Financial Decisions

11 Dividends v. Growth

Instructor: A. Ashta

References: Higgins Ch. 4

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Dividend Policy
What should be payout ratio?

Alternative uses of cash

Capital expenditure Reducing Debt

Financing Growth 1. GROWTH & MANAGEMENT

Product Life Cycle Management Objectives Growth requires assets and financing Sustainable Growth equation Management Strategies

2. SUSTAINABLE GROWTH 3. TOO MUCH GROWTH 4. TOO LITTLE GROWTH

Management Strategies

5. GROWTH AND INFLATION

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1. GROWTH & MANAGEMENT

Product Life Cycle
Introduction Growth Maturity Decline
Cash Infusion Cash Infusion Cash Surplus Cash Surplus

Management Objectives
Maximum possible growth Unwilling to sell new equity Maintain / Target capital structure Maintain / Target Dividend Policy
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2. New Sales Require New Assets, Which Must Be Financed

Assets Liabilities and owners equity

New assets supporting increased sales

New borrowings Increases in Owners equity

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SUSTAINABLE GROWTH
New Assets required for Sales Growth
Working Capital Needs Fixed Asset Needs

Financing required for Asset Growth Financing limits Growth

Own funds limited to Retained Earnings Debt limited in proportion to RE So, total funding is limited This limits assets growth This limits sustainable Growth

The Sustainable Growth Equation

g = PART* = R x ROE
P = Profit Margin, A = Asset Turnover, R = Retention Rate, T* = Equity Multiplier (Financial Leverage) based on Opening Equity
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Sustainable Growth Equation

g = (1 - b) x RO = R x RO RE EAT Sales Assets = x x x EAT Sales Assets Opening Equity

g = growth rate b = dividend distribution rate R = retention rate RE = Retained Earnings EAT = Earnings after tax = Opening Equity
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An example of Sustainable Growth rate with no debt

Year Capital = Equity Assets Sales Cost EAT Dividend Retained Earnings Growth Dividend payout ratio Retention Ratio ROE Case 1 0 100 100 1000 800 200 120 80 0,6 0,4 200% 1 180 180 1800 1440 360 Case 2 0 100 100 1000 800 200 200 0 1 0 200% 1 100 100 1000 800 200 Case 3 0 100 100 1000 800 200 0 200 0 1 200%
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1 300 300 3000 2400 600

80,00%

0%

200%

An example of sustainable growth rate with some debt

Year Equity Debt Capital Assets Asset turnov er Sales Cost EAT=20% profit margin Div idend Retained Earnings Growth Div idend payout ratio Retention Ratio ROE With no debt 0 1 0 100 100 180 100 180 10 10 1000 1800 800 1440 200 360 120 80 80,00% 0,6 0,4 200% With debt 0 1 60 140 40 93,33333333 100 233,3333333 100 233,33 10 10 1000 2333 800 1866,4 200 466,6 120 80 133% 0,6 0,4 200%

growth rate= Profit margin x retention ratio x Turnov Lev Asset er x erage 1,333333333 0,2 0,4 10 1,666666667
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A Graphical Representation of Sustainable Growth (from the book)

60 Growth rate in sales (%) 50 40 30 20 10 0 0 5 10 15

Cash deficits

Balanced growth g* = 1.4 ROA

Balanced growth g* = 0.4 ROA Cash surpluses

20

25

30

35

40

Return on assets (%)

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A Sustainable Growth Analysis of Triad Guarantee Inc., 1994 - 1998

1994 Required ratios: Profit margin, P Retention ratio, R Asset turnover, A (times) Financial leverage T^ (times) Triad's sustainable growth rate, g* (%) Triad's actual growth rate, g (%) 0,39 1,00 0,20 1,30 10,01 53,2

1995 0,38 1,00 0,21 1,41 11,25 36,4

1996 0,37 1,00 0,27 1,40 13,99 46,5

1997 0,39 1,00 0,32 1,52 18,97 49,3

1998 0,39 1,00 0,31 1,84 22,25 40,6

Asset Turnover 0.4 Times Triad's sustainable growth rate in 1998 (%) 28,70

What If? Financial Leverage 2.2 Times 26,6

Both Occur 34,3

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Triad Guarantee Inc., Sustainable Growth Challenges, 1994 1998

60
1994

50 Growth rate in sales (%)

Cash deficits 1996

1997

40
1995

1998

30

20
Balanced grow th 1998

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Balanced grow th 1994 Cash surpluses

0 0 2 4 6 8 10 12 14 Return on assets (%)

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3. Financing Growth: TOO MUCH

GROWTH
Sell new Equity
Rarely used: Not required, expensive, reduces EPS, market price undervalued, uncertainty of issue success

