The Emco Steel Company has experienced a slow (3 percent per year) but steady increase in earnings per share. The firm has consistently paid out an average of 75 percent of each year’s earnings as dividends. The stock market evaluates Emco primarily on the basis of its dividend payout because growth prospects are modest.

Emco’s management presents a proposal to the board of directors that would require the outlay of $50 million to build a new plant in the rapidly expanding Florida market. The expected annual return on the investment in this plant is estimated to be in excess of 30 percent, more than twice the current company average.

To finance this investment, a number of alternatives are being considered. They include the following:

a. Finance the expansion with externally raised equity.

b. Finance the expansion with 50 percent externally generated equity and 50 percent internally generated equity. This alternative would necessitate a dividend cut for this year only.

c. Finance the expansion with a mix of debt and equity similar to their current relative proportions in the capital structure. Under this alternative, dividends would not be cut. Rather, any equity needs in excess of that which could be provided internally would be raised through a sale of new common stock.

Evaluate these various financing alternatives with reference to their effects on the dividend policy and common stock values of the company. P-698