Presentation on theme: "Capital Structure, long term financing Policy, and dividend policy"— Presentation transcript:
1 Capital Structure, long term financing Policy, and dividend policy
2 Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equalCapital restructuring involves changing the amount of leverage a firm has without changing the firm’s assetsThe firm can increase leverage by issuing debt and repurchasing outstanding sharesThe firm can decrease leverage by issuing new shares and retiring outstanding debt
3 Choosing a Capital Structure What is the primary goal of financial managers?Maximize stockholder wealthWe want to choose the capital structure that will maximize stockholder wealthWe can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACCRemind students that the WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of the firm by discounting the firm’s expected future cash flows at the discount rate – the process is the same as finding the value of anything else. Since value and discount rate move in opposite directions, firm value will be maximized when WACC is minimized.
4 The Effect of LeverageHow does leverage affect the EPS and ROE of a firm?When we increase the amount of debt financing, we increase the fixed interest expenseIf we have a really good year, then we pay our fixed cost and we have more left over for our stockholdersIf we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholdersLeverage amplifies the variation in both EPS and ROERemind the students that if we increase the amount of debt in a restructuring, we are decreasing the amount of outstanding shares.
5 Example: Financial Leverage, EPS and ROE – Part I We will ignore the effect of taxes at this stageWhat happens to EPS and ROE when we issue debt and buy back shares of stock?Click on the Excel icon to go to a spreadsheet that contains all of the information for the example presented in the instructors manual.
6 Example: Financial Leverage, EPS and ROE – Part II Variability in ROECurrent: ROE ranges from 6% to 20%Proposed: ROE ranges from 2% to 30%Variability in EPSCurrent: EPS ranges from $0.60 to $2.00Proposed: EPS ranges from $0.20 to $3.00The variability in both ROE and EPS increases when financial leverage is increased
7 Break-Even EBITFind EBIT where EPS is the same under both the current and proposed capital structuresIf we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholdersIf we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
8 Example: Break-Even EBIT Click on the Excel icon to see the graph of the break-even analysis
9 Example: Homemade Leverage and ROE Current Capital StructureInvestor borrows $500 and uses $500 of her own to buy 100 shares of stockPayoffs:Recession: 100(0.60) - .1(500) = $10Expected: 100(1.30) - .1(500) = $80Expansion: 100(2.00) - .1(500) = $150Mirrors the payoffs from purchasing 50 shares from the firm under the proposed capital structureProposed Capital StructureInvestor buys $250 worth of stock (25 shares) and $250 worth of bonds paying 10%.Payoffs:Recession: 25(.20) + .1(250) = $30Expected: 25(1.60) + .1(250) = $65Expansion: 25(3.00) + .1(250) = $100Mirrors the payoffs from purchasing 50 shares under the current capital structureThe choice of capital structure is irrelevant if the investor can duplicate the cash flows on their own.Note that all of the positions require an investment of $500 of the investors money.We are still ignoring taxes and transaction costs. If we factor in these market imperfections, then homemade leverage will not work quite as easily, but the general idea is the same.
10 Capital Structure Theory Modigliani and Miller Theory of Capital StructureProposition I – firm valueProposition II – WACCThe value of the firm is determined by the cash flows to the firm and the risk of the assetsChanging firm valueChange the risk of the cash flowsChange the cash flows
11 Capital Structure Theory Under Three Special Cases Case I – AssumptionsNo corporate or personal taxesNo bankruptcy costsCase II – AssumptionsCorporate taxes, but no personal taxesCase III – AssumptionsBankruptcy costs
12 Case I – Propositions I and II Proposition IThe value of the firm is NOT affected by changes in the capital structureThe cash flows of the firm do not change; therefore, value doesn’t changeProposition IIThe WACC of the firm is NOT affected by capital structureThe main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change; and we haven’t changed the risk of existing cash flows, the value of the firm won’t change.
13 Case I - Equations WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA – RD)(D/E)RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets(RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverageRemind students that case I is a world without taxes. That is why the term (1 – TC) is not included in the WACC equation.
