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Dividend Policy and Corporate Capital Structure
FuzzyTronic, IncFuzzyTronic, Inc.
byby
Agung SulistijoAgung Sulistijo
Endi FitriEndi Fitri
Nurdiansyah TanjungNurdiansyah Tanjung
SutrisnaSutrisna
Yuni Dwi WijayantiYuni Dwi WijayantiMM UGM; AP 14 A MM UGM; AP 14 A
JAKARTAJAKARTA
20092009
FuzzyTronic, Inc.
• FuzzyTronic, Inc. is a developer and major supplier of
automotive transmission software to all the major
automobile manufacturer
• It was founded in 1990 by Wong Xau, young Chinese
graduated student in mathematics, in his basement
apartment in San Francisco.
• He wanted to test the commercial possibility of
“Fuzzy Logic”, a new branch of mathematics.
• To help him manage the company he recruited David
Myers, who has a background in finance as a CFO of
Fuzzy Tronic, Inc.
FuzzyTronic, Inc.
• In 1992, Myers had supervised the Initial Public
Offering (IPO) of FuzzyTronic common stocks
• 1992 to 1996, the firm achieved few milestones of
success, including selling fuzzy logic software to
Japanese and Hong Kong manufacturing firms.
• 1996, Japanese and other competitors enter to this
market
• To gain the market, in the same year FuzzyTronic
innovated a advanced software control mechanism
that would shift transmissions more smoothly.
FuzzyTronic, Inc.
• Fuzzy Tronic’s optimal capital structure involved very
little of debt because of the substantial operating risk
facing the firm.
• From 1992 to 1996, FuzzyTronic reinvesting all the
earning back to business and paid no dividend to its
investors.
• Myers realized that the stockholder clearly expected
the US$ 0.90 dividend payment and healthy dividend
boost in 1998 – 1999.
• Meanwhile, firm’s sustainable growth in sales &
earning was only 5 percent.
The DataTable 1Table 1
Statement of Revenue & ExpenseStatement of Revenue & Expense
The DataTable 2Table 2
Statement of Financial ConditionStatement of Financial Condition
The DataTable 3Table 3
1997 Investment Opportunity Set and Corporate Capital Cost1997 Investment Opportunity Set and Corporate Capital Cost
Notes :Notes :
Weighted average capital cost is based on a 7 percent after tax cost of debt and a 14 percent cost of Weighted average capital cost is based on a 7 percent after tax cost of debt and a 14 percent cost of
commoncommon
Equity at the optional capital structureEquity at the optional capital structure
QQ--11Examine the data shown in Table 2. Using this information, what is
FuzzyTronic’s optimal capital structure, and what is the firm’s
current weighted average cost of capital?
The Optimal Capital Structure
The optimal capital structure of the FuzzyTronic Inc. is
Long Term DebtUS$ 55,000 ( 5.21%)
Common Equity US$ 1,000,000 ( 94.79%)
Total US$ 1,055,000 (100.00%)
The mixed of debt, preferred and common equity that causes its stock price to be maximized
In this case
Weighted Average Cost of Capital
The weighted average of the after tax component cost of capital – debt, preferred stock, and component of the equity. Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure.
In this case
WACC = [ WD x RD (1WACC = [ WD x RD (1--T) ] + [ WE x RE ]T) ] + [ WE x RE ]
Long Term Debt EquityWD = WE =
Debt + Equity Debt + Equity
Interest of Debt DividendRD = RE =
Total Debt Total Equity
Weighted Average Cost of Capital
Actual Forecast
1996 1997 1998 1999 2000
Long-term debt 55 55 55 55 55
Total Common equity 1000 1051 1076 1073 1075
Interest Expense 7 7 7 7 7
Net Income 189 201 213 222 238
Cost of debt 12.7% 12.7% 12.7% 12.7% 12.7%
After tax cost of debt 7.6% 7.6% 7.6% 7.6% 7.6%
% of finance debt 5.21% 4.97% 4.86% 4.88% 4.87%
Devidend expense 135 150 187.5 225 235.5
Cost of equity 13.5% 14.3% 17.4% 21.0% 21.9%
% of finance equity 94.79% 95.03% 95.14% 95.12% 95.13%
WACC 13.19%13.19% 13.94% 16.95% 20.32% 21.21%
The optimal capital structure is reached at the lowest WACC
In FuzzyTronic Inc. case, the optimal capital structure is on year of 1996 (WACC = 13.19 %)
QQ--22Given the information provided in table 1, what is the total dividend
expense that FuzzyTronic will face in 1997, 1998, 1999, and 2000?
Total Dividend Expenses
The dividend per share multiplied by common equity outstanding.
