Capital Structure

Gearing

1.    Operating gearing

-       Refer to the percentage of fixed cost in the total cost.

-       High operating gearing means high business risk.

-       High operating gearing means the fixed cost of the company is high and variable cost is low.

-       High fixed cost will bring high risk to company, because company can not cut the fixed cost in short term.

2.    Financial gearing

-       Use to analysis the value of company actually how many percent is coming from debt.

(i)            Capital gearing

Ø  Focuses on the total capital is in the form of debt.

(ii)          Income gearing

Ø  Look at the proportion of income is taken by interest charges to debt holder.

-       High financial gearing means high financial risk, because no matter company get profit or loss also necessary to pay fixed amount interest to debt holders in certain period.

-       If the company does not have enough cash flow to afford it, it will cause the company bankrupt.

Modigliani-Miller Model

Assumptions of Modigliani-Miller Model

1. There is no taxation.
2. In prefect capital market everybody have full information and no transaction cost. They know which share is good and no need agency fee and etc.
3. No cost of financial distress and bankruptcy.
4. Can sell or buy any share immediately will not cost.
5. Interest change is same between individual and company borrowing.

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Modigliani-Miller Proposition I

-       In a perfect market, the market value of geared firm (V_L) is same as ungeared firm (V_U). à V_L = V_U

-       The capital structure can not affect the value of company.

-       Company can only increase their firm’s value by making good investment decision. Capital structure is financial decision.

-       Only expected return and risk will affect the value of firm.

-       If there is mispriced, geared firm (V_L) not equal to ungeared firm (V_U) , investor can sell the overvalue share and buy undervalue share to earn arbitrage profit.

-       Therefore, value is not affected by financial decision(capital structure) but investment decision(risk)

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Modigliani-Miller Proposition II

-       When the firm increases the debt level (borrowing), the cost of equity will also increase.

-       Because shareholders will see the risk of their investment increase when the firm increase the debt level (borrowing), therefore shareholders will require high level of return, so the cost of equity of firm increase.

-       k_E = k₀ + (V_D / V_E) ( k₀ – k_D )

²  k_D : the interest rate (cost of debt)

²  k_E : the return on (levered) equity (cost of equity)

²  k₀ : the return on unlevered equity (cost of capital)

²  V_D : the value of debt

²  V_E : the value of levered equity

-               Expected rate of return of equity (kE) is affected by the DE Ratio

-               VD / VE  = Debt Equity Ratio (DE Ratio)

-       When VD ↑ , VD / VE ↑  à kE ↑, means cost of equity increase. Therefore, the required rate of return increases.

-       Invest in gear firms have a higher risk and higher return. It is actually a trade off between risk and return

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Modigliani-Miller Proposition III

-       Rate of return new projects = WACC and WACC is constant regardless is geared and ungeared firm.

-       Value of firm will remain the same.

-       An investment should be accepted when NPV>0.

-       Focus on investment decision, not financial decision.

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The MM Propositions I & II (with Corporate Taxes)

-           With corporate tax, value of geared firm will increase.

-       This is because overall cost of capital (WACC) reduce due to the cost of debt fall after the tax saving.

-       Tax saving only occurs for firm that issue debt because interest payment will reduce the profit which lead to a tax deduction. Company cash inflow will increase.

Proposition I

-       V_L = V_U + T_C V_D

²  VL > VU because TCVD > 0

Proposition II

-       k_E = k₀ + (V_D/V_E)×(1-T_C)×(k₀ - k_D)

²  kE1 = k0 + (VD / VE) (k0 – kD)

kE1 ↑ when VD ↑

²  kE2 = k0 + (VD / VE) x (1-Tc)(k0 – kD)

kE2 ↑ when VD ↑

²  But, kE1 ↑ > kE2 ↑ due to tax benefit.

²  Overall cost of capital reducesà value of firm increase.

Additional considerations

-       The financing decision (capital structure) can not affect the value of firm. But after tax come in the result will different.

-       After the tax come the elements need to consider are:

1.    Financial Distress

-       The major disadvantage for a company taking high level of gearing (debt) is it will increase the financial distress, and increase probability of bankrupt because the firm is necessary to return the borrowing.

-       Although increase debt can increase tax saving, but also will increase cost of financial distress (financial risk) and probability of bankrupt.

2.    Agency Costs

-       Agency costs are the incremental costs of having an agent make decisions for a principal.

-       In a company have shareholders, bond holders and management terms these 3 parties.

-       Interest and information that they can get is different. Manager will have more information compare to the shareholders and bondholders because of unequal information between this 3 parties, it lead to manager cheat the other 2 parties to benefit himself.

