Mergent Database for Company and Industry Research.
· To access go to the Ashford Library and select “Find Articles and More” in the top menu panel. Next, select “Databases A-Z” and go to section “M” for “Mergent”.
Modigliani & Merton (1958). The Cost of Capital, Corporation Finance, and the Theory of Investment. American Economic Review, 261 – 297. Retrieved from ProQuest database.
Imagine you are a representative of management in the company you have selected for your Week 6 Assignment and you must make a capital budgeting decision. The decision is to implement a new computer network system to decrease the time between customer order and delivery. The cost will be 10% of last year’s profits. You are charged with describing the important considerations in the decision-making process to upper management. In your response, be sure to include the following:
· A description of the important factors, in addition to quantitative factors, that were considered when making this capital budgeting decision.
· An explanation of how these factors are significant to the company.
· A summary of how you will determine the criteria to rank capital budgeting decisions and whether some criteria are more important than others.
· A calculation of the proposed return on investment based on criteria you select and justification for that ROI.
Develop a 200 – 250 word explanation supporting your recommendations.
Tip: For help with reading an annual report access this handy guide from
Revisit the company you chose for your Week 6 Final Project. Using the annual report and other sources such as a 10k or 10q’s, discuss the dividend policy of your company.
Answer the following questions as part of your response:
· How would you describe your chosen company’s dividend policy?
· Why do you believe this company chose the dividend policy they have in place?
· Do you agree or disagree that they have selected the best dividend policy for the company?
· How might this dividend policy function in both perfect and imperfect capital markets?
· Calculate the dividend rate over the past 5 years. Define why you believe that it has or has not changed over the last 5 years.
Support your position with evidence from the text or external sources.
Your post should be 200-250 words in length.
Chapter 10
Dividend Policy: Distributions to Shareholders
Associated Press
Learning Objectives
A�er studying this chapter, you should be able to:
Describe the characteris�cs of common cash dividends.
Explain how dividend policy func�ons in perfect capital markets.
Show how imperfec�ons in capital markets impact dividend policy.
Summarize how dividend policy is put into prac�ce.
Processing math: 0%
Ch. 10 Introduction
Our study of the capital budge�ng process in Chapters 6, 7, and 8 covered the NPV criterion for iden�fying projects expected to increase corporate shareholders’ wealth.
In Chapter 9, we analyzed the considera�ons managers should make when selec�ng the mix of debt and equity used to finance investment projects. Again, this analysis was
presented within the framework of maximizing shareholders’ wealth. In this chapter, we discuss dividend policy, or the distribu�on of residual cash to shareholders, an act
upon which shareholders’ wealth ul�mately depends. Figure 10.1 depicts where the dividend decision occurs in terms of the financial balance sheet’s model of business
ac�vity.
To understand the importance of dividends, let’s consider the fundamental equa�on for value:
This equa�on expresses value as the sum of future cash flows, discounted at a risk-adjusted required return. This formula may be applied to stocks by recognizing that the
cash flows distributed to shareholders come in the form of dividends.
Now, suppose a fic��ous stock included in its corporate charter an iron-clad, irrevocable promise never to pay a dividend to stockholders. What would be the value of a
share of this stock? According to Equa�on (10.2), the value would be zero. Despite the firm’s profitability, it would be forced by its own charter to retain all residual cash
flows, never distribu�ng funds to shareholders. Because the present value of an infinite stream of zeros is zero, such a firm would be worthless to shareholders. For those
who argue that money could s�ll be made via price apprecia�on, consider who would be willing to purchase a valueless stock (especially at a higher price). Such an
investment strategy is known as the “next-bigger-fool” strategy. It will eventually break down when there are no buyers willing to make a bad investment, leaving the
shareholder with a worthless security.
Yet, you may be aware of firms that pay no dividends and sell for rela�vely high prices. For example, Apple (Ticker: AAPL) quit paying dividends in 1995. In 2012, the
company’s share price was a whopping $585.00, and investors must have an�cipated the reins�tu�on of dividend payments. It turns out they were right. In March 2012,
Apple announced a $2.65 dividend and the repurchase of $10 billion of stock.
This discussion points out two important facts about dividend policy: First, dividends are essen�al to stock value, and second, large future dividends may occur even if
current dividends are small or nonexistent.
In our assessment of dividend policy in this chapter, we will assume that the firm has iden�fied its investment projects and established its mix of debt and equity financing.
Thus, capital budge�ng is done, capital structure has been targeted, and we may isolate the dividend decision. Because we know our target capital structure, we also know
how much equity financing is needed to fund the firm’s promising investment projects. This will allow us to focus more closely on the distribu�on of residual cash to
shareholders.
Before we dive into our analysis of dividend policy, we will quickly examine two basic types of dividends: regular and special dividends. Following this discussion, we will
return to the format used to analyze capital structure, first exploring dividend policy analysis within a perfect capital market. A�er we have established how the process
func�ons in this ideal environment, we will once again introduce market imperfec�ons. Finally, we will look at dividend policy in prac�ce.
Processing math: 0%
As this graph shows, Procter & Gamble has an almost uninterrupted history of dividend increases.
10.1 Overview of Cash Dividends
Corporate law gives the firm’s board of directors the authority to declare dividends. This is generally done at quarterly board mee�ngs, with large corpora�ons usually paying
dividends four �mes a year. Regular dividends are generally paid on approximately the same dates year a�er year. Most U.S. firms that pay dividends follow the constant
dollar dividend policy, in which the company pays the same dollar amount every year unless the dividend increases. This policy represents an implicit promise to
shareholders to con�nue paying dividends, year a�er year, at or above the current regular dividend level. Over �me, companies following the constant dollar policy will have
a dividend payout that follows a stair-step pa�ern, which can be observed in Figure 10.2. The graph shows Procter & Gamble’s (Ticker: PG) quarterly dividend history from
1970 to 2012. As you can see, only in Q1 of 1983 did the amount of the dividend fall, but since then it has steadily increased.
Based on data from Yahoo Finance: h�p://finance.yahoo.com/q/hp?
a=06&b=1&c=1985&d=09&e=8&f=2012&g=v&s=pg&ql=1 (h�p://finance.yahoo.com/q/hp?
a=06&b=1&c=1985&d=09&e=8&f=2012&g=v&s=pg&ql=1)
Although not a legally enforceable guarantee, a firm declaring a $0.50 regular dividend in the current year is promising its shareholders that it can maintain the regular
dividend at or above that level in the future. Regular dividends, therefore, are a quasi-fixed cost. They are fixed in that, like interest payments, they represent an obliga�on of
the corpora�on. They are quasi in that, unlike interest payments, there is no legal contract that forces the firm to make payment. If the firm chooses not to make an interest
payment, it is an act of default, whereas choosing to forego an expected regular dividend payment is not. However, there is a penalty associated with the inability to
maintain a regular dividend at its expected level: the ire of investors. This disappointment is o�en reflected in declining of share prices.
Special dividends, on the other hand, carry no implicit promise. Boards declaring a special dividend are careful to designate it as such. A special dividend might be caused by
a special cash flow–genera�ng event. For instance, corpora�ons that have sold a division may find themselves with a large excess cash flow on hand. They could declare a
special dividend to put this excess cash in the hands of their stockholders. Some�mes a special dividend is part of a recapitaliza�on plan. For example, Domino’s Pizza issued
a $13.50 per share special dividend a�er comple�ng a $1.85 billion debt issue in 2012 (PR Newswire, 2012). The distribu�on was designated a special dividend to ensure that
investors would not expect the same windfall the following year.
Now that we have briefly overviewed cash dividends, we can move on to learning how they are distributed in perfect and imperfect markets.
Like capital structure, dividend policy is also irrelevant to shareholders in perfect capital markets. A firm is equally valuable whether it pays all of its residual cash to
shareholders (a 100% payout), or retains all of its cash flow (a 100% reten�on, or plowback, rate). Regardless of a firm’s dividend policy, shareholders’ wealth remains
unchanged in this environment. This irrelevance can be a�ributed to the perfect market assump�ons discussed in Chapter 9:
1. Perfect markets are fric�onless, so corpora�ons may raise new capital without incurring transac�on costs. Individuals may also buy (or sell) securi�es without commissions or
tax ramifica�ons.
2. Perfect markets lack informa�on asymmetry.
3. Perfect markets are strong-form efficient; therefore, security prices accurately reflect value, and agency problems do not exist.
Now, let’s analyze dividend irrelevance within this ideal context.
Imagine a corpora�on with 1,000 shares of stock issued and outstanding. The corpora�on has two assets: $100,000 in cash and an iden�fied, proprietary project. This project
will cost the firm an ini�al investment of $100,000 and has a net present value of $20,000. The corpora�on has no debt in its capital structure, and management has decided
to finance the project with 100% equity. Because the firm operates in perfect financial markets, the stock’s price will accurately reflect its value.
Let’s consider two alterna�ves for funding the project. First, the firm could retain all of its cash and fund the total cost of the project with internal equity. In this case, the
firm’s current dividend would be zero because all cash has been retained and reinvested in the project. The second alterna�ve is to distribute all the cash as dividends to
current shareholders and sell new stock to raise the equity needed to finance the project. In this case, the firm would pay a dividend of $100 per share and use external
equity to fund the project.
Irrelevance predicts that either dividend policy results in the same shareholder wealth. We examine the zero dividend scenario first. If all $100,000 is invested in the project,
which has a $20,000 NPV, then the stock’s price will be $120. To see this, recall the formula for net present value:
Recognizing that the sum of discounted future cash flows equals value, we can subs�tute value for this term in Equa�on (10.3).
In efficient markets, value equals price. We know NPV is $20,000 and the project costs $100,000, so we can make further subs�tu�ons and solve for the stock’s price.
Thus, with 1,000 shares outstanding, the price per share is $120 per share ($120,000/1,000 shares).
Now, let’s examine the funding plan that includes a dividend. The company distributes $100,000 cash to its shareholders, resul�ng in a $100 per share dividend
($100,000/1,000 shares), and then raises $100,000 by selling addi�onal stock. Thus, each current shareholder would have $100 in the bank (from the dividend) and a share
of stock valued at $20. By distribu�ng all of its cash, the corpora�on is le� with only one asset—the right to pursue the $20,000 NPV project. To raise the $100,000 needed
to finance the project, the corpora�on sells 5,000 shares of new stock to the public for $20 per share, the same rate as currently outstanding stock. Both the new and old
stockholders have iden�cal rights represen�ng iden�cal claims. The firm now has 6,000 shares, with a total value of $120,000. Ul�mately, the strategy of paying a dividend
and raising investment funds by selling stock results in present shareholder wealth of $120 ($100 in cash and a share of stock worth $20)—the same value as the first
dividend policy.
Table 10.1 summarizes this result for the two dividend strategies.
Table 10.1: Two dividend strategies compared
Firm paying no dividend Firm paying $100,000 in dividends
Total value $120,000 $120,000
Number of shares 1,000 6,000
Value per share $120 $20
Wealth of “old” shareholders
Number of shares 1,000 1,000
Value of shares $120,000 $20,000
Cash dividend received 0 $100,000
Total wealth $120,000 $120,000
As you can see in the table, neither the value of the firm nor the wealth of the shareholders has changed. The old shareholders who received the dividend simply converted
a por�on of their wealth from common stock to cash. Shareholders can reallocate their wealth easily by selling shares at $120 to raise cash (in the case of no dividend) or by
using cash to buy shares at $20 (in the case of dividend). Ul�mately, both policies result in iden�cal wealth for exis�ng stockholders, illustra�ng that dividend policy is
irrelevant to shareholder wealth within the environment of perfect capital markets.
You may object to this conclusion. You may know of individuals who prefer high-dividend-paying securi�es because they depend on income from their personal investments
to meet living expenses. Re�rees, for example, o�en require regular investment income to supplement Social Security payments. Recall, however, that in perfect capitalProcessing math: 0%
Many re�rees supplement their fixed incomes with investments.
What are the benefits and risks of this prac�ce?
Associated Press
markets there are no transac�on costs. Re�rees needing current income can, in such markets, manufacture
homemade dividends by selling some propor�on of their shares. Consider an individual who owns 60 shares of
stock worth $7,200 in the firm that elected the no dividend op�on. If this individual needs $6,000 to pay a
hospital bill, he could simply sell 50 shares of stock for $120 each, raising $6,000 in cash. He would s�ll own 10
shares of stock worth $1,200. Had the firm paid a $100 per share dividend and dropped each share’s value to
$20, the investor would collect $6,000 in total dividends, pay his hospital bill, and s�ll have $1,200 worth of
stock in his por�olio. Either way, his total remaining wealth a�er paying his hospital bill is $1,200.
You might assume that investors would prefer a high-payout policy over a homemade dividend. If there is a
large clientele with such a preference, the demand for high-payout stocks would drive up their prices. However,
in a perfect market, investors with zero dividend policies can simply sell shares of stock to generate cash
without transac�on costs. They won’t pay a premium for stock with characteris�cs they can duplicate for free;
therefore, in perfect markets homemade dividends can subs�tute for dividends generated by the firm.
What of investors who prefer to keep their funds invested in the firm’s stock rather than saved in a bank
account? Wouldn’t these investors pay a premium to invest with firms that adopt a low payout of cash? Again,
the answer is no. Consider the 100% payout policy. An investor with 60 shares of stock in such a firm would
receive dividends totaling $6,000 and would own 60 shares of $20 stock for a total wealth of $7,200. If the investor wished to maintain her total investment in the firm, she
could purchase 300 shares of the newly issued stock for $20 per share. Her total wealth consists of investment in the firm equal to $7,200, and she would own 360 shares
(6% of the firm’s equity). Note that this is the same posi�on she would be in had the firm chosen to retain all the cash: There would be 1,000 shares outstanding, she would
own 60 (6% of the total) and her investment would be worth $7,200. Again, dividend policy is irrelevant because investors can construct their own dividend policies
independent of that adopted by the firm.
