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# CAPITAL STRUCTURE AND DIVIDEND POLICY

Capital Structure

In the section of the notes titled “Cost of Capital,” we examined how the cost of capital is determined.
From those notes, you should have discovered that each type of funds the firm uses has a cost and that
the required rate of return for the firm is the weighted average of the costs of the individual
components of capital—that is, debt, preferred stock, and common equity—which is designated the
weighted average cost of capital, or WACC. The WACC is calculated as follows:

## ⎡⎛ Pr oportion ⎞ ⎛ After − tax ⎞⎤ ⎡⎛ Pr oportion of ⎞ ⎛ Cost of ⎞⎤ ⎡⎛ Pr oportion of ⎞ ⎛ Cost of ⎞⎤

WACC = ⎢⎜⎜ ⎟⎟ × ⎜⎜ ⎟⎟ ⎥ + ⎢⎜⎜ ⎟⎟ × ⎜⎜ ⎟⎟ ⎥ + ⎢⎜⎜ ⎟⎟ × ⎜⎜ ⎟⎟ ⎥
⎣⎝ of debt ⎠ ⎝ cost of debt ⎠⎦ ⎣⎝ preferred stock ⎠ ⎝ preferred stock ⎠⎦ ⎣⎝ common equity ⎠ ⎝ common equity ⎠⎦

= w k + w k + w ( k or k )
d dT ps ps s s e

The question we address in this section is whether the amount, or proportion, of each type of funds the
firm uses affects the overall value of the WACC. The above equation suggests that the required rate of
return, which is WACC, is affected by the proportion of debt, wd, the proportion of preferred stock,
wps, and the proportion of common equity, ws, the firm uses. But, the individual component costs of
capital might also be affected by the proportions of each type of funds that the firm uses. For example,
all else equal, the more debt a firm uses, the higher its cost of debt. In any event, if the overall WACC
is affected by how the firm finances itself—that is, how much debt and equity it uses—then we want
the be able to determine the proportion of each type of funds the firm should use to maximize its value.

! The Target Capital Structure—capital structure refers to the combination of funds, in the form of
debt and equity, a firm uses to finance its assets. A firm usually sets a target capital structure,
which is the proportion of debt and equity it wants to use to finance investments, that is used as a
benchmark when raising funds for investing in new capital budgeting projects. Generally if a
firm uses more debt, the risk associated with its future earnings is increased. At the same time,
however, because debt has a fixed cost (that is, interest), more debt allows the firm to earn a
higher expected rate of return. Thus, there is a risk/return tradeoff associated with increasing
(decreasing) debt. The firm should use the amount of debt that maximizes the value of the firm.
Stated differently, at the best, or optimal, capital structure, the value of the firm is maximized
because the overall WACC is minimized.

The following factors should be considered when making decisions about the capital structure of
a firm:
1. Business risk—firms with greater business risk generally cannot take on as much debt as
firms with less business risk. A more detailed discussion of business risk is given below.
2. Tax position—remember interest on debt is tax deductible, which makes debt attractive as a
source of financing. Also remember that more debt generally implies a greater chance of
bankruptcy, which is extremely expensive.
3. Financial flexibility—to strengthen its balance sheet, a firm might raise funds by issuing

## Capital Structure and Dividend Policy – 1

more common stock. On a relative basis, a stronger financial position—that is, stronger
balance sheet—generally implies the firm is better able to raise funds in the capital markets in
a slumping economy.
4. Managerial attitude (conservatism or aggressiveness)—some financial managers are more
conservative than others when it comes to using debt, thus they are inclined to use less debt,
all else equal.

