Capital Structure, Dividend Policy

(Chapters 14-18)
Profit and loss diagrams
Principle of financial leverage
Law of the Conservation of Investment
Value
Standard fallacy: risk vs. return
Weighted average cost of capital
Taxes and bankruptcy costs
Dividend policy
1

BUY STOCK (profit/loss diagram)

P0 = 100

Profit

t =1
D1 = 10
Buy Stock
(without payout)

25

Buy Stock
(with payout)
50

75

125

150

Future Stock Price (Pt)

-25

Loss

SHORT STOCK (profit/loss diagram)

P0 = 100
t =1
r = .15

Profit
Short Stock

D1 = 10

25

Short Stock
(with payout and
with interest on proceeds)
50

75

125

150

Future Stock Price (Pt)

Short Stock
(with payout only)
-25

Loss

LEND CASH (profit/loss diagram)

P0 = 100

Profit

t=1
r = .15
25

50

75

125

150

Future Stock Price (Pt)

-25

Loss

50% STOCK and 50% CASH:

Additivity Principle
P0 = 100

Profit

t =1

50% Stock, 50% Cash

r = .15

Buy Stock

D1 = 0

25

Lend Cash
50

75

125

150

Future Stock Price (Pt)

-25

Loss

Additivity Principle: Add vertical distances of dashed lines to the horizontal axis.

X% STOCK and (100-X)% CASH:

Principle of Financial Leverage
P0 = 100
t =1
r = .15
D1 = 0

100% Stock

Profit
Question: Suppose the
stock has a higher
expected return than
cash,
how
does
leverage affect overall
risk
and
expected
return?
50

50% Stock, 50% Cash

(Lending)

25

75

125

150

Future Stock Price (Pt)

150% Stock, -50% Cash
(Borrowing)
-25

Loss

Principle of Financial Leverage: More borrowing increases the range of possible

gains and losses.

Valuing an Asset
Conceptually, there are two ways you can get the value of
an asset:
Calculate the value of what the asset provides
that is, compute the present value of the expected cash flows

Calculate the value of all claims to the asset

for example, compute the value of a company by adding up all the
claims investors have on the companys cash flows

Question: Does the ratio of debt to equity affect the value

of the corporation?

Assets = Liabilities + Equities

Law of the Conservation of

Investment Value
If the investment value of an enterprise as a whole is by definition the present
worth of all its future distributions to security holders, whether on interest or
dividend account, then this value in no wise depends on what the companys
capitalization is. Clearly, if a single individual or a single institutional investor
owned all the bonds, stocks, and warrants issued by a corporation, it would not
matter to this investor what the companys capitalization was (except for details
concerning the income tax). Any earnings collected as interest could not be
collected as dividends. To such an individual it would be perfectly obvious that
total interest- and dividend-paying power was in no wise dependent on the kind
of securities issued to the companys owner. Furthermore, no change in the
investment value of the enterprise as a whole would result from a change in its
capitalization. Bonds could be retired with stock issues, or two classes of junior
securities (i.e. common stock and warrants) could be combined into one, without
changing the investment value of the company as a whole. Such constancy of
investment value is analogous to the indestructibility of matter and energy; it
leads us to speak of the Law of the Conservation of Investment Value, just as
physicists speak of the Law of the Conservation of Matter, or the Law of the
Conservation of Energy.

John Burr Williams, The Theory of Investment Value (1938), pp. 72-73.

Arbitrage Proof
Modigliani-Miller
Modigliani-MillerTheorem:
Theorem: The
Thevalue
valueof
ofaafirm
firmis
isindependent
independentof
of
its
itscapital
capitalstructure
structure(even
(evenwith
withuncertainty).
uncertainty).
Homemade leverage argument: dont pay for someone else to make
something you can make yourself for free.
Lexicon:
VU = EU (unlevered firm) VL = DL + EL (levered firm)
X XU = XL (= operating income)
Current Date

value of firm: V
value of stock: E
stock price per share: S

Future Date

Buy % shares of U

EU = VU

Buy % bonds of L

DL

min[X, rDL]

Buy % shares of L

DL

max[0, X rDL]

DL + EL = VL

Total

V
VUU==V
VLL
VVUU==VVLL

Pie Theory

Dept

Equity

10

Assumptions for the Conservation Law

(1) Operating income (from assets) is not affected by
capital structure (the total pie is fixed):
no bankruptcy costs
no differential transactions costs between issuing or trading stock and bonds
no changes in managerial incentives (stock options)
no changes in stockholder incentives (changes in the risk of assets)

(2) The proportion of the operating income that is

jointly allocated to stock and bonds is not affected
by the firms capital structure (only stockholders
and bondholders eat the pie):
no differential taxes between income from stock and bonds

11

Pie Chart with Taxes

Equity

Debt
Taxes

12

Stock Price Constancy

IfIfthe
thevalue
valueof
ofaafirm
firmis
isindependent
independentof
ofits
itscapitalization
capitalizationstructure,
structure,
then
thenso
sotoo
toois
isthe
thefirms
firmsstock
stockprice.
price.
Proof:
Step 1: Start with an unlevered firm (with n outstanding shares):
VU = EU = nSU
Step 2: The firm alters its capital structure by buying back
replacing them dollar for dollar with bonds:
VL = EL + DL = (n m)SL + mSL = nSL

m shares and

where in general the stock of the levered firm may sell at a different price per
share of SL.
Step 3: However, since VL = nSL and VU = nSU,
if VL = VU, then SL = SU

13

Note: If the firm starts with debt, for this to hold, the recapitalization cannot affect the market value of this debt.

