Linear Technologies Dividend Policy Dr. C. Bülent Aybar

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1 Linear Technologies Dividend Policy Dr. C. Bülent Aybar Professor of International Finance

2 Review of Dividend Policy The firm initiated a dividend in Since then it has raised the dividend by $0.01 per share once a year or when it split its shares. Linear split its shares four times since 1992 The dividend has risen roughly tenfold from $ to $ The payout ratio has varied over time with profits. The initial dividend was 14.6 percent of earnings. The payout ratio fell through FY 2001 to 9.6 percent as profits rose dramatically. With the drop in sales in fiscal year 2002, the payout ratio stood at 27.3 percent. With another $0.01 increase, the payout ratio would be 33.1 percent in 2003.

3 Linear Tech. Dividends Per Share Dividend Per Share fold growth from $ in 1993 to 0.05 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q Dividend Per Share

4 Is There a Payout Policy? Linear Technology Payout Ratio Payout Ratio

5 Repurchases have been larger (totaling $2.13 versus $0.84) and more variable than dividends. Over the past five years, repurchases peaked at $125 million in Q3 of FY For seven quarters between Q3 of FY 1999 and Q1 of FY 2001, Linear made no repurchases

6 Share Repurchases Share Repurchases $125m in Q $140 $120 $100 $80 $60 $40 $20 $0 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Share Repurchases

7 Linear Tech. and Lintner 1956 Lintner s 1956 survey finds that firms have a long-run target payout ratio. Rather than payout a fixed proportion of earnings though, firms follow a partial adjustment process, increasing dividends by less than the increase in profits. Generally speaking, firms follow this conservative process of raising dividends to avoid decreasing the nominal dividend whenever possible. Linear follows a conservative payout policy but seems to have no longrun target payout ratio, increasing dividends even when profits fell dramatically. Would the following be a realistic statement? Linear initiated a token dividend and each year has given shareholders a token increase without regard to its payout ratio or profit level.

8 Linear Cash Flows June Fiscal Year Change Sales Net Income Operating Cash Flow Plus CAPX Capital Expenditure Market Value of Equity Shares Outstanding (Split Adjusted) Dividends Repurchases Dividend Policy Payout Ratio % 14.60% 11.60% 8.90% 11.20% 10.10% 11.40% 9.70% 9.60% 27.30% 27.50% 0.3 Dividend Yield % 0.50% 0.40% 0.50% 0.40% 0.40% 0.20% 0.10% 0.30% 0.50% 0.50% 0.80% Dividends Per Share (Split Adjusted) $0.00 $0.02 $0.03 $0.03 $0.04 $0.05 $0.06 $0.07 $0.09 $0.13 $0.17 $0.15 $0.24 Repurchases Per Share (Split Adjusted) $0.00 $0.00 $0.00 $0.02 $0.08 $0.04 $0.18 $0.35 $0.00 $0.22 $0.70 $0.53 Profitability Net Income (% of Sales) 20.90% 24.10% 28.30% % 35.40% 37.30% 38.30% 40.80% % 38.70% Cash Flow (% of Sales) 24.10% 28.10% 31.20% 39.20% 43.60% 39.80% 55.10% 55.30% 62.70% 57.50% 50.20% 43.10% Investment CAPX (% of Sales) 8.20% % 8.30% 18.60% 5.80% % 11.40% 13.20% 3.50% 2.20% Pre Investment Cash Flow / CAPX

9 Stable Margin Despite Declining Sales Net Income and CF as % of Sales % 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% CF/Sales Profit Margin Profit Margin CF/Sales

10 Can Linear Afford the Increase? Check the CFs While Linear sales have been variable, dropping by 47 percent in 2002, margins are very stable. Even with a large change in sales, operating and cash flow margins were hardly affected. Put another way, the variable cost structure gives Linear very little operating leverage. Capital expenditures were also quite modest, averaging less than 14 percent of sales since Pre-capital expenditure cash flow ranged from 4 to 19 times capital expenditures. These suggest that Linear has an ample cushion to pay a dividend of 31 percent of pre-investment cash flow and still meet its investment.

