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Unformatted text preview: FINC 202 2009 Lecture 07
Moving to an Optimal Capital Structure + Dividend Policy
Note: Some of this will be rolled over into Lecture 8 if not covered today 1 Four types of firm with ESPECIALLY HIGH Four indirect bankruptcy costs: indirect 1. Sellers of durables that require replacement parts over their life Automobiles, lawn mowers, aircraft 2. Sellers of products where it is difficult to tell the quality in advance Firm’s reputation used to be a guarantor of quality. Example airline services 2 1. Sellers of products reliant on services and products produced by other firms
Apple Computer in 1997: software producers did not produce Apple Mac versions of software produced for Windows 2. Sellers of products requiring continuous support/servicing
______________________________________ 3 Implications for Capital Structure (1) 1. Firms with volatile Cash Flows should use less debt than firms with less volatile Cash Flows • Utilities (in US) can have higher leverage than most firms because they often enjoy monopoly status and ________________________________ 4 Implications for Capital Structure (2) 1.
• • If the government can be relied upon to bail a distressed firm out
Firms will carry a higher level of debt, trusting in the safety net. Korean chaebol firms in the 1980s & 1990s • Familycontrolled conglomerates 2. 1. 2. Direct bankruptcy costs are higher if the firms assets are not easily:
Divisible (Cocacola brand name is not !) __________________________________ 5 How firms Choose Capital Structures
Three alternative views: 1.
• Tradeoff is dependent on firm’s position in company lifecycle
Highgrowth firms use less debt and more equity ________________________________________ 2. 3. Tradeoff is dependent on managers’ perception of other firms’ capital structure in the same industry Tradeoff is dependent on biases of management
6 Getting to the Optimal Capital Structure Getting 1. 1. 1. 2. Implementing v NO change Fast v slow implementation Four Paths 7 Change v NO Change
Let’s say we have identified an optimal capital structure different from the current one. This implies we are either overlevered Or underlevered • But is the over/underleverage meaningful? Should we do something about it? • Optimal structure maximises firm value But there may be more complex considerations See next slide Or should we just leave the structure unchanged? • And risk reducing/destroying firm value? _____________________________________________
8 Change v NO Change: Currently Underlevered Firm Currently
Firm has excess debt capacity But we (managers/shareholders) may: 1. 2. Value a high bond rating over a possible rise in firm value Require more flexibility than allowed by covenants imposed with extra debt If we’re not certain about future financing needs, we need ___________________________________________
9 Change v NO Change: Currently Underlevered Firm (2) Currently
Face very high bankruptcy costs if the firm is closely held and we __________________________________ Perhaps personal bankruptcy for shareholders • (Closely held firms with few shareholders who have signed personal guarantees.) 10 10 Change v NO Change: Currently Overlevered Firm Currently • Big fear of bankruptcy Strong _____________________________ • But what if we are: German firm? Japanese firm? Korean conglomerate (Chaebol)?
11 11 Immediate v Gradual Change
Benefits of immediate change are: • WACC⇓ and Firm Value⇑ ∆ Financing costs and EMH argument Disadvantages of immediate change are: 1. New decisionmaking environment is put in place 2. New optimum might have been miscalculated We might have to reverse the decision • How ______________________________________ 12 12 Immediate v Gradual Change: Currently Underlevered Firm Currently
Depends on the degree of confidence in the estimate of optimum leverage level The lower the degree ⇒ the slower we change Influence of the Industry Average: If the change is: 1. toward the Industry Average • Analysts & rating agencies more likely to be approving • _______________________________ 2. Away from Industry Average • Rating agencies etc will take time to see wisdom • ____________________________________
13 13 • Likelihood of Takeover (2 slides) Underlevered firms are more attractive to coporate raiders because they can… • Buy firm and increase leverage to fund the takeover JRJ Nabisco at end of 1980s • News item from The Economist July 25th 31st 2009:
After a 15hour board meeting, Porsche removed its chief executive, Wendelin Wiedeking, and accepted that the state of Qatar should take a stake in the company. The actions smooth the way for a merger with Volkswagen and peace between the warring Piech and Porsche families. The carmakers became embroiled in a row about the best way to combine after Mr Wiedeking ran up Porsche’s debt in an abortive attempt to buy VW.
