KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY

KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY

SCHOOL OF BUSINESS
POST GRADUATE (MBA FINANCE PART TIME 2/ EVENING)

ACF 683: CORPORATE FINANCIAL STRATEGY

SUBMITTED TO: PROFESSOR JOSEPH MAGNUS, FRIMPONG
INDIVIDUAL ASSIGNMENT 2

BY
NAME: INDEX NUMBER: REFERENCE NUMBER:
KOFI BROBBEY PEPRAH PG3954220 20738677
Question 1

In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt.
So, the value of equity is zero and the stockholders turn over control of the firm to the
bondholders. At this time, the bondholders hold assets whose value is exactly equal to what is
owed on the debt. In a perfect world, there are no costs associated with the transfer of
ownership, and the bondholders do not lose anything. The costs associated with bankruptcy
may eventually offset the tax-related gains from leverage. It is well-known that bankruptcy
costs imply an optimal debt-equity mix for the firm owing to a trade-off between the tax
advantage of leverage and the costs of bankruptcy.

Bankruptcy Cost

Higher costs of capital and an elevated degree of risk may, in turn, increase the risk of
bankruptcy. As the company adds more debt to its capital structure, the company's weighted
average cost of capital increases beyond the optimal level, further increasing bankruptcy
costs. bankruptcy costs arise when there is a greater likelihood a company will default on its
financial obligations because it has decided to increase its debt financing rather than use
equity. Bankruptcy costs vary depending on the structure and size of the company.

Direct Bankruptcy cost

Direct bankruptcy costs are incurred in the process of selling the assets of a bankrupt firm and
redistributing the proceeds. The direct cost of bankruptcy refers to the deadweight cost of
going bankrupt, which includes the legal and liquidation costs associated with the act of
bankruptcy. when the value of a firm's assets equals the value of its debt, then the firm is
economically bankrupt in the sense that the equity has no value. However, the formal turning
over of the assets to the bondholders is a legal process, not an economic one. There are legal
and administrative costs to bankruptcy. Because of expenses associated with bankruptcy,
bondholders won't get all that they are owned. The legal and administrative expenses
associated with the bankruptcy proceeding are the direct bankruptcy costs. Direct bankruptcy
cost include;

1. Professional and Legal fees

Bankrupt firms almost always employ outside professionals. Specifically, lawyers,

accountants, investment bankers, appraisers, auctioneers, and actuaries as well as those with
experience in selling distressed assets are all likely to be employed in larger bankruptcies.
Such professionals generally charge out at substantial fees. Similar professionals may well be
used in more normal times. Their use, however, is virtually certain to increase when a firm
gets into serious financial difficulty.

Companies that file for bankruptcy need the permission of the courts to do anything. Any
kind of internal restructuring or even raising of more funds have to be approved by the court.
Therefore, they have to file a lot of petitions. Sometimes, these petitions are contested by the
other parties. This frequent to and fro creates a lot of legal expenses that make bankruptcy an
expensive proposition.

2. Internal staff resources

Dealing with bankruptcy almost always requires a significant portion of the Board of
Directors and senior officer’s time and energy. Similarly, substantial amounts of both human
and other resources from other departments within the firm are likely to be taken up with the
process. For example, the legal, accounting, planning, personnel, and operations staffs all
tend to be involved in assessing and dealing with the implications of bankruptcy. The firm
must confront the business problems that manifest themselves and/or result from the
bankruptcy. The bankrupt firm may also need to negotiate, but, at a minimum, must
communicate with its various categories of interest holders. Their support will be needed to
implement the firm’s reorganization plans. The firm must also be able to cooperate with and
supply information to its hired outside professionals. All the while, the firm needs to keep its
everyday business operations on track under the strained circumstances of bankruptcy. The
internal costs of dealing with bankruptcy are rarely reported separately. Indeed, because the
tasks are typically only part of each cost center’s total assignment, such costs are especially
difficult to assess. Clearly, a bankrupt firm must devote substantial amounts of its own
resources to interacting with its hired professionals. The more work done by professionals,
the greater the amount of work to be done by the internal staffs who interact with them.

