Corporate Finance, 6th 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. 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 its insufficient profitability. 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. It also means moving away from the target financial structure defined by the shareholders and management by reducing net indebtedness.

Additionally, ...