Southeastern Steel Company

Case

Submitted To: Submitted By:

Dr. Suveera Gill Anmol Verma

Ekta Aggarval

Kanav Dosajh

Kinshuk Gupta

Nitesh Das

Tanya Trikha

Sakshi Wali

Southeastern Steel Company Case Facts

• Southeastern steel company (SSC) was formed 5 years ago to exploit a New continuous-casting process.

• SSC’s founders, Donald Brown and 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.

• One advantage of the new process was that it required relatively little capital in comparison with the typical Steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they own all of the shares.

• However, SSC has now reached the stage where 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.

Case Facts

• Therefore, Brown And Valencia have decided to take the

company public. Until now, 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.

• However, before talking with potential outside Investors, they

must decide on a dividend policy.

• Now as a part of Pierce Westerfield Carney (PWC) a national

consulting firm, we will review the theory of dividend policy

and Discuss the following questions.

A1.What is meant by the term Distribution Policy?

• Distribution policy is defined as the firm’s policy with regard

to paying out earnings as dividends versus retaining them for

reinvestment in the firm.

• Distribution policy involves:-

– How much free cash flow should be passed to

shareholders?

– How should cash be provided to the shareholders- Raising

Dividend OR Repurchasing Stock?

– Maintain a stable payment policy OR let the payments vary

as conditions change?

A2. The terms “irrelevance,” “bird-in-the-hand,” and “tax

preference” 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.

DIVIDEND IRRELEVANCE

• MM argued that the firm’s value is determined only by its

earning power and is not influenced by the manner in which

earnings are split between dividends and retained earnings.

• Investors can affect their return on a stock regardless of the

stock's dividend:-

– If a company's dividend is too small, an investor could sell

some of the company's stock to replicate the cash flow he

expected.

A2.Contd……

– If a company's dividend is too big, then the investor could buy more stock with the dividend that is over the investor's expectations.

• Dividend is Irrelevant to investors…

BIRD-IN-THE-HAND THEORY

• Myron Gordon and John Lintner, 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 dividends.

• Investors would regard a firm with a high payout ratio as being less risky and higher value than one with a low payout ratio, all other things equal.

A2.Contd…..

TAX PREFERENCE

• The tax preference theory recognizes that there are three tax-

related reasons for believing that investors might prefer a low

dividend payout to a high payout:-

– Long-term capital gains are taxed at a lower rate as

compared to dividend income.

– Taxes are not paid on capital gains until the stock is sold.

So, investors can control when capital gains are realized.

– 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.

A3. WHAT DO THE THREE THEORIES INDICATE

REGARDING THE ACTIONS MANAGEMENT

SHOULD TAKE WITH RESPECT TO DIVIDEND

POLICY?

• If the dividend irrelevance theory is correct, then Dividend

policy is of no consequence, and the firm may pursue any

Dividend policy.

• 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.

A4. WHAT RESULTS HAVE EMPIRICAL STUDIES OF

THE DIVIDEND THEORIES PRODUCED? HOW DOES

ALL THIS AFFECT WHAT WE CAN TELL MANAGERS

ABOUT DIVIDEND POLICY?

Unfortunately, empirical tests of the dividend 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.

B1. WHAT’S THE “INFORMATION CONTENT,” OR

“SIGNALING,” HYPOTHESIS?

• According to the dividend signalling hypothesis, dividend change announcements trigger share returns because they convey information about management’s assessment on firms’ future prospects.

• Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future.

• Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

SIGNALS

• A LARGER-THAN-NORMAL DIVIDEND INCREASE

“SIGNALS” THAT MANAGEMENT BELIEVES THE

FUTURE IS BRIGHT.

• A SMALLER-THAN-EXPECTED INCREASE, OR A

DIVIDEND CUT, IS A NEGATIVE SIGNAL .

• IF DIVIDENDS ARE INCREASED BY A “NORMAL”

AMOUNT, THIS IS A NEUTRAL SIGNAL.

