MEMORANDUM TO:
Board of directors
FROM:
Chief Financial Officer
Date:
February 7, 2011
SUBJECT:
DIVIDEND POLICY DECISION
PROBLEM STATEMENT In mid September 2001, Jennifer Campbell, the chief financial officer of Eastboro Machine Tools Corporation, a large CAD/CAM (computer-aided design and manufacturing) equipment manufacturer must decide whether to pay out dividends to the firm’s shareholders, or repurchase stock. If Campbell chooses to pay out dividends, she must also decide on the amount of the payout and how it would affect the company going forward. An additional question is whether the firm should embark on a campaign of corporate-image advertising and change its corporate name to reflect its new outlook of being a more technological company. When considering whether or not it is necessary to pay dividend to shareholders, Eastboro Machine Tools Corporation have a problem, the problem is the correct decision and implementation of Eastboro's dividend policy. In that it has to decide how to provide enough cash to ensure the upcoming aggressive growth of 15% compounded in the following years. SITUATION ANALYSIS After two massive restructurings, the firm has established itself as an industry leader in CAM/CAD technology business. Its product being the “Artificial Workforce” appears to have a bright future. Most of securities analysts are optimistic about the product’s impact on the company. This is why Campbell took the bold approach to assuming that the company would grow at a 15% compound rate. For 3 years in a row since 1996, dividends had exceeded earnings, except in 1999, dividends were decreased to a level below earnings. Despite losses in 1998 and 2000, small dividend was declared. It has not paid dividend in 2001 although it had committed earlier to pay sometime in 2001. DIVIDEND PAYOUT DECISION The dividend decision is part of the firm’s financing policy. The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value. The dividend payout decision which is chosen may affect the creditworthiness of the firm and therefore the costs of debt and the cost of equity; if the cost of capital changes, so may the value of the firm. Unfortunately, one cannot determine whether the change in value will be positive or negative without knowing more about the best option of the firm’s debt policy.Dividends is considered as a yardstick of a company's prospects and typically, mature, profitable companies pay dividends. If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors normally treat this as a signal that there
1
is possible problem. A steady or increasing dividend is certainly reassuring, but investors are concerned about companies that rely on borrowings to finance such payments. Retention of profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets, however if there is further investment to be had then retention of profits will be a good option as the management is debt adverse, and believes that 40% is the highest they will allow in relation to debt to equity ratio. There are several factors to be considered when contemplating on the dividend decision: these are clienteles, free cash flow and information signalling. These factors are an indication of how shareholders and potential investors judge the company and it also indicates the health of the company as dividend is a signal to the rest of the world as to the future prospects of their, this also tends to lead to a dividend policy of a steady, gradually increasing payment. The analysis of the dividend policy, Firstly the 40% payout ratio is in line with the average industry payout ratio which was 36% in electrical-industrial equipment and 22% in machine tool industry so declaring 40% dividend will bring Eastboro in line with the current market trend. And it would send a strong signal to the investors that the company was confident about it future earnings. However if the company continued to pay such high dividends then it will find itself short of cash in future when it has to make investments in new proposals, especially seeing that there is a deficit for all the years up to 2006 after dividend payments. A sensitivity analysis was done using three other payout ratios 0%, 10% and 20% they all showed that paying out less than 40% dividend was more beneficial for Eastboro with 0% payout being the best option and especially since it is in a new type of business which requires a lot of cash. Investor of companies like institutional value oriented investors likes opportunity for value to profit by buying when the share price is deflated, and so they are advocates for high dividend distribution. So are the short-term trading oriented investors. Residual-dividend payout: it is thought that company should pay all the cash leftover after investments in projects with positive Net Present Value; this is declared as residual dividend. Dividend payments tend not to be constant and so could be considered sticky. This means that if the company declares dividend which is less than previous year’s dividend if stockholders react negatively this can affect the share price and the company’s image could be hampered. Eastboro could look at this as an option, but only after projects are satisfied. Zero-dividend policy: Eastboro had recently laid emphasis on advanced technologies and CAD/CAM. This needed huge cash for future growth. Since the company belonged to high technology and high growth segment it was necessary that it preserves capital for its future expansion. Recent studies have shown that the percentage of firms paying dividend has decreased. Thus this clearly reflects a growing trend of company retaining its earnings rather than distributing it in the form of dividends. Institutional growth oriented investors prefers 2
company who retain their profits for future growth potential, likewise individual long-term retirement investors, prefers company who retain cash for growth potential. If Eastboro repurchase it stocks the various stakeholders will have confidence and this will indicate that the company is trying to allow the share price to be valuable and so there will be an increase in the share price, increase EPS and reduction in the dilution of the shares. However the lenders of money will see it as negative as this means that Eastboro would need to borrow to repurchase these shares so increasing their debt ratio. The purpose of this campaign was to enhance the firm’s visibility and image. It was proposed to change the name of the company from Eastboro Machine Tools Corporation to Eastboro Advanced Systems International Inc. This would involve a cost of $10 million. It was believed that the new name would be more consistent with the future products of the company. Also a survey of financial magazine readers revealed that there was relatively low awareness of Gainesboro and its business. Thus the new advertising campaign will help improve the awareness about the company amongst this segment of people. Recommendation and Implementation Eastboro Machine Tools has recently emphasis more on advanced techniques and CAD/CAM technologies. It expects its future growth to come from this particular product and market. Since these products belong to the high technology and high growth sector it becomes essential for the company to retain cash for future investments or project opportunities. This would be supported by the zero-dividend policy regime. A study was conducted which the percentage of companies paying cash dividends has decreased over the years, this is an indication that dividend payout is becoming a thing of the past. And reflects the growing trend amongst companies of retention of cash for fuelling future growth. The co-founder David Peterboro was against the company having a debt-equity ratio of more than 40%. There is a high possibility that an investment project might be rejected in future due to lack of cash. Thus it becomes essential to retain cash. Conclusion The main issues therefore with dividends are whether they influence the value of the firm, given its investment decision. As per Modigliani and Miller, the firm should keep retained earnings only keeping in mind its investment needs. If there are not sufficient investment opportunities then it should pay out the unused funds as dividends. The dividend policy of a firm is irrelevant in a perfect capital market because the shareholder can effectively undo the firm’s dividend strategy. If a shareholder receives a greater dividend than desired, he can reinvest the excess. On the other hand if he receives less he can sell off his shares of stock. Even in a perfect capital market a firm should not reject projects with positive cash flows so as to increase the dividends. There is tax benefit to be gained from low dividend payout. 3
.
4
