mba fin - lecture 6a

8/6/2019 Mba Fin - Lecture 6a

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Academy of Finance MBA Program, Finance

Lecture 6A

Optimal Capital Structure

Dividend Decision

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Financing the business

There only two ways to finance a company:

Debt

Make fixed payments in the future (interest and repayment of

principal)

Failure to make payments can mean losing control of the business

Note: Current liabilities are a form of short-term working capital

financing

Equity

Pay back whatever is left after debt obligations are met


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Sources of Debt and Equity

Debt

For private businesses, it is usually bank loans

For public companies, it can also be bond issues

Equity

For small businesses, it is the owners capital

For larger businesses, it can be venture or privateequity capital (usually on a preferred basis)

For publically traded firms, it is common stock

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Costs and Benefits of Debt

Costs

Bankruptcy costhigher business riskrelates to higher cost

Agency cost greaterseparation betweenstockholders andlenders relates to highercost

Loss of financingflexibility when there isuncertainty about futurefinancing needs

Benefits

Tax benefit

Adds discipline tomanagement


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What is the optimal level of borrowing?

Miller-Modigliani theorem

Under ideal conditions, when there are no taxes, no

agency costs, no threat of bankruptcy, and future

financing needs are known:

The value of a firm is independent of its capital structure

A firms value will be determined by its projected cash flows

Cost of capital will not change with leverage gains fromleverage will be offset by increases in the cost of equity

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Financing hierarchy

Managers value flexibility - External financing reducesflexibility more than internal financing

Managers value control - Issuing new equity weakens control

and new debt creates bond covenants

Therefore, financing with retained earnings should be themost preferred choice for financing, followed by debt. Newequity is the least preferred choice


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Survey results preference ranking for long-term finance

Retained Earnings 5.61

Straight Debt 4.88

Convertible Debt 3.02

External Common Equity 2.42

Straight Preferred Stock 2.22

Convertible Preferred 1.72

SourceSource ScoreScore

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What is the optimal capital structure?

The following approaches can be considered:

Minimize cost of capital

Maximise the overall value of the firm

Bring the firms capital in line with relevant peergroup

The structure that best suits where the firm is in

its lifecycle


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Framework for getting to the optimal

If actual debt ratio is greater than the optimal one:

Is the firm under

bankruptcy

threat?

Is the firm under

bankruptcy

threat?

Reduce debt quickly:

Debt/Equity swaps

Sell assets to pay off

debt

Renegotiate with

lenders

Reduce debt quickly:

Debt/Equity swaps

Sell assets to pay off

debt

Renegotiate with

lenders

Does the firm

have value-

adding projects?

Does the firm

have value-

adding projects?

Pay off debt with

new equity orretained earnings

Reduce or eliminate

dividends

Pay off debt with

new equity orretained earnings

Reduce or eliminate

dividends

Finance good projects

with new equity orretained earnings


with new equity orretained earnings

YES YES

NO NO

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Framework for getting to the optimal

If actual debt ratio is lower than the optimal one:

Is the firm a

takeover target?

Is the firm a

takeover target?

Increase leverage

Quickly

Equity/Debt swaps

Borrow money and

buy back shares

Increase leverage

Quickly

Equity/Debt swaps

Borrow money and

buy back shares

Does the firm

have value-

adding projects?

Does the firm

have value-

adding projects?

Pay dividends or buy

back stock

Pay dividends or buy

back stockFinance good projects

with debt


with debt

YES YES

NO NO


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Designing debt

Optimal financing instrument would have all the tax

advantages of debt while preserving the flexibility of equity

C/F characteristicsC/F characteristics Debt characteristicsDebt characteristics

Duration Set maturity

Currency if inflows Set currency mix

Sensitivity to uncertainty

about future inflation

Set fixed vs. floating Rate

* More floating rate if CF moves with

inflation, or if greater uncertainty aboutfuture

Growth pattern Straight debt versus Convertible

* Convertible if cash flows low now but

with high growth later

Cyclicality Option to match payments with C/F

stream

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Dividend decision

Calculated on the basis of retained after-tax profits and near-term earnings prospects

Better to consider expected free cash flows cash remainingafter expenses and after capital investment needs have been

met

Finance theory says that if the company has no positive-NPVprojects (projects with returns that exceed the hurdle rate),then excess funds should be returned to the owners in theform of dividends

The reality is different


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Why pay dividends?

Some shareholders require dividends

They are usually tax-neutral in terms of dividends vs.capital gains (i.e. Pension funds)

Signalling theory paying dividends indicates to themarket that the firm is confident about future cashflows

Wealth appropriation transfer of wealth fromlenders to owners (though lenders may not likethis)

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Why not pay cash dividends?

In order to retain flexibility Cash buffer in the event that future conditions are uncertain

Investment flexibility, to be able to exercise built in options oncurrent investments

For growth companies, it is expected that cash will beretained to finance growth, thus leading to higher capital gainbenefit of owning shares

Management has a good track record of investing the firmscash in high-return projects

Tax issues for shareholders


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Cash versus share buy-back

A buy-back is a one-time event

Shareholders have no further expectation from

the company

Cash dividends create expectations for future

dividend pay-outs

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What does a dividend payment signal?

That the company is profitable and expects to be

profitable in the future, leaving it with excess cash

Positive signal, share price increases

OR, that the company has few positive NPV

projects, thus returning cash to investors

Negative signal, share price declines

mba fin - lecture 6a

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