Both of the aforemen�oned scenarios break down once we introduce imperfec�on into the market. If we allow transac�on costs (e.g., brokerage commissions) to enter these
examples, then selling shares to construct a homemade dividend becomes costly and reduces the shareholder’s wealth. Clearly, it would be economically preferable for such
an individual to invest in a corpora�on adop�ng a higher payout. Thus, just as capital structure irrelevance disappears when perfect market assump�ons are relaxed, a
breakdown of irrelevance also occurs in dividend policy. We will now relax the perfect market assump�on to examine dividend policy in a context that more closely
resembles the real world.
Processing math: 0%
Stocks with different dividend prices are
like buying chocolate and vanilla ice
cream; some people prefer one over the
other. What other examples of
comparisons can you think of?
Ingram Publishing/SuperStock
10.3 Dividend Policy in Imperfect Capital Markets
Once transac�on costs enter our example, individuals are no longer neutral regarding dividend policy. Those who need steady income from their investments (e.g., re�rees)
are likely to prefer stocks that pay rela�vely higher dividends, also known as income stocks. Construc�ng their own homemade dividends would incur brokerage commissions,
effec�vely lowering their wealth.
Similarly, investors who wish to keep their savings fully invested in stocks may prefer firms that pay li�le or no dividends. There are firms with numerous promising projects
that con�nually reinvest all their residual cash into posi�ve NPV investments; these firms are known as growth companies. As their assets grow, the claims on the assets gain
in value, causing price apprecia�on or capital gains. Younger investors, saving for re�rement, o�en prefer to invest in the securi�es of such firms. These investors would
rather not receive large dividends and then use this cash to buy more of the company’s stock because of the brokerage commission they would have to pay on these
transac�ons.
Market Frictions and Dividend Policy: Transaction Costs and Taxes
The existence of two dividend clienteles does not necessarily mean that dividend policy affects firm value. Dividend policy remains irrelevant as long as there are enough
high-dividend income and growth stocks to sa�sfy demand for each. Compare this situa�on to buying ice cream. Some people prefer chocolate, and others choose vanilla.
The price of both flavors will be equal so long as there is no shortage of one flavor. The same holds true for stocks with different dividend policies: Adop�ng a high or low
payout does not lead to an increase in value, as long as demand for such issues is sa�sfied. Thus, irrelevance s�ll persists. We saw this in 2012; as yields on government
bonds approached zero, there s�ll wasn’t enough excess demand for high dividend paying stocks to shi� prices (Jakab, 2012).
In our example from Sec�on 10.1, the firm adop�ng a high-dividend payout sought outside equity to fund its investment in the
posi�ve NPV project. This capital was raised by selling new equity, which was done in a fric�onless, perfect capital market.
However, when firms issue and sell securi�es, they generally hire investment bankers to assist them in marke�ng the issue.
Investment bankers charge fees for their services, known as flota�on costs. These costs represent a leakage of cash from the firm,
lowering its value. Recall in our perfect markets example that the firm funding the project by foregoing dividend payments incurred
no fees. With flota�on or brokerage costs associated with other forms of raising capital, investors are no longer indifferent to
dividend policy. Because of transac�on costs involved in raising equity capital, firms should first fund all posi�ve NPV projects with
opera�ng cash flows and then determine the dividend policy regarding the le�over cash. This strategy is known as a residual
dividend policy; funds le� over a�er making all profitable investments are distributed to investors.
Taxes represent an important fric�on in capital markets. Individuals in high personal-tax brackets o�en prefer investments whose
returns come in the form of price apprecia�on (capital gains) rather than current income. To convince yourself of this, try the
following �me value problem: Suppose you are in the 50% tax bracket and invest $1,000 for 10 years in an investment that returns
10% per year before taxes. Now try two different scenarios. In the first, imagine that you must pay taxes at the end of each year at
the 50% tax rate. In the second case, suppose your investment compounds tax-free for 10 years and then you must pay a 50% tax
on your total gain. In which case will you be be�er off?
Paying taxes each year at a 50% rate effec�vely lowers your annual return from 10% to 5%. The a�er-tax value of your 10-year,
$1,000 investment is found by using the future value of a single cash flow formula from Chapter 3:
FV = $1,000(1.05)10 = $1,628.89
The tax-deferral feature of capital gains allows the investment to compound at 10% for 10 years; then 50% taxes are assessed against the gain:
FV (before taxes) =$1,000(1.10)10 = $2,593.74
In this second scenario, you see a capital gain of $1,593.74 on your original investment. The taxes on the gain must be paid ($1,593.75 × 0.50 = $796.87), leaving you with
$1,796.87 a�er tax. The deferral feature of capital gains results in $167.98 greater wealth.
The a�rac�veness of capital gains for this highly taxed individual lies in its tax-deferral feature. Dividends are taxed in the year they are paid, whereas capital gains are not
recognized for tax purposes un�l the security is sold at its appreciated value. In 2012, the capital gain has an even greater advantage because it is taxed at a maximum rate
of 15%, rather than the ordinary income maximum rate of 35%. Nevertheless, the benefit of tax-deferred compounding exists regardless of the rates.
Taxes and Investment Income
Processing math: 0%
Investment income may come in the form of interest, dividends, or reselling
at a profit. Typical investments include stocks, bonds, or mutual funds. Why
should a financial manager consider tax rates when choosing dividend
policies?
Many investors pay li�le or no taxes on their investment income. Investors such as low-income re�rees, college endowments, and pension plans pay no taxes on current
income and may be indifferent between capital gains and dividends. Does the existence of tax clientele necessarily lead to a prescribed dividend policy that will op�mize the
value of the firm? The answer is no. It is the ice cream story once more—as long as demand for firms with a par�cular dividend policy does not outstrip supply, investors will
be unwilling to pay a premium price based on the firm’s dividend strategy.
Transac�on costs, therefore, lead to one breakdown of the irrelevance proposi�on: The costs associated with raising external equity should be avoided if possible. Thus,
market fric�ons lead us toward a residual dividend policy.
Capital Gains Controversy
A par�cular type of capital gain received significant publicity in the early 2000s. Private equity managers were having a considerable por�on of their income taxed as
carried interest, qualifying them for the 15% long-term capital gain rate. This became a conten�ous poli�cal issue, promp�ng legisla�on aimed at preven�ng the low rate
from being applicable to high income. Master investor Warren Buffet even got involved when he admi�ed in 2011 that he paid only 17.4% in income taxes, which was
less than his secretary’s rate of more than 30% (Buffet, 2011). He argued that the rich shouldn’t pay a lower tax rate than middle-income ci�zens, and his admission
helped mo�vate proposed legisla�on aimed at “limi�ng the degree to which the most well-off can take advantage of tax expenditures and preferen�al rates on certain
income” (Na�onal Economic Council, 2012, p. 2). This legisla�on, known as “The Buffe� Rule” was a hotly-debated topic in the 2012 presiden�al elec�ons.
Cri�cal Thinking Ques�on
1. Do you think that wealthy individuals should be allowed to pay a lower tax rate using the capital gains rate? Why or why not?
Information Asymmetry and Dividend Policy: Signaling and Agency Costs
Dropping perfect market assump�on reintroduces asymmetry between the informa�on available to company insiders and outsiders. Like the signaling feature of debt,
dividend policy also allows insiders to give a credible signal to outsiders regarding the firms’ prospects.
Let’s examine the signaling effect within the context of the quasi-fixed nature of regular dividends. Recall from Chapter 9 that a firm’s management can signal higher
expected cash flows by taking on a greater propor�on of debt. The signal is credible because of the penalty associated with false signaling—a higher likelihood of bankruptcy.
Similarly, for firms using a constant dollar dividend policy, declaring a higher regular dividend signals to investors that the board, under advisement of management, believes
the corpora�on can maintain its dividend at the new level indefinitely into the future. If management expects a firm’s cash flows to be higher in the future, they may signal
to outsiders the improved prospects by increasing the regular dividend.
If management increases the regular dividend without expec�ng be�er prospects, then they have sent a false signal. There is some likelihood of the firm not being able to
meet its new, higher dividend payment. If the company performs poorly, managers may have to lower the dividend. Shareholders respond nega�vely to dividend decreases
by lowering their share valua�ons. Some�mes the response is drama�c enough to cost managers their jobs. This penalty for false signaling lends credibility to a dividend
increase.
Other policies do not share the constant dollar policy’s signal reliability. If the company follows a different type of dividend policy—such as a pure residual dividend policy or
a payout ra�o target policy—then investors cannot infer a signal from a dividend increase. Under the pure residual policy, dividends go up and down as earnings and
investment need changes. With a target payout ra�o policy, a dividend increase follows higher earnings, but there is no assurance from managers that earnings will con�nue
to be high, so there is no signal. Investors prefer the constant dollar policy because it allows managers to reliably signal a company’s future prospects.
A second outcome of introducing informa�on asymmetry into our economic environment is the poten�al for agency problems. In Chapter 9, we introduced the agency cost
of free cash flow argument, which predicts that firms o�en waste money when cash on hand is in excess of that needed to fund all posi�ve NPV projects. The poten�al for
agency costs does not go unno�ced by investors. They see the poten�al for waste within firms that produce cash flows in excess of their internal needs, yet fail to pay outProcessing math: 0%
this cash to residual claimants. In order to lower the poten�al for waste, firms should pay dividends at the highest possible level without limi�ng the cash needed to fund
an�cipated promising investment projects.
Now that we have examined how market inefficiencies affect dividend policy, we can more thoroughly examine the process in ac�on.
Processing math: 0%
10.4 Dividend Policy in Practice
Three proposi�ons that are at odds with dividend irrelevance have been presented:
1. The residual dividend policy prescribes funding all posi�ve NPV projects first and then determining the dividend payment.
2. Signaling with dividends prescribes paying regular dividends at a level that can be maintained by the firm.
3. The agency costs of free cash flow policy prescribe paying the highest possible dividend a�er funding all posi�ve NPV projects.
Taken together, these three proposi�ons suggest that managers take the following ac�ons when implemen�ng dividend policy:
Step 1. Forecast the cash needed to fund the firm’s investment projects for several years in the future.
Step 2. Forecast the residual cash flows the firm will generate for several years in the future.
Step 3. Using the informa�on from steps 1 and 2, subtract the cash needed for investment projects each year from the cash flows an�cipated that year in order to determine
each year’s free cash flow. This effec�vely implements the residual dividend policy’s recommenda�ons.
Step 4. Taking into account the variability of the year-to-year expected free cash flow, establish a maintainable regular dividend, thereby implemen�ng the recommenda�ons
of the signaling hypothesis.
Step 5. Large free cash flows le� in a par�cular year a�er the payment of a regular dividend and not needed to fund future investment projects should be disgorged. This
can be accomplished by se�ng the regular dividend at its highest maintainable level or by using a special dividend, thereby implemen�ng the recommenda�ons of the
agency costs of free cash flow argument.
Table 10.2 applies these recommenda�ons to a hypothe�cal firm. The company portrayed follows a constant dollar dividend policy but supplements the regular dividend with
a special dividend a�er Year 3, when cash flow genera�on is high.
Table 10.2: Implemen�ng dividend policy for a hypothe�cal firm (100,000 shares outstanding)
Dividend policy implementa�on Year 1 Year 2 Year 3 Year 4
Step 1. Forecast residual cash needed to fund the firm’s investments for several years. $200,000 $300,000 $100,000 $250,000
Step 2. Forecast residual cash flows produced by the firm. $350,000 $400,000 $450,000 $400,000
Step 3. Subtract cash flows needed from those produced. $150,000 $100,000 $350,000 $150,000
aCarried over to Year 2 to fund maintainable regular dividend of $1.25/share.
Note that certain predic�ons are possible when we consider firms’ applica�on of these steps in the real world. For example, we can expect that firms in high-growth
industries, where new and promising projects abound, will adopt a low (or zero) dividend payout. On the other hand, firms in mature industries would have a higher
dividend payout ra�o. Table 10.3 compares the average dividend payout ra�o for 15 diverse industries. No�ce how widely payout ra�os can vary from one category to the
next.
Table 10.3: Payout ra�os for selected industries, 1999–2012
Industry name Average payout ra�o Average # of firms
As predicted, the industries with the most growth (Internet, Medical Services, Wireless Networking, Biotechnology, and Electronics) have the lowest payout ra�os. We expect
firms in these industries to need significant investment funds, so they would retain and reinvest any cash flow generated. More mature firms, and those with li�le need for
constant compe��ve innova�on (Tobacco, Electric and Water U�li�es), have the highest payout ra�os.
Expectations and Dividend Policy
Another predic�on we can make is that firms lowering their regular dividend will experience a fall in stock prices when the announcement is made. One might also an�cipate
that corpora�ons announcing an increase in their regular dividend will see their share value increase. These predic�ons are based on the signaling effect of the dividend
announcement. If the change in the regular dividend signals new informa�on to the market, an impact on price will be forthcoming as investors evaluate the content of the
signal. However, we must keep in mind that investors may have already formed expecta�ons about future dividends when they value stocks. In some cases, the market is
expec�ng a firm to lower its dividend, perhaps because of recent and ongoing difficul�es. If a firm subsequently lowers its dividend, but by less than the amount expected,
the market may actually perceive this as good news (posi�ve signal) that circumstances are be�er than investors originally thought. On the other hand, a corpora�on raising
its dividend less than expected could find that share prices decline due to investors’ disappointment in the rela�vely low increase. Therefore, the wealth effect (share price
change) of a dividend change is a func�on of the actual change versus the expected change. In other words, it’s the unexpected part of the dividend announcement that has
an impact on value.
