Chapter 11: A Framework for Analyzing Dividend Policy

Problem 1.

 Current Projected EBITDA 1200 1350 Less Depreciation 200 250 EBIT 1000 1100 Less Interest Expenses 200 200 EBT 800 900 Less Taxes 320 360 Net Income 480 540 Free Cash Flow Computation EBIT 1000 1100 Less Interest 200 200 Less Taxes 320 360 Less (Cap. Exp.- Depr.) x (1- proportion financed by debt) 210 168 Less (Change in Working Cap.) x(1- prop. financed by debt) 35 35 Free Cash Flow to equity 235 337
1. The current payout ratio = (2x50m.)/480 =0.208333
2. It's currently paying out 100/95 =42.55% of free cash flow to equity
 Project Investment Beta IRR (Using Cash flows to equity) Reqd. return to equity A \$190m. 0.6 12.00% 11.80% accept B \$200m. 0.8 12.00% 12.90% reject C \$200m. 1 14.50% 14.00% accept D \$200m. 1.2 15.00% 15.10% reject E \$100m. 1.5 20.00% 16.75% accept
1. The required rate of return on equity = .085 + 1(.055) = .14 or 14%.

Projects C, D and E are NPV>0 projects according to this yardstick

The total capital expenditure needs for next year are: 200 + 100 + 190 = 490 m.

d. The maximum amount available is 337m.

e. We are told that the investment opportunities for the firm are changing. It is unclear exactly what this means. However, if this implies uncertainty, the firm might not want to pay out 100% of its free cash flow to equity.

 f. Cash balance next year = Cash balance this year 100 Plus Free Cash flow to equity 337 Less Dividends next year 125 = 312

Problem 2.

a.

 Change in FCFE = Reduction in prod. Costs 20000 plus reduction in inventory 15000 Plus addnl depreciation 2400 less capital expenditures 12000 less addnl taxes 13040 (tax rate)x(cost reductions-depreciation) = 12360

b. The amount of depreciation will decrease over time because we are using (accelerated) MACRS depreciation. The inventory reduction will contribute to cash flow only in the first year since there will not be any incremental reductions in inventory after this year.

Problem 3.

a. No, because there would be double taxation, i.e. both at the corporate level and at the personal level.

b. In that case, it might be preferable to increase dividends now. The alternative would be to either take a large capital gain when the business would be sold, or a large dividend just before the business is sold. Hence, unless there are other capital losses that can be offset only by capital gains, it would be preferable to take larger dividends now.

Problem 4.

 Project Investment Requirement After-tax return on capital A 15 27% B 10 20% C 25 16% D 20 14% E 30 12%

The afer-tax cost of debt = 12%(1-0.5) = 6%

The cost of equity = .08 + 1.25(0.055) = 14.875%

The market value of debt = \$500m.

The market value of equity = 15(100) = \$1500 m.

Hence, the WACC = (500/2000)(6%) + (1500/2000)(14.875%) = 12.656%

Assuming that the projects are as risky as the firm, all of them except E have NPV > 0. Hence, capital needed for investment = \$70m. However, 25% of this will come from debt issues. Hence free cash flow to equity = 100 - (0.75)(70) = \$47.5m.

a., b. Since the company has an extra \$47.5m., it should return that amount to shareholders. However, the firm should also look at estimates of future investment needs and future cash flows.

Problem 5.

 Project Initial Investment Beta IRR (to equity investors) Reqd. rate of return A \$500 2 21% 20% accept B \$600 1.5 20% 17% accept C \$500 1 12% 15% reject
 Free Cash flow to equity = Net Income 1000 Less (1-0.2)(Cap. Exp. - Depreciation) 480 Less (1-0.2)(Change in WC) 80 = 440

Note: Change in Working capital is computed as 5000(0.08).

Hence it can return a maximum of \$440 to shareholders

Problem 6.

The weighted average cost of capital =

 Initial Investment EBIT Annual Depr. Lifetime Salvage Cash flow per yr. NPV 10 1 0.5 5 2.5 1.1 -4.97358 40 5 1 10 10 4 -16.7809 50 5 1 10 10 4 -26.7809

a. Since all projects have NPV < 0, none of them should be accepted.

b. The firm has free cash flow to equity equal to Net Income + (1-d )(Capital expenditures - Depreciation) = 90 + 8 = \$98m. This is the maximum that it can pay out in dividends. This assumes that some of the depreciation is used to pay back debt. Alternatively, I would add back the entire depreciation to the net income to get \$ 100 million as FCFE.

