15.7Summary and Conclusions

This chapter analyzed two methods by which firms distrib-ute earnings to their shareholders: dividends and share re-purchases. In the absence of taxes and transaction costs,the two methods of distributing cash are virtually identical.However, taxable U.S. investors prefer share repurchases.

The chapter presented a few hypotheses that might ex-plain why corporations have paid out so much in tax-disadvantaged dividends instead of repurchasing theirshares, yet none of the explanations are entirely convinc-ing. We are still puzzled by the significant amount of divi-dends that U.S. corporations pay, and believe that tax-pay-ing shareholders would be better off if firms increased theirshare repurchase programs and simultaneously cut theirdividends. Firms may continue to pay dividends becausemanagers observe an increase in their stock prices whenthey announce dividend increases. However, we do not be-lieve that the positive stock price response to dividend in-creases provides a good rationale for paying a dividend.¹⁵

Other inexplicable puzzles also relate to dividend pol-icy and taxes. First, a number of U.S. firms implementedshare repurchase programs in the 1980s. This occurredeven as U.S. tax laws were changing to lessen the tax dis-advantage of dividends relative to share repurchases. Sec-ond, there are large differences across countries in both thetax treatment of dividends and the ability of firms to repur-chase shares. However, we do not observe systematic dif-

¹⁵This

topic is discussed in Chapter 19.

ferences in dividend yields across countries that corre-spond to these tax and institutional differences.¹⁶

Our analysis of the payout of dividends and taxes sug-gests that stocks with high dividend yields should offerhigher expected returns to attract tax-paying investors. Un-fortunately, testing this proposition has turned out to bedifficult. Historically, stocks with high dividend yields havehad higher returns than stocks with low dividend yields, butwe cannot conclude that the return premium representscompensation for taxes. Since dividend policies are highlycorrelated with investment policies cross-sectionally, it alsois likely that dividend policies are highly correlated withsystematic risk. Therefore, it may be impossible to distin-guish whether stocks with high dividend yields requirehigher rates of return because they are tax disadvantaged orwhether they receive higher rates of return because they arein some ways riskier. As Chapter 5 discussed, most recentempirical tests of asset pricing have failed to document a re-lation between systematic risk and expected returns, whichmakes us less sanguine about the possibility of determininghow dividends affect expected returns.

¹⁶As

an example, individual investors in Japan pay a tax of

only 20 percent on dividend income. Less than 25 percent ofall shares are held by individuals, however, and most other

shareholders pay no taxes on dividends. In Japan, averagedividend payout ratios are between 40 percent and 50 percentof earnings, about the same as in the United States, but

dividend yields are much lower in Japan given their muchhigher price/earnings ratios.

Key Concepts

Result	15.1:	(The Miller-Modigliani dividend	•There are no tax considerations.
		irrelevancy theorem.)Consider the choicebetween paying a dividend and using an equivalent amount of money to repurchaseshares. Assume: •There are no tax considerations. •There are no transaction costs.	•There are no transaction costs. •The choice between paying a dividend and retaining the earnings for reinvestment within the firm does not convey any information to shareholders.
Result	15.2:	•The investment, financing, and operating policies of the firm are held fixed. Then the choice between paying dividendsand repurchasing shares is a matter of indifference to shareholders. Consider the choice between paying out earnings to shareholders versus retainingthe earnings for investment. Assume:	Then a dividend payout will either increase or decrease firm value, depending on whether there are positive net present value (NPV) investments that could be funded by retaining the money within the firm. If there are no positive NPVinvestments, the money should be paidout. Result 15.3:In the United States, taxes favor share repurchases over dividends. The gain associated with a share repurchase over a cash dividend depends on:

