CASE 2: ANDERSON AUTOPARTS DIVIDEND POLICY

1. Evaluate John Forsyth's argument that a cut in dividends will cause the price of

Anderson's stock to decline

John Forsyth’s argument that a cut in dividends will cause the price of Anderson’s stock

to decline is true. Based on the selected financial history of Anderson Autoparts (Exhibit

1), it has shown an increasing trend which indicates that the growth of sales and earning

per share are increasing. Based on Exhibit 1, the dividend per share (DPS) is also

increasing over year which sends the success signals to financial market about Anderson

Autoparts future prospect as dividends are issued from a company’s retained earnings.

When Anderson Autoparts displays increasing dividend histories, they become more

attractive to investors. Once more investors buy in to take advantage of the benefit of

stock ownership, the stock price naturally increases, thereby reinforcing the belief that the

stock is strong. Once there is a cut in dividends, Anderson’s stock will decline as

investors assume that the company has cash flow problems or financially unstable. Thus,

they sell Anderson’s stock which could cause a fall in the stock price.  

2. Evaluate the theoretical and empirical evidence presented by Ian Lyle.

The theoretical evidence and empirical presented by Ian Lyle are Ian Lyle, director of

marketing "A dividend decision has aspects of a marketing decision. Appearances count.

If we lower DPS we run the risk of transmitting a wrong message." Lyle then hands out a

memo containing two pieces of evidence-one theoretical and one empirical--to support

his view. He refers to the equation Po = D/(K- g), which he feels is an indication that an

increase in DPS will raise the price of Anderson's stock. He then cites the experience of

Hawkins-Elgin, another industry firm, which eliminated dividends in 1991 and promptly
 saw the price of its stock drop 20 percent in 10 days. Lyle believes the firm should

strongly consider making the yearly dividend a constant percentage of EPS in order to

keep the growth of DPS in line with the growth of EPS

3. How do the following factors affect the dividend decision: the business risk of the

industry? the possibility that there may be a sudden change in production techniques or in

the firm's product mix?

The business risk of the industry is a potential factor that affect dividend decision. High

levels of business risk cause the relationship between current and expected future

profitability less certain. Thus, it is expected that the firms with higher level of business

risk will have lower dividend payments. The firm may pay lower dividends because

volatile earnings materially increase the risk of default. The possibility that there may be

a sudden change in a production technique or in the firm’s product mix also affect the

dividend to decline as there is uncertainty in the future. The investors may feel insecure

about the future of the company if there is a sudden change in a production technique or

in the firm’s product mix.

4. Evaluate the evidence presented by Helen Carrol in Exhibit 3. Specifically, is it

reasonable to conclude that a low payout has caused a high P/E? Defend your answer.
 Carrol presents data (as shown in Exhibit 3) that seem to contradict Lyle's evidence.

"Within each industry there is an inverse relationship between payout and the price to

earnings (P/E) ratio. Note especially the automobile manufacturers where the two foreign

producers have lower payouts and higher P/E's than the three American firms." Thus,

based on Exhibit 3, it is reasonable to conclude that a low payout has caused a high P/E

and vice versa.

5. Suppose the position of Jean Bloomingdale is adopted. That is, each year the firm

determines the cash it has generated internally, implements all attractive investment

projects, and pays out any remaining funds in dividends. Using the information in Exhibit

2, calculate the expected annual amount of dividends. Discuss the desirability of such a

policy, making sure you con- sider the impact on the firm's debt/equity mix and assuming

any funds needed are borrowed.

Year ($ 1997 1998 1999 2000 2001

million)
Net income 8.7 9.9 11.4 13.1 15.1
Common 4 4 4 4 4

share
 outstanding
Net income 8.7/4= 9.9/4= 11.4/4= 13.1/4= 15.1/4=

per share 2.175 2.475 2.850 3.275 3.775

share
Payout ratio 1/4= 0.25 1/4= 0.25 1/4= 0.25 1/4= 0.25 1/4= 0.25
Expected 2.175/4= 2.475/4= 2.850/4= 3.275/4= 3.775/4=

annual 0.544 0.619 0.713 0.819 0.944

dividends

Yes. It is desirable for such a policy by considering the impact on the firm's debt/equity

mix and assuming any funds needed are borrowed. It is because increasing annual

dividends will send success signals to the financial market in order to attract more

investors to buy the stock and trust Anderson’s firm is financially stable. Once the

investors invest more funds for the firm, the firm’s dependency on taking in more debts

will be reduced.

6. Evaluate Ian Lyle's suggestion to make DPS 50 percent of EPS each year. The format of

Exhibit 4 should be useful in the analysis.

