Lecture 10. Capital Structure and Dividend Policy
Readings: Chapters 16 and 18, and the article “Asymmetric Information and Dividend
Policy”
One reason for starting a firm is that by organizing resources it is possible to
manufacture a product or provide a service so as to earn a greater return (for the same risk
level) than individuals can earn by trying to do the same thing their own. Likewise, if
organizing a firm can provide the same return but at lower risk, it benefits individuals to
invest in firms rather than pursuing it themselves. A firm is therefore a vehicle for acquiring
financial capital and allocating it in such a way as to maximize the return to investors for a
given risk level.
One standard rule that results from this is that firms should not do for investors what
investors can already do on their own. This rule is very important when considering issues
of whether or not a firm should hold on to investors’ capital and reinvest it or disburse it in
the form of dividend payment, stock repurchases and/or debt redemption. The most simple
rule here is the if the return to investment (R) is greater than the investor required return (k,
this could be the WACC) it is advisable for the firm to retain investor capital and reinvest it
into productive opportunities. In that case, the firm can do something for the investors that
they can not do for themselves, that is, earning a higher return at a given risk level. If,
however, the return on reinvested funds is less than the cost of capital, then ideally firms
should return capital to investors in the form of dividends, stock repurchases or debt
redemption (usually in that order—you’ll see why). This is called the “residual theory” of
distribution. It is a key to understanding the relationships between allocation (i.e., how to
choose productive investments and allocate capital amongst corporate assets) and
acquisition of financial capital (i.e., how to structure financial capital and distribute the cash
flows earned by the firm).
By the time you have completed this week’s assignments, you should:



Be able to define and distinguish the following concepts: asymmetric information,
bird-in-the-hand theory, business risk, capital gains, capital structure, clientele,
clientele effect, credible signal, direct and indirect costs of financial distress and
bankruptcy, dividend irrelevance theory, dividend stability, dividends, financial
leverage, financial risk, fixed costs, free cash flow theory, growth stocks, income
stocks, operating leverage, optimal capital structure, optimal dividend policy,
signaling theory (as applied to both capital structure and dividends), tax preference
theory, variable,
Identify and articulate the factors that influence the capital structure of a firm, and
Identify and articulate the tax implications of dividend policy
Why Use Debt at All?
There are several important reasons for using debt in the firm’s capital structure.
These are reviewed in detail in Chapter 17 of the Brigham and Ehrhardt text, but a different
look will be taken here. The first and most obvious reason for using debt in the capital
structure is to lower the cost of capital. As you have learned and observed, the cost of
debt to a firm is lower than the cost of equity. This is due to the fact that debt represents a
fixed income contract where cash flows are predetermined and paid as legal liabilities.
Creditors also have priority in the event that the company is forced to distribute its capital
as a result of default or bankruptcy. Stockholders, on the other hand, are “residual” claimholders who receive what is left after all expenses and debt service has been covered.
This cash flow is potentially more risky as it can be high or low. Furthermore, the interest
payments to debt are tax deductible, which has the effect of lowering the cost of debt to the
firm (recall that when calculating the WACC, you multiply the cost of debt by 1-tx to adjust
for this deduction).
A firm’s ability to use debt financing is primarily based on the riskiness of its operating cash
flows. If you looked at the financial documents of different firms, you would immediately
see that they have very different mixes of debt and equity, which we refer to as their capital
structure. Even within an industry there is considerable variety. The following table gives
some examples:
Firm
Debt/Equity Ratio
General
Motors
17.32
Intel
0.23
Verizon
4.28
Black
Decker
&
3.74
The general guidelines for establishing the use of debt in the corporate capital structure
include the following:
o The greater the business risk (i.e., risk in the operating cash flow stream), the
lower the debt,
o The greater the firm’s operating profit levels, the higher the debt,
o The greater the firm’s existing level of debt, the less additional debt it can
afford,
o The greater the manager’s aggressiveness, the higher the debt, and
o The greater the growth opportunities, the lower the debt.
Business Risk versus Financial Risk
The risk of a firm is a function of two distinct factors. First, there is business (or
operating) risk. Some types of businesses are just more risky than others: the grocery store
business is less risky that the production of video game software. Second, there is financial
risk: the more debt (or financial leverage) you have the higher the required interest
payments (as opposed to dividends which are not required, but only paid at the discretion
of the firm) and the greater the financial risk.
