CFA Institute Exam CFA-Level-II Topic 3 Question 38 Discussion

Donnie Nelson, CFA, has just taken over as Chief Financial Officer of MavsHD, a high-tech company that delivers high-definition technology to a broad-based group of sports enthusiasts. MavsHD has 40% debt and 60% equity in its capital structure. For the year just ended, net income and dividends for MavsHD were equal to $145 million and $21.75 million, respectively. The consensus estimate for net income at the end of the current year is equal to $ 153 million. The company's current book value is $550 million. MavsHD's stock is currently trading on the NYSE for a price of S50 per share and has been steadily decreasing for the past twelve months.

MavsHD has gone through its pioneer and growth phases and is now settling in to the early stages of maturity. The business model is starting to shift from reliance almost exclusively on new customers, to a focus on retaining and satisfying existing customers. The previously experienced very high growth rate has slowed considerably. Nelson believes that the shareholder composition has changed over time as well, favoring shareholders who have a greater interest in dividend stability than explosive growth. In the past, however, the firm has favored a low dividend rate due to the availability of attractive internal investment opportunities.

Nelson wants to develop an optimal dividend policy for MavsIID that will create the most value for the shareholders and at the same time protect corporate assets. He is concerned, however, that there is sometimes a disconnect between an optimal dividend policy and how actual dividend rates are perceived in the marketplace.

Nelson is preparing a recommendation to senior management and the board of directors regarding the firm's dividend policy going forward. Nelson is considering recommending that MavsHD engage in a stock repurchase plan, and repurchase 1.5 million shares of the 12.75 million shares outstanding. This repurchase would eliminate any need to increase the cash dividend payout. Other managers at the firm, besides Nelson, believe MavsHD should increase its dividend and gravitate toward what they perceive to be the target payout ratio over the next eight years. Thus, at the end of the current year, the firm will increase the dividend payment by $250,000 over the dividend in the prior year.

During the board meeting, two of the directors raised concerns over Nelson's proposed repurchase plan. The directors' comments follow:

Director 1: I support the repurchase plan, especially relative 10 varying our dividend. Firms should not vary dividends---this lowers investors' confidence and can adversely impact the firm's cost of equity and its share price.

Director 2: A share repurchase does not take away the uncertainty associated with future stock value. According to the bird-in-the-hand theory, investors prefer higher dividends since capital gains are uncertain. The theory states that if we increase our dividend payout, the value of MavsHD equity will increase. Thus, 1 propose a dividend increase rather than a repurchase.

One of the board members, Jason Neely, proposed an alternative dividend policy plan one week after the meeting in which Nelson presented his plan. Neely's proposal involves utilizing a residual dividend model. Neely rationalizes his plan by claiming that relative to a stable dividend policy, his proposal would increase the volatility of dollar dividends paid to shareholders but would simultaneously increase the firm's ability to exploit value additive investment projects using internally generated funds. Because of this enhanced access to value additive projects, MavsHD's cost of equity capital will experience a marginal decrease which will further increase the overall value of the firm.

If MavsHD plans on making $160 million in net investments in the current year, what will be the company's dividend payout ratio using the residual dividend model?