Capital Structure Basics 1
Learning Objectives Break-even level of sales. Operating and financial leverage and risk. Risks and returns of leveraged buy-outs (LBOs). Effect of capital structure on value. 2
Break-even Analysis Steps to Solution Construct a chart to find the sales breakeven point = level of sales necessary to cover operating (not financial) costs. This requires that you calculate EBIT for different unit sales amounts. The point at which EBIT = 0 is the breakeven level of sales. 3
Break-even Analysis Assumptions ◦ Fixed costs remain constant as quantity changes. ◦ Variable costs vary as quantity of output changes. Variable Costs Fixed Costs 4
Fixed vs. Variable Costs Fixed costs may include salaries, depreciation, rent. Variable costs may include commissions, materials, labor. This is a generalization. For example, some salaries may be considered fixed and others variable. In the long-run all costs are variable. 5
Break-even Analysis Calculation of Break-even Quantity EBIT = Sales – Variable Costs - Fixed Costs Find Quantity which results in EBIT = $0 6
Break-even Analysis Calculation of Break-even Quantity Unit Salesbe = FC p – vc Where: Unit Salesbe = Break-even quantity FC = Total fixed costs p = Sales price per unit vc = Variable costs per unit 7
Break-even Analysis Calculation of Break-even Quantity Unit Salesbe = FC p – vc Example: Fixed Costs = $1, 000/year Price = $800/unit Variable Costs = $400/unit 8
Break-even Analysis Calculation of Break-even Quantity FC Unit Salesbe = p – vc Example: Fixed Costs = $1, 000/year Price = $800/unit Variable Costs = $400/unit = $1, 000 $800 – $400 = 2, 500 units 9
Break-even Analysis Now calculate total revenue. TR = p x Q p = Sales price per unit Q = unit sales 10
Break-even Analysis Calculate total revenue for different levels of sales. TR = p x Q Unit sales (Q) 0 500 1, 000 2, 500 x x x Price (p) $800 $800 = Total Revenue (TR) = $ 0 = $ 400, 000 = $ 800, 000 = $1, 600, 000 = $2, 000 11
The Concept of Leverage You cannot easily move a large boulder 12
The Concept of Leverage However, with the aid of a lever you can move an object many times your size. 13
The Concept of Leverage The longer the lever, the bigger the rock you can move. 14
The Concept of Leverage In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm’s financial performance. Operating leverage occurs due to fixed costs in the production process. With high fixed operating costs, a small change in sales will trigger a large change in operating income (EBIT). 15
Operating Leverage Measurement of Operating Leverage ◦ Degree of Operating Leverage (DOL) DOL = q % Change in EBIT % Change in Sales DOL > 1 means the firm has operating leverage. 16
Operating Leverage Example: S 1 = 3, 750 units S 2 = 5, 000 units FC = $1 mil and VC = $400/unit P = $800/unit Sales of 3, 750 units = (3, 750 * $800) = $3 mil Ø EBIT = $3 mil - $1 mil – $1. 5 mil= $. 5 mil Sales of 5, 000 units = (5, 000 * $800) = $4 mil Ø EBIT = $4 mil - $1 mil - $2 mil = $1 mil DOL = DOL= % Change in EBIT % Change in Sales ($1 - $. 5) / $. 5 ($4 - $3) / $3 = 100 33. 33 = 3. 0 17
Operating Leverage Measurement of DOL ◦ Calculation using alternate formula: DOL = Sales - Total VC Sales -Total VC - FC 18
Operating Leverage Measurement of DOL ◦ Calculation using alternate formula: DOL = Sales - Total VC Sales -Total VC - FC DOL = ($3 - $1. 5) / ($3 - $1. 5 - $1) = 1. 5 /. 5 =3 19
Operating Leverage Measurement of DOL ◦ Calculation using per unit information: DOL = Example: Sales - Total VC Sales -Total VC - FC Q P VC FC = = 3, 750 units $800 per unit $400 per unit $1, 000 per year. 20
Operating Leverage Measurement of DOL ◦ Calculation using per unit information: Sales - Total VC Sales -Total VC - FC DOL = DOL 3, 750 units = 3, 750(800) – 3, 750(400) – 1, 000 = 3 Interpretation: If sales change 1%, then EBIT will change 3% (same direction). 21
Operating Leverage Degree of Operating Leverage falls as sales rise Quantity 2, 500 (Qbe) 3, 250 3, 750 5, 000 DOL Undefined 4. 33 3 2 22
Operating Leverage Degree of Operating Leverage falls as sales rise Quantity 2, 500 (Qbe) 3, 250 3, 750 5, 000 v v DOL Undefined 4. 33 3 2 The higher the sales level above break-even, the less the percent change in EBIT for a given percent change in sales If FC = $0, DOL = 1 23
Leverage Table Number 1 24
Financial Leverage Degree of Financial Leverage ◦ Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock ◦ Financial Leverage measures changes in earnings per share as EBIT changes. DFLEBIT = % Change in NI % Change in EBIT Base Level of EBIT 25
