Ann Carter, Chief Financial Officer of Consolidated Electric Company (Con El), must make a recommendation to Con Els board of
Ann Carter, Chief Financial Officer of Consolidated Electric Company (Con El), must make a recommendation to Con El’s board of directors regarding the firm’s dividend policy. Con El owns two traditional regulated utility companies plus Con El Enterprises, Inc. (CEEI) whose main business is building and operating unregulated “merchant” generating plants all around the U.S. These new and highly efficient merchant plants sell power in competition with traditional utilities, which are regulated by public utility commissions. Although CEI’s operations are not subject to regulation, it does face intense competition from other merchant power producers such as Enron Corporation and the regulated utilities in whose territories it seeks to operate.
Con El’s board has been considering a change in dividend policy, but no consensus has emerged. Like most utilities, Con El has a relatively high payout ratio. Some think the high payout should be continued because its current stockholders have indicated a preference for this policy. However, others disagree on the grounds that deregulation and the loss of the utility industry’s monopoly structure is leading to increased competition, and in this new environment a lower payout ratio is more appropriate.
Ann Carter sees merits in both positions. Surveys of Con El’s stockholders show a strong preference for dividends—most want the company to maintain, if not increase, the payout ratio. Therefore, if the dividend were cut, those stockholders who want or need cash income would sell
their stock and switch to another stock with a higher payout, and those sales might depress Con El's stock price. On the other hand, Con El is facing increased competition, and most competitive firms have payout ratios that are less than half that of Con El. Moreover, Ann thinks Con El should generate more capital internally and use it to reduce the firm’s debt, which in her opinion is too high. A dividend cut would help in that regard.
Currently, Con El is still the sole supplier of power in its service area to all except a few large industrial firms that generate their own power. Moreover, Con El is relatively efficient, and its low costs have helped it ward off competition. Still, it does have some relatively inefficient plants, and the possibility exists that Enron or some other merchant producer will move in with efficient, low cost plants and take away business.
One Con El executive who advocates a high payout sent Ann the data in Table 1, along with some news clippings describing recent dividend actions taken by companies and groups of companies. Industrial companies typically pay out about 35 percent of their earnings, with the ratio rising in recession years when dividends are maintained even though earnings decline and declining in years when earnings are exceptionally high. Telephone companies, which are about 10 years ahead of the electrics in terms of exposure to competition, reduced their target payout ratios as competition increased.
Ann had employed a team of three interns from the local university during the fall, and the interns produced a report on utilities’ dividend policies over the past 30 years. Here is a summary of their conclusions:
- Until the 1970s, utilities provided safe, dependable dividends. Their stocks were called “widow and orphan stocks,” and they were bought by retirees and others seeking safety and cash income. Utilities’ sales and assets were growing more rapidly than most other industries, but the utilities could finance growth by issuing stocks and bonds.1 That led them to pay high dividends and thus to attract stockholder clienteles seeking high dividends.
- The situation changed during the 1970s and '80s. Inflation accelerated, driving up utilities’ costs. However, state and federal regulators had to approve utility price increases, and due to intense political pressure, regulators did not allow adequate cost pass-throughs. With costs rising but prices frozen, profits declined, as did stock prices.
- As profits fell, utilities were tempted to reduce their dividends, but none did. They recognized that their payout ratios were too high, but they felt compelled to maintain or even increase their dividends. New plants were under construction, and billions of dollars, raised by selling stocks and bonds, had been invested in these plants. Interest had to be paid on the construction-related bonds, and dividends on the stock. Of course, partially completed plants generate no electricity, hence no revenues. Therefore, the companies needed to complete the plants, and for that more capital was required. Some of this capital would be raised as debt, but some common equity would have to be raised to support the new debt. Most companies discussed with their investment bankers the pros and cons of getting more equity by cutting dividends versus issuing new stock. The investment bankers argued as follows:
1A major drawback to issuing stock is the fact that the announcement of a stock offering is generally taken by investors to be a negative signal regarding management’s outlook for the future. If future prospects look brighter to management than to investors, hence the stock is in management’s view undervalued, then the company would want to finance with debt rather than stock so as to avoid unnecessary dilution. On the other hand, if management is more pessimistic than the average investor, it would regard the stock as being overvalued, and in this situation existing stockholders would be better off if the company financed with stock than with debt. Investors know that this is the way management can be expected to act. Therefore, the announcement of a stock offering is taken by investors as a negative signal, hence stock prices tend to decline when stock offerings are announced.
