Corporate Finance II: Financing Investments and Managing Risk

Professor Heitor Almeida

Module 2: Understanding Debt Financing and Payout Policy

Table of Contents
Module 2: Understanding Debt Financing and Payout Policy .................................................. 1
Lesson 2-0. Objectives and Overview .................................................................................................................. 2

Lesson 2-1: Debt Financing ............................................................................................................... 9

Lesson 2-1.1. Bonds ............................................................................................................................................. 9
Lesson 2-1.2. Credit Rating ................................................................................................................................ 26

Lesson 2-2: The Many Different Types of Debt ............................................................................... 46

Lesson 2-2.1. The Many Different Types of Debt............................................................................................... 46

Lesson 2-3: Bank or Market Financing?........................................................................................... 53

Lesson 2-3.1. Bank or Market Financing? .......................................................................................................... 53

Lesson 2-4: Do Dividends and Share Repurchases Affect Firm Value? ............................................. 66
Lesson 2-4.1. Do Dividends and Share Repurchases Affect Firm Value? ........................................................... 66

Lesson 2-5: Main Factors Driving Payout Decisions ......................................................................... 78

Lesson 2-5.1. Main Factors Driving Payout Decisions ........................................................................................ 78

Lesson 2-6: Dividends or Repurchases? .......................................................................................... 87

Lesson 2-6.1. Dividends or Repurchases? .......................................................................................................... 87

Lesson 2-7: Module 2 Review ......................................................................................................... 99

Lesson 2-7. Module 2 Review ............................................................................................................................ 99
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-0 Module 2 Information

Lesson 2-0. Objectives and Overview

As we learned in the previous module, debt is the most important source of external
finance for most companies because companies dislike issuing equity. Issuing equity
causes a negative stock price reaction, therefore, debt is key for financial markets. What
we're going to do in this model is we're going to dig deeper to better understand debt
finance. We're going to talk about credit ratings, credit risk, debt structure. There's going
to be a lot more details about how debt financing works in the real world.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

It is our first goal. And then our second goal is to talk about the mirror image of
financing. Companies raise money from investors, but then they also have to decide
how much to pay out, when and how much are they going to return to investors? How
much cash are they going to return to investors? When should they do it? And that's
what we call payout policy. We're going to study dividends and repurchase. We're going
to talk about why companies’ payout and also the differences between dividends and
stock repurchase.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

In particular, in this model, you will learn the determinants of the yield to maturity. Why
do different companies have different yield to maturity, then the relationship between
the yield to maturity and the cost of debt. And we're going to talk about credit risk. Credit
risk is going to be a very important concept in this module, is the main driver of credit
markets. We're also going to learn how to use credit ratings as a summary measure of
credit risk. As we learn in the previous module, capital structure depends not only on
leverage, but it also depends on other characteristics, such as profitability, size, casual
risk.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

You're going to learn in this module how to use a credit rating to determine a company's
optimal capital structure. Then we're going to talk about what we call debt structure.
We're going to talk about different types of debt, debt comes in different flavors, such as
commercial paper, capital leases, bonds, bank financing. We're going to talk about the
definitions of these different types of debt and give some examples and learn what is
different about them.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

We're also going to talk about important characteristics of debt contract, such as
seniority, collateral and covenants. And what we're going to learn is that these are as
important as pricing for debt financing. Finally, we're going to talk about how companies
choose between bank and market financing. That probably is the most important choice
that a financial manager has to make is to choose between what type of debt are you
going to issues. Are going to issue bank debt, or are going to issue bonds? And we're
going to talk about how companies make this choice.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Then we're going to move on to payout. First, we're going to talk about the common
mistakes that investors and practitioners make when evaluating the impact of dividends
and repurchase on firm value. We're going to talk about the concept of delusion again.
And we're going to learn how to avoid mistakes when we evaluate companies’ payout.
And then we're going to talk about, why does payout matter? What are the reasons why
dividends and repurchase can impact form value? And why should companies’ payout?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Finally, we're going to talk about the differences between dividends and repurchase.
companies can payout cash using either dividends or repurchase. We're going to talk
about, what are these differences and how companies should choose between
dividends and repurchase.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-1: Debt Financing

Lesson 2-1.1. Bonds

In this lesson, we're going to talk about bond yields. Here is some data to get started in
April 1, 2022. A 10-year bond issued by the US government was paying a yield of 2.4%.
The yield to maturity is 2.4% whereas if you look at a 10-year bond issued by Kraft-
Heinz, a large US public company, the yield maturity on a bond of similar maturity also a
10-year bond was 4.2%. Why is the yield on the US government bond significantly
lower than the yield on the corporate bond?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The answer of course is that investors demand a compensation for bankruptcy for the
likelihood of default. The US government is not going, very unlikely to default on its debt
obligation. But the company like Kraft-Heinz has some risk of default as we're going to
learn in this module, okay? So right, what is the chance of default on US government
bonds?

When you think about it, it's not really zero, right? But it's very low. It has never
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
happened. The US government has never defaulted on debt and very unlikely to
happen in the future. In fact, if you recall our discussion of the cost of capital that we did
in the previous course, that is why we use the US government bonds to estimate the
risk-free rate in dollars. It's that's why we call the risk-free rate but when we think about
companies, there is a risk of default.

Here's some data for you using historical data from Standard & Poor's. What you see
here is the 10-year cumulative default probability. This is the probability that different
companies default in the next 10 years. This data is reported by credit ratings. In the
next lesson, we're going to talk more details about credit rating that's essentially a
measure of credit risk. You can see for example if a company is rated let's say BBB,
triple B, the chance that the issuer defaults in the next 10 years is 5.3%. It means that
95% of the time, a company rated BBB is going to pay its debt right in the next 10 years
but there is a 5.3% chance that the company is going to default.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

In fact, that is the credit rating of Kraft-Heinz, BBB-. And this credit rating is determined
by Standard & Poor's. What Standard & Poor and other credit rating agencies such as
Moody's do is that they use models to estimate the probability of default for each issuer.
The data that I just showed you is the historical probability. The historical data for
companies on average. There that have the same credit rating as Kraft-Heinz but we
actually have some data on the estimated default probability for Kraft-Heinz using
company specific characteristics. And this data on April 1, 2022 the annual default
probability for Kraft-Heinz was 0.4%. As you can see, it's very close to the historical
data. The historical data was 5% in 10 years. If you divide by 10, it's 0.5. So not that
different from the historical data, but this is a company specific default probability
estimated in this case, estimated by Standard & Poor's,
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Why is this probability 0.4%? The models that Standard & Poor's and Moody's used
look at different variables such as leverage, profitability, cash flow risk, market
conditions. In fact, these variables are like the factors that determine the company's
optimal capital structure that we talked about in the previous module, right?
We talked about the tradeoff theory, etc. We discussed that these variables are going to
determine the company's optimal leverage. For the same data, these different variables
are going to affect the company's chance of default. it's not the only leverage, there are
other variables as well.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The default probability that we looked at of course is an important determinant of what

we call the company's credit risk. The credit risk is the risk that investors take on when
lending money to the company. When you lend money to the US government, there is
very little, not significant credit risk, but when you lend money to the company, there is a
risk of default. In the case of Kraft-Heinz is 0.4% a year. Besides the probability of
default, recovery rates also matter. If a company defaults, the bondholders typically gets
some recovery. They're going to get some money back. You're not going to lose 100%,
you're going to get some money back.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

And in fact, here's a tree with two states for us to talk about this. If you are a bond
investor, you buy the 10-year Kraft-Heinz bond today. As we just looked at the default
probability in the next year, there is a 99.6% chance that the bond is going to pay off. in
this case, we also have the data on the yield. You're going to get a 4.2% return and
then there is a 0.4% chance that the issuer is going to default in that case. There's
going to be recovery. If Kraft-Heinz default, then investors are going to get some money
back.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

And we have data again, we have historical data on recovery rates, and we know that
recovery rates have been on average 40% of the face value. In the case of bonds later
in the course, we're going to talk about recovery rates for bank debt as well.

In this case, t he investors are getting 40% back, the return that they will get if the
company defaults are -60%. If everything goes as planned, you get a 4.2% return. In the
worst-case scenario, you’re going to get -60. What we can do now is we can calculate
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
the expected return. the expected return is just the average. It's close to 4.2 but it's not
exactly 4.2 because you have the risk of default. If you multiply 99.6% * 4.2 plus the
negative return that you're going to get in the event of default times the probability,
you're going to get 3.9%. It is the expected return that an investor expects when buying
a Kraft-Heinz bond.

We notice that the yield to maturity is not equal to the cost of debt. When we talk about
the cost of capital, for example, we already learned in this course how to estimate the
cost of capital. When you estimate the cost of capital for the company, what you need is
the cost of debt. That's what we called rD. In our WACC equation, the yield to maturity is
not an expected return, it's a promised return. the credit risk model that we just learned
makes this very clear. The company pays the yield to maturity if it does not default.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

In order to calculate the cost of debt starting from the yield to maturity, you can use
essentially the same equation that we used for Kraft-Heinz. It's 1 minus the probability
of default times the yield to maturity plus the probability of default times the investor's
return upon default, which is the recovery rate minus 1 in our case was -60%.It is not a
huge difference in this case but it's a few 0.3%.

However, there are going to be companies that have higher credit risk. Here's another
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
example for you. It's a company in the healthcare industry, Tenet Healthcare. It has a
credit rating of B+ and it has a 10-year yield to maturity of 6%. you can see that this
company is promising a higher return for investors. Why is that? One reason is because
it has a higher default probability. If you look at the Standard&Poor's estimate of the
annual default probability for this company at the same time that we looked at April,
2022 it's 2.9%.

We can do the calculation using the same formula for Tenet Healthcare. You would
obtain that the cost of that is 4.1%. You can now see the cost of that is significantly
lower than the yield to Maturity.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

To summarize what we talked about for Kraft-Heinz, the annual probability of default
was 0.4%. The yield was 4.2. The cost of debt was relatively close to the yield to
maturity, a little bit lower. For a company with higher credit risk, you can see that the
cost of that is significantly lower than the yield to maturity. What have we learned with
this example? First point is when credit risk is high. In the case of Tenet Healthcare,
you're going to have a higher yield to maturity. Investors are going to demand
compensation for default. The other point is once we make the adjustment. Once we
calculate the cost of debt, what you see is the differences in the cost of debt are much
smaller than the differences in the yield to maturity. In our example, the cost of debt for
Kraft-Heinz was 3.9%. The cost of debt for Tenet Healthcare was 4.1%. The differences
are going to be smaller once you make this adjustment.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

And the other point that I want to emphasize is that when credit risk is high, there's
going to be a significant difference between the cost of debt and the yield to maturity.
So to estimate the cost of debt, right? So which is what we need, right? To calculate the
cost of capital, right?

What we're going to do is we're going to start from the yield to maturity which we can
observe. That's basically the price of the bond as we already learned in this course,
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
right? When we're talking about the cost of capital but then we can use the analysis that
we developed in this lesson to adjust the yield to maturity.

Here is a useful rule of thumb for you. If credit risk is low, then this additional calculation
is not really going to matter, okay? Because the cost of debt is going to be very close to
the yield to maturity. You can think about an extreme example in which the default
probability is zero. In that case, the expected return is the yield to maturity. But if the
default probability is small, then it's going to be so close that it's not worth making the
adjustment, right? But if the credit risk is high, then my recommendation is that you
should use the probability of default to estimate the cost of debt. And you can use the
credit risk model that you learned in this lesson, okay? If you have the company specific
default probability, you can use that or you can use the historical data, okay? And so
now you might ask me what do I mean by low and high, right? When do I have to make
the adjustment? The rule of terms that I use is that I look at the credit rating. So anytime
the credit rating is equal or greater than A, right? Then I don't really worry about making
the adjustment because it's really not going to matter. But if the rating is lower, it is
probably worthwhile adjusting the cost of debt because if you use the yield to maturity,
you're going to overestimate the cost of capital for the company.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

In terms of the maturity, right? We discussed this already. I prefer to use the 30-year
maturity for the cost of debt. As long as possible, typically it's 30 years. But in many
cases, you're not going to have information about the 30-year. For example, in the two
cases that we looked at, the companies had a 10-year bond, but they didn't have a 30-
year bond. What you do in this case is you can use the 10-year but you can consider
matching the maturity. So how do you do that? Using Kraft Heinz as an example, right?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

We had the cost of that for the 10-year Kraft-Heinz bond. It was 3.9%. We also had the
10-year yield on the US government was 2.4% and then what that gives us is gives us a
spread. It's telling us that the expected return on the Kraft-Heinz bond is 1.5% higher
than the expected return on the US bond. So what you can do is you can apply the
spread to the 30-year US bond in order to estimate the cost of that.

So here's the calculation, the 30-year US bond in April was 2.5. So in this case, it wasn't
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
too different from the 10-year. It was actually very close. There are going to be cases
though in which the 30-year risk-free rate might be higher than the 10-year risk free
rate. This adjustment is going to matter more. In our example, you would get the 30
year cost of debt for Kraft-Heinz would be 4% instead of 3.9%. So if I am estimating the
cost of capital for Kraft-Heinz, I would use 4% rather than 3.9%, okay? So it's not too
different from what we had.

And the other point is you might be wondering, right? In some cases you might not have
information on the yield to maturity. For example, some companies do not have publicly
traded debt. So they don't issue bonds, they may just have bank debt. In that case, what
I typically do is I still use the spread method, even if I don't have data on interest rates,
right? What this model, the credit risk model that we develop in this module suggests is
that you can add the spread to the risk-free rate and I typically use the spread between
1% and 2%. For example, in the case of Kraft Heinz, the spread was approximately
1.5%, right? So and what you can also do is you can increase the spread if credit risk is
higher, the company has a lower rating, you can use a higher spread. Of course this
method is not going to be as precise as using firm specific data, but it's going to be in
the right ballpark.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
Lesson 2-1.2. Credit Rating

In this lesson, we're going to talk about credit rates, what they are, and how to use
credit ratings in corporate finance. Credit ratings are, of course, a fundamental variable
for credit markets. Here you can see a map of the world that shows you the credit
ratings of different countries. The US, you have many countries here, of course, not all
countries are rated. But the rated countries you can see, of course, this is not
completely updated, but it gives you an idea about the different credit ratings of different
countries around the world.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The ratings are between, if we use S&P ratings, the two major credit rating agencies
are Standard & Poor's and Moody's. If you use S&P ratings, the highest rating is AAA.
You start at AAA and then you go down to the junk ratings where the lowest possible
rating in this table is C. Beyond that, the company is in default. If Standard & Poor's
gives you a rating of D, that means that the company is not paying interest or you are
not able to pay the principal, etc. In this table, you'll also see a very potent breakpoint
that we're going to talk about later. It's the break point between what we call investment
grade rating and junk. The last possible investment-grade rating is BBB minus. If a
company goes from BBB minus to BB plus, then you are downgraded from investment
grade to junk. As we're going to talk about later, this downgrade is particularly important
for a company.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

What do the ratings measure? Just copying a sentence from Standard & Poor's. Our
ratings express our opinion about the ability and willingness of an issuer such as a
corporation or a government. I showed you the map of the world to meet its financial
obligations in full and on time. So essentially, the credit rating is a measure of the
probability of default.

