southeastern steel company dividend policy Financial management

5/24/2018 southeastern steel company dividend policy Financial management

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Jobi C. Cosme

BSA, AY 2013-2014

Mrs. Lilian Bunuan

Professor


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A junior consultant from Arthur Adamson & Company, anational consulting firm, which has been asked to help

Southeastern Steel Company prepare for its public offering.


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Southeastern Steel Company has now reached the stage inwhich outside equity capital is necessary if the firm is to

achieve its growth targets yet still maintain its target capital

structure of 60% equity and 40% debt. Brown and Valencia

have decided to take the company public but before talking

with potential outside investors, they must decide on a

dividend policy.


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Southeastern Steel Companys founders, Donald Brownand Margo Valencia, had been employed in the research

department of a major integrated-steel company; but when

that company decided against using the new process

(which Brown and Valencia had developed), they decided

to strike out on their own.

Brown and Valencia formed SSC 5 years ago while

avoiding issuing new stock and thus they own all of the

shares.


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SSC has now reached the stage in which outside equity

capital is necessary if the firm is to achieve its growth

targets.

And they would still like to maintain its target capital

structure of 60% equity and 40% debt.

Brown and Valencia have paid themselves reasonable

salaries but routinely reinvested all after-tax earnings in the

firm; so dividend policy has not been an issue.


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INTERNAL: Constraints

Income Stability

Managers/Control

EXTERNAL: Cost of selling new

stocks

ShareholderPreferences

Economy

InvestmentOppurtunities

Alternative Activities


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Southeastern Steel Company will undergo an initial public offering, and as

it is their first time in offering their shares of stock to the public, they must

present their companys ability to generate profit the best way possible; asthat is every investors goal, to generate profit; to invise in a firm that would

maximize their wealth.

SCC should use the residual dividend policy, as they are a 5 year

old company which uses a process that they have developed ontheir own.

Though we must assume under this model that investors are

indifferent between dividends and capital gain, most investors

that they would attract would most probably be the risk-tolerantinvestors, the ones who are after growth, capital gain rather than

dividends, as people who prefer dividens or cash in the near

future would steer clear of IPOs as they might find it risky.


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And as the firm is in a phase of growth it might not be

able to declare dividends as they need to pay their other

sources of capital such as debt, though they will be atgreat risk of clientele effect and also with a confusing

signaling effect due to their dividends as as it fluctuates.

The firm will make maximum use of lower-cost retained

earnings, they will minimize the floatation costs that

would result from issuing new stocks.

And using the residual dividend model for a couple of

years would also avoid issuing new stocks to fund futureprojects, that would result in a change in the capital

structure.


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But ideally, SCC should only use the residual dividend

model as a guide to arrive at their target payout ratio for the

long run.

Estimate earnings and investment opportunities, on

average, over the next 5 or so years.

Use this forecasted information to find the averageresidual model amount of dividends (and the payout

ratio) during the planning period.

Set a target payout policy based on the projected data.


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What is meant by the term dividend policy?

Dividend policy is the firms policy when it comes to paying out earnings asdividends or retaining them for reinvestment in the firm.

Explain briefly the dividend irrelevance theory that was put forward by Modigliani

and Miller. What were the key assumptions underlying their theory?

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.


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The key assumptions underlying the dividend irrelevance theory, among other

things,

that no taxes are paid on dividends

that stocks can be bought and sold with no transactions costs

and that everyoneinvestors and managers alikehas the same

information regarding firmsfuture earnings.


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Why do some investors prefer high-dividend-paying stocks, while other investors

prefer stocks that pay low or nonexistent dividends?

Some investors may prefer high-dividend-paying stocks because when a company

has hig payout ratio its stock price would have a high value, and also because

dividens are less risky than capital gain.

And some investors may prefer low-dividend-paying stocks because they want to

avoid incurring transaction costs.

Discuss (1) the information content, or signaling, hypothesis; (2) the clientele effect;

and (3) their effects on dividend policy.

An increase in the dividend is often accompanied by an increase in the stock price,

while a dividend cut generally leads to a stock price decline. One could argue that this

observation supports the premise that investors prefer dividends to capital gains. MM

argued thst a higher-than-expected dividend increa is a signal to investors that

management forcasts good future earnings. And that a dividend reduction, or a smaller-

than-expected increase, is a signal that management forecasts poor future earnings.

Which indicates that the changes in stock price do not demonstrate a preference for

dividends over retained earnings, rather such price changes indicates that dividend

announcements have information content, or signaling, about future earnings.