3.    Borrowing Capacity

-       Lenders prefer secured lending, and this sets an upper limit on gearing.

-       Because if the company was unable to afford the interest payment the lenders can sell company tangible assets to get the compensation.

-       Therefore, the borrowing capacity of company is depend on it tangible assets.

-       Investors willing to invest more if the company has high tangible assets. It will cause the company easy to issue bond. It will lead to high gearing level.

-       Investors not willing to invest more if the company has low tangible assets. It will cause the company difficult to issue bond. It will lead to low gearing level.

-       Tend to argue for lowering debt level.

4.    Managerial Preferences

-       The capital structure of the company will impact manager preferences as well.

-       Most of the time, the manager will not increase too must borrowing (debt) to cause or increase the probability bankrupt, because when the company bankrupt the manager will lost their jobs.

-       Tend to argue for lowering debt level.

5.    Pecking Order

-       Base on pecking order, when the firm designs to invest in new project they will consider about fist use internal finance, second issues debt and last issues equity.

-       The company only will issue debt and equity when the internal finance is not enough.

-       Reasons of pecking order view are transaction costs and asymmetric information (adverse selection).

-       In the pecking order view, the firm should use the method of financing with the least amount of transaction costs first. Financing methods with higher transaction costs are used next.

-       Base on the pecking order the company’s gearing level will low, if the company internal fund is enough.

-       Base on the pecking order the company’s gearing level will high, if the company internal fund is not enough.

-       Uncertainty.

6.    Financial Slack

-       Means the company has enough cash and excess debt capacity.

-       Therefore, the company will not fully use debt capacity and increase borrowing (debt) until lack level although optimal.

-       Tend to argue for lowering debt level.

7.    Signaling

-       Manager will not let company in risk level. Therefore they will not easy issue bond because they need to pay large amount of interest.

-       If they are not confident to generate high cash flow in future they will not issue bond to let company in risk level because they will lost the job if company bankrupt.

-       Although some people said manager issue share show the share price of company is overprice in market but in other side we also can describe that the company not able to pay fixed bond interest (do not have enough cash flow).

-       Uncertainty.

8.    Control

-       Most of the time the company will choice to increasing debt financing (issue debt) to increase fund because the shareholders not willing to affect their ownership.

-       In order to avoid the share of company will buy by the rival, most of the company may be choice to increasing debt financing.

9.    Tax Exhaustion

-       Many companies do not have very high debt level because their profits are not high enough to benefit from benefit of tax deduction.

-       Tend to argue for lowering debt level.

10. Industry Group Gearing

-       There is no prefer formula can be use to establish the best debt to equity ratio for firm in all situation.

-       Different industry have different gearing ratio.

-       Uncertainty.

Some further thoughts

Motivation

-       Debt is fixed payment, it will pressure manager to perform better to generate more cash flow to pay dividend to avoid company bankrupt.

-       Tend to argue for raising debt level.

Reinvestment Risk

-       High debt will lead to the company pay dividend to debt holders, thereby denying spare cash to the managers.

-       Tend to argue for raising debt level.

Operating and Strategic Efficiency

-       Geared firm will make decision carefully because they need to measure have enough or stable cash flow to pay bond dividend.

-       Tend to argue for raising debt level.

Dividend Policy

Assumption:

1.    No change in investment opportunities and returns on business investment.

2.    No change on company capital structure.

-       No change on debt to equity ratio.

-       No change in gearing ratio.

Modigliani-Miller’s dividend irrelevancy proposition

-       The value of company will not affect by capital structure of company.

-       The dividend policy of company will not affect the share value, market value and shareholders’ wealth.

-       The company should not give up positive Net Present Value project to increase dividend.

Modigliani-Miller’s dividend irrelevancy proposition – the conditions

1.    Ignore taxes. (company and personal taxes)

2.    Ignore transaction cost.

-       When investors buy or sell no need pay any fee.

-       No cost of issue new share.

3.    Lending and borrowing’s interest rate is same.

4.    All parties (company and investors) of market have full information.

5.    Investors are indifferent between dividends and capital gains.

Dividend – irrelevance position

-       Under the value of dividend unchanged situation, it will not cause shareholders unsatisfied although the company changes the timing to pay dividend to shareholders. (don’t pay dividend to shareholders)

-       That is because the shareholders can get the value from capital gain, although do no have dividend.

-       Therefore the dividend policy will not affect the shareholders’ wealth.

-       Under dividend – irrelevance position, dividend policy will not important.

