Question

IWT is a 6-year-old company founded 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, they 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 owners have decided to take the company public. Until now,

the owners 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

help IWT prepare for its public offering, has asked you to make a presentation to the owners

in which you review the theory of dividend policy and discuss 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?

(2) The terms “irrelevance,” “dividend preference” (or “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. Explain these terms, and briefly describe each theory.

Answer 1

a. (1) "Dividend Distribution policy" is a policy laid out by the board of the company that ascertains the principles on the amount of dividends to be paid to the shareholders as well as the principles to be followed on whether the earnings are to be distributed as dividends or are to be retained in the business by re-investing in the company. These principles are laid out in the dividend disribution policy. The current state of the economy has a great influence on the policy perse. Aggressive companies during a favorable economy and market conditions would prefer to re-invest the earnings into the business whereas during dull conditions would consider distributing the earnings as dividends to the shareholders. Such policies shabge over time based on the market conditoins.

(2) A dividend Irrelevance Theory indicates that the act of a company declaring dividends has no relevance or impact on the stock price of the underlying stock. It is mentioned that if the investor is expecting constant cash flows from the company, only a dividend payout need not satisfy the requirement. If dividends are not paid, the investor always has the option to sell a part of his shares to generate the equivalent cash flow. hence a dividend payout would have no relevance ot the underlying stock price or the expectations of the investor. This is popularly known as the MM theory.

In contrast to the irrelevance theory, A dividend preference theory indicates that the shareholders are not sure about a future capital gains by an increase in the underlying share price and hence would want a certainity in the dividends being paid out constantly by the company. Investors who believe in this theory would flock to stocks/companies that pay regular and high dividends.

The Tax effect theory states that investors also do consider the tax treatment of dividends while considering their investment decision. Believers of this theory feel that they would prefer a capital appreciation through increase in share price rather then a hefty dividend pay out since dividends paid out are taxed at a higher percentage than a capital gain through appreciation in the underlying share price. All these theories have an affect on the firm's value since the expectation of the investors is different in each of the theories. The investors would expect an appreciation in the share price (Equity value) by re-investing the earnings back into the business under the first and the third theories while in the second theory (Dividend preference theory), they would intend a part of the earnings of the previous year to be removed out of the business and be paid to the investors as dividends.