UNIT 9
Capital Structure and Dividend
Policy




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Optimal/Target capital structures
Business vs. financial risk
Hamada equation
Dividends vs. capital gains
Residual dividend model
U9-1
Optimal & Target Capital Structures


The firm’s optimal capital structure is
the capital structure that maximizes its
stock price.
The firm’s target capital structure is the
mix of debt, preferred stock, and
common equity with which the firm
plans to raise capital.
U9-2
What is business risk?

Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Low risk
Probability
High risk
0

E(EBIT)
EBIT
Note that business risk does not include financing
effects.
U9-3
What determines business risk?




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Uncertainty about demand (sales)
Uncertainty about output prices
Uncertainty about costs
Product, other types of liability
Operating leverage
U9-4
What is operating leverage, and how
does it affect a firm’s business risk?


Operating leverage is the use of
fixed costs rather than variable
costs.
If most costs are fixed, hence do not
decline when demand falls, then the
firm has high operating leverage.
U9-5
Effect of operating leverage

More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
Rev.
Rev.
$
TC
$
} Profit
TC
FC
FC
QBE

Sales
QBE
Sales
What happens if variable costs change?
U9-6
Using operating leverage
Low operating leverage
Probability
High operating leverage
EBITL

EBITH
Typical situation: Can use operating leverage
to get higher E(EBIT), but risk also increases.
U9-7
What is financial leverage?
Financial risk?


Financial leverage is the use of debt
and preferred stock.
Financial risk is the additional risk
concentrated on common
stockholders as a result of financial
leverage.
U9-8
Business risk vs. Financial risk


Business risk depends on business
factors such as competition, product
liability, and operating leverage.
Financial risk depends only on the
types of securities issued.


More debt, more financial risk.
Concentrates business risk on
stockholders.
U9-9
An example:
Illustrating effects of financial leverage


Two firms with the same operating leverage,
business risk, and probability distribution of
EBIT.
Only differ with respect to their use of debt
(capital structure).
Firm U
No debt
$20,000 in assets
40% tax rate
Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate
U9-10
Firm U: Unleveraged
Prob.
EBIT
Interest
EBT
Taxes (40%)
NI
Bad
0.25
$2,000
0
$2,000
800
$1,200
Economy
Avg.
0.50
$3,000
0
$3,000
1,200
$1,800
Good
0.25
$4,000
0
$4,000
1,600
$2,400
U9-11
Firm L: Leveraged
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI
Bad
0.25
$2,000
1,200
$ 800
320
$ 480
Economy
Avg.
0.50
$3,000
1,200
$1,800
720
$1,080
Good
0.25
$4,000
1,200
$2,800
1,120
$1,680
*Same as for Firm U.
U9-12
Ratio comparison between
leveraged and unleveraged firms
FIRM U
BEP
ROE
TIE
FIRM L
BEP
ROE
TIE
Bad
Avg
Good
10.0%
6.0%
∞
15.0%
9.0%
∞
20.0%
12.0%
∞
Bad
Avg
Good
10.0%
4.8%
1.67x
15.0%
10.8%
2.50x
20.0%
16.8%
3.30x
U9-13
Risk and return for leveraged
and unleveraged firms
Expected Values:
E(BEP)
E(ROE)
E(TIE)
Firm U
15.0%
9.0%
∞
Firm L
15.0%
10.8%
2.5x
Firm U
2.12%
0.24
Firm L
4.24%
0.39
Risk Measures:
σROE
CVROE
U9-14
The effect of leverage on
profitability and debt coverage



For leverage to raise expected ROE, must
have BEP > rd.
Why? If rd > BEP, then the interest expense
will be higher than the operating income
produced by debt-financed assets, so
leverage will depress income.
As debt increases, TIE decreases because
EBIT is unaffected by debt, and interest
expense increases (Int Exp = rdD).
U9-15
Conclusions
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
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Basic earning power (BEP) is
unaffected by financial leverage.
L has higher expected ROE because
BEP > rd.
L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return
is accompanied by higher risk.
U9-16
Why do the bond rating and cost of debt
depend upon the amount of debt borrowed?

As the firm borrows more money, the firm
increases its financial risk causing the
firm’s bond rating to decrease, and its
cost of debt to increase.
U9-17
What effect does more debt
have on a firm’s cost of equity?



If the level of debt increases, the risk of
the firm increases.
Increased risk increases the cost of
debt.
However, the risk of the firm’s equity
also increases, resulting in a higher rs.
U9-18
The Hamada Equation



Because the increased use of debt causes
both the costs of debt and equity to increase,
we need to estimate the new cost of equity.
The Hamada equation attempts to quantify
the increased cost of equity due to financial
leverage.
Uses the firm’s unlevered beta, which
represents the business risk of a firm if it had
no debt.
U9-19
The Hamada Equation
bL = bU[ 1 + (1 – T) (D/E)]


Suppose rRF and RPM = 6%, the firm’s
unlevered beta (bU) = 1.0, total assets
(D+E) = $2,000, and the tax rate (T) =
40%.
Debt and Equity should be at market
values.
U9-20
Calculating levered beta and cost
of equity
If D = $250, then E = $2,000 - $250 = $1,750.
bL = 1.0 [ 1 + (0.6)($250/$1,750) ] = 1.0857.
rs = rRF + (rM – rRF) bL
rs = 6.0% + (6.0%) 1.0857 = 12.51%.
 bL > bU because debt increases risk.
U9-21
How is a firm’s capital structure affected
by more/less business risk?