Financial Leverage Example: EBIT 1 = $500, 000 EBIT 2 = $1, 000 NI 1 = $180, 000 NI 2 = $480, 600 DFL = DFL= % Change in NI % Change in EBIT (480. 6 - 180) / 180 ($1 - $. 5) / $. 5 = 167 100 = 1. 67 26
Financial Leverage Measurement of DFL (Alternate formula) DFLEBIT = v EBIT – I If DFL > 1, the firm has financial leverage. A given percent change in EBIT will result in a larger percent change in NI. 27
Financial Leverage Example: EBIT = $500, 000 Interest Charges = $200, 000 500, 000 DFLEBIT=500, 000 = 500, 000 – 200, 000 = 1. 67 times Interpretation: When EBIT changes 1% (from an existing level of $50, 000) Net Income will change 1. 67% in the same direction. 28
Leverage Table Number 1 29
Combined Leverage Degree of Combined Leverage ◦ Measures changes in Net Income given changes in Sales ◦ Combines both Operating and Financial Leverage ◦ Computed for a specific level of sales % Change in NI DCLS = % Change in Sales Base Level of Sales 30
Combined Leverage Example: SALES 1 = $3, 000 SALES 2 = $4, 000 NI 1 = $180, 000 NI 2 = $480, 600 DCL = DCL= % Change in NI % Change in Sales (480. 6 - 180) /. 180 ($4 - $3) / $3 = 166. 7 33. 3 = 5. 0 31
Combined Leverage DCLS = DOLS x DFLEBIT Example: DOLS = 3. 0 DFLEBIT = 1. 67 DCL 3, 750 = 3. 0 x 1. 67 = 5. 0 times 32
Combined Leverage DCLS = Sales – VC Sales - VC - FC - I Example: DCL 3, 750 = = 3, 750(800) – 3, 750(400) – 1, 000 - $200, 000 3 mil – 1. 5 mil – 1 mil -. 2 mil = 1, 500, 000 300, 000 = 5 33
Combined Leverage DCLS = DOLS x DFLEBIT S S EBIT Example: DOLS = 3. 0 DFLEBIT = 1. 67 DCL 3, 750 = 3. 0 x 1. 67 = 5. 0 times Interpretation: When sales change 1%, Net Income will change 5. 0% in the same direction 34
Leverage Table Number 1 35
Effect of Leverage can help the firm or hurt it. If EBIT increases, financial leverage will magnify the increase in net income. If EBIT decreases, financial leverage will magnify the decrease in net income. 36
Capital Structure Theory Capital Structure is the mixture of sources of funds a firm uses. ◦ Debt ◦ Preferred Stock ◦ Common Stock 37
Capital Structure Theory A benefit of debt financing is that interest is tax deductible to the paying firm whereas payments to equity providers are not. Firms must trade-off this benefit against the increased financial risk associated with higher debt levels. 38
Capital Structure Theory Modigliani and Miller (M&M) M&M wrote an important paper in 1958 in which they proved that with certain assumptions there is no optimal capital structure. One is as good as any other. M&M’s Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations. 39
Capital Structure Theory Modigliani and Miller (M&M) In a later paper, M&M showed that when the tax deductibility of interest is considered, their model indicates that a capital structure of 100% debt is optimal. 40
Capital Structure in the Real World Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm. Affect on costs of capital: ◦ Since debt is cheaper than equity, use of debt will initially lower the WACC. ◦ At high levels of debt, the WACC will increase as investors perceive the risk of the firm to be increasing substantially. 41
Cost of Capital and Capital Structure kd ks ks ka ka K* kd We minimize K* at 50% debt 42
Homework Problems 1. You are given the following information for Firm XYZ: Fixed operating costs = $500, 000 Variable operating costs per unit = $40/unit Sales price per unit = $50/unit Calculate the break-even point in units for: (treat each scenario independently) a. fixed costs decrease to $450, 000 b. variable cost decreases to $37 per unit c. sales price increases to $55/unit d. changes for a, b, c, occur simultaneously 2. Company X has a sales price of $4. 00 per unit and a variable cost of $3. 40 per unit; fixed costs are $13, 000, no debt, and sales of 250, 000 units per year. Company Y has a sales price of $10. 00 per unit and a variable cost of $7. 00 per unit with fixed costs of $135, 000 and sales of 200, 000 units per year. Company Y also has interest payments of $60, 000 annually. Both companies are in the 40% tax bracket. a. compute DOL, DFL, and DCL for Company X b. compute DOL, DFL, and DCL for Company Y c. compare the relative risk of both companies 3. Why is the Modigliani and Miller theory of capital structure not really practical for firms in the real world? 4. Debt financing is often called a two-edged sword. What does this mean? 5. Given a net income of $50, 000, sales of $2, 000, variable costs of $25, 000, fixed operating costs of $175, 000, price per unit of $5. 00, interest expense of $20, 000, and EBIT of $1, 800, 000: a. calculate DOL b. calculate DFL c. calculate DCL 43
