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Managerial Finance

Managerial Finance

 

Problem Set #14

Question 1

Integrated Waveguide Technologies (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 the effects on distribution policy consistent with: (1) the signaling hypothesis (also called the information content hypothesis) and (2) the clientele effect.

 

c.

(1) Assume that IWT has completed its IPO and has a $112.5 million capital bud-get 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 IWT’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. Suppose IWT 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 makes a distribution through dividend payments.

(2) What is a stock repurchase? Describe the procedures a company follows when it makes a distribution through a stock repurchase.

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

f. Suppose IWT has decided to distribute $50 million, which it presently is holding in liquid short-term investments. IWT’s value of operations is estimated to be about $1,937.5 million; it has $387.5 million in debt and zero preferred stock. As mentioned previously, IWT has 100 million shares of stock outstanding.

 

(1) Assume that IWT has not yet made the distribution. What is IWT’s intrinsic value of equity? What is its intrinsic stock price per share?

2) Now suppose that IWT has just made the $50 million distribution in the form of dividends. What is IWT’s intrinsic value of equity? What is its intrinsic stock price per share?

(3) Suppose instead that IWT has just made the $50 million distribution in the form of a stock repurchase. Now what is IWT’s intrinsic value of equity? How many shares did IWT repurchase? How many shares remained outstanding after the repurchase? What is its intrinsic stock price per share after the repurchase?

 

g. Describe the series of steps that most firms take when setting dividend policy.

h. What are stock splits and stock dividends? What are the advantages and disadvantages of each?

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

 

Question 2

Gamut Satellite Inc. produces satellite earth stations that sell for $150,000 each. The firm’s fixed costs, F, are $1.5 million, 20 earth stations are produced and sold each year, profits total $400,000, and the firm’s assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $10 million to assets and $500,000 to fixed operating costs. This change will reduce variable costs per unit by $5,000 and increase output by 30 units. However, the sales price on all units must be lowered to $140,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 18%, and it uses no debt.

 

  1. Determine the variable cost per unit
  2. Determine the new profit if the change is made
  3. What is the incremental profit?
  4. What is the projects expected rate of return for the next year (defined as the incremental profit divided by the investment)?
  5. Should the firm make the investment? Why or why not?
  6. Would the firm’s break-even point increase or decrease if it made the change?
  7. Would the new situation expose the firm to more or less business risk than the old one? Show workings

Submit your answers in a Word document.


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