C APITAL S TRUCTURE AND D IVIDEND P OLICY
Szabolcs Sebestyén
szabolcs.sebestyen@iscte.pt
Degree in Business Administration
C ORPORATE F INANCE
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Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
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Capital Structure: Basic Concepts
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Capital Structure: Basic Concepts
The Capital Structure Question
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Capital Structure: Basic Concepts
The Capital Structure Question
The Pie Theory
Denoting by B the market value of the debt and by S the market
value of the equity, the value of the firm, V, is
V = B+S
Two important questions:
1
2
Why should the shareholders care about maximising the value of
the entire firm? Why should they not prefer the strategy that
maximises their own interests only?
What ratio of debt to equity maximises the shareholders’ interests?
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Capital Structure: Basic Concepts
The Capital Structure Question
Example: Debt and Firm Value
Example
The market value of J. J. Sprint plc is £1,000. The company currently
has no debt (unlevered company), and each of J. J. Sprint’s 100 shares
sells for £10. Suppose that J. J. Sprint plans to borrow £500 and pay the
£500 proceeds to shareholders as an extra cash dividend of £5 per
share. What will the value of the firm be after the proposed
restructuring?
Solution
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Capital Structure: Basic Concepts
The Capital Structure Question
Example: Debt and Firm Value
Solution (cont’d)
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Capital Structure: Basic Concepts
The Capital Structure Question
Conclusions
Changes in capital structure benefit the shareholders if and only
if the value of the firm increases
Managers should choose the capital structure that they believe
will have the highest firm value because this capital structure
will be most beneficial to the firm’s shareholders
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
Example: Leverage and Returns to Shareholders
Example
Autoveloce SpA currently has no debt in its capital structure. The firm
is considering issuing debt to buy back some of its equity. Both its
current and proposed capital structures are presented in the following
table:
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
Example: Leverage and Returns to Shareholders
Example (cont’d)
The effect of economic conditions on earnings per share (EPS) for the
all-equity case is shown below:
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
Example: Leverage and Returns to Shareholders
Example (cont’d)
The case of leverage for the proposed capital structure is presented in
the table below:
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
Example: Leverage and Returns to Shareholders
Example (cont’d)
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
Example: Leverage and Returns to Shareholders
Example (cont’d)
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
MM Proposition I (No Taxes)
Proposition (Modigliani and Miller Proposition I)
The value of the levered firm is the same as the value of the
unlevered firm. Formally,
VL = VU
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Capital Structure: Basic Concepts
Financial Leverage and Firm Value
A Key Assumption
The MM result hinges on the assumption that individuals can
borrow as cheaply as corporations
Is this a realistic assumption?
In practice, individuals can borrow at low rates (slightly above the
risk-free rate) through a margin account with a broker
By contrast, companies frequently borrow using illiquid assets as
collateral =⇒ they do not necessarily pay lower rates than
individuals
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Risk to Equity-Holders Rises with Leverage
Expected return increases with leverage, but so does risk
Levered shareholders have better returns in good times than do
unlevered shareholders, but have worse returns in bad times
This is what MM Proposition II is about
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
The Cost of Capital with Debt
Suppose a firm uses both debt and equity to finance its
investments
If the firm pays RB for its debt financing and RS for its equity,
what is the overall or average cost of its capital?
It will be a weighted average of each,
R=
B
S
× RS +
× RB
S+B
S+B
Interest is tax deductible at the corporate level, so the after-tax
cost of debt becomes RB × (1 − tc )
Then the weighted average cost of capital, RWACC is
RWACC =
Sebestyén (ISCTE-IUL)
S
B
× RS +
× RB × (1 − tc )
S+B
S+B
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: WACC
Example
ArcelorMittal, the European steel maker has debt with a market value
of e 4.4 billion and equity with a market value of e 71.4 billion.
ArcelorMittal had 8 different types of bonds in issue as of September,
2008, four of which were issued in Luxembourg (denominated in
euros) and the other four denominated in dollars. Assume that the
bonds are all the same, denominated in dollars and pay interest of 6
percent per annum. The company’s shares have a beta of 1.81. The
effective tax rate for the company was 13.1 percent in 2008. Assume
that the risk premium on the market is 9.5 percent and that the current
Treasury bill rate is 4.5 percent. What is this firm’s RWACC ?
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: WACC
Solution
To compute RWACC , we need
1
The after-tax cost of debt: 6% × (1 − 0.131) = 5.214%
2
The cost of equity
Res = RF + β × (ReM − RF ) = 4.5% + 1.81 × 9.5% = 21.695%
3
The proportions of debt and equity used by the firm:
S + B = e71.4 billion + e4.4 billion = e75.8 billion, so the proportions are
S/ (S + B) = e71.4 billion/e75.8 billion = 0.942 and
B/ (S + B) = e4.4 billion/e75.8 billion = 0.058
Hence, RWACC is
RWACC =
Calculations in Excel
Sebestyén (ISCTE-IUL)
4.4
71.4
× 5.214% +
× 21.695% = 20.738%
75.8
75.8
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Deriving MM Proposition II
Assuming no taxes, we have
RWACC =
S
B
× RS +
× RB
S+B
S+B
MM Proposition I implies that RWACC is a constant for a given
firm, regardless of the capital structure
Let R0 be the cost of capital for an all-equity firm
In a world without corporate taxes, RWACC must always equal R0
Setting RWACC = R0 and rearranging the above equation yields
MM Proposition II which states the expected return on equity, RS ,
in terms of leverage
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
MM Proposition II (No Taxes)
Proposition (Modigliani and Miller Proposition II)
In a world without corporate taxes, we have
RS = R0 +
Sebestyén (ISCTE-IUL)
B
× (R0 − RB )
S
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Implications
MM Proposition II implies that the required return on equity is a
linear function of the firm’s debt-equity ratio
If R0 exceeds the cost of debt, RB , then the cost of equity rises with
increases in the debt-equity ratio, B/S
Normally R0 should exceed RB , i.e., because even unlevered
equity is risky, it should have an expected return greater than that
of riskless (or lower-risk) debt
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Modigliani and Miller Proposition II (No Taxes)
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Example
Canary Motors, an all-equity firm, has expected earnings of £10
million per year in perpetuity. The firm pays all of its earnings out as
dividends, so the £10 million may also be viewed as the shareholders’
expected cash flow. There are 10 million shares outstanding, implying
expected annual cash flow of £1 per share. The cost of capital for this
unlevered firm is 10 percent. In addition, the firm will soon build a
new plant for £4 million. The plant is expected to generate additional
cash flow of £1 million per year.
