Kelowna Microchips Inc. (KMI) is a small company founded 15 years ago by electronics engineers Justin Langer and Suzanne Maher. KMI 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. KM also designs and markets custom application specific integrated circuits (ASICs) for industrial customers. The ASIC's design combines analog and digital or mixed-signal technology. In addition to Justin and Suzanne, Andrew Keegan, who provided capital for the company, is the third primary owner. Each owns 25% of the one million shares outstanding. The company has several other individuals, including current employees, who own the remaining shares. Recently, the company designed a new computer motherboard. The company's design is both more efficient and less expensive to manufacture, and the KMI design is expected to bedome standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, KM 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 owner. Instead, KMI sold the design to an outside firm. The sale of the motherboard design was completed for an after-tax payment of $30 million.

1. Justin believes the company should use the extra cash to pay a special one-time dividend. How will this proposal affect the stock price? How will it affect the value of the company?

2. Suzanne believes the company should use the extra cash to pay off debt and upgrade and expand its Page 704 existing manufacturing capability. How would Suzanne's proposals affect the company?

3. Andrew favours a share repurchase. He argues that a repurchase will increase the company's P/E ratio, return on assets, and return on equity. Are his arguments correct? How will a share repurchase affect the value of the company?

4. Another option discussed by Justin, Suzanne, and Andrew would be to begin a regular dividend payment to shareholders. How would you evaluate this proposal?

5. 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 "plowback" ratio. So, the dividend next year will be the earnings next year, E, times 1 minus the retention ratio. The most commonly used equation to calculate the growth rate is the return on equity times the retention ratio. Substituting these relationships into the dividend growth model, we get the following equation to calculate the price of a share of stock today: