Sarah Faheem - 18423
Mini Case Study
Integrated Waveguide Technologies (IWT) is a 6-year-old company founded by Hunt Jackson
and David Smithfield to exploit metamaterial plasmonic technology to develop and
manufacture miniature microwave frequency directional transmitters and receivers for use in
mobile Internet and communications applications. IWT’s technology, although highly
advanced, is relatively inexpensive to implement, and its patented manufacturing techniques
require little capital as compared to many electronics’ fabrication ventures. Because of the low
capital requirement, Jackson and Smithfield have been able to avoid issuing new stock and thus
own all of the shares. Because of the explosion in demand for its mobile Internet applications,
IWT must now access outside equity capital to fund its growth, and Jackson and Smithfield
have decided to take the company public. Until now, Jackson and Smithfield 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. Your new boss at the consulting firm Flick and
Associates, which has been retained to help IWT prepare for its public offering, has asked you
to make a presentation to Jackson and Smithfield in which you review the theory of dividend
policy and discuss the following issues.
a. (1) What is meant by the term “distribution policy”? How has the mix of dividend
payouts and stock repurchases changed over time?
Distribution policy is defined as the firm’s policy with regard to
i: the level of distributions
ii: the form of distributions (dividends or stock repurchases)
iii: the stability of distributions.
(2) The terms “irrelevance,” “dividend preference” (or “bird-in-the-hand”), and “tax
effect” have been used to describe three major theories regarding the way dividend
payouts affect a firm’s value. Explain these terms, and briefly describe each theory.
According to the thesis of "dividend irrelevance," investors have no preference between
dividends and capital gains, rendering dividend policy unimportant in terms of how it affects a
company's value. The term "bird-in-the-hand" relates to the idea that investors would prefer to
receive a dollar in dividends than to keep it invested in the company, in which case a firm's
value would be impacted by its payout policy.
The tax effect theory recognizes that there are two tax-related reasons for believing that
investors might prefer a low dividend payout to a high payout: (1) taxes are not paid on capital
gains until the stock is sold. (2) if a stock is held by someone until he or she dies, no capital
gains tax is due at all--the beneficiaries who receive the stock can use the stock’s value on the
death day as their cost basis and thus escape the capital gains tax
(3) What do the three theories indicate regarding the actions management should take
with respect to dividend pay-outs?
If the dividend irrelevance theory is correct, then dividend payout is of no consequence, and
the firm may pursue any dividend payout. If the bird-in-the-hand theory is correct, the firm
should set a high payout if it is to maximize its stock price. If the tax effect theory is correct,
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the firm should set a low payout if it is to maximize its stock price. Therefore, the theories are
in total conflict with one another
(4) What results have empirical studies of the dividend theories produced? How does all
this affect what we can tell managers about dividend pay-outs?
Unfortunately, empirical tests of the theories have been mixed (because firms don’t differ just
with respect to payout). Some evidence shows that high payout firms have higher required
stock return, which supports the tax effect theory. Research shows that in countries with
relatively low dividend tax penalties: a: more companies pay dividends and b: dividend
payments are larger. In countries with relatively high dividend tax penalties, more companies
repurchase stock.
b. Discuss the effects on distribution policy consistent with:
(1) The signalling hypothesis (also called the information content hypothesis)
It has long been recognized that the announcement of a dividend increase often results in an
increase in the stock price, while an announcement of a dividend cut typically causes the stock
price to fall. One could argue that this observation supports the premise that investors prefer
dividends to capital gains. However, MM argued that dividend announcements are signals
through which management conveys information to investors. Information asymmetries exist-managers know more about their firms’ prospects than do investors.
(2) The clientele effect.
Different groups, or clienteles, of stockholders prefer different dividend payout policies. For
example, many retirees, pension funds, have a need for current cash income. Therefore, this
group of stockholders might prefer high payout stocks. These investors could, of course, sell
some of their stock, but this would be inconvenient, transactions costs would be incurred, and
the sale might have to be made in a down market. Conversely, investors in their peak earnings
years who are in high tax brackets and who have no need for current cash income should prefer
low payout stocks.
c. (1) Assume that IWT has completed its IPO and has a $112.5 million capital budget
planned for the coming year. You have determined that its present capital structure (80%
equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the
residual distribution approach to determine IWT’s total dollar distribution. Assume for
now that the distribution is in the form of a dividend. Suppose IWT has 100 million shares
of stock outstanding. What is the forecasted dividend payout ratio? What is the forecasted
dividend per share? What would happen to the payout ratio and DPS if net income were
forecasted to decrease to $90 million? To increase to $160 million?
