Level II Corporate Finance item sets

Priya Raman is a buy-side analyst covering consumer packaging companies. She is preparing for a meeting with the chief financial officer of Calder Packaging, a listed maker of recyclable food containers. Calder Packaging has grown steadily for a decade, has little debt and generates more cash than it needs for its capital spending plans. Several large shareholders have asked the board to return more of that cash. Its earnings have grown by about 6% a year over the past five years, it has paid a dividend every year since it listed, and its only existing borrowing facility, a small revolving credit line, is currently undrawn.

Calder Packaging's chief financial officer, Tom Whitlock, has told investors that the board is considering a share repurchase of $360 million. The shares would be bought in the open market at the current price of $36.00. Whitlock has said that the company would prefer to keep its cash for a possible acquisition and would therefore finance the repurchase entirely with new long-term debt. The debt would carry a pre-tax interest rate of 6.0%, and Calder Packaging's marginal tax rate is 25%. Exhibit 1 shows the figures Raman uses for her analysis. She assumes that the repurchase takes place at the start of the year, that the new debt is drawn at the same time, and that operating results are unaffected.

Raman also wants to compare the debt-financed plan with an alternative in which the repurchase is paid for with existing cash. That cash currently earns 3.0% before tax in short-term deposits.

Some of Calder Packaging's directors are worried that buying shares at a large premium to book value will weaken the balance sheet. Raman plans to show them the effect on book value per share directly.

A second group of shareholders has asked whether a special cash dividend would be better than a repurchase. Many of them are individuals who live in the same country as Calder Packaging. That country uses a double taxation system: corporate profits are taxed at 25%, and dividends received by individuals are then taxed at 20%. Raman wants to show those shareholders how much of each dollar of pre-tax corporate profit is lost to tax when it is paid out as a dividend. She contrasts this with a dividend imputation system, under which shareholders receive a credit for the corporate tax already paid.

Finally, Raman reviews Calder Packaging's regular dividend. The company paid $0.90 per share last year. Whitlock has said that the board follows a stable dividend policy using a target payout adjustment model, with a target payout ratio of 40% of earnings and closes half of any gap between the current dividend and the target dividend each year, so that dividends adjust gradually rather than following earnings exactly. Raman forecasts earnings per share of $2.80 for next year, excluding any effect of the repurchase, and wants to estimate next year's dividend on that basis.

Raman notes that dividend smoothing of this kind is common among mature companies, because boards are reluctant to raise dividends to a level they may have to cut later. A dividend cut is usually read by the market as a negative signal about future earnings. She plans to ask Whitlock whether the board would ever pay a special dividend instead of raising the regular one, so that shareholders do not come to rely on a higher payment.

Raman intends to close her note with a recommendation on whether the repurchase is in the interest of long-term shareholders, taking into account the effect on earnings per share, the higher leverage and the alternative uses of the cash.