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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

DIVIDEND POLICY Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous casting process SSC's founders, Donald Brown and Margo Valencia, had been employed in the research department of a major integrated-steel company, but when that company decided against using the new process (which Brown and Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital compared to the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus own all of the shares. However, SSC has now reached the stage in which outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60% equity and 40% debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so the firm's dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy.

Assume that you were recently hired by Arthur Adamson & Company (AA), a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions:

  1. a. 1. What is meant by the term dividend policy?

2. Explain briefly the dividend irrelevance theory that was put forward by Modigliani and Miller. What were the key assumptions underlying their theory?

3. Why do some investors prefer high-dividend-paying stocks, while other investors prefer stocks that pay low or nonexistent dividends?

  1. b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, (3) catering theory, and (4) their effects on dividend policy.
  2. c. 1. Assume that SSC has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (60% equity and 40% debt) is optimal, and its net income is forecasted at $600,000. Use the residual dividend model to determine SSC's total dollar dividend and payout ratio. In the process, explain how the residual dividend model works. Then explain what would happen if expected net income was $400,000 or $800,000.

2. In general terms, how would a change in investment opportunities affect the payout ratio under the residual dividend model?

3. What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect signaling and clientele effects.)

  1. d. Describe the series of steps that most firms take in setting dividend policy in practice.
  2. e. What is a dividend reinvestment plan (DRIP), and how does it work?
  3. f. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?
  4. g. What are stock repurchases? Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.

a.1.

Summary Introduction

To explain: Dividend policy.

Introduction:

Stock Dividend:

When company decides to pay dividend in the form of shares instead of cash to its shareholders due to the shortage of liquid cash, itis said to be a stock dividend or scrip dividend

Explanation

The decision taken by the top management to divide its earnings between the equity shareholders and at the same time retaining the earnings for the investment purposes is called as a dividend policy...

2.

Summary Introduction

To explain: Dividend irrelevance theory and assumptions underlying the theory.

3.

Summary Introduction

To explain: Reason for the investors choosing high dividend paying stocks and pay low or nonexistent dividends

b.(1)

Summary Introduction

To discuss: The information content or signaling, hypothesis.

(2)

Summary Introduction

To discuss: Clientele effect.

(3)

Summary Introduction

To explain: Catering theory.

(4)

Summary Introduction

To explain: The effect of catering theory on dividend policy.

c.1.

Summary Introduction

To calculate: Amount to be raised through equity.

2.

Summary Introduction

To calculate: Payout ratio and the effect on it under the residual dividend model.

3.

Summary Introduction

To explain: advantages and disadvantages of residual policy.

d.

Summary Introduction

To determine: The series of steps that many company’s take in setting dividend policy in practice.

e.

Summary Introduction

To explain: dividend reinvestment plan and its working.

f.

Summary Introduction

To explain: Stock dividends, stock splits and their advantages as well as disadvantages.

g.

Summary Introduction

To explain: Stock repurchase and its advantages and disadvantages.

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