UNIT 9 Capital Structure and Dividend Policy Optimal/Target capital structures Business vs. financial risk Hamada equation Dividends vs. capital gains Residual dividend model

Optimal & Target Capital Structures The firm’s optimal capital structure is the capital structure that maximizes its stock price. The firm’s target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to raise capital.

What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. Low risk Probability High risk E(EBIT) EBIT

What determines business risk? Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage

What is operating leverage, and how does it affect a firm’s business risk? Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

Effect of operating leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. What happens if variable costs change? Sales $ Rev. TC FC QBE } Profit

Using operating leverage Low operating leverage Probability High operating leverage EBITL EBITH Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.

What is financial leverage? Financial risk? Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

Business risk vs. Financial risk Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued. More debt, more financial risk. Concentrates business risk on stockholders.

An example: Illustrating effects of financial leverage Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure). Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate

Firm U: Unleveraged Economy Bad Avg. Good Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400

Firm L: Leveraged Economy Bad Avg. Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U.

Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% TIE ∞ ∞ ∞ FIRM L Bad Avg Good ROE 4.8% 10.8% 16.8% TIE 1.67x 2.50x 3.30x

Risk and return for leveraged and unleveraged firms Expected Values: Firm U Firm L E(BEP) 15.0% 15.0% E(ROE) 9.0% 10.8% E(TIE) ∞ 2.5x Risk Measures: σROE 2.12% 4.24% CVROE 0.24 0.39

The effect of leverage on profitability and debt coverage For leverage to raise expected ROE, must have BEP > rd. Why? If rd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = rdD).

Conclusions Basic earning power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > rd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

Why do the bond rating and cost of debt depend upon the amount of debt borrowed? As the firm borrows more money, the firm increases its financial risk causing the firm’s bond rating to decrease, and its cost of debt to increase.

What effect does more debt have on a firm’s cost of equity? If the level of debt increases, the risk of the firm increases. Increased risk increases the cost of debt. However, the risk of the firm’s equity also increases, resulting in a higher rs.

The Hamada Equation Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity. The Hamada equation attempts to quantify the increased cost of equity due to financial leverage. Uses the firm’s unlevered beta, which represents the business risk of a firm if it had no debt.

The Hamada Equation bL = bU[ 1 + (1 – T) (D/E)] Suppose rRF and RPM = 6%, the firm’s unlevered beta (bU) = 1.0, total assets (D+E) = $2,000, and the tax rate (T) = 40%. Debt and Equity should be at market values.

Calculating levered beta and cost of equity If D = $250, then E = $2,000 - $250 = $1,750. bL = 1.0 [ 1 + (0.6)($250/$1,750) ] = 1.0857. rs = rRF + (rM – rRF) bL rs = 6.0% + (6.0%) 1.0857 = 12.51%. bL > bU because debt increases risk.

How is a firm’s capital structure affected by more/less business risk? If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt. However, lower business risk would lead to an optimal capital structure with more debt.

Other factors to consider when establishing the firm’s target capital structure Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate

How would these factors affect the target capital structure? Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks?

Conclusions on Capital Structure Capital structure decisions have a large judgmental content. Capital structures vary widely among firms, even similar ones in the same industry.

What is dividend policy? The decision to pay out earnings versus retaining and reinvesting them. Dividend policy includes High or low dividend payout? Stable or irregular dividends? How frequent to pay dividends? Announce the policy?

Dividend irrelevance theory Investors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test.

Why investors might prefer dividends May think dividends are less risky than potential future capital gains. If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.

Why investors might prefer capital gains May want to avoid transactions costs Maximum tax rate is the same as on dividends, but … Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever the stock is sold. If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost basis and escape all previously accrued capital gains.

What’s the “information content,” or “signaling,” hypothesis? Investors view dividend increases as signals of management’s view of the future. Since managers hate to cut dividends, they won’t raise dividends unless they think the raise is sustainable. However, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

What’s the “clientele effect”? Different groups of investors, or clienteles, prefer different dividend policies. Firm’s past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

The residual dividend model Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Residual dividend model Capital budget – $800,000 Target capital structure – 40% debt, 60% equity Forecasted net income – $600,000 How much of the forecasted net income should be paid out as dividends?

Residual dividend model: Calculating dividends paid Calculate portion of capital budget to be funded by equity. Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with equity. Calculate excess or need for equity capital. There will be $600,000 - $480,000 = $120,000 left over to pay as dividends. Calculate dividend payout ratio $120,000 / $600,000 = 0.20 = 20%.

Residual dividend model: What if net income drops to $400,000 Residual dividend model: What if net income drops to $400,000? Rises to $800,000? If NI = $400,000 … Dividends = $400,000 – (0.6)($800,000) = -$80,000. Since the dividend results in a negative number, the firm must use all of its net income to fund its budget, and probably should issue equity to maintain its target capital structure. Payout = $0 / $400,000 = 0%. If NI = $800,000 … Dividends = $800,000 – (0.6)($800,000) = $320,000. Payout = $320,000 / $800,000 = 40%.

How would a change in investment opportunities affect dividends under the residual policy? Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout.

Comments on Residual Dividend Policy Advantage Minimizes new stock issues and flotation costs. Disadvantages Results in variable dividends Sends conflicting signals Increases risk Doesn’t appeal to any specific clientele. Conclusion – Consider residual policy when setting long-term target payout, but don’t follow it rigidly from year to year.

Setting Dividend Policy Forecast capital needs over a planning horizon, often 5 years. Set a target capital structure. Estimate annual equity needs. Set target payout based on the residual model. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.