The firm will issue £4 million of either equity or debt (interest is 6%).
Discuss the effects of equity and debt financing.
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution
The project’s NPV is
NPV = −£4 million +
Sebestyén (ISCTE-IUL)
£1 million
= £6 million
0.1
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution (cont’d)
Before the market knows of the project, the market value balance sheet is:
Equity financing
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution (cont’d)
Equity financing (cont’d)
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution (cont’d)
The expected return to shareholders is
RS =
£11 million
= 0.10
£110 million
Since the firm is all equity, RS = R0 = 0.10 or 10%.
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution (cont’d)
Debt financing
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution (cont’d)
Debt financing (cont’d)
The shareholders’ expected yearly cash flow after interest is
£10
000 = £10, 760, 000
| million
{z } − £240,
| million
{z } + £1
| {z }
CF on old assets
CF on new assets
Interest
The shareholders’ expected return is
£10, 760, 000
= 10.15%
£106, 000, 000
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Example: MM Propositions I and II
Solution (cont’d)
Verifying MM Proposition II by plugging values into
RS = R0 +
B
× (R0 − RB )
S
yields
10.15% = 10% +
Sebestyén (ISCTE-IUL)
£4, 000, 000
× (10% − 6%)
£106, 000, 000
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Capital Structure: Basic Concepts
Modigliani and Miller Proposition II (No Taxes)
Again on Assumptions
In reality, almost any industry has a debt-equity ratio to which
companies in that industry tend to adhere
Is the theory still true?
Two other assumptions (besides equal borrowing costs for
individuals and firms) of MM are
I
I
Taxes were ignored
Bankruptcy costs and other agency costs were not considered
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Capital Structure: Basic Concepts
Corporate Taxes
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Capital Structure: Basic Concepts
Corporate Taxes
The Basic Insight
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Capital Structure: Basic Concepts
Corporate Taxes
Example: Taxes and Cash Flow
Example
Wasserprodukte GmbH has a corporate tax rate, tc , of 35 percent and
expected earnings before interest and taxes (EBIT) of e 1 million each
year. Its entire earnings after taxes are paid out as dividends.
The firm is considering two alternative capital structures. Under Plan
I, Wasserprodukte would have no debt in its capital structure. Under
Plan II, the company would have e 4,000,000 of debt, B. The cost of
debt, RB , is 10 percent.
What is the total cash flow to shareholders and bondholders under
each scenario?
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Capital Structure: Basic Concepts
Corporate Taxes
Example: Taxes and Cash Flow
Solution
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Capital Structure: Basic Concepts
Corporate Taxes
Present Value of the Tax Shield
The previous analysis shows a tax advantage to debt
The interest is
Interest =
RB
|{z}
×
Interest rate
B
|{z}
Amount borrowed
All this interest is tax-deductible
The reduction in corporate taxes (tax shield from debt) is
tc
|{z}
Corporate tax rate
× RB × B
| {z }
Interest paid
Whatever the taxes the firm would pay each year without debt,
the firm will pay tc RB B less with the debt of B
The PV of the tax shield (assuming equal risk as the interest on
debt and perpetual cash flows) is
tc RB B
= tc B
RB
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Capital Structure: Basic Concepts
Corporate Taxes
Value of the Levered Firm
The annual after-tax cash flow of an unlevered firm is
EBIT × (1 − tc )
The value of an unlevered firm is the present value of that,
VU =
EBIT × (1 − tc )
R0
Adding the tax shield to the value of the unlevered firm gives the
value of the levered firm
Proposition (MM Proposition I (corporate taxes))
In a world with corporate taxes, the value of a levered firm is
VL =
Sebestyén (ISCTE-IUL)
EBIT × (1 − tc ) tc RB B
+
= VU + tc B
R0
RB
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Capital Structure: Basic Concepts
Corporate Taxes
Example: MM with Corporate Taxes
Example
Divided Airlines is currently an unlevered firm. The company expects
to generate e 153.85 in earnings before interest and taxes (EBIT) in
perpetuity. The corporate tax rate is 35 percent, implying after-tax
earnings of e 100. All earnings after tax are paid out as dividends.
The firm is considering a capital restructuring to allow e 200 of debt.
Its cost of debt capital is 10 percent. Unlevered firms in the same
industry have a cost of equity capital of 20 percent.
What will the new value of Divided Airlines be?
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Capital Structure: Basic Concepts
Corporate Taxes
Example: MM with Corporate Taxes
Solution
EBIT × (1 − tc )
+ tc B =
R0
e100
+ 0.35 × e200 = e570
=
0.20
VL =
Sebestyén (ISCTE-IUL)
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Capital Structure: Basic Concepts
Corporate Taxes
Expected Return and Leverage under Taxes (1)
Proposition (MM Proposition II (corporate taxes))
In a world with corporate taxes we have
RS = R0 +
Sebestyén (ISCTE-IUL)
B
× (1 − tc ) × (R0 − RB )
S
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Capital Structure: Basic Concepts
Corporate Taxes
Expected Return and Leverage under Taxes (2)
Applying MM Proposition II to Divided Airlines, we get
RS = 0.20 +
Sebestyén (ISCTE-IUL)
200
× (1 − 0.35) × (0.20 − 0.10) = 0.2351
370
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Capital Structure: Basic Concepts
Corporate Taxes
RWACC and Corporate Taxes
Remember that the WACC with corporate taxes (VL = S + B) is
S
B
× RS +
× RB × (1 − tc )
VL
VL
For Divided Airlines, RWACC is equal to
RWACC =
370
200
× 0.2351 +
× 0.10 × (1 − 0.35) = 0.1754
570
570
Hence, Divided Airlines has reduced its RWACC from 0.20 (with no
debt) to 0.1754 with reliance on debt
However, the value of the firm is unchanged:
VL =
Sebestyén (ISCTE-IUL)
EBIT × (1 − tc )
e100
=
= e570
RWACC
0.1754
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Limits to the Use of Debt
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Limits to the Use of Debt
Costs of Financial Distress
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Limits to the Use of Debt
Costs of Financial Distress
Bankruptcy Risk or Bankruptcy Cost?
