1. Goal of the Lecture:
Understand how to determine the proper mix of debt and equity to use to fund corporate investments.

2. Capital Structure and Dividend Policy
1. Capital Structure Theory - What Percent of Capital
Should Be Raised Through Selling Stock, Bonds
and Preferred?
2. Dividend Policy Theory – how much cash to pay
out to shareholders instead or retain in the firm.
Time Permitting We May Cover the Effects of Fixed Financial Costs in a Firm’s Risk
a. Business or Operating Risk
b. Financial Risk

3. Firm’s Weighted Cost of Capital (WCC)
General Formula
WCC = Wdebtki + Wpskps + Wsks
where, Wdebt = weight of debt in firm’s capital structure
Wps = weight of preferred stock
Ws = weight of common stock
ki = after-tax cost of debt
kps = after-tax cost of preferred stock
ks = after-tax cost of common stock

4. Calculating Capital Structure Weights From Market Prices If Firm Has No Target Weights
FIRM SECURITIES VALUES
Common stock = 1,000,000 shares * $50/share= 50 mm
Debt = 50,000 bonds * $950/bond = mm
Preferred = 100,000 shares * $90/share = 9 mm
106.5 mm
Figure the Weights?
Weights
Ws = 50/106.5 = 47%
Wd = 47.5/106.5 = 45%
Wps = 9/106.5 = 8%
WCC = .45(6.30) + .08(11.11) + .47(25) =
= 15.48
Note: You may need to make adjustments for projects that are not average risk projects such as projects for different divisions.

5. Capital Structure Refers a Firm’s Various Sources of Long-Term Financing as a Proportion of Total Capital
Manager’s Goal: Increase EPS Through Leverage, But by Enough to Offset the Increase in Risk so that Stock Price Increases.
Two Capital Structure Theories of Leverage
a. Traditional - Share Price will Increase with Leverage up to a Point (Too Much Risk)
b. Net Operating Income Theory - Any Increase in Leverage and EPS will be Offset by Increased Risk (Assuming No Taxes) Leaving the Share Price Unchanged.
Illustration using the constant growth model.
P = D1/ (ks - g)
Increasing leverage may increase D1 and g but will increase beta (risk) so that ks will increase. Theoretically, P stays the same because the positive effect of the increase in D1 and g is just offset by the negative effect of the ks increase.

6. Traditional Theory - As Debt is Added, D/E Rises But kavg Falls Because Debt has Lower Cost. Eventually kE and kD Rise Due to Rising Bankruptcy Probabilities, Pushing kavg Up
Net Operating Income Theory - (Modigliani and Miller)
No optimal capital structure and no advantage of debt over equity financing. kavg stays constant no matter what the debt level. Unlike in the graph above, the kavg line would be flat with no minimum kavg (assumes no taxes).

7. Net Operating Income Theory - Modigliani and Miller With Corporate Taxes Changes the Theory’s Implications
REMEMBER: The Value of the Firm Is the Discounted
Value of It’s After-Tax Cash Flows Going to
Bondholders and Stockholders.
Without Income Taxes - income goes to
1. stockholders bondholders
With Income Taxes - income goes to
1. stockholders bondholders government.
Because interest paid on debt is tax deductable we can
reduce the amount going to the government (and increase
the amount going to bondholders and stockholders) by
increasing the amount of debt in the capital structure.

9. Value of the Levered Firm With Corporate Taxes Is the Value of the Unlevered Firm Plus the Present Value of the Debt’s Tax Shield
Assume no growth in EBIT. The unlevered firm’s value, is
Vu =
where EBIT = earnings before interest and taxes
T = corporate tax rate
ksu = the unlevered cost of equity capital
Then the value of the levered firm, VL is
VL = VU + (present value of the tax shield from debt)
VL = VU + (tax rate)(value of debt) = VU + (T)(B)
When there is a difference in personal tax rates on bond
and stock income then adjust the equation above to
VL = VU + [1 - (1 - T)(1 - Ts)/(1 - TB)]B
where T = corporate tax rate
Ts = stock tax rate
TB = bond tax rate
B = face value of bonds
Because bondholders demand the same after tax rate of return as stockholders (assuming equal risk), if TB > Ts, then interest rates on bonds must be higher than stock returns so that after tax returns will be equal. This reduces the advantage of debt.

