DISTRIBUTION POLICY

DISTRIBUTION POLICY
Technology Inc. is a 5-year old company founded by Jim Hunt and David Smith to exploit technology used to develop and manufacture miniature microwave
frequency directional transmitters and receivers for use in mobile Internet and communications applications. The technology, although highly-advanced, is relatively
inexpensive to implement and their patented manufacturing techniques require little capital in comparison to many electronics fabrication ventures. Because of the low
capital requirement, Hunt and Smith 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, Technology Inc. must now access outside equity capital to fund its growth and Hunt and Smith have decided to take the company public. Until now,
they 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 Morgan and Associates, which has been retained to help Technology Inc. prepare for its public offering, has asked you to make a
presentation to Hunt and Smith in which you review the theory of dividend policy and discuss the following issues.

Distributions

1) What is meant by the term “distribution policy”?
2) How have dividend payouts versus stock repurchases changed over time?

Dividends

1) The terms “irrelevance,” “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.
a) Explain what these terms mean, and briefly describe each theory.
b) What do the three theories indicate regarding the actions management should take with respect to dividend payout?
c) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?
2) Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on distribution policy.
3) Residual dividend theory
a) Assume that Technology Inc. has a $100.0 million capital budget planned for the coming year. You have determined its present capital structure (70% equity and
30% debt) is optimal, and its net income is forecasted at $120 million. Use the residual distribution model approach to determine total dollar distribution. Assume for
now that the distribution is in the form of a dividend and 100 million shares are 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 $60 million? To increase to $140 million?
b) In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
c) What are the advantages and disadvantages of the residual policy? (Hint: don’t neglect signaling and clientele effects.)
d) Describe the series of steps that most firms take in setting dividend policy in practice.

Stock Repurchase

1) What is a stock repurchase? Describe the procedures a company follows when it make a distribution through a stock repurchase.
2) Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.

Stock dividends and stock splits

1) What are stock dividends and stock splits?
2) What are the advantages and disadvantages of stock dividends and stock splits?
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