! Business and Financial Risk—the risk associated with a firm can be divided into two
components: (1) the risk associated with the type of business the firm operates—that is,
competitive conditions, whether the industry is capital-intensive or labor-intensive, dangers
associated with the manufacturing process, and so forth—is termed its business risk; and the risk
associated with how the firm is financed—that is, what portion of the financing is debt and what
portion is equity—is termed its financial risk.
" Business risk—we evaluate business risk by examining the stability of a firm’s operations
and its ability to maintain operating income. Generally less business risk is associated with
greater stability in sales, operating expenses, and the like, greater flexibility in the ability to
change selling prices, and less relative fixed operating costs (that is, operating leverage,
which was discussed in the section of the notes titled “Forecasting, Planning, and Control”).
" Financial risk—this risk is associated with the ability of a firm to meet its financial
obligations, which means this form of risk arises when the firm uses sources of financing that
require fix payments or obligations—that is, financial leverage (discussed in the section of
the notes titled “Forecasting, Planning, and Control”) exists. Financial risk affects the ability
of a firm to generate stable income for common stockholders—that is, financial risk affects
the risk of common stock.

! Determining the Optimal Capital Structure—remember that the optimal capital structure is the
combination of debt and equity that maximizes the value of the firm.
" EBIT/EPS analysis of the effect of financial leverage—we can evaluate the attractiveness of a
particular capital structure by examining how changing the proportion of debt a firm uses
affects its EPS. To illustrate, consider a hypothetical firm with assets equal to \$400,000 that
currently has no debt. If the firm issues debt, common stock will be repurchased at \$10 per
share. Debt can be issued based on the following schedule:

## Amount Debt/Asset Cost of Shares of Stock

Equity of Debt Ratio Debt, kd Outstanding
\$400,000 \$ 0 0.0% 0.0% 40,000
320,000 80,000 20.0 6.0 32,000
240,000 160,000 40.0 9.0 24,000
160,000 240,000 60.0 20.0 16,000

Total capital = \$400,000, which currently is all equity, and 40,000 shares of stock are
outstanding. To evaluate the impact of changing the capital structure, we keep the amount of
total capital the same—that is, \$400,000. Therefore, if the firm is financed with \$80,000 debt,
the remaining \$320,000 in capital will be equity and only 80 percent of the equity that exists
if no debt is used will exist if 20 percent of the firm’s capital structure is debt. In this case,

## Capital Structure and Dividend Policy – 2

the number of shares of stock outstanding will be 32,000 = 0.8 x 40,000. The number of
shares outstanding under the other alternatives is similarly computed.

Assuming that operating expenses, such as cost of goods sold, depreciation, and so forth, are
not affected by capital structure decisions, the firm is expected to generate the operating
income, EBIT, as follows:

## Type of Economy Operating Income (EBIT) Probability

Boom \$200,000 0.1
Normal 120,000 0.6
Recession 40,000 0.3

## Type of Economy Boom Normal Recession

Probability 0.1 0.6 0.3
Proportion of Debt (D/A) = 0%
Debt = 0.0(\$400,000) = \$0 Equity = \$400,000 - \$0 = \$400,000
Interest = \$0 Shares of stock = \$400,000/\$10 = 40,000

## EBIT \$200,000 \$120,000 \$40,000

Interest 0 0 0
Earnings before taxes 200,000 120,000 40,000
Taxes (40%) (80,000) (48,000) (16,000)
Net income \$120,000 \$ 72,000 \$24,000
EPS (40,000 shares) \$3.00 \$1.80 \$0.60
Expected EPS \$1.80
Standard deviation of EPS \$0.72

## Proportion of Debt (D/A) = 20%

Debt = 0.2(\$400,000) = \$80,000 Equity = \$400,000 - \$80,000 = \$320,000
Interest = 0.06(\$80,000) = \$4,800 Shares of stock = \$320,000/\$10 = 32,000

## EBIT \$200,000 \$120,000 \$40,000

Interest (4,800) (4,800) (4,800)
Earnings before taxes 195,200 115,200 35,200
Taxes (40%) (78,080) (46,080) (14,080)
Net income \$117,120 \$ 69,120 \$21,120
EPS (40,000 shares) \$3.66 \$2.16 \$0.66
Expected EPS \$1.86
Standard deviation of EPS \$0.90

## Capital Structure and Dividend Policy – 3

Debt = 0.4(\$400,000) = \$160,000 Equity = \$400,000 - \$160,000 = \$240,000
Interest = 0.09(\$160,000) = \$14,400 Shares of stock = \$240,000/\$10 = 24,000

