WARNER BODY

WORKS
A case study on dividend policy
MBA Finance, Second Trimester, Group 2

Submitted to: Submitted by: Roll No

Prof. Dr. Radhe Shyam Pradhan Binita Shah 9
Faculty, Financial Management Birendra Byahut 10
Daya Krishna Ghimire 11
Dikshya Kumari Pandey 12
Dipesh Chand 13
Harihar Sharma 14
Janardan Subedi 15
ST
31 MARCH 2019
Khagendra Adhikari 16

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 TABLE OF CONTENTS
Background of the case 2

Question 1 3

Question 2 8

Question 3 10

Question 4 11

Question 5 14

Question 6 16

Question 7 17

Question 8 19

Question 9 21

Conclusion and Recommendation 22

Lessons Learnt 24

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Background of the case
Warner Body works is one of the leading producers of custom coachwork for auto
mobiles delivery trucks and other special purpose vehicles. In 2010, Warner body works
acquired a number of small firms engaged in the research of robotics and material science
as a move to broaden its product line. To finance these acquisitions debt was used
because at that time Warner had relatively small debt outstanding.
For the past 30 years, Warner has been practicing to pay out 60% of its earnings as
dividend payout. Due to its liberal dividend policy, most of its stock holders are income-
seeking rather than growth oriented.
Every year the directors of Warner Body works have a director’s meeting to plan for the
coming year. At the meeting of January 2016, the various issues regarding the company’s
dividend policy was brought forth. Due to its liberal policy, the company had to turndown
some expansion opportunities with high rates of return because of capital limitations.
The tax on dividends (75%) was much higher than that of capital gains (28%). Thus,
some argued that for the directors who owned large holdings of Warner stock it would be
more profitable to retain earnings. This way the price of share would increase and they
could obtain cash by selling some of the stocks which would have lower tax cost. Also,
the company’s current ratio had decreased and debt ratio had increased by a great amount
since 2007 to 2015.
On the other hand, it was argued that the company would lose the stock holders who were
interested in high dividends which would lower their share price. But it can also be said
that even though these stock holders would be lost, the company could then gain the
attention of more growth-oriented investors and in turn result in higher stock prices along
with the internal growth of the company.
Looking at these arguments, the vice president of finance has to come up with the most
appropriate solution to tackle the issue. There are four dividend policy options provided
to him out of which he has to choose the best one.
POLICIES DETAILS
1 A continuation of the present policy of paying out 60 percent of the
earnings
2 A policy of lowering the present payout to some percentage below 60
percent for example 20, 30 or 40 percent and maintaining the payout ratio

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 relatively constant at this new figure
3 Establishing the dollar amount of dividends for example $1 per share a year
and maintaining the dividend at this rate. As earnings fluctuated, the
dividend payout would fluctuate
4 Setting a relatively low dividend payout such as 50 cents per share and
supplementing it periodically with an extra dividend that would depend on
availability of funds and the need for capital.

Question 1
Evaluate the advantages and disadvantages of each of the four dividend policies,
considering each as it applies in this specific case to Warner Body Works.

Solution:
Dividend policy refers to the policy marked out by companies regarding the amount it
would pay to their shareholders as dividend. It determines the division of earnings
between payments to stockholders and reinvestment in the firms. It is concerned with
determining the proportion of firm’s earnings to be distributed in the form of cash
dividend and the proportion of earnings to be retained. Basically, a firm has three
alternatives regarding the payment of dividends.
 It can distribute all of its earnings in the form of cash dividends.
 It can retain all of its earnings for reinvestment.
 It can distribute a part of earnings as dividends and rest the rest for reinvestment
purpose.

1. A continuation of the present policy of paying out 60% of the earnings

A firm pays a specific percentage of earnings to its shareholders each period. A major
shortcoming of this approach is that if the firm’s earnings drop or are volatile, so too will
the dividend payments. Investors view volatile dividends as negative and risky which can
lead to lower share prices. A regular dividend policy is based on the payment of a fixed-
dollar dividend each period.

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Advantages:
 Individuals, organization, social organization that need stable income would
prefer this policy as it provides a regular dividend payment. For example: retirees
who are in need of the dividend for their expenses would stay with the
organization.
 It minimizes uncertainty to investors as there is a regular payment of dividend.
The investors are now safe to invest in the company’s share.
 A regular dividend policy decreases agency costs by reducing the free cash flow
available to the managers of the firm.
 As the payment of dividends indirectly results in a closer monitoring of
management's investment activities, this is also one of the advantages for the
investors.
 Thus, as per policy, Warner Body Works’ current stockholders is in support of
high regular dividend.
 Finally, legal listing in many states requires dividend stability.

Disadvantages:
 This policy would not be appropriate where the companies have low free cash
flow because they are compelled to pay the regular dividend even if there are no
earnings.
 Need to finance the growth with debt financing which could affect its long term
liquidity because the company is paying high dividend and now the company has
less retained earnings and has to make use of debt.
 As they are paying high dividends, they have to bear opportunity cost of not
investing in future projects.
 The high payment of dividend leads to low current ratio and increment of
dividend.
 If a firm pays out substantial dividends, it may need to raise external capital at a
later stage through the sale of stock in order to finance the profitable investment
projects. In this case, the controlling interest of the stockholders may be diluted.

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2. Lowering the present payout to below 60% and maintaining the payout ratio
relatively constant at this new figure.

Advantages:
 Individuals in upper income tax brackets might prefer lower dividend payouts,
given the immediate tax liability, in favor of higher capital gains with the deferred
tax liability.
 Low payouts can decrease the amount of capital that needs to be raised, thereby
lowering flotation costs.
 As there is less need to raise external equity, controlling interest of the
stockholders will not be diluted.
 It resolves uncertainty, as dividend earnings are less risky than capital gains.
 With the reduction in the dividend payout, there is a risk that the current income
seeking investors would sell their stock. Aggressive investors would more than
take up that slack caused by possible liquidation of income seeking investors,
which would result in the increase of the stock price if dividends were cut.
 Since high dividends hurt investors, while low dividends-high retention helps the
firm's investors, low dividend stocks are more valuable to the company.

Disadvantages:
 It could signal that the firm is having financial difficulties. Therefore, the firm has
reduced its dividend payout.
 Majority of the Current stockholders are in favor of stable growth rate than
growth potential. Therefore, these groups would sell their stocks if the dividend
payout ratio is reduced. Eventually, this could reduce the marker price per share
of the company.

3. Establishing a dollar amount of dividend and increasing with the increase in income
Relatively stable dollar dividend is maintained. The dividend per share is increased or
decreased only after careful investigation by the management.

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A stable dollar dividend policy is a based on the payment of a fixed-dollar dividend each
period, for example paying $1 per share. This dividend per share does not fluctuate more
as the firms paying regular dividends typically do not increase the dividend until they are
confident that any increase in earnings is sustainable. As this policy provides dividend
stability, it is the most popular kind of dividend policy for dividend paying firms.

Advantages:
 Investors may use the dividend policy as a part for information that is not easily
accessible. This dividend policy may be useful in assessing the company's long-
term earnings prospects. Increase in the dividend would signal the prosperity of
the firm. It would attract the growth seeking investors.
 Here in the case of Warner Body Works this could be a better option as the firm
needs to retain its earnings to support the acquisitions. Further, as the dividend per
share of 2015 is $1.25 the firm can convince its investors to provide a dividend
per share of $1(which is not very less than $1.25) and increase it with the increase
in income as it has a potential growth.

Disadvantages:
 Many investors like retired individuals, college endowment funds, and income
oriented mutual funds rely on dividends to satisfy instant personal income need. If
dividends fluctuate from year to year, investors may have to sell or buy stock to
satisfy their current needs, thereby incurring expensive transaction costs.
 Income seeking investors would sell the stocks as the dividend income is
uncertain.

4. Low dividend payout and supplementing it with extra income

The firm applying this policy determines a minimum constant dividend plus some extra
number of dividends depending upon the earnings. The minimum limit of the dividend
per share is fixed and additional dividend is paid over the regular low dividends in the
years of relatively high earnings. As soon as the earnings decline to normal level, the firm
cuts its extra dividend and pays only the normal or minimum dividend.

