Shenzhen Medical Devices Dividend Policy Decision

Shenzhen Medical Devices Ltd. (SMDL) is a hypothetical company based in Shenzhen, China. SMDL is emerging as a leader in providing medical testing equipment to the pharmaceutical and biotechnology industries. SMDLs primary markets are growing, and the company is spending 100 million a year on research and development to enhance its competitive position. SMDL is highly profitable and has substantial positive free cash flow after funding positive NPV projects. During the past three years, SMDL has made significant share repurchases.

Subsequent to the removal of tax on cash dividends from shares held more than a year in mainland China, SMDL management is proposing the initiation of a cash dividend. The first dividend is proposed to be an annual dividend of 0.40 a share to be paid during the next fiscal year. Based on estimated earnings per share of 3.20, this dividend would represent a payout ratio (DPS/ EPS) of 0.125 or 12.5%. The proposal that will be brought before the board of directors is the following: Proposed: Shenzhen Medical Devices Ltd. will institute a program of cash dividends. The first dividend will be an annual dividend of 0.40 a share, to be paid at a time to be determined during the next fiscal year. Thereafter, an annual dividend will be paid, equal to or above this amount, consistent with the intention of reaching a target payout ratio of 25% in line with managements expectation for long-term sustainable earningsthereby retaining funds sufficient to finance profitable capital projects.

The companys board of directors will formally consider the dividend proposal at its next meeting in one months time. Although some directors favor the dividend initiation proposal, other directors, led by Director Z, are skeptical of it. Director Z has stated: The initiation of a cash dividend will suggest to investors that SMDL is no longer a growth company. As a counterproposal, Director Z has offered his support for the initiation of an annual 2% stock dividend. Director W, a director who is neutral to both the cash dividend and stock dividend ideas, has told Director Z the following: A 2% stock dividend will not affect the wealth of our shareholders.

The exhibit below presents selected pro forma financials of SMDL, if the directors approve the initiation of a cash dividend.

Exhibit: Selected pro forma financials in millions

Income statement

Sales 1200

Earnings before taxes 155

Taxes 35

Net income 120

Ratios

Current ratio 2.1

Debt/ Equity 0.27

Interest coverage 10.8

ROA 10%

ROE 19.3%

P/E 20

Five - year forecasts

Sales growth 8% annually

Earnings growth 11% annually

Projected cost of capital 10%

Other information

Proposed dividend 15 million

Share repurchase 32 million

Debt repayment 4 million

Required:

Using the information provided, address the following:

1 Critique Director Zs statement.

2 Justify Director Ws statement.

3 Identify and explain the dividend policy that the proposed 0.40 a share cash dividend reflects