An erra�c pa�ern of paying dividends could be full of unexpected changes that surprise investors. Managers seek to avoid irregularity by se�ng a regular dividend at a
reasonable maintainable rate. Many managers also avoid issuing regular dividend increases in large, randomly occurring jumps. Rather, they tend to adopt a smooth stream
of steadily but moderately increasing dividend payments. Such a stream can absorb the shock of earnings reversals that occur from �me to �me. This type of payment
schedule is known as smooth-stream dividend strategy and can be viewed as an a�empt to minimize dividend disappointments. An example of the smooth-stream dividend
strategy in prac�ce is shown for Hershey in Table 10.4.
Table 10.4: Hershey’s annual dividend, EPS, and payout ra�o, 1990–2011 (adjusted for stock splits)
Year Dividend EPS Payout ra�o
1990 0.25 0.55 45.4%
1991 0.24 0.61 38.5%
1992 0.26 0.68 38.1%
1993 0.29 0.72 39.9%
1994 0.31 0.76 41.1%
1995 0.34 0.85 40.5%
1996 0.38 1.00 38.0%
1997 0.42 1.12 37.7%
1998 0.46 1.15 40.2%
1999 0.50 1.05 47.8%
2000 0.54 1.18 45.8%
2001 0.58 0.72 81.0%
2002 0.63 1.42 44.4%
2003 0.72 1.70 42.5%
2004 0.84 2.25 37.1%
2005 0.93 1.99 46.7%
2006 1.03 2.34 44.0%Processing math: 0%
http://pages.stern.nyu.edu/~adamodar/
The dividend payment process has four key dates: (1) announcement date, (2) ex-dividend date, (3) date of
record, and (4) payment date.
2007 1.14 0.93 122.2%
2008 1.19 1.36 87.6%
2009 1.19 1.90 62.7%
2010 1.28 2.21 57.9%
2011 1.38 2.74 50.4%
Based on data from Yahoo Finance: h�p://finance.yahoo.com/q/hp?s=HSY&a=06&b=1&c=1985&d=09&e=8&f=2012&g=v
(h�p://finance.yahoo.com/q/hp?s=HSY&a=06&b=1&c=1985&d=09&e=8&f=2012&g=v)
No�ce that even though Hershey’s dividends increase smoothly, the dividend payout ra�o (Dividends/EPS) is somewhat erra�c, ranging from 38% to 122%. We must also
point out that firms are so reluctant to reduce dividends—due to the nega�ve response from investors—they may con�nue to pay dividends even if they exceed current
earnings. This was the case in 2007 for Hershey.
The Process of Paying Dividends
When a corporate board declares payment of dividends, the announcement includes a date of record. On that date, the corpora�on reviews its stock transfer books to
determine who owns shares and is en�tled to the dividend proceeds. The dividend announcement also specifies a dividend payment date. This date is a few weeks a�er the
date of record, the payment delay being necessary to allow paperwork and check wri�ng to be completed.
The date of record is preceded by the ex-dividend date. Only investors who purchase a share of stock prior to the ex-dividend date are en�tled to the dividend. For example,
when shares are bought a few days a�er the ex-dividend date, the old owner will receive the dividend payment, even though the stock has changed hands. Brokerage firms
specify an ex-dividend date in order to assure investors that their names will appear as stockholders on the corporate books by the date of record. Because it normally takes
a few days to se�le a stock purchase or sale, the ex-dividend date precedes the date of record by about two business days.
Figure 10.3 illustrates a dividend payment �me line. Point A is the April 1 announcement of a dividend payable on May 19. Point C is the date of record, May 5, and Point B
is the ex-dividend date, May 1. The dividend checks are mailed on the payment date of May 19.
Figure 10.3: Dividend payment �meline
In the �meline, anyone holding stock by the ex-dividend date will receive the May 19 dividend check, even if they subsequently sell their shares. Those who buy the stock on
or a�er May 1 will receive no dividend because the transac�on occurred a�er the date-of-record deadline. This means that if you bought shares on May 2, you would not be
en�tled to a dividend, whereas had you purchased shares two days earlier, you would receive the dividend check. This may seem unfair un�l you realize that, theore�cally,
the stock’s price drops on the ex-dividend date by the amount of the dividend. Thus, by purchasing the stock on May 2, you pay less than if had you purchased the stock two
days earlier. Those who sell their shares on May 2 will receive their dividend for stock they no longer own, but they receive less on the sale of their stock than they would
have had they sold earlier and foregone the right to collect the dividend. In this way, the dividend payment system works out fairly for all par�es.
In the previous paragraph we said “theore�cally, the stock’s price drops on the ex-dividend date by the amount of the dividend.” In reality, a company’s stock price may not
drop by the exact dividend amount following the ex-dividend date, due to the new informa�on con�nually fed into the market. The stock price could actually rise if, for
example, the firm announced an oil discovery a�er the close of trading the previous day. This posi�ve news would more than offset the decline caused by the stock going ex-
dividend. Even if there is no new informa�on arriving in the market place that day, the price drop on the ex-dividend rate may be smaller than the dividend per share. This is
because investors, on average, need to pay tax on a dividend, so the drop will approximately equal (Dividend) × (1 – t), where t is the average tax rate.
Stock Repurchases
Firms considering issuing a special dividend will o�en opt for a stock repurchase instead. Similar to the dividend, the repurchase distributes excess cash to exis�ng
shareholders, lowering the poten�al for agency costs. Once stock is repurchased, it becomes known as treasury stock. Treasury stock is held by the corpora�on and may be
reissued to the public without going through the costly registra�on requirements associated with issuing completely new shares. Many firms also use treasury stock to fund
execu�ve bonuses and employee re�rement plans. For this reason, some firms repurchase stock to provide them with shares to fund such programs. Some�mes companies
choose to re�re the stock, permanently reducing the number of shares outstanding. Stock repurchases can also be used as a takeover defense when a large block of stock is
repurchased at a premium from a poten�al acquirer. These targeted repurchases, called greenmail transac�ons, were used in the 1980s but are uncommon now.
We will discuss three methods for accomplishing share repurchases: open market purchases, fixed-price tender offers, and Dutch Auc�ons.
In an open market purchase, the corpora�on buys its own stock in the secondary market, but must publicly announce in advance their inten�on to repurchase shares. In
June 2012, the clothing company Guess announced in a press release that it would “repurchase, from �me-to-�me and as market and business condi�ons warrant, up to
$500 million of its common stock” (Guess, 2012). This announcement is typical of open market share buyback programs, with no definite period or price range specified.
During the crash of 1987 the United States Securi�es and Exchange
Commission announced it would make it easier for companies to buy back
their stocks. Dozens of companies jumped at the chance and the Dow began
to rise. Why do you think some companies chose to repurchase shares,
while others did not?
Guess is just one company that decided to repurchase its own stock
in the secondary market. Do you think it is fair for companies to do
this?
PR Newswire/Associated Press
When the share price drops, the company could become a buyer, and other investors never know if they are
selling to the company or other outside investors. Also, there is no assurance that the repurchase plan will ever
be completed. In fact, there is evidence that companies actually purchase only about 78% of the announced
target number of shares (Stephens & Weisbach, 1998). In the two weeks a�er the stock market crash of 1987,
about 600 companies (9.3% of all listed companies in the U.S.) announced open market repurchase programs.
Over the following five months, only about 40% of those firms decreased their shares outstanding, while one-
third actually saw an increase (Ne�er & Mitchell, 1989).
A Crisis Is Averted
Share repurchases are some�mes interpreted as posi�ve signals that the firm’s stock is undervalued. The reasoning behind this signal follows: Managers are looking for
posi�ve NPV projects, or projects whose costs are less than their value. With their superior informa�on, managers who choose to repurchase shares send a signal that they
consider the firm’s stock to be priced below value, and view the purchase as a posi�ve NPV investment. Knowing that repurchases might be viewed as a signal of the firm’s
value, what prevents managers from abusing repurchases for corporate gain? There are rules that prevent companies from using open market repurchases to manipulate
share prices. For example, the maximum amount of stock that can be bought on a single day is 5% of the average trading volume for the previous month. Addi�onally, all
shares purchased by a firm on a single day must be purchased through a single brokerage firm. (Share buybacks by corporate issuers are governed by the Securi�es Exchange
Act of 1934 under Rule 10b-18, �tled Purchases of Certain Equity Securi�es by the Issuer and Others.)
As opposed to an open market purchase, a tender offer is a formal offer to buy all shares tendered, up to a given total. Firms generally use the tender offer method when
repurchasing a large number of shares. The repurchase price (or bid price) is explicitly stated in the tender offer announcement and exceeds the current market price. Thus,
the term bid premium is used to describe the percentage by which the tender offer price exceeds the share’s market price as of the date of the offer’s announcement.
Typical bid premiums are 15% to 20% above the preannouncement share price. There is no obliga�on on the part of the stockholder to tender their shares; if they wish, they
can con�nue to hold them. If more shares are tendered than the number sought by the firm, the tender offer is oversubscribed, and the corpora�on has the op�on of
purchasing some or all of the excess shares.
Finally, a Dutch Auc�on repurchase allows the firm to set a price range it will consider for the shares. Shareholders submit offers with the number of shares they wish to sell
at a price within the specified range. When the auc�on period ends, the company looks at all the offers and creates a supply curve. It then chooses the lowest price that
allows it to repurchase the desired number of shares and pays everyone who submi�ed an offer at or below that price. Let’s consider an example. Company A wants to
repurchase 1 million shares for a price between $25 and $30 per share. Table 10.5 shows the range of bids submi�ed by investors, with the number of bids submi�ed in the
le� column, and the price per share for those bids in the middle column. The right column totals up the number of shares, star�ng at the lowest number and working up to
the 1,000,000 goal (similar to what the firm managers will do). The company will reach its target number of shares once it purchases those through the $27.75 price.
Therefore the firm will offer this price to all investors submi�ng offers at or below $27.75, no ma�er what their actual offer was.
Processing math: 0%
Stock repurchases via Dutch Auc�on are different than purchasing
shares through the secondary market in that there is more
flexibility in the share price. What are some other differences?
Associated Press
Table 10.5: A Dutch Auc�on example
Number of shares Price per share Total number of shares (1,000,000 goal)
150,000 $26.00 150,000
250,000 $27.00 400,000
350,000 $27.25 750,000
200,000 $27.50 950,000
50,000 $27.75 1,000,000
150,000 $28.00 1,150,000
On June 28, 2012, AOL (the old America On-Line), announced a Dutch Auc�on repurchase. The press release gave the following details: the repurchase was to distribute the
proceeds from the sale of AOL patents to Microso�. Shareholders had un�l August 2, 2012, to submit their offer to tender shares at a price between $27 and $30 per share.
AOL allocated $400 million for the repurchase, but reserved the right to terminate or extend the repurchase (AOL.com, 2012).
A major func�on of stock repurchases is to lower the number of outstanding shares. In this respect they differ
from special dividends. Because there are fewer outstanding shares, future regular dividends may increase a�er
a repurchase. For example, if a corpora�on forecasts that $1,000,000 is available for regular dividends each
year for the foreseeable future and has 1,000,000 shares outstanding, then the firm could maintain a $1 per
share annual dividend. Let’s assume the firm has sufficient addi�onal free cash to either pay a special dividend
or repurchase 200,000 shares. If the firm pays a special dividend with this cash, it will con�nue to pay the $1
per share dividend. On the other hand, if the excess cash is used to repurchase shares, then only 800,000
shares will be outstanding, and the corpora�on could theore�cally pay a $1.25 per share regular dividend
($1,000,000 distributed among 800,000 shares).
Increasing the dividend level through the reduc�on of shares means that remaining shares increase in value.
Investors, realizing this, will demand a higher price for tendering, leading to the bid premium referred to
earlier. Although it might appear that repurchasing shares will increase shareholder wealth more than a special
dividend, this is not necessarily the case. Note that the share repurchase alterna�ve from the previous
paragraph increases the dividend by 25%, from $1 to $1.25. The special dividend alterna�ve distributes cash,
enabling individual investors to use these funds to buy addi�onal shares. With the special dividend alterna�ve,
shareholders in this example have the op�on of increasing their holdings by 25% if they reinvest the
disbursement to buy stock in the corpora�on. In theory, shareholders’ wealth would be iden�cal under either
the special dividend or the share repurchase alterna�ve.
Even though shareholder wealth might be theore�cally equal in either alterna�ve, in reality this is not the case. We overlooked taxes in this argument. Dividends are taxed as
regular income, but share repurchases may be taxed as capital gains. This creates a tax advantage to the repurchase alterna�ve, pu�ng more cash in the pockets of
stockholders, making it preferable to the dividend op�on. However, when repurchases are made through a tender offer, the firm incurs considerable transac�on costs, which
tend to offset some of the tax advantages. Tender offer repurchases are therefore generally reserved for instances where the firm intends to buy back a substan�al amount
of stock, and transac�on costs can be spread across numerous shares with minimal impact on shareholders’ wealth.
