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 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.
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?
b. Discuss (1) the information content, or signaling, hypothesis; (2) the clientele effect; and (3) their effects on dividend policy.
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 approach 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 net income was forecasted at $400,000 and 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. What is a dividend reinvestment plan (DRIP), and how does it work?
e. Describe the series of steps that most firms take in setting dividend policy in practice.
f. What are stock repurchases? Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.
g. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?