Question

Fully explain how firms should return cash to shareholders? How are these decisions made, and what factors are considered in the firm's payout decisions?

Answer 1

Firms should return cash to its shareholders in the following ways :-

1) Cash Dividends -    This is the most simplest method of returning cash to the shareholders and is often done as a " special interim dividend".
2) Share Buy- Back - This route is through when the company is offering to buy back its shares from the shareholders. Shareholders participation is their right but not the obligation.
3) Reduction of Capital- Both the above methods of returning cash to the shareholders is done when the company has profits but if it does not have profits or wants to retain them, reduction of capital is another way where the cash is returned through reduction of capital.

4) Scheme of Arrangement- This involves insertion of a new holding company in the corporate structure. If done in a right way, it can result in the new holding company having much larger share than the original company reserves which can then be used to implement a return via capital reduction.


These decisions are made with the help of professional advisers, including accountants and financial advisers to ensure these issues are done correctly with the approval of shareholders via voting in the meetings.
Many things are kept in mind while undertaking such actions including :-

i) If a company has raised funds for a business acquisition which never took place and it no longer needs money.
ii) If it sold a non core subsidiary of the company but does not have immediate use from the proceeds of the sale.
iii) if it is using returns of funds to the shareholders to gather their support in tactical defense to unwelcome a potential takeover.
iv) It has sufficient fund for future growth prospects in reserves and can return some of shareholders wealth in form of cash.

The factors considered in the firm's payout decisions are as follows :-

1) Liquidity Position - The liquidity position of the firm is an important factor that should be kept in mind while undertaking such actions. A growing profitable firm may not be liquid.
2) Cost and availability of alternative forms of financing - The ability of a firm to raise money externally will have a direct impact on the firm's payout ratio.
3) Legal Constraints - Legal aspects are also kept in mind while undertaking such issues. Some aspects of the law may not agree with the payout decisions.
4) Inflation- On one hand investors would like more cash at the current but from firm's viewpoint it caused more money to invest for more equipment.
5) Growth and Profitability - If the company has more profitable projects to undertake in future, it cannot payout themoney to shareholders.


I hope this answer makes sense and helps you.
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