Cut payout Reduce Investment

Cut payout Invest in Projects

Ci g

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.

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