Question

East Coast Warehouse Club   

Frank​ O'Connor, CFO of East Coast Warehouse​ Club, was reviewing notes from the annual​ shareholders' meeting the week before. Most of the meeting was​ routine: greetings from the CEO and chairman of the​ board, review of last​ year's results, plans for the coming​ year, election of directors​ (no surprises), ratification of the​ auditors, and so on. The only unexpected incident occurred during a​ question-and-answer period with the CFO when a major institutional shareholder asked if and when the company expected to start paying dividends. The question was met with loud applause and a few cheers of​ "Hear, hear!" Frank​ answered, not quite​ truthfully, that the matter was being discussed internally and was on the agenda for the next board of​ directors' meeting. In any​ case, it was on the agenda now.

                                              

When the directors met the following​ month, they looked over a report they had asked the CFO to compile on the pros and cons of instituting dividends. The report first provided a review of the​ company's financial situation. A recent economic downturn and high energy prices had been devastating for other​retailers, but had actually been good for East Coast because​ hard-pressed consumers looked for the lowest prices on everything from groceries to computers to automobile tires and batteries. East Coast had recently added gas pumps to many locations and could sell gasoline for a few cents less per gallon than other retailers. The gas business was​ thriving, and company research showed that gas sales brought customers to the stores for other purchases. On the other​ hand, East​ Coast's growth policy had become cautious. Its extensive real estate holdings were losing value in a declining​ market, and the company was unwilling to build stores so close together that it would be competing with itself or so far from its regional base that distribution would become inefficient. Ten percent of total assets were now in cash and​ short-term investments. ​ Long-term debt had fallen from 38% of assets a few years ago to less than 22%.

Cash flow from operations was more than double the investment in new assets.

There was no question that East Coast could pay a​ dividend, but should​ it? Frank wondered what some of his bright young staffers long dash—several of whom had used East​ Coast's generous education benefits to obtain MBA —would have to say about this​ question, so he put it on the agenda for the regular Wednesday afternoon staff meeting.

Questions

1.  The following is a partial list of comments made by staffers at the meeting. To help Frank make a​ decision, identify the dividend policy or theory each reflects and comment on its usefulness.

a. ​ "What difference does it make if we pay dividends or​ not? Shareholders can always sell a few shares and make their own​ dividends." ​ Response: ​ "That works for the big​ shareholders, but what about the little​ guys?"

b. ​ "From a tax​ perspective, our shareholders would be better off paying the capital gains tax than paying the tax on​ dividends."

c. ​ "Stock prices go up and down due to market factors we​ can't control. A dividend is something you can count​ on."

d.  ​"Some of our shareholders want dividends. You heard that at the​ shareholders' meeting." ​ Response: ​ "That's right, ​ but, of​ course, maybe some of them​ don't. They might prefer that we try to grow the business​ faster."

e. ​ "Our business has been doing​ well, but​ we're in tough times. A lot of retailers are​ hurting, and the market is down. By paying a​ dividend, we send a message to our shareholders that we expect to stay strong for the foreseeable​ future."

f.  ​"Before we think of paying​ dividends, we should be sure we have enough cash to cover our operating expenses and capital​ budget." ​ Response: ​ "That's right, and once we start paying​ dividends, we will never be able to cut​ them."

2.  When Frank thought he had gathered enough ideas about dividend theory and​ policy, he asked the following​ question: ​ "Let's say we decide that our shareholders want some kind of distribution. ​ What's the best way to do​ it?" Evaluate the merits of the following suggestions.

a. ​ "How about a 20% or 30% stock​ dividend? They will feel as if​ they're getting​ something, and it​ won't use any​ cash."

Answer 1

I am answering the first 4 subparts of the 1st question

1)

a) It is based on Dividend irrelevance policy. It states that dividend policy is irrelevant and has no effect on firm's stock price or cost of capital. It is based on the concept of homemade dividends. For e.g A stockholder dosent like the firms dividend policy. If the firms dividend is to big, he can just take the excess cash received and use it to buy more stocks of the firm.If the firms dividend is to small, he can sell a little bit of his stocks of the firm to get the cash flow he needs. In both the cases the combination of the value of his investment in the firm and cash in hand will be the same. But it can be a problem for small investrs if price of the stock is too high and they own very less shares or a single share. in that case they cannot create their own desired dividend by selling the shares nor can they buy new shares in the company if they are not happy with the firms dividend policy as they may not have the required capital to do so.

b) It is based on Tax aversion policy. Historically dividends have been taxed at higher rates than capital gains in many countries. In the late 1990s in the U.S dividends were taxed as ordinary income with rates as high as 39.1% while long term capital gain tax were taxed at 20%. Under such circumstances, as per the tax aversion theory investors will prefer not to receive any dividends. It is also important to note that since 2003, tax laws in U.S changed so that dividend and long term capital gains are both taxed at same rate of 15%

c)It is based on Dividend preference theory ( Bird in hand). Acording to Myron Gordon and John Lintner the required rate of return on equity capital decreases as dividend payout increases. This is beacause the investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current dividend payments. They base their arguement on the fact that when measuring total returns the dividend yield component ( D1/P0 ) has less risk than the growth component ( g)

d) It is based on theory of Clientele effect . It refers to varying dividend preferences of different groups of investors, such as individuals, institutions and corporations. It states that different groups desire different level of dividends. Suppose the institutional investors are well aware of the business of the company and of the view that comapny has many investment opportunities with positive NPV's and has to react quickly to capitalze on those opportunities. In this case the institutional investors would want the dividend payout to be low. On the other hand the individual investors who aren't aware of the business of the company in detail may prefer a higher dividend policy.