Lecture 10. Capital Structure and Dividend Policy

Lecture 10. Capital Structure and Dividend Policy

Readings: Chapters 16 and 18, and the article “Asymmetric Information and Dividend Policy”

One reason for starting a firm is that by organizing resources it ispossible to manufacture a product or provide a service so as to earn a greater return (for the same risk level) than individuals can earn by trying to do the same thing their own. Likewise, if organizing a firm can provide the same return but at lower risk, it benefits individuals to invest in firms rather than pursuing it themselves. A firm is therefore a vehicle for acquiring financial capital and allocating it in such a way as to maximize the return to investors for a given risk level.

One standard rule that results from this is that firms should not do for investors what investors can already do on their own. This rule is very important when considering issues of whether or not a firm should hold on to investors’ capital and reinvest it or disburse it in the form of dividend payment, stock repurchases and/or debt redemption. The most simple rule here is the if the return to investment (R) is greater than the investor required return (k, this could be the WACC) it is advisable for the firm to retain investor capital and reinvest it into productive opportunities. In that case, the firm can do something for the investors that they can not do for themselves, that is, earning a higher return at a given risk level. If, however, the return on reinvested funds is less than the cost of capital, then ideally firms should return capital to investors in the form of dividends, stock repurchases or debt redemption (usually in that order—you’ll see why). This is called the “residual theory” of distribution. It is a key to understanding the relationships between allocation (i.e., how to choose productive investments and allocate capital amongst corporate assets) and acquisition of financial capital (i.e., how to structure financial capital and distribute the cash flows earned by the firm).

By the time you have completed this week’s assignments, you should:

• Be able to define and distinguish the following concepts: asymmetric information, bird-in-the-hand theory, business risk, capital gains, capital structure, clientele, clientele effect, credible signal, direct and indirect costs of financial distress and bankruptcy, dividend irrelevance theory, dividend stability, dividends, financial leverage, financial risk, fixed costs, free cash flow theory, growth stocks, income stocks, operating leverage, optimal capital structure, optimal dividend policy, signaling theory (as applied to both capital structure and dividends), tax preference theory, variable,
• Identify and articulate the factors that influence the capital structure of a firm, and
• Identify and articulate the tax implications of dividend policy

Why Use Debt at All?

There are several important reasons for using debt in the firm’s capital structure. These are reviewed in detail in Chapter 17 of the Brigham and Ehrhardt text, but a different look will be taken here. The first and most obvious reason for using debt in the capital structure is to lower the cost of capital. As you have learned and observed, the cost of debt to a firm is lower than the cost of equity. This is due to the fact that debt represents a fixed income contract where cash flows are predetermined and paid as legal liabilities. Creditors also have priority in the event that the company is forced to distribute its capital as a result of default or bankruptcy. Stockholders, on the other hand, are “residual” claim-holders who receive what is left after all expenses and debt service has been covered. This cash flow is potentially more risky as it can be high or low. Furthermore, the interest payments to debt are tax deductible, which has the effect of lowering the cost of debt to the firm (recall that when calculating the WACC, you multiply the cost of debt by 1-tx to adjust for this deduction).

A firm’s ability to use debt financing is primarily based on the riskiness of its operating cash flows. If you looked at the financial documents of different firms, you would immediately see that they have very different mixes of debt and equity, which we refer to as their capital structure. Even within an industry there is considerable variety. The following table gives some examples:

Firm / Debt/Equity Ratio
General Motors / 17.32
Intel / 0.23
Verizon / 4.28
Black & Decker / 3.74

The general guidelines for establishing the use of debt in the corporate capital structure include the following:

• The greater the business risk (i.e., risk in the operating cash flow stream), the lower the debt,
• The greater the firm’s operating profit levels, the higher the debt,
• The greater the firm’s existing level of debt, the less additional debt it can afford,
• The greater the manager’s aggressiveness, the higher the debt, and
• The greater the growth opportunities, the lower the debt.

Business Risk versus Financial Risk

The risk of a firm is a function of two distinct factors. First, there is business (or operating) risk. Some types of businesses are just more risky than others: the grocery store business is less risky that the production of video game software. Second, there is financial risk: the more debt (or financial leverage) you have the higher the required interest payments (as opposed to dividends which are not required, but only paid at the discretion of the firm) and the greater the financial risk.

