The Chinese

University of Hong Kong

Department of Finance

FIN6092 Advanced Financial Management

Case Study:

Champion Road Machinery: Dividend Policy – A

Question of to be or not to be

Team members

CHAN Pui Ching Angela (09046580)

CHIU Yu Cheuk Tommy (09046640)

LANDOLT Ryan Brooks (09068750)

LIN Tsun Kit Stephen (09028690)

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COPORATE FINANCE DEPARTMENT

To: The Board of Directors Date: 30th July, 1994

From: Scott Hall, CFO and VP of Finance Page(s): 20

17
Re: Recommendation on dividend policy

SECTION 1 Executive Summary

This report analyses options and provides recommendations on
Champion Road Machinery (“the Company”)’s dividend policy in
the aftermath of the Initial Public Offering (IPO) this year.

We have analyzed the Company’s cash flow forecast, cash position

and borrowing capacity in the near term, against our cyclical
nature of business and estimated fund requirements for capital
expenditures, working capital and possible acquisition activities.

With regards to the Company’s three main types of shareholders:

Sequoia’s executives and investors, other institutional and retail
investors, we have evaluated their respective preferences and
expectations on our dividend policy.

Assessment of the pros and cons has been done on three

alternative dividend policies: no distribution, regular dividend and
one-off distribution via special dividend or stock repurchase.

The report concludes that, on the back of the Company’ excellent

track record in selecting value-creating investment, and in line
with the Company’s existing shareholders’ expectation of a capital
gain instead of a recurring income stream, the Company does not
have to follow its competitors in making regular dividend
payments. Moreover, in view of our cyclical business, we could
avoid an investors’ expectation for a recurring income stream and
thus downside risk being posed by regular dividends’ changes to
our stock price.

The Company should fund its growth and acquisition on the

strength of improved cash flows as a result of IPO proceeds and
higher profitability. Thus we also do not recommend making a
one-off distribution at the next board meeting. However, if we
cannot ascertain worthwhile investments in the next 9 months, we
recommend a one-off distribution to the shareholders in the form
of a share repurchase.

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SECTION 2 Introduction
2.1 Background

Since Sequoia Associates (“Sequoia”) acquired the Company in

1988, the performance of the business has significantly improved.
In the past few years, we have implemented measures to improve
the financial health of the company by doing the right things:
focusing on process improvement, being responsive to customer
design recommendations, maximising workforce productivity,
expanding and improving the quality of its product lines.

Through the years, the Company has introduced new product

series and focused on expanding the company’s existing markets
by acquiring other companies that fit with the Company’s core
business.

Six years after Sequoia’s takeover, there was another milestone

for the Company when we completed the IPO in April this year.
During the first half of the year, we were performing well above
expectations and our latest forecast is pointing us towards a
healthy cash flow for the full year. As a result the Corporate
Finance Department was asked by the board in July to recommend
whether the Board should declare a dividend.

2.2 Structure of the paper

To answer this question, we have analysed the issue from two

different perspectives: the firm and shareholders.

First, we looked at endogenous factors within the boundary of the

firm and determined the surplus cash position of the Company in
1994 and the near future. We accomplished that by answering the
following questions:

• What is the movement of cash in 1994?

• What is the projected growth of the operating cash flow in

the next 2-3 years?

• What is the current / future requirement for capital

expenditure (capex) and provision for working capital?

• Are there any other expansion or M&A activities and what is

the cash requirement for such activities?

• What is the company’s capacity to raise funds given the

current and target level of leverage?

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 • Does the company have residual cash after considering all of
the above?

After we have established the cash position of the company, we

then analysed the amount and nature of the dividend, if any, that
we would recommend the Board of Directors to declare. We have
considered different options by answering these questions:

• Who are the shareholders and what are their motivations

and objectives?

• Will the majority of the shareholders welcome a dividend

declaration / demand a dividend?

• What form of dividend will they expect (regular vs. special

vs. share repurchase)?

• What are the tax implications of different forms of

dividends for the shareholders?

To reach our recommendation, we analysed the pros and cons of

three different options and ranked them by a nominal scale.

SECTION 3 Establishing the Cash Position

3.1 Cash movement in 1994

According to our initial forecast, the Company is expected to

realise net profits of $8.1 million. The Company has been
successful in working capital management since the current
management took over. We expect working capital as a
percentage of sales to decrease from 12.4% in 1993 to 11.6% in
1994. This represents a net increase in working capital of $ 2.38
million.

Net capital expenditure or capex over and above depreciation in

1994 is expected to be $ 3.0 million. Thus for the purpose of
estimating cash flow, we include the net amount of $ 3.0 million to
represent capex net of depreciation of fixed assets.

In April 1994, the Company successfully increased its share capital

through an IPO. The net cash proceeds from the IPO were $ 26.6
million. Part of the cash was used to pay down long-term debt,
totalling $ 12.3 million.

Therefore, the total net cash flow of the Company in 1994 is $ 17.5
million (See Exhibit 1).

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3.2 Forecast of Net Income (1995 – 1997)

In the years since the current management has taken over, the
performance of the company has improved significantly. Operating
margins have improved steadily from 5.4% in 1991 to 8.8% in
1994. We expect this improvement to continue until reaching 10%
in 1997. As a result, we forecast that the net income of the
Company will grow by an average of 15% a year in the next three
years.

3.3 Capex requirement and working capital management

Capital expenditure is likely to accelerate in the next three years

to cope with the rapid expansion in the soil compactors and small
grader divisions. We expect the net capex to exceed the average
depreciation in the next few years. The total forecast net capex for
1995, 1996 and 1997 are $ 4.0 million, $ 5.0 million and $ 5.5
million respectively.

Total working capital employed is expected to be maintained at

11.0% to 11.5% in the next three years.

3.4 M&A and other expansion opportunities

We would like to make at least one acquisition to diversify our

business in 1995. We have seen a lot of promise in the snow
removal equipment sector, which is growing at 20% p.a. and has
great synergy with our existing spare parts and dealership
divisions. We have identified a couple of targets and will accelerate
our search in the following months. Our expectation is to present
the deal to the Board for approval before the end of this year.

In line with our previous M&A experience with the acquisition of

the soil compactors and small grader business, we would not
expect the snow removal equipment business to account for more
than 10% of the Company’s total sales. For new acquisition, we
normally require a return on capital of 15%. As snow removal
equipment is a niche market, we assume that the industry average
net margins are between 12% and 15 %. This will put the
indicative size of the acquisition at $ 5-12 million. (Exhibit 3)

We are also looking at opportunities for international expansion in

the next few years. The emerging markets in Latin America are
undergoing an economic boom. There is a big construction boom
in the former Soviet nations and Eastern European countries
following the fall the Berlin Wall in 1989. Expanding the
Company’s foothold in these key growth markets will help
spearheading revenue growth while hedging the business’ cyclical
risks of our core North America and European markets. We expect
sales to markets outside North America to reach 45% of our total

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 sales by 1997, with emerging market sales accounting for one
forth of the sales (Exhibit 4).

In order to achieve these targets, we will invest in the

development of these new markets by opening sales offices and
increasing the marketing expenses in Eastern Europe and Latin
America. As emerging markets are inherently more risky, we
expect at least a 20% return from our investment. The total
investment in new offices, headcounts, marketing and fixed assets
required to develop these emerging markets is expected to be $
35 million over the next three years. (Exhibit 3)

3.5 Gearing and borrowing capacity

After paying off all the debt this year, the Company’s effective
gearing (total liabilities / total assets) is forecast to be 37% (Exhibit
2). As the Company’s target gearing is 50%, the Company has
room to raise debt to finance future expansion and M&A activities
without exceeding the target gearing ratio.

Considering peer companies’ relatively high gearing (Finning 67%;

Caterpillar 82%) and based on the strength of our balance sheet,
we anticipate that the Company can raise $ 15 – 20 million of debt
without significantly increasing the risks of financial distress.

3.6 Position in residual cash

Considering all the factors above, the total cash required in 1995 is
between $26.5 million and $33.5 million.

The cash position at the end of 1994 is $ 17.5 million. Therefore,

there will not be any residual cash in the business at the end of
1994 / beginning of 1995 assuming the acquisition of the snow
removal equipment business takes place in Q195.