Standard Fallacy
A firm can invest in a project with an expected rate of
return of 10% and borrow money at an interest rate of 5%.
Should the project be funded with debt or equity?
Let the proportion x of the project be financed by stock
and 1 x by debt. Then the expected rate of return to
stockholders E(Rj) is determined by:
.10 = (1 x).05 + xE(Rj)
E(Rj) = .05 + .05/x
The more debt financing (the lower x), the greater E(Rj).
Therefore, debt is good. In fact, say x = .05, then E(Rj) =
1.05 (105%!).
14

Standard Fallacy (continued)

What about risk? Suppose the annual standard deviation of the return
of the project is 20%. Then
.202 = Var[(1 x).05 + xRj] = x2Var(Rj)
.20 =|x|Std(Rj) SD(Rj) = .20/|x|
So the more debt, the more risk. With no debt (x = 1) SD(Rj) = .20.
With very high levels of debt such as x = .05, SD(Rj) = .20/.05 = 4
(400%!)
High expected return goes with high risk.* Does the tradeoff leave an
investor in the stock indifferent? Yes, because the investor can
achieve the same tradeoff by his own borrowing.
* Another proof that investors must be risk averse. If they were not, then we
should see leverage driven to the limit whenever possible. What stops this is the
15
higher and higher levels of risk.

Weighted Average Cost of

Capital (WACC)
The cost of capital is another name for the
discount rate or expected return.
The WACC is the overall expected return of
the firm as a whole.
To see why, think of the firm as a portfolio
consisting of D/(D+E) fraction of value in debt
and E/(D+E) fraction of value in equity, then

Rwacc

D
E

RD
RE
DE
DE

16

Significance of WACC
Under the conditions for the MM Theorem, for
capital budgeting projects that have the same
risk as the average firm investment, WACC is
the proper discount rate in calculating its present
value.
If not same risk as average, then use the CAPM
(to be developed later).
If capital structure affects firm value, then still
holds as longs as capital structure is not changed.
17

Required Return on Equity for

a Levered Firm
The MM theorem implies that the WACC must
be the same no matter what the amount of
leverage.
Think what would happen if the firm only has one
investor who holds all the debt and equity.

Let R0 be the WACC of an all equity firm.

The WACC of a levered firm is given by

D
E
R0
RD
RE
DE
DE

18

Required Return on Equity

(continued)
Multiplying both sides by (D+E)/E

DE
D
R0 RD RE
E
E
Rearranging terms

D
RE R0 ( R0 RD )
E
19

Modigliani - Miller Part II

(No Taxes)

D
RE R0 ( R0 RD )
E
The required return on equity is a linear
function of the firm's debt-to-equity ratio.
The higher the debt-to-equity ratio, the higher
the expected return on equity (assuming R 0 >
RD).
20

Federal Income Taxation

year
71-78
79-81
82-86
87
88-90
91-92
93-96
97-00
01-02
03-05

--------- personal tax rates --------corporate

interest
dividends cap gains*
48%
70%
70%
35%
46%
70%
70%
28%
46%
50%
50%
20%
40%
39%
39%
28%
34%
28%
28%
28%
34%
31%
31%
28%
35%
40%
40%
28%
35%
40%
40%
20%
35%
39%
39%
20%
35%
35%
15%
15%

* actually much lower in practice due to delay of tax payment until realization

21

Effect of Taxes
When the firm pays taxes, you can think of the
government as just another claimant.
Thus there are now three claims on the firm
(1) Equity holders
(2) Debt holders
(3) The government (IRS)

22

Key Feature of the US Tax Code

Interest payment on debt occurs on a before-tax
basis, whereas as dividends are paid on an aftertax basis.
To see the general effect, assume that Earnings
Before Interest and Taxes (EBIT) is constant in
perpetuity.
Earnings after taxes for the all equity firm are:
EBIT(1 Tc)
23

All-Equity Firm
Assume earnings after taxes are equal to FCF to
equity. Then, because there are no bondholders,
this is also the total cash flow paid out after
taxes.

