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Easy 4.0 Education Inc.

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TABLE OF CONTENT

1. Cost of Capital
Case 5: It’s Better To Be Safe Than Sorry – Evaluating Project Risk

2. Capital Structure

3. Dividend Policy
Case 6: Much Ado About Nothing (NuSkin) – Dividend Policy

4. Corporate Governance & Refresher on Financial Analysis

Case 1: Are We Getting Too Big for Out Boots? (Gillian Pool & Spa) – Analzing Financial statement

5. Financial Planning and Working Capital Issues

6. Working Capital: Current Asset & Liability

Case 2: The Elusive Cash Balance (Hunt Distributing) – Cash Budgeting

7. Project Evaluation (single project)

8. Cash Flow Estimation & Capital Budgeting Decisions

Case 3: Too Hot To Handle – Capital Budgeting

9. Project Evaluation (project comparation & ranking)

Case 4: I Wish I Had a Crystal Ball – Real Options & Capital Budgeting

10. Merger & Acquisition

11. Leasing

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TOPIC 1: COST OF CAPITAL (WACC)

Long-term capital:
- Debt (public bond or bank debt);
- Preferred shares;
- Common shares

Cost of capital:
• Required return of investors is the most important aspect of the cost of each type of capital to the firm
• Cost of raising the money from investors for new capital must also be considered

™ Required Income Statement

- Firm have to operate profitably in order to provide their investor’s return:
- Use required rate of return to estimate the financial performance that would satisfy these expectations (work from
Bottom (net income) to top (Revenue) à Required Income Statement
à How high must sales/revenue be this year in order to:

0
Þ Provide debt holders with their interest payments
Þ And our equity holders with their required rate on investment

Example:
BV
• Firm has raised $1,000 of equity capital (market value = $2,000), $1,000 of preferred equity capital, and $1,000 of
debt capital
• Shareholders expect a return of 10%, preferred Equity Capital (Part of SE) 1,000
shareholders expect an 8% dividend yield, and Market Value of Equity 2,000 BV
debtholders expect a 6% rate of return (coupon Preferred Equity (Part of SE) 1,000 MV
Debt Capital 1,000
payments)
• We some other basic data: Required Return Equity 10% on market value 10% return on $2,000
o Tax rate is 20% Required Dividend Payment 8% $800 for Preferred SH's
o The firm has fixed costs (SG&A) of $500 Debt required return 6%
per year
o The firm’s COGS are 80% of revenue Tax rate 20%
COGS as % revenue 80%
Fixed Costs (SG&A) 500

Solution:
Net income 280
neg
=10%*2000+8%*1000 1 NI 280
Tax 70 350*20% 3
Tax 70
EBT 350 280/(1-20%) 2 EBT 350
Interest 60 6%*1000 4 Interest 60
EBIT 410 350+60 5 EB 410
SG&A 500
II
sGAA 5W
Gross Profit 910 410+500 6 Gross
profit910
COGS 3640 4550*80% 8 COGS 3640
Revenue 4550 910/(1-80%) 7
Rev 4550

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Impact of Tax Shield 60 340
Original Without interest Tax Shield* Required without interest Tax Shield**
After Tax Net income 280 328 340
Tax 70 82 85
EBT
Interest
350
60
Tnt60 20 410
0
425
0
EBIT 410 410 425
SG&A 500 500 500
Gross Profit 910 910 925
COGS 3640 3640 3700
Revenue
Note*
4550 4550
75 4625

Same Revenue but not claim interest expense --> same EBIT but higher tax
it means we have to pay debt, prefer share and common shares holders all with after tax NI (328 is not enough)
Note**
We need 200(for CS holders) + 80 (for PS holders) + 40 (debt holers) = 340 after tax NI
Note***
Tax Shield = 60*20% = 12 --> release the firm from $75 Revenue (4625-4550)

™ Investor Required Returns and Investment decision:

Kd
•
Lyke
Investors in the debt and equity of the company have required returns depending on:
- The nature of the security they invest in (debt vs. equity)
- The risk level of the firm, the nature of its activities, investment projects

• The requirement returns of investors are the “costs of capital” to the company
- The “cost of capital” is used as discount rate to calculate the NPV of new investments to determine if they
are acceptable
à NPV >0 if benefits exceed the costs

• IOS and WACC: Investment Opportunity Schedule vs. Cost of

Capital
- IOS rank projects from highest IRR
- IOS intercepts the WACC at a capital budget of $152.7 MCC
Million MC
- WACC is flat but increases at $391 Million dkdflotation
feedkdflotation
o When internal common equity via Retained Kekflotation
Earnings have been used up and the firm needs to WACC
source further common equity externally which is breakeven e
costly
ME 1 7 2.5M
• Calculation of the “break point” when exhaust RE
- With simple numbers, if for instance 40% of financing is from common
equity for a company, and it has $1 million of retained earnings available
- Once $1M/ .40 = $2.5 M of capital is needed for new investments then
- Retained earnings are exhausted and the company must raise further
common equity capital externally so that the MCC rises
9.4mm 450mm
E
D 0.6M I 5M
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™ The Weighted Average Cost of Capital (WACC)

ee e
' + 2
!"## = %& ( + %* ( + %, (1 − 0) (

- V= Market Value of the firm’s capital (V = E + P + D)

- E/ P/ D = Market Value of Common Equity/ Preferred Shares/ Debt
- Ke = Market Cost of Common Equity - CAPM
- Kp = Market Cost of Preferred Shares – YTM (will be given)
- Kd = Market Cost of Debt – Dividend Yield
- T = Corporate Tax Rate
- NOTE: %, (1 − 0) because interest is tax deductible

™ Marginal Cost of Capital (MCC):

MCC is the weighted average cost of the next dollar of financing to be raised

1) investors’ required/expected return for their capital

- Ke = Cost of Equity – CAPM
Fts
- Kp = Cost of Preferred Shares – YTM (will be given)
k waa
Maf - Kd = Cost of Debt – Dividend Yield

2) When firms raise capital, however, there may be additional costs to the firm on top of the required rate of
return of investors – flotation costs
o Underwriting discounts paid to investment dealers
o Direct costs associated with the issue (i.e. legal & accounting costs)
o Flotation cost are tax deductible (assume expense immediately)
o Net proceeds on the sale of each security is less than what the investor invests
o Cost of capital = investor’s required return + flotation cost
As a consequence, when a firm raises capital it does not receive all of the capital that it raises

- Flotation costs: the additional cost of issuing securities, which reduces the financing received, effectively
increasing the financing costs to the firm

o
pPV F u
I I z I I
4T
3t
TT

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v Preferred share valuation:
- Straight preferred shares can be viewed as perpetuities
because of the perpetual, constant dollar dividend they offer,
as in Figure

Example: What is the price of a $100 par-value preferred shares that pays a 7% dividend if the required return is
10%?

