Capital Structure and the Dividend Policies Investment Term Paper

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Capital Structure and the Dividend Policies

Investment in firms

Miller-Modigliani Theorem

Impact of taxes

Impacts of bankruptcy

Dividend Signaling

Clientele effect

The general principles for investment are applicable to every business and these may be outlined simply through saying the one should invest in projects that provide greater yields than the basic minimum acceptable rate. The rate is naturally to be dependent on the risk involved in the project. It should also reflect the basic financing mix used and this means the mixture of the owners' funds or equity or capital and borrowed money or debt. The returns from the project will have to be measured through the cash flows generated as also the timing of the cash flows, and these cash flows can be either additive or depletive.

The important part of financial management is to choose a correct financial mix that gets a return as per the current cost of money and are also commensurate with the type of assets that the finance has been used for. There may be situations when the investments are not being able to earn the correct rate, then there is no purpose in continuing with the business and it is better to return the money to the shareholders. The days of the individual entrepreneurs is almost finished and to day most of the organizations depend on the equity-based structure for establishment, development and growth. The return to the stockholders is through various forms, but the most important aspect is the dividend.


All stockholders in a business expect to earn money from the business and this is given in the form of returns and these are dividends and stock buybacks. The method to be used depends on the preferences and types of stockholders who have invested in the business. The main aim in any business is always to achieve the highest possible returns. One of the best ways of making money for the shareholders is to have a good amount of debt. This happens as the company management has only got to makes fixed payment for debt. These payments are composed of the repayment of the debt and the concerned interest. There is the greatest requirement to pay these in time, as if these are not paid, the stockholder may end up loosing the business. The origin of debt can be from various methods and for small private businesses comes from bank loans. For large organizations whose shares are publicly traded, it comes from bonds. It should be remembered that all interest bearing liabilities, both of the short-term variety as well as the long-term variety are in the category of debt. (Corporate Finance: Lecture Note Packet 2)

There are some benefits of using debt and the most important financial benefit is the tax benefit. The other benefit is the compulsory discipline that it imposes on the management. Apart from the possibility of bankruptcy that has been discussed, there are direct costs of debt in both the interest as also the agency costs for getting the debt organized through an agent. Once the debt has been taken, it also reduces the future opportunity for the organization to take other loans. The cost in terms of interest is the market interest rates that have to be paid on the borrowing, a default premium on the basic interest rate depending on the reputation of the organization and the benefits come from the savings in taxes that the organization obtains from not paying taxes as the payment of interest is treated as an expense, and thus deductible. This tax benefit in dollar terms due to interest payments in a year is the multiple of the tax rate by the total interest paid in the year. (Corporate Finance: Lecture Note Packet 2)

Investment in firms:

The other route of getting money for the business is through equity, or contributions of the stockholders. Here, there are no permissible or required direct payments in the form of interests, but the return of the stockholders is the balance left after all payments have been made to others. This equity or capital can come in different forms. It may have come for very small businesses from the owners having invested their savings, for larger businesses it may have come through venture capital, and for established organizations it is the form of common stock. The valuation of equity of an organization can be either in terms of accounting or what may be called the book value of equity or in terms of market value as quoted in the exchanges, and which keeps changing on a day-to-day basis. (Corporate Finance: Lecture Note Packet 2)

The payments to the equity holders are called dividends and these cannot be deducted as part of expenses for the organization. This difference leads to complacency of the managers when the organization has no debt, and they get high income and cash flow every year. This situation leads to inefficiency and thus investment in poor projects, as there are practically no costs that have to be borne by the management. On the other hand, if the projects are executed with debt, the debt has to be returned in time to ensure that future debts will be obtainable for other projects. (Corporate Finance: Lecture Note Packet 2)

Getting into the details of dividend income, there are the regular dividends which are the cash distribution of earnings, and when it comes from other sources, it is called 'liquidating dividend'. The regular dividends are of the type that the stockholders expect the organization to pay and they may be quarterly, monthly, semiannually or annually. These are expected to be maintained. There are also extra dividends which may not be repeated or special dividends which are also not likely to be repeated. There are also stock dividends which are paid in the form of shares and are in effect similar to stock break-ups. These result in the increase of the number of shares and thus lead to the reductions in the price of the shares. There is now an increasing tendency for high payout in the form of dividends and this is both due to the presence of institutional investors as also in the exclusion of 80% of dividend from taxes. The dividends provide current income to some people who desire it, and also help in their legal and institutional requirements. (Capital Structure and Payout Policies)

For getting to the correct policy on dividends, the firm has to know the opinion of the shareholders. Their wishes are generally affected by 3 factors. The first of these is the position of the shareholders in the tax bracket, and if they are at the high end, they may prefer to get capital gains rather than dividends as the rate of taxes on dividends is higher than that on capital gains. This would lead to low payouts of dividend. On the other hand, if the shareholders are form the low tax ranges, then there tax payment on dividends may be lower than what they would have to pay on capital gains, and they may prefer shares which give high dividends. Another impact comes from the other opportunities for investment that are available to the shareholders, and this situation exists mainly in closely held companies. When the shareholders feel that they have suitable opportunities to invest in other business, then they may decide to withdraw money from the business through high dividends. (Dividend Policy)

Again, in this sort of companies, if there is only one controlling individual, or individuals who are closely related, then they would generally find it easier to control the organization when they regularly pay low dividends. This would also build up funds within the organization, so that they will not need to gather equity financing from other investors. The other situation may happen when the firms have good investment opportunities in capital projects, as then they will pay low dividends so that the surplus can be invested in the new capital projects. Savings in dividends are also used by some firms to reduce their debt ratios in excess of the debt ratio they desire to have. The savings may be used to move closer to the desired capital structure. On the other hand, when the firms have debt ratios lower than their desired debt ratios, dividend payment may be high to reach the targeted debt ratio. (Dividend Policy)

There is a difference in the cost of retained earnings and new equity when raised due to the high cost of flotation of equity. This may lead firms which desire to have high equity to finance the additional desired equity from savings, rather than from new flotation. This also will reduce dividends. Dividends are also a signal, and thus dividends are increased when the management thinks that profits are likely to increase in the near future. This has been discussed later. So far as the investors are concerned, they feel that a stable growth in dividends is an indicator of low risk. This may also…

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