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	IV	Capital Structure

	•The difference between the capital	•Tax-paying shareholders prefer that
	gains rate and the tax rate on	firms use lower required rates of
	ordinary income.	return for internally financed projects
	•The tax basis of the shares—that is,	if the alternative is paying taxable
	the price at which the shares were	dividends.
	purchased.
		Result 15.6:The combination of the corporate tax
	•The timing of the sale of the shares	deductibility of interest payments and the
	(if soon, the gain is less, but if too	personal taxes on dividends (and share
	soon, the gain may not qualify for	repurchases) implies that:
	the long-term capital gains rate).
		•The U.S. tax code favors debt
Result 15.4:	Stocks with high dividend yields are
		financing over financing investments
	fundamentally different from stocks with
		by issuing equity.
	low dividend yields in terms of their
		•For taxable shareholders, the tax
	characteristics and their risk profiles.
		preference for debt over internally
	Therefore, it is nearly impossible to assess
		generated equity (that is, retained
	whether the relation between dividend yield
		earnings) is less than the tax
	and expected returns is due to taxes or risk.
		preference for debt over newly issued
Result 15.5:	Tax-exempt and tax-paying shareholders
		equity. Indeed, individual investors
	agree about which projects a firm should
		with sufficiently high personal tax
	fund from external equity issues but may
		rates have a tax preference for
	disagree about which projects should be
		financing new investment with
	financed from retained earnings. In
		retained earnings, rather than paying
	particular:
		out the earnings and financing new
	•Tax-exempt shareholders require the	investment with debt.
	same expected return for internally
	financed projects as they do for
	externally financed projects.

Key Terms

classical tax system539	imputation systems539
dividend payout ratio533	investor clienteles541
dividend policy532	Miller-Modigliani dividend irrelevancy theorem	532
dividend yields534	pecking order of financing choices552

Exercises

15.1.Explain why the proportion of earnings distributed15.3.The Tax Reform Act of 1986 removed the tax

in the form of a share repurchase has increasedpreference for capital gains. Does this eliminate the

substantially over the past 25 years.tax preference for share repurchases over dividends?15.2.You are considering buying IBM stock which is15.4.Hot Shot Uranium Mines is issuing stock for the

trading today at $98 a share. IBM is going ex-first time and needs to determine an initial

dividend tomorrow, paying out $2.00 per share. Ifproportion of debt and equity. In its first years, the

you believe the stock will drop to $96.50firm will have substantial tax write-offs as it

following the dividend, should you buy the stockamortizes the uranium in the mine. In later years,

before or after the dividend payment? Explainhowever, it will have high taxable earnings. Make

how your answer depends on the tax rate ona proposal regarding the firm’s optimal capital

ordinary income, capital gains, and your expectedstructure and future payout policy.

holding period.

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How Taxes Affect Dividends and Share Repurchases

555

15.5.	Suppose you are a manager who wants to retain as	rate on dividends is 40 percent and the
	much as possible of the firm’s earnings in order to	effective personal tax rate on capital gains and
	increase the size of the firm. How would you react	share repurchases is zero.
	to proposals to repurchase shares that would make	b.The XYZ Corporation announces that it will
	it less costly to distribute cash to shareholders?	stop paying dividends. Instead, the company
	How does your reaction relate to your answer in	will engage in a stock repurchase plan under
	exercise 15.1?	which future cash that would previously have
15.6.	Hunter Industries has generated $1 million in	been earmarked for dividend payments will
	excess of its investment needs. The firm can invest	now be used exclusively for stock repurchases.
	the excess cash in Treasury bonds at 8 percent or	Assuming no information effects, what should
	distribute the cash to shareholders as a dividend.	the new price of a share of XYZ stock be when
	Assume that the corporate tax rate is 40 percent	market participants first learn of this
	and that the firm is owned by three different kinds	announcement?
	of taxpayers: The first type is tax exempt, the	15.9Alpha Corporation earned $150 million in before-
	second type has a 25 percent marginal tax rate,	tax profits in 1996. Its corporate tax rate is 35
	and the third type has a 40 percent marginal tax	percent. Daniel Reptella, who owns 20 percent of
	rate. Describe the decision preferred by the three	the firm’s shares, has a personal marginal tax rate
	different investors, indicating the reasons for the	of 40 percent. From Daniel’s perspective, what is
	decision and providing calculations to show your	the effective tax rate on Alpha’s profits if its entire
	conclusions. Next, consider the possibility that the	after-tax profits are distributed as a dividend?
	firm can invest in preferred stock that pays 7	15.10.You are engineering an LBO of Acme Industries,
	percent per year. Describe how this would affect	an industrial bottle maker. After the LBO, the firm
	Hunter’s decision, given the 70 percent dividend	will be financed 90 percent with debt and 10
	exclusion fozr corporate investors.	percent with equity. Fred Farber, the CEO, will
15.7.	Suppose that the capital gains tax rate is expected	own 30 percent of the shares. Fred thinks the
	to increase in three years. How would this affect	proposed capital structure is too highly levered
	Bill Gates’s decision on whether Microsoft should	and points out that, in the first few years, the firm
	use some of the company’s excess cash to	will not be able to use all its debt tax shields.
	repurchase shares?	Initially, the interest payments are $400 million
15.8	The XYZ Corporation has an expected dividend of	per year and EBITis only $300 million per year.
	$4 one period from now. This dividend is expected	However, EBITis projected to increase 20 percent
	to grow by 2 percent per period.	per year for the next five years.
	a.What is the value of a share of stock, assuming	Give Fred a pure tax argument that supports the
	that the appropriate discount rate for expected	high level of debt. Take into account his personal
	future dividends—e.g., the expected rate of	taxes as well as corporate taxes. Does your tax
	appreciation in the share price of XYZ between	argument depend on whether Fred wants to dilute
	dividends—is 10 percent per period? For your	his ownership of the company in the future?
	answer, assume that the effective personal tax

