LECTURE 12EBF 2054 Financial Management

Capital Structure and LeverageBusiness vs. financial riskOptimal capital structureOperating leverageCapital structure theory

What is business risk?Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

What determines business risk?Uncertainty about demand (sales)Uncertainty about output pricesUncertainty about costsProduct, other types of liabilityOperating leverage

What is operating leverage, and how does it affect a firms business risk?Operating leverage is the use of fixed costs rather than variable costs.If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

Operating BreakevenOutput quantity at EBIT (operating income)=0 Illustration: Sales price per unit (P), Units of output (Q), Variable cost per unit (V) and fixed operating cost (F)Solve for the breakeven Quantity QBE :

Your uncle is considering investing in a new company that will produce high quality photo frame. The sales price would be set at $125.00 per unit. The variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000. What sales volume would be required to break even, i.e., to have EBIT = zero?Breakeven volume (units) =F / (P - V) = 24,000 units

What is financial leverage?Financial risk?Financial leverage is the use of debt and preferred stock (fixed income securities).

Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

Business risk vs. Financial riskBusiness risk Riskiness of the firms assets if uses no debtdepends on business factors such as competition, product liability, and operating leverage.

Financial risk Additional risk placed on the common stockholders as a result of using debtdepends only on the types of securities issued.More debt, more financial risk.Concentrates business risk on stockholders.

Optimal Capital StructureThe capital structure (mix of debt, preferred, and common equity) at which P0 (stock Price) is maximized. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.

Why do the bond rating and cost of debt depend upon the amount of debt borrowed?As the firm borrows more money, the firm increases its financial risk causing the firms bond rating to decrease, and its cost of debt to increase.

What effect does more debt have on a firms cost of equity?If the level of debt increases, the riskiness of the firm increases.

We have already observed the increase in the cost of debt.

However, the riskiness of the firms equity also increases, resulting in a higher rs.

Finding Optimal Capital StructureThe firms optimal capital structure can be determined two ways:Minimizes WACC.Maximizes stock price.

Both methods yield the same results.

Capital Structure TheoriesPecking order TheoryTrade off TheorySignaling TheoryAgency cost theory

What are signaling effects in capital structure?Assumptions:Managers have better information about a firms long-run value than outside investors.Managers act in the best interests of current stockholders.

What can managers be expected to do?Issue stock if they think stock is overvalued.Issue debt if they think stock is undervalued.As a result, investors view a stock offering negatively--managers think stock is overvalued.

DIVIDEND POLICY Distributions to shareholdersInvestor preferences on dividendsSignaling effectsResidual modelDividend reinvestment plansStock repurchasesStock dividends and stock splits

What is dividend policy?The decision to pay out earnings versus retaining and reinvesting them.Dividend policy includesHigh or low dividend payout?Stable or irregular dividends?How frequent to pay dividends?Announce the policy?

Dividend irrelevance theoryInvestors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policyIf they want cash, they can sell stock.If they dont want cash, they can use dividends to buy stock.Proposed by Modigliani and Miller (MM)and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test.

Why investors might prefer dividendsMay think dividends are less risky than potential future capital gains.If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.

Why investors might prefer capital gainsMay want to avoid transactions costsMaximum tax rate is the same as on dividends, but Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever the stock is sold.If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost basis and escape all previously accrued capital gains.

Whats the information content, or signaling, hypothesis?Investors view dividend increases as signals of managements view of the future. Since managers hate to cut dividends, they wont raise dividends unless they think the raise is sustainable. However, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

Whats the clientele effect?Different groups of investors, or clienteles, prefer different dividend policies.Firms past dividend policy determines its current clientele of investors.Clientele effects hold back changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

The Residual Dividend ModelFind the retained earnings needed for the capital budget.Pay out any leftover earnings (the residual) as dividends.This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.16-*

Residual Dividend Model16-*Capital budget $800,000Target capital structure 40% debt, 60% equityForecasted net income $600,000How much of the forecasted net income should be paid out as dividends?

Residual Dividend Model:Calculating Dividends Paid

Calculate portion of capital budget to be funded by equity.Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with equity.Calculate excess or need for equity capital.There will be $600,000 $480,000 = $120,000 left over to pay as dividends.Calculate dividend payout ratio.$120,000/$600,000 = 0.20 = 20%.16-*

Example: (RDM)Chicago Bookstore has the following data, dollars in thousands. If it follows the residual dividend model, what will its dividend payout ratio be?Capital budget= $5,000% Debt =45%Net income (NI)= $5,000

STEP:1. % Equity = 1.0 %Debt =55%2. Equity needed to support the capital budget = %Equity x Capital budget =0.55 x $5000 = $2,750

3. Dividends paid = NI -Equity needed if positive (otherwise, $0.0)= $5,000- $2,750= $2,250Payout ratio = Dividends paid / NI = $2,250 /$ 5,000 = 45.00%

Stock RepurchasesBuying own stock back from stockholdersReasons for repurchases:As an alternative to distributing cash as dividends.To dispose of one-time cash from an asset sale.To make a large capital structure change.

Advantages of RepurchasesStockholders can tender or not.Helps avoid setting a high dividend that cannot be maintained.Repurchased stock can be used in takeovers or resold to raise cash as needed.Income received is capital gains rather than higher-taxed dividends.Stockholders may take as a positive signal--management thinks stock is undervalued.

Disadvantages of RepurchasesMay be viewed as a negative signal (firm has poor investment opportunities).Selling stockholders may not be well informed, hence be treated unfairly.Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

Stock dividends vs. Stock splitsStock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned.Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

Stock dividends vs. Stock splitsBoth stock dividends and stock splits increase the number of shares outstanding, so the pie is divided into smaller pieces.Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investors wealth unchanged.But splits/stock dividends may get us to an optimal price range.Stock dividends vs. Stock splits

Example: stock price after SplitMybank recently declared a 2-for-1 stock split. Prior to the split, the stock sold for $85 per share. If the firm's total market value is unchanged by the split, what will the stock price be following the split?Number of new shares =2Number of old shares =1Old (pre-split) price= $85

New price = Old price x (No. Old shares / No. New shares)= $85 x (1/2)= $ 85 x 0.5= $42.50

When and why should a firm consider splitting its stock?Theres a widespread belief that the optimal price range for stocks is $20 to $80. Stock splits can be used to keep the price in this optimal range.Stock splits generally occur when management is confident, so are interpreted as positive signals.On average, stocks tend to outperform the market in the year following a split.

Example: Stock dividendA firm has 1M shares of common stock outstanding. Net income is $500,000, the P/E ratio is 9 and management is considering 10% stock dividend.Calculate the changes in stock priceCalculate the changes in firm value if an investor have 200 shares in the firm.

Information givenNo shares: 1MNI: $500,000P/E: 9Stock dividend:10%Current stock priceEPS= 500,000/1,000,000 = 0.5Stock price: P/E=9P/0.5=9P=$4.50

New stock price1M* (1+10%)= 1,100,000New EPS = $500,000/1,100,000 = $ 0.455New PriceP/E =9P/0.455=9P= $4.095

Changes in firm valueCurrent firm value (200 shares)200*$4.50 = $900

New firm value (with 10% stock dividend)200*(1+0.1)=220New firm value220*$4.095=$900.9 almost the same as $900

Conclusion:Stock split or Stock dividend will have no effect on firm value.

END OF LECTURE 12

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