Session 8: Optimal Capital
Structure and dividend policy
C15.0008 Corporate Finance
Topics
Optimal Capital Structure Review
• The main theory we consider is the tradeoff theory.
• Debt gives you a tax-shield. Hence more
debt is GOOD.
• Debt increases probability of distress. This
increases expected distress costs, and
agency costs. Hence more debt is BAD
• At some level of debt, the two balance out.
That is the optimal level of debt
WACC approach
V =  UCFt/(1+rWACC)t
UCF = EBIT(1-T) + depreciation – capex – nwc
• Calculate WACC at various debt levels
– rB from debt rating via interest coverage and leverage
ratios
– rS from Prop. II
rS = r0 + (1- TC)(B/S)(r0 - rB)
– WACC = (B/(S+B)) rB(1-T)+(S/(S+B)) rS
• Adjust expected cash flows for financial distress
costs
At the level of betas
CAPM:
r0 = rF + U(rM - rF) (unlevered equity)
rS = rF + L(rM - rF) (levered equity)
rB = rF + B(rM - rF) (firm’s debt)
Prop. II:
rS = r0 + (1- TC)(B/S)(r0 - rB)
 rS = rF + U(rM - rF) + (1- TC)(B/S)(U- B)(rM - rF)
= rF + [U + (1- TC)(B/S)(U- B)](rM - rF)
 L = U + (1- TC)(B/S)(U- B)
(If debt is riskless, B =0)
 L = [1+ (1- TC)(B/S) ]U
Worksheet..
APV approach
VL = VU + PV(tax shield) - PV(financial distress costs)
• PV(tax shield) = t [TC(interest expense)t] / (1+ rB)t
– The expected tax rate decreases as debt
increases. Use likelihood of distress.
• PV(financial distress costs) =
Prob * PV (financial distress costs if financial
distress takes place)
– The probability increases as the debt rating
declines
– Cost are usually estimated as a percentage of predistress firm value (~10-20%)
Worksheet
Binomial Tree
Firm:
• Single remaining cash flow in 1 year
EBIT $10 million or $2 million (prob. 50%)
no salvage value
• Corporate tax rate: T=40%
• Unlevered required return: r0=10%
• In the event of bankruptcy
– Financial distress costs are 15% of VU
– Pay taxes, financial distress costs, residual goes to
bondholders
The Unlevered Firm
VU = S
Liquidating dividend is only cash flow
Value via DCF
EBIT(1-T)=10(1-0.4)=6
[0.5(6)+0.5(1.2)]/1.1=3.27
EBIT(1-T)=2(1-0.4)=1.2
The Levered Firm
• $2 million amount of (risky) 1-year debt
• Promised interest rate = 56.65% (rf=2%)
• Promised payment (at maturity)
2(1+56.65%)=3.13
– Solvent for high EBIT
Payment to bondholders: 3.13
– Bankrupt for low EBIT
Payment to bondholders:
EBIT-taxes-financial distress costs =
EBIT-(EBIT-int.exp.)T-0.15VU =
2-[2-2(56.65%)]0.4-0.15(3.27) = 1.16
Debt Value
Replicate using the unlevered firm (rf=2%)
6
3.27
3.13
B
1.2
1.16
H=0.41, B*=-0.656, B=2 (trading at
par!!)
Equity Value
Replicate using the unlevered firm (rf=2%)
6
3.27
1.2
(EBIT-56.65%(B))(1-T)-B=3.32
S
0
H=0.69, B*=0.814, S=1.45
rS=14.49%
Firm Value
VU = S = 3.27
VL = S + B = 1.45 + 2 =3.45
VL = VU + PV(tax shield) - PV(f.d. costs) ?
In this case, the tax shield is risk-less (even though
the debt is risky):
PV(tax shield) = [56.65%(2)(0.4)/1.02]
= 0.444
Financial Distress Costs
Replicate using the unlevered firm (rf=2%)
6
3.27
0
FD
1.2
0.491
H = -0.102, B* = -0.602, FD = 0.267
VL = VU + PV(tax shield) - PV(f.d. costs)
= 3.27 + 0.444 - 0.267 = 3.45
Optimal Capital Structure
The optimal amount of debt
• Decreases as business risk increases (distress
costs)
• Decreases as in tangible assets increase
(distress costs)
• Increases as the corporate tax rate increases
(tax shields)
• Decreases as the growth rate increases
(growing firms are riskier. Hence distress costs)
This slide is important!!!
Industry Data
Industry
Debt
Ratio
EBITDA/
Value
Fixed Assets/
Capital
Biotech
3.78%
2.63%
15.33%
Food
22.85% 12.60%
Wholesaler
s
59.54%
Electric
Utility
89.22%
58.07% 16.58%
Source: http://www.stern.nyu.edu/~adamodar/
Empirical Evidence
• Consistent with much of the theory (e.g., over
time, across industries, across tax regimes)
• Profitable companies within industries appear
underlevered (pecking order theory)
• Leverage increasing (decreasing) transactions
have positive (negative) effects on stock prices
• Too many high-rated companies?
• Financial flexibility—another real option?
• Targeting a debt rating?
Capital Structure in Practice
What do CFOs look at in determining debt policy?
Financial flexibility
Debt rating
Volatility
Tax savings
59%
57%
48%
45%
Most firms (81%) have at least a flexible target
debt-equity ratio.
Source: http://www.stern.nyu.edu/~adamodar/
Dividend Policy
• Dividend policy: theory and evidence
• Dividend decisions in practice
• Stock dividends, splits, and repurchases
Two Questions
• How much of earnings should the firm retain as
cash?
– Liquidity
– Fund future projects/acquisitions without going to the
capital markets
– Reserve for future debt payments
• How should the residual be paid out?
– Dividends
– Stock repurchases
A More Refined Question
Let’s assume that
• Investment decisions (projects) are fixed
• Financing decisions (capital structure) are fixed
Does dividend policy affect stock price?
Does dividend policy affect firm value?
The dividend decision is a tradeoff between paying
dividends, issuing equity, and repurchasing stock.
An Example
A firm generates a cash-flow of $1 million. It
needs $500K for investment. Three
alternatives:
(1) Invest $500K, pay $500K dividends
(2) Invest $500K, pay $1 million dividends,
raise $500K new equity
(3) Invest $500K, pay $0 dividends,
repurchase $500K of stock
Three Views of Dividend Policy
(1) Dividend policy is irrelevant
(2) High dividends are good
(3) Low dividends are good
“Good” here means higher stock price,
which means
• Higher cash flows
• Lower cost of equity ( rS = D/P + g )
Dividend Irrelevance
Miller/Modigliani: in perfect markets,
investors can create their own dividends,
therefore dividend policy is irrelevant
• Do-it-yourself dividends = stock sales
• Undo-it-yourself dividends = stock
purchases with the money from dividend
income
Example of Dividend Irrelevance
• Two dividend payment dates: 0, 1
• Investor prefers cash-flows of 10 and 10 each
• Company decides to pay 11 and 8.9. Cost of
equity is 10%
• Investor can choose to keep 10 and invest 1 in
the company’s shares.
• Investment of 1 gives an expected cash flow of
1.1
• 8.9 + 1.1 = 10. Thus investor can recreate her
preferred cash-flow
Some reasons why dividends
matter
If
Then
Managers misuse free
cash flow

