1 IIS Chapter 16 - Planning the Firm’s Financing Mix Chapter 17 – Dividend Policy and International Financing

2 IIS Tujuan Pembelajaran 1 Mahasiswa mampu untuk: Menjelaskan konsep struktur modal yang optimal Menjelaskan inti dari teori struktur modal Memasukkan konsep agency cost dan arus kas bebas dalam siskusi manajemen struktur modal Menggunakan alat dasar pengelolaan struktur modal

3 IIS Pokok Bahasan 1 Struktur keuangan dan struktur modal Sekilas teori struktur modal Agency cost, arus kas bebas, dan struktur modal Alat dasar pengelolaan struktur modal

4 IIS Tujuan Pembelajaran 2 Mahasiswa mampu untuk: Menjelaskan untung rugi antara membayar dividen dan menahan laba di dalam perusahaan Menjelaskan hubungan antara kebijakan dividen terhadap harga saham Menjelaskan pertimbangan praktis dalam kebijakan dividen Membedakan jenis–jenis kebijakan dividen yang seringkali digunakan Menjelaskan tujuan dan prosedur pembelian kembali saham

5 IIS Pokok Bahasan 2 Pembayaran dividen vs menahan laba Apakah kebijakan dividen mempengaruhi harga saham? Kebijakan dividen dalam praktek Prosedur pembayaran dividen Dividen saham dan pemecaham saham Pembelian kembali saham

6 IIS Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity Financial Structure

7 IIS Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity Capital Structure

8 IIS Why is Capital Structure Important? 1) Leverage: Higher financial leverage means higher returns to stockholders, but higher risk due to fixed payments. 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

9 IIS What is the Optimal Capital Structure? In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. This is known as the Independence hypothesis: firm value is independent of capital structure.

10 IIS Independence Hypothesis Firm value does not depend on capital structure.

11 IIS Independence Hypothesis: Rix Camper Manufacturing Company Capital Structure: 100% equity, no debt Stock price: $10 per share Shares outstanding: 2 million Operating income (EBIT): $2,000,000 Calculate EPS: With no interest payments and no taxes, EBIT = net income. $2,000,000/2,000,000 shares = $1.00

12 IIS Independence Hypothesis: Rix Camper Manufacturing Company Capital Structure: 100% equity, no debt Stock price: $10 per share Shares outstanding: 2 million Operating income (EBIT): $2,000,000 Calculate the Cost of Capital: k = + g = + 0 = 10% D P 10.00

13 IIS Independence Hypothesis: Rix Camper Manufacturing Company $20 million capitalization $8 million in debt issued to retire $8 million in equity. Equity = $12m / $20m = 60% Debt = $8m / $20m = 40% Capital Structure: 60% equity, 40% debt Shares outstanding: $12 million / $10 = 1,200,000 shares. Interest = $8m x.06 = $480,000

14 IIS Independence Hypothesis: Rix Camper Manufacturing Company Capital Structure: 60% equity, 40% debt Stock price: $10 per share Shares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000 Calculate EPS: $1,520,000/1,200,000 shares = $1.267

15 IIS Independence Hypothesis: Rix Camper Manufacturing Company Capital Structure: 60% equity, 40% debt Stock price: $10 per share Shares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000 Calculate the Cost of Equity: k = + g = + 0 = 12.67% D P 10.00

16 IIS Independence Hypothesis: Rix Camper Manufacturing Company Capital Structure: 60% equity, 40% debt Stock price: $10 per share Shares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000 Calculate the Cost of Capital:.6 (12.67%) +.4 (6%) = 10%

17 IIS Cost of Capital kc 0% debt Financial Leverage 100% debt. kc = cost of equity kd = cost of debt ko = cost of capital Independence Hypothesis

18 IIS Increasing leverage causes the cost of equity to rise. Independence Hypothesis Cost of Capital kc kd 0% debt Financial Leverage 100% debt

19 IIS Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt Financial Leverage 100% debt

20 IIS Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt Financial Leverage 100% debt

21 IIS kc kd Independence Hypothesis Cost of Capital kc ko kd 0% debt Financial Leverage 100% debt

22 IIS Independence Hypothesis If we have perfect capital markets, capital structure is irrelevant. In other words, changes in capital structure do not affect firm value.

23 IIS Dependence Hypothesis Increasing leverage does not increase the cost of equity. Since debt is less expensive than equity, more debt financing would provide a lower cost of capital. A lower cost of capital would increase firm value.

