Chapters 4 and 5 Capital Structure Decision and Dividends & Dividend
Chapters 4 and 5 Capital Structure Decision and Dividends & Dividend
Chapters 4 and 5 Capital Structure Decision and Dividends & Dividend
$6.00
$5.00
Break-even Point:
EPS
$4.00
EPS = $2; EBIT = $800,000
Current
$3.00
Propose
d
$2.00
$1.00
$0.00
$500,000 $1,000,000 $1,500,000
EBIT
Example: Homemade Leverage and ROE
• Current Capital Structure • Proposed Capital Structure
– Investor borrows $2000 – Investor buys $1000
and uses $2000 of their worth of stock (50
own to buy 200 shares shares) and $1000 worth
of stock of Trans Am bonds
– Payoffs: paying 10%.
• Recession: 200(1.25) - . – Payoffs:
1(2000) = $50 • Recession: 50(.50) + .
• Expected: 200(2.50) - . 1(1000) = $125
1(2000) = $300 • Expected: 50(3.00) + .
• Expansion: 200(3.75) - . 1(1000) = $250
1(2000) = $550 • Expansion: 50(5.50) + .
– Mirrors the payoffs 1(1000) = $375
from purchasing 100 – Mirrors the payoffs
shares from the firm from purchasing 100
under the proposed shares under the
capital structure current capital
structure
Capital Structure Theory
• Modigliani and Miller Theory of Capital
Structure
– Proposition I – firm value
– Proposition II – WACC
• The value of the firm is determined by
the cash flows to the firm and the risk
of the assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows
Capital Structure Theory Under
Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs
Case I – Propositions I and II
• Proposition I
– The value of the firm is NOT affected by
changes in the capital structure
– The cash flows of the firm do not change,
therefore value doesn’t change
• Proposition II
– The WACC of the firm is NOT affected by
capital structure
Case I - Equations
• WACC = RA = (E/V)RE + (D/V)RD
• RE = RA + (RA – RD)(D/E)
Interest 0 500
Taxable Income 5000 4500
Total Debt
Stockholders’ Equity
The evaluation of lease financing decisions from the point of
view of the lessee involves the following steps:
Return = P 1 - Po + D1
Po
P1 - Po D1
= +
Po Po
P1 - Po D1
= + Po
Po
P1 - Po D1
Return = +
Po Po
Paying Dividends:
If we pay dividends,
P1 - Po D1
Return = +
Po Po
Paying Dividends:
P1 - Po D1
Return = +
Po Po
Paying Dividends:
• 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.
P1 - Po D1
Return = +
Po Po
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?
Thus, dividend policy means the practice
that management follows in making dividend
payout decisions, or in other words, the size
and pattern of cash distributions over the
time to shareholders.
It is a guideline followed by the management
in declaring of dividend.
Is Dividend Policy Important?
Three viewpoints:
P1 - Po D1
Return = +
Po Po
Therefore, one dividend policy is as
good as another.
High Dividends are Best
• Some investors may prefer a
certain dividend now over a risky
expected capital gain in the
future.
P1 - Po D1
Return = +
Po Po
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.
Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory
2) Clientele Effects
3) Information Effects
4) Agency Costs
5) Expectations Theory
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.
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.
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.
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.
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.
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.
Dividend Policies