QUESTION TWO

Southeastern Choma Co $($SCC$)$ was formed $5$ years ago to exploit a new continuous casting process.

SCC$$s founders, Chonanga and Hamududu, had been employed in the research department of a

major integrated$-$steel company, but when that company decided against using the new process

$($which Chonanga and Hamududu 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 Chonanga and Hamududu have been able to avoid issuing new stock, and

thus they own all of the shares. However, SCC 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 $60$ percent equity and $40$ percent debt. Therefore, Chonanga and Hamududu havedecided to take the company public. Until now, Chonanga and Hamududu 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 Akakulubeliwa Akina & Company $($AA$),$ a

national consulting firm, which has been asked to help SSC prepare for its public offering. John

Mwila, the senior AA consultant in your group, has asked you to make a presentation to Chonanga

and Hamududu in which you review the theory of dividend policy and discuss the following

questions.

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

b$.$ The terms $$irrelevance$,$bird$-$in$-$the$-$hand,$$ and $$tax preference$$ have been used to describe

three major theories regarding the way dividend policy affects a firm$$s value. Explain what

these terms mean, and briefly describe each theory.

c$.$ What do the three theories indicate regarding the actions management should take with

respect to dividend policy?

d$.$ Explain the relationships between dividend policy, stock price, and the cost of equity under

each dividend policy theory by constructing two graphs, Dividend payout should be placed

on the X axis.

e$.$ What results have empirical studies of the dividend theories produced?