Chapter 4

Firm Financing and

Capital Structure
Decision

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
• The Capital Structure Question
• The Effect of Financial Leverage
• Capital Structure and the Cost of Equity
Capital
• M&M Propositions I and II with Corporate
Taxes
• Bankruptcy Costs
• Optimal Capital Structure
• The Pie Again
• Observed Capital Structures
• A Quick Look at the Bankruptcy Process
Capital Restructuring
• We are going to look at how changes in
capital structure affect the value of
the firm, all else equal
• Capital restructuring involves changing
the amount of leverage a firm has
without changing the firm’s assets
• Increase leverage by issuing debt and
repurchasing outstanding shares
• Decrease leverage by issuing new
shares and retiring outstanding debt
Choosing a Capital Structure
• What is the primary goal of
financial managers?
– Maximize stockholder wealth
• We want to choose the capital
structure that will maximize
stockholder wealth
• We can maximize stockholder
wealth by maximizing firm value or
minimizing WACC
The Effect of Leverage
• How does leverage affect the EPS and ROE
of a firm?
• When we increase the amount of debt
financing, we increase the fixed interest
expense
• If we have a really good year, then we pay our
fixed cost and we have more left over for our
stockholders
• If we have a really bad year, we still have to
pay our fixed costs and we have less left over
for our stockholders
• Leverage amplifies the variation in both EPS
and ROE
Example: Financial Leverage, EPS and ROE

• We will ignore the effect of taxes at

this stage
• What happens to EPS and ROE when we
issue debt and buy back shares of
stock?

Financial Leverage Example

Example: Financial Leverage, EPS and ROE
• Variability in ROE
– Current: ROE ranges from 6.25% to 18.75%
– Proposed: ROE ranges from 2.50% to
27.50%
• Variability in EPS
– Current: EPS ranges from $1.25 to $3.75
– Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS
increases when financial leverage is
increased
Break-Even EBIT
• Find EBIT where EPS is the same under
both the current and proposed capital
structures
• If we expect EBIT to be greater than
the break-even point, then leverage is
beneficial to our stockholders
• If we expect EBIT to be less than the
break-even point, then leverage is
detrimental to our stockholders
Example: Break-Even EBIT

EBIT EBIT  400,000


400,000 200,000
 400,000 
EBIT     EBIT  400,000 
 200,000 
EBIT  2EBIT  800,000
EBIT  $800,000
800,000
EPS   $2.00
400,000
 Financial Leverage: EPS and EBIT for the Trans Am Corporation

$6.00

$5.00

Break-even Point:
EPS

$4.00
EPS = $2; EBIT = $800,000

Current
$3.00
Propose
d
$2.00

$1.00

$0.00
$500,000 $1,000,000 $1,500,000

EBIT
Example: Homemade Leverage and ROE
• Current Capital Structure • Proposed Capital Structure
– Investor borrows $2000 – Investor buys $1000
and uses $2000 of their worth of stock (50
own to buy 200 shares shares) and $1000 worth
of stock of Trans Am bonds
– Payoffs: paying 10%.
• Recession: 200(1.25) - . – Payoffs:
1(2000) = $50 • Recession: 50(.50) + .
• Expected: 200(2.50) - . 1(1000) = $125
1(2000) = $300 • Expected: 50(3.00) + .
• Expansion: 200(3.75) - . 1(1000) = $250
1(2000) = $550 • Expansion: 50(5.50) + .
– Mirrors the payoffs 1(1000) = $375
from purchasing 100 – Mirrors the payoffs
shares from the firm from purchasing 100
under the proposed shares under the
capital structure current capital
structure
Capital Structure Theory
• Modigliani and Miller Theory of Capital
Structure
– Proposition I – firm value
– Proposition II – WACC
• The value of the firm is determined by
the cash flows to the firm and the risk
of the assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows
 Capital Structure Theory Under
Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs
Case I – Propositions I and II

• Proposition I
– The value of the firm is NOT affected by
changes in the capital structure
– The cash flows of the firm do not change,
therefore value doesn’t change
• Proposition II
– The WACC of the firm is NOT affected by
capital structure
Case I - Equations
• WACC = RA = (E/V)RE + (D/V)RD

• RE = RA + (RA – RD)(D/E)

