Financial Analysis, Planning and
Forecasting
Theory and Application
Chapter 17
Interaction of Financing, Investment,
and Dividend Policies
By
Alice C. Lee
San Francisco State University
John C. Lee
J.P. Morgan Chase
Cheng F. Lee
Rutgers University
1
Outline









17.1 Introduction
17.2 Investment and dividend interactions: the interval-vs.external financing decision
17.3 Interactions between dividend and financing policies
17.4 Interactions between financing and investment decisions
17.5 Implications of financing and investment interactions for
capital budgeting
17.6 Debt capacity and optimal capital structure
17.7 The implication of different policies on the beta coefficient
determination
17.8 Summary and conclusion
Appendix 17A. Stochastic dominance and its applications to
capital-structure analysis with default risk
2
17.2 Investment and dividend interactions: the
interval-vs.-external financing decision

Internal financing
Changes in equity accounts between balance-sheet dates are
generally reported in the statement of retained earnings.
Retained earnings are most often the major internal source of
funds made available for investment by a firm.
TABLE 17.1 Payout ratio—Composite for 500 firms
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
0.580
0.567
0.549
0.524
0.517
0.548
0.533
0.547
0.612
0.539
0.491
0.414
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
0.405
0.462
0.409
0.429
0.411
0.380
0.416
0.435
0.422
0.399
0.626
0.525
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
0.343
0.559
0.887
0.538
0.439
0.418
0.137
0.852
0.340
0.346
0.327
0.774
1998
1999
2000
2001
2002
2003
2004
2005
2006
0.234
0.435
0.299
0.383
0.040
0.259
0.311
0.282
0.301
3
17.2 Investment and dividend interactions: the
interval-vs.-external financing decision
17.2.2 External financing: External financing usually takes
one of two forms, debt financing or equity financing.
(17.1)
p(1 - d)(1 + L)
(rr )( ROE )
S*=
t - p(1 - d)(1 + L)

1  (rr )( ROE )
where p = Profit margin on sales, d = Dividend payout ratio,
L = Debt-to-equity ratio, t = Total asset-to-sales ratio.
rr = Retention Rate, ROE = Return on Equity
(0.055)(1 - 0.33)(1 + 0.88)
S*=
= 10.5%
0.73 - (0.055)(1 - 0.33)(1 + 0.88)
Let c = Nominal current assets to nominal sales, f = Nominal fixed
assets to real sales, j = Inflation rate.
*
S
So real sustainable growth r is
(1 + j)p(1 - d)(1 + L) - jc
.
S =
(1 + j)c + f - (1 + j)p(1 - d)(1 + L)
*
r
(17.2)
4
17.3 Interactions between dividend and
financing policies


Cost of equity capital and dividend policy
Default risk and dividend policy
P / E  a0  a1 g  a2 p  a3 Lev  u,
(17.3)
where g = Compound growth of assets over eight previous years;
p = Dividend payout ratio on an annual basis;
Lev = Interest charges/[operating revenues – operating expenses];
u = Error term.
P / E  a0  a1 ( g )  a 2 p  a3 ( Lev)  a 4 ( F1 )
 a5 ( F2 )  a6 ( F3 )  a7 ( F4 ).
(17.4)
where g = Compound growth rate, Lev = Financial risk measured
by times interest earned, and F1, F2, F3, F4 = Dummy variables
representing levels of new equity financing.
5
17.3 Interactions between dividend and
financing policies
TABLE 17.2 New-issue ratios of electric utility firms
F dummy variable grouping
New-issue ratio interval
Number of firms in interval
Mean dividend payout ratio
Dummy variable coefficient
Dummy variable t-statistic
A
B
C
D
E
0
49
0.681
1.86
(1.33)
0.001-0.05
16
0.679
3.23
(2.25)
0.05-0.1
11
0.678
1.26
(0.84)
0.1-0.15
6
0.703
0.89
(0.51)
0.15 and up
4
0.728
N.A.
(N.A.)
From Van Horne, J. C., and J. D. McDonald, “Dividend policy and new equity financing,” Journal of
Finance 26 (1971):507-519. Reprinted by permission.
C
C(1 - T)
S = V - (1 - L), S = V (1 - L* )
r
r
(17.5) and (17.6)
Where S = Total value of the firm’s stock, V = Total firm value,
C = Constant coupon payment on the perpetual bonds,
r = Riskless rate of interest, L = A complicated risk factor
associated with possible default on the required coupon payment.
6
17.4 Interactions between financing and
investment decisions
 Risk-free debt case
Maximize dV (xj, yt, Dt, Et) = W,
a) Uj = xj - 1  0 (j = 1, 2, ..., J); b) U t=F yt - Zt  0 (t = 1, 2, ...,
T); c) U tC= -Ct - [yt - yt-1 (1 + (1 - τ)r)] + Dt - Et  0
(17.7)
Max W’ = W - Lj(xj - 1) - Lft(yt - Zt)
- Lct {-Ct - [yt - yt-1(1 + (1 - τ) r)]} + Dt - Et).
(17.7′)
T
(17.8)
[ L ft Z jt + L ct C jt ] - L j  0
Aj+

