Capital Structure and the Dividend Policies Investment

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.

Analysis:

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 lead firms to provide for a gradual growth in dividends to signal to the people that the firm has low risk. This ends up reducing the cost of equity capital. (Dividend Policy)

The dividend policy is also determined by certain industries in U.S. And the standards for the banking industry is 38.29%, for computer software services is 13.70%, for drugs it is 38. 06%, for electric utilities in Eastern U.S. It is 67.09%, semiconductors it is 24.91%, for steel it is 51.96%, for tobacco it is 55% and for water utilities it is 67.35%. (Distributions to Shareholders and Dividends and Repurchases) There are many methods for firms to raise required amounts of funds, but the fundamental and most important instruments are the stocks or bonds. The mixture of different securities forming the capital of the firm is known as the capital structure. This brings in the fundamental question of determining the most desired ratio for debt to equity. This means that if $10 million is required for funding a project should all the money be collected by issuing stocks or half of stocks and half of bonds where the ratio of debt to equity is 1, or any other combinations.

Miller-Modigliani Theorem:

This leads to the Miller-Modigliani Theorem which states that in a situation where there are no taxes, default risk or agency costs, capital structure is irrelevant. Here the value of the firm is independent of the debt ratio and leverage does not matter. The firm will be valued only by the cash flows of its projects. Changes in leverage will also not change the cost of capital of the firm. This is because when the firm increases the leverage, the cost of equity will also increase, and this will be just enough to cross out any gains to the leverage. This may be viewed as a decrease in flexibility and managers like flexibility. The reduction of flexibility takes place more through outside financing than through funds generated by the organization. Managers also like control, and that is one of the problems of issuing new equity as it reduces controls and new debts give rise to more bond covenants.

These cost control measures come through the components of financing like debt, equity or preferred stock, and the related shares of each. In general it may be said that the cost of equity is the expected rate of return and coverage of the expected risk, and the yield comes in the form of both dividends and increases in market price. The costs of both these debt and equity have to be evaluated in terms of market value weights and not book value weights. The ready made measure of debt and equity being carried by a firm is to look at the total proportion of debt in the financing of the firm and this is called the debt to capital ratio or debt divided by the total of debt and equity. (Corporate Finance: Lecture Note Packet 2)

The contribution of the theorem is that it has shown that in a perfect capital market the decision on financing does not matter. Their famous proposition 1 states that the total value of the firm is identical with any ratio of debt to equity if there are no taxes. But in real life there is an impact of the capital structure. The help provided by the theories of Miller and Modigliani helps one to understand the conditions of the market, and that also explains why one particular structure is better than another. The theory also advises people to the types of market imperfection that one has to take care of after finding out about them. The imperfections that make differences are from taxes, the cost of bankruptcy and the costs of devising and enforcing the different types of agreements for debt. This has to be viewed in light of the fact that corporations are taxed at the highest rate of 34%.

Impact of Taxes:

The important point to note is that according to the tax laws, only earnings after payment of interests are subject to tax. This is the main reason why firms use debt financing. Let us view the surplus value of the firm as a cake. This is to be divided between the owners of the firm, shareholders and bondholders and the government. When there are no bondholders, the government takes away 34% directly as its share. If the capital of the firm has been equally contributed by the shareholders and the bondholders, then the returns to the government will not be able to earn 34% as it does not earn 34% on the portion of the bondholders. Thus, it earns less and the difference is an amount that can be taken over by the owners of the firm. The tax shield would be dependent on the present value of the interest tax shields. (Capital Structure and Payout Policies)

Thus it is clear that when corporate taxes are present the value of the firm reaches the peak when the entire capital of the firm is through debt. This does not provide a very useful clue as there is no firm which is totally financed through debt totally. There are many problems as to make it impossible in real life. The first of these are the institutional and legal limits that are enforced by many institutions which will not deal with firms that have debt to equity ratios higher than some specified limits. The second aspect comes from the costs of the firm going bankrupt, and this will compel the management to stay within some limits. The third aspect is the limit imposed by the taxable income of the firm, and this means that the firm will not be able to borrow more than a certain amount. At the end of it all, there are conflicts of interest between the stockholders and bondholders.

Impacts of bankruptcy:

It is thus clear that 100% debt is not an optimal policy for any firm, and a study of the real life world says that the average ratio of debt to value is below 40%. There have also been studies among 768 of the largest industrial firms and this has shown that as much as 126 of them have no debt at all. (Capital Structure and Payout Policies) The theoretical calculation that a 100% debt would be the most profitable is not seen in practice. There is a wide range in the observed values of debt to equity and thus the theory may have more to it than originally thought. This is due to the costs of bankruptcy, and this has many different costs. The direct and most visible costs are in terms of the legal fees and court costs. The other expenses arise from stoppage of operations, the doubts about purchase of the product in the customers and the avoidance of any credit from the suppliers. These are the valid reasons why no firm tries to push the debt-equity ratios to very high levels.

The concept of bankruptcy costs brings into account a situation where the marginal tax advantage may be equal to the marginal bankruptcy costs. The marginal cost of bankruptcy is not the same for all firms, and this may be one reason why all firms do not employ the same ratio of debt to equity. With an outstanding debt, the shareholders are likely to take action to that will benefit themselves at the cost of the bondholders. At that stage, there comes a difference in the maximization of the value of the firm and the value of equity. These conflicts are expressed in different forms like claim dilution, dividend payout and asset substitution. The method of claim dilution is through the ranking of different debts by the stockholders.

In this method, the proceeds from new debt issues will be higher than the priority for the debt. This advantage being given to the new debt decreases the value of the old debt and leads to a drop in its market value. The total combined value of both the debts is fixed. The decrease in the value of the old debt provides benefits to the stockholders at the cost of the old bondholders. But they are not fools and the price of the bond reflects the estimated present values of the expected cash flows. The bondholders have already included the affects of conflicts of interests while estimating cash flows and in the pricing of the debt. They have paid for only what they expected to get. With the area of conflicts of interest between the stockholders and bondholders reducing the price of the debt, all the costs of the conflict will land on the stockholders.

Still, though the shareholders will have to cover the costs of such conflicts, they try to take out value or benefits from the bondholders when the debt has become outstanding. The stockholders also have to bear the costs that happen due to the conflicts of interest, and this gives them a desire to reduce the costs of the agencies. To do this, the bond agreements are made enforceable contracts and these reduce the scope of action by the stockholders when the debt has been issued. These contracts may enforce certain actions like mergers, sale of assets and lines of business, dividend payouts, priority, total debts, etc. At the same time, there are also usually specifications for auditing.

Dividend Signaling:

Within the payment of dividends there may be a desire to pass on information. This may be a signal by the managers to the public or stockholders that the management is anticipating prospects and future policies for the firm. When the managers want to convey to the public that there is likely to be good results, then this may be conveyed to the public by increasing the dividend rates. The decrease in dividend rates is normally not done as the dividends are taken as expectations of future values of the firm. An obvious question is why the information is not passed on through advertisements, press releases or any other method than increasing dividends. These techniques are often used by managers to pass on other information about the company including new prospects. The biggest problem with these methods is that people often tend to disbelieve the, and this happens because only the good news is given in this manner. It is unlikely that the managers will ring up a reporter to pass on bad news about the company to them. The passing on of information through an increase in dividend is credible, as it is well-known that this is an expensive method of conveying information. This is unlikely to carry false information. (Capital Structure and Payout Policies)