PART II DETERMINANTS OF VALUATION

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1 CORPORATE FINANCIAL MANAGEMENT PART IV CAPITAL STRUCTURE AND DIVIDEND POLICY (chapter 12-14)

2 Chapter 12 CAPITAL STRUCTURE CONCEPTS

3 Introduction 1. Concepts 2. Capital structure Theory

4 1. Concepts Capital Structure Vs. Financial Structure Capital Structure Financial Structure Permanent s-t debt L-T debt P/S C/S Total current liabilities L-T debt P/S C/S 4

5 Continued Capital Structure Terminology Optimal capital structure o Minimizes a firm s weighted cost of capital o Maximizes the value of the firm Target capital structure o Capital structure at which the firm plans to operate Debt capacity o Amount of debt in the firm s optimal capital structure

6 Continued Capital Structure Assumptions Firm s investment policy is held constant Capital structure changes the distribution of the firm s EBIT among the firm s claimants Debtholders Preferred stockholders Common stockholders Constant investment policy leaving the debt capacity of the firm unchanged

7 2. Capital Structure Theory / 9

8 Continued Theoretical Perspectives on Capital Structure and Firm Valuation 1958 o Net Income Theory o Net Operating Income Theory o Tradition Theory

9 Net Income Theory (NI) cost of capital V Ka Ks V 100 % K d Debt Total Assets Debt Total Assets 100 %

10 Net Operating Income Theory (NOI) cost of capital Ks V Ka V 100 K d Debt Total Assets Debt Total Assets 100

11 Tradition Theory cost of capital Ks K a V V K d D % T A 100 D % T A

12 Continued Modigliani and Miller s Analysis ( 1958 ) I MM without a Corporate Income Tax o Assumptions: No taxes No transaction costs Individuals and corporations borrow at same rate o Results: Proposition I: V L =V U (=EBIT/k a =EBIT/k eu ) Proposition II: k el =k eu +B/E(k eu -k d )

13 Continued o Intuition: Proposition I: Through homemade leverage, Individuals can either duplicate or undo the effects of corporate leverage. Proposition II: The cost of equity rises with leverage, because the risk to equity rises with the leverage. Cost of equity (k el ) increases to exactly offset the benefits of more debt financing ( k d ), leaving the cost of capital ( k a ) constant see model 1

14 Model 1 Cost of Capital k e k a k d Debt The overall cost of capital is independent of the capital structure The firm s value is independent of the capital structure Total Assets

15 Continued o MM Arbitrage Proof VU = D/ k eu V L = D/ k el + I/ k d D paid to L s stockholders are reduced by the amount of I paid on the debt k e is higher for L because of the additional leverage-induced risk The values of U and L are identical due to arbitrage

16 Continued II MM with a Corporate Income Tax o Assumptions: Corporations are taxed at the rate T, on earnings after interest No transaction costs Individuals and corporations borrow at same rate o Results: Proposition I: V L =V U +BT(for a firm with perpetual debt)(v U =EBIT(1-T)/k eu V L =EBIT(1- T)/k a ) Proposition II: k el =k eu +B/E(k eu -k d )(1-T) (WACC=k a =k e *E/V+k d (1-T)*B/V)

17 Continued o Intuition: Proposition I: Since corporations can deduct interest payments but not dividend payments, corporate leverage lowers tax payments. Proposition II: The cost of equity rises with leverage, because the risk to equity rises with the leverage.

18 Continued o MM Arbitrage Proof VU = D/k e VL = D/k e + I/k d D distributed to U s stockholders are reduced by the taxes paid on operating income and the value of U drops Since I is tax deductible, L realizes a tax savings PV of tax shield = value of debt ( B ) Χ tax rate (T)

19 VL = VU + Value of Tax Shield Mkt Value of Firm V L PV of Tax Shield V U Debt $

20 Model 2 Cost of Capital k e k a k i = k d ( 1 - T ) The cost of capital decreases with the amount of debt Firm maximizes its value by choosing a capital structure that is all debt Debt Total assets

21 Case1: Continued A EBIT = $4,000,000 40% 40% 8% 8% EBIT 12% $1,000 $1,000 Ka Ke L

22 Ke V L TD 20 Vu=20 Ka 10 Ka 10 Kd(1 T) 100 T A Kd(1 T) 100

23 Continued Case2: A is just about to commence operations as an international trading company. The firm expects to earn $1.2 million earnings before taxes. It is known that the capitalization rate for an allequity firm in this business is 10%,that is, k eu =10%. Further, A can borrow at a rate of 6%. Assume that the tax rate is zero and the MM assumptions apply. (1) According to MM, what will be the value of A if it uses no debt? If it uses $4 million debt? (2) What are the values of the WACC and k el at debt levels of $4 million? (3) Assume the initial facts of the problem (k d =6%, EBIT=$1.2 million, k eu =10%), but now assume that a 40% percent tax rate exists. Find the new market values for A with zero debt and with $4 million debt. And Find WACC and k el at debt levels of $4 million?

