Why are dividends lower when constrained by NPAT?

By Nick Crawley on June 22 2009

Why are returns reduced when dividends are restricted to accounting profits?

In many countries the calculation of dividends is not simply the payout of any free cashflow left over after the repayment of debt service and reserve accounts, it is restricted to be the smaller of the freecashflow and either the Net Accounting Profit in the Period or also to include the Retained Earnings brought forward in the period.

This means that a dividend is only paid out if there is sufficient free cash flow and let say, retained profit (either definition).

Retained Profit is a different function to FreeCashflow and so at any time, they are generally different, especially at the stage in a project when dividends would be expected to be paid. Lets take a look at what each is made up of:

FreeCashflow is generally the result of adding:

Revenue
Operating costs
Interest on cash deposits
Working capital adjustments
Tax (when paid)
Capital expenditure
Senior debt (P+I + fees)
Mezzanine debt (P+I+fees)
Reserve account movements

Profit is generally derived from:

Revenue
Operating costs
Depreciation (accounting basis)
Amortisation of Goodwill or intangibles
Interest on cash deposits
Interest paid on borrowings
Tax (payable, exclusive of losses and calculated using tax depreciation basis)

As you might be able to see from the above points the only way for free cashflow to be the same as profit is if all of the above hold true:

There is no debt (senior or mezzanine or any other types)
There are no working capital adjustments
Depreciation and amortisation are zero
Tax is paid as it becomes due
Tax losses are zero
There are no reserve account movements
Interest is received as it becomes due

As you can imagine, in a typical project finance transaction these functions are generally quite different because those conditions almost never apply.

So if the accounting profit is a constraint on the release of freecashflow (dividends) then it doesn’t matter if there is $10m of free cash to distribute if there are not corresponding accounting profits - no dividends will be paid. The accounting profit function is generally lower than the free cash flow owing to the often significant losses that can accumulate during project development and construction. The freecashflow that accumulates during the period whilst accounting profit is catching up with cash performance is called ‘trapped cash’. This trapped cash is a major problem for equity investors and is partially solved by the use of shareholder loans although that has issues to be discussed another time…