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Advantages:
 This policy could be considered right if the firm’s earnings are quite volatile. In
this case the company needs to pay more dividends, only if it makes higher
earnings. Hence ensures more flexibility to the company in terms of dividend
payments. If the firm does good earnings in some years, it may pay extra
dividends.
 This policy ensures that the investors get a certain minimum amount as dividend.
This minimum limit is independent of the income or the earning of the company.
 The investors have less expectation with this sort of policy. Hence, at the time of
growth when they get more than the expected then it can lead to satisfaction. This
can be related with regards to the expectancy theory.
 This sort of policy prevents negative signaling as there is a pre fixed minimum
limit for those investors who are satisfied with the minimum level that is pre
fixed.

Disadvantages:
 There is an uncertainty in how much the investors are getting as the dividend with
this sort of policy; hence it may not attract those parties who are seeking a stable
dividend.
 The investors might think that the company has a weak financial position, so it is
going for a reduction in dividend payout which may be a cause for negative
signaling to the investors.

Question 2
Evaluate the advantages and disadvantages of having an announced dividend policy.
Should Warner Body Works follow announced dividend policy?

Solution:
The advantage of announced dividend policy is:
Attracts investors:

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As the company is declaring a high dividend, many companies would invest and thus it
would lead the company for expansion opportunities. This shows that the company will
be in a strong position thereby leaving the competitors behind. In this way, announcing
high divided would attract a large number of investors.

Reduces uncertainty
The biggest advantage of having an announced dividend policy is that it would reduce
investor uncertainty, and reductions in uncertainty are generally associated with lower
capital costs and higher stock prices, other things being equal. If dividends declared are
known by the investors then the investors can make further planning such as expansion of
their business because the investors are in a safer side.

Reduction of cost of capital on future projects

Dividend payment will naturally reduce the present profit but will definitely reduce the
cost of future equity funding, by announcing high dividend payout in advance the firm
can increase the market price of its share as their will be high demand for it because
investors will perceive it as a high productive which will lead to high flow of share and
thus reduction in cost of capital. Further the company needs no go for debt financing.

Disadvantage:
Difficult to alter the dividend policy once announced.
It is difficult for the company to change its dividend policy once announced because
change in policy would incur high cost. It will also be risky for the company to change its
policy because the company might not be aware of the consequences of the changed
policy. The shareholders also may be reluctant to accept the changed policy and it also
led to decrease in corporate flexibility. Therefore, the company needs to keep all these
factors in mind before changing its dividend policy.

Opportunity cost of reinvestment.

As the company has already declared the dividend to its share holders, now the company
is compelled to pay the dividend even if the company has others opportunities aside. The

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company now has to pay the dividend at the cost of expansion opportunity. The company
might have huge profit if it had invested in other future projects but as the company has
already declared, the company has to give priority to its shareholders.

Not suitable for unionized company:

The announced dividend policy is not suitable for unionized company because it will lead
to conflict between the managers and the union. If the company is declaring high
dividend then the union labors will capture the earnings by asking the managers to
increase their salaries
May damage corporate image:

Reduce credibility of the company

In case if the company is not able to provide the dividend to its shareholders that it had
already declared then it will hamper the reputation of the company in future. Disputes
will take place between the company and its shareholders. Even in the future, the public
will not be interested to invest in the shares of the company.

Thus, we can conclude by saying that the company should not follow announced
dividend policy. This case illustrates that the company has opportunities available but the
company has declared high dividend. If the company would have retained its earnings
rather than issue of stock and payment of high dividend then the company would have
utilized its retained earnings for other expansion. With fewer shares of stock outstanding,
earnings per share would be higher today and would have shown a higher growth rate
over the past decade. Similarly, Murray implied that though dividends are cut, aggressive
investors will continue to invest in the firm which will result in increasing price of the
stock.

Question 3
What effect does the dividend policy have on the growth rate of earnings per share?

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Solution:
Dividend Policy is deciding how much it will pay out to shareholders in form of dividend
out of its earning and how much it will retain. Earnings per share can be defined as the
portion of a company's profit allocated to each outstanding share of common stock. EPS
serves as an indicator of a company's profitability. EPS can be calculated as Net Income
divided by number of shares outstanding.