– RA is the “cost” of the firm’s business risk,

i.e., the risk of the firm’s assets
– (RA – RD)(D/E) is the “cost” of the firm’s
financial risk, i.e., the additional return
required by stockholders to compensate for
the risk of leverage
Figure 2.3: the cost of equity & the WACC;
M&M Propositions I & II with no taxes
Case I - Example
• Data
– Required return on assets = 16%, cost of debt
= 10%; percent of debt = 45%
• What is the cost of equity?
– RE = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91%
• Suppose instead that the cost of equity is
25%, what is the debt-to-equity ratio?
– .25 = .16 + (.16 - .10)(D/E)
– D/E = (.25 - .16) / (.16 - .10) = 1.5
• Based on this information, what is the
percent of equity in the firm?
– E/V = 1 / 2.5 = 40%
The CAPM, the SML and Proposition II
• How does financial leverage affect
systematic risk?
• CAPM: RA = Rf + A(RM – Rf)
– Where A is the firm’s asset beta and
measures the systematic risk of the firm’s
assets
• Proposition II
– Replace RA with the CAPM and assume that
the debt is riskless (RD = Rf)
– RE = Rf + A(1+D/E)(RM – Rf)
Business Risk and Financial Risk
• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)
– E = A(1 + D/E)
• Therefore, the systematic risk of the
stock depends on:
– Systematic risk of the assets, A, (Business
risk)
– Level of leverage, D/E, (Financial risk)
Case II – Cash Flow

• Interest is tax deductible

• Therefore, when a firm adds debt, it
reduces taxes, all else equal
• The reduction in taxes increases the
cash flow of the firm
• How should an increase in cash flows
affect the value of the firm?
Case II - Example
Unlevered Firm Levered Firm

EBIT 5000 5000

Interest 0 500
Taxable Income 5000 4500

Taxes (34%) 1700 1530

Net Income 3300 2970

CFFA 3300 3470

Interest Tax Shield
• Annual interest tax shield
– Tax rate times interest payment
– 6250 in 8% debt = 500 in interest expense
– Annual tax shield = .34(500) = 170
• Present value of annual interest tax shield
– Assume perpetual debt for simplicity
– PV = 170 / .08 = 2125
– PV = D(RD)(TC) / RD = DTC = 6250(.34) = 2125
Case II – Proposition I

• The value of the firm increases by the

present value of the annual interest tax
shield
– Value of a levered firm = value of an
unlevered firm + PV of interest tax shield
– Value of equity = Value of the firm – Value
of debt
• Assuming perpetual cash flows
– VU = EBIT(1-T) / RU
– VL = VU + DTC
Example: Case II – Proposition I
• Data
– EBIT = 25 million; Tax rate = 35%; Debt =
$75 million; Cost of debt = 9%; Unlevered
cost of capital = 12%
• VU = 25(1-.35) / .12 = $135.42 million
• VL = 135.42 + 75(.35) = $161.67 million
• E = 161.67 – 75 = $86.67 million
Figure 2.4: M&M Proposition I with taxes
Case II – Proposition II
• The WACC decreases as D/E increases
because of the government subsidy on interest
payments
– RA = (E/V)RE + (D/V)(RD)(1-TC)
– RE = RU + (RU – RD)(D/E)(1-TC)
• Example
– RE = .12 + (.12-.09)(75/86.67)(1-.35) = 13.69%
– RA = (86.67/161.67)(.1369) + (75/161.67)(.09)(1-.35)
RA = 10.05%
Example: Case II – Proposition II

