Montgomery Corporation In January, the board of directors of the Montgomery Corporation, one of Canada's largest retail store chains, was having its regularly scheduled meeting to establish and declare the next quarterly dividend. (Statements for the firm and industry are shown in Tables 1 and 2 Q. However, this meeting wasn't so regular. One of the directors, Sidney Mobler, who was also a vice- president in the company and chief financial officer, had brought a guest: Don Jackson, a financial analyst. Don had spent a considerable amount of time in the finance department and more than a few hours in Sidney's office developing a proposal concerning the company's dividend policy. He had finally persuaded Sidney to allow him to present his idea to the board. Table 1 Selected financial data, Montgomery Corporation (in $ millions, except per-share data) 20XR 20XS 20XT 20XU 20XV 20XW 20XX Sales $27,357.4 $30,019.8 $35.882.9 $38,828.0 $40,715.3 $44,281.5 $48,000.0 Net income. $ 650.1 $ 861.2 $ 1,342.2 $ 1,454.8 $ 1,303.3 $ 1,351.3 $ 1,700.0 $ 16.7 $ 21.5 $ 16.8 $ 22.6 Amount to preferred dividends......... Amount to common dividends........... Amount to retained earnings.......... $ 429.1 $ 476.3 $ 537.0 $ 630.8 $ 639.0 $ 648.3 $ 725.4 $ 221.0 $ 384.9 $ 805.2 $ 807.3 $ 642.8 $ 686.2 $ 952.0 Common shares outstanding.. 347.9 351.4 354.6 361.6 363.1 376.6 378.0 $ 1.96 $ 2.46 S 3.80 $ 4.06 $ 3.60 $ 3.65 $ 4.51 $ 1.36 $ 1.36 $ 1.48 $ 1.70 $ 1.76 $ 1.76 $ 1.96 EPS (on average common shares....... DPS (on average common shares....... Payout ratio (DPS/EPS)*.............. Total retained earnings. 69.4% 55.3% 38.9% 41.8% 48.9% 48.2% 43.5% $ 7,041.2 $ 7,426.1 $ 8,231.3 $ 9,038.6 $ 9,681.4 $10,367.6 $11,319.6 Cash balance. $ 1,170.7 $ 1,307.6 $ 1,502.5 $ 1,765.0 $ 2,357.2 $ 2,984.4 $ 3.235.0 * DPS (dividends per share)/EPS (earnings per share). Table 2 Selected financial data, other retail chains 20XR 20Xs 20XT 20XU 20XV 20XW 20XX $0.69 $0.93 $1.38 $1.82 $2.29 $2.35 $2.50 $0.05 $0.05 $0.08 $0.09 $0.10 $0.12 $0.13 7.2% 5.4% 5.8% 4.9% 4.4% 5.1% 5.2% $0.38 $0.61 $0.81 $1.10 $0.95 $0.23 $0.30 $0.09 $0.11 $0.13 $0.17 $0.20 $0.20 $0.20 23.7% 18.0% 16.0% 15.0% 21.1% 87.0% 66.7% Ears Department Stores EPS.. DPS. Payout ratio... The Lake EPS.. DPS....... Payout ratio... Price One Inc. EPS........... DPS. Payout ratio... Ureka EPS.. DPS. Payout ratio... $0.10 $0.19 $0.37 $0.51 $0.80 $1.21 $1.40 $0.01 $0.02 $0.04 $0.08 $0.11 $0.16 $0.24 10.0% 10.5% 10.8% 15.7% 13.8% 13.2% 17.1% $0.35 $0.38 $0.54 $0.55 $0.66 $0.91 $1.10 $0.06 $0.06 $0.07 $0.10 $0.11 $0.13 $0.18 17.1% 15.8% 13.0% 18.2% 16.7% 14.3% 16.4% Sporty EPS.......... $2.75 $2.94 $3.13 $2.91 $2.66 $3.53 $4.70 DPS.. $0.92 $1.00 $1.08 $1.18 $1.18 $1.24 $1.48 ........... Payout ratio. 33.5% 34.0% 34.5% 40.5% 44.4% 35.1% 31.5% National Wheels EPS. $0.16 $0.23 $0.35 $0.48 $0.58 $0.80 $1.10 DPS.. $0.02 $0.02 $0.04 $0.05 $0.07 $0.09 $0.12 Payout ratio. 12.5% 8.7% 11.4% 10.4% 12.1% 11.3% 10.9% Note: DPS refers to dividends per share; EPS refers to earnings per share. Page 699 Ladies and gentlemen, Don began, after being introduced by Sidney, I'll skip the preliminaries and get right to the point. I think that Montgomery's dividend policy is not in the best interests of our shareholders. Observing the rather chilly stares from around the room, he hastened on: Now, I don't mean we have a bad policy or anything like that; it's just that I think we could do an even better job of increasing our shareholders' wealth with a few small changes." He paused for effect. Let me explain. Up to now our policy has been to pay a constant dividend every year, increasing it occasionally to reflect the company's growth in sales and income. The problem is, that policy takes no account of the investment opportunities that the company has from year to year. In other words, this year we will use most of our net income to pay the same, or a greater, dividend than last year, even though there might be company investments available that would pay a much greater return if we committed