Description
Based upon the Learning Activities in Topic 2, the optimal capital structure is governed by a variety of factors, including taxes and the costs of financial distress. Compare and contrast the capital structure of JP Morgan Chase with one other non-banking member of the Dow Jones Industrial Average (DJIA) using at least five different factors described in Topic 2.
Based upon the Learning Activities in Topic 3, why do some firms pay no dividends while others consistently pay dividends? In other words, what are the primary drivers behind the dividend decision?
Based upon the last video in Topic 3, how will the market generally interpret a dividend cut combined with a stock repurchase?
Optimal Capital Structure
Introduction
The optimal capital structure for a firm reflects the best debt-to-equity ratio that minimizes the cost of capital and, therefore, maximizes the value of common stock. In other words, the optimal capital structure for a company is one that reflects the ideal balance or weighting of debt and equity that minimizes the cost of capital. As you read this section, look for the factors that can affect capital structure for a firm.
The mix of debt and equity that a firm uses to finance its operations is called its capital structure. The more debt that is employed, the more leverage a firm will have, and the larger the potential variation in earnings for shareholders will be.The largest factor that will affect a firm’s optimal capital structure is the firm’s confidence in being able to make timely debt payments. Different businesses lend themselves to very different capital structures. A company with a steady customer base, large amounts of fixed capital or other good collateral, and insensitivity to the business cycle and other shocks to revenue all point to a company having the capacity for more debt. The paragon of such a firm would be a utility company: Revenues will be very steady, because even financially strapped customers don’t want to freeze in the winter or swelter in the summer. Companies with uncertain, highly variable revenues or a lack of good collateral will not be able to raise as much debt financing.Another key factor is that interest paid on debt is tax deductible in most countries. If all else were equal, companies would probably choose to carry more debt versus less debt because of the tax benefits.Too much debt, however, and the costs can outweigh the tax benefits. As debt level increases, so does the cost of debt that investors will charge in higher expected yields. The added risk is also a factor for equity investors: Leverage multiplies the systematic risk of a company, causing investors to demand a higher return on equity. Potential financial distress can also cause a loss of customers (who wants to buy a car with a warranty if the company won’t be around to back it up?) or suppliers (will the company be able to pay for the raw materials received?).In theory, every project should be evaluated with a WACC using a capital structure utilizing costs of capital that reflect the risks of the project considered. Likewise, the capital structure (that is, weights) utilized in the calculation should ideally reflect the optimal mix for the marginal capital required for the project. In reality, most firms determine their target capital structure based on the overall nature of the firm’s operations, and only consider the effects of specific projects if they are relatively larger in scale (for example, if a large capital purchase would provide collateral that would facilitate more debt).Primarily, the choice of capital structure affects the cost of capital for each of the components of WACC. On the whole, companies tend to avoid the extreme amounts of debt that can have a drastic influence on operating cash flows; only in extremely distressed companies do we need to consider significant changes to free cash flows. Therefore, the decision on optimizing capital structure is relatively independent from capital budgeting decisions.Specifically, it is a goal of financial managers to choose a capital structure that minimizes WACC, which will, in turn, maximize the value of the firm. Because our WACC is the basis for discounting used in finding the NPV of projects (or the hurdle rate with which IRR is compared), a lower WACC will increase the value of our conventional positive NPV projects and cause some conventional projects that were originally rejected to cross the threshold into value-adding propositions.Consider the following projections by financial managers at firm XYZ:
Table 4.2 Cost of Capital Projections
% debt Cost of debt After-tax cost of debt % Equity Cost of equity WACC
0% 5.0% 3.0% 100% 7.0% 7.00%
10% 5.0% 3.0% 90% 7.3% 6.84%
20% 5.2% 3.1% 80% 7.6% 6.70%
30% 5.5% 3.3% 70% 8.0% 6.61%
40% 5.8% 3.5% 60% 8.6% 6.55%
50% 6.2% 3.7% 50% 9.4% 6.56%
60% 6.8% 4.1% 40% 10.6% 6.69%
70% 7.5% 4.5% 30% 12.6% 6.93%
80% 8.5% 5.1% 20% 16.6% 7.40%
90% 10.0% 6.0% 10% 28.6% 8.26%
100% 16.0% 9.6% 0% 45.0% 9.60%
COST OF CAPITAL PROJECTIONS
Assuming firm XYZ’s tax rate to be 40% and given the projected costs of capital at each level of debt and equity, we can see that WACC is minimized at a 40%/60% debt/equity mix. Below this mix, we aren’t utilizing enough of the cheaper debt. Above this level, the increased costs of both debt and equity cause WACC to increase as we add more debt to the mix.In practice, we are rarely able to precisely know what the cost of capital will be for our company at specific levels of debt. We can create estimates based upon observed costs at other companies, but short of trying a new capital structure, it is impossible to know for certain what the precise WACC will be.
Key Takeaway
Because debt is typically tax deductible, in addition to having a lower cost of capital, there is a benefit to having some debt.
As debt increases, the chance of bankruptcy causes the cost of both debt and equity to rise.
The optimal capital structure is the one that maximizes firm value by minimizing WACC.
Note. Adapted from “Capital Structure,” by Scott, A. K. S. and Barnhorst, B. C., 2014, Managerial Finance, Chapter 15, Section 3-4. Copyright 2014 Flat World Knowledge, Inc.
