In Their Own Words

Anthony S. Thornley on Why Qualcomm Pays No Dividends

Qualcomm has consistently been able to generate for its shareholders a significantly higher return than the shareholders could get from being paid a dividend. It has no "excess" cash for dividends. If Qualcomm paid a dividend, our shareholders would view it very negatively. Qualcomm would be saying, "We have run out of good profit opportunities." Our shareholders don't like dividends as much as they like the capital gains from Qualcomm's growth and profitability.

Anthony S. Thornley is Executive Vice President and Chief Financial Officer of Qualcomm. Qualcomm trades on NASDAQ and is part of the Standard & Poor's 500 Index. Its average annual growth rate in earnings over the past five years has been 65 percent.

Alan J. Fohrer on Why Edison International Pays Dividends

Utility investors like dividends. Historically, Edison International has paid out considerably more than 50 percent of its earnings as dividends. Investors have viewed utilities such as Edison as defensive stocks where dividends are a cushion against stock market volatility. As a utility, Edison has had limited growth opportunities and has been able to finance their growth out of retained earnings and new stock. In 1994, Edison reduced its dividend reflecting changes in the utility business and Edison's increasing participation in higher growth, nonutility business.

Alan J. Fohrer is Executive Vice President and Chief Financial Officer of Edison International.

If s = 0, Div1 = Div0. In other words, there is no change in dividends at all. Real-world companies can be expected to set s between 0 and 1.

An implication of Lintner's model is that the dividends-to-earnings ratio rises when a company begins a period of bad times, and the ratio falls when a company reaches a period of good times. Thus, dividends display less variability than do earnings. In other words, firms smooth dividends.

Dividends Provide Information to the Market

We previously observed that the price of a firm's stock frequently rises when its current dividend is increased. Conversely, the price of a firm's stock can fall significantly when its dividend is cut. In other words, there is information content in dividend changes. For example, consider what happened to Pacific Enterprises a number of years ago. Faced with poor operating results, Pacific Enterprises omitted its regular quarterly dividend. The next day the common stock dropped from 24/8 to 18/8. One reason may be that investors are looking at current dividends for clues concerning the level of future earnings and dividends.

A Sensible Dividend Policy

The knowledge of the finance profession varies across topic areas. For example, capital-budgeting techniques are both powerful and precise. A single net-present-value equation can accurately determine whether a multimillion dollar project should be accepted or rejected. The capital-asset-pricing model and the arbitrage-pricing model provide empirically validated relationships between expected return and risk.

Conversely, the field has less knowledge of capital-structure policy. Though a number of elegant theories relate firm value to the level of debt, no formula can be used to calculate the firm's optimum debt-equity ratio. Our profession is forced too frequently to employ

© The McGraw-Hill Companies, 2002

Chapter 18 Dividend Policy: Why Does It Matter? 521

The Pros and Cons of Paying Dividends

Pros

Cons

1. Cash dividends can underscore good re

1.

Dividends are taxed as ordinary income.

sults and provide support to stock price.

2. Dividends may attract institutional in

2.

Dividends can reduce internal sources of

vestors who prefer some return in the

financing. Dividends may force the firm

form of dividends. A mix of institutional

to forgo positive NPV projects or to rely

and individual investors may allow a firm

on costly external equity financing.

to raise capital at lower cost because of

the ability of the firm to reach a wider

market.

3. Stock price usually increases with the

3.

Once established, dividend cuts are

announcement of a new or increased

hard to make without adversely affect

dividend.

ing a firm's stock price.

4. Dividends absorb excess cash flow and

may reduce agency costs that arise

from conflicts between management

and shareholders.

P I Ross-Westerfield-Jaffe: I IV. Capital Structure and I 18. Dividend Policy: Why Corporate Finance, Sixth Dividend Policy Does It Matter?

