CHAPTER FIVE:

FINANCING DECISIONS
 LONG-TERM FINANCING SOURCES
 Long-Term Financing Sources include:
 Long-term debt
 Long-term bank loans
 Mortgages

 Corporate bonds

 Corporate notes

 Equity
 Common stock
 Hybrid Securities
 Preferred Stock
 Warrants
 Convertibles
 Lease or Buy
 CORPORATE BONDS
 Debt securities issued by corporations.
 Investors lend money to the corporation in exchange
for a specified promised amount of interest income
(coupon) .
 Most bonds issued with face values of $1,000 and
maturities of 10 to 30 years.
 Investors receive the face value at the end of the
bond’s term.
 CORPORATE BONDS… CONT’D
 Forms of Bonds
 Bearer Bonds
 Often referred to as coupon bonds because they
are not registered to any particular person.
 The coupons are submitted twice a year and the
authorized bank pays the interest.
CORPORATE BONDS… CONT’D
 Registered Bonds
 Some bonds are sold in a fully registered form.
 They come with your name already on them.
 Twice a year, you receive a check for the
interest.
 At maturity, the registered owner receives a
check for the principal.
CORPORATE BONDS… CONT’D
A partially registered bond is a cross
between a registered bond and a coupon
bond.
 The bond comes registered to you; however, it
has coupons attached which you send in for
payment.
 Two types:
 Term Bond
 Serial Bond
CORPORATE BONDS… CONT’D
 Legal Aspects:
 Bond Indenture
 Specifies the conditions under which the
bond has been issued.
 Outlines both the rights of bondholders and
duties of the issuing corporation.
 Specifies the timing of interest and principal

payments,
 Specifies any restrictive covenants, and
sinking fund requirements.
CORPORATE BONDS… CONT’D
 Common standard debt provisions in the
indenture include:
 The maintenance of satisfactory accounting
records
 Periodically furnishing audited financial
statements
 The payment of taxes and other liabilities
when due
 The maintenance of all facilities in good
working order
 Identification of any collateral pledged against
the bond
CORPORATE BONDS… CONT’D
 Common restrictive provisions (or covenants)
in the indenture include:
 The maintenance of a minimum level of
liquidity
 Prohibiting the sale of accounts receivable
 The imposition of certain fixed asset
investments
 Constraints on subsequent borrowing
 Limits on annual cash dividend payments
 Additional provision – maintain sinking fund deposit
CORPORATE BONDS… CONT’D
 Risks associated with Bonds:
 Interest Rate Risk – refers to risk of a
decline in bond values due to rising interest
rates.

 Reinvestment Rate Risk - refers to the risk of

decline in income due to a drop in interest rates (i.e.
earnings reinvested at lower rates).

 Default Risk - refers to the risk that the issuer

defaults on payment of principal, interest, or both on
a bond
CORPORATE BONDS… CONT’D
 Cost of Bonds
 The longer the bond’s maturity, the higher the
interest rate (or cost) to the firm.

 The larger the size of the offering, the lower

will be the cost (in % terms) of the bond.

 The greater the risk of the issuing firm, the

higher the cost of the issue.
CORPORATE BONDS… CONT’D
 General Features
 Convertibility (convertible bonds)
 Call provision
 Stock purchase warrants

 Bond Rating
 Bond ratings are based on both qualitative and
quantitative factors
MOODY’S AND S&P BOND RATINGS
CORPORATE BONDS… CONT’D
• Factors affecting bond ratings include:
• Financial ratios: debt ratio, times-interest-
earned ratio, and EBIT Interest coverage ratio,
EBITDA (earning before interest, tax,
depreciation, an amortization) ratio, etc.
• Mortgage provisions
 Subordination provisions
 Guarantee provisions
 Length of maturity of the bond and use of
Sinking fund
 Stability of the issuer’s sales and earnings
 Regulation: Is the issuer regulated or future
regulation likely to adversely affect the issuer?
CORPORATE BONDS … CONT’D
 Antitrust (any antitrust actions pending against
the firm that could erode its position)
 Overseas operations
 Environmental factors
 Product liability
 Pension liabilities
 Labor unrest
 Accounting policies (conservative accounting
policies result in higher rating)
 COMMON STOCK
 Common stockholders are the true owners
of the business.
 Sometimes referred to as residual claimants or
owners.
 Bear greater risk than other claimants.
 Expect to receive higher returns (from
dividends and/or capital gains) than other
claimants such as bondholders.
 COMMON STOCK… CONT’D
 Ownership
 The common stock of a company can be
privately owned (also called closely owned) or
publicly owned.

 Many small corporations are privately or

closely owned - where shares are traded very
infrequently without the aid of an exchange.

 Large and/or publicly owned corporations have

widely held shares which are actively traded
on an exchange.
 COMMON STOCK… CONT’D
 Par Value
 Unlike the case for bonds and preferred stock,
par value for common stock is a relatively
useless value.
 Firms often issue common stock with no par
value.
 The stocks will be recorded at the sale price in the
accounting records.

 Low par values may have some advantages in

contexts where corporate taxes are based on par
value.
COMMON STOCK… CONT’D
 Stockholder rights
 Traditional voting
 Each share owned gives the shareholder the
right to vote for one individual for each set
on the board of directors.
 If the majority of shareholders vote as a
block, the minority could never elect a
director.
COMMON STOCK… CONT’D
 Cumulative voting
 Empowers minority stockholders by permitting each
stockholder to cast all of his or her votes for one
candidate for the firm’s board of directors.

 Example:
 Under traditional voting, a shareholder with 100
shares can vote 100 shares for each of 5 members of
the board of directors.
 Under cumulative voting, a shareholder with 100
shares can vote 500 shares for just one member
running for the board of directors.
COMMON STOCK… CONT’D
 Preemptive Rights
 Gives a shareholder the right to maintain his or her
proportionate share of the company.
 All new shares issued must be done so through a “rights
offering.”
 Proxies
 Frequently used in the voting process.
 Many smaller stockholders do not attend the annual
meeting.
 Shareholders must sign a proxy statement giving their
votes to another party who will then vote their shares.
 Dividends
 Payment is at the discretion of the BODs.
 Dividends may be made in cash, additional shares of stock,
and even merchandise.
 TYPES OF COMMON STOCK
 Most firms have one type of common stock
 Classified stock sometimes used to meet the
special needs of the company

 Example: Class A stock, Class B stock, etc (but

they have no standard meanings)

 Small, new companies seeking funds from outside

sources frequently use different types of common stock
 TYPES OF COMMON STOCK… CONT’D

 Example: issuance of stock by a company

that went public:

 Class A stock - sold to the public and paid a

dividend, but this stock had no voting rights for five
years

 Class B stock - retained by the organizers of the

company (founders’ shares) had full voting rights for
5 years, but the legal terms stated that dividends
could not be paid on this stock until the company had
established its earning power by building up REs to a
designated level
TYPES OF COMMON STOCK… CONT’D

 The use of classified stock enabled:

 the public to take a position in a conservatively
financed growth company without sacrificing
income
 the founders retained absolute control during
the crucial early stages of the firm’s
development
 outside investors were also protected against
excessive withdrawals of funds by the original
owners
 TYPES OF COMMON STOCK… CONT’D

 Companies sometimes issue classified stock

limiting voting right - to avoid treat of
takeover

 A firm that issue classified shares could

designate Class B shares as founders’ shares and
Class A shares as those sold to the public

 Others could reverse these designations; or

could use stock classifications for entirely
different purposes
THE MARKET FOR COMMON STOCK
 Common stocks of small companies not actively
traded owned by only a few people, usually the
managers privately owned, or closely held,
corporations, and their stock is called
closely held stock

 Stocks of most larger companies owned by a large

number of investors – who are not active in
management called publicly owned
corporations and their stock is called
publicly held stock
MARKET FOR COMMON … CONT’D
 The stocks of smaller publicly owned
firms are not listed on an exchange
 They trade in the OTC market
 The companies and their stocks are said
to be unlisted
 Larger publicly owned companies
generally apply for listing on a formal
exchange, and they and their stocks
are said to be listed
MARKET FOR COMMON … CONT’D
 Stock market transactions classified
into 3 types:
1. Trading in the outstanding shares of
established, publicly owned companies: the
secondary market
2. Additional shares sold by established,
publicly owned companies: the primary
market
3. Initial public offerings by privately held
firms: the Initial Public Offering (IPO)
market- market for stock that is just being
offered to the public
 THE DECISION TO GO PUBLIC:
INITIAL PUBLIC OFFERINGS
 Going public means selling some of a
company’s stock to outside investors and then
letting the stock trade in public markets
 Advantages of Going Public
 Increases liquidity & allows founders to harvest
their wealth
 Permits founders to diversify
 Facilitates raising new corporate cash
 Establishes a value for the firm
 Facilitates merger negotiations
 Increases potential markets
 Disadvantages of Going Public
 Cost of reporting
 Disclosure
 Loss of Control
 INITIAL PUBLIC OFFERING… CONT’D

