Warner Body WorksA case study on dividend policySubmitted by:

Minakshi Pathak

Muna Baral Padam Shrestha

Pragati DahalPrathana Shrestha

Ravi Bhandari Rithu Malekhu

Rubina Shrestha

2013

Financial ManagementInstructor: Dr. Radhe shyam Pradhan

2013/04/10

Table of Contents

Chapter 1 Introduction…………………………………………………………………………….11.1 Background of the case..........................................................................................................31.2 Statement of the problem.......................................................................................................41.4 Objectives of the case study..................................................................................................41.5 Significance of the case study................................................................................................41.6 Organization of the case study...............................................................................................4

Chapter 2 Literature Review............................................................................................................5Chapter 3 Research Methodology...................................................................................................8Chapter 4 Analysis of the case.......................................................................................................10

Question 1..................................................................................................................................10Question 2..................................................................................................................................16Question 3..................................................................................................................................19Question 4..................................................................................................................................21Question 5..................................................................................................................................25Question 6..................................................................................................................................26Question 7..................................................................................................................................28Question 8..................................................................................................................................31Question 9..................................................................................................................................33

Chapter 5 Conclusion and Recommendation................................................................................355.1 Lessons Learnt.....................................................................................................................36

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Chapter 1 Introduction

1.1 Background of the case-

Warner Body works is one of the leading producers of custom coachwork for auto mobiles

delivery trucks and other special purpose vehicles. In 2000, Warner body works acquired a

number of small firms engaged in the research of robotics and material science as a move to

broaden its product line. To finance these acquisitions debt was used because at that time Warner

had relatively small debt outstanding.

For the past 30 years, Warner has been practicing to pay out 60% of its earnings as dividend

payout. Due to its liberal dividend policy, most of its stock holders are income-seeking rather

than growth oriented.

Every year the directors of Warner Body works have a director’s meeting to plan for the coming

year. At the meeting of January 2006, the various issues regarding the company’s dividend

policy was brought forth. Due to its liberal policy, the company had to turndown some expansion

opportunities with high rates of return because of capital limitations.

The tax on dividends (70%) was much higher than that of capital gains (28%). Thus some argued

that for the directors who owned large holdings of Warner stock it would be more profitable to

retain earnings. This way the price of share would increase and they could obtain cash by selling

some of the stocks which would have lower tax cost. Also, the company’s current ratio had

decreased and debt ratio had increased by a great amount since 1997 to 2005.

On the other hand, it was argued that the company would loose the stock holders who were

interested in high dividends which would lower their share price. But it can also be said that even

though these stock holders would be lost, the company could then gain the attention of more

growth oriented investors and in turn result in higher stock prices along with the internal growth

of the company.

Looking at these arguments, the vice president of finance has to come up with the most

appropriate solution to tackle the issue. There are four dividend policy options provided to him

out of which he has to choose the best one.

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1.2 Statement of the problem

This case analysis will deal with following problems

Analyze the four options of dividend policies the firm can undertake and determine

which will be most profitable for the company.

The implications of the announcing their change in dividend policy.

1.4 Objectives of the case study

To understand the use of various dividend policies and their effects on share prices.

To understand the implications of tax rates on dividend policies.

To understand the implications of announcing dividend policy.

1.5 Significance of the case study

This case dealt with analyzing different dividend policies that the firms could undertake at

different situations, their advantages and disadvantages, which are relevant to the financial

concepts studied in our financial management course. We also got a view of how capital gains

are different from dividend policies from the point of view of stock holders as well as company

directors and how these affect the price per share of the company.

1.6 Organization of the case study

The overall report is divided into five chapters. First chapter deals with background of the study,

introduction of the case “Warner Body Works”, statement of problem, objectives of the study,

significance of the study, organization of the study. The second chapter literature review deals

with the review of the conceptual framework for the study. The third chapter research

methodology deals with how the case has been carried out and consists of the units like research

design, source of data, data selection procedure and the limitations of the study. The fourth

chapter deals case analysis and discussion of the questions. The fifth chapter consists of the

conclusion and recommendations of the case.

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Chapter 2 Literature Review

Dividend policy determines the division of earnings between payments to stock holders and

reinvestment in the firm as retained earnings. Retained earnings are one of the most significant

sources of funds for financing corporate growth, but dividends constitute the cash flow that

accrues to the stockholders.

Dividends may affect capital structure.

• Retaining earnings increases common equity relative to debt.

• Financing with retained earnings is cheaper than issuing new common equity.

Dividend Payout Ratio

The percentage of earnings paid to shareholders in dividends.

