Chapter 16: Payout Policy

• Many companies pay a regular cash dividend.

– Public companies often pay quarterly.
– Sometimes firms will throw in an extra cash dividend.
– The extreme case would be a liquidating dividend.
• Often companies will declare stock dividends.
– No cash leaves the firm.
– The firm increases the number of shares outstanding.
• Some companies declare a dividend in kind.
– Wrigley’s Gum sends around a box of chewing gum.
– Dundee Crematoria offers shareholders discounted
cremations.
1
Standard Method of Cash Dividend
Payment
Cash Dividend - Payment of cash by the firm
to its shareholders.

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.

Record Date - Person who owns stock on this

date received the dividend.
2
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date

Declaration Date: The board of directors declares a payment

of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders (typical clearing is 3 days). 3
Price Behavior around the Ex-Dividend Date

In a perfect world, the stock price will fall by the

amount of the dividend on the ex-dividend date.
-t … -2 -1 0 +1 +2 …

$P

$P - div
The price drops Ex-
by the amount of dividend
the cash Date
dividend Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date. 4
The Benchmark Case: An Illustration of the
Irrelevance of Dividend Policy
• A compelling case can be made that dividend
policy is irrelevant. Since investors do not need
dividends to convert shares to cash they will
not pay higher prices for firms with higher
dividend payouts.
• Under some important assumption, M&M
(1961) proved that dividend policy is irrelevant.
The assumptions are
1. No taxes.
2. No transaction costs.
3. Perfect capital market (symmetric information, no 5
agency problems, other)
The Benchmark Case: An Illustration of the
Irrelevance of Dividend Policy (example 1)
York Corporation , an all-equity firm
• At date 0, the managers are able to forecast
cash flows perfectly.
• The firm will receive a cashflow of $10,000 at
date 0 and $10,000 at date 1
• The firm will dissolve at date 1.(end its life)
• The firm has no additional positive NPV
projects

6
 An Illustration of the Irrelevance of
Dividend Policy (example 1)
I ) Current Policy:Dividends set equal to cashflow
Dividends (Div.) at each date = $10000
The firm value will be :
DIV 1
V 0  DIV 0 
1  rs
$10000
V 0  $10000   $19090.91
1.1

7
 An Illustration of the Irrelevance of
Dividend Policy (example 1)

Assume 1,000 shares are outstanding,

then, price just before dividend is paid is
$10
P 0  $10   $19.09
1.1
After the imminent dividend is paid, the stock
price will fall to $9.09 (19.09-10)

8
 An Illustration of the Irrelevance of
Dividend Policy (example 1)
I I) Alternative Policy: Initial dividend > cash flow

Pay $11 per share immediately i.e., $11 X 1000 shares =

$11,000 as dividend.
The extra $1,000 must be raised by issuing new stock.

Since the investment decision did not change, the

required return (cost of capital) is still 10%. So the new
shareholders should receive at t=1: $1000 1.1  $1100
Date 0 Date1
Total dividends to old shareholders $11,000 $8,900
Dividends per share $11 $8.9
9
 An Illustration of the Irrelevance of
Dividend Policy (example 1)
The PV of dividends per share (cum-dividend) with the
alternative policy:
$8.9
P 0  $11   $19.09
1.1

• The indifference proposition:

-The value of the firm at t=0 is the same not
matter which scenario we consider .
-The change in dividend policy did not affect
the value of the share (cum-dividend).
10
 An Illustration of the Irrelevance of
Dividend Policy (example 1)
The mechanics of the policy:
At t=0 (Ex-dividend), the price of the share will drop to
$8.09 (8.9/1.1). This means that York needs to issue
1000/8.09 = 123.61 shares. There will be a total of 1123.61
shares outstanding. This leads to the following distribution
of t=1 cash flow:

Number of shares (%) T=1 Dividend

old shareholders 1000 (89%) $8,900
new shareholders 123.61 (11%) $1,100
Total 1123.61(100%) $9,000
11
 An Illustration of the Irrelevance of
Dividend Policy (example 2)
Pumpkin Pie Inc. currently has 1,000 shares outstanding
with a total market value of $42,000. It expects cash flows
from operations to be $10,000 next year. It wants to expand
its product lines to include cookies and determines that it is
a positive NPV project. The new product line requires a
new oven that costs $8,000.
Dividend Policy #1
Pay out any cash that is leftover after investing in all positive NPV projects.
For next year, Pumpkin Pie Inc. will pay out $2,000 ($10,000 - $8,000) as
cash dividend.
Dividend Policy #2
Pumpkin Pie is considering a $3,000 cash dividend ($3 per share).