24 IIS Dependence Hypothesis Since the cost of debt is lower than the cost of equity… increasing leverage reduces the cost of capital. Cost of Capital kc kd Financial Leverage kc kd ko

25 IIS Moderate Position The previous hypothesis examines capital structure in a “perfect market.” The moderate position examines capital structure under more realistic conditions. For example, what happens if we include corporate taxes?

26 IIS Rix Camper example: Tax effects of financing with debt unlevered levered EBIT2,000,000 2,000,000 - interest expense 0 (480,000) EBT2,000,000 1,520,000 - taxes (50%) (1,000,000) (760,000) Earnings available to stockholders 1,000, ,000 Payments to all securityholders 1,000,000 1,240,000

27 IIS Moderate Position Cost of Capital kc kd Financial Leverage kc kd because of the tax benefit associated with debt financing. Even if the cost of equity rises as leverage increases, the cost of debt is very low...

28 IIS Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt reduces the cost of capital. ko

29 IIS Moderate Position So, what does the tax benefit of debt financing mean for the value of the firm? The more debt financing used, the greater the tax benefit, and the greater the value of the firm. So, this would mean that all firms should be financed with 100% debt, right? Why are firms not financed with 100% debt?

30 IIS Why is 100% Debt Not Optimal? Bankruptcy costs: costs of financial distress. Financing becomes difficult to get. Customers leave due to uncertainty. Possible restructuring or liquidation costs if bankruptcy occurs.

31 IIS Why is 100% Debt Not Optimal? Agency costs: costs associated with protecting bondholders. Bondholders (principals) lend money to the firm and expect it to be invested wisely. Stockholders own the firm and elect the board and hire managers (agents). Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases.

32 IIS Cost of Capital Financial Leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

33 IIS Cost of Capital Financial Leverage kc kd kc kd If a firm borrows too much, the costs of debt and equity will spike upward, due to bankruptcy costs and agency costs. Moderate Position with Bankruptcy and Agency Costs

34 IIS Cost of Capital Financial Leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

35 IIS Cost of Capital Financial Leverage kc kd kc kd ko Moderate Position with Bankruptcy and Agency Costs

36 IIS Cost of Capital Financial Leverage kc kd kc kd ko Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital. Moderate Position with Bankruptcy and Agency Costs

37 IIS Cost of Capital Financial Leverage kc kd kc kd ko Moderate Position with Bankruptcy and Agency Costs

38 IIS Capital Structure Management EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity.

39 IIS Capital Structure Management EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.

40 IIS EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: Sell 200,000 shares of common stock at $30 per share, Borrow $6,000,000 by issuing 10% bonds.

41 IIS If we expect EBIT to be $2,000,000: Financing stock debt EBIT2,000,0002,000,000 - interest 0 (600,000) EBT2,000,0001,400,000 - taxes (40%) (800,000) (560,000) EAT1,200, ,000 # shares outst.1,000, ,000 EPS $1.20 $1.05

42 IIS If we expect EBIT to be $4,000,000: Financing stock debt EBIT4,000,0004,000,000 - interest 0 (600,000) EBT4,000,0003,400,000 - taxes (40%) (1,600,000) (1,360,000) EAT2,400,000 2,040,000 # shares outst.1,000, ,000 EPS $2.40 $2.55

43 IIS If EBIT is $2,000,000, common stock financing is best. If EBIT is $4,000,000, debt financing is best. So, now we need to find a breakeven EBIT where neither is better than the other.

44 IIS If we choose stock financing: EPS EBIT $1m $2m $3m $4m stock financing

45 IIS If we choose bond financing: EPS EBIT $1m $2m $3m $4m bond financing

46 IIS Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing

47 IIS Breakeven Point Set two EPS calculations equal to each other and solve for EBIT: Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S

48 IIS Breakeven Point Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800, , ,000

49 IIS Breakeven Point Stock Financing Debt Financing.6 EBIT =.6 EBIT - 360, EBIT =.6 EBIT - 360, EBIT = 360,000 EBIT = $3,000,000

50 IIS Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million, debt financing is best.

51 IIS In-class Problem Plan A: Sell 1,200,000 shares at $10 per share ($12 million total). Plan B: Issue $3.5 million in 9% debt and sell 850,000 shares at $10 per share ($12 million total). Assume a marginal tax rate of 50%.

52 IIS Breakeven EBIT Stock Financing Levered Financing (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) 1,200, ,000 EBIT = $1,080,000

53 IIS Analytical Income Statement Stock Levered EBIT1,080,0001,080,000 I 0 (315,000) EBT1,080, ,000 Tax (540,000) (382,500) NI 540, ,500 Shares1,200, ,000 EPS.45.45

54 IIS Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. For EBIT greater than $1.08 m, the levered plan is best. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m

55 IIS In-class Problem Plan A: Sell 1,200,000 shares at $20 per share ($24 million total). Plan B: Issue $9.6 million in 9% debt and sell shares at $20 per share ($24 million total). Assume a 35% marginal tax rate.