References and Additional Readings

Aharony, Joseph, and Itzhak Swary. “Quarterly DividendBagwell, Laurie Simon, and John Shoven. “Cash

and Earnings Announcements and Stockholders’Distributions to Shareholders.” Journal of Economic

Returns: An Empirical Analysis.” Journal of FinancePerspectives3, no. 3 (1989), pp. 129–40.

35, no. 1 (1980), pp. 1–12.Black, Fischer. “The Dividend Puzzle.” Journal ofAllen, Franklin, and Roni Michaely. “Dividend Policy.”Portfolio Management(1976), pp. 5–8.

Chapter 25 in Handbooks in Operations Research andBlack, Fischer, and Myron Scholes. “The Effects of

Management Science: Volume 9, Finance,RobertDividend Yield and Dividend Policy on Common

Jarrow, V. Maksimovic, and W. Ziemba, eds. Amster-Stock Prices and Returns.” Journal of Financial

dam, The Netherlands: Elsevier Science, B.V., 1995.Economics1 (1974), pp. 1–22.

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Strategy, Second Edition		Repurchases

556	Part Part IV	Capital Structure
	IV	Capital Structure

Blume, Marshall. “Stock Return and Dividend Yield:

Some More Evidence.” Review of Economics and

Statistics62 (1980), pp. 567–77.

Boyd, John, and Ravi Jagannathan. “Ex-Dividend Day

Behavior of Common Stocks.” Review of Financial

Studies7, no. 4 (1994), pp. 711–41.

Brennan, Michael. “Taxes, Market Valuation, and

Corporate Financial Policy.” National Tax Journal23

(1970), pp. 417–27.

Chen, Nai-fu; Bruce Grundy; and Robert F. Stambaugh.

“Changing Risk, Changing Risk Premiums, and

Dividend Yield Effects.” Journal of Business63

(1990), pp. S51–S70.

Donaldson, Gordon. Corporate Debt Capacity: AStudy of

Corporate Debt Policy and the Determination of

Corporate Debt Capacity.Boston: Harvard Graduate

School of Business Administration, 1961.

Dunsby, Adam. Share Repurchases and Corporate

Distributions: An Empirical Study.Working paper,

University of Pennsylvania, Philadelphia, 1993.

Eades, Kenneth; Patrick Hess; and Han Kim. “On

Interpreting Security Returns during the Ex-Dividend

Period.” Journal of Financial Economics13, no. 1

(1984), pp. 3–34.

Elton, Edwin, and Martin Gruber. “Marginal

Stockholders’Tax Rates and the Clientele Effect.”

Review of Economic and Statistics52 (1970), pp.

68–74.

Fama, Eugene, and Harvey Babiak. “Dividend Policy:

An Empirical Analysis.” Journal of the American

Statistical Association63 (December 1968),

pp. 1132–61.

Frank, Murray and Ravi Jagannathan. “Why Do Stock

Prices Drop by Less Than the Value of the Dividend?

Evidence From a Country Without Taxes.” Journal of

Financial Economics47 (1998), pp. 161–88.

