I need some help with the attached minicase. Thanks!

George Liu, the CEO of Penn Schumann was a creature of habit. Every month he and Jennifer Rodriquez, 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 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 earning as dividends, though the figure in 2008 was only 35%. Penn was spending over $4 billion a year on R&D, but the strong operation 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 17-4 to 17-6. 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. Rodriquez 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. Rodriquez 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 $116. That's an increase of over 10%.\" A smile came over Mr. Liu's face. \"Wonderful, he exclaimed, \"here comes my homard a la nage. Let's come back to this idea over dessert.\" Evaluate the arguments of Jennifer Rodriquez and George Liu. Do you think the company is holding too much cash? If you do, how do you think it could be best paid out? Table 17-4 Penn Schumann, Inc., balance sheet (figures in millions) Cash and short-term investments Receivables Inventory Total assets Property, plant, & equipment 2008 7,061 2,590 1,942 11,593 21,088 2007 5,551 2,214 2,435 10,200 19,025 Less accumulated depreciation Net fixed assets Total assets Payables Short-term debt Total liabilities Long term debt Shareholder's equity Total liablities and equity 5,780 15,308 26,901 6,827 1,557 8,384 3,349 15,168 26,901 4,852 14,173 24,373 6,215 2,620 8,835 3,484 12,054 24,373 Note: Shares outstanding, millions Market price per share ($) 538 105 516 88 Table 17-5 Penn Schumann, Inc., Income Statement (figures in millions of dollars) Revenue Costs Depreciaiton EBIT Interest Tax Net Income Dividends Earning per share ($) Dividends per share ($) 2008 16,378 8,402 928 7,048 323 1,933 4,792 1,678 8.91 3.12 Net Income Depreciation Decrease (increase) in receivables Decrease (increase) in inventories Increase (decrease) in payables Total cash from operations Capital expenditures Increase (decrease) in short-term debt Increase (decrease) in long-term debt Dividends paid Cash provided by financing activities Net increase in cash 2008 4,792 928 (376) 493 612 6,449 (2,063) (1,063) (135) (1,678) (2,876) 1,510 2007 13,378 7,800 850 4,728 353 1,160 3,215 1,350 6.23 2.62 Solution: It is true that company is currently holding too much of cash. The amount of cash and cash equivalents in the balance sheet of the company at the end of year 2008 is $7.061 Billion, which is $1.510 Billion higher than the cash and cash equivalents of $5.551 Billion held by the company at the end of the year 2007. This means that in spite of company paying dividends to the tune of 35% payout ratio and incurring a capital expenditure of $2.063 Billion. This means that the company is generating enough cash to manage its current operations, pay reasonable amount of dividends and incur a reasonable amount of capital expenditure. The liquidity ratios of the company are as follows: 2008 =11593/8384 =10200/8835 =1.38 Current ratio =Current Assets / Current Liabilities 2007 =1.15 Quick ratio = (Current Assets - Inventory) / Current Liabilities =1.15 =0.88 Thus, increase in the cash with the company has increased the liquidity ratios for the company substantially. The quick ratio increased from 0.88 in 2007 to 1.15 in 2008 and current ratio increased from 1.15 in 2007 to 1.38 in 2008. At the same the leverage ratios for the company decreased substantially. 2008 2007 =3349/15168 =3484/12054 =0.22 =0.29 =(3349+1557)/26901 =(3484+2620)/24373 Debt Equity Ratio = Long term debt / Equity Total Debt to Asset ratio = (Short term loan + Long term loan)/ Total Assets =0.18 =0.25 Interest Coverage ratio = EBIT/Interest =7048/323 =4728/353 =21.82 =13.39 The debt equity ratio improved from 0.29 in 2007 to 0.22 in 2008(lower is good), the total debt to asset ratio improved from 0.25 in 2007 to 0.18 in 2008 and interest coverage ratio improved from 13.39 in 2007 to 21.82 in 2008 (higher is good). Although the dividend per share improved from 2.62 to 3.12, the dividend payout ratio declined from 42% of net income in 2007 to 35% in 2008. Even if the company has paid all the cash generated in year 2008 i.e. $1.510 Billion as dividends, the liquidity and leverage ratios for the company would still have improved in year 2008 over that in year 2007. Thus, we can conclude that the company is sitting on excess cash. Now to answer what should company do with this excess cash and whether Ms. Rodriquez is correct in her statement or not, we should look at some of the characteristics of the pharmaceutical industry and evaluate some of the behavioral and signaling theories regarding dividend payment. Increase in dividends by a firm is may or may not be received as a positive signal by the investors about the health of the company and may or may not have a positive impact on the share price but investors take dividend cuts very serious and any dividend cut has a string negative impact on the stock price of the company. Therefore, companies distribute a relatively low proportion of current earnings to offset fluctuations in operational cash flow. Pharmaceutical industry is a high-risk industry where the success of the company is highly dependent upon the discovery of new drugs and patents. This require higher amount of R&D expenses. However, even with a high R&D expenses the discovery of new drugs is highly uncertain. And hence the operational cash flows have high fluctuations. Thus, if the company does not want to create a situation of dividend cut, it is preferable to continue with a low payout ratio and should try to reach the target payout ratio gradually over a period of time because stockholders prefer a steady progression in dividends. It depends on the shareholders and their preferences (clientele effect). If stockholders prefer current income, the cash dividend is a better option as compared to repurchase plan. However, if the stockholders are looking for growth of the stock then repurchase is a good option. Another issue we need to consider is that by distributing a large chunk of dividends the shareholders might have to pay the taxes in the higher tax bracket. So instead of a large chink of higher dividends they would prefer small trenches of dividends over a period of time so that their tax burden is reduced. Thus, Penn Schumann should evaluate the profile of its shareholders and see how the dividend payments by the company can impact the net receipts by them. Generally, pharmaceutical sector is considered as a high-risk growth sector and investors in this sector look for higher capital appreciation and lower dividend payments. Thus, repurchase seems to be better option for Penn Schumann. Both dividend payments and repurchase operate as positive signal to the financial market, improving the image of the company. It will also depend on the taxation issues and the tax bracket for the income. If the tax on dividend income is lower then the capital gain tax, dividend payment is beneficial for the stockholders and it will create positive impact on the share price. If the reverse is true, the repurchase is better and will create a positive impact on the stock price. Another advantage of the stock repurchase is that the dividend payout will be kept at lower level, so the total cost of capital to the firm will be low, as they don't have to reach the capital market for finance every now and then. The firm has certain molecules in the pipeline. If the R&D efforts for these molecules are positive then the firm may need huge cash to invest on commercializing these molecules. By not increasing the dividend payments and going for stock repurchase, the need to reach the market for every cash need would be reduced. And as we know, the retained earnings have slightly lower cost of capital as compared that for the new equity issue. Thus, stock repurchase will keep the future cost of capital at a slightly lower level than increasing the dividend payout increase. Thus the decision will depend on lot of factors. However, given the circumstances of the case a stock repurchase has more positive feature than the dividend payout increase and should be selected by Penn Schumann. It will send positive signals to the market about the proactive nature of management of the company and remove the impression, if any, that the management is sitting on a huge pile of idle cash