Berkshire Hathaway had two classes of sharesClass A and Class Btrading on the New York Stock Exchange. As of January 24, 2018, approximately 11 per cent of the Class A shares were held by members of the general public; 48 per cent were held by institutions and 41 per cent by insider investors. At the end of 2017, the average price of Berkshire Hathaway's Class A stocks was $297,600 per share. The Class B shares were created in 1996. They gave the Class A shareholders the right to convert each Class A share into 30 Class B shares. On January 21, 2010, each Class B share was split into 50 shares. As of January 24, 2018, approximately 35 per cent of Berkshire Hathaway's Class B shares were held by members of the general public; 47 per cent were held by institutions and 19 per cent by insider investors. At the end of 2017, the average price of Berkshire Hathaway's Class B stocks was $200 per share.

DIVIDEND POLICY

Buffett's strategy was to make it a priority to diligently reinvest earnings in the company's existing multi-sector businesses. In 2012, Berkshire Hathaway made capital expenditures of $12.1 billion in current businesses and new acquisitions. Buffet's principles were articulated in a two-step priority, which made it clear that funds would not be used for dividend payments: (1): The first priority with available funds would always be to evaluate whether they could be diligently reinvested in the existing businesses; (2): The next step was to search for acquisitions unrelated to the current businesses.

Buffet considered another valid use of funds to be share repurchase at a fair price. The company employed a share repurchase option under which the shares would be repurchased at a premium, up to 120 per cent of book value. Buffett considered the share repurchase option to be a better alternative to a dividend payment.

Example

To emphasize why the repurchase option might be better, Buffett provided an example with two scenarios. Assume there were two equal owners of a business with a net worth of $2 million. If the return on net worth was 12 per cent per annum, the earnings would be $240,000 per year. Assume there also existed a buyer who had agreed to buy into the company at a value of 125 per cent of net worth. The offer thus implied that the market value for the company would be $2.5 million and each individual share would be worth $1.25 million.

Scenario A: Pay Out One-Third of the Earnings as a Dividend and Reinvest the Remaining Two-Thirds

This scenario reflected the preference of investors who wanted a balanced investment policy that catered to both current income and capital appreciation.

In year zero, one-third of the earnings ($240,000 ¹/₃= $80,000) would be paid to the owners as a dividend, which gave each of them an income of $40,000. After payment, the company would be left with $160,000 to reinvest in the business. Earnings would continue to grow, and dividends would increase proportionately. Thus, dividends and earnings would grow by 8 per cent per annum (12 per cent earned on net worth less 4 per cent paid out from net worth). After 10 years, the company's net worth would be $4,317,850the result of the original $2 million compounded at 8 per cent per annum. The dividend payment would be $86,357. The market value of each individual's holding would be $2,698,656.

Scenario B: Sell Off

This scenario reflected Buffet's philosophy and was followed by Berkshire Hathaway.

Under this scenario, there would be no dividend payment and the entire earnings would be reinvested in the business. In order to maintain an income without dividends, each owner would sell 3.2 per cent of their respective holding. Based on the prospective buyer's offer, the sale would earn 125 per cent of the shares' book value. So, in year zero, each owner would be able to earn the same $40,000 from the sale of shares ($2.5 million 3.2 per cent 2). At the same time, the entire earnings of $240,000 would be reinvested in the company, which has a growth rate of 12 per cent per annum. After 10 years, the company's net worth would be $6,211,696the result of the original $2 million compounded at 12 per cent per annum. Because the owners had been selling shares each year, the percentage of each owner's share would have dropped. After 10 years, each owner would hold 36.12 per cent of the business, which would amount to a value of $2,243,665. The market value would be 125 per cent of the net worth, meaning the market value of the individual shares would amount to $2,804,425.

Thus, the sell-off scenario, while providing the owners with their required income, added more value to the capitalapproximately $105,770 more than with the dividend scenario.

Buffet's other argument against paying dividends considered the needs of individual shareholders. When a company paid a dividend, it decided the amount that each shareholder would receive. Thus, dividend payments permitted the company to decide the shareholder's income. For example, if a company decided to pay out 40 per cent of the earnings, any shareholder who wanted income amounting to 50 per cent or 60 per cent would be dismayed. The sell-off option, however, allowed shareholders to sell their shares in accordance with their income requirement.

To reassert the philosophy of sell off as a substitute for dividend, Buffett revealed that from 2005 until 2012, he had annually divested 4.25 per cent of his shares. Thus, his original holdings of 712,497,000 B- equivalent shares were decreased to 528,525,623 sharesa loss of almost 26 per cent. However, even though the percentage of Buffet's ownership had decreased, the book value of his holdings had increased significantly from $28.2 billion for 2005 to $40.2 billion for 2012a gain of over 140 per cent.³⁶

CURRENT FACTORS INFLUENCING THE DIVIDEND DECISION

As of the end of 2017, Berkshire Hathaway was in possession of $115.95 billion in cash and short-term investments. A portfolio manager calculated that Berkshire Hathaway was in a position to pay a one- time dividend of $20 billion and still be left with enough cash to cover future investment requirements. Buffet had said that his inclination was toward share repurchase instead of a cash dividend payment because a dividend payment implied a promise of payment forever.⁴²However, Berkshire Hathaway's share repurchase offer was applicable only when shares hit 120 per cent of book value, and early in 2018, both the Class A and Class B shares were trading near 170 per centfar above the company's limit for repurchase.

question

Considering the history of Berkshire Hathaway and Buffet's historical investment strategy, what would you recommend the company do with almost $116 billion in cash and cash-equivalent reserves? Are Buffet's strategic reasons for not paying dividends sustainable? Is the company's share repurchase plan still a viable alternative to a dividend? Looking at Berkshire Hathaway's financials (see Exhibits ), if you were in Buffet's position, would you alter the dividend policy or leave it unaltered?