• Suppose that the firm changes its

capital structure so that the debt-to-
equity ratio becomes 1.
• What will happen to the cost of equity
under the new capital structure?
– RE = .12 + (.12 - .09)(1)(1-.35) = 13.95%
• What will happen to the weighted
average cost of capital?
– RA = .5(.1395) + .5(.09)(1-.35) = 9.9%
Figure 2.5: : the cost of equity & the WACC;
M&M Propositions I & II with taxes
Case III: Bankruptcy Costs
• Now we add bankruptcy costs
• As the D/E ratio increases, the probability of
bankruptcy increases
• This increased probability will increase the
expected bankruptcy costs
• At some point, the additional value of the
interest tax shield will be offset by the
expected bankruptcy cost
• At this point, the value of the firm will start
to decrease and the WACC will start to
increase as more debt is added
Bankruptcy Costs
• Direct costs
– Legal and administrative costs
– Ultimately cause bondholders to incur
additional losses
– Disincentive to debt financing
• Financial distress
– Significant problems in meeting debt
obligations
– Most firms that experience financial
distress do not ultimately file for
bankruptcy
More Bankruptcy Costs
• Indirect bankruptcy costs
– Larger than direct costs, but more difficult to
measure and estimate
– Stockholders wish to avoid a formal bankruptcy
filing
– Bondholders want to keep existing assets
intact so they can at least receive that money
– Assets lose value as management spends time
worrying about avoiding bankruptcy instead of
running the business
– Also have lost sales, interrupted operations and
loss of valuable employees
Figure 2.6: The Static theory of capital structure.
The optimal capital structure and the
value of the firm
Figure 2.7: The Static theory of capital structure.
The optimal capital structure and the
cost of capital
Conclusions
• Case I – no taxes or bankruptcy costs
– No optimal capital structure
• Case II – corporate taxes but no bankruptcy
costs
– Optimal capital structure is 100% debt
– Each additional dollar of debt increases the cash
flow of the firm
• Case III – corporate taxes and bankruptcy
costs
– Optimal capital structure is part debt and part
equity
– Occurs where the benefit from an additional
dollar of debt is just offset by the increase in
expected bankruptcy costs
Figure 2.8: The Capital Structure Question
Managerial Recommendations
• The tax benefit is only important if the
firm has a large tax liability
• Risk of financial distress
– The greater the risk of financial distress,
the less debt will be optimal for the firm
– The cost of financial distress varies across
firms and industries and as a manager you
need to understand the cost for your
industry
Figure 2.9: The Extended Pie Model
The Value of the Firm
• Value of the firm = marketed claims +
nonmarketed claims
– Marketed claims are the claims of
stockholders and bondholders
– Nonmarketed claims are the claims of the
government and other potential stakeholders
• The overall value of the firm is
unaffected by changes in capital
structure
• The division of value between marketed
claims and nonmarketed claims may be
impacted by capital structure decisions
Observed Capital Structure
• Capital structure does differ by
industries
• Differences according to Cost of Capital
2000 Yearbook by Ibbotson Associates,
Inc.
– Lowest levels of debt
• Drugs with 2.75% debt
• Computers with 6.91% debt
– Highest levels of debt
• Steel with 55.84% debt
• Department stores with 50.53% debt
Work the Web Example
• You can find information about a
company’s capital structure relative to
its industry, sector and the S&P 500 at
Yahoo Marketguide
• Click on the web surfer to go to the
site
– Choose a company and get a quote
– Choose ratio comparisons
Bankruptcy Process – Part I
• Business failure – business has
terminated with a loss to creditors
• Legal bankruptcy – petition federal
court for bankruptcy
• Technical insolvency – firm is unable to
meet debt obligations
• Accounting insolvency – book value of
equity is negative
Bankruptcy Process – Part II
• Liquidation
– Chapter 7 of the Federal Bankruptcy
Reform Act of 1978
– Trustee takes over assets, sells them and
distributes the proceeds according to the
absolute priority rule
• Reorganization
– Chapter 11 of the Federal Bankruptcy
Reform Act of 1978
– Restructure the corporation with a
provision to repay creditors
LEASE FINANCING DECISIONS
AND EVALAUTION
Definition
• Leasing as financial service is a contractual agreement where
the owner (lessor) of asset (say, equipment/machinery)
transfers the right to use the asset to the user (lessee) for an
agreed period of time in return for a rental.
• Leasing is an arrangement that provides a
firm with the use and control over the assets
without buying and owning the same. It is a
form of hiring assets.
• Lease is a contract between a lessor, the owner
of the asset , and the lessee, the user of the
asset.
Definition

• “It is a contract where a party being the owner (lessor) of an asset

provides the asset for use by the lessee at a consideration (rentals),
either fixed or dependent on any variables, for a certain period, with an
understanding that at the end of such period, the asset, subject to the
embedded options of the lease, will be either returned to the lessor or
disposed off as per the lessor's instructions”.
CLASSIFICATION OF LEASES
• Operating lease
• Finance lease
• Leveraged lease
• Sale and lease back lease
Operating leases
• Operating lease is also called as service lease, and characterized with the
following features:

 It is a short-term lease on a periodic basis. The lease period is

less than the useful life of the asset.
 The lease is cancelable at short notice by the lessee.
 Amortization of the original cost of the asset is not possible in
an operating lease, as the period is less than the assets useful
service life.
Operating leases

 Operating lease will always carry an option of

renewing the lease agreement after the expiry
of the term, for the benefit of the lessee.
 Lessor is the person responsible for the
maintenance of the asset in case of operating
lease.
 Operating lease will impose high degree of
 Financial leases

• Long term non-cancellable lease contracts.

