Question

You are a financial consultant and specialize in providing advice regarding financial modeling.  One of your major clients is a large manufacturing firm. The firm is expecting a strong level of sales growth which will lead to a higher net profit margin and will require the addition of new warehouses and new distribution centers. The firm’s average collection period (ACP) will not be affected.

The manufacturing firm’s CEO comments, “Due to our higher expected profitability, our shareholders will be expecting a larger dividend.  Therefore, we should increase our payout ratio.”

Would you recommend that the firm increase its payout ratio?

Answer 1

The payout ratio depends on multiple factors and the company must weigh all options before taking the final call. It does not solely depend on shareholders expectations but depends more on the future financial outlook of the firm. In this case the company has substantial capital investments lined up for the future and will require funds for the capital projects. Although it can rely on external sources of finance to fund the investments, retained earnings will be the cheapest source of finance which will return reduce the overall cost of capital for the firm. The shareholders would rather prefer the company reduce its cost of capital than pay large dividends now and borrow for future financial needs.