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
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 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.
Was this article helpful?