2. Payout and Investment Opportunities

To see how the availability of investment opportunities affects the value of payout decisions, let us go back to our simple example from the previous section, where we considered a firm with a cash flow of 100 today and 110 in one year.

Now we drop one of the initial assumptions, namely that investors and the firm have the same investment opportunities.

In competitive capital markets, it seems fair to assume that investors, on average, have access to investment opportunities on which they can expect to earn the cost of capital. Their investment decisions are, therefore, value neutral, in the sense that they can expect to earn a fair return given the risk of the investment. This is, in fact how the cost of capital is defined: It reflects the rate of return the investor could earn when putting the same amount of money into an alternative investment with identical risk (see the module Cost of Capital and Valuation for a detailed discussion).

 

But what about the firm? 

So far, we have assumed that the firm invests retained earnings at the cost of capital. Since the resulting investment return is equal to that of the shareholders' alternative investment opportunities, changes in the payout policy are value neutral. 

Not surprisingly, this picture changes when we allow for reinvestment returns that differ from the cost of capital. As soon as the reinvestment return differs from the cost of capital, changes in the payout policy have potential value implications.

 

To see this more clearly, let us slightly modify the original example.

 

Modified example:

Let us assume that the firm decides to withhold parts of the initial cash flow for reinvestment into an additional project. In the original example, we have assumed that the firm withholds 60 of the original cash flow of 100 and reinvests these funds at a reinvestment return that equals the cost of capital of 10%.

Now we consider reinvestment returns that differ from the cost of capital. Using the terminology from the module on Growth and Investment in the Steady State, we refer to the reinvestment return as Return on Incremental Capital (ROIC) and the cost of capital as Weighted Average Cost of Capital (WACC).

 

Case 1: Reinvestment Return Larger than the Cost of Capital (ROIC > WACC)

If the reinvestment return (ROIC) exceeds the cost of capital (WACC), a dollar inside the company is more valuable than a dollar outside the company. Reducing current dividends with the purpose of investing the retained funds into such projects would, therefore, be a value-enhancing decision.

To see this more explicitly, let us assume that our firm can invest 60 of the current free cash flow into a project with identical risk that is expected to generate a return (ROIC) of 20%.

 

How will the market react to the announcement of this change in the payout policy?

Upon the announcement, shareholders will update their expectations about the future cash flows of the firm. Instead of 100 today and 110 in one year, they now expect to collect 40 today (= 100 - 60) and 182 in one year (= 110 + 1.2 × 60). The equity value will therefore increase to 205.5 and the stock price will go to 20.55 after the announcement:

  

\( E' = Div_0 + \frac{Div_1}{(1+k_A)} = 40 + \frac{182}{1.1} = 205.5 \)

    

\( P' = \frac{E'}{N} = \frac{205.5}{10} = 20.55 \)

   

Shareholders are better off by keeping the money inside the firm because inside the firm is where the money generates higher returns.

 

Case 2: Reinvestment Return Smaller than the Cost of Capital (ROIC < WACC)

Not surprisingly, the opposite is true if the firm reinvests into projects that fail to cover the cost of capital. In this case, retaining funds for reinvestment is a value-reducing decision.

To see this, let us assume that, as before, the firm announces that it will retain 60 of the initial cash flow for reinvestment into a new project, but that the market expects this new project to generate a reinvestment return (ROIC) of only 5%.

Accordingly, shareholders will update their expectations about the firm's future cash flows. With the additional project, they now expect to collect 40 today (= 100 - 60) and 173 in one year (= 110 + 1.05 × 60). The equity value will therefore drop to 197.3 and the stock price will go to 19.73 after the announcement:

  

\( E' = Div_0 + \frac{Div_1}{(1+k_A)} = 40 + \frac{173}{1.1} = 197.3 \)

    

\( P' = \frac{E'}{N} = \frac{197.3}{10} = 19.73 \)

    

Clearly, in such instances, a dollar inside the firm is less valuable than a dollar paid out to shareholders. Therefore, shareholders are better off insisting on larger payouts.

   

Management implications

The management implications that follow from these considerations are rather straightforward:

  • If the firm's reinvestment return (ROIC) exceeds the cost of capital (WACC), a dollar is more valuable inside the firm:
    • Reducing current dividends to secure funding for the additional projects is a value-enhancing proposition. 
    • Firms should pursue a conservative payout policy and make sure that their ability to make the value-enhancing investments is not jeopardized.
    • Focus on large payouts that reduce the firm's ability to engage in valuable investment propositions lowers firm value (underinvestment).
       
  • In contrast, if the reinvestment return (ROIC) is lower than the cost of capital (WACC) firms should not reinvest. A dollar is more valuable when paid out to shareholders:
    • Increasing current dividend payments at the expense of new investments (with ROIC < WACC) is a value-enhancing proposition.
    • Firms should pursue an aggressive payout policy to make sure that no NPV-negative projects are being implemented.
    • Importantly, this could (and often does) mean that a slower rate of growth can be more valuable! Case 2 above illustrates this nicely.  With the additional value-destroying project, the firm could grow its FCF1 considerably from 110 to 173. Growth, however, does not equal value creation! The reason is that the capital that is necessary to finance growth has opportunity costs (it could be invested elsewhere). Shareholders are better off if the firm opts for a lower rate of growth by not taking the additional project and, instead, returning the money to its shareholders.
       
  • In light of this basic trade-off between reinvestment return and cost of capital, the announcement of a material payout could also convey new information to the shareholders, namely that the firm has run out of valuable investment opportunities. If unexpected, such a signal might not be welcomed by investors with open arms and therefore result in a lower stock price.