Calculated as:

The payout ratio provides an idea of how well earnings support the dividend payments. More

mature companies tend to have a higher payout ratio.

Retention Ratio

The percent of earnings credited to retained earnings. In other words, the proportion of net

income that is not paid out as dividends.

Calculated as:

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The retention ratio is the opposite of the dividend payout ratio. In fact, it can also be calculated

as one minus the dividend payout ratio.

Dividend Policy and Stock Value

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 its dividend policy. The optimal dividend policy is the one that

maximizes the firm's value.

Investors and Dividend Policy

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.

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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.

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

Types of Dividend Policies

• Constant Dollar Dividend Policy

• Constant Payout Ratio

• Regular with Extras

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Chapter 3 Research Methodology

Research is defined as human activity based on intellectual application in the investigation of

matter. The primary purpose for applied research is discovering, interpreting, and the

development of methods and systems for the advancement of human knowledge on a wide

variety of scientific matters of our world and the universe.

3.1 Research Design

The research was started with an objective of studying and analyzing the dividend policy

problems of the Warner Body Works. To meet this objective, all the necessary information

(descriptive data) is collected and then presented.

3.1.1 Descriptive research

To further support the study, descriptive research was conducted. The descriptive research was

carried out to study and analyze the methods of enhancing performance in similar situations. In

the course of descriptive research, Internet was used as the major source.

3.2 Data collection procedures

3.2.1 Sources of data

Only secondary data have been used for the purpose of the study.

Secondary Data

a. Internet searching

b. Text books

3.3 Data Analysis Tools

Collected data have been categorized into homogeneous nature for clear understanding and

these data have been presented in graphs, bar diagrams and figures.

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3.4 Limitations of the study

It has certain limitations that are as follows:

The case analysis was completed in a very short span of time. So due to the time

constraint, the analysis may not deal with the minute issues related with the topic under

study.

The analysis part of the study only deals with a certain time period and ignores other

times where significant events may have occurred and thus caused price fluctuations in

the concerned market.

The case analysis depends extensively on quantitative analysis as an in depth analysis of

numerical were necessary. The research papers that were consulted to some extent

showed varied results and thus created confusion.

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Chapter 4 Analysis of the case

Question 1

Evaluate the advantages and disadvantages of each of the four dividend policies,

considering each as it applies in this specific case to Warner Body Works.

Solution:

Dividend policy refers to the policy marked out by companies regarding the amount it would pay

to their shareholders as dividend. It determines the division of earnings between payments to

stockholders and reinvestment in the firms. It is concerned with determining the proportion of

firm’s earnings to be distributed in the form of cash dividend and the proportion of earnings to be

retained. Basically a firm has three alternatives regarding the payment of dividends.

It can distribute all of its earnings in the form of cash dividends.

It can retain all of its earnings for reinvestment.

It can distribute a part of earnings as dividends and rest the rest for reinvestment purpose.

1. A continuation of the present policy of paying out 60% of the earnings

A firm pays a specific percentage of earnings to its shareholders each period. A major

shortcoming of this approach is that if the firm’s earnings drop or are volatile, so too will the

dividend payments. Investors view volatile dividends as negative and risky which can lead to

lower share prices. A regular dividend policy is based on the payment of a fixed-dollar dividend

each period.

Advantages:

Individuals, organization, social organization that need stable income would prefer this

policy as it provides a regular dividend payment. For example: retirees who are in need of

the dividend for their expenses would stay with the organization.

It minimizes uncertainty to investors as there is a regular payment of dividend. The

investors are now safe to invest in the company’s share.

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A regular dividend policy decrease agency costs by reducing the free cash flow available

to the managers of the firm.

As the payment of dividends indirectly results in a closer monitoring of management's

investment activities, this is also one of the advantages for the investors.

Thus as per policy, Warner Body Works’ current stockholders is in support of high

regular dividend.

Finally, legal listing in many states requires dividend stability.

Disadvantages:

This policy would not be appropriate where the companies have low free cash flow

because they are compelled to pay the regular dividend even if there are no earnings.

Need to finance the growth with debt financing which could affect its long term liquidity

because the company is paying high dividend and now the company has less retained

earnings and has to make use of debt.

As they are paying high dividends, they have to bear opportunity cost of not investing in

future projects.

The high payment of dividend leads to low current ratio and increment of dividend.

If a firm pays out substantial dividends, it may need to raise external capital at a later

stage through the sale of stock in order to finance the profitable investment projects. In

this case, the controlling interest of the stockholders may be diluted.

