Case 9POWERLINE NETWORK CORPORATION (PNC)

(Dividend Policy)Directed Version

This is one of a series of cases dealing with various financial issues faced by Powerline NetworkCorporation. Background material on the company is provided in the document entitled Background

Material on Powerline Network Corporation (PNC).

Bill Bostic, Sue Chung, and Sam De Felice, were assigned the task of explaining the key elementsof financial management to PNCs board of directors, and they are now preparing for Session 9, whichdeals with dividend policy. Thus far, PNC has needed to retain all of its earnings, but its future sales andasset growth requirements are likely to decline, and as growth slows the company expects to generate freecash flow that can be paid out to stockholders.

The dividend issue has never been seriously considered for several reasons. First, the firms rapidgrowth has absorbed all of its cash flows to fund capital investment opportunities. Second, PNCs directorsdid not personally need dividend income; hence if dividends had been paid, they would have simply paidabout 40 percent of them out to cover state and federal taxes and then reinvested the remainder, ending upworse off than before. However, in 2003 a new tax law took effect, lowering the maximum federal tax rateon dividends from 39.6 percent to 15 percent and the maximum rate on capital gains from 20 percent to 15percent. Under the old tax structure, stockholders potential after-tax returns were maximized by havingthe company retain and reinvest earnings to generate capital gains. Under the new law, with both dividendsand capital gains taxed at 15 percent, the tax disadvantage of dividends has been largely eliminated.1

Also, several PNC directors (and officers) are thinking about retirement, and when they do retire,they will need cash income. This is making them more interested in dividends. Finally, PNC President RayReed and several other large stockholders (including Bill Bostic and some of the other officers) would liketo diversify their holdings, which would mean selling some PNC shares and reinvesting the proceeds inother securities. Obviously, they would like to sell their shares at as high a price as possible, and Billthinks that paying a dividend might increase the price of the shares. This view was reinforced at the com-panys last annual meeting, when several stockholders asked about dividends and commented that a divi-dend would be well received.

Bill is also aware that since the new tax law took effect, many companies have increased their divi-dends, and stock market pundits have been arguing that companies such as PNC could increase their stockprices by initiating cash dividends. Indeed, in mid-2004 Microsoft announced the largest dividend action inhistory, 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, stockheld at the time of the owners death escapes the estate tax.

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quarterly dividend, and a very large stock repurchase program.2 Many other companies have taken similaractions, and they have typically seen a popwhich may not be permanentin their stock prices. However,given its rapid growth and need for funds, few-if any-analysts expect PNC to pay dividends for a couple ofyears. Indeed, one influential analyst recently published a report in which he forecasted no dividends forthe next two years, then an initial dividend of $0.50, then rapid grow in the dividend for the next two years(75% in the first year and 40% in the second), and finally a constant growth rate of about 7.6% thereafter.Bill thinks this forecast is consistent with most analysts views, but PNCs management has not indicatedthat it agrees.

Before the recent tax change, Ray Reed and PNCs directors stated publicly that they had no plansto pay dividends any time soon. However, the dramatic change in the tax situation and the inevitability thatslower growth will make free cash flow available has moved dividend policy to the front burner. Of course,excess funds not needed in operations could be used to buy marketable securities or for acquisitions, butmost investors, including PNCs outside directors, strongly dislike companies that hoard cash in marketablesecurities or acquire other companies just because cash is available. Of course, strategic reasons arise forholding cash or for acquiring other companies, but if no compelling business reasons for these actionsarise, empirical evidence suggests that investors would be better off if companies distributed excess cashand let stockholders make their own reinvestment decisions.