If there were higher business risk, then
the probability of financial distress would
be greater at any debt level, and the
optimal capital structure would be one
that had less debt.
However, lower business risk would lead
to an optimal capital structure with more
debt.
U9-22
Other factors to consider when
establishing the firm’s target capital
structure
1.
2.
3.
4.
5.
6.
7.
Industry average debt ratio
TIE ratios under different scenarios
Lender/rating agency attitudes
Reserve borrowing capacity
Effects of financing on control
Asset structure
Expected tax rate
U9-23
How would these factors affect
the target capital structure?
1.
2.
3.
4.
5.
6.
Sales stability?
High operating leverage?
Increase in the corporate tax rate?
Increase in the personal tax rate?
Increase in bankruptcy costs?
Management spending lots of money
on lavish perks?
U9-24
Conclusions on Capital Structure
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
Capital structure decisions have a large
judgmental content.
Capital structures vary widely among
firms, even similar ones in the same
industry.
U9-25
What is dividend policy?
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The decision to pay out earnings versus
retaining and reinvesting them.
Dividend policy includes

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High or low dividend payout?
Stable or irregular dividends?
How frequent to pay dividends?
Announce the policy?
U9-26
Dividend irrelevance theory
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Investors are indifferent between dividends
and retention-generated capital gains.
Investors can create their own dividend policy
 If they want cash, they can sell stock.
 If they don’t want cash, they can use
dividends to buy stock.
Proposed by Modigliani and Miller and based
on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true.
Need an empirical test.
U9-27
Why investors might prefer dividends


May think dividends are less risky
than potential future capital gains.
If so, investors would value highpayout firms more highly, i.e., a high
payout would result in a high P0.
U9-28
Why investors might prefer capital gains


May want to avoid transactions costs
Maximum tax rate is the same as on
dividends, but …
 Taxes on dividends are due in the year
they are received, while taxes on capital
gains are due whenever the stock is sold.
 If an investor holds a stock until his/her
death, beneficiaries can use the date of the
death as the cost basis and escape all
previously accrued capital gains.
U9-29
What’s the “information content,”
or “signaling,” hypothesis?

Investors view dividend increases as signals
of management’s view of the future.

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Since managers hate to cut dividends,
they won’t raise dividends unless they
think the raise is sustainable.
However, a stock price increase at time of a
dividend increase could reflect higher
expectations for future EPS, not a desire for
dividends.
U9-30
What’s the “clientele effect”?
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Different groups of investors, or
clienteles, prefer different dividend
policies.
Firm’s past dividend policy determines
its current clientele of investors.
Clientele effects impede changing
dividend policy. Taxes & brokerage
costs hurt investors who have to
switch companies.
U9-31
The residual dividend model


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Find the retained earnings needed for
the capital budget.
Pay out any leftover earnings (the
residual) as dividends.
This policy minimizes flotation and
equity signaling costs, hence minimizes
the WACC.
U9-32
Residual dividend model
 Target   Total 
 


Dividends  Net Income -  equity    capital 
 ratio   budget 
 Capital budget – $800,000
 Target capital structure – 40% debt, 60%
equity
 Forecasted net income – $600,000
 How much of the forecasted net income
should be paid out as dividends?
U9-33
Residual dividend model:
Calculating dividends paid



Calculate portion of capital budget to be funded by
equity.
 Of the $800,000 capital budget, 0.6($800,000)
= $480,000 will be funded with equity.
Calculate excess or need for equity capital.
 There will be $600,000 - $480,000 = $120,000
left over to pay as dividends.
Calculate dividend payout ratio
 $120,000 / $600,000 = 0.20 = 20%.
U9-34
Residual dividend model:
What if net income drops to $400,000?
Rises to $800,000?

If NI = $400,000 …
Dividends = $400,000 – (0.6)($800,000) = -$80,000.
 Since the dividend results in a negative number, the
firm must use all of its net income to fund its budget,
and probably should issue equity to maintain its target
capital structure.
 Payout = $0 / $400,000 = 0%.


If NI = $800,000 …
Dividends = $800,000 – (0.6)($800,000) = $320,000.
 Payout = $320,000 / $800,000 = 40%.

U9-35
How would a change in investment
opportunities affect dividends under
the residual policy?


Fewer good investments would lead
to smaller capital budget, hence to a
higher dividend payout.
More good investments would lead to
a lower dividend payout.
U9-36
Comments on Residual
Dividend Policy



Advantage
 Minimizes new stock issues and flotation
costs.
Disadvantages
 Results in variable dividends
 Sends conflicting signals
 Increases risk
 Doesn’t appeal to any specific clientele.
Conclusion – Consider residual policy when
setting long-term target payout, but don’t
follow it rigidly from year to year.
U9-37
Setting Dividend Policy

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Forecast capital needs over a planning
horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual
model.
Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat
if necessary.
U9-38