Chapter 36 Returning 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 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. Today this may even mean yielding a negative return given the negative interest rates in certain regions of the world. It is true that the financial risk of the firm is then reduced, but it is not what shareholders are looking for (shareholders theoretically manage financial risks at their portfolio level). 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. ...

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