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2. Lowering the present payout to below 60% and maintaining the payout ratio relatively

constant at this new figure.

Advantages:

Individuals in upper income tax brackets might prefer lower dividend payouts, given the

immediate tax liability, in favor of higher capital gains with the deferred tax liability.

Low payouts can decrease the amount of capital that needs to be raised, thereby lowering

flotation costs.

As there is less need to raise external equity, controlling interest of the stockholders will

not be diluted.

It resolves uncertainty, as dividend earnings are less risky than capital gains.

With the reduction in the dividend payout, there is a risk that the current income seeking

investors would sell their stock. Aggressive investors would more than take up that slack

caused by possible liquidation of income seeking investors, which would result in the

increase of the stock price if dividends were cut.

Since high dividends hurt investors, while low dividends-high retention help the firm's

investors, low dividend stocks are more valuable to the company.

Disadvantages:

It could signal that the firm is having financial difficulties. Therefore the firm has

reduced its dividend payout.

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Majority of the Current stockholders are in favor of stable growth rate than growth

potential. Therefore, these groups would sell their stocks if the dividend payout ratio is

reduced. Eventually, this could reduce the marker price per share of the company.

3. Establishing a dollar amount of dividend and increasing with the increase in income

Relatively stable dollar dividend is maintained. The dividend per share is increased or

decreased only after careful investigation by the management.

A stable dollar dividend policy is a based on the payment of a fixed-dollar dividend each period,

for example paying $1 per share. This dividend per share does not fluctuate more as the firms

paying regular dividends typically do not increase the dividend until they are confident that any

increase in earnings is sustainable. As this policy provides dividend stability, it is the most

popular kind of dividend policy for dividend paying firms.

Advantages:

Investors may use the dividend policy as a part for information that is not easily

accessible. This dividend policy may be useful in assessing the company's long-term

earnings prospects. Increase in the dividend would signal the prosperity of the firm. It

would attract the growth seeking investors.

Here in the case of Warner Body Works this could be a better option as the firm needs to

retain its earnings to support the acquisitions. Further, as the dividend per share of 2005

is $1.25 the firm can convince its investors to provide a dividend per share of $1(which is

not very less than $1.25) and increase it with the increase in income as it has a potential

growth.

Disadvantages:

Many investors like retired individuals, college endowment funds, and income oriented

mutual funds rely on dividends to satisfy instant personal income need. If dividends

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fluctuate from year to year, investors may have to sell or buy stock to satisfy their current

needs, thereby incurring expensive transaction costs.

Income seeking investors would sell the stocks as the dividend income is uncertain.

4. Low dividend payout and supplementing it with extra income

The firm applying this policy determines a minimum constant dividend plus some extra amount

of dividends depending upon the earnings. The minimum limit of the dividend per share is fixed

and additional dividend is paid over the regular low dividends in the years of relatively high

earnings. As soon as the earnings decline to normal level, the firm cuts its extra dividend and

pays only the normal or minimum dividend.

Advantages:

This policy could be considered right if the firm’s earnings are quite volatile. In this case

the company needs to pay more dividends, only if it makes higher earnings. Hence

ensures more flexibility to the company in terms of dividend payments. If the firm does

good earnings in some years, it may pay extra dividends.

This policy ensures that the investors get a certain minimum amount as dividend. This

minimum limit is independent of the income or the earning of the company.

The investors have less expectation with this sort of policy. Hence, at the time of growth

when they get more than the expected then it can lead to satisfaction. This can be related

with regards to the expectancy theory.

This sort of policy prevents negative signaling as there is a pre fixed minimum limit for

those investors who are satisfied with the minimum level that is pre fixed.

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Disadvantages:

There is an uncertainty in how much the investors are getting as the dividend with this

sort of policy; hence it may not attract those parties who are seeking a stable dividend.

The investors might think that the company has a weak financial position, so it is going

for a reduction in dividend payout which may be a cause for negative signaling to the

investors.

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Question 2

Evaluate the advantages and disadvantages of having an announced dividend policy.

Should Warner Body Works follow announced dividend policy?

Solution:

The advantage of announced dividend policy is:

Attracts investors:

As the company is declaring a high dividend, many companies would invest and thus it would

lead the company for expansion opportunities. This shows that the company will be in a strong

position thereby leaving the competitors behind. In this way, announcing high divided would

attract a large number of investors.

Reduces uncertainty

The biggest advantage of having an announced dividend policy is that it would reduce investor

uncertainty, and reductions in uncertainty are generally associated with lower capital costs and

higher stock prices, other things being equal. If dividends declared are known by the investors

then the investors can make further planning such as expansion of their business because the

investors are in a safer side.

