Financial Subject: Payout Policy

The payout policy refers to the way cash is being distributed to shareholders. The cash to be
distributed comes from the free cash flow. The way to compute FCF is as follows:

We start with the Earnings Before Interest and Taxes (EBIT) which is also called the operating
profit. The EBIT is just above the interest expenses in the income statement. From the EBIT
we have to deduct the taxes.
The effective tax rate used to compute the Net Operating Profit After Taxes (NOPAT) is
simply given by the amount of taxes paid by the company divided by the companys Earnings
Before Tax in absolute value.

To the NOPAT we add back the depreciations and amortizations (D&A), since they are not
actual cash flows. Depreciation and amortization cost reflects the wear and tear of the
companys Property, Plant and Equipment (PP&E) and is only an accounting measure, the
company doesnt pay out any money to cover this expense. The amounts are easily found in
the companys financial statements. When forecasting, it is straightforward to compute the
D&A if the company follows a clearly defined investment scenario.

Next, we deduct the Capital Expenditures (CapEx). Finally, we have to adjust the cash flows
to the changes in working capital. Working capital is defined as the difference between
current assets and current liabilities

The formula for calculating the free cash flow (FCF) is then:

FCF = +
Net Incr. in Working Capital

With

= (1 )

Free cash flow may be used to remunerate the external fund providers, shareholders and lenders.
The basic way to remunerate shareholders is to pay them dividends. When markets are perfect the
payment of the dividend leads to a drop of the market price of the share by the exact amount of the
dividend.
An alternative way is to buy backs its outstanding shares on the market. The firm may rely on a
simple open market repurchase, or a tender offer which may or may not succeed- or an auction.
The buy-back may also be targeted towards specific shareholders. The buy-back leads to a decrease

in the number of outstanding sahres. The impact of an open market repurchase on the stock price is
supposed to be equal to zero. The total market value of assets of the firm indeed decreases, as cash
is used to buy outstanding shares. But the magnitude of this drop is exactly compensated by the
decrease in the number of shares.