Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may In turn Impact on Investors and perceptions of the many in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors. Dividends are payments made to shareholders from a firm’s earnings, whether those earnings were generated in the current period or in previous periods. It is a portion of the corporate profit.
The dividend Is most often quoted In terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price. Referred to as dividend yield. Dividends may affect capital structure. Retaining earnings increases common equity relative to debt. ; Financing with retained earnings is cheaper than Issuing new common equity. There are various theories that try to explain the relationship of a firm’s dividend policy and common stock value:- Dividend Irrelevance Theory This theory purports that a firm’s dividend policy has no effect on either its value or its cost of capital.
Investors value dividends and capital gains equally. Optimal Dividend Policy Proponents believe that there Is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price. Dividend Relevance Theory The value of a firm is affected by dividend policy. The optimal dividend policy is the one that maximizes the firm’s value. Information Content or Signaling Signaling hypothesis says that investors regard dividend changes as signals of management’s earnings forecasts.
Clientele Effect The clientele effect is the tendency of a firm to attract the type of investor who likes its dividend policy. Free Cash Flow Hypothesis All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows. Residual Dividend Policy Residual dividend policy is used by companies, which finance new projects through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the project capital needs are met.
This equity is also known as residual equity. Dividend / Retained Earnings Decision There are various constraints that may impact on a firm’s decision to pay out earnings in the form of dividends. ; Cash flow constraints ; Contractual constraints ; Legal constraints ; Tax considerations ; Return considerations Stock Dividends vs.. Stock Splits Stock Dividend Here, the firm issues new shares in lieu of paying a cash dividend. If it is 10%, shareholders would get 10 shares for each 100 shares of stock owned.
It will not affect the par value of the share. Stock Split When the board votes a stock split, the firm increases the number of shares outstanding, say 2:1 . This will reduce the par value of the share. Stock Buyback: Instead of paying dividends to the shareholders, companies can buyback their own stock in a share repurchase from its earnings. A share repurchase distributes cash to the existing shareholders in exchange for a fraction of the firm’s outstanding equity. That is, cash is exchanged for reduction in the number of shares outstanding. The re-issuance.
Case Background Gainsayers Corporation was founded in 1923 by two mechanical engineers, James Gaines and David Carbons. It was the industry leader in press and mould manufacturing. Its revenues declined from $911 million in 1998 to $757 million in 2004. To combat the decline in revenues and weakening profit margin it followed a two prong approach. First it devoted a greater share of its research and development budget to CAD/CAM to establish its industry leadership. Second the company underwent two major restructuring. The company had set the objective of achieving 15% CARR growth.
In order to achieve it, following three points were proposed: 1) Mix of production to shift substantially. 2) The company would expand aggressively in the international arena. 3) The company would expand by Joint ventures and acquisitions of small software companies. Traditionally, it was a conservative company and preferred to keep its debt-equity ratio below 40%. The two restructuring program implemented resulted in net loss. However the company continued to pay dividends which exceeded earnings. In 2004, it declared dividends in spite of heavy losses.
The board did not declare any dividends for the two quarters of 2005, but committed itself to resuming dividend payment as soon as possible. Problems Ashley Swenson, Chief Financial Officer of Gainsayers Machine Tools Corporation had to submit a recommendation to the board of directors regarding the company’s dividend policy. She had to contemplate her choice from the following three dividend policies: 1) Zero-dividend policy- The rationale behind this option was that since the company was expected to achieve high growth it should try and preserve cash rather than distributing it in the form of cash.
But she had to consider the question, “Was a high dividend in the long term interests of the company and its shareholders, or would the strategy backfire and make investors skirmish? ” 2) 40% dividend payout or a dividend of around $0. 20 per share: This option would imply an annual dividend payment of $0. 8 per share, the highest since 2001. It was believed that since the company had experienced increase in both sales and earnings so it could afford to pay such high dividends. It would also signal to the investors that the company had conquered its problems and was confident about its future earnings. ) Residual- evident policy- There was another section of the finance department which felt that the company should give dividend only after investing in all the projects with positive Net Present Value. 4. Share repurchase- Gainsayers management was thinking of using its funds to repurchase stocks instead of paying out a dividend. Image Advertising and Name Change There was very low awareness about Gainsayers and its business as per the survey conducted among the readers of financial magazines. Cathy Williams, who was the director of Investors relation, retained a consulting firm that recommended a individual investors.
The objective was to enhance the firm’s image and visibility. Thus it was necessary to evaluate the effect of this program on the dividend policy of the company. It was also necessary to consider the various capital providers reaction if it declared a repurchase in 2005. Analysis While doing the analysis following assumptions were made: 1) Although, the company has been assigned an “A” grade by Value Line, while considering the rate of borrowing, 5. 3% is taken which is the AAA corporate bond rate. ) While determining the debt to be issued in each year, the interest expense that has to be paid for it is also included in the debt. Thus to arrive at this figure we consider the geometric progression which gives a factor of 1. 056 for interest rate of 5. 3%. 3) The maximum debt capacity is limited to 40% of the equity value. Question 1) In theory, to fund an increase in dividend payout or a stock buyout, a firm might invest less, borrow more or issue more stock. Which of these 3 elements are Generator’s management willing to vary, and which elements remain fixed as a company policy?