Indirect Bankruptcy Cost

The indirect cost refers to the lost sales and higher costs associated with the perception that a
firm is in trouble. Since it is expensive to go bankrupt, a firm will spend resources to avoid
doing so. The costs of avoiding a bankruptcy filing incurred by a financially distressed firm
are called indirect bankruptcy costs. Indirect cost would include the costs of a short-run
focus, as well as costs stemming from a loss in market share. The indirect costs include
reduction in product demand resulting from customer fears of future difficulty in servicing,
increases in input costs resulting from deterioration in the relationship between the firm and
its suppliers, and the flight of key personnel to other firms. Thus, these costs relate to long-
run shifts in supply and demand functions facing the firm, and they are difficult to specify let
alone measure

1. Asymmetric information

Asymmetric information may under certain circumstances, lead to the incidence of

bankruptcy costs as a drain away from the firm. There are two types of asymmetric
information that causes bankruptcy cost. First, uncertainty about the formal bankruptcy court
settlement may lead to a situation in which bankruptcy costs would not be internalized
through informal settlement. Second, stockholders are assumed to know the true going
concern value of the firm relative to its liquidation value, but bondholders are uncertain
unless a verification cost to a third party is incurred. The cost of verification is essentially the
bankruptcy cost, and it may be incurred depending on the bondholder's expected gain from
formal settlement relative to this cost.

2. High labour Turnover

Companies that file for bankruptcy create a lot of fear in their employees. Their employees
are continuously worried about the future prospects of their jobs. As a result, good employees
who are capable of leaving the company and joining another one tends to do so. The
company ends up losing all its best performers, which creates a huge impact if the company
continues its business after filing for bankruptcy.

3. Goodwill

There is a significant impairment of intangible assets when a company files for bankruptcy.
The brand value and the goodwill of the firm in question end up taking a hit when bankruptcy
is filed. The sales of the company also get impacted since fewer people buy products because
of the tarnished brand image.

4. Capital reduction

After companies file bankruptcy, they lose the trust of their customers as well as their
vendors. As a result, they witness vendors reducing the credit period and suppliers increasing
the credit period. This causes a credit squeeze as the company suddenly needs more funds in
the form of working capital in order to continue its operations. This becomes a significant
problem since companies facing bankruptcy are already facing a shortage of funds and have
to borrow at very high-interest rates.

5. High Cost of Capital

Bankruptcy leads to a sudden and marked increase in the cost of capital that a firm has.
Companies that are facing bankruptcy typically have more debt than they should have.
Hence, there is a higher risk of default, which causes lenders to charge a premium. To make
matters worse, filing bankruptcy further jeopardizes the interests of the lenders. As a result,
very few lenders and willing to give funds to the company. Those willing to do so have to
follow a lot of legal processes. Hence, they charge high-interest rates for the inconvenience as
well as for the risk that they are undertaking.

Bankruptcy Cost relevance in the capital structure theory

Capital structure or financial leverage decision should be examined concerning how debt and
equity mix in the firm’s capital structure influence its market value. Debt to equity mix of the
firm can have important implications for the value of the firm and cost of capital. In
maximizing shareholders wealth firm use more debt capital in the capital structure as the
interest paid is a tax deductible and lowers the debt’s effective cost. Further equity holders do
not have to share their profit with debt holders as the debt holders get a fixed return.
However, the higher the debt capital, riskier the firm, hence the higher its cost of capital.
Therefore, it is important to identify the important elements of capital structure, precise
measure of these elements and the best capital structure for a particular firm at a particular
time.

The capital structure theories include;

a. Capital Structure Irrelevance Theory of Modigliani and Miller

Modigliani and Miller demonstrate that under certain assumptions the market value of a firm
is independent of its capital structure. These assumptions include the absence of taxes,
transactions costs, and bankruptcy costs. Miller argued that the introduction of corporate and
personal taxes does not alter the capital structure irrelevance result in the absence of
bankruptcy costs. The inclusion of bankruptcy costs, generally considered in conjunction
with the tax deductibility of interest payments, has led others to conclude that capital
structure will affect the value of the firm. In this case, value-maximizing firms may choose
optimal capital structures consisting of both debt and equity.

b. Trade off Theory

One of the basic theory that have dominated the capital structure theory which recommends
that optimal level of the debt is where the marginal benefit of debt finance is equal to its
marginal cost. Firm can achieve an optimal capital structure through adjusting the debt and
equity level thereby balancing the tax shield and financial distress cost.

