1. UNIT 9 Capital Structure and Dividend Policy
Optimal/Target capital structures
Business vs. financial risk
Hamada equation
Dividends vs. capital gains
Residual dividend model

2. Optimal & Target Capital Structures
The firm’s optimal capital structure is the capital structure that maximizes its stock price.
The firm’s target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to raise capital.

3. What is business risk?
Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Note that business risk does not include financing effects.
Low risk
Probability
High risk
E(EBIT)
EBIT

4. What determines business risk?
Uncertainty about demand (sales)
Uncertainty about output prices
Uncertainty about costs
Product, other types of liability
Operating leverage

5. What is operating leverage, and how does it affect a firm’s business risk?
Operating leverage is the use of fixed costs rather than variable costs.
If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

6. Effect of operating leverage
More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
What happens if variable costs change?
Sales $
Rev. TC FC
QBE }
Profit

7. Using operating leverage
Low operating leverage
Probability
High operating leverage
EBITL
EBITH
Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.

8. What is financial leverage? Financial risk?
Financial leverage is the use of debt and preferred stock.
Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

9. Business risk vs. Financial risk
Business risk depends on business factors such as competition, product liability, and operating leverage.
Financial risk depends only on the types of securities issued.
More debt, more financial risk.
Concentrates business risk on stockholders.

10. An example: Illustrating effects of financial leverage
Two firms with the same operating leverage, business risk, and probability distribution of EBIT.
Only differ with respect to their use of debt (capital structure).
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate

11. Firm U: Unleveraged Economy Bad Avg. Good Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest
EBT $2,000 $3,000 $4,000
Taxes (40%) , ,600
NI $1,200 $1,800 $2,400

12. Firm L: Leveraged Economy Bad Avg. Good Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1, , ,200
EBT $ $1,800 $2,800
Taxes (40%) ,120
NI $ $1,080 $1,680
*Same as for Firm U.

13. Ratio comparison between leveraged and unleveraged firms
FIRM U Bad Avg Good
BEP % % %
ROE % % %
TIE ∞ ∞ ∞
FIRM L Bad Avg Good
ROE % % %
TIE x x x

14. Risk and return for leveraged and unleveraged firms
Expected Values:
Firm U Firm L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ x
Risk Measures:
σROE 2.12% 4.24%
CVROE

15. The effect of leverage on profitability and debt coverage
For leverage to raise expected ROE, must have BEP > rd.
Why? If rd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income.
As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = rdD).

16. Conclusions
Basic earning power (BEP) is unaffected by financial leverage.
L has higher expected ROE because BEP > rd.
L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

17. Why do the bond rating and cost of debt depend upon the amount of debt borrowed?
As the firm borrows more money, the firm increases its financial risk causing the firm’s bond rating to decrease, and its cost of debt to increase.

18. What effect does more debt have on a firm’s cost of equity?
If the level of debt increases, the risk of the firm increases.
Increased risk increases the cost of debt.
However, the risk of the firm’s equity also increases, resulting in a higher rs.

19. The Hamada Equation
Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity.
The Hamada equation attempts to quantify the increased cost of equity due to financial leverage.
Uses the firm’s unlevered beta, which represents the business risk of a firm if it had no debt.

20. The Hamada Equation bL = bU[ 1 + (1 – T) (D/E)]
Suppose rRF and RPM = 6%, the firm’s unlevered beta (bU) = 1.0, total assets (D+E) = $2,000, and the tax rate (T) = 40%.
Debt and Equity should be at market values.

21. Calculating levered beta and cost of equity
If D = $250, then E = $2,000 - $250 = $1,750.
bL = 1.0 [ 1 + (0.6)($250/$1,750) ] =
rs = rRF + (rM – rRF) bL
rs = 6.0% + (6.0%) = 12.51%.
bL > bU because debt increases risk.

22. How is a firm’s capital structure affected by more/less business risk?
If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt.
However, lower business risk would lead to an optimal capital structure with more debt.

23. Other factors to consider when establishing the firm’s target capital structure
Industry average debt ratio
TIE ratios under different scenarios
Lender/rating agency attitudes
Reserve borrowing capacity
Effects of financing on control
Asset structure
Expected tax rate

24. How would these factors affect the target capital structure?
Sales stability?
High operating leverage?
Increase in the corporate tax rate?
Increase in the personal tax rate?
Increase in bankruptcy costs?
Management spending lots of money on lavish perks?

25. Conclusions on Capital Structure
Capital structure decisions have a large judgmental content.
Capital structures vary widely among firms, even similar ones in the same industry.

26. What is dividend policy?
The decision to pay out earnings versus retaining and reinvesting them.
Dividend policy includes
High or low dividend payout?
Stable or irregular dividends?
How frequent to pay dividends?
Announce the policy?

27. Dividend irrelevance theory
Investors are indifferent between dividends and retention-generated capital gains.
Investors can create their own dividend policy
If they want cash, they can sell stock.
If they don’t want cash, they can use dividends to buy stock.
Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test.

28. Why investors might prefer dividends
May think dividends are less risky than potential future capital gains.
If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.

29. Why investors might prefer capital gains
May want to avoid transactions costs
Maximum tax rate is the same as on dividends, but …
Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever the stock is sold.
If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost basis and escape all previously accrued capital gains.

30. What’s the “information content,” or “signaling,” hypothesis?
Investors view dividend increases as signals of management’s view of the future.
Since managers hate to cut dividends, they won’t raise dividends unless they think the raise is sustainable.
However, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

31. What’s the “clientele effect”?
Different groups of investors, or clienteles, prefer different dividend policies.
Firm’s past dividend policy determines its current clientele of investors.
Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

32. The residual dividend model
Find the retained earnings needed for the capital budget.
Pay out any leftover earnings (the residual) as dividends.
This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

33. Residual dividend model
Capital budget – $800,000
Target capital structure – 40% debt, 60% equity
Forecasted net income – $600,000
How much of the forecasted net income should be paid out as dividends?

34. Residual dividend model: Calculating dividends paid
Calculate portion of capital budget to be funded by equity.
Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with equity.
Calculate excess or need for equity capital.
There will be $600,000 - $480,000 = $120,000 left over to pay as dividends.
Calculate dividend payout ratio
$120,000 / $600,000 = 0.20 = 20%.

35. Residual dividend model: What if net income drops to $400,000
Residual dividend model: What if net income drops to $400,000? Rises to $800,000?
If NI = $400,000 …
Dividends = $400,000 – (0.6)($800,000) = -$80,000.
Since the dividend results in a negative number, the firm must use all of its net income to fund its budget, and probably should issue equity to maintain its target capital structure.
Payout = $0 / $400,000 = 0%.
If NI = $800,000 …
Dividends = $800,000 – (0.6)($800,000) = $320,000.
Payout = $320,000 / $800,000 = 40%.

36. How would a change in investment opportunities affect dividends under the residual policy?
Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.
More good investments would lead to a lower dividend payout.

37. Comments on Residual Dividend Policy
Advantage
Minimizes new stock issues and flotation costs.
Disadvantages
Results in variable dividends
Sends conflicting signals
Increases risk
Doesn’t appeal to any specific clientele.
Conclusion – Consider residual policy when setting long-term target payout, but don’t follow it rigidly from year to year.

38. Setting Dividend Policy
Forecast capital needs over a planning horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual model.
Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.