a. There is not a precise solution to this problem; rather, it is a judgment call. In the problem are listed various possibilities for coming to grips with the cash-flow shortfall. In addition, there may be others, such as the sale of plant and equipment. A cash flow of $7 million is $1.8 million more than capital expenditures and the dividend. If the cash flow were to fall by $5 million, this a~uasulr plus would disappear. In addition, other things must give. One probably would use most of the cash and marketable securities, but not all. The bank line should be fully utilized, or nearly so. In a slack period, it may be possible to cut capital expenditures. Due to competition, the company probably should maintain advertising and promotion expenses at approximately the same level. Otherwise, sales may suffer even more. To build for the future, the company probably should not cut its R&D expenditures, although something could give here. The dividend may be reduced, but there will be an adverse informational effect (see Chapter 11). If the recession is expected to be short, many firms will try to maintain their dividend.

Based on this discussion, a possible proposal to offset the $5 million in reduced cash flow might be (in thousands):

Chapter 10 Making Capital S t r u c t u r e Decisions 307 E l i i a t i o n of previous annual surplus $1,800 Decrease in cash and marketable securities 900 Additional borrowings under line of cre t 1,700 Capital expenditure reduction -600

$5,000 Again, there is no right or wrong solution. If $5 million is the maximum decline in cash flow and the industry recession is expected to be short in duration, the firm probably has adequate financial flexibility.

Once in a recession, however, it should try to negotiate a larger Line of credit so that it has some margin for error.

b. If the cash-flow shortfall is $9 million, the solution must be harsher.

Capital expenditures will need to be cut further, and all other items will need to be cut. The dividend, if maintained at all, will be sharply reduced. Indeed, survival becomes the theme. If the bank line cannot be increased, a possible remedy might be (in thousands):

Elimination of previous surplus $1,800 Decrease in cash and marketable securities 1,000 Additional borrowings under line of credit 1,700 Capital expenditures reduction 2,000 Reduction in R&D expenditures 800 Reduction in advertising and promotions 800 Reduction of dividend -900

$-9,000 Obviously, the company has utilized a good deal of its resources to stem the cash-flow decline. Further cuts will be needed if the recession continues. Additional financing will need to be sought, as the firm is completely inflexible after one really bad year. Again, these are only examples of solutions.

Selected References CLEARYSE, AN, "The Relationship between Firm Investment and Financial Status," Journal of Finance, 54 (April 1999), 673-92.

DIAMOND, DOUGLAS W., "Reputation Acquisition in Debt Markets," Journal of Political Economy, 97, No. 4 (1989), 828-62.

DONAI~ONG,O RDON, Corporate Debt Capacity.

Boston: Division of Research, Harvard Business School, 1961.

-, "Strategy for Financial Emergencies," Haroard Business Rcview, 47 (November-December 1969), 67-79.

GUEDESJ,O SE, and TIM OPLER," The Determinants of the Maturity of Corporate Debt Issues,"

Journal of Finance, 51 (December 1996), 1809-33.

JUNGK, OOYULY, ONG-CHEOKLIM , and RENE M. STULZ,

"Timing, Investment Opportunities, Managerial Discretion, and the Security Issue Decision,"

Journal of Financial Econmnics, 47 (October 19%), 159-85.

LEVY, HAIM, and ROBERT BROOKS, "Financial Break-

Even Analysis and the Value of the Firm," Financial Management, 15 (Autumn 1986), 22-26.

308 Part I11 Financing and Dividend Policies MYERS, STEWART C., "Capital Structure Puzzle," Journal ofFinance, 39 (July 1984), 575-92.

-, "Still Searching for Optimal Capital Structure,"

Journal of Applied Corporate Finance, 6

(Spring 1993), 4-14.

PIPER, THOMAS R., and WOLF A., WEINHOLD", HOW Much Debt Is Right for Your Company," Harvard Business Reviezu, 60 (July-August 1982), 106-14.

RAJAN, RAGHURAMG ., and LUIGZI INGALE"SW, hat Do We Know about Capital Structure? Some Evidence from International Data," Journal of Finance, 50 (December 1995), 1421-60.

SHYAM-SUNDER, LAKSHMIa, nd STEWART C. MYERS,

"Testing Static Tradeoff Against Pecking Order Models of Capital Structure," Journal of Financial Economics, 51 (February 1999), 219-44.

Wachowicz's Web World is an excellent overall Web site produced and maintained by my coauthor of Fundamentals of Financial Management, John M. Wachowicz Jr. It contains descriptions of and links to many finance Web sites and articles.

www.prenhall.com/wachowicz.

C H A P T E R Dividends and Share Repurchase: A Theory and Practice T he third major decision of a company is the distribution of cash to its stockholders. This can take two forms: dividends and share repurchase. In a typical year the aggregate amount of dividends paid by American corporations exceeds the amount of funds devoted to share repurchase, but the latter has risen dramatically in relative importance.

In keeping with this shift, the proportion of U.S. companies paying cash dividends has declined over time to where now it is only about one-quarter.

Dividends and share repurchase, of course, reduce the amount decisions of the firrrtthe investment and the financing decisions-it has both theoretical and managerial facets. This chapter-structured much the same as Chapter 9 on capital structure-begins with dividend payout under perfect capital-market assumptions. There follows a systematic analysis of the implications of various market imperfections and financial signaling.

Our attention is then directed to share repurchase as a substitute for cash dividends in the distribution of excess cash, using the framework developed earlier. This is followed by the special topic of of earnings retamed in a company and affect the total amount of inter- stock dividends and stock splits. Finally, the chapter itemizes what a nal financ~ng.C onseguently, they must be considered in relation to a company in pract~ces hould analyze ~na pproach~ngd ivldend and share company's overall financ~ngd ecis~onW. e beg~no ur inquiry by looking at repurchase decisions. Before delving into the heart of the matter, we the percentage ot earnings a company pays out in cash dividends to its need to understand certaln procedures a srockholders. Known as the dividend layout ratio, like the other major PROCEDURAL ASPECTS OF PAYING DIVIDENDS When the board of directors of a corporation declares a cash dividend, it specifies a date of record. At the close of business that day, a list of stockholders is drawn up from the stock transfer books of the company. Stockholders on the list are entitled to the dividend, whereas stockholders who come on the books after the date of record are not entitled to the dividend. When the board of directors of United Chemical Company met on May 8, it declared a dividend of 25 cents a share payable June 15 to stockholders of record on May