12
 Homemade Dividends

• Pumpkin Pie Inc. is a $42 stock about to pay a $2 cash

dividend.
• Bob Investor owns 80 shares and prefers $3 cash
dividend.
• Bob’s homemade dividend strategy:
– Sell two shares ex-dividend
homemade dividends $3 Dividend
Cash from dividend $160 $240
Cash from selling stock $80 $0
Total Cash $240 $240
Value of Stock Holdings $40 × 78 = $39 × 80 =
$3,120 $3,120 13
 Dividend Policy is Irrelevant
• Since investors do not need dividends to convert
shares to cash, dividend policy will have no impact on
the value of the firm.
• In the above example, Bob Investor began with total
wealth of $3,360: $42
$3,360  80 shares 
share
 After a $3 dividend, his total wealth is still $3,360:
$39
$3,360  80 shares   $240
share
 After a $2 dividend, and sale of two ex-dividend shares,his
total wealth is still $3,360:
$40
$3,360  78 shares   $160  $80
share 14
 Irrelevance of Stock Dividends
XYZ Inc. has two million shares currently outstanding at $15
per share. The company declares a 50% stock dividend. How
many shares will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by
50%:
2 million×1.5 = 3 million shares
After the stock dividend what is the new price per share and
what is the new value of the firm?
The value of the firm was $2m × $15 per share = $30 m. After
the dividend, the value will remain the same.
Price per share = $30m/ 3m shares = $10 per share
15
 Dividends and Investment Policy

• Firms should never forgo positive NPV projects

to increase a dividend (or to pay a dividend for
the first time).
• Note that the dividend-irrelevance argument
assumes that “The investment policy of the firm
is set ahead of time and is not altered by
changes in dividend policy.”
• A final note:
-Dividends are relevant
-Dividend policy is irrelevant
16
 Repurchase of Stock

• Instead of declaring cash dividends, firms

can rid itself of excess cash through
buying shares of their own stock.
• Recently share repurchase has become
an important way of distributing earnings
to shareholders.
• When tax avoidance is important, share
repurchase is a potentially useful adjunct
to dividend policy.
17
 Share Repurchase

Types:
1. Tender offers - If offer price is set wrong,
some stockholders lose.
2. Auction
3. Open-market repurchase
4. Targeted repurchase (Greenmail)

18
 Stock Repurchase versus Dividend
Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets Liabilities & Equity
A.Original balance sheet
Cash $150,000 Debt 0
Otherassets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10

19
 Stock Repurchase versus Dividend
If they distribute the $100,000 as cash dividend, the balance
sheet will look like this:

Assets Liabilities & Equity

B. After $1 per share cash dividend
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000/100,000 = $9

20
 Stock Repurchase versus Dividend
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:

Assets Liabilities& Equity

C. After stock repurchase
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10

21
 Violation of M&M Assumptions
(1) Taxes
• In Canada, individual investors face a lower dividend
tax rate due to the dividend tax credit.
• However, capital gains for individuals are taxed at 50%
of the marginal tax rate so the effective tax rate on
dividend income is higher than the tax rate on capital
gains.

If dividends are taxed more heavily than capital gains,

investors should pay more for stocks with low
dividends (i.e., investors would be happy with a lower
pretax rate of return from firms offering capital gains
rather than dividends).

22
 Example (Table 16.1)
Firm A Firm B
Next year’s price $112.50 $102.50
Dividend $0 $10
Total pretax payoff $112.50 $112.50
Today’s stock price $100 $97.78
A is preferred to B because it does not pay highly taxed dividends
Dividend tax (40%) 0 10×0.4= $4.00
Capital gain tax (20%) 12.5×0.2=$2.5 4.72×0.2=$0.94
After tax income 12.5-2.5=$10 14.72-4.94=$9.78
After tax return 10/100=10% 9.78/97.78=10%
Before tax return 12.5/100=12.5% 14.72/97.78=15.05%
A and B provide same return after tax, B provides higher return pretax
23
 Dividends Decrease Value
(if one considers only the issue of taxes)
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.
• Since capital gains are taxed at a lower rate than
dividend income, companies should pay the
lowest dividend possible.
• Dividend policy should adjust to changes in the
tax code.
24
Evidence on Dividends and Taxes in Canada
• Prior to 1972, capital gains were untaxed in
Canada
• In 1985, a life-time exemption on capital gains
was introduced.
• Anticipation of the tax break on capital gains
caused investors to bid up prices of low-
dividend yield stocks.
• Firms responded by lowering their dividend
payouts.
• The dividend tax credit works to reduce taxes
on dividends received from Canadian firms.
25
 Violation of M&M Assumptions
(2) Transaction costs

• Also, in the real world there are transaction costs. This

may suggest that
– Shareholders may pay high transaction costs for
selling shares instead of receiving dividends.
– Issuing shares to raise equity my involve high fees
to investment bankers.

