Cost of Capital,

Capital Structure &

Dividend Policy

AFABLE | DEDASE | LOS BAÑOS

 Table of Contents

1 2

Required Returns Operating and

and Cost of Capital Financial Leverage

3 4

Capital Structure Dividend Policy

Determination
1 Required
Return and
the Cost of
Capital
 REQUIRED RETURN AND COST OF CAPITAL

1 CREATION OF VALUE

2 OVERALL COST OF CAPITAL OF THE FIRM

3 THE CAPITAL ASSET PRICING MODEL

4 REQUIRED RATE OF RETURN SPECIFIC TO PROJECT AND GROUP

CREATION OF
VALUE
 CREATION OF VALUE

If the return on a project exceeds what

the financial markets require, it is said to
earn an excess return. This excess
return, as we define it, represents the
creation of value.
VALUE CREATION SOURCES

INDUSTRY ATTRACTIVENESS
Relative position of an industry in the spectrum of value-creating
investment opportunities.
- Positioning in the growth phase of a product cycle
- Barriers to competitive entry
- Other protective devices (patents, temporary monopoly power,
and/or oligopoly pricing)

COMPETITIVE ADVANTAGE
Company’s relative position within an industry.
- Cost advantage
- Marketing and price advantage
- Perceived quality advantage
- Superior organizational capability (corporate culture)
KEY SOURCES OF VALUE CREATION
COST OF
CAPITAL
 COST OF CAPITAL

The overall cost of capital of a firm is a proportionate average of the costs of the
various components of the firm’s financing.

Cost of equity capital

1 The required rate of return on investment of the common shareholders of the company.

Cost of debt
2 The required rate of return on investment of the lenders of a company.

Cost of preferred stock

3
The required rate of return on investment of the preferred shareholders of the company.
 WHAT IS IT, REALLY?
The cost of capital is the firm’s required rate of return that will just satisfy all
capital providers.

Assume that you opened an Ube Cheese Pandesal (UCP) business and borrow some money
from two friends at two different costs, then add some of your own money:
● Gary - $2,000
● Anna - $3,000
● You - $5,000

with the expectation of at least a certain minimum return, and seek out an investment:
● Gary - 5%
● Anna - 10%
● You - 15%

What is the minimum return you can earn that will just satisfy the return expectations of all
capital providers?
 COMPUTATION

(1) (2) (3) (2) x (3) (1) x (2)

CAPITAL INVESTED % ANNUAL PROPORTION WEIGHTED ANNUAL

PROVIDERS CAPITAL COST OF TOTAL COST COST
(USD) (INVESTOR FINANCING (INVESTOR
RETURN) RETURN,
USD)

GARY 2,000 5% 20% 1.0% 100

ABBY 3,000 10% 30% 3.0% 300

YOU 5,000 15% 50% 7.5% 750

10,000 100% 11.5% 1,150

 ON A FIRM’S PERSPECTIVE

(1) (2) (3) (2) x (3) (1) x (2)

TYPE OF INVESTED % ANNUAL PROPORTION WEIGHTED ANNUAL

FINANCING CAPITAL COST OF TOTAL COST COST
(USD) (INVESTOR FINANCING (INVESTOR
RETURN) RETURN,
USD)

DEBT 2,000 5% 20% 1.0% 100

PREFERRED 3,000 10% 30% 3.0% 300

STOCKS

COMMON 5,000 15% 50% 7.5% 750

STOCK

10,000 100% 11.5% 1,150

 OVERALL COST OF CAPITAL

DEBT (ki) PREFERRED EQUITY (ke)

STOCK (kp)
 COST OF DEBT

The required rate of return on investment of the lenders of a company. Focused on non-
seasonal debt that bears an explicit interest cost:
- For the most part, our concern is with long-term debt.
- Continuous short-term debt, such as an accounts-receivable-backed loan, also
qualifies. (A bank loan to finance seasonal inventory requirements would not qualify.)

We ignore:
- Accounts payable
- Accrued expenses
- Other obligations not having an explicit interest cost

The assumption is that the firm is following a hedging (maturity matching) approach to
project financing. That is, the firm will finance a capital project, whose benefits extend over a
number of years, with financing that is generally long term in nature.
DISCOUNT RATE (YIELD TO MATURITY)
Where:
P0= the current market price of the debt issue
Σ = the summation for periods 1 through n
N = the final maturity
t = the period
It = the interest payment in period t
Pt = the payment of principal in period t
kd = the discount rate

If the payments occur only at final maturity, only

Pn will occur
AFTER-TAX COST OF DEBT

Where:
ki= the after-tax cost of debt
kd = the discount rate
t = the company’s marginal tax rate
COST OF DEBT COMPUTATION

Assume that UCP has $1,000 par value zero-coupon bonds outstanding. UCP bonds are
currently trading at $385.54 with 10 years to maturity. UCP tax bracket is 40%.

$385.54 = $0 + $1,000 .
(1 + kd)10

(1 + kd)10 = $1,000/$385.54
(1 + kd)10 = $2.5938
1 + kd = $2.5938(1/10)
1 + kd = 1.1
kd = 0.1 or 10%
COST OF DEBT COMPUTATION

Assume that UCP has $1,000 par value zero-coupon bonds outstanding. UCP bonds are
currently trading at $385.54 with 10 years to maturity. UCP tax bracket is 40%.

ki = kd(1-t)

ki = 0.1(1-0.4)

ki = 0.06 or 6%
 COST OF PREFERRED STOCK

Cost of preferred stock is the required rate of return on investment of the preferred
shareholders of the company.

Where:
DP= the stated annual dividend
P0 = current market price of the preferred stock
COST OF PREFERRED STOCK COMPUTATION
Assume that UCP has preferred stock outstanding with par value of $100, dividend
per share of $6.30, and a current market value of $70 per share.

kp = $6.30 / $70

kp = 0.09 or 9%
 COST OF EQUITY
● The cost of equity capital is by far the most difficult cost to measure.

● Equity capital can be raised either internally by retaining earnings or

externally by selling common stock.

1 Capital Asset Pricing Model (CAPM)

2 Before Tax Cost of Debt + Risk Premium

 DIVIDEND DISCOUNT MODEL (DDM)
The cost of equity capital, ke, is the discount rate that equates the present value of all
expected future dividends with the current market price of the stock.

Where:
P0 = the market price of a share of stock at time 0
Dt = the dividend per share expected to be paid at the end of
time period t
ke = the appropriate discount rate
Σ = the sum of the discounted future dividends from period 1
through infinity, depicted by the symbol ∞.
 DIVIDEND DISCOUNT MODEL

1 Constant Growth Model

2 Growth Phases Model

 DDM: CONSTANT GROWTH MODEL

The constant dividend growth assumption reduces the model to:

Where:
P0 = the market price of a share of stock at time
0
D1 = the current dividend per share
ke = the appropriate discount rate
g= the dividend growth rate

Assume that dividends will grow at the

constant rate g forever.
CONSTANT GROWTH MODEL COMPUTATION

Assume that UCP has common stock outstanding with a current market value of
$64.80 per share, current dividend of $3 per share, and a dividend growth rate of 8%
forever.

ke = (D1/P0) + g

ke = ($3(1.08)/$64.80) + 0.8

ke = .05 + .08
ke = .13 or 13%
 DDM: GROWTH PHASES MODEL
If the growth in dividends is expected to taper off in the future, the constant growth
model will not do. The growth phases model leads to the following formula:

Where:
P0 = the market price of a share of stock at time 0
D1 = the current dividend per share
ke = the appropriate discount rate
g= the dividend growth rate

Assume that dividends will grow at the constant rate g forever.

THE CAPM
 CAPITAL ASSET PRICING MODEL (CAPM)
The CAPM requires the following required rate of return, Rj, for a share of common
stock:

Where:
Rj = the rate of return for a share of a common stock
Rf = the risk-free rate
R m = the expected return for the market portfolio
βj = the beta coefficient for stock j.
 BETA

Beta is a measure of the responsiveness of the excess

β
returns for a security (in excess of the risk-free rate)
to those of the market, using some broad-based
index, such as the S&P 500 Index as a surrogate for
the market portfolio.
 BETA

To free us of the need to calculate, there are providers of historical beta information on
a large number of publicly traded stocks:

● Value Line Investment Survey

● Standard & Poor’s Stock Reports
● Reuters

These services allow us to obtain the beta for a stock with ease, thereby greatly
facilitating the calculation of the cost of equity capital.
CAPM COMPUTATION

Assume that UCP has a company beta of 1.25. Research suggests that the risk-free
rate is 4% and the expected return on the market is 11.2% .

Rj = 4% + (11.2%-4%)1.25
Rj = 4% + 9%
Rj = .13 or 13%
 BEFORE TAX COST OF DEBT + RISK PREMIUM
The cost of capital, ke, is the sum of the before tax cost of debt and a risk premium in
expected return for common stock over debt.
 SECURITY MARKET LINE

Because of the market’s aversion to systematic risk, the greater the beta of a stock,
the greater its required return.

The risk-return relationship is described by this equation is known as the security

market line.

It implies that in market equilibrium, security prices will be such that there is a linear
trade-off between the required rate of return and systematic risk, as measured by
beta.
SECURITY MARKET LINE
COMPUTATION

Assume that UCP typically adds a 3% premium to the before tax cost of debt.

ke = 10% + 3%

ke = .13 or 13%
 OVERALL COST OF CAPITAL

DEBT (ki) PREFERRED EQUITY (ke)

STOCK (kp)

=6% =9% =13%

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Once we have computed the costs of the individual components of the firm’s financing,
we would assign weights to each financing source according to some standard and then
calculate a weighted average cost of capital (WACC).

Where:
kx = the after-tax cost of the xth method of financing
Wx = the weight given to that method of financing as a percentage of the firm’s total financing
Σ = the summation for financing methods 1 through n.
 COST OF CAPITAL

TYPE OF COST (%) TYPE OF PROPORTION OF

FINANCING FINANCING TOTAL FINANCING

DEBT 6%
DEBT 20%
PREFERRED 9%
STOCKS PREFERRED 30%
STOCKS
COMMON 13%
STOCK COMMON STOCK 50%
 COST OF CAPITAL

(1) (2) (1) x (2)

TYPE OF FINANCING COST (%) PROPORTION OF WEIGHTED COST

TOTAL FINANCING

DEBT 6% 20% 1.2%

PREFERRED STOCKS 9% 30% 2.7%

COMMON STOCK 13% 50% 6.5%

100% 10.4%
 WACC LIMITATIONS: WEIGHTING SYSTEM

MARGINAL COST
Because the firm raises capital marginally to make marginal investments in new
projects, we need to work with the marginal cost of capital for the firm as a
whole.

CAPITAL RAISED IN DIFFERENT PROPORTIONS THAN WACC

Raising capital is “lumpy,” and strict proportions cannot be maintained.
 WACC LIMITATIONS: FLOTATION COST

Flotation costs are the costs incurred by a company in offering its securities to the
public such as underwriting, legal, listing, and printing fees.

It is involved in the sale of debt instruments, preferred stock, or common stock affect
the profitability of a firm’s investments.

1 Adjustments to Initial Outlay (AIO)

2 Adjustments to Discount Rate (ADR)

 ADJUSTMENT TO INITIAL OUTLAY

Where:
CFt = the project cash flow at time t
ICO = the initial cash outlay required for the project
k = the firm’s cost of capital
AIO COMPUTATION

Suppose that an investment proposal costs $100,000 and that to finance the
project the company must raise $60,000 externally. Both debt and common stock
are involved, and aftertax flotation costs (in present value terms) come to $4,000.
Therefore $4,000 should be added to $100,000, bringing the total initial outlay to
$104,000. In this way, the proposal is properly “penalized” for the flotation costs
associated with its financing. The expected future cash flows associated with the
project are then discounted at the weighted average cost of capital. If the project
were expected to provide annual after-tax cash inflows of $24,000 for 20 years and
the weighted average cost of capital were 20 percent, the project’s net present
value would be:
AIO COMPUTATION

NPV = $24,000(PVIFA20%,20) − $104,000

NPV = $116,870 − $104,000
NPV = $12,870

This amount contrasts with a net present value of $116,870 − $100,000 = $16,870 if no adjustment
is made for flotation costs.
 ADJUSTMENT TO DISCOUNT RATE

● Each component cost of capital would be recalculated by finding the discount

rate that equates the present value of cash flows to the suppliers of capital with
the net proceeds of a security issue, rather than with the security’s market
price.

● The resulting “adjusted” component costs would then be weighted and

combined to produce an overall “adjusted” cost of capital for the firm. The
“adjusted” cost of capital figure thus calculated will always be greater than the
“unadjusted” cost of capital figure, which we have described in this chapter.
 AIO VS ADR

AIO ADR

Add Flotation Cost (FC) Subtract FC from the proceeds (price) of the
to the Initial Cash Outlay security and recalculate yield figures
(ICO)
Impact: Increases the cost for any capital
Impact: Reduces the NPV component with flotation costs

Result: Increases the WACC, which decreases

the NPV
 ECONOMIC VALUE ADDED (EVA)

● Another way of expressing the fact that to create value a company must earn
returns on invested capital greater than its cost of capital is through the
concept of Economic Value Added (EVA).

● Trademarked name for a specific approach to calculating economic profit

developed by the consulting firm of Stern Stewart & Co.

● EVA is the economic profit a company earns after all capital costs are deducted.
 EVA COMPUTATION

Infosys Technologies Limited, one of India’s largest Information Technology companies,

follows a Stern Stewart & Co. style approach to EVA. Based on figures reported in Infosys
Technologies 2007 annual report, here is a condensed version of their EVA calculation
for fiscal year 2007:

EVA = Net operating profit after taxes - (Average capital employed × Cost of capital)
 EVA COMPUTATION

(In millions of Indian Rupees – Rs.)

