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seems to react negatively to all of them, however, suggesting that it does not attach much
credibility to the firm™s statements. The negative reaction to the dividend cut seems to
persist in the case of the firms with the earnings declines, while it is reversed in the case
of the firms with earnings increases or better investment opportunities.
Woolridge and Ghosh also found that firms that announced stock dividends or
stock repurchases in conjunction with the dividend cuts fared much better than firms that
did not. Finally, they noted the tendency across the entire sample for prices to correct
themselves, at least partially, in the year following the dividend cut. This would suggest
that markets tend to overreact to the initial dividend cut, and the price recovery can be
attributed to the subsequent correction.
In an interesting case study, Soter, Brigham and Evanson looked at Florida Power
& Light's dividend cut in 199411. FPL was the first healthy utility in the United States to
cut dividends by a significant amount (32%). At the same time as it cut dividends, FPL
announced that it was buying back 10 million shares over the next 3 years, and
emphasized that dividends would be linked more directly to earnings. On the day of the
announcement, the stock price dropped 14%, but recovered this amount in the month
after the announcement, and earned a return of 23.8% in the year after, significantly more
than the S&P 500 over the period (11.2%) and other utilities (14.2%).

Lessons for Firms
There are several lessons for firms that plan to change dividend policy. First, no
matter how good the reasons may be for a firm to cut dividends, it should expect markets
to react negatively to the initial announcement for two reasons. The first reason is the
well-founded skepticism with which markets greet any statement by the firm about
dividend cuts. A second is that large dividend changes typically make the existing
investor clientele unhappy. Although other stockholders may be happy with the new
dividend policy, the transition will take time, during which stock prices fall. Second, if a
firm has good reasons for cutting dividends, such as an increase in project availability, it



11 Soter, D., E. Brigham and P. Evanson, 1996, The Dividend Cut "Heard 'Round the World": The Case of
FPL, Journal of Applied Corporate Finance, v9, 4-15. This is also a Harvard Business School case study
authored by Ben Esty.


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will gain at least partial protection by providing information to markets about these
projects.

In Practice: From Fixed to Residual Dividends “ Some Ideas
In the United States and Western Europe, firms have locked themselves into a
dance with investors where they institute dividends and are then committed to
maintaining these dividends, in good times and in bad. In fact, much of what we observe
in dividend policy from sticky dividends to the reluctance to increase dividends in the
face of good news and to cut dividends in the face of bad news can be traced to this
commitment. It is also this commitment that has led companies to increasingly shift to
stock buybacks as an alternative to dividends.
Given the change in the tax law in 2003, there should be added incentive for
companies to pay dividends now. It would help the cause if we can add flexibility to
dividend policy, in effect allowing companies to adjust dividends to changing earnings.
There are three ways in which we can do this:
a. Target a dividend payout ratio rather than a dollar dividend: This is the simplest way
to make dividends a function of earnings and it mirrors what is already being done by
companies in some markets.
b. Switch to a policy of paying out whatever is leftover as free cashflows to equity each
year as dividends.
c. Set a fixed dividend based upon the predictable component of earnings and a
contingent dividend that is tied to the extent to which earnings exceed the predictable
component.
There may be some resistance on the part of investors to these changes but they will be
overcome. There will be enough investors, however, who see the advantages of a flexible
dividend policy and buy the stock of companies


Conclusion
We began this chapter by expanding our definition of cash returned to stockholder
to include stock buybacks with dividends. Firms in the United States, especially, have
turned to buying back stock and returning cash selectively to those investors who need it.



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With this expanded definition of cash returned to stockholders, we first used a
cash flow based approach to decide whether a firm is paying too much or too little to its
stockholders. To form this judgment, we first estimate what the firm has available to pay
out to its stockholders; we measure this cash flow by looking at the cash left over after
reinvestment needs have been and debt has been serviced, and call it the free cash flow to
equity. We then look at the quality of the firm™s projects; firms with better projects get
more leeway from equity investors to accumulate cash than firms with poor projects. We
next consider the effect of wanting to increase or decrease the debt ratio on how much
cash is returned to stockholders. Finally, we consider all three factors “ the cash flow
available for stockholders, the returns on existing investments and the need to increase or
decrease debt ratios “ in coming up with broad conclusions about dividend policy. Firms
with a good track record in investing can pay out less in dividends than is available in
cash flows, and not face significant pressure from stockholders to pay out more. When
the managers of firms are not trusted by their stockholders to invest wisely, firms are
much more likely to face pressure to return excess cash to stockholders.
We also analyzed a firm™s dividend policy by looking at the dividend policies of
comparable firms in the business. In this approach, a firm that is paying out less in
dividends than comparable firms would be viewed as paying too little and one that is
paying out more would be viewed as paying too much. We use both a narrow definition
of comparable firms (firms in the same line of business), and a broader definition (all
firms). We control for differences in risk and growth across firms, using a multiple
regression.
We closed the chapter by looking at how firms that intend to change their
dividend policy can minimize the side-costs of doing so. This is especially true when
firms have to reduce their dividends to meet legitimate reinvestment needs. While the
initial reaction to the announcement of a dividend cut is likely to be negative, firms can
buffer some of the impact by providing information to markets about the investments that
they plan to accept with the funds.