Miller (1988) confirmed the fact that firms increase the risk of bankruptcy due to the debt
capital in their capital structure. In the trade off theory cost of debt are linked with direct as
well as indirect cost of bankruptcy. Apart from the bankruptcy cost, agency cost is also
considered in the trade off model.

c. Pecking Order Theory

Myers and Majluf (1984) propose pecking order theory which indicated that management
prefer internally generated funds rather using external funds. Pecking order theory suggest
that firm prefer internal financing over debt capital and explains that firms utilize internal
funds first then issue debt and finally as the last resort issue equity capital.

Based on the pecking order theory, capital structure decisions are intended to eliminate the
inefficiencies caused by information asymmetry which is a cause of indirect bankruptcy cost.
Information asymmetry between insiders and outsiders and separation of ownership explain
why firms avoid capital markets. Debt issue of a firm give a signal of confidence to the
market that firm is an outstanding firm that their management if not afraid of debt financing.
Pecking order can occur due to the agency conflict between managers and owners and outside
investors.

Conclusion

Bankruptcy cost have been advocated by many as the factor which causes firms to limit their
use of debt. As the capital backing of investments and operations of firms include debt and
equity, the capital structure is usually represented by the debt ratio, or the leverage ratio, as
commonly referred to. The capital structure of a firm is, in practice, related to decisions made
in financing the firm. The common way to choose a debt ratio in financing is to trade-off the
potential benefits and costs related to the debt. This is in line with the trade-off Theory It is
widely believed that the main benefit from debt financing is corporate income tax savings,
conventionally referred to as the tax shield, and the main cost is the resulting bankruptcy risk,
conventionally referred to as bankruptcy cost or financial distress cost.

Question 2

Dividend is a share of profit and retained earnings that a company pays out to its
shareholders. Dividend is usually a part of the profit that the company shares with its
shareholders. When a company generates a profit and accumulates retained earnings, those
earnings can be either reinvested in the business or paid out to shareholders as a dividend.
The annual dividend per share divided by the share price is the dividend yield.

Distribution of dividend out of current earnings is crucial in financial management decision

making process. Since, there is no statutory obligation on a company to pay dividend,
therefore, it depends upon company's policy to pay it or not. The distribution of dividend has
two sides of financial importance. First, from the investor’s perspective, and second is from
company’s viewpoint.

From investors point of view, every shareholder wants to increase its current returns on
investments thus, they, prefer more dividend in order to increase their wealth. The more
logical standpoint of shareholders may, be of time value of money which is “receipt of
dividend today has more value than receiving the same later or at the time of liquidation of
company”.

From the side of company's management, the earnings may be retained for future purposes
instead of paying dividend. In case the higher amount of earnings is paid to shareholders, as
dividend, may reduce cash in hand as well as retained earnings of the company. On the
contrary, if lesser or no amount is paid to shareholders then a substantial amount of earnings
may be used in future for business growth, or diversification purposes as ploughing back of
profits. Since, retained earnings bear less cost of capital therefore may be proven as economic
source of finance without incurring extra efforts and diluting shareholders right in a company.

Types of Dividends

1. Cash Dividend
The cash dividend refers to the distribution of the cash to the shareholders a return on their
investment. The shareholders can also opt to re-invest the dividend and increase the size of
their investment. The cash dividend is paid regularly; it may be monthly, quarterly, or yearly.
The dividend-paying companies are usually established companies with strong cash flow
(Dividend-paying companies are considered financially stable as per dividend signaling
theory). However, payment of the dividend may restrict the growth of the company as
financing problems may arise due to a shortage of funds.

2. Stock Dividend

The stock dividend is when a company issues additional stock to the shareholders instead of
the cash. The company may not have cash resources to pay the dividend, or they may have
some other preference for cash to be invested. Hence, a stock dividend is paid when a
company wants to give a return/reward to its shareholders but does not have the funds to do
so. In another word, not in the form of cash.

Further, the stock dividend has a well-known tax advantage as no tax is payable until the
investor sells the shares and realizes the cash. However, there is one important aspect to
understand about the stock issuance in the form of a stock dividend. Once a stock dividend is
released, the number of shares increases by a certain percentage.