Business Risk: This source originates in the risk that is inherent in the operating activity
(i.e., asset allocation) of the firm (e.g., the choice to make cars in the case of General
Motors). Anything that adds risk to that productive activity contributes to business risk:
changing consumer tastes, changes in the general economy, labor problems, swift and
unpredictable changes in technology, volatility in the prices of raw materials, etc. This can
be related to the concept of operating leverage.
Operating leverage is degree to which a firm’s costs are fixed or variable. Fixed
costs typically result from capital investments, in assets such as buildings, and equipment.
The cost of operating a plant is, in the short term, fixed regardless of whether it is running
at high or low capacity. Variable costs are those that vary with the level of production. If
demand declines I can reduce the cost of materials, but not the cost of the machinery in the
production line (though I can reduce the cost of running that machinery). Some costs are
to a degree fixed and to a degree variable. For example, take labor costs. It depends on
how people are employed: salaried workers involved in the oversight of an operation tend
to represent fixed costs, while hourly workers involved in the production process represent
variable costs. The importance of this distinction is that a greater proportion of fixed costs
(i.e., higher operating leverage) increases the volatility of the operating cash flow and is
generally associated with more business risk. The more fixed assets the firm owns, the
more revenues are pre-committed to the fixed payments. Once those fixed payments are
covered, however, the greater the increase in operating profits for a given increase in
revenues. With less operating leverage, cash flow volatility is more closely related to sales
volatility as expenses vary more proportionally to sales.
Financial Risk: This form of risk results from the degree of financial leverage used to fund
the firm. As we have noted, greater debt means that more operating cash flows are precommitted to the fixed interest and principal payments. If the firm has no debt, then there
are no required, contractual payments due to the investors of the firm. As a simplified
example, consider two firms, identical except in their financial leverage (that is, they have
the same business risk). Their EBIT’s will be identical. We will ignore taxes and assume
each firm has a book value of $200 (split between debt and equity) and that the return on
debt is 10%.
Firm A
(All Equity, E = $200)
Cash Flow
Year 1 Year 2 Year 3 Year 4
EBIT
10
16
6
40
Interest
Payment
0
0
0
0
Net Income
10
16
6
40
ROE
5%
8%
3%
20%
Firm B
(Half Debt and Half Equity, $E = 100 and $D = 100)Cash
Flow
Year 1 Year 2 Year 3 Year 4
EBIT
10
16
6
40
Interest
Payment
(10)
(10)
(10)
(10)
Net Income
0
6
(4)
30
ROE
0%
6%
-4%
30%
There are two things readily notable about the example. First, note that in the case of the
lowest EBIT level, $6, the ROE is lower in the high debt case (firm B) than in the low debt
case. For the high EBIT level, however, $40, the ROE is much higher in the high debt
case. This is because regardless of the level of operating earnings (EBIT), the interest
payment is fixed. The payment to shareholders, however, is a residual claim whose
volatility increases in the presence of leverage. The ROE itself if more volatile for firm B
than for firm A.
You can also relate this to the duPont ratio, in which the third component is the
leverage ratio. Recall that the higher the leverage ratio the greater the increase (and
decrease) in ROE for a given change in ROA.
Optimal Capital Structure
The concept of optimal capital structure revolves around the question of: “How much
debt should the firm take on?” In considering this question, we typically begin with an “all
equity firm” (one having no debt) and add debt as long as the value of the firm increases.
At some point, more debt will start to decrease value, and we will have reached the optimal
capital structure.
One possible answer to this question is that we increase debt until the weightedaverage cost of capital, WACC, is minimized. The WACC is used as the rate at which
operating free cash flows are discounted to determine corporate value. It stands to reason
that, for a given operating free cash flow, the lower the WACC the higher the value of the
firm. The graph below provides an idea of how this would work.
