2013

Warner Body
Works
A case study on dividend policy
Submitted by:
Minakshi Pathak
Muna Baral
Padam Shrestha
Pragati Dahal
Prathana Shrestha
Ravi Bhandari
Rithu Malekhu
Rubina Shrestha

Financial Management
Instructor: Dr. Radhe shyam Pradhan
2013/04/10

Table of Contents
Chapter 1 Introduction.1
1.1 Background of the case..........................................................................................................3
1.2 Statement of the problem.......................................................................................................4
1.4 Objectives of the case study..................................................................................................4
1.5 Significance of the case study................................................................................................4
1.6 Organization of the case study...............................................................................................4
Chapter 2 Literature Review............................................................................................................5
Chapter 3 Research Methodology...................................................................................................8
Chapter 4 Analysis of the case.......................................................................................................10
Question 1..................................................................................................................................10
Question 2..................................................................................................................................16
Question 3..................................................................................................................................19
Question 4..................................................................................................................................21
Question 5..................................................................................................................................25
Question 6..................................................................................................................................26
Question 7..................................................................................................................................28
Question 8..................................................................................................................................31
Question 9..................................................................................................................................33
Chapter 5 Conclusion and Recommendation................................................................................35
5.1 Lessons Learnt.....................................................................................................................36

Chapter 1 Introduction
1.1 Background of the caseWarner Body works is one of the leading producers of custom coachwork for auto mobiles
delivery trucks and other special purpose vehicles. In 2000, 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 directors meeting to plan for the coming
year. At the meeting of January 2006, the various issues regarding the companys 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 (70%) 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 companys current ratio had
decreased and debt ratio had increased by a great amount since 1997 to 2005.
On the other hand, it was argued that the company would loose 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.

1.2 Statement of the problem

This case analysis will deal with following problems

Analyze the four options of dividend policies the firm can undertake and determine
which will be most profitable for the company.

The implications of the announcing their change in dividend policy.

1.4 Objectives of the case study

To understand the use of various dividend policies and their effects on share prices.

To understand the implications of tax rates on dividend policies.

To understand the implications of announcing dividend policy.

1.5 Significance of the case study

This case dealt with analyzing different dividend policies that the firms could undertake at
different situations, their advantages and disadvantages, which are relevant to the financial
concepts studied in our financial management course. We also got a view of how capital gains
are different from dividend policies from the point of view of stock holders as well as company
directors and how these affect the price per share of the company.
1.6 Organization of the case study
The overall report is divided into five chapters. First chapter deals with background of the study,
introduction of the case Warner Body Works, statement of problem, objectives of the study,
significance of the study, organization of the study. The second chapter literature review deals
with the review of the conceptual framework for the study. The third chapter research
methodology deals with how the case has been carried out and consists of the units like research
design, source of data, data selection procedure and the limitations of the study. The fourth
chapter deals case analysis and discussion of the questions. The fifth chapter consists of the
conclusion and recommendations of the case.

Chapter 2 Literature Review

Dividend policy determines the division of earnings between payments to stock holders and
reinvestment in the firm as retained earnings. Retained earnings are one of the most significant
sources of funds for financing corporate growth, but dividends constitute the cash flow that
accrues to the stockholders.
Dividends may affect capital structure.
Retaining earnings increases common equity relative to debt.
Financing with retained earnings is cheaper than issuing new common equity.
Dividend Payout Ratio
The

percentage

of

earnings

paid

to

shareholders

in

dividends.

Calculated as:

The payout ratio provides an idea of how well earnings support the dividend payments. More
mature companies tend to have a higher payout ratio.
Retention

Ratio

The percent of earnings credited to retained earnings. In other words, the proportion of net
income that is not paid out as dividends.
Calculated as:

The retention ratio is the opposite of the dividend payout ratio. In fact, it can also be calculated
as one minus the dividend payout ratio.

Dividend Policy and Stock Value

There are various theories that try to explain the relationship of a firm's dividend policy and
common stock value.
Dividend Irrelevance Theory
This theory purports that a firm's dividend policy has no effect on either its value or its cost of
capital. Investors value dividends and capital gains equally.
Optimal Dividend Policy
Proponents believe that there is a dividend policy that strikes a balance between current
dividends and future growth that maximizes the firm's stock price.
Dividend Relevance Theory
The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that
maximizes the firm's value.

Investors and Dividend Policy

Information Content, or Signaling
Signaling hypothesis says that investors regard dividend changes as signals of management's
earnings forecasts.
Clientele Effect
The clientele effect is the tendency of a firm to attract the type of investor who likes its dividend
policy.

Free Cash Flow Hypothesis

All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net
present value projects (free cash flows), have higher values than firms that retain free cash flows.

Dividend / Retained Earnings Decision

There are various constraints that may impact on a firm's decision to pay out earnings in the form
of dividends.
Cash flow constraints
Contractual constraints
Legal constraints
Tax considerations
Return considerations

Types of Dividend Policies

Constant Dollar Dividend Policy
Constant Payout Ratio
Regular with Extras

Chapter 3 Research Methodology

Research is defined as human activity based on intellectual application in the investigation of
matter. The primary purpose for applied research is discovering, interpreting, and the
development of methods and systems for the advancement of human knowledge on a wide
variety of scientific matters of our world and the universe.