In order to show the effect on the growth rate of earnings per share the calculations
should be done as below.

Table1: Calculation of ROE

2007 2015
Net Income (EAT) 31.2 104.3
Shareholder’s Equity 97.3 487
Return on Equity (ROE) 32.07% 21.41%

Here,
g = ROE*(1 - DPR)

Where, g = growth rate

ROE = Return on Equity
DPR = Dividend Payout Ratio

For 2007, g = 32.07(1-0.6)

= 12.826%

For 2015, g = 21.41% (1-0.6) = 8.56%

In the above calculation for the year 2007 given a ROE of 32.07% and a dividend payout
of 60% the growth rate is 12.8326%. Likewise, for the year 2015 when ROE is 21.41%
and a dividend payout is 60% the growth rate in 8.56%. In the year 2015 the earning after
tax has increased proportionally lower in comparison to Share holder's equity. This
shows the lower growth rate in earning per share when dividend payout ratio is constant

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at 60%. The reason behind this is that retained earnings are not invested for reinvestment
purpose while huge amount of its earning is spent in the payment of interest in debt due
to increment in debt ratio to 60% in the year 2015. This reduces the net income after tax
and with the increased accumulated retained earnings and external equity the
shareholder's equity is also increased. As such the return on equity is decreased reducing
growth rate on earning per share. From this analysis we can see reduction in growth rate
of earning per share due to dividend policy.

In the above calculation Return on Equity is calculated as below:

ROE: Common Stock + Retained Earning
2007, ROE = 25 + 72.3 = 97.3
2015, ROE = 50 + 437 = 487

Question 4
Could the figures in Table 3 be considered proof that firms with low payout ratios
have high price/earnings ratios? Justify your answer.

Solution:

Table 3 is presented below:

Particulars Payout P/E

Playboy 17% 25
Uniroyal 0% 19
Hewlett Packard 11% 17
Data point 0% 16
Texas instrument 30% 13
Xerox 40% 10
ATT 67% 8
Allied Stores 45% 6

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As we can see, in the table companies having low payout ratio like Hewlett Packard
(11%) and Playboy (17%) have high P/E ratios i.e. 17 times and 25 times respectively.
Whereas companies having high payout ratios like ATT (67%) and Allied Stores (45%)
have low P/E ratios of 8 and 6 respectively. However, companies with payout ratio of
30% and 40 % have price earnings ratio of 13 times and 10 times.

It is seen that even those firms that do not pay dividend have high P/E ratios as compared
to those who are paying dividends. Thus, the firms with low payout ratios have high P/E
ratios. The table shows that there is an inverse relationship between payout ratio and P/E
ratios. Firms like ATT and Allied Stores who have high payout ratios have low P/E ratios.

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According to table and the graph, we can see that there is inverse relationship between
payout ratio and price earning ratio. But is there a perfect inverse relation? The firm with
highest payout ratio should have the lowest price earning ratio and vice versa. But this is
not the case in the table. As per the case, the company ATT should have the lowest price
earning ratio, but what we can see is that instead of ATT, allied stores has the lowest price
earning ration. So, we can conclude the relation is relatively inverse.

But theoretically, this is the case.

Payout ratio = Annual dividend / earnings per share

Payout ratio identifies the percentage of net profit paid to stockholders in the form of
dividends, over a specified timeframe. Dividend payout ratio assesses the company’s
ability to sustain its dividend payments, and is therefore useful predictors of continued
profitability. A low payout ratio represents a secure future, while a high ratio suggests that
a company has failed to reinvest its profits and may not be able to sustain dividend
payments.

 Investors naturally find high dividend payouts attractive, but if these go hand-in-
hand with declining profits it could mean that the company is failing to reinvest,
or that dividends are about to be reduced.

 Investors should be wary of payout ratios above 75%, because of the implication
that a company is not reinvesting its profits, or profits are struggling, or the
company is making desperate efforts to tempt investment.

 A new, fast-developing company may choose to reinvest all its profit into the
business, and pay no dividends at all.

