1. Session 8: Optimal Capital Structure and dividend policy C15.0008 Corporate Finance Topics

2. Optimal Capital Structure Review The main theory we consider is the trade- off 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

3. WACC approach V =  UCF t /(1+r WACC ) t UCF = EBIT(1-T) + depreciation – capex –  nwc Calculate WACC at various debt levels –r B from debt rating via interest coverage and leverage ratios –r S from Prop. II r S = r 0 + (1- T C )(B/S)(r 0 - r B ) –WACC = (B/(S+B)) r B (1-T)+(S/(S+B)) r S Adjust expected cash flows for financial distress costs

4. At the level of betas CAPM:r 0 = r F +  U (r M - r F ) (unlevered equity) r S = r F +  L (r M - r F ) (levered equity) r B = r F +  B (r M - r F ) (firm’s debt) Prop. II: r S = r 0 + (1- T C )(B/S)(r 0 - r B )  r S = r F +  U (r M - r F ) + (1- T C )(B/S)(  U -  B )(r M - r F ) = r F + [  U + (1- T C )(B/S)(  U -  B )](r M - r F )   L =  U + (1- T C )(B/S)(  U -  B ) (If debt is riskless,  B =0)   L = [1+ (1- T C )(B/S) ]  U

5. Worksheet..

6. APV approach V L = V U + PV(tax shield) - PV(financial distress costs) PV(tax shield) =  t [T C (interest expense) t ] / (1+ r B ) 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 pre- distress firm value (~10-20%)

7. Worksheet

8. 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: r 0 =10% In the event of bankruptcy –Financial distress costs are 15% of V U –Pay taxes, financial distress costs, residual goes to bondholders

9. The Unlevered Firm V U = S Liquidating dividend is only cash flow Value via DCF [0.5(6)+0.5(1.2)]/1.1=3.27 EBIT(1-T)=10(1-0.4)=6 EBIT(1-T)=2(1-0.4)=1.2

10. The Levered Firm $2 million amount of (risky) 1-year debt Promised interest rate = 56.65% (r f =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-0.15V U = 2-[2-2(56.65%)]0.4-0.15(3.27) = 1.16

11. Debt Value H=0.41, B*=-0.656, B=2 (trading at par!!) B 3.13 1.16 Replicate using the unlevered firm (r f =2%) 3.27 6 1.2

12. Equity Value H=0.69, B*=0.814, S=1.45 r S =14.49% S (EBIT-56.65%(B))(1-T)-B=3.32 0 Replicate using the unlevered firm (r f =2%) 3.27 6 1.2

13. Firm Value V U = S = 3.27 V L = S + B = 1.45 + 2 =3.45 V L = V U + 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

14. Financial Distress Costs H = -0.102, B* = -0.602, FD = 0.267 V L = V U + PV(tax shield) - PV(f.d. costs) = 3.27 + 0.444 - 0.267 = 3.45 FD 0 0.491 Replicate using the unlevered firm (r f =2%) 3.27 6 1.2

15. 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!!!

16. Industry Data IndustryDebt Ratio EBITDA/ Value Fixed Assets/ Capital Biotech3.78%2.63%15.33% Food Wholesaler s 22.85%12.60%59.54% Electric Utility 58.07%16.58%89.22% Source: http://www.stern.nyu.edu/~adamodar/

17. 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?

18. Capital Structure in Practice What do CFOs look at in determining debt policy? Financial flexibility59% Debt rating57% Volatility48% Tax savings45% Most firms (81%) have at least a flexible target debt-equity ratio. Source: http://www.stern.nyu.edu/~adamodar/

19. Dividend Policy Dividend policy: theory and evidence Dividend decisions in practice Stock dividends, splits, and repurchases

20. 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

21. 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.

22. 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

23. 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 ( r S = D/P + g )

24. 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

25. 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

26. Some reasons why dividends matter Managers misuse free cash flow  Transaction costsare high  Issuance costs  Personal Taxes  Clientele effects  High dividends are good High/Low dividends Low dividends are good Low dividends High/low dividends If Then

27. Information Effects Unexpected changes in dividends cause stock price reactions: D   P  D   P  Why? Because dividends convey news about future earnings.

28. 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

29. Stock Repurchases Signal that stock is under-valued Increase debt-equity ratio Eliminate certain stockholders (targeted) Tax benefits Stock price reaction is positive!

30. Disappearing Dividends

31. Disappearing Dividends cont’d Reasons: SEC Rule 10b-18, Executive compensation through stock options

32. 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)

33. Practical Considerations Restrictions, e.g., bond covenants Liquidity Access to capital markets Earnings predictability Ownership

34. Types of dividend policies Constant payout ratio Constant dollar dividend Small regular dividend plus special dividends Target payout ratio, slow adjustment, stepwise progression

35. GE’s Dividend

36. Payment Procedure Declaration date -- dividend announced Ex-day -- stock first trades without right to dividend Payment date -- checks mailed Declaration Ex-dayPayment

37. 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

38. Exam points Dividend irrelevance Factors that affect dividend policy Tax effects Information effects

39. 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