Debt puts pressure on the firm, because interest and principal
payments are obligations
If these obligations are not met, the firm may risk some sort of
financial distress
The ultimate distress is bankruptcy where ownership of the firm’s
assets is legally transferred from the shareholders to the
bondholders
Debt obligations are fundamentally different from equity
obligations
The possibility of bankruptcy has a negative effect on the value
of the firm
However, it is not the risk of bankruptcy itself that lowers value;
rather it is the costs associated with bankruptcy that lower value
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Limits to the Use of Debt
Description of Financial Distress Costs
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Limits to the Use of Debt
Description of Financial Distress Costs
Direct Costs
Legal costs
Administrative and accounting fees
Bankruptcy costs can be absolutely massive with large companies
(e.g., Lehman Brothers, Enron, etc.)
Empirical studies showed that
I
I
I
the direct costs of financial distress are estimated to be about 3% of
the firm’s market value (White, 1983 JF; Altman, 1984 JF; and Weiss,
1990 JFE)
the direct costs are about 8% of pre-bankruptcy assets (Bris, Welch
and Zhu, 2006 JF)
the proportional costs can be between 20 − 25% for smaller firms
Since few firms end up in bankruptcy, the cost estimates must be
multiplied by the probability of bankruptcy to yield the expected
cost of bankruptcy
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Limits to the Use of Debt
Description of Financial Distress Costs
Indirect Costs
Impaired ability to conduct business
I
I
Bankruptcy hampers conduct with customers and suppliers
Sales are frequently lost due to fear of impaired service and loss of
trust
These costs are difficult to measure, but the total distress costs are
estimated between 10 − 20% of firm value (Altman, 1984 JF; and
Andrade and Kaplan, 1998 JF)
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Limits to the Use of Debt
Description of Financial Distress Costs
Agency Costs
When a firm has debt, conflicts of interest arise between
shareholders and bondholders
Thus, shareholders are tempted to pursue selfish strategies
These conflicts of interest, which are magnified in financial
distress, impose agency costs on the firm
Three possible kinds of selfish strategy are
I
I
I
Incentive to take large risks
Incentive towards underinvestment
Milking the property
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Corporate Finance
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Limits to the Use of Debt
Description of Financial Distress Costs
Incentives to Take Large Risks
Firms near bankruptcy often take great chances, because they
believe that they are playing with someone else’s money
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Limits to the Use of Debt
Description of Financial Distress Costs
Incentives to Underinvest
Shareholders of a firm with a significant probability of bankruptcy
often find that new investment helps the bondholders at the
shareholders’ expense
The shareholders contribute the full investment, but the
shareholders and the bondholders share the benefits
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Limits to the Use of Debt
Description of Financial Distress Costs
Milking the Property
Pay out extra dividends or other distributions in times of financial
distress
This leaves less in the firm for the bondholders
This strategy is known as milking the property
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Limits to the Use of Debt
Description of Financial Distress Costs
Summary of Selfish Strategies
The distortions occur only when there is a probability of
bankruptcy or financial distress
Who pays for the cost of selfish investment strategies?
Ultimately the shareholders
Rational bondholders protect themselves by raising the interest
rate that they require on the bonds
For firms that face these distortions, debt will be difficult and
costly to obtain, and these firms will have low leverage ratios
Sebestyén (ISCTE-IUL)
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Corporate Finance
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Limits to the Use of Debt
Can Costs of Debt Be Reduced?
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Limits to the Use of Debt
Can Costs of Debt Be Reduced?
Protective Covenants
Protective covenants: agreement between shareholders and
bondholders to achieve lower rates
Covenants can be the lowest–cost solution to the
shareholder-bondholder conflict
A negative covenant limits or prohibits actions that the company
may take
I
I
I
I
I
Limitations on the amount of dividends a company may pay
Cannot pledge any of its assets to other lenders
Cannot merge with another firm
Cannot sell or lease major assets without approval by the lender
Cannot issue additional long-term debt
A positive covenant specifies an action that the company agrees
to take or a condition the company must abide by
I
I
Maintain working capital at a minimum level
Furnish periodic financial statements to the lender
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Limits to the Use of Debt
Integration of Tax Effects and Financial Distress Costs
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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60 / 141
Limits to the Use of Debt
Integration of Tax Effects and Financial Distress Costs
The Optimal Amount of Debt (1)
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Limits to the Use of Debt
Integration of Tax Effects and Financial Distress Costs
The Optimal Amount of Debt (2)
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Limits to the Use of Debt
Integration of Tax Effects and Financial Distress Costs
Trade-Off Theory of Capital Structure
A firm’s capital structure decision involves a trade-off between
the tax benefits of debt and the costs of financial distress
The trade-off theory of capital structure implies that there is an
optimal amount of debt for any individual firm
This amount becomes the firm’s target debt level
Since financial distress costs are impossible to express in a precise
way, there is no formula to determine a firm’s optimal debt level
exactly
Sebestyén (ISCTE-IUL)
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Corporate Finance
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Limits to the Use of Debt
Integration of Tax Effects and Financial Distress Costs
Pie Again
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Corporate Finance
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Limits to the Use of Debt
Integration of Tax Effects and Financial Distress Costs
Marketable and Non-Marketable Claims
Marketable claims: claims of shareholders and bondholders, they
can be bought and sold in financial markets
Non-marketable claims: claims of government and potential
litigants in lawsuits, non-tradable claims
Non-marketable claims owners pay nothing to the firm for the
privilege of receiving taxes/fees from the firm in the future
When speaking of the value of the firm, VT , we are referring just
to the value of the marketable claims, VM , and not to the value of
non-marketable claims, VN : VT = VM + VN
VM can change with changes in the capital structure, and it also
implies a change in VN
Rational financial managers will choose a capital structure to
maximise VM
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Corporate Finance
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Limits to the Use of Debt
The Pecking Order Theory
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Limits to the Use of Debt
The Pecking Order Theory
The Importance of Timing
So far we have evaluated the choice in terms of tax benefits,