 It used to be the case that dividends provided over 40% of an investor’s returns.
But in the last 20 years, it’s been more like 20%

Price earning ratio is equal to a stock's market capitalization divided by its after-tax
earnings over a 12-month period, usually the trailing period but occasionally the current

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or forward period. The higher the P/E ratio, the more the market is willing to pay for each
dollar of annual earnings. Companies with high P/E ratios are more likely to be
considered "risky" investments than those with low P/E ratios, since a high P/E ratio
signifies high expectations. Companies that are not currently profitable (that is, ones
which have negative earnings) don't have a P/E ratio at all.

Also, we understand that for the markets where retained earnings (RE) has more effect on
market price per share (MPS), low payout ratio indicates that huge portion of dividend
has been retained for investment on project with higher rate on return. The effect will be
reflected by increase in MPS and thus increased P/E ratio.
Payout ratio= earning distributed as divided/ net income (NI)
P/E ratio = market price per share (MPS) / earnings per share (EPS)
For market with higher RE effect on MPS:
Low payoutHigh retention for more profitable projectincreased MPShigh
P/E
However, for the markets where MPS is more sensitive to dividend, low rate of dividend
would indicate decrease in profit of the company. This in turn reduces the MPS and
finally P/E ratio also declines.
Low payoutlow profitdecreased MPS low P/E

In summary, price earnings ratio and payout ratio both depicts the profitability of the
firm. So theoretically they should have direct relationship. However, the table shows the
relatively inverse relationship. So, we conclude that the above-mentioned companies
must be operating in market where retained earning has more impact on MPS rather than
dividend. Hence the inverse relation between PE and payout has been obtained.

Question 5
How does the firm’s debt position affect the dividend policy?

Solution:

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Since the debt capital is cheaper, most organizations prefer to include certain portion in
their capital structure. However, the debt capital has a direct impact on the dividend
policy.
First, more debt capital means more amount to be paid as interest as well as loan. They
have to retain more amount of money to repay the loan and interests i.e. less amount of
money will be available to distribute as dividend. The company, therefore, would follow
conservative dividend policy.
Second, with increased debt capital the firms are bound to several debt contracts such as
future dividend can be paid out of earnings generated after the signing of the loan
agreement, dividend cannot be paid when net working capital is below a specified
amount etc. in this case the firms will follow conservative dividend policy by retaining
more money out of their net income.
Use of high amount of debt capital will make creditors reluctant to further provide loans.
Hence the firms have to retain more money to meet the future requirement of expansion
or growth. In another word when debt ratio is increased the lenders will not be interested
in the lending additional fund in case if the firm finds other investment opportunities.
Such a condition will compel the firm to follow residual dividend policy so that the
required funds can be financed internally out of its earning.
However, in contrary, with increased use of debt the return for equity shareholder would
be riskier. That means their required rate of return increases. Therefore, the firm will have
to pay more amount as cash dividend.
In the case of Warner Body Works, it has followed liberal dividend policy i.e. high
amount of fixed payout ratio (60%). Less amount of money was retained for further
growth and expansion. As it had high debt ratio it could not borrow money from its
creditors. As a result, the firm was forced to turn down few expansion projects with high
rate of return.

Question 6
Evaluate Murray’s argument that a reduction in the dividend payout rate would
increase the price of the stock versus Bassler’s opinion that such a reduction would
drastically reduce the price of the stock.

