Case 9: Dividend Policy
Case 9
POWERLINE NETWORK CORPORATION (PNC)
(Dividend Policy)
Non-Directed Version
This is one of a series of cases dealing with various financial issues faced by Powerline Network
Corporation. Background material on the company is provided in the document entitled Background
Material on Powerline Network Corporation (PNQ).
Bill Bostic, Sue Chung, and Sam De Felice, were assigned the task of explaining the key elements
of financial management to PNC’s board of directors, and they are now preparing for Session 9, which
Jeals with dividend policy. Thus far, PNC has needed to retain all of its earnings, but its future sales and
isset growth requirements are likely to decline, and as growth slows the company expects to generate free
cash flow that can be paid out to stockholders.
The dividend issue has never been seriously considered for several reasons. First, the firm’s rapid
srowth has absorbed all of its cash flows to fund capital investment opportunities. Second, PNC’s directors
lid not personally need dividend income; hence if dividends had been paid, they would have simply paid
‘bout 40 percent of them out to cover state and federal taxes and then reinvested the remainder, ending up
vorse off than before. However, in 2003 a new tax law took effect, lowering the maximum federal tax rate
n dividends from 39.6 percent to 15 percent and the maximum rate on capital gains from 20 percent to 15
vercent. Under the old tax structure, stockholders’ potential after-tax returns were maximized by having
he company retain and reinvest earnings to generate capital gains. Under the new law, with both dividends
ind capital gains taxed at 15 percent, the tax disadvantage of dividends has been largely eliminated.!
Also, several PNC directors (and officers) are thinking about retirement, and when they do retire,
hey will need cash income. This is making them more interested in dividends. Finally, PNC President Ray
%eed and several other large stockholders (including Bill Bostic and some of the other officers) would like
o diversify their holdings, which would mean selling some PNC shares and reinvesting the proceeds in
other securities. Obviously, they would like to sell their shares at as high a price as possible, and Bill
hinks that paying a dividend might increase the price of the shares. This view was reinforced at the cor
vany’s last annual meeting, when several stockholders asked about dividends and commented that a divi-
lend would be well received.
Bill is also aware that since the new tax law took effect, many companies have increased their divi-
lends, and stock market pundits have been arguing that companies such as PNC could increase their stock
vrices by initiating cash dividends. Indeed, in mid-2004 Microsoft announced the largest dividend action in
tistory, which included a one-time special dividend of $30 billion, a substantial increase in the regular
1. There is still a tax advantage to capital gains in that the gains, and thus the tax, can be deferred until the stock is sold. Also, stock
eld at the time of the owner's death escapes the estate tax, ¥
53+9: Dividend Policy
terly dividend, and a very large stock repurchase program.? Many other companies have taken similar
‘ms, and they have typically seen a pop—which may not be permanent—in their stock prices. However,
1 its rapid growth and need for funds, few-if any-analysts expect PNC to pay dividends for a couple of
s. Indeed, one influential analyst recently published a report in which he forecasted no dividends for
text two years, then an initial dividend of $0.50, then rapid grow in the dividend for the next two years
@ in the first year and 40% in the second), and finally a constant growth rate of about 7.6% thereafter.
thinks this forecast is consistent with most analysts’ views, but PNC’s management has not indicated
it agrees.
Before the recent tax change, Ray Reed and PNC's directors stated publicly that they had no plans
ay dividends any time soon, However, the dramatic change in the tax situation and the inevitability that
‘er growth will make free cash flow available has moved dividend policy to the front burner. Of course,
ss funds not needed in operations could be used to buy marketable securities or for acquisitions, but
t investors, including PNC’s outside directors, strongly dislike companies that hoard cash in marketable
rities or acquire other companies just because cash is available. Of course, strategic reasons arise for
ing cash or for acquiring other companies, but if no compelling business reasons for these actions
2, empirical evidence suggests that investors would be better off if companies distributed excess cash
let stockholders make their own reinvestment decisions.
