Southeastern Steel Company

Case
Submitted To: Submitted By:
Dr. Suveera Gill Anmol Verma
Ekta Aggarval
Kanav Dosajh
Kinshuk Gupta
Nitesh Das
Tanya Trikha
Sakshi Wali
Southeastern Steel Company Case Facts

Southeastern steel company (SSC) was formed 5 years ago
to exploit a New continuous-casting process.
SSCs founders, Donald Brown and Margo Valencia, 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 Valencia 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 Valencia have been able to avoid
issuing new stock, and thus they own all of the shares.
However, SSC 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.


Case Facts
Therefore, Brown And Valencia have decided to take the
company public. Until now, Brown and Valencia 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.
Now as a part of Pierce Westerfield Carney (PWC) a national
consulting firm, we will review the theory of dividend policy
and Discuss the following questions.

A1.What is meant by the term Distribution Policy?
Distribution policy is defined as the firms policy with regard
to paying out earnings as dividends versus retaining them for
reinvestment in the firm.
Distribution policy involves:-
How much free cash flow should be passed to
shareholders?
How should cash be provided to the shareholders- Raising
Dividend OR Repurchasing Stock?
Maintain a stable payment policy OR let the payments vary
as conditions change?

A2. 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 firms value.
Explain what these terms mean, and briefly describe each
theory.

DIVIDEND IRRELEVANCE
MM argued that the firms value is determined only by its
earning power and is not influenced by the manner in which
earnings are split between dividends and retained earnings.
Investors can affect their return on a stock regardless of the
stock's dividend:-
If a company's dividend is too small, an investor could sell
some of the company's stock to replicate the cash flow he
expected.



A2.Contd
If a company's dividend is too big, then the investor could
buy more stock with the dividend that is over the investor's
expectations.
Dividend is Irrelevant to investors
BIRD-IN-THE-HAND THEORY
Myron Gordon and John Lintner, argued that investors
perceive a dollar of dividends in the hand to be less risky than
a dollar of potential future capital gains in the bush. Hence,
stockholders prefer dividends.
Investors would regard a firm with a high payout ratio as being
less risky and higher value than one with a low payout ratio,
all other things equal.

A2.Contd..
TAX PREFERENCE
The tax preference theory recognizes that there are three tax-
related reasons for believing that investors might prefer a low
dividend payout to a high payout:-
Long-term capital gains are taxed at a lower rate as
compared to dividend income.
Taxes are not paid on capital gains until the stock is sold.
So, investors can control when capital gains are realized.
If a stock is held by someone until he or she dies, no capital
gains tax is due at all-- the beneficiaries who receive the
stock can use the stocks value on the death day as their
cost basis and thus escape the capital gains tax.

A3. WHAT DO THE THREE THEORIES INDICATE
REGARDING THE ACTIONS MANAGEMENT
SHOULD TAKE WITH RESPECT TO DIVIDEND
POLICY?
If the dividend irrelevance theory is correct, then Dividend
policy is of no consequence, and the firm may pursue any
Dividend policy.
If the bird-in-the-hand theory is correct, the firm should set a
high payout if it is to maximize its stock price.
If the Tax preference theory is correct, the firm should set a
low payout if it is to maximize its stock price.
Therefore, the theories are in total conflict with one another.
A4. WHAT RESULTS HAVE EMPIRICAL STUDIES OF
THE DIVIDEND THEORIES PRODUCED? HOW DOES
ALL THIS AFFECT WHAT WE CAN TELL MANAGERS
ABOUT DIVIDEND POLICY?
Unfortunately, empirical tests of the dividend theories have been
inconclusive (because firms dont differ just with respect to
payout), so we cannot tell managers whether investors prefer
dividends or capital gains.

Even though we cannot determine what the optimal dividend
policy is, managers can use the types of analyses discussed in
this chapter to help develop a rational and reasonable, if not
completely optimal, dividend policy.
B1. WHATS THE INFORMATION CONTENT, OR
SIGNALING, HYPOTHESIS?
According to the dividend signalling hypothesis, dividend
change announcements trigger share returns because they
convey information about managements assessment on firms
future prospects.
Managers hate to cut dividends, so wont raise dividends
unless they think raise is sustainable. So, investors view
dividend increases as signals of managements view of the
future.
Therefore, a stock price increase at time of a dividend increase
could reflect higher expectations for future EPS, not a desire
for dividends.