11 Cash Balance Also note that Linear has a large cash balance. In 2003, the cash balance stood at $1.57 billion, or 16.2 percent of Linear s market value. This is a higher percentage than at Microsoft. With an interest rate of 3% and a corporate tax rate of 35%, Linear could fund a dividend of $0.06 per share or $75 million out of after-tax interest income for more than 27 years.

12 Cash Balance in Comparables Linear Technology Cash Balance Dividends 75.0 Intel Cash Balance Dividends Maxim Cash Balance Dividends 25.6 Microsoft Cash Balance Dividends Intel, Maxim, and Microsoft have similarly large cash positions in comparison to their dividend payments.

13 Question? Linear has ample resources to increase its dividend and perhaps payout substantially more of its cash balance without facing much risk of financial distress. Is carrying cash inside the firm costly for outside shareholders?

14 Double Taxation The interest on cash balances is taxed once at the corporate level and again when it is distributed to shareholders. Indeed, this double taxation makes equity a costly form of new finance. But if Linear s marginal tax rate is lower than the personal tax rate of its investors, then there are no adverse tax consequences of retaining cash inside the firm. At the time of the case the top personal tax rate is 38 percent and the top corporate tax rate is 35 percent.

15 Another way of measuring the effective personal tax rate is to look at the difference in yields between municipal and AAA-rated corporate bonds. These data provided in Exhibit 8 may help us to approximate the effective personal tax rate. The tax rate satisfying the following equation can be extracted R muni =R corp (1-T p )

16 Case for Distribution This tax rate estimate peaks at 36.5 percent in 1999 and falls to 21.3 percent in The average over the eight years of data is 31.2 percent. This suggests that corporate tax rate is not necessarily lower than personal tax rate!

17 Cash Distribution Rule If the corporate tax rate satisfy the following, the firms should not retain any excess cash: Tc>(Tp-Td)/(1-Td) With a distribution tax of 15 percent and a personal tax rate of 38 percent, the corporate tax rate would have to be below 27 percent to justify retaining excess funds inside the firm. With the effective tax rate of 31.2 percent, the corporate tax rate would have to be below 19 percent.

18 Is there an Agency Problem? Linear managers might use internal resources to pursue their own objectives, at the expense of firm value. This may be valid concern, although there is no historical cause for concern. Linear has focused on its core analog business, and Coghlan says the firm has no intention of pursuing acquisitions in the future. Also, management still has a substantial amount of wealth in the firm. The CEO has about 1.5 million shares and options, with a market value of approximately $45 million. This is about equal to his total compensation over the last ten years,

19 Alternative Distribution Method The impact of $1 dividend on the Announcement and Ex Dividend Day Announcement Day Ex-Day Theory Price Change Price Change Modigliani and Miller Irrelevance 0-1 Taxes - -(1-td ) Signaling + -1 Agency + -1 Clientele Effects Depends on Clientele Demand Possibly less than -1 Market Conditions Depends on Sentiment -1

20 Taxes Historically, dividends have been taxed at a higher rate than capital gains. For example, in the spring of 2003, the top ordinary income tax rate applicable to dividends was 38 percent, whereas the top tax rate on capital gains was 20 percent. Even when the tax rates are equal, repurchases have an advantage. For example, suppose both rates are equal to 15% and there are 100 shares outstanding at $10 per share. Suppose further that the tax basis is $9 per share. Paying a dividend of $1 per share leads to a total tax of %15x$1x100=$15 and lowers the unrealized capital gains on all shares!