Reduction of cost of capital on future projects

Dividend payment will naturally reduce the present profit but will definitely reduce the cost of

future equity funding, By announcing high dividend payout in advance the firm can increase the

market price of its share as their will be high demand for it because investors will perceive it as a

high productive which will lead to high flow of share and thus reduction in cost of capital.

Further the company needs no go for debt financing.

Disadvantage:

Difficult to alter the dividend policy once announced.

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It is difficult for the company to change its dividend policy once announced because change in

policy would incur high cost. It will also be risky for the company to change its policy because

the company might not be aware of the consequences of the changed policy. The shareholders

also may be reluctant to accept the changed policy and it also lead to decrease in corporate

flexibility. Therefore the company needs to keep all these factors in mind before changing its

dividend policy.

Opportunity cost of reinvestment.

As the company has already declared the dividend to its share holders, now the company is

compelled to pay the dividend even if the company has others opportunities aside. The company

now has to pay the dividend at the cost of expansion opportunity. The company might have huge

profit if it had invested in other future projects but as the company has already declared, the

company has to give priority to its shareholders.

Not suitable for unionized company:

The announced dividend policy is not suitable for unionized company because it will lead to

conflict between the managers and the union. If the company is declaring high dividend then the

union labors will capture the earnings by asking the managers to increase their salaries

May damage corporate image:

Reduce credibility of the company

In case if the company is not able to provide the dividend to its shareholders that it had already

declared then it will hamper the reputation of the company in future. Disputes will take place

between the company and its shareholders. Even in the future, the public will not be interested to

invest in the shares of the company.

Thus we can conclude by saying that the company should not follow announced dividend policy.

This case illustrates that the company has opportunities available but the company has declared

high dividend. If the company would have retained its earnings rather than issue of stock and

payment of high dividend then the company would have utilized its retained earnings for other

expansion. With fewer shares of stock outstanding, earnings per share would be higher today and

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would have shown a higher growth rate over the past decade. Similarly, Murray implied that

though dividends are cut, aggressive investors will continue to invest in the firm which will

result in increasing price of the stock.

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Question 3

What effect does the dividend policy have on the growth rate of earnings per share?

Solution:

Dividend Policy is deciding how much it will pay out to shareholders in form of dividend out of

its earning and how much it will retain. Earnings per share can be defined as the portion of a

company's profit allocated to each outstanding share of common stock. EPS serves as an

indicator of a company's profitability. EPS can be calculated as Net Income divided by number

of shares outstanding.

In order to show the effect on the growth rate of earnings per share the calculations should be

done as below.

Table1: Calculation of ROE

  1997 2005

Net Income(EAT) 31.2 104.3

Share holder's Equity 97.3 487

Return on Equity(ROE) 32.07% 21.41%

Here,

g = ROE*(1 - DPR)

Where, g = growth rate

ROE = Return on Equity

DPR = Dividend Payout Ratio

For 1997, g = 32.07(1-0.6)

= 12.826%

For 2005, g = 21.41%(1-0.6) = 8.56%

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In the above calculation for the year 1997 given an ROE of 32.07% and a dividend payout of

60% the growth rate is 12.8326%. Likewise for the year 2005 when ROE is 21.41% and a

dividend payout is 60% the growth rate in 8.56%. In the year 2005 the earning after tax has

increased proportionally lower in comparison to Share holder's equity. This shows the lower

growth rate in earning per share when dividend payout ration is constant @ 60%. The reason

behind this is that retained earning are not invested for reinvestment purpose while huge amount

of its earning is spent in the payment of interest in debt due to increment in debt ratio to 60% in

the year 2005. This reduces the net income after tax and with the increased accumulated retained

earning and external equity the shareholder's equity is also increased. As such the return on

equity is decreased reducing growth rate on earning per share. From this analysis we can see

reduction in growth rate of earning per share due to dividend policy.

In the above calculation Return on Equity is calculated as below:

ROE: Common Stock + Retained Earning

1997, ROE = 25 + 72.3 = 97.3

2005, ROE = 50 + 437 = 487

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Question 4

Could the figures in Table 3 be considered proof that firms with low payout ratios have

high price/earnings ratios? Justify your answer.