The strength of the effects of a stock offering announcement depends on the extent of information asymmetry between management and investors. If investors know a great deal about a company and its operations, then the announcement (and the reasons for it) will have been anticipated, and there will be relatively little pressure on the stock price. Because of regulation, investors know more about utilities than about most other companies, so the price pressure when utilities issue stock is relatively small. Therefore, other things held constant, utilities are better able to provide stockholders with cash dividends and then raise equity by issuing stock.
- A dividend cut would lower the stock price, increase the number of shares needed to raise a given amount of money, and thus lead to a dilution of future earnings. Those lower earnings would lead to still lower stock prices, which would dilute earnings even more. A downward spiral could set in, driving the stock price ever lower. The fear of such a spiral kept utilities from cutting their dividends.
- The amount of new equity generated by cutting dividends would not be adequate to meet the company’s needs, so new stock would still have to be issued. Selling stock after a dividend cut had knocked prices down would be difficult and expensive.
- Investors had been conditioned to expect annual dividend increases, and a failure to meet those expectations would lead to disappointment and a lower stock price. Indeed, if the dividend were increased by more than the expected amount, this would benefit the stock price and make it easier to issue stock
Some Con El executives noted that the investment bankers’ recommendations were self-serving—the higher the payout, the more stock the companies would have to issue, hence the more fees the bankers would earn. Nevertheless, Con El followed the bankers’ advice and kept its payout ratio high.
- The typical utility entered the 1990s with a much higher payout ratio than most competitive companies, even though many utilities were by then facing stiff competition. Many utility executives wanted to align their dividend policies with the new market realities, but they were afraid of what might happen to stock prices if they cut the dividend.
- The telephone companies had seen a large part of their business deregulated, and increase, about 10 years earlier. Therefore, as Table 1 shows, the telco’s increase, about 10 years earlier. Therefore, as Table 1 shows, the telco’s competition payout ratios have been declining in recent years. That decline is continuing and may even accelerate. (None of the telcos cut their dividends. They just raised them less rapidly than earnings.)
- A number of utilities have reduced or omitted their dividends in recent years. Note, though, that except for MPL as discussed below, all of the cuts were by companies that had suffered huge losses as a result of huge cost over-runs associated with building nuclear plants. Thus, until MPL, dividend reductions were always the direct result of earnings reductions, and dividend cuts always led to large stock price declines. However, some astute observers pointed out that it was not clear if the resulting stock price declines were caused by the dividend cuts or by the operating problems. In other words, the “effect” of a stock price decline might have been “caused” by either the operating problem or the lower dividend. Still, until 1998, no utility had ever cut its dividend except under extremely unfavorable operating circumstances.
- On May 9, 1998, MPL Group, the financially sound holding company that owns Midwest Power & Light, dropped a bombshell on the financial community—it reduced its annual dividend by 32 percent, from $2.48 to $1.68 per share. In its announcement, MPL stressed that it had studied the situation carefully and had concluded that maintaining a high payout rate (over 90%) in an increasingly competitive environment was not in its shareholders’best interests. The company stated that it needed flexibility to deal with the volatile competitive environment, and trying to maintain such a high dividend would not provide that flexibility.
