Chapter 13: Capital Structure and

Dividends
Learning Goals
Describe the basic types of capital, external assessment of capital structure,
the capital structure of non-United States firms, and the optimal capital
structure.
Discuss the EBIT-EPS approach to capital structure.
e!ie" the return and ris# of alternati!e capital structures and their lin#a$e to
mar#et !alue, and other important capital structure considerations.
Explain cash di!idend payment procedures, di!idend rein!estment plans, the
residual theory of di!idends, and the #ey ar$uments "ith re$ard to di!idend
rele!ance or irrele!ance.
Understand the #ey factors in!ol!ed in formulatin$ a di!idend policy and the
three basic types of di!idend policies.
E!aluate the #ey aspects of stoc# di!idends, stoc# splits, and stoc#
repurchases.
The Firms Capital Structure
%ccordin$ to finance theory, firms possess a tar$et capital structure that
"ill minimi&e their cost of capital.
Unfortunately, theory can not yet pro!ide financial mana$ers "ith a
specific methodolo$y to help them determine "hat their firm's optimal capital
structure mi$ht be.
Theoretically, ho"e!er, a firm's optimal capital structure "ill (ust balance
the benefits of debt financin$ a$ainst its costs.
The ma(or benefit of debt financin$ is the tax shield pro!ided by the
federal $o!ernment re$ardin$ interest payments.
The costs of debt financin$ result from)
The increased probability of ban#ruptcy caused by debt obli$ations.
The a$ency costs resultin$ from lenders monitorin$ the firm's actions.
The costs associated "ith the firm's mana$ers ha!in$ more information
about the firm's prospects than do in!estors *asymmetric information+.
,apital Structures of United States and -on-United States
.irms
In $eneral, non-United States companies ha!e much hi$her debt le!els
than United States companies primarily because United States capital mar#ets
are relati!ely more de!eloped.
In addition, in most European countries and /apan, ban#s are more
in!ol!ed because they are permitted to ma#e e0uity in!estments in non-financial
corporations1a practice prohibited in the United States.
Similarities bet"een United States and forei$n corporations include)
Similarity of industry capital structure patterns.
Similarity of lar$e corporation capital structures.
In addition, it is expected that differences in capital structures "ill further
diminish as countries rely less on ban#s and more on security issuance.
The Optimal Capital Structure
In $eneral, it is belie!ed that the mar#et !alue of a company is maximi&ed
"hen the cost of capital *the firm's discount rate+ is minimi&ed.
The !alue of the firm can be defined al$ebraically as follo"s)
Debt atios !or Selected "ndustries
#$S%#&"T 'pproach to Capital Structure
The EPS-EBIT approach to capital structure in!ol!es selectin$ the capital
structure that maximi&es EPS o!er the expected ran$e of EBIT.
Usin$ this approach, the emphasis is on maximi&in$ the o"ners' returns
*EPS+.
% ma(or shortcomin$ of this approach is the fact that earnin$s are only one
of the determinants of shareholder "ealth maximi&ation.
This method does not explicitly consider the impact of ris#.
Example
The capital structure of Bu&& ,ompany, a soft drin# manufacturer is sho"n in the table
belo". ,urrently, Bu&& ,ompany uses only e0uity in its capital structure. Thus the current debt
ratio is 2.223. %ssume Bu&& ,ompany is in the 423 tax brac#et.
EPS-EBIT coordinates for Bu&& ,ompany's current capital structure can
be found by assumin$ t"o EBIT !alues and calculatin$ the associated EPS in the
table belo".
Bu&& ,ompany is considerin$ alterin$ its capital structure "hile
maintainin$ its ori$inal 5622,222 capital base as sho"n in the table belo".
This may be sho"n $raphically as sho"n on the follo"in$ slide.
&asic Shortcoming o! #$S%#&"T 'nal(sis
%lthou$h EPS maximi&ation is $enerally $ood for the firm's shareholders,
the basic shortcomin$ of this method is that it does not necessary maximi&e
shareholder "ealth because it fails to consider ris#.
