Ih CASE 46 AT&T DIVIDEND POLICY On January 9, 1982, AT&T signed a consent decree with the US. Justice Department, which had argued that AT&T was making it tough for people to buy equipment and services from competing companies. The proposed remedy. was to have AT&T spin off the companies that provide local telephone service. These companies—commonly called “Baby Bells’—still enjoy a monopoly over substantial portions of their slow-gmwing but stable markets, In contrast, AT&T was to provide high-tech equipment and services in fast-growing areas. Asaresult, when the breakup finally happened in 1984, AT&T was transformed from a company with extremely stable camings into a multibilliondollar start- up operation with uncertain earning: potential. Thenew AT&T had to decide on a dividend policy. The following case uses fictitious characters and conversa tions, but the issues discussed were very real, ‘The AT&T board of directors set up a committee to study and recommend how: much to pay out as dividends. The committee has’ four members: Jerry ‘Cunningham, chief financial officer, who has the responsibility to keep the com= pany financially sound Joan Sheehan investor relations manager, Whose function is to provide a conduit for information to investors and to keep investors ashappy as possible; Brian Kennedy, an outside director who heads a high-tech company; and Bill Larson, another outside director, who heads a mature, highly successful auto manufacturing firm, The following isa transoript of their meeting, SHEEHAN Up until divestiture, ATST followed the same approachas most other utilitieswe paid stable, generous dividends, By that, Imean the dividend was 70-80 percent of the eamings in a normal year. Since earnings grew steadily with only occasional, small declines, the dividend rate could be periodically increased, Of course, the dividend was never cut, even in bad years, because shareholders depended on the dividend, Widows and orphans could buy thestock, secure in the knowledge that therewould be no surprises, There were many other owners too—stable dividends have a lot of devotees. Naturally, over the years, we acquired a set of stockholders who liked that dividendCASE 46 ATST 297 policy. Our first option is to keep these shareholders happy and continue the same pattem: pay gut a lange perentage of normal eamnings. ‘LARSON I’m afraid you'll find that policy is no longer practical. Look at the ‘businesses you're in today. You have long-distance calling, where MCI, Sprint, and other people are trying to eat your lunch. You manufacture telephone equipment, but you have no track reaord asan independent company on which to base sales forecasts. You have a new line of PCs—just like every other high- tech company. And you've got whatever gadgets are developed by the research, group, which will ‘probably entail substantial start-up costs. There’s lots of promise here, but there's also lots of risk and variability. If you try to pay out ahigh percentage of your normal eamings, you'll find that you'll eam less than dividends in some years. That means youd have to draw down your capital reserves to pay’ dividends! Shareholders don’t like that kind of thing. ‘cunninciam Some chief financial officers don’t like that kind of thing, either! ‘This corporation is constrained by theamountof cash flow it has. We have good investment opportunities for every bit of cash flow we're expected to make. Idon’t want to go out and borrow’ money when earnings are down—or worse yet, try to sell additional shares—to raise money to pay dividends! ‘arson AtUS. Motors, we solve the problemby keeping the dividend at a low pertentage of normal eamings and then paying extra dividends once a year when eamings are high enough to warrant it. That way, we are able to pay sharcholders a nice yield, but we don’t have to cut dividends in bad years—we just stop paying the extra dividend, ‘cunnincitam That’snot abad way to go,but I think it will besome time before we make enough to warrant extra payments. xewnepy Why don’t you do what my corporation does: Don't pay dividends. You plow every bit of money back into the business I might point out that it has some tax advantages, too, Shareholders have to pay taxes on dividends but they don’t have to pay’ taxes on the higher share price until they sell the stock. SHEEHAN You're absolutely right, of course, And your shareholders would probably support you in that policy since itis the one you have followed cone sistently. However, we have a clientele of shareholders who bought AT&T shares thinking they were going to get income. And if we don'tpay adividend, they will be extremely unhappy. Many of them would sell the stock, Unless we found enough people who liked the new dividend policy to replace them, it would depress the share price, ‘KENNEDY It wouldn’thurt the share price in the long mn. ‘SHEEHAN True, but 'm sure the price of the stock would drop on the day we announced the change, and my telephone rings in the short run! I think you'd find that yours would too, Jerry. CUNNINGHAM Thave no doubt you're right. Unfortunately, that doesn’t eave us with many options. We have to start out paying a high percentage of the weexpect to make. How about giving a stock dividend instead of cash during the298 PART IX MISCELLANEOUS TOPICS fourth quarter? That way, it would look like we were doing something for the shareholders, and yet it wouldnt cost us any cash. How would that go down? SHEEHAN Itwould not be well received by several thousand shareholders who were going to use the dividend for Christmas gifts. Kennepy The shareholders could always sell a few percent of their shares to raise money. SHEEHAN It can be very expensive to sell just a few shares, For some of our smaller shareholders, their stockbrokers would get more money than they did! ‘And it would certainly be much less convenient, CunninGHam So what options are leit? SHEEHAN Essentially, given the constraints, there is only one that is attractive from a shareholder relations viewpoint: Pay a dividend based on the olel divi dend policy ancl announce that it wort be raised untill the dividend is only 40 percent of normal eamings, which is more typical of a lange manufacturing company, That way, people who really want a dividend will