652  Capital Structure, Dividends, and Share Repurchases its net earnings over these years. Even for a company like Procter & Gamble, it would have been close to impossible to reinvest that amount of cash, given that it had already spent some $2 billion per year on R&D and $8 billion on advertising. Companies with cash surpluses have three basic alternatives for paying out the surpluses to shareholders: dividend increases, share repurchases, and extraordinary dividends. All three provide a positive signal to the capi- tal market about a company’s prospects. The potential negative signal that a cash payout could send is that the company has run out of investment oppor- tunities. This assumes that investors did not already know that the company was generating more cash flow than it could reinvest. However, such cases are extremely rare; investors typically anticipate payouts long before manag- ers make that decision, as illustrated by the simple math in our example in Exhibit 33.11.30 Dividends Companies that increase their dividends receive positive market reactions av- eraging around 2 percent on the day of announcement.31 For companies that initiate dividend payments, the impact is even greater.32 In general, investors interpret dividend increases as good news about the company’s long-term EXHIBIT 33.11  Surplus Cash Flow, Given Earnings of $1 Billion Surplus under given conditions, $ million 50 700 800 900 Projected return on capital, % 25 400 600 800 15 – 333 667 15 10 5 Projected growth rate, % 30 One such rare example is that of Merck, one of the largest pharmaceutical companies worldwide. In 2000, it announced a $10 billion share repurchase, which led to a 15 percent fall in its share price in the next four weeks (although the initial price reaction was favorable). This would have happened if inves- tors assumed that Merck had been unable to find interesting R&D opportunities and could no longer maintain its long-term earnings growth target of 20 percent. See J. Pettit, “Is a Share Buyback Right for Your Company?” Harvard Business Review 79, no. 4 (2001): 141–147. 31 See, for example, S. Benartzi, R. Michaely, and R. Thaler, “Do Changes in Dividends Signal the Future or the Past?” Journal of Finance 52, no. 3 (1997): 1007–1034; and J. Aharony and I. Swarey, “Quarterly Dividends and Earnings Announcements and Stockholders,” Journal of Finance 35, no. 1 (1980): 1–12. 32 P. Healey and K. Palepu, “Earnings Information Conveyed by Dividend Initiations and Omissions,” Journal of Financial Economics 21, no. 2 (1988): 149–175. Payouts to Shareholders  653 outlook for future earnings and cash flows. On average, they are right, ac- cording to the evidence. Most companies that increase their dividend payout usually do so after strong earnings growth and when they are able to main- tain such high levels of earnings in the year following the dividend increase. Companies that start paying dividends for the first time typically continue to experience high rates of earnings growth. The drawback of increasing dividends is that investors interpret this action as a long-term commitment to higher payouts. Companies, especially in the United States, have created expectations among shareholders that dividends will be cut only in case of severe setbacks. The stock market greatly penalizes companies for cutting dividends from customary long-term levels. Between 1994 and 2008, only 5 percent of U.S. listed companies with revenues greater than $500 million cut their dividends, and in almost every case, the company faced a severe financial crisis. A few companies do not commit to dividends or dividend growth rates that are supposed to be upheld even in the face of adverse events or declin- ing business conditions. Instead, they have variable dividend policies and try to manage investor expectations of future payouts by explicitly relating the dividend payouts to business results. For example, in 2016 Anglo-Australian resources companies BHP and Rio Tinto adopted a dividend payout policy in which dividends are more closely related to underlying business results. BHP switched to a minimum dividend payout ratio equal to 50 percent of underlying profit, with additional payouts made in the form of special divi- dends or share repurchases if and when the company’s financial position al- lowed (for example, to pay out divestment proceeds).33 From a value creation perspective, a variable dividend policy is not better or worse than a fixed (or progressive) dividend policy. But it does create more financial flexibility, sav- ing managers from feeling compelled to uphold dividends even if that means forgoing attractive investment opportunities or divesting assets. Managers considering increases in dividend commitments—whether in the form of fixed dividends or a payout ratio for variable dividends—should be confident that future cash flows from operations will be sufficient to pay for capital expenditures as well as higher dividends. Furthermore, a higher divi- dend payout could lead to higher taxable income for shareholders, depending on the jurisdiction and their individual tax position. Such shareholders could suffer a tax loss if a company would make unexpected, significant changes to the dividend payout ratio. In other words, dividend increases are useful to handle structural cash surpluses over time but much less suitable for a one- time surplus payout. 33 BHP’s new dividend policy was announced in the release of the second half-year results for 2015 on February 23, 2016. Rio Tinto’s dividend policy states that it expects to pay out dividends in a range of 40 to 60 percent of aggregate underlying profit through the cycle (https://www.riotinto.com/ investors-87.aspx).