distress costs and agency costs
However, timing is another important consideration: issue equity
when it is overvalued and otherwise issue debt
It is based on asymmetric information: the manager must know
more about the firm’s prospects than the typical investor does
However, if a firm issues equity, investors will infer that the
shares are overvalued =⇒ they will not buy until the share price
has fallen enough
Only the most overvalued firms have any incentive to issue equity
The end result is that no one will issue equity
In reality, due to taxes, financial distress costs and agency costs a
firm may issue debt only up to a point
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Limits to the Use of Debt
The Pecking Order Theory
Rules of the Pecking Order
Rule 1 Use internal financing
Investors are likely to price a debt issue with the
same scepticism that they have when pricing an
equity issue
The way out is to finance projects out of retained
earnings
Rule 2 Issue safe securities first
Since equity is riskier than debt, investors fear much
more for equity
If outside financing is required, debt should be
issued before equity
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Limits to the Use of Debt
The Pecking Order Theory
Implications of the Pecking Order Theory
There is no target amount of leverage
I
I
Unlike the trade-off model, the pecking order theory does not
imply a target amount of leverage
Each firm chooses its leverage ratio based on financing needs
Profitable firms use less debt
I
They generate cash internally, implying less need for outside
financing
Companies like financial slack
I
I
Firms accumulate cash today to fund profitable projects in the
future
However, there is a limit to the amount of cash a firm will want to
accumulate as too much free cash may tempt managers to pursue
wasteful activities
Sebestyén (ISCTE-IUL)
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Corporate Finance
69 / 141
Limits to the Use of Debt
How Firms Establish Capital Structure
Outline (Part 1)
1
Capital Structure: Basic Concepts
The Capital Structure Question
Financial Leverage and Firm Value
Modigliani and Miller Proposition II (No Taxes)
Corporate Taxes
2
Limits to the Use of Debt
Costs of Financial Distress
Description of Financial Distress Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
The Pecking Order Theory
How Firms Establish Capital Structure
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Limits to the Use of Debt
How Firms Establish Capital Structure
Empirical Regularities
Most corporations have low debt-asset ratios
I
I
There is quite a lot of variation in the debt ratios See figure
Companies do not issue debt up to the point where tax shelters are
completely used up
A number of firms use no debt
I
I
They have levels of cash and marketable securities well above their
levered counterparts
Typically, the managers of those firms have high equity ownership
There are differences in the capital structures of different
industries
I
See table
Most corporations employ target debt-equity ratios
I
See figure
Sebestyén (ISCTE-IUL)
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Limits to the Use of Debt
How Firms Establish Capital Structure
Factors Affecting the Target Debt-Equity Ratio
Taxes
I
Highly profitable firms are more likely to have larger target ratios
than less profitable ratios
Types of assets
I
I
The costs of financial distress depend on the types of assets that the
firm has
Firms with large investments in tangible assets are likely to have
higher target debt-equity ratios than firms with large investment in
R+D
Uncertainty of operating income
I
I
Firms with uncertain operating income (e.g. pharmaceutical firms)
have a high probability of experiencing financial distress, even
without debt
Thus these firms must finance mostly with equity and issue little
debt
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Valuation and Capital Budgeting for the Levered Firm
Outline Part (2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
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Corporate Finance
73 / 141
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
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Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Adjusted Present Value Approach
The adjusted present value (APV) approach separates project
cash flows from financing cash flows and values these separately
If the combined PVs are positive, the project should be taken
The value of a project to a levered firm (APV) is equal to the value
of the project to an unlevered firm (NPV) plus the NPV of the
financing side effects (NPVF):
APV = NPV + NPVF
Possible side effects:
I
I
I
I
The tax subsidy to debt: tc B; this has the highest value in reality
The costs of issuing new securities: bankers participate in the
public issuance of debt, so they must be compensated
The costs of financial distress
Subsidies to debt financing: the interest on debt issued by state and
local governments may not be taxable to the investor, or the tax
may be discounted
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Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Adjusted Present Value Approach: An Example
Example
Consider a project of P. B. Singer plc with the following characteristics:
Cash inflows: £500,000 per year for the indefinite future
Cash costs: 72% of sales
Initial investment: £520,000
tc = 28% and R0 = 20%
Evaluate the project assuming
a
that both the firm and the project are financed with only equity;
b
that the firm finances the project with exactly £135,483.90 in debt.
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Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Adjusted Present Value Approach: An Example
Solution
a
Both the firm and the project are financed with only equity
The project’s cash flows are
(£)
Cash inflows
Cash costs
500, 000
−360, 000
Profit before tax
Corporate tax
140, 000
−39, 200
Unlevered cash flow (UCF)
100, 800
NPV = −£520, 000 +
£100, 800
= −£16, 000
0.20
=⇒ the project would be rejected
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Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Adjusted Present Value Approach: An Example
Solution (cont’d)
b
The firm finances the project with exactly £135,483.90 in debt
The APV of the project is
APV = NPV + tc × B = −£16, 000 + 0.28 × £135, 483.90 = £21, 935
=⇒ the project should be accepted
The debt amount is chosen so that the ratio of debt to the PV of the project
under leverage is 0.25:
£135, 483.90
= 0.25
£21, 935 + £520, 000
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Valuation and Capital Budgeting for the Levered Firm
Flow to Equity Approach
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
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Valuation and Capital Budgeting for the Levered Firm
Flow to Equity Approach
Flow to Equity Approach
The flow to equity (FTE) approach discounts the cash flow from
the project to the shareholders of the levered firm at the cost of
equity capital, RS
For a perpetuity this becomes
Cash flow from project to equity-holders of the levered firm
RS
It can be carried out in three steps:
1
2
3
Calculating levered cash flow (LCF)
Calculating RS
Valuation
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Valuation and Capital Budgeting for the Levered Firm
Flow to Equity Approach
Flow to Equity Approach: An Example
Example
Consider again the project of P. B. Singer plc with the characteristics:
Cash inflows: £500,000 per year for the indefinite future
Cash costs: 72% of sales
Initial investment: £520,000
tc = 28%, R0 = 20% and RB = 10%
Evaluate the project assuming that the firm finances the project with
exactly £135,483.90 in debt.