Stock Dividends and Stock Splits
In Sec�on 10.1, we discussed two kinds of cash dividends: regular and special. Here, we will cover a different type of dividend: the stock dividend. A stock dividend is the
payment of addi�onal stock to shareholders; they change the number of shares of stock that are outstanding, but do not increase the cash flows paid to investors. Let’s look
at an example. Assume a company issues a 10% stock dividend, en�tling the holder of 100 shares of stock to 10 addi�onal shares (new total of 110 shares). Note that if this
company had 2,000 shares outstanding prior to the stock dividend, it would have 2,200 shares outstanding a�er the stock dividend—a 10% increase overall. The stockholder’s
100 shares represented a 5% ownership interest in the firm’s equity before the dividend, and the 110 shares represents 5% of the equity a�er the stock dividend. Thus, the
shareholder’s propor�onal claim on the firm’s cash flows remains unchanged at 5%.
A stock split increases the number of shares outstanding by replacing old shares with new shares on a propor�onal basis. A firm offering a two-for-one split doubles the
number of shares outstanding, doubling each individual’s shareholdings. Like a stock dividend, a split does not change a shareholder’s ownership interest in the firm. Our
example firm, with 2,000 shares before a two-for-one split, would have 4,000 shares outstanding a�er the split. An owner of 100 shares would end up with 200 shares, both
of which represent 5% of the firm’s equity.
If we think of shares of stock as coins, stock dividends and stock splits are like changing how we count our coins. Before a split let’s say we have four dimes. A�er a two-for-
one split, we have eight nickels, and our value remains unchanged. Another way of viewing this is to realize that the value of stock is grounded in its claim on le�-hand-side
cash flow–producing assets. All splits and stock dividends do is change the units in which we count the claims, not the value of the le�-hand-side assets. Thus, if you own
claims totaling 5% of the total le�-hand-side value, it is immaterial whether that 5% is counted as 110 shares, 100 shares, or 200 shares; the value is the same. On the other
hand, if accompanying the split is a signal of increased le�-hand-side value, then an increase in shareholder wealth may occur.
O�en with a split, dividends effec�vely increase. In a two-for-one split, a stock that paid a $3 per share dividend prior to the split would be expected to pay a dividend of
$1.50 a�er the split. However, should the firm announce that the dividend following the split was going to be $1.75 per share, it has revealed some posi�ve informa�on
about the value of the stock. In this case, stock selling for $40 prior to the two-for-one split may jus�fiably sell for more than $20 a�erward. Of course, the same informa�on
Processing math: 0%
could arguably be conveyed by not spli�ng the stock and simply raising the dividend from $3 to $3.50 per share. Splits, in this case, can be seen as a device used to draw
more a�en�on to the posi�ve dividend news.
We have described splits that increase the number of shares and reduce share price, but it can happen the other way. A reverse split represents a propor�onal reduc�on in
shares that leaves ownership interests and value unchanged. If we go back to the idea of exchanging coins, reverse splits are like moving from nickels to dimes. Reserve splits
reduce the number of shares outstanding and subsequently increase the price per share. For example, a company could offer one share for every two shares tendered,
reducing shares outstanding by 50%. Some�mes reverse splits are used to consolidate control of a company. If a company carries out a reverse split where one share is
issued for every 500 tendered, investors with fewer than 500 shares will be paid in cash, and their shares will be added to the company’s Treasury Stock. The result is that
only large shareholders will remain as owners of the company.
Stock dividends and splits are so alike that a rule has been adopted to dis�nguish them: If the number of shares outstanding changes by more than 25%, the change is
termed a stock split. Ac�on involving a change of less than 25% is termed a stock dividend.)
Field Trip: Stock Splits
Learn more about upcoming stock splits here: h�p://biz.yahoo.com/c/s.html (h�p://biz.yahoo.com/c/s.html)
Pick one of the be�er-known firms announcing a split and find its website using a search engine. The corpora�on’s site should include informa�on about the upcoming
split.
Record the firm’s name, its web address, the split terms, and the date. Then read the ra�onale given for the split.
Reflec�on Ques�ons
1. What reason does the company give for spli�ng its stock?
2. How do you think the split will impact the post-split value of shares?
Processing math: 0%
http://biz.yahoo.com/c/s.html
Ch. 10 Conclusion
Like the capital structure decision, iden�fying a firm’s op�mal dividend policy can be a challenging task. No formula exists to provide the answer, nor is there general
agreement on the wisdom of a par�cular strategy. Managers can feel confident in their decision if they take a few careful and far-sighted considera�ons when forecas�ng:
Minimize transac�on costs, limit poten�al agency problems, and aim to meet the expecta�ons of investors. Most firms, in fact, follow a pa�ern of slow but steady dividend
growth, supplemented by an occasional special dividend.
Processing math: 0%
Ch. 10 Learning Resources
Key Ideas
When capital markets are perfect, dividend policy is irrelevant.
When a corpora�on raises its regular dividend, the increase carries with it the implicit promise that the new level of payment can be maintained.
The decision to increase a regular dividend is a signal that the firm can support a higher payment level.
Dividend payments tend to lower a corpora�on’s free cash flow and may, therefore, lower agency costs.
Many firms a�empt to manage investors’ expecta�ons by adop�ng a smooth stream dividend strategy.
An alterna�ve to paying a special dividend is to repurchase shares.
Stock dividends and stock splits change the number of shares of stock that are outstanding but do not increase the cash flows that are paid to investors.
Key Equa�ons
Cri�cal Thinking Ques�ons
1. Investors and stock analysts are forward-looking. They are concerned with expected future dividends when es�ma�ng value. There are occasions when these analysts see a
firm’s problems even before management faces up to the difficul�es. Explain why a stock’s price might increase when the firm announces it is lowering its dividend and will
use the retained cash to retool an inefficient factory.
2. Suppose Bioenergy, Inc. has a market value of $50,000,000 and is 100% equity financed. Its market value per share is $25 because there are 2,000,000 shares outstanding.
The firm pays no dividend. At the last shareholders’ mee�ng, there were complaints about the no-dividend policy. As a director of Bioenergy, what factors should you
consider as you contemplate ini�a�ng a dividend? [Hint: Discuss why you should analyze (a) the current and expected level of cash flows, (b) the cash needed to fund
expected posi�ve NPV investment opportuni�es, (c) the variability of expected cash flows, (d) other means of financing investment projects and the costs associated with
using other sources of capital, and (e) if there have been some wasted funds expended in the firm in the past.]
3. On Thursday, May 3, the board of directors of ACME, Inc. declares a $1.50 per share dividend, payable on Thursday, May 31 to the shareholders of record as of Thursday, May
17. When is the ex-dividend date? Do you think it is a good idea to buy the stock on May 8 and sell it on May 15? Why or why not?
4. Dividend reinvestment plans (DRPs) are in place at many large corpora�ons. DRPs allow stockholders to have their dividends automa�cally reinvested in the company’s stock.
Stockholders avoid brokerage commissions by par�cipa�ng in DRPs, and at �mes the firm sells the stock to plan par�cipants at a light (3–5%) discount from the current
market price. What clientele do you think might find this feature a�rac�ve?
5. What kind of dividend policy would you expect growth companies to have? Why?
6. One mo�ve for stock splits is the trading range hypothesis. The argument says that stocks with high prices tend not to be bought by many small investors. Thus, lowering the
price per share by way of a stock split makes the stock more a�rac�ve to the low-price clientele. More demand for the stock should increase equity’s value. Do you think this
is true? Why or why not?
The percentage by which the tender offer price exceeds the share’s market price as of the date of the offer’s announcement. Typical bid premiums are 15% to 20% above the
preannouncement share price.
A dividend policy where the company pays the same dollar amount every year unless the dividend increases. A company that follows this policy has made an implicit
promise to con�nue to pay dividends, year a�er year, at or above the current regular dividend level.
date of record
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The date the corpora�on uses to determine who owns shares and is en�tled to the dividend proceeds.
dividend payment date
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
This date is a few weeks a�er the date of record, the payment delay being necessary to allow paperwork and check wri�ng to be completed.
ex-dividend date
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The date on or a�er which a security begins trading without the dividend included in the contract price.
Firms with numerous projects that con�nually reinvest their residual cash into posi�ve NPV investments.
income stocks
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Stocks that pay a rela�vely high dividend.
open market purchases
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
When a corpora�on buys its own stock in the secondary market just as any other investor. The firm must publicly announce its inten�on to repurchase shares in advance.
During a tender offer, each stockholder may elect to tender shares or con�nue to hold the shares. When more shares are tendered than the number sought by the firm, it
has the op�on of purchasing some or all of the excess shares tendered.
Dividend policy that distributes any remaining funds to investors a�er making all profitable investments first.
special dividends
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
A higher than usual payout to stockholders in a company as a share of company profits (may not be con�nued).
Treasury stock is held by the corpora�on and may be reissued to the public without going through the costly registra�on requirements that issuing completely new shares
entails.
Web Resources
Many investors rely on a company’s dividend yield as a guide to selec�ng stocks. To learn more about how the “dogs” are selected, go to:
h�p://www.dogso�hedow.com (h�p://www.dogso�hedow.com)
The Stock Center at Market Edge is a good source of dividend informa�on:
h�p://www.marketedge.com/ (h�p://www.marketedge.com/)
An excellent website about corporate finance and valua�on has been created by NYU finance professor Aswath Damodaran:
h�p://pages.stern.nyu.edu/~adamodar/ (h�p://pages.stern.nyu.edu/~adamodar/)
Capital Structure: Right-Hand-Side Decisions and the
Value of the Firm
Exactostock/SuperStock
Learning Objectives
A�er studying this chapter, you should be able to:
Describe the characteris�cs of perfect capital markets and how they relate to capital structure.
Iden�fy the characteris�cs that make capital markets imperfect, and explain how they relate to capital structure.
Explain how the trade-off theory components are used to determine target capital structure.
Iden�fy other factors that affect a firm’s debt capacity.
Ch. 9 Introduction
Managers choose products and services that create value for shareholders. Chapters 6, 7, and 8 discussed how these investment decisions, reflected on the le�-hand side of
the financial balance sheet, affect shareholders’ wealth. Recall that inves�ng in posi�ve NPV projects adds to the wealth of shareholders, whereas inves�ng in nega�ve NPV
projects detracts from it. In this chapter, we examine how managers choose the mix of financing required to support these investment decisions. We call this the capital
structure decision. As we turn our a�en�on to the right-hand side of the balance sheet, we assume that capital budge�ng decisions have been made. Our concern is with
choosing the mix of debt and equity used to fund the firm’s assets, and whether this capital structure choice will affect shareholders’ wealth.
You might think that there is a standard propor�on of debt that most firms use—a financial rule-of-thumb—but the debt-equity mix varies enormously across companies.
Some, such as young high-tech or biotech firms use li�le or no debt, whereas public u�li�es use high levels of debt. Even private equity firms, such as Bain, KKR, the
Blackstone Group and Warburg Pincus, o�en finance their purchases of companies with 60% or even 80% debt.
Why do debt ra�os vary so much from company to company? It all comes back to the financial goal of the corpora�on: Management chooses a specific capital structure in
the belief that its choice will maximize the firm’s worth, and ul�mately shareholder wealth. How each of these decisions can be op�mal yet so different is explained in this
chapter as we explore the link between capital structure and firm value.
This figure illustrates where leakages may impact the financial balance sheet.
Just as fric�on hinders our ability to push a cart of boxes, so too
does fric�on impede the movement of funds in a capital market.
9.1 Perfect Capital Markets and Capital Structure
Our discussion of the debt-equity mix begins with the assump�on that capital markets are perfect. Perfect capital markets are an ideal and do not reflect the real world, but
they are very useful for developing an understanding of capital structure’s impact on share value and also in understanding dividend policy, which will be covered in Chapter
10. Under the very strict (and unrealis�c) assump�ons of perfect markets, we will see that capital structure has no impact on value. That is, right-hand-side decisions are
irrelevant to shareholders under perfect market condi�ons, so any mix of debt and equity results in the same overall value of the firm. Also, in perfect capital markets, the
cost of borrowing is assumed to be the same for both investors and companies (which is not the case in actual capital markets). It may seem like a poor use of �me to study
something that is irrelevant to firm value, but this model gives us insights about why capital structure may ma�er in the real world. As we relax the assump�ons of perfect
capital markets, we will begin to iden�fy the factors that help determine a company’s op�mal capital structure.
Perfect capital markets may be characterized as
being strong-form efficient,
having no informa�on asymmetry,
having no leakages such as taxes or transac�on costs.
Strong-form efficiency defines a market in which security prices reflect all per�nent informa�on. Prices in such markets are unbiased es�mates of value, fully reflec�ng the
cash flows and risk expected to accrue to security holders. In strong-form efficient markets, securi�es offering the same cash flows with equal risk will be equally priced.
As strong-form efficiency suggests, the informa�on reflected in prices includes both insider and outsider informa�on. This is a natural outcome of the second characteris�c of
perfect markets, their lack of informa�on asymmetry. Because everyone has the same informa�on, no dis�nc�on between insiders and outsiders is necessary in perfect
capital markets. Furthermore, there is no agency problem in these markets. If, for example, managers were underperforming or gran�ng themselves excessive perquisites,
their employers, the shareholders, would observe these ac�ons. Shareholders, in turn, would correct such inappropriate behavior—possibly firing the managers. In this
perfect market, managers would foresee this shareholder response and would not act inappropriately in the first place.
The third characteris�c of perfect capital markets is that no leakages occur as cash flows move between the firm and capital suppliers. Examples of leakages include taxes
(where a por�on of the cash that otherwise would flow to security holders is paid to the government) and transac�on costs (cash paid to investment bankers as part of the
firm’s capital acquisi�on). Figure 9.1 illustrates some common leakages.