When we begin the analysis, the firm is an “all equity” firm and the WACC is equal to the
cost of equity. As we add debt, the cost of equity capital increases due to the increase in
financial risk. The weighted-average cost of capital, however, decreases due to the
replacement of high cost equity with low cost debt. It is also evident that the cost of debt
rises with an increasing debt ratio, but the WACC continues to fall to a point. Beyond that
point, the WACC rises because, even though you are replacing higher cost equity with
lower cost debt, the financial risk premia added to both the cost of debt and the cost of
equity outweighs the benefit of that replacement.
Cost of Capital
Cost
of
Equity
WACC
Cost
of
Debt
Optimal
Debt Ratio
To further understand what is going on in the diagram, think back of the session
where we covered the determination of a bond yield and the WACC. The bond yield, which
becomes the cost of debt to the firm once it borrows in the bond markets, is driven by
different factors. One of those factors is default risk. Typically, default risk increases with
the amount of debt taken on by the firm. This is so because higher debt means greater
interest and principal servicing requirements. Since these payments are fixed and required
regardless of the operating performance of the firm, higher levels translate into higher risk,
and hence, investors require a higher rate of return.
Technically, what has happened here is that there has been an increase in the
likelihood of bankruptcy and/or financial distress. When firms enter bankruptcy, they face
two types of additional costs: first, there are direct costs of the bankruptcy process, e.g.,
legal fees, and, second, there are indirect costs, i.e., those associated with an insolvent
firm conducting its normal business. For example: Would you buy a computer from a firm
that might go out of business? Even prior to an official declaration of bankruptcy, firms in
financial distress experience these costs. In general, higher the debt the greater the future
probability of financial distress and bankruptcy. We can think of these future costs,
weighted by their probability and discounted, as the present value of the cost of financial
distress and bankruptcy. Equity holders and less senior debt holders require higher rates of
return as this present value is greater. We can explain the minimizing of WACC as
involving the trade-off between the benefit of the tax advantage of debt versus the cost of
financial distress and bankruptcy.
Because of these factors, the cost of equity is also directly related to the amount of
debt in the capital structure. The risk of the residual cash flow available to the stockholders
increases with greater amounts of debt. If a firm enters into bankruptcy, shareholders often
lose most or all of their investment in the firm.
Another way to look at optimal capital structure is to consider beginning with the
value of the all equity firm and considering the change as you add debt to the capital
structure mix. Based on the tax effect alone, the analysis would call for an optimal capital
structure of all debt. By using all debt, it would be possible to eliminate as much income
from taxes as possible. This is impractical, however, because of the existence of
bankruptcy costs. The higher the debt, the higher the bankruptcy costs, and eventually,
the increase in bankruptcy costs exceeds the tax savings generated by the use of
additional debt, and value decreases with more debt. The graph is shown below.
Firm Value
Value with only
Tax Effect
Included
Value with Tax
and Distress
Effects Included
Value of
All Equity
Firm
Optimal
Other Factors Influencing Capital Structure Choice
Debt Ratio
While this is the traditional explanation of the optimal capital structure, more recently
scholars have suggested several additional considerations:
o Signaling Theory: Since investors are uncertain about the true value of
firms, one thing managers of good firms would like to do is inform, or signal,
the market of their quality. We assume that managers know their firm’s
situation better than do investors, and this is call asymmetric information.
Managers could, of course, announce in a press conference that they were a
good firm, but this). We is unlikely to have any effect on the market’s view of
the firm (What else would you expect the manager of a firm to say?). To
influence the market managers most do something to convince the market
that they are a good firm. This is often called sending a credible signal. One
action that signals a good firm is issuing debt (another, as we shall see is
paying dividends). We know that more debt increases financial leverage and
makes the firm more risky. Managers do not want the firm to go bankrupt, so
they will only allow high financial leverage if they themselves truly believe that
the firm is strong. The key is that weak firms could not mimic this, i.e., issue
high debt to pretend to be good firms, since they might actually go bankrupt.
o Free Cash Flow/Constraining Mangers: Managers do not always use
money in ways that are best for investors. That fleet of corporate jets winging
the CEO’s family to vacation hot spots probably does not do much to
increase ROE! The more free cash flow around, the more likely it is to be
misused. Debt helps to correct this. Since debt has required interest
payments, more debt leaves less cash to be misused! In this way, debt
serves as a device to discipline management by keeping them from wasting
cash flows that are needed to service debt.