Answer Invest less: There is no mention of the kind of investments that Gainsayers makes, so it is not possible to comment on whether the management invested less. Borrow more: According to Gainsayers expounder, David Carbons, having a debt-equity ratio higher than 40 % was “unthinkable, indicative of sloppy management and flirting with trouble”. Senior management took pride in saying that the company managed on its own. The company had reached a level of 22% in 2004 which was the highest it reached in last 25 years. Thus exceeding the debt-equity ratio beyond 40% was out of question.
So the company can borrow only Upton a maximum of 120. 05 million. But in the year 2004, the directors borrowed to pay dividends despite the fact that it had made the largest loss in its history. Issue more stock: As per exhibit 2, the common stock and capital in excess of par hasn’t changed significantly during the years 2003-04 which means that the company did not issue more stock to pay dividends. Question 2) What is the effect of varying dividend payout levels on Generator’s financing needs and unused debt capacity? Answer Please refer exhibits and 5 for solution.
As seen from exhibit 3, when the dividend payout ratio is 40%, the company will have to raise more debt than the prescribed limit of 40% from the year 2006 onwards. This is indicated by the negative value of the unused debt capacity. Further exhibit 5 shows the sensitivity of debt-equity ratio to the various dividend payout ratios. Question 3) How might Generator’s various capital providers react if they declare a dividend in 2005? What are the arguments for and against zero payout, 40% and residual payout? What are the long term dividend policy recommendations for the Board?
Answer 1) Institutional growth oriented: These types of investors are interested in companies retained earnings so that it can use these funds to fuel its future growth. Hence they will react negatively to dividend payments. 2) Institutional value oriented: In this tragedy, investors select stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals.
The result is an opportunity for value investors to profit by buying when the price is deflated. Typically, value investors select stocks with lower-than- average price-to-book or price-to-earnings ratios and/or high dividend yields. Thus they will favor that the company pay high dividends. ) Individual investors long term retirement: These types of investors prefer stocks which retain cash to support future growth. Thus they will prefer that the company doesn’t pay dividends. 4) Short-term trading oriented: These types of investors will benefit from the declaration of dividends.
Thus they will react favorably to dividend declarations. Arguments for and against for various policies: Zero-dividend policy: Gainsayers 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 hat it preserves capital for its future expansion. 40 percent dividend payout: The average industry payout was 36% in electrical- industrial equipment and 26% in machine tool industry so declaring 40% dividend will bring Gainsayers in line with the current market trend.
Further 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 might find itself short of cash in future when it has to make investments in new proposals. Residual-dividend payout: Some managers in finance department believed that the many should pay all the cash leftover after investments in projects with positive Net Present Value should be declared as dividend. As per professor, John Lintier, dividend payments tend to be sticky.
It means that if the company declares dividend which is less than previous year’s dividend then the stockholders will negatively and hence the share price might get hammered. Long term dividend policy recommendations: Gainsayers is currently focusing on advanced technologies and CAD/CAM which require huge capital. Thus it becomes essential for it to retain its earnings to support future expansions. Also a recently publishes study suggested that the percentage of firms paying cash flows has decreased from 66. 5 percent in 1978 to 20. 8 percent in 1999.
Thus this clearly reflects a growing trend of company retaining its earnings rather than distributing it in the form of dividends. Question 4) How might Generator’s various capital providers react if they declare a purchases back its shares from the investors. This results in a reduction in the number of outstanding shares. This is generally done when the management thinks that its shares are undervalued. As the number of outstanding shares reduces the earnings per share will increase. This will result in a higher market price of the remaining shares. Lenders: Due to the share repurchase the debt-equity ratio increases.
This increases the risk borne by debt providers and hence such actions will be viewed negatively by them. Investors: For those investors who opt to return their shares to the company, they get their worth of the share from the company. On the other hand those investors who do not offer their shares are rewarded in terms of a higher share price which is due to the higher earnings per share. Question 5) Should Swenson commend the corporate-image advertising campaign and corporate name change to the directors? Would this campaign have any bearing on the dividend policy?
Answer: 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 Gainsayers Machine Tools Corporation to Gainsayers 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 Gainsayers and its business. Thus the new advertising campaign will help improve the awareness about the company amongst this segment of people.
Recommendation and Implementation Gainsayers Machine Tools has recently emphasis more on advanced techniques and CAD/CAM technologies. It expects its future growth to come from this particular product. Since these products belong to the high technology and high growth sector it becomes essential for the company to retain cash for future. This is well supported by the zero-dividend policy. Also as per a survey the percentage of companies paying cash dividends has decreased from 66. 5 % in 1978 to 20. % in 1999. This reflects the growing trend amongst the companies of retaining cash for fuelling future growth.
The co-founder David Carbons 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. The company is trying to move from its traditional production of electrical-industrial equipment and machine tools to the new advanced technologies. The new name suggested reflects this trend. Further very few readers of financial magazines are aware of this company. Hence it is a good idea to invest $10 million in enhancing the visibility and image of the company.
Conclusions The important issues which needs attention when dealing with dividends is whether they influence the value of the firm, given its investment decision. As per Modeling 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 invest the excess. On the other hand if he receives less he can sell off the shares of stock.