- The annual dividend is the par value multiplied by the dividend rate: $100 × 7% = $7
2:;< $>.@@
- 8*9 =
=<
=
@.A@
= $70.00
kp Pif p PYp
Cost of Preferred Equity – rearrange the perpetuity formula:
2:;< 2:;<
8* = =<
à %* = +<

- New preferred share financing:

=<
o Method 1: "BCDEFGB %*,J&K = (ALM)
- f: is the after-tax cost of floatation as a percentage of the total amount of financing

2:;<
o Method 2: %*,J&K =
N+
- Net Proceed = total amount of cash received after netting out all flotation cost (after-tax)

Example:

- Price: $25.00

-
per Series 35 Share to yield 6.5%
Taxes on floatation costs 40% Kp
Solution lax rate 40
Method 1:
65
= O.P%
Kp
0
<
%*,J&K = (ALM) = Q.RS×(TUVQ%) = 6.61%
f
fi
(AL )
WS
Method 2:
2:;< O.P%×YP
47
%*,J&K = N+
= YPL@.>P(ALZ@%) = 6.61%

v Debt/Bond Valuation:
- Bonds pay periodic interest and Face value at maturity
\ A b

pv O
- [ = ^1 − (A_= )` a + (A_= )`
=] ] ]

- Value = Interest * PVIFA(k,n) + Face Value * PVIF (k,n)

- Market required rate Kd determines bond market value is the “YTM”

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Cost of Debt: Kd
- If know the debt investor’s required rate of return %, , the corporate tax rate and the flotation cost percentage
for debt, can estimate the cost of debt
= (ALc)
o Method 1: %,,J&K = ]ALM
]
K'd
\(ALc) A b
o Method 2: dGF efghGGBE = ^1 − (A_= )` a + (A_=i )`
(IRR calculation – solve Ki)
=i i
Solve for Ki = the after-tax and after-flotation cost of debt
Not required in exam

Example:
my
- If the investor requires a 10% return, 40% is the corporate tax rate and there is a 3% after-tax flotation cost,g
then the firm’s cost of debt is:
= (ALc) @.A(ALZ@%)
o %,,J&K = ]ALM = AL@.@j = 6.19%
]

v Cost of Common Equity (CAPM or DDM)

- %& = lM + m& × (ln − lM )

2T 2:;r
- 8@ = → %& = + s&
=o Lp +r

- All sources of financing can have higher required returns as more is raised, but only Common equity has an
internally generated component
2:;
o Retained Earnings! No flotation costs: %& = + r + s&
r
o After exhaust RE, have to raise outside equity and pay flotation costs so use NP in calculation:
=
%&,J&K = r
(ALM)

™ MCC impact on investment:

• Firm may utilize internally generated cash flow (retained earnings to fund projects
– Use Retained earnings to avoid flotation cost of raising new equity (most expensive one)

• The firm may also use combinations of internally generated and externally supplied capital
– Maintaining the weight of Debt, Preferred shares and Common shares
– Gives rise to something called equity breakpoint!

• If the firm runs out of retained earnings, it will need to raise new equity capital if it wants to invest equity
– Newly raised equity will cost the marginal cost of common equity

' + 2
!"## = %& ( + %* ( + %, (1 − 0) (
MCC

r
' + 2
Below the breakpoint: !"## = %& ( + %*,J&K ( + %,,J&K (1 − 0) (

' + 2
Above the breakpoint: !"## = %&,J&K ( + %*,J&K ( + %,,J&K (1 − 0) (

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-
Example: Q20-27
BV
A firm has the following balance sheet items:

Common stock: 400,000 shares at $8 each $3,200,000

Retained earnings $1,200,000
Debt: 8% coupon, 15 years to maturity $2,000,000

o
Preferred shares: 6% dividend $1,500,000

o The before – tax interest cost on new 15-year debt would be 7%, and each $1,000 bond would net the firm
$972 after issuing costs.
NPo
price. I
Common shares could be sold to net the firm $10 per share, a 12% discount from the current market

1436
o
o
Current shareholders expect a 16% return on their investment.
ke46k
Preferred shares could be sold at par to provide a yield of 5.5%, with after-tax issuing and underwriting
expense amounting to 5% of par value.
o 5.5
The Firm’s tax rate is 30%, and internally generated funds are Kp f
5 anticipated new
insufficient to finance
capital projects.

- Compute the firm’s marginal cost of capital.

MCC k'd K'pike
Solution: ke
1) Start with cost of debt – tax rate is 30%, new debt would have a before tax cost of 7% and would net the firm
$972 after issue costs

- Since you are not required to calculate IRR’s with a financial calculator, you would be given the result of
estimating the required return on debt securities for the firm via the bond valuation formula:

T
NP AL

I
TS
xTyzi { A
972 = 70 × (1 − 0.3) w | + 1000 × (A_= )TS
=i i

(coupon = 70; Face value = 1,000)

Ø Assume after tax cost of debt is %: = 5.17% (IRR from above formula) kp fP
2) Preferred shares could be sold at par to provide a yield of 5.5%, with after-tax flotation costs of 5% of par value
f wp

0k'p
2:;< @.@PP

Ef EE
Ø Cost of new preferred share financing: %*,J&K = = AL@.@P = 5.79%
N+
kp
3) The company can sell common shares to net the firm $10 per share, which is “a 12 % discount from the current
price”
Ø The price must be $10/.88 = $11.36 and the flotation cost percentage is 12% after tax

4) Common shareholders required return is 16% so if after-tax flotation costs are 12%, then you can calculate the
f
cost of new Common share financing:

0kg
=r AO%
Ø %&,J&K = (ALM) = (ALAY%) = 18.18%
ke _is.is o
5) All component costs for new financing:
f
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- Common equity from retained earnings cost 16%

- External common equity costs 18.18%
- External new debt costs 5.17% after tax
- External new preferred equity costs 5.79%

6) Market value weights of all the components: • = € + 8 + [

- E – market value of common equity:

o Shares are currently trading at $10/(1-.12)=$11.36

E
o E = $11.36 (400,000 shares) = $4,544,000

- P – market value of preferred equity:

2:;< O% ,:;:,&J, Å:&Ç,∗$AP@@,@@@ bÑÖ& (ÑÇÜ&

p
o 8* = =<
= P.P% á&àÜ:á&, á&âÜáJ
= $1,636,364

- D – market value of Bonds/Debt:

_1000 86

jut
o (Book value $2M with $1,000 face value per bond so 2,000 bonds are outstanding)
o 8% coupon, 15 years to mature and required return of 7% so market value of 2,000 bonds:

[=
ã@
@.@>
A A@@@
To
^1 − (A_@.@>)TSa + (A_@.@>)TS = $1,091.08
hfju EE.is
$1091.08 ∗ 2000 (ŒD•ŽGf g• ŽgŒBE) = $2,182.160
c 1000 5
- Total Value = D + P + E = $2,182,160 + $1,636,364 + $4,544,000 = $8,362,524 1 78
o D/V = 26%
o P/V = 19.6%
o E/V = 54.4%
V
' + 2
7) !"## = %& ( + %* ( + %, (1 − 0) ( = 26%(0.0517) + 19.6%(0.0579) + 54.4(0.1818) = 12.36% after
Return earnings has been used up.
016
8) Use WACC for average risk projects financed in the usual proportions.

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Case 5: It’s Better to be Safe than Sorry – American structured products
- Cost of capital calculation with flotation costs
- Determine acceptable projected combining IOS and WACC schedules

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kd 6.072
beforetax

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Kpk Ffg 0.0556 ke 0.0611.2 0.15 0.06 0.168
Dividend5,08mL 0.51

ke 0.51 4 0121 0.12 14.68

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0.556 1 OGtX14.68 11.38

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What does the investment schedule look like?

Below Equity Breakpoint WACC

Above Equity Breakpoint WACC

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Practice:

26. (LO 20.5, 20.6, 20.7) A firm has the following capital structure based on market values: equity 60 percent and debt 40 percent.