If shareholders did not re0uire ris# premiums *additional return+ as the firm
increased its use of debt, a strate$y focusin$ on EPS maximi&ation "ould "or#.
Unfortunately, this is not the case.
Choosing the Optimal Capital Structure
The follo"in$ discussion "ill attempt to create a frame"or# for ma#in$
capital bud$etin$ decisions that maximi&es shareholder "ealth *i.e., considers
both ris# and return+.
Perhaps the best "ay to demonstrate this is throu$h the follo"in$
example.
%ssume that Bu&& ,ompany is attemptin$ to choose the best of se!eral
alternati!e capital structures1specifically, debt ratios of 2, 72, 82, 92, 42, 62,
and :2 percent. .urthermore, for each of these capital structures, the firm has
estimated EPS, the ,; of EPS, and re0uired return.
If "e assume that all earnin$s are paid out as di!idends, "e can use the
&ero $ro"th !aluation model <P2 = EPS>ks? to estimate share !alue as sho"n in
the table belo".
Other "mportant Considerations
Dividend Fundamentals
,ash Di!idend Payment Procedures
% di!idend is a redistribution from earnin$s.
@ost companies maintain a di!idend policy "hereby they pay a re$ular di!idend on a
0uarterly basis.
Some companies pay an extra di!idend to re"ard shareholders if they'!e had a
particularly $ood year. @any companies pay di!idends accordin$ to a preset payout ratio, "hich
measures the proportion of di!idends to earnin$s.
@any companies ha!e paid re$ular di!idends for o!er a hundred years.
,ash Di!idend Payment Procedures
Di!idend $ro"th tends to la$ behind earnin$s $ro"th for most corporations *see example
next slide+.
Since di!idend policy is one of the factors that dri!es an in!estor's decision to purchase a
stoc#, most companies announce their di!idend policy and tele$raph any expected chan$es in
policy to the public.
Therefore, it can be seen that many companies use their di!idend policy to pro!ide
information not other"ise a!ailable to in!estors.
,ash Di!idend Payment Procedures
Date of record) The date on "hich in!estors must o"n shares in order to recei!e the
di!idend payment.
ex di!idend date) .our days prior to the date of record. The day on "hich a stoc# trades
ex di!idend *exclusi!e of di!idends+.
In the financial press) Transactions in the stoc# on the ex di!idend date are indicated by
an AxB next to the !olume of transactions.
In $eneral, stoc# prices fall by an amount e0ual to the 0uarterly di!idend on the ex
di!idend date.
Distribution date) The day on "hich a di!idend is paid *payment date+ to stoc#holders. It
is usually t"o or more "ee#s before stoc#holders "ho o"ned shares on the date of record
recei!e their di!idends.
Cash Dividend $a(ment $rocedures
Example
%t the 0uarterly di!idend meetin$ on /une 72th, the /illian ,ompany board
of directors declared an 5.C2 cash di!idend for holders of record on @onday, /uly
7st. The firm had 722,222 shares of stoc# outstandin$. The payment
*distribution+ date "as set at %u$ust 7st. Before the meetin$, the rele!ant
accounts sho"ed the follo"in$.
Dhen the di!idend "as announced by the directors, 5C2,222 of the
retained earnin$s *5.C2>share
x
722,222 shares+ "as transferredto the di!idends
payable account. %s a result, the #ey accounts chan$ed as follo"s)
/illian ,ompany's stoc# be$an sellin$ ex di!idend on /une 86th, 4 days
prior to the date of record */uly 7st+. This date "as found by subtractin$ : days
*because of the "ee#end+ from /uly 7st.
Stoc#holders of record on /une 84th or earlier recei!ed the ri$hts to the
di!idends, "hile those purchasin$ on /une 86th or later did not. %ssumin$ a
stable mar#et, the price of the stoc# "as expected to drop by 5.C2>share on /une
86th. Dhen the %u$ust 7st payment date arri!ed, the firm mailed payments to
holders of record and recorded the follo"in$)
Thus, the net effect of the di!idend payment is a reduction of the firm's
assets *throu$h a reduction in cash+ and e0uity *throu$h a reduction in retained
earnin$s+ by a total of 5C2,222 *the di!idend payment+.