• Examples include plant, machinery, land ,building, ships and
aircraft.
• Financial leases amortize the cost of the asset over the term of
the lease.
• Financial leases, sometimes called capital leases, differ from
operating leases in that
• they
(1) do not provide for maintenance service,
(2) are not cancellable, and
(3) are fully amortized (that is, the lessor receives rental payments
equal to the full price of the leased equipment plus a return on
invested capital).
Financial leases

• According to IASB the lease is said to be financial lease if:

i. The lease transfers ownership of the asset to the lessee by the end of the
lease term; (or)
ii. The lessee has the option to purchase the asset at a price, which is expected
to be sufficiently lower than the fair market value, at the inception of the
lease; (or)
iii. The lease term is for a major part of the useful life of the asset; (or)
iv. The present value of the minimum lease payments is greater than or
substantially equal to the fair market value of the asset at the inception of
the lease.
 Sale and lease back

• Under a sale-and-leaseback arrangement, a firm that owns

land, buildings, or equipment sells the property to another firm
and simultaneously executes an agreement to lease the
property back for a stated period under specific terms.
• The capital supplier could be an insurance company, a
commercial bank, a specialized leasing company, the finance
arm of an industrial firm, a limited partnership, or an
individual investor.
• The sale-and-leaseback plan is an alternative to a mortgage.
• Note that the seller immediately receives the purchase price
put up by the buyer. At the same time, the seller-lessee retains
the use of the property.
 Leveraged Leases

• A leveraged lease is a three-sided arrangement among the

lessee, the lessor, and the lenders:
• 1. As in other leases, the lessee uses the assets and makes
periodic lease payments.
• 2. As in other leases, the lessor purchases the assets, delivers
them to the lessee, and collects the lease payments. However,
the lessor puts up no more than 40 to 50 percent of the
purchase price.
• 3. The lenders supply the remaining financing and receive
interest payments from the lessor.
Factors Influencing Lease Financing
• Why should a company lease instead of
securing a loan or buying:
1) Convenience and Flexibility
2) Shifting the risk of Obsolescence
3) Maintenance and Specialized Services
1. Convenience and Flexibility

• If an asset is needed for a short period of time, leasing makes

sense.
• Buying an asset and waiting to resell after use is time
consuming, inconvenient and costly.
• Long term financial leases also offer flexibility to the user.
Financial institutions put restrictions on borrowers,
conversion of loan into equity and appointment of directors.
• Leases can be negotiated faster, especially if the leasing
industry is well developed.
• SMEs find it difficult to raise funds from banks and other
financial institutions.
2. Shifting the risk of Obsolescence

• When the technology embedded in assets as in

computers, is subject to rapid and
unpredictable changes, a lease can shift the
risk of obsolescence to the lessor.
• The lessor e.g manufactures are in a better
position to assume the risk of obsolescence
and manage the fast advancing technology.
3.Maintenance and Specialized Services

• A lease can look for advantages in

maintenance and specialized services.
• A computer manufacture who leases out
computers are better equipped to provide
effective maintenance.
• The cost may be less than if the lessee would
have to incur if they were to maintain the
leased asset.
• The lessor are able to provide maintenance
and services cheaply because of economies of
scale.
Evaluating leasing as a source of finance
• It is important to recognize that evaluating leasing as a source
of finance may involve both an investment decision and a
finance decision.
• The optimal overall decision can be reached in several ways,
as follows:
■ make the investment decision first, then optimize the financing
method;
■ make the financing decision first, and then evaluate the
investment decision;
■ combine the investment and financing decisions.
• If the investment decision is made first, an investment project
might be rejected which would have been accepted if the
lowest-cost financing method had been taken into account.
Evaluation by the Lessee
• Any prospective lease must be evaluated by
both the lessee and the lessor.
• The lessee must determine whether leasing an
asset will be less costly than buying it, and the
lessor must decide whether or not the lease
will provide a reasonable rate of return.
Evaluation by the Lessee