Figure 9.1: The financial balance sheet, illustra�ng some leakages
Because such leakages do not exist in perfect capital markets, these markets are some�mes characterized as
being fric�onless. In physics, fric�on refers to resistance as objects are moved. The more fric�on there is, the
more energy it takes to move an object. Thus, it is easier to push a heavy box across a smooth �le floor than
across a carpeted floor. The analogy to economic fric�on is straigh�orward: As cash or securi�es move from
the claimants to the firm, between claimants, or from the firm to claimants, there is no loss of value in a
fric�onless market. Anyone who has sold a house for $150,000 yet nets only $135,000 a�er commissions,
lawyer’s fees, and taxes can a�est to the fric�ons that exist in most markets.
Next we will look at capital structure in perfect capital markets.
The Irrelevance of Capital Structure in Perfect Markets
In perfect capital markets, the mix of financing used to fund investment decisions is considered irrelevant to
shareholders. We illustrate capital structure’s irrelevance by developing a simple example that assumes capital
markets are perfect and the firm’s investments are iden�fied. Suppose the firm in our example is a small,
closely held corpora�on that does business as a donut shop. Further suppose that you are the sole owner of
Chris�e & Cole/Corbis
As levers are used in mechanics to amplify strength, finance also
uses the concept of levers to demonstrate the strength of good and
bad cash flows.
Exactostock/SuperStock
the shop, providing 100% of the corpora�on’s capital. All of the shop’s capital is provided via stock, so its
capital structure is all equity, and you own all the shares.
In the perfect markets we have described, the value of the donut shop is unaffected by the fact that you have chosen to finance it using only equity. Had you decided to loan
the company half of its capital and provided the other half in the form of equity, then the total value of your investment would be unchanged. Why doesn’t capital structure
ma�er? Capital structure is irrelevant because it does not affect the cash flows that the shop generates or their riskiness, and it is these characteris�cs of the shop that
determine its value. To see this, ask yourself whether customers care about a donut shop’s capital structure when they choose to make a purchase. No, they care about
price, flavor, cleanliness, selec�on, service, and convenience. These shop characteris�cs are independent of the propor�on of debt and equity the business chooses to use as
sources of capital. Customers are interested in the shop’s menu, not its balance sheet.
In our example, all of the cash flows to you, the owner, whether it is an all-equity firm or a 50% debt–50% equity firm. You receive the same cash flow stream whether all
the cash comes in the form of dividends or part of the return is dividend income and part is interest income. Since there are no taxes or transac�on costs, you see no
advantage in receiving interest income or dividend income. As the sole owner you receive iden�cal cash flow and bear iden�cal risk with either capital structure; therefore,
your business will have the same value with either structure. To put it another way, the components of value (the size and riskiness of expected cash flows) are determined
by the le�-hand side of the financial balance sheet and are reflected in the values of the right-hand-side claims. Thus, the le�hand side is cri�cal to a firm’s valua�on.
It follows that in a perfect capital market, capital structure has no impact on value. This is the irrelevance proposi�on we referred to at the beginning of this sec�on. It
means that when capital markets are perfect, managers need not waste their �me worrying about right-hand side decisions. One capital structure is as good as another, and
they all result in the same value for owners.
Irrelevance is probably best understood by recognizing that both cash and risk flow from the le�-hand side of the balance sheet (from assets and the products those assets
produce) to the right-hand side of the balance sheet (to financial claims such as debt and equity). Capital structure simply determines how these cash flows and risk are
distributed to claimants. A pie is a good analogy: A firm’s capital budge�ng determines the size of the pie, and capital structure determines who gets the pieces of the pie. In
a perfect world, capital structure has no impact on the size of the pie (i.e., the value of the firm).
Leverage and the Risk of Common Stock in Perfect Markets
The term financial leverage describes the propor�on of debt used in a firm’s capital structure. The presence of
debt in a firm’s capital structure has a magnifying effect on financial performance; just as a lever in physics
magnifies strength, financial leverage can make good cash flows to shareholders even be�er (and poor cash
flows to shareholders even worse). An all-equity firm is considered unlevered because it does not use debt to
finance its investment decisions. To demonstrate this property of leverage, we extend the donut shop example.
Suppose your donut company, The Whole Donut, Inc., required $1,000,000 in financing. The firm can be
financed either using half debt and half equity or all equity. The company can borrow $500,000 at an interest
rate of 6%. As you consider the two financing alterna�ves, your market research consultant has iden�fied three
possible cash flow scenarios for the coming year: a best case of $170,000; an expected level of cash flows of
$100,000; and a worst-case scenario, when cash flows total only $30,000. Table 9.1 shows the returns to
shareholders on the common-stock investment for both the unlevered (all-equity) financial structure and the
leveraged firm financed with $500,000 of debt and $500,000 of equity.
Table 9.1: The effect of financial leverage
Worst case Expected Best case
A. Total investment $1,000,000 $1,000,000 $1,000,000
B. Opera�ng cash flows $30,000 $100,000 $170,000
C. Return on total investment (B/A) 3% 10% 17%
All equity
D. Payments on fixed claims $0 $0 $0
E. Total residual cash flow (B – D) $30,000 $100,000 $170,000
F. Equity investment $1,000,000 $1,000,000 $1,000,000
G. Return on equity (E/F) 3% 10% 17%
Leveraged firm
H. Payments to fixed claims (6% of
$500,000)
$30,000 $30,000 $30,000
I. Residual cash flow (B – H) $0 $70,000 $140,000
J. Equity investment $500,000 $500,000 $500,000
K. Return on equity (I/J) 0% 14% 28%
First, let’s look at the rows labeled D through G in Table 9.1. For the all-equity financed firm the ROE (return on equity) ranges from 3% under the worst-case scenario to 17%
for the best case, with an expected ROE of 10%. Now, let’s look at the leveraged firm; rows H through K show results for the same firm when financed with a mix of debt
and equity. For the leveraged company, the ROE ranges from 0% under the worst-case scenario to 28% for the best case, with an expected ROE of 14%. The leveraged firm
has a higher expected ROE, but twice the range of possible ROEs compared to the all-equity firm. The table demonstrates the trade-off between risk and return when using
financial leverage. All else being equal, shareholders have a higher expected return with debt financing, but they also have a higher return variability.
This is in line with what we have already learned about risk and investment: risk-averse investors require a higher expected return if they an�cipate exposure to more risk or
variability. In our example, the 4% increase in the expected ROE will compensate investors for the greater risk created by leverage, but stock prices (and thereby firm value)
will remain the same.
This sec�on has shown that capital structure is irrelevant in perfect capital markets. But markets in the real world are not perfect. Therefore, in the following sec�on, we
relax the perfect market assump�ons to be�er reflect reality.
9.2 Imperfect Capital Markets and Capital Structure
To be�er reflect capital structure’s effect on the firm in the real world, we will relax the perfect market assump�ons made in Sec�on 9.1. In this sec�on, we introduce
imperfec�ons into our model of capital markets, crea�ng an environment that is more complicated and realis�c. As with any real-world decision that involves uncertainty,
capital structure choice will involve pros and cons, or trade-offs between the poten�al benefits of leverage and its poten�al adverse effects. Let’s begin by relaxing the
assump�on of no leakages.
Leakages
In the real world, claimants do not always receive the full cash flows; fric�ons, such as leakages, interfere. Just as fric�on lowers our ability to do physical labor, fric�ons in
capital markets lower the cash flows to investors. The first leakage we will discuss is taxes.
Taxes
Let us return to the donut shop example to illustrate how tax func�ons as a leakage. Table 9.2 shows cash flows to claimholders of The Whole Donut Inc. when the firm is
unlevered and when it is leveraged with $500,000 of debt bearing a 6% interest rate. We have assumed a 30% corporate tax rate. As Table 9.2 shows, the unlevered firm
pays $30,000 in taxes to the government, whereas the levered firm pays only $21,000. With debt financing, the leakage to the government is $9,000 less, and cash flows to
investors are $9,000 greater compared to the unlevered financing model. The $9,000 is the tax savings resul�ng from the interest being a tax-deduc�ble expense. We could
compute the interest tax savings directly as the interest expense �mes the tax rate ($9,000 = $30,000 × 0.30).
Table 9.2: The effect of taxes on cash flows
Cash Flow Unlevered $500,000 of 6% debt
A. Expected opera�ng cash flow before taxes $100,000 $100,000
B. Interest payments to debtholders (6%) $0 $30,000
C. Cash flow a�er interest payments (A – B) $100,000 $70,000
D. Corporate taxes (30% of C) -$30,000 -$21,000
E. Cash flow to residual claims (C – D) $70,000 $49,000
F. Total cash flows to all claimants (B + E) $70,000 $79,000
So, why is there a tax difference between leveraged and unlevered firms? Interest payments made by the corpora�on are paid before corporate income taxes, whereas
dividend payments are paid a�er. Thus, a firm may reduce taxes paid to the government by using more debt in its capital structure. Conceptually, a corpora�on could avoid
taxes altogether by financing exclusively with debt. If all cash flows were distributed to claimants in the form of interest payments, the government would collect no
corporate taxes because all interest would be paid before taxes. On the other hand, a corpora�on financed solely with equity would pay taxes before any distribu�ons could
be made to its suppliers of capital because dividends would be paid a�er taxes. Few firms are all-equity financed, and none are all-debt financed. The Internal Revenue
Service would probably claim that an all-debt financing scheme was a tax-avoidance strategy and would impose taxes on that por�on of the debt they felt was de facto
equity. Normally, corpora�ons have a mix of debt and equity.
As we have shown, increasing leverage reduces taxes, which increases the cash flows available to investors, thereby increasing the value of the firm. Let’s return to the pie
analogy to further explore this concept. When taxes (or other leakages) are introduced into otherwise perfect markets, a piece of the cash flow pie is effec�vely given to a
third party. By avoiding taxes through debt financing, less of the pie is distributed to third par�es, leaving more cash flows available for distribu�on to the capital suppliers. In
either case, levered or unlevered, the corpora�on’s risk is en�rely borne by these capital suppliers, so firm value will be directly linked to the amount of cash security holders
can claim. Minimizing taxes will increase cash flows, thereby increasing the value of the company. Figure 9.2 illustrates this impact of debt on a firm’s value.
Figure 9.2: Firm value with debt
This figure shows the decreasing relevance of leverage as the firm’s tax rate goes to zero (perfect markets).
Joe discusses how he used leverage to build up his business by turning his
leverage into equity, then using that equity to get more leverage. Do you
think Joe could have made his business as successful if he did not con�nue
to apply for leverage? Would you have made the same decision if it had
been your company? As you con�nue reading this sec�on, think about how
the risks associated with leverage may impact your decision.
The upper horizontal line in Figure 9.2 represents the irrelevance of leverage when capital markets are perfect. Regardless of the debt-equity mix that the corpora�on
chooses for its capital structure, firm value remains unchanged. The upward-sloping line shows the benefits of leverage. As more debt is incorporated into the firm’s capital
structure, a greater propor�on of opera�ng cash flows is distributed before taxes are paid. The deduc�bility of interest payments allows the firm to distribute more of its
cash flows, a characteris�c known as the tax shield of debt. This benefit increases firm value as the firm uses more debt.
By studying Figure 9.2, we conclude that a firm should use almost no equity in its capital structure. Indeed, in the 1980s some firms did leverage themselves to such an
extent that debt represented 70%, 80%, and even 90% or more of their capital. Yet the majority of corpora�ons did not follow the lessons of Figure 9.2, choosing instead to
keep a more moderate level of debt in their financing mix. Why didn’t they take full advantage of the debt tax shield? We answer that ques�on next, as we study a second
leakage, bankruptcy costs.
Growing Through Leverage
Bankruptcy Costs
As more and more debt is added to a firm’s capital structure, that debt becomes riskier because interest payments are fixed. If a company performs poorly, it may decide not
to pay dividends to stockholders, but it must pay interest to debtholders. Bonds and loans are contractual agreements, so if these claimants are not paid on �me and in full
they can bring legal ac�on against the company. As debt levels rise, smaller varia�ons in performance can leave a company unable to service its debt. The possibility of
default on mandatory debt service payments increases with debt levels. A default that cannot be corrected or nego�ated can lead to bankruptcy. Therefore, the probability of
bankruptcy increases as debt increases.
This figure shows how the likelihood of bankruptcy changes as more debt is introduced into a firm’s capital
structure.
Figure 9.3 is a stylized graph showing cash flows for The Whole Donut, Inc. under different economic condi�ons. Figure 9.3a shows our firm with $500,000 of debt, which
carries a 6% interest rate and requires $30,000 of annual interest payments. These required payments are represented by the do�ed horizontal line. Because the cash flows
never dip below that line, we know the firm can make its interest payments regardless of the future economic scenario. Thus, at this level of leverage, our firm’s debt is
riskless.
Figure 9.3: Bankruptcy risk with increasing debt
Now, suppose that the firm chooses to take greater advantage of debt’s tax-shielding benefits by borrowing a greater propor�on of its capital. Suppose the firm borrows
$700,000, as illustrated in Figure 9.3b. At that level of debt, the loan would no longer be riskless. Even at a 6% interest rate, lenders stand the chance of not being paid
under certain economic condi�ons because the cash flow curve falls below the $42,000 threshold. The shaded areas illustrate poten�al cash shor�alls when condi�ons are
poor for our firm’s business. Knowing this, lenders will require a higher interest rate to compensate them for this risk, say 8%. Figure 9.3c shows the interest payment
threshold of $56,000 when $700,000 is borrowed at 8%.
If the economy turns sour and cash flows are insufficient to cover interest payments, The Whole Donut, Inc. stands a chance of being unable to pay its contractual interest
(or other fixed obliga�ons). Firms unable to meet their fixed claims are in default, and this may lead to bankruptcy. Some firms may avoid default during these shor�alls by
keeping a cash reserve on hand or having other sources of capital that can be accessed to meet these obliga�ons. They may choose to borrow funds to make the payments,
or even sell more stock. However, if the shor�all is extreme, the firm may be unable to raise more cash and could be forced into bankruptcy.
