Temporary Excess Cash

In some cases, firms are tempted to pay or initiate dividends in years in which their operations generate excess cash. Although it is perfectly legitimate to return excess cash to stockholders, firms should also consider their own long-term investment needs. If the excess cash is a temporary phenomenon, resulting from having an unusually good year or a non-recurring action (such as the sale of an asset), and the firm expects cash shortfalls in future years, it may be better off retaining the cash to cover some or all these shortfalls. Another option is to pay the excess cash as a dividend in the current year and issue new stock when the cash shortfall occurs. This is not very practical because the substantial expense associated with new security issues makes this a costly strategy in the long term. Figure 10.12 summarizes the cost of issuing bonds and common stock, by size of issue in the United States.9

Figure 10.12: Issuance Costs for Slocks and Bonds

□ Cost of Issuing bonds M Cost of Issuing Common Stock

Source: Ibbotson, Sindelar and Ritter (1997)

9 Ibbotson, R. G., J. L. Sindelar and J. R. Ritter. 1988, Initial Public Offerings, Journal of Applied Corporate Finance, v1(2), 37-45.

Figure 10.12: Issuance Costs for Slocks and Bonds

□ Cost of Issuing bonds M Cost of Issuing Common Stock

Since issuance costs increase as the size of the issue decreases and for common stock issues, small firms should be especially cautious about paying out temporary excess cash as dividends. This said, it is important to note that some companies do pay dividends and issue stock during the course of the same period, mostly out of a desire to maintain their dividends. Figure 10.13 reports new stock issues by firms as a percentage of firm value, classified by their dividend yields, in 1998.

Figure 21.11: Equity Issues by Dividend Class, United States - 1998

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