Please note that these theories are not incompatible, and our ultimate
understanding of the optimal capital structure may well involve all of them. As noted above,
optimal capital structure is not subject to mathematical precision in the sense of
discounting. It is more often a judgment call, and the more aware and knowledgeable you
are about the relevant factors, the better your own judgment will be
Dividends: An Overview
The second question relating to the left-hand side of the balance sheet is how much
in dividends the firm should pay to equity holders. Since interest payments are fixed, there
is no corresponding question regarding payments to debt holders. Equity holders have a
claim upon the ‘profits’ of firm as measured by net income or, alternately, free cash flow.
These can either be paid out to equity holders as dividends or held by the firm as retained
earnings. The latter would help the firm grow and benefit the equity holders in the form of
capital gains. The firm needs to find its optimal dividend policy. A naïve approach might be
to retain enough earnings to fund all positive NPV projects, and pay out the remainder to
equity holders. But this scheme does not take into account the tax consequences of
dividends or their role in signaling. We shall shortly turn to several theories of dividend
payments. But first we should mention four empirical facts about dividends:
1. A significant portion of dividends are paid out of earnings.
2. Individuals in high tax brackets receive large amounts of dividend income and
pay a significant amount of tax on it.
3. Corporations smooth dividends (discussed below).
4. The market reacts positively (negatively) to announcements of dividend
increases (decreases).
Any plausible theory will need to be consistent with these facts.
Theories of Dividend Policy
1. Dividend Irrelevance Theory
Under several assumptions, it can be shown that dividend policy is irrelevant,
that is, the mixture of dividends and retained earnings does not matter. The most
important of these assumptions is that there are no taxes. The stock of firms that
pay high dividends are often thought of as income stocks, and those who pay
little or no dividend (instead keep all net income as retained earnings) as growth
stocks. The dividend irrelevance theory says that there is no difference between
these two types of stocks, since any investor could themselves convert one into
the other. If an investor held a growth stock, they could convert it into an income
stock by selling a portion of it each dividend period, e.g., if they wanted a five
percent dividend, they could just sell five percent of their holdings in the stock.
On the other hand, if an investor held an income stock, they could convert it into
a growth stock by reinvesting all their dividends into more shares. This works if
there are no taxes, but if dividends are taxed, for example, you could only
reinvest your after-tax dividend and converting an income stock into a growth
stock would entail a tax loss.
Conclusion: Dividend policy is irrelevant.
2. Bird-in-the-Hand Theory
We have already seen that investors are risk adverse. Capital gains are more
uncertain than dividends, since dividends are a check in the mail, while retained
earnings should generate future capital gains, but we cannot be certain of this.
This analysis would suggest that investors would want all net income to be
disbursed as dividends. It is important, to note, however, that such a policy would
force firms to forgo positive NPV projects or else spend more money in raising
additional funds.
Conclusion: Pay out all net income as dividends.
3. Tax Preference Theory
A major factor determining dividend policy is the taxation of dividends. All net
income is taxed at the corporate level, but at the personal level capital gains is
usually treated less harshly than dividends in the tax code. (Note the current
proposals by the Bush administration may well change this.) Thus every dollar
paid as a dividend entails a greater tax loss than a dollar retained and used to
fund future growth and capital gains. This would suggest that the lower amount
paid in dividends benefits the investor.
Conclusion: Pay out as few dividends as possible.
4. Information Content or Signalling Hypothesis
So far we have thought of dividends solely as a means for the firm to get money
to equity investors. Signalling theory suggests an additional use of dividends. We
have discussed above how debt can function as a credible signal of high firm
value to the market. Dividends can do the same. Good firms should be able to
pay higher dividends than bad firms. By paying dividends, firms may send a
signal to the market of their quality. The fact that dividends are taxed at the
personal level makes this an even stronger signal, since the good firm is
announcing that they can pay such high dividends and that despite the tax loss
they can still adequately compensate their equity investors.
Conclusion: Good firms will pay out dividends as a signal of their value.
5. Clientele Effect
Different investors have different needs and preferences. Some prefer the
income from dividends, others the increase in capital gains, and others
something in between.. Different firms respond to the different needs of these
groups, or clientele, by offering a variety of dividend policies. Here dividend
policy is determined by the preferences of the investors in a specific firm.