Bankruptcy has many forms, but for our purposes it may be characterized as the transfer of control of assets from the residual claimants (i.e., shareholders) to fixed
claimants (i.e., lenders). A simple example will help illustrate bankruptcy and its impact. Suppose a bank lends someone the cash to purchase an automobile. The bank is a
fixed claimant, and the borrower is the owner of the car. Let’s say the owner is unable to make the payments the loan requires and is in default. This is like bankruptcy in
that the borrower must transfer ownership of the vehicle to the fixed claimant (to the bank). If this is done without fric�on, as in a perfect market se�ng, there is no loss in
the value of the automobile or the bank’s claim.
However, in an imperfect market, the bank incurs some costs when repossessing a car. It pays lawyers to do the legal paperwork, the state charges fees to transfer the car’s
�tle, and so on. These are the direct costs of this transfer. Addi�onally, the car’s owner may have neglected to maintain the vehicle in an effort to conserve cash and avoid
default. Once the bank has possession of the car, this deferred maintenance must be done at a cost to the bank. Bank officers will also spend considerable �me doing in-
house paperwork, making phone calls, and so on in order to take possession of the car. It must also absorb the adver�sing costs associated with selling the automobile.
The figure shows forecasted cash flows across economic condi�ons, highligh�ng the impact of poten�al
bankruptcy costs.
In a perfect market, even repossessing a car due to a borrower’s
bankruptcy does not have a nega�ve impact on the bank, but in
reality, markets are far from perfect.
McClatchy-Tribune/Ge�y Images
These ac�vi�es are costly and represent the indirect costs of the transac�on. Both the direct and indirect costs
of transferring ownership of the car represent fric�ons in this transac�on, and they effec�vely lower the value
of the car to the bank.
Similarly, corporate bankruptcies are characterized by fric�ons. Residual claimants will not costlessly transfer
their ownership rights to fixed claimants once they recognize that the firm cannot meet its fixed claims. There
are costs inherent to the bankruptcy procedure.
The direct costs of bankruptcy include a�orney’s fees and court fees. Indirect bankruptcy costs include
management’s �me spent on paperwork, phone calls, mee�ngs, and so on, which could otherwise be spent on
more produc�ve ac�vi�es. Furthermore, some key employees may conclude that, given the firm’s financial
distress, now is a good �me to take another job, which is also costly to the corpora�on. Customers may stay
away from the firm’s products because they fear that the firm’s guarantees will not be honored as a result of
the bankruptcy. Distressed airlines, for example, o�en find demand for their services declines as customers
worry about deferred aircra� maintenance or canceled flights. These represent bankruptcy’s indirect costs.
All costs, direct or indirect, lower the firm’s cash flows in the event of bankruptcy. Returning to our earlier
example, imagine that The Whole Donut, Inc. began experiencing financial distress because of difficulty in
making interest payments. It is possible that the shop would try to conserve cash by reducing labor costs. The money saved could be used to meet interest payments on the
firm’s debt. However, the shop’s regular customers may begin to no�ce that they must wait longer to be served, that the shop isn’t as clean as it used to be, and that
employees aren’t as friendly due to overwork. The Whole Donut, Inc. could lose business, lowering cash flows, as a result of the cost-cu�ng strategy brought on by financial
distress. Had the company foregone leverage in its capital structure, these financial difficul�es and their accompanying nega�ve impact on firm value might have been
avoided.
Figure 9.4 is similar to Figure 9.3, but it shows the reduc�on of cash flows in the event of bankruptcy. It is important to note that the expected cash flow for the firm is no
longer $100,000. The fric�on caused by financial distress lowers the cash available to claimants in several poten�al economic condi�ons. Recognizing this, investors
incorporate these costly outcomes into their cash flow es�mates, lowering their es�mate of the firm’s expected cash flow. They may also require a higher return because of
the greater variability of cash flows given poten�al bankruptcy costs. The value of the firm must decline since expected cash flows are lower and/or risk is higher.
Figure 9.4: Bankruptcy costs
The expected cash flows are reduced by the expected costs of bankruptcy. Expected bankruptcy costs are calculated by mul�plying the likelihood of bankruptcy �mes the
poten�al costs. If there is very li�le or no debt in the firm’s capital structure, the corpora�on will not be in danger of default, and no poten�al bankruptcy costs will be
included when investors value the firm. This occurs because the probability of bankruptcy is zero or close to zero. Yet, as more debt is added, the likelihood that these costs
will be incurred becomes greater, and the expected value of bankruptcy costs rise, lowering firm value. Figure 9.5 shows the impact of bankruptcy costs on firm value as
leverage increases.
Figure 9.5: Leverage and firm value
This figure highlights leverage’s effect on firm value, taking into account taxes and bankruptcy costs.
Agency cost problems are especially troublesome in industries like
tobacco and oil. What are your thoughts about crea�ng debt in
order to reduce agency costs?
Stockbyte/Thinkstock
The lesson here is that as leverage increases, so does the likelihood of incurring bankruptcy costs or costs associated with financial distress. These poten�al costs reduce firm
value, par�ally offse�ng the tax benefit of debt. This is the first trade-off men�oned earlier: Managers must balance the tax advantage of debt against the poten�al for
costly bankruptcy. Leveraging the firm reduces the leakages to the government (lowers taxes), while increasing poten�al leakages to third par�es in the form of bankruptcy
proceedings or financial distress (lawyers’ fees, court costs, customers lost to compe�tors, etc). The role of leverage and bankruptcy costs is an important topic. But what
happens when corporate managers know more about the firm’s ac�vi�es than do most corporate owners? We address this issue, informa�on asymmetry, next.
Information Asymmetry
When capital markets are perfect, no informa�on gap exists between corporate insiders and outsiders. This means that all market par�cipants have the same, or symmetric,
informa�on. In such condi�ons no agency problem would exist because investors would observe the problem (excessive perquisite consump�on, growth for growth’s sake,
shirking behavior, etc.) and take remedial ac�on. When we drop the assump�on of symmetric informa�on, we get a much more realis�c view of how corpora�ons conduct
their affairs. Next, we discuss an issue related to the informa�on asymmetry present in an imperfect market: agency costs.
Agency Costs
Asymmetric informa�on means that corporate managers know more about many of the firm’s ac�vi�es than do most corporate owners—the outside shareholders. Under
these condi�ons, agency problems can arise and be quite costly. How does leverage affect agency problems? The answer lies in the discipline of debt.
To understand the discipline of debt, first consider the nature of the manager–stockholder agency problem. Managers control corporate expenditures and oversee their own
efforts. They may choose to invest cash in wasteful purchases—unneeded corporate jets, luxury offices, and so on—and they may choose to play a lot of golf or take two-
hour lunches on company �me. These resources, corporate cash and managerial effort, could be put to be�er, wealth-producing use. In sum, agency problems can be costly
for the corpora�on. Now, consider bankruptcy, the likelihood of which increases with leverage. In the event of bankruptcy, or financial distress that could lead to bankruptcy,
managers are o�en fired, demoted, or re�red early. These consequences of bankruptcy are especially costly to managers who have most of their “wealth” linked to their jobs
(e.g., their human capital and financial capital). Shareholders, who also suffer from bankruptcy’s costs, are not affected to the same degree as managers are because
investors’ por�olios are diversified. With so much depending on their careers, managers are highly mo�vated to avoid bankruptcy.
But what happens to agency costs when a firm’s leverage increases? Leverage increases the likelihood of
financial distress, threatening management’s job security. Management’s fear of bankruptcy causes them to
become more frugal, conserving cash to minimize the chances of a default. In order to accomplish this,
managers of highly leveraged firms work hard to cut wasteful pursuits. As a result, agency costs are reduced,
and firm value increases. They may play less golf during business hours and work harder to avoid financial
distress. In essence, they waste less money, and they waste less �me. This is the discipline of debt. The
discipline of debt argument asserts that firms become more efficient and therefore more valuable as leverage
increases.
Some industries may be more suscep�ble to agency costs than others. Michael Jensen developed the discipline
of debt theory, arguing that the agency cost problem would be par�cularly severe in companies with large cash
flows and limited growth or investment opportuni�es. Such companies have excessive funds for managers to
spend but few value-crea�ng investments to make. Industries that fit this descrip�on include the tobacco or
cigare�e industry and, when oil prices are high, the oil and gas industry. Debt reduces the cash available to
managers to spend by requiring it be paid to lenders. Dividends do not func�on in the same way as debt;
being somewhat discre�onary, they usually don’t have the same agency cost-reducing effect that debt has.
Figure 9.6 illustrates the effect of debt’s discipline on firm value.
Figure 9.6: Leverage and firm value, with agency costs
This figure shows four scenarios where leverage impacts a firm’s value:(1) markets are perfect, (2) taxes are
introduced, (3) bankruptcy costs are included, and (4) the discipline of debt is also considered.
Now that we have discussed how informa�on asymmetry can lead to agency cost problems, and how those problems can be addressed, we can discuss another factor
related to informa�on asymmetry in imperfect markets: debt signaling.
Signaling With Debt
Knowing that leverage may lead to financial distress and possibly the loss of their jobs, you might ask why a manager would ever take on more debt financing. With
informa�on asymmetry, outside stockholders must es�mate firm value without all the informa�on that inside managers have. Ra�onal investors will typically assign at best an
average value (but more likely a lower value) to aspects of a business about which they are uncertain. Managers don’t want their companies undervalued (they own stock in
the company, and their performance is o�en related to share price). Issuing debt helps address this undervalua�on problem.
Debt may be viewed as management’s signal of the firm’s future cash flow prospects. When firms take on greater leverage, the managers, whose decision it was to increase
leverage, must believe that the firm’s future cash flows are sufficiently large and steady enough to make higher interest payments. Thus, such leveraging decisions signal
management’s faith in the corpora�on’s cash flow–producing capabili�es. Because leverage is increasing, the signal to outsiders is that the firm has a greater capacity for
servicing its debt, meaning cash flows are expected to increase in management’s view. Therefore, the corpora�on’s value will increase in the opinion of outsiders, based on
the signal from management.
But why don’t managers simply announce that cash flow prospects have improved? An announcement would convey the same informa�on as the leveraging signal, so why
opt for the riskier op�on? The answer lies in the faith outsiders put in the informa�on; that is, increasing leverage is a more credible signal than an announcement from
management. Posi�ve announcements carry li�le weight with outsiders, as managers generally suffer few penal�es for misrepresen�ng a company’s future cash flow
prospects. Nega�ve announcements, however, are usually taken seriously because they are usually made only when a situa�on is so severe that there is no “glossing it over.”
In contrast, a leveraging signal is credible because of the poten�al penalty for managers—loss of their job if the firm can’t meet its debt payments.
Consider the opposite signal, increasing the equity base. Suppose a firm issued and sold addi�onal stock using the funds to pay off debt. Such ac�on reduces fixed claims on
cash flows, thereby reducing the likelihood of financial distress. Perhaps management feels the firm’s future cash flows may be more variable or at a lower level than they
have been in the past. In order to reduce the chance of default, management reduces leverage, signaling to stockholders that the firm has less value. Perhaps instead,
management sold the stock to raise funds because, with their inside informa�on, they feel the stock’s value is currently too high. In this case, the firm realizes it is wise to
sell some stock to raise funds before the market discovers its error and lowers equity’s price. In both cases, the signal is clear: Firm value is too high in light of management’s
informa�on. Leverage, therefore, may be a credible signal of management’s superior informa�on about firm value: Increasing leverage signals increasing value and vice versa.
Clearly, there are trade-offs to consider when deciding which capital structure should be used to finance the firms’ investments in an imperfect market. Tax benefits are
par�ally offset by bankruptcy costs, which tend to be offset by the discipline of debt. Debt may also be viewed as a signal of the firms’ future prospects, given the inside
informa�on of management. Note that there are no formulas in this chapter that let us solve for the op�mal degree of leverage. Instead, managers must evaluate the
characteris�cs of the firm and its environment in order to arrive at the best es�mate of the firm’s op�mal capital structure. The next sec�on outlines factors that should be
considered in making that decision.
9.3 Determining Target Capital Structure: Trade-Off Theory
So far we have discussed what is o�en called the trade-off theory of capital structure. The trade-off theory argues that companies have an op�mal level of debt (a mix of
debt and equity that maximizes value). This op�mum point is a trade-off between the tax and agency cost reduc�on benefits of debt and its bankruptcy costs. This op�mum
point becomes the target capital structure that companies strive to maintain. Another way to look at the target capital structure is as the company’s debt capacity, or the
maximum amount of debt that can be safely serviced. Debt capacity implies that debt is a valuable resource and that a company that does not u�lize its capacity to borrow
may not be maximizing value for shareholders. In this sec�on, we discuss the characteris�cs that determine a company’s debt capacity, as suggested by the trade-off theory:
taxes, poten�al bankruptcy costs, agency costs, and signaling.
Taxes
As we have shown, taxes func�on as a leakage that can nega�vely impact the value of a firm. Tax rates can vary between states, countries, and even industries. Fortunately,
there are op�ons for shielding a firm from taxes, with some firms seeing more of a benefit from these op�ons than others. The higher the tax bracket a firm finds itself in,
the greater the tax-shielding benefit of debt will be for that corpora�on, and the more leverage the firm should employ in its capital structure. On the other hand, firms with
large tax-loss carry-forwards or high deprecia�on expense will garner less benefit from leverage’s tax shield and will choose lower levels of debt. This is also true for start-up
firms that have not yet reached profitability and therefore pay no taxes. When determining target capital structure, managers must weigh a firm’s tax burden against its
ability to carry debt. Without proper considera�on, a firm may find itself in danger of bankruptcy.