Solution:

Table 3 is presented below:

Particulars Payout P/E

Playboy 17% 25

Uniroyal 0% 19

Hewlett Packard 11% 17

Data point 0% 16

Texas instrument 30% 13

Xerox 40% 10

ATT 67% 8

Allied Stores 45% 6

Selected Stock Market Data

01020304050607080

Payout ratios

P/E ratios

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As we can see, in the table companies having low payout ratio like Hewlett Packard (11%) and

Playboy (17%) have high P/E ratios i.e. 17 times and 25 times respectively. Whereas companies

having high payout ratios like ATT (67%) and Allied Stores (45%) have low P/E ratios of 8 and

6 respectively. However companies with payout ratio of 30% and 40 % have price earning ratio

of 13 times and 10 times.

It is seen that even those firms that do not pay dividend have high P/E ratios as compared to

those who are paying dividends. Thus the firms with low payout ratios have high P/E ratios. The

table shows that there is an inverse relationship between payout ratio and P/E ratios. Firms like

ATT and Allied Stores who have high payout ratios have low P/E ratios.

According to table and the graph, we can see that there is inverse relationship between payout

ratio and price earning ratio. But is there a perfect inverse relation? The firm with highest payout

ratio should have the lowest price earning ratio and vice versa. But this is not the case in the

table. As per the case, the company ATT should have the lowest price earning ratio, but what we

can see is that instead of ATT, allied stores has the lowest price earning ration. So we can

conclude the relation is relatively inverse.

But theoretically, this is the case.

Payout ratio = Annual dividend / earnings per share

Payout ratio identifies the percentage of net profit paid to stockholders in the form of dividends,

over a specified timeframe. Dividend payout ratio assesses the company’s ability to sustain its

dividend payments, and is therefore useful predictors of continued profitability. A low payout

ratio represents a secure future, while a high ratio suggests that a company has failed to reinvest

its profits and may not be able to sustain dividend payments.

Investors naturally find high dividend payouts attractive, but if these go hand-in-hand

with declining profits it could mean that the company is failing to reinvest, or that

dividends are about to be reduced.

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Investors should be wary of payout ratios above 75%, because of the implication that a

company is not reinvesting its profits, or profits are struggling, or the company is making

desperate efforts to tempt investment.

A new, fast-developing company may choose to reinvest all its profit into the business,

and pay no dividends at all.

It used to be the case that dividends provided over 40% of an investor’s returns. But in

the last 20 years, it’s been more like 20%

Price earning ratio is equal to a stock's market capitalization divided by its after-tax earnings

over a 12-month period, usually the trailing period but occasionally the current or forward

period. The higher the P/E ratio, the more the market is willing to pay for each dollar of annual

earnings. Companies with high P/E ratios are more likely to be considered "risky" investments

than those with low P/E ratios, since a high P/E ratio signifies high expectations. Companies that

are not currently profitable (that is, ones which have negative earnings) don't have a P/E ratio at

all.

Also, we understand that for the markets where retained earnings (RE) has more effect on market

price per share (MPS), low payout ratio indicates that huge portion of dividend has been retained

for investment on project with higher rate on return. The effect will be reflected by increase in

MPS and thus increased P/E ratio.

Payout ratio= earning distributed as divided/ net income (NI)

P/E ratio = market price per share (MPS) / earnings per share (EPS)

For market with higher RE effect on MPS:

Low payout High retention for more profitable project increased MPS high P/E

However, for the markets where MPS is more sensitive to dividend, low rate of dividend would

indicate decrease in profit of the company. This in turn reduces the MPS and finally P/E ratio

also declines.

Low payout low profit decreased MPS low P/E

In summary, price earning ratio and payout ratio both depicts the profitability of the firm. So

theoretically they should have direct relationship. However the table shows the relatively inverse

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relationship. So we conclude that the above mentioned companies must be operating in market

where retained earning has more impact on MPS rather than dividend. Hence the inverse relation

between PE and payout has been obtained.

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Question 5

How does the firm’s debt position affect the dividend policy?

Solution:

Since the debt capital is cheaper, most organizations prefer to include certain portion in their

capital structure. However the debt capital has a direct impact on the dividend policy.

First, more debt capital means more amount to be paid as interest as well as loan. They have to

retain more amount of money to repay the loan and interests i.e. less amount of money will be

available to distribute as dividend. The company, therefore, would follow conservative dividend

policy.

Second, with increased debt capital the firms are bound to several debt contracts such as future

dividend can be paid out of earnings generated after the signing of the loan agreement, dividend

cannot be paid when net working capital is below a specified amount etc. in this case the firms

will follow conservative dividend policy by retaining more money out of their net income.

