Infomatic Specialists Inc. (ISI), which develops software for the healthcare industry, was founded five years ago by Juan Benitez and Peggy Stark, who are still its sole shareholders. ISI has now reached the stage where external capital is necessary for the company to achieve its growth objectives while maintaining its target capital structure of 60% equity and 40% debt. Therefore, Benitez and Stark have decided to take the company public. Until now, Benitez and Stark have paid themselves reasonable salaries, but they have routinely reinvested all after-tax profits into the company, so dividend policy hasn't been an issue. However, before talking to potential outside investors, they should decide on a dividend policy. Let's say you were recently hired by Arturo Anderson & Company (AA), a national accounting firm, which was asked to help ISI prepare for its public offering. Mattie Millard, the lead AA consultant in his group, has asked him to give a presentation to Benitez and Stark in which he reviews the theory of dividend policy and discusses the following questions:

a.

(1) What is meant by the term dividend policy?

(2) The terms irrelevance and relevance have been used to describe theories about how dividend policy affects the value of a company. Explain what these terms mean and briefly discuss the relevance of dividend policy

(3) Explain the relationships between dividend policy and (i) share price and (ii) cost of capital in each theory of dividend policy.

To discuss

(1) the content of the information, or the indication, the hypothesis;

(2) the clientele effect;

(3) the free cash flow hypothesis; and

(4) its effects on dividend policy.