## EBIT \$200,000 \$120,000 \$40,000

Interest (14,400) (14,400) (14,400)
Earnings before taxes 185,600 105,600 25,600
Taxes (40%) (74,240) (42,240) (10,240)
Net income \$111,360 \$ 63,360 \$15,360
EPS (40,000 shares) \$4.64 \$2.64 \$0.64
Expected EPS \$2.24
Standard deviation of EPS \$1.20

## Proportion of Debt (D/A) = 60%

Debt = 0.6(\$400,000) = \$240,000 Equity = \$400,000 - \$240,000 = \$160,000
Interest = 0.20(\$240,000) = \$48,000 Shares of stock = \$160,000/\$10 = 16,000

## EBIT \$200,000 \$120,000 \$40,000

Interest (48,000) (48,000) (48,000)
Earnings before taxes 152,000 72,000 (8,000)
Taxes (40%) (60,800) (28,800) 3,200
Net income \$91,200 \$ 43,200 \$(4,800)
EPS (40,000 shares) \$5.70 \$2.70 \$(0.30)
Expected EPS \$2.10
Standard deviation of EPS \$1.80

## Summarizing the results provided above, we have the following:

Proportion
of Debt Expected EPS Standard Deviation
0.0% \$1.56 \$0.72
20.0 1.86 0.90
40.0 2.24 1.20
60.0 2.10 1.80

According to this information, the firm’s EPS peaks at a capital structure that includes 40
percent debt and 60 percent equity. However, this capital structure might not be optimal, as
we will see in the sections that follow.
" EPS Indifference analysis—if our hypothetical firm wants to decide between two capital
structures, say, all equity financing and 40 percent debt, then the financial manager would
want to know at what levels of sales it is better to be an all equity firm and at what levels of
sales it would be better to be financed with 40 percent debt. This decision can be made by
graphing EPS for both financing plans at various levels of sales. The following graph shows
the EPS figures for our hypothetical firm at different sales levels assuming the firm has fixed
operating costs equal to \$600,000 and variable operating costs equal to 70 percent of sales.

EPS(\$)

## 1.00 40% Debt Financing

0.80
0.60
0.54 100% Stock Financing
0.40

0.20

0 Sales
(\$ millions)
2 2.1 2.2
EPS Indifference
\$2.12 million

The preferred financing plan is the one that produces the higher EPS. Thus, as you can see
from the graph, financing the firm with all equity is preferable if sales are below \$2.12
million; otherwise, the financing plan with 40 percent debt is preferred.
" The effect of capital structure on stock prices and the cost of capital—when we try to find the
optimal capital structure for a firm, we want to determine the mix of debt and equity that
maximizes the value of the firm—that is, its stock price—not the EPS. The proportion of debt
in the optimal capital structure will be less than the proportion of debt needed to maximize
EPS because the market valuation of the stock, P0, considers the risk associated with the
firm’s operations expected well into the future and EPS is based only on the firm’s operations
expected for the next few years.

To determine a firm’s optimal capital structure, first consider the fact that the relationship of
the cost of equity, ks, and the amount of debt the firm uses to finance its assets can be
illustrated as follows:

## Capital Structure and Dividend Policy – 5

Required Return on
Equity, ks (%)

## ks = kRF + risk premium

financial risk
particular level of operations
kRF
Risk-free rate of return

% Debt in
Capital Structure

According to the graph, for a given level of operations, the required return on (cost of)
equity, ks, is affected by the firm’s financial risk, which is based on the amount of debt
used to finance its assets. Although debt increases the cost of equity, the tax benefit
associated with using debt (interest paid is tax deductible) generally requires firms to use
some debt to finance assets. But, at some point, the tax benefit is overshadowed by the
additional risk the firm incurs by increasing the amount of debt it uses, which causes the
cost of additional debt to increase significantly. In other words, the risk of bankruptcy
increases so significantly that increases in the cost of debt, kd, more than offset the benefit
associated with the tax deductibility of the interest payments. Therefore, the relationship
of the cost of debt, the cost of equity, and the WACC with the amount of debt used to
finance assets might look like the following:

Cost of
Capital (%) Cost of
equity, ks

WACC
Minimum After-tax cost
WACC of debt, kdT

## Optimal Amount Proportion of Debt in

of Debt the Capital Structure

## Capital Structure and Dividend Policy – 6

As you can see from the graph, (1) if the firm uses only equity to finance its assets (that is,
zero debt is used) then WACC = ks; (2) as the firm begins to use some debt for financing,
WACC declines, primarily because the tax benefit offered by the debt more than offsets the
increased cost of equity, ks; (3) at some point the tax benefit associated with debt is more than
offset by increases in the before-tax cost of debt and the cost of equity that result from
increases in the risk associated with the additional debt and, at this point, WACC begins to
increase; and (4) the point where WACC is the lowest is the optimal capital structure—this is
the point where the value of the firm is maximized. Remember that WACC represents a cost
to the firm—that is, it is the average rate of return the firm pays for the funds it uses to
finance its assets, which is similar to the interest paid by an individual on a mortgage—and,
rationally, the firm wants to minimize any of its costs, all else equal.

! Degree of Leverage—the information provided in this section has been discussed in great detail
in the section of the notes titled “Forecasting, Planning, and Control,” so this section should
serve as a review. As we will illustrate in this section, all else equal, if a firm can reduce its
operating leverage, it can use more debt (that is, increase its financial leverage), and vice versa.
" Degree of operating leverage (DOL)—remember that DOL refers to the percentage change in
operating income, designated either NOI or EBIT, that results from a particular percentage
change in sales. In previous notes, we showed that DOL can be computed as follows:

% change in NOI Q( P − V ) S − VC
DOL = = =
%change in sale Q(P − V ) − F S − VC − F

where Q represents the number of products (units) the firm currently sells, P is the price per
unit, V is the variable cost ratio (as a percent of sales), F is the fixed operating costs, S is
current sales stated in dollars such that S = Q × P, and VC is the total variable costs of
operations such that VC = Q × V.

All else equal, firms with riskier operations have higher DOLs.
" Degree of financial leverage (DFL)—refers to the percentage change in EPS that results from
a particular percentage change in earnings before interest and taxes, EBIT. DFL is computed
as follows:

## % change in EPS EBIT S − VC − F

DFL = = =
% change in EBIT EBIT − I S − VC − F − I

where I is the dollar interest paid on outstanding debt. The DFL equation given here applies
only to firms that have no preferred stock outstanding.

All else equal, firms with riskier financial positions have higher DFLs.
" Degree of total leverage (DTL)—refers to the percentage change in EPS that results from a
particular percentage change in sales. DTL combines DOL and DFL, and it is computed as
follows:

## Capital Structure and Dividend Policy – 7

% change in EPS
DTL = = DOL× DFL
% change in sale
Q( P − V ) S − VC
= =
Q(P − V) − F − I S − VC − F − I

All else equal, firms that have high DTLs are considered riskier in general than firms with
low DTLs.

## To illustrate the concept of leverage, consider the following situation:

Current Sales 5%
Expected Less Than
Sales Expected %∆
Sales \$250,000 \$237,500 -5.0%
Variable operating costs (60% of sales) (150,000) (142,500) -5.0%
Gross profit 100,000 95,000 -5.0%
Fixed operating costs ( 75,000) ( 75,000) 0.0%
Net operating income, NOI = EBIT 25,000 20,000 -20.0%
Interest ( 12,500) ( 12,500) 0.0%
Taxable income 12,500 7,500 -40.0%
Taxes (40%) ( 5,000) ( 3,000) -40.0%
Net income \$ 7,500 \$ 4,500 -40.0%

## DOL = 4.0 = \$100,000/\$25,000

DFL = 2.0 = \$25,000/(\$25,000 - \$12,500) = \$25,000/\$12,500
DTL = 8.0 = 4.0 H 2.0 = \$100,000/(\$25,000 - \$12,500) = \$100,000/\$12,500

The table shows that when DOL = 4.0, a 5 percent decrease (increase) in sales will cause a 20
percent decrease (increase) in NOI; when DFL = 2.0, a 20 percent decrease (increase) in
EBIT will cause a 40 percent decrease (increase) in EPS (net income divided by the number
of shares of common stock that are outstanding); and, in combination, when DTL = 8.0, a 5
percent decrease (increase) in sales will cause a 40 percent decrease (increase) in EPS.

