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

Question

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

Answer A }

Gordon growth model allows investors to calcaute the value of stock exclusive of market conditons.Now the price is directly proprtional to the dividend paid and the retention ratio and inversely proportional to "Growth-return on equity".Assuming if the company has decided not to bring in a large outside owner for investment, the cost of new plant has to come from retianed earnigns + External debt.Both the options reduces the EPS, which in turn lowers the Dividend per share. Also with new debt and new plant manufacturing, the same brings in systemic risk and interest rate risk into the balance sheet of the company and it affects the performance in long term (atleast till the debt is paid out).View above, It can be considered as a prudent decision for ETI for having sold the desing for 30 million $ which can help the company to provide perpetual dividens and keep the stock price stable.

Answer B }

Yes the tax treatment for incorproated entity vs LLC are different. If considered as an incorporated business for more than 15 years, Corporation is preferred when compared to LLC. As coporation it is a differnet entity and owners have the flexbility to hold both common stock and preference stock. Also a host of their expenses as working employees of the companies are offset as business expenditure and since it is in a stabilized phase Corproation is more preferred. Company can have retained earnings. Also LLC is treated as sole propreitorship basis for taxation purpose. Hence it is better to stay as a Corporation and pay investors including self via generous dividends.

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