Presentation on theme: "Goal of the Lecture: Understand how to determine the proper mix of debt and equity to use to fund corporate investments."— Presentation transcript:
1 Goal of the Lecture:Understand how to determine the proper mix of debt and equity to use to fund corporate investments.
2 Capital Structure and Dividend Policy 1. Capital Structure Theory - What Percent of CapitalShould Be Raised Through Selling Stock, Bondsand Preferred?2. Dividend Policy Theory – how much cash to payout to shareholders instead or retain in the firm.Time Permitting We May Cover the Effects of Fixed Financial Costs in a Firm’s Riska. Business or Operating Riskb. Financial Risk
3 Firm’s Weighted Cost of Capital (WCC) General FormulaWCC = Wdebtki + Wpskps + Wskswhere, Wdebt = weight of debt in firm’s capital structureWps = weight of preferred stockWs = weight of common stockki = after-tax cost of debtkps = after-tax cost of preferred stockks = after-tax cost of common stock
4 Calculating Capital Structure Weights From Market Prices If Firm Has No Target Weights FIRM SECURITIES VALUESCommon stock = 1,000,000 shares * $50/share= 50 mmDebt = 50,000 bonds * $950/bond = mmPreferred = 100,000 shares * $90/share = 9 mm106.5 mmFigure the Weights?WeightsWs = 50/106.5 = 47%Wd = 47.5/106.5 = 45%Wps = 9/106.5 = 8%WCC = .45(6.30) + .08(11.11) + .47(25)== 15.48Note: You may need to make adjustments for projects that are not average risk projects such as projects for different divisions.
5 Capital Structure Refers a Firm’s Various Sources of Long-Term Financing as a Proportion of Total CapitalManager’s Goal: Increase EPS Through Leverage, But by Enough to Offset the Increase in Risk so that Stock Price Increases.Two Capital Structure Theories of Leveragea. Traditional - Share Price will Increase with Leverage up to a Point (Too Much Risk)b. Net Operating Income Theory - Any Increase in Leverage and EPS will be Offset by Increased Risk (Assuming No Taxes) Leaving the Share Price Unchanged.Illustration using the constant growth model.P = D1/ (ks - g)Increasing leverage may increase D1 and g but will increase beta (risk) so that ks will increase. Theoretically, P stays the same because the positive effect of the increase in D1 and g is just offset by the negative effect of the ks increase.
6 Traditional Theory - As Debt is Added, D/E Rises But kavg Falls Because Debt has Lower Cost. Eventually kE and kD Rise Due to Rising Bankruptcy Probabilities, Pushing kavg UpNet Operating Income Theory - (Modigliani and Miller)No optimal capital structure and no advantage of debt over equity financing. kavg stays constant no matter what the debt level. Unlike in the graph above, the kavg line would be flat with no minimum kavg (assumes no taxes).
7 Net Operating Income Theory - Modigliani and Miller With Corporate Taxes Changes the Theory’s ImplicationsREMEMBER: The Value of the Firm Is the DiscountedValue of It’s After-Tax Cash Flows Going toBondholders and Stockholders.Without Income Taxes - income goes to1. stockholders bondholdersWith Income Taxes - income goes to1. stockholders bondholders government.Because interest paid on debt is tax deductable we canreduce the amount going to the government (and increasethe amount going to bondholders and stockholders) byincreasing the amount of debt in the capital structure.
9 Value of the Levered Firm With Corporate Taxes Is the Value of the Unlevered Firm Plus the Present Value of the Debt’s Tax ShieldAssume no growth in EBIT. The unlevered firm’s value, isVu =where EBIT = earnings before interest and taxesT = corporate tax rateksu = the unlevered cost of equity capitalThen the value of the levered firm, VL isVL = VU + (present value of the tax shield from debt)VL = VU + (tax rate)(value of debt) = VU + (T)(B)When there is a difference in personal tax rates on bondand stock income then adjust the equation above toVL = VU + [1 - (1 - T)(1 - Ts)/(1 - TB)]Bwhere T = corporate tax rateTs = stock tax rateTB = bond tax rateB = face value of bondsBecause bondholders demand the same after tax rate of return as stockholders (assuming equal risk), if TB > Ts, then interest rates on bonds must be higher than stock returns so that after tax returns will be equal. This reduces the advantage of debt.