The concept of leverage can be used to determine the impact that a change in capital structure
will have on the riskiness, thus the WACC, of a firm. Generally, we associate greater risk
with higher degrees of leverage, whether the leverage is operating, financial, or a
combination of both (total).

! Liquidity and Capital Structure—a manager might not operate at the optimal capital structure
because s/he might (1) find it difficult, if not impossible, to determine the optimal capital
structure; (2) be reluctant to take on the amount of debt necessary to achieve the optimal capital
structure (that is, have a conservative attitude toward debt financing); or (3) provide important
services that prohibit him or her from endangering the ability of the firm to survive, which might
be the case if the firm is financed using the optimal mix of capital.

## Capital Structure and Dividend Policy – 8

Often, firms use measures of financial liquidity, such as the times-interest-earned (TIE) ratio, to
provide an indication of financial strength. Remember that the TIE ratio gives an indication of
how many times a firm can cover the interest payments associated with its debt financing.
Generally, a firm with a higher TIE ratio is said to have greater financial liquidity and lower
threat of bankruptcy than a firm with a lower TIE ratio.

! Capital Structure Theory—academicians have proposed many theories regarding the capital
structures of firms. The two major theories are summarized as follows:
" Trade-off theory—more than 40 years ago Franco Modigliani and Merton Miller, who have
since won the Nobel prize for Economics, developed a theory that showed firms should favor
using debt in their capital structures because the tax deductibility of interest payments is such
a benefit. Under a very restrictive set of assumptions, they showed that the value of a firm
increases as it uses more and more debt. In fact, according to their theory, the value of the
firm is maximized when it is financed with nearly 100 percent debt. However, the theory
ignored the costs associated with bankruptcy, which can be considerable. When the costs of
bankruptcy are considered, there is a point where the benefit of the tax deductibility of debt is
more than offset by increases in the cost of debt and the cost of equity that result from the
risk associated with the firm’s heavy use of debt.
" Signaling theory—most people agree that managers and other “insiders” possess more
information about the firm than outside investors. The fact that managers have asymmetric
information, which means they have some information that outside investors do not, could
mean that any action taken by a firm, including how it raises funds (capital), might provide a
signal to the less-informed investors. For example, studies have shown that when firms issue
new common stock to raise funds the per share value of the stock decreases. It has been
suggested that this occurs because managers would only issue new common stock if they felt
that the firm’s future prospects were unfavorable. Consider the fact that when new stock is
issued, new stockholders join the firm’s existing stockholders to share in any future changes
in value. Thus, if the firm’s future was extremely optimistic, managers would want to make
existing stockholders happy by allowing them to receive all of the increase in value that will
result from the favorable prospects, which means managers would choose to issue debt rather
than equity. When debt is issued, only the contracted costs need to be paid—that is, fixed
interest and the repayment of the debt—and the remaining gains from the favorable projects
accrue to the stockholders.
! Variations in Capital Structures among Firms—there are wide differences in capital structures
among firms in the United States. Much of the difference depends on the type of operations,
including the stability of sales, that is associated with the firm. For example, firms in industries
that have high degrees of research and development costs, such as pharmaceuticals, generally
have capital structures that contain lower proportions of debt than firms in industries that have
relatively stable, predictable cash flows, such as utilities.

! Capital Structures around the World—capital structures vary significantly around the world. In
countries where the debt is closely held so that the costs of monitoring firms are relatively low
(that is, where bank loans or syndicates are used), firms have greater proportions of debt than
firms in countries where debt is held by a large number of diverse investors. In countries where

## Capital Structure and Dividend Policy – 9

firms are required to regularly provide information about operations and finances to stockholders,
firms have greater proportions of equity than firms in countries where such information is not
required. In essence, whichever form of financing is more easily monitored by investors to ensure
their best interests are being followed by management is the one that is more prevalent in capital
structures.

! Chapter 9 Summary Questions—You should answer these questions as a summary for the
" What do we mean when we say that a firm's capital structure contains 40 percent debt?
How much equity must there be?

