1 chapter 16: payout policy many companies pay a regular cash dividend. –public companies often...

1

Chapter 16: Payout Policy

• Many companies pay a regular cash dividend.

– Public companies often pay quarterly.

– Sometimes firms will throw in an extra cash dividend.

– The extreme case would be a liquidating dividend.

• Often companies will declare stock dividends.

– No cash leaves the firm.

– The firm increases the number of shares outstanding.

• Some companies declare a dividend in kind.

– Wrigley’s Gum sends around a box of chewing gum.

– Dundee Crematoria offers shareholders discounted cremations.

2

Standard Method of Cash Dividend Payment

Record Date - Person who owns stock on this date received the dividend.

Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.

Cash Dividend - Payment of cash by the firm to its shareholders.

3

Procedure for Cash Dividend Payment

25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.

Declaration Date

Cum-dividend

Date

Ex-dividend

Date

Record Date

Payment Date

…

Declaration Date: The board of directors declares a payment of dividends.Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.Record Date: The corporation prepares a list of all individuals believed to be stockholders (typical clearing is 3 days).

4

Price Behavior around the Ex-Dividend Date

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.

$P

$P - div

Ex-dividend

Date

The price drops by the amount of the cash dividend

-t … -2 -1 0 +1 +2 …

Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

5

The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy

• A compelling case can be made that dividend policy is irrelevant. Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts.

• Under some important assumption, M&M (1961) proved that dividend policy is irrelevant. The assumptions are

1. No taxes.

2. No transaction costs.

3. Perfect capital market (symmetric information, no agency problems, other)

6

The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy (example 1)

York Corporation , an all-equity firm

• At date 0, the managers are able to forecast cash flows perfectly.

• The firm will receive a cashflow of $10,000 at date 0 and $10,000 at date 1

• The firm will dissolve at date 1.(end its life)

• The firm has no additional positive NPV projects

7

An Illustration of the Irrelevance of Dividend Policy (example 1)

I ) Current Policy:Dividends set equal to cashflow

Dividends (Div.) at each date = $10000

The firm value will be :

sr

DIVDIVV

1

100

91.19090$1.1

10000$10000$0 V

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Assume 1,000 shares are outstanding, then, price just before dividend is paid is

09.19$1.1

10$10$0 P

After the imminent dividend is paid, the stock price will fall to $9.09 (19.09-10)

9


I I) Alternative Policy: Initial dividend > cash flow

Pay $11 per share immediately i.e., $11 X 1000 shares = $11,000 as dividend.

The extra $1,000 must be raised by issuing new stock.

Since the investment decision did not change, the required return (cost of capital) is still 10%. So the new shareholders should receive at t=1: 1100$1.11000$

Date 0 Date1

Total dividends to old shareholders $11,000 $8,900

Dividends per share $11 $8.9

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The PV of dividends per share (cum-dividend) with the alternative policy:

09.19$1.1

9.8$11$0 P

• The indifference proposition:

-The value of the firm at t=0 is the same not matter which scenario we consider .

-The change in dividend policy did not affect the value of the share (cum-dividend).

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The mechanics of the policy:

At t=0 (Ex-dividend), the price of the share will drop to $8.09 (8.9/1.1). This means that York needs to issue 1000/8.09 = 123.61 shares. There will be a total of 1123.61 shares outstanding. This leads to the following distribution of t=1 cash flow:

Number of shares (%) T=1 Dividend

old shareholders 1000 (89%) $8,900

new shareholders 123.61 (11%) $1,100

Total 1123.61(100%) $9,000

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Pumpkin Pie Inc. currently has 1,000 shares outstanding with a total market value of $42,000. It expects cash flows from operations to be $10,000 next year. It wants to expand its product lines to include cookies and determines that it is a positive NPV project. The new product line requires a new oven that costs $8,000.

Dividend Policy #1Pay out any cash that is leftover after investing in all positive NPV projects. For next year, Pumpkin Pie Inc. will pay out $2,000 ($10,000 - $8,000) as cash dividend. Dividend Policy #2Pumpkin Pie is considering a $3,000 cash dividend ($3 per share).

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Homemade Dividends

• Pumpkin Pie Inc. is a $42 stock about to pay a $2 cash dividend.• Bob Investor owns 80 shares and prefers $3 cash dividend.• Bob’s homemade dividend strategy:

– Sell two shares ex-dividend

homemade dividendsCash from dividend $160Cash from selling stock $80Total Cash $240Value of Stock Holdings $40 × 78 =

$3,120

$3 Dividend$240

$0$240

$39 × 80 =$3,120

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Dividend Policy is Irrelevant• Since investors do not need dividends to convert

shares to cash, dividend policy will have no impact on the value of the firm.