Business Risk: This source originates in the risk that is inherent in the operating activity (i.e., asset allocation) of the firm (e.g., the choice to make cars in the case of General Motors). Anything that adds risk to that productive activity contributes to business risk: changing consumer tastes, changes in the general economy, labor problems, swift and unpredictable changes in technology, volatility in the prices of raw materials, etc. This can be related to the concept of operating leverage.

Operating leverage is degree to which a firm’s costs are fixed or variable. Fixed costs typically result from capital investments, in assets such as buildings, and equipment. The cost of operating a plant is, in the short term, fixed regardless of whether it is running at high or low capacity. Variable costs are those that vary with the level of production. If demand declines I can reduce the cost of materials, but not the cost of the machinery in the production line (though I can reduce the cost of running that machinery). Some costs are to a degree fixed and to a degree variable. For example, take labor costs. It depends on how people are employed: salaried workers involved in the oversight of an operation tend to represent fixed costs, while hourly workers involved in the production process represent variable costs. The importance of this distinction is that a greater proportion of fixed costs (i.e., higher operating leverage) increases the volatility of the operating cash flow and is generally associated with more business risk. The more fixed assets the firm owns, the more revenues are pre-committed to the fixed payments. Once those fixed payments are covered, however, the greater the increase in operating profits for a given increase in revenues. With less operating leverage, cash flow volatility is more closely related to sales volatility as expenses vary more proportionally to sales.

Financial Risk: This form of risk results from the degree of financial leverage used to fund the firm. As we have noted, greater debt means that more operating cash flows are pre-committed to the fixed interest and principal payments. If the firm has no debt, then there are no required, contractual payments due to the investors of the firm. As a simplified example, consider two firms, identical except in their financial leverage (that is, they have the same business risk). Their EBIT’s will be identical. We will ignore taxes and assume each firm has a book valueof $200 (split between debt and equity) and that the return on debt is 10%.

Firm A

(All Equity, E = $200)

Cash Flow / Year 1 / Year 2 / Year 3 / Year 4
EBIT / 10 / 16 / 6 / 40
Interest Payment / 0 / 0 / 0 / 0
Net Income / 10 / 16 / 6 / 40
ROE / 5% / 8% / 3% / 20%

Firm B

(Half Debt and Half Equity, $E = 100 and $D = 100)Cash

Flow / Year 1 / Year 2 / Year 3 / Year 4
EBIT / 10 / 16 / 6 / 40
Interest Payment / (10) / (10) / (10) / (10)
Net Income / 0 / 6 / (4) / 30
ROE / 0% / 6% / -4% / 30%

There are two things readily notable about the example. First, note that in the case of the lowest EBIT level, $6, the ROE is lower in the high debt case (firm B) than in the low debt case. For the high EBIT level, however, $40, the ROE is much higher in the high debt case. This is because regardless of the level of operating earnings (EBIT), the interest payment is fixed. The payment to shareholders, however, is a residual claim whose volatility increases in the presence of leverage. The ROE itself if more volatile for firm B than for firm A.

You can also relate this to the duPont ratio, in which the third component is the leverage ratio. Recall that the higher the leverage ratio the greater the increase (and decrease) in ROE for a given change in ROA.

Optimal Capital Structure

The concept of optimal capital structure revolves around the question of: “How much debt should the firm take on?” In considering this question, we typically begin with an “all equity firm” (one having no debt) and add debt as long as the value of the firm increases. At some point, more debt will start to decrease value, and we will have reached the optimal capital structure.

One possible answer to this question is that we increase debt until the weighted-average cost of capital, WACC, is minimized. The WACC is used as the rate at which operating free cash flows are discounted to determine corporate value. It stands to reason that, for a given operating free cash flow, the lower the WACC the higher the value of the firm. The graph below provides an idea of how this would work.

When we begin the analysis, the firm is an “all equity” firm and the WACC is equal to the cost of equity. As we add debt, the cost of equity capital increases due to the increase in financial risk. The weighted-average cost of capital, however, decreases due to the replacement of high cost equity with low cost debt. It is also evident that the cost of debt rises with an increasing debt ratio, but the WACC continues to fall to a point. Beyond that point, the WACC rises because, even though you are replacing higher cost equity with lower cost debt, the financial risk premia added to both the cost of debt and the cost of equity outweighs the benefit of that replacement.