The current yield on government T-bills is 3 percent, the expected return on the market portfolio is 10 percent, and the firm’s beta is
approximated at 2.15. The firm’s common shares are trading at $30, and the current dividend level of $4 per share is expected to grow at an
annual rate of 5 percent. The firm can issue debt at a 3-percent premium over the current risk-free rate. The firm’s tax rate is 30 percent, and
the firm is considering a project to be funded out of internally generated funds that will not alter the firm’s overall risk. This project requires
an initial investment of $15 million and promises to generate net annual after-tax cash flows of $2.25 million perpetually. Should this project
be undertaken?

28. (LO 20.5, 20.6, 20.7) A company can issue new 20-year bonds at par that pay 6-percent annual coupons. The net proceeds to the firm
(after taxes) will be 96 percent of par value. They estimate that new preferred shares providing a $2 annual dividend could be issued to
investors at $25 per share to “net” the firm $23.50 per share issued (after taxes). The company has a beta of 1.18, and present market
conditions are such that the risk-free rate is 3 percent, while the expected return on the market index is 10 percent. The firm’s common
shares trade for $30, and they estimate the net proceeds from a new common share issue would be $27 per share (after tax considerations).
The firm’s tax rate is 30 percent.

1. Determine the firm’s cost of long-term debt, preferred shares, and common equity financing (internal and external sources) under
the conditions above.
2. What is the firm’s weighted average cost of capital, assuming that it has a “target” capital structure consisting of 30-percent debt,
20-percent preferred equity, and 50-percent common equity? Assume that it has $3 million in internal funds available for
reinvestment and requires $5 million in total financing.
3. Suppose everything remains as above, except that the company decides it needs $8 million in total financing. Calculate the firm’s
marginal cost of capital.

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30. (LO 20.7) A firm wishes to raise funds in the following pro- portions: 20-percent debt, 20-percent P/S, and 60-percent CE (common
equity). Assume the cost of internally generated funds is 15 percent. Annual after-tax cost of debt is 5.86 percent. Cost of preferred equity is
6.12 percent. It believes all of the CE component can be raised using internally generated funds.

a. Find the WACC.

b. Now suppose the firm wants to raise $10 million for investment purposes, and it has only $4 million of internally generated funds
available. Determine the “break point” of the CE component. Break point is the maximum investment in which all targeted equity can be
financed internally.

c. Determine the marginal cost of capital (MCC) if the firm must raise funds beyond the break point. Assume the cost of new common equity
issues is 20 percent.

TOPIC 2: CAPITAL STRUCTURE – FIND THE LOWEST WACC, HIGHEST FIRM VALUE

™ Capital Structure: mix of Debt and Equity (common shares) ke

-
kd.it
Debt holders have regular periodic payments and repayment of principal, and can force the firm into bankruptcy
to satisfy their claims

- Earnings are available to common shareholders only after all

other claims have been paid, so equity holders have “residual”
claims on earnings and assets

• Debtholders are entitled to their claim on the firm and

related periodic payments e.g. $50 Million
• Shareholders take more risk (no regular payments are
guaranteed), and receive whatever value exists above
what is owed to the debtholders

Equity vs. Debt: summary

• Equity and Debt investors have two different relationships with the firm:

- Equity holder are not entitled to any return, but receive all of the net profits of the firm
Þ Equity holders risk “everything” for the chance of unlimited returns
Þ Equity holders à Risk & upside of the firm (UNLIMITED risk & UNLIMITED upside)

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- Debt holders are entitled to a fixed return, but do not receive any of the net profits of the firm
Þ Debt holders accept limited risk (priority in bankruptcy) in exchange for limited return
Þ Bond holder à fixed return; forgo upside of the firm (NO risk & NO upside)

• Debt holders shift the bulk of risk and return to equity holders by imposing a fixed cost on the firm

Optimal capital structure of debt and equity:

' + 2
Þ Lowest WACC: !"## = %& ( + %* ( + %, (1 − 0) (
ëÑ9í bÇìK9i
Þ Highest firm valuation: d8• = ∑J:óA (A_=)i
− ”Œ”F”•– hgEF

™ Operating Leverage:

• Fixed operating costs create “operating” leverage

Þ The higher the firm’s fixed costs, the higher the firm’s operating leverage

o SG&A (or other fixed costs)

o Interest expense - ALWAYS have to pay à a fixed cost for the firm
§ The more debt a firm has (capital structure decision) the higher interest expense
§ More debt à more interest expense à more fixed cost à more operating leverage

• Operating leverage is one type of “business” risk

Þ Variation in EBIT if sales/revenue change
Þ The higher the fixed cost, the higher the variability of earnings relative to Revenue

Example: company when revenue change +/- 10%

Revenue-10% % Change Original % Change Revenue +10%
Net Income 207 -26% 280 26% 353
Tax(20%) 52 -26% 70 26% 88
EBT 259 -26% 350 26% 441 Leverage
Interest (Fiixed) 60 0% 60 0% 60
EBIT 319 -22% 410 22% 501 Leverage
SG & A (Fixed) 500 0% 500 0% 500
Gross Profit 819 -10% 910 10% 1,001
COGS(80%) 3,276 -10% 3,640 10% 4,004
Revenue 4,095 -10% 4,550 10% 5,005
Revenue-10% Original Revenue +10%

- Fixed SG&A of $500 create “Operating Leverage” I

o More volatile EBIT if Sales revenue changes à One sources of “business” risk
- Fixed Interest of $60 create “Operating leverage” (“finance leverage” according to wendy)
o More volatile Net Income if EBIT changes

- The more volatile a firm’s earning, the more risk equity investors are facing
o Investors will require higher rate of return in react to higher risk

2nd
o More debt à more leverage à higher risk for equity holder à higher Ke

- Ways to measure risk movefluctuation NI of

=> common conclusion: risks are higher for firms with more financial leverage (all else equal)

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1) Debt burden coverage ratio
- How much cash flow does the firm generate relative to its debt burden
(how many times the firm’s cash flow cover what the firm owes as debt and interest)

- EBITDA serves as a proxy for cash flow

'õ\c2ú
- •”˜GB ™DfBGŒ #gšGf•sG = ùûrü †i°y¢£ à An expanded interest coverage ratio
AL
TU§

- SF: sinking fund a fund formed by periodically setting aside money for the gradual
repayment of a debt or replacement of a wasting asset.