• In the above example, Bob Investor began with total wealth of $3,360:

share

42$shares 80360,3$

240$share

39$shares 80360,3$

80$160$share

40$shares 78360,3$

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend, and sale of two ex-dividend shares,his total wealth is still $3,360:

15

Irrelevance of Stock DividendsXYZ Inc. has two million shares currently outstanding at $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid?

A 50% stock dividend will increase the number of shares by 50%:

2 million×1.5 = 3 million shares

After the stock dividend what is the new price per share and what is the new value of the firm?

The value of the firm was $2m × $15 per share = $30 m. After the dividend, the value will remain the same.

Price per share = $30m/ 3m shares = $10 per share

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Dividends and Investment Policy

• Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time).

• Note that the dividend-irrelevance argument assumes that “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”

• A final note:

-Dividends are relevant

-Dividend policy is irrelevant

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Repurchase of Stock

• Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.

• Recently share repurchase has become an important way of distributing earnings to shareholders.

• When tax avoidance is important, share repurchase is a potentially useful adjunct to dividend policy.

18

Share Repurchase

Types:

1. Tender offers - If offer price is set wrong, some stockholders lose.

2. Auction

3. Open-market repurchase

4. Targeted repurchase (Greenmail)

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Stock Repurchase versus Dividend

$10=/100,000$1,000,000=Price per share 100,000=outstanding Shares

1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000assetsOther

0Debt$150,000Cash

sheet balance Original A.Equity &Liabilities Assets

Consider a firm that wishes to distribute $100,000 to its shareholders.

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$9=00,000$900,000/1 = shareper Price

100,000=goutstandin Shares

900,000Firm of Value900,000Firm of Value

900,000Equity850,000assetsOther

0Debt$50,000Cash

dividendcash shareper $1After B.

Equity & sLiabilitie Assets

If they distribute the $100,000 as cash dividend, the balance sheet will look like this:

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Assets Liabilities & Equity

C. After stock repurchase

Cash $50,000 Debt 0

Other assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000

Shares outstanding= 90,000

Price per share = $900,000 / 90,000 = $10

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

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• In Canada, individual investors face a lower dividend tax rate due to the dividend tax credit.

• However, capital gains for individuals are taxed at 50% of the marginal tax rate so the effective tax rate on dividend income is higher than the tax rate on capital gains.

If dividends are taxed more heavily than capital gains, investors should pay more for stocks with low dividends (i.e., investors would be happy with a lower pretax rate of return from firms offering capital gains rather than dividends).

Violation of M&M Assumptions(1) Taxes

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Example (Table 16.1)

Firm A Firm B

Next year’s price $112.50 $102.50

Dividend $0 $10

Total pretax payoff $112.50 $112.50

Today’s stock price $100 $97.78

A is preferred to B because it does not pay highly taxed dividends

Dividend tax (40%) 0 10×0.4= $4.00

Capital gain tax (20%) 12.5×0.2=$2.5 4.72×0.2=$0.94

After tax income 12.5-2.5=$10 14.72-4.94=$9.78

After tax return 10/100=10% 9.78/97.78=10%

Before tax return 12.5/100=12.5% 14.72/97.78=15.05%

A and B provide same return after tax, B provides higher return pretax

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Dividends Decrease Value (if one considers only the issue of taxes)

Tax Consequences• Companies can convert dividends into capital

gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.

• Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.

• Dividend policy should adjust to changes in the tax code.

25

Evidence on Dividends and Taxes in Canada

• Prior to 1972, capital gains were untaxed in Canada

• In 1985, a life-time exemption on capital gains was introduced.

• Anticipation of the tax break on capital gains caused investors to bid up prices of low-dividend yield stocks.

• Firms responded by lowering their dividend payouts.

• The dividend tax credit works to reduce taxes on dividends received from Canadian firms.

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• Also, in the real world there are transaction costs. This may suggest that – Shareholders may pay high transaction costs for

selling shares instead of receiving dividends.– Issuing shares to raise equity my involve high fees

to investment bankers.

Violation of M&M Assumptions(2) Transaction costs

27

Violation of M&M Assumptions(3) Agency Costs

• Consider a firm with excess cash.• Consider a firm that has $1 million in cash after

selecting all available positive NPV projects.• The firm has several options:

– Select additional capital budgeting projects (by assumption, these are negative NPV).

