Session 8: Optimal Capital Structure and dividend policy

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Session 8 Optimal Capital Structure and dividend
policy

• C15.0008 Corporate Finance Topics

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Optimal Capital Structure Review

• The main theory we consider is the trade-off
  theory.
• Debt gives you a tax-shield. Hence more debt is
  GOOD.
• Debt increases probability of distress. This
  increases expected distress costs, and agency
  costs. Hence more debt is BAD
• At some level of debt, the two balance out. That
  is the optimal level of debt

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WACC approach

• V ? UCFt/(1rWACC)t
• UCF EBIT(1-T) depreciation capex ?nwc
• Calculate WACC at various debt levels
• rB from debt rating via interest coverage and
  leverage ratios
• rS from Prop. IIrS r0 (1- TC)(B/S)(r0 - rB)
• WACC (B/(SB)) rB(1-T)(S/(SB)) rS
• Adjust expected cash flows for financial distress
  costs

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At the level of betas

• CAPM r0 rF ?U(rM - rF) (unlevered
  equity) rS rF ?L(rM - rF) (levered equity)
• rB rF ?B(rM - rF) (firms debt)
• Prop. II rS r0 (1- TC)(B/S)(r0 - rB)
• ? rS rF ?U(rM - rF) (1- TC)(B/S)(?U- ?B)(rM
  - rF)
• rF ?U (1- TC)(B/S)(?U- ?B)(rM -
  rF)
• ? ?L ?U (1- TC)(B/S)(?U- ?B)
• (If debt is riskless, ?B 0)
• ?L 1 (1- TC)(B/S) ?U

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Worksheet..
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APV approach

• VL VU PV(tax shield) - PV(financial distress
  costs)
• PV(tax shield) ?t TC(interest expense)t / (1
  rB)t
• The expected tax rate decreases as debt
  increases. Use likelihood of distress.
• PV(financial distress costs) Prob PV
  (financial distress costs if financial distress
  takes place)
• The probability increases as the debt rating
  declines
• Cost are usually estimated as a percentage of
  pre-distress firm value (10-20)

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Worksheet
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Binomial Tree

• Firm
• Single remaining cash flow in 1 year EBIT
  10 million or 2 million (prob. 50) no
  salvage value
• Corporate tax rate T40
• Unlevered required return r010
• In the event of bankruptcy
• Financial distress costs are 15 of VU
• Pay taxes, financial distress costs, residual
  goes to bondholders

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The Unlevered Firm

• VU S
• Liquidating dividend is only cash flow
• Value via DCF

EBIT(1-T)10(1-0.4)6
0.5(6)0.5(1.2)/1.13.27
EBIT(1-T)2(1-0.4)1.2
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The Levered Firm

• 2 million amount of (risky) 1-year debt
• Promised interest rate 56.65 (rf2)
• Promised payment (at maturity)
  2(156.65)3.13
• Solvent for high EBITPayment to bondholders
  3.13
• Bankrupt for low EBITPayment to
  bondholdersEBIT-taxes-financial distress costs
  EBIT-(EBIT-int.exp.)T-0.15VU
  2-2-2(56.65)0.4-0.15(3.27) 1.16

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Debt Value
Replicate using the unlevered firm (rf2)

• H0.41, B-0.656, B2 (trading at par!!)

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Equity Value
Replicate using the unlevered firm (rf2)

• H0.69, B0.814, S1.45 rS14.49

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Firm Value

• VU S 3.27
• VL S B 1.45 2 3.45
• VL VU PV(tax shield) - PV(f.d. costs) ?
• In this case, the tax shield is risk-less (even
  though the debt is risky)
• PV(tax shield) 56.65(2)(0.4)/1.02
• 0.444

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Financial Distress Costs
Replicate using the unlevered firm (rf2)

• H -0.102, B -0.602, FD 0.267
• VL VU PV(tax shield) - PV(f.d. costs)
  3.27 0.444 - 0.267 3.45

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Optimal Capital Structure

• The optimal amount of debt
• Decreases as business risk increases (distress
  costs)
• Decreases as in tangible assets increase
  (distress costs)
• Increases as the corporate tax rate increases
  (tax shields)
• Decreases as the growth rate increases (growing
  firms are riskier. Hence distress costs)

This slide is important!!!
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Industry Data
Industry Debt Ratio EBITDA/ Value Fixed Assets/ Capital
Biotech 3.78 2.63 15.33
Food Wholesalers 22.85 12.60 59.54
Electric Utility 58.07 16.58 89.22
Source http//www.stern.nyu.edu/adamodar/
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Empirical Evidence

• Consistent with much of the theory (e.g., over
  time, across industries, across tax regimes)
• Profitable companies within industries appear
  underlevered (pecking order theory)
• Leverage increasing (decreasing) transactions
  have positive (negative) effects on stock prices
• Too many high-rated companies?
• Financial flexibilityanother real option?
• Targeting a debt rating?