'õ\c2ú
h•Eℎ •–g¦ Fg BGŽF = à a direct measure of CF that available to cover debt
,&ßâ

2) Altman Z-score:
- Estimates the risk of a frim becoming bankrupt in next 1-2 years
(multiple linear regression model)

¨A = working capital / Total Assets

¨Y = Retained Earnings / Total Assets
¨j = EBIT / Total Assets
¨Z = Market Value Equity / Total liability à related to capital structure
¨P = Sales / Total Assets

© = 1.2¨A + 1.4¨Y + 3.3¨j + 0.6¨Z + 0.999¨P

- Z > 2.99 = safe zone

- 1.81 < Z < 2.99 = grey/“caution” zone
- Z < 1.81 = distress zone

3) Leverage beta e RFtKRu Rey

- We can think of the beta for a firm as a whole “asset” beta as a weighted average of the
firm’s equity and debt betas
buys
MEEE
' 2
mú99&â/'( = 2_' m&àÜ:âÅ + 2_' m2&ßâ

6 y
- Debt beta is assumed to be zero (Debt is risk free), rearranging gives us:

EE
2
m&àÜ:âÅ = mú99&â (1 + ' )
ainri
- Equity beta is higher if there is more business risk (operating leverage), and if there is more
financial risk (operating/financing leverage)
o As D/E ratio increase, «¬-®¯°± increase

- If Equity Beta is higher, the required return of the Shareholder is higher

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ëì;(²i ,²³ ) ¥W
m= (Ñá(²³ )
= ¥Wi
³

%& = lb + m&àÜ:âÅ (lµ¶ − lb )

Add financial leverage, increase beta à higher beta means higher Ke

Bequity_Basset 0
Example: Basset 0.9
- Consider Grand Sport, Inc., which is currently all-equity and has a beta of 0.90.
- The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity.
- Since the firm will remain in the same industry, its asset beta should remain 0.90.
- I
However, assuming a zero beta for its debt, its equity beta would become twice as large:
2 A
m&àÜ:âÅ = mú99&â ·1 + ' ¸ = 0.9 ∗ ·1 + A¸ = 1.80
RFt CRn Rf
4) Financial leverage also affects EPS variability
NI
I
['õ\cL\Jâ&á&9â](ALâ)
€8¹ = # ìM 9íÑá&9 ½/æ
EPSIIIffhores
- if more debt, higher interest charges

D
- EPS is more volatile if more debt, for any
given EBIT
- Solve for the EBIT level at which EPS is
the same for different debt level

O
Financial leverage and EPS
Practice Question:
JCB is considering two capital structures:
- Plan I: All-equity plan with 160,000 shares outstanding
- Plan II: 80,000 shares outstanding, $2.8 million in debt @ 8% interest and no taxes.
a) If EBIT is $350,000, which plan has a higher EPS?
b) If EBIT is $500,000, which plan has a higher EPS?
c) What is the "Break-even EBIT"?

Solution:
['õ\cL\Jâ&á&9â](ALâ) [jP@,@@@L@](AL@)
a) Plan I: €8¹ = # ìM 9íÑá&9 ½/æ
= AO@,@@@
= 2.1875
['õ\cL\Jâ&á&9â](ALâ) [jP@,@@@LY,ã@@,@@@∗ã%](AL@)
Plan II: €8¹ = # ìM 9íÑá&9 ½/æ
= ã@,@@@
= 1.575
['õ\cL\Jâ&á&9â](ALâ) [P@@,@@@L@](AL@)
b) Plan I: €8¹ = = = 3.125
# ìM 9íÑá&9 ½/æ AO@,@@@
['õ\cL\Jâ&á&9â](ALâ) [P@@,@@@LY,ã@@,@@@∗ã%](AL@)
Plan II: €8¹ = # ìM 9íÑá&9 ½/æ
= ã@,@@@
= 3.45
['õ\cL@](AL@) ['õ\cLY,ã@@,@@@∗ã%](AL@)
c) = à EBIT = 448,000
AO@,@@@ ã@,@@@

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™ Modigliani and Miller (M&M)

v M&M Conditions: O
v Optimal capital structure: Lowest WACC à highest firm valuation (maximize shareholder’s wealth)

- Assume: two firms are identical in every way except capital structure: one has no debt (unlevered) and the
other has debt (levered)
o Markets are perfect (no transaction costs, no taxes, symmetric information)
o Capital structure does not affect firm cash flows (EBIT or FCF is unchanging regardless of
financing/leverage)
o No bankruptcy – no risk of borrowing Rev
debt Exp unlevered
- M&M Example 100 EquityCwo EBIT 80,000
§ Unlevered earnings = $80,000 (no interest expense for unlevered firm)
§ Face Value of Debt = $500,000 Sooooo
Interest 5
§ Cost of Debt = Risk-Free Rate (no bankruptcy) = 5%
§ Levered earnings = $55,000 D EBT
o $80,000 - $500,000 * 5% = $55,000
o No taxes
C fT5J
levered
o All cash flows and debts are perpetual
§ VL = Value of Levered firm
o VL = EL (Value of Equity) + DL (Value of Debt)
§ VU = Value of Unlevered firm
o VU = EU (Value of Equity)

- Arbitrage argument:
§ Two investment strategies:
1) If you buy 1% of the unlevered firm, you will receive:
1% * $80,000 = $800
2) If you buy 1% of the levered firm’s Equity and 1% of the Debt of you will receive:
1% * $55,000 + 1% * $500,000 * 5% = $550 + $250 = $800
§ Since both strategies have the same payoff, they must have same value (arbitrage argument)
o 1%EU =1%EL +1%DL
o 1%VU =1%VL (where1%EL +1%DL =1%VL)
Þ Value of unlevered and levered firms is the same! (in absence of arbitrage)
Þ Cost of Eu = Cost of EL + DL

v M&M Proposition 1:
- If the arbitrage argument holds true •Ü = •ø , then value of the firm will be indifferent from different capital
structure (Capital Structure is Irrelevant)
- If M&M Proposition 1 holds then the WACC for the unlevered and levered firms must be the same
o If cash flows are identical then the discount rates must also be identical to arrive at the same present
values:
Þ •Ü = •ø Vu Vu
ëb
Þ • = ¿úëë → ¿úëë
ëb¡ ëb¬
= ¿úëë
EDIT
¡ ¬ WAA
Þ #ÃÜ and #ÃÇ are identical (CF = EBIT according to Wendy) U
Þ !"##Ü = !"##Ç
Cf THEN
'¬
Þ Ä&Ü = ' _2
2¬
Ä&Ç + ' _2 Ä,
WACCHETT
¬ ¬ ¬ ¬
Þ If Ä&Ü = 10%, Ä,Ç = 5% (Kd always lower than cost of equity Ke) à Ä&Ç > Ä&Ü WACCu WACC
Þ Equity holders of levered frim gets more return because Ä, < Ä&Ç
(extra income generated by debt has been issued to equity holders)
Akira
y
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T 2
v M&M Proposition 2: Ä&Ç = Ä&Ü + ' (Ä&Ü − Ä,Ç )
KE
- If M&M Proposition 1 holds true, then levered cost of equity
rises with the amount of debt a firm issues since the risk of the
equity rises KI
- Because of the arbitrage argument the increase in cost of
equity perfectly offsets the cost of debt
- There is no way to improve a company’s WACC just by
switching equity to debt: Kd Kd
D
o The saving (Ä, < Ä&Ü )
from putting on more debt will O E
be perfectly offset by the increasing cost of levered
2
equity Ä&Ç > Ä&Ü Ä&Ç − Ä&Ü = ' (Ä&Ü − Ä,Ç )
' 2
o If Ä&Ü = 10%, !"##Ç = '_2 Ä&Ç + '_2 Ä, = 10%
o As we increase the weight of debt (D/E ratio increase), since Ä, < Ä&Ü , Ä&Ç has to increase
(upward sloping)
o WACC is constant for all capital structure Vu_Vc Chick
o There is No Optimal Capital Structure (No Impact of financing)
Vu EET VEGETA
v M&M Perfect world + Tax
- If interest expense is not tax deductible, then there is no change to the M&M conclusions
taxi
CFutCFc
- If interest expense is deducted before taxes are paid, however, then the conclusions will change taxshield
with
- After tax cash flows to the unlevered and levered firms are now different: 30 Cfu CFL
§ CF for unlevered firm: #ë = #à – 0 ∗ #à = #Ã(1 − 0)
§ CF for levered firm:#Ãø = #Ã – 0 ∗ (#Ã − %, [) 1 D Kd
#Ãø = #Ã(1 − 0) + 0%, [ (tax shield) Es
tooo
§ As long as tax rate ≠ 0, #Ãø > #ë , Cash flow no longer identical because of the tax shield:
o #Ãø = #ë + F•˜ Eℎ”G–B
o If debt is perpetual, PV of the Tax shield = T ∗ D
âÑŸ 9í:&Ç, *&á *&á:ì, c= 2
§ In perpetual, PV of the Tax shield = = ] =0∗[
=] =]

