Information Systems Technology (IST), which develops software for the health care industry, was founded five years ago by Donald Brown and Margaret Clark, who are still its only stockholders. IST 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 55% equity and 45% debt. Therefore, Brown and Clark have decided to take the company public. Until now, Brown and Clark 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 Andrew Adamson & Company (AA), a national accounting firm, which has been asked to help IST prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Clark in which you review the theory of dividend policy and discuss the following questions:
Discuss the signaling hypothesis and the clientele effects, and their implications for IST's dividend policy.
Assume that IST has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (55 percent equity and 45% debt) is optimal, and its net income is forecasted at $440,000. Use the residual dividend policy approach to determine IST's total dollar dividend and payout ratio. In the process, explain what the residual dividend policy is and then explain what would happen if net income were forecasted at $300,000, or at $700,000.
What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect signaling and clientele effects.)