– Acquire other companies (empire building)– Purchase financial assets– Repurchase shares

28

Violation of M&M Assumptions(4) Information Asymmetry

Dividends as SignalsDividend increases send good news about

cash flows and earnings. Dividend cuts send bad news.

Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.

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Desire for Current Income(5) Market Imperfection

Dividends and IncomeTrusts and endowment funds may be

prohibited to invest in non-dividend paying firms. Since they manage funds by themselves, they may not be willing to spend the fees required in other intermediaries to pass this requirement.

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Summary of all Effects

• Reasons for Low Dividend– Personal Taxes– High Issuing Costs

• Reasons for High Dividend– Information Asymmetry

• Dividends as a signal about firm’s future performance

– Lower Agency Costs• capital market as a monitoring device• reduce free cash flow, and hence wasteful

spending– Desire for Current Income

31

The Clientele Effect: A Resolution of Real-World Factors? (cont.)

Clienteles for various dividend payout policies are likely to form in the following way:

Group Stock

High Tax Bracket Individuals

Low Tax Bracket Individuals

Tax-Free Institutions

Corporations

Zero to Low payout stocks

Low-to-Medium payout

Medium Payout Stocks

High Payout Stocks

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

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The Clientele Effect Example

• 40% of investors prefer high dividends• 60% of investors prefer low dividends• 20% of firms pay high dividends• 80% of firms pay low dividendHigh dividend firms in short supply (price ↑), Low dividends

firm in high supply (price ↓).Some firms will change policy and increase dividends, till

40% of firm pay high dividends, and 60% of firms will pay low dividends.

Once payouts of corporations conform to the desires of shareholders, no single firm can affect its market value by switching from one dividend strategy to another.

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The Dividend Decision

1. Firms have longer term target dividend payout ratios.

2. Managers focus more on dividend changes than on absolute levels.

3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings.

4. Managers are reluctant to make dividend changes that might have to be reversed.

5. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt.

Lintner’s “Stylized Facts”

(How Dividends are Determined)

34

Summary and Conclusions

• The optimal payout ratio cannot be determined quantitatively.

• In a perfect capital market, dividend policy is irrelevant due to the homemade dividend concept.

• A firm should not reject positive NPV projects to pay a dividend.

• Personal taxes and issue costs are real-world considerations that favor low dividend payouts.

• Many firms appear to have a long-run target dividend-payout policy. There appears to be some value to dividend stability and smoothing.

• There appears to be some information content in dividend payments. Agency consideration may also lead to high dividends.

35

Practice question 1: Time Line

On April 5, the board of directors of Capital City Golf Club declared a dividend of $0.75 per share payable on Tuesday, May 4, to shareholders of record as of Tuesday April 20. Suppose you bought 350 shares of Capital City stock on April 6 for $8.65 a share. Assume there are no taxes, no transaction costs, and no news between your purchase and sale of the stock. If you were to sell your stock on April 16, for how much would you be able to sell your stock? What if you were to sell the stock on April 21?

36

Practice question 2: M&M TheoremThe net income of Novis Corporation, which has 10,000 outstanding shares and a 100% payout policy is $32,000. The expected value of the firm one year hence is $1,545,600. The appropriate discount rate for Novis is 13%.

1. What is the current value of the firm?2. What is the ex-dividend price of Novis’s stock if the board

follows its current policy?3. At the dividend declaration meeting, several board

members claimed that the dividend is too small and is probably depressing Novis’ price. They proposed that Novis sell enough new shares to finance a $4.25 dividend. (a) comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations. (b) If the proposal is adopted, at what price will the new shares sell and how many will be sold?

37

Practice question 3: Dealing with TaxesNational Business Machine Co. (NBM) has $2 million of extra cash. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulting investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in TB yielding 7%, or an 11% preferred stock. Only 30% of the dividends from investing in preferred stock would be subject to corporate taxes. Another alternative is to pay out the cash as dividends and let the shareholders invest on their own in treasury bills with the same yield. The corporate tax rate is 35%, and the individual tax rate is 31%. Should the cash be paid today or in three years? Which of the two options generates the highest after-tax income for the shareholders?

38

Practice question 4: Real World Factors?

In the May 4, 1981, issue of Fortune, an article entitled “Fresh Evidence That Dividends Don’t Matter” stated, “All told, 115 companies of the S&P 500 firms raised their payout every year during the period 1970-1989. Investors in this group would have fared somewhat better than investors in the 500 as a whole with a median return of 10.7% versus 9.4% for the S&P 500.”