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Valuation and Capital Budgeting for the Levered Firm
Flow to Equity Approach
Flow to Equity Approach: An Example
Solution
Step 1: Calculating levered cash flow (LCF)
(£)
Cash inflows
Cash costs
Interest
500, 000
−360, 000
−13, 548
Income after interest
Corporate tax
126, 452
−35, 407
Levered cash flow (LCF)
91, 045
Alternatively,
LCF = UCF − (1 − tc ) RB B =
= £100, 800 − 0.72 × 0.10 × £135, 483.90 = £91, 045
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Valuation and Capital Budgeting for the Levered Firm
Flow to Equity Approach
Flow to Equity Approach: An Example
Solution (cont’d)
Step 2: Calculating RS
The target debt-to-value ratio of 1/4 implies a target debt-to-equity ratio of
1/3, so
B
(1 − tc ) (R0 − RB ) =
S
1
= 0.20 + (1 − 0.28) (0.20 − 0.10) = 0.224
3
RS = R0 +
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Valuation and Capital Budgeting for the Levered Firm
Flow to Equity Approach
Flow to Equity Approach: An Example
Solution (cont’d)
Step 3: Valuation
The PV of the project’s LCF is
£91, 045
LCF
=
= £406, 451
RS
0.224
Since the initial investment is £520,000 and £135,483.90 is borrowed, the
firm must advance the project £384,516.10 out of its own cash reserves.
The NPV is
NPV = £406, 451 − £384, 516.10 = £21, 935
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
Weighted Average Cost of Capital Method
Recall that
RWACC =
S
B
RS +
R B ( 1 − tc )
S+B
S+B
The weights for equity and debt are target ratios, and are
generally expressed in terms of market values
The NPV of the project will be
∞
NPV =
t=1
Sebestyén (ISCTE-IUL)
UCFt
∑ (1 + R
WACC )
t
− Initial investment
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
WACC Approach: An Example
Example
Evaluate again the project of P. B. Singer, assuming that the firm
finances the project with exactly £135,483.90 in debt, using the WACC
method.
Solution
RWACC =
3
1
× 0.224 + × 0.10 × 0.72 = 0.186
4
4
The PV of the project is
PV =
£100, 800
= £541, 935
0.186
The NPV becomes
NPV = £541, 935 − £520, 000 = £21, 935
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
Summary (1)
1
Adjusted present value (APV) method:
∞
NPV =
t=1
I
I
I
UCFt
∑ (1 + R
0)
t
+ Additional effects of debt − Initial investment
UCFt is the project’s cash flow at date t to the equity-holders of an
unlevered firm
R0 is the cost of capital for project in an unlevered firm
The middle term implies that the value of a project with leverage is
greater than the value of the project without leverage
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
Summary (2)
2
Flow to equity (FTE) method:
∞
NPV =
t=1
I
I
I
LCFt
∑ (1 + R
S)
t
− (Initial investment − Amount borrowed)
LCFt is the project’s cash flow at date t to the equity-holders of a
levered firm
RS is the cost of equity capital with leverage
Cash flow after interest (LCF) is used
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
Summary (3)
3
Weighted average cost of capital (WACC) method:
∞
NPV =
t=1
I
I
UCFt
∑ (1 + R
WACC )
t
− Initial investment
RWACC is the weighted average cost of capital
Since RWACC < R0 , the value of a project with leverage is greater
than the value of the project without leverage
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Valuation and Capital Budgeting for the Levered Firm
Weighted Average Cost of Capital Method
Guidelines
Use WACC or FTE if the firm’s target debt-to-value ratio applies
to the project over its life
Use APV if the project’s level of debt is known over the life of
the project
Typical capital budgeting situations are more amenable to either
the WACC or the FTE approach than to the APV approach as
financial managers usually think in terms of target debt-to-value
ratios
WACC is by far the most widely used method in the real world
Calculations in Excel
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Valuation and Capital Budgeting for the Levered Firm
Capital Budgeting when the Discount Rate Must Be Estimated
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
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Valuation and Capital Budgeting for the Levered Firm
Capital Budgeting when the Discount Rate Must Be Estimated
Example: Cost of Capital
Example
World-Wide Enterprises (WWE) is a large conglomerate thinking of
entering the widget business, where it plans to finance projects with a
debt-to-value ratio of 25 percent (or, alternatively, a debt-to-equity
ratio of 1/3).
There is currently one firm in the widget industry, Asian Widgets
(AW). This firm is financed with 40 percent debt and 60 percent equity.
The beta of AW’s equity is 1.5.
AW has a borrowing rate of 12 percent, and WWE expects to borrow
for its widget venture at 10 percent. The corporate tax rate for both
firms is 0.40, the market risk premium is 8.5 percent, and the riskless
interest rate is 8 percent.
What is the appropriate discount rate for WWE to use for its widget
venture?
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Valuation and Capital Budgeting for the Levered Firm
Capital Budgeting when the Discount Rate Must Be Estimated
Example: Cost of Capital
Solution
Since AW is WWE’s only competitor in widgets, we look at AW’s cost of
capital to calculate R0 , RS and RWACC for WWE’s widget venture
Step 1: Determining AW’s cost of equity capital
RS = RF + β × (ReM − RF ) = 8% + 1.5 × 8.5% = 20.75%
Step 2: Determining AW’s hypothetical all-equity cost of capital
AW’s all-equity cost of capital is
B
(1 − tc ) (R0 − RB )
S
0.4
× 0.60 × (R0 − 12%)
20.75% = R0 +
0.6
RS = R0 +
from which R0 = 18.25%
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Valuation and Capital Budgeting for the Levered Firm
Capital Budgeting when the Discount Rate Must Be Estimated
Example: Cost of Capital
Solution (cont’d)
Step 3: Determining RS for WWE’s widget venture
Cost of equity capital for WWE’s widget venture is
B
(1 − tc ) (R0 − RB ) =
S
1
= 18.25% + × 0.60 × (18.25% − 10%) = 19.9%
3
RS = R0 +
Step 4: Determining RWACC for WWE’s widget venture
B
S
R B ( 1 − tc ) +
RS =
S+B
S+B
1
3
= × 10% × 0.60 + × 19.9% = 16.425%
4
4
RWACC =
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Corporate Finance
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Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
96 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Beta and Leverage
Recall that in a world without taxes we have
B
β Equity = β Asset 1 +
S
With corporate taxes and β Debt = 0 we have
B
β Equity = 1 + (1 − tc )
β Unlevered firm
S
Since 1 + (1 − tc ) B/S > 1 for a levered firm =⇒
β Unlevered firm < β Equity
Leverage increases the equity beta less rapidly under corporate
taxes because, under taxes, leverage creates a riskless tax shield,
thereby lowering the risk of the entire firm
Sebestyén (ISCTE-IUL)
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Corporate Finance
97 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Beta and Leverage
The generalised formula for the levered beta, where β Debt 6= 0, is
β Equity = β Unlevered firm + (1 − tc ) ( β Unlevered firm − β Debt )
B
S
Then the unlevered beta can be expressed as
β Unlevered firm =
Sebestyén (ISCTE-IUL)
S
B (1 − tc )
× β Equity +
× β Debt
B ( 1 − tc ) + S
B ( 1 − tc ) + S
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
98 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Example: Unlevered Betas
Example
Ross McDermott plc is considering a scale-enhancing project. The
market value of the firm’s debt is £100 million, and the market value of
the firm’s equity is £200 million. The debt is considered riskless. The
corporate tax rate is 28 percent. Regression analysis indicates that the
beta of the firm’s equity is 2. The risk-free rate is 10 percent, and the
expected market premium is 8.5 percent. What would the project’s
discount rate be in the hypothetical case that Ross McDermott plc is
all-equity?