1. The firm decides to acquire a particular

building or piece of equipment. This decision is
based on regular capital budgeting procedures,
and the decision to acquire the asset is a “done
deal” before the lease analysis begins.
2. Once the firm has decided to acquire the
asset, the next question is how to finance it.
Well-run businesses do not have excess cash
lying around, so new assets must be financed in
some manner.
3. Funds to purchase the asset could be obtained
Evaluation by the Lessee
• Lease is comparable to a loan in the sense that
the firm is required to make a specified series
of payments, and a failure to make these
payments can result in bankruptcy.
• Thus, it is most appropriate to compare the
cost of leasing with that of debt financing.
11
The Lease Versus Purchase
Decision
• A frequent decision made by managers is
whether to purchase or lease assets.
• Factors that might make leasing the preferred
alternative include:
– Possible to structure lease to provide off-
balance-sheet financing.
• Leases classified as operating leases result in
off-balance-sheet financing.
• Leases classified as capital leases do not result
in off balance sheet financing.
– Potential tax advantages.
• Potential to deduct entire lease payment for tax
purposes.
– Ability to manage risk of obsolescence.
• Use of short term leases shifts risk of
obsolescence to lessor.
– In some cases, possible to secure 100% financing
via leasing
• Banks frequently will not finance 100% of a
purchase price but lessors frequently will
finance 100%.
Off-Balance-Sheet Financing

A party incurs a financial obligation, but IASB

does not define nor require the obligation to be
recognized in the Balance Sheet as a liability; IF
it is an operating lease deal!
• Using off-balance-sheet financing makes financial
ratios, particularly the debt to equity ratio, look
better.
– On balance sheet financing would increase the
numerator and raise the debt to equity ratio;
therefore, off balance sheet financing fails to raise
the ratio

Total Debt
Stockholders’ Equity
The evaluation of lease financing decisions from the point of
view of the lessee involves the following steps:

1) Determine the present value of after-tax cash outflows under

the leasing option.
2) Determine the present value of after-tax cash outflows under
the buying or borrowing option.
3) Compare the present value of cash outflows from leasing
option with that of buying/borrowing option.
4) Select the option with lower presented value of after-tax cash
outflows.
Illustration-Lessee’s perspective
•ABC limited company is interested in acquiring the use of an asset
costing Birr 500,000. It has two options:
i. To borrow the amount at 18% p.a. repayable in 5 equal installments or
ii. To take on lease the asset for a period of 5 years at the yearend rentals of
Birr 120,000.
•The corporate tax is 50% and the depreciation is allowed on write down
value (w.d.v) at 20% a year. The asset will have a salvage of Birr180,000 at
the end of the 5th year.
•Required: You are required to advise the company about lease or buy
decision. Will your decision be changed if the firm is allowed to claim an
investment allowance at 25% at the end of year 1?
Additional information
•1) The present value of $1 at 18% discount
factor is:
1st year –0.847
2nd year –0.718
3rd year –0.609
4th year –0.516
5th year –0 .437
•(2) The present value of an annuity of Birr1 at
18% p.a. is Birr 3.127.
Solution
Solution
Solution
Example 2
Solution
Solution
Solution
Solution
 Chapter 4: The End!
Next …
Chapter 5: Dividends & Dividend Policy

Your Reading Home Work:

Ross et al Chapter 18: PP. 510-548
AND
Van Horne & Wachowicz Chapter 18: PP. 475-504
Chapter 5– Dividend and
Dividend Policy
Introduction
• Once a company makes a profit, it must
decide on what to do with those profits.
– They could continue to retain with the company; or
– They could pay out the profits to the owners;
• The dividend policy decisions involves two
questions:
1) What fraction of earnings should be paid out, on
average, over time?
2) What type of dividend policy should the firm
follow?
• More over the management has to satisfy
various stakeholders form the profit.
Stock Returns:

Return = P 1 - Po + D1
Po
P1 - Po D1
= +
Po Po

P1 - Po D1
= + Po
Po

Capital Gain Dividend Yield

Dilemma: Should the firm use
retained earnings for:

a) Financing profitable capital

investments?
b) Paying dividends to stockholders?
Financing Profitable Capital
Investments:
If we retain earnings for
profitable investments, dividend
yield will be zero, but the stock
price will increase, resulting in a
higher capital gain.

