TO PAY OR NOT TO PAY:
AN EXPERIENTIAL EXERCISE IN
DETERMINING A FIRM’S PAYOUT POLICY
Professor Robert M. Hull (Corresponding Author)
rob.hull@washburn.edu (R. Hull)
Professor William Roach
Brenneman Professor Robert A. Weigand
All of:
School of Business, Washburn University;
1700 SW College Avenue, Topeka, KS 66621
Phone: + 1-670-231-1010; FAX: + 785-670-1063
Beatrice Presentation
November 1, 2005
Washburn University
TO PAY OR NOT TO PAY:
AN EXPERIENTIAL EXERCISE IN
DETERMINING A FIRM’S PAYOUT POLICY
Under Review by Journal of Financial Education:
Submitted 7/7/2005; Favorable Review Received 8/30/2005
Plans for Resubmission: December 2005
Published in Working Paper Series:
Washburn University Working Paper Series, September 2005
To Be Presented by Professor Roach at:
2005 Decision Science Institution Conference
Session IE9: Case Study and Experiential Approach Examples
November 20, 2005; 8:00 a.m. − 9:30 a.m.; San Francisco, CA
Overview
* We develop a classroom exercise simulating the cash dividend
payout decision process. The benefits to business students
include
(i) a thorough investigation of the complex payout issues managers
must consider when determining dividend policy, and
(ii) the opportunity to address the long-term trend of declining
dividend payouts.
* The exercise provides business instructors with several options for
incorporating the dividend payout decision-making process into
their classroom styles; among these are
(i) experiential learning through peer group interaction and roleplaying, and
(ii) the opportunity to conduct a financial analysis of a firm that has
recent initiated a regular dividend payout.
JEL Classification:
Key Words:
G35 (Payout Policy); I22 (Financial Education)
Payout, Collaborative Learning
Cash Dividends, Student Engagement
Organization of Paper
• Section I gives an introduction.
• Section II provides a deeper background on the payout literature,
focusing on the important relationship between dividend payout
and firm value. We also discuss the decline in dividend payouts in
the U.S. and frame this issue as an appropriate topic for
consideration by the next generation of managers in MBA and
other business school programs.
• Section III present our class exercise on the payout decisionmaking process. The appendices supply resources on the
dividend payout exercise including the actual tasks and
supplementary materials with questions and solutions.
• Section IV provides concluding comments.
Major Purpose
Our major purpose is to offer a learning exercise to address
two timely issues.
* The first issue concerns the firm’s choice of dividend
payout (cash dividends ÷ operating earnings). Bernstein
(2005) argues that the low dividend payout makes no
sense.
* The second issue concerns student engagement through
active and collaborative learning. Burbridge (2005)
argues that students need to become more involved in
active and collaborative learning.
Addressing the Two Issues
•
•
•
To address the above two issues, we design a class exercise on
dividend payout policy to engage students in a manner where learning
the “stuff of management” can take place by studying the current
controversial topic of low dividend payouts.
Our payout exercise challenges students to participate in the
collaborative and cooperative aspects of team learning (D. Johnson and
R. Johnson, 1975; Keaton, 1976; Bouton and Garth, 1983; Michaelsen,
1994; McKeachie, 1994) through an experiential simulation of the payout
decision-making process where students will have an opportunity to
debate the many relevant factors used when making dividend policy
choices.
By involvement in the payout decision-making process through roleplaying (as a member of a consulting team or of a Board of Directors),
students can begin to experience how the payout choice is made in
practice. This will lead to an increased appreciation of the complex
factors faced by managers who are responsible for determining their
firm's dividend policy.
TEACHING OUTCOMES
Teaching Outcomes Include:
(1) Students will delve deeper into payout policy by
examining research issues.
(2) Students will use newer valuation metrics and traditional
methods of financial analysis in conjunction with real firm
data to make decisions about a firm’s payout policy.
(3) Students will (within a team setting) become familiar
with the decision-making process as practiced by Board
of Directors.