Edition rules of thumb, such as treating the industry's average ratio as the optimal one for the firm. The field's knowledge of dividend policy is, perhaps, similar to its knowledge of capital-structure policy. We do know that:

1. Firms should avoid having to cut back on positive NPV projects to pay a dividend, with or without personal taxes.

2. Firms should avoid issuing stock to pay a dividend in a world with personal taxes.

3. Repurchases should be considered when there are few positive new investment opportunities and there is a surplus of unneeded cash.

The preceding recommendations suggest that firms with many positive NPV projects relative to available cash flow should have low payout ratios. Firms with fewer positive NPV projects relative to available cash flow might want to consider higher payouts. In addition, there is some benefit to dividend stability, and unnecessary changes in dividend payout are avoided by most firms. However, there is no formula for calculating the optimal dividend-to-earnings ratio.

CASE Study: How Firms Make the Decision to Pay Dividends: The Case of Apple Computer

Perhaps the most important dividend decisions a firm must make are when to pay dividends for the first time and when to omit them once they have started.We study the case of Apple Computer for clues to why firms pay dividends and later on omit them.

In 1976 two young friends, Stephen Wozniak and Steven Jobs, built the Apple I Computer in Jobs's garage in the "Silicon Valley" area of Northern California and founded Apple Computer, Inc. The first Apple was built and sold without a monitor, or keyboard.The Apple II was introduced in 1977 and was targeted at the home and educational markets as a personal computer.The Apple II was very successful, and by 1980 over 130,000 units had been sold and Apple's revenues were $117

Ross-Westerfield-Jaffe: I IV. Capital Structure and I 18. Dividend Policy: Why I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy Does It Matter? Companies, 2002

Edition

Part IV Capital Structure and Dividend Policy million. In 1980 Apple "went public" with an initial public offering (IPO) of common stock. Shortly thereafter,Wozniak left Apple and John Scully was hired from Pepsi to become president.Apple did not do well with its Lisa (1983) and Apple III computers, but the Macintosh (1984) was a huge hit— primarily in the home and educational markets. In 1985, after a widely publicized struggle for power with Scully, Jobs left to start another computer company called Next.

In many ways 1986 was a watershed year for Apple. By the end of l986,Apple had revenues of $1.9 billion and net income of $154 million. From 1980 to 1986 its annual growth rate in net income was 53 percent. In 1986, with Mac Plus, Apple launched an aggressive effort to penetrate the expanding office computer market—the domain of its main rival IBM. However, its future prospects were not necessarily bright. Much depended on Apple's ability to do well in the business market. Competition was very intense in early 1987, and Sun Microsystems slashed the price of its least costly computer workstation to try to stop encroachment by the Apple Mac. However,Apple surprised everyone with large earnings gains in the final quarter of 1987 and by disclosing the fact that the sales on Macintosh models had increased by 41 percent.

To demonstrate its faith in its future, to underscore the recent success of the Mac, and to attract more institutional investors, on April 23, l987,Apple declared its first ever quarterly dividend of $.12 per share. It also announced a two-for-one stock split.The stock market reacted very positively to the announcement of Apple's initial dividend. On the day of the announcements, its stock increased by $1.75. Over a four-day time span the stock rose by about 8 percent.

The initial dividend turned out to be a positive portent, and the next four years were good years for Apple. At the end of 1990, Apple's revenues, profits, and capital spending had achieved record highs.

1986

1990

Growth per Annum from 1986 to 1990

1997

Growth per An from 1990 to 1

Revenues (in millions)

$1,902

$5,558

31%

$7,081

4%

Net income (in millions)

154

475

33

-379

NA

Capital spending (in millions)

66

223

36

63

-16

Stock price

$ 20

$ 48

24

$ 24

-10

Long-term debt (in millions)

0

0

0

950

NA

Dividends per share

0

$ .45

0

-100

Why do firms like Apple decide to pay dividends? There is no single answer to this question. In Apple's case, one part of the answer can be traced to Apple's attempt to "signal" the stock market about the potential growth and positive NPV prospects of its attempt to penetrate the office computer market.The payment of dividends can also "ratify" good results.Apple's initial dividend served to convince the market that Apple's success was not temporary.