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Solution:
Mark Bassler, trustee of the endowment fund of major university and long-time member
of Warner’s board of directors, is of the opinion that a reduction in the dividend payout
rate would drastically reduce the price of the stock. His argument is based on the fact that
majority stockholders of Warner Body Works are income-oriented investors who have an
overwhelming preference for a policy of high dividends as opposed to a policy of a low
payout. Also, for the trust, dividends and capital gains are not interchangeable. Therefore,
a reduction in the dividend payout rate would mean that most of its investors would sell
the Warner stocks in order to reinvest in another company that paid higher dividends. The
liquidation of Warner Body Works from so many portfolios would have a disastrous
effect on the stock price as it would send a wrong signal to the market.
Roger Murray, production manager of the Robotics Division, suggests that a reduction in
the dividend payout rate would increase the price of the stock. His suggestion is based on
the understanding that if it known that a firm has expansion (investment) opportunities
that promises a relatively high rate of return, aggressive investors would be more than
willing to take up the slack caused by possible liquidation of income-seeking investors.
Moreover, his argument is verified by the fact that if dividend payout is reduced, income-
seeking individuals would most likely sell off their Warner stocks for better paying
stocks. This would reduce the number of stocks outstanding and thus increase the
earnings per share. The increase in earnings would eventually show a higher growth rate
which would in turn induce growth-oriented institutions and individual investors to
purchase Warner stock. Having growth-oriented stockholders would ensure that Warner
Body Works is continuously growing and doing better than before. Hence, the company’s
stock price is likely to soar up.
From the above evaluation of the two arguments, it can be seen that Murray’s argument
has more weight than that of Bassler’s. In fact, what Murray suggests covers for the gap/
problem mentioned by Bassler. Warner Body Works has been making all its acquisitions
by issuing new stock as all its cash goes out in the form of dividends to its stockholders.
Therefore, reduction in the dividend payout rate would mean that the company can make
acquisitions for cash. Making acquisitions for cash would mean that there are fewer

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stockholders in the company thus increasing the earnings per share and the growth rate.
Thus, retaining the earnings and ploughing it back into the company as suggested by
Murray would prove to be beneficial for the company. We are therefore in favour of
Murray’s argument rather than Bassler’s.

Question 7
Might stock dividends be of use here?

Solution:
A stock dividend is a pro-rata distribution of additional shares of a company’s stock
to owners of the common stock. In simpler terms, stock dividend is a dividend
payment made in the form of additional shares, rather than a cash payout. It is also
known as a "scrip dividend." Companies may decide to distribute stock to
shareholders of record if the company's availability of liquid cash is in short supply.
These distributions are generally p acknowledged in the form of fractions paid per
existing share. An example would be a company issuing a stock dividend of 0.05 shares
for each single share held.
Unlike a cash dividend, a stock dividend is usually not taxable to the shareholder when it
is received, but rather when it is sold. Stockholders who are supposed to receive a
fractional share will often receive a check for the amount equal to the market value of the
fractional share.

A practical example of stock dividends:

Company ABC has 1 million shares of common stock. The company has five investors
who each own 200,000 shares. The stock currently trades at $100 per share, giving the
business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000

shares of common stock (20% of 1 million) and sends these to the shareholders based on

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their current ownership. All of the investors own 200,000, or 1/5 of the company, so they
each receive 40,000 of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares
of common stock. The 20% dilution in value of each share, however, results in the stock
price falling to $83.33. Here’s the important part: the company (and our investors) are
still in the exact same position. Instead of owning 200,000 shares at $100, they now own
240,000 shares at $83.33. The company’s market capitalization is still $100 million.
A company may opt for stock dividends for a number of reasons including inadequate
cash on hand or a desire to lower the price of the stock on a per-share basis to
prompt more trading and increase liquidity (i.e., how fast an investor can turn his
holdings into cash). Why does lowering the price of the stock increase liquidity? On the
whole, people are more likely to buy and sell a $50 stock than a $5,000 stock; this usually
results in a large number of shares trading hands each day.
One of the more interesting theories of corporate dividend policy is that managements
should opt for stock dividends over all other kinds. This will allow investors that want
their earnings retained in the business (and not taxed) to hold on to the additional
stock paid out to them. Investors that want current income, on the other hand, can sell
the shares they receive from the stock dividend, pay the tax and pocket the cash - in
essence, creating a “do-it-yourself” dividend.
In the case of Warner Body Works, they have a huge cash outflow in the form of
dividends as they have a current dividend policy of 60%. Therefore, they are forced to
turn down some expansion opportunities that promised relatively high rates of return.
Moreover, the problem that the company is facing is such that its stockholders consist of
mainly income-seeking investors which mean that if dividends are not distributed or are
paid at a rate lower than the present rate, the stockholders are likely to sell the company’s
stock to reinvest in another company that is paying higher dividends. Therefore, it would
be very difficult for Warner Body Works to instantly reduce its dividend payout rate. To
solve this cash problem, Warner Body Works could payout stock dividends instead of
cash dividends. This way it will be able to increase its liquidity and can thus invest in the
more lucrative investment opportunities.