have a long time to sell their stock and there won’tbe any rush todo so. I might point out that it would be a good idea to keep the dividend reinvest ment program. Shareholders wih subscribe to the program allow us to use their dividend fo purchase new shares either from the company or on the open mar= ket, at our discretion. It has been a very popular program with shareholders and it is also a good source of new capil. cunnycam I'm in favor of raising all the new capital we can. In fact, how about issuing stock? ARSON Won’t that reduce earings per share? cunnmvciaM It will actually help earings per share in the long run, because any additional money we get canbe invested in projects that earn more than the equity cost of capital. LARSON hope you're right, Jenry, but, as you know, projects don't always eam, as muchas managers expect them to eam. SHEEHAN The stock analysis that cover our stock wouldn't like a stock issue, We'rea new company without a proven track record, I think a new stock issue would hurt investor confidence, KENNEDY If you're really so hard up, you canalways go to your friendly banker or float more debt. CUNNINGHAM The crecliterating companies tell us that we have as much debt as we can handle if we want to keep our debt rating. matfraid we are pretty well boxed in. This is very frustrating. We carr tissue debt, and we cai’t issue stock, and now I’m finding that we can’t get any money by changing dividend policy. LARSON It is an interesting situation, At my company and at many others, we estimate how much money we'll need to reinvest in the business, and we payCASE 46 AT&T — 200 out the remainder as dividends. You don’t have that option, For the timebeing, Fl go along with Joan's suggrstion, KENNEDY Isstill don’t understand why shareholders are so anxious to pay taxes, but I'm willing to accept the fact that your shareholders are. Vl go along, with Joan’s proposal too. CUNNINGHAM. [concur Joan, please write up a summary of the meeting and. a proposal that we can bring to the next boant of directors meeting. Thank you, gentlemen, LARSON Brian, let's have lunch and you can try to convince me to cut the divie dend at U.S. Motors. KENNEDY Fine, Lel/s go, Lunch with Larson and Kennedy KENNEDY My firm is growing very rapidly, and we have plenty of investment opportunities for the funds. IE makes sense for us to hold on to every dollar, because we can make more for our shareholders than they can. LARSON U.S, Motors is not in that position, During recessions or sales declines. we may be a little tight on cash, but most of the time we have plenty. Why shouldin't we pay it to the shareholders? KENNEDY Because shareholders will have to pay kes on the income, If you reinvest it, and make mone money, the price of your shares will rise, and the shareholders won't have to pay taxesion the increase in value until they sell the shares. If you don'thave any investment opportunities thatlook good, you can. always purchase shares of your company’s stock on the open market. LARSON Thave two objections to your suggestion. First, many of our sharehold- ers are pension funds, college endowment funds, and institutions that don’t ay taxes, Obviously our dividends don’t increase their tax burtien. Second, if wedid as you suggested and routinely boughtsharesin the open market rather than paying dividends, our shareholders, asa whole, probably would pay less taxes. But the IRS knows that too, and they aren't happy about the idea of losing the tax revenue. KENNEDY I admit the IRS can make waves, but there are lots of good business reasons you can give them for buying, the shares. For example, you can always say you Want to purchase the shares so that you have stock you canuse tobuy another corporation, LARSON That position is easier to justify for a company like yours than a com- pany like mine, which hasan enormous free cash flow, No, Brian, Iseeyour point but Fmafraid that my company does not have the kind of investment opportu nities that letus use yourstzategy safely. 7d be willing togo along with your idea. if you had some real evidence of your theory or could prove that it made a big difference, but [ haven'theard any facts from you, just theories. Am [ righ?300 PART IX MISCELLANEOUS TOPICS KENNEDY I‘maffaid you are right. My argument makes sense tome, but I must admit that financial experts haven't come up with conclusive proof. LARSON In fact, seem to remember some young MBA telling me that firms that pay’no dividend have aslightly lower share price than you’d otherwise expect. You could probably citean expert who took a different views Let's just agree to disagree and get on with lunch, QUESTIONS 1. (@) Are stockholders likely to view a stock dividend as an acceptable sub- stitute for a cash dividend? Defend your answer. (©) Why doyou think corporations issue stock dividends? 2. Under what cicumstances, if any, does it make sense to forego positive NPV projects in onder to avoid a cut in DPS? Explain, 3. (@) Whatis the short-run residual theory of dividends? The long-run resid ‘ual theory? (©) Of the two theories, do you advise using the short-run or the long-run ‘theory? (© Which, if any, of the residual theories does AT&T appear tobe follow- ‘ing? Explain. 4, Do dividends matter? Would the firm be able to raise the price of its shares by adopting one dividend policy, and depress it by adopting a different one? Why or why not? 5, Should management care if shareholders are replaced by a different shar holder group? How upset could shareholders be? 6 Some theories of finance say that managers of companies do not manage companies in onder to maximize profits, but to make their own life easier. Make a case that Jerry Cunningham is just trying to make his own job eas jet, Then defend him against those charges, 7, How coull dividend policy affect Cunningham's own financial interests? 8. Is adividend mwinvestment program a good idea? Is ita goed substitute for a low dividend payout ratio? 9, Is Sheehan right when she says that issuing more stock will “not be well received” by stock analysts, thereby implying that the price of the stock will, ‘be depressed? 10 Based on information in the case and financial theory, what diviclend pol- icy do you recommend that AT&T pursue? Defend your recommendation,