Integrated Waveguide Technologies Preparing for a Public Offering

Introduction

Distribution policy is a set of principle stipulating the guidelines for cash dividends payout to the shareholders and stock repurchases. Dividends mean the company's earnings distributed to the stockholders declared during the year, interim dividends, or at the end of a financial year referred to as the final dividend. Dividends account as a source of income for the investors but also have an information signaling effect. Therefore, a dividend distribution is informing the management of the earnings to allocate as dividends and contribute to sharing purchase investment decisions. Dividend distribution policy is informed by multiple factors such as financial flexibility, investment opportunities for the company, tax consideration, contractual and legal restrictions, the volatility of expected future earnings, and flotation costs (Baker & Weigand, 2015).
Dividends may be distributed in the form of stock repurchases or cash dividends. Cash dividends offer investors a stream of income. Stock repurchases entail the buyback of a firm shares. Stock repurchases are employed as a strategy for managing a company's real earnings. Moreover, the stock repurchases have an inverse relationship with the EPS. The dividend distribution policy ought to be stable to ensure investor confidence. Therefore, management faces the tradeoff of adopting a capital budgeting decision to lower dividends and use the resources for new investment, which potentially decreases the stock prices or the undertake borrowing to pay dividends that result in a stock price increase (Travlos et al., 2001).
According to Farre-Mensa et al. (2014), the stock repurchases have replaced cash dividend payouts as the prime distributor of a firm's earnings. Skinner (2007) observes that over the decades, the earnings and payout have evolved, yielding three principal categories of firms; firms that make regular stock repurchases and pay dividends, firms that undertake regular stock repurchases, and firms that undertake occasional repurchases with firms that pay dividends exclusively are largely becoming extinct. Stock repurchases have been identified to boost earnings per share, a tax-efficient approach of returning excess capital to investors since the stock repurchases incur capital gains tax. In contrast, the dividend income is taxed as ordinary income. Stock repurchases signal a stock undervaluation, which enables the managers not to pursue unsustainable firm growth, which potentially impacts the long-term profitability and value of the firms negatively (Farre-Mensa et al., 2014).
Dividend Policy Theories
Dividend policy literature has produced a diversified theoretical foundation with foundations on the concept of dividend relevance, capital gains, and the tax and transaction cost indifference (Baker & Weigand, 2015). According to Mohanasundari & Vidhya (2016), the founding theories are premised on the correlation between dividend payment and firm value.
Dividend irrelevance theory
The Modigliani- Miller (MM) dividend irrelevance theory contends that a firm's value is independent of the dividend policy; hence a company's declaration of dividends has no adverse effect on the stock prices. Modigliani and Miller posit that a firm's value is determined by the basic earning power and its business risk instead of the pattern of income distribution between retained earnings and dividends. The theory is premised on the assumption that firms operate on the perfect capital market of the absence of transaction costs and capital gain taxes (Al-Malkawi et al., 2010). Systematic analysis of the literature by Mohanasundari & Vidhya (2016) identifies that the MM dividend irrelevance theory is founded on a perfect capital market concept while, in reality, markets are imperfect. Empirical analysis by Black & Scholes (2010) of a portfolio of 25 common stock listed on the New York Stock Exchange identified no causal relationship between dividend yield and stock returns, which are consistent with the dividend irrelevance theory. However, subsequent empirical analysis has demonstrated a positive relationship between stock prices and dividend policy, with stock prices rising with the cash dividend (Travlos et al., 2001).
Dividend preference theory/Bird-in-Hand Theory
Myron Gordon (1963) and John Litter (1964) proposed that the dividend preference theory posits that investors are risk-averse and indifferent between capital gains tomorrow and dividends today. Consequently, investors prefer stocks characterized by high and stable dividend payout as opposed to future uncertain capital gains. Founded on the argument "one bird in the hand is better than two birds in the bush," the theory contends that dividend payouts reduce the risk of uncertainty about a firm's performance. According to the theory, investors' high preference for companies that pay higher dividends drives down the cost of capital while driving the company's share price; hence, higher dividend payouts maximizes a firm's value. The theory critics argue that operating cashflows riskiness determines a firm's risk instead of the firm's approach in the distribution of its earnings. The critics further argue that the firm's riskiness determines the dividend policy, contrary to the dividend preference hypothesis (Al-Malkawi et al., 2010).
