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Petersen & Peterson Company is a 6-year-old company founded by Jackson Peterson

Petersen & Peterson Company is a 6-year-old company founded by Jackson Peterson and Mary Peterson to exploit metamaterial plasmonic technology to develop and manufacture miniature microwave frequency directional transmitters and receivers for use in mobile Internet and communications applications. The technology, although highly advanced, is relatively inexpensive to implement and their patented manufacturing techniques require little capital in comparison to many electronic fabrication ventures. Because of the low capital requirement, Jackson and Mary have been able to avoid issuing new stock and thus own all of the shares. Because of the explosion in demand for its mobile Internet applications, the company must now access outside equity capital to fund its growth and the couples have decided to take the company public. Until now, Jackson and Mary 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. Your supervisor at the consulting firm Ernst Young & Associates, which has been retained to help the company prepare for its initial public offering, has asked you to make a presentation to Jackson and Mary in which you plan to review the theories of dividend policy and discuss capital structure decisions.
a. Explain to the Petersons the term a “distribution policy”?
b. Describe the following theories of dividend payout preferences and how they will affect dividend policy of Peterson & Peterson Company:
i. dividend irrelevance theory
ii. bird-in-the-hand theory
iii. tax effect theory, and
iv. information content hypothesis (signaling theory)
Peterson & Peterson Company plans to undertake a massive capital expansion project next year that will require $10 million investment. The company’s target capital structure consists of 60% debt and 40% equity. Peterson has 1million shares of stock outstanding. If net income next year is
$6 million and the company follows a residual distribution policy with all distributions as dividends, determine the following:
c. the company’s dividend per share for next year
d. the company’s forecasted dividend payout ratio
e. the amount of equity financing and long-term debt needed to finance the project
f. What are the advantages and disadvantages of the company’s residual policy? (Hint: do not neglect signaling and clientele effects.)
g. Peterson Company plans to repurchase some of its own outstanding stock in the future if it sees that its stock price is undervalued in the market and more specially to reorganize its capital structure. Identify three advantages and three disadvantages of stock repurchases.
Boehm Corporation produces satellite earth stations that sell for $150,000 each. The firm’s fixed costs are $1.5 million, 20 earth stations are produced and sold each year. Profits are $400,000 and the firm’s assets (all equity financed) are $5million. Due to technological advances in the industry the firm estimates that it can change its production process by adding $10 million to assets and $500,000 to fixed operating costs. This change will reduce variable costs per unit by $5,000 and increase output by 30 units. However, the sales price on all units must be lowered to $140,000 to permit sales of the additional units. Boehm Corporation has tax carryforwards that render its tax rate zero, its cost of equity is 18% and it has no debt in its capital structure. Thus, the company’s profit is equal to earnings before interest and taxes (EBIT)
h. Determine the company’s variable cost per unit and break-even quantity under the initial plan.
i. Determine the company’s variable cost per unit and break-even quantity under the proposed plan.
j. Would the new proposed plan expose the firm to more or less business risk than the initial plan. Show your work.

Full Answer Section

b. Dividend Payout Theories:

i. Dividend Irrelevance Theory: This theory suggests that dividend policy has no impact on a company's stock price as long as the capital structure (debt-to-equity ratio) remains constant. Investors can achieve the same returns through a combination of stock appreciation and dividends regardless of the payout ratio.
ii. Bird-in-the-Hand Theory: This theory argues that investors, particularly retirees and income-focused individuals, prefer current income over potential capital gains. Companies with predictable and stable dividend payouts are seen as more attractive to these investors.
iii. Tax Effect Theory: This theory highlights the tax implications of dividends. Dividends are typically taxed higher than capital gains for individual investors. Companies with a lower payout ratio allow investors to potentially benefit from lower capital gains tax rates.
iv. Information Content Hypothesis (Signaling Theory): This theory suggests that dividend policy decisions send signals about a company's future prospects. A company consistently increasing dividends might signal strong financial health and growth expectations. Conversely, a sudden dividend cut could signal financial difficulties or limited future investment opportunities.

c. Dividend per Share:

The company follows a residual distribution policy, meaning all earnings after funding necessary investments are paid out as dividends.

Capital expansion requires $10 million.
Target capital structure: 60% debt, 40% equity.
Equity needed: $10 million (total) x 40% = $4 million.
Net income: $6 million.

Dividend per share = (Net income - Equity financing) / Shares outstanding = ($6 million - $4 million) / 1 million shares = $2 per share

d. Forecasted Dividend Payout Ratio:

Dividend payout ratio = Dividends / Net income = ($2/share * 1 million shares) / $6 million = 33.33%

e. Equity and Debt Financing:

The company needs $4 million in equity financing as calculated above.

Debt financing = Total project cost - Equity financing = $10 million - $4 million = $6 million

f. Advantages and Disadvantages of Residual Policy:

Advantages:

Signals confidence in future investment opportunities.
Aligns management and shareholder interests (both benefit from higher profits).

Disadvantages:

May not be suitable for companies needing to retain earnings for growth.
Ignores investor preference for dividends (might not attract income-focused investors).
Can be risky if future earnings fall short of expectations.

Clientèle Effect: A residual policy might attract growth-oriented investors who are comfortable with lower dividends and expect capital appreciation.

Signaling Effect: Consistent residual payouts with increasing earnings could signal strong future prospects.

g. Stock Repurchases:

Advantages:

Increases earnings per share (EPS) by reducing outstanding shares.
Signals management's belief that the stock is undervalued.
Can be a more tax-efficient way to return capital to shareholders compared to dividends.

Disadvantages:

May reduce funds available for investment and growth.
Can be seen as manipulative if the stock price is artificially inflated.
May benefit existing shareholders at the expense of potential investors.

Boehm Corporation: Capital Budgeting Decision

h. Initial Plan:

Variable cost per unit = Total costs - Fixed costs / Units produced = ($400,000 profit + $1.5 million fixed costs) / 20 units = $95,000 / unit
Break-even quantity (BEQ) = Fixed costs / (Price per unit - Variable cost per unit) = $1.5 million / ($150,000 - $95,000) = 15.79 units (round up to 16 units)

i. Proposed Plan:

New variable cost per unit = $95,000 (initial) - $5,000 (reduction) = $90,000/unit
New output = 20 units (initial) + 30 units (increase) = 50 units
New break-even quantity = ($1.5 million + $500,000) fixed costs / ($140,000 - $90,000) = $2 million / $50,

Sample Answer

Peterson & Peterson Company: Capital Structure and Dividend Policy

a. Distribution Policy:

A distribution policy refers to the company's strategy for dividing its profits between dividends paid to shareholders and retained earnings reinvested in the business. It outlines how much of the company's earnings will be distributed as dividends and how much will be kept for future growth.