10. Capital Structure Example
Example: SI Inc. is an all-equity firm that generates EBIT of $3 million per year. Its cost of equity capital is 16 percent, its marginal corporate tax rate is 35 percent, and it has 1 million shares outstanding.
a What is SI’s market value?
b. If SI issues $4 million of debt and uses it to buy back some shares, what will be its new market value and new equity value?
c. Show that the change in per-share value goes up even though total equity decreases.
a. Vu = $3,000,000( ) / .16 = $12,187,500
b. VL = $12,187, (.35)($4,000,000)=$13,587,500
equity = $13,587,500 - $4,000,000 = $9,587,500
c. Before buyback, share price= $12,187,500/1,000,000 =
After buyback of $4,000,000/ = 328,218 shares
we get a new price of
P =$9,587,500/(1,000, ,218) = 14.27

11. Dividends and Retained Earnings
1. DIVIDENDS = EARNINGS - RETAINED EARNINGS
Over 60% of all funds used by firms are internally generated
2. DIVIDEND POLICY INCLUDES
a. Level of dividends - dollars per share or Payout Ratio
Div. Payout Ratio = Dividends per share / earnings per share
Payout ratio is more comparable across firms than dollars per share
b. Stability of Dividends - non-decreasing
3. STABILITY OF DIVIDENDS
a. Dividends per share - increase with earnings
b. Long range target payout
c. Constant payout ratio => constant % of earnings.
d. Residual dividend policy - payout only what is left over after investments - no regard to stability.

12. => retain more earnings
4. AVERAGE PAYOUT RATIOS IN US IS BETWEEN 30 AND 60%.
QUESTION: Why might firms wish to keep dividends stable or non-decreasing?
Avoid bad signals.
THEORIES OF DIVIDEND PREFERENCE
a. Dividend Preference Theory – based on risk
b. Dividend Aversion – high taxes on dividends
taxes can be delayed on capital gains
=> retain more earnings
c. Signaling - unexpected changes signal info
d. Preference for current income by shareholders
e. Flotation costs -> save by retaining
f. Transaction costs -> trading costs to sell stock
g. Present shareholders may want to maintain control –retain cash to avoid new equity issue.

13. 6. DIVIDEND IRRELEVANCE
a. Investors can undo –buy or sell stock
b. Assumes it is costless to buy and sell.
7. FACTORS AFFECTING DIVIDEND POLICY
a. Legal constraints - State rules that dividends may not exceed current income plus cumulative retained earnings. No liquidating dividend.
b. Bond Indentures - same – stricter
c. IRS – no unwarranted retention to avoid taxes
d. Controlling owners dictate dividend policy.
e. Investment Constraints - large investments
f. Stable are earnings allows higher payout utilities
g. Access to capital markets - small firms retain more earnings.

14. 8. THE POLICY MOST COMMONLY FOLLOWED IS A SMOOTHED, RESIDUAL DIVIDEND POLICY.
a. Maintain target payout and capital structure.
9. DIVIDENDS, FINANCING AND CAPITAL STRUCTURE
ARE CONNECTED.
Cumulative dividends paid affects how much funds
the firm will have to raise.
Capital structure weights change as earnings are retained -> equity increases.
10. DIVIDEND REINVESTMENT
Shareholders still pay tax
But may get a break on stock price.
11. REPURCHASE STOCK
May increase price per share.
STOCK SPLITS, REVERSE SPLITS, AND STOCK DIVIDENDS
Many of these announcements should have little affect on stock price unless they are signals.

15. Business Risk - Factors Affecting:
Fixed Operating Costs Produce Operating Leverage and Fixed Financing Costs Produce Financial Leverage But Leverage Creates Risk
Business Risk - Factors Affecting:
a. Sensitivity of Sales to Business Cycle
b. Firm Size and Industry Competition
c. Operating Leverage (Proportion of Fixed
to Variable Operating Costs in Total Costs)
d. Input Price Variability
e. Ability to Adjust Output Prices
Degree of Operating Leverage
DOL = % Change in EBIT / % Change in Sales
= [Sales - Variable Costs] / EBIT
= 1 + Fixed Cost / EBIT

16. Financial Risk - Factors Affecting:
a. Variability of Shareholder Earnings Per Share (EPS) which is also Earnings After Taxes (EAT)
b. Financial Risk Increases with Leverage
Degree of Financial Leverage
DFL = % Change in EPS / % Change in EBIT
= EBIT / [EBIT - I - L - d/(1 - T)]
where, I = Interest, L = Lease Payments, and d = preferred dividends (Grossed Up by [1 - T] because there is No Tax Deduction)
Degree of Combined Leverage: Operating and Financial
DCL = DOL x DFL
= % Change in EPS / % Change in Sales
= [Sales - Variable Costs] / [EBIT - I - L -d/(1 - T)]
Note: The larger is DCL, the larger the firm’s return variance .

17. Leverage - DOL, DFL, and DCL
“DOL - As sales rise, fixed cost per unit falls. DFL - Fixed Cost Financing causes EPS to fluctuate. DCL - Combined effects of operating and financial leverage.”
Example:
Clark Comp. has the following income statement in millions.
Sales
Variable Costs
Revenues Before Fixed Costs 26
Fixed Costs
EBIT
Interest
EBT
Taxes (30%)
EAT
a) Calculate DOL, DFL, and DCL.
b) If sales increase by 20%, by what % will EAT increase and to what amount?
a. DOL = (50-24)/13 = 2.0
DFL = 13/(13-3) = 1.3
DCL = 2 x 1.3 = 2.6
b. EAT % Increase = .20 x 2.6 = .52 = 52%
EAT Amount Increase = 7 x 1.52 = $10.64