FINA 6212 Financial Management

LECTURE 3
PROF. NICHOLAS CHEN
Today’s plan

• Corporate financing
oFinancial markets and intermediaries
oDebt policy
• Cost of Capital
oFinancial leverage
oOperating leverage
• Payout policy
Patterns of Corporate Financing

• Firms may raise funds from external sources or

retain profits rather than distribute them to
shareholders
• Should a firm elect external financing, they
may choose between debt or equity sources
Patterns of Corporate Financing
Patterns of Corporate Financing

Aggregate balance sheet for manufacturing corporations

in the United States, 2014 (figures in billions)

Current assets $ 2,454 Current liabilities $1,802

Fixed assets 3,321 Long term debt 2,014
Less 1,791 Other long term 1,324
Deprecication Liabilities
Net fixed assets 1,530 Total long term liabilities 3,338

Other long term 5,129 Stockholders' equity 3,973

Total assets 9,113 Total liabilities and 9,113

stockholders' equity
Patterns of Corporate Financing

How do we define financial leverage?

Debt 1,802  3,338

  .56
Total assets 9,113

Long term liabilities 2,014

  .34
Long term liabilities  equity 2,014  3,973
Debt Ratios

Debt to Net Worth for Non-Financial Firms, 1965-2014

50

45 Book debt ratio

40

35
Debt ratio, %

30

25

20
Market debt ratio
15

10

0
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Holdings of Corp Equities (2014)

Percent of Holdings
Holdings of Corp Debt (2014)

Percent of Holdings
Dual-Class Shares and Private Benefits

• Some companies have two classes of

stock
• Same cash-flow rights, different control
rights
• Greater control rights grant private
benefits
Preferred Stock

• Takes priority over common stock when

receiving dividends
• Gains some voting rights if corporation
fails to pay preferred dividend
The Flow of Savings to Corp.
Financial Markets

Money

Primary OTC
Markets Markets

Secondary
Markets
The Flow of Savings to Corp.

Company

Banks Obligations Funds

Insurance Cos. Intermediary /

Brokerage Firms Institutions
Obligations Funds

Depositors
Investor
Policyholders
Investors
Example: The Flow of Savings to Corp.

Company

Loan $2.5 mil

Commercial Institution
Banks

Deposits $2.5 mil

Depositors Investor
The Role of Financial Markets and
Intermediaries

• Payment Mechanism
o Allows individuals to make and receive payments quickly
and safely over long distances

• Borrowing and Lending

o Channels savings towards those who can best use them

• Pooling Risk
o Allows individuals to share risk, i.e., insurance
companies

• Information
o Allows estimation of expected rates of return
Today’s plan

• Corporate financing
oFinancial markets and intermediaries
oDebt policy
• Cost of Capital
oFinancial leverage
oOperating leverage
• Payout policy
M&M (Debt Policy Doesn’t Matter)

• Modigliani & Miller

oWhen there are no taxes and capital
markets function well, it makes no difference
whether the firm borrows or individual
shareholders borrow. Therefore, the market
value of a company does not depend on its
capital structure.
19
MM Proposition I
- capital structure irrelevance

• If we assume in a perfect capital market:

o a) No taxes
o b) No bankruptcy costs
o c) Fixed real investment policy**
• Then it follows that…
o The market value of the firm is independent of the
choice of capital structure (i.e., there is no unique
financing method which maximizes firm value.)
o ** Point (c) basically means that the financing
decision does not change any future investment
decisions.
20

MM Proposition I (Cont.)

• “Proving the Theorem”

o Can be done mathematically (Modigliani and Miller, AER 1958)
o Alternatively, we can come to the same conclusions with the
following:
• The following two pizzas are of the same size. Which pizza is
worth more? (ok… assume they have the same toppings)
21

MM Proposition I (Cont.)

• None of the pizza slices is lost: No taxes or bankruptcy

costs.
• The size of the pizza (firm): Fixed investment policy.

• The values of the two pizzas are the same whether you
cut it into 10 slices or 20 slices.
• Similarly, the value of a levered firm is unaffected by its
choice of capital structure.

• Levered firm value equals unlevered firm value.

o VL = E + D = Vu
MM Proposition I: Capital Structure Irrelevance

Debt Value
New Debt Value

Asset Value

Equity Value

The value of assets (the firm) is determined by the future cash flows
generated by the asset or the underlying business.
In a perfect world, it does not matter how you finance your investment or
the combination of the financing methods (through equity or debt).
No Magic in Financial Leverage

MM’s Proposition I
If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.
V is independent of the debt ratio.
M&M (Debt Policy Doesn’t Matter)
Example - Macbeth Spot Removers - All Equity Financed
Data
Number of shares 1,000
Price per share $10
Market value of shares $ 10,000

Outcomes
A B C D
Operating income $500 1,000 1,500 2,000 Expected
Earnings per share $.50 1.00 1.50 2.00 outcome
Return on shares (%) 5% 10 15 20
M&M (Debt Policy Doesn’t Matter)
Data
Example: Number of shares 500
50% debt Price per share $10
Market value of shares $ 5,000
• Issue $5000 of Market value of debt $ 5,000
debt at an
interest rate of
Outcomes
1 0 % a n d
repurchase A B C D
500 shares Operating income $500 1,000 1,500 2,000
• Reduce the Interest $500 500 500 500
shares t0 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
M&M (Debt Policy Doesn’t Matter)

Example - Macbeth’s
- All equity financed
- Debt replicated by investors

Outcomes
A B C D
Earnings on two shares $1.00 2.00 3.00 4.00
LESS : Interest @ 10% $1.00 1.00 1.00 1.00
Net earnings on investment $0 1.00 2.00 3.00
Return on $10 investment (%) 0% 10 20 30
Borrowing and EPS at Macbeth
Proposition I and Macbeth

Example - Macbeth continued

Current Structure : Proposed Structure :

All Equity Equal Debt and Equity
Expected earnings per share ($) 1.50 2.00
Price per share ($) 10 10
Expected return per share (%) 15 20
29

MM Proposition II

• MM II: The cost of levered equity is equal to

the cost of unlevered equity plus a premium
that is proportional to the debt-equity ratio.

• MM I is about the _________

• MM II is about the __________________
• Even though the firm value is the same after
introducing debt (MM I), the equity becomes riskier
(MM II).
30

MM Proposition II (Cont.)

• Proof of MM II
WACC is a weighted average of the cost of equity and debt. In a world
without taxes, it’s just equal to:

E D
rassets  WACC  requity  rdebt
V V
• Let’s solve the above equation for the cost of equity:

rassetsV  Drdebt D
requity   rassets  (rassets  rdebt )
E E
How does this WACC compared to CAPM?

• Big picture: ________________

o CAPM: combination of market portfolio and risk-free
government debt
o WACC: combination of equity and risky corporate
debt
Leverage and Returns

expected operating income

Expected return on assets  rA 
market value of all securities

 D   E 
rA    rD     rE 
DE  DE 
M&M Proposition II

Example - Macbeth continued

rE  rA  rA  rD 
D
E
expected operating income
rE  rA 
market value of all securities
1500
  .15
10,000
M&M Proposition II

Example - Macbeth continued

expected operating income

rE  rA 
market value of all securities
1500
  .15
10,000
rE  rA  rA  rD 
D
E

rE  .15  .15  .10 

5000
5000
 .20 or 20%
M&M Proposition II

Q: How can shareholders be indifferent to

increased leverage when it increases expected
return?
A: ______________________________
WACC

WACC is the traditional view of capital

structure, risk and return.

 D  E
WACC  rA   rD     rE  
 V  V
M&M Proposition II
After-Tax WACC

• The tax benefit from interest expense

deductibility must be included in the cost of
funds
• This tax benefit reduces the effective cost of
debt by a factor of the marginal tax rate

 D  E
WACC   rD     rE  
 V  V
Old Formula
After-Tax WACC

Tax-Adjusted Formula

D  E
WACC  rD  (1  Tc )      rE  
V   V
Union Pacific WACC
Today’s plan

• Corporate financing
oFinancial markets and intermediaries
oDebt policy
• Cost of Capital
oFinancial leverage
oOperating leverage
• Payout policy
Company Cost of Capital

• A company’s cost of capital can be compared to

the CAPM required return

SML
Required return

5.7
Company cost
of capital

2.0

0
0.53
Project beta
Company Cost of Capital

rassets  COC  rdebt  VD   requity VE 

IMPORTANT
V  DE
D  market value of debt E, D, and V are all
E  market value of equity market values of equity,
debt and total firm value

rdebt  YTM on bonds

requity  rf  B(rm  rf )
44

Levered firm

• Leverage: relative amount of debt on a firm’s total debt and

equities.
o Leverage = D/(D + E)
• Unlevered firm: a firm that does not have debt outstanding.
o The equity beta and cost of equity are equal to the asset beta
and cost of asset.
• Levered firm: a firm that has debt outstanding.

o Is the equity beta greater or less than the asset

beta?
Company Cost of Capital

Company cost of capital (COC) is based on the average

beta of the assets

The average beta of the assets is based on the % of

funds in each asset

Assets = debt + equity

D E
β assets  β debt     β equity   
V  V 
46

Adjusting Project Risk for Leverage (Cont.)

• Since the assets of a firm are claimed by a portfolio of debt and

equity we can write

Equity Debt
 Assets   Equity    Debt 
Debt  Equity Debt  Equity

Thus, the firm's asset beta is a weighted average of the debt and equity betas.

The assumption that  Debt = 0 is often made:

Equity
 Assets   Equity 
Debt  Equity
Capital Structure and COC

Expected returns and betas prior to refinancing

13
Expected return (%)

requity= 9.8
rassets= 9.1

rdebt= 4.2

βdebt βassets βequity

48

Asset beta and equity beta

• We can rewrite the formula for the asset beta to get an

expression for the equity beta (equity risk):

Equity
 Assets   Equity  , which means that:
Debt  Equity
Debt
 Equity   Assets   Assets 
Equity

• What does this say about equity risk?

Equity risk increases with _________________.
Capital Structure and Equity Cost

Capital structure - the mix of debt & equity within

a company

Expand CAPM to include capital structure:

r = rf + β(rm − rf)
This becomes:
requity = rf + βequity(rm - rf)
50

Example of asset beta

• Dell is a publicly traded company. Dell’s beta for its common

stock is 1.82 and its debt is 10% of its capital structure. What
is the appropriate discount rate for evaluating the assets of Dell?
Assume a risk free rate of 5% and a market risk premium
(market return minus risk-free rate) of 9%.
Step 1: asset beta
Equity
 Assets   Equity   1.82 1  0.1  1.638
Debt  Equity
Step 2: expected rate of asset or discount rate

E[rassets ]  rf   (rm  rf )  .05  1.638.09   19.74%

51

Revisit discount rates

• Sort these returns from the smallest to the largest. Provide

intuition for this ordering.
Returns: WACC, Rf, RE, RD

• Generally the order will be rf < rD < ________ < rE.

• The risk-free rate by definition is free of risk and therefore has

the smallest return. Because debt holders have first claim on
assets in the event of bankruptcy, the debt holders face less
risk than the equity holders and therefore the cost of debt is
less than the cost of equity. Because WACC is a weighted
average of the cost of debt and equity then it makes sense that
the WACC would be between these rates.
Today’s plan

• Corporate financing
oFinancial markets and intermediaries
oDebt policy
• Cost of Capital
oFinancial leverage
oOperating leverage
• Payout policy
Operating leverage
Operating leverage

PV(asset)  PV(revenue) - PV(fixed cost) - PV(variable cost)

PV(revenue)  PV(fixed cost)  PV(variable cost)  PV(asset)

PV(fixed cost)
β revenue  β fixed cost 
PV(revenue)
PV(variable cost) PV(asset)
 β variable cost  β asset
PV(revenue) PV(revenue)
Operating leverage

PV(revenue) - PV(variable cost)

β asset  β revenue
PV(asset)

 PV(fixed cost) 
 β revenue 1  
 PV(asset) 
H int :
what is the β fixed cost ?
Intuition: Operating leverage

• Operating leverage ________ the asset beta

o In recessions, the costs of maintaining the installed
capital drain the operating cash flows.
o Making the firms even worse in bad times
• Which firms have more capital to maintain?
o Value firms (with high book-to-market equity ratio)
Today’s plan

• Corporate financing
oFinancial markets and intermediaries
oDebt policy
• Cost of Capital
oFinancial leverage
oOperating leverage
• Payout policy
Payout Policies
Some facts

• Stock repurchases
o In 2014, Apple bought back $56 billion
o IBM $14 billion
o Exxon mobil $13 billion
• Non–dividend payers
o Amazon, and Google
Dividend & Stock Repurchases

U.S. Data 1980-2013

How Firms Pay Dividends

Stock Dividend - Distribution of additional

shares to a firm’s stockholders

Cash Dividend - Payment of cash by the firm

to its shareholders
Dividend Terms

• Record Date
• Declaration Date
• Payment Date
• Ex-Dividend Date
Dividend Payments

Dec.15, 2014 Feb. 4, 2015 Feb. 6, 2015 Mar. 3, 2015

Pfizer Dividend will be

Shares start to Dividend checks
declares regular paid
trade ex are mailed
quarterly dividend to shareholders
dividend. to shareholders.
of $.28 per share. registered
on this date.

Declaration Ex-dividend Record Payment

date date date date
The Payout Decision
Dividend Decision Survey (2004)
The Information Content of Dividends

Senior Executive Dividend Policy Features

(How Dividends are Determined)
1. Managers are reluctant to make dividend
changes that might have to be reversed
2. Managers “smooth” dividends and hate to cut
them. Dividends changes follow shifts in long-
run, sustainable levels of earnings.
3. Managers focus more on dividend changes
than on absolute levels
The Information Content of Dividends

• Dividends and stock repurchase decisions

contain information
• The information contained in the decisions
varies
• Asymmetric information may be conveyed

• Which one, dividend increase and stock

repurchase, signals greater future profits?
o ___________________
Dividend Policy is Irrelevant

Miller and Modigliani

• Since investors do not need dividends to
convert shares to cash they will not pay higher
prices for firms with higher dividend payouts. In
other words, dividend policy will have no
impact on the value of the firm.
Dividend Policy is Irrelevant
Dividend Policy is Irrelevant

• Assume 1 million shares

• Two cases
o No dividend, stock price per share is $11
o With dividend of $1 per share from surplus, stock
price per share is $10.
 $10 + $1 = $11
• No difference between the value without
dividend and that with dividend
Dividend Theories

Leftists (M&M) - Dividend does not effect value

Rightists - Dividends increase value

• Clientele Effect
• Signal for good profits

Middle of the roaders - Leftist theory with some

reality thrown in
• Tax
• Growth
Dividends Increase Value

Market Imperfections and Clientele Effect

There are natural clients for high-payout stocks,
but it does not follow that any particular firm can
benefit by increasing its dividends. The high
dividend clientele already have plenty of high
dividend stock to choose from.

These clients _________ the price of the stock

through their demand for a dividend paying stock.
Dividends Increase Value

Dividends as Signals
Dividend increases send good news about
cash flows and earnings. Dividend cuts send
bad news.

Because a high dividend payout policy will be

costly to firms that do not have the cash flow
to support it, dividend increases signal a
company’s good fortune and its manager’s
confidence in future cash flows.
Taxes and Dividend Policy

In the U.S., shareholders are taxed twice (figures in dollars)

Rate of Income Tax

0% 23.80%
Operating income 100 100
Corporate tax (T c = .35) 35 35
Aftertax income (paid as div) 65 65
Income tax 0 15.47
Cash to shareholder 65 49.53
Dividends Decrease Value

Tax Consequences
Companies can convert dividends into capital
gains by shifting their dividend policies. If
dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a
move and value the firm more favorably.

In such a tax environment, the total cash flow

retained by the firm and/or held by shareholders
will be higher than if dividends are paid.
Taxes and the Radical Left

• Since capital gains are taxed at a lower rate

than dividend income, companies should
o Repurchase stock
Dividends Increase Value

Apple stock price increased, despite paying no

dividend. It sent a signal of growth.
o After Jobs died in 2011, Apple starts to pay dividends