Linear Technology Payout Policy, Financing Needs and Tax Consequences:

Linear Technology announced its first dividend on October 13, 1992. CFO Paul Coghlan explained that Linear was well positioned in the strong analog industry. He expanded to say that Linear wanted to show investors that buying shares in Linear was not as risky as buying shares in most technology companies and that offering a dividend would give Linear access to new investors with income goals in addition to growth goals. In 1994, Linear initially set the quarterly dividend at a relatively low level of $0.05 per share. They realized that investors respected companies for paying a dividend, but strategically wanted to remain realistic on how much they could afford to payout for sustainability in the technology market.

In 2002 Linear’s management and board debated on whether to increase the dividend. Coghlan argued for an increase in the dividend price to validate Linear’s ability to be profitable and cash flow positive even in times of struggle and believed money could be returned to shareholders in the form of share repurchases. One of the primary reasons that Linear buys back stock is to offset the exercise of employee stock options. Coghlan’s analysis took into account the current market conditions of the technologies sector. Interest rates were low, which encouraged Linear to use cash balances to buy back more shares.

Looking at this competitively, of the 16 technology companies on the SOX index, only 6 of these paid out dividends to its shareholders. Coghlan considered Intel and Maxim as the benchmarks for this market. In 2002 Intel paid out $0.10 per share and Maxim paid out $0.02 per share. Linear at $.05 per share was in the ball park of its competition. An increase in the dividend meant that the dividend payout ratio that was 15% was to move up to around 25-30%. This would let investors know that Linear was positive about their abilities as a company and this would be a sign to the market that they were just as healthy as the benchmark companies.

The purpose of all publicly held companies is to increase shareholder value. The dilemma for Linear was what their best approach for increasing shareholder value in a turbulent time. Examination of their dividend payout is a multi-layered approach in determining how they would best increase shareholder value. In 2003, Linear had $1,565.2M in Cash and Short-Term Investments. At this time Linear was generating strong profits and cash flows.

Linear was noted as looking at new business opportunities, but as a relatively conservative company, they would not sacrifice margins for top-line sales growth. As such, their financing needs were minimal. Given the company’s ability to maintain high profit margins and generate positive net operating cash flow while in a market downturn speaks favorably for Linear. In assessing their financing, the case study analyzes the competition among analog companies was based in part on hiring and retaining top engineering talent who would continuously develop high-performance products. In addition, capital investments in new fabrication facilities were important, although the cost of a new analog “fab” was approximately $200M and could be used for 10+ years were as a digital fab was priced at $2B.

In 2003, the House put forward a bill where both dividends and capital gains would be taxed at a rate of 15%. Studies show that investors demand compensation for the positive link between dividend yields and future returns due to increased tax burden. For companies with strong excess cash flow, like Linear, it could be suggested that in order to balance the tax consequences, they split between dividends and stock buy-backs. Companies considering paying dividends must anticipate investor’s tax burden. Anticipated tax cuts or increases can delay or accelerate a firm’s dividend

payments, which can lead them to hold higher or lower cash balances and, for capital constrained firms, can significantly increase or decrease aggregate investment for periods after the tax change.

Paying Out the Entire Cash Balance in Special Dividend or Repurchasing Share

Comparing and contrasting the payout of the 2003 cash balance in either a special dividend or a share repurchase requires the evaluation of multiple perspectives and factors. In the case of a special dividend of $4 per share will decrease the value of the stock by $4. When valuing a company through Free Cash Flows its Enterprise Value is the present value of all future cash flows. The share price drops by $4 ex-dividend when $13.2M is paid out through a $4 special dividend and no change will be seen in EPS. In contrast to the share repurchase there will be a small increase in EPS since less remaining shares are divided by the same earnings. Also to note is that share repurchase will cause no change in stock price since the firm’s assets decline because cash is used for the repurchase, however at the same time the supply of shares is reduced. These two effects offset each other, leaving the share price unchanged.

While firm value is most notably changed in the special dividend, what should be analyzed is the affect on shareholder value since maximizing shareholder value is the goal of every U.S. publicly traded company. Exhibit 3 lays out the financials of the two payout options from a shareholder perspective. In the end the total shareholder value is the same for either scenario, the difference is whether the shareholder is holding cash or shares. What makes the difference between a dividend payout and a share repurchase comes down to signaling, the human psych deals best with and trusts steady and smooth. We don’t have as much trust in a company that is up and down versus a company that has a steady growth path. Dividend smoothing has become a norm for large companies. According to our class text in surveying CFOs they would rather raise new funds then change dividends to fund new profitable projects. This is not the case with repurchases. Repurchases have been on the rise since 2003 and have outpaced dividends in total dollar amount. CFOs believe that repurchases are not as telling of a sign for companies and they are far more likely to change a repurchase plan in order to have cash on hand to fund new profitable projects. In perfect markets a shareholder is indifferent to a dividend or a repurchase. A few key factors that have to be looked at in the bigger picture is whether a company is in the position to payout a dividend or repurchase stocks. “Cash is King” and having enough on hand is crucial to long-term survival of a company.