Corporate Bonds, Preferred Stock, and Leasing 44
Learning Objectives Bond contract terms Differences among types of bonds Features of preferred stock Lease versus purchase Balance sheet treatment of leases 45
Bond Basics Bondholders are lending the corporation funds for some stated period of time. The corporation promises to make certain payments to the owner of the bond. 46
Bond Basics Indenture ◦ Definition: the contract between the corporation and the investor Provisions included in the indenture: ◦ ◦ par value coupon rate and payment dates maturity date any special features 47
Bond Basics Par Value ◦ (e. g. $1, 000) also called Face Value Coupon Interest Rate ◦ The stated rate of interest. The rate that is multiplied by the par value to determine the annual dollar interest paid. Maturity ◦ Time at which the original principal (Par Value) is repaid to the bondholder. 48
Special Features of Bond Indentures Collateral ◦ If the debt is secured by specific assets, the lender is entitled to take the assets in the event of default. Plan for repayment at maturity ◦ Staggered maturities makes it easier for the firm to raise the necessary funds. Sinking funds allow the firm to set aside the funds over time to ensure the ability to repay the loan. 49
Special Features of Bond Indentures Provisions for early repayment ◦ Call provisions allow the issuer to refinance the debt, usually done if interest rates fall. ◦ Issuing new bonds to replace old bonds is known as refunding. 50
Call example Original issue: 12% coupon Coupon currently required for similar risk bonds: 10% coupon Refinancing will save $20 per year on each $1, 000 bond. Interest savings offset by the expenses of calling the original issue and issuing the new bonds. In addition, the call price the issuer must pay is usually greater than the face value. 51
Special Features of Bond Indentures Restrictions on company operations that are designed to reduce risk to bondholders. ◦ Restrictions on additional debt ◦ Restrictions on payment of dividends ◦ Minimum working capital required Name of independent trustee to oversee the bond issue 52
Bond Ratings Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt 53
Bond Ratings Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt Investment Grade Below Investment Grade (Junk) AAA AA A BBB BB B CCC CC C D Best Quality High Quality Upper Medium Grade Speculative Very Speculative No Interest Being Paid Currently in Default 54
Types of Bonds Debenture Subordinated Debenture 55
Types of Bonds Debenture Subordinated Debenture A debenture is an unsecured bond. A subordinated debenture is a debenture that has lower priority for payment than other debentures designated as senior. 56
Types of Bonds Debenture Subordinated Debenture n Mortgage Bond A mortgage bond is secured by real assets such as airplanes, railroad cars, or real estate. 57
Types of Bonds Debenture Subordinated Debenture Mortgage Bond Convertible Bond A convertible bond is a bond that gives the investor the right to convert the bond into a given number of shares of stock on or after a given future date. The conversion ratio is the number of shares the investor will get for each bond converted. 58
Types of Bonds Debenture Subordinated Debenture Mortgage Bond Convertible Bond The conversion value is the market price per share times the conversion ratio. e. g. If the stock price = $20 and the conversion ratio = 45, the conversion value = $20 x 45 = $900. 59
Types of Bonds Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond A variable rate bond pays investors interest that is adjusted according to an established time table and a market rate index. e. g. Coupon rate is LIBOR + 300 basis points 60
Types of Bonds Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond Putable Bond A putable bond can be cashed in before maturity at the option of the bond’s owner. 61
Types of Bonds Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond Putable Bond Junk Bond A junk bond is a bond that is rated below investment grade. 62
Types of Bonds Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond Putable Bond Junk Bond International bonds are bonds that are sold in countries other than where the issuer is domiciled. 63
