Module 4: Capital Structure and Dividend Policy

• Reading 4.1 – Capital structure theory

• Reading 4.2 – Capital structure theory in perfect markets

• Reading 4.3 – Impact of corporate taxes on capital structure

• Reading 4.3 – Impact of personal taxes on capital structure

• Reading 4.3 – Other influences on capital structure

• Reading 4.4 – Impact of bankruptcy costs on capital structure

• Reading 4.5 – Selecting the optimal capital structure

• Reading 4.6 – Dividend policy: Theoretical foundation

• Reading 4.6 – Dividend policy in practice

• Reading 4.7 – The mechanics of dividend payments

• Reading 4.8 – Stock dividends and stock splits

• Reading 4.8 – Share repurchases

How Module 4 has been tested on the exam:

How a Company Creates Value: ROIC > WACC

Reading 4.2 : Capital Structure Theory in Perfect

Markets

What is meant by “perfect markets” = As long as investors have homogeneous expectations regarding the future earnings of firms and there are no transaction costs or taxes

Miller & Modigliani (MM)

• Proposition I: A firm’s choice of financing should not affect the value of its assets.

• Because leverage does not affect business risk, KL= KU � firm value is independent of leverage.

Miller & Modigliani (MM)

• Proposition II: Cost of equity of a levered firm = cost of equity of unlevered firm + risk premium. Risk premium rises as leverage increases.

• The net effect is that the advantage of cheaper debt is offset exactly by an increase in the cost of equity.

Reading 4.3-1, 2, & 4.4-1 : Impact of Taxes and

Bankruptcy Costs on Capital Structure

Corporate Taxes

• Corporate taxes favour debt financing because it is tax deductible.

• The use of moderate levels of debt in a firm’s capital structure decreases the weighted average cost of capital and increases the value of the firm.

• Firm value is increased by tax savings of interest payments:

Mini case 4.3 Q7

Modifying MM

• Proposition I:

• Proposition II:

• Levered cost of equity = unlevered cost of equity + risk premium (difference between unlevered cost of equity and cost of debt)

• In the presence of corporate taxes, the value of the firm increases as debt is added to the capital structure. The greater the debt usage, the higher the value of the firm will be.

• The cost of equity to the levered firm increases less rapidly than when there are no corporate taxes.

Two important differences between these propositions and those of the no-tax case in

Personal Taxes

• Do we need to consider the tax rates of the typical investor?

• While issuing debt has tax advantages for a company, it has tax disadvantages for the typical investor.

• Can we use one tax rate that covers majority of investors?

• The reading assumes investors are individuals…who invests more in bonds, individual investors or pension funds?

Minicase 4-5

Sept 2014 exam:

Bankruptcy cost

• As debt takes a larger share in a company’s capital structure, the probability of bankruptcy increases.

• The cost of bankruptcy is split into two:

– Direct costs – Legal costs of dealing with default/reorganization/bankruptcy

– Indirect costs – Perception that company is in financial trouble (loss of sales/customers/suppliers), time dealing with problem

June 2013 exam:

Reading 4.4 page 2

Reading 4.3 : Other Influences on Capital

Structure

Generally, companies will borrow less if they have:

• High business risk

• Significant intangible assets

• Lower tax rates

Business risk

• Risk of the company's operations with respect to the variability of EBIT.

• Operating leverage - Extent that a firm's costs are fixed. Fixed costs are incurred regardless of sales level.

Remember: Break even sales volume

Minicase 4-6

From June 2011 exam:

Agency costs

• Bondholders have different interests than shareholders or management.

• Does the typical CEO indentify more with shareholders or bondholders?

• These different interests could have a negative impact on the bondholders…represent agency costs.

• Typical actions to counter agency costs -- demanding a higher interest rate and imposing tougher covenants in the bond indenture.

Signaling and asymmetric information

• Signaling - The company conveys information about its future prospects trough its actions.

• Asymmetric information – When it is assumed that current shareholders have greater information than other investors.

• Can we gain insight into a company’s future prospects by its financing decisions?

Pecking Order Theory

Aswath Damodaran

Why issue convertible preferred shares when you don’t have to??

Reading 4.5 : Selecting the optimal capital structure

In practice, the key to an optimal capital structure is to minimize the company’s Weighted Average Cost of Capital:

Leverage-indifference EBIT level

• Defined as EBIT level at which return on assets = interest cost of debt.

• Used when comparing share financing with debt financing, and preferred share financing with common share financing.

• When comparing debt financing with preferred share financing, Equation 4-18 will not have an answer since it is assumed debt interest and preferred share dividend yield are the same in both scenarios.

• In this case, compare after tax interest cost on debt with dividend yield on preferred shares.

March 2013 exam:

Other factors influencing capital structure

• Industry Averages

• Market value of debt or book value? What do you include as debt?

