Dividend Policy at Linear Technology - Case Study Example

Dividend Policy at Linear Technology Introduction Dividends refer to the distribution of earnings. These distributions may take the form of cash dividends, share repurchase, stock dividends and stock splits. Cash dividend is the most common form. It affects the value of the firm as well as the wealth of the shareholders as both cash and earnings retained are decreased simultaneously. The repurchase of shares also reduces the value of the company as cash is paid out to shareholders and the number of shares and therefore equity is reduced. Stock splits and stock dividends however, do not involve the outflow of funds nor do they have any impact on the value of the company. Linear technology has used all four types of dividend distributions. The company has used stock splits four times since its initial public offer (IPO) in 1993, 1996, 1999 and 2000, each of which has been 2 for 1 split. The company has also had share purchases every year since 1993 and every year thereafter except in 2000. Most of these share repurchases were done in 2002 and 2003. Choice of dividend policy The dividend policy that Linear Technology chooses at a particular point in time will depend on a number of factors. These factors include the signal it wants to send to its shareholders, the need for funds to invest in new projects, the type of shareholders that the firm has, and the amount of cash the firm has at its disposal. The method of dividend payment should also depend on the tax implications. Investment in New Projects Linear Technology does not appear to be investing in any new projects. The figures also indicate that research and development expenses have declined since it reached its peak in 2001. This signifies that the company has to a certain extent run out of ideas. It is therefore sending the wrong signal to its shareholders who may believe that the company’s growth prospects are good. The only technology company that showed signs of consistent growth over the period has been Microsoft. Linear seems to be totally focused on satisfying shareholders in terms of dividend payouts and maintaining a positive cash flow. There is no mention of any new projects or initiatives to grow the business. If Linear Technology wants to grow it could obtain a loan easily because the company does not currently have any debts. Furthermore, interest on corporate debt is tax exempt and the interest rate on AAA rated corporate debt has fallen every year since 1995. This may help to increase the value of the company and also increase the returns on shareholders funds. An advantage of using debt to fund growth is that interest paid on loans is allowable as a deduction for tax purposes while a dividend is not. Funding Requirements Linear technology desires to have sufficient cash flows so that the company can withstand any financial crisis. The company however, has the capacity to obtain debt. Linear technology manages it payroll expenses by issuing stock options to compensate employees. Therefore, when the company does well employees receive a higher profit share and so the company is able to maintain a positive cash flow as well as pay out dividends on a quarterly basis. Available Resources The company has a significant amount of cash available and this can be backed up with its capacity to borrow. Linear currently has over $1.5m in cash and short term investments. This may not however, be sufficient to finance a major project but would become useful in the company’s bid to obtain a loan as it would provide a cushion in the event that the company is not able to pay interest expenses out of regular earnings. Costs and Benefits of Retaining Excess Funds Retaining excess funds can result in agency costs. Managers may be tempted to pay themselves excessively. It is more likely that they may not exercise care in the use of such funds since the pressures that normally arise from having limited funds do not exist. This lead to a waste of funds that could have been used to pay dividends. The benefits of retaining excess funds are numerous. The company may see opportunities that it can take hold of and so cash may be needed at different points in the future for possibilities such as these as well as planned investments. It is financially prudent always have some funds in reserve instead of continually going to the market to obtain relatively small amount of funds. If the funds are not available to do so it may need to issue more shares or borrow funds. Debt increases the financial risk of the company and therefore places the shareholders investments at risk. Interest and principal payments have to be paid on time in order for Linear Technology to have a good credit rating. There is a cost involved in issuing additional shares which would result in dilution of the company’s earnings. Excess funds may be used as cushion to protect Linear Technology against the uncertainties involved in its operations. The market is competitive and the company may have to lower prices if it is to remain competitive or even stay in business. This may be a short term scenario that could help prevent its early demise. Having excess funds in place in this instance is considered crucial. Takeover possibilities may present themselves and so having excess funds in place could provide Linear Technology with a good chance of financing a takeover. This added to the fact that the company is not geared currently could provide the company with adequate bargaining power to obtain a loan in order to make a successful bid. Dividend as a signal Companies pay dividends to there shareholders for various reasons. They may want to send a signal to the shareholders that they are doing well. However, for some shareholders it may mean that the company’s growth rate is slowing which is true for Linear Technology. The company grew rapidly up to 2001. However, both sales and net income decreased from $972 and 427 in 2001 to $512m and $197m respectively in 2002. The company’s results improved up to the third quarter of 2003 and if things continue in the same manner there will be an improvement over 2002. The fact is, whether or not dividend is paid should depend on the shareholders and what they prefer since the preferences of various shareholder groups vary. The trend in Microsoft’s share price would suggest that the company’s shareholders prefer dividends. However, this does not appear to be the same for Intel, Maxim and Cisco as there are no definite trends to suggest that share prices are in response to the payment or non payment of dividends. Linear technology has consistently paid a constant or an increased dividend whether or not the company does well. Despite the fact that both sales revenue and net income fell to almost 1999 levels in 2002 the company still increased