MPL knew that a dividend reduction would probably be viewed as a negative signal by stockholders, at least initially. Therefore, management tried to ease the blow by making the following statement at the same time it announced the dividend cut: (1) The cut was motivated by a desire to establish a more fundamentally sound financial position, not by financial difficulties. (2) A major stock repurchase program would be undertaken both to help stabilize the stock price and to distribute cash to stockholders in a form other than dividends, with tax advantages to stockholders. (3) Management felt that these actions taken would lead to a financially stronger company, to a higher future growth rate in earnings and dividends, and to a higher stock price.
Prior to the dividend announcement, MPL’s management had dropped hints that it might reduce the dividend. However, the hints had been picked up by few analysts. Still, on May 5, four days before the company’s announcement, a widely followed analyst did release a report stating that MPL might cut the dividend. The stock fell by $2 (or 5.9%) that day. Here are some data related to the cut:
April 29, 1998 Closing price: $35.375
May 5: A leading analyst suggested that the dividend might be cut. The stock price declined by $2.
May 9 MPL announced a 32 percent dividend reduction, a new target payout ratio of 60 to 65 percent, and a large stock repurchase program. Management also suggested that the dividend would grow faster in the future and that capital gains would replace some of the old dividend yield. Still, the announcement led to another drop of $4.375 (13.7%), to $27.50. As a result, the stock was down 22.3 percent in just 10 days
Investor reactions were initially negative. Here is a typical comment:
“The company should have warned us this was coming. I bought the stock a month ago expecting to receive a good dividend, and for them to cut it even though the cash is available is just not fair.”
Analysts’ recommendations on MPL:
Number recommending each action:
On April 29, 1998(10 days prior)
On June 29,1998(2 months after)
On April 29,1999(1 year after)
Buys as % of total:
MPL’s stock price mirrored the trend in analysts’ recommendations:
MPL Price as %of Average Utility Price
Thus, MPL’s stock dropped relative to the industry average from January 1998 until just after the dividend cut, but it did significantly better than the
average electric after the cut.
- MPL’s payout ratio hit 91 percent in 1997. However, projections at the time indicated that the payout would decline to the industry average (79%) by 2003 if the company did not cut its dividend but held the dividend growth rate to 1 percent per year. Under this plan, it would take until 2007 for earnings growth to reduce the payout to the target 60 to 65 percent level.
- After MPL reduced its dividend and enjoyed a subsequent stock price bounce-back, a few other large, healthy utilities followed MPL’s lead and reduced their dividends. There were rumors that more companies’ CFO’s wanted to reduce their dividends, but that their boards rejected this action.
- Table 1 provides some information on dividend policy among electric, telephone, and industrial companies. Two points are worth noting: (1) The utilities’ payout ratios have historically been high relative to unregulated, competitive firms, and (2) the telephone companies, which several years ago began to face competition much like what the electrics are now facing, lowered their payout ratios.
- Table 4 gives some information on Con El’s stockholders as reflected in responses to questionnaires sent out in 1989 and 1999. (The students were concerned about the form of the questionnaire. The original questionnaire had been hastily prepared at the request of the president by a PR person and then sent out with the next set of quarterly dividend checks. Stockholders who received their dividends by direct deposit did not receive a questionnaire. The same questionnaire and mailing procedure was used again in 1999.)
- Table 5 provides information on Con El’s earnings, cash flows, capital expenditures, and dividends for 1999, with projected data for 2000 through 2004. The projected data were calculated with a spreadsheet model. The projections are obviously subject to much uncertainty, because new investment opportunities could be found, projects that currently appear promising could be revised downward, profits could be higher or lower than forecasted, and so on. Indeed, the increasingly competitive environment makes the forecasts far less certain than was true in the past.