Bond Risk Hierarchy Common Stock Preferred Stock More Risk Subordinated Debentures Senior Debentures 2 nd Mortgage Bonds 1 st Mortgage Bonds Less Risk Higher Priority of Claim Lower 64
Features of Preferred Stock A hybrid security with both debt and equity characteristics. Has priority over common stock in receipt of dividends and in liquidation. Dividends are fixed as a percentage of par value. Only participating preferred stock (which is rare) shares in the residual income with the common stockholders. 65
Investors in Preferred Stock Corporations can generally exclude from taxable income 70% of dividend income received on preferred stock issued by another corporation. e. g. Company X owns Company Y preferred stock that pays 4% dividends. If Company X’s marginal tax rate = 40%, the after tax yield on this investment AT yield = 4%[1 -(. 3 x. 4)] = 3. 52% Compare to 4% on fully taxable investment: AT yield = 4%(1 -. 4) = 2. 4% 66
Leasing A lease is a contractual arrangement where a party who needs an asset (lessee) contracts with another party who owns the asset (lessor) to use that asset for a specified period of time, without conveyance of title. A long-term non-cancelable lease contract is very similar financially to a debt obligation from the perspective of the lessee. 67
Benefits of Leasing to the Lessee Flexibility and convenience Few restrictions Avoid the risk of obsolescence 100 percent financing Tax savings Ease of obtaining credit 68
Genuine Leases Versus Shams Lease payments for operating leases are fully deductible to businesses but only interest portions of debt payments are deductible. The IRS strictly examines lease arrangements to ensure that they are genuine lease agreements and not installment sales in disguise. 69
Operating and Capital Leases An operating lease has a term that is substantially shorter than the useful life of the asset and is cancelable by the lessee (e. g. car rental for a business trip). A capital lease is long term and noncancelable. The economic value is mostly depleted by the end of the lease (e. g. a ten year lease of a truck. ) 70
Accounting Treatment of Leases Both operating and capital leases appear on the income statement. ◦ Payments on operating leases are tax-deductible expenses. ◦ Depreciation for the leased asset and imputed interest from capital lease payments are deductible. Capital leases also appear on the balance sheet because they are the functional equivalent of a purchase financed with debt. 71
Homework Problems 1. Four years ago, you purchased a convertible bond at par with a ten year maturity with an 8% coupon. The conversion ratio of the bond is 25. The current market price of the stock is $50. Calculate the conversion value. 2. Using the information in the previous question, if the current market interest rate is 9. 5% on similar non-convertible bonds, should you convert? Explain. 3. You purchased a fifteen-year 10% coupon bond at par five years ago. The bond can be redeemed for $900 after five years. The current required rate of return on similar non-convertible bonds is 9%. Should you redeem the bond? Explain. 4. Why are junk bonds called high-yield bonds? 5. Explain why preferred stock is known as a hybrid security. 72
Common Stock 73
Learning Objectives Characteristics of common stock. Advantages and disadvantages of equity financing. Process of issuing common stock. Understand rights and warrants. 74
Stock Quote Company Issuing the Stock 75
Stock Quote Description of Preferred Stock (Class B Preferred and Class C Preferred) 76
Stock Quote Ticker Symbol 77
Stock Quote Annual Dividend per Share in dollars p = Initial Dividend 78
Stock Quote Volume of Trading The number of shares changing hands. 79
Stock Quote Daily Trading Range 6½ = $6. 50 80
Stock Quote Closing Price 81
Stock Quote Price Change from Close on Previous Trading Day 82
Stock Quote Trading Range over the Past Year s = stock split = new 52 week high achieved on this day 83
Stock Quote Dividend Yield = Dividend Closing Price 84
Stock Quote Price to Earnings (PE) Ratio = Closing Price 85 Earnings per Share
Characteristics of Common Stock Dividends ◦ Vary over time ◦ Not guaranteed Residual Claim Voting Rights Sometimes Preemptive Right to buy New Stock 86
Management of Publicly Traded Corporations Shareholders elect a group of individuals called the Board of Directors who oversee the management of the corporation. The Board of Directors selects the managers who are responsible for day-to -day operations of the firm. 87
