Integrative Problem
Information Systems Inc. (ISI), 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. ISI 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 60%equity and 40% 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 ISI 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:
a. (1) What is meant by the term dividend policy?
(2) The terms irrelevance and relevance have been used to describe theories regarding the way dividend policy affects a firm’s value. Explain what these terms mean, and briefly discuss the relevance of dividend policy.
(3) Explain the relationships between dividend policy and (i) stock price and (ii) the cost of equity under each dividend policy theory.
b. Discuss (1) the information content, or signaling, hypothesis; (2) the clientele effect; (3) the free cash flow hypothesis; and (4) their effects on dividend policy.
c. (1) Assume that ISI has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (60 percent equity and 40% debt) is optimal, and its net income is forecasted at $600,000. Use the residual dividend policy approach to determine ISI’s total dollar dividend and payout ratio. In the process, explain what the residual dividend policy is, and use a graph to illustrate your answer. Then explain what would happen if net income were forecasted at $400,000, or at $800,000.
(2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
(3) What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling and clientele effects.)
d. What are some other commonly used dividend payment policies? What are their advantages and disadvantages? Which policy is most widely used in practice?
e. What are dividend reinvestment plans (DRIPs), and how do these plans work?

Integrative Problem Information Systems Inc. (ISI), which develops...