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Chapter 13: Capital Structure and

Learning Goals
Describe the basic types of capital, external assessment of capital structure,
the capital structure of non-United States firms, and the optimal capital
Discuss the EBIT-EPS approach to capital structure.
e!ie" the return and ris# of alternati!e capital structures and their lin#a$e to
mar#et !alue, and other important capital structure considerations.
Explain cash di!idend payment procedures, di!idend rein!estment plans, the
residual theory of di!idends, and the #ey ar$uments "ith re$ard to di!idend
rele!ance or irrele!ance.
Understand the #ey factors in!ol!ed in formulatin$ a di!idend policy and the
three basic types of di!idend policies.
E!aluate the #ey aspects of stoc# di!idends, stoc# splits, and stoc#
The Firm’s Capital Structure
 %ccordin$ to finance theory, firms possess a tar$et capital structure that
"ill minimi&e their cost of capital.
 Unfortunately, theory can not yet pro!ide financial mana$ers "ith a
specific methodolo$y to help them determine "hat their firm's optimal capital
structure mi$ht be.
 Theoretically, ho"e!er, a firm's optimal capital structure "ill (ust balance
the benefits of debt financin$ a$ainst its costs.
 The ma(or benefit of debt financin$ is the tax shield pro!ided by the
federal $o!ernment re$ardin$ interest payments.
 The costs of debt financin$ result from)
 The increased probability of ban#ruptcy caused by debt obli$ations.
 The a$ency costs resultin$ from lenders monitorin$ the firm's actions.
 The costs associated "ith the firm's mana$ers ha!in$ more information
about the firm's prospects than do in!estors *asymmetric information+.
 ,apital Structures of United States and -on-United States
 In $eneral, non-United States companies ha!e much hi$her debt le!els
than United States companies primarily because United States capital mar#ets
are relati!ely more de!eloped.
 In addition, in most European countries and /apan, ban#s are more
in!ol!ed because they are permitted to ma#e e0uity in!estments in non-financial
corporations1a practice prohibited in the United States.
 Similarities bet"een United States and forei$n corporations include)
 Similarity of industry capital structure patterns.
 Similarity of lar$e corporation capital structures.
 In addition, it is expected that differences in capital structures "ill further
diminish as countries rely less on ban#s and more on security issuance.
The Optimal Capital Structure
 In $eneral, it is belie!ed that the mar#et !alue of a company is maximi&ed
"hen the cost of capital *the firm's discount rate+ is minimi&ed.
 The !alue of the firm can be defined al$ebraically as follo"s)
Debt atios !or Selected "ndustries
#$S%#&"T 'pproach to Capital Structure
 The EPS-EBIT approach to capital structure in!ol!es selectin$ the capital
structure that maximi&es EPS o!er the expected ran$e of EBIT.
 Usin$ this approach, the emphasis is on maximi&in$ the o"ners' returns
 % ma(or shortcomin$ of this approach is the fact that earnin$s are only one
of the determinants of shareholder "ealth maximi&ation.
 This method does not explicitly consider the impact of ris#.
 Example
 The capital structure of Bu&& ,ompany, a soft drin# manufacturer is sho"n in the table
belo". ,urrently, Bu&& ,ompany uses only e0uity in its capital structure. Thus the current debt
ratio is 2.223. %ssume Bu&& ,ompany is in the 423 tax brac#et.
 EPS-EBIT coordinates for Bu&& ,ompany's current capital structure can
be found by assumin$ t"o EBIT !alues and calculatin$ the associated EPS in the
table belo".
 Bu&& ,ompany is considerin$ alterin$ its capital structure "hile
maintainin$ its ori$inal 5622,222 capital base as sho"n in the table belo".
 This may be sho"n $raphically as sho"n on the follo"in$ slide.
&asic Shortcoming o! #$S%#&"T 'nal(sis
 %lthou$h EPS maximi&ation is $enerally $ood for the firm's shareholders,
the basic shortcomin$ of this method is that it does not necessary maximi&e
shareholder "ealth because it fails to consider ris#.
