Question

Electronic Timing, Inc. (ETI), is a small company founded 15 years ago by electronics engineers Tom Miller and Jessica Kerr. ETI 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. ETI 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 Tom and Jessica, Nolan Pittman, who provided capital for the company, is the third primary owner. Each owns 25 percent of the 1 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 manufacture, and the ETI design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, ETI determined that the costs involved in building the new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside owner. Instead, ETI 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. Tom 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. Jessica believes the company should use the extra cash to pay off debt and upgrade and expand its existing manufacturing capability. How would Jessica’s proposals affect the company?

3. Nolan favors 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 Tom, Jessica and Nolan 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, ?1 , times 1 minus the retention ratio. The most commonly used equation to calculate the sustainable 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: ?0 = ?1(1−?) ??−???×?
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.

6. Does the question of whether the company should pay a dividend depend on whether the company is organized as a corporation or an LLC?

Answer 1

1)Extra cash to pay one time special dividend : Tom's View -

If a company, here, Electronic Timing, Inc. (ETI) chooses to pay one time special dividend in effect to extra cash realized will impact a company positively as it will hold a optimistic point of view from stakeholders side indicating that the company is performing well.

Company choosing to pay dividend from extra cash uses it's retained earnings to pay the shareholders , that is, the dividend payout ratio. A dividend payment indicates an upward trend and cause the stock prices to go up as more and more interested investors will buy stock in impression of an optimistic notion regarding companies performance.

Thereby , increase in the number of oustanding shares will cause the company's valuation to go up.

2)Extra cash to pay off debt and upgrade and expand its existing manufacturing capability : Jessica's View -

If Electronic Timing, Inc. (ETI) chooses to pay of its debt and upgrade its existing manufacturing capability using the extra cash, it will imact the company in a positive way as it implies optimum utilization of its cash flows for business operations.

This might not directly impact the company's valuation or possibly lead to an increase in stock price but will benefit the company indirectly. Here's how.It might not deem to stakeholders but over the time might prove to be more profitable and cost effective way of using company's extra realized cash.

Firstly, paying of debt keeps company in good credit score and thereby achieving investor confidence which may also impact company's share price positively. Second, expanding its manufacturing capablity might not give results in short term but in long term may prove to be more feasible, cost saving and fetching more profitable outcomes, which will give more profits in books of accounts , increasing company valuation.

3) Share repurchase: Nolan's View -

A share repurchase is where a company buys back its own shares from the market and thereby increases the P/E ratio. Here's how. A company buyng back its own shares may cause the number of outstanding shares to reduce which in turn increases demand for those shares causing the share price to increase due to increased demand, increasing Earning Per Share of the co. thereby increasing price to earning ratio.

A share repurchase causes the number of outstanding shares to reduce and therefore increases return on its assets and equity. Like earlier the co. was paying same amount of  return on its equity to its shareholders, but if the no. of shares reduce the return on equity per share would increase. All this causing a positive impact on comany's valuation.

4) As same in the option 1, regular dividend payment would imact positively on investor sentiment causing the demand for shares to increase in market thereby increasing price per share and keeping the company valuation stable.

5)?0 = ?1(1−?) ??−???×?

Simply put,

After the declaration of a dividend, the share's price often increases. However, because a dividend increases the number of shares outstanding while the value of the company remains stable, it dilutes the book value per common share, and the stock price is reduced accordingly.

After upgrading it's manufacturing capabilty in this case affects the gordon's rowth model as stocks may react positively because the company will not try to issue new shares and dilute current shareholders.

6) A dividend is a payment made to a corporation's owners, called shareholders, from the corporation's profits. Limited liability companies (LLCs) does not pay dividends to their owners. Instead,members of a LLC receive draws and distributions to achieve the same purpose as dividends.