Dividend einvestment $lans
Di!idend rein!estment plans *DIPS+ permit stoc#holders to rein!est their di!idends to
purchase additional shares rather than to be paid out in cash.
Dith bank-directed DIPS, ban#s purchase additional shares on the open mar#et in hu$e
bloc#s "hich substantially reduces per share commissions.
Dith company-directed DIPS, the company itself issues ne" shares in exchan$e for the
cash di!idend completely eliminatin$ commissions.
Dith brokerage-directed DIPS, bro#era$e firms such as ,harles Sch"ab "ill rein!est
di!idends for shareholders "ho hold stoc#s in street name at no char$e.
'dvantages o! D"$S
.or Stoc#holders
Substantial reduction in commission costs.
They pro!ide in!estors "ith an automatic sa!in$s mechanism.
.or ,ompanies
Eood"ill
eduction in cost of deli!erin$ di!idend chec#s.
%n inexpensi!e means of raisin$ e0uity capital for firms company-directed
plans.
Dividend $olic( Theor(
The esidual Theory of Di!idends
The residual theory of di!idends su$$ests that di!idend payments should
be !ie"ed as residual1the amount left o!er after all acceptable in!estment
opportunities ha!e been underta#en.
Usin$ this approach, the firm "ould treat the di!idend decision in three
steps as sho"n on the follo"in$ slide.
The esidual Theory of Di!idends
In sum, this theory su$$ests that no cash di!idend is paid as lon$ as the
firm's e0uity need is in excess of the amount of retained earnin$s.
.urthermore, it su$$ests that the re0uired return demanded by
stoc#holders is not influenced by the firm's di!idend policy1a premise that in
turn su$$ests that di!idend policy is irrele!ant.
Di!idend Irrele!ance %r$uments
@erton @iller and .ranco @odi$liani *@@+ de!eloped a theory that sho"s
that in perfect financial mar#ets *certainty, no taxes, no transactions costs or
other mar#et imperfections+, the !alue of a firm is unaffected by the distribution of
di!idends.
They ar$ue that !alue is dri!en only by the future earnin$s and ris# of its
in!estments.
etainin$ earnin$s or payin$ them in di!idends does not affect this !alue.
Di!idend Irrele!ance %r$uments
Some studies su$$ested that lar$e di!idend chan$es affect stoc# price
beha!ior.
@@ ar$ued, ho"e!er, that these effects are the result of the information
con!eyed by these di!idend chan$es, not to the di!idend itself.
.urthermore, @@ ar$ue for the existence of a Aclientele effect.B
In!estors preferrin$ di!idends "ill purchase hi$h di!idend stoc#s, "hile
those preferrin$ capital $ains "ill purchase lo" di!idend payin$ stoc#s.
Di!idend Irrele!ance %r$uments
In summary, @@ and other di!idend irrele!ance proponents ar$ue that1
all else bein$ e0ual1an in!estor's re0uired return, and therefore the !alue of the
firm, is unaffected by di!idend policy because)
F The firm's !alue is determined solely by the earnin$ po"er and ris# of its assets.
F If di!idends do affect !alue, they do so because of the information content, "hich si$nals
mana$ement's future expectations.
F % clientele effect exists that causes shareholders to recei!e the le!el of di!idends they
expect.
Di!idend ele!ance %r$uments
,ontrary to di!idend irrele!ance proponents, Eordon and Gintner
su$$ested stoc#holders prefer current di!idends and that a positi!e relationship
exists bet"een di!idends and mar#et !alue.
.undamental to this theory is the Abird-in-the-handB ar$ument "hich
su$$ests that in!estors are $enerally ris#-a!erse and attach less ris# to current
as opposed to future di!idends or capital $ains.
