Jobi C.

Cosme
BSA, AY 2013-2014

Mrs. Lilian Bunuan
Professor

A junior consultant from Arthur Adamson & Company, a
national consulting firm, which has been asked to help
Southeastern Steel Company prepare for its public offering.
Southeastern Steel Company 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. Brown and Valencia
have decided to take the company public but before talking
with potential outside investors, they must decide on a
dividend policy.

Southeastern Steel Companys 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.

Brown and Valencia formed SSC 5 years ago while
avoiding issuing new stock and thus they own all of the
shares.

SSC has now reached the stage in which outside equity
capital is necessary if the firm is to achieve its growth
targets.

And they would still like to maintain its target capital
structure of 60% equity and 40% debt.

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.

INTERNAL:
Constraints
Income Stability
Managers/Control









EXTERNAL:
Cost of selling new
stocks
Shareholder
Preferences
Economy
Investment
Oppurtunities
Alternative Activities

Southeastern Steel Company will undergo an initial public offering, and as
it is their first time in offering their shares of stock to the public, they must
present their companys ability to generate profit the best way possible; as
that is every investors goal, to generate profit; to invise in a firm that would
maximize their wealth.

SCC should use the residual dividend policy, as they are a 5 year
old company which uses a process that they have developed on
their own.

Though we must assume under this model that investors are
indifferent between dividends and capital gain, most investors
that they would attract would most probably be the risk-tolerant
investors, the ones who are after growth, capital gain rather than
dividends, as people who prefer dividens or cash in the near
future would steer clear of IPOs as they might find it risky.


And as the firm is in a phase of growth it might not be
able to declare dividends as they need to pay their other
sources of capital such as debt, though they will be at
great risk of clientele effect and also with a confusing
signaling effect due to their dividends as as it fluctuates.

The firm will make maximum use of lower-cost retained
earnings, they will minimize the floatation costs that
would result from issuing new stocks.

And using the residual dividend model for a couple of
years would also avoid issuing new stocks to fund future
projects, that would result in a change in the capital
structure.
But ideally, SCC should only use the residual dividend
model as a guide to arrive at their target payout ratio for the
long run.

Estimate earnings and investment opportunities, on
average, over the next 5 or so years.

Use this forecasted information to find the average
residual model amount of dividends (and the payout
ratio) during the planning period.

Set a target payout policy based on the projected data.

What is meant by the term dividend policy?
Dividend policy is the firms policy when it comes to paying out earnings as
dividends or retaining them for reinvestment in the firm.
Explain briefly the dividend irrelevance theory that was put forward by Modigliani
and Miller. What were the key assumptions underlying their theory?
Dividend irrelevance refers to the theory that investors are indifferent between
dividends and capital gains, making dividend policy irrelevant with regard to its
effect on the value of the firm.

The key assumptions underlying the dividend irrelevance theory, among other
things,
that no taxes are paid on dividends
that stocks can be bought and sold with no transactions costs
and that everyoneinvestors and managers alikehas the same
information regarding firms future earnings.

Why do some investors prefer high-dividend-paying stocks, while other investors
prefer stocks that pay low or nonexistent dividends?
Some investors may prefer high-dividend-paying stocks because when a company
has hig payout ratio its stock price would have a high value, and also because
dividens are less risky than capital gain.
And some investors may prefer low-dividend-paying stocks because they want to
avoid incurring transaction costs.
Discuss (1) the information content, or signaling, hypothesis; (2) the clientele effect;
and (3) their effects on dividend policy.
An increase in the dividend is often accompanied by an increase in the stock price,
while a dividend cut generally leads to a stock price decline. One could argue that this
observation supports the premise that investors prefer dividends to capital gains. MM
argued thst a higher-than-expected dividend increa is a signal to investors that
management forcasts good future earnings. And that a dividend reduction, or a smaller-
than-expected increase, is a signal that management forecasts poor future earnings.
Which indicates that the changes in stock price do not demonstrate a preference for
dividends over retained earnings, rather such price changes indicates that dividend
announcements have information content, or signaling, about future earnings.