Net operating profit after taxes Rs. 34,910

Less: Average capital employed × Cost of

capital

Rs. 94,170 × 14.97% 13,690

EVA Rs. 21,220

This says that Infosys Technologies earned roughly Rs. 21,220 million more in profit than
is required to cover all costs, including the cost of capital. Since a cost is charged for
equity capital, a positive EVA generally indicates shareholder value is being created.
 STRENGTH OF ECONOMIC VALUE ADDED

EVA’s strength comes from its explicit recognition that a firm is not really creating
shareholder value until it is able to cover all of its capital costs.

In short, a firm showing a positive accounting profit could actually be destroying

value because shareholders might not be earning their required return.

● a positive EVA value generally indicates that shareholder value is being created.
● A negative EVA value suggests value destruction.
PROJECT ACCEPTANCE AND/OR REJECTION
 DETERMINING PROJECT-SPECIFIC RATE OF
RETURN

1. Calculate the required return for equity-financed project

Where:
βk = the slope of the characteristic line that describes the relationship between excess
returns for project k and those for the market portfolio.

As can be seen, the right-hand side of this equation is identical to that of (CAPM Rj) except for the
substitution of the project’s beta for that of the stock. Rk, then, becomes the required return for the
project, which compensates for the project’s systematic risk.
 DETERMINING PROJECT-SPECIFIC RATE OF
RETURN

2. Adjust the financing structure of the firm (financing weights).

COMPUTATION
Assume a computer networking project is being considered with an IRR of 19%.
Examination of the firms in the networking industry allows us to estimate an all-equity
beta of 1.5. Our firm is financed with 70% equity and 30% debt at ki = 6%. The expected
return on the market is 11.2% and the risk-free rate is 4%. Will you accept the project?

Rk = 4% + (11.2% - 4%)1.5
Rk = 4% + 10.8%
Rk = 14.8%
 WACC COMPUTATION

WACC = .30(6%) + .70(14.8%)

WACC = 1.8% + 10.36%

WACC = 12.1%

IRR = 19%

IRR that is greater than or equal to the firm's cost of

IRR > WACC capital should be accepted.
 GROUP-SPECIFIC REQUIRED RATE OF
RETURN

Rather than determine project-specific required returns, some companies categorize

projects into roughly risk-equivalent groups and then apply the same
CAPM-determined required return to all projects included within that group.

ADVANTAGES:
● It is not as time-consuming as computing required returns for each project.
● It is often easier to find proxy companies for a group than it is for individual
projects.
GROUP-SPECIFIC REQUIRED RATE OF
RETURN

● The horizontal bars represent the

required returns, or hurdles, for four
different groups.
● The cost of capital for the firm as a
whole is depicted by the dashed line.
● Projects from a group that provide
expected returns above their
group-specific bar should be
accepted.
● Those below their respective bars
should be rejected.
Operating
and
Financial
Leverage
 Operating and Financial Leverage

OPERATING LEVERAGE TOTAL LEVERAGE

FINANCIAL LEVERAGE CASH-FLOW ABILITY TO

SERVICE DEBT

OTHER METHODS OF ANALYSIS

 Operating Leverage

1 Break-Even Analysis
Costs
Degree of Operating
2
Leverage (DOL) Production of
Goods and
DOL and Services
3
Break-Even Point

DOL and Business

4 Risk
Break-Even Analysis

Measures at which
point the company’s
Total Sales is equal
to its Total Cost
 Break-Even Analysis
Formula (in units): Formula (in sales):

= Fixed Costs . = Fixed Costs .

SP - VC Contribution Margin
(CM)

Where : Where :
SP - Selling Price per unit Contribution Margin is equal to
VC - Variable Cost per unit (Sales- Variable Cost)/ Sales
 Sample Computation (in Units)
Given (in USD):
BE (in units)= Fixed Costs .
Fixed Cost 100,000 SP - VC
BE = $100,000 .
Selling Price 50
$50- $25
Variable Cost 25 BE = 4,000 units
 Sample Computation (in Sales)
Given (in USD):
BE (in Sales)= Fixed Costs .
Fixed Cost 100,000 CM
BE = $100,000 .
Selling Price 50
($50- $25)/$50
Variable Cost 25 BE = $100,000 .
50%
BE = $200,000
 Sample Computation (in Sales)
Given (in USD):
BE (in Sales)= Fixed Costs .
Fixed Cost 100,000 CM
BE = $100,000 .
Selling Price 50
($50- $25)/$50
Variable Cost 25 BE = $100,000 .
50%
BE = $200,000
 Degree of Operating Leverage

Higher DOL
> % change in sales means greater
Measures
impact in % change of EBIT sensitivity of a
firm’s operating
profit to a change
Lower DOL
> % change in sales means minimal
in a firm’s sales
impact in % change of EBIT
 Degree of Operating Leverage

Formula Where :
Q - no. of units
P - price per unit
= Q(P-V) . V - Variable Cost per unit
FC - Fixed Cost
Q(P-V)-FC
 Sample Computation (in Units)
Given (in USD):
DOL (in units)= Q(P-V) .
Fixed Cost 100,000 Q(P-V)-FC
DOL = 5,000 ($50-$25) .
Selling Price 50
5,000($50-$25)-$100,000
Variable Cost 25 DOL = 125,000 .
125,000-100,000
No. of Units 5,000
DOL = 5
 Sample Computation (in Units)
Given (in USD):
DOL (in units)= Q(P-V) .
Fixed Cost 100,000 Q(P-V)-FC
DOL = 6,000 ($50-$25) .
Selling Price 50
6,000($50-$25)-$100,000
Variable Cost 25 DOL = 150,000 .
150,000-100,000
No. of Units 6,000
DOL = 3
DOL (5,000 units) = 5

> Interpretation:
Any 1 % change in sales from the 5,000-unit sales
causes a 5% change in EBIT

DOL (6,000 units) = 3

> Interpretation:
Any 1 % change in sales from the 6,000-unit sales
causes a 3% change in EBIT
DOL and Break-Even Point

Closeness to break-even
point means higher
sensitivity of operating
profits to changes in sales
DOL and Business Risk

High DOL does not mean

High Business Risk,

but can be viewed as

“potential risk” or
“potential opportunity”
 Financial Leverage

EBIT-EPS Break-Even or
1
Indifference, Analysis
Capital

Degree of Financial
2
Leverage (DOL)
Debt

3 DFL and Financial Risk

EBIT-EPS Break-Even/
Indifference, Analysis

Analysis of effect of
financing
alternatives on
earnings per share
(EPS)
 EBIT-EPS Break-Even or
Indifference, Analysis
1 2
Calculation of
EBIT- EPS Chart
Earnings per Share

3 4
Indifference Point
Effect on Risk
Determined
Mathematically
 EBIT-EPS Break-Even/
Indifference, Analysis
Corporate X with $10M Common Stock Equity

“I want to raise another $5M for expansion!”

BUT HOW?

