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 applicationspecific 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 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 "reten- tion" or “plowback" ratio. So, the dividend next year will be the earnings next year, E, 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 19 E,I -b) Re-ROE × b P. 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.

Explanation / Answer

A company usually pays a dividend for the following reasons:

1.Signifies Financial Strength - It shows that the company is confident of its operation and plan to grow in the near future.

2. Signifies Maturity - A company that pays out the dividend on a constant basis shows the sign of consistent sales and profits.

Whereas,

In this case, the company should opt for expanding its manufacturing capability instead of paying out dividends because of the fact that had the company manufactured the motherboard they could have gone more money out of the deal instead of $30 million by selling to the third party. To avoid future losses like this, the company should invest the money in expanding its operations.

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