Question

Northeastern 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 (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 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.

3.         What do the three theories indicate regarding the actions management should take with respect to dividend payout?

Answer 1

A company pays dividend to its shareholders so as to give them returns on the capital provided but one should know that, the company is not legally obliged to pay dividend to equity shareholders. Now, when a company pays dividend , it makes the shareholders happy as they receive two kinds of returns -

1. return in form of dividend

2. return in form of growth in share price.

Types of Dividend Policy -

a] Stable Dividend Policy - This policy gives a steady and predictable dividend payout each year irrelevant of the earnings.

b] Constant Dividend Policy - This policy pays a percentage of its earnings as dividends every year which accounts for volatility in the earnings every year.

c] Residual Dividend Policy - This policy pays out the revenue which remains after the company has paid for capital expenditures (CAPEX) and working capital.

In the above scenario , the company has to maintain a debt-equity ratio of 60:40 . Also, the promoters are getting paid reasonably through the salaries. The aim of raising the money through issuing of equity is to achieve the growth targets and exploit a new process which is relatively less costly. In such scenario, it is advisable to go with a residual dividend policy , as the company is new it would be best that the earnings and dividends go hand in hand. It will also benefit the investors as the value of share prce will achieve a better growth rate , resulting in a capital appreciation . Also it takes into account a volatility parameter of a raw company model with a new process.