15 Case I - Example Data What is the cost of equity? Required return on assets = 16%, cost of debt = 10%; percent of debt = 45%What is the cost of equity?RE = 16 + ( )(.45/.55) = 20.91%Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?25 = 16 + ( )(D/E)D/E = ( ) / ( ) = 1.5Based on this information, what is the percent of equity in the firm?E/V = 1 / 2.5 = 40%Remind students that if the firm is financed with 45% debt, then it is financed with 55% equity.At this point, you may need to remind them that one way to compute the D/E ratio is %debt / (1-%debt)The second question is used to reinforce that RA does not change when the capital structure changesMany students will not immediately see how to get the % of equity from the D/E ratio. Remind them that D+E = V. We are looking at ratios, so the actual $ amount of D and E is not important. All that matters is the relationship between them. So, let E = 1. Then D/1 = 1.5; Solve for D; D = 1.5. Then V = = 2.5 and the percent equity is 1 / 2.5 = 40%. They often don’t understand that the choice of E = 1 is for simplicity. If they are confused about the process, then show them that it doesn’t matter what you set E equal to, as long as you keep the relationships intact. So, let E = 5; then D/5 = 1.5 and D = 5(1.5) = 7.5; V = = 12.5 and E/V = 5 / 12.5 = 40%.
16 The CAPM, the SML and Proposition II How does financial leverage affect systematic risk?CAPM: RA = Rf + A(RM – Rf)Where A is the firm’s asset beta and measures the systematic risk of the firm’s assetsProposition IIReplace RA with the CAPM and assume that the debt is riskless (RD = Rf)RE = Rf + A(1+D/E)(RM – Rf)Intuitively, an increase in financial leverage should increase systematic risk since changes in interest rates are a systematic risk factor and will have more impact the higher the financial leverage.The assumption that debt is riskless is for simplicity and to illustrate that even if debt is default risk-free, it still increases the variability of cash flows to the stockholders, and thus increases the systematic risk.
17 Business Risk and Financial Risk RE = Rf + A(1+D/E)(RM – Rf)CAPM: RE = Rf + E(RM – Rf)E = A(1 + D/E)Therefore, the systematic risk of the stock depends on:Systematic risk of the assets, A, (Business risk)Level of leverage, D/E, (Financial risk)Point out once again that this result assumes that the debt is risk-free. The effect of leverage on financial risk will be even greater if the debt is not default free.
18 Case II – Cash Flow Interest is tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equalThe reduction in taxes increases the cash flow of the firmHow should an increase in cash flows affect the value of the firm?Point out that the government effectively pays part of our interest expense for us; it is subsidizing a portion of the interest payment.
19 Case II - Example Unlevered Firm Levered Firm EBIT 5,000 Interest 500 500Taxable Income4,500Taxes (34%)1,7001,530Net Income3,3002,970CFFA3,470The levered firm has 6,250 in 8% debt, so the interest expense = .08(6,250) = 500CFFA = EBIT – taxes (depreciation expense is the same in either case, so it will not affect CFFA on an incremental basis)
20 Interest Tax Shield Annual interest tax shield Tax rate times interest payment6,250 in 8% debt = 500 in interest expenseAnnual tax shield = .34(500) = 170Present value of annual interest tax shieldAssume perpetual debt for simplicityPV = 170 / .08 = 2,125PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125Point out that the increase in cash flow in the example is exactly equal to the interest tax shieldThe assumption of perpetual debt makes the equations easier to work with, but it is useful to ask the students what would happen if we did not assume perpetual debt.
21 Case II – Proposition IThe value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm = value of an unlevered firm + PV of interest tax shieldValue of equity = Value of the firm – Value of debtAssuming perpetual cash flowsVU = EBIT(1-T) / RUVL = VU + DTCRU is the cost of capital for an unlevered firm = RA for an unlevered firmVU is jus the PV of the expected future cash flow from assets for an unlevered firm.
22 Example: Case II – Proposition I DataEBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%VU = 25(1-.35) / .12 = $ millionVL = (.35) = $ millionE = – 75 = $86.67 million
24 Case II – Proposition II The WACC decreases as D/E increases because of the government subsidy on interest paymentsRA = (E/V)RE + (D/V)(RD)(1-TC)RE = RU + (RU – RD)(D/E)(1-TC)ExampleRE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35) RA = 10.05%
25 Example: Case II – Proposition II Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.What will happen to the cost of equity under the new capital structure?RE = 12 + (12 - 9)(1)(1-.35) = 13.95%What will happen to the weighted average cost of capital?RA = .5(13.95) + .5(9)(1-.35) = 9.9%Remind students that a D/E ratio = 1 implies 50% equity and 50% debt.The amount of leverage in the firm increased, the cost of equity increased, but the overall cost of capital decreased.
27 Case III Now we add bankruptcy costs As the D/E ratio increases, the probability of bankruptcy increasesThis increased probability will increase the expected bankruptcy costsAt some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy costAt this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is addedNote that we are talking about “expected” in a statistical sense. If the firm goes bankrupt – it will have a certain level of costs it will incur. If the firm is all equity, then the expected bankruptcy cost is 0 since the probability of bankruptcy is 0. As the firm adds debt, the probability of incurring the bankruptcy costs increases, and thus the expected bankruptcy cost increases.