10 Capital Structure Example Example: SI Inc. is an all-equity firm that generates EBIT of $3 million per year. Its cost of equity capital is 16 percent, its marginal corporate tax rate is 35 percent, and it has 1 million shares outstanding.a What is SI’s market value?b. If SI issues $4 million of debt and uses it to buy back some shares, what will be its new market value and new equity value?c. Show that the change in per-share value goes up even though total equity decreases.a. Vu = $3,000,000( ) / .16 = $12,187,500b. VL = $12,187, (.35)($4,000,000)=$13,587,500equity = $13,587,500 - $4,000,000 = $9,587,500c. Before buyback, share price= $12,187,500/1,000,000=After buyback of $4,000,000/ = 328,218 shareswe get a new price ofP =$9,587,500/(1,000, ,218) = 14.27
11 Dividends and Retained Earnings 1. DIVIDENDS = EARNINGS - RETAINED EARNINGSOver 60% of all funds used by firms are internally generated2. DIVIDEND POLICY INCLUDESa. Level of dividends - dollars per share or Payout RatioDiv. Payout Ratio = Dividends per share / earnings per sharePayout ratio is more comparable across firms than dollars per shareb. Stability of Dividends - non-decreasing3. STABILITY OF DIVIDENDSa. Dividends per share - increase with earningsb. Long range target payoutc. Constant payout ratio => constant % of earnings.d. Residual dividend policy - payout only what is left over after investments - no regard to stability.
12 => retain more earnings 4. AVERAGE PAYOUT RATIOS IN US IS BETWEEN 30 AND 60%.QUESTION: Why might firms wish to keep dividends stable or non-decreasing?Avoid bad signals.THEORIES OF DIVIDEND PREFERENCEa. Dividend Preference Theory – based on riskb. Dividend Aversion – high taxes on dividendstaxes can be delayed on capital gains=> retain more earningsc. Signaling - unexpected changes signal infod. Preference for current income by shareholderse. Flotation costs -> save by retainingf. Transaction costs -> trading costs to sell stockg. Present shareholders may want to maintain control –retain cash to avoid new equity issue.
13 6. DIVIDEND IRRELEVANCEa. Investors can undo –buy or sell stockb. Assumes it is costless to buy and sell.7. FACTORS AFFECTING DIVIDEND POLICYa. Legal constraints - State rules that dividends may not exceed current income plus cumulative retained earnings. No liquidating dividend.b. Bond Indentures - same – stricterc. IRS – no unwarranted retention to avoid taxesd. Controlling owners dictate dividend policy.e. Investment Constraints - large investmentsf. Stable are earnings allows higher payout utilitiesg. Access to capital markets - small firms retain more earnings.
14 8. THE POLICY MOST COMMONLY FOLLOWED IS A SMOOTHED, RESIDUAL DIVIDEND POLICY. a. Maintain target payout and capital structure.9. DIVIDENDS, FINANCING AND CAPITAL STRUCTUREARE CONNECTED.Cumulative dividends paid affects how much fundsthe firm will have to raise.Capital structure weights change as earnings are retained -> equity increases.10. DIVIDEND REINVESTMENTShareholders still pay taxBut may get a break on stock price.11. REPURCHASE STOCKMay increase price per share.STOCK SPLITS, REVERSE SPLITS, AND STOCK DIVIDENDSMany of these announcements should have little affect on stock price unless they are signals.
15 Business Risk - Factors Affecting: Fixed Operating Costs Produce Operating Leverage and Fixed Financing Costs Produce Financial Leverage But Leverage Creates RiskBusiness Risk - Factors Affecting:a. Sensitivity of Sales to Business Cycleb. Firm Size and Industry Competitionc. Operating Leverage (Proportion of Fixedto Variable Operating Costs in Total Costs)d. Input Price Variabilitye. Ability to Adjust Output PricesDegree of Operating LeverageDOL = % Change in EBIT / % Change in Sales= [Sales - Variable Costs] / EBIT= 1 + Fixed Cost / EBIT
16 Financial Risk - Factors Affecting: a. Variability of Shareholder Earnings Per Share (EPS) which is also Earnings After Taxes (EAT)b. Financial Risk Increases with LeverageDegree of Financial LeverageDFL = % Change in EPS / % Change in EBIT= EBIT / [EBIT - I - L - d/(1 - T)]where, I = Interest, L = Lease Payments, and d = preferred dividends (Grossed Up by [1 - T] because there is No Tax Deduction)Degree of Combined Leverage: Operating and FinancialDCL = DOL x DFL= % Change in EPS / % Change in Sales= [Sales - Variable Costs] / [EBIT - I - L -d/(1 - T)]Note: The larger is DCL, the larger the firm’s return variance .
17 Leverage - DOL, DFL, and DCL “DOL - As sales rise, fixed cost per unit falls. DFL - Fixed Cost Financing causes EPS to fluctuate. DCL - Combined effects of operating and financial leverage.”Example:Clark Comp. has the following income statement in millions.SalesVariable CostsRevenues Before Fixed Costs 26Fixed CostsEBITInterestEBTTaxes (30%)EATa) Calculate DOL, DFL, and DCL.b) If sales increase by 20%, by what % will EAT increase and to what amount?a. DOL = (50-24)/13 = 2.0DFL = 13/(13-3) = 1.3DCL = 2 x 1.3 = 2.6b. EAT % Increase = .20 x 2.6 = .52 = 52%EAT Amount Increase = 7 x 1.52 = $10.64