Bill provided the directors with a widely used finance textbook and indicated the relevant chaptersfor each session. Several of the directors have been going through the book and e-mailing him questionsthey would like to discuss. Here are three questions relating to the dividend session that Bill will have toaddress:

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 ofthe empirical studies seem to have been done before the 2003 tax law change. Have there been anypost-2003 studies on this issue? I also wonder if there would there be any point in asking our ownstockholders about their desire for dividends. We could insert a questionnaire when we send out theannual report. Finally, how would our dividend decision be affected if the tax rate on dividends wasrestored 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 onthose 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 ourcash 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 fornew capital. That might make it seem reasonable to pay a cash dividend. But in our business itshard to tell what our profits will be or what our research and development team will come up with,

2. Press reports suggest that Microsofts huge dividend was prompted in part by politics. In 2004, dividends are taxed at a maxi-mum rate of 15%. However, the Democrat nominee for president, John Kerry, has indicated that if elected he will attempt to raise tax rates onupper-income individuals, and part of Kerrys program is an increase in the tax on dividends. Microsoft wanted to beat the potential increase,hence the huge 2004 payout.

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thus what our future cash needs will be. If we start paying dividends and then the business situationchanges, could we reverse course and eliminate the dividend without a negative impact on our stockprice?

Bill will have to address these questions in the session.

In addition to the email questions, Ray Reed asked Bill to explain the Residual Dividend Model,discussed in some finance textbooks. The key feature of the residual model is a graph that shows the costof capital and return on investments as percentages on the vertical axis and dollars of capital raised on thehorizontal axis. An Investment Opportunity Schedule (IOS) that plots potential projects IRRs is shownon the graph, along with a Marginal Cost of Capital (MCC) schedule that shows how the WACC changesas more and more funds are raised. The IOS schedule declines, the MCC schedule rises, and the dollaramount at which the two lines cross indicates the size of the optimal capital budget. Ray wants Bill to usethe model when he discusses payout policy, so Bill and Sue Chung developed the data in Table 1 to illus-trate the concept.

Mature companies with relatively stable product lines and customers can generally forecast cashflows and investment requirements fairly accurately for their next 5 to 10 years. But, such forecasts foryoung, rapidly growing companies in high tech industries are much less dependable. Consequently, whileBill has made some long-run forecasts in the past, he has never had much faith in them. Still, he recog-nizes the need for such a forecast when he addresses dividend policy, so he asked Sue to make a projectionfor use in the session. Sue plans to create a model that forecasts sales revenues, net assets, and net incomebased on projected profit margins. The forecasted annual changes in net assets would represent the compa-nys financial requirements, and the forecasted net income would represent the amount of new equity thatwould be available if PNC paid no dividends. PNCs 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 capitalstructure that has 56 percent common equity and 44 percent debt, both measured at book values. (The mar-ket value capital structure implied by these book value weights implies more common equity.) With Billsagreement, she disregarded preferred stock. Thus, 56 percent of the increase in net assets should be raisedas equity, and the difference between this equity requirement and net income would represent the amount ofdividends that the company could pay without causing the capital structure to depart from the assumedoptimum.

After discussions with Bill, Sue decided to assume in the model that PNC will not issue any newcommon stock, so the number of shares will remain constant at the current level, 2,626,000 shares. Itquickly 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,he told her that, in his opinion, there would be no great harm in departing from the assumed optimal equityratio, at least if the departure was no more than 5 or 6 percent. If the departure were greater than that, thenthe 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-knownanalyst projected the dividends shown in Table 2. Management is aware of the forecast, but it has neitherconfirmed 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 assetgrowth. This concerns Bill, because he knows that if analysts forecasts are widely off the mark, and ifactual 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.

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The key parameters for Sues model are given in Table 3. She provided data for three scenariosaBase Case Scenario where the most likely growth rates and profit margins are used, a Good Scenario wheresales and assets grow quite rapidly and the profit margin is relatively high, and a Bad Scenario wheregrowth is slow and profit margins are low. She held the equity ratio, shares outstanding, initial sales andassets, and dividend projections constant across all the scenarios, but she plans to set the model up so that itcan be changed very easily.

