Download Solutions Guide: Please reword the answers to essay

Solutions Guide: Please reword the answers to essay type parts so as to guarantee
that your answer is an original. Do not submit as your own.
General Access Company is a fast growing Internet Access provider that initially went
public in early 2003. Its revenue growth and profitability have steadily risen since the
firm's inception in late 2001. GAC's growth has been financed through the initial
common stock offering, the sale of bonds in 2006, and the retention of all earnings.
Because of its rapid growth in revenue and profits, with only short term earnings declines,
GAC's common stockholders have been content to let the firm reinvest earnings as part of
its plan to expand capacity to meet the growing demand for its services. This strategy has
benefited most stockholders in terms of stock splits and capital gains. Since the
company's inital public offering in 2003, GAC's stock twice has been split 2 for 1. In
terms of total growth, the market price of GAC's stock, after adjustment for stock splits,
has increased by 800% during the 7 year period 2003 - 2009. Because GAC's rapid
growth is beginning to slow, the firm's CEO, Marilyn McNeely, believes that its shares
are becoming less attractive to investors. McNeely has had discussions with her CFO,
Bobby Joe Rook, who believes that the firm must begin to pay cash dividends. He argues
that may investors value regular dividends and that by beginning to pay them, GAC
would increase the demand and therefore the price for its shares. McNeely decided that at
the next board meeting she would propose that the firm begin to pay dividends on a
regular basis. McNeely realized that if the board approved her recommendation, it would
have to (1) establish a dividend policy and (2) set the amount of the initial annual
dividend. She had Rook prepare a summary of the firm's annual EPS. It is given in the
following table. Year EPS 2009 3.70 2008 4.10 2007 3.90 2006 3.30 2005 2.20 2004 .83
2003 .55 Rook indicated that he expects EPS to remain within 10% (plus or minus) of the
most recent (2009) value during the next 3 years. His most likely estimate is an annual
increase of about 3%. After much discussion, McNeely and Rook agreed that she would
recommend to the board one of the following types of dividend policies: 1. Constant
payout ratio dividend policy 2. Regular dividend policy 3. Low regular and extra
dividend policy McNeely realizes that her dividend proposal would significantly affect
future financing opportunities and costs and the firms share price. She also knows that
she must be sure that her proposal is complete and that it fully educates the board with
regard to the long term implications of each policy. a. Analyze each of the three dividend
policies in light of GAC;s financial position. b. Which dividend policy would you
recommend? Justify your recommendation. c. What are the key factors to consider when
setting the amount of a firms initial annual dividend? d. How should Ms. McNeely go
about deciding what initial annual dividend she will recommend to the board? e. In view
of your dividend policy recommendation in part b, how large an initial dividend would
you recommend? Justify your recommendation.
(a) The company has experienced positive and increasing earnings since it went public in 2000.
Management believes that EPS should remain stable over the next three years (10%). This
stable earning pattern is conducive to having some form of regular dividend payout policy.
Either the regular dividend policy or the low-regular-and-extra dividend policy would be
consistent with the earnings stability. The constant payout ratio could work but may be
unacceptable to the shareholders due to the nature of the industry. Competition in the
Internet access industry is strong. Should General Access experience volatility in their
earnings they would pass this volatility on to its shareholders through dividend changes.
(b) The low-regular-and-extra dividend policy should be adopted for two reasons. First, this
approach provides the dividend stability consistent with the firm’s earnings stability and
growth. Secondly, the firm has the flexibility to increase or decrease dividends when
earnings vacillate due to economic or competitive conditions.
(c) There are six factors the board should consider before setting an initial dividend policy:
(1) Legal constraints—Are there legal restrictions that come into play that will prohibit the
firm from paying a dividend? A common constraint in most states is the firm cannot pay
dividends out of “legal capital,” which is normally measured as the par value of
common stock, plus perhaps any paid-in capital in excess of par.
(2) Contractual constraints—Loan covenants may be in place that place some prohibitions
on the ability of the firm to pay dividends.
(3) Internal constraints—This factor addresses whether or not the firm has the available
funds to make the cash dividend payments. Although legally a firm can borrow to pay
dividends, most lenders are reluctant to make such loans.
(4) Growth prospects—If the firm needs the funds to invest in new or ongoing projects they
may wish to retain earnings to fund the investments. The firm can pay dividends and
then raise funds externally, but often these external sources are more expensive and/or
increase the risk of the firm.
(5) Owner considerations—Although it is impossible to maximize the wealth of every
single owner, managers should consider the tax status, owners’ other wealth
opportunities, and ownership dilution possibilities when making the dividend decision.
(6) Market consideration—How will market participants view the dividend decision? This
factor is concerned with the information content of the decision to institute a dividend
payout where none previously existed.
(d) Ms. McNeely will want to set a dividend that is high enough to inform stockholders of the
financial strength of the firm. She needs to be cautious of not setting it too high and forcing
the firm into a dividend cut possibility in future years. The volatility of EPS is an important
consideration. A worst-case scenario for EPS volatility is minus 10%. EPS could be as low
as $3.33, but could rise to $4.07 in a best-case outcome. The most likely scenario growth of
5% results in an EPS of $3.89. She should also look at the dividend policies of competitor
firms. What is their current policy and what policy did they follow when they first started
paying out a dividend? Investor’s may partially form their expectations from the decisions of
these competitors.
(e) The initial dividend should be approximately $0.72 per share per year ($0.18 per quarter).
General Access has had EPS in excess of $0.72 since 2001, the year after they went public.
This amount is a payout ratio of about 20% based on 2003 EPS. This is a substantial initial
dividend, which is probably what is needed by the market since investors in General Access
have experienced rapid share price appreciation. To start with too low of a dividend would
signal a decline in the investment potential of the firm. To make the dividend higher may
place financial stress on the firm in the near future should profits decline. Even if the firm’s
EPS declined 10% to $3.33 the payout ratio would increase to only 21.6%. If better than
expected earnings are experienced, the firm can declare the extra dividend to share this
wealth with stockholders.