Bankruptcy
Two considera�ons must be given to bankruptcy when determining debt capacity: the likelihood of default and the costs of bankruptcy. We will look at each of these
considera�ons in turn, star�ng with what determines a firm’s likelihood of default.
Likelihood of Default
To es�mate the likelihood of default, a firm must es�mate the level of expected cash flows and their variability. To illustrate this, we will compare three firms’ future cash
flows, as shown in Table 9.3, using a sine-wave model in Figure 9.7.
As you can see, Firm A has a greater debt capacity than either Firm B or Firm C. Given the es�mated minimum level of cash flow, Firm A could take on fixed obliga�ons of
$75,000 per year that would be virtually riskless. This is not the case for Firms B and C. Firm B could carry more debt than Firm C because its cash flows are less variable.
Any amount of debt taken on by Firm C would carry a risk premium because in some economic condi�ons the firm would produce a cash flow deficit, which increases its
likelihood of default.
Figure 9.7: Debt capacity, Firms A–C
This figure illustrates forecasted cash flows and debt capaci�es for Firms A–C across varying economic
condi�ons.
During tough economic �mes, luxury
goods shops like jewelry stores are
especially impacted. When economies
improve, do you think people are likely to
re-indulge in luxury goods or stay
prac�cal?
Associated Press
The product market in which a firm competes plays a key role in determining its cash flow characteris�cs. For example, u�li�es
operate in markets where product demand is rela�vely price-inelas�c; that is, price has li�le impact on demand for the product.
Consumers and businesses use a certain level of energy, regardless of the economic climate. This rela�vely stable demand enables
providers to use high degrees of leverage in their capital structure. Extremely cyclical businesses, like home construc�on, would be
more uncertain of their level of future cash flows, and producers of nonessen�al luxury goods may find that product demand varies
radically with economic condi�ons. Such firms would carry lower propor�ons of debt than u�li�es with their more stable cash flows.
A second factor that impacts a firm’s likelihood of default is its mix of opera�onal fixed costs and variable costs. This is known as the
company’s opera�ng leverage. Fixed costs do not vary with produc�on; these are costs such as rent or salaried workers. Variable
costs are dependent on the firm’s ac�vity; these include raw materials, labor, and sales commissions. Fixed costs increase a firm’s
poten�al for financial distress in an economic downturn; as fixed costs increase, so does the likelihood of default. On the other hand,
we see the opposite effect during good economic �mes, with fixed costs benefi�ng the firm when ac�vity increases. O�en, firms may
subs�tute fixed costs for variable costs in their opera�ng structure in the same way they might subs�tute debt for equity in their
capital structure. Just as added debt increases financial leverage, more fixed opera�ng costs increase opera�ng leverage. Both types
of leverage tend to magnify the firm’s performance and risk: Leverage makes good �mes be�er and makes bad �mes worse.
To illustrate opera�ng leverage, consider the opera�ng costs for two retail clothing stores, as represented in Table 9.4. Store A pays its
salesperson a 50% commission on sales, (a variable cost), while Store B pays its salesperson a salary of $2,000 a month (a fixed cost).
Now, consider two possible economic environments: good and poor. In poor �mes, both firms sell $1,000 worth of goods in a month;
in good �mes both stores sell $5,000 worth of goods in a month. Which store has more opera�ng leverage? Which is more likely to
default on its payments to its sales staff? Which can maintain a higher degree of financial leverage? In this example, the store with
lower opera�ng leverage (lower fixed costs) has greater debt capacity.
Table 9.4: The effect of opera�ng leverage on profitability
Good economic �mes Poor economic �mes
Store A Salary $0 $0
Commissions $2,500 $500
Opera�ng profit (or loss) $2,500 $500
Store B
Salary $2,000 $2,000
Commissions $0 $0
Opera�ng profit (or loss) $3,000 ($1,000)
Now that we have covered the factors that impact a firm’s likelihood of default, we can move on to the other aspect of bankruptcy that should be considered when
establishing debt capacity: bankruptcy costs.
Cost of Bankruptcy
The costs of bankruptcy are another determinant of corporate borrowing capacity. Recall from Sec�on 9.2 that bankruptcy is essen�ally the transfer of asset ownership from
residual claimants to fixed claimants. The fric�ons associated with such a transfer are somewhat predictable. For example, the liquidity of the firm’s assets affects the level of
expected bankruptcy costs.
Characteris�cs of the assets themselves can impact the ease of transfer, thereby affec�ng bankruptcy costs. As a general rule, tangible assets are more easily sold (more
liquid) than intangible assets. This means that businesses whose assets are primarily land, buildings, and equipment would have lower bankruptcy costs than those whose
value depends on intangibles, such as the firm’s reputa�on or the brand value of its products. Cash and marketable securi�es are easily (almost costlessly) transferred from
owner to owner, while work-in-progress inventory is o�en sold in financial distress yielding $0.50 or less per dollar invested. Asset specificity adds to cost of transfer,
lowering liquidity and increasing expected bankruptcy costs. For example, an abandoned nuclear power plant, despite its tangible nature, has almost no alterna�ve use—thus
it is considered a highly specific asset. This plant may have cost billions of dollars to construct, but almost no one would be willing to receive it as a gi�—free of charge. In
fact, most would require compensa�on just for accep�ng such a gi�. In a bankruptcy, such an asset would have a very high transfer cost. On the other hand, a delivery truck
can be more easily sold because it can be used in a variety of ways. The vehicle’s use is not highly specific, a characteris�c that enhances its marketability and helps
contribute to lower bankruptcy costs.
To summarize, bankruptcy’s impact on leverage depends on the likelihood of its occurrence and the costs associated with the procedure, should it occur. Evalua�on of these
considera�ons involves analysis of the firm’s capacity to generate future cash flows and of the nature of the assets underlying the business. This explains why lenders look at
two factors when considering the debt capacity of a borrower: (1) the primary source of repayment (cash flow) and (2) the collateral (the assets backing the loan) that could
be sold as a secondary source of repayment. As a result, firms (or individuals) with high and steady cash flows who hold assets easily marketed for their full value can borrow
more than those without these characteris�cs. By borrowing more, they are able to take greater advantage of debt’s tax-shielding benefit.
Next, we discuss how agency cost problems play into determining target capital structure.
Agency Problems
We covered agency cost problems in detail in Sec�on 9.2. As you recall, mature companies with high cash flows and few posi�ve NPV investment projects o�en find
themselves with excess cash on hand. Firms that are flush with free cash flow (cash not needed to fund promising projects) have a higher poten�al for wasted money and
�me than those s�ll in their forma�ve stage. Addi�onally, managers of widely owned companies are less likely to be held accountable for costly ac�vi�es because no single
stockholder owns sufficient stock to present a threat to incumbent management. When combined, free cash flow and widely dispersed ownership are ingredients that foster
wasted resources. These firms may benefit from the discipline of debt because leveraging upward puts more pressure on management to perform effec�vely and efficiently.
As fixed claims increase, free cash flow is paid out, reducing the possibility for discre�onary expenditures, like excessive perquisites. If the poten�al for costly agency
problems exists within the firm, incorpora�ng debt into the target capital structure can add value.
Signaling
Another considera�on in determining target capital structure is the use of leverage as a signal to outside shareholders and analysts. If, for example, managers are confident
that the firm’s performance is improving, then a strong signal would be to borrow funds and use the proceeds to repurchase some shares. By taking on more debt,
management is signaling the firm’s ability to meet a higher level of fixed claims. Addi�onally, insiders might direct the firm to repurchase shares when the share price is
below its value—in other words, when buying one’s own shares is a posi�ve NPV investment. When determining debt capacity, managers must decide if the condi�ons are
right for debt signaling, and how their signal will be interpreted by firm outsiders.
Field Trip: Small Business Lending
To see small business lending in ac�on, visit:
h�p://www.bankrate.com/calculators/index-of-small-business-calculators.aspx (h�p://www.bankrate.com/calculators/index-of-small-business-calculators.aspx)
There are many useful links on this page for a small business owner, including free access links to calculate current ra�os, quick ra�os, debt-to-asset ra�os, return on
assets, gross profit margin, and opera�ng profit percentage.
Reflec�on Ques�on
Suppose you own a florist shop and want to track your gross profit margin and opera�ng profit percentage over the course of a year. How will these figures fluctuate
from season to season? What factors might impact these numbers?
Now that we have covered how the components of trade-off theory play into determining capital structure, we will look at other factors management may consider when
establishing debt capacity.
9.4 Determining Target Capital Structure: Looking Beyond the Trade-off Theory
The empirical evidence doesn’t support the no�on that companies constantly fine-tune their capital structure to be at or near their op�mal mix of debt and equity. Observers
see companies going years between security issues that would bring them back toward their historical debt ra�os. How can this slow response be explained? In this sec�on,
we look beyond trade-off theory, at other factors that also appear important to companies when determining debt capacity.
Transaction Costs
Transac�on costs may help explain the delayed response some companies have shown in issuing securi�es. Also known as issuance costs, transac�on costs are the costs
associated with issuing securi�es in the public capital markets. There are two types of transac�on costs: direct and indirect. Direct costs are the fees paid to lawyers,
accountants, and investment bankers; lis�ng fees paid to exchanges, prin�ng, adver�sing and marke�ng costs; and management �me spent on the issuance process rather
than other ac�vi�es. Indirect costs include underpricing of security issues by underwriters and any reac�ons in the price of exis�ng securi�es to the announcement of a new
issue. Table 9.5 shows the direct costs for various sizes and types of securi�es.
Table 9.5: Sample transac�on costs for corporate securi�es
Amount issued (in millions) New equity IPO Seasoned equity Conver�ble bonds Straight bonds
>$40 12.2% 8.8% 7.4% 2.9%
$40–$100 8.5% 5.5% 3.5% 2.1%
>$100 6.8% 4.0% 2.6% 2.2%
Weighted average 11.0% 7.1% 3.8% 2.2%
Source: Lee, Lochhead, Ri�er, & Zhao (1996).
Here we define the various securi�es listed in the table:
New equity IPO is the very first issuance of stock for a company; the company’s ini�al public offering. Determining the market value of an IPO is difficult, so underwriters
and investors tend to severely underprice these issues. This leads to large indirect issuance costs in addi�on to the high direct costs. More on this below.
Seasoned equity is an issue of more common stock being offered to the public by a company that already has publicly traded common stock outstanding. These new shares
will dilute exis�ng ownership, so some shares of stock have preemp�ve rights, which give exis�ng shareholders the right to buy shares in any new stock issues to maintain
their original propor�onal ownership. Most states do not require companies to include preemp�ve rights in their ar�cles of incorpora�on, so this right is not guaranteed.
Seasoned equity offerings are valued based on the market value of the exis�ng shares, so underwriter underpricing is much less than in IPOs.
Conver�ble bonds are bonds characterized by both a debt and equity component. While the debt por�on is rela�vely easy to value the equity por�on can be complex,
increasing the cost of issuance.
Straight bonds are also known as nonconver�ble bonds. This debt is rela�vely easy to value. Once the bond issue is rated and a coupon rate set, it is a standard present
value exercise.
Looking at Table 9.5, we observe some clear pa�erns. First, no�ce that smaller issues cost more than larger issues of the same security. This suggests higher fixed costs
associated with the underwri�ng and issuance process. Second, the more difficult a security is to value, the higher the costs. Equity for a new firm is the most difficult to
value because the company has a limited track record, may be offering a new product in a rela�vely new market, and may have untested managers (venture capital or
private equity costs could be higher s�ll, since those valua�ons would be more complex than for companies ready to go public). On the other hand, seasoned equity is
simpler because there is an exis�ng stock price, but the value of the stock (new and exis�ng) ul�mately depends on what the company plans to do with the proceeds. If
investors believe that managers will make poor use of the money, they will push share prices down (increasing indirect issuance costs). Valua�on, then, is more complex than
se�ng the price at or near current market value; it must also include analysis of the firm’s intended use of the issuance’s proceeds.
As discussed earlier in this chapter, asymmetric informa�on complicates the process of pricing equity (both new and seasoned). To illustrate, consider a company with a
posi�ve NPV project it wants to finance. The firm has the op�on of issuing either debt or equity. If the CEO works for the benefit of exis�ng shareholders, she will offer only
equity if it is fairly or overpriced. This means that investors may be paying too much for the new stock offerings. To combat this, investors will only buy new shares at a
discount, so we see new shares selling below the price of the shares immediately before the new stock offering is announced. This is supported by the following facts:
Offerings of seasoned equity generally occur the year following steady share price increases (consistent with the stock being over valued).
Stock performance tends to be subpar for five years following the issuance of a seasoned equity offering.
With the high transac�on costs related to issuing equity, companies must take careful considera�on before incorpora�ng security issues into their target capital structure.
These costs have even led to the development of an alterna�ve theory of how companies make the debt-equity decision: the pecking order theory.
The Pecking Order Theory
So far, this chapter has argued that firm value can be maximized at some target amount of debt; that is, that companies have an op�mal capital structure. The pecking order
theory of capital structure takes an en�rely different view of how companies choose their financing mix. This theory, developed by Stuart Myers of MIT, argues that the high
costs of issuing securi�es in the capital market drives companies to fund as much of their investment as possible from internal sources (e.g., retained earnings). By using
internal sources, companies hope to avoid the costs associated with issuing pricey securi�es (e.g., equity). When external funds must be used, companies will choose to use
funds in order of their safety and cost effec�veness. First, they will issue safe debt. If more funds are needed for investment in produc�ve assets, companies will then issue
The pecking order theory says that companies raise funds by first using internal resources, then safe debt,
risky debt, and finally equity.
