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Optimal Dividend Policy

Optimal Dividend Policy. 05/29/2008 Ch. 11. Is there an Optimal Dividend Policy?. Balance between cash needs of the company for investment purposes and cash payments to the shareholders Not part of the debate is the type of dividend, share repurchase or cash dividend What we need to measure

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Optimal Dividend Policy

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  1. Optimal Dividend Policy 05/29/2008 Ch. 11

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

  3. Free Cash Flow to Equity • How much cash could we give back out of current operations at a sustainable rate? • Note we could sell all 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 • FCFE -- Components • Net Income • Minus Capital Expenditures • Minus Increase in Working Capital • Plus net new debt borrowing FCFE = NI – Cap. Spend + Dep. – ΔWC + Net New Debt

  4. Payout Ratio: Dividends to FCFE • 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 • Exactly 100% -- means company is meeting new investment needs and paying out remainder in dividends • 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

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

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

  7. Example of Jensen’s Alpha • Stock price change for the year… • Look at Pepsi for 2007 • Price at start of the year, $62.56 • Price at end of year, $75.90 • Dividends paid $1.425 • Stock Return, 23.60% • Expected Return: • Look at beta, and market data • Beta (should be around 0.95…) • Market return for 2007, 5.15% • Risk-free rate, 2.5% • Expected Return = 2.5% + 0.95 x (2.65%) = 4.90% • Jensen’s Alpha = 23.60% - 4.49% = 18.7%

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

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

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