Use of high amount of debt capital will make creditors reluctant to further provide loans. Hence

the firms have to retain more money to meet the future requirement of expansion or growth. In

another word when debt ratio is increased the lenders will not be interested in the lending

additional fund in case if the firm finds other investment opportunities. Such a condition will

compel the firm to follow residual dividend policy so that the required funds can be financed

internally out of its earning.

However in contrary, with increased use of debt the return for equity shareholder would be

riskier. That means their required rate of return increases. Therefore, the firm will have to pay

more amount as cash dividend.

In the case of Warner Body Works it has followed liberal dividend policy i.e. high amount of

fixed payout ratio (60%). Less amount of money was retained for further growth and expansion.

As it had high debt ratio it could not borrow money from its creditors. As a result the firm was

forced to turn down few expansion projects with high rate of return.

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Question 6

Evaluate Murray’s argument that a reduction in the dividend payout rate would increase

the price of the stock versus Bassler’s opinion that such a reduction would drastically

reduce the price of the stock.

Solution:

Mark Bassler, trustee of the endowment fund of major university and long time member of

Warner’s board of directors, is of the opinion that a reduction in the dividend payout rate would

drastically reduce the price of the stock. His argument is based on the fact that majority

stockholders of Warner Body Works are income-oriented investors who have an overwhelming

preference for a policy of high dividends as opposed to a policy of a low payout. Also for the

trust, dividends and capital gains are not interchangeable. Therefore, a reduction in the dividend

payout rate would mean that most of its investors would sell the Warner stocks in order to

reinvest in another company that paid higher dividends. The liquidation of Warner Body Works

from so many portfolios would have a disastrous effect on the stock price as it would send a

wrong signal to the market.

Roger Murray, production manager of the Robotics Division, suggests that a reduction in the

dividend payout rate would increase the price of the stock. His suggestion is based on the

understanding that if it known that a firm has expansion (investment) opportunities that promises

a relatively high rate of return, aggressive investors would be more than willing to take up the

slack caused by possible liquidation of income-seeking investors. Moreover, his argument is

verified by the fact that if dividend payout is reduced, income-seeking individuals would most

likely sell off their Warner stocks for better paying stocks. This would reduce the number of

stocks outstanding and thus increase the earnings per share. The increase in earnings would

eventually show a higher growth rate which would in turn induce growth-oriented institutions

and individual investors to purchase Warner stock. Having growth-oriented stockholders would

ensure that Warner Body Works is continuously growing and doing better than before. Hence,

the company’s stock price is likely to soar up.

From the above evaluation of the two arguments, it can be seen that Murray’s argument has more

weight than that of Bassler’s. In fact, what Murray suggests covers for the gap/ problem

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mentioned by Bassler. Warner Body Works has been making all its acquisitions by issuing new

stock as all its cash goes out in the form of dividends to its stockholders. Therefore, reduction in

the dividend payout rate would mean that the company can make acquisitions for cash. Making

acquisitions for cash would mean that there are fewer stockholders in the company thus

increasing the earnings per share and the growth rate. Thus retaining the earnings and ploughing

it back into the company as suggested by Murray would prove to be beneficial for the company.

We are therefore in favour of Murray’s argument rather than Bassler’s.

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Question 7

Might stock dividends be of use here?

Solution:

A stock dividend is a pro-rata distribution of additional shares of a company’s stock to

owners of the common stock. In simpler terms, stock dividend is a dividend payment made

in the form of additional shares, rather than a cash payout. It is also known as a "scrip

dividend." Companies may decide to distribute stock to shareholders of record if the

company's availability of liquid cash is in short supply. These distributions are generally p

acknowledged in the form of fractions paid per existing share. An example would be a

company issuing a stock dividend of 0.05 shares for each single share held.

Unlike a cash dividend, a stock dividend is usually not taxable to the shareholder when it is

received, but rather when it is sold. Stockholders who are supposed to receive a fractional share

will often receive a check for the amount equal to the market value of the fractional share.

A practical example of stock dividends:

Company ABC has 1 million shares of common stock. The company has five investors who each

own 200,000 shares. The stock currently trades at $100 per share, giving the business a market

capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of

common stock (20% of 1 million) and sends these to the shareholders based on their current

ownership. All of the investors own 200,000, or 1/5 of the company, so they each receive 40,000

of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares of

common stock. The 20% dilution in value of each share, however, results in the stock price

falling to $83.33. Here’s the important part: the company (and our investors) are still in the exact

same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at

$83.33. The company’s market capitalization is still $100 million.