Problem 7.

 Current Next year in 2 yrs in 3 yrs EBIT 80 72 64.8 58.32 Depreciation 70 63 56.7 51.03 Working Capital 70 63 56.7 51.03 Change in WC -7 -6.3 -5.67 Net Income 48 43.2 38.88 34.992 Dividends 24 21.6 19.44 17.496 Increase in Cash 91.6 82.44 74.196

If these funds are invested at 10%, the size of the war chest will be 91.6(1.1)2 + 82.44(1.1) + 74.20 = \$275.72m.

Problem 8. The strategy described may or may not be optimal. A disadvantage is that a large amount of cash is being accumulated. If there are no desirable projects in the telecommunications industry, these resources may be misused by management. On the other hand, there may be strategic advantages in acquiring a large target in three years. For that purpose, it may be necessary to have high flexibility in the form of cash.

Problem 9.

 Current 1 2 3 Net Income \$ 100.00 \$ 110.00 \$ 121.00 \$ 133.10 + Deprec'n \$ 50.00 \$ 54.00 \$ 58.32 \$ 62.99 - Cap Ex \$ 60.00 \$ 60.00 \$ 60.00 \$ 60.00 - Chg in WC \$ 10.00 \$ 10.00 \$ 10.00 \$ 10.00 = FCFE \$ 80.00 \$ 94.00 \$ 109.32 \$ 126.09 Dividends Paid \$ 66.00 \$ 72.60 \$ 79.86 Cash Balance \$ 50.00 \$ 78.00 \$ 114.72 \$ 160.95

Total cash at the end of three years = \$ 160.95 million

Problem 10.

 Project Equity Investment CF to Equity Return to Equity Beta Cost of Equity A 100000 12500 12.50% 1 11.75% B 100000 14000 14.00% 1.5 14.50% C 50000 8000 16.00% 1.8 16.15% D 50000 12000 24.00% 2 17.25%

I am assuming that the cash flow to equity divided by the equity investment to get the return on equity. Take projects A and D. The capital expenditures will be \$ 150,000.

Net Income next year = (Gross Profit - Interest - Depreciation) (1-tax rate) = (\$1,000,000(1.1)(1-0.4)-100,000-100,000)(1-0.4) = \$276,000.

a. FCFE = = Net Income - (Net Cap. Expenditures)(1-d ) - D WC(1-d ) = \$276,000 - (150,000-100,000)(1-0.4) - (1,000,000-500,0000)(0.10)(1-0.4) = \$216,000. This is the amount that the company can afford to pay out in dividends.

b. If the company actually pays out \$1 per share, or \$100,000 next year, it will have \$150,000 + 216,000 - 100,000 = \$266,000 at the end of next year.

Problem 11.

a. The firm has net positive financing needs, since its net income is less than projected net capital expenditures. Hence it cannot afford to pay any dividends; as it is, it must raise additional equity capital.

b.

 Current 1 2 3 4 Net Income \$ 10.00 \$ 14.00 \$ 19.60 \$ 27.44 \$ 38.42 - (Cap Ex-Depr) \$ 20.00 \$ 22.00 \$ 24.20 \$ 26.62 \$ 29.28

It will be 4 years before dividends can be paid.

Problem 12.

 Year Net Income Cap. Exp. Depr. Noncash Working Capital Change in Noncash WC Dividends FCFE 1991 240 314 307 35 25 70 220.8 1992 282 466 295 -110 -145 80 266.4 1993 320 566 284 215 325 95 -44.2 1994 375 490 278 175 -40 110 271.8 1995 441 494 293 250 75 124 275.4

a. Conrail could have paid dividends each year equal to its FCFE.

b. The average accounting return on equity that Conrail is earning = 13.5%, compared to a required rate of return = 0.07 + 1.25(0.125-0.07) = 13.875. Hence Conrail’s projects have done badly on average. It’s average dividends have been much lower than the average FCFE. Hence, it would seem that Conrail has been paying too low dividends.

Problem 13.

 1996 1997 1998 1999 2000 Net Income 485.1 533.61 586.97 645.67 710.23 Cap. Exp. 339.12 366.25 395.55 427.19 461.37 Depreciation 331.56 358.08 386.73 417.67 451.08 Noncash Working Capital 262.5 275.63 289.41 303.88 319.07 Change in Noncash WC 12.5 13.13 13.78 14.47 15.19 Proportion of Net Cap. Exp. Financed by debt 0.3 0.3 0.3 0.3 0.3 FCFE 471.06 518.71 571.15 628.87 692.4

a. Conrail can use its FCFE each year to pay dividends or buy back stock.

b. The greater the uncertainty the lower should the payout be as a proportion of FCFE.