 If shareholders did not re0uire ris# premiums *additional return+ as the firm
increased its use of debt, a strate$y focusin$ on EPS maximi&ation "ould "or#.
 Unfortunately, this is not the case.
Choosing the Optimal Capital Structure
 The follo"in$ discussion "ill attempt to create a frame"or# for ma#in$
capital bud$etin$ decisions that maximi&es shareholder "ealth *i.e., considers
both ris# and return+.
 Perhaps the best "ay to demonstrate this is throu$h the follo"in$
 %ssume that Bu&& ,ompany is attemptin$ to choose the best of se!eral
alternati!e capital structures1specifically, debt ratios of 2, 72, 82, 92, 42, 62,
and :2 percent. .urthermore, for each of these capital structures, the firm has
estimated EPS, the ,; of EPS, and re0uired return.
 If "e assume that all earnin$s are paid out as di!idends, "e can use the
&ero $ro"th !aluation model <P2 = EPS>ks? to estimate share !alue as sho"n in
the table belo".
Other "mportant Considerations
Dividend Fundamentals
 ,ash Di!idend Payment Procedures
 % di!idend is a redistribution from earnin$s.
 @ost companies maintain a di!idend policy "hereby they pay a re$ular di!idend on a
0uarterly basis.
 Some companies pay an extra di!idend to re"ard shareholders if they'!e had a
particularly $ood year. @any companies pay di!idends accordin$ to a preset payout ratio, "hich
measures the proportion of di!idends to earnin$s.
 @any companies ha!e paid re$ular di!idends for o!er a hundred years.
 ,ash Di!idend Payment Procedures
 Di!idend $ro"th tends to la$ behind earnin$s $ro"th for most corporations *see example
next slide+.
 Since di!idend policy is one of the factors that dri!es an in!estor's decision to purchase a
stoc#, most companies announce their di!idend policy and tele$raph any expected chan$es in
policy to the public.
 Therefore, it can be seen that many companies use their di!idend policy to pro!ide
information not other"ise a!ailable to in!estors.
 ,ash Di!idend Payment Procedures
 Date of record) The date on "hich in!estors must o"n shares in order to recei!e the
di!idend payment.
 ex di!idend date) .our days prior to the date of record. The day on "hich a stoc# trades
ex di!idend *exclusi!e of di!idends+.
 In the financial press) Transactions in the stoc# on the ex di!idend date are indicated by
an AxB next to the !olume of transactions.
 In $eneral, stoc# prices fall by an amount e0ual to the 0uarterly di!idend on the ex
di!idend date.
 Distribution date) The day on "hich a di!idend is paid *payment date+ to stoc#holders. It
is usually t"o or more "ee#s before stoc#holders "ho o"ned shares on the date of record
recei!e their di!idends.
Cash Dividend $a(ment $rocedures
 Example
 %t the 0uarterly di!idend meetin$ on /une 72th, the /illian ,ompany board
of directors declared an 5.C2 cash di!idend for holders of record on @onday, /uly
7st. The firm had 722,222 shares of stoc# outstandin$. The payment
*distribution+ date "as set at %u$ust 7st. Before the meetin$, the rele!ant
accounts sho"ed the follo"in$.
 Dhen the di!idend "as announced by the directors, 5C2,222 of the
retained earnin$s *5.C2>share
722,222 shares+ "as transferredto the di!idends
payable account. %s a result, the #ey accounts chan$ed as follo"s)
 /illian ,ompany's stoc# be$an sellin$ ex di!idend on /une 86th, 4 days
prior to the date of record */uly 7st+. This date "as found by subtractin$ : days
*because of the "ee#end+ from /uly 7st.
 Stoc#holders of record on /une 84th or earlier recei!ed the ri$hts to the
di!idends, "hile those purchasin$ on /une 86th or later did not. %ssumin$ a
stable mar#et, the price of the stoc# "as expected to drop by 5.C2>share on /une
86th. Dhen the %u$ust 7st payment date arri!ed, the firm mailed payments to
holders of record and recorded the follo"in$)
 Thus, the net effect of the di!idend payment is a reduction of the firm's
assets *throu$h a reduction in cash+ and e0uity *throu$h a reduction in retained
earnin$s+ by a total of 5C2,222 *the di!idend payment+.
