Question

ABC paid shareholders a high dividend relative to net income, it also repurchased stock (Treasury stock) over the past several years. The firm relied on debt to fund an increasing share of assets. Fully identify the potential advantages and risks of such a capital structure policy and how the growing medical and economic crisis enveloping the world as of 2020 will change, even if temporarily, such strategies.

Answer 1

Advantages

• Having a high debt in the capital structure would mean lower average cost funds as equity is costlier than debt. This also increases the returns to equity holders (RoE) since on a lower equity base (after the share buyback) the shareholders get a higher share of profits.
• Interest portion of debt is tax deductible and the company can benefit from savings in tax.
• Debt can be used to fund growth opportunities where there is resource constraint and when raising equity can be a lenghtly and costly process, and could lead to dilution in ownership.
• Buyback of shares will lead to better control over the company by existing shareholders and will help in faster decision making. The treasury stock can be re-issued at any time to raise additional capital.
• Investor perception will be good on a comapny which pays out high dividends.

Risks:

• High debt will result in high leverage. This will impact the credit outlook, ability to raise additional debt and increase the solvency risk.
• Debt, unlike equity, carries fixed and committed cash outflows towards interest and principal repayments. This will have an impact on the cash flow of the company. If the company is unable to generate sufficient cash flows, it is likely default on debt payments which will lead to further consequences like, law suits, downgrade in credit rating, insolvency etc.
• Payment of high divdiend and share buy back will also result in cash outgo from business which can otherwise be retained within the business and be used for growth and reduce reliance on debt.
• High dividend will reduce the free revenue reserves in balance sheet and result in lower equity. This will lead to high gearing and low equity ratios. This will weaken the balance sheet.

In the present economic scencario caused by the outbreak of Covid-19 pandemic, global demand has fallen and economists warn of deep recession. This will impact the demand and corporates could face reduction in turnover and profits, which in turn will exert liquidity pressures.

So, the company will have to change its strategy not to pay any dividends or buy back shares due to the uncertain economic conditions. This will save cash outflow for the comapny and this cash can be used for meeting fixed overheads which cannot be cut. Fixed overheads also include interst and debt repayments which cannot be postponed.

The company will also not raise additional debt until the demand recovers.