Question

Case Study: Establishing General Access Company’s Dividend Policy and Initial Dividend

General Access Company (GAC) is a fast-growing internet access provider that initially went public in early 2003. Its revenue growth and profitability have steadily risen since the firm’s inception in late 2001. GAC’s growth has been financed through the initial common stock offering, the sale of bonds in 2006, and the retention of earnings. Due to its rapid growth in revenue and profits with only short-term earnings declines, GAC’s common stockholder have been content to let the firm reinvest earnings as part of its plan to expand capacity to meet the growing demand for its services. This strategy has benefited most stockholders in terms of stock spilts and capital gain. Since the company’s initial public offering in 2003, GAC’s stock twice has been spilt 2-for-1. In terms of total growth, the market price of GAC’s stock, after adjustment for stock split has increased by 800% during the 7-year period 2003-2009.

As the GAC’s growth is becoming to slow, the firm’s CEO, Marilyn McNeely believes that its shares are becoming less attractive to investors. McNeely had discussion with the CFO, Bobby Joe Rook, who believes that the firm must begin to pay cash dividends. He argues that many investors value regular dividends and by paying them, GAC would increase the demand and price for its shares. McNeely decided that at the next board meeting, she would propose that the firm begin to pay dividends on a regular basis. McNeely realized that if the board approved her recommendation, it would have to (1) establish a dividend policy and (2) set the amount of the initial annual dividend. She had Rook to prepare a summary of the firm’s annual Earnings Per Share (EPS). It is given in the following table.

Year	EPS
2009	$3.70
2008	$4.10
2007	$3.90
2006	$3.30
2005	$2.20
2004	$0.83
2003	$0.55

Rook indicated that he expects EPS to remain within 10% (plus or minus) of the most recent (2009) value during the next years. His most likely estimate is an annual increase of about 3%. After much discussion, McNeely and Rook agreed that she would recommend to the board one of following types of dividend policies:

1. Constant-payout-ratio dividend policy
2. Regular dividend policy
3. Low-regular-and-extra dividend policy

McNeely realizes that her dividend proposal would significantly affect future financing opportunities, costs and the firm’s share price. She also knows that she must be sure that her proposal is complete and fully educates the board with regard to the long term implications of each policy.

Based on the case study, answer the following questions.

1. Analyze each of the three dividend policies in light of GAC’s financial position.
2. Which dividend policy would you recommend? Justify your recommendation.
3. Discuss any four key factors to consider when setting the amount of a firm’s initial annual dividend?
4. How should McNeely go about deciding on what initial annual dividend she will recommend to the board?
5. In view of your dividend policy recommendation in part (b), how large an initial dividend would you recommend? Justify your recommendation.

Answer 1

The alternative dividend payout policies that a firm may follow. They need to evaluate the alternatives with regard to both the financial facts of the firm as well as the stockholders' dividend preferences.

a.         The company has experienced positive and increasing earnings since it went public in 2003. Management believes that EPS should remain stable over the next three years (±10%). This stable earning pattern is conducive to having some form of regular dividend payout policy. Either the regular dividend policy or the low-regular-and-extra dividend policy would be consistent with the earnings stability. The constant payout ratio could work but may be unacceptable to the shareholders due to the nature of the industry. Competition in the Internet access industry is strong. Should General Access experience volatility in their earnings they would pass this volatility on to its shareholders through dividend changes.

b.         The low-regular-and-extra dividend policy should be adopted for two reasons. First, this approach provides the dividend stability consistent with the firm's earnings stability and growth. Secondly, the firm has the flexibility to increase or decrease dividends when earnings vacillate due to economic or competitive conditions.

c.         There are six factors the board should consider before setting an initial dividend policy:

1.         Legal constraints-Are there legal restrictions that come into play that will prohibit the firm from paying a dividend? A common constraint in most states is the firm cannot pay dividends out of “legal capital,” which is normally measured as the par value of common stock, plus perhaps any paid-in capital in excess of par.

2.         Contractual constraints-Loan covenants may be in place that place some prohibitions on the ability of the firm to pay dividends.

3.         Internal constraints-This factor addresses whether or not the firm has the available funds to make the cash dividend payments. Although legally a firm can borrow to pay dividends, most lenders are reluctant to make such loans.

4.         Growth prospects-If the firm needs the funds to invest in new or ongoing projects they may wish to retain earnings to fund the investments. The firm can pay dividends and then raise funds externally, but often these external sources are more expensive and/or increase the risk of the firm.

5.         Owner considerations-Although it is impossible to maximize the wealth of every single owner, managers should consider the tax status, owners' other wealth opportunities, and ownership dilution possibilities when making the dividend decision.

6.         Market consideration-How will market participants view the dividend decision? This factor is concerned with the information content of the decision to institute a dividend payout where none previously existed.

d.         Ms. McNeely will want to set a dividend that is high enough to inform stockholders of the financial strength of the firm. She needs to be cautious of not setting it too high and forcing the firm into a dividend cut possibility in future years. The volatility of EPS is an important consideration. A worst-case scenario for EPS volatility is minus 10%. EPS could be as low as $3.33, but could rise to $4.07 in a best-case outcome. The most likely scenario growth of 5% results in an EPS of $3.89. She should also look at the dividend policies of competitor firms. What is their current policy and what policy did they follow when they first started paying out a dividend? Investor's may partially form their expectations from the decisions of these competitors.

e.         The initial dividend should be approximately $0.72 per share per year ($0.18 per quarter). General Access has had EPS in excess of $0.72 since 2004, the year after they went public. This amount is a payout ratio of about 20% based on 2009 EPS. This is a substantial initial dividend, which is probably what is needed by the market since investors in General Access have experienced rapid share price appreciation. To start with too low of a dividend would signal a decline in the investment potential of the firm. To make the dividend higher may place financial stress on the firm in the near future should profits decline. Even if the firm's EPS declined 10% to $3.33 the payout ratio would increase to only 21.6%. If better than expected earnings are experienced, the firm can declare the extra dividend to share this wealth with stockholders.