 Self-dealing(often designed to minimize

personal tax liabilities – high salaries,
nepotism, personal transactions like
leasing arrangements) become much
harder to arrange if a company is publicly
owned
 Inactive market/low price (for small
companies)
 Investor relations – public companies must
keep investors aware of current developments
(CFOs of newly public firms spend much time
talking with investors & analysts)
 INITIAL PUBLIC OFFERING… CONT’D

The Process of Going Public

 Selecting an Investment Banker
 The Underwriting Syndicate
 Regulation of Securities Sales –
registration with SEC
 The Road show and Book-Building
 INITIAL PUBLIC OFFERING… CONT’D

PRIVATE PLACEMENTS:
 Ina private placement, securities are
sold to one or a few (institutional)
investors
 most common with bonds
 also occur with stocks
PRIVATE PLACEMENTS… CONT’D
 Primary advantages of private placements:
(1) lower flotation costs

(2) greater speed, since the shares do not have to

go through strict registration process (e.g. that
of SEC in U.S.)
 The most common type of private
placement occurs when a company places
securities directly with a financial
institution - insurance company or a
pension fund
PRIVATE PLACEMENTS… CONT’D
 Primary disadvantage of private
placement - securities do not go through
the registration process (of regulators
such as SEC)
 Under SEC rules they cannot be sold except to
another large, “sophisticated” purchaser in the
event the original buyer wants to sell them
 SEC rules permit any institution with $100
million or more to buy and sell private
placement securities
 THE DECISION TO GO PRIVATE
 The entire equity of a publicly held
firm purchased by a small group of
investors (that usually includes firm’s
current senior management)

 The current management group may:

 acquire all of the equity of the company, or
 participate in the ownership with a small
group of outside investors
 DECISION TO GO PRIVATE … CONT’D

 Outside investors place directors on

the firm’s board and arrange for the
financing needed to purchase the
publicly held stock
 Such deals frequently involve
substantial borrowing, often up to 90%
 commonly known as leveraged buyouts
(LBOs)
 DECISION TO GO PRIVATE … CONT’D

 Regardless of the structure of the deal,

going private initially affects the right-hand
side of the balance sheet – the liabilities and
capital
 does not affect the assets - simply
rearranges the ownership structure
 Going private involves no obvious
operating economies, yet the new owners
are generally willing to pay a large
premium over the stock’s current price in
order to take the firm private
 DECISION TO GO PRIVATE … CONT’D

 Whatis the motive behind going

private?
 Managers may regard the firm as being
grossly undervalued or else think that
they could significantly boost the firm’s
value under private ownership
 Going private can increase the value of
some firms sufficiently to enrich both
managers and public stockholders
 DECISION TO GO PRIVATE … CONT’D

 Advantages to going private:

(1) Administrative cost savings
(2) Increased managerial incentives
(3) Increased managerial flexibility
(4) Increased shareholder participation
(5) Increased financial leverage
 ADVANTAGES TO GO PRIVATE… CONT’D

(1) administrative cost savings

 Because going private takes the stock of a firm
out of public hands, it saves on costs associated
with securities registration, annual reports, SEC
& exchange reporting, responding to stockholder
inquiries, etc
 The top managers of private firms also are free
from meetings with security analysts, government
bodies, and other outside parties
ADVANTAGES TO GO PRIVATE… CONT’D

(2) Increased managerial

incentives
 A larger potential gain comes from the
improvement in incentives for high-level
managerial performance.
 Their increased ownership means that
the firm’s managers benefit more
directly from their own efforts, hence
managerial efficiency tends to increase
after going private.
ADVANTAGES TO GO PRIVATE… CONT’D

(3) Increased managerial flexibility

 Managers do not have to worry about what a
drop in next quarter’s earnings will do to the
firm’s stock price, hence they can focus on long-
term, strategic actions that ultimately will have
the greatest positive impact on the firm’s value.

 Managerial flexibility concerning asset sales is

also greater in a private firm, since such sales do
not have to be justified to a large number of
shareholders with potentially diverse interests.
 ADVANTAGES TO GO PRIVATE… CONT’D

(4) Increased shareholder participation

 Going private typically results in replacing a
dispersed, largely passive group of public
shareholders with a small group of investors who
take a much more active role in managing the
firm.

 These new equity investors have a substantial

position in the private firm, hence they have a
greater motivation to monitor management and to
provide incentives to management than do the
typical stockholders of a public corporation.
ADVANTAGES TO GO PRIVATE… CONT’D

(5) Increased financial leverage

 Going private usually entails a drastic increase in
the firm’s use of debt financing, which has two
effects.
 First, the firm’s taxes are reduced because of the
increase in deductible interest payments, so more
of the operating income flows through to
investors.
 Second, the increased debt servicing requirements
force managers to hold costs down to ensure that
the firm has sufficient cash flow to meet its
obligations.
 HYBRID FINANCING
 Important types of long-term capital and
include:
(1) preferred stock - a hybrid security that
represents a cross between debt and common
equity
(2) warrants - derivative securities issued by firms
to facilitate the issuance of some other type of
security
(3) convertibles - combine the features of debt (or
preferred stock) and warrants
 PREFERRED STOCK
 Possess
the characteristics of
both common stocks and bonds
 Perpetual securities with no maturity
date – like common stocks
 Fixed income securities – like bonds
 preferred stock usually pays a fixed dividend
NB: Accountants classify
preferred stock as equity on the
balance sheet
 PREFERRED STOCK… CONT’D
NB: From a finance perspective
preferred stock lies somewhere b/n
debt and common equity
 it imposes a fixed charge and thus increases
the firm’s financial leverage
 yet omitting the preferred dividend does not
force a company into bankruptcy
 It
has a priority claim on the firm’s
earnings and assets in case of liquidation
(next to debt)
 PREFERRED STOCK… CONT’D
 Dividend expressed as either a birr amount or as
a percentage of par value
 par value may have real significance
 Dividend is said to be in arrear if a firm fails
to pay a preferred stock dividend (cumulative
feature)
 an arrearage must be paid before
common stockholders receive dividend
 Many have call features as they are
perpetual stocks
 PREFERRED STOCK … CONT’D
 Call options give the issuing firm the option
to retire them should the need or advantage
arise

 Some preferred stocks have mandatory sinking

funds which allow the firm to retire the issue
over time

 Participating preferred stock allow

preferred stockholders to participate with
common stockholders in the receipt of dividends
beyond a specified amount
 PREFERRED STOCK … CONT’D
 Riskier
than bonds from the investor
perspective because:
 Bond terms are legal obligations
 The investor cannot expect the firm to redeem
preferred stock for a preset face value
 mustbe sold in the market at an
uncertain price
 Preferred stock prices are therefore more
variable and thus riskier than bond prices
 PREFERRED STOCK… CONT’D
 Disadvantages of Preferred Stock
 Dividends are not deductible for tax purposes
 Offers no protection from inflation
 Increases financial risk (like bonds)
 Tends to be less marketable than either bonds
or common stock resulting in a large bid-ask
spread
 Inferior position to bondholders
 Yields are insufficient for most (non-corporate)
investors to justify risk
 WARRANTS
 Warranty is a certificate issued by a
company that gives the holder the right to
buy a stated number of shares of the
company’s stock at a specified price for some
specified length of time

 Issued along with debt

 Used to induce investors to buy long-term debt with a
lower coupon rate than would otherwise be required
 WARRANTS … CONT’D
 Warrants are long-term call options that
have value because holders can buy the
firm’s common stock at the exercise price
regardless of how high the market price
climbs

 This option offsets the low interest rate on the

bonds and makes the package of low-yield
bonds plus warrants attractive to investors
 CONVERTIBLES
 Convertibles are securities which are
bonds or preferred stocks that, under
specified terms and conditions, can
be exchanged for common stock at the
option of the holder

 Bonds or preferred stocks that can be

converted into common stock
 CONVERTIBLES … CONT’D
 Unlike the exercise of warrants,
conversion does not provide new
capital
 Debt (or preferred stock) is simply
replaced on the balance sheet by
common stock
 Reducing the debt or preferred stock, of
course, will improve the firm’s financial
strength and make it easier to raise
additional capital
 CONVERTIBLES … CONT’D
 When convertible bonds are first
issued, the number of shares to be
given for each bond upon conversion
is stated

