor projects and dividends that exceed free cash
flows to equity may not think that they have investment problems rather than dividend
problems. They may also disagree that the most efficient way of dealing with these
problems is to eliminate some of the capital expenditures. In general, their views will be


the same as managers who have a poor investment track record. They will claim the
period used to analyze project returns was not representative, it was an industry-wide
problem that will pass, or the projects have long gestation periods.
Overall, it is unlikely that these managers will convince the stockholders of their
good intentions on future projects. Consequently, there will be a strong push towards
cutbacks in capital expenditures, especially if the firm is borrowing money to finance the
dividends and does not have much excess debt capacity.

11.5. ˜: Stockholder Pressure and Dividend Policy
Which of the following companies would you expect to see under greatest pressure from
its stockholders to buy back stock or pay large dividends? (All of the companies have
costs of capital of 12%.)
a. A company with a historical return on capital of 25%, and a small cash balance
b. A company with a historical return on capital of 6%, and a small cash balance
c. A company with a historical return on capital of 25%, and a large cash balance
d. A company with a historical return on capital of 6%, and a large cash balance
The managers at the company argue that they need the cash to do acquisitions. Would
this make it more or less likely that stockholders will push for stock buybacks?
a. More likely
b. Less likely

D. Good Projects and High Payout
The costs of trying to maintain unsustainable dividends are most evident in firms
that have a selection of good projects to choose from. The cash that is paid out as
dividends could well have been used to invest in some of these projects, leading to a
much higher return for stockholders and higher stock prices for the firm.
Consequences of High Payout
When a firm pays out more in dividends than it has available in free cash flow to
equity, it is creating a cash shortfall. If this firm also has good projects available but
cannot invest in them because of capital rationing constraints, the firm is paying a hefty


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