To further understand what is going on in the diagram, think back of the session where we covered the determination of a bond yield and the WACC. The bond yield, which becomes the cost of debt to the firm once it borrows in the bond markets, is driven by different factors. One of those factors is default risk. Typically, default risk increases with the amount of debt taken on by the firm. This is so because higher debt means greater interest and principal servicing requirements. Since these payments are fixed and required regardless of the operating performance of the firm, higher levels translate into higher risk, and hence, investors require a higher rate of return.

Technically, what has happened here is that there has been an increase in the likelihood of bankruptcy and/or financial distress. When firms enter bankruptcy, they face two types of additional costs: first, there are direct costs of the bankruptcy process, e.g., legal fees, and, second, there are indirect costs, i.e., those associated with an insolvent firm conducting its normal business. For example: Would you buy a computer from a firm that might go out of business? Even prior to an official declaration of bankruptcy, firms in financial distress experience these costs. In general, higher the debt the greater the future probability of financial distress and bankruptcy. We can think of these future costs, weighted by their probability and discounted, as the present value of the cost of financial distress and bankruptcy. Equity holders and less senior debt holders require higher rates of return as this present value is greater. We can explain the minimizing of WACC as involving the trade-off between the benefit of the tax advantage of debt versus the cost of financial distress and bankruptcy.

Because of these factors, the cost of equity is also directly related to the amount of debt in the capital structure. The risk of the residual cash flow available to the stockholders increases with greater amounts of debt. If a firm enters into bankruptcy, shareholders often lose most or all of their investment in the firm.

Another way to look at optimal capital structure is to consider beginning with the value of the all equity firm and considering the change as you add debt to the capital structure mix. Based on the tax effect alone, the analysis would call for an optimal capital structure of all debt. By using all debt, it would be possible to eliminate as much income from taxes as possible. This is impractical, however, because of the existence of bankruptcy costs. The higher the debt, the higher the bankruptcy costs, and eventually, the increase in bankruptcy costs exceeds the tax savings generated by the use of additional debt, and value decreases with more debt. The graph is shown below.

Other Factors Influencing Capital Structure Choice

While this is the traditional explanation of the optimal capital structure, more recently scholars have suggested several additional considerations:

• Signaling Theory: Since investors are uncertain about the true value of firms, one thing managers of good firms would like to do is inform, or signal, the market of their quality. We assume that managers know their firm’s situation better than do investors, and this is call asymmetric information. Managers could, of course, announce in a press conference that they were a good firm, but this). We is unlikely to have any effect on the market’s view of the firm (What else would you expect themanager of a firm to say?). To influence the market managers most do something toconvince the market that they are a good firm. This is often called sending a credible signal. One action that signals a good firm is issuing debt (another, as we shall see is paying dividends). We know that more debt increases financial leverage and makes the firm more risky. Managers do not want the firm to go bankrupt, so they will only allow high financial leverage if they themselves truly believe that the firm is strong. The key is that weak firms could not mimic this, i.e., issue high debt to pretend to be good firms, since they might actually go bankrupt.
• Free Cash Flow/Constraining Mangers: Managers do not always use money in ways that are best for investors. That fleet of corporate jets winging the CEO’s family to vacation hot spots probably does not do much to increase ROE! The more free cash flow around, the more likely it is to be misused. Debt helps to correct this. Since debt has required interest payments, more debt leaves less cash to be misused! In this way, debt serves as a device to discipline management by keeping them from wasting cash flows that are needed to service debt.

Please note that these theories are not incompatible, and our ultimate understanding of the optimal capital structure may well involve all of them. As noted above, optimal capital structure is not subject to mathematical precision in the sense of discounting. It is more often a judgment call, and the more aware and knowledgeable you are about the relevant factors, the better your own judgment will be

Dividends: An Overview

The second question relating to the left-hand side of the balance sheet is how much in dividends the firm should pay to equity holders. Since interest payments are fixed, there is no corresponding question regarding payments to debt holders. Equity holders have a claim upon the ‘profits’ of firm as measured by net income or, alternately, free cash flow. These can either be paid out to equity holders as dividends or held by the firm as retained earnings. The latter would help the firm grow and benefit the equity holders in the form of capital gains. The firm needs to find its optimal dividend policy. A naïve approach might be to retain enough earnings to fund all positive NPV projects, and pay out the remainder to equity holders. But this scheme does not take into account the tax consequences of dividends or their role in signaling. We shall shortly turn to several theories of dividend payments. But first we should mention four empirical facts about dividends: