Optimal Dividend Policy 05292008 Ch 11 Is there

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Optimal Dividend Policy 05/29/2008 Ch. 11

Optimal Dividend Policy 05/29/2008 Ch. 11

Is there an Optimal Dividend Policy? n Balance between cash needs of the company

Is there an Optimal Dividend Policy? n Balance between cash needs of the company for investment purposes and cash payments to the shareholders n Not part of the debate is the type of dividend, share repurchase or cash dividend n What we need to measure Free Cash Flow to Equity Holders n Project Performance n 2

Free Cash Flow to Equity n How much cash could we give back out

Free Cash Flow to Equity n How much cash could we give back out of current operations at a sustainable rate? n n Note we could sell assets and give all the cash to equity holders (after paying off debt) but this is a liquidity event… Want to know cash flow available in an on-going concern n FCFE -- Components n Net Income n Minus Capital Expenditures n Minus Increase in Working Capital n Plus net new debt borrowing FCFE = NI – Cap. Spend + Dep. – ΔWC + Net New Debt 3

Payout Ratio: Dividends to FCFE n Given the current level of FCFE, what percent

Payout Ratio: Dividends to FCFE n Given the current level of FCFE, what percent is paid out in Dividends Less than 100% -- means company is accumulating cash above current investment needs n Exactly 100% -- means company is meeting new investment needs and paying out remainder in dividends n Over 100% -- means company is drawing down cash and cash equivalents Dividend Payout Ratio = Dividends/Earnings Cash to Equity/FCFE Ratio = Dividends/FCFE Where dividends are both cash and stock repurchases n 4

Analyzing Project Performance n Once we know the current payout stream we need to

Analyzing Project Performance n Once we know the current payout stream we need to know the projects competing for the payout and the past success of the projects… n Don’t want to keep money in the firm if the firm can not earn the ROE required by investors n Want to use internal funds if projects are beating the ROE required by investors n The internal measure of project quality is NPV or IRR above the hurdle rate 5

Analyzing Performance with Outside Data n What if we don’t know the projects (their

Analyzing Performance with Outside Data n What if we don’t know the projects (their respective NPVs or IRRs)? n n n Accounting returns… Economic Value Added… Jensen’s alpha n Let’s just use Jensen’s alpha… n Find the stocks actual return n Find the expected return given the market’s performance n Find the difference (alpha) 6

Example of Jensen’s Alpha n Stock price change for the year… n Look at

Example of Jensen’s Alpha n Stock price change for the year… n Look at Pepsi for 2007 n Price at start of the year, $62. 56 n Price at end of year, $75. 90 n Dividends paid $1. 425 n Stock Return, 23. 60% n Expected Return: n Look at beta, and market data n Beta (should be around 0. 95…) n Market return for 2007, 5. 15% n Risk-free rate, 2. 5% n Expected Return = 2. 5% + 0. 95 x (2. 65%) = 4. 90% n Jensen’s Alpha = 23. 60% - 4. 49% = 18. 7% 7

Evaluating Dividend Policy n Two Dimensions (see page 505) n Project Quality n Cash

Evaluating Dividend Policy n Two Dimensions (see page 505) n Project Quality n Cash Return vs. FCFE n Box 1 (upper left) – Poor Projects & <FCFE n Box 2 (upper right) – Good Projects & <FCFE n Box 3 (lower left) -- Poor Projects & >FCFE n Box 4 (lower right) – Good Projects & >FCFE n Based on these boxes, when do you raise and when do you lower dividends? 8

Problems Due Tuesday June 3 Chapter 10 n Number 12 Chapter 11 n Number

Problems Due Tuesday June 3 Chapter 10 n Number 12 Chapter 11 n Number 12 – Should the company pay dividends, if so how much? n Number 13 – What projects should it take and what if any dividends should it pay? n Number 14 – What should the dividend be? n Number 16 – How much can the company afford in dividends? 9