Bill provided the directors with a widely used finance textbook and indicated the relevant chapters
zach session, Several of the directors have been going through the book and e-mailing him questions
would like to discuss. Here are three questions relating to the dividend session that Bill will have to
‘ess:
Director 1: The background material you provided was not clear about whether most investors pre~
‘fer companies to use available cash to pay dividends or to reinvest it in the business. Also, most of
the empirical studies seem to have been done before the 2003 tax law change. Have there been any
post-2003 studies on this issue? I also wonder if there would there be any point in asking our own
stockholders about their desire for dividends. We could insert a questionnaire when we send out the
annual report. Finally, how would our dividend decision be affected if the tax rate on dividends was
restored to the 38 percent level that existed before 2003?
Director 2: Stockholders should want us to retain and reinvest earnings if we can earn more on
those funds than they could earn themselves on other investments. That being the case, if we fore-
cast that we will have enough capital budgeting projects with positive NPVs to absorb all of our
cash flows, is there any reason to pay a dividend? Would it ever make sense to pay a dividend and,
in the same year, issue new stock to help fund our capital budget?
Director 3: Our forecasts show a decline in the asset growth rate,, which will reduce our need for
new capital. That might make it seem reasonable to pay a cash dividend. But in our business it
hard to tell what our profits will be or what our research and development team will come up with,
thus what our future cash needs will be. If we start paying dividends and then the business situation
changes, could we reverse course and eliminate the dividend without a negative impact on our stock
price?
2, Press reports suggest that Microsoft's huge dividend was prompted in part by polities. In 2004, dividends were taxed at a maxi-
(rate of 15%. However, the Democrat nominee for president, John Kerry, has indicated that if elected he will attempt to raise tax rates on.
income individuals, and part of Kerry's program is an increase in the tax on dividends. Microsoft wanted to beat the potential increase,
« the huge 2004 payout.
84Case 9: Dividend Policy
In addition to the email questions, Ray Reed asked Bill to explain the “Residual Dividend Model,”
Jiscussed in some finance textbooks. The key feature of the residual model is a graph that shows the cost
of capital and return on investments as percentages on the vertical axis and dollars of capital raised on the
rorizontal axis, An “Investment Opportunity Schedule (IOS)” that plots potential projects” IRRs is shown
an the graph, along with a “Marginal Cost of Capital (MCC) schedule” that shows how the WACC changes
1s more and more funds are raised. The IOS schedule declines, the MCC schedule rises, and the dollar
amount at which the two lines cross indicates the size of the optimal capital budget. Ray wants Bill to use
he model when he discusses payout policy, so Bill and Sue Chung developed the data in Table 1 to illus-
rate the concept.
Mature companies with relatively stable product lines and customers can generally forecast cash
‘lows and investment requirements fairly accurately for their next 5 to 10 years. But, such forecasts for
young, rapidly growing companies in high tech industries are much less dependable. Consequently, while
Bill has made some long-run forecasts in the past, he has never had much faith in them. Still, he recog-
sizes the need for such a forecast when he addresses dividend policy, so he asked Sue to make a projection
for use in the session. Sue plans to create a model that forecasts sales revenues, net assets, and net income
sased on projected profit margins. The forecasted annual changes in net assets would represent the compa-
ay’s financial requirements, and the forecasted net income would represent the amount of new equity that
would be available if PNC paid no dividends. PNC’s optimal capital structure was discussed in the last ses-
sion, but that issue is still somewhat in doubt. To make her model simple, Sue decided to assume a capital
structure that has 56 percent common equity and 44 percent debt, both measured at book values. (The mar-
set value capital structure implied by these book value weights implies more common equity.) With Bill’s
agreement, she disregarded preferred stock. Thus, 56 percent of the increase in net assets should be raised
as equity, and the difference between this equity requirement and net income would represent the amount of
dividends that the company could pay without causing the capital structure to depart from the assumed
optimum.
