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price for its dividend policy. Even if the projects are passed up for other reasons, the cash


this firm is paying out as dividends would earn much better returns if left to accumulate
in the firm.
Dividend payments also create a cash deficit that now has to be met by issuing
new securities. Issuing new stock carries a potentially large issuance cost, which reduces
firm value. But, if the firm issues new debt, it might become overleveraged, and this may
reduce value.
Stockholder Reaction
The best course of action for stockholders is to insist that the firm pay out less in
dividends and invest in better projects. If the firm has paid high dividends for an extended
period of time and has acquired stockholders who value high dividends even more than
they value the firm™s long-term health, reducing dividends may be difficult. Even so,
stockholders may be much more amenable to cutting dividends and reinvesting in the
firm, if the firm has a ready supply of good projects at hand.
Management Responses
The managers of firms that have good projects, while paying out too much in
dividends, have to figure out a way to cut dividends, while differentiating themselves
from those firms that are cutting dividends due to declining earnings. The initial
suspicion with which markets view dividend cuts can be overcome, at least partially, by
providing markets with information about project quality at the time of the dividend cut.
If the dividends have been paid for a long time, however, the firm may have stockholders
who like the high dividends and may not particularly be interested in the projects that the
firm has available. If this is the case, the initial reaction to the dividend cut, no matter
how carefully packaged, will be negative. However, as disgruntled stockholders sell their
holdings, the firm will acquire new stockholders who may be more willing to accept the
lower dividend and higher investment policy.

11.6. ˜: Dividend Policy and High Growth Firms
High growth firms are often encouraged to start paying dividends to expand their
stockholder base, since there are stockholders who will not or cannot hold stock that do
not pay dividends. Do you agree with this rationale?
a. Yes


b. No

Step 4: Interaction between Dividend Policy and Financing Policy
The analysis of dividend policy is further enriched ““ and complicated ““ if we
bring in the firm™s financing decisions as well. In Chapter 9, we noted that one of the
ways a firm can increase leverage over time is by increasing dividends or repurchasing
stock; at the same time, it can decrease leverage by cutting or not paying dividends. Thus,
we cannot decide how much a firm should pay in dividends without determining whether
it is under- or over-levered and whether or not it intends to close this leverage gap.
An underlevered firm may be able to pay more than its FCFE as dividend and
may do so intentionally to increase its debt ratio. An overlevered firm, on the other hand,
may have to pay less than its FCFE as dividends, because of its desire to reduce leverage.
In some of the scenarios described above, leverage can be used to strengthen the
suggested recommendations. For instance, an under-levered firm with poor projects and a
cash flow surplus has an added incentive to raise dividends and to reevaluate investment
policy, since it will be able to increase its leverage by doing so. In some cases, however,
the imperatives of moving to an optimal debt ratio may act as a barrier to carrying out
changes in dividend policy. Thus, an over-levered firm with poor projects and a cash flow
surplus may find the cash better spent reducing debt rather than paying out dividends.

Illustration 11.5: Analyzing the Dividend Policy of Disney and Aracruz
Using the cash flow approach, described above, we are now in a position to
analyze Disney™s dividend policy. To do so, we will draw on three findings:
Earlier, we compared the cash returned to stockholders by Disney between 1994 and

2003 to its free cash flows to equity. On average, Disney paid out 38.83% of its free
cash flow to equity as dividends. In recent years, though, Disney has had significant
operating problems, and its net income reflects these troubles.
We then compared Disney™s return on equity and stock to the required rate of return,

and found that the company had under performed on both measures.
Finally, in our analysis in chapter 8, we noted that Disney was slightly under levered,

with an actual debt ratio of 21% and an optimal debt ratio of 30%.


Given its recent operating problems, we would recommend that Disney maintain its
existing dividend payments for the next year. If the higher earnings that the company has
reported in recent quarters are sustained, the free cash flows to equity will be higher than
the dividend payments, In table 11.10, we forecast the free cashflows to equity for Disney
over the next 5 years and compare it to existing dividend payments:
Table 11.10: Forecasted FCFE and Cash Available for Stock Buybacks: Disney
Current Rate 1 2 3 4 5
Net Income $1,267 6.00% $1,343 $1,424 $1,509 $1,600 $1,696
- (Cap Ex -
Deprec'n) (1 -
DR) ($20) $9 $41 $79 $123 $174
- Change in
Working Capital
(1 - DR) ($185) $22 $23 $24 $26 $28
FCFE $1,471 $1,313 $1,359 $1,405 $1,450 $1,494
Dividends $429 0.00% $429 $429 $429 $429 $429
Cash available
for stock
buybacks $1,042 $884 $930 $976 $1,021 $1,065

Revenues $27,061 6.00% $28,685 $30,406 $32,230 $34,164 $36,214
Non-cash WC $519 $31 $33 $35 $37 $39
Expenditures $1,049 10.00% $1,154 $1,269 $1,396 $1,536 $1,689
Depreciation $1,077 6.00% $1,142 $1,210 $1,283 $1,360 $1,441

Note that we have assumed that revenues, net income and depreciation are expected to
grow 6% a year for the next 5 years and that working capital remains at its existing
percentage (1.92%) of revenues. We have also assumed that capital expenditures will
grow faster (10%) over the next 5 years to compensate for reduced investment in prior
years. Finally, we assumed that 30% of the net capital expenditures and working capital
changes would be funded with debt, reflecting the optimal debt ratio we computed for
Disney in chapter 8. Based upon these forecasts, and assuming that Disney maintains its
existing dividend, Disney should have about $4.876 million in excess cash that it can
return to its stockholders either as dividends or in the form of stock buybacks over the


