Central Canada Steel (CCS) was formed 5 years ago to exploit a new continuous-casting process. CCS's founders, Donald Brown and Margo Lapointe, 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 Lapointe had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical steel company, so Brown and Lapointe have been able to avoid issuing new stock, and thus they own all of the shares. However, CCS has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets yet maintain its target capital structure of 60% equity and 40% debt. Therefore, Brown and Lapointe have decided to take the company public. Until now, Brown and Lapointe have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so 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 Pierce Westerfield Carney (PWC), a national consulting firm, which has been asked to help CCS prepare for its public offering. Martha Millon, the senior PWC consultant in your group, has asked you to make a presentation to Brown and Lapointe in which you review the theory of dividend policy and discuss the following questions.
a. 1. What is meant by the term "distribution policy"?
2. The terms "irrelevance," "bird-in-the-hand," and "tax preference" have been used to describe three major theories regarding the way dividend payouts affect a firm's value. Explain what these terms mean, and briefly describe each theory.
3. What do the three theories indicate regarding the actions management should take with respect to dividend payout?
4. What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?
b. 1. Discuss: The information content, or signalling, hypothesis
2. The clientele effect, and
3. Their effects on distribution policy.
c. 1. Assume that CCS 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 forecast at $600,000. Use the residual distribution model approach to determine CCS's total dollar distribution. Assume for now that the distribution is in the form of a dividend. Then, explain what would happen if net income were forecasted at $400,000, or at $800,000.
2. In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
3. What are the advantages and disadvantages of the residual policy?
d. 1. What are stock repurchases? Discuss the advantages and disadvantages of a firm repurchasing its own shares.
e. Describe the series of steps that most firms take in setting dividend policy in practice.
f. What are stock splits and stock dividends? What are the advantages and disadvantages of stock splits and stock dividends?
g. What is a dividend reinvestment plan (DRIP), and how does it work?