- Describe the payout policy of Linear Technology
Linear Technology’s payout policy involves stock repurchase and dividend payout. Firms opt for payout dividends after a move from a high growth state to a mature or more stable state. The company has been repurchasing stocks, although employee compensation is sometimes done using stock options and profit sharing (Baker, & Berkley Wagonfeld, 2003). The market interest rates have been low and with the company wanting to use case conservatively, it opts for buying its own stock. Unlike dividends, stock repurchases do not impact the value of the firm. Further, Linear Technology has been paying dividend since 1992 due to the good expectations derived from analog circuits and being a top performer in the industry. After issuing its initial public offering, Linear Technology posted positive cash flows.
Dividend payout indicates a strong market position for the company, as well as a move to a mature state. Linear Technology had set the initial dividend per share at $0.05 with nominal dividend increasing annually by about 15% to 50% depending on the cash balance and financial performance (Baker, & Berkley Wagonfeld, 2003). The company has paid dividends each quarter. The payment of dividend has been done to attract investors into the company in a thoughtful payout ratio. A low level of dividend would be made even when the company gets less than expected earnings. Therefore, Linear Technology does not stop paying dividends to its investors, as payout has kept on growing with 2003 growth being 25%.
2. Why do firms pay dividends? Why has the rate of dividend initiations changed over time?
Companies pay dividend to reward their shareholders for capital provision to run the business. The board of directors determines the percentage of earning to utilize in paying dividends, as well as the amount to retain in the business. Further, companies would pay dividend to minimize agency costs concerning the high cash-low debt capital structures that may occur in the event dividend is not paid. Therefore, dividends are a better way of sharing profits with investors and entice them to continue investing with the company. When a company’s share prices are stagnant or plummeting, dividends help investors make a profit. However, dividends could attract more investors, thus leading to an increase in the company’s stock price. Dividends are an indication of a firm’s financial well-being (Baker, & Berkley Wagonfeld, 2003).
The rate of dividend initiations has changed from between 1962 and 2000 starting with an increase from 1970 and 1980. It then went down suddenly and moved slowly thereafter at an average rate of 2%. These changes could be attributed to the company’s dividend payout policy over the years the rate of dividend initiations changed. When a company initiates a dividend, it is possible that it makes profits, but with no possibility of growth (Baker, & Berkley Wagonfeld, 2003). The stock is then sold, thereby decreasing the stock prices. Linear Technology over the last year initiated less and less dividends, an indication that the firm was still growing while reinvesting. However, its stock prices have not dropped much.
3. Should Linear return cash to its shareholders?
Linear Technology should return cash internally and reinvest for taxation purposes. Linear Technology’s dividends and stock repurchases are taxed at the personal rate of the investors. The investors’ tax rate relative to the firm’s determines whether the company would keep cash in the firm or buy back shares. The option type indicates that taxes are imposed at the corporate rate and then at personal rate. Linear Technology’s tax rate is 29% while in 2001, it was 30%, which was more than twice the income before taxes (Baker, & Berkley Wagonfeld, 2003). As such, if the shareholder tax rate is higher, then the company should keep the cash internally. The company should return enough cash to invest in NPV projects, but at the same time avoid getting into future business risks.
Linear Technology could return the cash to shareholders by spending half of it in repurchasing stock on cash since it has fallen from $65 to $30.98 (Baker, & Berkley Wagonfeld, 2003). It would allow the stock to go up, leaving Linear Technology with a cash buffer if they need to make a strategic acquisition. Additionally, the company needs to continue the policy of paying dividends with a slight increase as it has done over the past years. Such a decision would ensure that investors and mutual funds that require dividends would invest more in Linear technology providing a comfort to investors that the company maintains enough cash generation to sustain a growth in dividend. To avoid stock price shocks, Linear technology should announce its dividend policy on the same day.
4. If Linear were to pay out its entire cash balance as a special dividend, what would be the effect on value? On the share price? On earnings? On earnings per share?
Paying out entire cash balance would have no change on Linear Technology’s value. The number of shares and share value would not change as shown in 2003 figures. An increase in share price is evident as the addition of special dividend to the share value is executed. The company’s earnings before interest and taxes remain unchanged as monies used are from Linear Technology’s cash balance which does not impact income. An increase in earning coincides with an increase in earnings per share. Further, paying out entire case as a special dividend might lead to a lack of funds for operations, forcing the company to lower the share prices to enable more investors to buy them cheaply to raise the needed funds for operations (Baker, & Berkley Wagonfeld, 2003). Stiff competition might arise affecting Linear technology’s operations.
Earnings before interest and taxes would also remain the same as before the special dividend pay-out since it comes from the cash balance and has no effect on the income. A repurchase reduces the company’s outstanding shares, the market value is distributed between less shares. As such, the new share price would be more important than the original price. A similar effect would be witnessed for the company’s earnings per share. An increase for the earnings would translate to the same for the earnings per share. Since a reduction in the number of shares is made, the earnings per share becomes greater than the original earnings per share (Baker, & Berkley Wagonfeld, 2003).
5. What if Linear Technology repurchased shares instead of providing a payout?
A share repurchase is a tax-efficient method of rewarding shareholders, which could positively affect the company’s earnings per share and share price. A share repurchase for Linear technology would improve its earnings per share, thereby sending a positive message to investors about the firm’s profitability. It may boost Linear technology’s share price in the long run. However, repurchasing of shares could indicate a shortage of profitable investment opportunities or a lack of confidence in Linear Technology’s short-term financial prospects (Baker, & Berkley Wagonfeld, 2003). Repurchase of shares would afford Linear technology a lot of flexibility since it can go into the market at any convenient time. The repurchase would drive value for the company’s shareholders.
The company could make an offer to shareholders to buy a fixed number of shares at a fixed price above the current market price. Repurchasing shares would, however, have a small negative earnings per share surprise associated with the changes in corporate policies. Firms decrease employment or research and development, which could also translate into a significant decrease in cash holdings (Kumar, & Lee, 2006). However, there would be no change in debt or equity issuance in this case. Since repurchasing shares reduces a firm’s outstanding shares, an impact would be felt in per-share measures of profitability and case flows, for example, the company’s cash flow per share and earnings per share.
6. What should Paul Coghlan recommend to the board?
Shareholders see a company’s dividend as its growth potential. Since Linear Technology could afford more dividend than closest rivals, the company needs less cash for future investments. As such, the company should not hold case due to the underlying low risk rate. The company needs to focus on keeping investors satisfied since they influence the prices of the stock. Therefore, Paul Coghlan should recommend to the board a launch of a massive share repurchase to help pay back stockholders without the influence of tax rate on dividends. The company needs to keep the same dividend of $0.05 per share quarterly.
Repurchasing of, for example, $55.9 million shares a minimum as was evident in 2003 could be considered. Paul might advise the board to keep the dividend constant since the payments seem inflexible. Rather than paying out dividend on the current quarter, Linear Technology could repurchase stock or invest the capital assets, which could save the company of higher income taxes. Linear Technology stands to benefit in the long run due to the buyback in earnings per share, thereby generating more demand for stocks.
References
Baker, M. P. & Berkley Wagonfeld, A. (2003). Dividend policy at linear technology, HBS Case 9-204-066. Retrieved from Harvard Business Publishing https://cb.hbsp.harvard.edu/cbmp/access/37227892
Kumar, A. & Lee, C. (2006). Retail investor sentiment and return comovements. Journal of Finance, 61(5), 2451–2486.
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