Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

AFFORDABLE DIVIDENDS

A company’s affordable dividend is the maximum it can distribute in light of its planned sales growth, margins on sales, and investment requirements without violating its target capital structure—that is, without having to issue additional shares or debt in excess of its target debt-to-equity ratio.3 To solve for the affordable dividend, we begin with the following basic equation for the source and use of cash:

(4.1)

Assuming that depreciation is the only material non-cash charge, Equation (4.1) can be rewritten as follows:

(4.2)

If a business replaces existing facilities in kind, and if the costs of these facilities remain constant, then capital expenditures less depreciation approximates the cost of real growth in productive capacity. However, capital expenditures may also rise because of inflationary forces and regulatory requirements such as environmental controls. The capital expenditures less depreciation figure thus impounds not only the cost of real growth, but price changes, product mix changes, regulation, and technological improvements as well.

Equation (4.2), which serves as the basis for deriving the affordable dividend payout rate, has the following components—earnings retained, change in debt capacity, and investment in fixed and working capital. ...