Chapter 14: Capital Structure and Dividend Policy Outline: Capital Structure of a Company Use of Private Equity Dividend Policy Dividend Considerations

Chapter 14: Capital Structure and Dividend Policy

Outline: Capital Structure of a Company Use of Private Equity Dividend Policy Dividend Considerations Repatriation of Capital for

Multinational Companies (MNCS)

v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 1

Capital Structure of a Company

Optimal and target capital structures Trade-offs between financing with

long-term debt and common stock Capital structure theory

Trade-off theory Business and financial risk

Operating risk and operating leverage Financial risk and financial leverage

Target capital structurev3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 2

Discussion Question

What are the advantages and disadvantages of debt financing?Answers:

Advantages Costs less than

equity Fixed or floating

rates Capital markets for

long-term debt are efficient

Earnings are not diluted

Owners of the company’s debt do not vote


Disadvantages Has priority of claim over equity Inability to service debt will cause

bankruptcy Increases company

risk and can increase WACC

Usually accompanied by liens on assets

Places monitoring requirements on the company

Advantages and Disadvantages of Common Stock Financing

Advantages No obligation to

make fixed payments to investors.

Does not mature. Cushion against

losses for creditors. If company has

bright future, equity can be raised on attractive terms.

Disadvantages May dilute voting

rights, control and value.

Cost of underwriting is significant.

Unlike debt, common equity financing has no tax shield.

May erode the stock price.


Capital Structure Theory: Trade-Off Theory Companies trade off the use of debt and

equity in their capital structures. As debt is substituted for equity, the

overall cost of capital (WACC): At first decreases as debt is increased. Then rises as more debt is added.

The mix of debt and equity associated with the lowest WACC is the optimal capital structure.

Real-world factors.


Discussion Question

What is the difference between operating leverage and financial leverage?

Answer:Operating leverage is the result of fixed costs in operations; it magnifies the impact of changes in sales on EBIT.

Financial leverage results from fixed financing costs (interest); it magnifies the results of changes in EBIT on net income.


Degree of Operating Leverage (DOL) DOL shows the responsiveness of operating profit to

changes in sales. Example: sales increase 20% but operating profit

increases 33% because fixed costs are stable at $2,000.


% Change in EBITDegree of Operating Leverage =

% Change in Sales

33%= = 1.65

20% The percentage change in EBIT is 1.65 times as much

as the percentage change in sales; proportionately EBIT is 1.65 times as volatile as sales. If sales decline, EBIT declines proportionately faster.

Degree of Financial Leverage (DFL)

More debt in capital structure = higher interest. Larger fixed interest expense causes net income to be

more volatile in response to changes in operating income.

Example: 33% increase in EBIT results in a 50% increase in net income.


Net income will increase proportionately 1.515 times as fast as EBIT. If EBIT declines, net income will decline proportionately faster.

% Change in Net IncomeDegree of Financial Leverage =

% Change in EBIT

50% = = 1.515

33%

Other Considerations in the Capital Structure Decision Rating agency and lender

considerations Limit actions to comply with covenants. Ratings triggers require scrutiny.

Issue of control Too much equity risks takeover, too much

debt risks bankruptcy. Regulatory restrictions and minimum

capital requirements


Discussion QuestionWhich of the following is often used in the final stages of a leveraged buyout or venture capital investment in order to raise the full amount of capital needed for purchasing a company using private equity?a) Leveraged buyoutsb) Venture capitalc) Growth capitald) Distressed investmentse) Mezzanine capital

Answer: e


Advantages and Disadvantages of Private Equity

Advantages Simplicity Better alignment of

ownership and management

Capital structure Tax advantages Reduced reporting

requirements

Disadvantages Increased debt load

in LBOs Loss of control for

existing owners Required exit

strategy


Constraints on Dividend Policy

Bond indentures and loan covenants

Prevent stockholders from draining assets.

Preferred stock Cumulative dividends in

arrears must be paid in full before any common dividend can be paid.

Impairment of capital Dividend payments usually

cannot exceed retained earnings on the balance sheet.

Cash adequacy Sufficient cash to pay

dividends?

Tax on excess accumulated earnings

IRS special surtax on improperly accumulated income (avoiding personal taxes).

Control of privately held companies

Maximize retained earnings, minimize dividends.

Investment opportunities Limit the size of dividends to

increase available capital. Availability of alternative

capital sources Ability to raise new equity may

increase likelihood of dividend payouts.


Information Content of Dividends Valid evidence that

dividends have a “signaling” effect.

Given stable dividends or constant growth rate: Deviation impacts share

price Increase bids up,

decrease bids down Choice of dividend

policy between profit distribution/capital gains yield does not influence stock price.


Dividend Payment Procedures

Date DefinitionDeclaration date Date board announces (declares)

dividend

Record date Date specified by board when holders-of-record are entitled to receive declared dividend

Ex-dividend date Date stock is sold without dividend entitlement (two days prior to holder-of-record date)

Payment date Date dividend is paid


Dividend Reinvestment Plans (DRIPs) Allow investors to

increase ownership of shares in the company.

Existing shareholders purchase shares:

Directly from the company

On a when-desired basis

Normally with no commission

Automatic reinvestment of dividends in additional shares allowed.

Shares distributed under DRIPs may be: Held in the treasury Repurchased by the

company in the market

New, authorized shares of stock that have not been issued yet (shelf registered)

Benefits smaller shareholders.


Different Types of Dividends

Cash dividends

Stock dividends

Special dividends

Liquidating dividends

Stock splits


Stock Repurchases

Advantages Reduces number of

shares outstanding Increases earnings per

share Increases market price

per share if market hasn’t reevaluated firm’s prospects

Investor can “create” dividend by selling shares

Disadvantages Regular repurchases

may be viewed by investors as attempt to: Increase stock price in

absence of better alternatives

Counteract earnings dilution from executives exercising stock options

Inadvisable unless P/E ratio is believed lower than justified


Repatriation of Capital by Multinational Companies (MNCs) Foreign subsidiary pays dividends to parent

company. Governments often act to restrict

repatriation of capital, including dividend payments.

MNCs unbundle cash flows from subsidiaries; easier to justify to foreign governments than dividends: Management fees Transfer pricing Intracompany loans


Documents

Chapter 14: Capital Structure and Dividend Policy Outline: Capital Structure of a Company Use of Private Equity Dividend Policy Dividend Considerations