508 Part 5 Capital Structure and Dividend Policy
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15-11 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 in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they 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 percent equity and 40 percent debt. There fore, 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) Discuss why some investors may 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 percent equity and 40 percent 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 what the residual dividend model is. Then, explain
what would happen if net income were forecasted at $400,000, or at $800,000.
Please go to the Thomson NOW Web site to access the Cyberproblems.
15-11 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 in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they 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 percent equity and 40 percent debt. There fore, 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) Discuss why some investors may 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 percent equity and 40 percent 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 what the residual dividend model is. 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?
residual payment policy?
(3) What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling and
clientele effects.)
clientele effects.)
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?