Examining Aracruz, we find that the firm is paying out more in dividends than it
has available in free cashflows to equity. If you couple this finding with large investment
needs, potentially good project returns and superior stock price performance, is seems
clear that Aracruz will gain by cutting its dividends. In fact, this conclusion is
strengthened when we forecast the free cashflows to equity for the next 5 years and
compare them to the dividends being paid in Table 11.11;
Table 11.11: Expected FCFE and Cash Available for Dividends
Current Rate 1 2 3 4 5
Net Income $148 5.00% $155 $163 $171 $180 $189
- (Cap Ex - Deprec'n) (1 -
DR) $176 $120 $126 $133 $139 $146
- Change in Working Capital
(1 - DR) ($5) $5 $5 $6 $6 $6
FCFE ($23) $30 $32 $33 $35 $37
Expected Dividends $109 0.00% $109 $109 $109 $109 $109
Cash available for stock
buybacks ($79) ($78) ($76) ($74) ($73)

Non-cash WC $1,003 5.00% $1,053 $1,106 $1,161 $1,219 $1,280
Capital Expenditures $150 $8 $8 $8 $9 $9
Depreciation $421 5.00% $347 $365 $383 $402 $422

In making these estimates, we assumed that revenues, net income, capital expenditures
and depreciation will all grow 5% a year for the next 5 years and the non-cash working
capital will remain at 15% of revenues. For capital expenditures, which have been
volatile over the last few years, we used the average amount from 2000-03 as the base
year number. If Aracruz maintains its existing dividends, the firm will find itself facing
cash deficits in each of the next 5 years, aggregating to about $381 million. While the
case for cutting dividends is strong, Aracruz has a potential problem because of its share
structure, where the “preferred shares” held by outside investors get no voting rights but
are compensated for with a larger dividend. Cutting dividends may violate the
commitments given to preferred stockholders and trigger at least a partial loss of control.
While there is no easy solution, it highlights a cost of trading off dividends for control.


Figure 11.4: A Framework for Analyzing Dividend Policy

How much did the firm pay out? How much could it have afforded to pay out?
What it could have paid out What it actually paid out
Net Income Dividends
- (Cap Ex - Depr™n) (1-DR) + Equity Repurchase
- Chg Working Capital (1-DR)

Firm pays out too little Firm pays out too much
FCFE > Dividends FCFE < Dividends

Do you trust managers in the company with What investment opportunities does the
your cash? firm have?
Look at past project choice: Look at past project choice:
Compare ROE to Cost of Equity Compare ROE to Cost of Equity

Firm has history of Firm has history Firm has good Firm has poor
good project choice of poor project projects projects
and good projects in choice
the future

Give managers the Force managers to Firm should Firm should deal
flexibility to keep justify holding cash cut dividends with its investment
cash and set or return cash to and reinvest problem first and
dividends stockholders more then cut dividends

A Comparable Firm Approach to Analyzing Dividend Policy
So far, we have examined the dividend policy of a firm by looking at its cash
flows and the quality of its investments. There are managers who believe that their
dividend policies are judged relative to those of their competitors. This “comparable-
firm” approach to analyzing dividend policy is often used narrowly, by looking at only
firms that are similar in size and business mix, for example. As we will illustrate, it can
be used more broadly, by looking at the determinants of dividend policy across all firms
in the market.

Using Firms in the Industry
In the simplest form of this approach, a firm™s dividend yield and payout are
compared to those of firms in its industry and judged to be adequate, excessive, or
inadequate, accordingly. Thus, a utility stock with a dividend yield of 3.5% may be
criticized for paying out an inadequate dividend if utility stocks, on average, have a much
higher dividend yield. In contrast, a computer software firm that has a dividend yield of
1.0% may be viewed as paying too high a dividend, if software firms on average pay a
much lower dividend.
While comparing a firm to comparable firms on dividend yield and payout may
have some intuitive appeal, it can be misleading. First, it assumes that all firms within the
same industry group have the same net capital expenditure and working capital needs.
These assumptions may not be true, if firms are in different stages of the life cycle.
Second, even if the firms are at the same stage in their life cycles, the entire industry may
have a dividend policy that is unsustainable or sub-optimal. Third, it does not consider
stock buybacks as an alternative to dividends. The third criticism can be mitigated when
the approach is extended to compare cash returned to stockholders, rather than just

divfund.xls: There is a dataset on the web that summarizes the dividend yields
and payout ratios, by sector, for U.S. companies.


Illustration 11.6: Analyzing Disney™s Dividend Payout Using Comparable Firms
In comparing Disney™s dividend policy to its peer group, we analyze the dividend
yields and payout ratios of comparable firms in 2003, as shown in Table 11.12. We
defined comparable firms as entertainment companies with a market capitalization in
excess of $ 1 billion.
Table 11.12: Payout Ratios and Dividend Yields: Entertainment Companies
Company Name Dividend Yield Dividend Payout
Astral Media Inc. 'A' 0.00% 0.00%
Belo Corp. 'A' 1.34% 34.13%
CanWest Global Comm. Corp. 0.00% 0.00%
Cinram Intl Inc 0.00% 0.00%
Clear Channel 0.85% 35.29%
Cox Radio 'A' Inc 0.00% 0.00%
Cumulus Media Inc 0.00% 0.00%
Disney (Walt) 0.90% 32.31%
Emmis Communications 0.00% 0.00%
Entercom Comm. Corp 0.00% 0.00%


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