Is the evidence that investors prefer dividends to capital gains? Why or why not?

39

Chapter 17Does Debt Policy Matter?

• The Effect of Capital Structure in a Competitive Tax Free Environment

• Financial Risk and Expected Returns

• The Weighted Average Cost of Capital

• A Final Word on After Tax WACC

40

M&M (What is it all about?)

• What is the capital structure question?

• Why maximizing equity value and firm value is the same (under what assumptions)?

41

M&M (Debt Policy Doesn’t Matter)

Modigliani & MillerIt makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

Major Assumptions (not all):(1) Individuals and firms borrow/lend at same rate.(2) No Bankruptcy costs(3) No transaction costs(4) No taxes

42

The Idea.. Can We Create Value By Splitting a Pie?

UL VV

DrEBIT

receive firm levered a in rsShareholde

D Dr

receive sBondholder

D

The derivation is straightforward:

DrDrEBIT

is ers stakeholdall to flow cash total the Thus,

DD )(

The present value of this stream of cash flows is VL

EBITDrDrEBIT

Clearly

DD )(

The present value of this stream of cash flows is VU

43


Profits0101V

Return DollarInvestment Dollar

U ..

L

LL

L

L

01V

Profits01E01(DTotal

Interest)-Profits0101EEquity

Interest.0101DDebt


.

.).

(..

.

44


)

(..

LL

L

D.01(V

interest)-Profits0101E


Interest)-Profits01D01(VTotal

Profits0101VEquity

Interest.01-01DBorrowing


LU

U

L

(.).

..

.

45

Example 1

CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50

Proposed$20,000

$8,000$12,000

2/38%240$50

Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)

46

EPS and ROE Under Current Capital Structure

Recession ExpectedExpansion

EBIT $1,000 $2,000 $3,000

Interest 0 0 0

Net income $1,000 $2,000 $3,000

EPS $2.50 $5.00 $7.50

EBIT/A 5% 10% 15%

ROE 5% 10% 15%

Current Shares Outstanding = 400 shares

47

EPS and ROE Under Proposed Capital Structure

Recession ExpectedExpansion

EBIT $1,000 $2,000 $3,000

Interest 640 640 640

Net income $360 $1,360 $2,360

EPS $1.50 $5.67 $9.83

EBIT/A 5% 10% 15%

ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

48

EPS and ROE Under Both Capital StructuresAll-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50EBIT/A 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares

LeveredRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83EBIT/A 5% 10% 15%ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

49

Financial Leverage and EPS

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1,000 2,000 3,000

EP

S

Debt

No Debt

Break-even point

EBI in dollars, no taxes

Advantage to debt

Disadvantage to debt EBIT

50

Homemade LeverageRecession Expected Expansion

EPS of Unlevered Firm $2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300

Less interest on $800 (8%) $64 $64 $64

Net Profits $36 $136 $236

ROE (Net Profits / $1,200) 3% 11% 20%

We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm.

Our personal debt equity ratio is:3

2200,1$

800$

E

D

51

Homemade (Un)Leverage

Recession Expected ExpansionEPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236Plus interest on $800 (8%) $64 $64 $64Net Profits $100 $200 $300ROE (Net Profits / $2,000) 5% 10% 15%

Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm.This is the fundamental insight of M&M

52

Example (text) - Macbeth Spot Removers - All Equity Financed

201510% 5(%) shares on Return

2.001.501.00$.50shareper Earnings

2,0001,5001,000$500Income Operating

D C BA

Outcomes

10,000 $Shares of ValueMarket

$10shareper Price

1,000shares ofNumber

Data


Expected outcome

53

Example

cont.

50% debt


3020100%(%) shares on Return

321$0shareper Earnings

500,11,000500$0earningsEquity

500500500$500Interest

000,21,5001,000$500Income Operating

CBA

Outcomes

5,000 $debt of ueMarket val

5,000 $Shares of ValueMarket

$10shareper Price

500shares ofNumber

Data

D

54

Example - Macbeth’s - All Equity Financed

- Debt replicated by investors

3020100%(%) investment$10 on Return

3.002.001.000 $investment on earningsNet

1.001.001.00$1.0010% @Interest :LESS

4.003.002.00$1.00shares twoon Earnings

DCBA

Outcomes


MM'S PROPOSITION I

If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY

It should cost no more to assemble a chicken than to buy one whole.