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
99 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Example: Unlevered Betas
Solution
Step 1: Determining beta of hypothetical all-equity firm
The unlevered beta is
S
=
S + ( 1 − tc ) × B
£200 million
= 1.47
= 2×
£200 million + (1 − 0.28) × £100 million
βU = βS ×
Step 2: Determining the discount rate
RS = RF + β U × (RM − RF ) = 10% + 1.47 × 8.5% = 22.5%
Sebestyén (ISCTE-IUL)
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Corporate Finance
100 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Example: Non-Scale-Enhancing Project
Example
The Irish firm, J. Lowes plc, which currently manufactures staples, is
considering a e 1 million investment in a project in the aircraft
adhesives industry. The corporation estimates unlevered after-tax cash
flows (UCF) of e 300,000 per year into perpetuity from the project. The
firm will finance the project with a debt-to-value ratio of 0.5 (or,
equivalently, a debt-to-equity ratio of 1 : 1).
The three competitors in this new industry are currently unlevered,
with betas of 1.2, 1.3, and 1.4. Assuming a risk-free rate of 5 percent, a
market risk premium of 9 percent, and a corporate tax rate of 12.5
percent, what is the net present value of the project?
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
101 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Example: Non-Scale-Enhancing Project
Solution
Step 1: Calculating the average unlevered beta in the industry
1.2 + 1.3 + 1.4
= 1.3
3
Step 2: Calculating the levered beta for J. Lowes’s new project
β Unlevered firm =
B
1
β S = 1 + ( 1 − tc )
β U = 1 + 0.875 ×
× 1.3 = 2.4375
S
1
Step 3: Calculating the cost of levered equity for the new project
RS = RF + β S × (RM − RF ) = 5% + 2.4375 × 9% = 26.9%
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
102 / 141
Valuation and Capital Budgeting for the Levered Firm
Beta and Leverage
Example: Non-Scale-Enhancing Project
Solution (cont’d)
Step 4: Calculating the WACC for the new project
RWACC =
B
S
1
1
RB (1 − tc ) + RS = × 5% × 0.875 + × 26.9% = 15.6%
V
V
2
2
Step 5: Determining the project’s value
UCF
− Initial investment =
RWACC
e300, 000
=
− e1 million = e923, 077
0.156
NPV =
Sebestyén (ISCTE-IUL)
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Corporate Finance
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Dividend Policy
Outline Part (2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
104 / 141
Dividend Policy
Types of Dividend
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
105 / 141
Dividend Policy
Types of Dividend
Types of Dividend
Public companies usually pay regular cash dividends
Paying a cash dividend reduces corporate cash and retained
earnings
Stock dividend is paid out in shares of equity
It is not a true dividend as no cash leaves the firm
Rather, it increases the number of shares outstanding, thereby
reducing the value of each share
A stock dividend is commonly expressed as a ratio, e.g., a 2%
stock dividend means 1 new share for every 50 currently owned
With a stock split, the firm increases the number of shares
outstanding =⇒ the share price should fall
It is similar to a stock dividend, but it is usually much larger
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
106 / 141
Dividend Policy
The Irrelevance of Dividend Policy
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
107 / 141
Dividend Policy
The Irrelevance of Dividend Policy
Current Policy: Dividends Set Equal to Cash Flow
Example
Bristol Corporation is an all-equity firm started 10 years ago. The financial
managers know now (date 0) that the firm will dissolve in one year (date 1).
The managers know with certainty that the firm will receive a cash flow of
£10,000 immediately and another £10,000 next year.
At date 0, dividends at each date are set equal to the cash flow. Then the
value of the firm, assuming RS = 10% is
V0 = Div0 +
£10, 000
Div1
= £10, 000 +
= £19, 090.91
1 + RS
1.10
If 1,000 shares are outstanding, the value of each share is
£10 +
£10
= £19.09
1.10
After the dividend is paid, the share price will immediately fall to £9.09
(= £19.09 − £10)
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
108 / 141
Dividend Policy
The Irrelevance of Dividend Policy
Alternative Policy: Initial Dividend Is Greater than
Cash Flow
Example
Another policy is to pay £11 per share now =⇒ total dividend payout of
£11,000
The extra £1,000 is raised through equity issuance, and the new shareholders
will desire enough cash flow at date 1 to ensure a 10% return =⇒ they will
demand £1,100 at date 1, leaving only £8,900 to the old shareholders
The PV of the dividends per share is
£11 +
£8.90
= £19.09
1.10
New shareholders are not entitled to the immediate dividend, so they would
pay £8.09 (= £8.90/1.10) per share
Thus 123.61 (= £1, 000/£8.09) are issued
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
109 / 141
Dividend Policy
The Irrelevance of Dividend Policy
The Indifference Proposition
Sebestyén (ISCTE-IUL)
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Corporate Finance
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Dividend Policy
The Irrelevance of Dividend Policy
Homemade Dividends (1)
Suppose investor X prefers dividends per share of £10 at both
dates 0 and 1
Would she be disappointed if the firm’s management adopted the
alternative policy (£11 now and £8.90 at date 1)?