3. Property Dividend

The property dividend refers to the distribution of the property to the shareholders a return on
their investment. For property dividends, the company has to assess market value and record
the dividend on the fair value.

4. Liquidating Dividend

The liquidating dividend is when the company is winded up, and the company’s assets are
distributed among shareholders by paying in the form of a dividend. It may be a partial or full
liquidation which means the company may decide to sell only partial assets of the business or
all of the assets. However, it is important to note that shareholders of the company do not
stand first in the line for asset distribution. First of all, creditors are paid from the company’s
assets, and then the remaining amount is paid to the equity holders.

Relevance of Dividend
Proponents of dividends point out that a high dividend payout is important for investors
because dividends provide certainty about the company's financial well-being. Typically,
companies that have consistently paid dividends are some of the most stable companies over
the past several decades. As a result, a company that pays out a dividend attracts investors
and creates demand for their stock.

Dividends are also attractive for investors looking to generate income. However, a decrease
or increase in dividend distributions can affect the price of a security. The stock prices of
companies that have a long-standing history of dividend payouts would be negatively
affected if they reduced their dividend distributions. Conversely, companies that increased
their dividend payouts or companies that instituted a new dividend policy would likely see
appreciation in their stocks. Investors also see a dividend payment as a sign of a company's
strength and a sign that management has positive expectations for future earnings, which
again makes the stock more attractive. A greater demand for a company's stock will increase
its price. Paying dividends sends a clear, powerful message about a company's future
prospects and performance, and its willingness and ability to pay steady dividends over time
provides a solid demonstration of financial strength.

The importance of dividend can be spelt out as follows;

1. Growth and Expansion of Profits

One of the primary benefits of investing in dividend-paying companies is dividends tend to

steadily grow over time. Well-established companies that pay dividends typically increase
their dividend payouts from year to year. One of the basics of stock market investing is
market risk, or the inherent risk associated with any equity investment. Stocks may go up or
down, and there is no guarantee they increase in value. while investing in dividend-paying
companies is not guaranteed to be profitable, dividend stocks offer at least a partial return on
investment that is virtually guaranteed. It is very rare for dividend-paying companies to ever
stop paying dividends, in fact, most of these companies increase the amount of their
dividends over time.

Additionally, in this low-interest-rate environment, the dividend yield offered by dividend-

paying companies is substantially higher than rates available to investors in most fixed-
income investments such as government bonds

2. Dividends Are Helpful in Equity Evaluation

Just as the impact of dividends on total return on investment, or return of investment (ROI) is
often overlooked by investors, so too is the fact that dividends provide a helpful point of
analysis in equity evaluation and stock selection. Evaluation of stocks using dividends is
often a more reliable equity evaluation measure than many other more commonly used
metrics such as price-to-earnings ratio.

Most financial metrics used by analysts and investors in stock analysis are dependent on
figures obtained from companies' financial statements. The potential problem with evaluating
stocks solely based on a company's financial statements is companies can, and unfortunately
sometimes do, manipulate their financial statements through misleading accounting practices
to improve their appearance to investors. Dividends, however, offer a solid indication of
whether a company is performing well. In short, a company has to have real cash flow to
make a dividend payment.

Examining a company's current and historical dividend payout gives investors a firm
reference point in basic fundamental analysis of the strength of a company. Dividends
provide continuous, year-to-year indications of a company's growth and profitability, outside
of whatever up-and-down movements may occur in the company's stock price over the course
of a year. A company consistently increasing its dividend payments over time is a clear
indication of a company that is steadily generating profits and is less likely to have its basic
financial health threatened by the temporary market or economic downturns. An additional
benefit of using dividends in evaluating a company is that since dividends only change once a
year, they provide a much more stable point of analysis than metrics that are subject to the
day-to-day fluctuations in stock price.

3. Reducing Risk and Volatility

Dividends are a major factor in reducing overall portfolio risk and volatility. In terms of
reducing risk, dividend payments mitigate any losses that occur from a decline in stock price.
But the risk reduction benefit of dividends goes beyond that basic fact.

4. Dividends Offer Tax Advantages

The way dividends are treated in regard to taxes makes dividends a very tax-efficient means
of obtaining income. Qualified dividends are taxed at substantially lower rates than ordinary
income.