1. All Common Stock ($50/share; 100K shares)

2. All Debt @ 12 % interest
3. All Preferred Stock with an 11% dividend
 EBIT-EPS Break-Even/
Indifference, Analysis
Corporate X with $10M Common Stock Equity

Present Annual EBIT at $1.5M,

but with expansion expected to rise to

$2.7M

Income Tax Rate - 40%

O/S Shares of Common Stock - 200,000
 EBIT-EPS Break-Even/
Indifference, Analysis
Corporate X with $10M Common Stock Equity

If through 1st Choice (All Common Stock),

Shares can be sold at $50/share

At 100,000 shares
NOTE!

> Interest on debt is deducted BEFORE taxes

while

> Preferred Stock Dividends are deducted AFTER taxes

Calculation of Earnings per Share
Formula:

EPS = (EBIT - I) (1-t) - PD .

NS

Where :
I - Annual Interest Paid
PD - Annual Preferred Dividend Paid
t - Corporate tax rate
NS - No. of shares of common stock O/S
EBIT - EPS Chart
 Indifference Point
Determined Mathematically
Formula:

(EBIT1,2 - I1) (1-t) - PD1 .= (EBIT1,2 - I2) (1-t) - PD2

.
NS1 NS2

Where :
EBIT - EBIT Indifference Point between two alt. fin. methods (e.g. Option 1&2)
1,2
I I - Annual Interest Rate Paid under fin methods Option 1&2
1, 2
t - Corporate tax rate
NS NS - No. of shares of common stock O/S under fin methods Option 1&2
1, 2
 Sample Computation
Common Stock Debt

(EBIT1,2 - I1) (1-t) - PD1 .= (EBIT1,2 - I2) (1-t) - PD2 .

NS1 NS2

(EBIT1,2 - 0) (1-.40) - 0 .= (EBIT1,2 - 600,000) (1-0.40) - 0 .

300,000 200,000
 Sample Computation

(EBIT1,2) (.60) (200,000) .= (EBIT1,2) (.60) (300,000)- (0.60) ($600,000) (300,000)

(EBIT1,2)(60,000)= $108,000,000,000

EBIT1,2 = $1,800,000
The EBIT-EPS indifference point,

where EPS for the two methods of financing are the

same,

is at $1.8M.
 Effect on Risk

For risky (flat) distribution:

There is significant probability that EBIT will fall below the
indifference point; hence, DEBT OPTION IS TOO RISKY.

For safe (peaked) distribution:

There virtually no probability that EBIT will fall below the
indifference point; hence, DEBT SHOULD BE USED
Degree of Financial Leverage

Measure of the sensitivity

of a firm’s Earnings per
Share (EPS) to a change
in the firm’s
Operating Profit (OP)
 Degree of Financial Leverage

Formula Where :
I - Annual Interest Paid
PD - Annual Preferred Dividend
= EBIT . Paid
EBIT-I-[PD/(1-t)] t - Corporate tax rate
Sample Computation (For Debt-Financing)
Given (in USD):
DFL = EBIT .
Amt to be Raised 5,000,000 EBIT-I-[PD/(1-t)]
EBIT (post-exp) 2,700,000
DFL = $2,700,000 .
Interest Rate 12% $2,700,000 - $600,000

DFL = 1.29
Sample Computation (For Preferred Fin.)
Given (in USD):
DFL = EBIT .
Amt to be Raised 5,000,000 EBIT-I-[PD/(1-t)]
EBIT (post-exp) 2,700,000
DFL = $2,700,000 .
Dividend Rate 11% $2,700,000 - [$550,000/(0.60)]
Income Tax 40%
DFL = 1.51
DFL and Financial Risk

Total Firm Risk =

Business Risk + Financial Risk

DFL magnifies Risk.

Total Leverage

Combining
Financial Leverage with
Operating Leverage;
2-step magnification
 Total Leverage

Degree of Total Leverage

1
(DTL) Operating
Leverage
Production of
Financial
Goods and
Leverage Services
2 DTL and Total Firm Risk
Degree of Total Leverage (DTL)

Measures total
sensitivity of a firm’s
earnings per share
to a change in the
firm’s sales
 Degree of Total Leverage
Formula (thru units): Formula (thru sales):

= Q(P-V) . = EBIT+FC .
Q(P-V)-FC-I-[PD/(1-t)] EBIT-I-[PD/(1-t)]

Where :
Q - no. of units I - Annual Interest Paid
P - price per unit PD - Annual Preferred Dividend Paid
V - Variable Cost per unit t - Corporate tax rate
FC - Fixed Cost
 Sample Computation (in Units)
$200K Debt @ 8% IR $16,000

Interest Rate 8% DTL (in units)= Q(P-V) .

Dividend Rate 11% Q(P-V)-FC-I-[PD/(1-t)]
Income Tax 40%

Selling Price $50 DTL = 8,000($50-$25) .

Variable Cost $25 8,000($50-$25)-$100,000-$16,000
Fixed Costs $100,000

Income Tax Rate 40% DTL = 2.38x

No. of Units 8,000
 Sample Computation (in Sales)
$200K Debt Amt@ 8% IR $16,000

Interest Rate 8% DTL (in Sales)= EBIT+FC .

Dividend Rate 11% . EBIT-I-[PD/(1-t)
Income Tax 40%

Selling Price $50 [8,000($50-$25)-$100,000]+$100,000

Variable Cost $25 [8,000($50-$25)-$100,000]-$16,000
Fixed Costs $100,000 = 200,000
Income Tax Rate 40% 84,000
No. of Units 8,000
DTL = 2.38x
DTL (8,000 units) = 2.38

> Interpretation:
Any 1 % change in no. of units produced and sold
will result in a 2.38 % increase in earnings per share.
DTL and Total Firm Risk

Proper overall level of firm risk

involves trade-off between total
firm risk and expected return.

Objective:
Maximizing shareholder value
Cash-Flow Ability to Service Debt

Analysis of cash-flow
ability of the firm to
service fixed financial
charges
 Cash-Flow Ability to Service Debt

1 2

Coverage Ratios Debt-Service Coverage

 Coverage Ratios

1) Interest Coverage Ratio: 2) Debt-Service Coverage

= EBIT . = EBIT .
Interest Expense Interest Expense + Prin. Payment .
(1- Tax Rate)
 Sample Computation
(Interest Coverage Ratio)
Given (in USD):
ICR = EBIT .
EBIT 6,000,000 Interest Expense
Interest Expense 1,500,000 = 6,000,000 .
1,500,000
= 4.0x
Interest Coverage Ratio= 4.0x

> Interpretation:
EBIT can cover interest charges by 4 times.

Or that

EBIT can drop as much as 75% and the firm will still
be able to cover interest payments from earnings
 Sample Computation
(Debt-Service Coverage)
Given (in USD):
DSC = EBIT .
EBIT 6,000,000 Interest Expense + Prin. Payment
Interest Expense 1,500,000 (1- Tax Rate)
= $6,000,000 .
Principal Payment 1,000,000 $1,500,000+ 1,000,000
Income Tax Rate 40% (1- 0.4)
= 1.89x
Debt Service Coverage = 1.89x

> Interpretation:
EBIT can cover interest and annual principal
by 1.89 times.