IuotsthaiEcd.D
Perfect world Perfect world + tax
ëb 'õ\c ëb(ALc) 'õ\c(ALc)
•Ü = = = =⁄
= €Ç + [Ç = •ø •Ü = =
⁄ =⁄ =⁄

•Ü = €Ç + [Ç = •ø c=] 2
•ø = •« + =]
= •« + [0
' 2 ' 2
!"## = %& ( + %, ( !"## = %& ( + %, (1 − 0) (
T
WI
2 2
Ä&Ç = Ä&Ü + ' xÄ&Ü − Ä,Ç { Ä&Ç = Ä&Ü + ' xÄ&Ü − Ä,Ç {(1 − 0)
t
§
2
Leverage cost of Equity is now: Ä&Ç = Ä&Ü + xÄ&Ü − Ä,Ç {(1 − 0)
'
E
o We are holding Û®¬ (ÜÝݬ° Þ¬°Ü) = ßà ∗ áâß Constant
2 2
o Since (1 − 0) < 1 → ' xÄ&Ü − Ä,Ç {(1 − 0) < ' xÄ&Ü − Ä,Ç {
o Ä&Ç (upward sloping) becomes flatter, can no longer perfectly offset the saving (Ä, < Ä&Ü ) from
putting on more debt

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§ Levered cost of equity rises with the amount of debt a
firm issues, but at a slower rate than the corresponding
increase in D/E
o Rise in Cost of Equity no longer perfectly
offsets increase of Debt in capital structure
o WACC is falling as we increase debt à
therefore, the more debt, the lower WACC
2 '

Fl
o !"##Ç = ( %, (1 − 0) + ( Ä&Ç

E
OO
v M&M Perfect world + Tax + Bankruptcy
- A firm has violated a contractual payment obligation and a creditor enforces their legal rights to recoup their
money
§ The firm is liquidated to repay creditors
§ Once all creditors are repaid, any remaining value is distributed to shareholders
§ If creditors do not receive 100% of their money, shareholders receive 0%
§ Shareholders usually receive 0% in bankruptcy
- Reactions to Bankruptcy:
§ Agency problems: change in behavior of Shareholders (harmful to debtholders)
Þ If EV (enterprise value
of the firm) < debt,
shareholders gets
nothing
Þ When EV = Cash = $800
à Gamble: invest in
negative NPV project
(high risk high return)

- Bankruptcy Costs
§ Direct cost (in bankruptcy)
o Lawyers, consultants, commissions, fees, time efforts
o Accumulated tax losses (Loss of ability to use prior losses to shelter future income from taxation)
o Liquidation of assets (at poor “fire sale” prices) – Liquidation value vs. DCF/Multiples valuation

§ Indirect (before bankruptcy): costs of financial distress à as we get closer to bankruptcy, risk increase
1) Employees – leave for other firms (decrease productivity; no replacement) à loss of key staff,
distracted management, decrease sales à negative impact on CF
2) Suppliers – tightening trade credit terms, allow only cash purchase à cash crunch
3) Customers – lost sales revenue as customers walk away due to concerned about honoring warranty
claims, etc. à negative impact on CF
4) Investors:
a. Creditors – impose constraints/terms (miss certain ratios) à increase monitoring
b. Shareholders – sell shares, price drops à disaster for companies which planning to raise
capital in stock market
c. Management – Agency cost: Distortion of management decision (gamble on negative NPV
projects) à poor decision making: too much risk (gamble) or too little risk (CAPEX = 0)
5) Acquisition – competitors
6) Government – all of the firm’s stakeholder “vote” for government support
ð Lower firm value

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- Tradeoff Theory:
§ In reality the firm must balance the good and bad of capital structure decisions:
o Benefits = Tax Shield
o Costs = financial distress
o Rethink VL:
VL = Vu + PV Tax Shield – PV financial distress costs

§ PV of Financial Distress
o The PV of Financial Distress is the
expected value of the costs of financial
distress (indirect bankruptcy costs) for a
given level of debt
o PV(Financial Distress) varies with debt
levels
o The optimal capital structure represents a
tradeoff between the benefits of debt and
the costs/risk of debt

§ There are BOTH Benefits and Costs of

increasing debt:
o WACC falls initially, because the benefits
of the tax-deductibility of interest expense
outweigh the marginal increases in
component costs
o But, at higher levels of debt, the tax
advantage of debt is offset and the value of
the firm falls as WACC starts to rise
o There is an optimal capital structure that maximize firm value and minimizes the cost of capital
(WACC) because debt has both benefit (interest tax shields) and costs (expected cost of
bankruptcy)

§ One we identified an optimal capital structure, we might use this capital structure to
o Financing decisions for new investment – breakpoint
o Homemade leverage – replicate what you think is the best leverage
o Identity the M&M conditions that apply – determines the assumption made

™ Homemade Leverage
- Replicate a desired capital structure for a firm, regardless of the firm’s capital structure decision

Example: same firm value (EV: enterprise Value) but different capital structure EV =Ve+Vd)
o Firm A (unlevered) has $10 million of equity
o Firm B (levered) has $3 million of equity and $7 million of debt
o EBIT for A and B = $2 million
o M&M perfect world, interest rate = 8%
o You own $400,000 of Firm B’s shares
o Replicate the cash flow you receive from firm B using Firm A’s shares

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centered capitalstructure

40492 7

™ “Pecking Order Theory” of Capital Structure

• Firms have a “pecking order” of financing of new projects due to the desire to NOT divulge information, for
instance, to competitors (Asymmetry information between stakeholders)
- First Choice: Financing new projects with internal funds, retained earnings, involves the most privacy and
no marginal cost (no flotation cost); eliminate market uncertainty
- Second Choice: debt financing, with only privileged disclosures to lenders
- Last Choice: public issues of equity, with full disclosure of investment plans, market uncertainty (stock
price fluctuation)
• We would usually assume firms keep their capital structure weights as they invest in further projects but the
pecking order theory involves there being a preference for particular financing sources
• Capital structure would change after new investments according to this theory

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Practice:

t 0.2
24. (LO 21.2) Calculate the EPS indifference EBIT* level given the following information. The corporate tax rate is 20 percent. Under a 75-
percent D/E ratio, the number of common shares outstanding is 30,000; pre-tax cost of debt is 10 percent; and outstanding debt is $675,000.
Under a 30-percent D/E ratio, the number of common shares outstanding is 65,000; pre-tax cost of debt is 6 percent; and outstanding debt is
$420,000. Discuss the implication of the indifference EBIT* and indicate which option is better, given an EBIT of $125,000.

