Case 2: Dividend Policy at Linear Technology

Group 6
Katie Santangelo Bradley Rue Morgan White Viet Nguyen Pui Lam Ming (Clarissa)

Executive Summary Linear Technology is a corporation that specializes in designing, manufacturing, and marketing semiconductors that are used in electronic applications such as cellular telephones, digital cameras, complex medical devices, and navigation systems. Its headquarters are in Milpitas, California, and it was founded in 1981. In April 2003, Paul Coghlan, the chief financial officer, was faced with the decision of whether to increase Linears dividend that quarter. The CFO and the companys CEO, Robert Swanson, were satisfied with the companys third-quarter financials for the 2003 fiscal year. However, the sales and net income still fell significantly below Linears previous record levels. The sales, gross profit, and net income for Linear Technology were at an all-time high in 2001. That year closed with a net income of $427 million. The net income decreased in 2002 to $198 million. The drop in sales led to lower profit sharing. In the fiscal year of 2003, the company experienced growth. The first half of the year had sales of $287 million, while the second half of 2002 had sales of $241 million. There was evident growth in 2003, but they were still far below sales levels from 2001. The dividend payout policy in other technology firms is a strong factor influencing Linears dividend policy decisions. Intel and Maxim are two firms that paid dividends and were used as benchmarks for Linear Technology. Intel first initiated a quarterly dividend of $0.10 per share and Maxim had a quarterly dividend of $0.02. Microsoft declared an initial quarterly dividend of $0.04 and Cisco uses cash for investment opportunities and buying back stock. Linear Technology has a dividend payout policy that is determined by its CFO. Coghlan decided that increased dividends will move Linear Technologys payout ratio to a level that exceeds its competitors.

The central issues to solve in the case are how Linear should deal with its lagging sales, and how they should address this problem in their dividend policy going forward. Tax and Payout Policy Rollins refers to the proposals by President Bush in 2003 which changed the taxation of investment income. President Bush first wanted to eliminate double taxation on dividends, and adjust capital gains tax by making each investors tax base rise by retained and taxed earnings per share. The bill that ended up being passed by Congress was less costly, taxing dividends and capital gains at a rate of 15%. This was still a large decrease in previous taxes on investments. Before this proposal passed, Rollins preferred companies with minimal or no dividends, because of the high income tax rates that applied to income from dividends. After the proposal however, Rollins is indifferent to the policy that companies choose to share their profits with shareholders. If investors pay out dividends, the tax on these dividends will be a much more manageable amount than previously. The company only needs to be concerned with paying out dividends versus buying back shares when considering their current clientele, as well as the type of investors they would like to attract in the future. Dividend as a way to overcome agency problem Dividends can help overcome agency problems by restricting cash available to managers. As the company pays out dividends, less cash is left on hand for managers to make decisions with. This reduces the likelihood of managers throwing excess cash into projects that may have large short term cash flows and possibly result in bonuses for managers, but ultimately have a negative NPV, destroying shareholder value. Using the excess cash to pay dividends shifts the power into the hands of the shareholders, providing them with a steady income while keeping the managers of the company on a tighter, more restrictive cash policy.

Alternatives Both dividend payment and stock repurchase are ways for companies to share earnings with their stockholders. The former would distribute real cash payments which increase stockholders return per share, while the latter increases earnings per share through decreasing the number of shares outstanding. Although both options are appealing towards investors, stock repurchase offers more incentive to investors to continue investing in the stocks as well as to managers to further increase firms value. Repurchasing stocks offers several benefits to both investors and managers over paying dividends. First and foremost, stock repurchase are not taxed while dividends are taxed. Effectively, it would provide more earnings to investors. In addition, dividends are a one-time payment which increases earnings periodically and there is no guarantee that there would definitely be a dividend payment in the case of a bad quarter, whereas with stock repurchase, there would be a continuous increase in earnings because profits earned are split among fewer shares. Secondly, buying back stock can increase a companys return on equity, especially when shares are undervalued. If share prices are undervalued, investors would feel more confident in purchasing the stock, and thus increases demand for the stock in the market. This would lead to an increase in share price and thus earnings per share and return on equity both increase. Moreover, when repurchasing stocks, companies would offer a price higher than the current stock price in order to provide more incentive for investors to sell the stocks. The price offered by the company would indicate the best price the company feels that the stock should be valued at, and this would boost investors confidence.

Thirdly, with dividend payments, stock price tends to decrease which decreases stockholders benefits momentarily, whereas with an effective stock repurchase, stock price would go up, increasing stockholders return. However, there are also disadvantages with stock repurchase option. In order to make full use of stock repurchase, companies need to value their stock correctly. If the stocks are already overpriced, and companies continue to buy back their stocks, it would hurt the stockholders instead. Moreover, unless there is an extremely bad quarter, dividends, once started, are usually paid out periodically, yet stock repurchase may be a one-time action, and thus only benefit stockholders at that time. Scenario Analysis Based on the financial information given, we found out how a special dividend would affect the share price, the earnings and the earnings per share. Using the data, we have found out that a special dividend would result in a dividend of $4.91 per share. That would be the entire cash flow of $1,552 million divided by the total number of shares outstanding which at FYE 2002 was 316.2 million common stock shares. So as of the ex-dividend date, the share price would lower by the amount of the dividend which would make the share price $26.52. Paying out the dividend would have no effect on earnings or earnings per share. If the shares are repurchased then they would repurchase 49,379,574 shares or $1,552 million divided by the original FYE share price of $31.43. If they retained the cash then they earn the interest on the cash. Thus, the $1,552 million would turn into $1,598,560,000 due to the 3% interest rate on retained cash.

Decision Time Now the decision remains whether or not Linear Technology should increase the dividends. The pros of increasing a dividend are that it is a positive signal towards investors. Increasing dividends shows that earnings are up and that the company has the ability to sustain or increase future earnings. Increasing dividends also makes shareholders happy. Shareholders enjoy the increase, because it is an increase in their income. The downside of increasing dividends is that there is less money to invest in positive NPV projects. This means that there is a decreased chance of increasing earnings. Another con is that at the ex-dividend date, the share price decreases. We decided that since the earnings are down that Linear Technology should just maintain or very slightly increase the dividend. With the decrease in earnings we find it unwise to increase the dividend until the economy takes an upswing and earnings are going back in the positive direction. The reason we need to at least sustain our dividend is so we do not send negative signals to investors. If the dividend is increased, it should not be by more than .03 cents per share.