24 Continued Solution: (1) V L =V U =EBIT/k eu =1.2m/10%=12m (2) E=V-B=12m-4m=8m k el =k eu +B/E(k eu -k d )=10%+(10%-6%)*4m/8m =12% WACC=10% (3) V U =EBIT*(1-T)/k eu =1.2*(1-40%0/10%=7.2m V L =V U +BT=7.2m+4m*40%=8.8m k el =k eu +B/E*(1-40%)(k eu -k d )=10%+(10%- 6%) *(1-40%)*4m/4.8m =12% WACC=k e *E/V+k d (1-T)*B/V=12%*4.8/8.8+6%*(1-T) *4/8.8=8.18%

25 Continued II Capital Structure with a Corporate Income Tax, Financial Distress Costs, and Agency Costs o B & A costs increase with the amount of leverage, eventually offset the marginal benefits from the value of the tax shield o Market value of levered firm = Market value of unlevered firm + PV of tax shield - PV of bankruptcy costs - PV of agency costs See optimal debt ratio slide

26 Continued obankruptcy Costs : Lenders may demand higher interest rates Lenders may decline to lend at all Customers may shift their business to other firms Distress incurs extra accounting & legal costs If forced to liquidate, assets may have to be sold for less than market value

27 Continued o Agency Costs(Stockholder-Bondholder Relationship) : Investing in projects with high risk and high returns can shift wealth from bondholders to stockholders Stockholders may forgo some profitable investments in the presence of debt Stockholders might issue high quantities of new debt and diminish the protection afforded to earlier bondholders Bondholders will shift monitoring and bonding costs back to the stockholders by charging higher interest rates

28 Optimal Debt Ratio Mkt Value of the Firm Mkt value of levered firm PV B & A Costs V L PV of Tax Shield V U Optimal Debt Ratio Debt Ratio

29 Model 3 Least Cost Capital Structure is Optimal Cost of Capital k e k a k i 0 Optimal Capital Structure B B + E

30 Continued Other Impacts on the Optimal Capital Structure o Business risk o Personal tax effects Could reverse some tax benefits o Industry effects Profitability and bankruptcy patterns o Signaling effects Asymmetric information o Managerial preferences Pecking order theory

31 ...continued Business risk: Variabilility or uncertainty of a firm s operating income (EBIT) Factors Influencing a Firm s Business Risk: Variability of sales volume Variability of selling price Variability of cost Amount of market power Extent of product diversification Firm s growth rate Degree of operating leverage ( DOL ) Both systematic and unsystematic risk Financial risk:variability of EPS and increased probability of bankruptcy using fixed-cost source of funds Factors indicating financial risk: Debt-to asset ratio Debt-to-equity ratio Fixed charge coverage ratio DFL Probability distribution of profits Times interest earned ratio EBIT-EPS analysis

32 10...continued

33 ...continued 11

35 Chapter 13 Capital Structure Management in Practice

36 Introduction Breakeven Analysis DOL / DFL / DCL EBIT-EPS Analysis

37 1. Breakeven Analysis - - Graphic Method Cost Revenue ($) Negative EBIT TR TC V.C. Qb F.C. Output (Sales)

38 Continued Algebraic Method TR = P Q P TC = F + v Q EBIT = TR TC EBIT = 0, TR = TC P Q =F + v Q b b F F + Q b = ( = ) ( ) P v P v F Cash = 1 ( v ) P

39 2. DOL / DFL / DCL Basic concepts Operating Leverage: Results from fixed operating costs (Costs of sales/general & administrative costs) such that a change in sales revenue is magnified into a relative large change in EBIT Financial Leverage: Results from fixed capital costs (Interest charges/preferred dividends/income taxes) such that a change in EBIT is magnified into a relative large change in EPS

40 Continued operating leverage financial leverage Sales Operating costs EBIT Interest EBT Income taxes EAT P/S dividends Earnings available to C/S EPS Variable operating costs Contribution margin Fixed operating costs Fixed capital costs Variable capital costs Fixed capital costs

41 Leverage Model % Sales DOL % EBIT DFL % EPS

42 Continued Measurement of operating and financial leverage Degree of operating leverage(dol) o Definition:Measured as a % change in EBIT resulting from a given % change in sales o Equation: DOL at X = Sales - VC - FC = EBIT Sales - Variable Costs EBIT Original values

43 Continued derivation DOL = EBIT S = Q ( p v ) EBIT = ( p v ) Q EBIT = S VC EBIT / EBIT / S pq p Q

44 Continued

45 Continued Q =60,000 units P=$10 v=$1 F= $240,000 60,000(10 1) 540,000 DOL = = = ,000(10 1) 240, ,000 F=0, DOL =1 F 0, DOL 60, % EBIT 1.8% 1% EBIT 1.8%

46 ...continued

47 Continued Degree of financial leverage(dfl) o Definition: Measured as the % change in EPS resulting from a given % change in EBIT o Equation: DFL at X = EBIT EBIT - I - D p / (1 - T ) P/S dividends on a before tax basis

48 Continued derivation ) /(1 ]/ ) )(1 [( ) / (1 / / ]/ ) )(1 [( T D I EBIT EBIT EBIT EBIT N D T I EBIT N T EBIT EBIT EBIT EPS EPS DFL N D T I EBIT EPS P P P = = = =

49 Continued

50 Continued Degree of financial leverage(dcl) o Definition: Measured as a % change in EPS resulting from a given % change in sales o Equation: DCL at X = The higher I or lower EBIT, the higher DFL. DCL at X = DOL x DFL Sales - Variable Costs EBIT -I -D p / ( 1 - T ) See DCL model

51 DCL Model % Sales DOL DCL % EBIT DFL % EPS

52 Continued ABC Company Income statement(abc ) Sales (80,000 units $2/unit ) ) $ 160,000 Fixed Costs 60,000 Variable Costs ($0.80/unit) 64,000 EBIT $ 36,000 Interest 12,000 EBT $ 24,000 Taxes(50 12,000 Net earnings $ 12,000 EPS(8,000 shares) (8,000 ) ) $1.50

53 Continued DOL & DFL Trade Off o A firm can trade off operating and financial leverage to control DCL o A firm with a high DOL may choose a capital structure with a low DFL to avoid a high DCL

54 3. EBIT-EPS Analysis Technique for comparing alternative capital structures Assumption investing policy and dividend policy are constant Disregarding the implicit costs of debt financing The market value of the firm's common stock is affected by EPS Results EBIT being constant, we can find out the best decision on capital structure which leads to the highest EPS. EBIT being unknown, we can visualize the impact of different financing plan on EPS over a range of EBIT levels.

55 Continued Determine indifference point( the level of EBIT where EPS would be identical under either debt or equity financing) ( EBIT - I d ) ( 1 - T ) - D p N d Debt financing = ( EBIT - I e ) ( 1 - T ) - D p N e Equity financing

56 Graphical Analysis of EBIT - EPS EPS Debt Financing Advantage to equity financing Equity Financing Advantage to debt financing Indifference Point EBIT

57 Continued Factors Considered in Capital Structure Decisions Tendency to cluster around industry average Need for funds Benchmark leverage ratios Managerial risk aversion Retain control

58 Chapter 14 DIVIDEND POLICY

59 Investment Decisions Determine the level of future earnings and future potential dividends Financing Decisions Influence the cost of capital, which can determine the number of acceptable investment opportunities Dividend Decisions Influences the amount of equity capital in a firm s capital structure and the cost of capital No (Taxes, Transactions costs, Issuance costs) Fixed investment policy

60 Introduction 1. Determinants of dividend policy 2. Dividend policy theory 3. Dividend policies in practice 4. Stock dividend and stock split 5. Stock repurchase

61 1. Determinants of dividend policy Variations in payout Legal constraints Restrictive covenants Tax considerations Liquidity and CF considerations Earnings stability Growth prospects(ios) Inflation Shareholder preference Protection against dilution Borrowing capacity & access to capital markets

62 2. Dividend policy theory Irrelevance of Dividends Theory(MM) Assumptions o No (Taxes,Transactions costs,issuance costs) Fixed investment policy Wealth of a shareholder is not effected by dividend policy Dividend can have informational content Signaling effect Clientele effect