28 Bankruptcy Costs Direct costs Financial distress Legal and administrative costsUltimately cause bondholders to incur additional lossesDisincentive to debt financingFinancial distressSignificant problems in meeting debt obligationsMost firms that experience financial distress do not ultimately file for bankruptcy
29 More Bankruptcy Costs Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and estimateStockholders want to avoid a formal bankruptcy filingBondholders want to keep existing assets intact so they can at least receive that moneyAssets lose value as management spends time worrying about avoiding bankruptcy instead of running the businessThe firm may also lose sales, experience interrupted operations and lose valuable employees
32 Conclusions Case I – no taxes or bankruptcy costs No optimal capital structureCase II – corporate taxes but no bankruptcy costsOptimal capital structure is almost 100% debtEach additional dollar of debt increases the cash flow of the firmCase III – corporate taxes and bankruptcy costsOptimal capital structure is part debt and part equityOccurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs
34 Managerial Recommendations The tax benefit is only important if the firm has a large tax liabilityRisk of financial distressThe greater the risk of financial distress, the less debt will be optimal for the firmThe cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry
36 The Value of the FirmValue of the firm = marketed claims + nonmarketed claimsMarketed claims are the claims of stockholders and bondholdersNonmarketed claims are the claims of the government and other potential stakeholdersThe overall value of the firm is unaffected by changes in capital structureThe division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions
37 Observed Capital Structure Capital structure does differ by industriesDifferences according to Cost of Capital 2004 Yearbook by Ibbotson Associates, Inc.Lowest levels of debtDrugs with 6.38% debtPaper and computers with – 10.68% debtHighest levels of debtAirlines with 64.22% debtElectric utilities with 49.03% debtSee Table 17.7 in the book for more detail
38 Bankruptcy Process – Part I Business failure – business has terminated with a loss to creditorsLegal bankruptcy – petition federal court for bankruptcyTechnical insolvency – firm is unable to meet debt obligationsAccounting insolvency – book value of equity is negative
39 Bankruptcy Process – Part II LiquidationChapter 7 of the Federal Bankruptcy Reform Act of 1978Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority ruleReorganizationChapter 11 of the Federal Bankruptcy Reform Act of 1978Restructure the corporation with a provision to repay creditors
40 Quick Quiz Explain the effect of leverage on EPS and ROE What is the break-even EBIT and how do we compute it?How do we determine the optimal capital structure?What is the optimal capital structure in the three cases that were discussed in this chapter?What is the difference between liquidation and reorganization?
41 Cash DividendsRegular cash dividend – cash payments made directly to stockholders, usually each quarterExtra cash dividend – indication that the “extra” amount may not be repeated in the futureSpecial cash dividend – similar to extra dividend, but definitely won’t be repeatedLiquidating dividend – some or all of the business has been soldCash dividends reduce cash and retained earnings (and liquidating dividends may also reduce paid-in capital)
42 Dividend PaymentDeclaration Date – Board declares the dividend and it becomes a liability of the firmEx-dividend DateOccurs two business days before date of recordIf you buy stock on or after this date, you will not receive the dividendStock price generally drops by about the amount of the dividendDate of Record – Holders of record are determined and they will receive the dividend paymentDate of Payment – checks are mailed
44 Does Dividend Policy Matter? Dividends matter – the value of the stock is based on the present value of expected future dividendsDividend policy may not matterDividend policy is the decision to pay dividends versus retaining funds to reinvest in the firmIn theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future
45 Illustration of Irrelevance Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year. Investors require a 12% return.Market Value with constant dividend = $16,900.51Market Value with reinvestment = $16,900.51If the company will earn the required return, then it doesn’t matter when it pays the dividendsAssuming that the second dividend is a liquidating dividend and the firm ceases to exist after period 2.PV = 10,000 / ,000 / = 16,900.51PV = 9,000 / ,120 / = 16,900.51
46 Low Payout Please Why might a low payout be desirable? Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liabilityFlotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costsDividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends
47 High Payout Please Why might a high payout be desirable? Desire for current incomeIndividuals that need current income, i.e. retireesGroups that are prohibited from spending principal (trusts and endowments)Uncertainty resolution – no guarantee that the higher future dividends will materializeTaxesDividend exclusion for corporationsTax-exempt investors don’t have to worry about differential treatment between dividends and capital gains
48 Dividends and SignalsAsymmetric information – managers have more information about the health of the company than investorsChanges in dividends convey informationDividend increasesManagement believes it can be sustainedExpectation of higher future dividends, increasing present valueSignal of a healthy, growing firmDividend decreasesManagement believes it can no longer sustain the current level of dividendsExpectation of lower dividends indefinitely; decreasing present valueSignal of a firm that is having financial difficulties
49 Clientele EffectSome investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payoutsSome investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts
50 Implications of the Clientele Effect What do you think will happen if a firm changes its policy from a high payout to a low payout?What do you think will happen if a firm changes its policy from a low payout to a high payout?If this is the case, does dividend POLICY matter?If a firm changes its policy, it will just have different investors. Consequently, dividend policy won’t affect the value of the stock.