## " What does it mean to operate at the optimal capital structure?

" How do such factors as business risk, financial flexibility and risk, tax position, and
managerial attitude affect the capital structure of a firm?

" How can EBIT/EPS analysis and EPS indifference analysis help the financial manager with
such analyses?

## Capital Structure and Dividend Policy – 10

" If a firm currently is financed with equity only, how would you expect its cost of capital to
change as its capital structure is changed to included greater and greater proportions of
debt? When does adding more debt become detrimental?

" How can the concept of leverage be used to help a financial manager make decisions about
the capital structure of the firm?

" According to the trade-off theory of capital structure, what is the best way to finance a firm
(optimal capital structure)? Why?

" Does the signaling theory propose the same capital structure would be optimal? Why?

## Capital Structure and Dividend Policy – 11

" Why do the capital structures of firms vary so much among firms in different industries and
in different countries?

" Can decisions about the capital structure of a firm affect its capital budgeting decisions?
How?

Dividend Policy

Dividends are cash payments made to stockholders. Decisions about when and how much of earnings
should be paid as dividends is part of the firm’s dividend policy. Earnings that are paid out as
dividends cannot be used by the firm to invest in projects with positive net present values—that is, to
increase the value of the firm. The dividend policy that maximizes the value of the firm is said to be
the optimal dividend policy.

! Dividend Policy and Stock Value—researchers argue whether there exists an optimal dividend
policy. Some academicians argue that a firm’s dividend policy does not affect the value of a firm
(dividend irrelevance theory), while other argue that the dividend policy is an important factor in
the determination of a firm=s value (dividend relevance theory).

## ! Investors and Dividend Policy—investors’ reactions to changes in dividend policies can be

summarized as follows:
" Information content, or signaling—there is a belief that managers change dividends (increase
or decrease) only when it is necessary—that is, decreases occur only when the firm is facing
financial difficulty, while increases occur only when it is expected that the firm can continue
to pay higher dividends long into the future. If this is true, then changes in a firm’s dividend
policy provide information to investors, who will react accordingly. For example, investors
would consider an increase (decrease) in dividends to be good (bad) news, and thus increase
(decrease) the price of the firm’s stock.
" Clientele effect—investors might choose a particular stock due to the firm’s dividend
policy—that is, some investors prefer dividends and others do not. If such a clientele effect
does exist, then we would expect that a firm’s stock price will change when its dividend
policy is changed.
" Free cash flow hypothesis—if investors truly want managers to maximize the value of the
firm, then dividends should be paid only when the firm has no investments with positive net

## Capital Structure and Dividend Policy – 12

present values. In other words, a firm should pay dividends only when it has funds that are
not needed to invest in positive NPV projects—that is, only free cash flows should be paid as
dividends. If this theory is correct, then we might expect a firm’s stock price to increase when
it decreases dividends to invest in positive NPV projects, and we might expect the stock price
to decrease when the firm increases dividends because it no longer has as many positive NPV
projects as it did in prior years.