Or that

EBIT can drop as much as 47% and the firm will still
be able to cover interest payments from earnings
Probability of Cash Insolvency

Coverage Ratios only tell one

part of the story.

- Deviation of funds
- Undermined Cash Outflows
 Other Methods of Analysis

1 Comparison of Capital Structure Ratios

Operating

2 Surveying Investment Analyst and Lenders

3 Security Ratings
Comparison of Capital Structure Ratios
Surveying Investment Analysts and Lenders

- Investment Analysts

- Institutional Investors

- Investment Bankers
Security Ratings
Capital
Structure
Determination
 Definition

Capital Structure is the

mix (or proportion) of a
firm’s permanent
long-term financing
represented by debt,
preferred stock, and
common stock equity.
 A Conceptual Look

1 2 3
Capital Structure is We should not be Changes in the
concerned on how a confused on any effects financing mix are
firm can affect its total of a change in the assumed to occur by
valuation (debt plus financing mix with the issuing debt and
equity) and its cost of results of investment or repurchasing common
capital by changing its asset management stock or by issuing
financing mix. decisions made by the common stock and
firm. retiring debt.
 Rates of Return

1
I Annual Interest on Debt
Ki =
B Market Value of Debt Outstanding

2
E Earnings available to common shareholder
Ke =
S Market value of common stock outstanding

3
O Net Operating Income
Ko =
V Total Market Value of the firm
 Definition

Capitalization Rate is the

discount rate used to
determine
the present value of a
stream of expected future
cash flows.
 Capitalization Rate
The firm’s net operating income is equal to interest paid plus earnings
available to common shareholders. ‘Ko’ here (Operating Income) is an
overall capitalization rate for the firm. It is defined as the weighted
average cost of capital, and may also be expressed as:

Generally, we want to know what happens to ki (Interest on Debt), ke (Earnings

available), and ko (Operating Income) when the amount of financial leverage, as
denoted by the ratio B/S (Debt or Equity) increases.
Net Operating
Income Approach
 Definition

Net Operating Income

Approach is a theory of
capital structure in which the
weighted average cost of
capital and the total value of
the firm remain constant as
financial leverage is
changed.
 Net Operating Income Approach

Assume that a firm has $1,000 in debt at 10% interest, that the expected
annual net operating income (NOI or EBIT) figure is $1,000, and that the
overall capitalization rate, Ko, is 15 percent. Given this information, we may
calculate the value of the firm as follows:
 Net Operating Income Approach

The earnings available to common shareholders, E, is simply net operating

income minus interest payments, O − I, or $1,000 − $100 = $900. The
implied required return on equity is:

E $900
Ke = = 15.88%
S $5,667

Earnings available to common shareholders

 Net Operating Income Approach

Suppose that the firm increases the amount of debt from $1,000 to $3,000
and uses the proceeds of the debt issue to repurchase common stock. The
valuation of the firm would then proceed as follows:
 Net Operating Income Approach

The earnings available to common shareholders, E, is equal to net operating

income minus the now higher interest payments, or $1,000 − $300 = $700.
The implied required return on equity is:

E $700
Ke = = 19.09%
S $3,667

Earnings available to common shareholders

 Net Operating Income Approach

IMPORTANT: Not only is the total value of the firm unaffected by changes in
financial leverage but so is share price. To illustrate, assume in our example that
the firm with $1,000 in debt has 100 shares of common stock outstanding. Thus
the market price per share is $5,667/100 = $56.67. The firm then issues
$2,000 in additional debt and at the same time repurchases $2,000 of stock at
$56.67 per share, or 35.29 shares if we permit fractional shares.

It now has 100 − 35.29 = 64.71 shares outstanding. We saw that the total
market value of the firm’s stock after the change in capital structure is $3,667.
Therefore, the market price per share is $3,667/64.71 = $56.67, the same as
before the increase in financial leverage resulting from recapitalization.
 Definition

Recapitalization is an
alteration of a firm’s capital
structure. For example, a
firm may sell bonds to
acquire the cash necessary
to repurchase some of its
outstanding common stock.
The Traditional
Approach
 Definition

Traditional Approach is a
theory of capital structure in
which there exists an optimal
capital structure and where
management can increase the
total value of the firm
through the judicious use of
financial leverage.
 Definition

Optimal Capital Structure is

the capital structure that
minimizes the firm’s cost of
capital and thereby
maximizes
the value of the firm.
NOTE: The traditional approach to capital structure implies that (1) the cost of
capital is dependent on the capital structure of the firm, and (2) there is an
optimal capital structure.
The Total Value
Principle
 The Total Value Principle

❏ Modigliani and Miller (M&M) in their original position advocate that the
relationship between financial leverage and the cost of capital is explained
by the net operating income approach.
❏ M&M argue that the total risk for all security holders of a firm is not altered
by changes in the firm’s capital structure. The total value of the firm must
be the same, regardless of the firm’s financing mix.
❏ M&M position is based on the idea that no matter how you divide up the
capital structure of a firm among debt, equity, and other claims, there is a
conservation of investment value.
 The Total Value Principle

❏ The support for this position rests on the idea that investors are able to
substitute personal for corporate financial leverage. Thus investors have the
ability, through personal borrowing, to replicate any capital structure the firm
might undertake. Firms may enter arbitrage.
 Definition

Arbitrage is finding two

assets that are
essentially the same,
buying the cheaper, and
selling the more expensive.
 Definition

❏ Company L cannot command a higher total value simply because it has a financing
mix different from Company NL’s. M&M argue that Company L’s investors would be
able to maintain their same total dollar return for a smaller personal investment
outlay and with no increase in financial risk by engaging in arbitrage.
 Definition
These arbitrage transactions would continue until Company L’s shares declined in price
and Company NL’s shares increased in price enough to make the total value of the two
firms identical.

For example, assume that you are a rational investor who owns 1 percent of the stock of
Company L, the levered firm, with a market value of $40,000 × 0.01 = $400. You should:

❏ Sell the stock in Company L for $400.

❏ Borrow $300 at 12 percent interest. This personal debt is equal to 1 percent of the
debt of Company L – the same percentage as your previous ownership interest in
Company L. (Your total capital available for investment is now $400 + $300 = $700.)
❏ Buy 1 percent of the shares of Company NL, the unlevered firm, for $666.67 and still
have $700 − $666.67 = $33.33 left over for other investments.
Presence of Market
Imperfections and
Incentive Issues
 Bankruptcy Costs

❏ If there is a possibility of bankruptcy, and if administrative and other costs

associated with bankruptcy are significant, the levered firm may be less
attractive to investors than the unlevered one.
❏ If the firm goes bankrupt, assets presumably can be sold at their economic
values with no liquidating or legal costs involved.
❏ In the event of bankruptcy, security holders as a whole receive less than
they would have in the absence of bankruptcy costs.
❏ If capital markets are less than perfect, there may be administrative costs,
and assets may have to be liquidated at less than their economic values.
Bankruptcy Costs
 Other Issues
Agency Costs
Costs associated with monitoring
management to ensure that it
behaves in ways consistent with the
firm’s contractual agreements with
creditors and shareholders.
Transactions Costs
It tends to restrict the arbitrage
process. Arbitrage will take place
only up to the limits imposed by
transactions costs, after which it is
no longer profitable
Debt & Incentive
Working in the opposite direction
from bankruptcy and agency costs
is the notion that high debt levels
create incentives for management
to be more efficient.
Institutional Restrictions
Regulatory bodies often restrict
stock and bond investments to a list
of companies meeting certain
quality standards
The Effect Of
Taxes
 Corporate Taxes

❏ Interest payments are a tax deductible expense to the debt-issuing firm.