Because current di!idends are less ris#y, in!estors "ill lo"er their re0uired
return1thus boostin$ stoc# prices.
Factors that '!!ect Dividend $olic(
Ge$al ,onstraints
@ost state securities re$ulations pre!ent firms from payin$ out di!idends
from any portion of the company's Ale$al capitalB "hich is measured by the par
!alue of common stoc#1or par !alue plus paid-in-capital.
Di!idends are also sometimes limited to the sum of the firm's most recent
and past retained earnin$s1 althou$h payments in excess of current earnin$s is
usually permitted.
@ost states also prohibit di!idends "hen firms ha!e o!erdue liabilities or
are le$ally insol!ent or ban#rupt.
E!en the IS has ruled in the area of di!idend policy.
Specifically, the IS prohibits firms from ac0uirin$ earnin$s to reduce
stoc#holders' taxes.
The IS can determine that a firm has accumulated an excess of earnin$s
to allo" o"ners to delay payin$ ordinary income taxes *on di!idends+, it may le!y
an excess earnin$s accumulation tax on any retained earnin$s abo!e 5862,222.
It should be noted, ho"e!er, that this rulin$ is seldom applied.
,ontractual ,onstraints
In many cases, companies are constrained in the extent to "hich they can
pay di!idends by restricti!e pro!isions in loan a$reements and bond indentures.
Eenerally, these constraints prohibit the payment of cash di!idends until a
certain le!el of earnin$s are achie!ed or to a certain dollar amount or percenta$e
of earnin$s.
%ny !iolation of these constraints $enerally tri$$ers the demand for
immediate payment.
Internal ,onstraints
% company's ability to pay di!idends is usually constrained by the amount
of a!ailable cash rather than the le!el of retained earnin$s a$ainst "hich to
char$e them.
%lthou$h it is possible to borro" to pay di!idends, lenders are usually
reluctant to $rant them because usin$ the funds for this purpose produces no
operatin$ benefits that help to repay them.
Ero"th Prospects
-e"er, rapidly-$ro"in$ firms $enerally pay little or no di!idends.
Because these firms are $ro"in$ so 0uic#ly, they must use most of their
internally $enerated funds to support operations or finance expansion.
Hn the other hand, lar$e, mature firms $enerally pay cash di!idends since
they ha!e access to ade0uate capital and may ha!e limited in!estment
opportunities.
H"ner ,onsiderations
%s mentioned earlier, empirical e!idence supports the notion that
in!estors tend to belon$ to AclientelesB1 "here some prefer hi$h di!idends, "hile
others prefer capital $ains.
They tend to sort themsel!es in this "ay for a !ariety of reasons,
includin$)
F Tax status
F In!estment opportunities
F Potential dilution of o"nership
@ar#et ,onsiderations
Perhaps the most important aspect of di!idend policy is that the firm
maintain a le!el of predictability.
Stoc#holders that prefer di!idend-payin$ stoc#s prefer a continuous
stream of fixed or increasin$ di!idends.
Shareholders also !ie" the firm's di!idend payment as a Asi$nalB of the
firm's future prospects.
.ixed or increasin$ di!idends are often considered a Apositi!eB si$nal,
"hile erratic di!idend payments are !ie"ed as Ane$ati!eB si$nals.
T(pes o! Dividend $olicies
,onstant-Payout-atio Policy
Dith a constant-payout-ratio di!idend policy, the firm establishes that a
specific percenta$e of earnin$s is paid to shareholders each period.
% ma(or shortcomin$ of this approach is that if the firm's earnin$s drop or
are !olatile, so too "ill the di!idend payments.
%s mentioned earlier, in!estors !ie" !olatile di!idends as ne$ati!e and
ris#y1"hich can lead to lo"er share prices.
e$ular Di!idend Policy
% re$ular di!idend policy is based on the payment of a fixed-dollar
di!idend each period.
It pro!ides stoc#holders "ith positi!e information indicatin$ that the firm is
doin$ "ell and it minimi&es uncertainty.