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Moreover, the company is currently paying a tax of about 70% on dividends. If it were to
issue stock dividends instead, it would have to pay tax of only 28% that too only if the
stockholder sells the stock. This is because as explained above, stock dividends are
taxable only on sale. Therefore, Warner Body Works could save on its taxes if it were to
issue stock dividends instead of cash dividends.
Now, from the investor’s perspective, if the company were to issue stock dividend instead
of cash dividend, it would still be beneficial to them as their earnings in terms of earnings
per share and stock price are likely to increase, assuming of course that the company’s
investment with the retained income proves profitable. Also, this option as explained
earlier would allow investors that want their earnings retained in the business (and not
taxed) to hold on to the additional stock paid out to them. Investors that want current
income, on the other hand, can sell the shares they receive from the stock dividend, pay
the tax and pocket the cash - in essence, creating a “do-it-yourself” dividend.

Question 8
What specific dividend policy should Murray recommend to the board of directors
at its next meeting? Fully justify your answer.

Solution:

In the given case there are four dividend policy alternatives provided. The first dividend
policy is in favor of continuation of 60% dividend payout ratio. The second policy is in
favor of lowering the present payout ratio whereas third policy favors establishing a fixed
dollar rate assuming the earnings will be increased and hence the dollar dividend will also
be increased. Similarly, fourth policy is in favor of providing very low dividend of only
$0.50.

Theoretically justifying the fourth policy of paying only $0.50 dividend is not advisable.
Since most the stockholders of the organization are income seeker who prefers high
dividend payout ratio. In such a condition this might leave a negative impact among the
stockholders and consequently they will not prefer to hold the organization's stocks. As

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such this might lead to negative rumors in the market and hence the market price of the
shares may reduce drastically.
Hence this policy is rejected on the ground of this assumption. However, to justify among
other three alternatives and decide which should be chosen growth rate on Earning per
share based on three policies are calculated. On the basis of the growth rate the decision
can be made.

Table showing growth rate on various dividend policies

Retention Dividend
Dividend Policies Ratio Payout Ratio ROE g%

First Dividend Policy 40% 60% 21.42 8.57

Second Dividend Policy
DPR (20%) 80% 20% 21.42 17.14
DPR (30%) 70% 30% 21.42 14.99
DPR (40%) 60% 40% 21.42 12.85

Third Dividend Policy* 48% 52% 21.42 11.44

In the above table we can see that the highest growth rate on EPS due to dividend policy
is when the dividend payout ratio is only 20%. This indicates that 80% of the earning
should be retained for the investment opportunity. Internal financing is cheaper than that
of external financing as such it provides advantage of reduction in cost of capital and
hence increase return on capital. Likewise, since the case discloses that many of the
investors who seek for growth are willing to invest in Warner Body due to its prospect of
expansion. this can be opportunity for them.
Hence on the basis of highest growth rate we can justify the second dividend policy with
20% dividend policy should be recommended by Murray.
Working Notes

Calculation of Payout Ratio for Third Dividend Policy

EPS= $2.09
DPS = $1 per share
Dividend payout ratio= {1/2.09} * 100 = 48 percentage

Calculation of Payout Ratio for the fourth dividend policy

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 EPS=$2.09
DPS=$0.5 per share
Dividend payout ratio= {0.5/2.09} * 100 = 24 percentage

Calculation of growth rate (g)

G= ROE * (1-Dividend Payout Ratio) in percentage
Where, return on equity is calculated by dividing Net Income by Shareholder's Equity

Return on Equity 2007 2015

Net income 31.2 104.3
Shareholders’ Equity 97.3 487
ROE 32.07 21.42
Substituting the Dividend Payout ratio in the above equation we found the growth rate for
the analysis part.

Question 9
The tax law was changed to reduce the tax rate on dividends from 70 percent to 50
percent and the capital gains tax rate from 28 percent to 20 percent. How might
these changes have affected Warner Body Works' optimal payout ratio?