Sue was initially concerned that her model would not maximize or optimize anything. Shewould have been happier if the model prescribed the dividends that would maximize the stock price.However, after discussions with Bill and Sam, it became apparent that given the state of theoretical knowl-edge about dividends, an optimizing model simply could not be developed. About all a dividend model cando is to provide a rough guideline as to what will probably happen to cash flow and accounting ratios underdifferent payout policies, and then the board will have to make the final dividend decisions based on thatinformation, along with its experience and judgment. Sam pointed out that different companies that appearto be in similar situations often have very different dividend policies (and capital structures), and it is virtu-ally impossible to prove that one policy is better than another in terms of maximizing the stock price.

Bill then asked Sue to develop a set of questions that deal with the issues they plan to cover in thesession. As with the other sessions, they will use an Excel model both to quantify the analysis and to helpthe directors learn more about how Excel is used in financial analysis. Obviously, some issues cannot atthis point be quantified, but Bill wants to discuss qualitative as well as quantitative issues. Assume that youare Sue Chung, and you must now prepare for the session.

QUESTIONS

1. Explain the Residual Dividend Model and discuss how it could be used to provide insightsinto a logical dividend payout policy. Use the data in Table 1 to construct a graph to illus-trate the model, indicating the approximate total dollars of dividends and the payout ratiounder each of the two investment opportunity conditions. Explain the implications of themodel for dividend policy.

2. Does PNCs current clientele of investors appear to be satisfied with the companys divi-dend policy? Suppose PNC conducted a survey of its current stockholders and the vastmajority indicated that they wanted more cash income and thus would prefer for the compa-ny to pay out most of its earnings rather than retain them. Might it still be in the best inter-ests of all the stockholders, including those who want dividend income, for the firm to retainand reinvest all of its cash in spite of the survey results? Are clientele effects reflected in theresidual model?

3. What signals do managers send investors through their dividend actions? Should PNC beconcerned about signaling effects if it established a payout policy and later thought aboutaltering that policy? Are signaling effects reflected in the residual model?

4. Agency costs refer to costs stockholders must bear to insure that managers operate in thebest interests of stockholders rather than in the managers own personal interests. Areagency costs likely to be more important for a company whose managers own a large per-centage of its shares or a company whose managers do not own much of its stock? Howmight dividend policy affect agency costs?

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5. When firms in general, and PNC in particular, establish a dividend policy,a. How should the target dividend stream be set?b. Should the company strive to make its dividends stable, and what does dividend stability mean?c. Should the firms dividend policy be formally announced or should the board just declare what it thinks is the optimal dividend at each individual board meetings?

6. Should PNC distribute cash to its stockholders in the form of cash dividends or by repur-chasing stock? Would it matter if the cash to be distributed resulted from regular operationsversus the sale of a division or some other one-time event?

7. What is a dividend reinvestment plan, how do these plans operate, and what are their prosand cons? Should PNC initiate a dividend reinvestment plan when it starts paying cash divi-dends?

8. One of PNCs directors suggested that the company should pay stock rather than cash divi-dends. The same director also recommended that the company split its stock. What are thepros and cons of (a) stock dividends and (b) stock splits?

9. Suppose two companies in the same industry had radically different cash dividend policies,with one paying out close to 100% while the other paid out 0%. Would these cash dividendpolicies have any bearing on the likelihood of the companies splitting their stock? Explain.

10. Should dividend policy (or, more broadly, cash distribution policy) be established independ-ently of or in conjunction with capital struc-ture policy? If PNC decided to change its capi-tal structure, might that affect its dividend policy?

11. Comment on the three questions the directors asked Bill Bostic to consider. You may referto points you have made earlier in your answers.

12. Would you recommend that PNC plan to pay out dividends at the level that the security ana-lyst expects it to pay? If not, what would you recommend? Should whatever is decided atthis time be communicated to the investing public now, or should PNC hold off with anyannouncement until closer to the time dividends will actually be paid? What are your rec-ommendations regarding PNCs dividend policy?

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These were the inputs Sue used in her model. Other values could be used, including the onesthat Sue did not change in the different scenarios.

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Powerline Network Corporation (PNC): Dividend Policy - Case 9, Directed

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