NO: she could reinvest the £1 unneeded funds, yielding £1.10 at
date 1
Thus she would receive her desired cash flow of £11−£1 = £10
now and £8.90+£1.10 = £10 at date 1
The opposite case can also be shown
These combinations of date 0 and date 1 dividends is called
homemade dividends
Since both the firm and the investors can move along the different
combinations of homemade dividends, dividend policy is
irrelevant
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
111 / 141
Dividend Policy
The Irrelevance of Dividend Policy
Homemade Dividends (2)
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
112 / 141
Dividend Policy
The Irrelevance of Dividend Policy
Two True Statements
Dividends are relevant
I
I
Investors prefer higher dividends to lower dividends at any single
date if the dividend level is held constant at every other date
This can be accomplished by management decisions that improve
productivity, increase tax savings, or strengthen product marketing
Dividend policy is irrelevant
I
I
Dividend policy cannot raise the dividend per share at one date
while holding the dividend level per share constant at all other
dates
Dividend policy merely establishes the trade-off between
dividends at one date and dividends at another date
Overall, managers choosing either to raise or to lower the current
dividend do not affect the current value of the firm
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
113 / 141
Dividend Policy
The Irrelevance of Dividend Policy
Dividends and Investment Policy
An increase in dividends through issuance of new shares neither
helps nor hurts the shareholders
Similarly, a reduction in dividends through share repurchases
neither helps nor hurts the shareholders
What about reducing capital expenditures to increase dividends?
Firms should never give up a positive NPV project to increase a
dividend (or to pay a dividend for the first time).
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
114 / 141
Dividend Policy
Share Repurchases
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
115 / 141
Dividend Policy
Share Repurchases
Ratios of Various Payouts to Earnings
Source: Figure 3 of Brandon and Ikenberry, 2004, ’Reappearing dividends’, Journal of Applied
Corporate Finance.
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
116 / 141
Dividend Policy
Share Repurchases
Types of Share Repurchases
Open market purchases: the company purchases its own equity
at the stock exchange
I The firm does not reveal itself as the buyer =⇒ the seller does not
know who the buyer is
Tender offer: the firm announces to all of its shareholders that is
willing to buy a fixed number of shares at a specific price
Targeted repurchase: the firm repurchases shares from specific
individual shareholders
I
I
I
A single large shareholder can be bought out at a price lower than
those in a tender offer
The legal fees may also be lower than those in a more typical
buyback
The shares of large shareholders are often repurchased to avoid a
takeover unfavourable to management
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
117 / 141
Dividend Policy
Share Repurchases
Dividends vs Repurchases: A Conceptual Example
Example
Telephonic Industries has excess cash of £300,000 (or £3 per share) and is
considering an immediate payment of this amount as an extra dividend. The
firm forecasts that, after the dividend, earnings will be £450,000 per year, or
£4.50 for each of the 100,000 shares outstanding. Because the price-earnings
ratio is 6 for comparable companies, the shares of the firm should sell for £27
(= £4.50 × 6) after the dividend is paid. Because the dividend is £3 per share,
the equity would have sold for £30 a share before payment of the dividend.
Proposed dividend
Forecast annual earnings after
dividend
Market value of equity after
dividend
Sebestyén (ISCTE-IUL)
For entire firm (£)
Per share (£)
300, 000
3.00
450, 000
4.50
2, 700, 000
27.00
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
118 / 141
Dividend Policy
Share Repurchases
Dividends vs Repurchases: A Conceptual Example
Example (cont’d)
Alternatively, the firm could use the excess cash to repurchase some of its
own equity. Imagine that a tender offer of £30 a share is made. Here, 10,000
shares are repurchased so that the total number of shares remaining is 90,000.
With fewer shares outstanding, the earnings per share will rise to £5 (=
£450,000/90,000). The price-earnings ratio remains at 6 because both the
business and financial risks of the firm are the same in the repurchase case as
they were in the dividend case. Thus, the price of a share after the repurchase
is £30 (= £5 × 6).
Forecast annual earnings after
repurchase
Market value of equity after
repurchase
Sebestyén (ISCTE-IUL)
For entire firm (£)
Per share (£)
450, 000
5.00
2, 700, 000
30.00
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
119 / 141
Dividend Policy
Share Repurchases
Dividends vs Repurchases: Real World Considerations
Flexibility: firms often view dividends as a commitment to their
shareholders, while repurchases do not represent such a
commitment
I
A firm with a permanent increase in cash flow is likely to increase
dividend, and vice versa
Executive compensation: executives are frequently given share
options as part of their overall compensation
I
Share options will always have greater value when the firm
repurchases shares as the share price will be greater after a
repurchase than after a dividend
Offset to dilution: exercise of options causes dilution shares
I
Firms frequently buy back shares of equity to offset this delution
Undervaluation: many firms buy back shares because they
believe that the equity is undervalued
I
Empirical studies support this, and long-term performance of
shares after a buyback is better than the share price of comparable
companies without repurchase
Taxes: repurchases provide a tax advantage over dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
120 / 141
Dividend Policy
Personal Taxes and Dividends
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
121 / 141
Dividend Policy
Personal Taxes and Dividends
Firms without Sufficient Cash to Pay a Dividend (1)
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
122 / 141
Dividend Policy
Personal Taxes and Dividends
Firms without Sufficient Cash to Pay a Dividend (2)
In a world of personal taxes, firms should not issue equity to pay
dividends
The direct costs of issuance will add to this effect
Since the size of new issues can be lowered by a reduction in
dividends, a low-dividend policy is favourable
A company with a large and steady cash flow for many years in
the past might be paying a regular dividend
If the cash flow unexpectedly dries up for a single year, many
managers might issue the equity anyway, as shareholders prefer
dividend stability
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
123 / 141
Dividend Policy
Personal Taxes and Dividends
Firms with Sufficient Cash to Pay a Dividend
Consider a firm with £1 million in extra cash after selecting all
positive NPV projects
The firm has the following alternatives to a dividend:
1
Select additional capital budgeting projects: the firm must invest
in negative NPV projects
Research suggests that many managers do this to keep the funds in
the firm
2
Acquire other companies: the advantage is acquiring profitable
assets
However, acquisition often has heavy costs
Acquisitions are invariably made above market price
3
Purchase financial assets: it depends on personal and corporate tax
rates
If personal tax rates are higher than corporate tax rates, a firm will
have an incentive to reduce dividend payouts, and vice versa
4
Repurchase shares: in a world of taxes, shareholders will generally
prefer a repurchase to a dividend
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
124 / 141
Dividend Policy
Personal Taxes and Dividends
Why Would a Firm Ever Pay a Dividend Instead of
Repurchsing Shares?
