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Market reacts positively to dividend increases and negatively dividend decreases.

Three explanations are provided for this notion.

i. Information content (signalling) hypothesis,

ii. Free cash flow hypothesis

iii. Clientele effect

Discuss these hypotheses related to dividend policy.

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Elin Hessel
Elin HesselLv2
28 Sep 2019

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Three parts to the question:

1a. When the stock prices changes around the declaration date indicate that important information is contained in its dividend announcements. This would validate the ______________ hypothesis

a. dividend irrelevance

b. bird in hand

c. information content

d. clientele

e. residual dividend policy

1b. Catering theory (or clientel effect)

a. is when firms cater to the preference of its investors

b. is when a firm contracts out for food service for its annual meeting

c. is when a firm refuses to pay a dividend

d. is when a firm pays out "all" of its earnings in dividends

1c. Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?

a. Its earnings become more stable

b. Its access to the capital markets increases

c. Its R&D efforts pay off, and it now has more high-return investment opportunities

d. Its accounts receivable decrease due to a change in its credit policy

e. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages

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. 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 what these terms mean, 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. c. (1) Assume that SSC has completed its IPO and has a $112.5 million capital budget planned for the coming year. You have determined that its present capital structure (80% equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the residual distribution approach to determine SSC’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. Suppose SSC has 100 million shares of stock outstanding. What is the forecasted dividend payout ratio? What is the forecasted dividend per share? What would happen to the payout ratio and DPS if net income were forecasted to decrease to $90 million? To increase to $160 million? (2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual distribution policy? (3) What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling and clientele effects.) d. (1) Describe the procedures a company follows when it make a distribution through dividend payments. (2) What is a stock repurchase? Describe the procedures a company follows when it make a distribution through a stock repurchase. e. Discuss the advantages and disadvantages of a firm repurchasing its own shares.

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. 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 what these terms mean, 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.

c. (1) Assume that SSC has completed its IPO and has a $112.5 million capital budget planned for the coming year. You have determined that its present capital structure (80% equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the residual distribution approach to determine SSC’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. Suppose SSC has 100 million shares of stock outstanding. What is the forecasted dividend payout ratio? What is the forecasted dividend per share? What would happen to the payout ratio and DPS if net income were forecasted to decrease to $90 million? To increase to $160 million? (2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual distribution policy? (3) What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling and clientele effects.)

d. (1) Describe the procedures a company follows when it make a distribution through dividend payments. (2) What is a stock repurchase? Describe the procedures a company follows when it make a distribution through a stock repurchase.

e. Discuss the advantages and disadvantages of a firm repurchasing its own shares.

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