Step 4: What to do with the returns
Given the returns generated, the company then needs to once again allocate between the various options, in order to optimise company value – To repay its debt and thereby reduce leverage on its balance sheet? To distribute the returns to its equity holders? Or to retain the returns within the company’s balance sheet (retained earnings)? Some considerations that would guide the allocation decision at this stage include contractual debt repayments, shareholders expectations of dividends (e.g. shareholders of listed companies with a track record of a steady dividend distribution may have this expectation), availability of investment opportunities for the company (in the absence of investment or growth opportunities, additional resources retained within the company might generate less value than if it were deployed elsewhere by equity holders and vice versa).
From the lenders’ perspective, we would naturally prefer that the company use the return to repay our debt. After all, we still want our money back. It’s not saying that reinvesting into assets or paying the shareholder is a bad thing, but to lenders, we would prefer these to happen after debt has been repaid.
There should be a balance as to how the returns are being allocated. Spend too little on asset reinvestment, then asset productivity might worsen. Spend too little on paying the dividends, you might end up with grumpy shareholders who demand a change in management. Spend too little on debt repayment, the bank will start asking money from you. It is, therefore, one of the important decisions to be made by the CEO of the company.
Ultimately, at each stage of the capital cycle, the management of the company makes decisions that impact how efficiently (or inefficiently) capital is allocated. While it is neither the responsibility nor the obligation of lenders to make these capital allocation decisions for the company, it is essential for lenders to analyse the extent to which a company is allocating capital efficiently. The role of banks is to add value by to providing leverage to efficient companies which then use the leverage provided to further generate value. On the flipside, inefficiently managed companies destroy value, and leverage provided to such companies is also value that is being destroyed.