16. 3/6/2003
Chapter Mini Case
Situation 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, 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 where 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, 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 & Co., 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. The return on a stock consists of two elements, dividends and capital gains. In rate of return terms, the total return consists of a dividend yield plus a capital gains yield, the g term in the following equation: D1 P0
rs
=
+
g
This equation can be transformed into the constant growth stock valuation model: P0 = D1 rs - g
If a company increases its dividend payout, that raises the numerator of the stock price equation, D1, and that tends to increase the stock price. However, raising the dividend will lower the amount of earnings available for reinvestment, and thus it will lower the growth rate, which will tend to lower the stock price. (Under certain conditions, g = (1-payout)(ROE). If the payout were increase to 100%, or 1.0, then g would drop to zero.) Thus, increasing the dividend payout has two opposing effects on a firm's stock price. Management must then seek to find the payout policy that balances these two forces and thereby maximizes the stock price. a. (1.) What is meant by the term "dividend policy"? Answer: See Chapter 16 Mini Case Show (2.) 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.
DIVIDEND THEORIES
M-M Dividend Irrelevance Theory
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Proposed by Merton Miller and Franco Modigliani, this theory argues that dividend policy has no effect on either the price of a firm's stock or its cost of capital. Firm value, they contended, is determined by basic earning power and business risk. Therefore, a firm's value is based only on fundamental factors, and dividend policy is irrelevant. Bird-In-The-Hand Theory Others, including Myron Gordon, who developed the DCF stock valuation model, disagreed. They argued that investors regard capital gains as being riskier than dividends, hence that a dollar of dividends contributes more to stock price than a dollar of retained earnings. According to this theory, the cost of capital would decrease, and the stock price would increase, dividend as payout is increased. Tax Preference Theory Still others argue that tax factors cause investors to prefer capital gains to dividends, hence to prefer a low dividend payout. First, long-term capital gains are taxed at a lower rate than dividends. In addition, capital gains are not taxed until the gain is realized. Due to the time value of money, taxes paid in the future will have a lower effective cost than those paid today. Finally, if a stock is held until death, no capital gains tax is due at all. Because of these tax advantages, investors should prefer low payout.
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The Theories Conflict
The three theories conflict with one another, so managers get no clear signal from academic theories as to what their dividend payouts should be. There is some truth in each of the theories, so some investors undoubtedly prefer more dividends, some prefer less dividends (and more growth), and others are indifferent. Still, if there are more of one group of investors than the others, then that might lead managers to adopt the majority-held payout policy. Unfortunately, empirical tests have not been able to determine the preferred policy. (3.) What do the three theories indicate regarding the actions management should take with respect to dividend policy? Answer: See Chapter 16 Mini Case Show (4.) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend policy? b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on dividend policy. Answer: See Chapter 16 Mini Case Show
ESTABLISHING DIVIDEND POLICY IN PRACTICE The optimal payout ratio for a firm is a function of four factors. (1) Investors' preferences for dividends versus capital gains. (2) The firm's investment opportunities. (3) Its target capital structure. And (4), the availability and cost of external capital. The last three elements can be combined into what has become the residual dividend model. Within the residual dividend model, firms must determine the optimal capital budget, determine the amount of equity needed to fund the capital budget (based upon the target capital structure), use retained earnings to meet equity requirements whenever possible, and pay dividends only if more earnings are available than are needed for dividends. The residual dividend model can be expressed as: Dividends = Net Income - [(Target equity ratio) * (Total capital budget)] PROBLEM 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. Net Income Target equity ratio Total capital budget Dividends = = = Resulting Payout = $600,000 60% $800,000 Net Income - [(Target equity ratio) * (Total capital budget)] $600,000 60% * $800,000 $120,000 20.0%
(2.) What if Net Income dropped to $400,00? A rise to $800,000 Net Income Dividends = $800,000 Net Income - [(Target equity ratio) * (Total capital budget)]
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= = Resulting Payout =
$800,000 $320,000 40.0%
-
60%
*
$800,000
(2.) In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy? Answer: See Chapter 16 Mini Case Show
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