It's a measure of the chance that an issuer default. As the agencies, including S&P,
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
Moody's, and Fitch, are smaller agencies that is also relatively important. What they say
is that it's not a purely objective measure. It also incorporates judgment calls. So the
credit rating agencies also use qualitative analysis about the company in order to
determine the credit rating. But what we can do is, of course, we have data right on the
credit ratings, we have data on firm characteristics. What researchers have done is to
back out which variables matter. Again, we look at corporate finance research to
examine this. This comes from a paper that I have written in the past. It's a regression
where we are relating a company's credit rating to form characteristics.

So here we have ROA, we learned in this course already. It's a measure of profitability.
We have size and leverage. Very clearly what you can see here is that companies that
are more profitable, larger, and have lower leverage are going to have higher credit
ratings.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

You can also see it on this table, we have the different ratings, not the pluses and
minuses, just the six basic ratings. Then you have some basic firm characteristics. You
have leverage, total of that is a fraction of the market value of assets, and then you
have the interest coverage. So, it's EBIT operating income divided by interest payments.
This is what we call interests coverage. You can see that the companies that are more
profitable and that have lower leverage have higher credit ratings. Two different ways to
show how credit ratings are related to firm characters.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The bottom line is, of course, leverage matters. Highly levered companies have lower
ratings, but other variables also matter. Size, profitability. I didn't show you cash flow
risk, but cash flow risk is another variable that affects credit ratings. When Standard &
Poor's estimates that the company has a lot of volatility in cash flows, then you might
give a lower rating because the chance of default is higher.

This is a corporate finance course and the big question is, what can we do with ratings?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
Why do we care? How can a financial manager use the credit rating to guide financial
policy? That really is the most important topic I want to discuss with you in this lesson. A
good starting point is the trade-off model of capital structure that we talked about in the
previous module in this course. Here we have leverage on the X-axis and we have
value.

As we learned a company can gain the median. US public company can gain 5% in
value by moving 0-30 percent leverage so 30% is the optimal leverage ratio for the
medium public company in the US. That's the nice feature that we learned in the
previous module. However, not all firms are like the median firm. We talked about that
as well in the previous module, the idea that optimal leverage depends on firm
characteristics and these firm characteristics actually turn out to be the same ones that
affect the credit rating, profitability, size, and etc.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The important point that I want to emphasize here in this lesson is that the credit rating
is a summary measure of credit risk. The credit rating depends not only on leverage, but
also these other variables so you can use the credit rating to guide managerial
decisions.

For example, let's look at PepsiCo and then we're going to compare it with a company
or with a higher leverage. PepsiCo leverage in April 2022 is around 15%. I computed
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
that using our formula, it's the same one we used in the previous module. Remember
that to use the trade-off model, you have to use the specific formula. Is debt divided by
debt plus equity? You have the data here that gives a leverage or 15% for PepsiCo.

Where would you place PepsiCo in the trade-off model? We have the picture where
would PepsiCo be? Remember that we have the table that I showed you that relates
leverage to credit ratings. What this table is showing you is that the leverage of 30%
which according to the trade-off model, according to the data is the leverage of
the median public firm is associated on average with a rating of BBB.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The median public firm has a credit rating of BBB at a leverage ratio of 30% so that's
how you can interpret this table.

If you look at PepsiCo's credit rating using Standard & Poor's again, this is the printout
here for you to see. The credit rating of the company is A plus.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

How do we use that? If you think about the trade-off model, the fact that PepsiCo has a
credit rating of A plus, means that the company's probability to the left of the optimal. At
the optimal leverage ratio of 30%, the leverage is 30%, the credit rating is BBB.
PepsiCo has lower leverage and a higher credit rating. The point is that the company's
credit rating seems to be consistent with its leverage. PepsiCo has low leverage, it has
a high credit rating. The bottom line is the company can likely issue more debt without
reducing firm value and maybe can even increase it a bit. According to the trade-off
model, the company might be able to increase value by having a higher leverage so you
are relatively under levered.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's look at another example and I think this is going to make it even more clear how
useful it is to look at credit rating. Now let's think about Twitter. Twitter's leverage on
April 2022 is 17% so similar to PepsiCo using the same calculation.

Now you might be thinking, so we learned of the trade-off model so that's easy. Twitter
is also going to be under lever. You have similar leverage the trade-off model relates
value to leverage. Is that the right picture?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Remember, before you draw conclusions about capital structure, you have to look at the
credit rating. In this case, the credit rating suggests the different picture. The credit
rating of Twitter according to Standard and Poor's is BB plus. Remember, PepsiCo's
credit rating was A plus, Twitter has a junk rating at a low leverage ratio.

If Twitter was like the median public companies should have leverage of A, just like
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
PepsiCo. In this table here you see that accompany that has leverage of 17% should
have a rating of A but Twitter doesn't. Why is that? It's because of the other
characteristics.

The credit rating depends not only on leverage but also on other characteristics. So in
the case of Twitter, Twitter is a growth company that a lot of the profitability is in the
future. Current profits are relatively low, which means that the company is a high credit
risk. Even at a relatively low debt ratio, the company may have some trouble repaying
interest, so it has a lower ability to repay interests than a company like PepsiCo
because of profitability. That is why Standard and Poor gives Twitter a lower rate.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

In fact, what this means is that Twitter is probably over levered. If I was using the trade-
off model to analyze Twitter's capital structure. My conclusion would be that at the 17%
leverage ratio, Twitter's leverage is probably higher than the optimal because it has a
junk rating. I would probably place Twitter to the right of the optimal capital structure.

Besides leverage, it is important to look at the credit rating of the company. The credit
rating captures credit risk more broadly than leverage alone does in the case of Twitter;
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
the credit rating shows you that the company is probably over levered at 17%. The
optimal leverage ratio for Twitter is likely to be lower than that, and we only learn that
when we look at the credit rate, you might have been able to guess. If you know the
characteristics of the company and if you analyze profitability, etc. But the credit rating
is a summary variable that is very helpful.

If the company's rating is not what you would expect. That's in the case of Twitter, than
you should take into account when evaluating the company's capital structure.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Now you might be asking, okay, so we have two examples and they’re not really at the
optimal, so PepsiCo seems to be underlevered, Twitter seems to be overlevered, and
as we discussed it already in this course, companies can become overlevered. It's
relatively easy to explain because it could be just a result of poor performance, so
maybe the profits are not high. The company needs to issue that in order to finance
investments that could lead to a high leverage ratio or maybe there is a large
investment like M&A investment. When a company acquires another one using cash,
you might have to issue debt in order to do so, and that can increase the leverage as
well, so overleverage is relatively easy to explain, underleverage is maybe more
interesting, and what corporate finance researchers believe is that, that underleverage
may actually be a consequence of trying to target a high credit rating, so what PepsiCo
managers might be doing on purpose, trying to have a credit rating that is significantly
higher than the threshold that causes a downgrade to junk.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

There is some research in corporate finance that shows that the rating downgrade can
in fact matter. There is some evidence that a rating downgrade can for example, affect
the company's access to commercial paper. If you look at the debt structure of PepsiCo,
and by the way, we're going to talk more about the debt structuring in this module.

PepsiCo relies on the commercial paper market to access short-term finance. When a
company gets downgraded in particular to a junk rating, the company may lose access
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
to commercial paper. There are other regulations that are tied to rating. For examples,
bank capital requirements are tied to rating, so if PepsiCo wants to have a credit line
with the bank in order to manage liquidity, for examples, it might have to have a high
credit rating as well, or the bank may charge more to give PepsiCo credit line if the
rating is lower.

Then there is also what we call ratings triggers. If a company gets downgraded, you can
have covenant violations, etc. Bottom line is that there are many regulations, and
because of the way financial markets work, rating downgrade can restrict the company's
access to capital. Insurance companies, for example are restricted from investing in
bonds that are rated lower than BBB minus. Insurance companies are very important
buyers of bonds in the market, but they can only buy bonds that are rated investment
great. Those are some examples of situations in which a company can actually suffer
when you have a credit rating downgrade.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The bottom line is that financial managers target credit ratings and not only an optimal
leverage ratio, investment grade or higher is a typical target for financial managers. That
may be why PepsiCo has a relatively low leverage ratio that looks lower than what the
optimal should be.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-2: The Many Different Types of Debt

Lesson 2-2.1. The Many Different Types of Debt

Here is the debt structure for Monsanto. And this is what I mean by debt structure.
Instead of just looking at the total amount of debt that a company has. In the case of
Monsanto, it's $10.5 billion. What we're going to look at is what type of debt does a
company have? In this case, right, I listed here all the different types of debt securities
that Monsanto had of issue at that time. This is essentially September 2016, it's the
same time we're looking at in the previous example. You can see that there is
commercial paper, revolving credit, term loans. The purpose of this lecture is for us to
learn what's the difference between all these different types of debt. And how
companies choose between these different types of debt security.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The idea is that debt has many faces, so debt is not going to come only with on one
mask. There's going to be many different types of debt. Let's talk about these five types,
commercial paper, revolving credit, term loans, bonds, and capital leases.

Starting with commercial paper. If you look at the table, I showed you for Monsanto,
commercial paper represents 18.3% of the total debt that the company has. What's the
characteristic of commercial paper? Commercial paper is a short-term debt that the
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Professor Heitor Almeida
maturity is less than 270 days, so even less than a year. It's sold directly to the market.
So if a company has commercial paper, you're not really borrowing from a bank. You
are borrowing money directly from investors in the market. There is no intermediary,
okay? And because of this characteristic, this is a type of debt that is relevant only for
firms that have very high credit ratings. To be able to access this market where you can
freely borrow from investors on the short-term basis without an intermediary, what
happens is that this market is really only available for companies that have high credit
ratings.

Like Monsanto, for example, had a BBB credit rating. It can have some commercial
paper. But companies that have lower ratings or companies that don't have credit
ratings are not going to be able to access this market. If we look at the data, what I did
is I pulled out from the financial statistics of the United States how much commercial
paper was outstanding for the known financial corporate sector at the end of 2015. And
the figure was 176.5 billion. That might seem like a lot, but you'll see that it's a small
market compared to bonds and bank loans. Let me also say that if you had to obtain
this data for financial companies, you would see larger numbers. Financial companies,
like banks and insurance companies, they rely more on commercial paper. But non-
financial companies do not rely so much on this specific market.

Then, in that example, in the most Monsanto data we have revolving credit. And we
talked about this in Corporate Finance I already. Revolving credit it comes from a credit
line, it's a bank loan that originates from a credit line drawdown. That data shows us that
Monsanto has an undrawn credit line of 1 billion, 1.074 billion. But the revolving credit is
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
0. And here's the question I want you to think about. We talked about it in Corporate
Finance I, I wanted to refresh your memory. Why would Monsanto have a credit line if it
does not use it? The credit line is going to cost money and Monsanto is not using it.
What's going on?

The answer is that the credit line is used mostly for insurance in this case. The idea is
that Monsanto is going to draw on the credit line if it has trouble refinancing its other
liabilities. For example, in Corporate Finance I, we gave an example of accounts
payable. If a company has trouble refinancing accounts payable, it may be useful to
have a credit line that you can use to manage your liquidity. Or Monsanto may have
trouble refinancing commercial paper, right? We showed that Monsanto does use
commercial paper market. If you have trouble refinancing your commercial paper, it
might be useful to have a credit line that you can use as a backup. It makes sense
actually that you have a credit line, but you don't use it, if you're using it for insurance,
right? If you have drawn the whole thing, then it can no longer be used for insurance.
What you'll see in the data is that companies like Monsanto that held a high credit rating
are going to have undrawn credit lines that they use for insurance purposes.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Moving down that table, we have the term loans. So a term loan is a bank loan that
does not originate from a credit line drawdown. So it's a loan, it's money you borrow
from the bank with a fixed maturity. That's why it's called term. And it does not originate
from a credit line drawdown, otherwise it would be called revolving credit. It can be short
or long term.

And for Monsanto it wasn't a very important form of financing. Monsanto uses only 3%.
Only 3% of the total debt was coming from term loans. Essentially what Monsanto is
doing is using bonds for its finances. So, 79% of the debt that Monsanto has comes
from bonds that Monsanto issues in the financial market. Like the bonds we were talking
about, remember that I gave an example of a specific Monsanto bond. That is how the
company is financing itself long term. Rather than bank loans, they are using bonds.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

What is a capital lease? You can think of this essentially as renting, right? Instead of
buying equipment, buying a machine and borrowing money to buy the machine, what a
company can do is to rent the machine. This rental is going to generate a liability. So if
you have a lease, you're going to have to make the rental payments to the other party in
this transaction, right? So this capital lease that you see in Monsanto's balance sheet is
the lease that cannot be cancelled. The lessee is the company who rents the
equipment, right? So we call the lease a capital lease if the lease cannot be cancelled
before the end of the contract. So it has this liability component. If you have this lease,
you have to make the rental payment. However, for Monsanto, if you look at the data,
Monsanto actually didn't have any leases.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Capital leases are only going to be important in certain industries like airlines. Here you
have JetBlue. Let's look at JetBlue debt structure as another example. And it's very
similar to Monsanto's in many ways. For example, it's most of the debt that JetBlue has
comes from bonds. It doesn't really rely on bank loans that much. It has zero revolving
credit, right? But it has a credit line here, an undrawn credit line of 600 million. So
similar, right? The main difference here is that JetBlue does use leases. 8% of the total
debt that JetBlue has corresponds to leasing. So essentially, airlines are going to lease.
They use the leasing market to rent airplanes. Instead of borrowing money and buying
airplanes, airlines are also renting airplanes. And you can see that in the balance sheet
of JetBlue.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-3: Bank or Market Financing?

Lesson 2-3.1. Bank or Market Financing?

