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:
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