t=0
Ft - Lft + Lct - Lc,t-1 [1 + (1 - τ) r]  0.
(17.9)
dW
dW
- Lct  0;
+ Lct  0.
(17.10) and (17.11)
dDt
dE t
T
APV j = A j +  Z jt F t
t=0
(17.12)
7
17.4 Interactions between financing and
investment decisions
 Risky debt case
Rendleman (1978) not only examined the risk premiums associated
with risky debt, but also considered the impact that debt
financing could have on equity values, with taxes and without.
The argument is to some extent based on the validity (or lack
thereof) of the perfect-market assumption often invoked, which,
interestingly enough, turns out to be a double-edged sword.
Without taxes, the original M&M article claims, the investment
decision of a firm should be made independent of the financing
decision. But the financing base of the firm supports all the
firm’s investment projects, not some specific project. From this
we infer that the future investments of a firm and the risk
premiums embodied in the financing costs must be considered
when the firm takes on new projects.
8
17.5 Implications of financing and investment
interactions for capital budgeting




Equity-residual method
After-tax weighted-average, cost-of-capital
method
Arditti and Levy method
Myers adjusted-present-value method
9
17.5 Implications of financing and investment
interactions for capital budgeting
17.5.1 Equity-Residual Method
[( Rt - C t - dep t - rDt )(1 -  c ) + Dt ] - ( Dt - Dt 1 )
NPV(ER) = 
- [I - NP].
t
(17.13)
(1 + k e )
t=1
N
Table 17.3 Definitions of variables
Rt = Pretax operating cash revenues of the project during period t;
Ct = Pretax operating cash expenses of the project during period t;
dept = Additional depreciation expense attributable to the project in period t;
τc = Applicable corporate tax rate; I = Initial net cash investment outlay;
Dt = Project debt outstanding during period t;
NP = Net proceeds of issuing project debt at time zero;
rt = Interest rate of debt in period t; ke = Cost of the equity financing of the project;
kw = After-tax weighted-average cost of capital (i.e., debt cost is after-tax);
kAL = Weighted average cost of capital -- debt cost considered before taxes;
ρ = Required rate-of-return applicable to unlevered cash-flow series, given the
risk class of the project.
r, ke, and ρ are all assumed to be constant over time.
10
17.5 Implications of financing and investment
interactions for capital budgeting
17.5.2 After-tax weighted-average, cost-of-capital
method
N
( R t - C t - dep t )(1 -  c ) + dep t
(17.14)
NPV =

t=1
t
(1 + k w )
 I.
17.5.3 Arditti and Levy method
[( Rt - C t - dep t - rDt )(1 -  c ) + dep t ] + rDt (17.15)
NPV(AL) = 
I
t
(1 + k AL )
t=1
N
17.5.4 Myers adjusted-present-value method
N
( Rt - C t - dept )(1 -  c ) + dept
 c rDt .
APV = 
I
+