• Rating agencies

Methodology: Rating Companies in the North American Railway Industry – Dominion Bond Rating Service

Other factors influencing capital structure

• Rating Agencies

Methodology: Rating Companies in the North American Railway Industry – Dominion Bond Rating Service

Other factors influencing capital structure

• Financial flexibility

• Control

• Asset growth

• Level of cash flows

“How Do CFOs Make Capital Budgeting and Capital Structure Decisions?”, Journal of Applied Corporate Finance

Reading 4.6 : Dividend Policy: Theoretical

Foundation

Traditional bird-in-hand

• Shareholders prefer dividends now as opposed to potential payments in the future.

• No guarantee dividends now is a better option than investing in attractive projects for the future.

• Investors choose to invest in high or low dividend paying stocks depending on their risk/return trade off preference.

• Capital gains are more risky than dividend income.

Perfect-market view

• More nonsense from Miller & Modigliani

• Dividend policy is irrelevant to company valuation - it depends on company’s earning power and risk/reward.

• Assumptions required for this view to hold make this useless.

Tax differential effects

• The difference in tax treatment between dividends and capital gains might help determine a firm’s value.

• Pension plans are indifferent, taxable Canadian corporations would favour dividends, individual investors would prefer cap gains.

Signalling hypothesis

• Change in dividend amounts/policies give a clue to company’s future prospects.

• A dividend increase doesn’t always lead to an increase in share price, a dividend cut is almost always followed by a decline in share price.

Expectations view

• Investors develop expectations regarding a company’s future dividend increases based on historical patterns, current market conditions, or primarily from company guidance.

• Market’s reaction to dividend announcement is more of a function of the market’s expectation rather than the actual announcement.

Clientele effect

• Different types of investors will gravitate towards different kind of stocks based on their preferences.

• Investors seeking stable income will favour high dividend yield stocks that are larger companies with a stable history of dividend increases.

• Companies may not want to materially alter their dividend policies for fear of attracting different kind of investors.

Other factors affecting dividend policy

• Legal and mandated restrictions

• Firm liquidity

• Earnings volatility

• Control

Reading 4.6-2 : Dividend Policy in Practice

Two important features of dividend policy

1. Stability - Dividend stability and uninterrupted increases in the payout ratio over time are strong indicators of stability and high quality.

• Firms should set conservative dividend policies to maintain stability and avoid disappointing investors.

2. Industry norms - Dividend payout ratios vary across industries due to different industry characteristics.

Establishing a dividend policy

1. Constant dividend payout ratio policy – Pay out a constant % of earnings.

• Usually some sort of range (i.e 60-70%) that is based on some sort of average.

• Earnings are much more variable than actual dividend payments. Fluctuations of dividends is the direct result of fluctuations in dividends.

2. Residual dividend payout ratio policy – Pay dividends only when cash flow exceeds funding needs.

• If a company can earn a higher return reinvesting its cash flow rather than paying it out as dividends, then there is a case for a residual dividend payout policy.

• More suited for special dividends rather than for a regular dividend – too much uncertainty. Fluctuation in dividend is the result of fluctuations in funding needs.

3. Constant dollar dividend policy – Pay fixed dollar amount on a regular basis.

• Reduces uncertainty surrounding amount of dividend, much more preferable.

• Company will still estimate company’s funding needs over the next 3-5 years and determine an appropriate dividend amount.

• Often you see companies engage in short term borrowing to fund a dividend – however this can’t be a regular occurrence.

The right way to think about dividend policy

Aswath Damodaran

Reading 4.7 : The Mechanics of Dividend Payments

• Pay Date – December 31st 2009

• Record Date – November 25, 2009

• Ex date – two business days before Nov 25 � Nov 23

Have to buy the shares before Nov 23 to be entitled to the dividend. You can sell the shares on or after Nov 23rd

and still get the dividend.

* DRIPS

Reading 4.8 : Stock Dividends, Stock Splits, and

Share Repurchases

• Stock dividends – Dividend paid in shares in lieu of cash.

– Suited for smaller companies wanting to preserve cash, or companies who don’t have the cash to pay its regular dividend.

• Stock splits – Firm increases amount of shares outstanding by a certain ratio (i.e 2 for 1 stock split).

– Companies will do this once their share price is deemed “too high”.

– Value of company doesn’t change…just amount of outstanding shares.

– Reverse splits occur when a company is trying to avoid being a penny stock.

• Difference between stock dividends and splits is the accounting treatment.

