The Theory of Dividend Policy, Residual Policy, and the Stock Repurchase
IW Technologies (IWT) is a 6-year old company founded by Harold Jacksen and Donald Smith to exploit metamaterial plasmonic technology 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, J&S 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 J&S have decided to take the company public. Until now, J&S 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 FLT 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.
Discuss (1) the clientele effect, (2) the information content, or signaling, hypothesis, and (3) their effects on dividend policy.
Assume that IWT has a $112.5 million capital budget planned for the coming year. You have determined its present capital structure (80% equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the residual distribution model approach to determine IWT’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. IWT has 100 million shares. 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?
What would happen to the payout ratio and DPS if net income were forecasted to increase to $160 million?
In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect signaling and clientele effects.
Describe the procedures a company follows when it makes a distribution through dividend payments.
What is a stock repurchase? Describe the procedures a company follows when it makes a distribution through a stock repurchase.
What are stock repurchases? Discuss the advantages and disadvantages of a firm's repurchasing its own shares.
Suppose IWT has decided to distribute $50 million, which it presently is holding in very liquid short-term investments. IWT’s value of operations is estimated to be about $1,937.5 million. IWT has $387.5 million in debt (it has no preferred stock). As mentioned previously, IWT has 100 million shares of stock outstanding.
Assume that IWT has not yet made the distribution. What is IWT’s intrinsic value of equity? What is its intrinsic per share stock price?
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 per share stock price?
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 per share stock price after the repurchase?
Your paper must meet the following requirements:
Be approximately 4-6 pages in length, not including the cover page and reference page.
Be sure to follow the CSU-Global Guide to Writing and APA. Each paper should include an introduction, a body with at least two fully developed paragraphs, and a conclusion.
Your paper must be clearly and well written using excellent grammar and style techniques. If you need assistance with your writing style, start with Tools for Effective Writing at the CSU-Global Library, accessible from the library’s homepage.
Refer to the Portfolio Project grading rubric available in the Module 8 Folder for information on grading details.
The Dividend Policy
Name
Institutional Affiliation
The Dividend Policy
Ozuomba (2016) defines dividend policy as the policy that a firm uses to distribute its wealth among shareholders in proportion of their ownership. In corporate finance, every firm intending to introduce dividend policy has to consider the impact of the policy on stakeholders. Stakeholders play a crucial role in the success of the firm. The expectation of the stakeholders is that the policy will maximize their wealth. The expectation of the firm is that the policy will attract investors and increase the company’s wealth. This conflict in expectations creates a need for the J&S company to consider several factors in relation to the dividend policy before introducing one.
The Clientele Effect
This theory is used to explain how the company will be impacted by the introduction of a dividend policy. Investors will either make a response that will increase the wealth of the firm or reduce its wealth once a dividend policy has been introduced. J&S should understand that some investors would only invest in the company if the company promises high dividends. Other investors are only interested in the future of the company, especially if the firm has potential for growth. If the company introduces a dividend policy that pays little dividends, current shareholders are likely to sell their stocks and invest in a company that promises higher returns. High dividends will make potential investors to increase their shares in the firm, leading to an increase in its share price.
The Information Content of Dividends
The securities of a firm are likely to increase or decrease based on the information that is released to the public. Information about expanding the business investment programs or introducing higher dividend policies is likely to attract many investors to the firm compared to news about the arrest of a firm’s top manager. As a result, the J&S should take advantage of information content before going public.
Dividend Signaling
This theory holds that an announcement about introduction of dividend is a signal to the public that the firm has a bright future and hence the target for investment. A company that has not been paying dividends will attract investors once it announces that it is going public. Additionally, an announcement about an increase in dividend payout will also attract investors to the firm, hence increase its share price.
Computations on Dividends
What would happen if the payout ratio and DPS were forecasted to decrease to $90 million
What would happen if the payout ratio and DPS were forecasted to increase to $160 million
How a Change in the Investment Opportunities Affects Dividend under the Residual Policy
An increase in investment opportunities leads to a lower dividend payout. A decrease in investment opportunities reduces capital budget, implying that a firm has enough money for dividend payout.
Advantages and Disadvantages of Residual Policy