In many countries (e.g., UK) there is a fear that share repurchases
can lead to illegal price manipulation
Tax authorities can penalise firms repurchasing their own shares if
the only reason is to avoid taxes
These explanations are not sufficient to explain why firms pay
dividends instead of repurchasing shares
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
125 / 141
Dividend Policy
Real-World Factors Favouring a High-Dividend Policy
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
126 / 141
Dividend Policy
Real-World Factors Favouring a High-Dividend Policy
Factors Favouring a High-Dividend Policy (1)
Desire for current income: many individuals desire current
income
I
In the real world with transaction costs these individuals would bid
up the share price should dividends rise and vice versa
Agency costs: a dividend can be viewed as a wealth transfer from
bondholders to shareholders
I
I
I
Managers, acting on behalf of shareholders, may pay dividends to
keep the cash away from bondholders
By paying dividends equal to the amount of surplus cash flow, a
firm can reduce management’s ability to squander the firm’s
resources
It is not an argument for dividends over repurchases
Information content: the share price of a firm generally rises
when the firm announces a dividend increase, and vice versa
I
A dividend increase is management’s signal to the market that the
firm is expected to do well: information content effect
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
127 / 141
Dividend Policy
Real-World Factors Favouring a High-Dividend Policy
Factors Favouring a High-Dividend Policy (2)
Dividend signalling: could management increase dividends just
to make the market think that cash flows will be higher, even
when management knows that they will not rise?
I
I
I
I
Research shows that managers frequently attempt this strategy
Cost to raising dividends prevents raising without limit
Does a motive to signal imply that managers will increase
dividends rather than share repurchases?
No: most academic models imply that dividends and share
repurchases are perfect substitutes
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
128 / 141
Dividend Policy
The Clientele Effect
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
129 / 141
Dividend Policy
The Clientele Effect
The Clientele Effect
Clienteles are likely to form in the following way:
Group
Equities
Individuals in high tax brackets
Individuals in low tax brackets
Tax-free institutions
Zero- to low-payout shares
Low- to medium-payout shares
Medium- to high-payout shares
“In a world where many investors like high dividends, a firm can boost
its share price by increasing its dividend payout ratio”. True or false?
It is likely to be false: a firm can boost its share price only if an
unsatisfied clientele exists
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
130 / 141
Dividend Policy
The Clientele Effect
Preferences of Investors for Dividend Yield
Source: Adapted from Fig. 2 of Graham and Kumar, 2006, ’Do dividend clienteles exist? Evidence
on dividend preferences of retail investors’, Journal of Finance
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
131 / 141
Dividend Policy
Empirical Evidence about Dividends
Outline (Part 2)
3
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value Approach
Flow to Equity Approach
Weighted Average Cost of Capital Method
Capital Budgeting when the Discount Rate Must Be Estimated
Beta and Leverage
4
Dividend Policy
Types of Dividend
The Irrelevance of Dividend Policy
Share Repurchases
Personal Taxes and Dividends
Real-World Factors Favouring a High-Dividend Policy
The Clientele Effect
Empirical Evidence about Dividends
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
132 / 141
Dividend Policy
Empirical Evidence about Dividends
Dividends and Share Repurchases in the EU
Source: Fig. 4 of von Eije and Megginson, 2008, ’Dividends and share repurchases in the
European Union’, Journal of Financial Economics
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
133 / 141
Dividend Policy
Empirical Evidence about Dividends
Proportion of Cash Dividend Payers Among
European Industrial Firms
Source: Fig. 3 of von Eije and Megginson, 2008, ’Dividends and share repurchases in the
European Union’, Journal of Financial Economics
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
134 / 141
Dividend Policy
Empirical Evidence about Dividends
The Pros of Paying Dividends
Dividends appeal to investors who desire stable cash flow but do
not want to incur the transaction costs from periodically selling
shares of equity
Managers, acting on behalf of shareholders, can pay dividends in
order to keep cash from bondholders
The board of directors can use dividends to reduce the cash
available to spendthrift managers
Managers may increase dividends to signal their optimism
concerning future cash flow
Sebestyén (ISCTE-IUL)
C APITAL S TRUCTURE AND D IVIDEND P OLICY
Corporate Finance
135 / 141
Dividend Policy
Empirical Evidence about Dividends
The Cons of Paying Dividends
Dividends are taxed as ordinary income
Dividends can reduce internal sources of financing
I
Dividends may force the firm to forgo positive NPV projects or to
rely on costly external equity financing
Once established, dividend cuts are hard to make without
adversely affecting a firm’s share price
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Dividend Policy
Empirical Evidence about Dividends
Survey Responses on Dividend Decisions
Survey repondents were asked the question, ’Do these statements describe factors that affect
your company’s dividend decisions?’
Source: Adapted from Table 4 of Brav, Graham, Harvey and Michaely, 2005, ’Payout policy in the
21st century’, Journal of Financial Economics
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Corporate Finance
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Dividend Policy
Empirical Evidence about Dividends
Survey Responses on Dividend Decisions
Source: Adapted from Table 5 of Brav, Graham, Harvey and Michaely, 2005, ’Payout policy in the
21st century’, Journal of Financial Economics
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Appendix
Estimated Ratios of Debt to Equity
Source: J.P.H. Fan, S. Titman and G. Twite, 2006, ’An international comparison of capital structure
and debt maturity choices’, Working Paper.
Return
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Appendix
Average Capital Structure Ratios For Various
Industries
Return
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Appendix
Survey Results on the Use of Target Debt-Equity
Ratios
Source: Figure 1 of D. Brounen, A. de Jong and K. Koedijk, 2006, ’Capital structure policies in
Europe: Survey evidence’, Journal of Banking and Finance.
Return
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