The most important sources of debt financing for companies are banks and bond
markets. Going back to that data from the US government, I looked at the end of 2015,
how much outstanding bonds these companies have, and how much outstanding loans.
And you can see that the figures are very large. Companies had $4.8 trillion outstanding
bonds, at the end of 2015. And they have 2.6 trillion outstanding loans. That includes
revolving credit, by the way. So this raises an interesting question. How do companies
choose between these two forms of debt financing? What's the difference between
borrowing from the bond market or borrowing from a bank? Very important financial
decision to think about for a corporate financial manager.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

I want to give an example from the real world, thinking about two companies in the
same industry. And this is a picture, we're going to have Home Depot and Tile Shop.
Those are both retailers that sale similar stuff. Okay, let's look at their debt structure.

Home Depot is here. If you look at the debt structure of Home Depot, we're going to
find, to encounter a common pattern. We already saw the debt structure of JetBlue and
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Professor Heitor Almeida
the debt structure of Monsanto in our previous slides. Home Depot is actually going to
look very similar. There is a lot of bonds. So Home Depot is relying on the bonds
market. 96.5% of its debt comes from the bond market. A little bit of capital leases for
Home Depot. There is an undrawn credit line of $2 billion that the company's not really
using. So companies with high ratings, large public companies tend to use credit lines
for insurance as we've been talking about. So zero revolving credit and zero term loans.
So Home Depot is not relying on banks for its financing.

Tile Shop looks very different. Look at this, 47.5 million term loans. That is almost the
entire amount of debt outstanding that they have, 57.1, right? So out of $57.1 million of
debt, they have 47.5 in bank loans, so it's 83%. The other, a large item here is revolving
credit, right? So remember, revolving credit originates from a drawdown of a credit line,
it's also bank debt. You're drawing down a credit line from a bank, so both are bank
debt. Essentially what this picture is showing is that, other than a very small bond
issuance issue, and a small amount of capital leases, Tile Shop is relying mostly on
banks for its long term finances.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

That's the summary here, we have this very nice contrast. Two companies in the same
industry, one of them relies mostly on bonds. The other one relies mostly on banks.
What's the difference?

Again, let's look at data. The data helps a lot. This is Home Depot, okay? Here what I
have in the bottom is this notion of secured debt. We also have data on whether the
debt is secured or not, which we're going to talk about soon. What it is, essentially, a
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Professor Heitor Almeida
notion of collateral. Is the debt collateralized by assets or not? And here you see that for
Home Depot, most of the debt is unsecured, it's not collateralized.

Whereas, if you look at Tile Shop there is no unsecured debt. All the debt that Tile Shop
has is secured, is collateralized. So that's a very important difference, collateral.

That's one of the key differences between bank debt and bonds. Bank debt is typically
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
going to be secured by buildings, machinery, other types of collateral. Then bank is not
going to give you a loan, if you don't, we call it post collateral, right. If you don't have an
asset that you can post as collateral, initially meaning that if you default on your debt,
the bank can take over that asset. So if Tile Shop defaults, the bank is going to take
over the collateral. Whereas bonds are typically unsecured. If home Depot defaults,
essentially what's going to happen is what we were talking about in the Monsanto
example. Remember in the Monsanto example, we have this tree, if Home Depot
defaults on its debt, bond holders are going to take over the business and try to recover
some value. Bonds are only secured by the cash flows of the business. So they are
unsecured, really.

This is of course, going to affect recovery rates. We were talking about recovery rates in
the beginning of this module, but now what we have is recovery rates, specified by
different types of bonds. This actually comes from Moody's. And what you see here is
that secured bank debt has a much larger recovery rate than senior bonds, okay? So
senior unsecured bonds has a recovery rate of 40%. If you remember, that's exactly the
number we used In our numerical example. But secure bank debt is going to have a
higher than 80% recovery. So banks will get their money back, all right?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Here's a question for you to motivate the next thing we're going to talk about. If you look
at that data, the recovery rate for secured debt is 82% for banks. But we also have
secured bonds. They are not very common, but there are a few of them out there that
they will pull out the recovery rate for secured bonds and it was 65%. So it's lower,
right? If the only thing that mattered was collateral, the recovery rates should be the
same, but it's not. What's going on is a question for you to think about.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

What happens is that bank debt is going to come with an additional source of control for
the bank. Most commonly, in the data, this is represented by financial covenants.

So what's a covenant? A covenant is essentially a condition, a contractual condition that

a company has to satisfy in order to be able to maintain the loan. For example, a very
common covenant in the real world is that the company has to have a profitability higher
than a certain number. So if your EBITDA, for example, falls below X. This X is the
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
threshold. What happens is, the bank has the right to call the loan. Covenants can be
written on profits, they can be written on other variables as well, like leverage and
related variables. Essentially what happens is technical default. Meaning that if the bank
has the right to call the roll, essentially either the company pays, right? Or the bank is
going to take over some of the assets, so this is technical default. What happens in
practice is that that is a trigger for renegotiation. So the bank can use the covenant to
take control over the company and try to change the situation, to change what's going
on at the company.

This is a graphical way to think about covenants. So here we have EBITDA down the y
axis and we have time. This a company that is doing poorly. It's EBITDA is decreasing,
right? I also plotted the interest payment here. If your EBITDA falls below your interest
payment, that might trigger default, so you don't have enough profit to pay your interest,
right? But typically, if you have a bank loan, what will happen is that, there is going to be
the threshold. There's going to be a covenant that says that your EBITDA is not going to
be allowed to fall all the way down to your interest payment. Your EBITDA had to be
greater than X. If you cross the threshold if your EBITDA becomes lower than X The
bank will take control. The bank takes control, renegotiates the loan, does whatever it
needs to do in order to make sure it's going to get paid, right, and the company has to
comply with them. If the company did not have the covenant, then in principle, you
would be allowed to go all the way down to the interest payment before the bond
holders can take control. The bottom line is that these covenants are going to transfer
control to the bank earlier than if you only had bonds, if you only had market financing.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

To summarize, these are the differences we talked about, right? So, bonds are going to
give less control for investors, lower recovery rates. Bank debt has more control for the
bank and higher recovery rates, right? We haven't really talked much about interest
rates, but it's pretty obvious the way it should go, right? Banks have much higher
recovery, right, and they have more control. So typically what will happen is for the
same company, it will end up being a lower interest rate if it borrows from a bank and
gives more control to the bank, than if it goes to the bond market, right? The bond
market, you're going to pay more interest rate, but investors are going to have less
control over the company. They also going to recover less if the company defaults,
right?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's think about this. What source of that financing should a corporate financial
manager choose? So reflect on what we learned for a while and try to think about how
companies make these decisions in the real world.

Right, then you can see that it is not going to be an obvious decision, right? There's
going to be a tradeoff between paying lower interest rates, but losing control, right?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
If you go to a bank to borrow money, this bank financing route typically come with many
more conditions. And there's going to be an expectation that the bank is going to
interfere with corporate policies. So, you're going to have to give control to the bank. So,
the bank has a higher recovery rate, it can charge you a lower interest rate. That's not
an obvious trade off, all right. In fact, we have this nice way to describe bond financing,
which is arm's length, right. It's a type of financing that keeps your creditor away, okay.