Tax Preference Theory
The tax preference theory posits that some class of investors has a preference for long-term capital gains over the current dividend yield. Such an investor's preference is to invest in stocks by firms that invest their earnings into capital-appreciating projects instead of the distribution of the earnings in dividends. The theory is founded based on taxation of unfavorable dividend income and the time value of money. The theory holds that a dollar of dividends paid today attracts tax liability immediately, while a dollar capital gain to be earned in the future entails deferring the tax liability. This implies that the capital gain has a lower tax-adjusted cost compared to a dividend gain. Moreover, intergenerational transfer of capital gains attracts zero tax; hence long-term capital gains become favorable compared to current dividend payments (Al-Malkawi et al., 2010).
Clientele effect, the information content, or signaling, hypothesis, and their effects on dividend policy.
Clientele effect,
The M&M theory contends that market imperfections such as the differential taxes and transaction cost influence investor decisions, who prefer stocks that reduce the taxes and transactional cost resulting in the "dividend clientele effect." Accordingly, the firm's dividend policy determines the type of clientele a stock attracts with the transaction cost differential resulting in transaction cost minimization induced clientele while the tax differential resulting in tax minimization induced Institutional clientele charters that require prudence results to institution clientele that is being attracted to dividend-paying stocks. On the other hand, good quality firms pay dividends to attract institutional investors since they are more informed and able to monitor a firm's operations than individual investors (Al-Malkawi et al., 2010).
Signaling Hypothesis
The signaling hypothesis is founded on the proposition that a firm's performance. It prospects information asymmetry in the firm's performance, with insiders (directors and managers) privy to the firm's prospects, information the outsiders (stockholders) don't sufficiently have. The dividend payout Payment of higher dividends sends a positive signal to the investors that the management expected good sustainable future earnings. In contrast, lower or omission of dividends sends a negative signal of prospective poor future performance. Therefore, investors' reaction to dividend announcement signals the investor's understanding of the company's current and prospective performance and not the investor's preference for dividends over capital gains. Hence the share performance my not always be a measure of the firm's value (Al-Malkawi et al., 2010).
Computations
Question 4: Dividend Payout Ratio and Dividend Per Share
· Of the $112.5 million capital budget, 0.8 (112.5 million) = $90 million must be equity to keep at target capital structure. [0.2($112.5 million) = $22.5 million will be debt.
· With $140Million of net income, the residual is $140 – $90 = $50million = dividends paid.
· Dividend payout ratio = $50Million/$140Million = 0.357 = 35.7%
· Dividend Per Share = $50Million/100Million = $0.50 per share.
Question 3: Dividend Payout Ratio and Dividend Per Share
· With $90 of net income, the residual is $90– $90 = $0
· Implication: No dividend payout.
Question 4: Dividend Payout Ratio and Dividend Per Share
· With $160 Million of net income, the residual is $160– $90 = $70million = dividends paid.
· Dividend payout ratio = $70Million/$140Million = 0.5 = 50%
· Dividend Per Share = $70Million/100 million = $.70 Per share.
Question 5: Investment Opportunities Implication on Dividend Payout Ratio
· Under a residual policy, the availability of fewer good investment opportunities would result in a smaller capital budget and a higher dividend payout, while good, more good investment opportunities would lower dividend payout.
Question 6: Advantages and Disadvantages of a Residual Policy
A residual policy minimizes new stock issues, minimizing flotation cost on the one hand but is characterized by unstable dividends that have conflicting signals to investors, hence has no appeal to a particular clientele. Consequently, managers ought to adopt and consider the residual policy to inform the long-run instead of the short-run target payout ratio.