Different groups, or clienteles, of stockholders prefer different dividend payout
policies. If a firm retains and reinvests income rather than paying dividends, those
stockholders who need current income will be disadvantaged. The value of their stock
might increase, but they will be forced to go to the trouble and expense of selling off
some of their shares to obtain cash. On the other hand, stockholders who are saving
rather than spending dividends favor the low-dividend policy: The less the firm pays
out in dividends, the less these stockholders have to pay in current taxes and the less
trouble and expense they must go through to reinvest their after-tax dividends. All of
this suggests that a clientele effect exists, which means that firms have different
clienteles and that the clienteles have different preferenceshence, that a change in
dividend policy might upset the majority clientele and have a negative effect on the
stocks price. This suggests that a company should follow a stable, dependable
dividend policy so as to avoid upsetting its clientele.
Dividend policy changes should not be taken lightly, as it might upset a firms
clientele, as some may prefer low-dividend policy and others a high-dividend policy, a
firm may have a hard time trying to figure out which clientele they have or which kind of
clientele is more, so a drastic change in dividend policy will hurt a firm. dividend policy
should be changed slowly, rather than abruptly, in order to give stockholders time to
adjust.

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 SSCs 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.
First, we need to determine the amount of equity needed to finance the projects.
Required for the capital budget = $800,000
Capital budget from equity: 0.6($800,000) = $480,000
Capital budget from debt: 0.4($800,000) = $320,000
Optimal capital structure:
Debt $320,000 40%
Equity 480,000 60%
$800,000 100%

Residual dividend model, if net income exceeds the amount of equity the company
needsthen it should pay the residual amount out in dividends.

Net Income = $600,000
Residual to be paid out as dividend: $600,000 $480,000 = $120,000
Payout ratio: $120,000/$600,000 = 0.20 = 20%

If Net Income = $400,000
The firm will need to sell $80,000 new stock as the firm still needs $480,000 of capital
budget from equity, and under the residual dividend approach the firm will have to call
for a zero dividend payment.

If Net Income = $800,000
Residual to be paid out as dividend: $800,000 $480,000 = $320,000
Payout ratio: $320,000/$800,000 = 40%
In general terms, how would a change in investment opportunities affect the payout
ratio under the residual payment policy?
Good investment oppurtunities would lead to an increase in in the amount of equity
needed, and if investment opportunities were not good the result would be a decrease in
the amount of equity needed. If investment opportunities were good then the residual
amount would be smaller than if investment opportunities were bad. So a good
investment oppurtunity would result to a decrease in the payout ratio.
What are the advantages and disadvantages of the residual policy? (Hint: Dont
neglect signaling and clientele effects.)
The advantage of the residual policy is that under it the firm makes maximum use of
lower-cost retained earnings, they will minimize the floatation costs that would result
from issuing new stocks. Also, whatever negative signals are associated with stock issues
would be avoided.
And a disadvantage would be the unstable change in the dividend payments as the
dividends depends on factors such as the capital budget needed from equity and the net
income, and it may also send confusing signals to investors, which we should also consider
the clientele affect.

What is a dividend reinvestment plan (DRIP), and how does it work?
Dividend reinvestment plan (DRIP), under which stockholders can automatically
reinvest their dividends in the stock of the paying corporation.
There are two types of DRIPs: (1) plans that involve only old, already-outstanding
stock and (2) plans that involve newly issued stock. In either case, the stockholder
must pay taxes on the amount of the dividends even though stock rather than cash
is received.
Under an old stock plan, the company gives the money that stockholders who
elect to use the DRIP would have received to a bank, which acts as a trustee. The
bank then uses the money to purchase the corporations stock on the open market
and allocates the shares purchased to the participating stockholders accounts on a
pro rata basis. The transactions costs of buying shares (brokerage costs) are low
because of volume purchases, so these plans benefit small stockholders who do not
need current cash dividends.
A new stock DRIP invests the dividends in newly issued stock; hence, these plans
raise new capital for the firm. No fees are charged to stockholders, and some
companies have offered stock at discounts of 2% to 5% below the actual market
price. The companies offer discounts because they would have incurred flotation
costs if the new stock had been raised through investment bankers.