(4) Students will interact and share knowledge with other
students in a class exercise that challenges them to
verbally express their views.
Literature Review
Two Lines of Early Thought
Two distinctly different branches of thought emanate
from the early literature on corporate payout policy
and its primary historical manifestation, cash
dividends.
• The first line of thought emerges from the classic
works of Williams (1938), Gordon (1959), and
Lintner (1956), asserting that dividends are an
important determinant of firm value and a first-order
concern for value-maximizing managers.
• The second perspective, attributable to Miller and
Modigliani (1961) and echoed in Black (1976),
suggests cash dividends are irrelevant for firm
value, a trivial detail to be dealt with only after the
firm's investment policy is established.
FIRST VIEW
Dividends Are Directly
Related to Intrinsic Value
The value of a firm and its securities as the present
value of a stream of dividends and/or particular
definitions of free cash flow.
 Corporate surveys Lintner (1956), Fama and Babiak
(1968), Baker, Farrelly, and Edelman (1985), and
Baker, Veit, and Powell (2001) suggest managers
believe dividends should be related to permanent
(rather than temporary) increases in profits, consistent
with the idea that dividends are fundamentally related to
firm value.
 Graham and Dodd (1962) urge analysts to value firms
based on demonstrated earnings power (like
dividends), rather than speculative notions of future
earnings.
First View associated with Dividend
Valuation Model
P0 = D1 / (R-G) where
P0 is the price per Share
D1 is the perpetual dividend cash flow per share beginning at t = 0
R is the required rate of return
G is the growth rate in dividends
POR = D1 / EPS1 is the payout ratio
1-POR = proportion of earnings retained
See http://www.fool.com/news/commentary/2004/commentary04100402.htm
for an example of how an analyst used DVM to make money on stock picks
First View seen in fact Analysts Use the
Dividend Valuation Model even Today
• The view that dividends are related to firm value is firmly
rooted in the conventional wisdom of the early 20th century.
This view is reflected in classic texts and research papers,
valuation models still used by analysts today, and the
magnitude of dividend payout investors were accustomed to
receiving.
• Merrill Lynch uses the model as a component of its marketbeating Alpha Surprise Model.
• JP Morgan uses the model as an important input into the
valuation and stock selection process.
Figure One
Years
Dividend
Yield
Capital Total
Gains
Returns
1802-1870
6.4%
0.7%
7.1%
1871-1925
5.2%
2.2%
7.4%
1926-2001
4.1%
6.2%
10.3%
1982-2001
2.9%
11.6%
14.5%
Second View
Dividends Are Not Directly
Related to Firm Value
• Miller and Modigliani (M&M 1961) disagree with the idea that
dividends directly affect firm value. Posing the following
question early in their paper: "Do companies with generous
distribution policies consistently sell at a premium above
those with niggardly payouts?” is an obvious reference to
the wisdom that firms should pay out healthy dividends.
• M&M present a model that shows the value of a company is
determined by the firm's assets and the cash flows generated by
those assets, not how the cash flows are distributed to
shareholders.
• M&M contend that different payout policies constitute nothing
more than slicing a fixed pie of cash flows into different pieces,
and that in perfect, frictionless markets the value of these pieces
will always sum up to the value generated by the underlying
investment policy that produced the cash flows. Changing the
form of the distribution does not affect value.
Second View Expanded so that Dividends Can Cause Loss of
Value, Signal Information, Reduce Agency Costs, or Reduce Risk
•
•
•
•
•
Black (1976) takes M&M's ideas even further and asserts that when
taxes are considered, paying dividends actually destroys value.
Black (1976) coins an enduring phrase when he declares the
convention of dividends to be a "puzzle," and leaves the reader to
wonder why the corporate world has not adopted his vision of zero (or
near zero) dividend payouts.
One of the first attempts to explain why firms would want to pay
dividends suggests corporate dividend policy reflects managers'
expectations of future firm earnings, a specific application of an
economic concept known as signaling, pioneered by Ackerloff (1970)
and Spence (1973).