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Different groups, or clienteles, of stockholders prefer different dividend payout

policies. If a firm retains and reinvests income rather than paying dividends, those

stockholders who need current income will be disadvantaged. The value of their stock

might increase, but they will be forced to go to the trouble and expense of selling off

some of their shares to obtain cash. On the other hand, stockholders who are savingrather than spending dividends favor the low-dividend policy: The less the firm pays

out in dividends, the less these stockholders have to pay in current taxes and the less

trouble and expense they must go through to reinvest their after-tax dividends. All of

this suggests that a clientele effect exists, which means that firms have different

clienteles and that the clienteles have different preferenceshence, that a change individend policy might upset the majority clientele and have a negative effect on the

stocks price. This suggests that a company should follow a stable, dependable

dividend policy so as to avoid upsetting its clientele.

Dividend policy changes should not be taken lightly, as it might upset a firms

clientele, as some may prefer low-dividend policy and others a high-dividend policy, a

firm may have a hard time trying to figure out which clientele they have or which kind of

clientele is more, so a drastic change in dividend policy will hurt a firm. dividend policy

should be changed slowly, rather than abruptly, in order to give stockholders time to

adjust.


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Assume that SSC has an $800,000 capital budget planned for the coming year. You

have determined that its present capital structure (60% equity and 40% debt) is optimal,

and its net income is forecasted at $600,000. Use the residual dividend model approach to

determine SSCs total dollar dividend and payout ratio. In the process, explain how the

residual dividend model works. Then explain what would happen if net income wasforecasted at $400,000 and at $800,000.

First, we need to determine the amount of equity needed to finance the projects.

Required for the capital budget = $800,000

Capital budget from equity: 0.6($800,000) = $480,000Capital budget from debt: 0.4($800,000) = $320,000

Optimal capital structure:

Debt $320,000 40%

Equity 480,000 60%

$800,000 100%


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Residual dividend model, if net income exceeds the amount of equity the company

needsthen it should pay the residual amount out in dividends.

Net Income = $600,000

Residual to be paid out as dividend: $600,000 $480,000 = $120,000

Payout ratio: $120,000/$600,000 = 0.20 = 20%

If Net Income = $400,000

The firm will need to sell $80,000 new stock as the firm still needs $480,000 of capital

budget from equity, and under the residual dividend approach the firm will have to call

for a zero dividend payment.

If Net Income = $800,000

Residual to be paid out as dividend: $800,000 $480,000 = $320,000

Payout ratio: $320,000/$800,000 = 40%


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In general terms, how would a change in investment opportunities affect the payout

ratio under the residual payment policy?

Good investment oppurtunities would lead to an increase in in the amount of equity

needed, and if investment opportunities were not good the result would be a decrease in

the amount of equity needed. If investment opportunities were good then the residual

amount would be smaller than if investment opportunities were bad. So a good

investment oppurtunity would result to a decrease in the payout ratio.

What are the advantages and disadvantages of the residual policy? (Hint: Dont

neglect signaling and clientele effects.)

The advantage of the residual policy is that under it the firm makes maximum use of

lower-cost retained earnings, they will minimize the floatation costs that would result

from issuing new stocks. Also, whatever negative signals are associated with stock issues

would be avoided.

And a disadvantage would be the unstable change in the dividend payments as the

dividends depends on factors such as the capital budget needed from equity and the net

income, and it may also send confusing signals to investors, which we should also consider

the clientele affect.


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What is a dividend reinvestment plan (DRIP), and how does it work?

Dividend reinvestment plan (DRIP), under which stockholders can automatically

reinvest their dividends in the stock of the paying corporation.

There are two types of DRIPs: (1) plans that involve only old, already-outstandingstock and (2) plans that involve newly issued stock. In either case, the stockholder

must pay taxes on the amount of the dividends even though stock rather than cash

is received.

Under an old stock plan, the company gives the money that stockholders who

elect to use the DRIP would have received to a bank, which acts as a trustee. The

bank then uses the money to purchase the corporationsstock on the open market

and allocates the shares purchased to the participating stockholdersaccounts on a

pro rata basis. The transactions costs of buying shares (brokerage costs) are low

because of volume purchases, so these plans benefit small stockholders who do not

need current cash dividends.

A newstockDRIP invests the dividends in newly issued stock; hence, these plans

raise new capital for the firm. No fees are charged to stockholders, and some

companies have offered stock at discounts of 2% to 5% below the actual market

price. The companies offer discounts because they would have incurred flotation

costs if the new stock had been raised through investment bankers.


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Describe the series of steps that most firms take in setting dividend policy in practice.

Firms establish dividend policy within the framework of their overall financial plans.

The steps in setting policy are listed below:

The firm forecasts its annual capital budget and its annual sales, along with itsworking capital needs.

