Corporate Finance, 4th Edition

Chapter 36Returning cash to shareholders

It's all grist to the mill

Net income has only two possible destinations: either it is reinvested in the business in the form of internal financing or it is redistributed to shareholders in dividends or share buy-backs.

In pure financial logic, all funds that cannot be reinvested yielding at least the appropriate cost of capital (i.e. the cost of capital that reflects the risk of the project) should be returned, in one form or another, to shareholders.

In fact, when the capital structure of the firm already corresponds to the target fixed by shareholders and management, every cent left in the company in the form of cash will only yield the short-term interest rate, i.e. much less than the cost of equity. In this context, it is very likely that shareholders will value it at less than a cent given the low return provided. After all, shareholders do not need the firm to place cash at the bank. All in all, failure to comply with this rule will most likely lead to value destruction.

Additionally, the business risk should be financed through equity; otherwise, the firm is likely to face strong liquidity issues at the first downturn. Conversely, a company that has reached economic maturity with a strong strategic position may reduce its equity financing and select a higher gearing. The business cash flows have become sufficiently sound to support the cash requirements of debt.

Equity exists to support the business risk; therefore it is normal ...