Board of Directors Elections Majority voting ◦ For each seat open, one vote can be cast per share. Each position on the board is voted for separately. Cumulative voting ◦ Each shareholder gets one vote per share times the number of seats open. Votes may be spread out among candidates as desired. The top X vote getters are elected to the X seats to be filled. 88
Cumulative Voting Example Number of Directors Electable Excalibur Corporation has 3 seats open on its 9 member Board of Directors. There are 100, 000 shares outstanding. The minority interest owns 40, 000 shares. Does the minority have a chance of electing one Director if all shares are voted? The minority has 40, 000 x 3 = 120, 000 votes. Number they can elect = (40, 000 -1)(3+1) 100, 000 = 1. 6 = 1 director (always round down) 89
Cumulative Voting Example Number of Shares Needed for X Directors Excalibur Corporation has 5 seats open on its 9 member Board of Directors. There are 100, 000 shares outstanding. How many shares does the minority need to control to elect 2 directors? 2 X 100, 000 +1 5+1 Number of shares needed = = 33, 334. 33 90
Pros and Cons of Equity Financing Disadvantages of Equity Financing Dilution of ownership and power. Flotation costs ◦ Fees paid to investment bankers, lawyers, and accountants ◦ Usually higher than for debt issues. 91
Pros and Cons of Equity Financing Disadvantages of Equity Financing (cont. ) Signaling Effects ◦ Investors may think that managers would not issue stock unless it were overvalued in the market. ◦ Therefore, a stock issue is seen as a negative signal and investors will respond by selling the stock. ◦ Selling pressure causes the stock price to fall. 92
Pros and Cons of Equity Financing Advantages of Equity Financing No interest to pay. No obligation to pay dividends. Reduces financial risk. ◦ This may be a more important advantage to firms that already are relatively risky due to the kind of business they do (e. g. high tech) 93
Issuing Common Stock Sell to existing shareholders or to new shareholders? Initial Public Offering (IPO) Role of Investment Bankers ◦ Underwriting ◦ Best efforts Pricing the issue 94
Rights and Warrants Securities issued by a corporation that allow investors to buy new stock at a given price. Preemptive Right ◦ Allows a shareholder the right to maintain their % ownership by buying a proportional share of any new issue. ◦ The rights can also be sold in the open market. 95
Preemptive Right Example There are 60, 000 shares outstanding and another 20, 000 will be issued. Each shareholder will receive one right for each share held, a total of 60, 000 rights. To buy one share of the new issue, you will need to pay the subscription price plus 60, 000/20, 000 = 3 rights. 96
Rights and Warrants A warrant is a security giving the owner the option to buy shares of common stock at a certain exercise price for a set period of time. Like rights except that they are sold to investors rather than given away. Each warrant allows you to buy a particular number of shares. 97
Homework Problems 1. Describe the difference between a preemptive right and a warrant. 2. Company XYZ has 30 million shares of common stock outstanding. It wishes to issue another 1, 500, 000 shares. The current market price per share is $25 and the rights offering subscription price is $20 per share. a. How many rights will current stockholders receive? b. How many rights are needed to buy one additional share? 3. The Whitcomb Bank has 10 directors on its board and 1, 000 voting shares of common stock outstanding. The company uses cumulative voting rules and is planning to elect four new directors. How many shares of common stock would a group of shareholders need to insure that they could elect at least two directors at the next election? 4. How do you value a stock that is not publicly traded? 5. What are the advantages and disadvantages of equity financing? 98
Dividend Policy 99
Learning Objectives Factors that influence dividend policy How to pay dividends Major dividend theories Alternatives to cash dividends 10 0
Factors in Dividend Policy Need for funds Management expectations for the firm’s future prospects Stockholders’ preferences Restrictions on dividend payments Availability of cash 10 1
Dividend Payment Procedures On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006 10 2
Dividend Payment Procedures On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006 25 31 1 August 5 9 15 September Declaration Date that dividend is announced 10 3
