George Liu, the CEO of Penn Schumann, was a creature of habit. Every month, he and Jennifer Rodriguez, the company's chief financial officer, met for lunch and an informal chat at Pierre's. Nothing was ever discussed until George had finished his favorite escalope de foie gras chaude. At their last meeting in March, he had then toyed thoughtfully with his glass of Chateau Haut-Brion Blanc before suddenly asking, "What do you think we should be doing about our payout policy?"

Penn Schumann was a large and successful pharmaceutical company. It had an enviable list of highly profitable drugs, many of which had 5 or more further years of patent protection. Earnings in the latest 4 years had increased rapidly, but it was difficult to see that such rates of growth could continue. The company had traditionally paid out about 40% of earnings as dividends, though the figure in 2017 was only 35%. Penn was spending more than $4 billion a year on R&D, but the strong operating cash flow and conservative dividend policy had resulted in a buildup of cash. Penn's recent income statements, balance sheets, and cash-flow statements are summarized in Tables 17.3, 17.4, and 17.5.

The problem, as Mr. Liu explained, was that Penn's dividend policy was more conservative than that of its main competitors. "Share prices depend on dividends," he said. "If we raise our dividend, we'll raise our share price, and that's the name of the game." Ms. Rodriguez suggested that the real issue was how much cash the company wanted to hold. The current cash holding was more than adequate for the company's immediate needs. On the other hand, the research staff had been analyzing a number of new compounds with promising applications in the treatment of liver diseases.

If this research were to lead to a marketable product, Penn would need to make a large investment. In addition, the company might require cash for possible acquisitions in the biotech field. "What worries me," Ms. Rodriguez said, "is that investors don't give us credit for this and think that we are going to fritter away the cash on negative-NPV investments or easy living. I don't think we should commit to paying out high dividends, but perhaps we could use some of our cash to repurchase stock."

"I don't know where anyone gets the idea that we fritter away cash on easy living," replied Mr. Liu, as he took another sip of wine, "but I like the idea of buying back our stock. We can tell shareholders that we are so confident about the future that we believe buying our own stock is the best investment we can make." He scribbled briefly on his napkin. "Suppose we bought back 50 million shares at $105. That would reduce the shares outstanding to 488 million. Net income last year was nearly $4.8 billion, so earnings per share would increase to $9.84. If the price-earnings multiple stays at 11.8, the stock price should rise to $116. That's an increase of over 10%." A smile came over Mr. Liu's face."Wonderful, he exclaimed, "here comes my homard nage. Let's come back to this idea over dessert."

Evaluate the arguments of Jennifer Rodriguez and George Liu. Do you think the company is holding too much cash? If you do, how do you think it could be best paid out?

TABLE 17.3 Penn Schumann Inc. balance sheet (figures in millions of dollars)

TABLE 17.4 Penn Schumann Inc. income statement (figures in millions)

TABLE 17.5 Penn Schumann Inc. statement of cash flows (figures in millions)
Net income ................................................. $ 4,792
Depreciation .................................................... 928
Decrease (increase) in receivables ......................... (376)
Decrease (increase) in inventories ........................... 493
Increase (decrease) in payables .............................. 612
Total cash from operations ................................ $ 6,449
Capital expenditures ....................................... (2,063)
Increase (decrease) in short-term debt .................. (1,063)
Increase (decrease) in long-term debt ..................... (135)
Dividends paid ............................................. (1,678)
Cash provided by financing activities .................. $(2,876)
Net increase in cash ........................................ $ 1,510

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2017 2016 Cash and short-term investments Receivables Inventory $ 7.061 $ 5,551 2,214 2,435 $11,593 $10,200o $21,088 $19,025 4,852 $15,308 $14,173 $26,901 $%24,373 6,8276,215 15572620 $8,384 8,835 3,484 2,054 $26,901 $24,373 1.942 Total current assets Property, plant, and equipment Less accumulated depreciation 5,443 Net fixed assets Total assets Payables Short-term debt Total current liabilities 3,349 15.168 Long-term debt Shareholders' equity Total liabilities and equity Note Shares outstanding (millions) Market price per share (S) 516 105 2017 2016 $13,378 7,800 850 $4,728 353 1,160 $3,215 1,350 6.23 2.62 Revenue $16,378 8,402 928 7.048 323 1,933 $ 4,792 1,678 8.91 3.12 5 Depreciation EBIT Interest Tax Net income Earnings per share () Dividends per share ($)