The r isk iness of t he fir m’s asset s if no debt is used

The m or e st able t he dem and for a fir m’s pr oduct s, ot h

er t hings held const ant, t he low er it s business r isk.
Sales

Fir m s w hose pr oduct s ar e sold in volat ile m

ar ket s ar e ex posed t o m or e business r isk t h
Capit al st r uct ur e (m ix of debt, pr efer r ed, and com m on e Bu sin ess r isk an fir m s w hose out put pr ices ar e st able.
quit y) at w hich P0 is m ax im ized+W ACC is m inim ized. Sales pr ice

opt im al capit al st r uct ur es consider o Fir m s w hose input cost s ar e uncer t ai

nly t he financial aspect s of a fir m. n have higher business r isk.
Opt im al capit al st ruct ure I nput cost
higher business r isk < = > pr obabilit y of financial dist r ess w oul
The fast er pr oduct s becom e out dat ed, t
d be gr eat er < = > opt im al capit al st r uct ur e has less debt.
he gr eat er a fir m’s business r isk.
Pr oduct

Operat ing leverage

The ex t ent t o w hich fixed cost s ar e used in a fir m’s operat ions.

a high operat ing leverage im plies t hat a sm all chang

Op t im a l ca p it a l st r u ct u r e Ca p i t a l St r u ct u r e Operat ing leverage e in sales r esult s in a lar ge change in ROI C.
an d t ar g et st r u ct u r e a n d Le v e r a g e Fir m has higher operat ing leverage < = > higher business r isk.
WACC

The addit ional r isk placed on t he com m on

Div idend Discount Model
st ock holder s as a r esult of using debt.
The m ix of debt, pr efer r ed st ock, and com m on equi
Com pany has m or e debt < = > m or e financial r isk.
t y w it h w hich t he fir m int ends t o raise capit al.

Tar get capit al st r uct ur e cont ain considerat ion Financial Risk
s of t he fir m, t he cust om er s, t he societ y, and Target capit al st ruct ure
t he gover nm ent r egulat ion

The ex t ent t o w hich fixed incom e secur it ies (d

ebt and pr efer r ed st ock) ar e used in a fir m’s c
Fi n a n c i a l Ri s k
apit al st r uct ur e.

Financial Leverage

I f t he level of debt incr ease, t he r isk iness of fir m i

ncr eases, r esult ing in a higher rat e of r et ur n.
 The decision t o pay out ear nings ver sus r et aining and r einvest ing t hem.
Devidend Policy
For ecast capit al needs over a planning hor izon, oft en 5 year s.

Pay out any left over ear nings as div idends if m or Set a t ar get capit al st r uct ur e.
e ear nings ar e available t han ar e needed suppor t
t he opt im al capit al budget. Est im at e annual equit y needs.
Set t ing Dividend Policy
Set t ar get payout based on t he r esidual m odel.

Maint ain t ar get gr ow t h rat e if possible, var y ing

capit al st r uct ur e som ew hat if necessar y.

Re s i d u a l D i v i d e n d M o d e l Div id en d p o licy I nvest or s do n’t car e about payout.

t h eor ies w ant cash = > sell st ock
I f Div idends < 0 = > Payout = 0% I nvest or s can cr eat e t heir ow n div idend policy
Dividend irrelevance t heory do n’t w ant cash = > use div idends t o buy st ock
Mor e good invest m ent s = > need m or e m oney t o r ein
vest = > a low er div idend payout. Unr ealist ic assum pt ions (n o t axes or br okerage cost s)

I nvest or s pr efer a high payout

Shar eholder s can aut om at ically r einvest t heir div iden I nvest or s t hink div idends ar e less r isk y t h
ds in shar es of t he com pan y’s com m on st ock. Bir d- in- t he- hand
an pot ent ial fut ur e capit al gains

Dollar s t o be r einvest ed ar e t ur ned over t o t r us High payout w ould r esult in a high P0

t ee, w ho buy s shar es on t he open m ar ket.
Open Mar ket Pur chase Plan Div iden d Dividend relevance t heory I nvest or s pr efer a low payout.

Fir m issues new st ock t o DRI P enr ollees (u sually Re i n v e s t m e n t Pl a n Tax pr efer ence Capit al gains ar e t axed at low er rat es t han div idends
at a discount fr om t he m ar ket pr ice), hence, t he
se plans raise new capit al for t he fir m.
New St ock Plan
D i v i d e n d Po l i cy High payout w ould r esult in a low P0

I nvest or s r egar d div idend changes as signals of m anagem en t’s ear nings for ecast s.
Buy ing ow n st ock back fr om st ock holder s
Manager s do not raise div idends unless t hey believe fut ur e ear ning
As an alt er nat ive t o dist r ibut ing cash as div idends s w ill be sust ain t he higher level div idends
St ock Repur chases
To dispose of one- t im e cash fr om an asset sale. Reasons for r epur chases Si g n a l i n g h y p o t h e s i s A div idend r educt ion is a signal t hat m anagem ent for ecast
s poor fut ur e ear nings.
To m ake a lar ge capit al st r uct ur e change
Manager s should consider signaling effect s w hen t hey set div idend policy.
Fir m issues new shar es inst ead of pay ing a cash div idend

I ncr ease t he num ber of out st anding shar es, P0 decr ease
St ock div idends Differ ent gr oups of invest or s, or client eles, pr efer differ ent div idend policies.
I f 10%, get 10 shar es for each 100 shar es ow ned
Fir m’s past div idend policy det er m ines it s cur r ent client ele of invest or s.
t he sam e as a st ock div idend except for rat io ex pr ess
Alt er n at iv e div iden ds Cl i e n t e l e e f f e c t
A change in div idend policy m ight upset t he m aj or it y clie
a 2 for 1 st ock split = 100% st ock div idend nt ele and have a negat ive effect on t he st oc k’s pr ice.

Ther e’s a w idespr ead belief t hat t he opt im al pr ice r St ock split s
ange for st ock s is $2 0 t o $8 0. St ock split s can be u
sed t o keep t he pr ice in t his opt im al range.

Fact or s Affect ing Div idend policy