In this case
Year 1997 1998 1999 2000
Share Outstanding 150,000 150,000 150,000 150,000
Dividend per share 1.00 1.25 1.50 1.57
Total Dividend expense 150,000.00 187,500.00 225,000.00 235,500.00
QQ--33The case reports that in 1996, FuzzyTronic operated with an optimal
capital structure. If the firm desired to maintain this particular
capital structure over the 1997-2000 period, is it possible to give
shareholders the projected dividend payments you identified in
Question 2?
Why or why not?
The Optimal Capital Structure vs Dividend
The firm wanted to maintain its optimal capital structure as on 1996 (Long Term Debt : Common Equity = 5.21 : 94.79)
The firm also wanted to give shareholder the projected dividend payment
The facts :
•Shares outstanding was projected stay at 150,000 shares
•Long term debt also projected stay at US$ 55,000
•Dividend per share was projected increasing
•Meanwhile, firm’s sustainable growth in sales & earning was only 5 percent, lower than growth of projected dividend expense
The Optimal Capital Structure vs Dividend
The projected data shown that….
Actual Actual ForecastForecast
19961996 19971997 19981998 19991999 20002000
Long-term debt 55 5555 5555 5555 5555
Total Common equity 1000 10511051 10761076 10731073 10751075
Debt to Equity RatioDebt to Equity Ratio5.21%5.21% 4.97%4.97% 4.86%4.86% 4.88%4.88% 4.87%4.87%
94.79%94.79% 95.03%95.03% 95.14%95.14% 95.12%95.12% 95.13%95.13%
Net Income 189 201201 213213 222222 238238
NI's Growth 0 6.35% 5.97% 4.23% 7.21%
Devidend expense 135 150 187.5 225 235.5
DE's Growth 0 11.11% 25.00% 20.00% 4.67%
The firm’s willingness to maintain its optimal capital structure and pay projected dividend to its shareholder at the same time is a difficult possible things to do
The Optimal Capital Structure vs Dividend
To maintain its optimal capital structure, the firm has to increase the long term debt and/or decrease equity.
When the firm decreases the equity means that all the net income goes as dividend to its shareholder.
The data also shown that the growth of Net Income is not as much as growth of Dividend Expenses.
To do so, the firm has to seek good combination of the (1) Net Income, (2) Retained Earning, (3) Long term debt, and also has to boost its sales & earning.
QQ--44Dividend payments represent a cash expense that FuzzyTronic must
pay in each year if 1997-2000 period. Based on an examination of
the projected financial statements shown in table 2, how is the firm
financing this expense?
Do you think that this financing method is appropriate? Why or why
not?
Financing Dividend Expense
The projected calculated data shown that….
Actual Actual ForecastForecast
19961996 19971997 19981998 19991999 20002000
Net Income 189 201 213 222 238
NI's Growth 00 6.35%6.35% 5.97%5.97% 4.23%4.23% 7.21%7.21%
Devidend expense 135 150 187.5 225 235.5
DE's Growth 00 11.11%11.11% 25.00%25.00% 20.00%20.00% 4.67%4.67%
Net Income is distributed to (1) Retained Earning and back to the firm to boost its operational, and (2) Pay as dividend to firm’s shareholder.
Based on above data, the firm doesn’t use the appropriate financing method.
QQ--55Given the information shown in Table 3, what is the optimal capital
budget as FuzzyTronic for 1997?
Optimal Capital Budget
The set of projects that maximize the value of the firm
Based on table 3
Pending Investment OpportunitiesProjected
Rate of Return
Required Investment
WACC
A. Automotive transmission software project 16.00 % US$ 175,000 13 %
B. Office Automation project 12.00 % US$ 75,000 13 %
C. New marketing plan 13.50 % US$ 100,000 13 %
D. Acquisition of material supplier 10.00 % US$ 375,000 15 %
E. Laboratory expansion 13.00 % US$ 150,000 13 %
F. New release of current software products 11.00 % US$ 50,000 13 %
To optimize the capital budget, the firm can choose project A, which has a highest rate of return and low WACC.
QQ--66Given the current projections concerning FuzzyTronic dividend
payments and financial condition over the 1997 – 2000 period, what
is the market value of firm’s common stock?
What is FuzzyTronic’s market-to-book ratio and price-earning ratio?
Based on your answer to these questions, how does the market
asses the quality of FuzzyTronic’s earning and growth projects?