EBI1 675000 0.11 110.2 CEBIT 420Mx0.067 110.2

x
30000 650W nodebt

0.814354ft a8xfswow

4310.811 54W 0.8 20160

X a ow 0.8 20100

X 103757.14

FBIT 103757 14 75 better

103757.14 30 better

a
35. (LO 21.3) In the M&M no-tax world, an unlevered firm has a cost of equity of 12 percent and expected EBIT of $480,000. The firm
decided to issue $3 million of debt at a cost of 8 percent to finance a project, which has an ROI of 18 percent. It has 200,000 shares
outstanding.

a. Calculate the value of the firm and price per share before issuing the debt.
b. Calculate the firm’s new earnings per share after issuing the debt.
c. Calculate the value of the firm and the value of equity after the firm issues the debt.
d. Calculate the cost of equity after the firm issues the debt.
e. Calculate the new share price of the firm after it issues the debt.

a ke 0.12 EBII 480W d Ke Kut Ku Kd x

0112110.120.08 x
871L 4owow
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b 27.5
480Mt3owowxo.is 3owowxaos 3.9
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c Vd 3M
vi 48Mt 85mW
0112
51 8.5 3 55M

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36. (LO 21.4) Susan and Celia are twins but have very different attitudes toward debt. Susan believes that firms should have a D/E ratio of
0.2 while Celia believes that the D/E ratio should be 1.1. Both sisters have agreed that Okanagan Produce Inc. (OPI) is an excellent
investment. However, the D/E of 0.5 is not quite right. OPI has an EBIT of $750,000 per year and pays interest of $100,000 per year. The cost
of debt is 10 percent, and the twins can also borrow and lend at that rate. All cash flows are permanent and there are zero taxes.

a. Determine what the cash flows from OPI would be if the firm had the desired D/E ratio in the table below:

3mm Borrow
50mW 1571429
BWow 1428571

7500W 75mW
bOwo 157143
7000W 592857

b. Show the sisters how they can invest in OPI and still obtain their desired cash flows through borrowing and lending.

Assume each sister own 50

of
shares
of OPI
NI 650mF2 3250W desired
Susan want to own 12500W the desired equityvalue thedebtvaluethrough
comparewithold
DIE ratio
debt 2500W borrow or lend dividends I interest new
cashflow
olddebt bwow
lend25mW
325Mt Aww x o I 35mW 6071432
Celia Ve 714286 Venow lowon CFw z

debt 5own debt 785714.5

borrow 2857145

ooo 285714.5 01 296428.55

325

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TOPIC 3: DIVIDEND POLICY – HOW DOES IT AFFECT FIRM VALUE (M&M)

• Definition: After-tax earnings accrue to shareholders (Net Income)

- Reinvested (retained earnings) or paid out (dividends)

• Common Share Dividends are at the discretion of management and the Board of Directors and must be
“declared” before they are paid

- Dividends are not contractual obligations à Not paying a dividend is not a default event
- Size and timing of each dividend must be approved
o Dividend announcements are made in advance of Dividend payments
o Missing an expected announcement is noticed by the market
- Restrictions on cash dividends, for instance:
Þ Preferred share dividends have priority (i.e. common share dividends cannot be paid until missed
preferred share dividends are fully paid)
Þ Insolvency test: cash dividends cannot be paid out of capital if that would cause insolvency, or if it
would cash a breach of debt covenants

• Payment Procedure - Important dates:

o Announcement day (May 1st) : Dividend is declared by the board of Directors, announcing that the cash
dividend will be paid on (May 31st – the real payment date) to “holders of record” on (May 15th)

o Ex-Dividend Date (May 14th): the first date that the transaction will be settled after the record date (in
Canada, it takes 2 business days to settle the transaction) – also the last day to buy and get the dividend

o Record Date (May 15th): on the record date, the

company takes a snapshot of the owners and that is
the list of investors who will receive the dividend

o Payment Date (May 31st)

• Share valuation Model: DDM

2T
o We assume the next dividend is a full period away: 8@ = = Lp
o
o If the next dividend is about to be paid, then we add that dividend to
2T
the value: 8@ = = Lp + [”š”BGŒB
o
o As soon as the dividend is paid, the share drops back to the price that
assumes the next dividend is a full period away

• Types of Dividends – ways to return profit to shareholders

- Dividends can be paid in cash, shares of stock, or property (products)
- Traditional Cash Dividends (transfer cash owned by shareholders to shareholders)

Þ Regular Dividends: Typically occur with some regularity (e.g. every quarter, every year, etc.)
o Paid out of normal business operational profits
o Shareholder’s expectation of dividend payment is built into the price (if firm cut the
dividend payment, market will react negatively, share price may drop shapely)
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Þ Special Dividends: Typically a one-time payment
o Paid out of an excess accumulation of undistributed profits or from unusual one-time gains
(e.g. asset sales)

Þ Liquidating Dividends: When a firm is liquidated and all the value left for shareholders, after
satisfying other claims, is paid out

Þ NOTE: investor expectations differ between Regular and Special dividends, which impact how the
market views each type of dividend

- Share Repurchases (Also called Share Buy-Backs)

- Stock Dividends and Stock Splits à not real dividends

Þ Stock dividends are NOT a way to return money to shareholders

o The firm distributes shares of the company as a dividend instead of cash
o If Share price = $50, dividend = $10, distribute $10/$50= 0.20 shares instead of $10
o NO value is created
o Firm’s value is not impacted by the number of shares outstanding
o Dilution reduces the value of each share, but since each shareholder has more
shares, their total wealth is unaffected
o If market is efficient: double the amount of shares outstanding à share price
should drop by 50%
o If market is inefficient: double the amount of shares outstanding à share price
drop less than 50% à increase the equity value and thus market value of the
company
o Different than DRIP (Dividend Reinvestment Investment Program):
o Take cash dividends and buys shares in the open market

Þ Stock Splits
o Stock Dividends (e.g. 1 added share for each 10 shares held)
o Large Stock Dividend is a “Stock Split” (e.g. every 1 share splits to 2)
- Both stock dividends and splits increase the number of shares outstanding, diluting
the ownership
- There are also “reverse stock splits” that consolidate share ownership (E.g. every 10
turns to 1)

o When firms “split” their stock

o Firms issue some number of new shares for each share in existence, effectively
splitting the shares some number of times à Stock price adjust accordingly if the
market is efficient
o E.g. in a 2:1 stock split, all shareholders with 1 share will be given another share
(for a total of 2 shares)

o Firms can also “reverse split” or consolidate their shares à stock price adjust accordingly
and become more affordable
o E.g. 1:2 reverse stock split takes away 1 share for every 2 shares owned by an
investor
o In theory, there is no change in the value of the firm

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Example – Wendy: stock dividend

XYZ Inc. has two million shares currently outstanding at $15 per share. The company declares a 50% stock dividend.
How many shares will be outstanding after the dividend is paid?
• A 50% stock dividend will increase the number of shares by 50%: 2 million×1.5 = 3 million shares
• Value of the firm was $2m × $15per share = $30m; After the dividend, the value will remain the same.
• Price per share = $30m/ 3m shares = $10 per share

Example – Stock Split

XYZ has 100,000 shares outstanding, which are trading for $150 each.
a) What will be the outcome of a 2 for 1 Stock Split?
b) What will be the outcome of a 4 for 3 Stock Split?
c) What will be the outcome of a 3 for 4 Stock Split?

