Why do companies use debt to finance business deals instead of cut the dividend?

Question

Some time ago Altria bought a 35% stake in Juul, using $12.8 billion in cash.

However if one looks at Altria's financial reports, it's clear that this is money Altria didn't have. The company didn't have enough cash in reserve and already pays ~80% of its earnings as dividends. To finance this purchase, Altria used debt. Long-term debt more than doubled.

Chances are everyone who reads this StackExchange knows that debt is dangerous and should be avoided. Why, then, is Altria not avoiding this debt? It seems really easy how they could avoid it: just cut the dividend, to zero if necessary, and use the cash saved to invest in Juul. Even if that's not possible (because they want to invest in Juul right now), they could still cut the next dividend(s) and use the cash saved to pay down their debt as soon as possible. There is no sign of this however. Their press release says:

Altria expects to maintain a dividend payout ratio target of approximately 80% of adjusted diluted EPS. Future dividend payments remain subject to the discretion of Altria’s Board of Directors (Board).

In other words, Altria is expecting to keep paying the dividend.

My understanding is that Altria is not special in making this kind of decision, and dividend cuts are very rare. Why?

Answer 1

I'm going to try and provide a short/sweet answer compared to the other two provided.

When companies cut their dividend, it typically means they are hurting financially which is a red flag for investors. So investors may act on those fears and pull out their money causing the stock to drop a substantial amount. This isn't good for the company because it drops the company's market cap and usable capital. Another reason is because if Altria can take out a 2% or 5% or 7% loan to buy a company that will earn them 10% or 15% every year that they own the company, then why not borrow the money? With this new debt, the company can pay off the debt along with lining their pockets without cutting their dividend. This is all under the assumption that the company has a healthy balance sheet and accurate profit forecasts.

Does this mean that all companies should take on large amounts of debt to buy assets? No, but it's a companies choice to do so if they think they can get a greater return from owning those assets. Especially compared to letting the money sit in cash or paying off other debts.

Answer 2

Chances are everyone who reads this StackExchange knows that debt is dangerous and should be avoided.

While I do agree that debt is dangerous and should be avoided, not everyone does. Heck there are people on here that advocate taking pay day loans!

Even the most debt adverse financial commentators suggest that a mortgage is an acceptable risk. They may only advocate certain structures of mortgages, but they see it as a way for most families to build wealth.

Less debt adverse might suggest a well structured business loan in order to earn more money. The business might be rental real estate properties or owning a franchise. Theoretically the difference between the finance charge and return on investment is great and they can earn money on the arbitrage.

This is how, in my opinion, Altria sees this transaction. Either the loss to their future profitability was perceived to be so great, or that they could make so much money off of the acquisition that it was worth financing that transaction.

Companies do this all the time. For example, Darden will open new restaurants while they are holding debt and paying a dividend. There are countless other examples.

The dividend is seen as a very different matter. Many companies pay a dividend, despite its tax inefficiency, because it increase confidence in the company. They may even see it as a commitment to long term employees, that are now retired, that acquired the stock over many years of payroll deduction. They even get a lot of free marketing from paying a constant or even increasing dividend. Dividends tend to be a very sacred thing and the hallmark of a "blue chip" stock.

Answer 3

I think at the core of this question is a misunderstanding of debt. There's debt, and then there's debt. And that's not to say there is good debt and bad debt, as some people refer to mortgages as "good debt" and credit cards as "bad debt" but just that not all debts are the same. For example, not all mortgages are good so not all mortgages can be good debt as a category.

You should not, ever, use your your credit card that is already carrying a balance to pay for a fancy $250 dinner. The dinner isn't going up in value, it will literally end up in a toilet. The interest rate on credit cards is very high and you're already carrying a balance from other things you probably should have simply abstained from. It doesn't matter that the dinner will only cost $4 per month for the next 100 months. I think you are thinking of all debt this way. All debt is paying for something you don't need with money you don't have. But that's not what debt is. Debt is a tool.

Change the dinner to a $900 computer for your freelance work. You do freelance editing and earn $500 per month approximately, the primary tool for your trade was just stolen and you had no insurance. Sure, the computer is probably still going down in value like the dinner but you need it in order to earn the $500 each month. With debt you can replace the computer and keep earning that $500 in exchange for part of your future earnings. Yes, the money you used to pay for the computer comes at a cost as the loan requires a payment of $100 per month for 10 months so the bloodsucking good-for-nothing bank will earn $100 in interest, but that cost allowed you to keep working.

Lets call your freelance editing gig Lancelot Editors. Lancelot Editors earns $400 of net income each month, because your computer will cost the company $100 per month for the next 10 months. Lets assume there are no other expenses apart from the $75 reserved to pay taxes, though the lender may require you to carry insurance on this computer as protection and maybe you think it's a good idea anyway given your current predicament. The company has $325 of net earnings each month which go to you, the owner of Lancelot Editors. That's a dividend.

You use this $325 to live your life, you eat lunch pay rent, etc.

Why doesn't the company just retain the $325 to pay the computer faster? Because then you don't eat.

The major financing tool apart from debt is an equity sale. As an alternative to taking that $1,000 loan you could have just sold 5% of your business to Cruella de Vil for the $900 cost of the new computer. But now, every month when you distribute your $425 (because there is no longer a $100 loan payment) of earnings, Cruella gets $21.25 because she owns 5% of the company. And she will continue to own 5% of the company until she feels like selling it. Sure, $21.15 is less than the $100 loan payment in monthly terms but it goes on indefinitely while the loan will be paid back eventually.

In reality, corporate finance and capital planning is very complicated. But understand that in the case of the computer, you personally put up $0. Your $0 investment earned you $4,000 over the 10 months that followed (because the computer cost $1,000 of the $5,000 you earned), you never had to skip a lunch and all you had to do was agree to repay the money.

Just because the word is the same this kind of debt is not the same debt as buying consumer future-trash on a credit card and there are very legitimate reasons to pledge some earnings in the future in order to protect dividend payments right now.