Dear Board Members,
I feel great responsibility in sending this memorandum to you all, as my recommendation could and most probably would have an impact on our company’s future. It has indeed been a hard decision to make, but through careful analysis, I have reached the conclusion that it would be best to keep the dividend as it is now.
Before I brief you on the specifics of my decision, I feel the need to provide basic information about our company that surrounds this issue. To be more specific, I am referring to the past decisions on our dividend policy and our financing needs. Even if you are already aware of the specifics, please bear with me as this has played a crucial role in ...view middle of the document...
Furthermore, our research and development expenses were also modest, which all in all, contributed to our low financing needs. However, our recent plans to seek for business opportunities in Asian markets, as well as the uncertain effects of the Iraq war enhance our financing needs substantially.
With this basic information, we are given the task of deciding whether to increase the dividend rate or maintain the current rate. Why then, would a company want to increase dividends? Why should a company decide to increase its dividend rates?
There could be several reasons for a company issuing dividends. The first, though least likely, reason is that it prevents agency conflicts. With the issuance of dividends, the free cash flow is no longer in the hands of management, and thus reduces or even eliminates the agency costs. Most managers, however, do not view their policy on dividends as a means to impose self-discipline. The second reason could be that with asymmetric information, the issuance of dividends could signal a strong position in a risky market because it means that the company is able to afford the higher dividend. The last reason is that such further issuance of dividends attracts investors that are more sensitive to a company’s dividend policy, such as mutual funds, European investors companies and retail investors.
Historically, there has been a trend away from the issuance of dividends from the late 1970s to the twentieth century. This was greatly due to the abundant growth opportunities that hindered the managers from distributing the excess in cash flow. Moreover, managers have been reluctant to issue dividends as the information asymmetry made the payout ratio highly inflexible, reluctant to cut dividends. Today, however, the trend has changed because with the saturation and mature growth of the markets, there are not as many positive NPV projects. It also helped that the managers are no longer so strict on their payout ratios anymore.
Finally moving on to the analysis of our dividend policy, what should we thus do? Since we have reached a relatively mature growth and because we have an excess in free cash flow, should we increase the issuance of dividends? Or, due to potential business opportunities and the uncertain effects of the Iraq war, should we leave the payout ratio as it is today?
Let us first analyze the consequences of keeping the cash inside the firm. If our company decides to retain all the cash inside the firm, we would first have the advantage of cash liquidity. In other words, when new market opportunities arise and require costly funding, we would have the liquidity needed to enter such positive NPV projects. On the other hand, not using debt financing would mean higher tax costs for our company. This acts as an opportunity cost of keeping cash within our company. Despite this opportunity
Then, what if we pay out our entire cash balance as a special dividend? Numerical inference can be found at...