t
t
(1
+

(1
+
r
)
)
t=1
t=1
N
(17.16)
11
17.5 Implications of financing and investment
interactions for capital budgeting
Table 17.4
Application of four capital budgeting techniques
Inputs: 1. ke = 0.112 2. r = 0.041 3.
Method
1. Equity-residual
2. After-tax WACC
3. Arditti-Levy WACC
4. Myers APV
 c= 0.46
NPV results
$230.55
270.32
261.67
228.05
4.
 = 0.0802 5. w = .6
Discount rates
ke = .112
k w = .058
k AL = .069
r = .041 and  = .0802
From Chambers, D. R., R. S. Harris, and J. J. Pringle, “Treatment of financing mix in analyzing
investment opportunities,” Financial Management 11 (Summer 1982): 24-41. Reprinted by permission.
12
17.5 Implications of financing and investment
interactions for capital budgeting
Table 17.5 Inputs for simulation
Project
Net cash inflows per year
Project life
1
2
3
4
$300 per year
$253.77 per year
$124.95 per year
$200 per year, years 1-4
$792.58 in year 5
5 years
5 years
20 years
5 years
For each project the initial outlay is $1000 at time t = 0, with all subsequent outlays being
captured in the yearly flows.
Debt Schedule
1.Market value of debt outstanding remains a constant proportion of the project’s market value.
2.Equal principal repayments in each year.
3.Level debt, total principal repaid at termination of project.
Inputs:
ke = 0.112
k w = 0.085
 M = 0.085
W = 0.3
r
= 0.041
( M & M ) = 0.0986
c
= 0.46
13
From Chambers, D. R. , R. S. Harris, and J. J. Pringle, “Treatment of financing mix in analyzing
investment opportunities,” Financial Management 11 (Summer 1982): 24-41. Reprinted by permission.
17.5 Implications of financing and investment
interactions for capital budgeting
Table 17.6 Simulation results
Net-present-value under alternative debit schedule
Project
Capital budgeting
1
After-tax WACC
Arditti-Levy WACC
Equity-Residual
Myers APV (M&M)
Myers APV (M)
2
After-tax WACC
Arditti-Levy WACC
Equity-Residual
Myers APV (M&M)
Myers APV (M)
3
After-tax WACC
Arditti-Levy WACC
Equity Residual
Myers APV (M&M)
Myers APV (M)
4
After-tax WACC
Arditti-Levy WACC
Equity Residual
Myers APV (M&M)
Myers APV (M)
Constant debt ratio
Equal Principal
Level debt
182
182
182
160
182
0
0
0
-18
0
182
182
182
138
182
182
182
182
155
182
182
179
167
157
182
0
-1
-3
-19
0
182
169
128
119
182
182
174
147
146
182
182
187
202
166
182
0
7
32
-10
0
182
186
194
150
182
182
182
183
156
182
From Chambers, D. R. , R. S. Harris, and J. J. Pringle, “Treatment of financing mix in analyzing
investment opportunities,” Financial Management 11 (Summer 1982): 24-41. Reprinted by permission.
14
17.5 Implications of financing and investment
interactions for capital budgeting
a) Operating flows = (Rt - Ct - dept)(1 - τc) + dept
= ($4000 - $1000 - $500)(1 - 0.46) + $500
= $1850.
b) Financial flows = τc rDt
= (0.46)(0.09)($3600)
= $149.04
c)
kw = wr(1 - τc) + (1 - w)ke
= (0.6)(0.09)(1 - 0.46) + (1 - 0.6)(0.15)
= (0.029) + (0.06)
= 0.089.
kw
d)   (1   w)
c
0.089
(1  (0.46)(0.6))
 0.1229

15
17.6 Debt capacity and optimal capital structure
Table 17.7 Acceptance-rejection criteria
Accept
Rr  RQ* and S p  SQ
Reject
R p  RQ
and
Indeterminate
S p  SQ
R p  RQ
R p  RQ
and
Or
and
S p  SQ
S p  SQ
*In the special instance where both relationships are strict equalities the firm is,
of course, indifferent in attitude toward the project.
Re = WRp - Rd(W - 1), Re = Rd + W(Rp - Rd)
(17.17) and (17.17a)
Se = WSp.
(17.18)
dRe R p - R d
Se
=
.
R e = R d + ( R p - R d ),
dS e
Sp
(17.19) and (17.20)
Sp
(17.18a)
S e = W  S p .
16
17.6 Debt capacity and optimal capital structure
1
1
Re = R d +W ( R p - R d ), k p = W  R p + (1 - W  ) R d ,
(17.21) and (17.22)
1
( R p - R d ).
k p = Rd +
(17.22a)
W
 pe S p
(17.22a′)
'
kP = r d +
( R e - R d ),
S
e
'
where k P = Cost of financing a project, ρpe = Correlation
between Rp and Re, Sp = Estimated standard deviation of Rp,
Se = Estimated standard deviation of Re.
0=  (
S
S0
)t-1, P(C  0) = P(C  C - z  c ),
(17.23) and (17.24)
17
17.6 Debt capacity and optimal capital structure
NOI(1 -  )
NOI(1 -  ) rD
L
L
.
+
- k i D,V =
V =
k a (17.25) and (17.26)
r
ks
k s D( k i -  ) dk a k s ( dk i -  )
ka = ks +
V
,
L
0=
S
dD
+
=
V
L
D(1 -  )  D
S0
dD
,
(17.27) and (17.28)
(17.29)
S0
ks = 0.09 + (0.16 - 0.09)(1.5) = 0.195.
2
2 1/2
 c = ((80,000 ) + 2(0.5)(80, 000)(8,000) + (8,000 ) )
= $84,285.23.
z=
C -0
c
$100,000
=
= 1.25.
$80,000
$118,000
z =
= 1.40.
$84,285
18
17.6 Debt capacity and optimal capital structure
Table 17.8
Valuation information for Project X
A. Project Cash-Flow Information
1. NOI = $18,000
2. Project maturity = infinity
3. Marginal tax rate for ABC = 45%
4. Initial cash outlay = $800,000
B. Required Return Information
1. Rf = 0.09
2. Rm = 0.16
3. β0 = 1.5
C. Debt-Capacity Information
1. Standard deviation in project cash flows = $8,000
2. Correlation between firm and project cash flows = 0.5
3. Cost of new debt, r = 0.10
19
17.6 Debt capacity and optimal capital structure
Fig. 17.1 (a) Distribution of
unencumbered cash flows for
ABC Company.

