Integrated Waveguide Technologies, Inc. (IWT) is a 6-year-old company founded by Hunt Jackson and David
Smithfield to exploit metamaterial plasmonic technology to develop and manufacture miniature microwave
frequency directional transmitters and receivers for use in mobile Internet and communications applications.
IWT’s technology, although highly advanced, is relatively inexpensive to implement, and its patented
manufacturing techniques require little capital as compared to many electronics fabrication ventures. Because
of the low capital requirement, Jackson and Smithfield 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, IWT must now
access outside equity capital to fund its growth, and Jackson and Smithfield have decided to take the company
public. Until now, Jackson and Smithfield 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 new boss at the consulting firm Flick and Associates, which has been retained to help IWT prepare for its
public offering, has asked you to make a presentation to Jackson and Smithfield in which you review the
theory of dividend policy and discuss the following issues.
A. (1) What is meant by the term “distribution policy”? How has the mix of dividend payouts and stock
repurchases changed over time?
(2) The terms “irrelevance,” “dividend preference,” or “bird-in-the-hand,” and “tax effect” have been
used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain
these terms, and briefly describe each theory.
(3) What do the three theories indicate regarding the actions management should take with respect to
(4) What results have empirical studies of the dividend theories produced? How does all this affect what
we can tell managers about dividend payouts?
B. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects
on distribution policy.
Assume you have just been hired as a business manager of Pizza Palace, a regional pizza restaurant chain. The
company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all
equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor
stated that most firms’ owners would be financially better off if the firms used some debt. When you
suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you
obtained from the firm’s investment banker the following estimated costs of debt for the firm at different
MINI CASE 7
If the company were to recapitalize, then debt would be issued and the funds received would be used to
repurchase stock. Pizza Palace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the riskfree rate is 6%, and the market risk premium is 6%.
A. Using the free cash flow valuation model, show the only avenues by which capital structure can affect
B. (1) What is business risk? What factors influence a firm’s business risk?
(2) What is operating leverage, and how does it affect a firm’s business risk? Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.
C. Write a 250-500 word recommendation of the financial decisions you propose for this company based
on an analysis of its capital structure and capital budgeting techniques
Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to
provide educational software for the rapidly expanding primary and secondary school markets. Although
EduSoft has done well, the firm’s founder believes an industry shakeout is imminent. To survive, EduSoft must
grab market share now, and this will require a large infusion of new capital. Because he expects earnings to
continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise
to issue new common stock at this time. On the other hand, interest rates are currently high by historical
standards, and the firm’s B rating means that interest payments on a new debt issue would be prohibitive.
Thus, he has narrowed his choice of financing alternatives to (1) preferred stock, (2) bonds with warrants, or
(3) convertible bonds.
How does preferred stock differ from both common equity and debt? Is preferred stock more risky
than common stock? What is floating rate preferred stock?
How can knowledge of call options help a financial manager to better understand warrants and
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