Question

CAPITAL STRUCTURE AND DIVIDEND PAYOUTS The board of directors of Baldwin Inc. met today to discuss the capital structure and dividend policy of the company. The board discussed the optimal capital structure of 60 percent debt and 40 percent equity and the likely effect of the capital structure on the company’s weighted average cost of capital (WACC) and the firm value. During the meeting it came up that debt provides tax benefits to the firm because interest is tax deductible whereas dividend is not. Therefore, the debt ratio of 60 percent was considered acceptable. However, Gregg, the CFO of the company, stressed that debt can put pressure on the firm because interests and principal payments are fixed obligations that the company must pay, no matter the profit of the company. He stated that if these obligations are not met, the company may risk some sort of financial distress and files for bankruptcy. Gregg continued to explain that if the company files for bankruptcy there are direct and indirect costs that Baldwin must incur. Mr. Milosvoski, a board member suggested that there are ways to reduce the cost of debt by hiring an expert to handle the company’s debt agreements between the shareholders and bondholders. He stated that protective covenants are incorporated as part of the loan agreement and must be taken seriously because a broken covenant can lead to default. He mentioned negative covenant and a positive covenant as types of protective covenants the company should take seriously. John Miller, another board member stated that one reason bankruptcy costs are so high is that different creditors and their lawyers contend with each other. He suggested that if debt can be consolidated, or if bondholders can be allowed to purchase stock of the company bankruptcy cost will be reduced. In this way, stockholders and debtholders are not pitted against each other because they are not separate entities. He cited examples in Japan where large banks generally take significant stock positions in the firms to which they lend money. The employee representative on the board, Ms. Johnson used the free cash flow hypothesis to state that firms with high free cash flow are very likely to undertake more wasteful activity which has a serious implication for capital structure. Since dividends leave the firm, they reduce free cash flow. Thus, according to her, an increase in dividends should benefit the stockholders by reducing the ability of corporate managers to pursue wasteful activities. She continued that since interest and principal also leave the firm, debt can reduce free cash flow and wasteful spending. But because corporate managers are not legally obligated to pay dividends, she suggested that debt of the company be increased. Philip Suzuki, director of Public Relations and a board member was of the view that determining optimal debt-equity ratio is not an easy task and varies across industries so Baldwin should follow the rules of the pecking-order theory when financing capital projects. No agreement was reached on the company’s capital structure, but the CEO and Gregg believed that the 60-40 debt-equity capital structure will minimize the cost of capital and improve the firm value. The board is retaining you as the financial consultant to assist with the company’s capital structure and dividend payout decisions. The Chairman of the board wants you to address the following questions:

1. Baldwin Inc. wants you to help them prepare a dividend policy which will guide the first dividend payout of the company in 2025. List five characteristics of a sensible dividend policy you want the board to know.

Answer 1

Currently the Baldwin Inc. is maintaining Debt equity ratio of 6:4. The BOD of the company are unable to decide optimal capital structure which could minimize the cost of capital and improve the firm value. We as financial consultant are required to suggest ideal dividend policy which can suite company's circumstances thereby balancing cost of debt and equity. Thus let us first understand about Dividend Policy.

A company’s DIVIDEND POLICY dictates the amount of dividends paid out by the company to its shareholders and the frequency with which the dividends are paid out. When a company makes a profit, they need to make a decision on what to do with it. They can either retain the profits in the company (retained earnings on the balance sheet), or they can distribute the money to shareholders in the form of dividends.The dividend policy used by a company can affect the value of the enterprise. Therefore the policy chosen must align with the company’s goals and maximize its value for its shareholders. While the shareholders are the owners of the company, it is the board of directors who make the call on whether profits will be distributed or retained.

The directors need to take a lot of factors into consideration when making this decision, such as the growth prospects of the company and future projects. Thus to select which Dividend Policy should be adopted we should first understand there various forms:

1) IRREGULAR DIVIDEND POLICY  

Under the irregular dividend policy, the company is under no obligation to pay its shareholders and the board of directors can decide what to do with the profits. If they a make an abnormal profit in a certain year, they can decide to distribute it to the shareholders or not pay out any dividends at all and instead keep the profits for business expansion and future projects.

The irregular dividend policy is used by companies that do not enjoy a steady cash flow or lack liquidity. Investors who invest in a company that follows the policy face very high risks as there is a possibility of not receiving any dividends during the financial year.

2) STABLE DIVIDEND POLICY

Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. Investing in a company that follows such a policy is risky for investors as the amount of dividends fluctuates with the level of profits. Shareholders face a lot of uncertainty as they are not sure of the exact dividend they will receive.

3) REGULAR DIVIDEND POLICY

Under the regular dividend policy, the company pays out dividends to its shareholders every year. If the company makes abnormal profits (very high profits), the excess profits will not be distributed to the shareholders but are withheld by the company as retained earnings. If the company makes a loss, the shareholders will still be paid a dividend under the policy.

The regular dividend policy is used by companies with a steady cash flow and stable earnings. Companies that pay out dividends this way are considered low-risk investments because while the dividend payments are regular, they may not be very high.

4) NO DIVIDEND POLICY

Under the no dividend policy, the company doesn’t distribute dividends to shareholders. It is because any profits earned is retained and reinvested into the business for future growth. Companies that don’t give out dividends are constantly growing and expanding, and shareholders invest in them because the value of the company stock appreciates. For the investor, the share price appreciation is more valuable than a dividend payout.

If the opinion given by Ms Johnson to be considered then Irregular Dividend Policy can be best suited for the organization as it will not have any fixed obligation of distribution but simultaneoulsy to avoid wasteful activities it can divert its cash flow towards Dividend Distribution.

CHARACTERISTICS OF DIVIDEND POLICY ARE :

(i) Liquidity: In order to pay dividends, a company will require access to cash. Even very profitable companies might sometimes have difficulty in paying dividends if resources are tied up in other forms of assets.

(ii) Repayment of debt: Dividend payout may be made difficult if debt is scheduled for repayment.

(iii) Stability of Profits: Other things being equal, a company with stable profits is more likely   to pay out a higher percentage of earnings than a company with fluctuating profits.

(iv) Control: The use of retained earnings to finance new projects preserves the company’s ownership and control. This can be advantageous in firms where the present disposition of shareholding is of importance.

(v) Legal consideration: The legal provisions lay down boundaries within which a company can declare dividends.

(vi) Likely effect of the declaration and quantum of dividend on market prices.

(vii) Tax considerations and

(viii) Others such as dividend policies adopted by units similarly placed in the industry, management attitude on dilution of existing control over the shares, fear of being branded as incompetent or inefficient, conservative policy Vs non-aggressive one.

(ix) Inflation: Inflation must be taken into account when a firm establishes its dividend policy.