Linear Technology was created in 1981, and went public on the Nasdaq 5 years later. Being very successful and having positive cash flows, Linear Technology announced its first dividend payment to its shareholders in October 1992. The company could afford it, and it had several goals in doing so: the first was to attract a new type of investors who seek not only growth, but income, like for example many mutual funds or European institutional investors, who only invest in dividend-paying firms. The second was to convey a positive image, that of a firm who was mature and strong enough to sustain its growth. Finally, it wanted to show that it represented a less risky investment than other technology companies, since dividend payment lowers the equity risk premium.
The first dividend payout was set at $0.05 per share, for a total amount of $8.3 million. The payout ratio (15% of the earnings) was strictly fixed in order to be sustainable on the long term; since investors appreciate dividends, but strongly penalize decreases in dividend payments, Linear Technology's CFO preferred to start offering a payout that was rather low, but that he would be able to maintain or increase in the future, in order not to be "hammered" by the company's shareholders and by the market. Indeed, the market could see a link between the dividend and the turnover growth rates. This policy of sending positive signals to the investors played a key role in 2002, when the management team and the board decided to keep increasing dividends in spite of lower earnings than in 2001, which was an exceptionally profitable year. As a direct consequence, the payout ratio increased to 27%, which represented an important change in the dividend policy of Linear Technology.
Few technology firms pay out a dividend to shareholders, and the general trend in the American economy is a decrease in the number of dividend payers. Furthermore, Linear Technology has a high dividend yield, at 1%, while the average return for technology firms is 0.3%. Its dividend strategy is thus a means for Linear Technology to distinguish itself from other companies. This choice is all the more sensible than dividend-paying companies are more attractive than non-paying ones. Linear Technology increases its popularity among investors by paying a growing dividend, and optimizes its shareholders' earnings.
We can also notice that Linear Technology has always spent more on repurchasing shares than on paying dividends: this other way to reward shareholders is preferred because it reduces the dilution caused by the exercise of employee stock options.
To conclude, Linear Technology's dividend policy seems very smart, because it strongly takes into account the signals that are sent to the market, and out of the general trend. Yet, management prefers share-buybacks to dividends when it comes to rewarding shareholders.
What are Linear's financing needs? Should Linear return cash to its shareholders? What are the tax consequences of keeping cash inside the firm?
Since the technology industry has suffered from recession, it is difficult to see the future. In the case, Linear Technology needs cash in order to secure their business. Once they have cash, they hardly face the financial distress. This means Linear has enough liquidity to adapt a severe environment. Also, they plan to expand their business abroad especially in Asia. So, they strongly require cash. On the other hand, Linear does not have a plan of M&A or entering other industry so far. These kinds of activities consume a large sum of money. In addition, Linear's core business field, analog fabrication facilities, requires less R&D cost than digital one. If we compare Linear's cash with its competitors, it is obvious that Linear has too much internal cash than others (see Exhibit 2 and 12). So, we think Linear does not need financing compared to other company.
We think it is the time for Linear to return its cash to its shareholders. Usually, dividends are taxed twice both at the corporate level and the stockholder level. So, there is some argument against for paying dividend. However, both tax on capital gain and dividend have lowered recently (see Exhibit 7). Therefore, high dividend yields are surely attractive for the investors. In addition, Linear does not have an aggressive business expansion plan such as M&A. This means that Linear can return cash to shareholders without harming its business opportunity or financial situation.
Then, we look at tax consequences in keeping cash inside of the firm. After taxed, there two ways for free cash flow, one is retain and the other is payout. Retained earnings are going to inside cash of the firm. Unlike payout, retained earnings not taxed (personal tax). The company can use this money to invest such as buying stocks or bonds. According to the case, the company has 1.5 billion dollar of cash and short-term debt securities. And it generates 52 million dollar of interest income. This receiving interest income is taxed before receiving, but it is not taxed afterward unless the company pays dividend. Therefore, keeping cash inside the firm gives the company to release from tax burden. Especially, companies which have a growth opportunity and many projects they tend to keep their cash inside to invest new project or develop their business.
If Linear were to pay out its entire cash balance as a special dividend, what would be the effect on value? On the share price? On earnings? On earnings per share? What if Linear repurchased share instead? Assume a 3% rate of interest.
Why do firms pay dividends? Why has the rate of individual initiations changed over time?
The main theoretical reason why firms pay dividends is paying back to shareholders funds that are not invested at a rate of return which is equal or higher than the WACC, i.e. firms pay dividends when cash is available, but cannot be used on profitable investments. Other aims include:
1. Communication: dividends can be considered as a means of communication between the company and the investors. A company which is really profitable is meant to show it in ways other firms cannot afford. Paying dividends is solid proof that the company has cash, since a company that has liquidity problems… cannot pay dividends. Thus, dividends can be considered as a positive signal regarding the cash level of the company.
Moreover, the amount of annually granted dividends depends on the net income of the previous year and the first quarters of the current year. Thus, the dividend policy is a positive signal regarding the company's forecast net income. For example, a company which maintains its dividend policy in spite of a deteriorating situation and shrinking income is a company which wants to prove to the market that the downturn is only temporary, and that its management is so confident in the upturn that it dares to pay out dividends. Following the same framework, reducing dividend payout can be interpreted by the market as a reaction to liquidity problems, whereas it can merely be induced by investment in heavy but profitable projects.
To summarize, dividends are an important means of communication because they are facts, as opposed to statements. Profits written on a balance sheet say one thing about a company's situation, while profits that induce cash dividends say another thing entirely.
2. Controlling management: paying dividends enables the company to solve part of the agency problem, which arises "when management and stockholders have conflicting ideas on how the company should be run" (www.investopedia.com). Agency theory assumes that "large-scale retention of earnings encourages management behavior that does not maximize shareholder value", like for instance an opportunistic acquisition of a competitor that does not create value, but that enhances the company's (and its CEO's) prestige. If the company pays dividends, managers have less cash to invest, so they have to be a lot more regarding on the return of the projects they choose to invest in.
3. Pleasing the shareholders: in an article published along with Jeffrey Wurgler in the Journal of Financial Economics on August 13th, 2003, entitled "Appearing and disappearing dividends: the link to catering incentives", Malcolm Baker (one of the authors of this case), states that investors are very fond of receiving dividends - especially since 2002 - even though it theoretically does not make them wealthier, since the share price decreases by the amount of the per share dividend payout. It is mere psychology: having a bird in the hands is better than having two in the bush.
However, there are also times when investors prefer not to receive dividends because growth opportunities appear to generate more value for them - between 1995 and 2000 for example.
According to this theory, the main objective of the firm is thus to satisfy shareholders' expectations. And since shareholders' expectations fluctuate over time, so the rate of dividend payouts should fluctuate accordingly.
