This week, we'll be looking at how companies make their dividend decisions, that is, whether to pay a dividend, increase it, reduce it, or possibly eliminate it entirely. As managers of a public company are generally responsible for doing everything ethically possible to increase the share price and therefore the wealth of shareholders, the question of dividend policy is a strategic one: what is the best course for managers to take with respect to dividends in order to boost the market value of their company?

Although many investors look for companies that pay high dividends, many others prefer companies that pay modest or no dividends. Why is this? Well, for one thing, to the extent that a company pays a cash dividend, that cash is no longer available for reinvestment in new capital projects. For productive companies that generate strong returns on their invested capital, it is generally better to recycle their free cash back into the company than to pay it away to shareholders in the form of a dividend. Over the long run, this results in greater growth in future earnings and dividends.

There is also a body of very interesting academic research which suggests that in a world where dividend income is taxed at the same rate as capital gains, investors will be indifferent to a company's dividend policy. In other words, it will not matter to them if they receive their returns on equity in the form of dividends or capital gains when they ultimately sell their shares. In such a world, it will therefore not matter what strategy managers take with respect to dividend payouts because investors will not pay more for a company's shares (increase the market value) based on any particular strategy adopted by management, e.g., high dividends, low dividends, etc. because these will not affect their wealth.

It may be that changes in dividends can affect the price investors will pay for a company's shares because of some information conveyed with the dividend increase or decrease that signals something important about the company's future business prospects. If so, then management dividend policy may indeed impact the market value of the company.

This debate is covered in the attached Powerpoint slides and in this week's case about the directors of an auto parts producer trying to decide on an appropriate dividend policy for the firm. Please read the case and answer Questions: 1, 2, 4, 7(a), 10.

Your answers will be generally qualitative here so try not to simply "parrot" the arguments made by the various players in the case but rather to demonstrate your understanding of the material with an evaluation of the arguments.

CASE 4 ANDERSON AUTO PA DIVIDEND POLI CY .In a way, this is a pleasant problem to have, remarked Harry Gidwitz, the of to Ian director of marketing, as they entered the company's boardroom. "I suspect we wouldn't have to deal with it if ture didn't look so good." ANDERSON Anderson is a relatively small auto parts producer with annual sales of $150 mil- lion. Despite a reputation for low cost and above average quality products, Anderson's sales history is not especially impressive. There have been a number of problems that have plagued the firm. Though automakers are not able to man- uacture parts as cheaply as outside suppliers (due largely to higher wage differ- entials, the practice of relying on outside suppliers runs the disastrous produc tion risk that the supply of parts will be interrupted. For this reason and because dulomakers want to minimize inventory costs, auto parts suppliers must be able to provide "just-in-time" delivery (parts arrive when needed) and equipment of quality. Until recently, Anderson could do But an improved quality control system and a more efficient distribution network now enables the firm to deliver "as needed" with low Anderson historically has also had difficulty in developing the innovative demand This Thefirm of new auto parts that are quite useful to car manufacturers. For example, it oped a new stainless steel exhaust system that is much lighter than the tra- ditional cast iron system. Sales e result of all these changes is that in 1996 (present year) Anderson's increased by 20 percent and its earnings per share by 73 percent. And