- Con El’s weighted average cost of capital (WACC) as estimated by the company for use in evaluating average-risk capital expenditures is currently 10 percent, down from 12 percent a few years ago, when inflation was higher. The 10 percent is based on the use of retained earnings; the WACC would be somewhat higher if the company found it necessary to issue new common stock. Obviously, the WACC could change over the next 5 years, and it would be higher if the company were required to raise a substantial amount of new equity by issuing stock. (Some stock will be sold through the firm’s dividend reinvestment plan and issued to employees through its stock purchase plan. Those funds were taken into account in the 10 percent WACC estimate.)
- The data on capital expenditures for the period 2000–2004 as shown in Table 5 represents the financial staff’s estimate at this time of the dollar amounts of projects that will have positive NPVs, assuming a corporate WACC of 10 percent.
- Table3 gives data on price/earnings ratios, market/book ratios, returns on equity, and other financial information for Con El, MPL, and some benchmark electrics and industrial companies. The interns included this information because they though that the utilities’ poor stock market performance might be related to their high dividend payment policies.
- Due to some required investments in 2000, the 2000 ROE is likely to fall to 11 percent from the 12 percent earned in 1999, but to rise a bit thereafter. See the “Key Inputs” section of Table 5.
- As a part of its dividend cut announcement, MPL stated that it was replacing some of its cash dividends with stock repurchases, and it gave two reasons for this action. (1) The company will gain flexibility if it employs a repurchase program to distribute cash to stockholders rather than continue to pay high cash dividends. If funds are needed internally, or if cash flows are reduced for any reason, repurchases can be delayed. Cash dividends, on the other hand, cannot be omitted or reduced without serious repercussions. MPL reasoned that one reduction was bad enough, but going into an increasingly competitive environment with a high payout ratio might lead to frequent forced dividend reductions unless the payout ratio were lowered significantly. (2) Stockholders who pay taxes would be better off having the company distribute excess cash through repurchases rather than through cash dividends.
- The interns also prepared a spreadsheet model that showed what would happen to the payout ratio and the amount of stock the company would have to issue in the future under different conditions. This model was used to generate the data in Table 5, and it can be used for sensitivity analysis.
After reviewing the interns’ report, Ann was not sure what step to take next. She could see some merit in following MPL’s lead and moving the payout ratio down toward the range that competitive, unregulated companies generally use. However, she knew that Con El’s board was proud of the fact that the company had never reduced the dividend over its entire 90-year life. She also knew from Table 4, as well as from discussions with stockholders, that investors would be upset if the dividend were cut. Indeed, Ann’s own mother had invested a high percentage of her retirement savings in Con El’s stock, and she needed the quarterly dividend check. Ann knew that her mother could sell a few shares quarterly to make up for the lower dividends, but she dealt with a full service broker, so the cost of selling a few shares would be high. Moreover, selling shares would be less convenient than depositing a check. So, if cash dividends were reduced, this would create both a real and a psychological hardship for many stockholders.
At that point, Ann decided to ask your consulting firm to help her analyze the situation and make a recommendation to the board. She asked you to consider three choices: (1) Hold constant the current dividend of $1.18 per share. (2) Increase the dividend by a relatively small percentage, such as 2 percent. (3) Cut the dividend sharply as MPL had done. At any rate, your task is to study the situation and help Ann decide what to recommend to her board. She wants you to analyze all the issues, and to answer the following set of questions that she prepared.
- Why was it logical for electric utilities to have relatively high payout ratios before the 1970s? What has happened to the electrics’ dividend payout ratios over time? Is this development consistent with growing competition in the industry?
- Do investors in general prefer dividends to retained earnings? What about Con El’s particular set of stockholders?
- Do Con El’s current investors appear to like its dividend policy? If the company changed its dividend policy, would the new policy appeal to more or fewer investors than the current policy? Does this matter?
- How do investment opportunities influence the optimal dividend policy? As a part of your answer, construct a hypothetical graph and use it to illustrate the relationship between a firm’s marginal cost of capital curve (MCC), its investment opportunities (the Investment Opportunity Schedule, or IOS), the size of its capital budget, and its optimal dividend policy. Show dollars raised and invested on the horizontal axis and percentage costs and returns on the vertical axis. Use reasonable, but hypothetical, data (as opposed to actual company numbers) to draw a graph that illustrates Con El’s situation.