Dividend einvestment $lans
 Di!idend rein!estment plans *DIPS+ permit stoc#holders to rein!est their di!idends to
purchase additional shares rather than to be paid out in cash.
 Dith bank-directed DIPS, ban#s purchase additional shares on the open mar#et in hu$e
bloc#s "hich substantially reduces per share commissions.
 Dith company-directed DIPS, the company itself issues ne" shares in exchan$e for the
cash di!idend completely eliminatin$ commissions.
 Dith brokerage-directed DIPS, bro#era$e firms such as ,harles Sch"ab "ill rein!est
di!idends for shareholders "ho hold stoc#s in street name at no char$e.
'dvantages o! D"$S
 .or Stoc#holders
 Substantial reduction in commission costs.
 They pro!ide in!estors "ith an automatic sa!in$s mechanism.
 .or ,ompanies
 Eood"ill
 eduction in cost of deli!erin$ di!idend chec#s.
 %n inexpensi!e means of raisin$ e0uity capital for firms company-directed
Dividend $olic( Theor(
 The esidual Theory of Di!idends
 The residual theory of di!idends su$$ests that di!idend payments should
be !ie"ed as residual1the amount left o!er after all acceptable in!estment
opportunities ha!e been underta#en.
 Usin$ this approach, the firm "ould treat the di!idend decision in three
steps as sho"n on the follo"in$ slide.
 The esidual Theory of Di!idends
 In sum, this theory su$$ests that no cash di!idend is paid as lon$ as the
firm's e0uity need is in excess of the amount of retained earnin$s.
 .urthermore, it su$$ests that the re0uired return demanded by
stoc#holders is not influenced by the firm's di!idend policy1a premise that in
turn su$$ests that di!idend policy is irrele!ant.
 Di!idend Irrele!ance %r$uments
 @erton @iller and .ranco @odi$liani *@@+ de!eloped a theory that sho"s
that in perfect financial mar#ets *certainty, no taxes, no transactions costs or
other mar#et imperfections+, the !alue of a firm is unaffected by the distribution of
 They ar$ue that !alue is dri!en only by the future earnin$s and ris# of its
 etainin$ earnin$s or payin$ them in di!idends does not affect this !alue.
 Di!idend Irrele!ance %r$uments
 Some studies su$$ested that lar$e di!idend chan$es affect stoc# price
 @@ ar$ued, ho"e!er, that these effects are the result of the information
con!eyed by these di!idend chan$es, not to the di!idend itself.
 .urthermore, @@ ar$ue for the existence of a Aclientele effect.B
 In!estors preferrin$ di!idends "ill purchase hi$h di!idend stoc#s, "hile
those preferrin$ capital $ains "ill purchase lo" di!idend payin$ stoc#s.
 Di!idend Irrele!ance %r$uments
 In summary, @@ and other di!idend irrele!ance proponents ar$ue that1
all else bein$ e0ual1an in!estor's re0uired return, and therefore the !alue of the
firm, is unaffected by di!idend policy because)
F The firm's !alue is determined solely by the earnin$ po"er and ris# of its assets.
F If di!idends do affect !alue, they do so because of the information content, "hich si$nals
mana$ement's future expectations.
F % clientele effect exists that causes shareholders to recei!e the le!el of di!idends they
 Di!idend ele!ance %r$uments
 ,ontrary to di!idend irrele!ance proponents, Eordon and Gintner
su$$ested stoc#holders prefer current di!idends and that a positi!e relationship
exists bet"een di!idends and mar#et !alue.
 .undamental to this theory is the Abird-in-the-handB ar$ument "hich
su$$ests that in!estors are $enerally ris#-a!erse and attach less ris# to current
as opposed to future di!idends or capital $ains.