Dividend Payment Procedures On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006 25 31 1 August Declaration Date 5 9 15 September Date of Record All owners of record will receive the dividend. 10 4
Dividend Payment Procedures On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006 25 31 1 5 August 9 15 September 4 days Declaration Date of Record 10 5
Dividend Payment Procedures On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006 25 31 1 August 7 9 15 September Ex-Dividend Date Declaration Date of Record To allow time for the official list of stockholders to be updated, stockholders must buy stock before the exdividend date which is 2 days prior to date of record. 10 6
Dividend Payment Procedures On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, 2006, payable September 15, 2006 25 31 1 August 7 9 15 September Ex-Dividend Date Declaration Date of Record Payment Date that the dividend is paid out to the stockholders. 10 7
Dividend Reinvestment Plans A dividend reinvestment plan (DRIP) is a plan in which stockholders are allowed to reinvest their dividends in additional shares of stock instead of receiving them in cash. Popular with investors because they can avoid commission costs. Dividends paid and reinvested are still taxable income to the investor. 10 8
Leading Dividend Theories Residual Theory of Dividends ◦ Hypothesizes that dividends should be determined only after the firm has first examined their need for retained earnings to finance the equity portion of funds needed for their capital budget. ◦ Thus, dividends arise from the “residual” or left-over earnings. 10 9
Leading Dividend Theories n Residual Theory of Dividends Example: Net Income = $150 million Total Amount of Funds Needed to Finance Positive NPV Projects = $100 million Optimal Capital Structure: 60%D, 40%E Equity Funds Needed = $100 million x. 4 = $40, 000 Dividend to be Paid = $110 million ($150 million NI - $40, 000 Equity Funds Needed) 11 0
Leading Dividend Theories Clientele Dividend Theory ◦ Hypothesizes that different firms have different types of investors. ◦ Some investors, such as elderly people on fixed incomes, tend to prefer to receive dividend income. ◦ Others, such as young investors often prefer growth, and tend to like their income in the form of capital gains rather than as dividend income. 11 1
Leading Dividend Theories Signaling Dividend Theory ◦ Hypothesizes that since management is better informed about the firm’s prospects, dividend announcements are seen as signals of future performance. ◦ Since investors usually respond negatively to dividend decreases, managers tend not to increase dividends unless the increase is expected to be sustainable. 11 2
Leading Dividend Theories Bird in the Hand Theory ◦ Hypothesizes that stockholders prefer to receive dividends instead of having earnings reinvested. ◦ The dividend payment is more certain than the unknown future capital gain. 11 3
Leading Dividend Theories Modigliani and Miller Dividend Theory ◦ M&M originally argued in 1961 that, without taxes or transactions costs, the way that the firm’s earnings are distributed (capital gains versus dividends) is irrelevant to firm value. 11 4
Alternatives to Cash Dividends Stock Dividends ◦ Existing shareholders receive additional shares of stock instead of cash dividends. ◦ Payment is expressed as a percentage of current stock holdings. e. g. if there is a 10% stock dividend, you would receive one additional share for every 10 that you currently own. 11 5
Alternatives to Cash Dividends Stock Splits ◦ If total shares will increase by more than 25%, the company will usually declare a stock split. ◦ Purpose is usually to bring the stock price into a more popular trading range. ◦ Expressed as a ratio to original shares. e. g. a 2 -1 split means that each investor will end up with twice as many shares. 11 6
Homework Problems and Questions 1. Explain the difference between a stock dividend a stock split. 2. Net income is $2, 500, 000; dividends declared are $500, 000. What is the dividend payout ratio? 3. Why is it important for a firm to understand the makeup of its stockholders before it determines a dividend policy? 4. Would it be a common practice for a high-growth firm to have a 100% dividend payout ratio? Explain. 5. What is the rationale of managers who view a stock split as a way to increase the total value of their firm’s stock? 11 7
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