Common Stock Market Value
Growth n1 = 11.1%
Growth n2 = 25.0%
Growth n3 = 20.0%
Growth n4 = 4.7%
Assumed Constant growth = 4,7%
Dividend n1 = US$ 0.900
Rs = 0.14
Common Stock Market Value
D0 = 0.90 D2 = 1.25D1 = 1.00 D4 = 1.57D3 = 1.50
growth = 11% 25% 20% 5%
=
−
=
3
1.57P14% 5%
17.444
P3 + D3 = 18.944
PV = 0.8771
PV = 0.9617
PV = 12.4084
P0 = 14.72
Common Stock Market Value, assumed by the year 1999 deviden will grow in constant growth 4.7% after the 5th year
P0 = 14.72 P3 = 18.94
Share Price at P3 > P0, Therefore we can accept the investment
Book Value/ Share (1996) = Common Equity/ Share outstandingU$6.67 = U$ 1.000/150
Market to Book ratio = Price per share / Book Value per ShareU$2.19 =U$ 14.62 /U$6.67
EPS = Net Income / Share OutstandingU$1.26 =U$ 189/150
Price Earning Ratio = Price per share / EPSU$11.60 =U$ 14.62/U$1.26
QQ--77In considering the transmission software project, suppose David
Myers uses the residual dividend model to establish FuzzyTronic’s
1997 dividend payment, and then continues to use the projected
financial statement data shown in Table 1 and 2 to establish the
firm’s projected financial condition. Given these assumptions,
(a)what dividend payment can FuzzyTronic offer its shareholders in
1997, and
(b)how is the firm’s stock price likely to change as a result of this
modification in the firm’s planned 1997 dividend payment?
Residual Dividend Model
States that firms should pay dividend only when more earning are available than needed to support the optimal capital budget.
Target equity as 1996 is 94.79 % of Total Debt + Equity
Net Income 1997 = US$ 201,000
Net Income new project = 16% x US$ 175.000 = US$ 28.000
Total NI = US$ 229.000
Capital budget for 1997 = US$ 175,000
Common equity outstanding = 150,000 shares
Dividend = Net Income – target equity x capital budget
= 229.000 – ( 175,000 x 94.79%)
= US$ 63.117,5
Dividend per share = 63.117,5/150,000
= US$ 0.42
The effect to stock price
The investor will see lower return as the projection of dividend after new project released. Means that the value of the stock will decrease as they predict low dividend return.
The firm’s stock price is likely to go down
Nevertheless, the long term investor with the longer view will react positively as they predict that in the near future the net income of the firm will slowly higher and boost up stock value.
QQ--88Review your answer to Question 7. Is there any reason to suspect
that this answer does not accurately reflect the change in
(a)the 1997 dividend payment that FuzzyTronic will offer its
shareholder, and
(b)the firm’s stock price if it accepts the transmission software
project? In particular, what aspect of your application of the residual
dividend model is flawed in Question 7?
How should you change the assumptions used in this question?
Effect of Decreasing Dividend
When the firm run the new project, the projected Earning per share will decrease to US$ 0.42 instead of US$ 1,00 as earlier projection for 1997 and also decrease from the previous year.
For most investor, the decreasing dividend growth is a bad sign and will push the value of the stock lower.
Target equity as 1996 is 94.79 % of Total Debt + EquityNet Income 1997 = US$ 201,000Total NI after project = US$ 229.000Capital budget for 1997 = US$ 175,000Common equity outstanding = 150,000 shares
Dividend per share = US$ 1Divided = US$ 150,000
a. Dividend = Net Income – (target equity x capital budget)150,000 = 229.000 – (target equity x 175,000)
New Target equity = 45,1 %
Dividend = Net Income – (target equity x capital budget)150,000 = Net Income – (0,9479 x 175,000)
New Target Net Income = 315,882New target project = 315,885 -201,000 = 114,885
• Book value per lembar saham 1996
Equity/ Jumlah saham = 1.000.000/150.000 = 6,6
• Book value 1997 = (1.000.000 +((0.9479-0.451) x 175.000))/150.000 = 7,2
QQ--99Revise the pro forma financial statements shown in table 1 and 2 to
reflect the impact of the transmission software project on
FuzzyTronic’s overall financial condition. In developing these revised
financial statements, what important details about the project do
you need to gather from the case
The Impact of the Transmission Software Project
• The project required US$ 175,000 of investment
• The project predicted gives 16% of return a year
• The project change the WACC to 13%
The Important detail about the project that need to gather from the case :
• How the firm finance its new project
• Debt to equity ratio after the project
• What is the impact of the project to the cost of good sold
and expenses
• How the firm distribute its new project return
Revised Statement of Revenue and Expenses
