Excess Cash and Shareholder Payout Strategies
28 Pages Posted: 4 Sep 2012
Date Written: September 3, 2012
On 19 March 2012, the iconic technology company Apple announced a program to distribute its “excess” cash to shareholders in the form of dividends and share buybacks. This announcement follows a pattern similar to the then iconic Microsoft’s (MSFT) announcement in 2004. Likewise, the bluest of blue chips IBM took a path-breaking decision regarding share buybacks in the 1980s. And, in April 2012, IBM in line with many large corporations announced a major share buyback program and raised its dividends. Not to be left behind, in April 2012, Google announced a two-for-one stock split, even though this action should not be considered in the same category as stock buybacks and dividends. Similarly, in April 2012 Goldman, a financial leader, raised its dividend by 31%. On the contrary when JP Morgan’s $2 billion trading loss became public in May 2012, JPM canceled its share buyback program. These actions underscore the dictum that senior management’s major job is to allocate capital, including distributing it when necessary. In light of these events, this paper explores the analytical and empirical issues related to “excess cash”; dividends and share repurchases; and posits an analytical framework within which executives can allocate “excess cash” among competing uses including delevering, growth, special and regular dividends, and share buybacks. Bridging the gap between academia and practice, we find that once management meets its transactions, precautionary, and speculative (mergers and acquisitions) demands for cash, it turns its attention to capital structure and shareholder payout decisions. Assuming that the corporation’s capital structure is optimal (academic), and its rating agencies are content (pragmatic), the corporation pays out dividends to satisfy its core shareholders (clientele effects), based on comparables analysis and regarding how it wants to position itself in the eyes of equity investors. Management then buys back shares if this decision is Expected Net Present Value (NPV) positive, or alternatively has an Expected Internal Rate of Return (irr) higher than the company’s cost of equity. These observations are consistent with the Miller-Modigliani (M&M) theorems in that management engages in shareholder payout strategies to satisfy or exploit all the imperfections that the M&M theorems abstract from, such as clientele effects, signaling, and market under or over-valuations.
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