Solution:
In the case the stockholders are in high tax bracket due to which only 30% of their
income in form of dividend will remain in hand. In situation of they require cash they can
sell their stock and can earn more since it has tax bracket of only 28%. In this question
the tax effect is reduced to 50 percent and capital gain tax rate is reduced to 20 percent.
To show the effect of these changes in optimal payout ratio further calculation is done as
shown in the table below.

Payou Dividend EAT in DPS Number of share Average

t in million million outstanding {million} Stock Price
policy
0.2 20.86 104.3 0.42 50 14.62
0.3 31.29 104.3 0.63 50 14.62
0.4 41.72 104.3 0.83 50 14.62
0.6 62.58 104.3 1.25 50 14.62

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 Dividend in million Tax @ 70% Tax @ 50% Tax Saving per share
0.42 0.294 0.21 0.084
0.63 0.441 0.315 0.126
0.83 0.581 0.415 0.166
1.25 0.875 0.625 0.25
In the above table Dividend per share is calculated based on the various dividend payout
ratio. Stockholders tend to prefer low tax bracket. As such when tax rate is reduced to
50% the stockholders will be benefited by (0.7*1.25 - 0.5*1.25), $0.25.
Likewise, reduction in capital gain also benefits the stockholders by extra 8% in
principal. Whatsoever reduction in tax rate in still higher than that of capital gain tax rate.
As a result, stockholders prefer to earn through capital gain or they seek for maximization
of shareholder's wealth through expansion and growth. In such a condition the firm
should retain more and use the fund for better investment opportunities which likely to
give higher return. This will definitely enhance the shareholder's wealth. Hence the
optimal payout ratio should be reduced.
Conclusion and Recommendation
Dividend policy is a very important tool for any company. It gives the information
regarding the sound financial position of the company and thus helps the potential
investors to make investment decisions. It is advisable that companies that have
expansion opportunities that promise high return should opt for residual dividend policy.
Whereas those companies that do not have such opportunities should opt for liberal
dividend policy. In this case, Warner Body Works have avenues open for expansion
opportunities with relatively high returns but since it has been following a considerably
liberal dividend policy, it has had to turn down several such opportunities. A company
such as Warner Body Works, that follows a liberal dividend policy of paying out 60% of
its earnings as cash dividends, tends to attract more of income-seeking investors rather
than growth-oriented investors. Therefore, it would be advisable that companies do not
make such liberal and rigid dividend policy from the very start. Moreover, a company
need not always give out cash dividend, it could also opt for stock dividend. Opting for
stock dividend instead of cash dividend would allow the firm to retain some of its earning
and reinvest such earnings in the expansion opportunities available to it thus opening
avenues for growth. Also, this will allow investors that want their earnings retained in the

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business (and not taxed) to hold on to the additional stock paid out to them. Investors that
want current income, on the other hand, can sell the shares they receive from the stock
dividend, pay the tax and pocket the cash - in essence, creating a “do-it-yourself”
dividend.
Another important issue that has been noted in this case is the need to exercise caution
while designing the company’s capital structure. A debt ratio would imply that most of
the company’s earnings would go into interest payments and therefore leading to cash
deficiency. Therefore, a company should also consider internal financing rather than
holding it within the firm as it is cheaper and hence reduces the cost of capital, increasing
the net income of the company. Also, a higher debt in the capital structure would lead to
higher demand for dividend from the part of equity holders because the higher amount of
debt leads to increase in riskiness and the shareholders will sanction additional debt only
if they get higher return. This will ultimately result in the change of dividend policy.
Managers should focus on capital budgeting decisions and ignore investor preferences.

Lessons Learnt
The key lessons learnt from this case are:
1. Although a liberal dividend policy attracts investors, it is not always beneficial
for a company as it would require the company to turn down expansion
opportunities available to it.
2. A company following residual dividend policy can make acquisitions for cash
rather than issuing new stock. The main advantage of this is that the number of
shares outstanding would be lower thus earnings per share would be higher.
3. Stock dividends are better option than cash dividends.
4. The tax advantage of capital gains favors retention of earnings.

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