Session-04

DIVIDEND POLICY
&
CAPITAL STRUCTURE
FUZZY TRONIC INC.
-Case Discussion
Q Nos. 1 to 7
Let us focus on the Directive
Questions:

What is FT
FT’s
s Optimal Capital
structure as well WACC?

The case reports that Fuzzy Tronic

was operating with an optimal
capital structure in 1996, the year
the firm initiated the payment of
dividends.
Using the balance sheet data for this
year as a guide,
id the
th firm’s
fi ’ optimal
ti l
debt ratio is:

Total liabilities* ÷ Total assets =

$137 ÷ $1,137 = 12%

And its optimal equity ratio is

Total equity ÷ Total Assets =

$1,000
$ , ÷$$1,137
, = 88%
* One can also take LTL too
According to the data shown in Table
3 Fuzzy Tronic
3, Tronic’s
s after tax cost of
debt is 7 percent, and the firms cost
of equity capital is 14 percent.
percent

Thus, the weighted average cost of

Thus
capital is
(wtd) *(kd) + (wte) *(Ke)

(0.12)(0.07)
(0 12)(0 07) + (0.88)(0.14)
(0 88)(0 14) =
13.16%
2. What is the total dividend
expenses in 1997,
1997 98,
98 99 and
2000?
Year  Forecast  Number of  Total Dividend
Dividends per  shares 
share outstanding
1997  $1.00 150,000 $150,000
1998  1.25 150,000 187,500
1999  1.50  150,000  225,000 
2000  1.57 150,000 235,500
 
 
3. Dividends are paid from residual
earnings and increasing the
dividend payment reduces the rate
of growth in retained earnings,
earnings
which in turns alter the corporate
capital structure.
structure
According to the data shown in the case
1996 1997 1998 1999 2000
Net Income $189  $201  $213  $222  $238 
Less: Dividend expense
Less:     Dividend expense ‐135 ‐150 ‐188 ‐225 ‐236
Equals:  Change in retained  $54  $51  $25  ($3) $2 
earning

Total equity capital
Total equity capital $1,000 
$1 000 $1,051 
$1 051 $1,076 
$1 076 $1,073 
$1 073 $1,075 
$1 075
Equity ratio (TE / TA) 88% 88% 86% 81% 78%
Please note that the increasing
annual dividend payments claim a
larger and larger proportion of the
firm’s net income over the 1997-
2000 period.
period
Hence Fuzzy Tronic is not able to
maintain its target equity ratio of
88% percent beyond 1997.

Why so?

This change in capital structure

occurs because fuzzy Tronic
Tronic’s
s annual
growth in dividends exceeds the
growth in sales and income
                                                                      GROWTH COMPUTATIONS

Sales Growth
31 t D
31st December 1996
b 1996 2049 ‐
32nd December 1997 2151 0.050 4.98
33rd December 1998 2259 0.050 5.02
34th December 1999 2372 0.050 5.00
35th December 2000 2500 0.054 5.40
5.10

Income Growth
Net Income ‐1996 189
Net Income ‐1997 201 0.0635 6.349
Net Income ‐1998 213 0.0597 5.970
Net Income ‐1999 222 0.0423 4.225
Net Income ‐2000 238 0.0721 7.207
5.94

Dividend Growth
Dividend Growth
Dividiend 1997 150,000
Dividiend 1998 187,500 0.25 25
Dividiend 1999 225,000 0.2 20
Di idi d 2000
Dividiend 2000 235 500
235,500 0 047
0.047 4 667
4.667
16.56
Q.No.4

This question is helps us discover the

sources of cash used to meet Fuzzy
Tonics increasing dividend
expenditures over the 1997-2000
1997 2000
period .

The co unable to completely fund its

dividend growth over the 1997-2000
1997 2000
periods from net income because
Rate of growth in dividends
(averaging 16% over the 1997-2000
1997 2000
period) exceeds the rate of growth in
sales and profits (averaging less
than 6 % over the same period).
Is it from short-term or long-term
L
Loans? ?
Where is the money supporting the
fi
firm’s
’ dividend
di id d growth
th coming
i f
from?
?

To answer this
T thi question,
ti one mustt
prepare common size representation
off the
th li bilit accounts
liability t shown
h i
in
Table 2 and then examine the
relative
l ti f di
funding contribution
t ib ti
provided by various liabilities over
th 1997-2000
the 1997 2000 periods:
i d
                                                         Common‐size Statement
1997 1998 1999 2000
$ % $ % $ % $ %
Accounts Payable $34  3  $46  4 $69  6 $95  7
Income taxes Payable 18 2  28 2 43 3 53 4
Accrued expenses 20 2  30 2 51 4 79 6
Current debt obligations other 0 0  0 0 0 0 0 0
Current liabilities – other 16 1  19 2 29 2 29 2
Total Current liabilities $88  7  $123  10  $192  15  $256  19 
Long term debt 55 5  55 4 55 4 55 4
Total Liabilities $143  12  $178  14  $247  19  $311  23 

Common stock $422  35  $422  34 $422  32 $422  30

Retained earnings 629 53  654 52 651 49 653 47
Total common equity $1,051  88  $1,076  86  $1,073  81  $1,075  77 
Total liabilities & equity $1,194  100  $1,254  100  $1,320  100  $1,386  100 

Note: percentage may not sum to 100% due to rounding up

Thus, when Fuzzy’s net income is
insufficient to pay the dividend
payments (i.e. in 1999), the
firm is financing its dividend increase
with current liabilities particularly
accounts payable and accrued
expense.

