mini-case-ch18 - Chapter 18 Distributions to Shareholders:...

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Chapter 18 Distributions to Shareholders: Dividends and Repurchases MINI CASE 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 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 & 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 “distribution policy”? Answer: Distribution policy is defined as the firm’s policy with regard to (1) the level of distributions, (2) the form of distributions (dividends or stock repurchases), and (3) the stability of distributions. a. 2. The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain what these terms mean, and briefly describe Mini Case: 18 - 1
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each theory. Answer: 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. “Bird-in-the-hand ” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value. The dividend irrelevance theory was proposed by MM, but they had to make some very restrictive assumptions to “prove” it (zero taxes, no flotation or transactions costs). MM argued that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends, because new stock will have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore, according to MM,
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This note was uploaded on 04/12/2011 for the course ECON 101 taught by Professor Buddin during the Spring '08 term at UCLA.

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mini-case-ch18 - Chapter 18 Distributions to Shareholders:...

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