After discussions with Bill, Sue decided to assume in the model that PNC will not issue any new
zommon stock, so the number of shares will remain constant at the current level, 2,626,000 shares. It
quickly became obvious that the capital structure could not be maintained at a constant level without issu-
ing new shares if PNC was to meet its sales and asset forecasts. When she discussed this point with Bill,
te told her that, in his opinion, there would be no great harm in departing from the assumed optimal equity
catio, at least if the departure was no more than 5 or 6 percent. If the departure were greater than that, then
the board would probably want to take some action to get back to the optimal level, or at least close to it.
Even though PNC has not seriously considered dividends, security analysts have. One well-known
analyst projected the dividends shown in Table 2. Management is aware of the forecast, but it has neither
confirmed nor disputed this projection, Rather, management has simply told analysts that it has not yet for-
mulated a dividend payment policy because at this time all of its cash,flow is needed to finance asset
growth. This concerns Bill, because he knows that if analysts’ forecasts are widely off the mark, and if
actual results are not as high as those forecasted, the stock will be hammered. Bill would like to get a bet-
ter handle on what PNC is likely to do in the future so as to guide analysts in the right direction.
The key parameters for Sue’s model are given in Table 3. She provided data for three scenarios—a
Base Case Scenario where the most likely growth rates and profit margins are used, a Good Scenario where
sales and assets grow quite rapidly and the profit margin is relatively high, and a Bad Scenario where
growth is slow and profit margins are low. She held the equity ratio, shares outstanding, initial sales and
55¢ 9: Dividend Policy
4s, and dividend projections constant across all the scenarios, but she plans to set the model up so that it
be changed very easily.
Sue was initially concerned that her model would not “maximize” or “optimize” anything. She
ild have been happier if the model prescribed the dividends that would maximize the stock price.
vever, after discussions with Bill and Sam, it became apparent that given the state of theoretical know!-
¢ about dividends, an optimizing model simply could not be developed. About all a dividend model can
s to provide a rough guideline as to what will probably happen to cash flow and accounting ratios under
erent payout policies, and then the board will have to make the final dividend decisions based on that
vrmation, along with its experience and judgment. Sam pointed out that different companies that appear
¢ in similar situations often have very different dividend policies (and capital structures), and it is virtu-
impossible to prove that one policy is better than another in terms of maximizing the stock price.
Bill, Sam, and Sue identified the following set of issues for discussion in the session. Bill then
tts to end with a recommendation as to PNC’s future dividend payment policy.
Explain the Residual Dividend Model and discuss how it could be used to provide insights
into a logical dividend payout policy.
Discuss the following terms and their effects on dividend policy:
+ The clientele effect
+ Signaling effects
+ Agency costs
Discuss the desirability of stable dividends versus flexible dividends that depend on funds
availability and investment opportunities.
Discuss the desirability of establishing a dividend policy and then announcing it, versus sim-
ply looking at the situation at each board meeting and then declaring a dividend.
Discuss the pros and cons of dividends versus stock repurchases.
Discuss the pros and cons of dividend reinvestment plans in general, and for PNC in particu-
Jar.
Discuss the pros and cons of stock dividends versus cash dividends.
Discuss the pros and cons of stock splits, and the relationship between dividend payout
ratios and stock splits. *
Discuss the relationship between dividend policy and capital structure policy, and how a
change in one policy might affect the other.
Bill then asked Sue to develop a set of questions dealing with these issues, plus any other relevant
ves that occur to her, and to recommend some dividend action or actions. As with the other sessions,
will also develop an Excel model to help quantify the analysis. Assume that you are Sue Chung, and
must now prepare for the session.
