Assignment 14

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.

1a) 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 level of distributions, form of distribution and the
stability of distribution to the share holders
 The occurrence of dividends versus stock repurchases has changed dramatically during
the past 30 years. First, the percentage of cash distribution relative to net income was
27% until the early 2000s, but it has dramatically increased since then. The combined
payout ratio of dividends and repurchases have also exceeded 90% since 2012. Second,
the percentage of companies paying dividend has changed over time (66.5% in 1978 Vs
20.8% in 1999). Third, there is considerable variation in distribution policies with some
companies paying a high percentage of their income as dividends and others paying
none.

1b) 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.

 Dividend irrelevance theory: The firms value is determined only by its basic earning
power and its business risk i.e., the value of the firm depends only on the income
produced by its assets, not on how this income is split between dividends and RE
 Dividend Preference theory: The that dividend policy does not affect a stock’s value or
risk. Therefore, it does not affect the required rate of return on equity. In other words, a
 bird in the hand is worth more than two in the bush. Therefore, shareholders prefer
dividends and are willing to accept a lower required return on equity.
 Tax Effect Theory: First, the time value of money means that a dollar of taxes paid in the
future has a lower effective cost than a dollar paid today. So even when dividends and
gains are taxed equally, capital gains are never taxed sooner than dividends. Second, if a
stock is held until the shareholder dies, then no capital gains tax is due at all: the
beneficiaries who receive the stock can use its value on the date of death as their cost
basis and thus completely escape the capital gains tax.

1c) What do the three theories indicate regarding the action’s management should take with respect to
dividend payouts?

According the irrelevance theory, the dividend is irrelevant and the other two theories
explains the stockholders prefers dividends and it is significant part of investors choice

1d) What results have empirical studies of the dividend theories produced? How does all this affect what
we can tell managers about dividend payouts?

 Taxes certainly affect dividend policies chosen by companies, Evidence shows that the investors
prefer to avoid taxation and investors require higher pretax returns on stocks with big dividend
payouts.

2) Discuss the effects on distribution policy consistent with: (1) the signaling hypothesis (also called the
information content hypothesis) and (2) the clientele effect.

Clientele effect explains the movement in a company's stock price according to the demands
and goals of its investors. These investor demands come in reaction to a tax, dividend or other policy
change which affects the shares. The clientele effect first assumes that specific investors are
preliminarily attracted to different company policies, and when a company's policy alters, they will
adjust their stock holdings accordingly. As a result of this adjustment, stock prices may fluctuate.

The signaling hypothesis defines that the investors reactions to changes in dividend policy do
not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price
changes following dividend actions simply indicate that there is important information, or signaling,
content in dividend announcements.

3a) 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?

Distr.=Net income−Required equity
   Case 1 Case 2 Case 3
Number of shares 100 100 100
Equity ratio (ws) 80% 80% 80%
Capital budget $112.50 $112.50 $112.50
Net income $140.00 $90.00 $160.00
Required Equity $90.00 $90.00 $90.00
Dist. paid: (NI – Req.
$50.00 $0.00 $70.00
equity)
Payout ratio (Dividend/NI) 35.71% 0.00% 43.75%
Dividend per share $0.50 $0.00 $0.70

3b) In general terms, how would a change in investment opportunities affect the payout ratio under the
residual distribution policy?

 Fewer good investments would lead to smaller capital budget, hence to a higher dividend
payout.
 More good investments would lead to a lower dividend payout.

3c) What are the advantages and disadvantages of the residual policy?

A residual dividend policy usually requires fewer new stock issues and lower flotation
costs. However, a variable dividend policy may send conflicting signals to investors. It also
represents an increased level of risk for investors, as dividend income remains uncertain and
does not appeal to any specific clientele

4a) Describe the procedures a company follows when it makes a distribution through dividend
payments.

When a company makes a distribution through dividend payments, the company should

1) Estimate the next 5 years earnings and investment opportunities.

2) Target the capital structure to find out the dollars of dividend using the estimation
3) Set a Target payout ratio based on the estimation

4b) What does a stock repurchase? Describe the procedures a company follows when it makes a
distribution through a stock repurchase

Stock repurchase is buying own stock back from stockholders and thereby decreasing the
number of shares but leaving the stock price unchanged

1) Estimate the next 5 years earnings and investment opportunities.