In 1996 and 1997, we expect strong investment needs in line with

the emerging market strategy. Funds for growth are expected to
be generated from retained earnings and, if exhausted, by dipping
into the debt market.

SECTION 4 The Shareholders

4.1 Shareholder composition of the Company

Sequoia is the majority shareholder of the Company. Prior to the

IPO there were 8.75 million shares outstanding, with the majority
held by 91 Sequoia executives and investors. After the IPO, there
are now a total of 11.17 million common shares outstanding. With
some of the Sequoia investors divesting their shares totalling 1.1
million, the shareholding post IPO splits approximately 7:3
between Sequoia and public shareholders.

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 A successful IPO is an accomplishment for any company and by
offering shares to the general public, we have successfully
marketed Champion Road to the investor community. Of the
shares owned by the public, 70% were sold to institutional
investors and 30% were sold to retail investors.

An understanding of the motivation of these different groups of

investors will play a significant part in our final analysis about the
optimal course of action.

4.2 Motivation and objectives of different groups of investors

Champion has three main categories of investors.

Majority Shareholder (Sequoia executives and investors)

Our majority shareholder, Sequoia is a private equity firm that

acquired underperforming companies that offered the potential for
growth in sales, earnings and cash flows, which would then
translate into stock appreciation. Sequoia’s investment
methodology is one that inherently involved high risk and also the
prospect of high return. The acquisition of the Company was no
exception to Sequoia.

We believe the objective for the Sequoia investors could be the

prospect and timing of an exit strategy. As part of the IPO
agreement, the original 91 pre-IPO shareholders could not sell any
stock (other than that allowed in the IPO) for a period of one year
after the IPO. This raises the question of what the Company can do
to maximize shareholder value in that time period, as well as after
the one-year lock up period.

Private equity investment is a risky business. Taking over a

company, improving efficiency, creating value, and ultimately
selling it at a significantly higher price than you paid for it is not
any easy job. There is no guarantee that you will make a profit,
and private equity investors therefore need to have certain
characteristics in order to be successful. One necessary
characteristic is patience. Sequoia Associates took over the
Company in 1988, almost six years prior to the IPO. Their objective
now is to decide where to go from here. Sequoia is unlikely to see
itself as managing the Company forever and they would probably
rather see cash be retained in the company to support positive
NPV projects so that they can exit on a high rather than giving out
dividends and just making out with whatever they can now that it
is a publicly traded company.

It seems that by growing the business, and hopefully the share

price over the long-term (i.e. the next 3-5 years), the Sequoia
investors could eventually be poised to profit handsomely. In this

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 regard, making a cash distribution seems to go against this
objective, unless it is determined that there are no worthwhile
investment opportunities in a reasonable time horizon.

Minority Shareholders (Institutional and other individual

(retail) investors)

The positioning of our stock issue was targeted at investors

interested mostly in capital gains. Although some institutional
investors may be motivated by a certain percentage of dividend
payout, they should be well aware that the Company is not
expecting to give out any dividend in the near future.

And while 70% of the issued stock had been purchased by

institutional investors, there is no reason to believe that these
mostly Canadian-based money managers did not see their
investment as one aimed at capital appreciation as opposed to a
regular income investment. It also seems safe to assume that that
retail portion of the shareholders would prefer possible large
capital gains rather then regular dividend payments.

It seems that the investment objectives of institutional and retail

investors do not necessarily conflict with each other. Both of these
two parties expect capital gains from an appreciation in the stock
price.

SECTION 5 Suggested options

After considering the above factors, we have come up with three
possible options for a dividend policy: 1) Do not distribute any
dividend; 2) Propose a regular dividend and 3) Distribute cash via
a special dividend or stock repurchase.

5.1 Option 1 – No dividend

The first Option is to declare no cash dividend.

The dividend policy decision should depend on capital budgeting

as well as debt policy (as we want to maintain a target 1:1 debt-to-
equity ratio). That is, the Company should distribute dividends only
if there is residual cash left behind, after investing in all projects
with positive net present value (NPV) while maintaining an
“optimal” debt-to-equity ratio.