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Live Case Study
A Framework for Analysing Dividends
Objective: To determine whether your firm should change its dividend policy, based
upon an analysis of its investment opportunities and comparable firms.

Key Questions:
How much could this firm have returned to its stockholders over the last few years?

How much did it actually return?
Given this dividend policy and the current cash balance of this firm, would you push

the firm to change its dividend policy (return more or less cash to its owners)?
How does this firm™s dividend policy compare to those of its peer group and to the

rest of the market?

Framework for Analysis:
1. Cash Return to Stockholders
How much has the firm paid out in dividends each year for the last few years?

How much stock has it bought back each year for the last few years?

Cumulatively, how much cash has been returned to stockholders each year for the last

few years?
2. Affordable Dividends
What were the free cash flows to equity that this firm had over the last few

years?
What is the current cash balance for this firm?

3. Management Trust
How well have the managers of the firm picked investments, historically?

(Look at the investment return section)
Is there any reason to believe that future investments of this firm will be

different from the historical record?
4. Changing Dividend Policy
Given the relationship between dividends and free cash flows to equity, and

the trust you have in the management of this firm, would you change this
firm™s dividend policy?


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5. Comparing to Sector and Market
Relative to the sector to which this firm belongs, does it pay too much or too

little in dividends? (Do a regression, if necessary)
Relative to the rest of the firms in the market, does it pay too much or too little

in dividends? (Use the market regression, if necessary)

Getting Information on analyzing dividend policy
You can get the information that you need to estimate free cash flows to equity
and returns on equity from past financials. You will also need a beta (see risk and return
section) and a debt ratio (see risk and return section) to estimate the free cash flows to
equity. Finally, you will need stock returns for your stock and the returns on a market
index over the period of your analysis.
Online sources of information:
http://www.stern.nyu.edu/˜adamodar/cfin2E/project/data.htm




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Questions
1. Stock buybacks really do not return cash to stockholders, since only those who sell
back stock receive the cash. Is this statement true or false? Explain.

2. In the last decade, we have seen an increase in the percent of cash returned to
stockholders in the form of dividends. Why?

3. Lube Oil, a chain of automobile service stations, reports net income of $ 100 million,
after depreciation of $ 50 million. The firm has capital expenditures of $ 80 million, and
the non-cash working capital increased from $ 25 to $ 40 million. Estimate the firm™s free
cash flow to equity, assuming that the firm is all equity financed.

4. Lube Oil, in question 3, paid a dividend of $ 20 million, and bought back $ 25 million
in stock. Estimate how much the cash balance of the firm changed during the year.

5. How would your answers to the last two problems change if you were told that Lube
Oil started the year with $120 million in debt and ended the year with $ 135 million?

6. Now assume that Lube Oil, in questions 3-5, has a return on equity of 5% and a cost of
equity of 10%. As a stockholder in Lube Oil, would you want the firm to change its
dividend policy. Why or why not?

7. Tech Products reported a net loss of $ 80 million for the latest financial year. In
addition, the firm reported a net capital expenditure of $ 70 million, and a change in non-
cash working capital of $ 10 million. Finally, the firm had $ 10 million in debt at the start
of the year that it paid off during the year. Estimate the free cash flow to equity.

8. Tech Products, from problem 7, pays a dividend of $ 40 million. Assuming that the
firm started the period with no cash, how did it raise the funding for the dividend
payment?

9. New Age Telecomm is a young, high-growth telecommunications firm. It pays no
dividends, though the average dividend payout for other firms in the telecommunications
sector is 40%. Is New Age paying too little in dividends? Why or why not?



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10. The following is a regression of dividend payout ratios on the risk and ln(market
capitalization: in millions) of chemical firms:
Dividend Payout ratio = 0.14 + 0.05 (ln (Market Capitalization)) “ 0.1 (Beta)
Harman Chemicals has a market capitalization of $ 1.5 billion and a beta of 1.2. It pays
out 22% of its earnings as dividends. How does this dividend payout compare to the
industry?




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Problems
1. JLChem Corporation, a chemical manufacturing firm with changing investment
opportunities, is considering a major change in dividend policy. It currently has 50
million shares outstanding and pays an annual dividend of $2 per share. The firm current
and projected income statement are provided below (in millions):
Current Projected for next
year
EBITDA 1200 1350
- Depreciation 200 250
EBIT 1000 1100
- Interest Expense 200 200
EBT 800 900
- Taxes 320 360
Net Income 480 540


The firm's current capital expenditure is $ 500 million. It is considering five projects for
the next year:
Project Investment Beta IRR (using cashflows to equity)
A $190 mil 0.6 12.0%
B $200 mil 0.8 12.0%
C $200 mil 1.0 14.5%
D $200 mil 1.2 15.0%
E $100 mil 1.5 20.0%
The firm's current beta is 1.0, and the current T. Bill rate is 5.5%. The firm expects
working capital to increase $50 million both this year and next. The firm plans to finance
its net capital expenditures and working capital needs with 30% debt.
a. What is the firm's current payout ratio?
b. What proportion of its current free cash flow to equity is it paying out as dividends?
c. What would your projected capital expenditure be for next year (i.e Which of the five

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