its dividends. It might have been more prudent for the company to allow dividends to remain stable even though some investors would like the company to payout more dividends. Pensioners however, depend on dividends as a form of income and so a fall or non-payment of dividends would send the wrong signal to this group. Dividend Irrelevance Modigliani and Miller’s theory indicates that dividend is irrelevant as shareholders will be able to manufacture their own dividends by simply selling shares. However, this is only so in a perfect capital market environment. Investors will face transaction costs such as brokers’ fees and this tends to deter them from wanting to sell shares as this tends to set off the gains from homemade dividends. If that were not so it would not make a difference whether investors are paid dividends or not as the value of the shares is reduced by the amount of dividends paid out. Again this is not always true as there are various factors that affect the price of share on the stock market. Some of these factors include the demand for the shares at a particular point in time.. It therefore means that the price of Linear Technology shares may be above or below the expected value. Janus Capital Management owns approximately 10% of Linear Technology’s stocks and enjoys the fact that the company pays dividends. This company is somewhat influential based on the percentage of linear Technology’s stock the company owns. It therefore means that if they decide to sell their shares in order to invest in the shares of another company it would seriously affect the value of Linear Technology’s share on the stock market. What really matters to investors who trade regularly is not so much the value of the company in and of itself. It is the value they can get for the shares on the stock market. Janus Capital Management’s senior stock broker’s opinion is very relevant to the dividend policy that Linear Technology chooses. They also welcome Linear Technology’s share repurchase as they benefit from this tremendously when the price of the shares is weak. Preference for dividends Some investors prefer a certain dividends to capital gains from selling shares. Therefore they prefer to invest in companies that pay dividends. This refers to the bird in hand theory which considers it less risky to get some dividend now than capital gains later, which may not realize. Those who abide by that theory will certainly prefer Linear Technology’s policy of not only paying out dividends quarterly but either paying a constant or an increased dividend per share. Some investors depend on dividends to pay expenses. This group includes pensioners. They would be seriously inconvenienced and therefore very disappointed if dividends are not paid out. The tax rate for pensioners is low and so they often fall in a low or zero tax bracket. Impact of dividend policy on share price It is obvious that Linear Technology’s dividend policy has impacted positively on the price of its shares. Since the company has been listed on NASDAQ, its share price has been either at the level of the average S&P share price. It was equal up to 1991 when it started increasing between that time and 1992. Since then it has been way above the average price of the S&P shares. However, there are other things that may have contributed to this inclusive of the company’s positive cash flows and the fact that the company’s shareholders bear no financial risk compared to other companies that have debt as part of their capital structure. It is worthy of note that the market to book ratio of non-dividend payers have been higher than dividend payers since 1990.Howver, there has been a change since 2001, obviously in anticipation of the tax changes. The Choice between Dividends and Repurchases The choice between dividends and the repurchase of shares would be influenced by the tax implications of both. Repurchase of shares results in capital gains. In the past the tax rate was lower for repurchases than dividends and therefore it benefited shareholders. However, with the changes that has come on stream since 2002 both are taxed at the same rate of 15 per cent and so they are really not any different in terms of their tax implications and their effects on the value of Linear Technology. Apparently Linear technology did not pay any attention to the fact that tax on dividends were above corporate tax rates for most of the years that the company paid dividends and that it would have been better to encourage shareholders to opt for stock repurchase instead of dividend income which was highly taxed. However, in a stock repurchase shareholders have a choice to sell or not to sell. Once a dividend payment is made they have to accept it. Additionally, tax on capital gains is normally deferred until shares are sold while it is taken immediately on dividends. Historical Trends in payout Policy The company’s dividends per share has never fallen below the previous period and even though sales and earnings fell to almost 1999 levels in 2002 the dividends per share was higher than the best year the company experienced in 2001. The company has also been carrying out regular repurchases of stocks. The only year that no repurchases were done was in 2000. Current tax and Market Environment The current tax environment augurs well for dividend payments. The tax rate is now below that of corporation tax and is now the same as capital gains tax. It therefore means that both institutional and individual shareholders will benefit more from dividend payments as they will not be taxed significantly as they were in the past. Since the announcement in 2002 Microsoft announced their first dividend payment. Microsoft focused on the tax implications of paying dividends to shareholders in their companies. Conclusion Linear Technology started paying dividends in 1992 approximately six years after it was listed on NASDAQ. This meant that the company gave itself sometime to grow to a certain level to the extent that it thought that its earnings were somewhat sustainable before it started paying out dividends. The company started to pay dividends in order to signal to its shareholders that the company was profitable and not as risky as investing in other technology companies. They also believed that by paying out dividends this would provide an incentive to investors who invests in stocks to obtain regular dividends to become attracted to and therefore invest in Linear Technology’s stocks. European investment firms which prefer to invest in firms that pay dividends would therefore be attracted to Linear Technology’s stocks. An optimal dividend policy can contribute to Linear Technology’s profitability, However, the company’s ultimate success will depend on its investment decisions. 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