Why did Apple announce a two-for-one stock split at the same time of its announcement of an initial cash dividend? It is often said that a stock split without a cash dividend is like giving shareholders two five-dollar bills for a $10 bill.Your wallet feels thicker but you are no better off. However, a stock split accompanied by a cash dividend can amplify the positive signal and pack a more powerful message than would be true otherwise. In addition,firms sometimes split their shares, because they believe a low stock price may attract more individual investors and as a consequence increase liquidity. However, the evidence is not clear on this point, and some firms like Berkshire Hathaway disdain stock splits. (Its stock was recently selling at $67,000 a share.)

Was Apple's decision to offer an initial dividend the best decision for the company? This is an impossible question to answer precisely. However, the stock market's positive reaction and Apple's subsequent performance suggest it was a good decision. Unfortunately, the years since 1990 have not been as good for Apple. Its revenue growth has moderated and its profits have declined due to a difficult transition from a high-priced, high-quality producer of personal computers to a more competitively priced producer. It experienced losses in 1996 and 1997. Apple's small market share has become a problem because software developers have been more interested in producing products that could run on Intel-based machines.At the end of l997,Apple's stock price was at $24 per share— lower than in 1990. In Figure 18.9, we plot Apple's earnings per share and dividends per share from

Ross-Westerfield-Jaffe: I IV. Capital Structure and I 18. Dividend Policy: Why I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy Does It Matter? Companies, 2002

Edition

Chapter 18 Dividend Policy: Why Does It Matter? 523

■ Figure 18.9 Dividend Pattern ofApple Computer from 1983 to 2000

Apple Eps And Dividend After 2002
Year

1981 to 1997. As can be seen, dividend changes have tended to lag earnings changes. In 1992, when earnings per share increased from $3.74 to $4.33 there was no change in dividend payouts. And when in 1993,earnings per share declined to $2.45, Apple did not change its dividend payouts. However, Apple's dividend was completely omitted in 1996.

Now we have another question, why did Apple omit its dividend in 1996? The firm had experienced several market setbacks. It was forced to retreat from its much heralded "cloning" strategy. In an important shift in strategic thinking, Apple had started licensing its Mac operating system to other manufacturers. Unfortunately, instead of attracting new buyers, this policy was eroding its own base and sales fell sharply. As a consequence, Apple experienced operating losses of $742 million in 1996 and $379 million in 1997.

Looking back at Figure 18.9, it can be seen that Apple's dividends have been more stable over time than its earnings.This is typical of the dividend policy of most firms. Stability cannot be maintained forever in the face of huge operating losses and most companies ultimately slash dividends if the losses continue.

Apple has not yet resumed its dividend, despite the fact that its earnings per share climbed to $3.45 in 2000. Its recent stock price was $109—a record high. Current sales appear strong, especially for its iMac consumer product.The market has responded well to its iBook and Power Book portables. A deal with EarthLink could make Apple the exclusive internet access provider bundled with Macs. Now we ask the question: Should Apple resume its dividend payout? ■ ■ ■ ■ ■

Ross-Westerfield-Jaffe: I IV. Capital Structure and I 18. Dividend Policy: Why I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy Does It Matter? Companies, 2002

Edition

524 Part IV Capital Structure and Dividend Policy

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Responses

  • renzo li fonti
    How to firms make decision to pay dividends: ross westerfield?
    7 years ago
  • lois
    How firms make the decision to pay dividends: the case of apple computers?
    7 years ago
  • celso
    How firms make a decision to pay dividends: the case of apple computer?
    7 years ago
  • prima
    How firm make the decision to pay dividend: the case of apple computer?
    7 years ago
  • Onni
    How firms make the decision to pay dividens:the case of apple computer?
    7 years ago

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