63 Continued Relevance of Dividends Policy Assumptions o Relaxed assumptions & dividend policy becomes important Risk aversion (bird-in-the-hand theory)(gl) Taxes(Tax Preference Theory)(LR) Transaction costs Issuance ( Flotation ) costs Agency costs Empirical evidence is mixed Many practitioners believe that dividends are important Informational content / Expensive external equity

64 Continued Case6 28% 40% 40% capital gains yield dividend yield Stock G growth stock 10% 5% Stock I income stock 5% 10% P = $10 KG = KI = capital gains yield + dividend yield =15%

65 Difference between MM/GL/LR value Cost of Equity (%) GL LR MM LR MM GL 0 50% 100%(Payout) 0 50% 100%(Payout)

66 3. Dividend policies in practice Passive Residual Policy(Residual dividend model) Setting the Target Pay-out Ratio Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the required rate Dividends can fluctuate significantly o Depends on the firm s investment opportunities In practice dividends can be smoothed Growth firms will have low dividend payout

67 Case7: Dallas Oil Company (DOC) (%) (%) Continued Ks MCC Ka 10 Kd(1 T) D/TA% 0 100

68 DOC 6 IRR% Continued MCC 10 IOSG IOSN 0 40 IOSB

69 Continued Stable $ Dividend Policies Reluctance to reduce dividends Increases in dividends tend to lag earnings Desirability o Information content o Many shareholders depend on dividends o Stability tends to reduce uncertainty o Legally desirable

70 Continued Constant Payout Ratio Pays a constant % of earnings as dividends Fluctuating dividends Small Regular Dividends Plus Extras Stockholders can depend on regular payout Accommodates changing earnings and investment requirements Small Firms and Dividends Tend to pay out a smaller % of earnings Rapid growth and limited access to capital markets

71 Continued Payment Procedures Declaration Date o Board of directors announce a dividend Record Date o Shareholders of record will receive dividends Ex-dividend Date o 4 business days before record date [2 days/nyse] Payment Date o Dividend checks mailed or direct deposited

72 Continued Dividend Reinvestment Plan Cash dividend reinvested automatically into additional shares Purchase new or existing shares o Purchasing new shares raises new equity capital for the firm Advantage o No brokerage commissions Disadvantage o Income tax liability

73 4. Stock dividends and Stock splits Stock dividends Payment of additional shares of C/S Effects of declaring stock dividends o Increases the number of shares outstanding o Accounting transaction:transfer pre dividend market value from retained earnings to other stockholders equity o Market price of C/S should decline in proportion to the # of new shares issued

74 Continued Reasons for Declaring a Stock Dividend o Broaden the ownership of the firm s shares o May result in an effective increase in cash dividends Provided the level of cash dividends is not reduced o Reduction in share price may broaden the appeal of the stock to investors Resulting in a real increase in market value Stock Splits Stock splits are similar to stock dividends Increases the number of shares outstanding Reduces the price of each outstanding share

75 5. Share repurchases By a tender offer, in the open market, or by negotiation with large holders Treasury stock Reduces the number of shares outstanding/increases EPS Usually announced So investors know the reason for additional trading So investors can wait for anticipated price increase Ignoring taxes, transaction costs, and other market imperfections, shareholders should be indifferent between equivalent returns from cash dividends and share repurchases.

76 Continued Advantages and disadvantages Advantages Converts dividend income into capital gains Greater financial flexibility Signal effect Disadvantages Company may over pay for the stock Trigger IRS scrutiny tax avoidance Some current stockholders may be unaware

77 ...continued

78 ...continued

79 ( ) $1,902 $5,558 31% $7,081 4% ( ) NA ( ) $ 20 $ $24 NA ( NA 0 $

80 $ EPS 4 DPS

83 =

東吳大學 104 學年度碩士班研究生招生考試試題第 2 頁, 共 7 頁 5. Consider a project with the following cash flows. Year Cash Flow 0 -$16, , ,000 What s the IRR o

東吳大學 104 學年度碩士班研究生招生考試試題第 2 頁, 共 7 頁 5. Consider a project with the following cash flows. Year Cash Flow 0 -$16, , ,000 What s the IRR o 東吳大學 104 學年度碩士班研究生招生考試試題第 1 頁, 共 7 頁一選擇題 60 分 ( 單選每題 3 分 ) 1. Which of the following items can be found on an income statement? a. Accounts receivable b. Long-term debt c. Sales d. Inventory 2. A 15-year,