56Table 1. Data Used for Residual Dividend Model
Case 9: Dividend Policy
Target Equity Ratio (no preferred to be used; debt ratio = 1 - equity ratio):
[Expected net income for coming year (could retain all or pay out some):
Total funds before needing to issue new stock (net income + debt for 56% equity ratio):
{Total dollars raised in each subsequent WACC interval (56% new stock, 44% debt):
56%
$4,000
$7,143
$1,000
(Cost of capital: WACC up to top of each interval: wacc: | Upto:
1. Retained earnings plus debt 105% | $7,143
2, Next $1,000 (new stock + debt) 11.5% | $8,143
3. Next $1,000 (more new stock + more debt) 125% | $9,143
4, Cost thereafter (new stock + debt) 13.5% | $10,143
Capital Budgeting Project: Data Used to Make Graph.
Projects’ Assumed WACO atthe
Cumulative |__IRRs Under Various Conditions | cumulative
Projects | Cost Cost Normal ‘Good Bad Cost
A $3,000 $3,000 12.0% 15.0% | 11.0% | 10.5%
B $2,000 $5,000 11.0% 14.0% | 10.0% | 10.5%
c $3,500 $8,500 10.0% 125% | 9.0% | 11.5%
D $6,000 _| $14,500 9.0%. 11.0% | 8.0% | 13.5%
Table 2. Analyst’s Forecasted
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Dividend
$0.00
$0.00
$0.50
$0.88
$1.23
$1.32
$1.42
$1.52
$1.64
$1.76
Growth rate
57
lends and Dividend Growth Rate29: Dividend Policy
Table 3. Model Input Data
Tput data used
in calculations;
bottom 7 change!
inthe
scenarios
Data for Scenarios
[Equity Ratio
[Shares outstanding (000s) 2,626
ISales revenue, latest year $82,739 $82,739 $82,739
[Total assets (net) at 12/31/04 $29,223 $29,223 $29,223
initial Dividend
Forecasted dividend growth 1.
Forecasted dividend growth ,
Forecasted dividend growth
Forecasted dividend growth jong run
Forecasted sales growth 2 20.0%
Forecasted sales growth s_ 10.0%
Forecasted sales growthiongun 5.0%
Profit Margin 2.0%
Forecasted asset growth 12 20.0%
Forecasted asset growth 3. 10.0%
Forecasted asset growth ongnan 5.0%
These were the inputs Sue used in her model. Other values could be used, including the ones that
did not change in the different scenarios.
58PNC Background Information
Background Information on
POWERLINE NETWORK CORPORATION (PNC)
This Document provides background information for all cases in the PNC Series. It should be read
in conjunction with each of the individual cases.
Powerline Network Corporation (PNC) was founded in southern California in 1993. It now has cus-
comers all across the globe. Its founder developed a computer chip that permitted digital signals to be
tansmitted over electric power lines, thus converting buildings’ interior wiring systems into computer net-
vorks. The founder needed funds to commercialize the chip, so he set up a corporation, raised some funds
tom friends and (eventually) a venture capital firm. The firm then went public in 1997. PNC’s primary
ompetition is wi-fi, which permits computers and other devices to be “untethered.” > Wi-fi is better for
aptop computers and other mobile devices. However, the powerline system has fewer security problems,
sperates over longer distances, allows faster transmissions, and experiences fewer interference problems.
PNC struggled in its early years. Its technology worked, but it had trouble manufacturing reliable
hips. Those problems led to higher costs, and thus higher prices, than wi-fi. However, im 2002 a
‘aiwanese contract chipmaker solved the manufacturing problems and brought PNC's costs down to a com-
vetitive level. At that point, equipment manufacturers began using PNC’s chips to connect desktop comput-
1, printers, TVs, stereo systems, and other devices, and sales and profits began to climb. The chip is not a
sne-size-fits-all product—different devices need somewhat different chips, so PNC’s engineers must work
vith equipment manufacturers to design the optimal chip for different products. This customizing requires
he company to spend continually on product development. Moreover, the rapid pace of technology forces
°NC to maintain ongoing research and development to increase transmission speed and reliability. Because
\f these factors, the recent growth in revenues, profits, and free cash flow is expected to slow to a more
ustainable level in coming years. Naturally, management wants to maintain growth at a high level, but it
ecognizes that its recent growth rate simply cannot be sustained.