This idea is incorporated into the finance literature on dividends and
information by Bhattacharya (1979), Miller and Rock (1985), and John
and Williams (1985). In these and other studies managers are
portrayed as intentionally communicating their expectations of future
firm earnings via dividend increases and decreases.
As seen later can also affect agency costs and risk.
Recent Attack On Second View
• DeAngelo and DeAngelo (2005) present a voluminous and
convincing critique of M&M's analysis, demonstrating that the finding
of dividend irrelevance obtains because M&M's framework
mandates 100% payouts — the effect of "niggardly" payouts cannot
be considered in their model. The irrelevance result is therefore
hardwired into their assumptions, which means their argument is
little more than an elegant tautology.
• DeAngelo and DeAngelo assert that M&M and Black have “ . . .
limited our vision about the importance of payout policy and sent
researchers off searching for frictions that would make payout policy
matter, while it has mattered all along . . . ”
Empirical Evidence
•
•
•
•
•
Some studies find a positive relation between dividend changes and
future earnings (Watts, 1973; Gonedes,1978; Nissim and Ziv, 2001).
Others disagree (Benartzi, Michaely and Thaler, 1997; Dyl and
Weigand, 1998; Grullon, Michaely and Swaminathan, 2002).
Studies of dividend initiation report some evidence of short-term
earnings growth following first-time dividend payments (Healy and
Palepu, 1988; Benartzi, Michaely and Thaler, 1997).
Researchers argue that dividends provide investors with a way to
monitor agent-manager behavior (Easterbrook, 1984; Jensen,1986).
Researchers offer mixed evidence as to whether dividends reduce
agency costs (Lang and Litzenberger, 1989; Borokhovich, Brunarski,
Harman and Kehr, 2005).
Researchers have proposed that dividend payments are associated
with lower firm risk (Venkatesh, 1989; Dyl and Weigand,1998; Grullon,
Michaely and Swaminathan, 2002).
Dividends and Payout Policy in
the 21st Century
•
•
•
•
•
The benefits of dividends make it difficult to justify the low market demand for
dividends and firms' propensity not to pay.
The average dividend yield on U.S. stocks from 1982-2001 was a paltry 2.9%.
The precipitous decline in dividends is underscored by the fact that yields
averaged 3.9% from 1982-1991, but only 2.0% from 1992-2001.
Fama and French (2001) confirm that the convention of cash dividend payments
has been in a long-term downtrend. While 67% of publicly-traded firms in the
U.S. paid dividends in 1978, only 21% of firms were dividend payers in 1999.
Fama and French find markets have become increasingly tilted toward firms that
are less likely to pay dividends — small firms with low profitability and high
growth opportunities. They also report all types of firms have become less likely
to pay dividends, however, including larger firms with slower growth
opportunities.
Julio and Ikenberry (2004) present evidence of a mild revival in the tendency to
pay dividends. They attribute renewed interest in dividends to firms needing to
reassure investors about the quality of their earnings in a post-Enron/Global
Crossing/Tyco world. Another reason firms may be more willing to pay dividends
is that tax rates in the U.S. on dividend income and capital gains are now equal
(15%). Julio and Ikenberry also suggest technology firms (like Microsoft) that
went public in the 1980s and 1990s are now maturing and facing slower growth
opportunities.
Recent Thinking & Findings:
Repurchases for Dividends
•
•
Recent survey evidence by Brav, Graham, Harvey and Michaely (2005)
indicates that share repurchase is now more highly-favored than dividends,
although respondents believe both forms of payout communicate important
information to markets (85% for repurchases and 80% for dividends). Thirty-six
percent of managers believe repurchases are as important as they were 15-20
years ago (implying the relative importance of repurchases has increased) while
only 40% believe dividends are as important (implying the relative important of
dividends has decreased).
