Analyzing Montgomerys Dividend Policy

Introduction

1. Refer to Figure 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?

Montgomery has maintained the dividend policy of paying a regular dividend to their stakeholders. This steady dividend policy increases every time the firm produces. Since 200, the amount committed to paying dividends has grown each year, but particular emphasis has been placed on the figures that show dividends paid on every share. In 2000, they paid.

36, 2001 they paid $1.48, 2002 they paid $ 1.70, 2003 and 2004 the firm paid $1.76 each year, and in 2005 it paid dividend per share of $ 1.96 showing a steady increase over the six years. The top-level management has been confident about the constant or slight annual increase of the DPS because of the yearly rise in the overall number of shares every year since 2000 (Baker, 2009).

2. Refer to Figure 2. What type of dividend policies would you say are being practiced by Montgomery’s competitors in the retailing industry? Do you think that any firms are following a residual policy?

The main competitors that Montgomery has been competing with are Wal- mart, J.

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C Penney, and Dollar General. The two firms are using the same policy used by Montgomery as they strive to increase their dividend per share each year. In 2004, despite Earnings per share, reducing by over 75% the dividend per share was held at $0.20. The dollar increased their profits by more than 17% despite the EPS decreasing by 14%.

It is clear that a growth and stable dividend are critical factors considered by any growing retail company.

We see that Wal-Mart, which is the biggest retail industry, also ignores emphasizing on capital growth as they go for stability in dividend and growth. The same case applies to J.C Penney, who maintains a stable dividend per share despite fluctuations in EPS. Montgomery has the highest average payout ratio compared to even Wal-Mart because of the long period they have been in the industry and with the same dividend policy, their DPS increase every year (Baker, 2009).

Question Two

2. Calculate the expected return to the common stockholders under the firm’s present policy, given an expected dividend next year of $2.10 and a growth rate of 7.1 percent. Montgomery’s stock currently sells for $35.(Use the dividend growth model): Expected return (K_e) = D₁ / P₀ + g

D₁ = $2.10,

g = 7.1%,

P₀ = $35, K_e,

• Expected return to stockholder = $2.10/$35 + 7.1% = 6+ 7.1 = 13.1%

1. Assume that, if Don Jackson’s proposal were adopted, next year’s dividend would be zero, but earnings growth would rise to 14 percent. What will be the expected return to the stockholders (assuming the other factors are held constant)?

Adopting Don’s suggestion will see the Stockholders earn no dividend at all, but the growth will increase by 14% with an expected return remaining the same as the growth rate.

• Expected Return to Stock holders= 0/$35+ 14% = 14%.

Don’s suggestion will see the stakeholders enjoy an additional 0.9% on their expected return, thus the need to see the advantages of Don’s policy. Therefore, the firm cannot completely ignore the idea of changing to a residual dividend policy. On the other hand, the same stockholders will only make a 14% gain by selling their shares yet the current dividend policy earns them a 13.1%. Since there are no advantages enjoyed by capital gain as a result of existing legislation, then it could be wise for the Company to maintain the dividend policy they are using. This is because the shareholders could only benefit from residual dividend policy if the firm grew to 14% a fact that is only speculation. If the growth fall below13. 1% then the current system is still the best (Baker &Filbeck, 2012).

Question three

Don’s suggestion supports the fact that dividend and capital budget should be paid from the current year’s net income, a case that is untrue. This happens because the firm is being limited by the cash they are holding. The company’s balance in 2005 was $3,235,000 being the maximum amount that can be paid to the capital budget together with a dividend without having to outsource for funds or sell its existing assets. Paying dividends from retained earnings will force firms to sell their property since they are not hard cash (Baker &Filbeck, 2012).

Question four

1. Don says the cost of the outside financing is more expensive than the cost of internal financing, due to the flotation costs charged by investment bankers. Given the data you have, what would you say is the firm’s cost of internal equity financing?

The cost of borrowing from outside sources will only be higher because of costs incurred during flotation.

1. Assume Montgomery can sell bonds priced to yield 13 percent. What is the firm’s after-tax cost of debt? (The tax rate is 25 percent.

Bonds yield=13%. Therefore, after tax cost = 13%, multiply by (1-0.25) = 9.75%.

1. Given the cost of debt and the cost of internal equity financing, why doesn’t Montgomery just borrow the total amount needed to fund the capital budget and the dividend as well.

Borrowing money for capital budget and dividend will affect the debt-equity, causing it to be out of proportion as it will increase the cost of financing of debts as well as the costs of all other financial means  (Baker &Filbeck, 2012).

Question five

Do you go along with Clarence Autry’s comment that it is what the stockholders want that counts, not their total rate of return? Why or why not?

Mr. Autry is against the residual dividend policy. This  means that the shareholders will not have a say or preference on the type of repayment they receive for investing in Montgomery as long as they earn the highest returns. If they are given the opportunity to choose, they will not go for that policy. There are no rules for determining whether shareholders can have a preference or how much they will benefit from it, thus making the issue very controversial. But the retailing industry as shown in the figures above for Wal-mart, J C Penney and dollar, they give shareholders a preference which is taking the current dividend paid rather than investing the cash in more attractive investments (Baker &Filbeck, 2012).

Question six

Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for a cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction, is the stock dividend an equivalent substitute for a cash dividend?

As much as the firm is in a position to pay share dividend and not cash dividend, not all stockholders will be comfortable for some will feel that nothing was actually paid to them. This is so because the share dividend is just but a mere paper which the shareholders sign to create more shares. This could only become beneficial if it increased the shareholders total cash dividend which will go into the role of a stock dividend to conserve funds (Baker, 2009).

Question seven

After all is said and done, do you think the firm’s dividend policy matters? If so, what do you think Montgomery’s policy should be.

Whether going for residual dividend policy or payment of a cash dividend, every financial analyst has his or her views. Many would argue that borrowing to invest rather than using the available money would increase costs due to flotation that are associated with borrowing from outside sources hence need to go for a residual dividend policy. On the other hand, Montgomery being an old firm that is used to the current dividend policy will be better off sticking to it. Consequently, leave residual dividend policy for new emerging retail companies (Baker, 2009).

References

1. Baker, K.  (2009). ‘Dividends and Dividend policy.’eighth edition, Harvard Business School Press: New York.
2. Baker, K. & Filbeck, G.  (2012). ‘Alternative investments: Instruments, Performance, Benchmark and Strategies.’2nd edition, Harvard Business School Press: New York.