14 14 • Likelihood of Takeover (2) Threat of takeover ⇑ then increase leverage faster Threat of takeover ⇓ if… • Antitakeover laws are in place • Company Articles of Association etc have anti
takeover provisions • Poison pills exist in management contracts etc • Company is very large • ________________________________
15 15 The Four Paths to Optimum (1a) IMMEDIATE
Recapitalisation “Leveraged Recapitalisations” Designed to increase the Debt Ratio fast May be restricted by bond covenants • • Issue new debt to retire some equity (via big dividend or Share buyback) May be good response to takeover threat DebtforEquity Swap Maybe shareholders are offered ____________________________________________
16 16 The Four Paths to Optimum (1b) IMMEDIATE
Recapitalisation to REDUCE Debt ratio • • Issue new equity to retire some existing debt EquityforDebt swap
17 17 Default risk as bargaining chip • Lenders prefer to take on equity than lose investment The Four Paths to Optimum (2) IMMEDIATE
Divestiture and Use of Proceeds • Sell off assets and use cash… • Choose assets earning less than their required •
returns (WACC) But is there a buyer? • …using the cash: Overlevered firm may retire debt Underlevered firm may ___________________________________
18 18 The Four Paths to Optimum (3) GRADUAL (3)
Financing of New Assets • Underlevered firm might use much higher debt ratio to finance new asset • Company (overall) debt ratio rises more modestly Overlevered firm does opposite Company (overall) debt ratio _________________________________________ • New assets also increase firm value irrespective of financing mix If NPVASSET > 0
19 19 The Four Paths to Optimum (4) GRADUAL (4)
Change Dividend Payout Ratio • Decreased payout ⇒ more cash available for retiring debt each period. • Increased payout ⇒ Decreases growth rate (g) attributable to internal equity Need for external financing for projects ⇑ ⇒ Debt Ratio ⇑ (as RE ⇓ ) over time Ie, more of g _____________________________________ 20 20 Choice of Path
Depends on: • Urgency of shift to optimum debt ratio • • Quality of new investments available Marketability of existing investments Is divestment ____________________________________
21 21 Dividend Policy 22 22 Topics • • • Dividend Basics Dividend and the Discounted Dividend Growth Model Competing Theories of Dividend’s impact on Share Price P0 23 23 Basics of Dividends
• • •
Profit distributions to shareholders Usually paid twiceyearly Trend towards quarterly 4 key dates Declaration date Exdividend date Owner before and at this date gets the dividend If sold the next day, the _____________________________________ • Share price _____________________ Holder of Record Date Payment date • Pex div = Pcum div − D 24 24 • • • • • a) b) c) d) Problem 1: Who gets the dividend?
Delaration date: 10th July Exdiv date: 10th August Holder of Record date: 12th August Payment day is 10th October • • In the computer age, this 2day interval may be unrealistically long Assume recording ownerdhip change takes a full day Grace Buyer buys the shares via a broker from Janet Seller on: 14th August 6th August 10th August 11th August 25 25 • • • • Solution 1
14th August: __________________ • •
Reason: ______________________________ 6th August: ___________________ Reason: ______________________________ 10th August: ___________________ • Reason: _________________________________ 11th August: ____________________
• Reason: __________________________________ 26 26 Must pass the Solvency Test in New Must Zealand Zealand
• • •
The Companies Act 1993 specifies two prerequisites: Liquidity test can firm pay debts as they fall due ? Balance sheet test do assets exceed liabilities ? prerequisites to be _________________________ The Act may be accessed online at: http://www.legislation.govt.nz/act/public/1993/0105/latest/DLM319570 http://www.legislation.govt.nz/act/public/1993/0105/latest/DLM319570. 27 27 Dividend Payout Ratio and the Dividend Discounted Dividend Growth Model Discounted