 Because current di!idends are less ris#y, in!estors "ill lo"er their re0uired
return1thus boostin$ stoc# prices.
Factors that '!!ect Dividend $olic(
 Ge$al ,onstraints
 @ost state securities re$ulations pre!ent firms from payin$ out di!idends
from any portion of the company's Ale$al capitalB "hich is measured by the par
!alue of common stoc#1or par !alue plus paid-in-capital.
 Di!idends are also sometimes limited to the sum of the firm's most recent
and past retained earnin$s1 althou$h payments in excess of current earnin$s is
usually permitted.
 @ost states also prohibit di!idends "hen firms ha!e o!erdue liabilities or
are le$ally insol!ent or ban#rupt.
 E!en the IS has ruled in the area of di!idend policy.
 Specifically, the IS prohibits firms from ac0uirin$ earnin$s to reduce
stoc#holders' taxes.
 The IS can determine that a firm has accumulated an excess of earnin$s
to allo" o"ners to delay payin$ ordinary income taxes *on di!idends+, it may le!y
an excess earnin$s accumulation tax on any retained earnin$s abo!e 5862,222.
 It should be noted, ho"e!er, that this rulin$ is seldom applied.
 ,ontractual ,onstraints
 In many cases, companies are constrained in the extent to "hich they can
pay di!idends by restricti!e pro!isions in loan a$reements and bond indentures.
 Eenerally, these constraints prohibit the payment of cash di!idends until a
certain le!el of earnin$s are achie!ed or to a certain dollar amount or percenta$e
of earnin$s.
 %ny !iolation of these constraints $enerally tri$$ers the demand for
immediate payment.
 Internal ,onstraints
 % company's ability to pay di!idends is usually constrained by the amount
of a!ailable cash rather than the le!el of retained earnin$s a$ainst "hich to
char$e them.
 %lthou$h it is possible to borro" to pay di!idends, lenders are usually
reluctant to $rant them because usin$ the funds for this purpose produces no
operatin$ benefits that help to repay them.
 Ero"th Prospects
 -e"er, rapidly-$ro"in$ firms $enerally pay little or no di!idends.
 Because these firms are $ro"in$ so 0uic#ly, they must use most of their
internally $enerated funds to support operations or finance expansion.
 Hn the other hand, lar$e, mature firms $enerally pay cash di!idends since
they ha!e access to ade0uate capital and may ha!e limited in!estment
 H"ner ,onsiderations
 %s mentioned earlier, empirical e!idence supports the notion that
in!estors tend to belon$ to AclientelesB1 "here some prefer hi$h di!idends, "hile
others prefer capital $ains.
 They tend to sort themsel!es in this "ay for a !ariety of reasons,
F Tax status
F In!estment opportunities
F Potential dilution of o"nership
 @ar#et ,onsiderations
 Perhaps the most important aspect of di!idend policy is that the firm
maintain a le!el of predictability.
 Stoc#holders that prefer di!idend-payin$ stoc#s prefer a continuous
stream of fixed or increasin$ di!idends.
 Shareholders also !ie" the firm's di!idend payment as a Asi$nalB of the
firm's future prospects.
 .ixed or increasin$ di!idends are often considered a Apositi!eB si$nal,
"hile erratic di!idend payments are !ie"ed as Ane$ati!eB si$nals.
T(pes o! Dividend $olicies
 ,onstant-Payout-atio Policy
 Dith a constant-payout-ratio di!idend policy, the firm establishes that a
specific percenta$e of earnin$s is paid to shareholders each period.
 % ma(or shortcomin$ of this approach is that if the firm's earnin$s drop or
are !olatile, so too "ill the di!idend payments.
 %s mentioned earlier, in!estors !ie" !olatile di!idends as ne$ati!e and
ris#y1"hich can lead to lo"er share prices.
 e$ular Di!idend Policy
 % re$ular di!idend policy is based on the payment of a fixed-dollar
di!idend each period.
 It pro!ides stoc#holders "ith positi!e information indicatin$ that the firm is
doin$ "ell and it minimi&es uncertainty.
