74. Capital Structure Concept. Dividend Policy. Концепция структуры капитала. Дивидендная политика.

A firm’s capital structure is the relative proportions of debt, equity, and other securities that a firm has outstanding + taxes. The value of the firm = market value of the debt + the market value of the equity + taxes (pie theory). Changes in capital structure benefit the stockholders only if the value of the firm increases. Modigliani and Miller proposed the idea that in a perfect market how a firm is financed is irrelevant to its value.

MM proposition I (no taxes): 1) Value of the levered firm is the same as the value of the unlevered firm. If levered firms are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms. This substitution is often called homemade leverage. As long as individuals borrow (and lend) on the same terms as the firms, they can duplicated the effects of corporate leverage on their own. 2) MM I implies that r_WACC is a constant for a given firm, regardless of the capital structure. Let r₀ be the cost of capital for an all-equity firm. r_WACC= r₀.

MM Proposition II (no taxes): r_S=r₀ + (B/S)*(r₀-r_B). The required return on equity is a linear function of the firm’s debt-to-equity ratio.

Taxes: 1) Tax shield = corporate tax rate x dollar amount of interest = T_c×r_B×B. 2) PV of tax shield = T_c*B, by assuming that the cash flows are perpetual.

MM Proposition I (with taxes): V(L)=(EBIT* (1-T_c))/r₀ + (T_c*r_B*B)/r_B = V(U) + T_c*B, where r₀ is the cost of capital to an all-equity firm, it now discounts after-tax cash flows. The value of the levered firm is value of an all-equity firm plus PV of tax shield.

MM Proposition II (with taxes): r_S=r₀ + B/S * (1-T_c)*(r₀-r_B); S=((EBIT-r_B*B)*(1-T_c)/r_S;

r_WACC=(B/V)*r_B*(1-T_c)+(S/V)*r_S, r_WACC declines with leverage in a world with corporate taxes. When a firm lowers its r_WACC, the firm’s value will increase: V(L)= (EBIT*(1-T_c))/ r_WACC.

Dividend policy is concerned with taking a decision regarding paying cash dividend in the present or paying an increased dividend at a later stage. The firm could also pay in the form of stock dividends which unlike cash dividends do not provide liquidity to the investors, however, it ensures capital gains to the stockholders. The expectation of dividends by shareholders helps them determine the share value.

Walter's model. Assumptions:1) Retained earnings are the only source of financing investments in the firm, there is no external finance involved. 2) The cost of capital, k _e and the rate of return on investment, r are constant. 3) The firm's life is endless.

Application: 1) If r>k_e, firm should have zero payout and make investments; 2) If r<k_e, firm should have 100% payouts and no investment of retained earnings; 3) If r=k_e, firm is indifferent.

Mathematical representation: P=Div/k_e+((r/k_e)*(EPS-Div))/k_e.

The market price of the share comprises of the sum total of: PV of an infinite stream of dividends and PV of an infinite stream of returns on investments made from retained earnings.

Criticism: 1) The assumption of no external financing apart from retained earnings, for the firm make further investments is not really followed in the real world. 2) The constant r and k_e are seldom found in real life, because as and when a firm invests more the business risks change.

Gordon's Model. Assumptions similar to the ones given by Walter + 1) The product of retention ratio RR and the rate of return r gives us the growth rate of the firm g. 2) The cost of capital k_e, is not only constant but greater than the growth rate i.e. k_e>g.

Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions and discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating a higher value of the share. => When retention rate increases, they require higher discounting rate.

Mathematical representation: P=(EPS*(1-RR))/(k_e-g)

Criticism: Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar.

Capital structure substitution theory & dividends. Company managements manipulate capital structure such that earnings-per-share are maximized. Thus, the resulting dynamic D/E target explains why some companies use dividends and others do not. When redistributing cash to shareholders, company managements can typically choose between dividends and share repurchases. But as dividends are in most cases taxed higher than capital gains, investors are expected to prefer capital gains. However, the CSS theory shows that for some companies share repurchases lead to a reduction in EPS. These companies typically prefer dividends over share repurchases.

Mathematical representation: D/E>(1-T_C)/(1-T_D)-1, where T_C is the tax rate on capital gains; T_D is the tax rate on dividends.

The CSS theory provides more guidance on dividend policy to company managements than the Walter model and the Gordon model.

M&M. Irrelevance of dividend policy

Assumptions: 1) No transaction costs; 2) perfect capital market; 3) no lags; 4) no taxes and floatation costs; 5) divisible securities; 6) no external financing.

The dividend irrelevancy in this model exists because shareholders are indifferent between paying out dividends and investing retained earnings in new opportunities. The firm finances opportunities either through retained earnings or by issuing new shares to raise capital. The amount used up in paying out dividends is replaced by the new capital raised through issuing shares. This will affect the value of the firm in an opposite ways. The increase in the value because of the dividends will be offset by the decrease in the value for new capital raising.