Question

Financial modeling question. One of the clients is a large manufacturing firm. The firm is expected a strong level of sales growth which will lead to a higher net profit margin and will require an increase in 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 higher expected profitability, our shareholders will likely expect a larger dividend. Therefore, we should increase our payout ratio."

Would this be a good recommendation to the firm to increase its payout ratio? Explain.

Answer 1

The firm is expected sales growth which will lead to higher net profit. A company might increase its dividend for a number of different reasons. Since a dividend represents a portion of company profits that is being paid to shareholders, news of a dividend increase is typically viewed as a positive development because it suggests that the company is confident in its future. However, a dividend increase can also be a sign that the company is running out of growth opportunities and is decided to, rather than invest, distribute some of its excess cash flow to shareholders.

In given case, it seems there is huge opportunity for growth & expansion. There is requirement in increase in warehouses and new distribution centres. This will require large amount of investment.

So it is advisable that it increase in profits should be reinvested in business and not to increase payout ratio.