21 Repurchasing 10 shares will lead to a tax of $1.50 (15% x ($10 $9) x 10), but leaves the other 90 shares unchanged. The $90 (($10 $9) x 90) in unrealized capital gains on these shares will eventually be taxed at the 15% rate, adding $13.50 to future tax bills. So, the total tax is unchanged ($1.5+$13.5=$15) However, a dividend moves the payment forward in time and so increases the present value of the tax cost. Repurchasing shares is a more tax efficient way to return capital to shareholders provided (1) the capital gains rate is less than or equal to the dividend tax rate and (2) both are positive. When the tax is zero on both, the timing advantage of repurchases goes away.

22 Signaling If managers have inside information about good future prospects, they may wish to signal this to outside investors, increasing their stock price in the process. Of course, even managers whose inside information is poor, might like investors to believe their firms have good future prospects. So, the signal must have some cost that weeds out these managers. In the case of dividends, the cost is taxes, foregone investment, or, anecdotally, the cost of having to decrease the nominal dividend in the future. CFO Coghlan understands that cutting the dividend has a cost. And, so paying a dividend is a strong commitment to have adequate resources to maintain the dividend at or above its current level. However, is it convincing that Linear s dividend, at its current level or a penny higher, could signal anything about the future prospects of the firm?

23 Agency Cost An agency problem can equally well be solved with a dividend or a repurchase. However, if dividends represent more of a commitment than a repurchase, a dividend may solve future agency problems in a way that a one-time repurchase will not. This is similar to the signaling story: If managers would like to prove that they will not waste the firm s resources, they can do so by returning as much of the firm s cash to shareholders as possible.

24 Stock Options and Dividends A specific conflict of interest between managers and shareholders involves executive stock options (ESOs). Paying a dividend reduces the value of an ESO. Typically, ESOs are not dividend protected. Swanson has just over 1 million options. Paying a $1.5 billion dividend reduces the share price by a little less than $5 per share. Without knowing the exercise price, we cannot put a precise value on the loss. If the shares are in the money and exercised immediately, the loss is $5 million dollars. This is clearly an upper bound value loss on the existing options, but it does not include the effect on future grants. Of the five CEOs described in the case, this is most pronounced for John Chambers at Cisco, and might explain th firm s strong stance against even a token dividend.

25 Policy Options Policy Share Price Earnings Shares EPS Retain $1.5B $31.43 $ $0.63 Repurchase $1.5B Shares $31.43 $153= 268= $ (1,500x3%) 316-(1,500/31.43) Pay a $1.5B dividend $26.68= $ $ (1,500/316) Calculations are based on Exhibit 7 Retain 1.5bn Cash Share Price m outstanding share, EPS=$0.63 Repurchase 1.5bn of Shares: 1.5bn/31.43=47.7m shares net left:268m shares Implication: Interest income on 1.5bn is lost, Net Income:$153m now, the EPS=$0.57 Pay $1.5bn Dividend: Implication, share price declines (1.5bn/316)=26.68 Net Income declines because of interest lost, and EPS=$0.48

26 Clientele Effects Investors may differ in their tax rates, transaction costs, and institutional restrictions. An example of a tax clientele is pension funds that are tax exempt and so are indifferent between dividends and capital gains. A high dividend payment may attract these investors, or more precisely repel taxable investors. An example of a transaction cost clientele is a small investor who incurs high transaction costs in selling a small number of shares. These investors may prefer a dividend payment to a homemade dividend that involves selling an equivalent dollar value in shares on the open market.

27 Clientele Effect and Institutional Constraints Some investors may be constrained by regulation or by laws. An example of an institutional constraint is an endowment or trust that is limited to spending income and not capital. Under Modigliani and Miller, the distinction between income and capital gains is arbitrary. But, an endowment charter makes the distinction relevant. Blaine Rollins, manager of the Janus Fund, claims that European mutual funds might be limited to investing in dividend paying stocks. Note that the institutional constraint here argues for a token dividend only.

28 Time Variation in Dividend Policy Dividend policy has changed considerably over the last forty years. In the early 1960s, most listed firms paid a dividend. In 1999, fewer than 21 percent of firms paid. In 2002 and 2003, dividend initiations and increases picked up slightly.