P1 - Po D1
Return = +
Po Po
 Paying Dividends:

If we pay dividends,

P1 - Po D1
Return = +
Po Po
 Paying Dividends:

If we pay dividends, stockholders receive

an immediate cash reward for investing,

P1 - Po D1
Return = +
Po Po
Paying Dividends:
• If we pay dividends, stockholders receive
an immediate cash reward for investing,
but the capital gain will decrease, since
this cash is not invested in the firm.

P1 - Po D1
Return = +
Po Po
So, dividend policy really involves
two decisions:
• How much of the firm’s earnings should be
distributed to shareholders as dividends,
and
• How much should be retained for capital
investment?
 Thus, dividend policy means the practice
that management follows in making dividend
payout decisions, or in other words, the size
and pattern of cash distributions over the
time to shareholders.
 It is a guideline followed by the management
in declaring of dividend.
Is Dividend Policy Important?

Three viewpoints:

1) Dividends are Irrelevant

2) High Dividends are Best
3) Low Dividends are Best
Three viewpoints:

1) Dividends are Irrelevant.

• If we assume perfect markets (no
taxes, no transaction costs, etc.)
dividends do not matter.
• If we pay a dividend, shareholders’
dividend yield rises, but capital gains
decrease.
Dividends are Irrelevant
• With perfect markets, investors are
concerned only with total returns and
do not care whether returns come in
the form of capital gains or dividend
yields.

P1 - Po D1
Return = +
Po Po
 Therefore, one dividend policy is as
good as another.
High Dividends are Best
• Some investors may prefer a
certain dividend now over a risky
expected capital gain in the
future.

P1 - Po D1
Return = +
Po Po
Low Dividends are Best
• Dividends are taxed immediately.
Capital gains are not taxed until
the stock is sold.
• Therefore, taxes on capital gains
can be deferred indefinitely.
Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory
2) Clientele Effects
3) Information Effects
4) Agency Costs
5) Expectations Theory
Other Considerations
1) Residual Dividend Theory:
• The firm pays a dividend only if it has
retained earnings left after financing
all profitable investment opportunities.
• This would maximize capital gains for
stockholders and minimize flotation
costs of issuing new common stock.
Other Considerations
2) Clientele Effects:
• Different investor clienteles prefer
different dividend payout levels.
• Some firms, such as utilities, pay out
over 70% of their earnings as
dividends. These attract a clientele
that prefers high dividends.
• Growth-oriented firms which pay low
(or no) dividends attract a clientele
that prefers price appreciation to
dividends.
Other Considerations
3) Information Effects:
• Unexpected dividend increases usually
cause stock prices to rise, and
unexpected dividend decreases cause
stock prices to fall.
• Dividend changes convey information
to the market concerning the firm’s
future prospects.
Other Considerations
4) Agency Costs:
• Paying dividends may reduce agency
costs between managers and
shareholders.
• Paying dividends reduces retained
earnings and forces the firm to raise
external equity financing.
• Raising external equity subjects the
firm to scrutiny of regulators (SEC)
and investors and therefore helps
monitor the performance of managers.
Other Considerations
5) Expectations Theory:
• Investors form expectations concerning
the amount of a firm’s upcoming dividend.
• Expectations are based on past
dividends, expected earnings, investment
and financing decisions, the economy, etc.
• The stock price will likely react if the
actual dividend is different from the
expected dividend.
Dividend Policies
1) Constant Dividend Payout Ratio: If
directors declare a constant payout
ratio of, for example, 30%, then for
every dollar of earnings available to
stockholders, 30 cents would be paid
out as dividends.
• The ratio remains constant over time,
but the dollar value of dividends
changes as earnings change.
Dividend Policies

2) Stable Birr Dividend Policy:

• The firm tries to pay a fixed Birr
dividend each quarter.
• Firms and stockholders prefer
stable dividends. Decreasing the
dividend sends a negative signal!
Dividend Policies
3) Small Regular Dividend plus Year-End
Extras
• The firm pays a stable quarterly
dividend and includes an extra year-end
dividend in prosperous years.
• By identifying the year-end dividend as
“extra,” directors hope to avoid
signaling that this is a permanent
dividend.
Dividend Payments
1) Declaration Date: The board of
directors declares the dividend,
determines the amount of the
dividend, and decides on the
payment date.
Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
Dividend Payments
2) Ex-Dividend Date: To receive the dividend, you
have to buy the stock before the ex-dividend
date. On this date, the stock begins trading
“ex-dividend” and the stock price falls
approximately by the amount of the dividend.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
Dividend Payments
3) Date of Record: Two days after the ex-
dividend date, the firm receives the list
of stockholders eligible for the dividend.

