3. Coping with Excess Cash

Many mature firms hold considerable amounts of cash that has been retained from past earnings or divestitures. This cash is not directly needed to support the firm's business activities, which is why it is often referred to as "excess cash."

Economically, excess cash can be considered negative debt: Instead of borrowing from the bank, the company lends money to the bank. The difference between how much the firm borrows from the bank (debt) and how much it lends to the bank (excess cash) is generally referred to as the firm's net debt:

 

Net debt = Debt - Excess cash (and other investments).

 

As we discuss in great detail in the module "Relative Valuation," net debt is also the measure of debt that analysts use when valuing firms.

For the purpose of our investigation here, the key issue is that the mirror-inverted characteristics of debt and excess cash also apply to interest tax effects. Whereas the debt-related interest expenses paid to the bank create a tax shield for the firm (they lower taxable income), the opposite is true of interest income earned on excess cash. This interest income the firm earns on excess cash increases the firm's taxable income and, therefore, brings about a tax penalty. By returning excess cash to shareholders, firms can resolve this tax penalty and thereby increase firm value.

 

The question is how to handle a situation where a firm pays out excess cash. Assuming the firm earns the same intrest rate on the excess cash as it pays on its debt, all we need to do is to adjust the definition of "debt" in the preceding analysis and work with "net debt" instead.

 

Let us practice this procedure with an example.