Now that we understand the basic mechanics of dividends and share repurchases, it is time to drop some of the strict assumptions from the previous section and look at the relevance of payout decisions in reality.
The purpose of this section is to investigate under which scenarios payout decisions actually do matter. The key question here is whether a dollar of cash is more valuable inside the firm or outside the firm. We discuss the main elements of an answer to that question.
- In principle, if the firm has investment opportunities that offer a higher return than the cost of capital, retaining cash (reducing payout) increases firm value, and vice versa.
- We look at the economic reality and see that (mature) firms, on average, do not have many investment opportunities that significantly enhance firm value. Reinvesting cash is therefore not necessarily a value-enhancing proposition.
- We also look at the empirical evidence about the value of excess cash holdings inside the firm and some of the determining factors
- Finally, we present a framework that allows us to assess the three main effects that payout decisions can have on firm value.
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