Questions to Consider
To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.
- How do various capital structure concepts—such as the Modigliani-Miller theorem, pecking order theory, or leverage—differ from each other?
- Why is it important for managers or leaders to optimize their capital structure?
Complete the following problems based on the Megaware case study below. Where appropriate, show or explain your work. You may use Excel to work on the problems.
Megaware Case Study
Megaware Incorporated is a technology firm that was founded eight years ago by John Thompson and Jill Dillman. Megaware manufactures various hardware and software components. Its products are used in personal computers and other peripheral devices. In addition to John and Jill, Nick Jones is also an owner of the firm because he provided capital. Each of the three owns 20 percent of the company. The current employees own the remaining part of the company.
The firm recently developed a new computer hardware component. The component is supposed to be more energy efficient and less costly to produce. After investigating the possibility of manufacturing the new hardware component, Megaware determined that constructing a new plant would be too costly. John, Jill, and Nick do not want to bring in another outside investor, so Megaware has decided to sell the hardware component for an after-tax payment of $42 million.
Case Study Problems
Problem 1. John thinks that the firm should use the excess cash flow to pay a special one-time dividend to the investors. How will implementing this proposal affect the value of the company as well as the stock price?
Problem 2. Jill believes that the firm should use the excess cash flow to pay off debt and expand its manufacturing capability. How would implementing this proposal affect the company?
Problem 3. Nick contends that a share repurchase will increase the company’s ROA, ROE, and P/E ratio. Do you agree? How will a share repurchase affect the value of the firm?
Problem 4. John, Jill, and Nick have discussed a proposal to commence a regular dividend payment to stockholders. Evaluate this plan.
Problem 5. The dividend growth model is used by many investors to value stock. Calculate the price of a share of Megaware stock today by using the following dividend growth model equation:
P0 = E1(1 − b) / Rs = ROE × b
The value of the stock equals next year’s dividends divided by the sustainable growth rate.
- The dividend-payout ratio is 1 minus b, where b is the retention ratio. The dividend next year (P0) will be the earnings next year (E1) times 1 minus the retention ratio: P0 = E1(1 − b).
- The sustainable growth rate (Rs) is the return on equity (ROE) times the retention ratio: Rs = ROE × b.
Based on your results, should Megaware pay a dividend or expand its manufacturing capability? Explain your decision.
Problem 6. Does the way a company is organized (as a corporation, LLC, or another structure) determine whether the company should pay a dividend?