(1) What is meant by the term “distribution policy”? How have dividend payouts versus 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?
Southeastern Steel Company (SSC) was formed five 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 at which 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. 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 alter-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.
Assume you were recently hired by Pierce Westerfield Carney (PWC), a national consulting firm that has been asked to help SSC prepare for its public offering. Martha Million, the senior PWC consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions.