South eastern steel company-Carol

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Kenyatta University *

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Nov 24, 2024

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SOUTHEASTERN STEEL COMPANY Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous casting process. SSC’s 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 )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 in which outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt. 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. Assume that you were recently hired by Arthur Adamson & Company (AA), a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions. 1. What is meant by the term “dividend policy”? A dividend policy is simply a guideline that a company uses to structure its dividend pay out to shareholders. A dividend policy acts as a guideline for the board of directors when determining whether to issue dividends to its stockholder and how much is to be paid out as dividends. Dividend policies are integral parts of the corporate strategies of most companies. Three types of dividend policies are commonly adopted by companies. The stable dividend policy is the most common since it seeks to make annual dividend payouts steady and predictable. A constant dividend policy on the other hand enables a company to pay only a percentage of its total earnings as dividends every year. This type of policy is subject to volatility but it enables shareholders to experience the full benefits of dividend booms. Thirdly there is the residual dividend policy whereby a company pays as dividends what remains after it has paid for its

capital expenditure and working capital. The choice of what dividend policy to use is mainly a management calling since top executives and directors are the main beneficiaries of a company’s dividends in most cases. 2. The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been used to describe three major theories regarding the way dividend policy affects a firm’s value. Explain what these terms mean, and briefly describe each Theory. Dividend irrelevance refers to the theory that investors are indifferent between dividends and capital gains, making dividend policy irrelevant with regard to its effect on the value of the firm. “Bird-in-the-hand” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value. The theory argues that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends, because new stock will have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly$1.Therefore, according to the theory, stockholders should be indifferent between dividends and capital gains. The “bird-in-the-hand” theory argues 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 a dollar of actual dividends to a dollar of retained earnings. If the bird-in-the- hand theory is true, then investors would regard a firm with a high payout ratio as being less risky than one with a low payout ratio, all other things equal; hence, firms with high payout ratios would have higher values than those with low payout ratios. The theory argues that a firm’s risk is dependent only on the riskiness of its cash flows from assets and its capital structure, not by how its earnings are distributed to investors.

The tax preference theory recognizes that there are two tax-related reasons for believing that investors might prefer a low dividend payout to a high payout:(1) taxes are not paid on capital gains until the stock is sold.(2) 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 stock’s value on the death day as their cost basis and thus escape the capital gains tax. 3. 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 payout is of no consequence, and the firm may pursue any dividend payout. 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 4. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on dividend policy. 1. The information content or signaling hypothesis states that Different groups, or clienteles, of stockholders prefer different dividend payout.. For example, many 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. These investors could, of course, sell some of their stock, but this would be inconvenient, transactions costs would be incurred, and the sale might have to be made in a down market. Conversely, 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.

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2. Clienteles do exist, but the real question is whether there are more members of one clientele than another, which would affect what a change in its dividend policy would do to the demand for the firm's stock. There are also costs (taxes and brokerage) to stockholders who would be forced to switch from one stock to another if a firm changes its policy. Therefore, we cannot say whether a policy change to appeal to one particular clientele or another would lower or raise a firm's cost of equity. One clientele is as good as another, so in their view the existence of clienteles does not imply that one dividend policy is better than another. Still, no one has offered convincing proof that firms can disregard clientele effects. We know that stockholder shifts will occur if policy is changed, and since such shifts result in transaction costs and capital gains taxes, policy changes should not be taken lightly. Further, dividend policy should be changed slowly, rather than abruptly, in order to give stockholders time to adjust. 3. It has long been recognized that the announcement of a dividend increase often results in an increase in the stock price, while an announcement of a dividend cut typically causes the stock price to fall. One could argue that this observation supports the premise that investors prefer dividends to capital gains. Dividend announcements are signals through which management conveys information to investors. Information asymmetries exist--managers know more about their firms' prospects than do investors. Further, managers tend to raise dividends only when they believe that future earnings can comfortably support a higher dividend level, and they cut dividends only as a last resort. Therefore, (1) a larger-than-normal dividend increase "signals" that management believes the future is bright, (2) a smaller-than-expected increase, or a dividend cut, is a negative signal, and (3) if dividends are increased by a "normal" amount, this is a neutral signal.

5) Explain 5 factors which affect dividend policies of firms a. Maintenance of Reserves: Various reserves for different purposes are needed for efficient running of a company. Reserves for — depreciation, working capital, bad debts, dividend equalization, expansion, taxation, debenture redemption, and preference share redemption are very common for a company to keep apart. The surplus is available for dividend. b. Existence of Earned Surplus: A company cannot pay dividends out of capital. Dividend is payable out of current profits or accumulated profits of a company. It can be paid after pro- viding for depreciations as per Companies Act. c. Cash Needs of a Company: Cash position is a big criterion to pay dividend. For a company, cash is needed for various contingencies. They cannot be ignored for the survival of a company. So, dividend policy has to be made after a serious consideration of the cash position of the company. d. Need for Growth and Expansion: A company, quite likely, is brought into being not to remain static. It is to grow and expand. For this, cash flow must exist. Every available amount cannot be spent for payment as dividend to shareholders. That will restrict the scope for its growth and expansion. Many companies follow orthodox dividend policy and provide for liberal ploughing back of profits into the business and these retained earnings are utilized for expansion and growth as a source of internal finance. e. Government Taxation Policy: In these days corporate taxation is a very important factor to take into consideration. Government levies huge amount of taxes on companies to

augment its revenue needs. This means the management is put into difficulty in maintaining stable or high rate of dividend. So, this has to be considered while formulating dividend policy.

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