Return of Capital
1. Return of Capital
So if we're talking about the return of capital, obviously corporate managers need to decide to retain excess earnings for possible future investments and operational requirements, or distribute the earnings to shareholders, which could be in the form of dividends or share buybacks. So here's an example of how this decision making process could work. Let's suppose the company is considering an investment, we can see the initial negative cash flow and the ensuing positive cash flows. We can see the cumulative cash flow and also the break even point. Let's pretend that this investment could generate an internal rate of return of 22%. This sounds like a great investment, but we really need to compare it to the weighted average cost of capital. We know from previous discussions exactly how we could calculate that. So suppose they calculated, the weighted average cost of capital is being fairly high, 28%, now they're in a position where they could make a decision, the internal rate of return at 22%, but the weighted average cost of capital is higher than that internal rate of return. So they make the decision to return capital to shareholders, this could come in the form of a dividend or a share buyback.2. Let's practice!
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