Linear Technologies

Dividend Policy

Dr. C. Bülent Aybar

Professor of International Finance
 Review of Dividend Policy
• The firm initiated a dividend in 1992. Since then it has raised
the dividend by $0.01 per share once a year or when it split
its shares.
• Linear split its shares four times since 1992
• The dividend has risen roughly tenfold from $0.0063 to
$0.0500.
• The payout ratio has varied over time with profits. The initial
dividend was 14.6 percent of earnings. The payout ratio fell
through FY 2001 to 9.6 percent as profits rose dramatically.
• With the drop in sales in fiscal year 2002, the payout ratio
stood at 27.3 percent. With another $0.01 increase, the
payout ratio would be 33.1 percent in 2003.
 Linear Tech. Dividends Per Share
Dividend Per Share
1993-2003

0.06000

0.05000 10 fold growth from $0.0065 in 1993 to 0.05

0.04000

0.03000

0.02000

0.01000

0.00000
1

3
Q

Q
Dividend Per Share
 Is There a Payout Policy?
Linear Technology Payout Ratio
1993-2003

0.3
0.3
0.2
0.2
0.1
0.1
0.0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Payout Ratio
• Repurchases have been larger (totaling $2.13 versus $0.84)
and more variable than dividends. Over the past five years,
repurchases peaked at $125 million in Q3 of FY 2003.
• For seven quarters between Q3 of FY 1999 and Q1 of FY
2001, Linear made no repurchases
 Share Repurchases
Share Repurchases
1993-2003
$125m in Q3 2003
$140
$120
$100
$80
$60
$40
$20
$0
1

3
Q

Q
Share Repurchases
 Linear Tech. and Lintner 1956
• Lintner‟s 1956 survey finds that firms have a long-run target payout
ratio. Rather than payout a fixed proportion of earnings though, firms
follow a partial adjustment process, increasing dividends by less than the
increase in profits.
• Generally speaking, firms follow this conservative process of raising
dividends to avoid decreasing the nominal dividend whenever possible.
• Linear follows a conservative payout policy but seems to have no long-
run target payout ratio, increasing dividends even when profits fell
dramatically.
• Would the following be a realistic statement?
– Linear initiated a „token‟ dividend and each year has given shareholders a
token increase without regard to its payout ratio or profit level.
 Linear Cash Flows

June Fiscal Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Change
Sales 119.4 150.9 200.5 265 377.8 379.3 484.8 506.7 705.9 972.6 512.3 440.8
Net Income 25.0 36.4 56.8 84.7 134.0 134.4 180.9 194.3 287.9 427.5 197.6 170.6 227.5
Operating Cash Flow Plus CAPX 28.8 42.4 62.5 103.9 164.7 151.0 267.0 280.4 442.3 559.6 257.2 189.9
Capital Expenditure 9.8 7.6 16.2 22.1 70.4 21.9 24.4 39.1 80.3 127.9 17.9 9.8
Market Value of Equity 660.6 1031.0 1597.2 2428.8 2241.0 3933.0 4631.8 10336.3 20153.9 14101.8 9938.2 9643.8 9643.8
Shares Outstanding (Split Adjusted) 280.0 285.6 290.4 294.4 298.8 304.0 307.2 307.4 315.2 318.9 316.2 312.4 312.4
Dividends 0.0 5.3 8.3 9.8 11.9 15.0 18.3 22.1 28.0 41.2 54.0 47.0 75.0
Repurchases 0.7 1.2 1.3 6.1 22.9 11.6 56.5 108.7 0.0 69.8 221.6 165.7
Dividend Policy
Payout Ratio 0.0 14.60% 14.60% 11.60% 8.90% 11.20% 10.10% 11.40% 9.70% 9.60% 27.30% 27.50% 0.3
Dividend Yield 0.0 0.50% 0.50% 0.40% 0.50% 0.40% 0.40% 0.20% 0.10% 0.30% 0.50% 0.50% 0.80%
Dividends Per Share (Split Adjusted) $0.00 $0.02 $0.03 $0.03 $0.04 $0.05 $0.06 $0.07 $0.09 $0.13 $0.17 $0.15 $0.24
Repurchases Per Share (Split Adjusted) $0.00 $0.00 $0.00 $0.02 $0.08 $0.04 $0.18 $0.35 $0.00 $0.22 $0.70 $0.53
Profitability
Net Income (% of Sales) 20.90% 24.10% 28.30% 0.3 35.50% 35.40% 37.30% 38.30% 40.80% 0.4 38.60% 38.70%
Cash Flow (% of Sales) 24.10% 28.10% 31.20% 39.20% 43.60% 39.80% 55.10% 55.30% 62.70% 57.50% 50.20% 43.10%
Investment
CAPX (% of Sales) 8.20% 0.1 8.10% 8.30% 18.60% 5.80% 0.1 7.70% 11.40% 13.20% 3.50% 2.20%
Pre Investment Cash Flow / CAPX 2.9 5.6 3.9 4.7 2.3 6.9 10.9 7.2 5.5 4.4 14.4 19.4
 Stable Margin Despite Declining Sales
Net Income and CF as % of Sales
1993-2003