Year ($ 1996 1997 1998 1999 2000 2001

millions)
Net income 0 8.7 9.9 11.4 13.1 15.1
Outstanding 0 14.6 12 9 14.8 10

share
Earning per 0 8.7/14.6= 9.9/12= 11.4/9= 13.1/14.8= 15.1/10=

share (EPS) 0.596 0.825 1.267 0.885 1.510

of EPS) 0.298 0.413 0.634 0.443 0.755

EPS has gone up.

7. Evaluate the following points made by Harry Gidwitz. (a) The firm's dividend decision is

relatively unimportant and is unlikely to affect the price of the firm's stock one way or

another. (b) It would be "amusing" to simultaneously pay dividends and sell stock,

perhaps to the same stockholders. (Can you think of any reasons why it might be in the

interest of existing stockholders for the firm to do this?)

(a) The firm’s dividend decision is relatively unimportant and is unlikely to affect the

price of the firm’s stock one way or another.

It is because Gidwitz wonders how much all of this matter anyway. He's sure that

Anderson will be able to raise money from external sources if necessary. "The

important thing this company faces are the successful implementation of the

commercial strategy we've begun in the last year or so. This is where we'll be judged

by investors." Still, he thinks it might be embarrassing for Anderson if it had to tap

external sources when, say, the share price was unusually low. And he admits he likes

the idea of avoiding external financing if possible, in order to minimize the hassle and

cost of raising the needed capital.

(b) It would be "amusing" to simultaneously pay dividends and sell stock, perhaps to the

same stockholders

It is because Gidwitz said, “we keep our stockholders happy and avoid the amusing

situation of simultaneously paying dividends and selling new shares. If we need

external funds, we borrow. Flotation costs are lower with a bond issue than a stock

issue anyway”
 8. Suppose Harry Gidwitz's position is adopted; that is, the firm implements all attractive

investments, DPS is $1.10, and no new common stock is issued Compute the firm's

debt/equity ratio in each of the next five years. Discuss the desirability of such a policy.

The format of Exhibit 4 can be used in the analysis.

As DPS $1.10, the debt/ equity ratio is calculated from Exhibit 4.

Year 1996 1997 1998 1999 2000 2001

equity

(D/E) ratio

Such of policy is not desirable to the firm as the firm’s debt/ equity ratio is increasing

from

0.250 to 0.430 (1996- 2001). It negatively affects the equity and stock price of the firm

as

most of the net income are used to reduce cost of debt.

9. What DPS do you recommend if the dividends are treated as a long-run residual? The

format of Exhibit 4 should be useful, and you may assume that any necessary borrowing

occurs in year 1 (1997).

Year ($ 1997 1998 1999 2000 2001

millions)
Net Income 8.7 9.9 11.4 13.1 15.1
Funds 14.6 12 9 14.8 10

needed
Residual 8.7- 14.6= 9.9-12= 11.4-9= 2.4 13.1- 14.8= 15.1-10=
 earnings -5.9 -2.1 -1.7 5.1
Residual No dividend No dividend 2.4/11.4= No dividend 5.1/15.1=

dividend payout payout 0.211 payout 0.338

policy

10. Play the role of a consultant. Based on your previous answers and other in- formation in

the case, what dividend policy do you recommend? Defend your recommendation.

Based on my previous answers and other information in the case, I recommend stable

dividend policy. Stable dividend policy causes the investors to obtain their dividend at

fixed rate. Stable dividend policy is also meant that payment of fixed percentage of net

income as dividends each year. The policy of constant payout is preferred by the firms

and investors as it shows the ability to pay dividends. Stable dividend policy also

indicates a sign of continued normal operations of the firm. Stable dividend policy also

stabilizes the market value of the share.

11. What additional information would you like to have to make a more informed decision in

question 10?

Additional information I would like to have to make a more informed decision in

question 10 is the firm needs to analyze certain factor before making their dividend

policy. The nature of the industry to which the company belong has an important effect

on dividend policy. Industries, where earnings are stable, may adopt a stable dividend

policy compared to the industries where earnings are earnings are uncertain and uneven.

The information for the number of shareholders also affect decision of having stable

dividend policy. The information of future growth, reinvestment opportunity, and

expansion of the firm is also needed to make more informed decision in question 10. I
also need to know the information of the firm’s leverage in their financial structure to

make more informed decision in question 10. There could be influence in the dividend

policy of the company due to the imposed changes by the government. The corporate

taxes information is also needed to make more informed decision in question 10. The

information of repayment of debt is also required to make more informed decision in

question 10.