Describe the series of steps that most firms take in setting dividend policy in practice.
Firms establish dividend policy within the framework of their overall financial plans.
The steps in setting policy are listed below:
The firm forecasts its annual capital budget and its annual sales, along with its
working capital needs.
The target capital structure, one that minimizes the WACC while retaining sufficient
reserve borrowing capacity to provide financing flexibility, will also be established.
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.
A long-term target payout ratio is then determined, based on the residual model
concept. Because of flotation costs and potential negative signaling, 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.
What are stock repurchases? Discuss the advantages and disadvantages of a firms
repurchasing its own shares.
Stock repurchase is a transaction in which a firm buys back shares of its own stock,
thereby decreasing shares out- standing, increasing EPS, and often increasing the stock
price.
Advantages of repurchases:
A repurchase announcement may be viewed as a positive signal by the investors that
management believes the shares are undervalued.
The stockholders have a choice when the firm distributes cash by repurchasing
stockthey can sell or not sell. With a cash dividend, on the other hand,
stockholders must accept a dividend payment and pay the tax. Thus, those
stockholders who need cash can sell back some of their shares, while those who do
not want additional cash can simply retain their stock. From a tax standpoint, a
repurchase permits both types of stockholders to get what they want.

Repurchased stock, called treasury stock, can be used later in mergers, when
employees exercise stock options, when convertible bonds are converted, and when
warrants are exercised. Treasury stock can also be resold in the open market if the
firm needs cash. Repurchases can remove a large block of stock that is overhanging
the market and keeping the price per share down.
Repurchases can be varied from year to year without giving off adverse signals, while
dividends may not. Dividends are sticky in the short run because managements are
reluctant to raise the dividend if the increase cannot be maintained in the future
managements dislike cutting cash dividends because of the negative signal a cut
gives. Therefore, if excess cash flows are expected to be temporary, managements
may prefer to make distributions as share repurchases rather than to declare
increased cash dividends that cannot be maintained.
Repurchases can be used to produce large-scale changes in capital structure.
Companies that use stock options as an important component of employee
compensation can repurchase shares and then reissue those shares when employees
exercise their options. This avoids having to issue new shares, which dilutes
earnings per share.

Disadvantages of repurchases:
Stockholders may not be indifferent between dividends and capital gains, and the
price of the stock might benefit more from cash dividends than from repurchases.
Cash dividends are generally dependable, but repurchases are not.
The selling stockholders may not be fully aware of all the implications of a
repurchase, or they may not have all the pertinent information about the
corporations present and future activities. This is especially true in situations
where management has good reason to believe that the stock price is well below its
intrinsic value. However, firms generally announce repurchase programs before
embarking on them to avoid potential stockholder suits.
The corporation may pay too high a price for the repurchased stock, to the
disadvantage of remaining stockholders. If its shares are not actively traded and if
the firm seeks to acquire a relatively large amount of its stock, the price may be bid
above its intrinsic value and then fall after the firm ceases its repurchase
operations.

What are stock dividends and stock splits? What are the advantages and
disadvantages of stock dividends and stock splits?
A stock dividend, is when a firm issues new shares in lieu of paying a cash dividend.
A stock split is an action taken by a firm to increase the number of shares outstanding,
such as doubling the number of shares outstanding by giving each stockholder two
new shares for each one formerly held.
Both stock dividends and stock splits increase the number of shares outstanding and
lower the stocks price in the market.
Advantage:
On average, the price of a companys stock rises shortly after it announces a stock
split or dividend. One reason that stock splits and stock dividends may lead to
higher prices is that investors often take stock splits/dividends as signals of higher
future earnings. Because only companies whose managements believe that things
look good tend to
split their stocks, the announcement of a stock split is taken as a signal that earnings
and cash dividends are likely to rise. Thus, the price increases associated with stock
splits/dividends may be the result of a favorable signal for earnings and dividends.
Small investors will be more inclined to purchase stocks as the price have been
reduced.
By creating more shares and lowering the stock price, stock splits may also
increase the stocks liquidity. This tends to increase the firms value.
Disadvantage:
When small stock dividends are declared, like 5% or 10%. No economic value is
being created or distributed; yet stockholders have to bear the administrative costs of
the distribution.

it is inconvenient to own an odd number of shares as may result after a small stock
dividend.
Reference(s):
Fundamentals of Financial Management 12th edition - Brigham Houston
http://wiki.fool.com/Key_Factors_That_Influence_Dividend_Policies