5. Dividends Preserve Purchasing Power of Capital

Dividends also help out in another area that investors sometimes fail to consider: the effect of
inflation on investment returns. For an investor to realize any genuine net gain from an
investment, the investment must first provide enough of a return to overcome the loss of
purchasing power that results from inflation.

Dividend Policy

A dividend policy can be defined as the dividend distribution guidelines provided by the
board of directors of a company. It sets the parameter for delivering returns to the equity
shareholders, on the capital invested by them in the business. While taking such decisions,
the company has to maintain a proper balance between its debt and equity composition. Some
financial analysts believe that the consideration of a dividend policy is irrelevant because
investors have the ability to create "homemade" dividends. These analysts claim that income
is achieved by investors adjusting their asset allocation in their portfolios.

The irrelevance of dividend policy can be traced to Residual approach and Miller and
Modigliani Hypothesis.

Residual Approach

Under this theory, dividend decision has no effect on the wealth of the shareholders or the
prices of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned.
This theory regards dividend decision merely as a part of financing decision because the
earnings available may be retained in the business or for re-investment. But if the funds are
not needed in business, then it may be distributed as dividend. It means, in each period a firm
has to decide whether to retain its earnings or to distribute part or all of them to shareholders
as cash dividend. As long as there are investment opportunities, firm will retain the earnings
to finance these projects, otherwise will be distributed to shareholders. In the words of J.C.
Van Horne, if the dividend policy is strictly a financing decision, then the payment of
dividends is a passive residual. The passive residual nature, and wide fluctuations makes
dividend policy irrelevant and investor become indifferent between dividend pay-out and
retention of earnings. On the contrary, investors opt to take dividend if the firm's rate of
return is below than expectations or below the market level. If firm's rate of return is more
than expected or above market average rate of return, a shareholder will prefer to retain the
earnings. Thus, a firm should retain the earnings if it has profitable investment opportunities
otherwise it should pay them as dividends.
The assumption of this theory is that raising financing from external sources involves higher
cost. This can be explained with the help of example.

Suppose, A Ltd wants to raise ₵10,00,000 additional funds to finance an investment project
and its floatation cost is ₵1,00,000. A Ltd has to raise ₵11,00,000 from issue of shares so that
the net proceed with the company remains ₵10,00,000 after paying floatation cost of Rs
1,00,000. It means that the issue of new capital is more expensive than financing the project
through retained earnings. The dividend will be paid only after using available profits for
investment needs. This referred as Residual Theory of dividend.

Modigliani and Miller Approach (MM-Model)

Modigliani and Miller have also given comprehensive argument for irrelevancy of dividends.
They assert that, given the investment decision of the firm, the dividend pay-out ratio is a
mere detail. It does not affect the wealth of shareholders. MM argued that the value of the
firm is determined by the earning power of the firm's assets or its investment policy and that
the manner in which the earnings stream is split between dividends and retained earnings
does not affect this value. They concluded that, under the conditions of perfect capital
market, rational investors, and absence of tax discrimination between dividend income and
capital appreciation, may have no influence on the market prices of the share. The MM-
Model has following assumptions:

a) There are perfect capital markets, and investors behave rationally,

b) Information is available to all at no cost,
c) No investor is large enough to affect the market price of shares,
d) There are no floatation and transaction costs,
e) There is no tax,
f) The firm has rigid investment policy, and not subject to change,
g) There is no uncertainty in respect of future investment and profit of the firm, thus,
every investor is certain about future investments and profits. Hence, discount rate is
equal to cost of capital (r = Ke)

Crux of MM-Model

This model state that the effect of dividend is neutralized by issue of new securities. In simple
words, a payment of dividend increases the market value of share, but on the same time it
reduces the balance of funds available to a firm as retained earnings. In order to meet the
requirement of future needs of funds, firm will make a fresh issue which result into increase
in total number of shares available in the market, and reduce the market price of the share.
Thus, dividend has no effect on wealth of the shareholders. MM model suggest that the sum
of the discounted value per share after financing and dividends paid is equal to the market
value per share before the payment of dividends. In other words, the stock's decline in the
market price because of external financing offsets exactly the payment of the dividend. Thus,
the shareholders are at indifferent point either to get dividend or increase value through
retained earnings.