634  Capital Structure, Dividends, and Share Repurchases approach to deciding a company’s capital structure, payout, and financing. The remainder of the chapter discusses key theoretical and empirical findings on capital structure and payout that form the basis for our guidelines and approach. Practical Guidelines Finance theory has much to say about capital structure and payout—for example, about the costs and benefits of leverage, the way markets react to shareholder payouts, and the ability of managers to time their buying back of shares.1 But it does not tell us how to set an effective capital structure and payout policy for a given company. Building on insights from finance theory (explored later in this chapter), we offer the following practical guidelines to help executives make the right choices on capital structure and payout: • Decisions about capital structure, dividends, and share repurchases should be an integral part of overall cash deployment. This matches investment needs across businesses with funding opportunities and payouts to sharehold- ers to best support the company’s strategy and risk preferences. When deciding to deploy cash (for example, by using it for share repurchases), companies should consider all alternative uses of cash and set priorities for the uses according to their potential to create value, as laid out in Ex- hibit 33.1. The greatest opportunity to create value comes from investing cash in business operations (organic growth) and acquisitions at returns above the cost of capital.2 The returns are typically higher for organic growth, making it the first choice for deploying cash. One level below is using cash for growth by acquisitions, where returns on capital tend be somewhat lower because acquiring assets usually requires paying a premium.3 Financing—that is, using (or raising) cash to adjust a com- pany’s capital structure—should assume a lower priority. This does not mean that capital structure decisions are unimportant; rather, they are a necessary means of ensuring that sufficient funding is available to cap- ture attractive investment opportunities and withstand cash shortfalls. At the bottom of the list of cash alternatives are payout decisions. These don’t drive value directly but should aim to return cash to shareholders when a company has insufficient opportunities to reinvest at returns above the cost of capital. 1 For an overview of the literature, see M. Barclay and C. Smith, “The Capital Structure Puzzle: The Evidence Revisited,” Journal of Applied Corporate Finance 17, no. 1 (2005): 8–17. 2 Following the conservation of value principle in Chapter 4, this is the primary source of value creation for companies. 3 See M. Goedhart and T. Koller, “The Value Premium of Organic Growth,” McKinsey on Finance, no. 61 (2017): 14–15. Practical Guidelines  635 • For their capital structure, large companies should target investment-grade credit ratings between A+ and BBB− to maintain adequate flexibility for dif- ficult times. Most large exchange-listed companies worldwide have capi- tal structures in this range of credit ratings. Lower ratings typically lead to a significant loss of flexibility, due to restrictive covenants built into loan agreements for sub-investment-grade companies. Higher credit ratings offer little or no additional benefits, as a company typically has enough flexibility to pursue investment opportunities once it reaches a solid investment-grade rating. • Payout decisions should consider their short-term impact on stock prices. Divi- dends and share repurchases are value neutral over the long term but can lead to earlier recognition of value creation in a company’s share price. Although long-term value creation comes from business opera- tions and investments that generate returns above the cost of capital, not from a company’s payouts to shareholders, short-term price increases can result from increased payouts that signal management discipline in the use of capital and confidence in the company’s outlook. In applying this guideline, keep in mind that such increases in share price reflect higher expectations of future value creation. If the company fails to meet these expectations, the price will drop again. • Dividends should be set at a level that a company can sustain under plausible adverse conditions—for example, during the bottom of the earnings cycle. Most shareholders expect that regular dividends (or dividend payout ratios) will be cut from customary levels only in cases of severe setbacks.4 In- vestors almost always perceive the cutting of regular dividends as a signal of significantly lower future value creation, so these cuts gener- ally lead to sharp declines in share price and increases in share price volatility. • Share repurchases should be used to return excess cash over and above divi- dend levels to shareholders. Investors do not consider share buybacks to be the same long-term commitment as regular dividends. As a result, repurchases are a flexible way to pay out cash amounts that vary from year to year. Unlike dividends, share repurchases typically increase a company’s earnings per share, but that does not mean share repur- chases create value. Keep in mind that repurchasing shares, like paying regular dividends, is value neutral. In fact, both types of payouts could even indirectly destroy value if they come at the expense of attractive investments; that is why these decisions need to be part of planning a company’s broader cash deployment. 4 A small number of companies have a variable dividend policy that targets a fixed payout ratio (or range) of dividends relative to earnings.