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Principles Of Finance

The Dividend Principle

            Most businesses would undoubtedly like to have unlimited investment opportunities that yield returns exceeding their hurdle rates, but all businesses grow and mature. As a consequence, every business that thrives reaches a stage in its life when the cash flows generated by existing investments is greater than the funds needed to take on good investments. At that point, this business has to figure out ways to return the excess cash to owners. In private businesses, this may just involve the owner withdrawing a portion of his or her funds from the business. In a publicly traded corporation, this will involve either paying dividends or buying back stock. the discussion of dividend policy, we introduce the basic trade-off that determines whether cash should be left in a business or taken out of it. For stockholders in publicly traded firms, we note that this decision is fundamentally one of whether they trust the managers of the firms with their cash, and much of this trust is based on how well these managers have invested funds in the past. Finally, we consider the options available to a firm to return assets to its owners—dividends, stock buybacks and spin-offs—and investigate how to pick between these options.

Corporate Financial Decisions, Firm Value, and Equity Value

            If the objective function in corporate finance is to maximize firm value, it follows that firm value must be linked to the three corporate finance decisions outlined—investment, financing, and dividend decisions. The link between these decisions and firm value can be made by recognizing that the value of a firm is the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the projects of the firm and the financing mix used to finance them. Investors form expectations about future cash flows based on observed current cash flows and expected future growth, which in turn depend on the quality of the firm�s projects (its investment decisions) and the amount reinvested back into the business (its dividend decisions). The financing decisions affect the value of a firm through both the discount rate and potentially through the expected cash flows.