Case 1 Linear Technologies

Group 15

2006120001

2006120124

2007120155

2007120262

Three main issues arise when it comes to dividend policy in firms. The first issue is whether

dividend is needed or not and the second issue is regarding which one would be the best option

among various payout methods. Lastly, the third issue is about dividend rate. Whether these

issues will affect corporate values has been debated over the years. This paper will talk about

such issues through the case study of Linear Technology.

1. Why dividend is needed.

Linear Technologys payout policy, unlike many competitors in the Semiconductor Industry,

has a relatively large portion in dividends. Linear has provided steady dividends since 1992 in a

gradually increasing rate in small amounts. Why do firms pay dividends? Can dividends raise

the value of firms?

To answer these questions, lets assume that Linear pays out its entire cash balance as a

special dividend. For the detailed reference and information, the appendix attached at the end

can be reviewed. There would be two different kinds of approaches to this example. The first

approach would be adopting the assumptions of M&M1 and adjusting Linears situations to it.

In conclusion with M&M, the value of the firm will remain steady regardless of the dividend

policy. We can simulate two symmetric firms that only vary in the dividend payout ratio. If

there is a difference in firm values or share prices between these firms, investors would not let it

be and just do their households. Investors in the market would reveal the opportunity of

arbitrage. Therefore, the value of two symmetric firms should be the exactly the same. To sum

up, there would be no change in value, earnings or EPS. The stock price would just decline just

as the amount of dividend payout. However, if we peel the onion of assumptions, things get

different.

On the other hand, by taking the second approach and sticking to the fact that dividend

policies can affect the value of the firm, we can compare new result with the prior result. As the

cost of capital is lower than Linears Return on Equity, Linears stock is a growth stock. Being a

growth stock means the company earns more than what its shareholders request for their

investment. On this condition, paying out entire cash balance will possibly lower Linears future

earnings, EPS, stock price and its company value, as the company has lesser amount of cash in

its hands for future investment after paying dividend.

But Linear has paid out constant dividends in spite of the results above. The reasons are as

follows. Linear believes that offering dividends appeals to potential investors who not only

focus on the growth of the firm but also have interests in definite incomes. Some shareholders

may prefer dividends now rather than uncertain income of the future. They also thought that

providing dividends can give a signal which represents stability of business as supported by

1 See M.H. Miller, F. Modigliani: Dividend Policy, growth and the Valuation of Shares

dividend signaling hypothesis. It can also make it easier to get more money by getting into debts.

And other numerous studies assert the fact that firms with more favorable inside information

optimally pay higher dividends and receive appropriately higher prices for their stock2.

2. Whats the best option between dividends and repurchase?

Linear is powering through stock repurchase in the recent fiscal years. There are two major

reasons explaining this increasing amount of stock repurchase. Linears employee compensation

is mostly based on stock options and profit sharing. In order to counterbalance the exercise of

stock options, Linear is buying back stock. Another reason is the lack of profitable investment

opportunities. But the practical reasons exist. Stock repurchases are discretionary compared to

dividends. Additionally, stock repurchase doesnt affect the value of the shareholders3.

Go back to the example mentioned above. If the company pays out by repurchasing shares,

the two approaches do not show a difference. Since the firms stocks are growth stocks, the cash

used to repurchase stocks lacks the opportunity of generating high cash flows. Accordingly, the

market price would result in decreased future earnings, EPS, and the firm value of Linear. The

number of outstanding shares, instead of the price, will decrease. While the price of stock would

increase just as the amount of cash paid out to repurchase the outstanding stocks. It is important

that in both cases, earnings and earnings per share before the payment are not affected.

3. About the dividend rate

Firms judge the rate of dividend initiations by earnings. However, simply put, if dividend

rate changes depending on the change of earnings, the fluctuation of dividend will increase. This

would not be good. Because cutting dividends means uncertain future cash flows. If a company

cuts dividend rate, shareholders will need higher opportunity costs of capital, as a result stock

prices will go down. Thus, Linear has retained constantly increasing dividend rates in small

amounts.

Under the theoretical assumptions such as M&M, there is no difference whether firms pay

out dividends or not. And if the cost of capital is lower than a firms ROE, no dividend can raise

a firms value. However, considering the real-life factors, firms should keep on steady level of

dividend rate or repurchasing shares. Repurchasing shares seems to be a better solution. As a

conclusion, Linears CFO Paul Coghlan should recommend to the board that Linear should

maintain the dividend rate and repurchase its stocks, so that the stock repurchase amount of

2003 exceeds that of 2002.

2 See Kose John and Joseph Williams: Dividends, Dilution, and Taxes: A Signaling Equilibrium

3 See Larry Y. Dann, Common stock repurchases: An analysis of returns to bondholders and stockholders

Appendix 1

1) Basic Calculations/Assumptions Used.

Since there is no long term debt, . Thus,

.

The corporate tax rate is assumed 30%.

Capital gains tax rate and tax rate on dividends is assumed 15%.

(reflecting the upcoming change in tax rates)

The entire forecasted sales amount for 2003 would be

(in millions of dollars). Accordingly the

entire Earnings Before Interests and Tax (EBIT) for 2003 would be

approximately . Which can lead us to a

Net Income of

2) The Miller & Modigliani Approach.

Two symmetric firms that only vary in dividend payout ratio.

Firm A: Steady, continuous EBIT that equals to $327. Cost of capital =

3.8316%, tax rate = 30%, No dividend payout. 312.4 shares outstanding.

(1) Value of Firm =

(2) Share price =

(3) EPS(Earnings per share) =

Firm B: Steady, continuous EBIT that equals to $327. Cost of capital = 3.8316%,

tax rate = 30%, Dividend payment $0.05 per share(27% payout ratio), 312.4

shares outstanding.

(1) Value of Firm =

(2) Share price(Before payment) =

(3) Share price(After payment)

(4) EPS =

Appendix 2

Year 2002 2001 2000 1999

Net Sales

512,282 972,625 705,917 506,669

Operating Incomes

225,099 546,285 374,396 257,926

Net Income

197,629 427,456 287,906 194,293

Diluted EPS

0.6 1.29 0.88 0.61

Cash + Short-term

Invest. 1,552,030 1,549,002 1,175,558 786,707

Working Capitals

1,558,584 1,525,624 1,141,426 779,837

Total Assets

1,988,433 2,017,074 1,507,256 1,046,914

Long-Term Debt

- - - -

Stockholders Equity

1,781,454 1,781,957 1,322,197 906,794

ROE ( NI / S )

0.110937 0.23988 0.217748 0.214264

Source: Linear Technology 2003 Annual Report (http://www.linear.com/docs/39086)