Infomatic Specialists Inc. (ISI), which develops software for the health care industry, was founded five years ago by Juan Benitez and Peggy Stark, who are still its only stockholders. ISI has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain 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 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 Arturo Anderson & Company (AA), a national accounting firm, which has been asked to help ISI prepare for its public offering. Mattie Millard, the senior AA consultant in your group, has asked you to make a presentation to Benitez and Stark in which you review the theory of dividend policy and discuss 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 regarding the way
dividend policy affects a firm’s value. Explain what these terms mean, and briefly discuss the
relevance of dividend policy.
(3) Explain the relationships between dividend policy and (i) stock price and (ii) the cost of equity
under each dividend policy theory.
b. Discuss (1) the information content, or signaling, hypothesis; (2) the clientele effect; (3) the free cash
flow hypothesis; and (4) their effects on dividend policy.
c. (1) Assume that ISI has an $800,000 capital budget planned for the coming year. You have
determined that its present capital structure (60 percent equity and 40% debt) is optimal, and its
net income is forecasted at $600,000. Use the residual dividend policy approach to determine ISI’s
total dollar dividend and payout ratio. In the process, explain what the residual dividend policy is,
and use a graph to illustrate your answer. Then explain what would happen if net income were forecasted at $400,000, or at $800,000.
(2) In general terms, how would a change in investment opportunities affect the payout ratio under the
residual payment policy?
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(3) What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling
and clientele effects.)
d. What are some other commonly used dividend payment policies? What are their advantages and disadvantages? Which policy is most widely used in practice?
e. What are dividend reinvestment plans (DRIPs), and how do these plans work?
f. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and splits? When should a stock dividend as opposed to a stock split be used?
g. What are stock repurchases, and why are they used? What are the advantages and disadvantages of stock repurchases?