Question

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.Do you agree with Ms. Johnson’s statement that an increase in dividend is beneficial to the stockholders of Baldwin? Explain with three reasons why or why not. Additionally, Baldwin Inc. is planning to pay dividends of $3 per share to shareholders in 2020 (total dividend is $3 million). But because of personal taxes on dividend income, the company wants to postpone the dividend to next 5 years when they believe a new tax legislation will be passed by Congress to give tax exemption on dividend and investment income. Suggest three alternatives to the board of how the available cash can be used in place of the dividend. Finally, 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

Ms Johnson’s statement that the increase in Dividend is beneficial to the Stockholders of Baldwin Inc. can be agreed with, due to the following reasons:

1. The increase in debt will increase a fixed cash outflow for the organisation, leading to less liquidity for Baldwin.

2. The tax to be paid on the Dividend payout will only be attracted when the Dividend is paid by Baldwin, which will be out of the Reserves saved by the company, also, it is not a fixed outflow for the company. The Dividend is paid by most companies out of the reserves. Therefore, only the tax component will be cash outflow.

3. The overall benefit saved by Baldwin by not paying out Interest and fixed payments of debt is much higher than the tax paid against the Dividend declared. Also, the increase in Dividend will indirectly attract more stockholders and retain the current stockholders.

Therefore, the suggestion made by Ms Johnson, seems to be more beneficial to Baldwin in the long run