No Magic in Financial Leverage

56

Proposition I and Macbeth

(%) shareper return Expected

($) shareper Price

2.001.50($) shareper earnings ExpectedEquity and Debt Equal

: StructureProposed

Equity All

: StructureCuttent

Macbeth continued

57

Leverage and Returns

securities all of uemarket val

income operating expectedr assets on return Expected a

ED

Er

ED

Drr EDA

58

M&M Proposition II

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

E

Drrrr DAAE

Macbeth continued (All equity firm)

59

M&M Proposition II

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

20%or 20.5000

500010.15.15.

Er

Macbeth continued (D/E=1)

E

Drrrr DAAE

60

Leverage and Risk

20%-020%shares on Return

$2.00-02($) shareper Earnings:debt % 50

10%-5%15%shares on Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

20%-020%shares on Return

$2.00-02($) shareper Earnings:debt % 50

10%-5%15%shares on Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

Macbeth continued

Leverage increases the risk of Macbeth shares

61


Asset Value 100 Debt (D) 30

Equity (E) 70

Asset Value 100 Firm Value (V) 100

rd = 7.5%

re = 15%

Market Value Balance Sheet example

%75.12100

7015.

100

30075.

A

EDA

r

ED

Er

ED

Drr

62


Asset Value 100 Debt (D) 40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5% changes to 7.875%

re = ??

Market Value Balance Sheet example – continued

What happens to Re when debt costs rise?

%0.16

100

60

100

4007875.1275.

e

e

r

r

63


V

EB

V

DBB EDA

V

EB

V

DBB EDA

DAAE BBE

DBB DAAE BB

E

DBB

64

r

DE

rD

rE

M&M Proposition II

rA

Risk free debt Risky debt

65

r

DV

rD

rE

WACC

WACC (traditional view)

66

After Tax WACC

V

Er

V

DTcrWACC ED )1(

Tax Adjusted Formula

67

After Tax WACC

Example - Union Pacific

The firm has a marginal tax rate of 35%. The cost of equity is 10.0% and the pretax cost of debt is 5.5%. Given the book and market value balance sheets, what is the tax adjusted WACC?

68

After Tax WACC

Example - Union Pacific - continued

Balance Sheet (Market Value, billions)Assets 22.6 7.6 Debt

15 EquityTotal assets 22.6 22.6 Total liabilities

Balance Sheet (Market Value, billions)Assets 22.6 7.6 Debt

15 EquityTotal assets 22.6 22.6 Total liabilities

MARKET VALUES

69

Summary: No Taxes

• In a world of no taxes, the value of the firm is unaffected by capital structure.

• This is M&M Proposition I:

VL = VU

• Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

• In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders

)( DAAE rrE

Drr

70

Question (illustrating Prop I and II)

Turtle Motors, and all-equity firm, has an expected cash flow of $10 million per year in perpetuity. There are 10 million shares outstanding, implying expected annual cash flow of $1 per share. The cost of capital for this unlevered firm is 10%. The firm will soon build a new plant for $4 million. The plant is expected to generate additional cash flow of $1 million per year.

a. Find the projects NPVb. Write down the market value balance sheet of Turtle Motors before

and after the new project is announced (assume efficient capital markets and that the firm announces it will raise equity to finance the new plant).

c. Assume the firm decides to finance the new project by issuing shares. Write down the market balance sheet upon share issuing and upon payment of the project. How many shares are issued? Describe the change in firm value, shareholders required return and share price throughout the process.

d. Repeat (c) but assume that the firm decides on issuing debt which entail a 6% interest in perpetuity.

71

Chapter 18 How Much Shout a Firm Borrow

• Corporate Taxes and Value

• Corporate and Personal Taxes

• Cost of Financial Distress

• Pecking Order of Financial Choices

72

Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Capital Structure & Corporate Taxes

73


Income Statement of

Firm U

Income Statement of

Firm L

Earnings before interest and taxes $1,000 $1,000Interest paid to bondholders - 80 Pretax income 1,000 920 Tax at 35% 350 322 Net income to stockholders 650 598

Total income to both bondholders and stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.

74

Capital Structure & Corporate TaxesExample - You own all the equity of Space Babies Diaper Co. The

company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000.

Should you do this and why?

($ 1,000 s) All Equity

EBIT 900Interest Pmt 0Pretax Income 900Taxes @ 35% 315Net Cash Flow 585

1/2 Debt

900100800280520

Total Cash Flow

All Equity = 585

*1/2 Debt = 620*1/2 Debt = 620

(520 + 100)

75


PV of Tax Shield = (assume perpetuity)

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 2,000,000 x (.05) x (.35) = $35,000

PV of $35,000 in perpetuity = 35,000 / .05 = $700,000

PV Tax Shield = $2,000,000 x .35 = $700,000

76

The MM Proposition I (Corp. Taxes)

DTVV CUL

)1()( CD TDrEBIT


Dr

receive sBondholder

D

DrTDrEBIT


DCD )1()(

The present value of this stream of cash flows is VL

DrTDrEBITClearly DCD )1()(

The present value of the first term is VU

The present value of the second term is TCD

DrTDrTEBIT DCDC )1()1(

DrDTrDrTEBIT DCDDC )1(

77

The MM Proposition II (Corp. Taxes)Start with M&M Proposition I with taxes:

)()1( DACL

AE rrTE

Drr

DTVV CUL

Since DEV LL

The cash flows from each side of the balance sheet must equal:

DCAUDEL DrTrVDrrE

DrTrTDEDrrE DCACLDEL )]1([

Divide both sides by EL

DCL

ACL

DL

E rTE

DrT

E

Dr

E

Dr )]1(1[

DTVDE CUL

)1( CLU TDEV

Which quickly reduces to

78

The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes

Debt-to-equityratio (D/EL)

Cost of capital: r(%)

rA

rD

)()1( DACL

AE rrTE

Drr

EL

LCD

LWACC r

ED

ETr

ED

Dr

)1(

)( DAL

AE rrE

Drr

79

Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes

All-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Taxes (Tc = 35% $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

LeveredRecession Expected Expansion

EBIT $1,000 $2,000 $3,000

Interest ($800 @ 8% ) 640 640 640

EBT $360 $1,360 $2,360

Taxes (Tc = 35%) $126 $476 $826

Total Cash Flow $234+640 $468+$640 $1,534+$640

(to both S/H & B/H): $874 $1,524 $2,174

EBIT(1-Tc)+TCrDD $650+$224 $1,300+$224 $1,950+$224

$874 $1,524 $2,174

80


Net working capital 10,752 7,144 Long-term debt21,460 Other long-term liabilities

Long-term assets 86,900 69,048 EquityTotal assets 97,652 97,652 Total value

Net working capital 10,752 7,144 Long-term debtPV interest tax shield 2,500 21,460 Other long-term liabilitiesLong-term assests 283,373 268,021 EquityTotal assets 296,625 296,625 Total value

Book values

Market values

Pfizer Balance Sheet, March 2004 (figures in $millions)

81


Pfizer Balance Sheet, March 2004 (figures in $millions)

(w/ $1 billion Debt for Equity Swap)

Net working capital 10,752 8,144 Long-term debt21,460 Other long-term liabilities

Long-term assets 86,900 68,048 EquityTotal assets 97,652 97,652 Total value

Net working capital 10,752 8,144 Long-term debtPV interest tax shield 2,850 21,460 Other long-term liabilitiesLong-term assests 283,373 267,371 EquityTotal assets 296,975 296,975 Total value

Book values

Market values

82

Can Debt Be So Valuable?

1. What about personal taxes?

2. Perhaps firms that borrow incur other costs – bankruptcy costs, for example.

83

C.S. & Taxes (Personal & Corp)Relative Advantage Formula

( Debt vs Equity )

1-Tp

(1-TpE) (1-Tc)

RAF > 1 Debt

RAF < 1 Equity

Advantage

84

C.S. & Taxes (Personal & Corp)

Corporate Tax

Income after Corp Taxes

$1.00

Tp

$1.00 – Tp

Personal Taxes .

Income after All Taxes

$1.00–Tc-TpE (1.00-Tc) =(1.00-TpE)(1.00-Tc)

TpE (1.00-Tc)

$1.00 – Tc

TcNone

To bondholders To stockholders

Operating Income ($1.00)

Paid out as interest

Or paid out as equity income

85

Example C.S. & Taxes (Personal & Corp)

Interest Equity Income

Income before tax $1 $1

Less corporate tax at Tc =.35 0 0.35

Income after corporate tax 1 0.65

Personal tax at Tp = .35 and Tpe = .105 0.35 0.068

Income after all taxes $0.675 $0.582

Advantage to debt= $ .068

86

Personal Taxes

• The value of a levered firm can be expressed in terms of an unlevered firm as:

DT

TTVV

P

pECUL

1

)1()1(1

Where:

TpE = personal tax rate on equity income

TP = personal tax rate on bond income

TC = corporate tax rate

87

Value of Leverage with Personal Taxes

The derivation is straightforward:

)1()1()( pECD TTDrEBIT


)1( pD TDr

receive sBondholder

)1()1()1()( pDpECD TDrTTDrEBIT


p

pECpDpEC T

TTTDrTTEBIT

as rewritten be can This

1

)1()1(1)1()1()1(

Continued…

88

Value of Leverage with Personal Taxes

p

pECpDpEC T

TTTDrTTEBIT

1

)1()1(1)1()1()1(

The first term is the cash flow of an unlevered firm after all taxes.

Its value = VU.

The second term is the advantage of leverage. Its PV in perpetuity is….

p

pEC

T

TTD

1

)1()1(1

The total cash flow to all stakeholders in the levered firm is:

The value of the sum of these two terms must be VL

DT

TTVV

P

pECUL

1

)1()1(1

89

Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes

ppE TT

)1()1()( pECpppE TTT-1 and TT

)1()1()( pECp TTT-1

Debt (D)

Val

ue

of f

irm

(V

)

VU

VL = VU+TCD

VL =VU

VL > VU

DT

TTVV

p

pECUL

1

)1()1(1

)1()1()( pECpppE TTT-1 and TT

VL < VU

90

Capital Structure

Structure of Bond Yield Rates

D

E

Bond

Yield

r

91

Costs of Financial Distress

• Bankruptcy risk versus bankruptcy cost.

• The possibility of bankruptcy has a negative effect on the value of the firm.

• However, it is not the risk of bankruptcy itself that lowers value.

• Rather it is the costs associated with bankruptcy.

• It is the stockholders who bear these costs.

92

Description of Costs

• Direct Costs– Legal and administrative costs (tend to be a small

percentage of firm value).

• Indirect Costs– Impaired ability to conduct business (e.g., lost sales)– Agency Costs

• Selfish Strategy 1: Incentive to take large risks• Selfish Strategy 2: Incentive toward underinvestment• Selfish Strategy 3: Cash In and Run• Other

93

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

94

Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

95

Conflicts of Interest (1)Circular File Company has $50 of 1-year debt.

Why does the equity have any value ?

Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total liabilities


Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total liabilities

Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total liabilities

96

Conflicts of Interest (1)

Circular File Company may invest $10 as follows.

y)probabilit (90% $0

$10Invest

y)probabilit (10% $120

Next Year PayoffsPossibleNow

Assume the NPV of the project is (-$2). What is the effect on the market values?

97


Circular File Company value (post project)

• Firm value falls by $2, but equity holder gains $3



98


Assumes a safe project with NPV = $5 and initial outlay of $10

While firm value may rise by pursuing project, the lack of a high potential payoff for shareholders makes shareholders reject the project.





99

Assets BV MV Liabilities BV MV

Cash $200 $200 LT bonds $300

Fixed Asset $400 $0 Equity $300

Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

Faster Airlines is contemplating on being the first to buy a new jet that can make the Vancouver-London flight in 2 hours.

$200$0

Example 2Balance Sheet of Faster Airlines

100

The Gamble Probability Payoff

Win Big 10% $1,000

Lose Big 90% $0

Cost of investment is $200 (all the firm’s cash)

Required return is 50%

Expected CF from the Gamble = $1000 × 0.10 + $0 = $100

NPV = –$200 + $100

(1.50)

NPV = –$133

Example 2

101

• Expected CF from the Gamble– To Bondholders = $300 × 0.10 + $0 = $30– To Stockholders = ($1000 - $300) × 0.10 + $0 =

$70

• PV of Bonds Without the Gamble = $200• PV of Stocks Without the Gamble = $0

• PV of Bonds With the Gamble = $30 / 1.5 = $20• PV of Stocks With the Gamble = $70 / 1.5 = $47

Example 2

102

• Should we accept the project?

Example 2 (cont)

• Consider a government-sponsored project that guarantees $350 in one period

• Cost of investment is $300 (the firm only has $200) so the stockholders will have to supply an additional $100 to finance the project

• Required return is 10%

•

18.18$10.1

350$300$

NPV

NPV

103

Example 2 (cont)• Expected CF from the government sponsored project:

– To Bondholder = $300– To Stockholder = ($350 - $300) = $50

• PV of Bonds Without the Project = $200• PV of Stocks Without the Project = $0

• PV of Bonds With the Project = $300 / 1.1 = $272.73

• PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55

104

Cash In and Run (example 2 cont)• Liquidating dividends

– Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.

– Such tactics often violate bond indentures.

• Increase perquisites to shareholders

and/or management

105

Protective Covenants• Agreements to protect bondholders• Negative covenant: Thou shalt not:

– Pay dividends beyond specified amount.– Sell more senior debt & amount of new debt is limited.– Refund existing bond issue with new bonds paying lower

interest rate.– Buy another company’s bonds.

• Positive covenant: Thou shall:– Use proceeds from sale of assets for other assets.– Allow redemption in event of merger or spinoff.– Maintain good condition of assets.– Provide audited financial information.– Segregate and maintain specific assets as security for debt.

106

Other Financial Distress Games

• Playing for Time

• Bait and Switch

107

Financial Choices

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

108

Issues and Stock Prices

• Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.

Any firm is a drop in the bucket.

Plenty of close substitutes.

Large debt issues don’t significantly depress the stock price.

109

Pecking Order Theory

Consider the following story:

The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first andequity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

110

The Pecking-Order Theory

• Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. – Rule 1

• Use internal financing first.– Rule 2

• Issue debt next, equity last.• The pecking-order theory is at odds with the trade-off

theory:– There is no target D/E ratio.– Profitable firms use less debt.– Companies like financial slack

111

How Do Companies Behave in Reality?

• Most Corporations Have Low Debt-Asset Ratios.

• Changes in Financial Leverage Affect Firm Value.

– Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.

– Another interpretation is that firms signal good news when they lever up.

• There are Differences in Capital Structure Across Industries (Note that growth implies significant equity financing, even in a world with low bankruptcy costs).

• There is Evidence that Firms Behave as If They had a Target Debt-to-Equity ratio.

112

A Recipe for Capital Structure Decisions

• Taxes– If corporate tax rates are higher than bondholder tax rates,

there is an advantage to debt.• Types of Assets

– The costs of financial distress depend on the types of assets the firm has.

• Uncertainty of Operating Income– Even without debt, firms with uncertain operating income

have high probability of experiencing financial distress.• Pecking Order and Financial Slack

– Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

113

Summary and Conclusions• Costs of financial distress cause firms to restrain their

issuance of debt.– Direct costs

• Lawyers’ and accountants’ fees– Indirect Costs

• Impaired ability to conduct business• Incentives to take on risky projects• Incentives to underinvest• Incentive to milk the property

• Pecking order provides another issue to consider – the signaling to the market

• There are other practical issues to consider such as tangibility of assets, variability of EBIT, etc.

114

Practice Q1: M&M (Taxes)Big-Red Company has $2 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm’s debt is held by one institution that is willing to sell it back to Big-Red for $2 million. Once Big-Red becomes an all equity firm, it will remain unlevered forever. If Big-Red does not retire the debt, the company will use the $2 million in cash to buy back some of its stock on the open market. The company will generate $1.1 million of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. Big-Red is subject to corporate tax rate of 35%, and the required rate of return on the firm’s unlevered equity is 20%. The personal tax rate on interest is 25% and the personal tax rate on equity is 10%. Ignore bankruptcy costs.

a. What will be the value of Big-Red if it chooses to retire all of its debt and become an unlevered firm?

b. What will be the value of Big-Red if it decides to repurchase stock instead of retiring the debt?

115

Practice Q2: Financial Distress

Water Corp. economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Water Corp. must choose between two mutually exclusive projects. Assume that the firm will liquidate one year from today (the day of the projects’ payoff). Water Corp. is obliged to make a $500 payment to bondholders at the end of the year. Assume the firm’s shareholders are risk-neutral. Consider the following information pertaining to the two projects:

116

Practice Q2: Financial Distress (cont)

Economy Prob Project Value Value ValuePayoff of Firm Equity Debt

Low Risk ProjectBad 0.5 $500 $500 $ 0 $500Good 0.5 700 700 200 500High Risk ProjectBad 0.5 $100 $100 $ 0 $100Good 0.5 800 800 300 500A. Which of the two projects maximizes the value of the firm?B. What is the value of the firm’s equity if the low risk project is undertaken, if the

high risk project is undertaken?C. Suppose that bondholders are fully aware that shareholders might choose to

maximize equity value rather than total firm value. To minimize this agency cost, the firm’s bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Water Corp. chooses to take on the high-risk project. By how much would bondholders need to raise the debt payment so that shareholder would be indifferent between the two projects?

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