Question

Integrated Waveguide Technologies (IWT) is a 6-year-old company founded by Hunt Jackson and David Smithfield to exploit metamaterial plasmonic technology to develop and manufacture miniature microwave frequency directional transmitters and receivers for use in mobile Internet and communications applications. IWT's technology, although highly advanced, is relatively inexpensive to implement, and its patented manufacturing techniques require little capital as compared to many electronics' fabrication ventures. Because of the low capital requirement, Jackson and Smithfield 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 Jackson and Smithfield have decided to take the company public. Until now, Jackson and Smithfield 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 Flick and Associates, which has been retained to prepare for its public offering and has asked you to address the following issues:

a.    (1) What is meant by the term "distribution policy"? How has the mix of dividend payouts and stock repurchases changed over time?

b.    Discuss the effects on distribution policy consistent with: (1) the signaling hypothesis (also called the information content hypothesis) and (2) the clientele effect.

c.    (1) Assume that IWT has completed its IPO and has a $112.5 million capital budget planned for the coming year. You have determined that its present capital structure (80% equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the residual distribution approach to determine IWT's total dollar distribution. Assume for now that the distribution is in the form of a dividend. Suppose IWT has 100 million shares of stock 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 $90 million? To increase to $160 million.

c.    (3) What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect signaling and clientele effects.)

e.   Discuss the advantages and disadvantages of a firm repurchasing its own shares.

Answer 1

a) Distribution policy refers to the division of a company's targeted audience( consumers) into various divisions based on various factors so as to Segment, Target and Position the same good differently for different markets.

There has been a change in the dividend policy in the sense that earlier the company relied on the growth prospects of the firm to ensure capital gains for investors but now they are also interested in paying dividends so as to retain investments.

b)

1) Signalling hypothesis says that actions undertaken by economic agents are mostly done with a view to send positive signals to other economic agents. So the dividend policy will signal the trust and confidence of the promoters in the investors of the company.

2) The clientele effect is tricky because here the perception and demands of investors will affect the price of the security. So the distribution policy must be consistent and investments should be drawn from like minded investors so that it is easier to synchronise their goals with the goals of the company.

e) Advanatges:

• Healthier Capital Structure
• Better earnings for remaining shareholders
• It also generally gives rise to temporarily higher stock prices

Disadvantages:

• A company sometimes finds it difficult to repurchase shares at the current market price
• A share repurchase may sometimes give a signal to investors that current investors are happy to leave their places in the company meaning that the company is no longer a good prospective investment