 For example, “each bond would be convertible

into 20 shares of stock and etc”

 Oneof the most important provisions of a

convertible security is the conversion
ratio, CR
 CONVERTIBLES … CONT’D
 CR is defined as the number of shares of stock a
bondholder will receive upon conversion

Conversion Ratio (CR) =

The conversion price is

on a per share basis

• The conversion price (Pc) is related to

the conversion ratio
 CONVERTIBLES … CONT’D
 The conversion price is the effective price
investors pay for the common stock when
conversion occurs
 LEASE FINANCING

 LEASING - BASICS
A lease is a contractual
agreement between a lessee and
lessor
 The agreement establishes that the lessee has
the right to use an asset and in return must
make periodic payments to the lessor, the
owner of the asset
 The lessor could be either the
asset’s manufacturer or an
independent leasing company
 LEASING BASICS … CONT’D
 If the lessor is an independent leasing
company, it must buy the asset, and then
deliver to the lessee
 For the lessee, it is the use of the
asset that is most important, not who
owns it
 The use of an asset can be obtained by a
lease contract; or the user can buy the
asset
 Thus, leasing and buying involve
alternative financing arrangements
for the use of an asset
LEASING BASICS … CONT’D
 TYPES OF LEASES
 According to SFAS 13 (par. 60), a
lease is classified as either:
 an operating lease

or

 a capital lease (also known as financial

lease)

 What is the basis for this classification?

 TYPES OF LEASES … CONT’D
 Principlefor classifying a lease as
either operating or capital for
reporting purposes:

 A lease that transfers substantially all of

the benefits and risks incident to the
ownership of property should be
accounted for as the acquisition of an
asset and the incurrence of an obligation
by the lessee
 All other leases should be accounted for
as operating leases
 (A) OPERATING LEASES
(1) Usually not fully amortized
 Payments required under the terms of the
lease not enough to recover the full cost of the
asset for the lessor
 The term or life of the operating lease is
usually less than the economic life of the
asset
 The lessor must expect to recover the costs of
the asset by renewing the lease or by selling
the asset for its residual value
 OPERATING LEASING… CONT’D
(2) Usually require the lessor to maintain
and insure the assets
(3) Cancellation option – gives the lessee the
right to cancel the contract before the
expiration date
 Asset must be returned to the lessor upon
cancellation
 Value of a cancellation clause depends on
whether future technological and/or economic
conditions are likely to make the value of the
asset to the lessee less than the value of the
future lease payments under the lease
 (B) FINANCIAL LEASES
 They are the exact opposite of
operating leases
(1) Do not provide for maintenance or
service by the lessor
(2) Fully amortized

(3) Lessee has a right to renew the lease on

expiration
(4) Cannot be canceled – the lessee must
make all payments or face the risk of
bankruptcy
 FINANCIAL LEASING… CONT’D
 Financial lease provides an
alternative method of financing to
purchase
 Two special types of financial leases
are:
 Sale and Lease-back Arrangement
 Leveraged Lease
 (I) SALE AND LEASE-BACK
 Occurs when a company sells an asset it
owns to another firm and immediately
leases it back
 Two things happen:

(1) The lessee receives cash from the sale

of the asset
(2) The lessee makes periodic lease
payments, thereby retaining use of the
asset
 (II) LEVERAGED LEASE
 A three-sided arrangement among the
lessee, the lessor, and the lenders:
(1) Lessee uses the assets & makes periodic lease
payments
(2) Lessor purchases the assets, delivers them to the
lessee, and collects the lease payments (however,
lessor puts up no more than 40 to 50% of the
purchase price)
(3) Lenders supply the remaining financing and
receive interest payments from the lessor
 LEVERAGED LEASING… CONT’D
 The lenders in a leveraged lease
typically use a nonrecourse loan

 the lessor is not obligated to the

lender in case of a default

 The lender is protected in two ways:

(1) The lender has a first line on the asset
(2) Lease payments made directly to the
lender in the event of loan default
 LEVERAGED LEASING… CONT’D
 The lessor puts up only part of the funds
but gets the lease payments and all the
tax benefits of ownership

 These lease payments are used to pay the debt

service of the nonrecourse loan

 The lessee benefits because, in a competitive

market, the lease payment is lowered when
the lessor saves taxes
 ACCOUNTING AND LEASING
A firm could arrange to use an asset
through a lease and not disclose the asset
or the lease contract on the balance sheet
(before November 1976 in the U.S.)
 Lessees needed only to report information on
leasing activity in the footnotes of their
financial statements
 Thus, leasing led to off–balance-sheet
financing
 FASB issued SFAS no. 13 – “Accounting
for Leases” (November, 1976)
 FINANCIAL LEASING… CONT’D
 Under SFAS 13, certain leases are
classified as capital leases (and all other
leases as operating leases)
 For a capital lease, the PV of the
lease payments appears on the right-
hand side of the balance sheet
 The identical value appears on the left-
hand side of the balance sheet as an
asset
 FINANCIAL LEASING… CONT’D
 SFAS 13 provides 4 criteria and at least one
should be met to classify a lease as capital lease
and these criterias are:
(1) The PV of the lease payment is at least 90% of the
fair market value of the asset at the start of the
lease
(2) The lease transfers ownership of the property to the
lessee by the end of the term of the lease
(3) The lease term is 75% or more of the estimated
economic life of the asset
(4) The lessee can purchase the asset at a price below
fair market value when the lease expires - called a
bargain-purchase-price option
 FINANCIAL LEASING… CONT’D
 These rules capitalize those leases that are
similar to purchases

Question: How can we choose between leasing and

buying options?

 Choice depends on cash flow analysis

THE CASH FLOWS OF LEASING:
BUY VS. LEASE
INCREMENTAL CASH FLOW CONSEQUENCES OF
LEASING INSTEAD OF PURCHASING
 NPV ANALYSIS OF THE LEASE VS.
BUY DECISION
 Method for evaluating leases is simple: discount
all cash flows at the after-tax interest rate
 Consider the following incremental cash flows
from leasing versus purchasing:
 NPV OF LEASING … CONT’D
 Let us assume that the firm can either borrow or
lend at the interest rate of 7.57575%. If the
corporate tax rate is 34%, the correct discount
rate is:
 the after-tax rate = 7.57575% x (1 - 0.34) = 5%
 NPV of the lease when 5% is used as discount
rate:

• NPV of the incremental cash flows from

leasing relative to purchasing is negative
… the firm should purchase
 NPV OF LEASING … CONT’D
 A lease payment is like the debt service on a
secured bond issued by the lessee, and the
discount rate should be approximately the
same as the interest rate on such debt
Question: Why not use rWACC as the discount
rate in lease-versus-buy analysis?
Answer:
 rWACC should not be used for lease analysis
because the cash flows are more like debt-service
cash flows than operating cash flows and, as
such, the risk is much less
 The discount rate should reflect the risk of the
incremental cash flows
 REASONS FOR LEASING
 GOOD REASONS FOR LEASING
 If leasing is a good choice, it will be because one
or more of the following will be true:
1. Taxes may be reduced by leasing
2. The lease contract may reduce certain
types of uncertainty
3. Transactions costs can be higher for
buying an asset and financing it with
debt or equity than for leasing the
asset
 BAD REASONS FOR LEASING
 Leasing and Accounting Income
 Firm’s Balance Sheet shows fewer
liabilities with an operating lease than
with either a capitalized lease or a
purchase financed with debt
With an operating lease, lease

