Your team was assigned the task of presenting to CFP’s board of directors on their dividend policy.Thus far, CFP has needed to retain all of its earnings, but its future sales and asset growth requirements are likely to decline, and as growth slows the company expects to generate free cash flow that can be paid out to stockholders.

The dividend issue has never been seriously considered for several reasons. First, the firm’s rapid growth has absorbed all of its cash flows to fund capital investment opportunities. Second, CFP’s directors did not personally need dividend income; hence if dividends had been paid, they would have simply paid about 40 percent of them out to cover state and federal taxes and then reinvested the remainder, ending up worse off than before. However, in 2003 a new tax law took effect,lowering the maximum federal tax rate on dividends from 39.6 percent to 15 percent and the maximum rate on capital gains from 20 percent to 15 percent. Under the old tax structure,stockholders’ potential after‐tax returns were maximized by having the company retain and reinvest earnings to generate capital gains. Under the new law, with both dividends and capital gains taxed at 15 percent, the tax disadvantage of dividends has been largely eliminated.

Also, several CFP directors (and officers) are thinking about retirement, and when they do retire,they will need cash income. This is making them more interested in dividends. Finally, CFP President Brian Smith and several other large stockholders (including some of the other officers) would like to diversify their holdings, which would mean selling some CFP shares and reinvesting the proceeds in other securities. Obviously, they would like to sell their shares at as high a price as possible, and the CFO thinks that paying a dividend might increase the price of the shares. This view was reinforced at the company’s last annual meeting, when several stockholders asked about dividends and commented that a dividend would be well received.

The CFO is also aware that since the new tax law took effect, many companies have increased their dividends, and stock market pundits have been arguing that companies such as CFP could increase their stock prices by initiating cash dividends. Indeed, in mid‐2004 Microsoft announced the largest dividend action in history, which included a one‐time special dividend of $30 billion, a substantial increase in the regular quarterly dividend, and a very large stock repurchase program.

Many other companies have taken similar actions, and they have typically seen a pop—which may not be permanent—in their stock prices. However, given its rapid growth and need for funds, few‐if any‐analysts expect CFP to pay dividends for a couple of years. Indeed, one influential analyst recently published a report in which he forecasted no dividends for the next two years, then an initial dividend of $0.50, then rapid grow in the dividend for the next two years (75% in the first year and 40% in the second), and finally a constant growth rate of about 7.6% thereafter. The CFO thinks this forecast is consistent with most analysts’ views, but CFP’s management has not indicated that it agrees.

Before the recent tax change, Brian Smith and CFP’s directors stated publicly that they had no plans to pay dividends any time soon. However, the dramatic change in the tax situation and the inevitability that slower growth will make free cash flow available has moved dividend policy to the front burner. Write a report in preparation of your presentation to the board of directors.


  1. What “signals” do managers send investors through their dividend actions? Should CFP be concerned about signaling effects if it established a payout policy and later thought about altering that policy? Are signaling effects reflected in the residual model?
  1. Excess funds not needed in operations could also be used to buy marketable securities or for acquisitions rather than used to pay dividends. Should the board consider these alternatives for the excess funds instead?
  2. How might dividend policy affect agency costs? Are agency costs likely to be more important for a company whose managers own a large percentage of its shares or a company whose managers do not own much of its stock?