Warner body works

Warner Body WorksA case study on dividend policy

Presented byAyush Nepal

Barsha ShresthaChhokpa SherpaDeepak PandeyMeera Khanal’Neelam Malla

Prakash PandeyPramila Nepal

Advantage and disadvantage of each of the four dividend policy?

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

Individuals, organization, social organization that need stable income would prefer this policy as it provides a regular dividend payment.

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

A regular dividend policy decrease agency costs As the payment of dividends indirectly results in a closer monitoring

of management's

Issue1

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

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

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

Disadvantage

2. Lowering the present payout to below 60% and maintaining the payout ratio relatively constant at this new figure ?Advantage• Individuals in upper income tax brackets might prefer lower

dividend payouts• Low payouts can decrease the amount of capital that needs

to be raised• 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

It could signal that the firm is having financial difficulties

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

Disadvantage

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

Advantage 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 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 incomeAdvantage This policy could be considered right if the firm’s

earnings are quite volatile This policy ensures that the investors get a certain

minimum amount as dividend The investors have less expectation with this sort of

policy 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.

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.

Issue 2Evaluate the advantages and disadvantages of having an announced dividend policy. Should Warner Body Works follow announced dividend policy?Advantage Attracts investors: Reduces uncertainty Reduction of cost of capital on future projects

Disadvantage: Difficult to alter the dividend policy once announced. Opportunity cost of reinvestment. Not suitable for unionized company Reduce credibility of the company

Issue3What effect does the dividend policy have on the growth rate of earnings per share?

Table1: Calculation of ROE  1997 2005Net Income(EAT) 31.2 104.3Share holder's Equity 97.3 487

Return on Equity(ROE) 32.07% 21.41%

Here, g = ROE x (1 - DPR) Where, g = growth rate

ROE = Return on EquityDPR = Dividend Payout Ratio

 For 1997, g = 32.07(1-0.6)

= 12.826% For 2005, g = 21.41%(1-0.6) = 8.56%

Issue 4Could the figures in Table 3 be considered proof that firms with low payout ratios have high price/earnings ratios? Justify your answer.

Selected Stock Market Data

Particulars Payout P/EPlayboy 17% 25Uniroyal 0% 19Hewlett Packard 11% 17Datapoint 0% 16Texas instrument 30% 13Xerox 40% 10ATT 67% 8Allied Stores 45% 6

Question 5How does the firm’s debt position affect 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. 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

Question 6Evaluate 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. 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.

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

Issue 7: Benefits of Stock Dividend for Company

It is beneficial for Warner Body Works to declare stock dividend on the basis of

financial position of the firm. The justifications to declare the stock dividend are as

follows:

Since, the current ratio of the firm has decreased in 2005 compared to 1997, the distribution of cash dividend will further decrease the current ratio. Hence, the issue of stock dividend will allow the company to maintain liquidity position by conserving the cash of the firm (current assets).

1997 20050.00

2.00

4.00

6.005.5

1.71

Current Ratio

CR

Rat

io

1997 20050.00%

20.00%

40.00%

60.00%

17%

60%

Debt Ratio

DR

In 2005, debt of company has increased up to 60%. In addition, the distribution of stock dividend will allow the firm to invest in future profitable projects. Such investment will help the firm to increase its basic earning power resulting in the increase in earnings per share.

Question 8What specific dividend policy should Murray recommend to the board of directors at its next meeting? Fully justify your answer..

1.Continuation of 60% dividend payout ratio

2.lowering the present payout ratio

3.Establishing a fixed dollar rate assuming the earnings will be increased and hence the dollar dividend will also be increased

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?

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

Conclusion

Residual dividend policy -expansion opportunities that promise high return

Otherwise, liberal dividend policy 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.

Caution while designing the company’s capital structure(Debt ratio) Managers should focus on capital budgeting decisions and ignore

investor preferences.

Lesson Learnt

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.

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.

Stock dividends are better option than cash dividends. The tax advantage of capital gains favors retention of earnings.

Thank you