Fig. 17.1 (b) Distribution of
unencumbered cash flows after
project is undertaken.
20
17.6 Debt capacity and optimal capital structure
( C - C ) (118,000 - C )
z=
=
= 1.25.
84,285
 c
D = DSC/kd = ($12,643.75)  (0.10) = $126,438.
V = NOI
(1 -  )
ks
rD
+
.
r
(17.25′)
($18, 000)(1- 0.45) (126, 438)(0.10)(0.45)
V

0.195
0.10
 $50, 769  $56,897  $107, 666.
21
17.7 The implication of different policies on the
beta coefficient determination



Impact of Financing Policy on Beta Coefficient
Determination
Impact of Production Policy on Beta Coefficient
Determination
Impact of Dividend Policy on Beta Coefficient
Determination
B(1   c )
 L  U (1 
)
(17.25')
S
0.32
U 
 0.23.
[1  (0.64)(1  0.4)]
Q  K a Lb
(17.31)
22
17.7 The implication of different policies on the
beta coefficient determination
(1  r )Cov(e, Rm )

(17.32)
Var ( Rm ) [1  (1  E )b]
Where r = the risk-free rate, Rm = return on the market
portfolio, e = random price disturbances with zero
mean, E  (P / Q)(Q / P) ,
  1   cov(v, Rm ) an elasticity constant
b = contribution of labor to total output,
 = the market price of systematic risk,
Q  K  (1 s ) [ L  (   1) K ] s
(17.33)
  0,0  s  1,0  s   1, L / K  (1   ) / (1  s  )3.
23
17.7 The implication of different policies on the
beta coefficient determination



(1  r ) Cov(e, Rm )  [(1   E ) s  1  w( pQ) 1 (1   ) K ]Cov(v, Rm )

