Mini Case

$(1)$

Mini Case

Central Canada Steel $($CCS$)$ was formed $5$ years ago to exploit a new

continuous$-$casting process. CCS$$s founders, Donald Brown and Margo

Lapointe, 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 Lapointe 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 Lapointe have been able to avoid issuing new stock,

and thus they own all of the shares. However, CCS has now reached the

stage where outside equity capital is necessary if the firm is to achieve its

growth targets yet maintain its target capital structure of $60\%$ equity and

$40\%$ debt. Therefore, Brown and Lapointe have decided to take the company

public. Until now, Brown and Lapointe have paid themselves reasonable

salaries but routinely reinvested all after$-$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 that you were recently hired by Pierce Westerfield Carney $($PWC$),$ a

national consulting firm, which has been asked to help CCS prepare for its

public offering. Martha Millon, the senior PWC consultant in your group,

has asked you to make a presentation to Brown and Lapointe in which you

review the theory of dividend policy and discuss the following questions.

a$.$

$1)$ What is meant by the term $$distribution policy$?$

$2)$ The terms $$irrelevance$,$bird$-$in$-$the$-$hand,$$ and $$tax preference$$

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?

$5)$ How does all this affect what we can tell managers about

dividend payouts?

$6)$ Discuss the information content, or signalling, hypothesis,

the clientele effect, and their effects on distribution policy.

Assume that CCS has an $$800,000$ capital budget planned for the

coming year. You have determined that its present capital structure

$(60\%$ equity and $40\%$ debt$)$ is optimal, and its net income is forecast

at $$600,000.$ Use the residual distribution model approach to

determine CCS$$s total dollar distribution. Assume for now that the

distribution is in the form of a dividend. Then, explain what would

happen if net income were forecast at $$400,000,$ or at $$800,000\mathrm{.}4$

In general terms, how would a change in investment

opportunities affect the payout ratio under the residual distribution

policy?

What are the advantages and disadvantages of the residual

policy? $($Hint: Don$$t neglect signalling and clientele effects.$)$

d$.$ What are stock repurchases? Discuss the advantages and disadvantages

of a firm repurchasing its own shares.

$458$

e$.$ Describe the series of steps that most firms take in setting dividend

policy in practice.

f$.$ What are stock splits and stock dividends? What are the advantages and

disadvantages of stock splits and stock dividends?

g$.$ What is a dividend reinvestment plan $($DRIP$),$ and how does it work?