70.00%
60.00% CF/Sales
50.00%
40.00%
30.00%
Profit Margin
20.00%
10.00%
0.00%
1 2 3 4 5 6 7 8 9 10 11 12

Profit Margin CF/Sales

 Can Linear Afford the Increase? Check the CFs
• While Linear sales have been variable, dropping by 47
percent in 2002, margins are very stable.
• Even with a large change in sales, operating and cash flow
margins were hardly affected. Put another way, the variable
cost structure gives Linear very little operating leverage.
• Capital expenditures were also quite modest, averaging less
than 14 percent of sales since 1996.
• Pre-capital expenditure cash flow ranged from 4 to 19 times
capital expenditures.
• These suggest that Linear has an ample cushion to pay a
dividend of 31 percent of pre-investment cash flow and still
meet its investment.
 Cash Balance

• Also note that Linear has a large cash balance. In 2003, the
cash balance stood at $1.57 billion, or 16.2 percent of
Linear‟s market value. This is a higher percentage than at
Microsoft.
• With an interest rate of 3% and a corporate tax rate of 35%,
Linear could fund a dividend of $0.06 per share or $75
million out of after-tax interest income for more than 27
years.
 Cash Balance in Comparables

Linear Technology
Cash Balance 1552.0
Intel, Maxim, and Microsoft
Dividends 75.0 have similarly large cash positions
Intel in comparison to their dividend
Cash Balance 12587.0 payments.
Dividends 526.0
Maxim
Cash Balance 765.5
Dividends 25.6
Microsoft
Cash Balance 38652.0
Dividends 857.4
 Question?

• Linear has ample resources to increase its dividend and

perhaps payout substantially more of its cash balance
without facing much risk of financial distress.
• Is carrying cash inside the firm costly for outside
shareholders?
 Double Taxation

• The interest on cash balances is taxed once at the corporate

level and again when it is distributed to shareholders.
• Indeed, this double taxation makes equity a costly form of
new finance.
• But if Linear‟s marginal tax rate is lower than the personal
tax rate of its investors, then there are no adverse tax
consequences of retaining cash inside the firm.
• At the time of the case the top personal tax rate is 38 percent
and the top corporate tax rate is 35 percent.
• Another way of measuring the effective personal tax rate is
to look at the difference in yields between municipal and
AAA-rated corporate bonds. These data provided in Exhibit
8 may help us to approximate the effective personal tax rate.
• The tax rate satisfying the following equation can be
extracted
– Rmuni=Rcorp(1-Tp)
 Case for Distribution

• This tax rate estimate peaks at 36.5 percent in 1999 and falls
to 21.3 percent in 2002.
• The average over the eight years of data is 31.2 percent.
• This suggests that corporate tax rate is not necessarily lower
than personal tax rate!
 Cash Distribution Rule

• If the corporate tax rate satisfy the following, the firms

should not retain any excess cash:
– Tc>(Tp-Td)/(1-Td)

• With a distribution tax of 15 percent and a personal tax rate

of 38 percent, the corporate tax rate would have to be below
27 percent to justify retaining excess funds inside the firm.
• With the effective tax rate of 31.2 percent, the corporate tax
rate would have to be below 19 percent.
 Is there an Agency Problem?
• Linear managers might use internal resources to pursue their
own objectives, at the expense of firm value. This may be
valid concern, although there is no historical cause for
concern.
• Linear has focused on its core analog business, and Coghlan
says the firm has no intention of pursuing acquisitions in the
future.
• Also, management still has a substantial amount of wealth in
the firm. The CEO has about 1.5 million shares and options,
with a market value of approximately $45 million.
• This is about equal to his total compensation over the last ten
years,
 Alternative Distribution Method
The impact of $1 dividend on the Announcement and Ex Dividend Day

Announcement Day Ex-Day

Theory Price Change Price Change
Modigliani and Miller Irrelevance 0 -1
Taxes - -(1-td )
Signaling + -1
Agency + -1
Clientele Effects Depends on Clientele Demand Possibly less than -1
Market Conditions Depends on Sentiment -1
 Taxes