Julio and Ikenberry (2004) show that, despite the substitution of share
repurchase for dividends, total payouts to shareholders as a percentage of
earnings have remained stable from 1984-2004. These authors also point out
that while both dividends and share repurchase signal managers' optimism
about the permanence and expected stability of earnings, repurchases offer the
additional benefit of explicitly communicating managers' belief that their shares
are undervalued. However; share repurchase indicates short-term optimism
while dividends represent a more reliable, long-term commitment to pay out
excess capital.
Our Exercise Will Challenge Students
to Work with Financial Statements
• Students will work with newer financial
metrics
• Students will work with traditional
financial ratio analysis methods
• Students will apply trend analysis
• Students will look at industry norms
FINANCIAL RATIO ANALYSIS
• Financial ratio analysis consists of various methodologies.
In our paper, we discuss (1) relatively more recent
valuation methods as represented by economic value
added (EVA®), return on invested capital and free cash
flow and (2) long-standing traditional methods as
epitomized by the DuPont Model.
• Blumenthal (1998) and Firer (1999) indicates that
traditional approaches typified by the DuPont Model will
continue to dominate financial analysis for some time
including the newer metrics like EVA.
• Financial ratios must be interpreted properly and
cautiously because of inherent accounting-based
limitations and unethical manipulation.
Class Exercise: “To Pay or Not to Pay”
• Our dividend exercise can be tailored to fit into the
typical class time slots of either 50 minutes or 75
minutes.
• We have found that it works nicely with class sizes
of 15 to 25 students. For larger class sizes, the
exercise can be repeated twice or the three teams
(described below) can choose to designate the
students who will represent their team in the
actual exercise.
Class Exercise: “To Pay or Not to Pay”
Three Teams and Three Tasks
•
•
•
•
•
•
•
In our exercise, students are assigned to one of three teams.
One team defends the "pro-dividend" side of the issue (see Appendix 1
for their task).
A second team advocates the "con-dividend" viewpoint (see Appendix 2
for their task).
Members assigned to the first two tasks are consultants. Consultants are
assumed to have academic and/or practical experience in terms of
financial management decision-making.
The third and final team makes up the Board of Directors (see Appendix
3 for their task).
Students forming the Board of Directors will render a final decision as to
whether there will be a change in the firm's dividend policy.
To challenge the competitive spirit of those arguing the “pro” and “con”
sides, we instruct Board members to consider the quality of the
arguments presented by the "pro" and "con" sides when making their
decision.
Class Exercise: “To Pay or Not to Pay”
•
By working in teams where students are assigned specific roles, we
utilize an experiential method that stresses cooperative and
collaborative learning through peer group interaction and role-playing
(Coleman, 1948; Collier, 1983; Meyers and Jones, 1993; Michaelsen,
Watson and Black, 1989; McKeachie, 1994).
• To achieve outcomes related to the exercise’s goal of student
engagement, we encourage adherence to the practices, principles, and
techniques related to group activities (Bouton and Gartch, 1983;
Fiechtner and Davis, 1985; Abelson and Babcock, 1986; Katzenback
and Smith, 1993; Robbins and Finley, 1995).
• Katzenback and Smith suggest that instructors adhere to the following:
● requires all members to contribute equivalent amounts of real work
so that a sense of mutual accountability is achieved;
● exploit the power of positive feedback, recognition, and reward;
● keep teams small enough so the students can communicate
openly with others and understand their roles and skills.
• In regards to the last suggestion, we have found the team sizes of
about six work the best.
Class Exercise: “To Pay or Not to Pay”
Two Possible Applications
• The case discussion can be applied one of two
ways. Instructors who prefer a shorter and more
direct method can focus on the material in
Appendices 1–3.
• Instructors who prefer that students conduct a
financial analysis of a specific firm can also apply
the materials in Appendices 4–8, which provides
financial data for Microsoft Corporation for several
years preceding and following their dividend
initiation.
Shortened Form of Exercise
• Using the shortened form of our exercise (which includes only
the first three appendices) has yielded satisfactory results and
positive feedback over the years.
• This form provides some advantages including the fact the
exercise can be accomplished in a shorter period of time for
instructors constrained by time.
• With the firm’s product assumed as unique for the shortened
form, there is no inherent advantage given to either team
through looking at industry norms that could dictate what payout
might be optimal.
• While lack of such particulars has some advantages, it does not
provide students with an opportunity to study an actual firm with
real data.
More Rigorous Exercise
• For instructors who want a more rigorous exercise, we supply real
data in the lengthened form of our exercise by looking at a firm that
has recently instituted paying dividend (Microsoft Corporation).
• This lengthened form adapts the materials given in Appendices 1–
3 with the supplementary materials supplied in Appendices 4–8. As
seen in these latter five appendices, students can pursue a variety
of possible activities.
• These five appendices contain a sample of assignments and
solutions that include recent valuation metrics and a flow chart of
an expanded DuPont analysis.
• As seen in the flow chart, ROE (and thus earnings available for
cash dividend distribution) has been influenced negatively over
time by margin management through increased costs.
Class Exercise: “To Pay or Not to Pay”
Prior to actually participating in our class exercise on dividend policy
decision-making, we suggest that instructors do the following:
• have students study assigned textbook readings and any supplied
materials accompanying lecture materials;
• hand out the assigned task given in the first three appendices
while providing needed instructions (see ground rules next
overhead);
• arrange team meetings using class time if necessary (and
encouraging chat room meetings if applicable);
• present the supplementary materials if a more rigorous application
is desired (e.g., offer additional resources in Appendices 4–8 to
help instructors further frame the controversial payout issues
students will debate when participating in the exercise).
Suggested Ground Rules
•
First, we encourage teams to delegate tasks to individuals with tasks
based on points of interest identified in the team meeting.
• Second, Board members are seated in the middle and are flanked on the
two sides by the “pro” and “con” team participants.
• Third, we allow one five minute “time-out” per team with the instructor
moderating the time-outs.
• Fourth, formal rules of a debate are not required.
• Fifth, when the debate is over, the Chair asks members of the “pro” and
“con” sides to leave the classroom.
• Sixth, we require each participant to turn in a one page summary of the
salient points describing their fundamental role in the exercise.
After presenting the general instructions including these ground rules, we
meet separately with each team to answer individual questions about the
assigned task and give further team-specific counsel. These separate
meetings can take place during class time with the instructor visiting
each team as they meet privately to go over their task and make
individual assignments. The instructor can also arrange to meet outside
class time with teams or representatives of teams.
Student Research Possibilities
•
•
•
•
•
Instructors can require advanced students (taking upper level finance or
MBA courses) to perform research supplementing textbook and lecture
materials on the payout debate.
Appendices 4–8 can be used for this research purposes.
Additionally, scholarly journal articles can be assigned by those
instructors who want to challenge more sophisticated students. Finance
journals are rich in articles related to the theoretical arguments and
empirical evidence about payout issues with textbooks having their own
list of references on dividend policy.
To further enhance student preparation for participation in the exercise,
instructors can encourage the use of spreadsheet and/or program
versions of the various payout models.
Concerning the Internet, there are web pages that can be used as part
of the student preparation for the exercise.
Internet Sites for
Analysts’ Assessment
Internet sites provide details to find analysts’
assessment and which can be used in
conjunction with financial ratio analysis to
make predictions about investment
possibilities. Sites include:
• http://finance.yahoo.com
• http://www.hoovers.com/free
• http://moneycentral.msn.com/home.asp
Assessing Student Satisfaction
•
•
•
•
To assess student satisfaction (especially when first conducting the exercise),
we suggest that formal student feedback be gathered so that the exercise can
be enriched and tailored to meet the needs of a particular type of student. To
help improve the peer learning process, students should be asked to comment
on other team members.
