You are the CFO of a company that expects to remain profitable and you currently

Question

You are the CFO of a company that expects to remain profitable and you currently have excess cash reserves, nice problem right? You are preparing for an internal management meeting where dividends are on the agenda. You know that your boss, the CEO, is considering starting a dividend program. What are some potential drawbacks to starting the dividend payouts that you think the CEO and the Board of Dividends should consider before starting? Under what circumstances might beginning, or increasing, dividend payouts, NOT be a good idea, and why? Stock repurchase programs have started to become more popular with business firms in lieu of dividends. What are some of the fundamental differences between these two mechanisms of transferring funds from a corporation to its shareholders? What are some advantages of each?

Explanation / Answer

While it is true that the firm currently has excess cash reserves, those reserves can best be utilized to fund positive NPV projects which will increase the value of the firm and thus, the value of the shares held by our current shareholders. This increase in value does not create any tax liability for those shareholders until or unless they opt to sell their shares. Dividends on the other hand, will create an immediate tax liability for the majority of our shareholders, who don't need or prefer dividend income at this time. If we commence a dividend program, we may find that our clientele changes, which is not one of our current goals. In addition, once we pay a dividend, we need to be prepared to maintain that dividend, as any decrease in the dividend at a later date would send the wrong message to our shareholders and to the market. Lastly, should we deplete our excess cash reserves by implementing a dividend program, we might find ourselves in the uncomfortable position of seeking additional equity financing which would be expensive and possibly also dilutive to our shareholders

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