Retaining cash in the business in anticipation of investment

opportunities will better position the Company for future growth. In
view of requirements for capex and potential acquisition activities,
the Company is not expected to have spare cash in the next 12
months. As we are currently actively looking at expanding the
business with the purchase of a snow removal equipment

Page 8 of 19
 manufacturer and also more overseas investment to support
international sales growth, the Company should more or less follow
the ‘residual dividend policy’.

From the angle of the shareholders, the Company examined the

dividend policy issue at the time of the IPO (April 1994). The
prospectus clearly stated that: “The Company does not anticipate
paying cash dividends on the common shares in the foreseeable
future, but intends to retain future earnings for reinvestment in the
business.” Therefore the IPO was targeted at investors interested
primarily in capital gains and the profile of the public shareholders
did not change since then. The management re-visited this issue
three months after the IPO and determined that no change was
required. Given that the majority shareholder would prefer keeping
the cash in the company to invest, not declaring any dividend will
be consistent with the shareholders’ expectations.

The Company’s patient approach in looking for good investments

and its good reputation for identifying the right targets has been
well recognized by the investment community. For instance, our
capital allocation program has been described by one analyst as
“very successful”. Thus the public shareholders should have less
concern about the Company sitting on a pile of cash and
destroying value.

Last but not least, this residual dividend policy approach could
avoid incurring additional issuance and time costs in financing
(debt and/or equity) in case good investment opportunities arise
after excess dividend payments.

5.2 Option 2 – Regular Dividend

Option 2 is to declare a regular cash dividend during the Annual

General Meeting.

As most of our competitors are declaring regular dividends – most

recent dividend yields of the major ones are: Caterpillar (US:
0.6%), Finning (Canada: 1.12%) and Toromont (Canada: 1.69%) –
some would argue that this provides a very good reference point
for the Company to follow.

Per Exhibit 5, based on $ 12 share price and 11,170,000

outstanding shares, if the Company pays an annualized dividend
yield (1.12%- 1.69%) which is comparable to Canadian-based
heavy equipment dealers, the regular dividend would amount to
$1.6 million to $ 2.3 million; while at a level similar to Caterpillar
(0.6%), it will only cost the company $ 800,000 in the first year.

In making regular cash dividends, some academics and

commentators would argue that the Company could convey a

Page 9 of 19
 message of confidence to the existing and potential investors on
its long-term profitability and growth.

Many of the large Canadian-based money managers subscribed for

70% of the newly issued shares at Champion’s IPO. Indeed, under
Canadian legislation or/and conventions, Champion’s stock has
already been considered to be eligible for most institutional
investments. Despite this, it may still be worthwhile considering
making regular cash distributions so as to broaden the potential
investor base, particularly targeted at those institutional investors
outside of Canada, who might expect a regular income stream.

Although this consideration is against the Pecking Order Theory, it

could be relevant as the Company seeks to diversify its business
internationally, it should have more financing needs for wider
range of investment opportunities, a higher profile and broader
investors base (as compared with Caterpillar and other Canadian
competitors) should help the Company raise funds, even possibly
in the international equity markets, for expansion.

However, a regular dividend is an implicit commitment to the

shareholders, which if not maintained, may be perceived as a
weakness of the Company. It is clear to us that once a regular
dividend is declared, there is an expectation from the minority and
potential shareholders that such dividends are going to continue.
In case of a future cut or elimination of such regular dividends,
there will be an adverse impact to the share price of the Company
(a possible 8 to 10% drop at the date of announcement according
to some studies).

While we agree that the Company could afford to make a regular

dividend of a similar level to that of its peers in the first year,
sustaining a regular pattern of dividend from year to year will
become a major challenge to the Company as we are engaged in a
cyclical business.

We conclude that regular dividend could pose a downside risk to

our share price and will place an unnecessary constraint to the
ability of the Company to create shareholder value.

5.3 Option 3 – Special Dividend or Share Repurchase

Option 3 is to declare a special dividend or initiate a share

repurchase programme.

Although we anticipate a big cash requirement due to the

proposed acquisition of a snow removal equipment manufacturer
early next year, there is an uncertainty in the timing of the

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 investment and the possibility that the acquisition will not be able
to meet our return on capital requirement cannot be ruled out. In
case we could not identify suitable targets in 1995, there will be
residual cash in the Company and a one-off cash distribution to the
shareholders should be the best option. This could avoid the
possibility that the Company would accumulate more cash than it
could invest profitably. With the one-off nature of the distribution
in the form of special dividend or share repurchase, the company
could avoid an expectation by the investment community for a
recurring dividend.

Public Shareholders will be relieved to see the company paying out

the excess cash instead of squandering it on unprofitable
investments or leaving it sitting in the bank. Having invested in the
Company for six years, Sequoia investors may also welcome some
accelerated cash return on their investment. This consideration is
particularly relevant when the Company has more cash than ever
before post-IPO.

Per pro-forma balance sheet as of December 31, 1994 (Exhibit 2),

the company is forecast to have a gearing of 37 percent, which is
well below its target of 50 per cent. Comparing against companies
in the same industry, Finning (67 percent gearing) and Caterpillar
(82 percent gearing), it is on the safe end. In case any investment
opportunities arise after the one-off distribution, it could raise
additional debt of around $15 – 20 million before breaching its
target gearing ratio.

This option may not agree well with the Pecking Order Theory and
extra issuance and time costs are inevitable if additional financing
is required for new investment opportunities, but the management
should weigh them against the opportunity costs of holding idle
cash sitting in the company for a prolonged period.

The choice of special dividend against share repurchase will be

dependent on the marginal tax faced by the investors. Per Exhibit
6, under the Canadian tax regime the effective tax rate on
dividends (29.4%) is lower than that on capital gains (32.7%), thus
minority shareholders, who are mostly Canadian investors, should
prefer a special dividend from a tax perspective. On the other
hand, the Sequoia investors are US based and they are more likely
subject to US effective tax rates (instead of Canadian rates), that
is, higher dividends tax rate (39.6%) versus lower capital gains tax
rate (28%). Consequently, the majority shareholders will prefer a
share repurchase over a special dividend.

5.4 Ranking criteria and results

To reach our final recommendation for the Board, we evaluated

each option against the following criteria:

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 • Pecking Order Theory: whether the option promotes the best
cash management practice in accordance with the Pecking
Order Theory

• Company growth: whether the option promotes company

growth

• Majority shareholder’s objectives: whether the option meets

the majority shareholder’s objectives

• Other shareholders’ objectives: whether the option meets

the minority shareholders’ objectives

The result of our analysis is summarised below using a weighted

scale of 1 to 3 (1 = least favourable, 3 = most favourable):

Criteria Weig Option 1 Option 2 Option 3a Option 3b

ht (Nothing) (Regular) (Special) (Repurch
ase)

Pecking
Oder 2 3 1 2
Theory

Growth 4 3 1 2

Majority
Sharehold 3 3 1 1 2
ers

Minority
Sharehold 1 3 2 2 1
ers

Weighted
3.0 1.1 1.7 1.9
Score

SECTION 6 Conclusion and Recommendation

Based on the above results, we recommend not declaring regular
dividends at the forthcoming Board meeting in August 1994
because it is in line with best cash management policy, promotes
growth and is generally in line with our shareholders objectives
and expectations. A cash buffer will allow us to respond quickly
once any worthwhile acquisition targets surface in the next few
months.

Page 12 of 19
However, we recognize that it is possible that we will be unable to
identify suitable value creating projects within the next 9 months,
in which case the Company will have residual cash. Therefore we
propose a “wait-and-see” approach to a one-off distribution in the
form of share repurchase.

We recommend that the Company should continue the patient,

prudent capital allocation policy that it is well known for. We
therefore propose to the Board that we will continue to evaluate
different investment opportunities in the next 9 months. In the
event that we cannot ascertain any investment targets with strong
positive net present values, we will decide on a one-off distribution
by the end of April 1995.

We propose to delay the decision on one-off distribution until April

1995 because it is more likely that we will: (1) have enough time
for project evaluation and negotiation; (2) see how the actual
operating results and balance sheet positions compare to our
forecasts.

Compared against a regular dividend, either a special dividend or a

stock repurchase can serve the same purpose of distributing cash
to the investors. However, the Company will not be perceived as
making a long-term commitment on returning cash to investors, as
the information implied in the announcement of a share
repurchase or special dividend program is considered to be
different from that of a regular dividend payment.

We would propose a share repurchase over special dividends as

the majority shareholders are subject to lower US capital gains tax
and would prefer share repurchase over special dividend.

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($'000)
Net Income 8,100
Add: Proceeds from IPO 26,600
Add: Deferred Tax adjustment 523
Less: Capital Expenditure (net of
depn) (3,000)
Less: Increase in Working Capital (2,382)
Less: Repayment of Debt (12,302)
Net Cash Flow 17,539

Exhibit 1 – Pro-forma Cash Flow Analysis of the Company in

1994

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 1994
($'000)

Balance Sheet

Assets:
Bank and Cash 17,539 balancing figure
Accounts Receivable 18,354 % of sales
Notes Receivable 1,886 % of sales
Inventory 25,057 % of sales
Prepaid Expenses 349 % of sales
63,184
add $3M capital
Property, Plant and expenditures (net of annual
Equipment 13,253 depreciation)
Other Assets 622 % of sales

77,059

Liabilities:
Bank Indebtedness 0 assume all cleared
Accounts Payable 23,532 % of sales
Income Tax Payable 4,139 ratio based on tax P/L
Current Portion of Long
Term Debt 0 assume all cleared
27,671
Long-Term Debt 0 assume all cleared
Deferred Income Taxes 1,178 ratio based on tax P/L

Shareholders' Equity:
add the net IPO proceeds
Share Capital 28,178 ($26.6M)
add current yr forecast P/L
Retained Earnings 20,032 $8.1M

77,059

Total debt to total assets 37%

Exhibit 2 – Pro-forma Balance Sheet of the Company as at

December 31, 1994

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 $ (‘000)
Total Sales 155,000
@ 5% 7,750
@ 10% 15,500
10% net margins 775
12% net margins 1860
ROC 15%
Lower Bound Investment Cost 5,167
Upper Bound Investment Cost 12,400

Exhibit 3 – Estimate of indicative acquisition costs of a snow

removal equipment manufacturer

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 1994 1997
North America 72% 55%
Western Europe 20% 20%
Latin America 5% 15%
Eastern Europe 2% 9%
Other Regions 1% 1%

($'000) ($'000)
15 23
Total 5,000 5,736

11 12
North America 1,600 9,655
3 4
Western Europe 1,000 7,147
3
Latin America 7,750 5,360
2
Eastern Europe 3,100 1,216

Other Regions 1,550 2,357

Geograhical Segmentation of Sales

100% 1%
2% 1%
5% 9%
Percetage of total Sales

90%
20% 15%
80%
70%
20%
60%
50%
40%
72%
30% 55%
20%

10%
0%
1994 1997
Year

North America Western Europe Latin America Eastern Europe Other Regions

Required ROC 20%

Estimated Investment 1995- 3
1997 4,900

($'000) 1995 1996 1997

1 1 6
Estimated Investment 7,450 0,470 ,980

Exhibit 4 – Geographical Segmentation of Sales

Page 17 of 19
Market Price of Champion Road: 12 $

Total number of outstanding 1

shares 1,170,000

If Champion
followed the
Dividend yields same yield

Caterpillar (US) 0.60% 804,240

1,
Finning (Canada) 1.20% 608,480
2,
Toromont (Canada) 1.69% 265,276

Exhibit 5 – Estimates of Regular Dividend Based on Industry

Dividend Yields

Page 18 of 19
CANADA

Dividend
$1,000Income
Tax
$294 paid
Effective tax rate on
29.4% dividend

$1,000Capital Gains
Tax
$327 paid
Effective tax rate on
32.7% dividend

UNITED
STATES

Dividend
$1,000Income
Tax
$396 paid
Effective tax rate on
39.6% dividend

$1,000Capital Gains
Tax
$280 paid
Effective tax rate on
28.0% dividend

Assume that US investors should pay at effective US tax rates (instead of

Canadian tax rates)
on both types of
income.

Exhibit 6 – Effective Dividend and Capital Gains Tax Rates

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