Considering the pecking order theory of capital structure, applying
for a bank loan would rate toward the bo�om of the ideal debt list
for most companies.
Bloomberg/Ge�y Images
risky debt. Finally, if the company doesn’t want to bear too much bankruptcy risk, they will issue equity. Figure
9.8 outlines the pecking order theory’s process of raising funds for investment.
Figure 9.8: Pecking order theory
Companies following the pecking order theory want to avoid issuing equity unless it is absolutely necessary, as the direct and indirect costs are very high. Debt issues—
par�cularly highly rated or rela�vely safe debt—will have the absolute lowest costs of all sources of external finance. Retained earnings have no issuance costs whatsoever,
and for this reason they are at the top of the pecking order. This model is significantly different than the trade-off theory, as it disregards a target debt level. Instead,
companies looking to invest in projects consider internally generated cash flow, their investment opportuni�es, and the costs associated with security issuance.
Next, we look at how a firm’s financial flexibility plays into determining its op�mal capital structure.
Financial Flexibility
Recent research points to the importance of financial flexibility as a driving force in capital structure and debt levels. For example, companies appear to have debt targets
somewhat lower than expected. DeAngelo, DeAngelo, and Whited (2011) argue that this allows companies to maintain financial flexibility, or the ability to raise funds for
investment (and paying dividends) during periods when cash genera�on is low. The no�on of financial flexibility also explains why companies some�mes issue debt and
exceed their es�mated target debt levels and then slowly adjust back toward the target. In a survey of about 250 global companies, Servaes and Tufano (2006) find that
financial flexibility (the ability to con�nue making investments and paying dividends) are the second and fourth ranked determinants of debt levels.
One important aspect of financial flexibility is maintaining a high credit ra�ng. Having a high credit ra�ng means companies are able to issue debt at a reasonable cost at any
�me. This helps support flexibility. The Servaes and Tufano survey found that corporate managers are very concerned with maintaining the firm’s credit ra�ng.
Ch. 9 Conclusion
As we said at the beginning of this chapter, debt acts like a lever in finance. When the firm is doing well, financial leverage increases the return to stockholders. When �mes
are tough, it magnifies the nega�ve effect on shareholders’ returns. The more leverage a company uses, the greater the magnifying effect. Thus, leverage can increase
expected returns, but it also increases variability or risk. In perfect capital markets, these two effects offset one another, leaving value unchanged.
In reality, there are market imperfec�ons that complicate decisions regarding capital structure. The choice can be likened to a balancing act between the benefits of debt and
its value-harming effects. Debt may increase cash flows to claimants by avoiding corporate taxes, by limi�ng agency problems, and by sending a posi�ve signal to outsiders.
On the other hand, added leverage increases the likelihood of a costly bankruptcy.
Although there is no precise method for finding the op�mal capital structure of a firm, certain characteris�cs of corpora�ons help to guide managers toward an appropriate
target structure. First, firms with high taxable income opera�ng in areas with high corporate tax rates should consider higher leverage. Next, corpora�ons with widely
dispersed ownership and excess free cash flow may find that leverage lowers poten�ally wasteful cash expenditures. Leverage may also be used as a signal of the increased
debt capacity of the borrower. Finally, firms may deviate from op�mal target debt levels to maintain financial flexibility.
As firms raise new capital, they also consider the costs associated with different forms of financing. These costs can be direct, like the fees paid to banks and lawyers, or they
may be indirect, like the underpricing of newly issued equity. The pecking order theory says firms will first a�empt to raise capital from sources with the lowest transac�on
costs (e.g., retained earnings) before issuing securi�es associated with higher fees or risky mispricing as is o�en the case with issues of new equity.
The benefits of leverage must be balanced against the corpora�on’s poten�al bankruptcy costs. Firms with more vola�le cash flows are in greater jeopardy of experiencing
financial distress than firms with stable cash flows. Therefore, businesses should consider the stability of their income when targe�ng their debt level. Should a firm have
financial difficulty, those with highly liquid or marketable assets should experience lower bankruptcy costs than those whose assets are unique or specific to their current use.
Firms with illiquid, highly specific assets have higher poten�al bankruptcy costs and must carefully consider their levels of debt. In Chapter 10, we examine corpora�ons’
dividend policy. As you will see, dividend policy and the capital structure decision share many of the same features.
Ch. 9 Learning Resources
Key Ideas
The mix of debt and equity used to finance the firm’s investments is known as its capital structure.
The debt-equity decision is ini�ally examined under the assump�on of perfect capital markets. Under such condi�ons, it can be shown that firm value is unaffected by
capital structure. The capital structure is said to be irrelevant because the mix of debt and equity financing has no impact on either the overall cash flows or their riskiness.
The use of debt in a firm’s capital structure is called leverage. Just as a lever increases power, the use of debt increases the impact of good (and bad) opera�ng results.
Because interest is tax deduc�ble, the use of debt protects cash flows from taxa�on.
Bankruptcy costs represent a poten�al leakage of cash flows from the firm, caused by the use of debt in its capital structure.
The capital structure decision involves balancing the benefits of debt, like its tax deduc�bility, against the poten�al costs associated with its use, including the poten�al for
bankruptcy.
The use of debt may be interpreted as a signal that the firm has improved prospects.
A firm’s target capital structure is affected by taxa�on, poten�al bankruptcy costs, agency costs, and signaling.
Cri�cal Thinking Ques�ons
1. Explain why there is no agency problem when there is no informa�on asymmetry.
2. Why does the Securi�es and Exchange Commission require firms with traded securi�es to have their financial statements audited by an outside accoun�ng firm according to
generally accepted accoun�ng principles? (Hint: Think of informa�on asymmetry.) Is the cost of having the firm’s financial statements audited an agency cost? Why or why
not?
3. Do you think a corpora�on must actually declare bankruptcy to incur costs associated with financial distress? Could rumors of financial problems lead to costs? How would
these costs lower firm value? Explain your answers.
4. Suppose two countries have iden�cal economic environments except that Country X allows interest payments to be deduc�ble for corporate income tax purposes and
Country Y allows only half of a firm’s interest expense to be deducted. Would you expect to see, on average, greater use of leverage by corpora�ons in Country X or in
Country Y?
5. Affiliated Industries Incorporated (AII) is a corporate giant. It is highly profitable, producing cash flows far beyond those required to fund its new posi�ve net present value
projects because it is in a mature industry with few growth opportuni�es. Yet AII has tradi�onally retained much of this residual cash rather than paying it out as dividends.
Would you, as a stockholder, be pleased or displeased if AII announced an increase in leverage by using its cash to repurchase a large propor�on of its stock? Explain using an
agency-related ra�onale.
6. Total leverage describes a firm’s degree of opera�ng leverage plus its degree of financial leverage. Consider two u�lity companies, each with 50% debt in their capital
structure. Washington State Electric generates hydroelectric power at its dam across the Rapid River in the Pacific Northwest. Smokey Mesa Power is located in Arizona and
generates its power at the coal-burning Black Cloud Power Plant. What are the raw materials for each electric genera�on process? Which u�lity is exposed to more price
uncertainty regarding its cost of these raw materials? Which u�lity has more opera�ng leverage? Which one has more total leverage?
7. Managers naturally want to protect their jobs. For them, the chance of a firm’s bankruptcy is more threatening than for the firm’s shareholders. Given this, do you think
managers are biased against certain poten�al investment projects that have high risk? Assuming they are, is this bias in the best interest of shareholders? What if the risky
project has a posi�ve NPV? Could this bias affect firm value, and, if so, will its affect get stronger as the firm takes on more debt? Is this type of agency cost a pro-leverage or
an�-leverage argument?
The direct (a�orney’s fees and court fees) and indirect (management’s �me spent on paperwork, phone calls, mee�ngs, and so on, that could otherwise be spent on more
produc�ve ac�vi�es) costs of filing for bankruptcy.
capital structure
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The mix of debt and preferred equity in a company’s por�olio.
The maximum amount of debt that can safely be serviced by a firm.
discipline of debt
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Financial theory that asserts firms become more efficient and therefore more valuable as leverage increases.
The ability of a firm to raise funds for investment (and paying dividends) during periods when cash genera�on is low.
pecking order theory
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Theory developed by Stuart Myers of MIT that argues that the costs of issuing securi�es in the capital market is so high that companies will try to avoid these costs.
Companies consider internally generated cash flow, their investment opportuni�es, and the costs associated with security issuance.
signal
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
An outward measure of the financial health of a company.
target capital structure
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The op�mum mix of debt, preferred stock, and equity that maximizes firm value.
trade-off theory of capital structure
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Theory that argues that companies have an op�mal level of debt (a mix of debt and equity that maximizes value). This op�mum point is a trade-off between the tax and
agency cost reduc�on benefits of debt and its bankruptcy costs.
Web Resources
For a step-by-step guide to the IPO process, see David Newton’s ar�cle, “The ABC’s of the IPO Process,” Entrepreneur Magazine:
h�p://www.entrepreneur.com/ar�cle/75252 (h�p://www.entrepreneur.com/ar�cle/75252)
Find small business tax informa�on at:
h�p://www.sba.gov/content/learn-about-your-state-and-local-tax-obliga�ons (h�p://www.sba.gov/content/learn-about-your-state-and-local-tax-obliga�ons) and
h�p://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed (h�p://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed)
Capital structure irrelevance was proven for perfect markets by Franco Modigliani and Merton Miller in one of the most important ar�cles ever wri�en in economics. They
have both received Nobel prizes, in part for their capital structure studies. Read “The Cost of Capital, Corpora�on Finance and the Theory of Investment,” American Economic
Review, 48 (June 1958) here:
h�ps://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/MM1958 (h�ps://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/MM1958 )
Students interested in agency problems or corporate takeover ba�les are advised to read Barbarians at the Gate, the story of the ba�le for control of RJR-Nabisco, which led
to one of the largest corporate takeovers in history. It was made into a movie, which can be viewed here:
h�p://youtu.be/iPhF_YwWvoM (h�p://youtu.be/iPhF_YwWvoM)
We provide professional writing services to help you score straight A’s by submitting custom written assignments that mirror your guidelines.
Premium Quality
Get result-oriented writing and never worry about grades anymore. We follow the highest quality standards to make sure that you get perfect assignments.
Experienced Writers
Our writers have experience in dealing with papers of every educational level. You can surely rely on the expertise of our qualified professionals.
On-Time Delivery
Your deadline is our threshold for success and we take it very seriously. We make sure you receive your papers before your predefined time.
24/7 Customer Support
Someone from our customer support team is always here to respond to your questions. So, hit us up if you have got any ambiguity or concern.
Complete Confidentiality
Sit back and relax while we help you out with writing your papers. We have an ultimate policy for keeping your personal and order-related details a secret.
Authentic Sources
We assure you that your document will be thoroughly checked for plagiarism and grammatical errors as we use highly authentic and licit sources.
Moneyback Guarantee
Still reluctant about placing an order? Our 100% Moneyback Guarantee backs you up on rare occasions where you aren’t satisfied with the writing.
Order Tracking
You don’t have to wait for an update for hours; you can track the progress of your order any time you want. We share the status after each step.
From brainstorming your paper's outline to perfecting its grammar, we perform every step carefully to make your paper worthy of A grade.
Preferred Writer
Hire your preferred writer anytime. Simply specify if you want your preferred expert to write your paper and we’ll make that happen.
Grammar Check Report
Get an elaborate and authentic grammar check report with your work to have the grammar goodness sealed in your document.
One Page Summary
You can purchase this feature if you want our writers to sum up your paper in the form of a concise and well-articulated summary.
Plagiarism Report
You don’t have to worry about plagiarism anymore. Get a plagiarism report to certify the uniqueness of your work.
Free Features $66FREE
Most Qualified Writer
$10FREE
Plagiarism Scan Report
$10FREE
Unlimited Revisions
$08FREE
Paper Formatting
$05FREE
Cover Page
$05FREE
Referencing & Bibliography
$10FREE
Dedicated User Area
$08FREE
24/7 Order Tracking
$05FREE
Periodic Email Alerts
$05FREE
Our Services
Join us for the best experience while seeking writing assistance in your college life. A good grade is all you need to boost up your academic excellence and we are all about it.
On-time Delivery
24/7 Order Tracking
Access to Authentic Sources
Academic Writing
We create perfect papers according to the guidelines.
Professional Editing
We seamlessly edit out errors from your papers.
Thorough Proofreading
We thoroughly read your final draft to identify errors.
Thorough Proofreading
We thoroughly read your final draft to identify errors.
Delegate Your Challenging Writing Tasks to Experienced Professionals
Work with ultimate peace of mind because we ensure that your academic work is our responsibility and your grades are a top concern for us!
We Analyze Your Problem and Offer Customized Writing
We understand your guidelines first before delivering any writing service. You can discuss your writing needs and we will have them evaluated by our dedicated team.
Clear elicitation of your requirements.
Customized writing as per your needs.
We Mirror Your Guidelines to Deliver Quality Services
We write your papers in a standardized way. We complete your work in such a way that it turns out to be a perfect description of your guidelines.
Proactive analysis of your writing.
Active communication to understand requirements.
We Handle Your Writing Tasks to Ensure Excellent Grades
We promise you excellent grades and academic excellence that you always longed for. Our writers stay in touch with you via email.
Thorough research and analysis for every order.
Deliverance of reliable writing service to improve your grades.