However, dividends paid are not a tax-deductible expense to the
dividend-paying corporation. Consequently, the total amount of funds available
to pay both debt holders and shareholders is greater if debt is employed.
 Corporate Taxes

❏ Tax Shields are tax deductible expense. The expense protects (shields) an
equivalent dollar amount of revenue from being taxed by reducing taxable
income.
❏ Total income available to all investors increases by an amount equal to the
interest tax shield times the corporate tax rate.
❏ If the debt employed by a company is permanent, the present value of the
annual tax-shield benefit using the perpetual cash-flow formula is:

Present value of (r ) (B) (tc )

= = (B) (tc )
tax-shield benefits of debt
r
 Corporate Taxes

Present value of (r ) (B) (tc )

= = (B) (tc )
tax-shield benefits of debt
r
Where r is the interest rate on the debt, B is the market value of the debt, and tc is the corporate tax rate.

Present value of
= ($5,000) (0.40) = $2,000
tax-shield benefits of debt

The “bottom line” is that the interest tax shield is a thing of value and that the overall value of Company D is
$2,000 higher because the company employed debt than it would be if the company had no debt. This
increased valuation occurs because the stream of income to all investors is $240 per year greater than in the
absence of debt. The present value of $240 per year discounted at 12 percent is $240/0.12 = $2,000.
 Corporate Taxes
Implied is that the risk associated with the tax-shield benefits is that of the stream of interest
payments, so the appropriate discount rate is the interest rate on the debt. Thus we have:

Present value of
Value of Levered Value of firm
= + tax-shield
Firm if unlevered
benefits of debt

For our example situation, suppose that the equity capitalization rate for company ND, which
has no debt, is 16 percent. Assuming zero growth and a 100 percent earnings payout, the value
of the (unlevered) firm is $1,200/0.16 = $7,500. The value of the tax-shield benefits is $2,000,
so the total value of Company D, the levered firm, is $7,500 + $2,000 = $9,500.
 Uncertainty of Tax-Shield Benefits

❏ The tax savings associated with the use of debt are not usually certain
❏ If taxable income should be low or turn negative, the tax-shield benefits
from debt are reduced or even eliminated.
❏ If the firm should go bankrupt and liquidate, the future tax savings
associated with debt would stop altogether.
❏ As financial leverage increases, the uncertainty associated with the
interest tax-shield benefits becomes a more and more important issue.
❏ As a result, this uncertainty may reduce the value of the corporate
tax-shield benefits.
 Corporate Plus Personal Taxes

❏ With the combination of corporate taxes and personal taxes on both debt
and stock income, the present value of the interest tax-shield benefits will
likely be lowered.
❏ The general consensus is that personal taxes act to reduce but not
eliminate the corporate tax advantage associated with debt.
❏ An optimal leverage strategy would still call for the corporation to have a
large proportion of debt.
❏ This is despite the fact that tax-shield benefits uncertainty may lessen the
“net” tax effect with extreme leverage.
Taxes and Market
Imperfections
Combined
 Bankruptcy Costs, Agency Costs, and Taxes
❏ If one allows for bankruptcy costs, and if the probability of bankruptcy
increases at an increasing rate with the use of financial leverage, extreme
leverage is likely to be penalized by lenders and investors.
❏ The presence of agency, or monitoring, costs accentuates this rise in the
cost of capital.
❏ The combined influence of bankruptcy and agency costs serves to limit the
range over which the net tax-shield benefits have a positive effect on share
price. In short, we have:

Value of Present value of Present value of

Value of firm
Levered = if unlevered + tax-shield - bankruptcy and
Firm benefits of debt agency costs
 Bankruptcy Costs, Agency Costs, and Taxes

❏ At the point where marginal bankruptcy/agency costs equal the marginal tax-shield benefits, the
cost of capital is minimized and share price is maximized. By definition, this represents the
optimal capital structure, as denoted by the mark along the horizontal axis.
 Impact of Additional Imperfections

❏ After some point of financial leverage, the interest rate charged by

creditors usually rises. The greater the financial leverage, of course, the
higher the interest rate charged.
❏ Institutional restrictions on lenders might also cause the cost of capital line
to turn up sooner than it does because of extreme financial leverage a
company may no longer be able to sell debt securities to institutions.
❏ The company must seek out unrestricted investors, and these investors will
demand even higher interest rates.
❏ The greater the importance attached to market imperfections, the less
effective the arbitrage process becomes, and the stronger the case that
can be made for an optimal capital structure.
 Financial Signaling

❏ The notion of signaling is closely related to monitoring costs and agency

relationships.
❏ Because strict managerial contracts are difficult to enforce, a manager
may use capital structure changes to convey information about the
profitability and risk of the firm.
❏ It is an indication of a company's health and/or actions. Signaling a certain
state or action may cause a company's stock to rise or fall in price.
❏ Generally speaking, the more money a signal costs a company to make, the
stronger the signal is thought to be.
For example, a company may make a statement indicating financial distress, but
reducing its dividends is thought to be a stronger signal.
 Financial Signaling

❏ The implication is that insiders (managers) know something about the firm
that outsiders (security holders) do not.
❏ As a manager, your pay and benefits may depend on the firm’s market
value, which gives you an incentive to let investors know when the firm is
undervalued through an announcement.
❏ Investors are aware of this phenomenon, so they regard debt issues as
“good news” and common stock issues as “bad news.”
❏ Unless the managerial contract is very precise, the manager is tempted to
give false signals.
 Timing and Financial Flexibility

❏ Once a company has determined an appropriate capital structure, it still has the
problem of timing security issues.
❏ When external financing is required, a company often faces the question of how
to time an issue appropriately and whether to use debt or common stock.
❏ The sequence would be timed to take advantage of known future changes in the
stock market and in the market for fixed-income securities. Unfortunately,
prices in financial markets, particularly in the equity market, are unstable.
❏ Financial flexibility is the ability to react and adapt to changing financial
conditions. We simply mean the extent to which today’s financing decision will
keep open future financing options.
 Timing and Financial Flexibility

❏ Remember that a company cannot issue debt continuously without building its
equity base. Sooner or later, default risk becomes too great. Therefore the
equity base must be increased over time, and this is where flexibility becomes
important.
❏ To preserve its flexibility in drawing from the capital markets, it may be better
for a firm to issue common stock now so that it will have unused debt capacity
for future needs.
❏ We must keep in mind that if the financial markets are efficient, all available
information is reflected in the price of the security. Under these circumstances,
the market price of the security is the market’s best estimate of the value of
that security.
 Financial Checklist

What is the appropriate capital structure for our company?