51 Dividend Policy in Practice Residual dividend policyConstant growth dividend policy – dividends increased at a constant rate each yearConstant payout ratio – pay a constant percent of earnings each yearCompromise dividend policyWe will talk about the residual policy and the compromise policy in more detailGiven the information content of dividends, will a constant growth policy be good for the stockholders?Given the information content of dividends – will a constant payout ratio be good for stockholders?
52 Residual Dividend Policy Determine capital budgetDetermine target capital structureFinance investments with a combination of debt and equity in line with the target capital structureRemember that retained earnings are equityIf additional equity is needed, issue new sharesIf there are excess earnings, then pay the remainder out in dividends
53 Example – Residual Dividend Policy GivenNeed $5 million for new investmentsTarget capital structure: D/E = 2/3Net Income = $4 millionFinding dividend40% financed with debt (2 million)60% financed with equity (3 million)NI – equity financing = $1 million, paid out as dividendsRemind students how to get % debt and % equity given D/E:If D/E = 2/3, then V = = 5, so D/V = 2/5 = 40% and E/V = 3/5 = 60%
54 Compromise Dividend Policy Goals, ranked in order of importanceAvoid cutting back on positive NPV projects to pay a dividendAvoid dividend cutsAvoid the need to sell equityMaintain a target debt/equity ratioMaintain a target dividend payout ratioCompanies want to accept positive NPV projects, while avoiding negative signals
55 Managements’ View of Dividend Policy Agree or Strongly Agree93.8% Try to avoid reducing dividends per share89.6% Try to maintain a smooth dividend from year to year41.7% pay dividends to attract investors subject to “prudent man” restrictionsImportant or Very Important84.1% Maintaining consistency with historic dividend policy71.9% Stability of future earnings9.3% Flotation costs to issue new equitySee Tables 18.2 and 18.3
56 Stock Repurchase Company buys back its own shares of stock Tender offer – company states a purchase price and a desired number of sharesOpen market – buys stock in the open marketSimilar to a cash dividend in that it returns cash from the firm to the stockholdersThis is another argument for dividend policy irrelevance in the absence of taxes or other imperfections
57 Real-World Considerations Stock repurchase allows investors to decide if they want the current cash flow and associated tax consequencesIn our current tax structure, repurchases may be more desirable due to the options provided stockholdersThe IRS recognizes this and will not allow a stock repurchase for the sole purpose of allowing investors to avoid taxes
58 Information Content of Stock Repurchases Stock repurchases send a positive signal that management believes that the current price is lowTender offers send a more positive signal than open market repurchases because the company is stating a specific priceThe stock price often increases when repurchases are announced
59 Example: Repurchase Announcement “America West Airlines announced that its Board of Directors has authorized the purchase of up to 2.5 million shares of its Class B common stock on the open market as circumstances warrant over the next two years …“Following the approval of the stock repurchase program by the company’s Board of Directors earlier today. W. A. Franke, chairman and chief officer said ‘The stock repurchase program reflects our belief that America West stock may be an attractive investment opportunity for the Company, and it underscores our commitment to enhancing long-term shareholder value.’“The shares will be repurchased with cash on hand, but only if and to the extent the Company holds unrestricted cash in excess of $200 million to ensure that an adequate level of cash and cash equivalents is maintained.”
60 Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding sharesSmall stock dividendLess than 20 to 25%If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 sharesLarge stock dividend – more than 20 to 25%
61 Stock SplitsStock splits – essentially the same as a stock dividend except expressed as a ratioFor example, a 2 for 1 stock split is the same as a 100% stock dividendStock price is reduced when the stock splitsCommon explanation for split is to return price to a “more desirable trading range”www: Click on the web surfer icon to find out about upcoming stock splits and dividends
62 Quick QuizWhat are the different types of dividends and how is a dividend paid?What is the clientele effect and how does it affect dividend policy relevance?What is the information content of dividend changes?What is the difference between a residual dividend policy and a compromise dividend policy?What are stock dividends and how do they differ from cash dividends?How are share repurchases an alternative to dividends and why might investors prefer them?