Electronic Timing, Inc. (ETI), is a small privately-held company founded 15 years ago by electronics engineers Tom Miller and Jessica Kerr. ETI manufactures integrated circuits to capitalize on the complex mixed-signal design technology and has recently entered the market for frequency timing generators, or silicon timing devices, which provide the timing signals or "clocks" necessary to synchronize electronic systems. Its clock products originally were used in PC video graphics applications, but the market subsequently expanded to include motherboards, PC peripheral devices, and other digital consumer electronics, such as digital television boxes and game consoles. ETI also designs and markets custom application-specific integrated circuits (ASICS) for industrial customers. The ASICS's design combines analog and digital, or mixed-signal, technology In addition to Tom and Jessica, Nolan Pittman, who provided capital for the company, is the third primary owner. Each owns 25 percent of the 1 million shares outstanding. Several other individuals, including current employees, own the remaining company shares. In addition to common stock, ETI's capital structure includes long-term, unsecured bank debt that has averaged approximately 30 percent of ETI's estimated "market" value for the past several years Recently, the company designed a new computer motherboard. The company's new design is both more efficient and less expensive to manufacture than the market alternatives, and the ETI design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, ETI determined that the costs involved in building a new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside equity owner, but they had considered employing additional debt financing. Instead of building a new plant, ETI sold the design to an outside firm. The sale of the motherboard design was completed for an after-tax payment of $30 million. Tome, Jessica, and Nolan have discussed several alternatives uses of the $30 million of cash Tom favors using the extra cash to pay a special one-time dividend. Jessica believes that the company should use the extra cash to pay off debt and upgrade and expand its existing manufacturing capability so that it can exploit the future unique opportunities she expects will arise from the ETI's ongoing research activities. Nolan is in favor of a share repurchase perhaps in combination with the use of additional borrowing because those actions will increase the company's PE ratio, return on assets, and return on equity. Tom, Jessica, and Nolan also discussed initiating a regular dividend payment to shareholders: they currently adjust their salaries and bonuses in line with ETI's annual earnings. Other owners have yet to realize a cash return on their investment in the company Tom, Jessica, and Nolan are at an impasse and have hired you to advise them with respect to the best use of the $30 million in cash, (1) ETI's investment, dividend, and capital structure policy, generally (2) They also are concerned that the concentration of equity ownership amongst themselves impedes ETI's ability to fully exploit the opportunities available to it. Although they are quite intelligent, neither Tom, Jessica, nor Nolan has any training in finance Thus, they have asked that you prepare a report and a presentation that includes well- developed and clearly expressed conceptually sound arguments for and against each alternative use of the cash together with a recommendation for the single action to be taken supported by the conceptual arguments. They are particularly interested in obtaining from you a framework they can employ in the future when making seemingly integrated invest ment, financing and distribution decisions for ETI. Finally, they would appreciate your thoughts on the corporate and personal costs and benefits of reducing their ownership stakes/raising new, external equity. Additional information: $8,750,000.00 Latest EBIT Unlevered competitor's equity beta 1.25 Risk free rate 3.5% 21.0% Corporate tax rate Borrowing cost 5.5% Current retention ratio 100.0% Return on reinvested equity 15.5% Potentially useful tidbit: One way to value a share of stock is the dividend growth, or growing perpetuity, model. Consider the following: The dividend payout ratio is 1 minus b, where b is the retention or reinvestment ratio. So, the dividend next year will be the earnings next year, E1, times 1 minus the retention ratio. The most commonly used equation to calculate the sustainable growth rate is the expected return on equity, ROE, times the retention ratio. Substituting these relationships into the dividend growth model, we obtain the following equation to calculate the price of a share of stock today: E1 x (1 b) Po R5 - ROE X b What are the implications of this result in terms of whether the company should pay a dividend or upgrade and expand its manufacturing capability? Explain. Electronic Timing, Inc. (ETI), is a small privately-held company founded 15 years ago by electronics engineers Tom Miller and Jessica Kerr. ETI manufactures integrated circuits to capitalize on the complex mixed-signal design technology and has recently entered the market for frequency timing generators, or silicon timing devices, which provide the timing signals or "clocks" necessary to synchronize electronic systems. Its clock products originally were used in PC video graphics applications, but the market subsequently expanded to include motherboards, PC peripheral devices, and other digital consumer electronics, such as digital television boxes and game consoles. ETI also designs and markets custom application-specific integrated circuits (ASICS) for industrial customers. The ASICS's design combines analog and digital, or mixed-signal, technology In addition to Tom and Jessica, Nolan Pittman, who provided capital for the company, is the third primary owner. Each owns 25 percent of the 1 million shares outstanding. Several other individuals, including current employees, own the remaining company shares. In addition to common stock, ETI's capital structure includes long-term, unsecured bank debt that has averaged approximately 30 percent of ETI's estimated "market" value for the past several years Recently, the company designed a new computer motherboard. The company's new design is both more efficient and less expensive to manufacture than the market alternatives, and the ETI design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, ETI determined that the costs involved in building a new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside equity owner, but they had considered employing additional debt financing. Instead of building a new plant, ETI sold the design to an outside firm. The sale of the motherboard design was completed for an after-tax payment of $30 million. Tome, Jessica, and Nolan have discussed several alternatives uses of the $30 million of cash Tom favors using the extra cash to pay a special one-time dividend. Jessica believes that the company should use the extra cash to pay off debt and upgrade and expand its existing manufacturing capability so that it can exploit the future unique opportunities she expects will arise from the ETI's ongoing research activities. Nolan is in favor of a share repurchase perhaps in combination with the use of additional borrowing because those actions will increase the company's PE ratio, return on assets, and return on equity. Tom, Jessica, and Nolan also discussed initiating a regular dividend payment to shareholders: they currently adjust their salaries and bonuses in line with ETI's annual earnings. Other owners have yet to realize a cash return on their investment in the company Tom, Jessica, and Nolan are at an impasse and have hired you to advise them with respect to the best use of the $30 million in cash, (1) ETI's investment, dividend, and capital structure policy, generally (2) They also are concerned that the concentration of equity ownership amongst themselves impedes ETI's ability to fully exploit the opportunities available to it. Although they are quite intelligent, neither Tom, Jessica, nor Nolan has any training in finance Thus, they have asked that you prepare a report and a presentation that includes well- developed and clearly expressed conceptually sound arguments for and against each alternative use of the cash together with a recommendation for the single action to be taken supported by the conceptual arguments. They are particularly interested in obtaining from you a framework they can employ in the future when making seemingly integrated invest ment, financing and distribution decisions for ETI. Finally, they would appreciate your thoughts on the corporate and personal costs and benefits of reducing their ownership stakes/raising new, external equity. Additional information: $8,750,000.00 Latest EBIT Unlevered competitor's equity beta 1.25 Risk free rate 3.5% 21.0% Corporate tax rate Borrowing cost 5.5% Current retention ratio 100.0% Return on reinvested equity 15.5% Potentially useful tidbit: One way to value a share of stock is the dividend growth, or growing perpetuity, model. Consider the following: The dividend payout ratio is 1 minus b, where b is the retention or reinvestment ratio. So, the dividend next year will be the earnings next year, E1, times 1 minus the retention ratio. The most commonly used equation to calculate the sustainable growth rate is the expected return on equity, ROE, times the retention ratio. Substituting these relationships into the dividend growth model, we obtain the following equation to calculate the price of a share of stock today: E1 x (1 b) Po R5 - ROE X b What are the implications of this result in terms of whether the company should pay a dividend or upgrade and expand its manufacturing capability? Explain