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CASE Montgomery Corporation In January 2016, the board of directors of Montgomery Corporation, one of the nation's largest retail store chains, was


CASE


Montgomery Corporation




In January 2016, the board of directors of Montgomery Corporation, one of the nation's largest retail store chains, was having its regularly scheduled meeting to establish and declare the next quarterly dividend. (Statements for the firm and industry are shown in Figures 1 and 2.) However, this meeting wasn't so regular. One of the directors, Sidney Mobler, who was also a vice president in the company and chief financial officer, had brought a guest: Don Jackson, a financial analyst. Don had spent a considerable amount of time in the finance department and more than a few hours in Mr. Mobler's office developing a proposal concerning the company's dividend policy. He had finally convinced Mr. Mobler to allow him to present his idea to the board.

"Ladies and gentlemen," Don began, after being introduced by Mr. Mobler, "I'll skip the preliminaries and get right to the point. I think that Montgomery's dividend policy is not in the best interest of the stockholders."

Observing the rather chilly stares from around the room, he hastened on: "Now, I don't mean we have a bad policy, or anything like that; it's just that I think we could do an even better job of increasing our stockholders' wealth with a few small changes." He paused for effect. "Let me explain. Up to now our policy has been to pay a constant dividend every year, while increasing it occasionally to reflect the company's growth in sales and income. The problem is, that policy takes no account of the investment opportunities that the company has from year to year. In other words, this year we will use most of our net income to pay the same, or a greater, dividend than last year, even though there might be company investments available that would pay a much greater return if we committed the funds to the firm's investments instead. In effect, the stockholders are being shortchanged: They will realize perhaps a 6 percent yield on their investment as a result of receiving the dividend, when they could realize a

12 percent or higher return as a result of the company's return on its investments. I see this as a serious shortcoming in the management of the stockholders' funds.

"Now, fortunately, correcting this situation is not difficult. All you have to do is adopt what is called a residual dividend policy. That is, each year the firm would


allocate money from income to those capital spending projects for which the return—that is, IRR—is greater than the cost of capital. Any money that is not used in the capital budget would be paid out to the stockholders in the form of dividends. In this way the firm would ensure that the stockholders' money is working the hardest way it can for them."



Figure 1


Selected financial data, Montgomery Corporation (in millions, except per share data)

2009

2010

2011

2012

2013

2014

2015

Sales................................................................................

$27,357.4

$30,019.8

$35,882.9

$38,828.0

$40,715.3

$44,281.5

$48,000.0

Net income........................................................................

$ 650.1

$ 861.2

$ 1,342.2

$ 1,454.8

$ 1,303.3

$ 1,351.3

$ 1,700.0

Amount to preferred dividends..............................................

$      16.7

$      21.5

$      16.8

$      22.6

Amount to common dividends...............................................

$ 429.1

$ 476.3

$ 537.0

$ 630.8

$ 639.0

$ 648.3

$    725.4

Amount to retained earnings.................................................

$ 221.0

$ 384.9

$ 805.2

$ 807.3

$ 642.8

$ 686.2

$    952.0

Common shares outstanding................................................

347.9

351.4

354.6

361.6

363.1

376.6

378.0

Earnings per share (on average common shares)............................................

$ 1.96

$ 2.46

$   3.80

$  4.06

$    3.60

$  3.65

$       4.51

DPS (on average common shares)........................................

$ 1.36

$ 1.36

$     1.48

$     1.70

$    1.76

$  1.76

$       1.96

Payout ratio (DPS/EPS)*.....................................................

69.4%

55.3%

 38.9%

41.8%

48.9%

48.2%

43.5%

Total retained earnings........................................................

$ 7,041.2

$ 7,426.1

$ 8,231.3

$ 9,038.6

$ 9,681.4

$10,367.6

$11,319.6

Cash balance.....................................................................

$ 1,170.7

$ 1,307.6

$ 1,502.5

$ 1,765.0

$ 2,357.2

$ 2,984.4

$ 3,235.0



2009


2010


2011


2012


2013


2014


2015


Dillard Department Store:

EPS

$0.69


$0.93


$1.38


$1.82


$2.29


$2.35


$2.50


DPS

$0.05


$0.05


$0.08


$0.09


$0.10


$0.12


$0.13


Payout ratio

7.3

%

5.4

%

5.8

%

5.0

%

4.4

%

5.1

%

5.2

%

Dollar General:

EPS

$0.38


$0.61


$0.81


$1.10


$0.95


$0.23


$0.30


DPS

$0.09


$0.11


$0.13


$0.17


$0.20


$0.20


$0.20


Payout ratio

23.7

%

18.0

%

16.1

%

15.5

%

21.1

%

87.0

%

66.7

%

Limited, Inc.:


EPS

$0.10


$0.19


$0.37


$0.51


$0.80


$1.21


$1.40


DPS

$0.01


$0.02


$0.04


$0.08


$0.11


$0.16


$0.24


Payout ratio

10.0

%

10.5

%

10.8

%

15.7

%

13.8

%

13.2

%

17.1

%

Nordstrom, Inc.:

EPS

$0.35


$0.38


$0.54


$0.55


$0.66


$0.91


$1.10


DPS

$0.06


$0.06


$0.07


$0.10


$0.11


$0.13


$0.18


Payout ratio

17.1

%

15.8

%

13.0

%

18.2

%

16.7

%

14.3

%

16.4

%

J.C. Penney:

EPS

$2.75


$2.94


$3.13


$2.91


$2.66


$3.53


$4.70


DPS

$0.92


$1.00


$1.08


$1.18


$1.18


$1.24


$1.48


Payout ratio

33.5

%

34.0

%

34.5

%

40.6

%

44.4

%

35.1

%

31.5

%

Wal-Mart Stores:

EPS

$0.16


$0.23


$0.35


$0.48


$0.58


$0.80


$1.10


DPS

$0.02


$0.02


$0.04


$0.05


$0.07


$0.09


$0.12


Payout ratio

12.5

%

8.7

%

11.4

%

10.4

%

12.1

%

11.3

%

10.9

%



Mr. Clarence Autry, who was also on the board of directors of the Exxon corporation and no stranger to the world of corporate finance, broke in. "Young man," he said dryly, "your proposal ignores reality. It's not whether the stockholders are theoretically better off that counts, it's what they want. You cannot tell the stockholders you're doing what's best for them by cutting the dividend; the dividend is what they want. Not only is that dividend sure money in their pockets now, but the fact that it's the same size as last time, or even higher, is a signal to them that their company is doing well and will continue to do so in the future. These decisions can't always be made on the basis of good-looking formulas from the back room, you know."

Ms. Barbara Reynolds, who was the head of directors' auditing committee, and somewhat of an accounting expert, agreed with Mr. Autry. "That's a good point, Clarence, and one that's well recognized by our competitors, too. If you check, I don't think you'll find a single one of them that's cut their dividend in the last six years, even though their net income may have declined significantly. Furthermore, the whole argument is meaningless, anyway, because the dividend is not really competing with the capital budget for funds—we don't turn away profitable projects in favor of paying the dividend. If there are worthy projects in which we want to invest, and we would rather use our available cash to pay the dividend, then we seek financing for the investments from outside sources. In a way, we can have our cake and eat it too." She chuckled, pleased at the analogy.

Don Jackson, however, was not to be intimidated so easily. "Yes, ma'am, what you say is true," he replied, "and I would respond that competitors are not treating their stockholders fairly, either. Furthermore, you do seek outside financing occasionally for large projects, but there are two problems associated with doing it routinely, as you suggest. First, it might be viewed as borrowing, or issuing stock, to pay the dividend, which would cast the company in a very poor light. Second, it's more expensive to finance from outside sources than from inside due to the fees charged by the investment banker. Therefore, I believe you should exhaust our inside sources of financing before turning to the outside."

Ms. Reynolds held her ground. "That's all very well, but it's still not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the company's cash balances were about to be drawn down too low, we could always declare a stock dividend instead of a cash dividend."

"Ladies, gentlemen, "Mr. Edward Asking, the chairman, intervened, "your comments are all very perceptive, but we must move on to the business at hand. All those in favor of changing to a residual policy, please raise your hand."



1. a.    Refer to Figure 1. Would you say that Montgomery's policy up to now has been to pay a constant dividend, with occasional increases as the company grows?

b.    Refer to Figure 2. What type of dividend policies would you say are being practiced by Montgomery's competitors in the retailing industry? Do you think that any firms are following a residual policy?

2. a.    Calculate the expected return to the common stockholders under the firm's present policy, given an expected dividend next year of $2.10 and a growth rate of 7.1 percent. Montgomery's stock currently sells for $35.

(Use the dividend growth model):


                       


b.    Assume that, if Don Jackson's proposal were adopted, next year's dividend would be zero but earnings growth would rise to 14 percent. What will be the expected return to the stockholders (assuming the other factors are held constant)?

3. Is the size of the capital budget limited by the amount of net income, as Don implies? What is the maximum size that the capital budget can be in 2016 without selling assets or seeking outside financing?

4. a.    Don says the cost of the outside financing is more expensive than the cost of internal financing, due to the flotation costs charged by investment bankers. Given the data you have, what would you say is the firm's cost of internal equity financing?

b.    Assume Montgomery can sell bonds priced to yield 13 percent. What is the firm's aftertax cost of debt? (The tax rate is 25 percent.)

c.    Given the cost of debt and the cost of internal equity financing, why doesn't Montgomery just borrow the total amount needed to fund the capital budget and the dividend as well?

5. Do you go along with Clarence Autry's comment that it's what the stockholders want that counts, not their total rate of return? Why or why not?

6. Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for the cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction, is the stock dividend an equivalent substitute for the cash dividend?

7.After all is said and done, do you think the firm's dividend policy matters? If so, what do you think Montgomery's policy should be?


I NEED THIS SHOWN IN EXCEL PLEASE.

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