Solution:
a) There will be 200,000 shares outstanding worth $75 each
b) There will be 133,333 shares outstanding worth 3„4 * $150 or $112.50 each
c) There will be 75,000 shares outstanding worth 4„3 * $150 or $200 each à reverse split

• Stock Dividends vs. Cash dividend + DRIP

- If you combine a cash dividend with a DRIP, the shareholders get more shares, so it is like a stock
dividend
- BUT the shareholders don’t get the cash with the stock dividend to buy shares with, just the shares
- Stock dividend does not require the company to have cash while Cash Dividend + DRIP does require

• Why do companies do Stock dividends or stock splits?

- Not obvious there is any benefit à Just spread the equity value over a different number of shares
- Also stock dividends are taxed!
- The primary argument it is that it allows firms to maintain their share price in a “desirable” range (e.g. $40
- $80 per share)
Þ This may increase the demand for the shares à if it increases the ability of investors to buy them
- Other arguments:
Þ If information is imperfect, maybe stock splits signal to investors that unexpectedly good things are
going to happen, so that management believes share prices will rise and fall outside the “optimal”
range
Þ E.g. in June 2014 Apple did a “7 for 1” split à Share prices reacted positively!

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™ Irrelevance Theorem in M&M perfect world firm value
• M&M extended their capital structure arguments to dividends
o Perfect market; NO Taxes; NO debt (since levered or unlevered are indifferent in the perfect world);

o All firms maximize value (NPV)

à firms will choose to invest all positive NPV projects, and only payout the residual as dividends
à Residual theory of dividends

ëb½‰ Lëú+'‰
•@ = ∑Á
âóA (A_Êr )‰

#Ãèâ = #à •fg• geGf•F”gŒ •F F”•G F

#"8€¨â = FgF•– #"8€¨ •gf egE”F”šG d8• efgCGhFE •F F”•G F

- Firm = PV of firm’s free-cash-flow (FC) – firm is valued as a perpetuity

- All FCF is paid as a dividend to shareholders
- Since FCF is after all investing decisions, shareholders receive the residual (free) cash flow

o Irrelevance Theorem
- The combination of perfect market and value maximization mean that the firm will always choose to
max its investments first à the firm invests in all NPV positive projects
Þ If CAPEX exceeds CFO the firm can easily raise money since markets are perfect
- Dividends are irrelevant for firm value because firm value is based solely on free-cash-flow
Þ Dividends can be financed by raising new capital

Example 22-2:
- A company is all equity financed. It has $100 M of cash flow from operations and $90 M of investments,
leaving $10 M as the residual amount to pay out as dividends to its shareholders.

$A@¶
- If the company has 10 million outstanding shares, each will get A@¶ = $1 cash dividend
- The strict residual dividend policy resulted in a $1 per share cash dividend.

- What if the company changed to having 30% debt for it new investments instead of all equity?
Þ Then the $90M of new investments would be financed with:
§ $90 M * 70% = $63 M from retained earnings and $27 M from new debt
§ The dividends per share under a “residual” policy would increase to
$ 100 M available – $ 63 M retained = $ 37 M to all 1M shareholders or $3.70 each

- What if the company had $150M of good investment?

Þ The $150M of new investment would be financed with:
§ $150M * 70% = $105M from equity and $45M from new debt
§ All $100M of earnings available to shareholders would be retained in the firm (zero
dividends); $5 million of new equity would need to be raised.

- A drawback of residual dividend policy is that dividends are volatile – dividend each period depends on
investment opportunities that period
- A positive effect is there isn’t any extra cash laying around that could be used for things like excessive
expense accounts, etc. (agency problems/conflicts)

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• “Bird in the hand” argument – “resolving uncertainty” in the minds of investors
- An argument that firms that pay a dividend are less risky than firms that do not pay dividends
o Lower risk = lower WACC = higher firm valuation
à therefore, dividends affect firm value (Capital Gains are riskier than dividends)

o However, repeat the MM example: firms that pay out their cash as a dividend would have to raise cash
for investment, causing the share price to drop
à shareholder wealth (Value of shares + dividend) unchanged

o WACC is determined by business risk, not payout policy

- A bird in the hand (certain) is worth more than two in the bush (uncertain)
- BUT a problem with argument is that investors can always get cash if they need to in a perfect world (no
transaction cost), and won’t rely on the company to pay out cash dividends to them (homemade dividend)

Share Repurchase
• A firm can also return cash (pay out earnings) to shareholders by repurchasing existing shares
o The firm buys its own shares in the stock market or provided tender offer with specified premium over
current market price
§ In Canada, the repurchased shares are cancelled
§ In the US, repurchased shares may be carried as Treasury stock or cancelled
2T
• With fewer shares in existence, the remaining shares are more valuable ( 8@ = = Lp + [”š”BGŒB )
o
o Firm’s value is not impacted by repurchases (reduce # of shares outstanding and share price goes up)
o Shareholders receive their payout in the form of a capital gain instead of cash

Example:

- Existing shareholder’s % of ownership change

- With fewer shares in existence, the remaining shares are more valuable
- Firm Value doesn’t change

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v Dividend irrelevance (to firm value) in M&M perfect world
- If shareholders can buy/sell shares at no cost and if firms can issue and repurchase equity at no cost,
- AND if investment policy is NOT affected by dividend policy (NO “Pecking Order Theory”)
- Dividends will not affect firm Value

v Homemade Dividends
- Like homemade leverage, an investor can create their own dividend stream by buying/selling shares
- Buy shares with dividend if the dividend is larger than wanted
- Sell shares if the dividend is smaller than desired

Example:
- ABC Inc. has a $42 share and is about to pay a $2 cash dividend à Ex dividend price will be $40 per share
- Bob investor owns 80 shares and prefers $3 cash dividend
o Company is about to pay him only a $2 * 80 = $160 cash dividend
o Bob prefers to receive $3 * 80 = $240
- Bob’s homemade dividend strategy: sell 2 shares ex-dividend
o Cash from selling stock = $40 * 2 = $80
o Total cash = $80 (from selling stock) + $160 (from dividend) = $240 à recreate the cash distribution
- Does Bob’s wealth change? NO
o Bob started with 80 shares worth $42 each = $42 * 80 = $3,360
o After the company pays $2 per share in dividends, stock price = $40
§ Bob would have $160 (cash from dividend) + $40 * 80 share = $3,360
o If Bob sell 2 shares to get the desired cash payout
§ Bob would have $240 (cash) + $40 * 78 = $3,360 à same wealth
o The only difference is Bob now owns a slightly smaller percentage of the equity of the company

PQ 22-30:
• BUT if contrary to the MM perfect world assumptions, dividends DO impact ability to invest in projects, the
situation can be much different!

o If there are positive NPV projects the firm cannot undertake due to financing constraints, then firm value
will increase if cash dividends are cut and this allows the firm to take the projects

o Firm has 1M outstanding shares. After tax EPS has been $8. The firm has 100% dividend payout and the
required return of shareholders is 15%
a) What is the current share price?
b) If the firm retains the earnings, just for the current year for investment purposes, what will be the
new share price if the new investment promises a return of 10, 15 or 20% in perpetuity?