Founder and CEO Ray Reed, has assembled a well-qualified team of managers. Moreover, the
voard of directors consists of bright people, all of whom invested in the company in its early days and have
\sefuul backgrounds in technology-related matters. However, none of the directors has a background in
inancial management. This is a potential problem because the board must approve decisions that require
he application of finance principles. Therefore, Ray asked his CFO, Bill Bostic, to set up a financial edu-
ation program for the directors. Bill then recruited his assistant, Sue Chung, and one of his former profes-
ors, Sam De Felice, to help him run the financial education training program. Fourteen sessions, each
1. ‘The PNC series of cases resulted from a program several University of Florida professors developed for a major NYSE-listed cor-
oration. The firm was concerned that its senior people did not understand finance well enough to make proper decisions, so it brought us in
> teach financial management to the directors, executives, and managers. It's also interesting to note that The Wall Street Journal, on June 21,
(004, put out a special section on Corporate Governance, and the lead article was entitled: “BACK TO SCHOOL: If directors are responsible
or finding problems, first they have to know where to look. Many don’t have a clue.” The first sentence in the article was a question posed to
irectors of a NYSE-listed firm: “Do you know what WACC is?” Many of the directors did not, yet the WACC was central to most of the
irm’s decisions. Our point is that the issues discussed in this set of cases are generally recognized as being critically important for well-man-
ged firms, hence equally important for finance students.
2. Wiefi stands for “Wireless fidelity,” and that is the name commonly used for the networking chips used in laptop computers and
ther wireless devices. .
5ckground Information
‘or two hours, are scheduled to precede the monthly board meetings. The program will include an
tion to financial management followed by sessions on risk analysis, stocks and bonds, the cost of
capital budgeting, capital structure, dividend policy, financial forecasting, working capital manage-
asing, mergers, and venture capital. Bill provided the directors with a copy of a finance textbook,
vill ask them to review relevant chapters before each session. In addition, he, Sue, and Sam pre-
case for each session. This document provides background material that is relevant for all the
ables 1 through 4 give some financial data on the company and the 8 companies it uses for compar-
anchmarking) purposes.
Je 1. PNC Ownership Distribution (Percentage of Shares Outstanding)*
Tot
Institutions
“Investment banks
“Pension funds
“Total institutional holdings
Pub! 7 _PNC Background Information
Table 2. Balance Sheets, PNC and Industry ($ in Thousands)
PNC Benchmark Companies
2002 2003 2004 | %of Assets | % of Sales
Cash $346 $478 $625] 2.85% 1.00% |
ST securities $507 $700 $625] 0.01% 0.01%
Accounts receivable $2,017 $2,786 $3,852] 14.24% 5.00%
Inventories $3,622 $5,002 $6,023] __ 25.64% 9.00%
Current assets $6,492 $8,966 $11,125] 42.74%| 15.01%
Net fixed assets $14,512 $15,208 $18,098] __57.26%| __ 20.10%!
Total assets $21,004 $24,174 $29,223] 10.00%] 35.11%!
Accounts payable $353 $399 $527] 2.85% 1.00%
Accruals $478 $541 $714) 1.41% 0.50%
Notes payable so $0 sol 0.94% 0.33%
Current liabil $831 $940 $1,241 5.20% 1.83%
Long: $4,986 $7,255 $9,239] 29.99%| 10.53%
Total $5,817 $8,195 $10,480] 35.19% «12.36%!