Overview of Dividend Policy
Introduction
A company has made a profit, and it is time to decide how much to pay out in dividends. In this section, you will discover the different strategies that are used for dividend payments. Take note of the policies and considerations that are made.How does a company decide how much to pay in dividends? Does a company arbitrarily choose a number like $1? Or does it pay a dividend based on what it has paid in the past? Or perhaps it takes the total amount of extra cash and divides by the number of shares and pays out every penny? Many different strategies and theories exist for dividend payments.
OPTIMAL DIVIDEND POLICY
There are several theories about the optimal dividend policy. The first is that dividends are a residual and should be only paid out after all investment projects have been undertaken. This is the residual theory of dividends, which holds that the dividend is a leftover amount paid after all suitable investment opportunities have been commenced. Under this theory, to figure out if there is money for a dividend payment, the firm first determines its optimal level of capital expenditures. Then it determines the level of financing available through equity. Next the firm uses retained earnings to finance these objectives. If retained earnings are sufficient to finance these projects, then any “residual” is used for the dividend payments. If retained earnings are insufficient to meet these requirements, the firm can sell new common stock.Other firms calculate dividends based on either a stable dividend policy, where the dividend is the same dollar amount each year, or a constant dividend payout ratio, where the dividend is the same percentage of earnings each year. A stable dividend in each year is easy to budget for, as the amount is predictable far in advance. Also, many investors prefer this type of company and dividend policy, as they use the dividend income for current consumption. A stable dividend also indicates stability to the market, an all-important characteristic in times of uncertainty. A constant dividend payout ratio is stable in the rate at which it pays dividends. The payout ratio is calculated as dividends divided by net income. This is inverse to the company’s retention ratio or the amount of net income it retains. Dividends vary more in a constant payout ratio because they are based on earnings, which can vary widely from year to year.In addition to these strategies, companies sometimes choose a low dividend plus extra policy. A low dividend policy is where the annual dividend is always low. The “extra” dividend is paid when the company believes it has extra cash, and it does not pay the extra when not fiscally responsible to do so. This gives the company greater financial flexibility as it is not tied to a set dividend dollar payout or payout ratio for the extra dividend.The most common strategy actually employed by companies is a variation of a stable dividend policy. Companies seem to avoid reducing the dividend for any reason, and therefore they keep a steady dividend well below the amount that could be paid using a different strategy. Periodic increases in this dividend level can then occur as the company grows. In recent years, observed dividend yields for most stocks have been dropping, even when stock prices have been depressed. Theories abound as to why this is the case, but a disadvantaged dividend tax policy (if dividends are taxed at a higher rate than capital gains, for example) in the United States is probably a large contributor.To compare expected dividends to our invested amount, we use the dividend yield. The dividend yield is the expected dividend divided by the share price.
DIVIDENDS AND CORPORATE VALUE
Shareholders receive cash flows from holding stock through two means: dividends and selling the stock. A shareholder who holds his or her stock with no intention to sell will thus receive only the dividend stream. Because the dividend stream is the future cash flows of the stock in this case, the theory is that the value of a share of stock should be the discounted present value of these cash payments. Thus, a company that can support a higher dividend output should demand a higher stock valuation.The trouble is that dividends are not very predictable. A company can choose to pay a dividend much lower than it can actually afford, and there might be very good reasons, from growth opportunities to tax treatment, for doing so. Furthermore, it can be difficult to estimate the value of a company that isn’t currently issuing any dividends! In practice, due to the large differences in observed dividend policies among companies, valuation is usually focused on the cash flows being generated that could one day be used to pay dividends.The level of dividends can be a useful signaling tool for companies. A company with a long record of steady or increasing dividends can signal that managers believe the cash flows of the company to be stable going forward, because a cut in dividends is usually interpreted as a very bad sign. For companies in high-growth industries, however, a lack of dividend payments might be perfectly acceptable, because the signal might be interpreted as indicating that the company is reinvesting earnings in high-growth endeavors.Most stock sales are merely between investors on the secondary market and don’t involve the company, but occasionally corporations will purchase their stock on the open market, spending cash but concentrating the ownership of the outstanding shareholders; each share will own a larger portion of the company, since the total number of shares will decline. Share repurchases used to be much less common, but in recent years, as dividends have fallen more out of favor while cash balances have increased, they have become more frequent. From a signaling perspective, the market tends to interpret the announcement of stock buybacks in a very positive light.
Key Takeaway
Dividends can either be a residual, constant percentage of earnings or a constant amount per share.
An announcement to increase dividends may have a positive impact on the value of the stock as the increase sends a positive message or signal to the investors regarding future growth prospects or reduced systematic risk.
Note. Adapted from “Dividend Policy,” by Scott, A. K. S. and Barnhorst, B. C., 2014, Managerial Finance, Chapter 16, Section 2. Copyright 2014 Flat World Knowledge, Inc.
Dividend Policy—A Further Explanation
Introduction
If you would like more details on what a dividend policy is and how it works, visit this site and watch this video for an explanation of dividend policies.
Investopedia: Dividends
LSBF Global MBA – Introduction to Dividend Policy
© LSBFGlobalMBA
Stock Repurchases and Raising Dividends Increase Stock Prices
Introduction
Watch the following two videos to (1) understand why firms buy back their own stock; and (2) better understand the primary drivers behind the dividend decision and how the thought processes concerning dividend decisions are so similar to the factors that affect the optimal capital structure.
Why Firms Buy Back Their Own Stock
The Dividend Decision