EMPIRICAL EVIDENCES

• In Favor:-

Pettit (1972, 1976) Aharony and Swary (1980)

Asquith and Mullins (1983)

Benesh, Keown and Pinkerton (1984) Dhillon and Johnson (1994) Lee and Ryan (2000, 2002)

Lippert, Nixon and Pilotte (2000)

Travlos, Trigeorgis and Vafaes (2001) Madjosz and Mestel (2003) Yilmaz and Gulay (2006)

EMPIRICAL EVIDENCES

• In Opposition:-

Lang and Litzenberger (1989)

Benartzi, Michaely and Thaler (1997)

Conroy, Eades and Harris (2000)

Chen, Firth and Gao (2002)

Abeyratna and Power (2002)

SUGGESTION

• Managerial communication to investors about the reasons for

the dividend cut, supported by managerial reputation effects,

may mitigate this problem.

• Richard Fairchild, (2010) "Dividend policy, signalling and free

cash flow: an integrated approach", Managerial Finance, Vol.

36 Iss: 5, pp.394 - 413

B2.Discuss The “CLIENTELE EFFECT”

• Different groups of investors, or clienteles, prefer different dividend policies.

• Firm’s past dividend policy determines its current clientele of investors.

• Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

• Result – Firm’s get stuck with their dividend distribution policies!

B3. Discuss their effects on Distribution Policy

SIGNALLING EFFECT

• A firm may need to cut dividends in order to invest in a new

value-creating project

• But the firm will be punished by the market, since investors

are behaviourally conditioned to believe that dividend cuts are

bad news!

• Thus, firms need to guard against the set patterns of Signaling

Effects, and hence are, in a way, forced to maintain dividend

levels.

B3. Effects on Distribution Policy(contd…..)

• Different client categories have different dividend preferences.

– Investors in their peak earnings years who are in high tax

brackets and who have no need for current cash income

should prefer low-payout stocks.

– retirees, pension funds, and university endowment funds

are in a low (or zero) tax bracket, and they have a need for

current cash income. therefore, this group of stockholders

might prefer high-payout stocks.

• A change in dividend policy must consider

– The clientele composition

– The ease of adjustment for the clientele

C1. 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, net

income forecasted is $600,000. use residual distribution model

approach to determine SSC’S total dollar distribution. Then,

explain what would happen if net income were forecasted at

$400,000 or at $800,000.

• To establish target distribution ratio, steps:

I. Determining the optimal capital budget

II. Determine the amount of equity needed to finance the budget

III. Uses reinvested earnings to meet equity requirements

IV. Pays dividends or repurchases stocks only if more earnings

are available

C1.Contd…..

• Of the $800,000 required for the capital budget,0.6($800,000) = $480,000 must be raised as equity

• If net income exceeds the amount of equity the company needs, then it should pay the residual amount out in dividends.

• Since $600,000 of earnings is available, and only $480,000 is needed, the residual is $600,000 - $480,000 = $120,000,

• So this is the amount that should be paid out as dividends.

• The payout ratio would be $120,000/$600,000 = 0.20 = 20%.

C1.Contd….

• If only $400,000 of earnings were available, the firm would

still need $480,000 of equity. It should then retain all of its

earnings

• And also sell $80,000 of new stock.

• If $800,000 of earnings were available, the dividend would be

Increased to $800,000 - $480,000 = $320,000, and the payout

ratio would rise to $320,000/$800,000 = 40%.

C2. In general terms, how would a change in investment

opportunities affect the payout ratio under the residual

distribution policy?

A change in investment opportunities would lead to

an increase (if investment opportunities were good) or a decrease

(if Investment opportunities were not good) in the amount of

equity needed,

Hence in the residual dividend payout.

More need of investment >> More need for retaining

earnings>>Less or Zero Payout Ratio

Less need of investment >> Less need for retaining

earnings>>Higher Payout Ratio

C3. What are the advantages and disadvantages of the

residual policy?

ADVANTAGES

• It reduces to the issues of new stocks and flotation costs

• Helps to set a target payout.

DISADVANTAGES

• Such a policy does not have any specific target clients.

• Signals conflicting with firm’s interests may be sent across.

• The amount payable as dividend fluctuates heavily if this

policy is practiced.

D. What are stock repurchases? Discuss the advantages and

disadvantage of a firm’s repurchasing its own shares.