Stock Buybacks

Historical Projected

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Revenue USD Mil 3,244 3,847 3,767 5,234 9,447 3,977 6,539 8,715 8,279 8,279 8,279 8,279 8,279

Operating Cash Flow USD Mil 650 865 697 1,689 3,013 924 2,999 3,485 2,898 2,898 2,898 2,898 2,898

Cap Spending USD Mil -221 -383 -509 -607 -1,245 -1,818 -2,019 -2,248 -2,070 -1,656 -1,242 -1,242 -1,242

Free Cash Flow (FCF) 429 482 188 1,082 1,768 -894 980 1,237 828 1,242 1,656 1,656 1,656

Debt (repay) 951 1,531 -1,052 -7 -250 -500 -500 0

Free Cash Flow to Equity (FCFE) 57 2,511 185 821 992 1,156 1,156 1,656

Dividends paid 0 -119 -208 -368 -553 -608 -669 -735

FCFE available after dividend paid 57 2,392 -23 453 439 548 487 920 2,848

Assumptions:

Revenue growth 18.59% -2.08% 38.94% 80.49% -57.90% 64.42% 33.28% -5.0% 0.0% 0.0% 0.0% 0.0%

OCF % of Revenue 20.04% 22.49% 18.50% 32.27% 31.89% 23.23% 45.86% 39.99% 35.0% 35.0% 35.0% 35.0% 35.0%

Cap spending % of Revenues 6.81% 9.96% 13.51% 11.60% 13.18% 45.71% 30.88% 25.79% 25.0% 20.0% 15.0% 15.0% 15.0%

Dividend increases (%) 16.67% -28.57% 100.00% 30.00% 0.00% 0.00% 115.38% 50.0% 50.0% 10.0% 10.0% 10.0%

Miscellaneous Data:

Earnings Per Share USD 0.3 0.54 0.66 1.13 3.67 1.08 1.98 3.51

Dividends USD 0.06 0.07 0.05 0.1 0.13 0.13 0.13 0.28 0.42 0.63 0.693 0.7623 0.83853 24.5%

Payout Ratio (%) 20.0% 13.0% 7.6% 8.8% 3.5% 12.0% 6.6% 8.0%

Shares Mil 997 1,000 956 973 952 888 911 877 877 877 877 877 877

Debt to Total Capital 36.4% 41.5% 41.0% 19.3% 40.3% 38.6% 45.5% 36.6%

Historical Projected

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Revenue USD Mil 3,244 3,847 3,767 5,234 9,447 3,977 6,539 8,715 7,927 7,305 7,305 7,305 7,305

Operating Cash Flow USD Mil 650 865 697 1,689 3,013 924 2,999 3,485 3,225 3,212 2,922 2,922 2,922

Cap Spending USD Mil -221 -383 -509 -607 -1,245 -1,818 -2,019 -2,248 -2,204 -1,624 -1,096 -1,096 -1,096

Free Cash Flow (FCF) 429 482 188 1,082 1,768 -894 980 1,237 1,021 1,588 1,826 1,826 1,826

Debt (repay) 951 1,531 -1,052 -7 -250 -500 -500 0

Free Cash Flow to Equity (FCFE) 57 2,511 185 1,014 1,338 1,326 1,326 1,826

Dividends paid 0 -119 -208 -491 -1,040 -1,144 -1,258 -1,384

FCFE available after dividend paid 57 2,392 -23 523 298 182 68 442 1,513

Assumptions:

Revenue growth 18.59% -2.08% 38.94% 80.49% -57.90% 64.42% 33.28% -9.0% -7.8% 0.0% 0.0% 0.0%

OCF % of Revenue 20.04% 22.49% 18.50% 32.27% 31.89% 23.23% 45.86% 39.99% 40.7% 44.0% 40.0% 40.0% 40.0%

Cap spending % of Revenues 6.81% 9.96% 13.51% 11.60% 13.18% 45.71% 30.88% 25.79% 27.8% 22.2% 15.0% 15.0% 15.0%

Dividend increases (%) 16.67% -28.57% 100.00% 30.00% 0.00% 0.00% 115.38% 100.0% 112.5% 10.0% 10.0% 10.0%

Miscellaneous Data:

Earnings Per Share USD 0.3 0.54 0.66 1.13 3.67 1.08 1.98 3.51 2.37 2.04

Dividends USD 0.06 0.07 0.05 0.1 0.13 0.13 0.13 0.28 0.56 1.19 1.309 1.4399 1.58389 41.4%

Payout Ratio (%) 20.0% 13.0% 7.6% 8.8% 3.5% 12.0% 6.6% 8.0% 23.6% 58.3%

Shares Mil 997 1,000 956 973 952 888 911 877 876 874 874 874 874

Debt to Total Capital 36.4% 41.5% 41.0% 19.3% 40.3% 38.6% 45.5% 36.6%

“Our growth plans are based on NYMEX natural gas prices of $5.75 for 2010, and as I said earlier, a range of $6 to $7 longer-term. We've begun stewarding the company based on the bottom end of this range.” EnCana CEO Randy Eresman March 2010