And again, we can draw on our research, right? People have done research on this
choice between banks and bonds, and how has it evolved over time. So here is an
interesting picture, looking at the US data in the last 30 years or so. What we've been
seeing is that companies are relying more and more on bond financing. So the ratio,
what we have in the y axis, is the ratio of bonds to total debt okay. This ratio has been
increasing. It used to be 50%, but it has been increasing to close to 70% recently. So
what companies are doing, is they are shifting from banks to bond finance.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

In terms of firm characteristics, people have also done research on this, and what the
research has found is very consistent with our example. Remember the Tile Shop,
Home Depot example. Bank financing is going to be more important for small
companies, young companies, and riskier companies. If you are riskier, you're likely to
pay a very high interest rate, anyway right? So, it might be better for you to go a bank.
Give more control to a bank so you can reduce the cost of financing. Once companies
grow, mature, become less Is risky, they tend to switch to bonds. This is like Home
Depot. So Tile Shop and Home Depot are two companies in different stages of their life
cycle in the same industry. Home Depot is a large public company uses bonds. Tile
Shop is also a public company but is much smaller and riskier. It uses banks for its debt
financing. Right? So, the bottom line is that this greater control that is associated with
bank funding is used for far small risky companies. But at some point, it seems to
become costly, right? So companies move away from banks and into bonds, in order to
have this arm’s length financing, in order to reduce the control that is associated with
bank funding.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-4: Do Dividends and Share Repurchases Affect Firm Value?

Lesson 2-4.1. Do Dividends and Share Repurchases Affect Firm Value?

Let's talk now about returning cash to investors. As we discussed in the introduction
returning cash to the investors is the mirror image of raising cash from investors. Some
of the same considerations we've already talked about in module one are going to apply
here as well, okay?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

We're talking about payout policy, of course, right? So what we study in payout policy in
corporate science is how to return cash to its investors, specifically to equity investors.
If you have debt investors, right? Debt investors are receiving interest. Interest is not
really a decision of the company, right? If you borrow money, you have to pay interest,
but payout is a decision. If you issue equity, you're not necessarily forced to pay
dividends and you're definitely not forced to do stock repurchase. That is a conscious,
voluntary decision of the company, right? Let's think about what determines this
decision. Why should this matter, why we need to talk about payout?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

And the first thing you're going to see is we're actually going to directly use this mirror
image idea. Remember that the dilution argument, right? That we talked about in
module one, what we discussed is the idea that dilution is an illusion, right? Let's think
about this, supposed somebody tells you the following argument that stock repurchases
reduce the number of shares. If you buy back shares, the number of shares outstanding
go down. Therefore, stock prices go up, right? Because the stock price is the equity
value divided by the number of shares outstanding.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Is this right or wrong? Remember, dilution is an illusion. The idea of dilution is that
issuing shares increases the number of shares outstanding, so stock prices must come
down, right? I showed you that dilution is an illusion, right? Of course, if dilution is an
illusion, reducing dilution is also an illusion, Don't get mixed up saying this but, right?

Reducing the illusion has to be wrong as well, right? So let's try to work this out. I think
you are capable of doing this on your own, it's very simple. What should happen to a
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Professor Heitor Almeida
company that in this case suppose you have a stock price of $80, share outstanding is
1,000, so your equity value is 80,000. What should happen to the stock price if the
company decides to repurchase 100 shares? Think about this.

Right, so your shares outstanding are going to go down, of course. You have 100 less
shares. But if the stock price if this was the right calculation, right? 80 divided by 900,
then of course, your stock price would go up.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

The problem is that the repurchase costs money. You're not going to be able to
repurchase shares for free. If you buy the shares at the market price that means you're
going to spend $8,000. So if you do the math 80 minus 8 divided by 900, exactly the
same stock price, right? So the stock repurchase at the market price cannot change the
stock price.

Remember the NPV idea. NPV and stock prices are the same thing as we learned in
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Professor Heitor Almeida
corporate finance one, right? So what we learned is that if a company buys back shares
of the market price the NPV should be zero, right? The company can only increase the
stock price if they manage to buy the shares for a deal, right? If you buy the shares on
the cheap obviously, that's going to be a good deal. But think about the other side, who
would sell, right? Who is going to be willing to sell shares at a cheap price? Most likely
they're going to pay a market price, right? So the NPV of the stock repurchase should,
to a first approximation should be zero. Remember, same idea we talked about in
module one when we are thinking issuing debt and issuing the equity.

Let's think now about dividends. Suppose a company decides to double the number of
dividends that it pays to investors, what's going to be the NPV? Let me give you an
example, an example from the real world.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's say that PepsiCo, right? This is PepsiCo, the company we talked about in
Corporate Finance I, it is paying $4 billion here of the dividends currently, okay?
Let's say that PepsiCo decides to double its annual dividends from 4 billion to $8 billion.

Shareholders might love this, right? You're going to receive $4 billion additional
annually, right? But the money is not free, right? The dividend has to come from
somewhere. If PepsiCo pays $4 billion additional dollars in dividends, you're going to
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
have $4 billion less in cash. The net effect is zero, okay? So that's how I like to think
about dividends. Dividends is just moving cash from one pocket to the other. You take
cash from one pocket and move to the other. Investors own that cash no matter if it is in
the company or the left pocket or if it's in your pocket, the right pocket, okay? Equity
investors will still own that cash, right? Meaning that moving cash from one pocket to
the other, paying a dividend, really shouldn't have any effect, okay?

What we've seen so far is very similar to module one. There should be no mechanical
effect, right? Paying your dividend or doing a stock repurchase is a transaction, in
principle, shouldn't create any value. And again, we can look at evidence. What
happens to stock prices, right? We have instances in the real world when companies
decide to change pay out policy. We can look at what happens to their stock prices
when they increase dividends or when they do a stock repurchase. We're bringing back
our researcher to show us the data, right?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's look at dividends first. This paper by Benartzi, Michaely and Thaler was written in
97. What they find is that stock prices tend to increase by 1.3% following the
announcement of a large increase in dividends. So this is an announcement return
around the day that a company announces an increase in dividends. By the same
token, stock prices tend to decrease by 2.5% when companies announce that dividends
will decrease, okay? So it doesn't look like this is zero NPV, the value is actually
changing following a changing dividends.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Same thing for dividend initiations and omissions. If the first time a company announce
is going to be a dividend on average stock prices go up by 3.4%. If a company omits the
dividend, if you use it to pay a dividend and you tell investors your cutting it to zero, your
stock prices is going to think it goes down by 7%. That's another paper by Michaely,
Thaler and another co-author, okay?

Repurchase this data is data that I compiled myself. The evidence of repurchase
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
announcement was kind of old and I just wanted to see what was happening more
recently. So a few years like go I did this table myself. This is not really published is just
something I use for my class. But you can look at all the events of stock repurchase
announcements in the marketplace between 99 and 2010. And then at the bottom here,
I computed the average market reaction to these repurchase announcements. What we
see is very similar to dividends when companies announce a new stock repurchase.
Their stock prices go up on average by 1.54%.