the fun to firm's estments ead. effect, our holders are being shortchanged: they will realize perhaps a 6 percent yield on their investment as a result of receiving the dividend, when they could realize a 12 percent or higher return as a result of the company's return on its investments. I see this as a serious shortcoming in our management of the shareholders' funds." Now, fortunately, correcting this situation is not difficult. All we have to do is adopt what is called a residual dividend policy. That is, each year we would allocate money from income to those capital spending projects for which the returnthat is, IRR- is greater than our cost of capital. Any money that is not so used in the capital budget would be paid out to the shareholders in the form of dividends. In this way we would ensure that the shareholders' money is working the hardest way it can for them." Clarence Autry, who was also on the board of directors of the Canadian Pacific and no stranger to the world of corporate finance, broke in. Young man, he said dryly, your proposal ignores reality. It's not whether the shareholders are theoretically better off that counts; it's what they want that counts. You cannot tell the shareholders you're doing what's best for them by cutting the dividend; the dividend is what they want. Not only is that dividend sure money in their pockets now, but the fact that it's the same size as last time, or even higher, is a signal to them that their company is doing well and will continue to do so in the future. These decisions can't always be made on the basis of good-looking formulas from the back room, you know. Barbara Reynolds, who was the head of the directors' auditing committee, and somewhat of an accounting expert, agreed with Clarence. That's a good point, and one that's well recognized by our competitors too. If you check, I don't think you'll find a single one of them that's cut their dividend in the last six years, even though their net income may have declined significantly. Furthermore, the whole argument is meaningless anyway, because the dividend is not really competing with the capital budget for funds. We don't turn away profitable projects in favour of paying the dividend. If there are worthy projects in which we want to invest, and we would rather use our available cash to pay the dividend, then we seek financing for the investments from outside sources. In a way, we can have our cake and eat it too. She chuckled, pleased at the analogy. Don, however, was not to be intimidated. Yes, ma'am, what you say is true, he replied, and I would respond that our competitors are not treating their shareholders fairly, either. Furthermore, we do seek outside financing occasionally for large projects, but there are two problems associated with doing it routinely, as you suggest. First, it might be viewed as borrowing, or issuing stock, to pay the dividend, which would cast the company in a very poor light. Second, it's more expensive to finance from outside sources than from inside due to the fees charged by the investment dealers. Therefore, I believe we should exhaust our inside sources of financing before turning to the outside." Barbara stood her ground. That's all very well, but it's still not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the company's cash balances were about to be drawn down too low, we could always declare a stock Page 700 dividend instead of a cash dividend." Ladies, gentlemen, Chairman Edward Asking intervened, your comments are all very perceptive, but we must move on to the business at hand. All in favour of changing to a residual dividend policy, please raise your hand. a. Refer to Table 1 . Would you say that Montgomery's policy up to now has been to pay a constant dividend, with occasional increases as the company grows? b. Refer to Table 2 Q. What type of dividend policies would you say are being practised by Montgomery's competitors in the retailing industry? Do you think that any firms are following a residual dividend