Eenerally, firms usin$ this policy "ill increase the re$ular di!idend once
earnin$s are pro!en to be reliable.
Go"-e$ular-and-Extra Di!idend Policy
Usin$ this policy, firms pay a lo" re$ular di!idend, supplemented by
additional di!idends "hen earnin$s can support it.
Dhen earnin$s are hi$her than normal, the firm "ill pay this additional
di!idend, often called an extra di!idend, "ithout the obli$ation to maintain it
durin$ subse0uent periods.
This type of policy is often used by firms "hosesales and earnin$s are
susceptible to s"in$s in the business cycle.
Other Forms o! Dividends
Stoc# Di!idends
% stoc# di!idend is paid in stoc# rather than in cash.
@any in!estors belie!e that stoc# di!idends increase the !alue of their
holdin$s.
In fact, from a mar#et !alue standpoint, stoc# di!idends function much li#e
stoc# splits. The in!estor ends up o"nin$ more shares, but the !alue of their
shares is less.
.rom a boo# !alue standpoint, funds are transferred from retained
earnin$s to common stoc# and additional paid-in-capital.
If Trimline declares a 723 stoc# di!idend and the current mar#et price of
the stoc# is 576>share, 5762,222 of retained earnin$s *723
x
722,222 shares
x

576>share+ "ill be capitali&ed.
The 5762,222 "ill be distributed bet"een the common stoc# *par+ account
and paid-in-capital in excess of par account based on the par !alue of the
common stoc#. The resultin$ balances are as follo"s.
.rom a shareholder's perspecti!e, stoc# di!idends result in a dilution of
shares o"ned.
.or example, assume a stoc#holder o"ned 722 shares at 582>share
*58,222 total+ before a stoc# di!idend.
If the firm declares a 723 stoc# di!idend, the shareholder "ill ha!e 772
shares of stoc#. Io"e!er, the total !alue of her shares "ill still be 58,222.
Therefore, the !alue of her share must ha!e fallen to 57C.7C>share
*58,222>772+.
Disad!anta$es of stoc# di!idends include)
The cost of issuin$ the ne" shares.
Taxes and listin$ fees on the ne" shares.
Hther recordin$ costs.
%d!anta$es of stoc# di!idends include)
The company conser!es needed cash.
Si$nalin$ effect to the shareholders that the firm is retainin$ cash because
of lucrati!e in!estment opportunities.
Stoc# Split
% stoc# split is a recapitali&ation that affects the number of shares
outstandin$, par !alue, earnin$s per share, and mar#et price.
The rationale for a stoc# split is that it lo"ers the price of the stoc# and
ma#es it more attracti!e to indi!idual in!estors.
.or example, assume a share of stoc# is currently sellin$ for 5796 and
splits 9 for 8.
The ne" share price "ill be e0ual to 8>9
x
5796, or 5J2.
,ontinuin$ "ith the example, assume that the in!estor held 722 shares
before the split "ith a total !alue of 579,622.
%fter the split, the shareholder "ill hold) 579,622>5J2 = 762 shares "orth
5J2 each
% re!erse stoc# split reduces the number of shares outstandin$ and raises
stoc# price1the opposite of a stoc# split.
The rationale for a re!erse stoc# split is to add respectability to the stoc#
and con!ey the meanin$ that it isn't a (un# stoc#.
-ot only do stoc# splits lea!e the mar#et !alue of shareholders unaffected, but they also
ha!e little affect from an accountin$ standpoint as this 8-for-7 split demonstrates.
Stoc# epurchases
Stoc# repurchase) The purchasin$ and retirin$ of stoc# by the issuin$
corporation.
% repurchase is a partial li0uidation since it decreases the number of
shares outstandin$.
It may also be thou$ht of as an alternati!e to cash di!idends.
%lternati!e easons for Stoc# epurchases
To use the shares for another purpose
To alter the firm's capital structure
To increase EPS and HE resultin$ in a hi$her mar#et price
To reduce the chance of a hostile ta#eo!er