Given the optimal capital budget and the target capital structure, we must now determine the
amount of equity needed to finance the projects.
Of the $112.5 million required for the capital budget,
0.8($112.5) = $90 million must be raised as equity
0.2($112.5) = $22.5 million must be raised as debt
If we are to maintain the optimal capital structure:
If a residual exists--that is, if net income exceeds the amount of equity the company needs-then it should distribute the residual amount out as either dividends or stock repurchases.
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Since $140 million of earnings is available, and only $90 million is needed, the residual is $140
- $90 = $50 million,
So, this is the amount which should be paid out as dividends.
Thus, the payout ratio would be $50/$140 = 0.357 = 35.7%.
DPS would be $50/100 = $0.50.
i: If only $90 million of earnings were available, the residual is $90 - $90 = $0, so nothing
should be paid out as dividends.
ii: Thus, the payout ratio would be zero, as would be the DPS.
If $160 million of earnings were available, the residual is $160 - $90 = $70 million, so this is
the amount which should be paid out as dividends. Thus, the payout ratio would be $70/$160
= 0.438 = 43.8%. The DPS would be $70/100 = $0.70
(2) In general terms, how would a change in investment opportunities affect the payout
ratio under the residual distribution policy?
A change in investment opportunities would lead to an increase (if investment opportunities
were good) or a decrease (if investment opportunities were not good) in the amount of equity
needed, hence in the residual dividend payout.
(3) What are the advantages and disadvantages of the residual policy?
The primary advantage of the residual policy is that under it the firm makes maximum use of
lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital. Also,
whatever negative signals are associated with stock issues would be avoided as it would send
investors conflicting signals over time regarding the firm’s future prospects
d. (1) Describe the procedures a company follows when it makes a distribution through
dividend payments.
i.
Declaration date
ii.
Dividend goes with stock (owner on this day will get dividend)
iii.
Ex-dividend date (purchaser on or after this date doesn't get dividend)
iv.
Holder-of-record date
v.
Payment date
(2) What is a stock repurchase? Describe the procedures a company follows when it
makes a distribution through a stock repurchase.
A firm may distribute cash to stockholders by repurchasing its own stock rather than paying
out cash dividends. Stock repurchases can be used (1) somewhat routinely as an alternative to
regular dividends, (2) to dispose of excess (nonrecurring) cash that came from asset sales or
from temporarily high earnings, and (3) in connection with a capital structure change in which
debt is sold and the proceeds are used to buy back shares.
A company announces intent to purchase of its own stock during a specific period. The
announcement is not binding; in fact, companies often don’t actually complete the repurchase.
Three methods are used for a repurchase: (1) Open market (usually through trustee) with stock
purchases spread over a period of time; (2) Tender offer, where company buys directly from
shareholders who wish to tender their stock to the company; or (3) Targeted stock repurchase
in which the company buys from a large block holder.
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e. Discuss the advantages and disadvantages of a firm repurchasing its own shares.
Advantages of repurchases:
i.
A repurchase announcement may be viewed as a positive signal that management
believes the shares are undervalued.
ii.
Stockholders have a choice--if they want cash, they can tender their shares, receive
the cash, and pay the taxes, or they can keep their shares and avoid taxes. On the
other hand, one must accept a cash dividend and pay taxes on it.
iii.
If the company raises the dividend to dispose of excess cash, this higher dividend
must be maintained to avoid adverse stock price reactions. A stock repurchase, on
the other hand, does not obligate management to future repurchases.
iv.
Repurchased stock, called treasury stock, can also be resold in the open market if
the firm needs cash.
v.
Repurchases can be varied from year to year without giving off adverse signals,
while dividends may not.
Disadvantages of repurchases:
i.
A repurchase could reduce the number of shares of company in the market which
can increase the share price which can give false illusion the investor.
ii.
It can also give false estimates of the company’s valuation as it can increase EPS
and ROI rapidly.
f. Suppose IWT has decided to distribute $50 million, which it presently is holding in
liquid short term investments. IWT’s value of operations is estimated to be about $1,937.5
million, and it has $387.5 million in debt (it has no preferred stock). As mentioned
previously, IWT has 100 million shares of stock outstanding.
(1) Assume that IWT has not yet made the distribution. What is IWT’s intrinsic value of
equity? What is its intrinsic stock price per share?