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A company may opt for stock dividends for a number of reasons including inadequate cash on

hand or a desire to lower the price of the stock on a per-share basis to prompt more trading

and increase liquidity (i.e., how fast an investor can turn his holdings into cash). Why does

lowering the price of the stock increase liquidity? On the whole, people are more likely to buy

and sell a $50 stock than a $5,000 stock; this usually results in a large number of shares trading

hands each day.

One of the more interesting theories of corporate dividend policy is that managements should opt

for stock dividends over all other kinds. This will allow investors that want their earnings

retained in the business (and not taxed) to hold on to the additional stock paid out to them.

Investors that want current income, on the other hand, can sell the shares they receive from the

stock dividend, pay the tax and pocket the cash - in essence, creating a “do-it-yourself” dividend.

In the case of Warner Body Works, they have a huge cash outflow in the form of dividends as

they have a current dividend policy of 60%. Therefore, they are forced to turn down some

expansion opportunities that promised relatively high rates of return. Moreover, the problem that

the company is facing is such that its stockholders consist of mainly income-seeking investors

which mean that if dividends are not distributed or are paid at a rate lower than the present rate,

the stockholders are likely to sell the company’s stock to reinvest in another company that is

paying higher dividends. Therefore, it would be very difficult for Warner Body Works to

instantly reduce its dividend payout rate. To solve this cash problem, Warner Body Works could

payout stock dividends instead of cash dividends. This way it will be able to increase its liquidity

and can thus invest in the more lucrative investment opportunities.

Moreover, the company is currently paying a tax of about 70% on dividends. If it were to issue

stock dividends instead, it would have to pay tax of only 28% that too only if the stockholder

sells the stock. This is because as explained above, stock dividends are taxable only on sale.

Therefore, Warner Body Works could save on its taxes if it were to issue stock dividends instead

of cash dividends.

Now, from the investor’s perspective, if the company were to issue stock dividend instead of

cash dividend, it would still be beneficial to them as their earnings in terms of earnings per share

and stock price are likely to increase, assuming of course that the company’s investment with the

retained income proves profitable. Also, this option as explained earlier would allow investors

that want their earnings retained in the business (and not taxed) to hold on to the additional stock

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paid out to them. Investors that want current income, on the other hand, can sell the shares they

receive from the stock dividend, pay the tax and pocket the cash - in essence, creating a “do-it-

yourself” dividend.

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Question 8

What specific dividend policy should Murray recommend to the board of directors at its

next meeting? Fully justify your answer.

Solution:

In the given case there are four dividend policy alternatives provided. The first dividend policy is

in favor of continuation of 60% dividend payout ratio. The second policy is in favor of lowering

the present payout ratio whereas third policy favors establishing a fixed dollar rate assuming the

earnings will be increased and hence the dollar dividend will also be increased. Similarly fourth

policy is in favor of providing very low dividend of only $0.50.

Theoretically justifying the fourth policy of paying only $0.50 dividend is not advisable. Since

most the stockholders of the organization are income seeker who prefers high dividend payout

ratio. In such a condition this might leave a negative impact among the stockholders and

consequently they will not prefer to hold the organization's stocks. As such this might lead to

negative rumors in the market and hence the market price of the shares may reduce drastically.

Hence this policy is rejected on the ground of this assumption. However to justify among other

three alternatives and decide which should be chosen growth rate on Earning per share based on

three policies are calculated. On the basis of the growth rate the decision can be made.

Table showing growth rate on various dividend policies

Dividend Policies

Retention

Ratio

Dividend

Payout Ratio ROE g %

First Dividend Policy 40% 60% 21.42 8.57

Second Dividend Policy        

DPR (20%) 80% 20% 21.42 17.14

DPR (30%) 70% 30% 21.42 14.99

DPR (40%) 60% 40% 21.42 12.85

Third Dividend Policy* 48% 52% 21.42 11.44

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In the above table we can see that the highest growth rate on EPS due to dividend policy is when

the dividend payout ratio is only 20%. This indicates that 80% of the earning should be retained

for the investment opportunity. Internal financing is cheaper than that of external financing As

such it provides advantage of reduction in cost of capital and hence increase return on capital.

Likewise since the case discloses that many of the investors who seek for growth are willing to

invest in Warner Body due to its prospect of expansion. this can be opportunity for them.

Hence on the basis of highest growth rate we can justify the second dividend policy with 20%

dividend policy should be recommended by Murray.