Feenberg, Daniel. “Does the Investment Interest

Limitation Explain the Existence of Dividends?”

Journal of Financial Economics9, no. 3 (1981),

pp. 265–70.

Grinblatt, Mark; Ronald Masulis; and Sheridan Titman.

“The Valuation Effects of Stock Splits and Stock

Dividends.” Journal of Financial Economics13,

no. 4 (1984), pp. 461–90.

Hubbard, Jeff, and Roni Michaely. “Do Investors Ignore

Dividend Taxation? AReexamination of the Citizens

Utilities Case.” Journal of Financial and

Quantitative Analysis32, no. 1 (1997), pp. 117–35.

John, Kose, and Joseph Williams. “Dividends, Dilution,

and Taxes.” Journal of Finance40, no. 4 (1985),

pp. 1053–70.

Kalay, Avner. “Stockholder-Bondholder Conflict and

Dividend Constraints.” Journal of Financial

Economics10, no. 2 (1982), pp. 211–33.

Keim, Don. “Dividend Yields and Stock Returns:

Implications of Abnormal January Returns.” Journal

of Financial Economics14 (1985), pp. 473–89.

Lewellen, Wilbur; Kenneth Stanley; Ronald Lease; and

Garry Schlarbaum. “Some Direct Evidence on the

Dividend Clientele Phenomenon.” Journal of

Finance33, no. 5 (1978), pp. 1385–99.

Litzenberger, Robert, and Krishna Ramaswamy. “The

Effects of Dividends on Common Stock Prices: Tax

Effects or Information Effects?” Journal of Finance

37, no. 2 (1982), pp. 429–43.

Long, John B., Jr. “The Market Valuation of Cash

Dividends: ACase to Consider.” Journal of

Financial Economics6, no. 2/3 (1978), pp. 235–64.

Michaely, Roni. “Ex-Dividend Day Stock Price Behavior:

The Case of the 1986 Tax Reform Act.” Journal of

Finance46 (1991), pp. 845–60.

Miller, Merton, and Franco Modigliani. “Dividend Policy,

Growth and the Value of Shares.” Journal of

Business34 (October 1961), pp. 411–33.

Miller, Merton, and Myron Scholes. “Dividends and

Taxes.” Journal of Financial Economics6, no. 4

(1978), pp. 333–64.

———. “Dividends and Taxes: Empirical Evidence.”

Journal of Political Economy90 (1982), pp. 1118–41.Peterson, Pamela; David Peterson; and James Ang.

“Direct Evidence on the Marginal Rate of Taxation

on Dividend Income.” Journal of Financial

Economics14 (1985), pp. 267–82.

Pettit, Richardson. “Taxes, Transaction Costs and the

Clientele Effect of Dividends.” Journal of Financial

Economics5, no. 3 (1977), pp. 419–36.

Poterba, James. “The Market Valuation of Cash

Dividends: The Citizens Utilities Case

Reconsidered.” Journal of Financial Economics15

(1986), pp. 395–406.

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CHAPTER	Bankruptcy Costs and Debt
16	Holder–Equity Holder Conflicts

Learning Objectives

After reading this chapter you should be able to:

1.Understand the effect of direct bankruptcy costs on borrowing rates and capital

structure choices.

2.Describe the factors contributing to the conflicts of interest between debt holders

and equity holders.

3.Explain how debt can cause equity holders to take on projects that are too risky

and to pass up positive NPVprojects.

4.Identify various situations in which debt holders and equity holders may disagree

on the liquidation decision.

5.Understand how bond covenants, bank loans, privately placed debt, project

finance, and convertible bonds can mitigate some of these debt holder–equity

holder conflicts.

6.Describe how conflicts between debt holders and equity holders affect capital

structure choices.

By May 1992, Terex Corporation, a producer of tractor trailers and earth-moving

machines, had experienced several quarters of depressed and sometimes negative

operating income (EBIT). Its stock had fallen 60 percent in the previous two years.

Many investors saw the company as having a significant risk of default, although

such default was not “imminent.” Randolph Lenz, the company’s chairman, chief

executive, and owner of 53 percent of the shares, decided that Terex would undertake

a leveraged acquisition despite these problems. Upon the announcement that it would

acquire the forklift division of Clark Equipment for $95 million, Terex’s stock rose

from 11⁵8

to 12. Although investors may have seen the increased risk as positive for

the company’s stock, the acquisition target was extremely speculative, causing the

value of Terex’s existing bonds to fall substantially.