! Dividend Policy in Practice—procedures that are followed in practice include the following:
" Types of dividend payments
# Residual dividend policy—as an investor, you should want the firm to retain any earnings
it can invest at a rate of return that is at least as high as your opportunity cost. Firms that
agree with this concept might follow a residual dividend policy where dividends are paid
only if earnings are greater than what is needed to finance the equity portion of the firm’s
optimal capital budget for the year. Therefore, if the residual dividend policy is followed,
the firm should not pay dividends when it is necessary to issue new common stock to
provide equity financing for the current capital budgeting needs.
# Stable, predictable dividends—some managers believe that dividends should never be
decreased unless it is absolutely necessary. These managers probably follow a stable,
predictable dividend policy, which requires that the firm pays a dividend that is the same
every year or is constant for some period and then is increased at particular intervals—
that is, dividend payments are fairly predictable. Greater predictability is associated with
greater certainty and lees risk, which implies a lower overall WACC and a higher firm
value. In practice, more firms actually follow some form of this dividend policy.
# Constant payout ratio—a firm’s dividend payout ratio is defined as the proportion of
earnings per share (EPS) that is paid out as dividends (DPS)—that is, payout ratio =
DPS/EPS. Firms that follow a constant payout ratio dividend policy pay the same
percentage of earnings as dividends each year. For example, a firm might pay 60 percent
of its earnings as dividends. If so, then dividends will fluctuate as earnings fluctuate.
# Low regular dividend plus extras—requires a firm to pay some minimum dollar dividend
each year and then to pay an extra dividend when the firm’s performance is above normal
(or above some minimum standard)
" Payment procedures—dividends are usually paid quarterly. The following dates are important
when establishing a dividend policy:
1. Declaration date—the date the board of directors states that a dividend will be paid to
stockholders. A dividend is not a liability to the firm until it is declared.
2. Holder-of-record date—the date the firm “opens” its ownership books to determine who
will receive dividends. Persons whose names appear in the ownership books after the
holder-of-record date, which is also called the date of record, but prior to the date the
dividend is paid will not receive a dividend payment.
3. Ex-dividend date—two working days before the holder-of-record date. Ex dividend means
without dividend; so, on the ex-dividend date, the stock begins to sell without the right to
receive the next dividend payment. In essence, the stock sells without the right to receive
the dividend payment because there is not enough time for the names of new stockholders
to be registered before the holder-of-record date.
4. Payment date—the date the firm mails the dividend checks.

## Capital Structure and Dividend Policy – 13

" Dividend reinvestment plans—plans that permit stockholders to have dividend payments
automatically reinvested in the firm’s stock. Dividend reinvestment plans, which are referred
to as DRIPs, allow stockholders to buy additional shares of a firm’s stock on a pro rata basis
using the cash dividend paid by the firm. Often there are little or no brokerage fees involved
with DRIPs.

! Dividend Policies around the World—there is great variation in dividend policies of firms in
different parts of the world. In most parts of the world, dividend policies are based on local tax
laws. For example, in countries where the tax on capital gains is less than the tax on dividends,
firms tend to retain greater amounts of earnings than in countries where the tax on dividends is
relatively small. Also, in countries that have few regulations to protect small stockholders,
companies tend to pay greater amounts of earnings as dividends.

! Factors Influencing Dividend Policy—when developing a dividend policy, the following factors
should be considered:
1. Constraints on dividend payments—the amount of dividends a firm pays might be limited by:
(a) restrictions in debt agreements that state the maximum amount of dividends that can be
paid in any year; (b) the amount of retained earnings, which represents the maximum amount
of dividends that can be paid at any time; (c) the liquidity position of the firm—if cash is not
available, dividends cannot be paid; and (d) limits of the IRS on the amount of earnings a
firm can retain for non-specific reasons.
2. Investment opportunities—firms that need great amounts of funds for positive NPV
investments usually pay relatively lower amounts of dividends than firms with few positive
NPV investments.
3. Alternative sources of capital—the higher the costs of issuing new common stock, generally
the lower the relative amount of dividends paid by a firm; firms that are concerned about
diluting current ownership through new issues of common stock are likely to pay relatively
low dividends.
4. Effects of dividend policy on ks—in an effort to minimize its WACC through the cost of
equity, ks, a firm will examine the effect a dividend policy has on its required rate of return.
Factors such as risk perception, information content (signaling), and preference for current
returns versus future returns (that is, dividend yield or capital gains) are considered when the
dividend policy is established.

! Stock Splits and Stock Dividends—to this point, we have examined the dividend policy that
relates to cash payments. Some firms pay dividends in the form of stock or change the number of
shares of stock that is outstanding through a stock split. As you will discover in the discussion
that follows, neither of these actions by themselves has economic value in the sense that each
does nothing to change stockholders’ wealth.
" Stock splits—an action taken by a firm to change the number of outstanding shares of stock.
Many firms believe their stock has an optimal price range within which their stock should
trade. If the price of the stock exceeds the price range, then the firm will execute a stock split.
If a firm initiates a 2-for-1 stock split, each existing stockholder will receive two shares of
stock for each one share he or she now owns. This action should cut the market price of the
stock exactly in half. But, there is evidence that shows the price of the stock actually settles

## Capital Structure and Dividend Policy – 14

above one half the pre-split price. Perhaps the reason this occurs is because investors believe
the split provides positive information; specifically that the firm expects the price of the stock
to increase further above the optimal range in the future. In any event, there really is no
specific economic value associated with a stock split. As an investor, unless the market reacts
positively or negatively to the split, the only effect the split has is to increase the number of
shares of stock you own, with each share valued at a lower relative price such that your
wealth position has not changed.
" Stock dividends—dividends paid in the form of stock rather than cash. Like stock splits, a
stock dividend does not have specific economic value; rather, it increases the total number of
shares of stock each stockholder owns. At the same time, the stock price per share decreases
because investors have not provided any funds for the additional shares of stock. A firm
might use a stock dividend to keep the price of its stock within a particular range.
" Balance sheet effects—for stock splits, the only effect on the balance sheet is that the number
of shares outstanding changes relative to the split, which also changes the stated par value of
the stock (if there is one). If a firm executes a 2-for-1 split, for example, it would double the
number of shares outstanding and halve the par value of the stock reported on the balance
sheet. The total dollar values in each common equity account would not change. When a
stock dividend is paid, on the other hand, the firm must transfer capital from retained
earnings to the “Common stock” account and the “Additional paid-in capital” account to
reflect the fact that a dividend was paid. The transfer from retained earnings is computed as
follows:

## Funds transferred = ⎡⎛ Number of shares ⎞×⎛ Stock dividend ⎞⎤ ×⎛ Market price ⎞

from retained earnings ⎢⎣⎜⎝ outstanding ⎟⎠ ⎜⎝ as a percent ⎟⎠⎥⎦ ⎜⎝ of the stock ⎟⎠

To illustrate, consider a firm that decides to pay a 5 percent stock dividend. The market price
of the firm’s stock is \$80 and it has 20 million shares of \$2 par stock outstanding before the
stock dividend. According to the above equation, the amount transferred would be:

## Transfer from = [(20,000,000 )× (0.05)]×\$80 =1,000,000×\$80 = \$80,000,000

retained earnings

After the stock dividend, the firm would show \$80 million less in retained earnings. In the
common equity portion of the its balance sheet, there would now be 21 million shares of
stock outstanding (20 million existing shares plus one million shares associated with the
stock dividend), the “Common equity” account would increase by \$2 million (1 million
shares × \$2 par), and the “Additional paid-in capital” would increase by \$78 million (\$80
million less that \$2 million increase in “Common equity”).
" Price effects—even though both stock splits and stock dividends only increase the number of
outstanding shares of stock, studies have shown that the market price of the stock affected by
such actions might change—if investors expect future earnings and cash dividends to
increase (decrease), then the price will increase (decrease) above the relative price associated
with the stock split or the stock dividend. For example, if investors believe a firm initiated a
2-for-1 stock split because its future earnings will cause the price of the stock to increase well
above its optimal range, then their reaction to the split will cause the post-split price of the

## Capital Structure and Dividend Policy – 15

stock to be greater than one half the pre-split price. If the future expectations do not pan out,
however, the price of the stock will eventually settle at about one half the pre-split price.

! Chapter 10 Summary Questions—You should answer these questions as a summary for the
" What does it mean to have an optimal dividend policy?

" How do the concepts of information content (signaling), the clientele effect, and the free
cash flow hypothesis affect dividend policy decisions?

" What dividend policies are followed in practice? Explain each practice.

" All else equal, which dividend policy probably results in the highest value for a firm's stock
if managers and investors have the same (symmetrical) information? Why?

## Capital Structure and Dividend Policy – 16

" Which dividend policy probably results in the highest value if managers and investors have
asymmetrical information? Why?

" What are the important dates associated with paying dividends?

## # Why is the ex-dividend date date important to stockholders?

" How do such factors as restrictions in debt agreements, capital budgeting opportunities,
availability of alternative sources of financing, and concern for the firm's cost of capital
affect dividend policy decisions?

" What are stock splits and stock dividends and what economic impact do they have?

" How do stock splits and stock dividends affect a firm’s balance sheet?