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Dividend or Not? A Collaboration Between FP&A and Treasury

  • By Nilly Essaides
  • Published: 11/30/2015
cashpile100sLarge oil companies insist on keeping their dividends untouched, despite a mega drop in their earnings. According to an article in the Wall Street Journal, the four biggest oil companies have seen their earnings plunge 70 percent year-over-year. The motivation for keeping dividends steady is clear. Their investors are already reeling from a big drop in stock price. At least this way they get income from their holdings. It’s also a way to smooth out the volatility of the stock price. But is this use of cash defensible when corporate resources dwindle so dramatically? The answer depends a lot on what financial planning and analysis (FP&A) and treasury conclude, based on cash flow and analysis of the weighted average cost of capital (WACC).

Broadly, companies can invest internally (in growth or maintenance projects), they can acquire other companies or return capital to shareholders. Treasury often handles the liquidity management aspects of that decision-making, i.e., how much cash to keep on hand and how much can be freed up to invest or give back to stockholders. But as FP&A professionals’ role evolves into strategic partners to senior management, they are often the ones making, reviewing and recommending business case scenarios for potential investments.

“What we see work best, is that [the group that makes those recommendations] resides in FP&A,” said Jason Logman, principal, EPM transformation practice for The Hackett Group. “There’s a capital group that gets involved in each project above a certain dollar and materiality threshold. They’re typically responsible for managing that portfolio.” (For more, see: AFP FP&A Guide, Making Capital Allocation Decisions: The Role of FP&A.)

This is where FP&A professionals’ work comes into play in the oil companies’ decisions. It’s also an intersection point between treasury and FP&A—around their shared interest in cash forecasting and the calculation of WACC. While treasurers are often the ones charged with calculating WACC, FP&A is the number one “consumer” of this often closely guarded number. To make sense of whether to invest cash or give it back to shareholders to drive shareholder value, FP&A needs to examine the firm’s hurdle rates versus potential investment and work with treasury to assess whether it has cash to spare.

With projections calling for even lower oil prices, many oil companies have suspended or slowed down their investment in new fields and extraction projects, because those projects no longer meet their internal rates of return.

Arriving at those hurdle rates is not an easy task. Hurdle rates are a practical solution to identifying what return over WACC the firms have to achieve to maximize shareholder value. But in many organizations, it’s more an art than a science. It’s an indication of a much deeper problem, which should be the focus of FP&A efforts going forward and the subject of ongoing conversations with their treasury peers, business unit managers and senior management. The key to making the right decisions is not an arbitrary hurdle rate but a more structured gating or framing process that delves deeper into the intricacies of the cash flow forecasting assumptions embedded in investment business cases. To get this right, leading companies are better off polishing their WACC and applying it consistently across investments, while spending extra time on ensuring managers submit realistic and risk-adjusted cash flow forecasts.

Companies that get their calculations right can then make the critical decision of whether they have enough cash around to keep dividends steady in an environment of volatile and down-trending oil prices and limited investment and growth opportunities. Without a careful analysis of alternative investment based on a realistic and more methodically determined WACC, and a thorough and accurate projection of cash flow from treasury and FP&A, that decision becomes disconnected from the firm’s strategic objective and not necessarily in the interest of shareholders. 
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