Question

In: Accounting

Integrated Waveguide Technologies, Inc. (IWT) is a 6-year-old company founded by Hunt Jackson and David Smithfield...

Integrated Waveguide Technologies, Inc. (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 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.
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.
(3) What do the three theories indicate regarding the actions management should take
with respect to dividend payouts?
(4) What results have empirical studies of the dividend theories produced? How does
all this affect what we can tell managers about dividend payouts?
b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect,
and (3) their effects on distribution policy.

Solutions

Expert Solution

PRESENTATION ON PUBLIC OFFERING

(by Flick and Associates for Flick and Associates)

Facts: Integrated Waveguide Technologies, Inc. (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 communication applications. IWT’s technology, although highly advanced, is relatively inexpensive to implement, and its patented manufacturing techniques requires little capital as compared to many electronic fabrication ventures. Because of the low capital requirement, Jackson and Smithfield has 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 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.

Answer No. a(1)

Distribution policy can be defined as the firm’s policy with regard to following:

(a) The level of distributions;

(b) The form of distributions; and

(c) The stability of distributions.

Answer No. a(2)

Dividend irrelevance refers to the theory that investors are indifferent between dividends and capital gains, making dividend policy irrelevant with regard to its effect on the value of the firm. “Bird-in-the-hand” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value.

The dividend irrelevance theory was proposed by MM, but they had to make some very restrictive assumptions to “prove” it (zero taxes, no flotation or transactions costs). MM argued that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends, because new stock will have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore, according to MM, stockholders should be indifferent between dividends and capital gains.

The “bird-in-the-hand” theory is identified with Myron Gordon and John Lintner, who argued that investors perceive a dollar of dividends in the hand to be less risky than a dollar of potential future capital gains in the bush; hence, stockholders prefer a dollar of actual dividends to a dollar of retained earnings. If the bird-in-the-hand theory is true, then investors would regard a firm with a high payout ratio as being less risky than one with a low payout ratio, all other things equal; hence, firms with high payout ratios would have higher values than those with low payout ratios.

MM opposed the Gordon-Lintner theory, arguing that a firm’s risk is dependent only on the riskiness of its cash flows from assets and its capital structure, not by how its earnings are distributed to investors.

The tax preference theory recognizes that there are two tax-related reasons for believing that investors might prefer a low dividend payout to a high payout:   (1) taxes are not paid on capital gains until the stock is sold. (2) if a stock is held by someone until he or she dies, no capital gains tax is due at all--the beneficiaries who receive the stock can use the stock’s value on the death day as their cost basis and thus escape the capital gains tax.

Answer No. a(3)

If the dividend irrelevance theory is correct, then dividend payout is of no consequence, and the firm may pursue any dividend payout. If the bird-in-the-hand theory is correct, the firm should set a high payout if it is to maximize its stock price. If the tax preference theory is correct, the firm should set a low payout if it is to maximize its stock price. Therefore, the theories are in total conflict with one another.

Answer No. a(4)

Unfortunately, empirical tests of the theories have been inconclusive (because firms don’t differ just with respect to payout), so we cannot tell managers whether investors prefer dividends or capital gains. Even though we cannot determine what the optimal dividend policy is, managers can use the types of analyses discussed in this chapter to help develop a rational and reasonable, if not completely optimal, dividend policy.


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