payments are treated as an expense

If the asset is purchased, both
depreciation and interest charges are
expenses
 BAD REASONS FOR LEASING… CONT’D
 The accounting income is higher with an operating
lease than with a purchase (thus ROA would be
higher)
 Leased assets do not appear on the Balance Sheet
with an operating lease
 The total asset value of a firm is less with an
operating lease than it is with either a purchase or a
capitalized lease
 The two preceding effects imply that the firm’s ROA
should be higher with an operating lease than with
either a purchase or a capitalized lease
 Leases tend to displace debt elsewhere in the firm – it
does not permit a greater level of total liabilities than
do purchases with borrowing
 EXERCISE
 Suppose a firm initially has $100,000 of assets
and a 150‐percent optimal debt‐equity ratio. The
firm’s debt is $60,000, and its equity is $40,000.
Suppose the firm must use a new $10,000
machine. The firm has two alternatives:
(1) The Firm Can Purchase the Machine. If it does,
it will finance the purchase with a secured loan
and with equity. The debt capacity of the
machine is assumed to be the same as for the
firm as a whole.
(2) The Firm Can Lease the Asset and Get 100-
Percent Financing. That is, the present value of
the future lease payments will be $10,000.
 EXERCISE … CONT’D
 If the firm finances the machine with both
secured debt and new equity, its debt will
increase by $6,000 and its equity by $4,000. Its
optimal debt‐equity ratio of 150 percent will be
maintained.
 Conversely, consider the lease alternative.
Because the lessee views the lease payment as a
liability, the lessee thinks in terms of a
liability‐to‐equity ratio, not just a debt‐to‐equity
ratio.
 The present value of the lease liability is $10,000.
 If the leasing firm is to maintain a liability‐to‐equity
ratio of 150 percent, debt elsewhere in the firm must
fall by $4,000 when the lease is instituted.
DEBT DISPLACEMENT ELSEWHERE IN THE
FIRM WHEN A LEASE IS INSTITUTED
 EXERCISE … CONT’D
 Because debt must be repurchased, net liabilities
only rise by $6,000 ($10,000 ‐ $4,000) when
$10,000 of assets are placed under lease.
 Debt displacement is a hidden cost of
leasing.
 If a firm leases, it will not use as much regular debt
as it would otherwise.
 The benefits of debt capacity will be lost,
particularly the lower taxes associated with
interest expense.
 CAPITAL STRUCTURE
DECISIONS AND THEORIES
CAPITAL STRUCTURE: GENERAL
 Firms need operating capital to support sales –
must be raised from long-term sources

 Capital structure - the mixture of debt &

equity financing a firm uses

 Most firms seek to keep their financing mix close

to a target capital structure
 CAPITAL STRUCTURE… CONT’D
 Capital structure decisions include a
choice of:
 a target capital structure,
 the average maturity of its debt,
and
 the specific source of financing it
chooses at any particular time it
raises new funding
 CAPITAL STRUCTURE… CONT’D
 Similar to operating decisions, managers should
make capital structure decisions designed to
maximize the firm’s value
 CAPITAL STRUCTURE… CONT’D
 Value of a firm is the PV of its expected
future free cash flow (discounted at its
WACC):

where:
• FCF = NOPAT – Net Investment in Operating Capital
• Net Investment in = Gross Investment – Depreciation
Operating Capital
 CAPITAL STRUCTURE… CONT’D
 WACC depends on the percentages of debt
and equity (wd & we), the cost of debt (rd),
the cost of stock (rs), and corporate tax rate
(T):

• The only way that any decision can

change a firm’s value is if it affects either
free cash flows or the cost of capital.
 CAPITAL STRUCTURE… CONT’D
 How do higher proportion of debt affect
WACC and FCF?

 Debt Increases the Cost of Common Stock, rs

 Debt Reduces the Taxes a Company Pays
 The Risk of Bankruptcy Increases the Cost of Debt,
rd

 What is the net effect on WACC?

 CAPITAL STRUCTURE… CONT’D
N.B.: WACC is a weighted average of
relatively low-cost debt and high-cost
equity

 If we increase the proportion of debt, then

 the weight of low-cost debt (Wd) increases
 the weight of high-cost equity (We) decreases

 If all else remained the same, the WACC

would fall and the value of the firm would
increase
 CAPITAL STRUCTURE… CONT’D
 However, both rd and rs increase due to
risk

 So, changing the capital structure affects

all the variables in the WACC equation

 But it’s not easy to say whether those changes

increase the WACC, decrease it, or balance out
exactly and leave the WACC unchanged
 BANKRUPTCY RISK REDUCES
FREE CASH FLOW
 As the risk of bankruptcy increases, some customers
may choose to buy from another company
 Financial distress also hurts productivity of workers
and managers
 they spend more time worrying about their
next job rather than their current job - this
reduces FCF
 Suppliers tighten their credit standards, which
reduces accounts payable and causes net operating
working capital to increase, thus reducing FCF
 The risk of bankruptcy can, therefore, decrease
FCF and reduce the value of the firm
 BANKRUPTCY RISK AFFECT
AGENCY COSTS
 Higher levels of debt may affect the
behavior of managers in two opposing
ways:
(i) when times are good, managers may
waste cash flow on perquisites and
unnecessary expenditures ….. an agency
cost
 the good news is the threat of bankruptcy
reduces such wasteful spending, and
hence increases FCF
AFFECTS AGENCY COSTS… CONT’D
 the bad news is a manager may become gun-shy
and reject positive NPV projects if they are risky

(ii) high debt can cause managers to forego

positive NPV projects unless they are extremely
safe

 this is called the underinvestment problem, and

it is another type of agency cost
 AFFECTS AGENCY COSTS… CONT’D
Debt:
 can reduce one aspect of agency costs ….
wasteful spending

 may increase another aspect of agency costs

…. Underinvestment

 So the net effect of increased use of debt on value

isn’t clear
 ISSUING EQUITY CONVEYS A
SIGNAL TO THE MARKET PLACE
 Managers are in a better position to forecast a
company’s FCF than are investors … called
informational asymmetry.

 Investors thus perceive the issuance of new

stocks by the company as a negative signal,
which causes the stock price to fall.

 Investors may perceive the true value of the

shares to be less than the prevailing market
price.
 TWO DIMENSIONS OF RISK
 Business Risk
vs.
 Financial Risk

 Dothese risks enter into the decisions of

capital structure?
 BUSINESS AND FINANCIAL RISK
(1) Business risk – the riskiness of the
firm’s stock if it uses no debt

(2) Financial risk – the additional risk

placed on the common stockholders as a
result of the firm’s decision to use debt
BUSINESS AND FINANCIAL… CONT’D
 The firm has a certain amount of risk
inherent in its operations: this is its
business risk

 If a firm uses debt, it partitions its investors

into two groups and concentrates most of
its business risk on one class of investors—
the common stockholders

 However, the common stockholders will demand

compensation for assuming more risk and thus
require a higher rate of return
 BUSINESS RISK
 Business risk in a stand-alone sense is a
function of the uncertainty inherent in
projections of a firm’s return on invested
capital (ROIC):

where
NOPAT = net operating profit after taxes
Capital = the sum of firm’s debt & common equity
 BUSINESS RISK… CONT’D
 Business risk can be measured by the
standard deviation of its ROIC, σROIC
 Business risk depends on a number of factors:
(i) Demand variability
(ii) Sales price variability
(iii) Input cost variability
(iv) Foreign risk exposure
(v) Ability to adjust output prices for changes in input costs
(vi) Ability to develop new products in a timely, cost-effective
manner
(vii) The extent to which costs are fixed: operating leverage
(high percentage of fixed costs)
OPERATING RISK AND LEVERAGE
 The mixture of fixed and variable costs depends
largely on the type of business
 The risk that comes from the mix of fixed and
variable costs is referred to as operating risk
 The greater the fixed operating costs relative to
variable operating costs, the greater the
operating risk

 How do operating risk affects cash flow risk, or

how sensitive a firm’s operating cash flows are to
changes in demand?
 OPERATING RISK … CONT’D
 The degree of operating leverage (DOL)
reflects the elasticity of the operating cash
flow

 DOL is the ratio of the % change in operating

cash flows to the % change in units sold

 A high degree of operating leverage, other

factors held constant, implies that a
relatively small change in sales results in a
large change in EBIT
OPERATING RISK … CONT’D
 The higher a firm’s fixed costs, the greater
will be its operating leverage
 Higher fixed costs are generally
associated with more highly automated,
capital intensive firms and industries
 Businesses that employ highly skilled
workers who must be retained and paid
even during recessions also have
relatively high fixed costs
 OPERATING RISK … CONT’D

where
 OPERATING RISK … CONT’D
 Example: Suppose the price per unit is $30, the
variable cost per unit is $20, and the total fixed
costs are $5,000. If we go from selling 1,000 units
to selling 1,500 units, an increase of 50% of the
units sold, operating cash flows change from:
Increased
by 50%

Increased
by 100%
 OPERATING RISK … CONT’D
 Operating cash flows doubled when units sold
increased by 50% - for any 1% change in units
sold, the operating cash flow changes by 2% (in
the same direction)
 The percentage change in operating cash
flows for a given change in units sold is:
OPERATING RISK … CONT’D
 The sensitivity to change in units sold from
1,000 units is:

• DOL of 2.0 means that a 1% change in units sold

results in a 1% × 2.0 = 2% change in operating cash
flow
OPERATING RISK … CONT’D
 DOL is sensitive to the number of units
produced and sold
 DOL is different at different no. of units sold
 For example,
OPERATING LEVERAGE … CONT’D
 Additional insight into the firm’s
profitability and its uncertainty can be
obtained by looking at the relation
between profitability and the number
of units produced and sold
 What number of units must be produced and
sold to just breakeven (i.e. to cover the
fixed operating costs)?
 Breakeven analysis can be used to
measure risk.
OPERATING LEVERAGE … CONT’D
 Operating breakeven occurs when EBIT = 0

where
• P is average sales price per unit of output
• Q is units of output
• V is variable cost per unit
• F is fixed operating costs
OPERATING LEVERAGE … CONT’D
 Breakeven Quantity (QBE) obtained as:

where
• P = average sales price per unit of output
• V = variable cost per unit
•F = fixed operating costs (total)
EXAMPLE
 Suppose a company is evaluating the riskiness of
two alternative plans, and the following data is
available regarding each plan:
EXAMPLE … CONT’D
 Which plan is more riskier (with higher
operating leverage)?

