Session 8: Optimal Capital Structure and dividend policy

C15.0008 Corporate Finance Topics

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

WACC approach

V = UCFt/(1+rWACC)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/(S+B)) rB(1-T)+(S/(S+B)) rS

• Adjust expected cash flows for financial distress costs

At the level of betasCAPM: r0 = rF + U(rM - rF) (unlevered equity)

rS = rF + L(rM - rF) (levered equity)

rB = rF + B(rM - rF) (firm’s 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

Worksheet..

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%)

Worksheet

Binomial Tree

Firm:• Single remaining cash flow in 1 year

EBIT $10 million or $2 million (prob. 50%) no salvage value

• Corporate tax rate: T=40%• Unlevered required return: r0=10%• In the event of bankruptcy

– Financial distress costs are 15% of VU

– Pay taxes, financial distress costs, residual goes to bondholders

The Unlevered Firm

VU = S

Liquidating dividend is only cash flow

Value via DCF

[0.5(6)+0.5(1.2)]/1.1=3.27

EBIT(1-T)=10(1-0.4)=6

EBIT(1-T)=2(1-0.4)=1.2

The Levered Firm

• $2 million amount of (risky) 1-year debt

• Promised interest rate = 56.65% (rf=2%)

• Promised payment (at maturity) 2(1+56.65%)=3.13

– Solvent for high EBITPayment to bondholders: 3.13

– Bankrupt for low EBITPayment to bondholders:EBIT-taxes-financial distress costs = EBIT-(EBIT-int.exp.)T-0.15VU = 2-[2-2(56.65%)]0.4-0.15(3.27) = 1.16

Debt Value

H=0.41, B*=-0.656, B=2 (trading at par!!)

B

3.13

1.16

Replicate using the unlevered firm (rf=2%)

3.27

6

1.2

Equity Value

H=0.69, B*=0.814, S=1.45 rS=14.49%

S

(EBIT-56.65%(B))(1-T)-B=3.32

0

Replicate using the unlevered firm (rf=2%)

3.27

6

1.2

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

Financial Distress Costs

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

FD

0

0.491

Replicate using the unlevered firm (rf=2%)

3.27

6

1.2

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!!!

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/

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 flexibility—another real option?• Targeting a debt rating?

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/

Dividend Policy

• Dividend policy: theory and evidence

• Dividend decisions in practice

• Stock dividends, splits, and repurchases

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

A More Refined Question

Let’s 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.

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

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 )

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

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 company’s 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

Some reasons why dividends matter

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

If Then

Information Effects

• Unexpected changes in dividends cause stock price reactions:

D P D P• Why? Because dividends convey news

about future earnings.

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

Stock Repurchases

• Signal that stock is under-valued

• Increase debt-equity ratio

• Eliminate certain stockholders (targeted)

• Tax benefits

Stock price reaction is positive!

Disappearing Dividends

Disappearing Dividends cont’d

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Reasons: SEC Rule 10b-18, Executive compensation through stock options

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)

Practical Considerations

• Restrictions, e.g., bond covenants

• Liquidity

• Access to capital markets

• Earnings predictability

• Ownership

Types of dividend policies

• Constant payout ratio

• Constant dollar dividend

• Small regular dividend plus special dividends

• Target payout ratio, slow adjustment, stepwise progression

GE’s 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

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

Exam points

• Dividend irrelevance

• Factors that affect dividend policy

• Tax effects

• Information effects

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