Now your boss wants you to evaluate the dividend policy of Information Systems, Inc. (ISI), which develops software for the health care industry. ISI was founded five years ago by Donald Brown and Margaret Clark, who are still its only stockholders. ISI has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets and still maintain its target capital structure of 60 percent equity and 40 percent debt. To achieve this goal, Brown and Clark have decided to take the company public. Until now, the two owners have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue. Before talking with potential out- side investors, however, they must decide on a dividend policy. Your boss has asked you to make a presentation to Brown and Clark in which you review the theory of dividend policy and discuss the following questions.

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

(2) The terms irrelevance and relevance have been used to describe theories regarding the way that dividend policy affects a firm’s value. Explain what these terms mean and briefly discuss the relevance of dividend policy.

(3) Explain the relationships between dividend policy and (i) stock price and (ii) the cost of equity under each dividend policy theory.

(4) What results have empirical studies of the dividend theories produced? How do these findings affect what we can tell managers about dividend policy?

b. Discuss

(1) The information content, or signaling, hypothesis,

(2) The clientele effect,

(3) The free cash flow hypothesis,

(4) Their effects on dividend policy.

c. (1) Assume that ISI has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (60 percent equity and 40 percent debt) is optimal, and its net income is forecasted at $600,000. Use the residual dividend policy approach to determine ISI’s total dollar dividend and payout ratio. In the process, explain what the residual dividend policy is and use a graph to illustrate your answer. Also, explain what would happen if net income were forecasted at either $400,000 or $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. What are some other commonly used dividend payment policies? What are their advantages and disadvantages? Which policy is most widely used in practice?

e. What is a dividend reinvestment plan (DRIP), and how does one work?