Plan A Plan B
ILLUSTRATION OF OPERATING LEVERAGE
EXAMPLE … CONT’D
 Assume further that there is uncertainty about
the level of future demand. The analyst
forecasts varying level of demand with the
following probabilities:

DEMAND PROBABILITY UNIT SALES

Terrible 0.05 0
Poor 0.20 40,000
Normal 0.50 100,000
Good 0.20 160,000
Wonderful 0.05 200,000

Required: •Evaluate the riskiness of Plan A and

Plan B
EXAMPLE … CONT’D
FINANCIAL RISK
 Financialrisk is the additional
risk placed on the common
stockholders as a result of the
decision to finance with debt.
 Stockholders face a certain amount of
risk that is inherent in a firm’s
operations— i.e. business risk
 indicates the uncertainty inherent in
projections of future operating income
FINANCIAL RISK… CONT’D
 Ifa firm uses debt, this concentrates
the business risk on common
stockholders
 The use of debt (financial
leverage) concentrates the firm’s
business risk on its stockholders
 the concentration of business risk
occurs because debtholders, who receive
fixed interest payments, bear none of
the business risk
FINANCIAL RISK… CONT’D
 Financing with debt increases the
expected rate of return for an investment,
but debt also increases the riskiness of the
investment to the common stockholders
 Financial leverage raises the expected
ROE, but it also increases the risk of the
investment as reflected in the increase in
standard deviation and increase in
coefficient of variation
FINANCIAL RISK… CONT’D
 Using leverage has both good and bad
effects: higher leverage increases
expected ROE, but it also increases
risk.
 Consider the previous example:
 Assume that only two financing choices are
being considered—remaining at zero debt, or
shifting to $100,000 debt (with 10% interest)
and $100,000 book equity. Evaluate the effect
of these two options. (use Plan B data)
EFFECTS OF FINANCIAL LEVERAGE: A FIRM
FINANCED
WITH ZERO DEBT OR WITH $100,000 OF DEBT
FINANCIAL LEVERAGE ... CONT’D
FINANCIAL LEVERAGE ... CONT’D
 Sothe use of debt (financial
leverage):
 has increased financial risk
(reflected in the increase in
standard deviation and coefficient
of variation), but
 it has also increased the expected
ROE
CAPITAL STRUCTURE THEORY
 CAPITAL STRUCTURE AND
FIRM VALUE
 The value of a firm (i.e. the value of all its
assets) is equal to the sum of its liabilities
and its equity.

Question:

 Does the way we finance the firm’s assets affect

the value of the firm and hence the value of its
owners’ equity?

 The answer is it depends!

CAPITAL STRUCTURE… CONT’D
 Use of debt financing increases risk to
owners

 The greater the use of debt financing (vis-àvis

equity financing), the greater the risk

 The role of taxes should be considered as

well in the decision of capital structure

 Interest payments are deductible for tax purposes,

whereas dividends are not - this bias affects a firm’s
capital structure decision
CAPITAL STRUCTURE … CONT’D
 There are different theories regarding
capital structure decisions

 Franco Modigliani and Merton Miller ... “The

Cost of Capital, Corporation Finance, and the
Theory of Investment,” American Economic
Review, June 1958

 Developed the basic framework for the analysis of

capital structure and the effect of taxes (known as
Modigliani and Miller theory)
 MODIGLIANI AND MILLER:
NO TAXES
 MM (1958) reasoned that if the following
conditions hold, the value of the firm is not
affected by its capital structure:

1. There are no brokerage costs

2. There are no taxes (hence no tax

advantage associated with debt financing
relative to equity financing … this isolates the
effect of financial leverage)
MODIGILIANI AND MILLER… CONT’D

(3)There are no bankruptcy costs.

(4) Investors can borrow at the same rate as
corporations

 Therefore, if individuals are seeking a given level

of risk, they can either
(1) borrow or lend on their own, or
(2) invest in a business that borrows or lends
MODIGILIANI AND MILLER… CONT’D

 Inother words, if an individual wants to

increase the risk of his/her investment,
he/she could
 invest in a company that uses debt to finance
its assets
or
 invest in a firm with no financial leverage
and take out a personal loan—increasing
his/her own financial leverage
MODIGILIANI AND MILLER… CONT’D

(5) All investors have the same information as

management about the firm’s future
investment opportunities.
(6) EBIT is not affected by the use of debt

 If these assumptions hold true, MM proved

that a firm’s value is unaffected by its
capital structure
MODIGILIANI AND MILLER… CONT’D

 Hence, the following situation must exist:

where:
• VL is the value of a levered firm, which is equal to
VU (the value of an identical but unlevered firm)
• SL is the value of the levered firm’s stock, and
• D is the value of its debt.
MODIGILIANI AND MILLER… CONT’D

 The WACC is a combination of the

cost of debt and the relatively higher
cost of equity, rs.

 As leverage increases, more weight is given to

low-cost debt, but equity gets riskier, driving
up rs.

 Under MM’s assumptions, rs increases by

exactly enough to keep the WACC constant.
MODIGI LIANI AND MILLER… CONT’D

 MM’s analysis implies that:

(1) the weighted average cost of capital to
the firm, WACC, is completely
independent of its capital structure

(2) regardless of the amount of debt the firm

uses, its WACC is equal to the cost of
equity that it would have if it used no
debt
MODIGILIANI AND MILLER… CONT’D

 If MM’s assumptions are correct, it does not

matter how a firm finances its operations,
so capital structure decisions would be
irrelevant.

 The value of any firm is established by

capitalizing its expected net operating
income (EBIT) at a constant rate (rsU) that
is based on the firm’s risk class.
MODIGILIANI AND MILLER… CONT’D
EBIT
 Hence, used b/c of
No Taxes

• Both firms are assumed to be in the same

business risk class
• rsU is the required rate of return for a
unlevered, or all-equity, firm of this risk class
when there are no taxes
MODIGILIANI AND MILLER… CONT’D
 Under the MM model, when there are no
taxes, the value of the firm is independent of
its leverage

• The discount rate is referred to as

the capitalization rate – a rate that
translates future earnings into a
current value
MODIGILIANI AND MILLER… CONT’D
 Consider Capital Corporation that has $20,000 of
assets, all financed with equity. There are 1,000
shares of Capital Corporation stock outstanding,
valued at $20 per share. The firm’s current
balance sheet is simple:
MODIGILIANI AND MILLER… CONT’D

 Suppose Capital Corporation has investment

opportunities requiring $10,000 of new capital.
Assume also that Capital Corporation can raise
the new capital either of three ways:
 Alternative 1: Issue $10,000 equity (500 shares of
stock at $20 per share)
 Alternative 2: Issue $5,000 of equity (250 shares
of stock at $20 per share) and borrow $5,000 with an
annual interest of 10%
 Alternative 3: Borrow $10,000 with an annual
interest of 10%
CAPITAL CORPORATION’S PROJECTED BALANCE
SHEET FOR ALTERNATIVE FINANCING SCHEMS
MODIGILIANI AND MILLER… CONT’D

 Itmay be unrealistic to assume that the

interest rate on the debt in Alternative 3
will be the same as the interest rate for
Alternative 2 since in Alternative 3 there
is more credit risk.

 For simplicity, let’s assume that the interest

rate between Alternative 2 and Alternative 3
will remain the same.
MODIGILIANI AND MILLER… CONT’D

 Assume that Capital Corporation has

$4,500 of operating earnings, and the
appropriate discount rate is 15%.