 2) Target the capital structure to find out the dollars of distribution using the estimation
3) Calculates the intrinsic value of stock at which it must be repurchased

5. Discuss the advantages and disadvantages of a firm repurchasing its own shares.

Advantages:

- Stockholders can decide to sell or not

- Helps avoid high dividend which cannot be maintained
- Income received is capital gains rather than higher tax dividends
- It can be used as stock options to employees
- It sends positive signal to investors since the repurchase is often done in the
situation where the share is undervalued

Disadvantages:

- Investors may prefer cash dividends compared to repurchase

- Company may pay too much for the repurchased stock
- Stockholder may not aware of the implications of a repurchase

6. 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; it has $387.5 million in
debt and zero preferred stock. As mentioned previously, IWT has 100 million shares of stock
outstanding.

(a) 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?

Given:

Short term investments = $50 million; Operation Value = $1937.5 mi; Debt = $387.5 mi

Number of Shares = 100 mi

Total Intrinsic Value of Firm = 1937.5 +50 = $1987.5 mi

Intrinsic value of equity = $1987.5 – 387.5 = $1600 million

Intrinsic Stock per share = $16

(b) 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?

Total Intrinsic Value of Firm = $1937.5 mi

Intrinsic value of equity = $1937.5 – 387.5 = $1550 million

Intrinsic Stock per share = $15.5

c) 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?

Total Intrinsic Value of Firm = $1937.5 mi

Intrinsic value of equity = $1937.5 – 387.5 = $1550 million

nPost = nPrior − (CashRep/PPrior)

= 100 – ($50/$16) = 96.875

Intrinsic stock per share = $16

Shares repurchased = $50/16 = 3.125 million

7. Describe the series of steps that most firms take when setting dividend policy.

1) Estimate the next 5 years earnings and investment opportunities.

2) Target the capital structure to find out the dollars of dividend using the estimation
3) Set a Target payout ratio based on the estimation

8 . What are stock splits and stock dividends? What are the advantages and disadvantages of each?

Stock Splits: It increases the number of shares outstanding. Normally it reduces the price per
share in proportion to the increase in shares. However, it splits only if the price is quite high,
management thinks the future is bright. Therefore, it considers as a positive signal and thus boost stock
prices

Stock Dividends: It is a dividend paid in additional shares rather than in cash. A

major advantage of paying dividends is that they can help provide shareholder loyalty. The major
disadvantage of paying dividends is the cash paid out to investors cannot be used to grow the business.

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

DRIP allows stockholders to have the company automatically use dividends to purchase
additional shares. It will allow the stockholders to acquire additional shares without brokerage fees.
Question 2

Gamut Satellite Inc. produces satellite earth stations that sell for $150,000 each. The firm’s fixed costs, F,
are $1.5 million, 20 earth stations are produced and sold each year, profits total $400,000, and the
firm’s assets (all equity financed) are $5 million. The firm estimates that it can change its production
process, adding $10 million to assets and $500,000 to fixed operating costs. This change will reduce
variable costs per unit by $5,000 and increase output by 30 units. However, the sales price on all units
must be lowered to $140,000 to permit sales of the additional output. The firm has tax loss
carryforwards that render its tax rate zero, its cost of equity is 18%, and it uses no debt.

A) Determine the variable cost per unit

Sales revenue = 150,000 * 20 = $3,000,000

Fixed Cost = 1.5 million

Profit = $400,000

Profit = Sales revenue – Fixed cost – variable cost

$400,000 = $3,000,000- $ 1,500,000 – V*20

V = $55000

B) Determine the new profit if the change is made

Change in sales revenue = 140,000 * 50 = $7,000,000

Change in Fixed Cost = $2,000,000
Change in Variable Cost/unit = $50000

New Profit = 7,000,000 – 2,000,000- 50000*50

= $2,500,000

C) What is the incremental profit?

Profit Increase = $2,500,000 - $400,000

= $2,100,000

D) What is the projects expected rate of return for the next year?

Rate of return = $2,100,000 / 15,000,000

= 0.14
= 14%

E) Should the firm make the investment? Why or why not?

Yes the firm should make the investment. Because the profit is increased and the higher
rate of return
F) Would the firm’s break-even point increase or decrease if it made the change?

Q old = F/ P- V

= 1,500,000 / (150,000-55000)

= 15.8 units

Q new = 2,000,000/ (140,000-50000) = 22.2 units

It has increased the breakeven point

G) Would the new situation expose the firm to business risk than the old one? Show workings

Higher Degree of leverage has higher business risk. So the Old situation has higher risk

DOL = Q(P-V)/ [ Q(P-v)-F)

DOL (old) = (3,000,000-1,100,000)/400000 = 4.75

DOL (New) = 1.8