- What “signals” do companies send investors through dividend actions? Should Con El be concerned about signaling effects if it decides to alter its dividend policy? If so, how should signaling be taken into account? Would the MPL situation have any effect on the signaling effect of a dividend cut by Con El, i.e., would the signaling effect on Con El be different given that MPL recently cut its dividend versus the likely signaling effect if MPL had not cut its dividend?
- How would (or should) a firm’s “clientele of stockholders” affect its dividend policy? Is it possible that it would be in the best interests of its current stockholders for Con El to cut its dividend, even though those stockholders say they do not want to see the dividend reduced?
- Agency costs refer to costs stockholders bare to insure that managers operate in stockholders’ best interests rather than in the interests of the managers themselves. Can dividend policy reduce agency costs? If so, what effect would that have on firms’ stock prices in general and on Con El in particular? Are agency costs more likely to be an issue for a company if its officers and directors own a large or a small percentage of the shares? Would agency costs be more or less important if a large percentage of its officers’ and directors’ wealth and income is dependent on the company’s stock price performance?
- When firms in general, and Con El in particular, establish their dividend policies,
- How should the target payout ratio be set?
- How stable should dividends be, and what does “stability” mean?
- Should a firm’s dividend policy be formally announced?
- If Con El decides that its dividend policy is not appropriate, how should it make the transition to a new policy? Would it ever be appropriate to conclude that the preferences of the current stockholders are inconsistent with the dividend policy that would maximize the firm’s value in the long run, and then to set a policy that would lead to a change in the composition of the firm’s stockholders? If management decides to change the dividend policy, might the change itself cause the stock price to decline below its “intrinsic” or “equilibrium” value, at least until the market adjusts to the new policy? If so, should management make an effort, and incur costs, to stabilize the price and minimize the temporary price decline? If so, what actions would you recommend?
- Is repurchasing stock a good alternative to cash dividends (a) on a regular basis and (b) on a temporary basis under conditions such as those facing Con El? In this connection, it should be noted that no the IRS has never challenged a large, publicly owned company’s repurchase program, and no challenge is likely. Therefore, the company’s own tax position is not an issue.
- Con El has a dividend reinvestment plan, but several directors have suggested that the plan be discontinued on the grounds that it is simply not worth the cost to the company of carrying it out. What are the pros and cons of dividend reinvestment plans, in general and for Con El in particular? If Con El decides to reduce its dividend, would this action make it more or less important for the company to continue its dividend reinvestment plan?
- One of Con El’s directors has suggested that the company should pay a stock dividend if it decides to cut the cash dividend. The same director also recommends that the company split its stock on the grounds that the company’s total market value would rise if a split were announced. What are the pros and cons of stock dividends and stock splits? Over time, and assuming other things are held constant, would companies with higher or lower payouts be more likely to use stock dividends and/or splits? Should Con El pay a stock dividend, split its stock, do both, or do nothing in this regard at this time? If you conclude that this is not the right time for Con El to split its stock, would a dividend reduction accelerate or retard the time before a split would be appropriate?
- Should dividend policy (or, more broadly, cash distribution policy) be established independently of or jointly with capital structure policy? If Con El decides to change its capital structure, how might that change feed back into its dividend policy? Might a change in dividend policy affect the firm’s optimal capital structure policy? For example, if Con El reduces its cash dividend, would this be more likely to lead to an increase or a decrease in the use of debt? Also, if Con El wants to avoid reducing its dividend, or at least to hold any reduction to a bare minimum, might that decision affect the optimal capital structure policy?
- Quantify as best you can how a change in dividend policy would affect the amount of stock the company would have to issue in the future.
- What recommendation would you advise Ann Carter to make the board regarding Con El’s dividend policy?