56 IIS Breakeven EBIT Stock Financing Levered Financing (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) 1,200, ,000 EBIT = $2,160,000

57 IIS Analytical Income Statement Stock Levered EBIT2,160,0002,160,000 I 0 (864,000) EBT2,160,0001,296,000 Tax (756,000) (453,600) NI1,404, ,400 Shares1,200, ,000 EPS

58 IIS Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m For EBIT greater than $2.16 m, the levered plan is best. For EBIT up to $2.16 m, stock financing is best.

59 IIS Chapter 17 – Dividend Policy and International Financing

60 IIS Return = Capital Gain Dividend Yield += Stock Returns: P 1 - Po + D 1 Po P 1 - Po D 1 Po Po

61 IIS Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders?

62 IIS If we retain earnings for profitable investments, dividend yield will be zero, P 1 - Po D 1 Po Po + Return = Financing Profitable Capital Investments:

63 IIS If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain. P 1 - Po D 1 Po Po + Return = Financing Profitable Capital Investments:

64 IIS If we pay dividends, stockholders receive an immediate cash reward for investing, Paying Dividends: P 1 - Po D 1 Po Po + Return =

65 IIS If we pay dividends, stockholders receive an immediate cash reward for investing, but the capital gain will decrease, since this cash is not invested in the firm. P 1 - Po D 1 Po Po + Return = Paying Dividends:

66 IIS So, dividend policy really involves two decisions: How much of the firm’s earnings should be distributed to shareholders as dividends, and How much should be retained for capital investment?

67 IIS Is Dividend Policy Important? Three viewpoints: 1) Dividends are Irrelevant 2) High Dividends are Best 3) Low Dividends are Best

68 IIS Three viewpoints: 1) Dividends are Irrelevant. If we assume perfect markets (no taxes, no transaction costs, etc.) dividends do not matter. If we pay a dividend, shareholders’ dividend yield rises, but capital gains decrease.

69 IIS With perfect markets, investors are concerned only with total returns and do not care whether returns come in the form of capital gains or dividend yields. P 1 - Po D 1 Po Po + Return = Dividends are Irrelevant

70 IIS Therefore, one dividend policy is as good as another. P 1 - Po D 1 Po Po + Return = Dividends are Irrelevant

71 IIS High Dividends are Best Some investors may prefer a certain dividend now over a risky expected capital gain in the future. P 1 - Po D 1 Po Po + Return =

72 IIS Low Dividends are Best Dividends are taxed immediately. Capital gains are not taxed until the stock is sold. Therefore, taxes on capital gains can be deferred indefinitely.

73 IIS Do Dividends Matter? Other Considerations: 1) Residual Dividend Theory 2) Clientele Effects 3) Information Effects 4) Agency Costs 5) Expectations Theory

74 IIS Other Considerations 1) Residual Dividend Theory: The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities. This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.

75 IIS Other Considerations 2) Clientele Effects: Different investor clienteles prefer different dividend payout levels. Some firms, such as utilities, pay out over 70% of their earnings as dividends. These attract a clientele that prefers high dividends. Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.

76 IIS Other Considerations 3) Information Effects: Unexpected dividend increases usually cause stock prices to rise, and unexpected dividend decreases cause stock prices to fall. Dividend changes convey information to the market concerning the firm’s future prospects.

77 IIS Other Considerations 4) Agency Costs: Paying dividends may reduce agency costs between managers and shareholders. Paying dividends reduces retained earnings and forces the firm to raise external equity financing. Raising external equity subjects the firm to scrutiny of regulators (SEC) and investors and therefore helps monitor the performance of managers.

78 IIS Other Considerations 5) Expectations Theory: Investors form expectations concerning the amount of a firm’s upcoming dividend. Expectations are based on past dividends, expected earnings, investment and financing decisions, the economy, etc. The stock price will likely react if the actual dividend is different from the expected dividend.

79 IIS Dividend Policies 1) Constant Dividend Payout Ratio: If directors declare a constant payout ratio of, for example, 30%, then for every dollar of earnings available to stockholders, 30 cents would be paid out as dividends. The ratio remains constant over time, but the dollar value of dividends changes as earnings change.