24

Levered Firm
First interest is paid to the bond holders (on a pretax basis):
RDD
Thus, remaining income is: EBIT RDD

The remaining cash flow (after taxes) to equity holders is:

(EBIT RDD)(1 Tc)
Total cash flow paid out (to debt and equity) after taxes:
(EBIT RDD)(1 Tc) + RDD
EBIT(1 Tc) + RDDTc
25

Comparison of the Total Cash

Flow paid out
Unlevered firm:
EBIT(1 Tc)
Levered firm:

EBIT(1 Tc) + RDDTc

Thus the levered firm pays out higher cash flows to its investors!
The difference, RDDTc, is the extra cash flow going to equity
holders that is not going to the government. This is the called
the tax shield. Clearly, the cash flow to investors depends in
this case on the debt-to-equity ratio.
26

Present Value of the Tax Shield

The extra cash flow to equity holders is RDDTc,
Applying the perpetuity formulae provides the
present value of this cash flow:
(RDDTc)/RD = TcD (= tax shield)

27

Modigliani -Miller Theorem

(with corporate taxes)
When the level of debt is constant in perpetuity:
VL = VU + TcD
The value of a levered firm equals the value of
the unlevered firm plus the value of the tax
shield.

28

Unlevered Firm :
Return on Equity with Taxes
What is the return on equity to an unlevered firm
in the constant perpetuity model?
R0 = EBIT(1 Tc)/VU
( = WACC for unlevered firm)
so that EBIT(1 Tc) = VUR0
29

Levered Firm :
Return on Equity with Taxes
What is the return on equity to a levered firm in
the constant perpetuity model?
RE = (EBIT RDD)(1 Tc)/E
Substituting the expression from the last slide
gives:
RE = [VUR0 RDD(1 Tc)]/E
30

Levered Firm
(continued)
Substituting for VU from the MM Theorem with taxes
gives (VL = VU + TcD):
RE = [(VL TcD)R0 RDD(1 Tc)]/E
Finally, recall that the value of the firm to the
investors is sum of debt and equity:
VL = D + E
RE = [(D + E TcD)R0 RDD(1 Tc)]/E
= R0 + (D/E)(R0 RD)(1 Tc)

31

Modigliani -Miller Theorem

(with corporate taxes)
RE = R0 + (D/E)(R0 RD)(1 Tc)
The required return on equity is a linear function of
the firm's debt-to-equity ratio and tax rate.
The higher the debt-to-equity ratio, the higher the
return on equity.
The higher the tax rate the lower the return on equity.
Tax advantage limited to size of EBIT (implies
growing firms should have lower D/E ratios).
32

Capital Structure Puzzle

Average S&P500 firms have ratio:
Interest/EBIT = (about) 35%
Puzzle: why is this not 100%?

33

Bankruptcy (no taxes)

Bankruptcy process:
workout
Chapter 11 reorganization
Chapter 7 liquidation

What costs are associated with bankruptcy?

Loss of sales and employees

Lawyers/Accountants
Agency
Underinvestment
Reputation
Fire sales of assets
Expert witnesses (by far the most justifiable
expense!)

34

Revised Pie Theory

Equity

Bankruptcy Costs

Dept

These costs are

borne by the
stockholders.
35

Caution
Here we have to be careful, because rational
customers should understand that if keeping the
projects going is a positive NPV investment, then
bankruptcy cannot affect the decision.
Berks Theory:
Why do employees suffer? Why are they not earning
their market wages? Risk. Equity holders insure
employees!!! Bankruptcy prevents risk sharing, and
thus is costly.
36

Revised Pie Theory:

Bankruptcy + Taxes

Taxes

Equity

Bankruptcy

Costs

Debt

37

Other Considerations
Agency costs: moral hazard: risky overinvestment
Asymmetric information
Signaling: leverage indicates CEO confidence
Adverse selection: lemons problem with equity
Unjustified differences of beliefs

38

Dividend dates
Declaration date (March 29, 1999)
Day the board of directors makes a decision to pay a
dividend

Ex-dividend date (Thursday, April 15, 1999)

2 business days before date of record. All brokerage
houses guarantee that if the stock is purchased
before this date, the holder will get the dividend
On April 15 the stock trades ex-dividend while on
April 14 it trades cum-dividend. [stock price falls]
39

Dividend dates (continued)

Date Record (Monday, April 19, 1999)
List of stockholders of record who will get a dividend

Payment Date (Friday, May 28, 1999)

Day the dividend checks are mailed

40

Irrelevance of Dividend Policy

To first order (that is, holding investment policy
fixed and ignoring taxes) dividend policy is
irrelevant -- it should not affect firm value.
The reason is any investor can change his
personal dividend policy by either selling or
buying more shares, and the firm can
accomplish the same thing through share
repurchase.
Since dividend policy is a financial decision,
this is really just and example of MM. In this
context, when might dividend policy matter? 41

Dividend Policy with Taxes

(in the US)
Since dividends are usually taxed at higher rate
than capital gains (even today!), it would seem
that it is not optimal for a firm to issue
dividends.
That is, rather than pay dividends firms should
reinvest the money or repurchase its shares and let
shareholders manufacture their personal dividends
by selling stock.
42

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