Academy of Finance MBA Program, Finance

Lecture 6A
Optimal Capital Structure Dividend Decision

Academy of Finance MBA Program, Finance

Financing the business

There only two ways to finance a company: Debt
Make fixed payments in the future (interest and repayment of principal) Failure to make payments can mean losing control of the business Note: Current liabilities are a form of short-term working capital financing

Equity
Pay back whatever is left after debt obligations are met

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Sources of Debt and Equity

Debt
For private businesses, it is usually bank loans For public companies, it can also be bond issues

Equity
For small businesses, it is the owners capital For larger businesses, it can be venture or private equity capital (usually on a preferred basis) For publically traded firms, it is common stock
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Academy of Finance MBA Program, Finance

Costs and Benefits of Debt

Costs
Bankruptcy cost higher business risk relates to higher cost Agency cost greater separation between stockholders and lenders relates to higher cost Loss of financing flexibility when there is uncertainty about future financing needs

Benefits
Tax benefit Adds discipline to management

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What is the optimal level of borrowing?

Miller-Modigliani theorem
Under ideal conditions, when there are no taxes, no agency costs, no threat of bankruptcy, and future financing needs are known:
The value of a firm is independent of its capital structure A firms value will be determined by its projected cash flows Cost of capital will not change with leverage gains from leverage will be offset by increases in the cost of equity

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Financing hierarchy
Managers value flexibility - External financing reduces flexibility more than internal financing Managers value control - Issuing new equity weakens control and new debt creates bond covenants Therefore, financing with retained earnings should be the most preferred choice for financing, followed by debt. New equity is the least preferred choice

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Survey results preference ranking for longterm finance

Source Retained Earnings Straight Debt Convertible Debt External Common Equity Straight Preferred Stock Convertible Preferred Score 5.61 4.88 3.02 2.42 2.22 1.72
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What is the optimal capital structure?

The following approaches can be considered:
Minimize cost of capital Maximise the overall value of the firm Bring the firms capital in line with relevant peer group The structure that best suits where the firm is in its lifecycle

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Framework for getting to the optimal

If actual debt ratio is greater than the optimal one:
Is the firm under Is the firm under bankruptcy bankruptcy threat? threat?
YES NO

Does the firm Does the firm have valuehave valueadding projects? adding projects?
YES

NO

Reduce debt quickly: Reduce debt quickly: Debt/Equity swaps Debt/Equity swaps Sell assets to pay off Sell assets to pay off debt debt Renegotiate with Renegotiate with lenders lenders

Finance good projects Finance good projects with new equity or with new equity or retained earnings retained earnings

Pay off debt with Pay off debt with new equity or new equity or retained earnings retained earnings Reduce or eliminate Reduce or eliminate dividends dividends

Academy of Finance MBA Program, Finance

Framework for getting to the optimal

If actual debt ratio is lower than the optimal one:
Is the firm a Is the firm a takeover target? takeover target?
NO

Does the firm Does the firm have valuehave valueadding projects? adding projects?
YES

NO

YES

Increase leverage Increase leverage Quickly Quickly Equity/Debt swaps Equity/Debt swaps Borrow money and Borrow money and buy back shares buy back shares

Finance good projects Finance good projects with debt with debt

Pay dividends or buy Pay dividends or buy back stock back stock

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Designing debt
Optimal financing instrument would have all the tax advantages of debt while preserving the flexibility of equity
C/F characteristics C/F characteristics Duration Currency if inflows Sensitivity to uncertainty about future inflation Debt characteristics Debt characteristics Set maturity Set currency mix Set fixed vs. floating Rate * More floating rate if CF moves with inflation, or if greater uncertainty about future Straight debt versus Convertible * Convertible if cash flows low now but with high growth later Option to match payments with C/F stream
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Growth pattern

Cyclicality

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Dividend decision
Calculated on the basis of retained after-tax profits and nearterm earnings prospects Better to consider expected free cash flows cash remaining after expenses and after capital investment needs have been met Finance theory says that if the company has no positive-NPV projects (projects with returns that exceed the hurdle rate), then excess funds should be returned to the owners in the form of dividends
The reality is different

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Why pay dividends?

Some shareholders require dividends
They are usually tax-neutral in terms of dividends vs. capital gains (i.e. Pension funds)

Signalling theory paying dividends indicates to the market that the firm is confident about future cash flows Wealth appropriation transfer of wealth from lenders to owners (though lenders may not like this)
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Academy of Finance MBA Program, Finance

Why not pay cash dividends?

In order to retain flexibility
Cash buffer in the event that future conditions are uncertain Investment flexibility, to be able to exercise built in options on current investments

For growth companies, it is expected that cash will be retained to finance growth, thus leading to higher capital gain benefit of owning shares Management has a good track record of investing the firms cash in high-return projects Tax issues for shareholders
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Cash versus share buy-back

A buy-back is a one-time event
Shareholders have no further expectation from the company

Cash dividends create expectations for future dividend pay-outs

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Academy of Finance MBA Program, Finance

What does a dividend payment signal?

That the company is profitable and expects to be profitable in the future, leaving it with excess cash
Positive signal, share price increases

OR, that the company has few positive NPV projects, thus returning cash to investors
Negative signal, share price declines

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