Up to this point, we have examined the firm’s capital structure decision within a

simplified setting which either ruled out the possibility of bankruptcy or, alterna-

tively, assumed that if bankruptcy occurs, the assets of the corporation would transfer

557

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558Part 1VCapital Structure

costlessly from equity holders to debt holders. This chapter moves beyond these sim-

plifying assumptions and examines the capital structure choice in a world where bank-

ruptcy imposes costs on the firm.

Treasurers of bankrupt firms who saw their firm’s stock price fall almost to zero

might claim that bankruptcy is extremely costly. However, while debt financing may

have significantly contributed to the bankruptcy, most of the loss in firm value leading

up to the bankruptcy cannot be attributed to debt financing per se but to misfortunes

affecting the firm’s actual business operations. Only those lost revenues or increased

operating costs attributed either directly or indirectly to the event of bankruptcy or,

more generally, to the threat of bankruptcy are relevant to a firm’s capital structure

decision. Therefore, as long as bankruptcy or the threat of bankruptcy does not affect

the cash flows available to the firm’s debt and equity holders, the possibility of bank-

ruptcy is irrelevant to a firm’s capital structure decision.

The extent to which bankruptcy reduces the cash flows of firms has been debated

extensively in the academic literature. The reductions in cash flows related to bank-

ruptcy or the threat of bankruptcy are generally classified as either direct bankruptcy

costs or indirect bankruptcy costs. Direct bankruptcy costsrelate to the legal process

involved in reorganizing a bankrupt firm. Indirect bankruptcy costsare not directly

related to the reorganization and can arise among financially distressed firms, or those

firms that are close to bankruptcy, but which may never actually go bankrupt. As shown

later in this chapter and in Chapter 17, most indirect bankruptcy costs arise because

financial distress creates a tendency for firms to engage in actions that are harmful to

their debt holders and nonfinancial stakeholderssuch as customers, employees, and

suppliers. As a result of these harmful actions, a financially distressed firm may find it

difficult to obtain credit and may find it more costly in other ways to efficiently carry

out its day-to-day business.

This chapter focuses on the conflicts of interest that can arise between a firm’s debt

holders and equity holders. In the chapter’s opening vignette, for example, Terex’s

acquisition of Clark Equipment may have been made with the interests of Terex’s stock-

holders in mind. Although this acquisition indeed benefited stockholders, it resulted in

a reduction in the value of Terex’s outstanding bonds and therefore was not in the best

interests of the company’s debt holders.

When these conflicts exist, the net present value (NPV) of a project, calculated

by discounting the cash flows to equity holders, can be substantially different from

the NPVcalculated with either the APVor WACC method. For example, Chapter 13

illustrated how the NPVof the equity holders’cash flows from a relatively safe

investment project could be negative, even though the NPVof the total cash flows

to both debt holders and equity holders is positive. In other words, firms that oper-

ate solely in the interests of their equity holders, thereby ignoring the interests of

their debt holders, may pass up value-creating projects. In addition, these firms may

take on excessively risky projects that benefit equity holders but lower the value of

the firm’s debt.

This chapter argues that the equity holders of a firm ultimately can be hurt by the

firm’s tendency to ignore the interests of its debt holders. This tendency may result in

a firm’s inability to obtain debt financing at attractive terms and, in some cases, it may

prevent a firm from obtaining any debt financing at all. One solution to this problem

(discussed later in the chapter) is to design the debt so that it minimizes the potential

for conflict. This can be accomplished through convertibility features and debt

covenants (see Chapter 2), which are terms included in many debt contracts to limit a

firm’s investment and financing choices. Because these solutions are imperfect,

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Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

559

however, firms generally will want to limit the amount of debt in their capital struc-

ture even when there are substantial tax benefits to debt financing.

Most of the key issues in this chapter are developed with a set of relatively simple

numerical examples. Unless specified otherwise, valuation in these examples assumes

risk neutrality, no direct bankruptcy costs, no taxes, and a risk-free rate of zero.