Exhibit 1- Special Dividend Exhibit 2- Share Repurchase

Special Dividend Cum-Dividend Ex-Dividend Share Repurchase Before Repurchase After Repurchase

Earnings $170,600,000.00 $170,600,000.00 Earnings$170,600,000.00 $170,600,000.00

Net Cash Flow $13,200,000.00 $0.00 Net Cash Flow $13,200,000.00 $0.00

Dividend Paid 0 $4 Shares Repurchased 0 427,600

Total Market Value $9,643,788,000.00 $8,394,188,000.00 Total Market Value$9,643,788,000.00 $9,630,588,000.00

Shares Outstanding 312,400,000 312,400,000 Shares Outstanding312,400,000 311,972,400

Share Price $30.87 $26.87 Share Price $30.87 $30.87

EPS 0.546 0.546 EPS 0.546 0.547

Exhibit 3- Total Shareholder Value Comparison

Shareholder Preference Assuming 4000 shares Special Dividend Repurchase

Share Price $26.87 $30.87

Shares Held 4,000 0

Dividend Paid $4.00 $0.00

Shares Repurchased 0 4,000

Shareholders Value in Stock $107,480.00 $0.00

Shareholder Value in Cash $16,000.00 $123,480.00

Total Shareholder Value$123,480.00 $123,480.00

There are several reasons for a company to offer dividends as distribution of a portion of its earnings. One reason for declaring dividends is for a company to demonstrate financial strength to its shareholders and to attract potential investors who use dividends as a source of income. The commitment to pay a regular dividend to its shareholders provides certainty about the company’s financial well being. An increase or decrease of a company’s dividend distribution rate also signals the company’s financial expectations and will have an immediate impact on the price per share of the firm. By lowering or eliminating dividends, the price per share will likely drop for companies that have a history of stable dividend payouts and the price will likely rise if these companies increase dividend payouts or make additional payouts. Firms without a dividend history are generally viewed favorably when they declare new dividends.

Dividend initiating companies are generally farther along in their lifecycle. Many technology firms have gone through an Initial Public Offering (IPO) during the last twenty years. Typically, IPO firms go public on the promise of growth to their investors expecting capital gains rather than dividends so the rate of dividend initiations will continue to decrease. These firms are expected to heavily reinvest in areas such as R&D and capital expenditures. Since the late 1990’s, these firms created a new trend of initiating dividends at a slower rate. This led other large, public companies to follow suit. Three decades ago, 67% of these firms paid a regular dividend, but by the time technology companies began to drive the market in the late 1990’s, only 21% of these firms were dividend paying companies.

Should Linear Technology increase its dividend this quarter?

In general, when a company's positive cash flow is paid out in the form of dividends, the shares outstanding will rise, causing a lower EPS. Here the use of Linear’s $13.2M net cash flow to pay out the special dividend or repurchase shares results in a sustained EPS. While the dividend payout decreases the price per share, the reduction in cash flow will also affect Linear’s ability to invest in growth areas. However, Linear has a strong balance sheet with no long-term debt and can maintain profit margins that will continue to generate positive net cash flow.

Aligned with the goal of maximizing the shareholder’s wealth, the comparison in Exhibit 3 shows that the total shareholder value will remain constant. Therefore, an equal combination of the dividend payout and the repurchase of shares is recommended. In conjunction with Coghlan's

vision, continuing a dividend policy will be favorable to the investor that shares in the same income and growth goals and proves to the market that Linear is confident in maintaining its profitability even through the downturns of market cycles.

Works Cited

1) Baker, Malcolm P., and Alison B. Wagonfield. "Dividend Policy at Linear Technology." Harvard Business School (2003). Web.

2) Smith, Tom W., Tewary, Armit. May 2003. A Good Line for Linear Technology. On-line. Available on the internet at: http://www.businessweek.com/investor/content/may2003/pi2003052_0260_pi044.htm. Accessed 23 April 2010.

3) Korinel, Anton, Stiglitz, Joseph. March 2008. Dividend Taxation and Intertemporal Tax Arbitrage. On-line. Available on the internet at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1106584. Accessed 23 April 2010.

4) Graham, John and Smart, Scott and Megginson, William. Corporate Finance: Linking Theory to What Companies Do. Mason, OH: South-Western Cengage Learning, 2010.