3.1 Research Design

The research was started with an objective of studying and analyzing the dividend policy
problems of the Warner Body Works. To meet this objective, all the necessary information
(descriptive data) is collected and then presented.
3.1.1 Descriptive research
To further support the study, descriptive research was conducted. The descriptive research was
carried out to study and analyze the methods of enhancing performance in similar situations. In
the course of descriptive research, Internet was used as the major source.
3.2 Data collection procedures
3.2.1 Sources of data
Only secondary data have been used for the purpose of the study.
Secondary Data
a. Internet searching
b. Text books
3.3 Data Analysis Tools
Collected data have been categorized into homogeneous nature for clear understanding and
these data have been presented in graphs, bar diagrams and figures.

3.4 Limitations of the study

It has certain limitations that are as follows:

The case analysis was completed in a very short span of time. So due to the time
constraint, the analysis may not deal with the minute issues related with the topic under
study.

The analysis part of the study only deals with a certain time period and ignores other
times where significant events may have occurred and thus caused price fluctuations in
the concerned market.

The case analysis depends extensively on quantitative analysis as an in depth analysis of

numerical were necessary. The research papers that were consulted to some extent
showed varied results and thus created confusion.

Chapter 4 Analysis of the case

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
firms 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 firms 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.
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 companys share.

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A regular dividend policy decrease 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 help 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.

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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.
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 2005 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:

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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 amount
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.
Advantages:

This policy could be considered right if the firms 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.

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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.

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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:
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.

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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 lead 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 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

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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.

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

Net Income(EAT)
Share holder's Equity
Return on Equity(ROE)

1997
31.2
97.3
32.07%

2005
104.3
487
21.41%

Here,
g = ROE*(1 - DPR)
Where, g = growth rate
ROE = Return on Equity
DPR = Dividend Payout Ratio
For 1997, g = 32.07(1-0.6)
= 12.826%
For 2005, g = 21.41%(1-0.6) = 8.56%

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In the above calculation for the year 1997 given an ROE of 32.07% and a dividend payout of
60% the growth rate is 12.8326%. Likewise for the year 2005 when ROE is 21.41% and a
dividend payout is 60% the growth rate in 8.56%. In the year 2005 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 ration is constant @ 60%. The reason
behind this is that retained earning 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 2005. This reduces the net income after tax and with the increased accumulated retained
earning 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
1997, ROE = 25 + 72.3 = 97.3
2005, ROE = 50 + 437 = 487

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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
Playboy
Uniroyal
Hewlett Packard
Data point
Texas instrument
Xerox
ATT
Allied Stores

Payout
17%
0%
11%
0%
30%
40%
67%
45%

P/E
25
19
17
16
13
10
8
6

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

21

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 earning 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.
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 companys 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.

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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 investors returns. But in
the last 20 years, its 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 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 earning 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.

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Question 5
How does the firms debt position affect the dividend policy?
Solution:
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.

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Question 6
Evaluate Murrays argument that a reduction in the dividend payout rate would increase
the price of the stock versus Basslers opinion that such a reduction would drastically
reduce the price of the stock.
Solution:
Mark Bassler, trustee of the endowment fund of major university and long time member of
Warners 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
companys stock price is likely to soar up.
From the above evaluation of the two arguments, it can be seen that Murrays argument has more
weight than that of Basslers. In fact, what Murray suggests covers for the gap/ problem

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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 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 Murrays argument rather than Basslers.

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Question 7
Might stock dividends be of use here?
Solution:
A stock dividend is a pro-rata distribution of additional shares of a companys 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 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. Heres 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 companys market capitalization is still $100 million.
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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 companys 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.
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 investors 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 companys 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

29

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-ityourself dividend.

30

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 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

Dividend Policies
First Dividend Policy
Second Dividend Policy
DPR (20%)
DPR (30%)
DPR (40%)
Third Dividend Policy*

Retention

Dividend

Ratio

Payout Ratio

ROE

g%

40%

60%

21.42

8.57

80%
70%
60%

20%
30%
40%

21.42
21.42
21.42

17.14
14.99
12.85

48%

52%

21.42

11.44

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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
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
Net income
Shareholders' Equity
ROE

1997
31.2
97.3
32.07

2005
104.3
487
21.42

Substituting the Dividend Payout ratio in the above equation we found the growth rate for the
analysis part.

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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 theses 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.

Number
Payout

Dividend

EAT

policy
0.2
0.3
0.4
0.6

in million
20.86
31.29
41.72
62.58

million
104.3
104.3
104.3
104.3

in
DPS
0.42
0.63
0.83
1.25

of

share

Average

outstanding

Stock

{million}
50
50
50
50

Price
14.62
14.62
14.62
14.62

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.
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Chapter 5 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 incomeseeking 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
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 companys capital structure. A debt ratio would imply that most of the
companys 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.

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5.1 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
2.

available to it.
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

3.
4.

outstanding would be lower thus earnings per share would be higher.

Stock dividends are better option than cash dividends.
The tax advantage of capital gains favors retention of earnings.

35