Dividends as a Residual

-       Company only will pay dividend after cover the future investment (required rate of return of the project) and have extra fund.

-       Company’s value increase only when the company invest in positive Net Present Value project.

-       The shareholders should receive the cash because they can use it to invest in other firms.

Dividend – relevance position

Under this real world the dividend policy of a company can affect the company.

The Clientele Effect

-       Investors will attract by company which can fulfill their requirement.

-       Different dividend policy of company can attract different kind of investors.

-       Therefore each company will build up a dividend policy which can satisfy and retain their shareholders.

-       In order to satisfy and retain the type of shareholder that the company target, each company will promote different dividend policy. Such as:

Ø  Promote high dividend payment, or

Ø  Promote low payout dividend payment, or

Ø  Promote stable dividend payment, or

Ø  Promote fluctuating dividend payment. (dividend payment depend by company earning, high earning pay high dividend, low earning pay low dividend)

Taxes

-       Personal taxes.

-       Taxation can affect investors whether prefer get capital gain or get dividend.

-       Individual shareholder can sell share by high price with no tax deducted, if they receive dividend pay by company they need to pay tax to government.

-       High tax rate will lead shareholders prefer low dividend payment.

-       Low tax rate will lead shareholders prefer high dividend payment.

Dividends as conveyors of information

-       No full information between shareholders and management term.

-       Shareholders are the owner but not manager of a company, shareholder only can get company information from annual report or decision making dividend of the company.

-       Therefore, if the company increase the dividend payment will give the shareholders a good signal about the company have favorable prospects.

-       Dividends as conveyors of information will cause company:

Ø  Promote high dividend payment.

ü  Some shareholder will consider that high dividend payment may be will lead to company do no have enough cash to do future investment or invest positive Net Present Value project, it will affect the future firm’s value.

Ø  Promote low dividend payment.

ü  Some shareholder will consider that low dividend payment can let the company have enough cash to do future investment or invest positive Net Present Value project, it will increase the future firm’s value.

Ø  Promote stable dividend payment.

ü  Only strong financial background company able to remain stable dividend payment no matter the company gain or less.

Resolution of Uncertainty – Bird-in-the-hand

-       Shareholders prefer receive high dividend today than receive in future because future is uncertainty.

-       Bird-in-the-hand will encourage the company:

Ø  Promote high dividend payment.

ü  Shareholders receive high dividend today to do other invest to increase their shareholders’ wealth, because future is uncertainty.

Ø  Promote fluctuating dividend payment.

ü  Current dividend is better than uncertainty in future, because the shareholders don’t know the company will get earning in future or not.

-       The correct way to solve the uncertainty are:

(i)            Do no receive high dividend payment today because it will lead to company do no have enough cash to do future investment or invest positive Net Present Value project, it will affect the future firm’s value.

(ii)          Increase cost of capital or use high cost of capital.

Owner control (agency theory)

-       Many companies will decide to pay high dividend and issuing new shares to raise cash for investment.

-       Because no full information between shareholders and management term, therefore shareholders worry management term will invest in negative Net Present Value project or project which is only benefit management term.

-       Therefore, shareholders will require high dividend, management term need fund for investment they need to ask shareholders. The shareholders can get the currently information of company.

-       Disadvantage of owner control:

Ø  Company need to pay transaction cost when issue new share, it will reduce firm’s value.

Ø  Shareholders need to pay tax when receive dividend, it will reduce shareholders’ wealth.

-       Owner control will cause company

Ø  Promote high dividend payment.

ü  High dividend payment wills easy shareholders to monitor the management term, because the manager need to provide more information to shareholders when decide to invest new project.

Ø  Promote fluctuating dividend payment.

ü  Shareholders can get the signal directly base on the dividend payment. If company gain they will receive high dividend. If company loss they will receive low dividend or don’t have dividend.

Scrip Dividends (Share Dividend)

-       Company paying share dividend to shareholders not normal cash dividend.

-       Advantage of scrip dividends

Ø  That cash does not leave the company.

Ø  Shareholders can save tax and transaction cost by holding share.

Share Repurchase and Special Dividends

-       Share repurchase means company buys back share by its own stock, it can increase EPS, and the share price of company.

-       Special dividend is similar to a normal dividend but is usually bigger and paid on a one-off basis.

The two key questions

1.     Can shareholder wealth be increased by changing the pattern of dividends over a period of years?

Ans: Yes, but that is not straightforward formula for us to calculate the best pattern. Because there are many different and unpredictable factors will affect it, such as clientele preference, tax system and other.