Increase Leverage
After a limit, increases cost of financing, risk

Reduce Payout
Limited to zero dividends

Profitable Pruning
Sell Disconcentric Diversifications Limits managment focus, Shareholders can achieve it by buying shares Reduces total growth and cash needs Sell slow-moving stock and debtors

Sourcing
Releases assets, Increases Asset turnover Retain unique or core competencies

Price increase
Reduces demand and growth Increases Profit margin and financing
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Mergers

4.Financing Growth: TOO LITTLE GROWTH

Ignore Problem
Become Target for takeover

Reduce Leverage Return Money to shareholders

Repurchase shares Higher Dividends

Buy Growth
But share prices fully reflect the targets future performance
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Financing Growth: Growth and

Inflation
Both Real Growth and inflation create similar financing needs
Working capital repsonds immediately Fixed assets respond after a lag

Inflation and growth signify compounded problem Inflation reduces value of debt
Inflation reduces value of future repayments, and so market value of debt. This should result in increased capacity. But bankers still use historical costs and limit financing.
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Sources of Capital to U.S. Nonfinancial Corporations, 1965 - 1998

Internal Retained profits Depreciation Subtotal External Increased liabilities New equity issues Subtotal Total

15.1% 50.5% 65.6%

41.5% -7.1% 34.4% 100.0%

Sources: Federal Reserve System, Flow of Funds Accounts, 1949-78, and Flow of Funds Accounts, various issues. Available at http://www.bog.frb.fed.us/releases/z1/htm.
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Net New Equity Issues, 1965 - 1998

100
Japan

50 0 Dollars in billions -50 -100

U.S.

U.K.

Germany

-150 -200 -250 -300 Year

1969

1974

1979

1984

1989

1994

Sources: Federal Reserve System, Flow of Funds Accounts, 1949-78 and various issues; OECD, Financial Statistics, Part 2, Financial Accounts of OECD Countries, various issues.
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Gross New Equity Issues and Initial Public Offerings, 1970 -1998
140

120

100

Dollars in billions

80

Gross new equity

60

40

IPOs
20

0 1970

1975

1980

1985

1990

1995

2000
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The Timberland Company, Sustainable Growth Calculations, 1995 - 1998

1995 Required ratios: Profit margin, P (%) Retention ratio, R (%) Asset turnover, A (times) Financial leverage, T^ (times) Timberland's sustainable growth rate, g* (%) Timberland's actual growth rate, g (%) (1,8) 100 1,6 2,8 (7,8) 2,8

1996 3,0 100 1,5 3,2 14,3 5,3

1997 5,9 100 1,9 2,5 28,6 15,4

1998 6,9 100 1,8 2,2 27,5 8,2

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Timberland Companys Sustainable Growth Problems, 1995 -1998

40 35 30 Growth rate in sales (%) 25 20 15 10

1996 1995 Balanced Grow th 1998 1997 Balanced Grow th 1995 Cash deficits

5 -1 0 (5) (10) Return on assets (%)

Cash surpluses

1998

-3

-2

10

11

12

13

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Calculate for the years 1997-2001

Profit Margin Retention ratio Asset turnover Financial Leverage (Hint: Use opening equity) Sustainable Growth rate Actual growth rate

Friedmans Inc. ($ in millions) 1996 Sales Net income Total assets Equity Dividends 145 190 1997 240 20 220 170 0 1998 290 11 270 180 0 1999 340 17 275 190 1 2000 410 20 320 210 2 2001 450 12 450 220
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1997 Profit margin Retention ratio Asset turnover Financial leverage Sustainable growth Actual growth

1998

1999

2000

2001

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1997 Profit margin Retention ratio Asset turnover Financial leverage Sustainable growth Actual growth 8,33% 1,00 1,09 1,52 13,79% 26,32%

1998 3,79% 1,00 1,07 1,59 6,47% 20,83%

1999 5,00% 0,94 1,24 1,53 8,89% 17,24%

2000 4,88% 0,90 1,28 1,68 9,47% 20,59%

2001 2,67% 0,75 1,00 2,14 4,29% 9,76%

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Questions?
Q. Do you think Friedmans Inc. is having a problem financing its growth?

Q. Is the increase in dividends a good idea for Friedmans?

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Questions?
Q. Do you think Friedmans Inc. is having a problem financing its growth?
Friedman has crossed his sustainable growth rate each year and has financed it by increasing its financial leverage and risk.

Q. Is the increase in dividends a good idea for Friedmans?

The raising of dividends has exacerbated the problem
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Setting Dividend Policy

Firms should ask the following questions when establishing dividend policy:
What are our investment opportunities? What kind of business risk do we face? Who are our stockholders? What is our liquidity position? Is legal listing important to us? Is control an issue?

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Readings
Campbell, Andrew & Park, Robert: Stop kissing frogs in HBR,July-Aug 2004
Recommend patience Careful assessment of growth opportunities Giving back cash otherwise

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