policy? Montgomery Corporation In January, the board of directors of the Montgomery Corporation, one of Canada's largest retail store chains, was having its regularly scheduled meeting to establish and declare the next quarterly dividend. (Statements for the firm and industry are shown in Tables 1 and 2 Q. However, this meeting wasn't so regular. One of the directors, Sidney Mobler, who was also a vice- president in the company and chief financial officer, had brought a guest: Don Jackson, a financial analyst. Don had spent a considerable amount of time in the finance department and more than a few hours in Sidney's office developing a proposal concerning the company's dividend policy. He had finally persuaded Sidney to allow him to present his idea to the board. Table 1 Selected financial data, Montgomery Corporation (in $ millions, except per-share data) 20XR 20XS 20XT 20XU 20XV 20XW 20XX Sales $27,357.4 $30,019.8 $35.882.9 $38,828.0 $40,715.3 $44,281.5 $48,000.0 Net income. $ 650.1 $ 861.2 $ 1,342.2 $ 1,454.8 $ 1,303.3 $ 1,351.3 $ 1,700.0 $ 16.7 $ 21.5 $ 16.8 $ 22.6 Amount to preferred dividends......... Amount to common dividends........... Amount to retained earnings.......... $ 429.1 $ 476.3 $ 537.0 $ 630.8 $ 639.0 $ 648.3 $ 725.4 $ 221.0 $ 384.9 $ 805.2 $ 807.3 $ 642.8 $ 686.2 $ 952.0 Common shares outstanding.. 347.9 351.4 354.6 361.6 363.1 376.6 378.0 $ 1.96 $ 2.46 S 3.80 $ 4.06 $ 3.60 $ 3.65 $ 4.51 $ 1.36 $ 1.36 $ 1.48 $ 1.70 $ 1.76 $ 1.76 $ 1.96 EPS (on average common shares....... DPS (on average common shares....... Payout ratio (DPS/EPS)*.............. Total retained earnings. 69.4% 55.3% 38.9% 41.8% 48.9% 48.2% 43.5% $ 7,041.2 $ 7,426.1 $ 8,231.3 $ 9,038.6 $ 9,681.4 $10,367.6 $11,319.6 Cash balance. $ 1,170.7 $ 1,307.6 $ 1,502.5 $ 1,765.0 $ 2,357.2 $ 2,984.4 $ 3.235.0 * DPS (dividends per share)/EPS (earnings per share). Table 2 Selected financial data, other retail chains 20XR 20Xs 20XT 20XU 20XV 20XW 20XX $0.69 $0.93 $1.38 $1.82 $2.29 $2.35 $2.50 $0.05 $0.05 $0.08 $0.09 $0.10 $0.12 $0.13 7.2% 5.4% 5.8% 4.9% 4.4% 5.1% 5.2% $0.38 $0.61 $0.81 $1.10 $0.95 $0.23 $0.30 $0.09 $0.11 $0.13 $0.17 $0.20 $0.20 $0.20 23.7% 18.0% 16.0% 15.0% 21.1% 87.0% 66.7% Ears Department Stores EPS.. DPS. Payout ratio... The Lake EPS.. DPS....... Payout ratio... Price One Inc. EPS........... DPS. Payout ratio... Ureka EPS.. DPS. Payout ratio... $0.10 $0.19 $0.37 $0.51 $0.80 $1.21 $1.40 $0.01 $0.02 $0.04 $0.08 $0.11 $0.16 $0.24 10.0% 10.5% 10.8% 15.7% 13.8% 13.2% 17.1% $0.35 $0.38 $0.54 $0.55 $0.66 $0.91 $1.10 $0.06 $0.06 $0.07 $0.10 $0.11 $0.13 $0.18 17.1% 15.8% 13.0% 18.2% 16.7% 14.3% 16.4% Sporty EPS.......... $2.75 $2.94 $3.13 $2.91 $2.66 $3.53 $4.70 DPS.. $0.92 $1.00 $1.08 $1.18 $1.18 $1.24 $1.48 ........... Payout ratio. 33.5% 34.0% 34.5% 40.5% 44.4% 35.1% 31.5% National Wheels EPS. $0.16 $0.23 $0.35 $0.48 $0.58 $0.80 $1.10 DPS.. $0.02 $0.02 $0.04 $0.05 $0.07 $0.09 $0.12 Payout ratio. 12.5% 8.7% 11.4% 10.4% 12.1% 11.3% 10.9% Note: DPS refers to dividends per share; EPS refers to earnings per share. Page 699 Ladies and gentlemen, Don began, after being introduced by Sidney, I'll skip the preliminaries and get right to the point. I think that Montgomery's dividend policy is not in the best interests of our shareholders. Observing the rather chilly stares from around the room, he hastened on: Now, I don't mean we have a bad policy or anything like that; it's just that I think we could do an even better job of increasing our shareholders' wealth with a few small changes." He paused for effect. Let me explain. Up to now our policy has been to pay a constant dividend every year, increasing it occasionally to reflect the company's growth in sales and income. The problem is, that policy takes no account of the investment opportunities that the company has from year to year. In other words, this year we will use most of our net income to pay the same, or a greater, dividend than last year, even though there might be company investments available that would pay a much greater return if we committed the fun to firm's estments ead. effect, our holders are being shortchanged: they will realize perhaps a 6 percent yield on their investment as a result of receiving the dividend, when they could realize a 12 percent or higher return as a result of the company's return on its investments. I see this as a serious shortcoming in our management of the shareholders' funds." Now, fortunately, correcting this situation is not difficult. All we have to do is adopt what is called a residual dividend policy. That is, each year we would allocate money from income to those capital spending projects for which the returnthat is, IRR- is greater than our cost of capital. Any money that is not so used in the capital budget would be paid out to the shareholders in the form of dividends. In this way we would ensure that the shareholders' money is working the hardest way it can for them." Clarence Autry, who was also on the board of directors of the Canadian Pacific and no stranger to the world of corporate finance, broke in. Young man, he said dryly, your proposal ignores reality. It's not whether the shareholders are theoretically better off that counts; it's what they want that counts. You cannot tell the shareholders you're doing what's best for them by cutting the dividend; the dividend is what they want. Not only is that dividend sure money in their pockets now, but the fact that it's the same size as last time, or even higher, is a signal to them that their company is doing well and will continue to do so in the future. These decisions can't always be made on the basis of good-looking formulas from the back room, you know. Barbara Reynolds, who was the head of the directors' auditing committee, and somewhat of an accounting expert, agreed with Clarence. That's a good point, and one that's well recognized by our competitors too. If you check, I don't think you'll find a single one of them that's cut their dividend in the last six years, even though their net income may have declined significantly. Furthermore, the whole argument is meaningless anyway, because the dividend is not really competing with the capital budget for funds. We don't turn away profitable projects in favour of paying the dividend. If there are worthy projects in which we want to invest, and we would rather use our available cash to pay the dividend, then we seek financing for the investments from outside sources. In a way, we can have our cake and eat it too. She chuckled, pleased at the analogy. Don, however, was not to be intimidated. Yes, ma'am, what you say is true, he replied, and I would respond that our competitors are not treating their shareholders fairly, either. Furthermore, we do seek outside financing occasionally for large projects, but there are two problems associated with doing it routinely, as you suggest. First, it might be viewed as borrowing, or issuing stock, to pay the dividend, which would cast the company in a very poor light. Second, it's more expensive to finance from outside sources than from inside due to the fees charged by the investment dealers. Therefore, I believe we should exhaust our inside sources of financing before turning to the outside." Barbara stood her ground. That's all very well, but it's still not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the company's cash balances were about to be drawn down too low, we could always declare a stock Page 700 dividend instead of a cash dividend." Ladies, gentlemen, Chairman Edward Asking intervened, your comments are all very perceptive, but we must move on to the business at hand. All in favour of changing to a residual dividend policy, please raise your hand. a. Refer to Table 1 . Would you say that Montgomery's policy up to now has been to pay a constant dividend, with occasional increases as the company grows? b. Refer to Table 2 Q. What type of dividend policies would you say are being practised by Montgomery's competitors in the retailing industry? Do you think that any firms are following a residual dividend policy