Electronic Timing, Inc. (ETI), is a small company founded 15 years ago by electr

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Electronic Timing, Inc. (ETI), is a small company founded 15 years ago by electronics engineers Tom Miller and Jessica Kerr. ETI manufactures integrated circuits to capitalize on the complex mixed-signal design technology and has recently entered the market for frequency timing generators, or silicon timing devices, which provide the timing signals or “clocks” necessary to synchronize electronic systems. Its clock products originally were used in PC video graphics applications, but the market subsequently expanded to include motherboards, PC peripheral devices, and other digital consumer electronics, such as digital television boxes and game consoles. ETI also designs and markets custom application specific integrated circuits (ASICs) for industrial customers. The ASIC’s design combines analog and digital, or mixed-signal, technology. In addition to Tom and Jessica, Nolan Pittman, who provided capital for the company, is the third primary owner. Each owns 25 percent of the $1 million shares outstanding. Several other individuals, including current employees, own the remaining company shares.

Recently, the company designed a new computer motherboard. The company’s new design is both more efficient and less expensive to manufacture, and the ETI design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, ETI determined that the costs involved in building a new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside owner. Instead, ETI sold the design to an outside firm. The sale of the motherboard design was completed for an aftertax payment of $30 million.

5 One way to value a share of stock is the dividend growth, or growing perpetuity, model. Consider the following: The dividend payout ratio is 1 minus b, where b is the “retention” or “plowback” ratio. So, the dividend next year will be the earnings next year, E1, times 1 minus the retention ratio. The most commonly used equation to calculate the sustainable growth rate is the return on equity times the retention ratio. Substituting these relationships into the dividend growth model, we get the following equation to calculate the price of a share of stock today:

What are the implications of this result in terms of whether the company should pay a dividend or upgrade and expand its manufacturing capability? Explain.

6Does the question of whether the company should pay a dividend depend on whether the company is organized as a corporation or an LLC?

Explanation / Answer

(5) The equation for current stock price clearly depicts the direct relationship between annual dividend payouts and current stock price. The relationship also shows that return on stock should always be less than the growth rate or in other words the exponential rate of growth (one which is greater than the stock's required return rate) is unsustainable in the long run. If the company has good growth and investment opportunities in the future then it is advisable to plough back a majority of its earnings into these future opportunities. This however would depress current dividend payouts (as the retention ratio would be high and payout ratio would be low) and consequently current intrinsic stock prices.The current market price (and not intrinsic price) might still be high as market price is equal to the sum of the intrinsic stock price and the present value of future growth opportunities (the ones in which a majority of current earnings are being invested instead of paying dividends). Additionally, these investments of earnings should be done only if the expected ROEs are greater than the firm's cost of equity, failing which the firm will only erode value and not grow value going forward. If the firm feels that growth potential and opportunities are unavailable in the future then it is advisable to payout a large part of earnings as dividends so as to prop up current stock prices and unlock value for current shareholders.

In conclusion firm's should plough back earnings into growth opportunities only if they create value in the future, otherwise they should payout earnings as dividends so as to unlock current stock value. In this company's context manufcturing capability expansion at the cost of elevating current stock prices make sense only if the expanded capacity can guarante ROEs greater than the firm's cost of equity. Otherwise it is more sensible to payout earnings as dividend and increase current stock value of the company.

(6) Dividend payout decisions are definitely impacted by factros such as company organization. A corporation has to promise shareholders a fixed amount or % of earnings as dividends and they are taxed at the corporate income tax rate, as a corporation is a separate legal entity. An LLC need not make any such promises as it is a limited liability partnership which essentially allows partners to plough back large shares (or even all) of its earnings into potential promised future growth. Also, dividends are taxed at individual income tax rates for LLCs.

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