5. Case study

Vince Cowley-Smith, CFA, Mansi Singh, CFA, and Tania Parker, CFA, are equity analysts for the Woolett Family Office Fund (WFOF). The family office and fund are domiciled in the United Kingdom, and manage more than GBP 950 million in investments, properties, and business ventures.

Cowley-Smith is currently reviewing two companies that are listed on the Frankfurt stock exchange. EK PharmaGen (EKPG) is a well-established biotechnology firm with global annual revenue of more than EUR 40 billion. Munich Rubber (MR) is a large supplier of tires and fittings to the global automotive industry and has a similar level of revenue. Both companies are currently trading at EUR 70 per share and paid a dividend of EUR 2.50 per share in the previous year.

EKPG is in a fast-changing industry and has a strong pipeline of promising R&D projects that are nearing the end of their pilot phases. EKPG issues an announcement to the market advising of a cut in dividends of EUR 0.50 in order to have the capital to bring some of its more successful innovations to the market.

MR is a mature company that has proven to the market over the previous decades its excellent

management of investor capital in providing steadily growing earnings and dividends. For the second year in a row, MR announces to investors that dividends will be maintained at EUR 2.50 per share.

Based on analysis of each companys investor base, Cowley-Smith has determined the following investor characteristics:

• EKPGs marginal investor is middle-aged with a marginal tax rate on dividends of 36% and a flat tax rate of 24% on capital gains.
• MRs marginal investor is retired with a flat tax rate on dividends and capital gains of 12%.

Cowley-Smith has been asked by Singh to help her research Labrador Security Systems (LSS), a

provider of security infrastructure to airports and other transport hubs. The company, situated in the small European country of Regenwalde, is due to announce its final dividend for the year, and the analysts make the following observations:

Singh: I would expect LSS to maintain its dividends over the next few years. Reliability of earnings has become a real worry, and I think that the company would be inclined to be conservative with how much it pays out.

Cowley-Smith: Also, there seems to be a lack of investment opportunities on the horizon, which is another good reason to be conservative with how much of the earnings are paid out as dividends.

The Regenwalde tax jurisdiction employs an imputation system for dividends to mitigate the double taxation of company profits. LSS announces a final dividend of EUR 1.20 per share, which equates to a payout ratio of 100%. The corporate tax rate in Regenwalde is 25%, and WFOF pays tax on all investment income at 15%.

Parker has been asked to prepare a report by the WFOF trustees on Petergate Original Lager (POL), a medium-sized brewer from the sub-Saharan country of Taurland. POLs earnings per share for the previous year was $3.00, and this is expected to increase to $3.20 in the current year. Parker has focused her attention on a recent directors statement from POL that highlighted board discussions regarding the brewers dividend policy. Over the past few years, POL has followed a dividend policy of paying out a constant amount of 80% of earnings. The directors believe that the payout level might need to be a little more conservative over the medium term and are considering the following:

1. Reducing the constant dividend payout ratio to 76%

2. Moving to a stable dividend policy based on the current payout level, but with an adjustment factor of 5 years

In her report to the WFOF trustees, Parker makes the following statements:

Statement 1: In the case of POL, dividends in Taurland are taxed at a higher rate than capital gains. Thus, investors would likely prefer POL to engage in share repurchases as a way to return capital to shareholders. This also has the added benefit of improving managerial flexibility, as repurchases are not expected to be as consistent as dividends.

Statement 2: POL has a lot of employee stock options expiring in this year, so it might not be a

good idea for the company to conduct share repurchases at the same time. However, POL is quite

underleveraged at the moment, so a share repurchase might be a good way to increase financial leverage.

1. explain whether the market will view MR and EKPGs announcements (answer separately) positive or negative. Why?

2. regarding analysts statements about Labrador Security Systems, are they correct? Explain why?

3. compare the dividiend policy under consideration by the directors of POL. List details and implications for the financial market.

4. In regard to statements made by Parker in her report, are they correct? Explain.