 Considering MM’s assumptions, the value

of Capital Corporation will be the same,
no matter which of the three financing
alternatives it chooses.
MODIGILIANI AND MILLER… CONT’D

 The total income to owners and creditors

would be equal to the level of the operating
earning under each alternative:

N.B. there are NOTAXES

MODIGILIANI AND MILLER… CONT’D

 Because there are no creditors to share with in

the case of all-equity financing (Alternative 1),
the value of equity for Capital
Corporation is the present value of the
earnings stream of $4,500 per period
discounted at 15%, or $30,000.
MODIGILIANI AND MILLER… CONT’D

 Determinationof the value of Capital

Corporation with debt financing
(Alternatives 2 and 3) is, a bit more
difficult.

 Capital Corporation’s owners view their

future earnings streams as more risky
than in the case of no debt
 Hence, the discount rate should be higher,
reflecting the debt used.
MODIGILIANI AND MILLER… CONT’D

 MM showed that the discount rate for the

earnings to equity owners is higher when
there is the use of debt and the greater the
debt the higher the discount rate

 Accordingly, the discount rate of the earnings

to owners is equal to the discount rate of a
firm with no financial leverage plus the
compensation for bearing risk appropriate
to the amount of debt in the capital
structure
MODIGILIANI AND MILLER… CONT’D

 Let re be the discount rate for a risky

earnings to owners and let rd be the
discount rate for risk-free debt earnings

 The risk premium is equal to re − rd and the

discount rate for the earnings to owners is:
MODIGILIANI AND MILLER… CONT’D

 When there are no taxes, the cost of equity

to a levered firm, rsL, is equal to:
(1) the cost of equity to an unlevered firm in the same
risk class, rsU, plus
(2) a risk premium whose size depends on both the
difference between an unlevered firm’s costs of debt
and equity and the amount of debt used
MODIGILIANI AND MILLER… CONT’D
 In the case of the Capital Corporation, the equity
discount rate for the financing alternatives is
calculated by adjusting the discount rate of the
earnings stream, re = 15%, for risk associated
with financial leveraging

 Given that the interest rate on debt, rd, is 10%,

we can analyze the three alternatives as follows:
MODIGILIANI AND MILLER… CONT’D

• The value of Capital Corporation’s

equity under each alternative is
calculated by valuing the earnings to the
owners stream using the appropriate
discount rate
MODIGILIANI AND MILLER… CONT’D
MODIGILIANI AND MILLER… CONT’D

• Summary:
Finan. EBIT Amo Amoun Wd We rd re WACC Value
Alternt. unt t of
of of Firm
Debt Equity
1 $4500 0 $30,000 0 1 0 0.15 0.15 $30,000

2 $4500 $5,00 $25,000 0.167 0.833 0.1 0.16 0.15 $30,000

0
3 $4500 $10,0 $20,000 0.333 0.667 0.1 0.175 0.15 $30,000
00

where: Value of Firm = EBIT/WACC

MODIGILIANI AND MILLER… CONT’D
 MM show that the value of the firm depends
on the earnings of the firm, not on how the
firm’s earnings are divided between
creditors and shareholders
 the value of the firm—the “pie”—is not affected
by how you slice it
 But ROE under each alternative varies
 Alternative 1 = $4500/20,000 = 15% ROE INCREASES
WHEN A FIRM
 Alternative 2 = $4000/25,000 = 16% USES DEBT

 Alternative 3 = $3500/20,000 = 17.5% FINANCING

 MODIGLIANI AND MILLER:
THE EFFECT OF CORPORATE TAXES

 MM relaxed the assumption that

there are no corporate taxes (in their
1963 publication)

 ◦ The law allows corporations to deduct

interest payments as an expense, but dividend
payments to stockholders are not deductible

 This differential treatment encourages

corporations to use debt in their capital
structures
MODIGILIANI AND MILLER… CONT’D

 As interest payments reduce the taxes paid

by a corporation, more of its cash flow is
available for its investors
 The tax deductibility of the interest payments shields
the firm’s pre-tax income
 According to MM, the value of a levered firm
is the value of an otherwise identical
unlevered firm plus the value of any “side
effects” – i.e., the tax shield
MODIGILIANI AND MILLER… CONT’D

 The value of a levered firm is equal to the value

of an unlevered firm in the same risk class (VU)
plus the gain from leverage.

 Under their assumptions, they showed that the

present value of the tax shield is equal to the
corporate tax rate, T, multiplied by the amount
of debt, D

 The value of a levered firm, thus, is equal to:

MODIGILIANI AND MILLER… CONT’D

 With zero debt (D = $0), the value of the firm

is its equity value:

rsU is the required discount rate in a world

with taxes
MODIGILIANI AND MILLER… CONT’D

 The cost of equity to a levered firm, with

corporate taxes, is equal to the sum of:

(1) the cost of equity to an unlevered firm

(2) a risk premium whose size depends on the

difference between the costs of equity and debt to an
unlevered firm, the amount of financial leverage
used, and the corporate tax rate:
EXAMPLE
 Compare two firms: Firm U (unlevered) and Firm
L (levered). Suppose both have the same $5,000
taxable income before interest and taxes. Firm U
is financed entirely with equity, whereas Firm L
is financed with $10,000 debt that requires an
annual payment of 10% interest. If the tax rate
for both firms is 30%, the tax payable and net
income to owners are calculated as follows:

Income to
All Investors
= $3,800
EXAMPLE … CONT’D
 If Firm LL (Lots of Leverage) has the same
operating earnings and tax rate as Firms U and
L, but uses $20,000 of debt (at the 10% interest
rate), the taxes payable and net income to owners
are as follows:
EXAMPLE … CONT’D
 If Firm L were to increase its debt financing from
$10,000 to $20,000, like Firm LL’s, the total net
income to the suppliers of capital—the creditors
and owners—is increased $300, from $3,800 to
$4,100, determined as follows:

The tax shield from interest deductibility is:

MODIGILIANI AND MILLER… CONT’D

 If Firm L has $10,000 of 10% debt and is subject

to a tax of 30% on net income, the tax shield is:

• Recognizing that the interest expense is the

interest rate on the debt, rd, multiplied by the
face value of debt, D, the tax shield for a firm
with a tax rate of τ is:
MODIGILIANI AND MILLER… CONT’D

 Suppose:
 The level of debt financing, D, is
considered permanent (i.e. when the
current debt matures, new debt in the
same amount is issued to replace it)

 Interest rate on the debt, rd, is

considered fixed

 Tax rate on the net income remain

constant at τ
MODIGILIANI AND MILLER… CONT’D

 Thetax shield represents a perpetual

stream whose value is:

• The discount rate is the interest rate

on the debt and the periodic stream is
the tax shield each period
MODIGILIANI AND MILLER… CONT’D

 Present value of interest tax shield (PVITS):

Simplifying,
MODIGILIANI AND MILLER… CONT’D

 Firm L with $10,000 of debt at an interest rate of

10% and a tax rate on income of 30%, has a
$3,000 tax shield:

•Tax shields from interest deductibility are

valuable
MODIGILIANI AND MILLER… CONT’D

 If a firm finances its assets with $50,000 of debt

and has a tax rate of 30%, the tax shield from
debt financing (and hence the increase in the
value of the firm) is $15,000

 The value of the firm is supplemented by the tax

subsidy resulting from the interest deducted from
income
BANKRUPTCY AND THE TRADE-OFF THEORY

 MM’s results depend on the assumption that

there are no bankruptcy costs

 Bankruptcy can be quite costly in practice

 It often forces a firm to liquidate/sell assets for less

than they would be worth if the firm were to continue
operating
BANKRUPTCY … CONT’D
 Firms in bankruptcy have very high legal
and accounting expenses as well as a hard
time retaining customers, suppliers, and
employees
 The threat of bankruptcy (not just
bankruptcy per se) creates problems
 Key employees leave
 Suppliers ref se to rant credit
 Customers seek more stable suppliers
 Lenders demand higher interest rates and impose
more restrictive loan covenants
BANKRUPTCY … CONT’D
 Bankruptcy-related problems most likely to
arise when a firm increases its use of debt
 Bankruptcy costs discourage firms from pushing
their use of debt to excessive levels
 Bankruptcy-related costs have two
components:
(1) the probability of financial distress
(2) the costs that would be incurred given that
financial distress occurs
BANKRUPTCY … CONT’D
 Firms whose earnings are more
volatile, all else equal, face a
greater chance of bankruptcy
 i.e. firms with high operating
leverage, and thus greater business
risk, should limit their use of
financial leverage
 use less debt than more stable firms
BANKRUPTCY … CONT’D
 Firms that would face high costs in
the event of financial distress should
rely less heavily on debt

 For example, firms whose assets are illiquid

and thus would have to be sold at “fire sale”
prices should limit their use of debt financing

 These arguments led to the

development of “the trade-off theory
of leverage”
BANKRUPTCY … CONT’D
 Trade-off theory:

 Firms trade-off the benefits of debt

financing (favorable corporate tax
treatment) against the higher interest
rates and bankruptcy costs

 The value of a levered firm, thus, is equal

to the value of an unlevered firm plus the
value of any side effects, which include
the tax shield and the expected costs due
to financial distress
FIGURE: EFFECT OF LEVERAGE ON VALUE
BANKRUPTCY … CONT’D
 Under MM’s assumptions (with
corporate taxes), a firm’s value will
be maximized if it uses virtually 100
percent debt
 D1 is a threshold level of debt
 Probability of bankruptcy so low (immaterial)
below D1
 Beyond D1, bankruptcy-related costs become
increasingly important, and they reduce the
tax benefits of debt at an increasing rate
BANKRUPTCY … CONT’D
 In the range from D1 to D2, bankruptcy
related costs reduce but do not completely
offset the tax benefits of debt

 Stock price rises at a decreasing rate as debt

ratio increases

 Beyond D2, bankruptcy-related costs

exceed the tax benefits

 Increasing the debt ratio lowers the value of the stock

 D2 is the optimal capital structure

BANKRUPTCY … CONT’D
 The “tradeoff” between the tax deductibility
of interest and the cost of distress can be
summarized in terms of the value of the
firm in the context of the MM model as
follows:

 Value of the Firm = Value of the firm if all-equity financed

+ Present value of interest tax shield
– Present value of financial distress
BANKRUPTCY … CONT’D
 Factors influencing the PV of the cost
of financial distress:
(1) The probability of financial distress
increases with increases in business risk
(2) The probability of financial distress
increases with increases in financial risk
(3) The costs of bankruptcy increase the
more the value of the firm depends on
intangible assets
 ESTIMATING THE OPTIMAL
CAPITAL STRUCTURE
 There are five steps for the analysis of each
potential capital structure:
(1) Estimate the interest rate the firm will pay.

(2) Estimate the cost of equity. The effect of

financial leverage on beta is estimated as
follows:
RATE OF RETURN ON EQUITY (ROE) AT
DIFFERENT DEBT LEVEL
OPTIMAL CAPITAL STRUCTURE… CONT’D

 then,

(3) Estimate the weighted average cost of capital.

(4) Estimate the free cash flows and their present
value, which is the value of the firm.
where, FCF is net operating profit
after taxes (NOPAT) minus the
required net investment in capital
OPTIMAL CAPITAL STRUCTURE… CONT’D

(5) Deduct the value of the debt to find the

shareholders’ wealth, which we want to
maximize. The value of debt can be obtained as
follows:

where, wd is weight of debt, and V indicates value of the firm

Illustration (Capital Structure).pptx
DIVIDEND DECISIONS
 THE LEVEL OF DISTRIBUTIONS
AND FIRM VALUE
 Managers must keep in mind the firm’s
objective - maximizing shareholder value -
when deciding how much cash to distribute
to stockholders.
 Free Cash Flows and Distributions.pptx

 Question: Can a company increase its value

through its choice of distribution policy?
DISTRIBUTIONS AND FIRM … CONT’D

 Distributionpolicy includes
three aspects:
 the level of distributions
 the form of distributions (cash
dividends versus stock repurchases)
 the stability of distributions
DISTRIBUTIONS AND FIRM … CONT’D

 Shareholder distributions for a wealth

maximizing firm affects the value of
operations only to the extent that they
change

 the cost of capital, or

 investors’ perceptions regarding expected FCF

 Whether dividend policy affects firm value

or not depends in part on investors’
preferences for returns as dividend yields
versus capital gains.
DISTRIBUTIONS AND FIRM … CONT’D

 The mix of yield return vs. gains return

determined by the following:

 the target distribution ratio (the percentage of

net income distributed to shareholders through
cash dividends or stock repurchases), and

 the target payout ratio (the percentage of net

income paid as a cash dividend)

 N.B. payout ratio < distribution ratio

DISTRIBUTIONS AND FIRM … CONT’D

A high distribution ratio & a

high payout ratio mean that a
company pays large dividends
and has small, or zero, stock
repurchases
 In this situation, the dividend yield is
relatively high and the expected capital
gain is low
DISTRIBUTIONS AND FIRM … CONT’D

 If a company has a large distribution

ratio but a small payout ratio, then it
pays low dividends but regularly
repurchases stock
 This results in a low dividend yield but a
relatively high expected capital gain yield
DISTRIBUTIONS AND FIRM … CONT’D

 If
a company has a low
distribution ratio, then it must
also have a relatively low payout
ratio

 This again results in a low dividend

yield and hopefully a relatively high
capital gain
 DISTRIBUTIONS AND FIRM … CONT’D

. Distribution
Ratio

High Low

Low Payout
High Payout Low Payout Ratio
Ratio Ratio

•Low Dividend Yield

•High Dividend Yield •Low Dividend Yield
•May be High
•Low Capital gain •High Capital Gain
Capital Gain Yield
DISTRIBUTIONS AND FIRM … CONT’D

 The target payout ratio should be based on

investors’ preferences for

 Dividends
vs.
 Capital gains
 DIVIDENDS VS. CAPITAL GAINS:
WHAT DO INVESTORS PREFER?
 Do investors prefer
(1) to have the firm distribute income as cash
dividends? Or
(2) to have it either repurchase stock or else plow
the earnings back into the business, both of
which should result in capital gains?
DIVIDEND VERSUS… CONT’D
 This preference can be considered in term
of the constant growth stock valuation
model:

• If the company increases the payout

ratio, D1 raises
• the increase in D1, taken alone, would
cause the stock price to rise
DIVIDEND VERSUS… CONT’D
 If D1 raises, less money will be available for
reinvestment – leads to a decline in the expected
growth rate (g), and that will tend to lower the stock’s
price

 Any change in payout policy, therefore, will

have two opposing effects

 The optimal dividend policy must strike a

balance between current dividends and
future growth so as to maximize stock price
 THEORIES OF INVESTOR
PREFERENCE FOR
 DIVIDEND YIELD vs. CAPITAL
GAINS
(1) the dividend irrelevance theory
(2) the “bird-in-the hand” theory
(3) the tax preference theory
(1) DIVIDEND IRRELEVANCE THEORY

 Dividend policy has no effect on either the price

of a firm’s stock or its cost of capital

 If dividend policy has no significant effects, then it

would be irrelevant

 MM argued that the firm’s value is

determined only by its basic earning power
and its business risk
DIVIDEND IRRELEVANCE … CONT’D
 … the value of the firm depends only on the income
produced by its assets, not on how this income is split
between dividends and retained earnings
 principal conclusion of MM’s dividend
irrelevance theory: dividend policy does not
affect the required rate of return on equity, rs
(this conclusion, however, has been hotly
debated)
 (2) BIRD-IN-THE-HAND THEORY:
DIVIDENDS ARE SAFER
 Myron Gordon and John Lintner argued
that rs decreases as the dividend payout is
increased

 This is because investors are less certain of receiving

the capital gains which are supposed to result from
retaining earnings than they are of receiving
dividend payments
BIRD-IN-THE-HAND … CONT’D
 According to Gordon and Lintner:

 Investors value a dollar of expected

dividends more highly than a dollar of
expected capital gains because the
dividend yield component, D1/P0, is less
risky than the g component in the total
expected return equation:

rs = D1/P0 + g
BIRD-IN-THE-HAND… CONT’D
 MM argued that rs is independent of
dividend policy, which implies that
investors are indifferent between
D1/P0 and g and, hence, between
dividends and capital gains

 MM called the Gordon-Lintner argument the

bird-in-the-hand fallacy
BIRD-IN-THE-HAND… CONT’D
 In MM’s view:
 Most investors plan to reinvest their dividends
in the stock of the same or similar firms
 In any event, the riskiness of the firm’s cash
flows to investors in the long run is
determined by the riskiness of operating cash
flows, not by dividend payout policy
(3) TAX PREFERENCE THEORY
 There are three tax-related reasons for
thinking that investors might prefer a low
dividend payout to a high payout:
(1) Long-term capital gains are taxed at a
maximum rate of 20 percent, whereas dividends
are taxed at higher effective rates (that go up to
40 percent)
(2) Taxes are not paid on the gain until a stock is
sold
 Due to time value effects, a dollar of taxes paid in
the future has a lower effective cost than a dollar
paid today
TAX PREFERENCE … CONT’D
(3) If a stock is held by someone until he or
she dies, no capital gains tax is due at
all—the beneficiaries who receive the
stock can use the stock’s value on the
death day as their cost basis and thus
completely escape the capital gains tax
TAX PREFERENCE … CONT’D
 Because of these tax advantages,
investors may prefer to have
companies retain most of their
earnings
 If so, investors would be willing to pay more
for low-payout companies than for otherwise
similar high-payout companies
 EMPIRICAL EVIDENCE AND THE LEVEL OF SHAREHOLDER
DISTRIBUTIONS: DIVIDEND IRRELEVANCE, BIRD-IN-THEHAND,
AND TAX PREFERENCE DIVIDEND THEORIES
 EMPIRICAL EVIDENCE AND THE LEVEL OF SHAREHOLDER
DISTRIBUTIONS: DIVIDEND IRRELEVANCE, BIRD-IN-THEHAND,
AND TAX PREFERENCE DIVIDEND THEORIES
 INFORMATION CONTENT, OR
SIGNALING, HYPOTHESIS
 Anincrease in the dividend is often
accompanied by an increase in the
price of a stock, while a dividend cut
generally leads to a stock price
decline

