Video Transcript: Cash Distributions

Hello, welcome. We're going to discuss cash distributions. A company must  have cash before it can make a cash distribution to shareholders. We'll examine  a company's sources of cash. Occasionally, the cash comes from a  recapitalization or the sale of an asset, but in most cases, it comes from the  company's internally generated free cash flow recall. That free cash flow is  defined as the amount of cash flow available for distribution to investors after  expenses, taxes and the necessary investments in operating capital. Thus the  sources of free cash flow depend on a company's investment opportunities and  its effectiveness in turning those opportunities into reality. Notice that a company with many opportunities will have large investments in operating capital and  might have negative free cash flow, even if it is profitable when growth, when  growth begins to slow, a profitable company's free cash flow will be positive and  very large. Home Depot and Microsoft are good examples of once fast growing  companies that are now generating large amounts of free cash flow, because  once a firm is established in their market and they're a leader and their industry,  they have more than likely, paid down the majority of their debt. Their operations are in place. They're no longer investing into large growth projects, and now  they are just generating free cash flow from current operations. There are only  five potentially good ways to use free cash flow. One, pay down interest  expenses after tax, pay down the principal on the debt. We want to knock out  that debt. First, it is such a burden, it holds liabilities onto our assets, and now  the owner of our assets shifts from us to the debt holder. So pay down the debt  as quickly as possible. Three, pay out dividends to your shareholders. Four,  repurchase stock, go to the market, actually go back and repurchase your own  stock. Buy short term investments or other non operating assets. So we can buy out the company stocks. You buy another company's corporate bond issuances,  if a company's free cash flow is negative, then its uses of free cash flow must  also be negative. For example, a growing company often issues new debt rather than repaying debt, and issues new shares of stock rather than repurchasing  outstanding shares. Even if free cash flow becomes positive, some of its uses  can be negative, such as repurchasing or issuing new debt. A company's capital  structure choice determines its payments for interest expenses and debt  principal. A company's value typically increases over time, even if the company  is mature, which implies its debt will also increase over the time, over time, if the company maintains a target capital structure, so a value will increase as we  have the right debt to equity mix, because we finance operations correctly and  optimally, it will help the rest of our operation turn in a more fluid fashion. If a  company instead were to pay off its debt, then it would lose viable tax shields  associated with the deductibility of interest expenses. Therefore, most  companies make net additions to debt over time, rather than net repayments.  Even if free cash flow is positive, the addition of debt is a negative use of cash,  free cash flow, which provides even more free cash flow for other uses. A 

company's working capital policies determine its level of short term investments  such as Treasury bills or other marketable securities. Marketable securities  being maybe another company stock, recognize that the decision, decision  involves a trade off between the benefits and costs of holding a large amount of  short term investments. In terms of benefits, a large holding, reduces the risk of  financial distress. Should there be an economic downturn? Also, if growth  opportunities turn out to be better than expected, short term investments provide a ready source of funding that does not incur the flotation or signaling cost due  to raise external funds. So we don't want to take on the additional cost of issuing new stock to raise capital, because then we can create negative cash, negative  free cash flows and instances like this. And we want to avoid negative free cash  flow as a possible i. However, there is a potential agency cost. If a company has a large investment in marketable securities, then managers might be tempted to  squander the money on perks such as corporate jets or high priced acquisitions  that are unnecessary and that aren't the most efficient, effective sources of  capital for our shareholders. However, many companies have much bigger short term investments than the previous reasons can explain. For example, Apple  has over $100 billion and Microsoft has about $60 billion as free cash flow. The  most rational explanation is that such companies are using short term  investments temporarily until deciding how to use the cash. So they're just sitting on the cash, and they're using short term investments right to fund whatever  they need in their operation. So they're just sitting on all this cash and they're  trying to decide on what to do with all this cash. And in the meantime, as they sit on this cash file, they're funding their operations with short term investments and liabilities, purchasing short term investments is a positive use of free cash flow,  and selling short term investments is negative use. If a particular use of free  cash flow is negative, then some other use must be larger than it otherwise  would have been, in summary, a company's investment opportunities and  operating plans determine its level of free cash flow. The company's capital  structure policy determines the amount of debt and interest payments. Working  Capital policy determines the investment in marketable securities. The  remaining free cash flow should be distributed to shareholders, with the only  question being how much to distribute in the form of dividends versus stock  repurchases. Obviously, our example is a simplification, because companies  sometimes scale back their operating plans for sales and asset growth if such  reductions are needed to maintain an existing dividend or temporarily adjust  their current financing mix in response to market conditions, and often use  marketable securities as a shock absorber for fluctuations and short term cash  flows. Still, there is an interdependence among operating plans, which have the  biggest impact on free cash flow, financing plans, which have the biggest impact on the cost of capital, working capital policies, which determine the target level  of marketable securities and shareholder distributions.