 Eenerally, firms usin$ this policy "ill increase the re$ular di!idend once
earnin$s are pro!en to be reliable.
 Go"-e$ular-and-Extra Di!idend Policy
 Usin$ this policy, firms pay a lo" re$ular di!idend, supplemented by
additional di!idends "hen earnin$s can support it.
 Dhen earnin$s are hi$her than normal, the firm "ill pay this additional
di!idend, often called an extra di!idend, "ithout the obli$ation to maintain it
durin$ subse0uent periods.
 This type of policy is often used by firms "hosesales and earnin$s are
susceptible to s"in$s in the business cycle.
Other Forms o! Dividends
 Stoc# Di!idends
 % stoc# di!idend is paid in stoc# rather than in cash.
 @any in!estors belie!e that stoc# di!idends increase the !alue of their
 In fact, from a mar#et !alue standpoint, stoc# di!idends function much li#e
stoc# splits. The in!estor ends up o"nin$ more shares, but the !alue of their
shares is less.
 .rom a boo# !alue standpoint, funds are transferred from retained
earnin$s to common stoc# and additional paid-in-capital.
 If Trimline declares a 723 stoc# di!idend and the current mar#et price of
the stoc# is 576>share, 5762,222 of retained earnin$s *723

576>share+ "ill be capitali&ed.
 The 5762,222 "ill be distributed bet"een the common stoc# *par+ account
and paid-in-capital in excess of par account based on the par !alue of the
common stoc#. The resultin$ balances are as follo"s.
 .rom a shareholder's perspecti!e, stoc# di!idends result in a dilution of
shares o"ned.
 .or example, assume a stoc#holder o"ned 722 shares at 582>share
*58,222 total+ before a stoc# di!idend.
 If the firm declares a 723 stoc# di!idend, the shareholder "ill ha!e 772
shares of stoc#. Io"e!er, the total !alue of her shares "ill still be 58,222.
 Therefore, the !alue of her share must ha!e fallen to 57C.7C>share
 Disad!anta$es of stoc# di!idends include)
 The cost of issuin$ the ne" shares.
 Taxes and listin$ fees on the ne" shares.
 Hther recordin$ costs.
 %d!anta$es of stoc# di!idends include)
 The company conser!es needed cash.
 Si$nalin$ effect to the shareholders that the firm is retainin$ cash because
of lucrati!e in!estment opportunities.
 Stoc# Split
 % stoc# split is a recapitali&ation that affects the number of shares
outstandin$, par !alue, earnin$s per share, and mar#et price.
 The rationale for a stoc# split is that it lo"ers the price of the stoc# and
ma#es it more attracti!e to indi!idual in!estors.
 .or example, assume a share of stoc# is currently sellin$ for 5796 and
splits 9 for 8.
 The ne" share price "ill be e0ual to 8>9
5796, or 5J2.
 ,ontinuin$ "ith the example, assume that the in!estor held 722 shares
before the split "ith a total !alue of 579,622.
 %fter the split, the shareholder "ill hold) 579,622>5J2 = 762 shares "orth
5J2 each
 % re!erse stoc# split reduces the number of shares outstandin$ and raises
stoc# price1the opposite of a stoc# split.
 The rationale for a re!erse stoc# split is to add respectability to the stoc#
and con!ey the meanin$ that it isn't a (un# stoc#.
 -ot only do stoc# splits lea!e the mar#et !alue of shareholders unaffected, but they also
ha!e little affect from an accountin$ standpoint as this 8-for-7 split demonstrates.
 Stoc# epurchases
 Stoc# repurchase) The purchasin$ and retirin$ of stoc# by the issuin$
 % repurchase is a partial li0uidation since it decreases the number of
shares outstandin$.
 It may also be thou$ht of as an alternati!e to cash di!idends.
 %lternati!e easons for Stoc# epurchases
 To use the shares for another purpose
 To alter the firm's capital structure
 To increase EPS and HE resultin$ in a hi$her mar#et price
 To reduce the chance of a hostile ta#eo!er