Stock repurchases: When a firm decides to distribute cash to

stock holders by repurchasing its own stock rather than paying

out cash dividends.

Stock Repurchases can be used:-

1) As an alternative to regular dividends.

2) To dispose excess cash.

3) In connection with capital structure change.

D.Contd…..

Advantages

• Positive signal to the market.

• Stockholder’s choice of paying taxes or retaining shares.

• To avoid adverse stock prices reactions.

• To produce large-scale changes in capital structure.

Disadvantages

• Repurchases could lower stock prices.

• Penalties could be imposed if repurchase was done primarily to save tax on dividends.

• Shareholders may not be fully informed bout the repurchase.

• Firms may end up paying too high for the shares.

E.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:

a) The firm forecasts its annual capital budget and its annual

sales, along with its working capital needs.

b) The target capital structure, presumably the one that minimizes

the WACC while retaining sufficient reserve borrowing

capacity to provide “financing flexibility,” will also be

established.

c) With its capital structure and investment requirements in

mind, the firm can estimate the approximate amount of debt

and equity financing required during each year over the

planning horizon.

E.Contd…..

d) a long-term target payout ratio is then determined, based on

the residual model concept.

e) an actual dollar dividend will be decided upon. The size of

this dividend will reflect

i. the long-run target payout ratio and

ii. the probability that the dividend, once set, will have to

be lowered, or, worse yet, omitted.

If there is a great deal of uncertainty about cash flows and capital

needs, then a relatively low initial dollar dividend will be set, for

this will minimize the probability that the firm will have to either

reduce the dividend or sell new common stock.

F. What are stock dividends and stock splits? What are the

advantages and disadvantages of stock dividends and stock

splits?

Answer:

STOCK DIVIDENS: When it uses a stock dividend, a firm issues new shares

in lieu of paying a cash dividend.

For example: In a 5 percent stock dividend, the holder of 100 shares would

receive an additional 5 shares.

STOCK SPLIT: In a stock split, the number of shares outstanding is

increased (or decreased in a reverse split) in an action unrelated to a

dividend payment.

For example: In a 2-for-1 split, the number of shares outstanding is doubled.

A 100 percent stock dividend and a 2-for-1 stock split would produce the

same effect, but there would be differences in the accounting treatments of

the two actions.

F. Continued…..

Answer:

ADVANTAGES OF STOCK SPLITS AND DIVIDENDS:

Optimal price range exists for stocks. Signal management’s belief that the future is bright.

DISADVANTAGES OF STOCK SPLITS AND DIVIDENDS:

Increase the number of shares outstanding. It is inconvenient to own an odd number of shares. It is hard to come up with a convincing rationale for small stock dividends, like 5 percent

or 10 percent. No economic value is being created or distributed, yet stockholders have to bear the administrative costs of the distribution.

g. WHAT IS A DIVIDEND REINVESTMENT PLAN

(DRIP), AND HOW DOES IT WORK?

• Under a dividend reinvestment plan (drip), shareholders have

the option of automatically reinvesting their Dividends in

shares of the firm’s common stock.

• Shareholders use the drip for 3 reasons:

(1) Brokerage costs are reduced by the volume purchases,

(2) The drip is a convenient way to invest excess funds,

(3) The company generally pays all administrative costs

associated with the operation.

In a new stock plan,

• the firm issues new stock to the drip members in lieu of cash

dividends.

• No fees is charged, and many companies even offer the stock

at a 5 percent discount from the market price on the dividend

date on the grounds.

NOTE:

Only firms that need new equity capital use new stock plans,

while firms with no need for new stock use an open market

purchase plan.

Closing of the case Key points discussed in the case:- • Distribution policy • Signaling hypothesis • Clientele effect • Stock Repurchase • DRIP • Residual Policy • The above parameters are essential and need to be analysed

critically by Brown and Valencia before making a public offering regarding the dividend policy.

• Since this is a new firm, which is likely to focus on growth, it might consider a low payout initially or no payout policy for the first few years.

• Target dividend scheme also might not be too useful for them as they are a new firm, and it involves a careful prediction of next 5 years' working capital and sales forecasts, which this company may not be able to do confidently now.

Any Questions