SIGNALS
A LARGER-THAN-NORMAL DIVIDEND INCREASE
SIGNALS THAT MANAGEMENT BELIEVES THE
FUTURE IS BRIGHT.
A SMALLER-THAN-EXPECTED INCREASE, OR A
DIVIDEND CUT, IS A NEGATIVE SIGNAL .
IF DIVIDENDS ARE INCREASED BY A NORMAL
AMOUNT, THIS IS A NEUTRAL SIGNAL.

EMPIRICAL EVIDENCES
In Favor:-
Pettit (1972, 1976)
Aharony and Swary (1980)
Asquith and Mullins (1983)
Benesh, Keown and Pinkerton (1984)
Dhillon and Johnson (1994)
Lee and Ryan (2000, 2002)
Lippert, Nixon and Pilotte (2000)
Travlos, Trigeorgis and Vafaes (2001)
Madjosz and Mestel (2003)
Yilmaz and Gulay (2006)


EMPIRICAL EVIDENCES
In Opposition:-
Lang and Litzenberger (1989)
Benartzi, Michaely and Thaler (1997)
Conroy, Eades and Harris (2000)
Chen, Firth and Gao (2002)
Abeyratna and Power (2002)

SUGGESTION

Managerial communication to investors about the reasons for
the dividend cut, supported by managerial reputation effects,
may mitigate this problem.
Richard Fairchild, (2010) "Dividend policy, signalling and free
cash flow: an integrated approach", Managerial Finance, Vol.
36 Iss: 5, pp.394 - 413

B2.Discuss The CLIENTELE EFFECT
Different groups of investors, or clienteles, prefer different
dividend policies.
Firms past dividend policy determines its current clientele of
investors.
Clientele effects impede changing dividend policy. Taxes &
brokerage costs hurt investors who have to switch companies.
Result Firms get stuck with their dividend distribution
policies!

B3. Discuss their effects on Distribution Policy
SIGNALLING EFFECT
A firm may need to cut dividends in order to invest in a new
value-creating project
But the firm will be punished by the market, since investors
are behaviourally conditioned to believe that dividend cuts are
bad news!
Thus, firms need to guard against the set patterns of Signaling
Effects, and hence are, in a way, forced to maintain dividend
levels.


B3. Effects on Distribution Policy(contd..)
Different client categories have different dividend preferences.
Investors in their peak earnings years who are in high tax
brackets and who have no need for current cash income
should prefer low-payout stocks.
retirees, pension funds, and university endowment funds
are in a low (or zero) tax bracket, and they have a need for
current cash income. therefore, this group of stockholders
might prefer high-payout stocks.
A change in dividend policy must consider
The clientele composition
The ease of adjustment for the clientele

C1. Assume that SSC 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, net
income forecasted is $600,000. use residual distribution model
approach to determine SSCS total dollar distribution. Then,
explain what would happen if net income were forecasted at
$400,000 or at $800,000.

To establish target distribution ratio, steps:
I. Determining the optimal capital budget
II. Determine the amount of equity needed to finance the budget
III. Uses reinvested earnings to meet equity requirements
IV. Pays dividends or repurchases stocks only if more earnings
are available

C1.Contd..
Of the $800,000 required for the capital
budget,0.6($800,000) = $480,000 must be raised as equity
If net income exceeds the amount of equity the company
needs, then it should pay the residual amount out in
dividends.
Since $600,000 of earnings is available, and only
$480,000 is needed, the residual is $600,000 - $480,000 =
$120,000,
So this is the amount that should be paid out as dividends.
The payout ratio would be $120,000/$600,000 = 0.20 =
20%.

C1.Contd.
If only $400,000 of earnings were available, the firm would
still need $480,000 of equity. It should then retain all of its
earnings
And also sell $80,000 of new stock.
If $800,000 of earnings were available, the dividend would be
Increased to $800,000 - $480,000 = $320,000, and the payout
ratio would rise to $320,000/$800,000 = 40%.

C2. In general terms, how would a change in investment
opportunities affect the payout ratio under the residual
distribution policy?
A change in investment opportunities would lead to
an increase (if investment opportunities were good) or a decrease
(if Investment opportunities were not good) in the amount of
equity needed,
Hence in the residual dividend payout.
More need of investment >> More need for retaining
earnings>>Less or Zero Payout Ratio
Less need of investment >> Less need for retaining
earnings>>Higher Payout Ratio

C3. What are the advantages and disadvantages of the
residual policy?


ADVANTAGES
It reduces to the issues of new stocks and flotation costs
Helps to set a target payout.

DISADVANTAGES
Such a policy does not have any specific target clients.
Signals conflicting with firms interests may be sent across.
The amount payable as dividend fluctuates heavily if this
policy is practiced.