We think information on the following attributes (on a scale of one to five) can be
important in any evaluative instrument an instructor might choose to use:
attendance and participation at team meetings; completion of delegated team
tasks; respect for others’ opinions; level of interest and commitment; and, level
of contribution in terms of competencies and creativity.
Alternately, students can also be asked to anonymously assess their peers by
simply stating who participated effectively and who did not participate effectively.
Student can also be required to evaluate their own performance as effective or
ineffective. Finally, students can be asked to write a paragraph or two on what
they have learned as team members, and to specify what problems they have
encountered in participating as a team member.
Task 1: Increasing Payout
•
•
•
•
INSTRUCTIONS: There are three “tasks”: Task One,
Task Two, and Task Three. You have been assigned
Task One . . . Details concerning your task are given below.
You are a consultant for Taskpro, Inc., which is a company that provides
specialists to help firms make financial management decisions. Taskpro has
just been hired by Divitable, Inc. to help Divitable determine if it should
increase its payout. As an expert in the area of dividend policy, you will be on
the team of consultants formed by Taskpro to advise Divitable about its
payout policy. You are aware that another firm, Taskcon, Inc., has also been
hired by Divitable to argue against Divitable increasing its payout . . .
. . . It is expected that you will give management a series of arguments for
why increasing its cash dividend payout is the correct path to follow . . .
. . . When you appear before the Board, you are to have a one page summary
of your arguments and findings that support an increase in dividends. To
supplement your one page summary, you are allowed to bring other notes
with you to the Board meeting . . .
Task 2: Decreasing Payout
INSTRUCTIONS: There are three “tasks”: Task One,
Task Two, and Task Three. You have been assigned
Task Two . . . Details of your task are given below.
You are employed as a consultant for Taskcon, Inc., which is a company
that provides consultants to advise firms on financial management
decision-making. Taskcon has recently been hired by Divitable Inc., to
supply arguments against increasing Divitable’s dividend payout.
Because of your past experience in dividend policy, you have been
assigned to the team that will advise Divitable against the pitfalls of
paying out too much dividends. Although you are not privy to inside
information on Divitable, you do know that it produces a unique array of
products making it hard to identify its specific industry or any major
competitors. You also know that the Conaby family controls 20 percent
of the voting shares of Divitable, which is a large-sized company by
NASDAQ standards having $20 billion in total assets . . .
Task 3: Board of Directors
INSTRUCTIONS: There are three “tasks”: Task One, Task Two,
and Task Three. You have been assigned Task Three . . .Your
task and instructions are described below.
You are a member of the Board of Directors of Divitable, Inc., which is listed on
NASDAQ . . . At the Board meeting, you will sit in judgment as each consulting
team presents its arguments. It will be your task to decide which team of
specialists presents the best arguments as this can highly influence your
decision . . . Board members are expected to hold their own private gettogether, prior to the official Board meeting, to formulate a strategy for the
meeting . . . After the consultants have presented their arguments, they will be
asked to leave the meeting. At that time, you and other Board members will
render your decision about whether your company’s payout will be increased.
Your decision and explanation will be made known to consultants.
Task Extension
(For Rigorous Application)
• INSTRUCTIONS: . . . you have been given additional information,
where Divitable is benchmarking its own dividend decision to that of
Microsoft Corporation. This information involves the following empirical
extensions to the case. As before, you are to discuss your task only
with designated classmates who have been assigned the same task as
yourself. Details of your extended task are given below.
• Perform a financial analysis of Microsoft for the years leading up to and
following the announcement that Microsoft would begin paying regular
cash dividends (Microsoft announced its initial dividend on January 16,
2003). Microsoft's financial statements from 2001-2004 are included on
the following pages . . .Your task is to critique the financial performance
of Microsoft and use your findings to support the argument for or
against a dividend payout increase by Divitable, Inc. (depending upon
whether you are an employee of Taskpro or Taskcon). Your financial
analysis should include the following . . .
