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Created 7/1/1996
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Business Administration 130:

Capital Structure

http://www.j-bradford-delong.net/Intro_Finance/BAonethirty17.html

Basics:

• Present value of a perpetuity: C/r
• Present value of a growing (or shrinking) perpetuity: C/(r-g)
• Present value of C dollars t years from now: C/[(1+r)^t]
• Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)^t])
• "Rule of 72": (1+r)^t = 2 (approximately) whenever rt=.72
• beta = [E((r₁-r*₁)(r_m-r*_m)]/[(r_m-r*_m)²]
• r*_i = r*_f + beta_i(r*_m-r_f)
• Expected return of a portfolio with N securities, a share 1/N invested in each security:
  
• Standard deviation of a portfolio with N securities, a share 1/N invested in each security:
  

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...

• IRS has tried to define "proportional" repurchases of shares as cash dividends for tax purposes (successfully); wants to define "regular" repurchases.

Lintner on dividends; firm managers are:

• Changes much more important than levels
• Transitory earnings don't lead to dividend changes
• Terrified of reversing a recent change in dividends

Partial adjustment model...

Dividend increases are good news--signal managerial optimism.

Dividend Controversy

• Right wing: increasing payouts raise value
• Middle of the road: who cares about dividend policy?
• Left wing: increasing payouts lowers value

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

	Assets	Liabilities + NW
Cash	$1,000	0	Debt
Fixed Assets	$9,000	$10,000 + NPV	Equity
Inv. Oppor.	NPV
Total	$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	$112.50	$102.50
Dividend	$0	$10.00
Total Pretax Payoff	$112.50	$112.50
Today's Stock Price	$100	$96.67
Captal Gain	$12.50	$5.83
Before-Tax Rate of Return	=12.5/100 x 100 = 12.5%	=15.83/96.67 x 100 = 16.4%
Tax on Dividends (50%)	$0	$5.00
Tax on Capital Gains (20%)	$2.50	$1.17
Total After-Tax Income	$10.00	$9.66
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.

• But the tax reform act of 1986 equalized the tax rates (now only a small gap exists).

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

Data
# of Shares	500/1000
Price	$10
Mkt Value of Shares	$5000/$10000
Mkt Value of Debt	$5000/$0
Interest @ 10%	$500/$0

Operating Income	500	1000	1500 (Expected Value)	2000
Unleveraged Company
Earnings per Share	$.50	$1.00	$1.50	$2.00
Return on Shares	5%	10%	15%	20%
Leveraged Company
Interest	$500	$500	$500	$500
Equity Earnings per Share	0	$1	$2	$3
Return on Shares	0%	10%	20%	30%

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.

Explanation?

• Bankruptcy costs
• Taxes
• Conflicts of interest between holders of different classes of securities.

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

Taxes: the Deductibility of Interest

	Firm U	Firm L
Operating Earnings	$1000	$1000
Interest	0	$80
Pretax Income	$1000	$920
Tax at 35%	$350	$322
Net Income to Stockholders	$650	$598
Total Income to Bondholders and Stockholders	$650	$678
Interest Tax Shield	$0	$28

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...

• ...as dividends: (1-Tc)(1-Tp)
• ...as capital gains (retained earnings): (1-Tc)(1-Te)
• ...as interest (1-Tp)
• What if the marginal holder is a pension fund, or a foundation? In America today, it is probably the case that debt has a noticeable tax advantage.

Financial distress:

Value of Firm	$500	$1000	$1500
Unleveraged
Value of Equity	$500	$1000	$1500
Moderately Leveraged
Value of Debt	$400	$400	$400
Value of Equity	$100	$600	$1100
Highly Leveraged
Value of Debt	$300	$800	$800
Value of Equity	$0	$200	$700
For the Lawyers...	$200

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

Agency problems and financial distress:

• Gambling for resurrection
• Refusal to contribute equity capital
• Cash-out-and-run
• Play for time (a version of gambling for resurrection)
• Bait-and-switch (RJR LBO: took $300 million from the bondholders)

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