Reading: Cash Distributions
Cash Distributions
•A
company must have cash before it can make a cash distribution to shareholders,
we will 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
FCF 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 source of FCF depends on a company’s investment
opportunities and its effectiveness in turning those opportunities into
realities.
•Notice
that
a company with many opportunities will have large investments in operating
capital and might have negative FCF even if it is profitable. When growth
begins to slow, a profitable company’s FCF 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 flows.
•There
are only five potentially “good” ways to use free cash flow:
(1) pay interest expenses (after tax)
(2) pay down the principal on debt
(3) pay dividends
(4) repurchase stock
(5) buy short-term investments or other non-operating assets.
(1) pay interest expenses (after tax)
(2) pay down the principal on debt
(3) pay dividends
(4) repurchase stock
(5) buy short-term investments or other non-operating assets.
•If a
company’s FCF is negative, then its “uses” of FCF 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
after FCF becomes positive, some of its “uses” can be negative.
•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 time if the company maintains a target capital structure.
•If
a
company instead were to pay off its debt, then it would lose valuable 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 FCF is positive. The addition of debt is a “negative use” of FCF, which
provides even more FCF for other uses.
•A
company’s working capital policies determine its level of short-term
investments, such as T-bills or other marketable securities.
Recognize that
the 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 costs due to raising external
funds.
•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.
•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. The most rational explanation is that such companies are
using short-term investments temporarily until deciding how to use the cash.
•Purchasing
short-term investments is a positive use of FCF, and selling short-term
investments is negative use. If a particular use of FCF 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 FCF. 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 FCF should be distributed to shareholders,
with the only question being how much to distribute in the form of dividends
versus stock repurchases.
•Obviously
this is a simplification, because companies (1) sometimes scale back their
operating plans for sales and asset growth if such reductions are needed to
maintain an existing dividend, (2) temporarily adjust their current financing
mix in response to market conditions, and (3) often use marketable securities
as shock absorbers for fluctuations in 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.
Last modified: Tuesday, August 14, 2018, 8:54 AM