❏ Taxes – The degree to which a company is subject to taxation is very important.
Much of the advantage of debt is tax related. If, because of marginal
profitability, a company pays little or no tax, debt is less attractive than it is for
the company subject to the full corporate tax rate
❏ Explicit cost – The higher the interest rate on debt, and the higher the
preferred stock dividend rate, the less attractive that method of financing, all
other things being the same.
❏ Cash-flow ability to service debt – The analysis focuses on both the business
and the financial risk of a company by how large and stable are the expected
future cash flows of the firm.
 Financial Checklist

❏ Agency costs and incentive issues – the willingness of shareholders to bear

the increased monitoring costs required by debt holders as the amount of debt
is increases.
❏ Financial signaling – What is likely to be the stock market reaction to a
particular financing decision, and why?
❏ EBIT-EPS analysis – At what point in earnings before interest and taxes (EBIT)
are earnings per share (EPS) of a company the same under alternative methods
of financing? How does this relate to the existing level of EBIT, and what is the
probability of falling below the EBIT-EPS indifference point?
 Financial Checklist

❏ Capital structure ratios – What effect does a method of financing have on the
company’s capital structure ratios (e.g., debt to equity, debt to total assets, and
debt to net worth)?
❏ Security rating – Is a particular method of financing likely to result in a
downgrade or an upgrade of a company’s security rating?
❏ Timing – Is it a good time to issue debt? Is it a good time to issue equity?
❏ Flexibility – If a company needs to finance on a continuing basis over time, how
does the method chosen this time affect future financing? How important is it
that a company has flexibility to draw on the debt markets in the future?
 Financial Checklist

❏ CONCLUSION:

These important issues and questions must be addressed when considering

the appropriate degree of financial leverage for a company. By undertaking a
variety of analyses, the financial manager should be able to determine, within
some range, the appropriate capital structure for his or her company.

The final decision is somewhat subjective, but it can be based on the best
information available. Hopefully, this decision will be consistent with
maximizing shareholder wealth.
4
Dividend Policy
 Dividend Policy

1 2 3

Passive versus Active Factors Influencing Dividend Stability

Dividend Policies Dividend Policy

4 5 6

Stock Dividends & Stock Repurchase Admin. Considerations

Stock Splits
 Definition

Dividends is a distribution of
a portion of a company's
earnings, decided by the
board of directors, to a class
of its shareholders.
Dividends can be issued as
cash payments, as shares of
stock, or other property.
 Definition

Dividend-payout ratio
determines the amount of earnings that
can be retained in the firm as a source
of financing.

Annual cash dividends divided by

annual earnings; alternatively, dividends
per share divided by earnings per share.
The ratio indicates the percentage of a
company’s earnings that is paid out to
shareholders in cash.
Passive versus
Active Dividend
Policies
 Passive versus Active Dividend Policies

❏ Dividends as a Passive Residual

❏ Each period, the firm must decide whether to retain its earnings or distribute
part or all of them to shareholders as cash dividends. (We rule out share
repurchase for now.)
❏ As long as the firm is faced with investment projects having returns
exceeding those that are required the firm will use earnings, plus the amount
of senior securities the increase in the equity base will support, to finance
these projects.
❏ When we treat dividend policy as strictly a financing decision, the payment of
cash dividends is a passive residual. The percentage of earnings paid out as
dividends will fluctuate from period to period in keeping with fluctuations in
the amount of acceptable investment opportunities available to the firm.
 Passive versus Active Dividend Policies

❏ Dividends as a Passive Residual

❏ Each The treatment of dividend policy as a passive residual, determined
solely by the availability of acceptable investment proposals, implies that
dividends are irrelevant.
Q: Should dividend payments be an active decision variable with earnings
retentions as a residual?
❏ We must examine the argument that dividends are irrelevant, which means
that changes in the dividend-payout ratio (holding investment opportunities
constant) do not affect shareholder wealth.
 Passive versus Active Dividend Policies

❏ Irrelevance of Dividends
❏ Miller and Modigliani (M&M) provide the most comprehensive argument for the
irrelevance of dividends. They assert that, given the investment decision of the
firm, the dividend-payout ratio is a mere detail and that it does not affect the
wealth of shareholders.

❏ As we pointed out in the previous chapter, when we considered the capital

structure decision, M&M assume perfect capital markets where there are no
transactions costs, no flotation costs to companies issuing securities, and no taxes.
Moreover, the future profits of the firm are assumed to be known with certainty.
 Passive versus Active Dividend Policies

❏ Current Dividends versus Retention of Earnings.

❏ After the firm has made its investment decision, it must decide whether (1) to retain
earnings or (2) to pay dividends and sell new stock in the amount of these
dividends in order to finance the investments.
❏ M&M suggest that the sum of the discounted value per share of common stock
after financing plus current dividends paid is exactly equal to the market value per
share of common stock before the payment of current dividends.
❏ In other words, the common stock’s decline in market price because of the dilution
caused by external equity financing is exactly offset by the payment of the
dividend.
 Definition

Dilution is a decrease
in the proportional
claim on earnings
and assets of a
share of common
stock because of the
issuance of additional
shares.
 Passive versus Active Dividend Policies

❏ Conservation of Value
❏ The total-value principle ensures that the sum of market value plus current
dividends of two firms identical in all respects other than dividend-payout ratios
will be the same.
❏ Investors are able to replicate any dividend stream the corporation might be able to
pay but currently is not.
❏ If dividends are lower than desired, investors can sell some shares of stock to
obtain their desired cash distribution.
❏ If dividends are higher than desired, investors can use dividends to purchase
additional shares of stock in the company.
 Arguments for Dividend Relevance

❏ Preference for Dividends

❏ The total-value principle ensures that the sum of market value plus current
dividends of two firms identical in all respects other than dividend-payout ratios
will be the same.
❏ Investors are able to replicate any dividend stream the corporation might be able to
pay but currently is not.
❏ If dividends are lower than desired, investors can sell some shares of stock to
obtain their desired cash distribution.
❏ If dividends are higher than desired, investors can use dividends to purchase
additional shares of stock in the company.
Factors Influencing
Dividend Policy
 Factors Influencing Dividend Policy

1 2 3

Legal Rules Funding Needs Liquidity

Of the Firm

4 5 6

Restrictions in Control
Ability to Borrow Debt Contracts
 Legal Rules

- Capital Impairment Rule

- Insolvency Rule

- Undue Retention of
Earnings Rule
Funding Needs of the Firm

Key is to determine the

likely cash flows in absence
of change in dividend policy
 Liquidity

Current Assets exceeds

Current Liabilities

Characterized by presence of
Cash as KING.
 Ability to Borrow

Shows the financial Flexibility

of the company
Restrictions in Debt Contracts

Protective Covenants in Loan

Agreements may put
restrictions in payment of
dividends to preserve ability
to service debt
 Control

A firm should know WHEN

to pay dividends to
shareholders
Dividend
Stability
 Dividend Stability

1 Valuation of Dividend Stability

2 Target Payout Ratios

3 Regular and Extra Dividends

 DIVIDEND STABILITY

Dividend stability is maintaining the position of the firm’s

dividend payments in relation to a trend line, preferably
one that is upward sloping.
 DIVIDEND STABILITY

Company A: Strict adherence to a Company B: Showing a long-run 50

constant 50 percent dividend-payout percent dividend-payout ratio but
ratio. dividend increases only when
supported by growth in earnings.
 VALUATION OF DIVIDEND STABILITY

Information Content
1 A stable dividend suggests that the company expects stable or growing
dividends in the future.

Current Income Desires

2 Some investors who desire a specific periodic income will prefer a company
with stable dividends to one with unstable dividends.

Institutional Considerations
3
a stable dividend may permit certain institutional investors to buy the common
stock as they meet the requirements to be placed on the organizations
“approved list.”
 TARGET PAYOUT RATIOS

A measure of the percentage of a company's earnings it would like to pay out

to shareholders as dividends over the long-term.

● Depends on what investors the management of a company are trying to

attract, what current investors' expectations are, and the growth goals
of the company.

● When earnings increase to a new level, a company increases dividends

only when it feels it can maintain the increase in earnings.

● Companies are also reluctant to cut the absolute amount of their cash
dividend.
 TYPES OF DIVIDEND

Regular Dividends
1
The dividend that is normally expected to be paid by the firm.

Extra Dividends
2
A nonrecurring dividend paid to shareholders in addition to the regular
dividend. It is brought about by special circumstances.
Stock Dividends &
Stock Splits
 Definition

Stock dividends are

payments of additional
shares of stock to
shareholders. Often used in
place of or in addition to a
cash dividend.
 Stock Dividends

Small-Percentage Stock Dividends

1 It is a stock dividend that represents an increase of less than
(typically) 25 percent of the previously outstanding common stock.

Large-Percentage Stock Dividends

2 Stock dividends that are typically 25 percent or higher of previously
outstanding common stock.
 Definition

Stock splits are the increase

in the number of shares
outstanding by reducing the
par value of the stock: for
example, a 2-for-1 stock split
where par value per share is
reduced by one-half.
 Value to Investors of Stock Dividends & Stock Splits

To the extent that an investor wishes to sell a few shares of stock for income, the stock
dividend/split may make it easier to do. Without the stock dividend or split, shareholders could
also sell a few shares of their original holdings for income.

Effect on Cash Dividends

1 When stock dividend increases, the total cash dividends increases. Whether this
increase in cash dividend has a positive effect on shareholders wealth, it will
depend on the trade-off between current dividends and the retention of
earnings, which we discussed earlier.

Large-Percentage Stock Dividends

2 A stock split and, to a lesser extent, a stock dividend are used to place a stock in a
lower, more popular trading range that may attract more buyers and may also affect
the mix of stockholders as individual holdings are increased and institutional
holdings are decreased.
Value to Investors of Stock Dividends & Stock Splits

Informational Content
3 The declaration of a stock dividend or a stock split may convey information to
investors. As taken up earlier, there may be a situation in which management
possesses more favorable information about the company than investors.

Instead of simply issuing an announcement to the press, management may use

a stock dividend or stock split to more convincingly state its belief about the
favorable prospects of the company.
 Definition

Reverse stock splits are a stock

split in which the number of
shares outstanding is
decreased: for example, a
1-for-2
reverse stock split where each
shareholder receives one new
share in exchange for every two
old shares held.
Stock
Repurchase
 Stock Repurchase

Investment or
1 Method of Repurchase 3
Financing Decision?

Repurchasing as Part Possible Signaling

2 4
of Dividend Policy Effect
Method Repurchase

1) Fixed Price Self-Tender

Offer

2) Dutch-auction
Self-Tender Offer

3) Open-Market Purchase
 Fixed Price Self-Tender Offer

- Makes a formal offer to shareholders to purchase a certain

number of shares at a fixed price

- Tender offer period: 2-3 weeks

- In case of shareholders tendering more shares, the

company may elect to purchase all or part of the excess
 Dutch Auction Self-Tender Offer

- No. of shares a specified plus a minimum and maximum

price willing to pay w/c is above current market price

- Tenders will be arranged from low to high; LOWEST PRICE

will be repurchased

- If more shares are tendered/below purchase price,

purchases will be on a pro rata basis, but if below, will be
paid at a maximum price
 Open Market Purchase

- Company buys stock through a brokerage house like any

other investor

- Brokerage fee is negotiated

Repurchasing as Part of Dividend Policy

To justify use of excess cash

with insufficient profitable
investment opportunities
 Repurchasing as Part of Dividend Policy

- With repurchase, fewer shares remain outstanding and

dividends per share rise; hence, market price will rise as
well

- Repurchase of stock offer tax advantage over payment of

dividends to the taxable investor
Investment or Financing Decision?

Investment Decision
- Shares held as “treasury stock”

Financing Decision
- Providing financial flexibility in
timing of return of payments to
shareholders
Possible Signaling Effect

- Repurchase indicates the

management’s belief about the
degree of undervaluation

- Highest effect on Fixed Price

Self-Tender Offer
Administrative
Considerations
 Administrative Considerations

1 Procedural Aspects

2 Dividends Reinstatement Plans

 PROCEDURAL ASPECTS

The first date on which a stock

purchaser is no longer entitled to the
recently declared dividend.
EX-DIVIDEND DATE PAYMENT DATE
The corporation
actually pays the
declared dividend.

DECLARATION DATE RECORD DATE

The date BOD announces the The date set by the BOD when a dividend
amount and date of the next is declared, on which an investor must be a
dividend. shareholder of record to be entitled to the
upcoming dividend.
 ILLUSTRATION
Suppose that when the board of directors of UCP met on May 8, it declared a dividend of
$1 per share payable June 15 to shareholders of record on May 31. Jane Doe owns some
UCP stock purchased well before May 31, so she is entitled to the dividend even though
she might sell her stock prior to the dividend actually being paid on June 15.
 DIVIDEND REINVESTMENT PLAN (DRIP)

An optional plan allowing shareholders to automatically reinvest dividend payments in

additional shares of the company’s stock.

● The firm can use existing stock.

● The firm can issue new stock.

Some plans offer discounts and eliminate brokerage costs for current shareholders.
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“Neptune is the farthest “Despite being red, Mars
planet from the Sun!” is a cold place!”
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Mercury is the closest

planet to the Sun and
the smallest one in the
Solar System
5 Events
 Review of Past Events

1 2 3
Saturn is composed Mercury was named Despite being red, Mars
mostly of hydrogen and after the Roman is a cold place full of
helium messenger god iron oxide dust

4 5 6
Venus has a beautiful Pluto is considered a Jupiter is the
name and is the second dwarf planet since the fourth-brightest object
planet from the Sun year 2006 in the night sky
Upcoming Events

Venus has a
beautiful name, but
it’s very hot
JUNE 06

APRIL 26 JULY 12
Mercury is the Despite being red,
closest planet to Mars is actually a
the Sun cold place
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