• Historically, dividends have been taxed at a higher rate than

capital gains. For example, in the spring of 2003, the top
ordinary income tax rate applicable to dividends was 38
percent, whereas the top tax rate on capital gains was 20
percent.
• Even when the tax rates are equal, repurchases have an
advantage. For example, suppose both rates are equal to 15%
and there are 100 shares outstanding at $10 per share.
• Suppose further that the tax basis is $9 per share. Paying a
dividend of $1 per share leads to a total tax of
%15x$1x100=$15 and lowers the unrealized capital gains on
all shares!
• Repurchasing 10 shares will lead to a tax of $1.50 (15% x ($10 – $9) x
10), but leaves the other 90 shares unchanged. The $90 (($10 – $9) x 90)
in unrealized capital gains on these shares will eventually be taxed at the
15% rate, adding $13.50 to future tax bills.
– So, the total tax is unchanged ($1.5+$13.5=$15)
• However, a dividend moves the payment forward in time and so
increases the present value of the tax cost.
• Repurchasing shares is a more tax efficient way to return capital to
shareholders provided
– (1) the capital gains rate is less than or equal to the dividend tax rate and
– (2) both are positive.
• When the tax is zero on both, the timing advantage of repurchases goes
away.
 Signaling

• If managers have inside information about good future prospects, they

may wish to signal this to outside investors, increasing their stock price
in the process.
• Of course, even managers whose inside information is poor, might like
investors to believe their firms have good future prospects. So, the signal
must have some cost that weeds out these managers.
• In the case of dividends, the cost is taxes, foregone investment, or,
anecdotally, the cost of having to decrease the nominal dividend in the
future.
• CFO Coghlan understands that cutting the dividend has a cost . And, so
paying a dividend is a strong commitment to have adequate resources to
maintain the dividend at or above its current level.
• However, is it convincing that Linear‟s dividend, at its current level or a
penny higher, could signal anything about the future prospects of the
firm?
 Agency Cost

• An agency problem can equally well be solved with a

dividend or a repurchase.
• However, if dividends represent more of a commitment than
a repurchase, a dividend may solve future agency problems
in a way that a one-time repurchase will not.
• This is similar to the signaling story: If managers would like
to prove that they will not waste the firm‟s resources, they
can do so by returning as much of the firm‟s cash to
shareholders as possible.
 Stock Options and Dividends

• A specific conflict of interest between managers and shareholders

involves executive stock options (ESOs).
• Paying a dividend reduces the value of an ESO. Typically, ESOs are not
dividend protected.
• Swanson has just over 1 million options. Paying a $1.5 billion dividend
reduces the share price by a little less than $5 per share.
• Without knowing the exercise price, we cannot put a precise value on the
loss. If the shares are in the money and exercised immediately, the loss is
$5 million dollars. This is clearly an upper bound value loss on the
existing options, but it does not include the effect on future grants.
• Of the five CEOs described in the case, this is most pronounced for John
Chambers at Cisco, and might explain th firm‟s strong stance against
even a token dividend.
 Policy Options

Policy Share Price Earnings Shares EPS

Retain $1.5B $31.43 $198 316 $0.63
Repurchase $1.5B Shares $31.43 $153= 268= $0.57
198-(1,500x3%) 316-(1,500/31.43)
Pay a $1.5B dividend $26.68= $153 316 $0.48
31.43-(1,500/316)

Calculations are based on Exhibit 7

Retain 1.5bn Cash Share Price 31.43 316m outstanding share, EPS=$0.63
Repurchase 1.5bn of Shares: 1.5bn/31.43=47.7m shares net left:268m shares
Implication: Interest income on 1.5bn is lost, Net Income:$153m now, the
EPS=$0.57
Pay $1.5bn Dividend: Implication, share price declines 31.43-(1.5bn/316)=26.68
Net Income declines because of interest lost, and EPS=$0.48
 Clientele Effects

• Investors may differ in their tax rates, transaction costs, and

institutional restrictions. An example of a tax clientele is
pension funds that are tax exempt and so are indifferent
between dividends and capital gains. A high dividend
payment may attract these investors, or more precisely repel
taxable investors.
• An example of a transaction cost clientele is a small investor
who incurs high transaction costs in selling a small number
of shares. These investors may prefer a dividend payment to
a “homemade dividend” that involves selling an equivalent
dollar value in shares on the open market.
 Clientele Effect and Institutional Constraints

• Some investors may be constrained by regulation or by laws.

• An example of an institutional constraint is an endowment or
trust that is limited to spending income and not capital.
• Under Modigliani and Miller, the distinction between
income and capital gains is arbitrary. But, an endowment
charter makes the distinction relevant.
• Blaine Rollins, manager of the Janus Fund, claims that
European mutual funds might be limited to investing in
dividend paying stocks. Note that the institutional constraint
here argues for a token dividend only.
 Time Variation in Dividend Policy

• Dividend policy has changed considerably over the last forty

years. In the early 1960s, most listed firms paid a dividend.
In 1999, fewer than 21 percent of firms paid. In 2002 and
2003, dividend initiations and increases picked up slightly.