D means Dividend here • • d ⇑ ⇒ D ⇑ ⇒ P0 ⇑ D1 ˆ= P0 rs − g d is the dividend payout ratio But there is a counterbalancing effect: d ⇑ ⇒ (1d) ⇓ ⇒ ∆ RE ⇓ …. ⇒ g ⇓ ⇒ (rS – g) ⇑ ⇒ P0 ⇓ • • g = (1 – d)ROE There are TWO opposing effects But are ______________________________ • 28 28 1. Three competing theories Dividend Irrelevance Based on Miller and Modigliani “Dividend Policy, Growth and the Valuation of Shares” in Journal of Business October 1961 2. 3. Bird in the Hand Before MM, it was thought that a firm’s value was a function of divdends Which we see in the Discounted Dividend Model That dates from the early 1960s or late 1950s Often referred to as “the Bird in the Hand Fallacy” But it ___________________________ Tax Preference 29 29 Theory (1) Dividend Irrelevance Miller and Modigliani (1961) • Dividend policy has: No effect on rs No effect on P0 • Assumes: No taxes No brokerage costs • ______________________________
30 30 Miller and Modigliani’s Dividend Irrelevance Miller Arithmetically Explained Arithmetically • Mellon Ltd is an allequity company which enjoys the potential for constant growth at 10% p.a. EPS0 = $90.91 and EPS1= $100 ROE = 10% • If it consistently pays all NPAT out as dividends (ie d = 100%): g = ROE(1 d) = 10% x (1 – 1) 31 31 ________________________________________ • If it pays no dividend at all (ie, d= 0%) g = ROE(1 d) = 10% x (1 – 0) = 10% • • Note: rS = Dividend Yield + Capital Gains Yield This implies: CGY = 0 when DivY = rS =10% DivY = 0 when CGY = g = rS __________________
32 32 Let Mellon Ltd pay 100% of NPAT as dividends every Let period forever period D1 D1 P0 = = rS − 0 rS D1 $100 = = $1, 000 rS 0.10 • Now let D1 = $0 and D2 onward = _____________
Constant growth model after one period of nonconstant growth D2 110 = = $1,100 rS − 0 0.1 And D1 P P0 = +1 1 + rS 1 + rS 0 $1,100 + 1.1 1.1 = $1000 =
33 33 Problem 2
What if Mellon Ltd chooses to pay no dividends for 6 years. Then from year 7, 100% of NPAT is paid out as a dividend each year forever. Show that the intrinsic value of a share is still $1,000. 34 34 Solution 2 35 35 Some Caveats
There are some hidden assumptions in this model: Do the firm’s existing projects _________________________________________ If new Capex is necessary, how is it funded? • Debt? • New issues of Equity? • Model assumes that rE = rS But rE > rS because flotation costs > 0 • More generally, however, the MM argument is stated in terms of the following slide Which does not require that d = 0% or 100% 36 36 More generally, on dividend irrelevance: Higher payout ratio (d) • Rise in D1 exactly offsets rise in (rsg)
higher payout ratio rise in current dividend income fall in reinvestment fall in future capital gains shareholder wealth unchanged 37 37 General Case on Dividend Irrelevance: Lower payout ratio (d) • Fall in D1 exactly offsets fall in (rsg)
lower payout ratio fall in current dividend income rise in reinvestment rise in future capital gains shareholder wealth unchanged
38 38 Dividend Irrelevance Conclusions: • shareholders should be indifferent to dividend policy • • reduction in dividend should not depress share price shareholders can create homemade dividends alternative to a dividend cut is a new share issue NB. Implicit assumptions: zero transaction and issue costs no taxes _________________________________________ • This is a reference to Dividend signalling Theory 39 39 Theory (2) Theory Bird-in-the-hand Bird-in-the-hand • Investors prefer dividends over capital gains d ⇑ ⇒ D ⇑ and rs ⇓ rs ⇓ balances g ⇓ in denominator of: And ________________ D1 P0 = rs − g
40 40 Theory (3) Theory Tax Preference Tax • Dividends taxed more highly than capital gains Investors will prefer capital gains • Because they can defer realising them d ⇑ ⇒ D ⇑ and rs ⇑ • That rS ⇑ AND g ⇓ ⇒ (rS – g) ⇑ ⇑ And ______________ D1 P0 = rs − g
41 41 • • Tests are inconclusive Which theory is right? No clear relationship between • Dividend policy and rs Common belief was that dividends determined the value of the firm. Prior to Miller and Modigliani (1961) Even long before Gordon (1959) and the discounted Dividend Model • Therefore firms thought they should have a high dividend payout ratio The MM paper blew this consensus apart. • And opened up almost 50 years of debate. Different firms choose different dividend policies • And d ranges from ______________________________________________
42 42 • Today: No clear consensus ...
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This note was uploaded on 12/23/2009 for the course BCOM FINC 202 taught by Professor Warwickanderson during the Spring '09 term at Canterbury.
- Spring '09