 Some have argued that this indicates that

investors prefer dividends to capital gains
SIGNALING HYPOTHESIS … CONT’D
 However, MM argued differently
 They noted that corporations are reluctant to cut
dividends, hence do not raise dividends unless they
anticipate higher earnings in the future

 MM’s argument:
 A higher-than expected dividend increase is a
“signal” to investors that the firm’s management
forecasts good future earnings
SIGNALING HYPOTHESIS … CONT’D
 Conversely, a dividend reduction, or a smaller
than expected increase, is a signal that
management is forecasting poor earnings in
the future

 MM argued that investors’ reactions

to changes in dividend policy do not
necessarily show that investors
prefer dividends to retained earnings
SIGNALING HYPOTHESIS … CONT’D
 MM rather argue that price changes
following dividend actions simply
indicate that there is an important
information, or signaling, content in
dividend announcements

 The initiation of a dividend by a firm that

formerly paid no dividend is certainly a
significant change in distribution policy
SIGNALING HYPOTHESIS … CONT’D

 Itappears that initiating firms’

future earnings and cash flows are
less risky than before the initiation

 There is a signaling effect when

firms with existing dividend
unexpectedly increase or decrease
dividend
CLIENTEL EEFFECT
 Different groups, or clienteles, of
stockholders prefer different dividend
payout policies

 Retired individuals, pension funds, and university

endowment funds generally prefer cash income, so
they may want the firm to pay out a high percentage
of its earnings

 Such investors are often in low or even zero tax

brackets, so taxes are of no concern
CLIENTELE EFFECT… CONT’D
 Stockholders in their peak earning years might
prefer reinvestment – less interested in current
dividend

 If a firm retains and reinvests income rather

than paying dividends, those stockholders who
need current income would be disadvantaged

 Stockholders who are saving rather than

spending dividends might favor the low dividend
policy
CLIENTELE EFFECT… CONT’D
 Therefore,

 investors who want current investment

income should own shares in high
dividend payout firms

 investors with no need for current

investment income should own shares in
low dividend payout firms
DIVIDEND STABILITY
 Profitsand cash flows vary over
time, as do investment
opportunities
 This suggests that corporations should
vary their dividends over time
 increasing them when cash flows are large
and the need for funds is low
 lowering them when cash is in short supply
relative to investment opportunities
DIVIDEND DECISIONS… CONT’D
 However, many stockholders rely on
dividends to meet expenses, and they
would be seriously inconvenienced if the
dividend stream were unstable
 Reducing dividends to make funds available
for capital investment could send incorrect
signals to investors, who might push down the
stock price b/c they interpreted the dividend
cut to mean that the company’s future
earnings prospects have been diminished
DIVIDEND DECISIONS… CONT’D
 Maximizing its stock price requires a
firm to balance its internal needs for
funds against the needs and desires
of its stockholders.

 In general, investors prefer firms that

follow a stable, predictable dividend
policy (regardless of the payout level)
 SETTING THE TARGET
DISTRIBUTION LEVEL: THE
RESIDUAL DISTRIBUTION MODEL

 When deciding how much cash to

distribute to stockholders, remember
the ff 2 points:
(1) Maximizing shareholder value is the
basic objective
(2) The firm’s cash flows belong to its
shareholders
TARGET DISTRIBUTION… CONT’D
 Implications

 Management should refrain from

retaining income unless they can
reinvest it to produce returns higher
than shareholders could themselves
earn by investing the cash in
investments of equal risk
TARGET DISTRIBUTION… CONT’D
 For a given firm, the optimal distribution
ratio is a function of 4 factors:
1. investors’ preferences for dividends vs. capita
gains
2. the firm’s investment opportunities these are
3. its target capital structure combined in
the residual
4. the availability and cost of external distribution
model
capital
TARGET DISTRIBUTION… CONT’D
 Under the residual distribution
model, a firm follows 4 steps when
establishing its target distribution
ratio:
(1) determines the optimal capital budget

(2) determines the amount of equity needed

to finance that budget, given its target
capital structure
(3) uses reinvested earnings to meet equity
requirements to the extent possible
TARGET DISTRIBUTION… CONT’D
(4) pays dividends or repurchases stock only
if more earnings are available than are
needed to support the optimal capital
budget

 Residual implies “leftover,” and the

residual policy implies that distributions
are paid out of “leftover” earnings
TARGET DISTRIBUTION… CONT’D
 If a firm rigidly follows the residual
distribution policy, then distributions paid
in any given year can be expressed as
follows:
TARGET DISTRIBUTION… CONT’D
 Suppose the target equity ratio is 60
percent, the firm plans to spend $50 million
on capital projects, and its net income were
$100 million. In this case,
 the firm would need $50(0.6) = $30 million of
common equity
 its distributions would be $100 – $30 = $70
million
 the firm would, therefore, use $30 million of the
retained earnings plus $20 million of new debt
($50 – $30) to finance the capital budget. This
would keep its capital structure on target.
ILLUSTRATION
 Consider the case of ABC Company. ABC’s
overall composite cost of capital is 10 percent.
However, this cost assumes that all new equity
comes from retained earnings. If the company
must issue new stock, its cost of capital will be
higher. Assume that ABC has $60 million in net
income and a target capital structure of 60
percent equity and 40 percent debt. Provided that
it does not make any cash distributions, ABC
could make net investments of $100 million,
consisting of $60 million from reinvested
earnings plus $40 million of new debt supported
by the retained earnings, at a 10 percent
marginal cost of capital.
ILLUSTRATION … CONT’D
 If the capital budget exceeded $100 million, the
required equity component would exceed net
income, which is of course the maximum amount
of reinvested earnings. In this case, ABC would
have to issue new common stock, thereby
pushing its cost of capital above 10 percent.ABC
forecasts its estimated capital budget under each
of the following state of nature (investment
opportunities):
Investment Estimated Determine:
Opportunities Capital Budget (a) required equity
Poor $40 million (b) distributions paid
Average $70 million (c) distribution ratio
Good $150 million
ABC’S DISTRIBUTION RATIO WITH $60 MILLION
OF NET INCOME WHEN FACED WITH
DIFFERENT INVESTMENT OPPORTUNITIES
(MILLIONS OF DOLLARS)
 FACTORS INFLUENCING
DIVIDEND POLICY: SUMMARY
 Four factors:
(1) constraints on dividend payments
(2) investment opportunities
(3) availability & cost of alternative
sources of capital
(4) effects of dividend policy on rs
FACTORS INFLUENCING … CONT’D

(1) Constraints
 Bond indentures
 Preferred stock restrictions
 Impairment of capital rule (dividend
payments cannot exceed the balance
sheet item “retained earnings”)
 Availability of cash
FACTORS INFLUENCING … CONT’D
 Penalty tax on improperly accumulated
earnings
 To prevent wealthy individuals from using
corporations to avoid personal taxes, some
tax laws provide for a special surtax on
improperly accumulated income
 If a firm’s dividend payout ratio is being
deliberately held down to help its
stockholders avoid personal taxes, the
firm would be subject to heavy penalties
FACTORS INFLUENCING … CONT’D

(2) Investment Opportunities

 Number of profitable investment
opportunities
 Possibility of accelerating or delaying
projects
(3)Alternative Sources of Capital
 Cost of selling new stock
 Ability to substitute debt for equity
 Control
FACTORS INFLUENCING … CONT’D
(4) Effects of Dividend Policy on rs
 The effect may be considered in terms of 4
factors:
(1) stockholders’ desire for current versus future
income
(2) perceived riskiness of dividends versus
capital gains
(3) the tax advantage of capital gains over
dividends
(4) the information content of dividends
(signaling)
Thank You!!!!