Created 7/1/1996
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Business Administration 130:

Capital Structure




Dividend Policy:

Defined as the tradeoff between retaining earnings on the one hand and paying out cash on the other hand.

You can't pay out your "par" capital as a dividend...

Share repurchases as an alternative to dividends...

Lintner on dividends; firm managers are:

Partial adjustment model...

Dividend increases are good news--signal managerial optimism.

Dividend Controversy

Franco Modigliani and Merton Miller; //Homemade leverage proof:


 Liabilities + NW





 Fixed Assets


 $10,000 + NPV


 Inv. Oppor.



$10,000 + NPV

 $10,000 + NPV

Suppose you issue $1,000 dividend, financed by issuing stock...

You haven't changed the assets of the company--it still has the same cash, fixed assets, and investment opportunities; hence it still has the same total value.

If the new stockholders did their math, they have stock worth the $1,000 they paid for it after the issue. Hence old stockholders must have stock worth $9,000 + NPV. Paying a dividend and issuing shares is the same transaction as old owners selling to new purchasers. If the second doesn't change the value of the firm, why should the first?

Dividends are irrelevant once one buys the proposition that the value of a firm is the value of its current assets plus future investment opportunities.

The Right Wing:

Dividends carry information that the firm truly is healthy

Investors don't fully trust managers to handle the firm's free cash flow--but here dividend policy has an impact because it eliminates negative NPV investments.

The Left Wing:

 No-Dividend Firm

High-Dividend Firm

 Next Year's Price






Total Pretax Payoff



Today's Stock Price



Captal Gain



Before-Tax Rate of Return

=12.5/100 x 100 = 12.5%

=15.83/96.67 x 100 = 16.4%

Tax on Dividends (50%)



Tax on Capital Gains (20%)



Total After-Tax Income



After-Tax Rate of Return

=10/100 x 100 = 10%

=9.66/96.67 x 100 = 10%

Moral: Cut your dividends and expropriate a piece of the government's share of the corporation by playing the angles of the tax system.

Middle of the Road;

If companies could increase their value by increasing dividends, wouldn't they have done so already? Perhaps dividends are where they are because they are where constrained-cash-flow advantages exactly offset tax arbitrage.

Capital Structure:

MM--value independent of capital structure

"homemade leverage" proof:

Macbeth Spot Removers


 # of Shares




Mkt Value of Shares


Mkt Value of Debt


Interest @ 10%


 Operating Income



1500 (Expected Value)


Unleveraged Company

 Earnings per Share





Return on Shares





Leveraged Company






Equity Earnings per Share





Return on Shares





Isn't this "leveraging up" transaction a good thing? You raise the expected return on equity from 15% to 20%.

Yes, but--investors could get the same return by borrowing $10 at 10% and buying two shares of the unleveraged company. Same payoffs. Hence how are you making your shareholders better off?

r*e = r*a + D/E(r*a-r*d); market value of the debt-equity ratio; note that r*d varies as debt becomes more risky as leverage rises.

How Much Should a Firm Borrow?

Dividend policy doesn't matter. Debt policy doesn't matter. Yet if debt policy were completely irrelevant, debt/equity ratios should vary at random. But almost all airlines, utilities, banks, and real estate development companies rely on debt, as do steel, aluminum, chemical, petroleum, and mining firms. By contrast it is rare to find a drug company, a computer company, or a service company that relies heavily on debt at all.


Shooting for theory that combines MM with bankruptcy, taxes, and other complications.

Taxes: the Deductibility of Interest

 Firm U

Firm L

Operating Earnings






Pretax Income



Tax at 35%



Net Income to Stockholders



Total Income to Bondholders and Stockholders



Interest Tax Shield



Interest tax shields can be valuable assets. So why doesn't everyone leverage their firm up to confiscate the government's share?

Corporate and Personal Taxes; Financial Distress:

The actual tax structure is more complicated:

Shovel out money...

Financial distress:

 Value of Firm





 Value of Equity




Moderately Leveraged

 Value of Debt




Value of Equity




Highly Leveraged

 Value of Debt




 Value of Equity




 For the Lawyers...


Read for p. 489 on bankruptcy costs and the Penn Central RR

Agency problems and financial distress:

Adam Smith
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