Issuing securities And considerable review

Reading  9, 10 (light on CAPM, heavy on SML), 12,13 (esp ), 14.1, 15, 16, 18 (but not the appendix) 22.1, 22.3.

Review Sessions  Review session: E. Chernobai, Weds., 12-11, NH 1110, 7:00-9:00.  Review session: Marshall, Thurs , NH 1006, 2:00-3:30.

Office hours  Marshall: Weds. 3:30 - 5:00 Thurs. 3:30 - 4:30 Fri. 11:00 – 12:00  Ge: Sat. 10:30 – 12:00, 1:00 – 5:00 Sun. ditto  Chernobai: Fri. 10:00 – 12:00  Seo: Thurs. 10:00 – 12:00, 1:00 – 2:00, 3:30 – 5:00 Fri. 9:00 – 12:00

Review item  What is a channel?

Answer  Debt and equity are channels.  They carry corporate earnings to investors.  The debt channel is exposed to personal taxes only.  The equity channel is exposed to corporate and personal taxes.  Some tax-class clienteles value debt over equity. Some value equity over debt.

Dividend review  Dividend smoothing is a fact. We rarely see firms changing dividend policy.  The fact is hard to understand, because dividends seem to be the basis of valuing firms.  Inescapable conclusion: Dividend policy is irrelevant to value of firms.

Elements of understanding  Separation theorem (no taxes)  Channels model (with taxes)

Separation theorem interpreted for dividends (Figure 18.4) C1C1 C0C0 slope=-(1+r) Low-dividendfirm High-dividend firm w Future return or dividendno

Homemade dividends  Investors who want higher dividends sell some shares to get cash.  Those who want lower dividends use high dividends to buy more shares.

Dividend equilibrium $ofoperating cashflows HiDiv value per$1 LoDiv value per$1 mqiliriu oiv E L mEquilibriu HiDiv ub D V*=1/RhRh V*=1/RLRL...

Dividend smoothing explained  Changing dividend policy does not raise value. It hurts, if anything.  Right now, December 2002, a tax decrease is proposed for dividend income to individuals. The effects are unclear.  A firm that changes dividend policy correctly can potentially increase its value.

After the tax code changes  firms raise their value by changing their dividend policy in the right direction.

Cut in capital gains tax rates $ of operating cash flows in the economy HiDiv value LoDiv value Increased value of old equity More LoDiv firms

Dilemma for a firm  Pay dividends: Shareholders pay extra taxes.  Invest in financial markets: Firm becomes a mutual fund.

Solution: use the cash to buy stock  Investors who sell are those who want cash.  Stock price is unaffected … in theory.  Stock price is little affected, in fact.

The IRS understands the buyback game.  Stock buyback for tax avoidance is illegal.  Therefore...

Excuses, excuses  always another reason for a stock buyback,  usually... our shares are a good investment  or...we disburse cash to prevent takeover.

Summary  Dividend policy is like capital structure.  It probably doesn’t matter.  If it does, it matters because of taxes, and even that is temporary.  In equilibrium, firms cannot increase value by changing capital structure or dividend policy

The Costs of Public Offerings Proceeds Direct CostsUnderpricing (in millions)SEOsIPOsIPOs %16.96%16.36% %11.63%9.65% %9.70%12.48% %8.72%13.65% %8.20%11.31% %7.91%8.91% %7.06%7.16% %6.53%5.70% 500 and up3.15%5.72%7.53%

What is capital structure?  The division of the value of the firms assets between debt and equity.

Worrisome question  When a firm sells debt and rebuys its equity, the new equity is smaller than before. Doesn’t equity therefore lose?  Answer: Old equity got the gains.  That is, shareholders at the time of the restructuring got the gains.

The MM Propositions I & II (No Taxes)  P1: Value is unaffected by leverage  P1: V L = V U  P2: Leverage increases the risk and return to stockholders (formula to follow)

Proposition II of M-M  r B is the interest rate  r s is the return on levered equity  r 0 is the return on unlevered equity  B is value of debt  S L is value of levered equity  r s = r 0 + (B / S L ) (r 0 - r B )

MM I with taxes  V U = market value of the unlevered firm  V L = market value of the levered firm  B = market value of bonds  T C = corporate tax rate  result  V L = V U + T C B

Short derivation  Each year the tax shield is r B T C B  Value of tax shield is  r B T C B/r B = T C B

Effect of tax shield  Increase of equity risk is partly offset by the tax shield  r S = r 0 + (1-T C )(r 0 - r B )(B/S L )  Leverage raises the required return less because of the tax shield.

MM II and WACC Debt-to-equity ratio (B/S) Cost of capital: r (%). r0r0 rSrS rBrB = r WACC

Channels

Value as equity Value as debt Operating C.F.’s of the whole economy D of Institutions D of rich investors V* = 1/Rb V* = 1/Rs as debt as equity Miller: Tax-class clienteles

Value as equity Value as debt Operating C.F.’s of the whole economy tax reform increased debt...

Exam review question  A portfolio consists of the risk-free asset and a risky asset A.  The standard deviation of return on A is.1.  Portfolio weights are.5,.5.  What is the standard deviation of the portfolio?