26
 Violation of M&M Assumptions
(3) Agency Costs
• Consider a firm with excess cash.
• Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
• The firm has several options:
– Select additional capital budgeting projects (by
assumption, these are negative NPV).
– Acquire other companies (empire building)
– Purchase financial assets
– Repurchase shares

27
 Violation of M&M Assumptions
(4) Information Asymmetry

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.

28
 Desire for Current Income
(5) Market Imperfection

Dividends and Income

Trusts and endowment funds may be
prohibited to invest in non-dividend paying firms.
Since they manage funds by themselves, they may
not be willing to spend the fees required in other
intermediaries to pass this requirement.

29
Summary of all Effects
• Reasons for Low Dividend
– Personal Taxes
– High Issuing Costs
• Reasons for High Dividend
– Information Asymmetry
• Dividends as a signal about firm’s future
performance
– Lower Agency Costs
• capital market as a monitoring device
• reduce free cash flow, and hence wasteful
spending
– Desire for Current Income

30
The Clientele Effect: A Resolution of Real-
World Factors? (cont.)
Clienteles for various dividend payout policies
are likely to form in the following way:
Group Stock

High Tax Bracket Individuals Zero to Low payout stocks

Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium Payout Stocks
Corporations High Payout Stocks

Once the clienteles have been satisfied, a corporation is

unlikely to create value by changing its dividend policy.
31
 The Clientele Effect Example
• 40% of investors prefer high dividends
• 60% of investors prefer low dividends
• 20% of firms pay high dividends
• 80% of firms pay low dividend
High dividend firms in short supply (price ↑), Low dividends
firm in high supply (price ↓).
Some firms will change policy and increase dividends, till
40% of firm pay high dividends, and 60% of firms will pay
low dividends.
Once payouts of corporations conform to the desires of
shareholders, no single firm can affect its market value
by switching from one dividend strategy to another.
32
 The Dividend Decision
Lintner’s “Stylized Facts”
(How Dividends are Determined)
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in
earnings.
4. Managers are reluctant to make dividend changes that
might have to be reversed.
5. Firms repurchase stock when they have accumulated a
large amount of unwanted cash or wish to change their
capital structure by replacing equity with debt. 33
 Summary and Conclusions
• The optimal payout ratio cannot be determined
quantitatively.
• In a perfect capital market, dividend policy is irrelevant
due to the homemade dividend concept.
• A firm should not reject positive NPV projects to pay a
dividend.
• Personal taxes and issue costs are real-world
considerations that favor low dividend payouts.
• Many firms appear to have a long-run target dividend-
payout policy. There appears to be some value to
dividend stability and smoothing.
• There appears to be some information content in
dividend payments. Agency consideration may also
lead to high dividends.
34
 Practice question 1: Time Line

On April 5, the board of directors of Capital City

Golf Club declared a dividend of $0.75 per share
payable on Tuesday, May 4, to shareholders of
record as of Tuesday April 20. Suppose you
bought 350 shares of Capital City stock on April
6 for $8.65 a share. Assume there are no taxes,
no transaction costs, and no news between your
purchase and sale of the stock. If you were to
sell your stock on April 16, for how much would
you be able to sell your stock? What if you were
to sell the stock on April 21?
35
 Practice question 2: M&M Theorem
The net income of Novis Corporation, which has 10,000
outstanding shares and a 100% payout policy is $32,000.
The expected value of the firm one year hence is
$1,545,600. The appropriate discount rate for Novis is 13%.
1. What is the current value of the firm?
2. What is the ex-dividend price of Novis’s stock if the board
follows its current policy?
3. At the dividend declaration meeting, several board
members claimed that the dividend is too small and is
probably depressing Novis’ price. They proposed that Novis
sell enough new shares to finance a $4.25 dividend. (a)
comment on the claim that the low dividend is depressing
the stock price. Support your argument with calculations. (b)
If the proposal is adopted, at what price will the new shares
sell and how many will be sold? 36
Practice question 3: Dealing with Taxes
National Business Machine Co. (NBM) has $2 million of
extra cash. NBM has two choices to make use of this cash.
One alternative is to invest the cash in financial assets. The
resulting investment income will be paid out as a special
dividend at the end of three years. In this case, the firm can
invest in TB yielding 7%, or an 11% preferred stock. Only
30% of the dividends from investing in preferred stock
would be subject to corporate taxes. Another alternative is
to pay out the cash as dividends and let the shareholders
invest on their own in treasury bills with the same yield. The
corporate tax rate is 35%, and the individual tax rate is 31%.
Should the cash be paid today or in three years? Which of
the two options generates the highest after-tax income for
the shareholders?