• Often, a bank trust department acts as

registrar and maintains this list for the
firm.
Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
Dividend Payments
4) Payment Date: Date on which the
firm mails the dividend checks to
the shareholders of record.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
Stock Dividends and Stock Splits
• Stock Dividend: Payment of additional
shares of stock to common stockholders.
• Example: Citizens Bancorporation of
Maryland announces a 5% stock dividend
to all shareholders of record. For each
100 shares held, shareholders receive
another five shares.
• Does the shareholders’ wealth increase?
Stock Dividends and Stock Splits
• Stock Split: The firm increases the
number of shares outstanding and
reduces the price of each share.
• Example: JKL, Inc. announces a
3-for-2 stock split. For each 100 shares
held, shareholders receive another 50
shares.
• Does this increase shareholder wealth?
• Are a stock dividend and a stock split the same?
Stock Dividends and Stock Splits
• Stock Splits and Stock Dividends are
economically the same.
• The number of shares outstanding
increases and the price of each share
drops. The value of the firm does not
change.
• Example: A 3-for-2 stock split is the
same as a 50% stock dividend. For each
100 shares held, shareholders receive
another 50 shares.
Stock Dividends and Stock Splits
• Effects on Shareholder Wealth: These
will cut the company “pie” into more
pieces but will not create wealth. A
100% stock dividend (or a 2-for-1 stock
split) gives shareholders two half-sized
pieces for each full-sized piece they
previously owned.
• Example: This would double the number
of shares, but would cause a $60 stock
price to fall to $30.
Stock Dividends and Stock Splits
Why bother?
• Proponents argue that these are used to
reduce high stock prices to a “more
popular” trading range (generally $15 to
$70 per share).
• Opponents argue that most stocks are
purchased by institutional investors who
have millions of dollars to invest and are
indifferent to price levels. Plus, stock
splits and stock dividends are expensive!
Stock Dividend Example
• An investor has 120 shares. Does
the value of the investor’s shares
change?
– Shares outstanding: 1,000,000.
– Net income = $6,000,000.
– P/E = 10.
– 25% stock dividend.
Stock Dividend Example
Before the 25% stock dividend:
– EPS = 6,000,000/1,000,000 = $6.
– P/E = P/6 = 10, so P = $60 per share.
– Value = $60 x 120 shares = $7,200.
After the 25% stock dividend:
– # shares = 1,000,000 x 1.25 = 1,250,000.
– EPS = 6,000,000/1,250,000 = $4.80.
– P/E = P/4.80 = 10, so P = $48 per share.
– Investor now has 120 x 1.25 = 150 shares.
– Value = $48 x 150 = $7,200.
Stock Dividends
In-class Problem

What is the new stock price?

– Shares outstanding: 250,000.
– Net income = $750,000.
– Stock price = $84.
– 50% stock dividend.
Stock Dividend Exercise … solution
Before the 50% stock dividend:
• EPS = 750,000 / 250,000 = $3.
• P/E = 84 / 3 = 28.
After the 50% stock dividend:
• # shares = 250,000 x 1.50 = 375,000.
• EPS = 750,000 / 375,000 = $2.
• P/E = P / 2 = 28, so P = $56 per share.

(A 50% stock dividend is equivalent to a

3-for-2 stock split.)
Stock Repurchases

– Stock Repurchases may be a

good substitute for cash
dividends.
– If the firm has excess cash,
why not buy back common
stock?
Stock Repurchases
• Stock Repurchases may be a good
substitute for cash dividends.
• If the firm has excess cash, why
not buy back common stock?
Stock Repurchases
• Repurchases drive up the stock
price, producing capital gains for
shareholders.
• Repurchases increase leverage, and
can be used to move toward the
optimal capital structure.
• Repurchases signal positive
information to the market—which
increases stock price.
Stock Repurchases
• Repurchases may be used to avoid a
hostile takeover.
• Example: T. Boone Pickens
attempted raids on Phillips
Petroleum and Unocal in 1985.
Both were unsuccessful because
the target firms undertook stock
repurchases.
Stock Repurchases
Methods:
• Buy shares in the open market through a
broker.
• Buy a large block by negotiating the
purchase with a large block holder,
usually an institution (targeted stock
repurchase).
• Tender offer: offer to pay a specific
price to all current stockholders.
End of chapter Five: