See attached file for balance sheet.
George Liu, the CEO of Penn Schumann was a creature of habit. Every month he and Jennifer Rodriquez, the company's chief financial officer, met for lunch and an informal chat at Pierre's. Nothing was ever discussed until George had finished his favorite escalope de foie gras chaude. At their last meeting in thoughtfully with his glass of Chateau Haut-Brion Blanc before suddenly asking, "What do you think we should be doing about our payout policy?"
Penn Schumann was a large and successful pharmaceutical company. It had an enviable list of highly profitable drugs, many of which had 5 or more further years of patent protection. Earnings in the latest 4 years had increased rapidly, but it was difficult to see that such rates of growth could continue. The company had traditionally paid out about 40% of earning as dividends, though the figure in 2008 was only 35%. Penn was spending over $4 billion a year on R&D, but the strong operation cash flow and conservative dividend policy had resulted in a buildup of cash. Penn's recent income statements, balance sheets, and cash flow statements are summarized in Tables 17-4 to 17-6.
The problem, as Mr. Liu explained, was that Penn's dividend policy was more conservative than that of its main competitors. "Share prices depend on dividends," he said. "If we raise our dividend, we'll raise our share price, and that's the name of the game." Ms. Rodriquez suggested that the real issue was how much cash the company wanted to hold. The current cash holding was more than adequate for the company's immediate needs. On the other hand, the research staff had been analyzing a number of new compounds with promising applications in the treatment of liver diseases. If this research were to lead to a marketable product, Penn would need to make a large investment. In addition, the company might require cash for possible acquisitions in the biotech field. "What worries me," Ms. Rodriquez said, "is that investors don't give us credit for this and think that we are going to fritter away the cash on negative-NPV investments or easy living.
I don't think we should commit to paying out high dividends, but perhaps we could use some of our cash to repurchase stock." "I don't know where anyone gets the idea that we fritter away cash on easy living." Replied Mr. Liu, as he took another sip of wine, "but I like the idea of buying back our stock. We can tell shareholders that we are so confident about the future that we believe buying our own stock is the best investment we can make." He scribbled briefly on his napkin. "Suppose we bought back 50 million shares at $105. That would reduce the shares outstanding to 488 million. Net income last year was nearly $4.8 billion, so earnings per share would increase to $9.84. If the price earnings multiple stays at 11.8, the stock price should rise to $116. That's an increase of over 10%." A smile came over Mr. Liu's face. "Wonderful, he exclaimed, "Here comes my homard a la nage. Let's come back to this idea over dessert."
Evaluate the arguments of Jennifer Rodriquez and George Liu. Do you think the company is holding too much cash? If you do, how do you think it could be best paid out?
See the attached file.
It is true that company is currently holding too much of cash. The amount of cash and cash equivalents in the balance sheet of the company at the end of year 2008 is $7.061 Billion, which is $1.510 Billion higher than the cash and cash equivalents of $5.551 Billion held by the company at the end of the year 2007. This means that in spite of company paying dividends to the tune of 35% payout ratio and incurring a capital expenditure of $2.063 Billion. This means that the company is generating enough cash to manage its current operations, pay reasonable amount of dividends and incur a reasonable amount of capital expenditure.
The liquidity ratios of the company are as follows:
Current ratio =Current Assets / Current Liabilities =11593/8384 =10200/8835
Quick ratio = (Current Assets - Inventory) / Current Liabilities
Thus, increase in the cash with the company has increased the liquidity ratios for the company substantially. The quick ratio increased from 0.88 in 2007 to 1.15 in 2008 and current ratio increased from 1.15 in 2007 to 1.38 in 2008.
At the same the leverage ratios for the company decreased substantially.
Debt Equity Ratio = Long term debt / Equity =3349/15168 =3484/12054
Total Debt to Asset ratio =(3349+1557)/26901 =(3484+2620)/24373
= (Short term loan + Long term loan)/ Total Assets =0.18 =0.25
Interest Coverage ratio = ...
The solution examines what occurs when a company holds too much cash. Penn Schumann, Inc is examined.