Conclusion: Set your dividend policy to the needs of your investors.
None is these theories is completely adequate to explain all the empirical facts with
which we began. For example, the tax preference theory seems to contradict that
fact that so much of net income is paid out as dividend and especially that so many
dividends go to investors in high tax brackets.
Dividend Stability
As mentioned above firms tend to ‘smooth’ dividends, that is, they try to keep them
as stable as possible. The graphs below show the EPS and dividends for General
Electric:
General Electric
$0.50
$0.45
$0.40
$0.35
EPS
$0.30
$0.25
$0.20
Dividend
2
20
0
1
2Q
20
0
1
4Q
20
0
0
2Q
20
0
4Q
2Q
20
0
0
$0.15
$0.10
and the corresponding payout ratios:
General Electric
60%
55%
50%
45%
40%
35%
30%
2
20
0
1
2Q
20
0
1
4Q
20
0
0
2Q
20
0
4Q
2Q
20
0
0
Payout Ratio
EPS is far more volatile than the payment of dividends, and a stable payout ratio is
sacrificed for a stable absolute dividend. In spite of changes in earnings and payout
ratios, firms tend to keep dividends level.
Management of the Cost of Capital and Firm Value via the Capital Structure Decision
Going back to the idea of the residual dividend theory can help us understand a model
of value management via the capital structure decision. When a firm is in its initial stages
of development, it requires reinvestment and should not encumber its cash flows with fixed
interest payments. Growth opportunities are usually higher at this stage as well, so equity,
with its flexible structure is the preferred method of financing. As the firm grows, the return
on investment (R) exceeds the cost of equity capital (k), and as long as this remains true,
the firm should reinvest free cash flows and not pay dividends or use debt as a means of
financing. An example of this is Microsoft Corporation, who has yet to pay a dividend and
uses no debt in its capital structure.
As the firm grows and its industry becomes more competitive, growth opportunities
may diminish. As R starts to approach k, the firm begins to think about alternative
strategies. Once R falls below k (which is still the cost of equity capital for the all equity
firm) the firm can replace equity with debt in a capital restructuring. This restructuring can
also be referred to as a debt for equity swap or recap. The recap serves to lower the
WACC by replacing high cost equity with low cost debt. The proceeds from the issue of
debt are used to buy back stock, thus distributing the accumulated profits back to the
shareholders in the form of a liquidating dividend. At this time the company will also
consider paying annual dividends to the remaining shareholders, and use additional debt to
finance any reinvestment needed to perpetuate the operation of the firm. The tax shelter of
the debt interest payments frees up more earnings to be paid as dividends. In this way,
value can be maintained as the firm changes from a high growth company providing its
investors with capital gain income to a lower growth company providing its investors with
higher dividend income.
One question still remains, however, and that is: “Why should a firm borrow money if
its investors can already borrow on their own?” The answer is that individual investors may
not be able to duplicate the leverage benefits offered by the firm on their own. If the firm
can do so efficiently, it can provide investors with a benefit that they can’t attain on their
own.
Measuring the Impact of Debt on the Cost of Equity Capital
As has been indicated, increasing the level of debt relative to equity will result in
investors adding a risk premium to the cost of equity. While the exact premium can be
difficult to measure, the Hamada model provides a good theory for how this works. The
Hamada model thoerizes that increases in financial leverage increase the firm’s beta,
which in turn increases the required return via the CAPM. The Hamada model for beta is
as follows:
l = u * (1+ (1-tx)(D/E)) = Bu + [Bu * (1-tx)(D/E)]
Where:
Bl = the beta for a levered firm (with debt)
Bu =the beta for the same firm, but unlevered (no debt)
Tx = the tax rate
D/E = the debt/equity ratio
As can be seen, if the D/E ratio is zero, then the beta is equal to the beta for the unlevered
firm. As the debt/equity ratio increases, so does the beta. When we put this into the
CAPM, we have the following:
ke = rf + Bl * (km – rf) = rf + [Bu *(km – rf)] + [Bu * (1-tx)(D/E) * (km – rf)]
It is important to see that in the full breakout of the equation, there are three terms. The
first is the risk free rate, rf, the second is the business risk premium, [Bu *(km – rf)], and the
third is the financial risk premium, [Bu * (1-tx)(D/E) * (km – rf)]. The risk free rate is the
minimum return. The business risk premium is based on the unlevered beta (also known
as the “asset beta). The financial risk premium is based on the leverage ratio.