37
Practice question 4: Real World Factors?
In the May 4, 1981, issue of Fortune, an article
entitled “Fresh Evidence That Dividends Don’t
Matter” stated, “All told, 115 companies of the S&P
500 firms raised their payout every year during the
period 1970-1989. Investors in this group would
have fared somewhat better than investors in the
500 as a whole with a median return of 10.7%
versus 9.4% for the S&P 500.”
Is the evidence that investors prefer dividends to
capital gains? Why or why not?

38
 Chapter 17
Does Debt Policy Matter?

• The Effect of Capital Structure in a

Competitive Tax Free Environment
• Financial Risk and Expected Returns
• The Weighted Average Cost of Capital
• A Final Word on After Tax WACC

39
 M&M (What is it all about?)
• What is the capital structure question?
• Why maximizing equity value and firm
value is the same (under what
assumptions)?

40
 M&M (Debt Policy Doesn’t Matter)
Modigliani & Miller
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.
Major Assumptions (not all):
(1) Individuals and firms borrow/lend at same rate.
(2) No Bankruptcy costs
(3) No transaction costs
(4) No taxes
41
The Idea.. Can We Create Value By
Splitting a Pie?
The derivation is straightforward:
Shareholde rs in a levered firm receive Bondholder s receive
EBIT  rD D rD D
Thus, the total cash flow to all stakeholders is
( EBIT  rD D)  rD D
The present value of this stream of cash flows is VL
Clearly
( EBIT  rD D)  rD D  EBIT
The present value of this stream of cash flows is VU

VL  VU 42
M&M (Debt Policy Doesn’t Matter)

Dollar Investment Dollar Return

.01VU .01  Profits

Dollar Investment Dollar Return

Debt .01DL .01  Interest
Equity .01EL .01  ( Profits - Interest)
Total .01(DL  EL ) .01  Profits
 .01VL

43
M&M (Debt Policy Doesn’t Matter)

Dollar Investment Dollar Return

.01EL .01  ( Profits - interest)
 .01(VL  DL )

Dollar Investment Dollar Return

Borrowing  .01DL - .01  Interest
Equity .01VU .01  Profits
Total .01(VU  DL ) .01  ( Profits - Interest)

44
 Example 1
Consider an all-equity firm that is considering going into
debt. (Maybe some of the original shareholders want to cash
out.)
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50 45
 EPS and ROE Under Current Capital
Structure

Recession ExpectedExpansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
EBIT/A 5% 10% 15%
ROE 5% 10% 15%
46
 EPS and ROE Under Proposed
Capital Structure

Recession ExpectedExpansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
EBIT/A 5% 10% 15%
ROE 3% 11% 20%
47
EPS and ROE Under Both Capital Structures
All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
EBIT/A 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
EBIT/A 5% 10% 15%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares 48

Financial Leverage and EPS
12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage
to debt EBI
EBIT
in dollars, no taxes 49
 Homemade Leverage
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300

Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%

We are buying 40 shares of a $50 stock on margin. We

get the same ROE as if we bought into a levered firm.
Our personal debt equity ratio is: D $800
 2
E $1,200 3 50
 Homemade (Un)Leverage
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236

Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%

Buying 24 shares of an other-wise identical levered firm

along with the some of the firm’s debt gets us to the ROE of
the unlevered firm.
This is the fundamental insight of M&M
51
 M&M (Debt Policy Doesn’t Matter)
Example (text) - 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
52
 M&M (Debt Policy Doesn’t Matter)
Example Data
Number of shares 500
cont.
Price per share $10
50% debt Market Value of Shares $ 5,000
Market val ue of debt $ 5,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
53
 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
54
 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.

AN EVERYDAY ANALOGY

It should cost no more to assemble a

chicken than to buy one whole.
 Proposition I and Macbeth

Macbeth continued

Cuttent Structure : Proposed Structure :

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

56
 Leverage and Returns

expected operating income

Expected return on assets  ra 
market val ue of all securities

 D   E 
rA   rD     rE  
 DE  DE

57
 M&M Proposition II
Macbeth continued (All equity firm)

rE  rA  rA  rD 
D
E

expected operating income

rE  rA 
market val ue of all securities
1500
  .15
10,000

58
 M&M Proposition II
Macbeth continued (D/E=1)
rE  rA  rA  rD 
D
E
expected operating income
rE  rA 
market val ue of all securities
1500
  .15
10,000

rE  .15  .15  .10

5000
5000
 .20 or 20%
59
 Leverage and Risk
Macbeth continued
Leverage increases the risk of Macbeth shares
Operating Income
Change
$1,500 to $500
All equity Earnings per share ($) 1.50 0.50 - $1.00
Return on shares 15% 5% - 10%
50 % debt : Earnings per share ($) 2 0 - $2.00
Return on shares 20% 0 - 20%

60
 Leverage and Returns
Market Value Balance Sheet example

Asset Value 100 Debt (D) 30

Equity (E) 70
Asset Value 100 Firm Value (V) 100

rd = 7.5%
 D   E 
rA   rD  
  Er  
re = 15%  D  E   D  E 
 30   70 
rA   .075  
  .15    12.75%
 100   100 

61
 Leverage and Returns
Market Value Balance Sheet example – continued
What happens to Re when debt costs rise?
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

rd = 7.5% changes to 7.875%

re = ??
 40   60 
.1275   .07875     re  
 100   100 
re  16.0%
62
 Leverage and Returns

 D  E
BA   BD     BE  
 V  V

BE  BA  BA  BD 
D
E

63
 M&M Proposition II
r
rE

rA

rD
D
Risk free debt Risky debt E
64
 WACC (traditional view)
r
rE

WACC

rD
D
V
65
 After Tax WACC

Tax Adjusted Formula

D  E
WACC  rD  (1  Tc)      rE  
V   V

66
 After Tax WACC

Example - Union Pacific

The firm has a marginal tax rate of

35%. The cost of equity is 10.0% and
the pretax cost of debt is 5.5%. Given
the book and market value balance
sheets, what is the tax adjusted
WACC?

67
 After Tax WACC

Example - Union Pacific - continued

Balance Sheet (Market Value, billions)

Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities

MARKET VALUES
68
 Summary: No Taxes

• In a world of no taxes, the value of the firm is unaffected

by capital structure.
• This is M&M Proposition I:
VL = VU
• Prop I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.

• In a world of no taxes, M&M Proposition II states that

leverage increases the risk and return to stockholders
D
rE  rA   (rA  rD )
E
69
 Question (illustrating Prop I and II)
Turtle Motors, and all-equity firm, has an expected cash flow of $10
million per year in perpetuity. There are 10 million shares
outstanding, implying expected annual cash flow of $1 per share.
The cost of capital for this unlevered firm is 10%. The firm will soon
build a new plant for $4 million. The plant is expected to generate
additional cash flow of $1 million per year.
a. Find the projects NPV
b. Write down the market value balance sheet of Turtle Motors before
and after the new project is announced (assume efficient capital
markets and that the firm announces it will raise equity to finance
the new plant).
c. Assume the firm decides to finance the new project by issuing
shares. Write down the market balance sheet upon share issuing
and upon payment of the project. How many shares are issued?
Describe the change in firm value, shareholders required return and
share price throughout the process.
d. Repeat (c) but assume that the firm decides on issuing debt which
entail a 6% interest in perpetuity.
70
 Chapter 18
How Much Shout a Firm Borrow

• Corporate Taxes and Value

• Corporate and Personal Taxes
• Cost of Financial Distress
• Pecking Order of Financial Choices

71
 Capital Structure & Corporate Taxes

Financial Risk - Risk to shareholders resulting

from the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

72
 Capital Structure & Corporate Taxes
The tax deductibility of interest increases the total distributed
income to both bondholders and shareholders.

Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598
Total income to both bondholders and
stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

73
 Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The
company has no debt. The company’s annual cash flow is
$900,000 before interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your equity position for 5%
bonds with a face value of $2,000,000.
Should you do this and why?

($ 1,000 s) All Equity 1/2 Debt Total Cash Flow

EBIT 900 900 All Equity = 585
Interest Pmt 0 100
Pretax Income 900 800 *1/2 Debt = 620
Taxes @ 35% 315 280
(520 + 100)
Net Cash Flow 585 520
74
 Capital Structure & Corporate Taxes
D x rD x Tc
PV of Tax Shield = = D x Tc
rD
(assume perpetuity)

Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000

PV Tax Shield = $2,000,000 x .35 = $700,000

75
 The MM Proposition I (Corp. Taxes)
Shareholde rs in a levered firm receive Bondholder s receive
( EBIT  rD D)  (1  TC ) rD D
Thus, the total cash flow to all stakeholders is
( EBIT  rD D)  (1  TC )  rD D
The present value of this stream of cash flows is VL
Clearly ( EBIT  rD D)  (1  TC )  rD D 
 EBIT  (1  TC )  rD D  (1  TC )  rD D
 EBIT  (1  TC )  rD D  rD DTC  rD D
The present value of the first term is VU
The present value of the second term is TCD
VL  VU  TC D 76
The MM Proposition II (Corp. Taxes)
Start with M&M Proposition I with taxes: VL  VU  TC D
Since VL  EL  D  EL  D  VU  TC D
VU  EL  D(1  TC )
The cash flows from each side of the balance sheet must equal:
EL rE  DrD  VU rA  TC DrD
EL rE  DrD  [ EL  D(1  TC )]rA  TC rD D
Divide both sides by EL
D D D
rE  rD  [1  (1  TC )]rA  TC rD
EL EL EL
D
r  rA   (1  TC )  (rA  rD )
Which quickly reduces to E EL 77
The Effect of Financial Leverage on the Cost of Debt and Equity
Capital with Corporate Taxes

Cost of capital: r D
(%) rE  rA   (rA  rD )
EL

D
rE  rA   (1  TC )  (rA  rD )
EL

rA

D EL
rW ACC   rD  (1  TC )   rE
DEL D  EL
rD

Debt-to-equity
ratio (D/EL)
78
 Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35% $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCrDD $650+$224 $1,300+$224 $1,950+$224 79
$874 $1,524 $2,174
 Capital Structure & Corporate Taxes
Pfizer Balance Sheet, March 2004 (figures in $millions)

Book values
Net working capital 10,752 7,144 Long-term debt
21,460 Other long-term liabilities
Long-term assets 86,900 69,048 Equity
Total assets 97,652 97,652 Total value

Market values
Net working capital 10,752 7,144 Long-term debt
PV interest tax shield 2,500 21,460 Other long-term liabilities
Long-term assests 283,373 268,021 Equity
Total assets 296,625 296,625 Total value

80
Capital Structure & Corporate Taxes
Pfizer Balance Sheet, March 2004 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)
Book values
Net working capital 10,752 8,144 Long-term debt
21,460 Other long-term liabilities
Long-term assets 86,900 68,048 Equity
Total assets 97,652 97,652 Total value

Market values
Net working capital 10,752 8,144 Long-term debt
PV interest tax shield 2,850 21,460 Other long-term liabilities
Long-term assests 283,373 267,371 Equity
Total assets 296,975 296,975 Total value

81
 Can Debt Be So Valuable?

1. What about personal taxes?

2. Perhaps firms that borrow incur other
costs – bankruptcy costs, for example.

82
C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )

1-Tp
(1-TpE) (1-Tc)

Advantage
RAF > 1 Debt
RAF < 1 Equity 83
 C.S. & Taxes (Personal & Corp)
Operating Income ($1.00)

Paid out as Or paid out as

interest equity income

Corporate Tax None Tc

Income after $1.00 $1.00 – Tc

Corp Taxes

Personal Taxes Tp TpE (1.00-Tc)

.

Income after All $1.00 – Tp $1.00–Tc-TpE (1.00-Tc)

Taxes =(1.00-TpE)(1.00-Tc)

To bondholders To stockholders
84
 C.S. & Taxes (Personal & Corp)
Example

Interest Equity Income

Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corporate tax 1 0.65
Personal tax at Tp = .35 and Tpe = .105 0.35 0.068
Income after all taxes $0.675 $0.582

Advantage to debt= $ .068

85
 Personal Taxes

• The value of a levered firm can be expressed

in terms of an unlevered firm as:
 (1  TC )  (1  TpE ) 
VL  VU  1  D
 1  TP 

Where:
TpE = personal tax rate on equity income
TP = personal tax rate on bond income
TC = corporate tax rate
86
 Value of Leverage with Personal Taxes
The derivation is straightforward:
Shareholde rs in a levered firm receive
( EBIT  rD D)  (1  TC )  (1  TpE )
Bondholder s receive
rD D  (1  Tp )
Thus, the total cash flow to all stakeholders is
( EBIT  rD D)  (1  TC )  (1  TpE )  rD D  (1  Tp )
This can be rewritten as
 (1  TC )  (1  TpE ) 
EBIT  (1  TC )  (1  TpE )  rD D  (1  Tp )  1  
 1  Tp 87 
Continued…
 Value of Leverage with Personal Taxes
The total cash flow to all stakeholders in the
levered firm is:  (1  TC )  (1  TpE ) 
EBIT  (1  TC )  (1  TpE )  rD D  (1  Tp )  1  
 1  Tp 
The first term is the cash The second term is the advantage
flow of an unlevered firm of leverage. Its PV in perpetuity
after all taxes. is….
Its value = VU.  (1  TC )  (1  TpE ) 
D  1  

 1  Tp 
The value of the sum of these
two terms must be VL
 (1  TC )  (1  TpE ) 
VL  VU  1  D
 1  TP  88
Effect of Financial Leverage on Firm Value with Both
Corporate and Personal Taxes
 (1  TC )  (1  TpE ) 
VL  VU  1   D
 1  Tp 
TpE  Tp
VL = VU+TCD
VL > VU
TpE  Tp and (1 - Tp )  (1  TC )  (1  TpE )
VU
VL =VU TpE  Tp and (1 - Tp )  (1  TC )  (1  TpE )

VL < VU (1 - Tp )  (1  TC )  (1  TpE )
Debt (D) 89
 Capital Structure
Structure of Bond Yield Rates
r

Bond
Yield

D
E
90
 Costs of Financial Distress

• Bankruptcy risk versus bankruptcy cost.

• The possibility of bankruptcy has a
negative effect on the value of the firm.
• However, it is not the risk of bankruptcy
itself that lowers value.
• Rather it is the costs associated with
bankruptcy.
• It is the stockholders who bear these
91
costs.
 Description of Costs
• Direct Costs
– Legal and administrative costs (tend to be a
small percentage of firm value).
• Indirect Costs
– Impaired ability to conduct business (e.g., lost
sales)
– Agency Costs
• Selfish Strategy 1: Incentive to take large risks
• Selfish Strategy 2: Incentive toward
underinvestment
• Selfish Strategy 3: Cash In and Run 92

• Other
 Financial Distress

Costs of Financial Distress - Costs arising from

bankruptcy or distorted business decisions
before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield
- PV Costs of Financial
Distress

93
 Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
94
 Conflicts of Interest (1)
Circular File Company has $50 of 1-year debt.

Circular File Company (Book Values)

Net W.C. 20 50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets 100 100 Total liabilities

Circular File Company (Market Values)

Net W.C. 20 25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets 30 30 Total liabilities

Why does the equity have any value ?

95
 Conflicts of Interest (1)

Circular File Company may invest $10 as follows.

Now Possible Payoffs Next Year

$120 (10% probabilit y)
Invest $10
$0 (90% probabilit y)
 Assume the NPV of the project is (-$2).
What is the effect on the market values?
96
 Conflicts of Interest (1)

Circular File Company value (post project)

Circular File Company (Market Values)

Net W.C. 10 20 Bonds outstanding
Fixed assets 18 8 Common stock
Total assets 28 28 Total liabilities

• Firm value falls by $2, but equity holder gains $3

97
 Conflicts of Interest (2)
Assumes a safe project with NPV = $5 and initial outlay of $10

Circular File Company (Market Values)

Net W.C. 20 25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets 30 30 Total liabilities

Circular File Company (Market Values)

Net W.C. 20 33 Bonds outstanding
Fixed assets 25 12 Common stock
Total assets 45 45 Total liabilities

While firm value may rise by pursuing project, the lack of a high
potential payoff for shareholders makes shareholders reject the project.
98
 Example 2
Balance Sheet of Faster Airlines

Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 $200
Fixed Asset $400 $0 Equity $300 $0
Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

Faster Airlines is contemplating on being the first to buy a new
jet that can make the Vancouver-London flight in 2 hours.
99
 Example 2

The Gamble Probability Payoff

Win Big 10% $1,000
Lose Big 90% $0

Cost of investment is $200 (all the firm’s cash)

Required return is 50%

Expected CF from the Gamble = $1000 × 0.10 + $0 = $100

$100
NPV = –$200 +
(1.50)
NPV = –$133
100
 Example 2

• Expected CF from the Gamble

– To Bondholders = $300 × 0.10 + $0 = $30
– To Stockholders = ($1000 - $300) × 0.10 + $0 =
$70

• PV of Bonds Without the Gamble = $200

• PV of Stocks Without the Gamble = $0

• PV of Bonds With the Gamble = $30 / 1.5 = $20

• PV of Stocks With the Gamble = $70 / 1.5 = $47
101
 Example 2 (cont)
• Consider a government-sponsored project that
guarantees $350 in one period
• Cost of investment is $300 (the firm only has $200) so
the stockholders will have to supply an additional $100 to
finance the project
• Required return is 10%
$350
NPV  $300 
• 1.10
NPV  $18.18

• Should we accept the project?

102
 Example 2 (cont)
• Expected CF from the government sponsored project:
– To Bondholder = $300
– To Stockholder = ($350 - $300) = $50

• PV of Bonds Without the Project = $200

• PV of Stocks Without the Project = $0

• PV of Bonds With the Project = $300 / 1.1 = $272.73

• PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55

103
 Cash In and Run (example 2 cont)
• Liquidating dividends
– Suppose our firm paid out a $200 dividend to
the shareholders. This leaves the firm
insolvent, with nothing for the bondholders, but
plenty for the former shareholders.
– Such tactics often violate bond indentures.
• Increase perquisites to shareholders
and/or management

104
 Protective Covenants
• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– Pay dividends beyond specified amount.
– Sell more senior debt & amount of new debt is limited.
– Refund existing bond issue with new bonds paying lower
interest rate.
– Buy another company’s bonds.
• Positive covenant: Thou shall:
– Use proceeds from sale of assets for other assets.
– Allow redemption in event of merger or spinoff.
– Maintain good condition of assets.
– Provide audited financial information.
– Segregate and maintain specific assets as security for debt.

105
 Other Financial Distress Games

• Playing for Time

• Bait and Switch

106
 Financial Choices

Trade-off Theory - Theory that capital structure is

based on a trade-off between tax savings and
distress costs of debt.

Pecking Order Theory - Theory stating that firms

prefer to issue debt rather than equity if internal
finance is insufficient.

107
 Issues and Stock Prices

• Why do security issues affect stock price?

The demand for a firm’s securities ought to
be flat.

 Any firm is a drop in the bucket.

 Plenty of close substitutes.
 Large debt issues don’t significantly
depress the stock price.
108
 Pecking Order Theory

Consider the following story:

The announcement of a stock issue drives down the stock

price because investors believe managers are more likely to
issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be

raised without sending adverse signals.

If external finance is required, firms issue debt first and

equity as a last resort.

The most profitable firms borrow less not because they

have lower target debt ratios but because they don't need
external finance.
109
 The Pecking-Order Theory

• Theory stating that firms prefer to issue debt rather than

equity if internal finance is insufficient.
– Rule 1
• Use internal financing first.
– Rule 2
• Issue debt next, equity last.
• The pecking-order theory is at odds with the trade-off
theory:
– There is no target D/E ratio.
– Profitable firms use less debt.
– Companies like financial slack
110
 How Do Companies Behave in Reality?

• Most Corporations Have Low Debt-Asset Ratios.

• Changes in Financial Leverage Affect Firm Value.
– Stock price increases with increases in leverage and vice-
versa; this is consistent with M&M with taxes.
– Another interpretation is that firms signal good news when
they lever up.
• There are Differences in Capital Structure Across Industries
(Note that growth implies significant equity financing, even in
a world with low bankruptcy costs).
• There is Evidence that Firms Behave as If They had a Target
Debt-to-Equity ratio. 111
 A Recipe for Capital Structure Decisions

• Taxes
– If corporate tax rates are higher than bondholder tax rates,
there is an advantage to debt.
• Types of Assets
– The costs of financial distress depend on the types of assets
the firm has.
• Uncertainty of Operating Income
– Even without debt, firms with uncertain operating income
have high probability of experiencing financial distress.
• Pecking Order and Financial Slack
– Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.
112
 Summary and Conclusions
• Costs of financial distress cause firms to restrain their
issuance of debt.
– Direct costs
• Lawyers’ and accountants’ fees
– Indirect Costs
• Impaired ability to conduct business
• Incentives to take on risky projects
• Incentives to underinvest
• Incentive to milk the property
• Pecking order provides another issue to consider – the
signaling to the market
• There are other practical issues to consider such as
tangibility of assets, variability of EBIT, etc.
113
 Practice Q1: M&M (Taxes)
Big-Red Company has $2 million in excess cash. The firm plans to
use this cash either to retire all of its outstanding debt or to
repurchase equity. The firm’s debt is held by one institution that is
willing to sell it back to Big-Red for $2 million. Once Big-Red
becomes an all equity firm, it will remain unlevered forever. If Big-Red
does not retire the debt, the company will use the $2 million in cash
to buy back some of its stock on the open market. The company will
generate $1.1 million of annual earnings before interest and taxes in
perpetuity regardless of its capital structure. The firm immediately
pays out all earnings as dividends at the end of each year. Big-Red is
subject to corporate tax rate of 35%, and the required rate of return
on the firm’s unlevered equity is 20%. The personal tax rate on
interest is 25% and the personal tax rate on equity is 10%. Ignore
bankruptcy costs.
a. What will be the value of Big-Red if it chooses to retire all of its debt
and become an unlevered firm?
b. What will be the value of Big-Red if it decides to repurchase stock
instead of retiring the debt?

114
 Practice Q2: Financial Distress

Water Corp. economists estimate that a good business

environment and a bad business environment are
equally likely for the coming year. The managers of
Water Corp. must choose between two mutually
exclusive projects. Assume that the firm will liquidate one
year from today (the day of the projects’ payoff). Water
Corp. is obliged to make a $500 payment to bondholders
at the end of the year. Assume the firm’s shareholders
are risk-neutral. Consider the following information
pertaining to the two projects:

115
 Practice Q2: Financial Distress (cont)
Economy Prob Project Value Value Value
Payoff of Firm Equity Debt
Low Risk Project
Bad 0.5 $500 $500 $0 $500
Good 0.5 700 700 200 500
High Risk Project
Bad 0.5 $100 $100 $0 $100
Good 0.5 800 800 300 500
A. Which of the two projects maximizes the value of the firm?
B. What is the value of the firm’s equity if the low risk project is undertaken, if the
high risk project is undertaken?
C. Suppose that bondholders are fully aware that shareholders might choose to
maximize equity value rather than total firm value. To minimize this agency cost,
the firm’s bondholders decide to use a bond covenant to stipulate that the
bondholders can demand a higher payment if Water Corp. chooses to take on
the high-risk project. By how much would bondholders need to raise the debt
payment so that shareholder would be indifferent between the two projects?
116