Financing dividend increases with

current liabilities is in-appropriate
in appropriate
and unsustainable over long periods
of time.
time
To fund projected dividend

1)increase its sales and/or profit

growth rate; or

2) issue additional common stock.

Q.No.5
Since only the automotive
transmission software project
displays a rate of return in excess of
Fuzzy Tronic’s marginal cost of
capital (IRR>MCC)this is the only
project the firm should undertake.

The optimal capital budget for 1997

is thus $175
$175,000
000
Q.No.6
Applying the (Div growth model)
Fuzzy Tronic’s common stock is
currently worth.
worth
  +  +    +    

$0.88
$0 88 - $0.96
$0 96 + $1.01
$1 01 + ($17.44
($17 44 X
0.675D) = $ 14.62 per share
Book value per share (1996) is

$ 1,000,000 /1,50,000 shares =

$6 67
$6.67

And its market to book ratio is

$ 14.62 / $6.67 = 2.2 times.

The firm’s current earnings per share

(1996) are:
$ 189,000 /1,50,000 shares = $ 1.26
1997:
$201 000 /150,000
$201,000 /150 000 shares =$1.34
=$1 34

And therefore the P/E Ratio

1996:
14 62/1 26 = 11.6
14.62/1.26 11 6 Times
1997:
14 62 / 1.34
14.62 1 34 = 10.9
10 9 Times
At present, Fuzzy Tronic’s common
stock is selling around 2 times book
and about 11 times the firm’s P/E
Ratio .
The case reports that the firm
(1) is relatively small in size
(2)operate in a new and poorly-
understood high technology
industry,
(3) has only recently initiated
dividend payments to its
shareholders and
shareholders,
(4) has relatively limited growth
prospects (without the
transmission software project).
Given this qualitative information
drawn from the case,case one should
recognize that Fuzzy Tronic’s
market to book and price earnings
market-to
ratios indicate that:

the market places a fairly high

premium on the firm’s
firm s current
earnings stream and growth
prospects.
prospects
Q.No.7
Under the residual dividend model,
model
Fuzzy Tronic must
(1) establish its optimal capital
budget,
(2) determine the amount of equity
(i.e. retained earnings)
needed to finance the capital
budget
(3) identify the quantity of retained
earnings available to supply
equity financing and
(4) establish a dividend payment
only when retained earnings
exceed the equity funding
requirement supporting the
optimal capital budget.

The solution to Question 5

demonstrates that the optimal
capital budget for 1997 is
$175,000, the cost of the
transmission software project.
The next step is to determine the
level of retained earnings necessary
to support this optimal capital
budget.
g

If the co pays no dividends in 1997,

and the optimal capital structure is
12 percent debt and 88 percent
C
Common equity
it the
th can raise:
i

$201,000
$201 000
0.88
Total financing = $228,409
Suppose if they go ahead with the
proposed dividend in 1997 what
happens?
201 000 -$150,000
201,000 $150 000 = $51
$51,000
000
available in residual earnings;
Thus Fuzzy Tronic can raise only
0.88 X Total Financing Required =
51 000
51,000
Total financing = $57955

So, it is not possible to pay the

desired dividend and also maintain
the capital structure in 1997
According to the residual dividend
model Fuzzy Tronic should retain
model,
sufficient earnings to support its
$175 000 capital expenditure and
$175,000
pay any residual earnings to
shareholders as dividends.
dividends
Thus firm should retain
0 88 x $175,000
0.88 $175 000 = $154,000
$154 000
Leaving a 1997 dividend payment of:
$201 000 - $154,000
$201,000 $154 000 = $47
$47,000
000
Or
$47 000 / 150,000
$47,000 150 000 shares = $0.31
$0 31
per share
If Fuzzy Tronic uses the projected
financial statement data shown in
Tables 1 and 2 to establish its
Projected financial condition over
the 1997-2000 periods, the valuation
data presented in the solution to
question 6 remain unchanged with
the exception of a decrease in the
1997 dividend payment from $1.00
per share to $ 0.31
0 31 per Share.
Share
The projected dividends over the
1998 -2000
2000 period remain $1.25,
$1 25 $
1.50 and $ 1.57, respectively and the
firm’s
firm s rate of sustainable annual
growth in earnings and dividends
remains 5%.
5%

In this context the value of Fuzzy

Tronic’s common stock will be?
(comparing to Q.No.6)
Q No 6)
     +     +     ‐      x          = 
       
 

$0.27 + $0.96 + $ 1.01 + $11.77 = $14.01

At this point, I don’t know why

F
Fuzzy T
Tronic’s
i ’ stock
k price
i f ll ?
falls?

Though
Th h the
h firm
fi accepts a positive
i i
net present value project (software
t
transmission)?!!
i i )?!!
The answer is relatively simple
acceptance of the project will charge
the firm’s projected financial
statement
statement, so the information
contained in Tables 1 and 2 is no
longer an appropriate foundation for
valuing Fuzzy Tronic’s common
stock.
stock
In Question 8 through 10, we will
revise the firm
firm’s
s pro forma financial
statement to include the impact of
the transmission software project,
project
and evaluate how this project will
affect Fuzzy Tronic
Tronic’s
s financial
performance, condition and dividend
payout plans.
plans