Question 1 / Solution 1
• Question 1. Report trends in Microsoft's basic
financial ratios and comment on the company's
financial health in the following categories:
– Liquidity: current and quick ratios
– Asset Management: days sales outstanding, fixed assets
turnover and total assets turnover
– Debt Management: debt ratio, times interest earned
– Profitability: return on assets and a DuPont analysis of
return on equity (profit margin, total asset turnover and
equity multiplier)*
• Solution 1. See Appendix 7 for numbers on
Microsoft from 2001−2004.
Appendix 7
Microsoft Financial Ratio Trend Analysis
2001
2002
2003
2004
3.56
3.81
4.22
4.71
Quick
Asset Management Ratios
3.56
3.76
4.17
4.69
Fixed Assets Turnover
Days Sales Outstanding
11.0
12.5
14.4
15.8
55.0
11.0
0.43
66.0
12.5
0.42
58.9
14.4
0.39
58.4
15.8
0.40
Liquidity Ratios
Current
Fixed Assets Turnover
Total Assets Turnover
Appendix 7
Microsoft Financial Ratio Trend Analysis
2001
2002
2003
2004
Debt / Equity Ratio
0.25
0.30
0.26
0.23
Debt / Total Assets Ratio
0.20
0.23
0.21
0.19
Debt Management
Times Interest Earned
No interest expenses reported.
Profitability
Profit Margin
Total Assets Turnover
Return on Assets
Equity Multiplier
Return on Equity
29.0% 27.6% 23.4% 22.2%
0.43
0.42
0.39
0.40
12.4% 11.6%
9.2%
8.8%
1.26
1.23
1.25
1.30
15.5% 15.0% 11.6% 10.9%
Question 2 / Solution 2
• Question 2. Discuss Microsoft's ability to build
value for its shareholders as evidenced by
trends in the following valuation metrics:
– NOPAT (net operating profit after tax)
– ROIC (return on invested capital)
– EVA© (economic value added)**
– FCF (free cash flow)
• Solution 2. Appendix 7 has numbers for
Microsoft Corporation from 2001−2004.
Trend Analysis for Recent Valuation
Metrics including EVA
 Appendix 7 supplies trend analysis for recent valuation metrics. Below we
define the relevant variables used in the metrics deployed.
• NOWC (Net Operating Working Capital) is Cash & Equivalents + Accounts
Receivables + Inventories – Accounts Payables – Accrued Expenses.
• OLTA (Operating Long Term Assets) is Net Property, Plant & Equipment.
• TOC (Total Operating Capital or Invested Capital) is NOWC + OLTA.
• NOPAT (Net Operating Profit after Tax) is Operating Income (or EBIT) times
(1−T) where T is the corporate tax rate estimated as Income Taxes divided by
Pre-Tax Income.
• ROIC (Return on Invested Capital) is NOPAT divided by the prior year’s TOC.
• EVA (Economic Value Added) is NOPAT minus the quantity consisting of the
WACC times the prior year’s TOC.
• FCF (Free Cash Flow) is NOPAT minus the quantity consisting of this year’s
TOC minus the prior year’s TOC.
Appendix 7
Microsoft (MSFT) Valuation Metrics Trend Analysis
(in billions of dollars where applicable)
2000
2001
2002
2003
2004
Net Operating Working Capital
$6,456 $5,663 $6,465
$9,285
$19,237
Operating Long Term Assets
$1,903 $2,309 $2,268
$2,223
$2,326
Total Operating Capital
$8,359 $7,972 $8,733
$11,508
$21,563
Cash Dividend
Cash Dividend Payout
$0
$0
$0
$857
$1,729
0
0
0
0.11
0.21
Appendix 7
Microsoft (MSFT) Valuation Metrics Trend Analysis
(in billions of dollars where applicable)
2001
2002
2003
2004
NOPAT (net operating profit after tax)
$7,721 $7,829 $7,531
$8,168
ROIC (return on invested capital)
92.4% 98.2% 86.2%
71.0%
EVA (economic value added)
$6,885 $7,032 $6,658
$7,017
FCF (free cash flow)
$8,108 $7,068 $4,756 -$1,887
Weighted Average Cost of Capital
10.0% 10.0% 10.0%
10.0%
A Description of the
DuPont Model
•
Below we define the key DuPont ratios in Appendix 8 where we show their
influence on ROE.
