Firms Utilize to Pay Cash?

¶ … firms utilize to pay cash?

Firms can disperse 'excess' cash by distributing these funds through the regular dividends paid to shareholders, through share repurchases, or special dividend payments. So-called 'special' dividend payments are differentiated from normal dividend allocations because they are usually the result of a large, special or non-recurring cash inflow and are not designed to be repeated. Regular cash dividends are funded with the firm's recurring earnings (Kent et al. 2005, p.1). If a firm anticipates a regular, healthy increase in cash flow, it will usually simply distribute this cash through regular dividend payments.

An acquisition that increased firm value would be an example of non-recurring 'special' instance. When a firm has a poor year, in contrast, the firm will often repurchase shares and not increase regular dividends or offer special dividends. Stock repurchases increase the value of corporate stock in a bad financial year because, to repurchase stock from current shareholders, the firm must traditionally pay the investors more than its market worth: hence share repurchasing increases the market value of the firm by driving up stock prices (Tajirian 2010).

There is a distinct advantage for a firm in using a 'special' dividend payment in a good year and a stock repurchase method in a bad year. When regular dividend payments are lowered, the market as a whole and shareholders see this as a 'bad' sign that the firm is faltering. Special dividends and stock repurchases are one-time events and do not radically shift expectations in terms of future, regular profits or losses.

What are the advantages and disadvantages of the various methods by which firms can pay out dividends?

Three general methods exist by which firms can pay dividends to shareholders: residual, stability, and hybrid methods. 'Residual' methods mean just that: companies pay dividends based upon their 'residual' or left-over profits, after the firm has paid off its operating expenses, its interest on current debt, and financed new projects. The firm usually keeps the same debt-to-equity ratio every quarter or year that dividends are paid to shareholders (How and why do companies pay dividends, 2010, Investopedia). The advantage to this method is that the firm's major expenses are paid for first and debt is kept fairly low. This mitigates the financial 'trouble' a firm might get into, should it attempt a risky venture (Residual dividend policy, 2010, Financial Maps of the World). The downside is that because the rate of return for investors is unstable, it may be more difficult to sell shares and raise capital for the firm.

The second method, the stability method, as the name suggests, offers a more stable source of income for shareholders. With the stability method, regardless of how much the firm earns or needs to finance its debt or internal operations, dividends are paid to shareholders at the same fraction of quarterly earnings or yearly earnings on a regular basis (How and why do companies pay dividends, 2010, Investopedia). Stability payments are thus more attractive to shareholders. This make it easier to finance firm operations by selling stock, but on the other hand the firm can be forced to pay shareholders when it needs the cash to finance its debt, invest in new projects, or simply to pay for its daily activities without going further into debt.

The final method is that of a hybrid method. Dividends are paid on a stable basis. But over the long-term, the debt-to-equity ratio is reviewed, and if the firm is regularly coming short on paying its debts and other expenses, payments to shareholders may be curtailed (How and why do companies pay dividends, 2010, Investopedia). This is the preferred method, given the added flexibility it offers the firm. Hybrid methods have the ability to ensure the firm's long-term financial health, as payments can be curtailed in times of sustained economic hardship -- but hybrid payments still offer stable returns for investors, in most instances.

How much cash should a firm hold?

On one hand, it might seem from an investor's point-of-view that it is always 'good' to receive more money in the form of larger dividend payments -- either 'special' dividends, regular payments, or in the form of stock repurchases. However, a long-term investor wants to see the firm's value grow, and paying too large a dividend can mean the firm has less money to reinvest in new projects and add to its long-term value (Tajirian 2010).