Problem 14.

 1995 1996 1997 1998 1999 2000 Net Income 66.00 77.22 90.35 105.71 123.68 144.7 Cap. Exp. 150.00 165 181.5 199.65 219.62 241.58 Depreciation 50.00 57.5 66.13 76.04 87.45 100.57 Noncash Working Capital 43.00 47.3 52.03 57.23 62.96 69.25 Change in Noncash WC 4.3 4.73 5.2 5.72 6.3 Proportion of Net Cap. Exp. Financed by debt 0.00 0 0 0 0 0 FCFE (without any debt) -34.58 -29.76 -23.1 -14.21 -2.6 FCFE (with 25% borrowing) -6.63 0.27 9.1 20.26 34.22

a., b. The payout will be constrained by the FCFE, which is given in the last two rows.

Problem 15. The required rate of return on equity was .07+1.2(.055) = 13.6%, while Cracker Barrel earned 25% on equity. Hence management is using its resources well, and the money is better retained and invested in the business than returned to investors.

Problem 16.

 1995 1996 Net Income 128 140.8 Cap. Exp. 50 55 Depr. 24 26.4 WC 500 550 Change in WC 50 FCFE 70.06

a. Manpower will have \$160.06m. next year to pay out as dividends

b. At the end of next year, Manpower should have 143+70.06-12 = \$201.06.

Problem 17.

If Manpower does not plan to use debt, but instead plans to payoff its debt, its FCFE would be 62.2 - 100 = -37.8, as shown below. In this case, its cash balance would drop by 37.8 + 12 = \$49.8m. from this year to the next.

 1995 1996 Net Income 128 140.8 Cap. Exp. 50 55 Depr. 24 26.4 WC 500 550 Change in WC 50 FCFE 62.2

Problem 18.

 Company FCFE Dividends Paid ROE Beta Reqd. ROR Is ROE > Cost of Equity? Dividends/FCFE Alexander & Brown 55 35 8% 0.8 11.40% no 63.64% American President 60 12 14.50% 1.3 14.15% yes 20.00% OMI Corporation -15 5 4.00% 1.25 13.88% no -33.33% Overseas Shipholding 20 12 1.50% 0.9 11.95% no 60.00% Sea Containers -5 8 14% 1.05 12.78% yes -160.00%

a. Alexander and Brown and Overseas Shipholding both have a bad record on returns on equity, while paying low dividends relative to FCFE. They should increase dividends.

b. Sea Containers should pay less in dividends, since it already has negative FCFE, while earning a high rate of return relative to its cost of equity.

c. If returns in this industry were expected to be higher in the future, I would moderate my recommendations for higher dividends.

Problem 19.

 Company Payout ratio Div. Yld Exp. Growth Black and Decker 24 1.3 23 Average for competitors 32 2.58 19.1

a., b., Black and Decker has a low payout ratio and low dividend yield, relative to competitors. However, this is consistent with the higher growth rate that Black and Decker has. Ceteris paribus, higher growth rates go hand in hand with lower payout ratios. By using the relationship Growth rate = ROEx(Retention ratio), we see that Black and Decker’s ROE is 30.26%, while that for its competitors is 30.16. This means that there is no significant difference in Black and Decker’s performance. Consequently, it would seem that Black and Decker should increase its payout ratio.

Problem 20.

1. Based on the regression, the predicted dividend yield for Black and Decker is 0.0478 - 0.0157(1.3) - 0.0000008(5,500) + 0.006797(0.35) + 0.0002(0.145) -0.09(0.04) = 2.21%
2. In this case, we are using a larger set of firms for comparison. Furthermore, we are using other bases for comparing Black and Decker with other firms. Even though we don’t need as many independent variables in the first part of the problem because we are making intra-industry comparisons, nevertheless, the adjustment is not exactly the same in both cases. Note that the qualitative answer is the same in both cases.

Problem 21. Using the relationship Growth rate = ROEx(Retention ratio), we can estimate Handy and Harman’s ROE to be .23/(1-0.23) = 29.87%. The comparable number for the industry is 18.18%. If Handy and Harman’s cost of equity is similar to that of other firms in the industry, its lower payout ratio is justified.

Problem 22. The high payout policy could end up draining the firm of its assets, thus reducing the value of existing bonds. This could increase equity values even though the value of the firm as a whole might drop due to the poor projects.