Solution:
2 $ã
a) 8f”hG = = = AP% = $53.33
r

b) If the firm undertakes the project, there will be no dividend in the current year. Starting next year, the dividend
will be $8.80 (if return is 10%), or $9.20 (if return is 15%), or $9.60 (if return is 20%). Therefore:
ã×A.A@ A
10% return would imply: ¹ℎ•fG ef”hG = AP% × AP% = $51.01
ã×A.AP A
15% return would imply: ¹ℎ•fG ef”hG = × = $53.33 -> nothing change
AP% AP%
ã×A.Y@ A
20% return would imply: ¹ℎ•fG ef”hG = AP%
× AP% = $55.65 -> Increase firm value

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- Given a 15% return on the new investment, shareholders are indifferent between receiving a dividend this
year or receiving increased dividends from next year. At 20%, they prefer the new investment. At 10% the
new investment should not be undertaken

™ Dividend policy choice (dividend vs. share repurchase) – no perfect market (direct effect)

• Tax Consideration:
- Lower income investors usually get higher after-
tax earnings from dividends

- Higher income investors with higher marginal tax

rates usual get better after-tax earnings from
capital gains
Þ E.g. in Ontario, for people with over
$200,000 income, effective tax rate on capital
gain is lower than dividends

- Stock with dividends may attract a different

investor base (“tax Clientele”) than stocks with
no dividends that generate capital gains

Þ Value of the firm may not be affected (firm valuation model only includes FCF and corp. tax rate), but
changes in changes in the dividend policy will be inconvenience and costly for investors who may have
to switch to the shares of other companies
E dividend policy target E tax clienteles

• Trading/transaction costs for individuals vs. for firms

- For Investors: Trading costs to sell shares for cash or to buy more shares with dividends can be high

- For Firm: Costs of issuing shares to get more equity funds for firms are high
Þ Marginal cost of capital is normally greater than cost of capital due to flotation cost
Þ From this perspective, dividend may affect firm value (low dividend, low WACC, higher firm value)

- Which party has the lower costs should be the one paying them
Þ High issue costs for firms would be a reason to retain earnings
Þ High trading costs for shareholders would be a reason to pay dividends

- DRIP (Dividend Reinvestment Plans):

o These are a way to reduce the costs for shareholders who do NOT want to receive a cash dividend
o Their dividends are automatically reinvested in newly issued shares in the company, with as many
shares being bought as the cash dividend will buy
o Good for companies who get to issue more shares without paying the usual costs of doing so
o Good for investors who do not want cash dividend BUT
§ Could end up with an odd number of shares being owned
§ Cash dividend is still fully taxable

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™ Asymmetric information
Dividend policy choice (dividend vs. share repurchase) – Signaling (indirect effect)
• Institutional investors are only allowed to buy dividend paying stocks. There will be greater demand if pays div.
• Imperfect Information or “Signaling” outsiders (Asymmetric Information)
- Investors do not know as much about the firm and its prospects as insiders do
- If management has different information than investors, they can signal their future expectations through the
dividend
- What might it signal if a company pays:
Þ Steady or constantly growing Cash Dividends (even in poor earnings years) à Firm’s future will be
good
Þ Low Regular Dividend plus “Extras” in good years à only in good years, not regular payment
Þ A Residual Dividend policy with a lot of variation in dividends from year to year
Þ Increasing the dividend implies future cash flows are increasing to pay the higher dividend and still
make investment (transaction costs make raising capital unattractive)
Þ Dividends combat agency theory by removing cash flow from managers, who need to ask investors
for cash flow to invest - Alternative is “empire building”

• Dividend Evidence:
- Empirically, there is some impact from dividends/payouts:
o Dividend initiation produces an average price reaction of +4%
o Dividend omission produces an average price reaction of -10% (huge penalty – “sticky” dividends set
at a confident level, management team will be very conservative about setting dividend level)
o Repurchases produce an average price reaction of +2%
o Tender offers (above market price) produce an average price reaction of 11%
- In order for any of these reactions to occur, the valuation of the firm must be changing
o This means that WACC is rising/falling or there is a change in (expected) FCF

™ Cash Dividend vs. Repurchases

Cash Dividends:
– Historical levels important
• Anchoring (i.e. whatever paid in the past is expected to pay in future)

– Dividends are “sticky”

• No market reward for increasing
• Huge market penalty for reducing or omitting
– Decide dividends before deciding on new investments (fear of market penalty)
– Dividends convey information
– Dividends tied to stable earnings
– Tax consequences not of first order importance (prefer by lower income people)

Repurchases:
– Historical levels not important
• No Anchoring
• i.e. can pay money to investors without creating expectation of higher future cash flows (Not
viewed as much as a “commitment”)
– Flexible – no need to smooth
• Positive market reaction when announced
• No consequences for not repurchasing
– First make investment decisions then make repurchase decision

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– Repurchases used to distribute temporary income
– Repurchases convey information
• Can signal positive information about a firm's cash flow (managers think equity is undervalued)
• Can signal negative information about a firm's cash flow (investors wonder - are there are no
good projects to invest in?) à from “residual” point of view
– Tax consequences not of first order importance (prefer by higher income people)
• Benefits high income shareholders because capital gains are taxed at a lower effective rate than
dividends for them
• If done regularly, tax authorities may conclude repurchases are done to avoid taxes and tax. Them
as if they are dividends

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Case 6: “Much Ado About Nothing” – Nuskin Products Inc
- Company has not been paying dividends
- Interesting discussion at Board about what to do next
- Assess pro’s and con’s of initiating a dividend payment

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Practice:

25. (LO 22.6) Investor A’s personal tax rate is 30 percent while Investor B’s is 22 percent. Investor A owns 1,000 shares of SNS Company
and receives an annual dividend of $1.75 per share. Investor B owns 1,000 shares of CGC Company and receives an annual dividend of $1.60
per share. Which investor receives the larger after-tax dividend amount?

33. (LO 22.3) MCC Corporation currently has cash flow from operations of $10 million, capital expenditures of $8 mil- lion, and pays a
dividend of $2 million (all are perpetuities). The firm has no growth prospects or debt, and shareholders expect an annual return of 5
percent. The total number of shares outstanding is 1,000. For the following investors, describe how they can achieve their desired cash flow
pat- terns and the value of their strategy (future value) at the end of the second year. Each investor owns 10 percent of the firm and there are
no taxes or transactions costs.

a. Marie lives in a very high-cost city and would like to receive a dividend of $400,000 at the end of year 1. She needs this money to
finance her lifestyle.
b. Charlie has found another investment opportunity that will cost $400,000 at the end of year 1, pay him 15 percent, and pay back
his initial investment of $400,000 at the end of year 2.
c. Radha is very frugal and would rather not receive dividends at the end of year 1.

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23. (LO 22.5) A firm follows a strict residual dividend policy. This firm will have profits of $800,000 this year. After screening all available
investment projects, the firm has decided to take three out of the 10 projects and those three will cost $600,000. The current equity market
value of this firm is $5,600,000 and the current market price of its shares is $32. Estimate the current year dividend per share. What is the
shortcoming of this policy?

29. (LO 22.3) CGC Company is considering its dividend policy. Currently CGC pays no dividends, has cash flows from operations of $10
million per year (perpetual), and needs $8 million for capital expenditures. The firm has no debt and there is no tax. The firm has 2 million
shares outstanding, which are currently trading at $50 per share. George, the majority owner of CGC (he owns 60 percent), would like to take
$20 million out of the company to fund his various charities. You have been hired by CGC to consider different alternatives.

a. George could sell stock to the market to raise the $20 million he requires. What are the advantages and disadvantages of this
strategy (i.e., the impact on the value of CGC and George’s control)?
b. CGC could pay a dividend so that George receives the $20 million.

i. Describe how the company can issue stock to create the dividend.
ii. What is the effect on the value of CGC and on George’s control of the firm?

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