Term Paper: Capital Structure and the Dividend

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[. . .] 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… [END OF PREVIEW]

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