Session 8 Optimal Capital Structure and dividend policy

Session 8: Optimal Capital Structure and dividend policy C 15. 0008 Corporate Finance Topics

Optimal Capital Structure Review • The main theory we consider is the tradeoff 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+r. WACC)t UCF = EBIT(1 -T) + depreciation – capex – nwc • Calculate WACC at various debt levels – r. B from debt rating via interest coverage and leverage ratios – r. S from Prop. II r. S = r 0 + (1 - TC)(B/S)(r 0 - r. B) – WACC = (B/(S+B)) r. B(1 -T)+(S/(S+B)) r. S • Adjust expected cash flows for financial distress costs

At the level of betas CAPM: r 0 = r. F + U(r. M - r. F) (unlevered equity) r. S = r. F + L(r. M - r. F) (levered equity) r. B = r. F + B(r. M - r. F) (firm’s debt) Prop. II: r. S = r 0 + (1 - TC)(B/S)(r 0 - r. B) r. S = r. F + U(r. M - r. F) + (1 - TC)(B/S)( U- B)(r. M - r. F) = r. F + [ U + (1 - TC)(B/S)( U- B)](r. M - r. F) 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+ r. B)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 predistress 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: r 0=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 EBIT(1 -T)=10(1 -0. 4)=6 [0. 5(6)+0. 5(1. 2)]/1. 1=3. 27 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 EBIT Payment to bondholders: 3. 13 – Bankrupt for low EBIT Payment to bondholders: EBIT-taxes-financial distress costs = EBIT-(EBIT-int. exp. )T-0. 15 VU = 2 -[2 -2(56. 65%)]0. 4 -0. 15(3. 27) = 1. 16

Debt Value Replicate using the unlevered firm (rf=2%) 6 3. 27 3. 13 B 1. 2 1. 16 H=0. 41, B*=-0. 656, B=2 (trading at par!!)

Equity Value Replicate using the unlevered firm (rf=2%) 6 3. 27 1. 2 (EBIT-56. 65%(B))(1 -T)-B=3. 32 S 0 H=0. 69, B*=0. 814, S=1. 45 r. S=14. 49%

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 Replicate using the unlevered firm (rf=2%) 6 3. 27 0 FD 1. 2 0. 491 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

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 22. 85% 12. 60% Wholesaler s 59. 54% Electric Utility 89. 22% 58. 07% 16. 58% Source: http: //www. stern. nyu. edu/~adamodar/

Empirical Evidence • Consistent with much of 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 Debt rating Volatility Tax savings 59% 57% 48% 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 $500 K for investment. Three alternatives: (1) Invest $500 K, pay $500 K dividends (2) Invest $500 K, pay $1 million dividends, raise $500 K new equity (3) Invest $500 K, pay $0 dividends, repurchase $500 K 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 ( r. S = 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 If Managers misuse free cash flow Transaction costs high Issuance costs Then High dividends are good are High/Low dividends are good Personal Taxes Low dividends Clientele effects High/low dividends

Information Effects • Unexpected changes in dividends cause stock price reactions: 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 Reasons: SEC Rule 10 b-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

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