In: Finance
Kelowna Microchips Inc. Kelowna Microchips Inc. (KMI) is a small company founded 15 years ago by electronics engineers Justin Langer and Suzanne Maher. KMI manufactures integrated circuits to capitalize on the complex mixed-signal design technology and has recently entered the market for frequency timing generators, or silicon timing devices, which provide the timing signals or “clocks” necessary to synchronize electronic systems. Its clock products originally were used in PC video graphics applications, but the market subsequently expanded to include motherboards, PC peripheral devices, and other digital consumer electronics, such as digital television boxes and game consoles. KMI also designs and markets custom application specific integrated circuits (ASICs) for industrial customers. The ASIC's design combines analog and digital or mixed-signal technology. In addition to Justin and Suzanne, Andrew Keegan, who provided capital for the company, is the third primary owner. Each owns 25 percent of the one million shares outstanding. The company has several other individuals, including current employees, who own the remaining shares. Recently, the company designed a new computer motherboard. The company's design is both more efficient and less expensive to manufacture, and the KMI design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, KMI determined that the costs involved in building a new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside owner. Instead, KMI sold the design to an outside firm. The sale of the motherboard design was completed for an after-tax payment of $30 million. QUESTIONS 1. Justin believes the company should use the extra cash to pay a special one-time dividend. How will this proposal affect the stock price? How will it affect the value of the company? 2. Suzanne believes the company should use the extra cash to pay off debt and upgrade and expand its existing manufacturing capability. How would Suzanne's proposals affect the company? 3. Andrew favours a share repurchase. He argues that a repurchase will increase the company's P/E ratio, return on assets, and return on equity. Are his arguments correct? How will a share repurchase affect the value of the company? 4. Another option discussed by Justin, Suzanne, and Andrew would be to begin a regular dividend payment to shareholders. How would you evaluate this proposal? 5. One way to value a share of stock is the dividend growth, or growing perpetuity, model. Consider the following. The dividend payout ratio is 1 minus b, where b is the “retention” or “plowback” ratio. So, the dividend next year will be the earnings next year, E1, times 1 minus the retention ratio. The most commonly used equation to calculate the growth rate is the return on equity times the retention ratio. Substituting these relationships into the dividend growth model, we get the following equation to calculate the price of a share of stock today: Click here for a description of Equation: Mini Case Question 5. where Rs = Expected rate of return What are the implications of this result in terms of whether the company should pay a dividend or upgrade and expand its manufacturing capability? Explain.
1). Kelowna Microchips Inc. needs to be careful on how it dispenses the extra cash as adividend. Issuing the extra cash as a dividend would mean that the shareholderscollectively will probably drop by the same amount because of the transfer of wealthfrom the company to the shareholders individually. Hence, the economic value of thecompany will also decrease.
2). Suzanne's proposal will support an expansionary policy for the company which can resultto a higher growth rate for Kelowna Microchips Inc.. As to the company's dividend policy, not issuing theextra cash as a dividend signals to the market that there are still better and more efficientuses of the cash than using it for dividends
3). Andrew is in favor of a share repurchase. He argues will increase the company's P/Eratio, return on assets, and return on equity. Are his arguments correct? How will a sharerepurchase affect the value of the company?A share repurchase if done correctly should be equivalent to the issuance of a cashdividend with the same amount as regards to effects on shareholders' wealth. The way theshare repurchases should be done in a way that it does not diminish or create shareholderwealth. Hence, Andrew's argument that the company's return and assets and return onequity will increase is not correct. However, the P/E ratio might go upwards for a timeuntil the market corrects it.
4). Another option discussed by Justin, Suzanne, and Andrew would be to begin a regulardividend payment to shareholders. How would you evaluate this proposal?A plan to issue a regular dividend to shareholders is a start in establishing a dividendpayout policy.
A dividend policy signals to the market that the company is making acommitment to its shareholders and hence the company strategies will have to be alignedwith that commitment.Therefore I would evaluate the proposal as regards the company's ability to stick to it. Forexample, it adopts a stable dividend policy - will it be able to have cash to honor suchpolicy year on, year off? Another factor would be does a regular dividend matter to ETI'sshareholders? Or do they prefer a different method of transferring wealth to them asidefrom a cash dividend?
5). The substituted dividend growth model is Dt=Dt-1(1+rb). This equation implies that thefuture dividends of the company are directly related to the amount of earnings it retainsand the rate of return if makes from its investments. However, in order to attain thecompany's targeted rate of return it also needs to retain more of its earnings in thecompany for upgrading or expanding its manufacturing plant rather than using it for cashdividends.In the expansionary phase, the company has to make trade offs - lower dividends forhigher growth.