When depreciation runs ahead of debt repayment, profit lags cash and company law blocks the dividend. Here is how to measure the trap and what a shareholder loan is worth.
A dividend trap is cash a project company has generated but cannot pay out, because depreciation runs ahead of debt repayment and keeps accounting profit, and so distributable reserves, below cash. In an illustrative 500 million project funded with 100 million of pure share capital, trapped cash builds to 30.8 million by year 7 and to 75.0 million before liquidation, and the equity IRR is 17.31 per cent. Funding the same 100 million as 90 of shareholder loan and 10 of shares releases every dollar as it is earned and lifts the IRR to 19.93 per cent, pre-tax.
Worked in full in The Infrastructure Investment Analyst by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In the UK and many other jurisdictions a company may pay dividends only out of distributable reserves, broadly its accumulated realised profits. A project company with a long-lived asset depreciated on a straight line and senior debt on an annuity profile has lower profit than cash in the early years, so the cash waterfall says the money is free while company law says it is not. Shareholder loans are the standard answer: interest and principal on a loan are not distributions, so they leave the company whatever the reserves are.
| Input | Value |
|---|---|
| Asset cost, depreciated straight line over 20 years, US$ millions | 500.0 |
| Senior debt, annuity over 15 years at 6.0% | 400.0 |
| Equity, case A: all share capital | 100.0 |
| Equity, case B: shareholder loan at 10.0% plus share capital | 90.0 + 10.0 |
| EBITDA, flat, every year of a 20-year life | 60.0 |
Senior debt service = 400.0 × 6% ÷ (1 − 1.06−15) = 41.19 a year. Cash after debt service = 60.0 − 41.19 = 18.81.
Profit, case A = EBITDA − depreciation − senior interest. Year 1: 60.0 − 25.0 − 24.0 = 11.0.
Cash trapped in the year = cash after debt service − profit = depreciation − senior principal. Year 1: 25.0 − 17.2 = 7.81.
Dividend = MIN(cash available, retained earnings). In Excel, per year: =MAX(0,MIN(CashBal,RetEarn)).
Case B waterfall: shareholder loan interest, then shareholder loan principal, then dividend limited to reserves.
| Year | Senior principal | Case A profit = dividend | Case A cash trapped (balance) | Case B SHL interest | Case B SHL repaid | Case B paid out |
|---|---|---|---|---|---|---|
| 1 | 17.2 | 11.0 | 7.8 | 9.0 | 9.8 | 18.8 |
| 2 | 18.2 | 12.0 | 14.6 | 8.0 | 10.8 | 18.8 |
| 3 | 19.3 | 13.1 | 20.3 | 6.9 | 11.9 | 18.8 |
| 4 | 20.5 | 14.3 | 24.8 | 5.8 | 13.1 | 18.8 |
| 5 | 21.7 | 15.5 | 28.1 | 4.4 | 14.4 | 18.8 |
| 6 | 23.0 | 16.8 | 30.1 | 3.0 | 15.8 | 18.8 |
| 7 | 24.4 | 18.2 | 30.8 | 1.4 | 14.3 | 18.8 |
In case A, the company earns 18.81 of free cash every year but may pay only its profit, 11.0 in year 1 rising by about a million a year. The difference accumulates, and by year 7 the company is sitting on 30.8 million it cannot distribute. From year 8, senior principal exceeds depreciation, profit exceeds cash, and the trapped balance unwinds, reaching nil in year 14. Once the senior debt is gone the company earns 60.0 of cash but only 35.0 of profit, so after the remaining reserves are used up, from year 17, 25.0 a year is trapped again until liquidation releases it. The year-20 payment in case A is 135.0: 60.0 of the year's cash plus 75.0 held back.
In case B, every dollar of the 18.81 leaves each year. The shareholder loan absorbs it as interest and principal, and because the loan interest is small relative to the cash, case B also banks 45.6 of retained earnings by year 6. Those reserves later cover the years in which cash exceeds profit, so case B never traps anything.
| Measure | Case A: shares | Case B: SHL + shares |
|---|---|---|
| Paid out by year 5 | 65.9 | 94.1 |
| Paid out by year 10 | 164.7 | 188.1 |
| Total paid out over 20 years | 582.2 | 582.2 |
| Equity IRR, pre-tax | 17.31% | 19.93% |
| NPV of equity flows at 9% | 100.5 | 115.7 |
The investors receive exactly the same 582.2 either way. The trap changes only timing, but timing is worth 2.62 points of IRR, or 15.3 of value on a 100 investment at a 9 per cent discount rate. That is the size of the prize a funding structure paper should quote.
| Shareholder loan | Share capital | Equity IRR | Peak trapped cash | Paid out by year 5 |
|---|---|---|---|---|
| 0 | 100 | 17.31% | 75.0 | 65.9 |
| 50 | 50 | 19.90% | 25.0 | 94.1 |
| 70 | 30 | 19.92% | 5.0 | 94.1 |
| 90 | 10 | 19.93% | 0.0 | 94.1 |
Most of the benefit arrives with the first half of the shareholder loan, which removes the early trap entirely. The remaining split decides only how much share capital is stuck in the company after the senior debt has gone, which a capital reduction can also release, at the cost of a legal process.
The usual mistake is to model equity returns straight off the cash flow waterfall, treating cash available for distribution as cash distributed, as in a first pass at CFADS. That model shows case A at 19.93 per cent too, because it ignores the reserves test. The second mistake is to assume the trap is fixed by the lock-up test, which is a lender's restriction and a different thing: the cost of a covenant lock-up is worked in how much a distribution lock-up costs project equity. A project can pass every lender test and still be unable to pay a dividend.
Before relying on a shareholder loan: tax deductibility of its interest, transfer pricing on the 10.0 per cent rate, interest limitation rules and withholding tax all change the after-tax answer and vary by country. The pre-tax result here shows the trap; the tax adviser prices the structure.
Add a retained earnings line and a reserves-limited dividend to the equity model, and measure the trap in IRR points. Here it costs 2.62 points on all-share equity and disappears with a 90/10 shareholder loan split. The book's own sculpted debt case is in the free workbook for this book.
Profit below cash. With straight-line depreciation of 25.0 a year and senior principal of 17.2 in year 1, profit is 7.81 below cash after debt service, and dividends are limited to profit. The gap accumulates as trapped cash, 30.8 million by year 7 in the illustrative project, until principal overtakes depreciation.
Interest and principal on a shareholder loan are not distributions, so they can be paid regardless of distributable reserves; the interest may also be tax deductible, subject to local rules. In the illustrative case, a 90 million shareholder loan alongside 10 million of shares lifts the pre-tax equity IRR from 17.31 to 19.93 per cent with identical total cash.
No, only its timing. Both structures in the illustrative case pay out 582.2 million over 20 years. The trapped cash comes out later, as the trap unwinds or on liquidation, and that delay costs 2.62 points of IRR and 15.3 million of value at a 9 per cent discount rate.
This article is one calculation from The Infrastructure Investment Analyst. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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