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. 84Case 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. 56Table 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 Rate29: 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. 58PNC 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. . 5ckground 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.