Bottom line, both dividends and repurchase increase the company's stock price in the
real world. Which is not consistent with the zero NPV argument we learned. So what we
are going to learn next is why do dividends and repurchases actually matter in practice
in the real world.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-5: Main Factors Driving Payout Decisions

Lesson 2-5.1. Main Factors Driving Payout Decisions

What we learned so far is that dividends and repurchase should be zero NPV but they
are not. Paying dividends, doing stock repurchase, do change companies stock prices.
So now what we're going to talk about is why is this the case, why do dividends and
repurchase matter in the real world? There are four arguments that we're going to
discuss related to taxes, signaling of information, cash management, and earnings
management.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's start with taxes. As we learned already when we were talking about capital
structure, investors will typically pay taxes personal taxes when they receive dividends
or when they sell shares that they own, either back to the company, really what
happens is if a company repurchase shares. The company will be buying back shares in
the market. You're not buying shares directly from any specific investor. So a stock
repurchase means that somebody is selling shares, so this would generate taxes.
For dividends, it is fairly straightforward as I have here in this table. So for example if
PepsiCo pays a four billion dollars dividend to investors it's going to be taxed, the
current tax rate in the US is 20%. So your four billion is going to turn into 3.2 billion. The
government is going to take some of it.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

It's not clear what the tax rate on repurchases is. It's a bit complicated because the
actual tax rate depends on the taxable gain, okay. Which is the amount to sell it for
minus the cost basis. The cost basis is a number that depends on the price. You can
think of it as the price you pay for a share. If it is only one share, the cost basis the price
you paid for that share. And the taxable gain is the price you'll sell for minus the cost
basis. In the real world there are lots of complications about how this tax is computed.
The maximum tax rate in the US is also 20%. It’s the capital gain tax for wealthy
investors
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

If PepsiCo, instead of paying dividends and repurchasing shares, right. So, as we

learned, both generate taxes. What if PepsiCo had done nothing, paid zero dividends
and repurchased zero shares? What would have happened to the personal taxes?

Here is the answer. PepsiCo would have saved a lot in taxes for investors if it had
retained the cash, right? So this table summarizes everything. Dividends generate a tax
rate of 20%, right? PepsiCo was doing five billion dollars in stock repurchase during
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Professor Heitor Almeida
2015. And investors were paying a tax rate, we are not sure exactly how much because
it depends on the cost basis. But it's positive, I mean it wouldn't be zero. So investors
are paying taxes when they sell shares. So they would get less than five billion, right. If
PepsiCo had retained the cash, then investors wouldn't have paid any of these taxes to
a first approximation. So PepsiCo would have saved a lot in taxes.

Bottom line is taxes are not going to help explain why companies pay out cash. It
actually goes the other way. From a tax management point of view, it's typically better to
have companies retain cash. And then you let investors choose. If investors want to get
some cash back they can do it by selling shares in the market. So investors choose
when they want to pay taxes or not. So taxes is not going to help explain the data by the
way, because the data will show us that dividends and purchasing increase stock price.
So taxes is not the reason for it. But it's important to know what are the tax implications.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

One argument that does help is signaling. So let's think about a real world example. We
have this fictitious example that we talked about, that PepsiCo is doubling its dividend.
Here is the cash flow statement of PepsiCo that we also used in corporate finance
minus one, right? So PepsiCo is currently generating 2.9 billion dollars in cash, right?
And it's paying a dividend of four billion dollars, it's here in the data. So what happens if
PepsiCo increases it's annually dividend to eight billion? Right?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

What happens is that now PepsiCo is going to start to losing cash. If you paid four
billion additional dollars in dividend, you're generating two billion, now you're going to
lose two billion dollars in cash a year, right? So what information would this convey to
investors, for PepsiCo to do that, right? For PepsiCo to be able to commit to a four
billion dollars dividend, it must be the cast that the company is very confident about its
ability to generate cash in the future. The only situation in which a PepsiCo's CFO, you
know would do something like that is if you sure that the PepsiCo is going to generate a
lot more cash in the future than what it's generating today, alright. So that's one possible
reason why the market responds positively to dividends or repurchase, right? Spending
cash, returning cash to investors is a positive signal about the company’s ability to
generate cash internally, right? So that's one possible explanation.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

And then there's cash management. We talked about the possibility that PepsiCo might
retain cash. So suppose you're thinking only about taxes. PepsiCo decides to retain tax
because it doesn't want investors to pay taxes. What will happen, of course, is retained
earnings. If you don't pay any dividends and repurchase, everything is going to go to
retained earnings because cash is going to start accumulating in the balance sheet.

What happens then? What happens when companies start accumulating too much
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
cash? We are going to bring up our research to help guide us. People have done
research on this. In fact, there is classic paper by Jared Harford written in 1999, that
shows that, essentially, the idea that cash burns a hole in the pocket. When companies
have too much cash, they end up doing wrong things. For example, acquisition. Harford
shows us that cash-rich companies are more likely to obtain acquisitions. But also that
these acquisitions end up destroy shareholder value. These are bad acquisitions. Cash-
rich acquirers destroy seven cents in value for each dollar of excess cash that they
carry in the balance. Cash burners are holding the bucket that causes managers to
engage in bad views. We are going to go back to this argument in module four when we
talk about the financing of M&A. We are again going to talk about this relation between
cash and M&A which is a very important topic but for now.

The key idea is that paying out cash may be a way to control this overspending, right?
If companies end up having too much cash, they may overspend it in bad acquisition for
example. One way to control this behavior is by giving the cash back to investors. That
argument by the way works both for repurchase and for dividends. Both are ways to
return cash to investors, get the cash out of the company, stop managers from
overinvesting in bad projects.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-6: Dividends or Repurchases?

Lesson 2-6.1. Dividends or Repurchases?

We have pretty solid arguments for why companies should pay out cash. We just talked
about a few of them, like signaling, cash management, but we haven't talked about how
we should do it. We haven't talked about the choice between dividends or stock
repurchase. That's the topic of this lesson.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's start with data. What you show here or what you see here is what has happened to
payout policy from the beginning of the 1970s up to recent dates using US date. So, this
is for the US. The blue line shows you the total payout, as a fraction of net income. You
can see that this line is around from 20 to 25%, fairly stable. Companies were paying
back 20 to 25% of their cash to investors. What has happened in the data, though, is
that the red line has decreased. The red line is the dividends, right. In the 70s almost
everything was dividends, so companies use it mostly or almost exclusively dividends to
return cash to investors. But more recently, share purchase have picked up. In the
current dates, repurchase and dividends are equally important.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

So that's the summary. It seems that now, both repurchase, and dividends are equally
important. So companies are doing more and more stock repurchase and cutting
dividends, paying fewer dividends, and keeping this 20 to 25% payout ratio fairly stable
over time.

Let's think about the arguments we learned to try to think about does this make sense
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
in terms of taxes, right? What we discussed is that repurchase are almost surely going
to generate fewer taxes for investors. Investors, for one thing, they don't need to sell the
stock if they're going to face a very high taxable gain. If they face a very high marginal
tax rate, right? With dividends there's no choice. If you pay a dividend, all the investors
are going to have to pay taxes. So, even though both have the same statutory tax rate
of 20%, what academics researches believe is that, the stock repurchase is going to
minimize taxes. So, there might be one reason why repurchase has picked up.

Let's think about signaling. As we discuss it, one reason to pay out, one reason to return
cash to investors is to signal that you're confident about the future. You're confident
about your ability to generate cash. Repurchase is going to have an additional role,
though. Consider a situation when a company believes the stock price is too low,
all right? So there is some violation of market efficiency. The stock price is $80, but the
company believes it should be $85. What the company can do is, it can signal that to
the market by telling the market that it is willing to buy stock at $80, right? The company
goes in the market and says I'm willing to pay $80, that is going to signal to the market
that the stock price may be too low. The company wants to buy it back, so maybe we
should increase the stock price. And notice that the difference here is that there is no
such effect with dividends. Both spend cash. But the dividend goes to everybody, and
there is no stock price associated with the dividend payment, right? So the dividend
cannot signal that the stock price is too low. Here's an advantage for stock repurchase.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let me talk about another argument. It's a reason why companies do repurchase in the
real world. This one is not a reason that I think makes sense from a welfare, from a
society point of view. But there is evidence that it does happen, which is earnings
management, okay? Repurchases are going to allow a company to manage earnings,
specifically, repurchase allow companies to increase earnings per share. Earnings per
share are calculated as earnings divided by shares outstanding, and what will happen
for most companies in the data, what will happen is that a stock repurchase is going to
mechanically increase your earnings per share, whereas dividends is not going to have
any effect, okay. Let me give you an example.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Suppose that the consensus analyst EPS forecast for next quarter is $3 a share. So
analysts are forecasting EPS, right? They believe that the company's going to produce
an EPS of $3 a share. But the company's CFO realizes that your EPS is actually going
to be $2.98 instead. Maybe your profits are going to come a little bit short, right? So
you're not going to be able to meet the analyst forecast. What should the CFO do?