Table 1
FuzzyTronic, Inc
Statement of Revenue and Expenses (Revised)
Desember 31, xxxx
Actual
1996 1997 1998 1999 2000
Net sales revenue 2,049.00 2,179.00 2,287.00 2,400.00 2,528.00
Cost of good sold (944.00) (990.00) (1,040.00) (1,093.00) (1,150.00)
Gross Profit 1,105.00 1,189.00 1,247.00 1,307.00 1,378.00
Selling & general expenses (617.00) (631.00) (660.00) (684.00) (720.00)
Research & development expenses (147.00) (153.00) (162.00) (158.00) (160.00)
Depreciation expenses (54.00) (77.00) (80.00) (105.00) (110.00)
Net operating income 287.00 328.00 345.00 360.00 388.00
Non operating revenue 40.00 45.00 45.00 45.00 45.00
Interest expense (7.00) (7.00) (7.00) (7.00) (7.00)
Earning before taxes 320.00 366.00 383.00 398.00 426.00
Income taxes (131.00) (149.83) (156.79) (162.93) (174.39)
Net income 189.00 216.17 226.21 235.07 251.61
Share outstanding (000s) 150.00 150.00 150.00 150.00 150.00
Devidends per share 0.90 1.00 1.25 1.50 1.57
Forecast
Table 2
FuzzyTronic, Inc
Statement of Financial Condition
Desember 31, xxxx
Actual
1996 1997 1998 1999 2000
Assets
Cash 435.00 450.00 470.00 500.00 525.00
Accounts receivable (net) 312.00 345.17 358.21 374.07 392.61
Inventory 174.00 183.00 192.00 201.00 211.00
Current assets - other 85.00 60.00 65.00 53.00 56.00
Total current assets 1,006.00 1,038.17 1,085.21 1,128.07 1,184.61
Property and equipment (net) 100.00 140.00 147.00 170.00 180.00
Otherassets 31.00 31.00 35.00 35.00 35.00
Total assets 1,137.00 1,209.17 1,267.21 1,333.07 1,399.61
Liabilities and Owner's equity
Account payable 30.00 34.00 46.00 69.00 95.00
Income taxes payable 17.00 18.00 28.00 43.00 53.00
Accrued expenses 19.00 20.00 30.00 51.00 79.00
Current debt obilgations - - - - -
Current liabilities- other 16.00 16.00 19.00 29.00 29.00
Total current liabilities 82.00 88.00 123.00 192.00 256.00
Long term debt 55.00 55.00 55.00 55.00 55.00
Total liabilities 137.00 143.00 178.00 247.00 311.00
Common stock 422.00 422.00 422.00 422.00 422.00
Retained earnings 578.00 644.17 667.21 664.07 666.61
Total common equity 1,000.00 1,066.17 1,089.21 1,086.07 1,088.61
Total liabilities and owners equity 1,137.00 1,209.17 1,267.21 1,333.07 1,399.61
Forecast
QQ--1010Compare the pro forma balance sheet you developed to answer
Question 9 with the pro forma statement shown in Table 2, and pay
particular attention to the projected capital structure changes at
FuzzyTronic in each year of the forecast. What is different about
these two forecasts?
In particular, why does the equity ratio deteriorate over the 1997 –
2000 forecast period in Table 2, while it remains relatively stable in
your revised forecast?
Comparison of New Pro Forma Balance Sheet
• Assume that other things is remain the same (Citeris Paribus)
• The impact of the new project as a based of pro forma revision is..
• Additional return
• Additional return (after tax) goes to account receivable and retained earning
• No change in dividend policy and debt structure
• The debt to capital ratio is changed as the increasing of retained earning
Actual
1996 1997 1998 1999 2000
Long Term Debt 55.00 55.00 55.00 55.00 55.00
Total Common Equity 1,000.00 1,066.17 1,089.21 1,086.07 1,088.61
Debt to Equity Ratio 5.21% 4.91% 4.81% 4.82% 4.81%
Forecast
QQ--1111Based on the revised pro forma financial statements you developed
in Question 9, should FuzzyTronic accepts or reject the transmission
software project? Assume that the firm uses the residual dividend
model to establish its 1997 dividend payment and identify
(a)the specific benefits that this project offers the firm
(b)the drawbacks that FuzzyTronic faces in accepting the project
New Project Decision
• The new project is projected will gives additional revenue to the firm 16% a year.
• In the first run, the firm has to use its fund to finance this new project.
• The initial investment, accounting wise, will change firm assets as a shifting cost from one asset (represent the value of the initial investment) and other assets (represent the investment itself)
• FuzzyTronics should implement this new project and gain additional Net Income which directs to increase in firm value (and stocks)
New Project Decision
Statement Before The Project After The Project
1996 1997 Pro Forma
Net Sales Revenue 2049 2151 2179
Net Income 189 201 229
Share Outstanding 150 150 150
Long Term Debt 55 55 55
Common Stock 422 422 422
Retained Earning 578 629 644.17
Total Common Equity 1000 1051 1066.17
Debt to Equity Ratio 5.50% 5.23% 5.16%
Book Value per share 6.67 7.01 7.11
Earning per Share 1.26 1.34 1.53
The FuzzyTronic Inc. should accept this project
What is the added value of the new project
THANK YOU
