HULT INTERNATIONAL BUSINESS SCHOOL MFIN : Corporate Finance Professor: Herb Meiberger

Case Solution: Dividend Policy at Linear Technology

Introduction:

Submitted by: Ashmita Srivastava Student ID: 86177

Linear Technology was founded in 1981 by Robert Swanson and is currently headquartered in Milpitas, California. Its primary focus is on designing, manufacturing and marketing integrated circuits used in cellular phones, digital cameras etc. It went public in 1986 on NASDAQ. The major forms of employee compensation for the company are profit sharing and employee stock option plans. Trends in Dividends: Linear Technology announced its first dividend on October 13th, 1992 @ $0.05 per share. The dividend was set low very thoughtfully because the company did not want to get in trouble in the long term by cutting dividends and a low payout ratio resulting in low investors confidence. Reasons for declaring dividends: Linear Technology was very well positioned in the industry. Positive cash flows To gain Investors confidence Access to new investors Major issues with declaring DividendsThere are a lot of controversies attached to declaring a dividend especially by a high tech company expecting good growth The general phenomenon is that declaring dividends sends a signal to the market that the growth rate of the company is expected to slow down in future. Tech companies compensate dividends by offering Stock options to their employees and hence use excess cash to repurchase shares to compensate the dilution caused when employees exercise the stock options. Declaring dividend increases the no. of shares outstanding lowering the earnings per share. Dividends are taxed twice at corporate level and at investor level, and hence repurchase is better. If the company declares an increase in dividend in 4th quarter of April 2003, its payout ratio will be higher than many tech companies in the industry Agency ProblemA major dilemma while deciding about whether to choose cash dividends or reinvesting arises because of the conflict of goals of stockholders and the management. If the cash dividend is declared, it will lower the cash balance and hence there will be less cash available for positive Net Present Value projects lowering the wealth of the company which is not desirable for the management but cash dividends makes the shareholders happy. Dividend Policies of the Competitors: It is not common for high tech companies to provide dividends. It is evident from the dividend policy at Maxim and Microsoft, who declared their first dividend as late as in 2002 and 2003

respectively. Cisco decided not to offer any dividends and to use its cash for investment and buyback purposes. It was only Intel that declared its dividends in the year 1992, a month before Linear technology declared theirs.

Analysis:
A company has the following options to distribute cash to its shareholders-

Payout Ratio Over the past 5 years1998 10.11% 1999 11.37% 2000 9.72% 2001 9.64% 2002 27.32%

Payout ratio= Dividend on Common Equity / Net Income (Exhibit 1)

Net Profit Ratio over the past 5 years: 1998 37.3% 1999 38.3% 2000 40.78% 2001 43.9% 2002 38.7%

Net Profit ratio= Net Income/Sales (Exhibit 1) LT is expecting its payout ratio to be around 25% to 30% in future. The Net Profit ratio seems quite impressing. As seen in Exhibit 2, LT has 6th highest cash balance ($1552 Million) compared to the companies in the semiconductor Index (SOX) in 2002 and $1.5 Billion by the end of 3Q of 2003. Linear Technologys current position: With a high payout ratio, net profit ratio and cash balance, LT had a lot of options to deal with its cash balance. However, it had no plans of acquisitions and hence a major use of cash was to be ignored. Now, there are 2 options- Increase in the dividends or repurchase of shares with is slow growth rate against the benchmark standards. It has involved itself in a stock split four times since the 1992, indicating that stock prices were quite high. If Dividends are increased:

If the dividends are increased, it is a good indicator that company can sustain it over a long period of time but at the same time it sends signal to the market about its slow growth which decreases its stock price. It will also result in a high payout ratio than most of the firms in the industry. Though it will make shareholders happy but according to Miller and Modigliani, as long as the firm is earning return that is expected by the market, it does not really matter if the returns to the shareholders come in the form of dividends or repurchase of shares. If repurchase of shares is done: If there is a repurchase of shares, it indicates that the company has less shares outstanding and hence the Earnings per share rises. It is a good way to distribute cash amongst the shareholders without raising dividends and hence avoiding the double taxation problem. It also send signals to the market that the share price of a company might rise as the company buyback shares when the share price is low. However, it is important that the company makes this decision at the right time by pricing its shares accurately.

Conclusion and Recommendation:

The decision depends on companys present and future growth as well as the pros and cons of both, declaring an increase in dividend and repurchase of shares. Paying cash dividends will not only reduce cash to invest in profitable projects but also involve double taxation and fall in stock price problems. On the other hand, repurchase of shares can increase shareholders wealth without raising dividends and hence avoiding double taxation and wrong signaling to the market about slower growth rate in future. As it is evident that there is no need of any financing for Linear Technology and it already has a high payout ratio, in my opinion it should not declare a further increase in dividends. Declaring an increase in dividends will further increase the payout ratio, not withstanding with the trend of the industry. Also, it would be a safe game to keep the dividends at present level to avoid any dividend cuts in future lowering investors confidence and also at the same time retain investors confidence by still offering a dividend.