Value of operations
+ Value of nonoperating assets
Total intrinsic value of firm
− Debt
Intrinsic value of equity
÷ Number of shares (100)
Intrinsic price per share
$1,937.50
50.00
$1,987.50
387.50
$1,600.00
$16.00
(2) Now suppose that IWT has just made the $50 million distribution in the form of
dividends. What is IWT’s intrinsic value of equity? What is its intrinsic stock price per
share?
Before
After Dividend
Value of operations
$1,937.50
$1,937.50
+ Value of nonoperating assets
50.00
0.00
Total intrinsic value of firm
$1,987.50
$1,937.50
− Debt
387.50
387.50
Intrinsic value of equity
$1,600.00
$1,550.00
÷ Number of shares (100)
Intrinsic price per share
$16.00
$15.50
Dividend per share
$0.50
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(3) Suppose instead that IWT has just made the $50 million distribution in the form of a
stock repurchase. Now what is IWT’s intrinsic value of equity? How many shares did
IWT repurchase? How many shares remained outstanding after the repurchase? What
is its intrinsic stock price per share after the repurchase?
nPost = nPrior − (CashRep/PPrior)
nPost = 100 − ($50/$16)
nPost = 100 − 3.125 = 96.875
Value of operations
+ Value of nonoperating assets
Total intrinsic value of firm
− Debt
Intrinsic value of equity
÷ Number of shares
Intrinsic price per share
Number of shares repurchased
Before
$1,937.50
50.00
$1,987.50
387.50
$1,600.00
100.00
$16.00
After Repurchase
$1,937.50
0.00
$1,937.50
387.50
$1,550.00
96.875
$16.00
3.125
g. Describe the series of steps that most firms take when setting dividend policy.
The steps in setting policy are listed below:
i. The firm forecasts its annual capital budgets and its annual sales, along with its working
capital needs, for a relatively long-term planning horizon, often 5 years.
ii. With its capital structure and investment requirements in mind, the firm can estimate
the approximate amount of debt and equity financing required during each year over
the planning horizon.
iii. A long-term target payout ratio is then determined, based on the residual model concept.
Because of flotation costs and potential negative signalling, the firm will not want to
issue common stock unless this is absolutely necessary. At the same time, due to the
clientele effect, the firm will move cautiously from its past dividend policy, if a new
policy appears to be warranted, and it will move toward any new policy gradually rather
than in one giant step.
iv.
An actual dividend, the size of this dividend will reflect (1) the long-run target payout
ratio and (2) the probability that the dividend, once set, will have to be lowered, or,
worse yet, omitted. If there is a great deal of uncertainty about cash flows and capital
needs, then a relatively low initial dollar dividend will be set, for this will minimize the
probability that the firm will have to either reduce the dividend or sell new common
stock. The firm will run its corporate planning model so that management can see what
is likely to happen with different initial dividends and projected growth rates under
different economic scenarios.
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h. What are stock splits and stock dividends? What are the advantages and disadvantages
of each?
Stock Split:
A stock split is when a company lowers the price of its stock by splitting each existing share
into more than one share. For example, a company might take one share of stock and split it
into two shares. The total combined value of the two new shares still equals the price of the
previous one share
Advantages of Stock Splits:
 Improve liquidity
 Make selling put options cheaper
 Often increase share price
Disadvantages of Stock Splits:
 Could increase volatility
 Stock splits costs money
Stock Dividend:
When it uses a stock dividend, a firm issues new shares in lieu of paying a cash dividend. For
example, in a 5 percent stock dividend, the holder of 100 shares would receive an additional 5
shares.
Advantages of Stock Dividend:
 Company's cash balance remains the same
 Decrease in share price may attract new investors
 Stock dividends are not treated as taxable for investors until sold
Disadvantages of Stock Dividend:
 Bonus shares dilute the share price
 Stock dividends may signal financial instability for the company
 Less cash income for the investor
i. What is a dividend reinvestment plan (DRIP), and how does it work?
Under a dividend reinvestment plan (DRIP), shareholders have the option of automatically
reinvesting their dividends in shares of the firm’s common stock. In an open market purchase
plan, a trustee pools all the dividends to be reinvested and then buys shares on the open market.
Shareholders use the drip for below reasons:
 Brokerage costs are reduced by the volume purchases.
 The DRIP is a convenient way to invest excess funds.
For example, consider an investor that receives a cash dividend on his shares. The investor
fully participates in a DRIP and reinvests the cash dividends for additional shares. During the
next dividend payout, the investor will receive more cash dividends due to the additional shares
purchased through the DRIP.
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