Why Borrow Money to Pay a Dividend?

In August of 2014, corporate bond rates are near historic lows. The 10-year Treasury Bond, for example, is at a rate of 2.3% (a 14-month low). So, it’s not surprising that corporations are taking advantage of low rates by issuing more corporate bonds. New issues of corporate bonds are on a record pace for the third consecutive year.

The rationale is the same as a home owner who refinances their mortgage. If you can refinance your loan from a 6 percent to a 4.5 percent rate, your borrowing costs (interest payments) decline. Lower interest payments mean that you have more cash available for other uses.

So, what are corporations doing with the proceeds? The Wall Street Journal does a great job of explaining the issue in their article: “With Rates Low, Firms Near Borrowing Record”. Here is a summary:

·   Investing in acquisitions, capital assets: With the economy slightly improving, companies are acquiring other businesses. Acquisitions have doubled since the same time last year. Companies are expanding operations and buying assets (equipment, buildings, machinery). Capital spending is up 90% from the same period last year.

·   Refinancing existing debt, rewarding shareholders: Like the homeowner, firms are refinancing existing debt. They are using the cash savings to reward shareholders. Companies are increasing dividend payments and also buying back common stock.

Earnings Per Share: Stock buybacks impact earnings per share or (EPS). Here's the formula:

(Earnings available to common shareholders)/ (Common shares outstanding)

If a firm buys back shares, there are fewer shares held by the public. The denominator of the formula (shares) declines. If the earnings stay the same and the denominator gets smaller, the fraction gets larger.

Say, for example, that you earn $5 per share and have 100 shares outstanding. EPS is ($5/100 shares), or 5%. If the firm buys back 20 shares, the new EPS is ($5/80 shares), or 6.25%.

Stock prices are driven, the large part, by the dollar amount of earnings per share. A typical investor will consider paying more for a stock that pays a higher earnings per share.

Finally, the decision to issue debt is all about the cost of funds. Firms can issue stock or debt. If you can borrow money at 5%- or issue more stock to investors who demand a 7% return- you probably issue debt. That 7% stock (equity) rate of return means dividends paid, and increases in the stock’s price.

Check out my podcast on this subject:

http://accountingaccidentally.podbean.com/e/accounting-accidentally-borrowing-money-to-reward-shareholders/

For blog and article writing, tutoring and speaking on investments and finance, contact me here:

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies (Sept. of 2014) and 1,001 Accounting Questions for Dummies (2015)

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