Preferred stock (6%) $1,890 $2,130 $2,206} 3.10%| 1.09%
Common stock $8,306 $7,911 $8,510] 12.82% 4.50%
Retained earnings $4,991 $5,939 48.88%| 17.16%
Total com equity $13,297 61.70%| 21.66%
Total liabs and eaty 400.00%| 35.11%
Table 3. Income Statements, PNC and Industry
Benchmark Companies
2002 2003 2004 | % of Assets | % of S:
Sales Revenui $31,506 $47,342 $82,739 100.00%|
Cash op costs $27,300 $42,000 $74,727 : 89.26%
Depreciation 2,902 3,042 3,620] 12.82%| _4.50%|
Total op costs 30,202 45,042 _78,347| _267.09%| 93.76%
Op Income (EBIT) ‘$1,303 $2,300 $4,392] 17.77%] 6.24%
Interest 374 508. 693] -2.28%| 0.80%
Taxable Income go20—~«S4,792——«S3,699| ——15.49%| 5.48%
Taxes 372 717 1,480] 6.20% 2.18%
Pid dividends 113 128 132] 0.23%| 0.08%
Net Income Saag $oas__$2,087| 9.07%] 3.18%
Free Cash Flow (FCF) NA -$1,488 _-$2,187| NA NA
9d in operations, and all current li
FCF = EBIT(1-T) - (Increase in net operating capital). All assets except ST secu!
ies except notes payable are costless.==_—- _,~
Background Information
able 4, Ratios and Other Financial Data
PNG. ‘Benchmarks
2002 2003 2004 2004
[Shares outstanding 2,589.0 2,600.0 2,626.2 NIA|
[Earnings per share $0.17 $0.36 $0.79 NA
idends per share $0.00 $0.00 $0.00} Nal
idend payout ratio 0% 0% 0% 20%
idend growth rate NIA NIA NA] 8.30%
[Stock Price, EOY” $10.50 $12.60 $21.00} NIA
IBook value per share $5.14 $5.33, $6.30] Nal
PIE 61.20 34.57 26.42| 30.1
Price/Book ratio 2.04 2.37 3.34| 42
Economic Value Added (EVA) “$1,346 $1,057 -$333] NiA|
Market Value Added (MVA) $13,888 __$18,911_$38,614 NiA|
[Beta Coefficient 1.42 1.62 1.35 1.35
Market Risk Premium 5.00% 5.00% 5.00% —5.00%|
Risk-Free Rate 5.00% 4.70% 4.80%] 4.80%
[Tax rate (Federal + State) 40% 40% 40%| 40%
IWAGC (Estimated values) 10.38% 10.38% __10.38%|__10.00%|
Free Cash Flow NIA -$1,488__-$2,187 NiA|
NOPAT $782 «$1,380 $2,635 $3.74|
Operating costs/Sales 95.86% 95.14% — 94.69%| 93.76%|
Depreciation/Fixed assets 20.0% 20.0% 20.0%| 22.4%
Days sales outstanding 23.4 215 17.0 18.3
Receivables/sales 6.4% 5.9% 47% 5.0%
InventoryiSales 11.5% 10.6% 7.3%| 9.0%
Fixed assets/Sales 46.1% 32.1% 21.9%| 20.1%
interest rate on all costiy debt 7.5% 7.0% 7.5% 7.0%
Preferred dividend yield 6.0% 6.0% 6.0%
DebtiAssets 27.7% 33.9% 35.2%
Preferred stock/Assets 9.0% 8.8% 3.1%
[Common equity/Assets 63.3% 57.3% 61.7%
EBITDA/Interest 14.2 10.5 13.4
Times interest earned (TIE) 35 45 73
[Current ratio 7.81 9.54 8.20
Return on Invested Capital (ROIC) 3.82% 5.88% NA
ROE 3.34% 6.84% 12.62%) 14.7%
‘DuPont Analysis:
[Total assets turnover (TATO) 750 196 283 285
|Assets/Common equity 1.58 175 1.77 1.62
Profit margin 1.41% 2.00% 2.52% _3.18%|
DuPont ROE 3.34% 6.84% 12.62%] 14.70%
EOY stands for End Of Year. BOY would indicate Beginning Of Year.