D. What are stock repurchases? Discuss the advantages and
disadvantage of a firms repurchasing its own shares.
Stock repurchases: When a firm decides to distribute cash to
stock holders by repurchasing its own stock rather than paying
out cash dividends.

Stock Repurchases can be used:-
1) As an alternative to regular dividends.
2) To dispose excess cash.
3) In connection with capital structure change.


D.Contd..
Advantages
Positive signal to the market.
Stockholders choice of paying taxes or retaining shares.
To avoid adverse stock prices reactions.
To produce large-scale changes in capital structure.
Disadvantages
Repurchases could lower stock prices.
Penalties could be imposed if repurchase was done primarily
to save tax on dividends.
Shareholders may not be fully informed bout the repurchase.
Firms may end up paying too high for the shares.

E.DESCRIBE THE SERIES OF STEPS THAT MOST FIRMS
TAKE IN SETTING DIVIDEND POLICY IN PRACTICE.
Firms establish dividend policy within the framework of their
overall financial plans. the steps in setting policy are listed below:
a) The firm forecasts its annual capital budget and its annual
sales, along with its working capital needs.
b) The target capital structure, presumably the one that minimizes
the WACC while retaining sufficient reserve borrowing
capacity to provide financing flexibility, will also be
established.
c) With its capital structure and investment requirements in
mind, the firm can estimate the approximate amount of debt
and equity financing required during each year over the
planning horizon.

E.Contd..
d) a long-term target payout ratio is then determined, based on
the residual model concept.
e) an actual dollar dividend will be decided upon. The size of
this dividend will reflect
i. the long-run target payout ratio and
ii. the probability that the dividend, once set, will have to
be lowered, or, worse yet, omitted.
If there is a great deal of uncertainty about cash flows and capital
needs, then a relatively low initial dollar dividend will be set, for
this will minimize the probability that the firm will have to either
reduce the dividend or sell new common stock.


F. What are stock dividends and stock splits? What are the
advantages and disadvantages of stock dividends and stock
splits?
Answer:
STOCK DIVIDENS: When it uses a stock dividend, a firm issues new shares
in lieu of paying a cash dividend.
For example: In a 5 percent stock dividend, the holder of 100 shares would
receive an additional 5 shares.
STOCK SPLIT: In a stock split, the number of shares outstanding is
increased (or decreased in a reverse split) in an action unrelated to a
dividend payment.
For example: In a 2-for-1 split, the number of shares outstanding is doubled.

A 100 percent stock dividend and a 2-for-1 stock split would produce the
same effect, but there would be differences in the accounting treatments of
the two actions.
F. Continued..
Answer:
ADVANTAGES OF STOCK SPLITS AND DIVIDENDS:

Optimal price range exists for stocks.

Signal managements belief that the future is bright.

DISADVANTAGES OF STOCK SPLITS AND DIVIDENDS:

Increase the number of shares outstanding.

It is inconvenient to own an odd number of shares.

It is hard to come up with a convincing rationale for small stock dividends, like 5 percent
or 10 percent. No economic value is being created or distributed, yet stockholders have
to bear the administrative costs of the distribution.





g. WHAT IS A DIVIDEND REINVESTMENT PLAN
(DRIP), AND HOW DOES IT WORK?
Under a dividend reinvestment plan (drip), shareholders have
the option of automatically reinvesting their Dividends in
shares of the firms common stock.

Shareholders use the drip for 3 reasons:
(1) Brokerage costs are reduced by the volume purchases,
(2) The drip is a convenient way to invest excess funds,
(3) The company generally pays all administrative costs
associated with the operation.
In a new stock plan,
the firm issues new stock to the drip members in lieu of cash
dividends.
No fees is charged, and many companies even offer the stock
at a 5 percent discount from the market price on the dividend
date on the grounds.
NOTE:
Only firms that need new equity capital use new stock plans,
while firms with no need for new stock use an open market
purchase plan.
Closing of the case
Key points discussed in the case:-
Distribution policy
Signaling hypothesis
Clientele effect
Stock Repurchase
DRIP
Residual Policy
The above parameters are essential and need to be analysed
critically by Brown and Valencia before making a public offering
regarding the dividend policy.
Since this is a new firm, which is likely to focus on growth, it might
consider a low payout initially or no payout policy for the first few
years.
Target dividend scheme also might not be too useful for them as
they are a new firm, and it involves a careful prediction of next 5
years' working capital and sales forecasts, which this company may
not be able to do confidently now.
Any Questions