One possible answer is that the CFO might repurchase shares. This is exactly what I
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
showed in a recent paper called the reenforce and cloned. What we've shown is that
companies that expect to fall just short of the analyst’s forecasts are much more likely to
repurchase shares than companies that meet the analysts forecasts without doing a
repurchase. This is what this graph shows. Zero here, you can think of zero as the point
at which companies were going to miss the analyst forecast. So companies that are just
to the left of missing the forecast are much more likely to repurchase shares than
companies that are just to the right. So that is unequivocal evidence, we believe, that
EPS management advise stock repurchase.

We also find that 37% of all stock repurchase are conducted by companies that are just
about to miss EPS targets? We also find that companies are more likely to do this when
compensation depends on EPS targets, right? EPS is a common way to set bonus
plans in companies, for example. And the same companies that do stock repurchase,
they end up reducing investments and deployment following these repurchase. So our
interpretation of this evidence is that it's actually a little bit troubling. As we learned
already in corporate finance in this course, we really shouldn't be focusing so much on
earnings per share. But what happens in practice is that analysts forecast earnings per
share, meeting our EPS target seems to matter. And one way that companies do this is
by using stock repurchase, even if it causes them to reduce employment, for example.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Let's go back to our question. Dividends or repurchases? Right? So this is like a race.
We've been running a race here. Right? We talked about four different arguments.
Taxes, signaling, earnings management, cash management. Here is the result of the
race. You know, repurchases win on almost everything. Taxes, signaling, earnings
management, cash management. Right? The only one that is a top possibly a tie is
cash management actually. Like both repurchase and dividends are ways of returning
cash to investors. All you need to do is to get the cash out of the company. Okay?
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

This is why academics like to think of the dividend puzzle. We saw the data. Companies
have been decreasing dividends over time and doing more repurchase. That makes
sense when you think about these arguments. But dividends haven't decreased to zero.
Companies still pay dividends. The recent data shows that dividend and repurchase are
equally important, right? We don't really know, and we don't really have a great story for
why companies pay dividends. That's interesting, right? You may think that dividend is
an obvious thing, once you dig deep and think about why should a company pay
dividend, we end up with the opposite conclusion, a dividend doesn't make any sense,
right? So, the science is very interesting this way. Maybe one explanation, it's due to
behavioral reasons. Maybe it's simply the fact that investors like dividends. They think
dividends matter, so companies have to pay dividends for that reason. It's an inefficient
market, kind of explanation.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

A related explanation that also sort of relies on inefficient markets but is a little bit more
sophisticated. This is actually a story I heard directly from company CFOs telling me
that that's the reason why they might not stock repurchase. So let me give you the
argument here. Let's take PepsiCo. Suppose that PepsiCo spends $5 billion to
repurchase stock at say $94, that's the current stock price. But the following year the
market tanks. There is a minus 20% negative return in the market. As we saw in
corporate finance one, PepsiCo's beta was approximately 0.5, right? So we would
expect PepsiCo stock to go down by 10%. Market goes down 20%, PepsiCo goes down
by 10%, right? So now the stock price is 84.5, the CFO repurchased shares at $94. The
stock price is now 84.5.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

So here's a question for you. Should the CFO be blamed for having repurchased the
stock at a high price?

No, right. Nobody should be able to predict the stock market. The reason why PepsiCo
stock price went down is because the market went down. It has nothing to do with the
company. However, this is the argument that CFOs told me when I was in a conference
once, and we were discussing why do companies pay dividends, do stock repurchase.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
One argument they gave me is that they are very concerned about doing stock
repurchase, and then seeing the market go down. The CFOs get blamed anyway, right?
Even if the decrease in the stock price has nothing to do with the company. If it's all
driven by the market. They still get blamed for having repurchased dock at a high price.

So that's a market risk story, right? Repurchase expose companies to the risk of buying
stock at a high price and there may well be a reason why companies have moved
completely away from dividends and into stock repurchase. They have done some of
that as we've shown in the data, but they haven't gone the whole way. That might be
because of this market risk story.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

Lesson 2-7: Module 2 Review

Lesson 2-7. Module 2 Review

In module 2, we talked about additional details of debt markets. We learned important

concepts such as the determinants of the yield to maturity and the relationship
between the yield to maturity and the cost of debt. We learned how to estimate the cost
of debt starting from the yield to maturity and when it is important to make this
adjustment. It all depends on credit risk. We learned the concept of credit risk. I showed
you a very simple credit risk model that you can use to do credit risk analysis and in
particular, to use that in order to estimate a company's cost of debt. We also talked
about credit ratings. Credit ratings is a very important measure in financial markets
because it is a summary measure of credit risk that depends not only on leverage, but
also another firm characteristics.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida

This allows us to use credit ratings to determine a company's optimal capital structure.
As I showed you with a couple of examples, the credit rating is a very useful additional
tool that you can use in order to characterize how much debt your company should
have. Then we talked about different flavors of debt including commercial paper, leases,
bonds, bank financing.

We talked about the differences between these different types of debt. We also talked
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
about different characteristics of debt contracts such as seniority, collateral, and
covenants. In particular, we learned that these characteristics can be as important as
pricing and they actually related to pricing as well. For example, if debt has collateral,
if debt is secured, typically it's priced lower than debt that isn't secure. So there is an
important relationship between the characteristics of debt contracts and the pricing of
debt. Then we learn how companies choose between bank and market financing is a
very important choice for large public companies. Are going to issue bank debt? Are you
going to issue bonds? We talked about how companies make this choice. In particular,
we learned that there is a trade-off. Issuing bank debt will typically allow companies to
have lower interest rates but will give more control to the bank. So many public
companies issue bonds in order to have more arm's-length debt as we learned.

Then we moved on to talk about payout. Our second big topic in this module is to think
about the company's payout policy. When should you pay cash to investors? How much
cash should you pay? In particular, we learn how to avoid mistakes such as delusions.
Delusions should not matter. There are common mistakes that investors and
practitioners make when they evaluate the impact of dividends and repurchase on firm
value and we learned how to avoid these mistakes. We also learned how to identify
the true reasons why pay out affects firm value. For example, signaling cash
management. We've talked about the importance of these arguments and then we
talked about why are dividends and repurchase different? What are the differences?
Those are alternative ways to pay out cash, but they are not the same. They have
different implications for income statements and the number of shares outstanding, etc.
 Corporate Finance II: Financing Investments and Managing Risk
Professor Heitor Almeida
In taxes, taxes are an important consideration as well. We talked about how companies
should choose between them.

In particular, we learned that there is actually a dividend puzzle. At least in the US, it's
not clear why companies should pay dividends because repurchase seems to be a
better way for companies to pay out debt.