If the unlevered beta (Bu), the risk free rate and the expected market return are known,
then the equation can be rewritten as:
ke = (rf + [Bu *(km – rf)]) + (Bu * (1-tx) * (km – rf)) * (D/E) = a + b*(D/E)
where a is a constant and equal to: (rf + [Bu *(km – rf)])
and b is a slope coefficient equal to: (Bu * (1-tx) * (km – rf))
and D/E is the variable. This is the form in which you will calculate the cost of equity in
your capital structure assignment.
To cement your understanding of this equation, work through the following example:
The unlevered (or asset) beta for a company is 1.20. It has a debt/equity ratio of 50% and
pays taxes at a rate of 40%. The risk free rate is 5% and the market risk premium (market
return less risk free rate) is 7%. What is the levered beta, the required rate of return for
equity, the business risk premium and the financial risk premium?
Answer:
The levered beta is: Bl = 1.20 * (1 + (.60)(.50)) + 1.20 * (1.30) = 1.56
The cost of equity capital is: ke = 5% + (1.56 * 7%) = 5% + 10.92% = 15.92%
The business risk premium is: 1.20 * 7% = 8.4%
The financial risk premium is: [1.20 * (.60)(.50)] * 7% = .36 * 7% = 2.52%.
When you add the risk free rate of 5%, the business risk premium of 8.4%, and the
financial risk premium of 2.52%, you get the cost of equity capital of 15.92%!
Managing Capital Structure and Dividend Policy
Setting capital structure and dividend policy is a matter of subjective judgement on the
part of management. The theoretical goal is to maximize the value of the shareholder
claim on the assets of the company. To do this it is sufficient to minimize the WACC in a
simple world. Let’s look at how this might be analyzed. Suppose the company has
decided upon the following policies:
Dividend payout ratio of 40% of earnings.
Total Debt to Equity ratio of 1/3.
Short term to long term debt ratio of 1/5.
The above policies are meant to maintain the capital structure of the company. Since the
debt/equity ratio remains constant and the short term to long term debt ratio remains
constant, the weights in the WACC formula will also remain constant. If we assume that
the cost of debt and equity are constant, the WACC will be constant and we can use it as a
single discount factor to determine corporate value.
Suppose we have the following additional information:
Item
Net Income
Short term Debt
Long Term Debt
Equity
EFN (after dividend)
2002A
2003E
$2.2MM
$1MM
$5MM
$18MM
$3.5MM
We need to answer several questions:
How much will be transferred to equity as retained earnings?
How much total capital will be needed?
How will that new capital be split between short-term debt, long-term debt and equity?
Answers:
Dividends equal to $0.88 MM (40% of NI) will be paid and the remaining $1.32MM will be
transferred to equity as retained earnings. This will increase equity to $19.32MM.
Total capital will consist of the following: Short term debt (current) $1MM
Long term debt (current) $5MM
Equity (after dividend)
EFN
Total capital needed
$19.32MM
$3.5MM
$28.82MM
Of the $28.82MM, 25% will be debt and 75% will be equity, according to the targets.
Therefore, debt and equity should be:
Debt = 0.25 * $28.82MM = $7.20MM
Equity = 0.75 * 28.82MM = $21.62MM
Of the debt, 1/6 should be short term and 5/6 should be long term, therefore:
Short term debt = 1/6 * 7.20 = 1.20MM
Long term debt = 5/6 * 7.20 = 6.00MM
Therefore, new capital issued in the year 2003 is expected to be:
New short term debt: $1.20MM - $1.00MM = $0.20MM
New long term debt: $6.00MM – 5.00MM = $1.00MM
New equity issued: $21.62MM - $19.32MM = $2.30MM
Total new capital issued (=EFN)
= $3.50MM.
Given these values (or the targets given above) it is possible to estimate the weights
needed to calculate the WACC. If we then know the cost of debt and equity capital, we can
estimate the WACC for the fixed capital structure (as you will in your assignment!!).