High dividends are
good
Transaction costs are
high

Issuance costs

High/Low dividends
Low dividends are
good
Personal Taxes

Low dividends
Clientele effects

High/low dividends
Information Effects
• Unexpected changes in dividends cause
stock price reactions:
D  P
D  P
• Why? Because dividends convey news
about future earnings.
Empirical Evidence
• Not conclusive
• Survey data suggest managers think dividend
policy is important
• Tax changes appear to trigger dividend policy
changes
• Non-payers tend to initiate dividends when the
spread between the M/B ratios of payers and
non-payers is high
Stock Repurchases
•
•
•
•
Signal that stock is under-valued
Increase debt-equity ratio
Eliminate certain stockholders (targeted)
Tax benefits
Stock price reaction is positive!
Disappearing Dividends
Disappearing Dividends cont’d
8.00%
Yield
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
2002
1998
1994
1990
1986
1982
1978
1974
1970
1966
1962
1958
1954
1950
1946
1942
1938
1934
1930
1926
0.00%
Year
Dividend Yield
Payout Yield
Reasons: SEC Rule 10b-18, Executive compensation through stock options
Conclusions
• Issuance costs of new equity matter,
dividend policy should be responsive to
investment opportunities
• Taxes, transaction costs, and agency
costs play a role
• Information effects are important (an
explicit policy is valuable)
Practical Considerations
•
•
•
•
•
Restrictions, e.g., bond covenants
Liquidity
Access to capital markets
Earnings predictability
Ownership
Types of dividend policies
• Constant payout ratio
• Constant dollar dividend
• Small regular dividend plus special
dividends
• Target payout ratio, slow adjustment,
stepwise progression
0
Date
Mar-05
Mar-03
Mar-01
Mar-99
Mar-97
Mar-95
Mar-93
Mar-91
Mar-89
Mar-87
Mar-85
Mar-83
Mar-81
Mar-79
Mar-77
Mar-75
Mar-73
Mar-71
Mar-69
Quarterly Dividend
GE’s Dividend
0.25
0.2
0.15
0.1
0.05
Payment Procedure
• Declaration date -- dividend announced
• Ex-day -- stock first trades without right to dividend
• Payment date -- checks mailed
Declaration
Ex-day
Payment
Exam points
• Recapitalizations
• Unlevering a levered firm to find return on
unlevered equity
• Relevering an unlevered firm at a target
ratio, WACC formula
• APV: Computing tax shields, default
probability, Cost of distress
• Valuing distress costs like options
Exam points
•
•
•
•
Dividend irrelevance
Factors that affect dividend policy
Tax effects
Information effects
Assignments
•
•
•
•
•
Chapter 17
Problems 17.2, 17.5, 17.11
Problem set 2 due Wednesday
Case USG due Monday, Jul 31
Start preparing for the exam