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 / Spring 2007 / Issue 46(originally published by Booz & Company)


Too Much Money

Pension Funding. This use of cash is attractive because it improves a company’s credit profile, and in some countries, including the U.S., it is also tax deductible. Moreover, accounting changes are under way to categorize net underfunded pension positions as debt rather than as a mere footnote on the balance sheet; this accounting change will make pension funding even more desirable. To limit the risks of overfunding, pensions should be endowed to only about 80 to 90 percent of their total.

Dividends. Especially in today’s more dividend-friendly tax environment, this is typically the first decapitalization option for a company with too much cash. However, most companies’ dividend level is dwarfed by the amount of excess capital, making this an inefficient route to redeploy cash. And because they are a fixed cost, large dividends impair operating liquidity and credit quality, making them especially inappropriate for cyclical or volatile sectors such as mining, pulp and paper, and automotive.

Notwithstanding media attention and investor interest, market gains from most dividend increases are small, at less than 1 percent. However, new or higher dividends can improve share performance for those companies with low volatility, low valuations, high margins, and dividends that are well below those of others in their industry. In a balanced capital structure, dividends should not exceed recurring and stable quarterly cash flow. Volatile or uncertain excess cash flow may be better distributed through share buybacks.

Debt. As a tactic that is similar to holding cash for growth, debt reduction is a source of financial strength by freeing debt capacity. However, debt reduction is not always possible: Many companies have illiquid or noncallable debt, and the cost to unwind it can be significant. Also, during the recent period of low-rate loans, many organizations refinanced their most costly debt with new debt under attractive terms.

Optimally capitalized companies should balance share repurchases with debt reduction to maintain the ideal mix of debt and equity. If debt reduction outpaces share repurchases, a company’s credit profile may improve; but because equity is more expensive than debt, its average cost of capital will be higher.

Triggered by analysts, investors, and heightened public concern about corporate governance and proper management of capital, interest is growing among companies in the possibilities of balanced capital structures and corporate decapitalization. Indeed, since July 2004, when Microsoft announced a massive $75 billion decapitalization that included a special dividend, a doubling of the regular dividend, and a $30 billion share repurchase, corporate boards around the world have begun to reevaluate their own cash positions.

There are many rules of thumb for cash allocation — setting aside a percentage of revenue or of fixed costs, for instance — but one-size-fits-all solutions are a mistake. Decapitalization is an extremely complex endeavor, requiring deep analyses to produce an effective allocation plan. However a company approaches the issue, though, one fact is undeniable: Too much cash is a wasted asset.

Author Profiles:

Justin Pettit ([email protected]) is a vice president with Booz Allen Hamilton based in New York who specializes in shareholder value and corporate finance. He is the author of Strategic Corporate Finance: Applications in Valuation & Capital Structure (Wiley, 2007).
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