Read the following passages and summarize 2 main points.
Under these cireumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then imme- diately sell them. By doing thal, he would rcalize more cash than il he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest, not even those bondholders needing cash for living If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the inves- tor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite coursc-reinvestment of the coupon-would give an investor additional bonds with market value far less than the cash he could have elccted. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a lar discount. An analysis similar to that made by our hypothetical bond holder is appropriate for owners in thinking about whelher a com- pany’s unrestricted earnings should be retained or paid out. Of course, the analysis is much more difficult and subject to error be cause the rate earned on reinvested carnings is not a cont figur must guess as to what the rate will average over the interme ractual e, as in our bond case, but rather a fluctuating figure. Owners re. However, once an informed guess is made, the rest of the can be expected to earn high returns, and you should wi diale futu analysis is simple: you should wish your carnings to he reinvested if them paid to you if low returns are the likely outcome of reinvesttment Many corporate managers reason very much along these lines in determining whether subsidiarics should distrihute carnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners. But payout decisions at the parent cumpany level otten are a different story . Hcre managers fre- quently have trouble putting themselves in the shoes oftheir share- With this schizoid approuch, the CEO of a multi-divisional company will instruct Subsidiary A, whose carnings on incremental capital may be expected to avcrage S”u, to distribute all available carnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO’s business school oath will allow no lcsser bchavior. But if his own long-term record with incremental capital is 5%-and market rates are I0%-he is likely to impose a dividend policy on shareholders of the parent company that merely follows some his- torical or industry-wide payout pattern. Furthermore, he will ex- pect managers of subsidiaries to give hii a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom wil he supply his owners with a similar enalysis pertaining to the whole company In judging whether managers should retain earnings, share- holders should not simply compare total incremental carnings in recent years to total ineremental capital because that relationship may be distorted by what is going on in a core business. inflationary peri dinary econonies can use smull amounts of incremental capital in that business at very high rates of return (as was dis- cussed in last year’s section on Goodwill,32 Bul, unless they are experiencing tremendous unit growth, outstanding businesses definition generate large amounts of excess cash. If a company sinks most of this money in other husincsses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incremental invested in the core busi- ness. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, em- yed a large portion of their retained earnings on an economi- cally unattractive, even disastrous, basis. Their marvelous core sinesses, however, whose earnings grow year after year, camou- flage repented failures in capital allocation elsewhere (usually in- volving high-priced acquisition of businesses that have inherently mediocre economics). The managers at fault periodically report on the lesson they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in subpar businesses). Managers of
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