Var ( Rm )   [(1   E ) s   w ( pQ)1 (1   ) K

(17.34)
Where p = expected price of output, µ = reciprocal of the price
elasticity of demand, w = expected wage rate, v = random
shock in the wage rate with zero mean;   1   cov(e, Rm )
r , Rm , e, E ,  ,  are as defined in Equation (17.30)
i   pi [1   F (di )]
(17.35)
i = the firm’s systematic risk when the market is informationally
imperfect and the information asymmetry can be resolved by
dividends;  pi = the firm’s systematic risk when market is
informaitonally perfect.  = a signaling cost incurred if firm’s net
after-tax operating cash flow X falls below the promised dividend D.
d i = firm’s dividend payout ratio. F (di ) = cumulative normal density
function in term of payout ratio.
24
17.8 Summary and conclusion
In this chapter we have attacked many of the irrelevance propositions of the
neoclassical school of finance theory, and in so doing have created a good
news-bad news sort of situation. The good news is that by claiming that
financial policies are important, we have justified the existence of academicians
and a great many practicing financial managers. The bad news is that we have
made their lot a great deal more difficult as numerous tradeoffs were
investigated, the more general of these comprising the title of the chapter.
In the determination of dividend policy, we examined the relevance of the
internal-external equity decision in the presence of nontrivial transaction costs.
While the empirical evidence was found to be inconclusive because of the many
variables that could not be controlled, there should be no doubt in anyone’s
mind that flotation costs (incurred when issuing new equity to replace retained
earnings paid out) by themselves have a negative impact on firm value. But if
the retained earnings paid out are replaced whole or in part by debt, the equity
holders may stand to benefit because the risk is transferred to the existing
bondholders -- risk they do not receive commensurate return for taking. Thus if
the firm pursues a more generous dividend-payout policy while not changing the
investment policy, the change in the value of the firm depends on the way in
which the future investment is financed.
25
17.8 Summary and conclusion
The effect that debt financing has on the value of the firm was analyzed
in terms of the interest tax shield it provides and the extent to which the
firm can utilize that tax shield. In Myers’ analysis we also saw a that a
limit on borrowing could be incorporated so that factors such as risk and
the probability of insolvency would be recognized when making each
capital-budgeting decision. When compared to other methods widely
used in capital budgeting, Myers’ APV formulation was found to yield
more conservative benefit estimates. While we do not wish to discard
the equity-residual, after-tax weighted cost-of-capital method or the
Arditti-Levy weighted cost-of-capital method, we set forth Myers’ method
as the most appropriate starting point when a firm is first considering a
project, reasoning that if the project was acceptable following Myers’
method, it would be acceptable using the other methods -- to an even
greater degree. If the project was not acceptable following the APV
criteria, it could be reanalyzed with one of the other methods. The
biases of each method we hopefully made clear with the introduction of
debt financing.
26
17.8 Summary and conclusion
Section 17.6 outlined practical procedures for attaining optimal capital structures
subject to probability-of-insolvency constraints or costs incurred attributable to
the risky debt financing. If management is able to specify the tolerance for risk,
or the rate at which monitoring costs are incurred, then an upper limit on debt
capacity can be stated as the amount of interest expense the firm can afford. In
the case of regulated firms, we also consider capital-structure decisions, in light
of the inability of the equity holders to acquire the benefits of the interest tax
shield; and we concluded that regulated firms, in the best interests of their
shareholders and of society, should issue debt only to the extent it does not
jeopardize the equity stake or the existence of the firm. In section 17.7, we have
discussed how different policies can affect the determination of beta coefficient.
In essence, this chapter points out the vagaries and difficulties of financial
management in practice. Virtually no decision concerning the finance function
can be made independent of the other variables under management’s control.
Profitable areas of future research in this area are abundant; some have already
begun to appear in the literature under the heading “simultaneous-equation
planning models.” Any practitioner would be well advised to stay abreast of
developments in this area.
27
Appendix 17A. Stochastic dominance and its applications
to capital-structure analysis with default risk
17.A.1 INTRODUCTION
17.A.2 CONCEPTS AND THEOREMS OF
STOCHASTIC DOMINANCE
17.A.3 STOCHASTIC-DOMINANCE APPROACH TO
INVESTIGATING THE CAPITALSTRUCTURE PROBLEM WITH DEFAULT
RISK
17.A.4 SUMMARY
28
Appendix 17A. Stochastic dominance and its applications
to capital-structure analysis with default risk
EFU ( X )  EGU ( X )
x
x
x
x
(17.A.1)
EFU ( X )   U ( X ) f ( X )dx, EFU ( X )   U ( X ) g ( X )dx
x
 [G(T )  F (t )]dt  0
x
(17.A.2a)and(17.A.2b)
where G(t) ≠ F(t) for some t.
(17.A.3)
29
Appendix 17A. Stochastic dominance and its applications
to capital-structure analysis with default risk

if X  0,
0,
Y1   X (1  T ) if X  0,
(17.A.4)
if Y  0,
if Y  0.
(17.A.5)

G1 (Y )  F (0)
F (Y /(1  T )
if X  0,
 0
Y2    (1  k ) X (1  T ) if 0  X (1  T )  D2  rD2 ,
 ( X (1  T )  TrD2 if x(1  T )  D2  rD2 , (17.A.6)
if Y  0,

 F (0)
G2 (Y )   F [Y /  (1  k )(1  T )] if 0  y   (1  k )[ D2  rD2 ],

 F [Y /  (1  T )  TrD2 ] if Y   [ D2  rD2 ].
(17.A.7)
if 0  Y   ( D2  rD2 ), (17.A.8)
G1 (Y )  G2 (Y )
G2 (Y )  G2 (Y )
(17.A.9)
if Y   ( D2  rD2 ),
30
Appendix 17A. Stochastic dominance and its applications
to capital-structure analysis with default risk
17.A.4 SUMMARY
In this appendix we have tried to show the basic
concepts underlying stochastic dominance and its
application to capital-structure analysis with default
risk. By combining utility maximization theory with
cumulative-density functions, we are able to set up
a decision rule without explicitly relying on
individual statistical moments. This stochasticdominance theory can then be applied to problems
such as capital-structure analysis with risky debt,
as was shown earlier.
31