80 IIS Dividend Policies 2) Stable Dollar Dividend Policy: The firm tries to pay a fixed dollar dividend each quarter. Firms and stockholders prefer stable dividends. Decreasing the dividend sends a negative signal!

81 IIS Dividend Policies 3) Small Regular Dividend plus Year- End Extras The firm pays a stable quarterly dividend and includes an extra year- end dividend in prosperous years. By identifying the year-end dividend as “extra,” directors hope to avoid signaling that this is a permanent dividend.

82 IIS Dividend Payments 1) Declaration Date: The board of directors declares the dividend, determines the amount of the dividend, and decides on the payment date. Jan.4 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

83 IIS Dividend Payments 2) Ex-Dividend Date: To receive the dividend, you have to buy the stock before the ex- dividend date. On this date, the stock begins trading “ex-dividend” and the stock price falls approximately by the amount of the dividend. Jan.4 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

84 IIS Dividend Payments 3) Date of Record: Two days after the ex- dividend date, the firm receives the list of stockholders eligible for the dividend. Often, a bank trust department acts as registrar and maintains this list for the firm. Jan.4 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

85 IIS Dividend Payments 4) Payment Date: Date on which the firm mails the dividend checks to the shareholders of record. Jan.4 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

86 IIS Stock Dividends and Stock Splits Stock Dividend: Payment of additional shares of stock to common stockholders. Example: Citizens Bancorporation of Maryland announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another five shares. Does the shareholders’ wealth increase?

87 IIS Stock Dividends and Stock Splits Stock Split: The firm increases the number of shares outstanding and reduces the price of each share. Example: Joule, Inc. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive another 50 shares. Does this increase shareholder wealth? Are a stock dividend and a stock split the same?

88 IIS Stock Dividends and Stock Splits Stock Splits and Stock Dividends are economically the same: The number of shares outstanding increases and the price of each share drops. The value of the firm does not change. Example: A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.

89 IIS Stock Dividends and Stock Splits Effects on Shareholder Wealth: These will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders two half-sized pieces for each full-sized piece they previously owned. Example: This would double the number of shares, but would cause a $60 stock price to fall to $30.

90 IIS Stock Dividends and Stock Splits Why bother? Proponents argue that these are used to reduce high stock prices to a “more popular” trading range (generally $15 to $70 per share). Opponents argue that most stocks are purchased by institutional investors who have millions of dollars to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!

91 IIS Stock Dividend Example An investor has 120 shares. Does the value of the investor’s shares change? Shares outstanding: 1,000,000. Net income = $6,000,000. P/E = % stock dividend.

92 IIS Before the 25% stock dividend: EPS = 6,000,000/1,000,000 = $6. P/E = P/6 = 10, so P = $60 per share. Value = $60 x 120 shares = $7,200. After the 25% stock dividend: # shares = 1,000,000 x 1.25 = 1,250,000. EPS = 6,000,000/1,250,000 = $4.80. P/E = P/4.80 = 10, so P = $48 per share. Investor now has 120 x 1.25 = 150 shares. Value = $48 x 150 = $7,200.

93 IIS Stock Dividends In-class Problem What is the new stock price? Shares outstanding: 250,000. Net income = $750,000. Stock price = $84. 50% stock dividend.

94 IIS Hint: stock price P/E = net income # shares ( )

95 IIS Before the 50% stock dividend: EPS = 750,000 / 250,000 = $3. P/E = 84 / 3 = 28. After the 50% stock dividend: # shares = 250,000 x 1.50 = 375,000. EPS = 750,000 / 375,000 = $2. P/E = P / 2 = 28, so P = $56 per share. (A 50% stock dividend is equivalent to a 3-for-2 stock split.)

96 IIS Stock Repurchases Stock Repurchases may be a good substitute for cash dividends. If the firm has excess cash, why not buy back common stock?

97 IIS Stock Repurchases Stock Repurchases may be a good substitute for cash dividends. If the firm has excess cash, why not buy back common stock?

98 IIS Stock Repurchases Repurchases drive up the stock price, producing capital gains for shareholders. Repurchases increase leverage, and can be used to move toward the optimal capital structure. Repurchases signal positive information to the market—which increases stock price.

99 IIS Stock Repurchases Repurchases may be used to avoid a hostile takeover. Example: T. Boone Pickens attempted raids on Phillips Petroleum and Unocal in Both were unsuccessful because the target firms undertook stock repurchases.

100 IIS Stock Repurchases Methods: Buy shares in the open market through a broker. Buy a large block by negotiating the purchase with a large block holder, usually an institution (targeted stock repurchase). Tender offer: offer to pay a specific price to all current stockholders.

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