Capital Structure &Dividend Policy

By:AsHra ReHmat

Capital Structure

• In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

Overview

• A firm's capital structure is the composition or 'structure' of its liabilities.

• For example, a firm that has $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources of capital.

• The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure

• Though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process factors like – fluctuations and – uncertain situations that may occur in the course of financing a firm.

• The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value.

• This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs.

• Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.

Capital structure in a perfect market

• Consider a perfect capital market firms and individuals can borrow at the same interest rate; no taxes; and investment returns are not affected by financial uncertainty.

• Modigliani and Miller made two findings under these conditions. – Their first 'proposition' was that the value of a company is independent of its

capital structure. – Their second 'proposition' stated that the cost of equity for a leveraged firm is

equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, risk is shifted between different investor classes, while total firm risk is constant, and hence no extra value created.

• Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt

Capital structure in the real world

• If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.1. Trade-off theory2. Pecking order theory3. Agency Costs4. Structural Corporate Finance5. Other

Trade-off theory• Trade-off theory allows the bankruptcy cost to exist. It

states that there is an advantage to financing with debt and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt).

• The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

• Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry.

Pecking order theory• This theory maintains that businesses adhere to a

hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company).

• Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

• The pecking order theory is popularized by Myers (1984) when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.

Agency Costs

• There are three types of agency costs which can help explain the relevance of capital structure.1. Asset substitution effect: As D/E increases, management has

an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside.

2. Underinvestment problem: If debt is risky, the gain from the project will accrue to debt holders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.

3. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

Summary • The goal of the capital structure decision is to determine the financial leverage that

maximizes the value of the company. • In the Modigliani and Miller theory developed without taxes, capital structure is

irrelevant and has no effect on company value.• Using more debt in a company’s capital structure reduces the net agency costs of equity.• The costs of asymmetric information increase as more equity is used versus debt,

suggesting the pecking order theory of leverage, in which new equity issuance is the least preferred method of raising capital.

• A company may identify its target capital structure, but its capital structure at any point in time may not be equal to its target for many reasons.

• Many companies have goals for maintaining a certain credit rating, and these goals are influenced by the relative costs of debt financing among the different rating classes.

• In evaluating a company’s capital structure, the financial analyst must look at the capital structure of the company over time, the capital structure of competitors that have similar business risk, and company-specific factors that may affect agency costs.

What is Dividend Policy :• “ Dividend policy determines the division of

earnings between payments to shareholders and retained earnings”.

- Weston and BringhamDividend Policies involve the decisions, whether-– To retain earnings for capital investment and

other purposes; or– To distribute earnings in the form of dividend

among shareholders; or– To retain some earning and to distribute

remaining earnings to shareholders.

Dividend Theories

Relevance Theories(i.e. which consider

dividend decision to be relevant as it affects the

value of the firm)

Walter’s Model

Gordon’s Model

Irrelevance Theories(i.e. which consider

dividend decision to be irrelevant as it does not affects the value of the

firm)Modigliani

and Miller’s Model

Traditional Approach

Walter’s Model

• Prof. James E Walter argued that in the long-run the share prices reflect only the present value of expected dividends. Retentions influence stock price only through their effect on future dividends. Walter has formulated this and used the dividend to optimize the wealth of the equity shareholders.

• Assumptions of Walter’s Model:– Internal Financing– constant Return in Cost of Capital– 100% payout or Retention– Constant EPS and DPS– Infinite time

Model Description

• If r>ke, the firm should have zero payout and make investments.

• If r<ke, the firm should have 100% payouts and no investment of retained earnings.

• If r=ke, the firm is indifferent between dividends and investments.

Mathematical representation• Mandar Mathkar has given a mathematical model for the

above made statements :

Gordon’s Model

• According to Prof. Gordon, Dividend Policy almost always affects the value of the firm. He Showed how dividend policy can be used to maximize the wealth of the shareholders.

• Assumptions:– All equity firm– No external Financing– Constant Returns– Constant Cost of Capital– Perpetual Earnings– No taxes– Constant Retention– Cost of Capital is greater then growth rate (k>br=g)

where,P = Market price of the shareE = Earnings per shareb = Retention ratio (1 - payout ratio)r = Rate of return on the firm's investmentske = Cost of equitybr = Growth rate of the firm (g)

Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share.

• Growth Firm (r > k):r = 20%k = 15% E = Rs. 4If b = 0.25

P0 = (0.75) 4 = Rs. 30 0.15- (0.25)(0.20)

If b = 0.50P0 = (0.50) 4 = Rs. 40 0.15- (0.5)(0.20)

Illustration :

• Normal Firm (r = k):r = 15%k = 15% E = Rs. 4If b = 0.25

P0 = (0.75) 4 = Rs. 26.67 0.15- (0.25)(0.15)

If b = 0.50P0 = (0.50) 4 = Rs. 26.67 0.15- (0.5)(0.15)

Illustration :

• Declining Firm (r < k):r = 10%k = 15% E = Rs. 4If b = 0.25

P0 = (0.75) 4 = Rs. 24 0.15- (0.25)(0.10)

If b = 0.50 P0 = (0.50) 4 = Rs. 20 0.15- (0.5)(0.10)

Illustration :

Modigliani & Miller’s Irrelevance Model

Value of Firm (i.e. Wealth of Shareholders)

Firm’s Earnings

Firm’s Investment Policy and not on dividend policy

Depends on

Depends on

Assumption– Capital Markets are Perfect and people are Rational– No taxes– Floating Costs are nil– Investment opportunities and future profits of firms

are known with certainty (This assumption was dropped later)

– Investment and Dividend Decisions are independent

MM Argument

• If a company retains earnings instead of giving it out as dividends, the shareholder enjoy capital appreciation equal to the amount of earnings retained.

• If it distributes earnings by the way of dividends instead of retaining it, shareholder enjoys dividends equal in value to the amount by which his capital would have appreciated had the company chosen to retain its earning.

• Hence,the division of earnings between dividends and retained earnings is IRRELEVANT from the point of view of shareholders.

Traditional Approach

• This theory regards dividend decision merely as a part of financing decision because– The earnings available may be retained in the

business for re-investment – Or if the funds are not required in the business

they may be distributed as dividends.• Thus the decision to pay the dividends or

retain the earnings may be taken as a residual decision

• This theory assumes that the investors do not differentiate between dividends and retentions by the firm

• Thus, a firm should retain the earnings if it has profitable investment opportunities otherwise it should pay than as dividends.