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Capital Structure in Practice

• What do CFOs look at in determining debt policy?
• Financial flexibility 59
• Debt rating 57
• Volatility 48
• Tax savings 45
• Most firms (81) have at least a flexible target
  debt-equity ratio.

Source http//www.stern.nyu.edu/adamodar/
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Dividend Policy

• Dividend policy theory and evidence
• Dividend decisions in practice
• Stock dividends, splits, and repurchases

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Two Questions

• How much of earnings should the firm retain as
  cash?
• Liquidity
• Fund future projects/acquisitions without going
  to the capital markets
• Reserve for future debt payments
• How should the residual be paid out?
• Dividends
• Stock repurchases

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A More Refined Question

• Lets assume that
• Investment decisions (projects) are fixed
• Financing decisions (capital structure) are
  fixed
• Does dividend policy affect stock price?
• Does dividend policy affect firm value?
• The dividend decision is a tradeoff between
  paying dividends, issuing equity, and
  repurchasing stock.

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An Example

• A firm generates a cash-flow of 1 million. It
  needs 500K for investment. Three alternatives
• (1) Invest 500K, pay 500K dividends
• (2) Invest 500K, pay 1 million dividends,
  raise 500K new equity
• (3) Invest 500K, pay 0 dividends,
  repurchase 500K of stock

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Three Views of Dividend Policy

• (1) Dividend policy is irrelevant
• (2) High dividends are good
• (3) Low dividends are good
• Good here means higher stock price, which means
• Higher cash flows
• Lower cost of equity ( rS D/P g )

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Dividend Irrelevance

• Miller/Modigliani in perfect markets, investors
  can create their own dividends, therefore
  dividend policy is irrelevant
• Do-it-yourself dividends stock sales
• Undo-it-yourself dividends stock
  purchases with the money from dividend income

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Example of Dividend Irrelevance

• Two dividend payment dates 0, 1
• Investor prefers cash-flows of 10 and 10 each
• Company decides to pay 11 and 8.9. Cost of equity
  is 10
• Investor can choose to keep 10 and invest 1 in
  the companys shares.
• Investment of 1 gives an expected cash flow of
  1.1
• 8.9 1.1 10. Thus investor can recreate her
  preferred cash-flow

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Some reasons why dividends matter
If
Then

• Managers misuse free cash flow ?
• Transaction costs are high ?
• Issuance costs ?
• Personal Taxes ?
• Clientele effects ?

High dividends are good
High/Low dividends
Low dividends are good
Low dividends
High/low dividends
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Information Effects

• Unexpected changes in dividends cause stock price
  reactions D? ? P? D? ? P?
• Why? Because dividends convey news about future
  earnings.

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Empirical Evidence

• Not conclusive
• Survey data suggest managers think dividend
  policy is important
• Tax changes appear to trigger dividend policy
  changes
• Non-payers tend to initiate dividends when the
  spread between the M/B ratios of payers and
  non-payers is high

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Stock Repurchases

• Signal that stock is under-valued
• Increase debt-equity ratio
• Eliminate certain stockholders (targeted)
• Tax benefits
• Stock price reaction is positive!

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Disappearing Dividends
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Disappearing Dividends contd
Reasons SEC Rule 10b-18, Executive compensation
through stock options
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Conclusions

• Issuance costs of new equity matter, dividend
  policy should be responsive to investment
  opportunities
• Taxes, transaction costs, and agency costs play a
  role
• Information effects are important (an explicit
  policy is valuable)

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Practical Considerations

• Restrictions, e.g., bond covenants
• Liquidity
• Access to capital markets
• Earnings predictability
• Ownership

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Types of dividend policies

• Constant payout ratio
• Constant dollar dividend
• Small regular dividend plus special dividends
• Target payout ratio, slow adjustment, stepwise
  progression

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GEs Dividend
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Payment Procedure

• Declaration date -- dividend announced
• Ex-day -- stock first trades without right to
  dividend
• Payment date -- checks mailed

Declaration
Ex-day
Payment
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Exam points

• Recapitalizations
• Unlevering a levered firm to find return on
  unlevered equity
• Relevering an unlevered firm at a target ratio,
  WACC formula
• APV Computing tax shields, default probability,
  Cost of distress
• Valuing distress costs like options

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Exam points

• Dividend irrelevance
• Factors that affect dividend policy
• Tax effects
• Information effects

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Assignments

• Chapter 17
• Problems 17.2, 17.5, 17.11
• Problem set 2 due Wednesday
• Case USG due Monday, Jul 31
• Start preparing for the exam