Question 7: Setting a Dividend Policy
Setting a dividend payment strategy entails several procedures, including:
· Forecasting capital requirements over the planning horizon typically five years
· Setting a target capital structure
· Estimating the annual equity requirements
· Establish the target dividend payout using the residual model
· Dividend growth rates are inherent, implying the firm ought to maintain the target growth, which could be achieved by revising the capital structure when inevitable.
Question 8: Stock Repurchase
Stock repurchases mean the buying of a firm's stock from the stockholders. Stock repurchases are adopted as large capital restricting strategy, alternative means of distribution of earnings as opposed dividends, or as a means of disposal of one-time cash earned from the sale of an asset.
Question 9: Advantages and Disadvantages of Stock Repurchases
A fundamental advantage of stock repurchases is that firms can avoid setting unsustainable dividends. Repurchased stocks are conveniently resold to raise capital. Distribution of excess cash through stock repurchase enables the reduction of agency costs. The stock repurchase is conceived as a management signal to the investors that the stock is overvalued, implying that the stock prices will increase. A stock repurchase implies that investors earn capital gains with lesser tax liability than dividends that have a higher tax liability. Moreover, stock repurchase is voluntarily implying that the stockholder could choose to or not to resell the stock, but cash dividends are obligatory.
Firm would need to bid higher than the prevailing stock price to attract a complete repurchase, hence higher cost implication. Firms would risk penalty imposition by The Internal Revenue Service (IRS) if the stock repurchases were a tax avoidance strategy. The stockholder's risk being unfairly treated due to information inadequacy.
Question 10 & 11: $50 Priori Distribution value of equity and Per Stock Price
· Intrinsic Value of Equity = (Value of Operations Short Term Investment – Debt)/Number of shares: ($1937.5Million $50 Million - $387.5 Million) = $1600 Million
· Intrinsic Per Share Stock Price = $1600M/100M = $16
Question 12: $50 Post Distribution Intrinsic Per Share Price
· IWT's intrinsic value of equity = $1937.5Million - $387.5 Million = $1550 Million
· Intrinsic per share stock price = $1550Million/100Millioin = $15.5
· The $50 million distribution results in a $0.5 drop-in instinct share price, equivalent to IWT's dividend per share commutated above.
Question13: Stock Repurchase
· Intrinsic Equity Vale After Repurchase = $1937.5 Million – 387.50 Million = $1550 Million
· Share Repurchases = $50 Million /16 = 3.125 Million Shares
· Outstanding Shares = 100 million – 3.125 Million = 96.875 Million Shares
· Post Repurchase intrinsic per-share stock price = $1550 Million/96.875 Million = $16
· IWT share price remained unchanged after the stock repurchase but the value of equity declines by $50 Million.
References
Al-Malkawi, H.-A. N., Rafferty, M., & Pillai, R. (2010). Dividend Policy?: A Review of Literatures and Empirical Evidence. International Bulletin of Business Administration, 5(9), 38–45. https://doi.org/10.12816/0037572
Baker, H. K., & Weigand, R. (2015). Corporate dividend policy revisited. In Managerial Finance (Vol. 41, Issue 2, pp. 126–144). https://doi.org/10.1108/MF-03-2014-0077
Black, F., & Scholes, M. (2010). The effects of dividend yield and dividend policy on common stock prices and returns. In Journal of Financial Economics (Vol. 1, Issue 1, pp. 1–22). https://doi.org/10.1016/0304-405X(74)90006-3
Farre-Mensa, J., Michaely, R., & Schmalz, M. (2014). Payout Policy. Annual Review of Financial Economics, 6, 75–134.
Mohanasundari, M., & Vidhya, P. (2016). Dividend Policy and Its Impact on Firm Value: A Review of Theories and Empirical Evidence. Journal of Management Sciences and Technology, 3(3), 59–69.
Travlos, Trigeorgis, & Vafeas. (2001). No Title. Multinational Finance Journal, 5(2), 87–112.