•
Margin Management (Data from Income Statement):
Net Profit Margin (NPM) = Net Income / Sales = NI / S (1)
•
Asset Management (Data from Balance Sheet):
Asset Turnover (AT) = Sales / Total Assets = S / TA (2)
•
Debt Management (Data from Balance Sheet):
Financial Leverage (FL) = Total Assets / Stockholders’ Equity = TA / E (3)
where Financial Leverage can also be referred to as the Equity Multiplier (EM).
•
When we multiply out the above three equations, we have:
ROE = NPM * AT * FL = (NI / S)*(S/TA)*(TA/E).
Canceling out from the denominators and numerators for “S” and “TA”, we get:
ROE = NPM / E. (4)
Appendix 8: DuPont Analysis of Microsoft Corporation
Expanded DuPont Analysis for Microsoft (MSFT) from 2001 to 2004 (in billions of dollars)
Sales
Comparison Key:
36.8
2004
2001
25.3
Gross Profit
minus
33.3
Net Profit
8.17
Net Profit
Margin
22.2%
29.0%
Financial
Leverage
Return on
Equity
10.9%
Return on
Assets
1.23
=
15.5%
1.25
X
8.84%
0
12.4%
net profit
sales
21.3
minus
7.72
divided by
Other Costs
total assets
equity
net profit
total assets
13.9
Sales
12
36.8
10.
25.3
95
Cash
Sales
61
74.8
divided by
47.3
Total Assets
Inventory
70.6
0.66
plus
92.4
59.3
0.75
plus
Current Assets
0.40
sales
total assets
32
25.3
Asset Turnover
39.7
Earnings Per Share
(diluted basis)
3.46
multiplied by
0.43
Shareholders' Equity
6.72
25.1
36.8
net profit
equity
Cost of Goods Sold
Fixed Assets
21.8
19.6
CONCLUSION: ROE has only been slightly influenced (in a negative manner) by
debt management (financial leverage decreased slightly) and asset management (asset
turnover has also decreased only slightly). However, ROE has been significantly influenced
(in a negative manner) by margin management where net profit margin has fallen 23 percent.
This fall stems from the 83 percent increase in costs compared to only a 45 percent increase in
sales. While there appears to be greater net profits to pay greater dividends, the overall return is down.
0.4
0.0
mm
plus
Accounts Receivable
5.9
3.7
plus
Other Current Assets
3.7
4.4
.0.03
Question 3 / Solution 3
Question 3. Compare Microsoft's stock returns
over the period 2001-2004 with the returns to
the S&P 500 and NASDAQ indices.
Solution 3. MSFT's historical stock prices can be
downloaded directly into a spreadsheet from
Yahoo!Finance:
http://finance.yahoo.com/q/hp?s=MSFT
S&P 500 at:
http://finance.yahoo.com/q/hp?s=%5EGSPC
NASDAQ at:
http://finance.yahoo.com/q/hp?s=%5EIXIC
•
Reading List for Researching Dividend Policy
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Concluding Statements
This paper has presented a class exercise to teach payout
policy. The class exercise is designed so that instructors
can enhance experiential learning.
The exercise addresses two timely issues.
The first issue concerns why do not firms pay more
dividends. Bernstein (2005) concludes that the “. . .
demand for dividends is approximately nil. This
phenomenon makes little sense.”
The second issue concerns student engagement through
active and collaborative learning. An engaged student is
one who combines knowledge with the ability to apply this
knowledge within an organizational and team setting so
that the “stuff of management” (e.g., the actual,
unquantifiable decision-making processes) can be better
experienced.