The target capital structure, one that minimizes the WACC while retaining sufficient

reserve borrowing capacity to provide financingflexibility,will also be established.

With its capital structure and investment requirements in mind, the firm can estimatethe approximate amount of debt and equity financing required during each year over

the planning horizon.

A long-term target payout ratio is then determined, based on the residual model

concept. Because of flotation costs and potential negative signaling, the firm will not

want to issue common stock unless this is absolutely necessary. At the same time, due

to the clientele effect, the firm will move cautiously from its past dividend policy, if a

new policy appears to be warranted, and it will move toward any new policy gradually

rather than in one giant step.


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What are stock repurchases? Discuss the advantages and disadvantages of a firmsrepurchasing its own shares.

Stock repurchase is a transaction in which a firm buys back shares of its own stock,thereby decreasing shares outstanding, increasing EPS, and often increasing the stock

price.Advantages of repurchases:

A repurchase announcement may be viewed as a positive signal by the investors thatmanagement believes the shares are undervalued.

The stockholders have a choice when the firm distributes cash by repurchasingstockthey can sell or not sell. With a cash dividend, on the other hand,stockholders must accept a dividend payment and pay the tax. Thus, thosestockholders who need cash can sell back some of their shares, while those who donot want additional cash can simply retain their stock. From a tax standpoint, arepurchase permits both types of stockholders to get what they want.


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Repurchased stock, called treasury stock, can be used later in mergers, whenemployees exercise stock options, when convertible bonds are converted, and whenwarrants are exercised. Treasury stock can also be resold in the open market if thefirm needs cash. Repurchases can remove a large block of stock that is overhangingthe market and keeping the price per share down.

Repurchases can be varied from year to year without giving off adverse signals, whiledividends may not. Dividends are stickyin the short run because managements arereluctant to raise the dividend if the increase cannot be maintained in the futuremanagements dislike cutting cash dividends because of the negative signal a cutgives. Therefore, if excess cash flows are expected to be temporary, managements

may prefer to make distributions as share repurchases rather than to declareincreased cash dividends that cannot be maintained.

Repurchases can be used to produce large-scale changes in capital structure.

Companies that use stock options as an important component of employeecompensation can repurchase shares and then reissue those shares when employees

exercise their options. This avoids having to issue new shares, which dilutesearnings per share.


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Disadvantages of repurchases:

Stockholders may not be indifferent between dividends and capital gains, and the

price of the stock might benefit more from cash dividends than from repurchases.

Cash dividends are generally dependable, but repurchases are not.

The selling stockholders may not be fully aware of all the implications of a

repurchase, or they may not have all the pertinent information about the

corporations present and future activities. This is especially true in situations

where management has good reason to believe that the stock price is well below its

intrinsic value. However, firms generally announce repurchase programs beforeembarking on them to avoid potential stockholder suits.

The corporation may pay too high a price for the repurchased stock, to the

disadvantage of remaining stockholders. If its shares are not actively traded and if

the firm seeks to acquire a relatively large amount of its stock, the price may be bid

above its intrinsic value and then fall after the firm ceases its repurchase

operations.


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What are stock dividends and stock splits? What are the advantages and

disadvantages of stock dividends and stock splits?

A stock dividend, is when a firm issues new shares in lieu of paying a cash dividend.

A stock split is an action taken by a firm to increase the number of shares outstanding,such as doubling the number of shares outstanding by giving each stockholder two

new shares for each one formerly held.

Both stock dividends and stock splits increase the number of shares outstanding and

lower the stocksprice in the market.

Advantage:

On average, the price of a companysstock rises shortly after it announces a stock

split or dividend. One reason that stock splits and stock dividends may lead to

higher prices is that investors often take stock splits/dividends as signals of higher

future earnings. Because only companies whose managements believe that things

look good tend to


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split their stocks, the announcement of a stock split is taken as a signal that earnings

and cash dividends are likely to rise. Thus, the price increases associated with stock

splits/dividends may be the result of a favorable signal for earnings and dividends.

Small investors will be more inclined to purchase stocks as the price have been

reduced.

By creating more shares and lowering the stock price, stock splits may also

increase the stocksliquidity. This tends to increase the firmsvalue.

Disadvantage:

When small stock dividends are declared, like 5% or 10%. No economic value isbeing created or distributed; yet stockholders have to bear the administrative costs ofthe distribution.

it is inconvenient to own an odd number of shares as may result after a small stockdividend.


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Reference(s):

Fundamentals of Financial Management 12th edition - Brigham Houstonhttp://wiki.fool.com/Key_Factors_That_Influence_Dividend_Policies

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southeastern steel company dividend policy Financial management