Working Notes

Calculation of Payout Ratio for Third Dividend Policy

EPS= $2.09

DPS = $1 per share

Dividend payout ratio= {1/2.09} * 100 = 48 percentage

Calculation of Payout Ratio for The fourth dividend policy

EPS=$2.09

DPS=$0.5 per share

Dividend payout ratio= {0.5/2.09} * 100 = 24 percentage

Calculation of growth rate (g)

G= ROE * (1-Dividend Payout Ratio) in percentage

Where, return on equity is calculated by dividing Net Income by Shareholder's Equity

Return On Equity 1997 2005

Net income 31.2 104.3

Shareholders' Equity 97.3 487

ROE 32.07 21.42

Substituting the Dividend Payout ratio in the above equation we found the growth rate for the

analysis part.

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Question 9

The tax law was changed to reduce the tax rate on dividends from 70 percent to 50 percent

and the capital gains tax rate from 28 percent to 20 percent. How might theses changes

have affected Warner Body Works' optimal payout ratio?

Solution:In the case the stockholders are in high tax bracket due to which only 30% of their income in

form of dividend will remain in hand. In situation of they require cash they can sell their stock

and can earn more since it has tax bracket of only 28%. In this question the tax effect is reduced

to 50 percent and capital gain tax rate is reduced to 20 percent. To show the effect of these

changes in optimal payout ratio further calculation is done as shown in the table below.

In the above table Dividend per share is calculated based on the various dividend payout ratio.

Stockholders tend to prefer low tax bracket. As such when tax rate is reduced to 50% the

stockholders will be benefited by (0.7*1.25 - 0.5*1.25), $0.25. Likewise reduction in capital gain

also benefits the stockholders by extra 8% in principal. Whatsoever reduction in tax rate in still

higher than that of capital gain tax rate. As a result stockholders prefer to earn through capital

gain or they seek for maximization of shareholder's wealth through expansion and growth. In

such a condition the firm should retain more and use the fund for better investment opportunities

which likely to give higher return. This will definitely enhance the shareholder's wealth. Hence

the optimal payout ratio should be reduced.

Payout

policy

Dividend

in million

EAT in

million DPS

Number of

share

outstanding

{million}

Average

Stock

Price

0.2 20.86 104.3 0.42 50 14.62

0.3 31.29 104.3 0.63 50 14.62

0.4 41.72 104.3 0.83 50 14.62

0.6 62.58 104.3 1.25 50 14.62

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Chapter 5 Conclusion and Recommendation

Dividend policy is a very important tool for any company. It gives the information regarding

the sound financial position of the company and thus helps the potential investors to make

investment decisions. It is advisable that companies that have expansion opportunities that

promise high return should opt for residual dividend policy. Whereas those companies that

do not have such opportunities should opt for liberal dividend policy. In this case, Warner

Body Works have avenues open for expansion opportunities with relatively high returns but

since it has been following a considerably liberal dividend policy, it has had to turn down

several such opportunities. A company such as Warner Body Works, that follows a liberal

dividend policy of paying out 60% of its earnings as cash dividends, tends to attract more of

income-seeking investors rather than growth-oriented investors. Therefore, it would be

advisable that companies do not make such liberal and rigid dividend policy from the very

start. Moreover, a company need not always give out cash dividend, it could also opt for

stock dividend. Opting for stock dividend instead of cash dividend would allow the firm to

retain some of its earning and reinvest such earnings in the expansion opportunities available

to it thus opening avenues for growth. Also, this will allow investors that want their earnings

retained in the business (and not taxed) to hold on to the additional stock paid out to them.

Investors that want current income, on the other hand, can sell the shares they receive from

the stock dividend, pay the tax and pocket the cash - in essence, creating a “do-it-yourself”

dividend.

Another important issue that has been noted in this case is the need to exercise caution while

designing the company’s capital structure. A debt ratio would imply that most of the

company’s earnings would go into interest payments and therefore leading to cash

deficiency. Therefore, a company should also consider internal financing rather than holding

it within the firm as it is cheaper and hence reduces the cost of capital, increasing the net

income of the company. Also, a higher debt in the capital structure would lead to higher

demand for dividend from the part of equity holders because the higher amount of debt leads

to increase in riskiness and the shareholders will sanction additional debt only if they get

higher return. This will ultimately result in the change of dividend policy. Managers should

focus on capital budgeting decisions and ignore investor preferences.

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5.1 Lessons Learnt

The key lessons learnt from this case are:

1. Although a liberal dividend policy attracts investors, it is not always beneficial for a

company as it would require the company to turn down expansion opportunities

available to it.

2. A company following residual dividend policy can make acquisitions for cash rather

than issuing new stock. The main advantage of this is that the number of shares

outstanding would be lower thus earnings per share would be higher.

3. Stock dividends are better option than cash dividends.

4. The tax advantage of capital gains favors retention of earnings.

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