2.     Is a steady, stable dividend growth rate better than one which varies from year to year depending on the firm’s internal need for funds?

Ans: Perform well or bad in no under control. Dividend payment remains stable or fluctuation which one is better and what reason affect it will show in following:

The dividend decision – the four forces

Forces promoting a high dividend payment

(i)    Some clienteles

-       Shareholders preference, different shareholders have different preference.

(ii)  Owner control (agency theory)

-       Shareholders require high dividend can let them easy to monitor management team, because manager needs to ask shareholders when need fund for investment. The shareholders can get the currently information of company.

(iii) Uncertainty (bird-in-the-hand)

-       Shareholders receive high dividend today to do other invest to increase their shareholders’ wealth, because future is uncertainty.

(iv) Signalling (Dividends as conveyors of information)

-       The company increase the dividend payment will give the shareholders a good signal about the company have favorable prospects.

Forces promoting a low payout dividend payment

(i)    Tax system

-       Different country will have different tax system. High tax rate will lead shareholders prefer low dividend payment

(ii)  Some clienteles

-       Shareholders preference, different shareholders have different preference.

(iii) High growth potential

-       The company has high growth potential therefore need more fund for future investment.

(iv) Unstable earning

-       Because of earning in future is uncertainty in order to measure company can save fund when company gain and have enough fund when company loss, company remain low dividend payment may be better.

(v)  Avoid future dividend cuts

-       If earning increase the dividend payment also will increase, if earning decrease the dividend payment also will decrease, because of future is uncertainty. In order to measure company can save fund when company gain and have enough fund when company loss, company remain low dividend payment may be better.

(vi) Lender agreement restrictions

-       Company need to pay interest to debt holders first therefore no enough funds to pay high dividend to shareholders.

(vii)  Low liquidity

-       Company has no enough cash flow.

Forces promoting a stable dividend payment

(i)    Some clienteles

-       Shareholders preference, different shareholders have different preference.

(ii)  Signalling

-       Dividend policy change is difficult to justify whether it is good or bad signal. If investors interpret this signal is positive they will continue invest, if no they may be will quit. In order to avoid this kind of confusing remain stable may be better.

(iii) Avoid future dividend cuts

-       If earning increase the dividend payment also will increase, if earning decrease the dividend payment also will decrease. In order to avoid dividend decrease, company will remain stable may be better.

(iv) Stability raises credit standing

-       Only strong financial background company able to remain stable dividend payment no matter the company gain or less.

  

Forces promoting a fluctuating dividend payment

(i)    Some clienteles

-       Shareholders preference, different shareholders have different preference.

(ii)  Owner control (agency theory)

-       Shareholders will require high dividend, management term need fund for investment they need to ask shareholders. The shareholders can get the currently information of company. It can avoid manager invest in project which only benefit management term.

(iii) Uncertainty (bird-in-the-hand)

-       Current dividend is better than future uncertainty dividend.

(iv) Signalling

-       Shareholders can get the signal directly base on the dividend payment. If company gain they will receive high dividend. If company loss they will receive low dividend or don’t have dividend.

Practical constraints to dividend payment

• Legal constraints

-       Different country have different tax rate (personal tax in dividend income), therefore every company have different dividend policy.

• Liquidity

-       The earnings and cash flow of company is no 100% match, because of accounting profit problem. Therefore dividend payment can not 100% depend on the accounting profit earning.

• Interest payment obligations

-       Company need to pay interest to debt holders first before pay dividend to shareholders.

• Investment opportunities

-       Low investment opportunity company normally can pay high dividend currently.

A suggested action plan for a dividend policy

(How to decide whether pay high or low dividend)

1. Do forecast in “surplus” cash flow, the dividend will only pay without give up positive Net Present Value project.
2. Base on the forecast of the company, most of the company will still choice a stable dividend payment because future is uncertainty. Therefore, the company needs to retain some cash in hand for uncertainty future.
3. Forecast is no 100% correctly, maintain stable dividend payment if company earning is more than company forecast can pay share dividend.

 Conclusion

The firm’s value and shareholders’ wealth will decrease when reject positive Net Present Value project to pay dividend.

Issuing new share will not benefit company because transaction cost will increase cost of capital of company and decrease firm’s value.

Pay dividend will not benefit shareholder because personal tax in dividend pay will reduce shareholders’ wealth.

Share dividend and can avoid paying cash dividend and retain cash in company.

Share repurchase can increase EPS, and the share price of company.

Company will pay dividend only when the company is low opportunity investment.

Most of company will maintain stable dividend payment. There do not prefer formula to calculate the optimal dividend-to-earning ratio.