CAPITAL STRUCTURE AND DIVIDEND POLICIES

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CAPITAL STRUCTURE AND DIVIDEND POLICIES : 

Presented by: Shobha kumari Shreeja .v Sohni sachdeva Sonam jain Sonali nandrajog CAPITAL STRUCTURE AND DIVIDEND POLICIES

CAPITAL STRUCTURE & FIRM VALUE : 

CAPITAL STRUCTURE & FIRM VALUE Different views on how capital structure influences value, i.e. relationship between financial leverage and cost of capital. ASSUMPTIONS: No income tax 100% dividend payout Q. What happens to rD , rE and rA when financial leverage, D/E changes?

Net Income Approach : 

Net Income Approach According to this approach, rD & rE remain unchanged when D/E varies. The constancy of rD & rE with respect to D/E means that rA declines as D/E increases.

Net Operating Income Approach : 

Net Operating Income Approach According to this approach the rD & rA remain constant for all degrees of leverage or risk. The market value of a firm depends on its net operating income & business risk. The change in leverage can not change these underlying factors. Hence, the degree of leverage can not influence the cost of capital of firm.

Traditional approach : 

Traditional approach According to this approach the cost of capital is dependent on capital structure & there is an optimal capital structure ( where the cost of capital is minimized )

Modigliani & Miller Position : 

Modigliani & Miller Position Assumptions underlying the analysis: Perfect Capital Market Rational Investors & Managers Homogeneous expectations Equivalent risk classes Absence of taxation

MM Proposition I : 

MM Proposition I The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure. V = D + E =O/r Where, V=market value of firm D=market value of debt E=market value of equity O=expected operating income r=discount rate applicable to the risk class to which the firm belongs

MM Proposition II : 

MM Proposition II It is also called Leverage Irrelevance Theorem. The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to D/E ratio times the difference b/w rA & rD. rE = rA +(rA - rD ) D/E Here if D/E increases, rE also goes up, but rA not affected. Risk-Return Trade off As leverage increases, equity shareholders require a higher return b’coz equity beta increases.

Taxation & Capital Structure : 

Taxation & Capital Structure Corporate Taxes: When taxes are applicable to corporate income, debt financing is advantageous as interest on debt is a tax-deductible expense. V= O(1-tc)/r + tcD It means: value of levered =value of unlevered + gain from firm firm leverage ( VL ) (VU ) (tcD)

Trade Off Model : 

Trade Off Model According to trade off theory, the optimal D/E ratio of the firm depends on the trade off b/w the tax advantage of debt on one hand & financial distress & agency costs on the other hand.

Signaling Theory : 

Signaling Theory Also called asymmetric information theory of capital structure. A critical premise of trade off theory is that all parties have the same info & homogeneous expectations. Myers argued that there is asymmetric info & divergent expectations which explains the pecking order of financing observed in practice. Myers explains the pecking order theory with the help of signaling theory.

CAPITAL STRUCTURE DECISION : 

CAPITAL STRUCTURE DECISION The basic question is that: How can the optimal Debt structure be determined? A variety of analysis are done to get a handle over this capital structure decision.

Types Of Analysis : 

Types Of Analysis EBIT-EPS analysis: Relationship between EBIT & EPS EPS= (EBIT-I) (1-t)/n1 Break-even EBIT level for 2 alternative financing plans can be obtained by solving eqn. (EBIT*-I1 ) (1-t)/n1 = (EBIT*-I2 ) (1-t)/n2 ROI-ROE analysis: ROE=[ ROI +(ROI-r) D/E ] (1-t)

CONTD. : 

CONTD. LEVERAGE analysis: 2 kinds of leverage: Operating Leverage- arises from the firm’s fixed operating costs. Financial Leverage- arises from the firm’s fixed financing costs. RATIO analysis: Firms have a look at certain ratios like interest coverage ratio, cash flow ratio etc. to assess whether they have a satisfactory capital structure.

CONTD. : 

CONTD. CASH FLOW analysis: It establishes debt capacity by examining the problem of default, or risk of bankruptcy. COMPARATIVE analysis: A common approach to analyzing the capital structure of a firm is to compare its D/E ratio to the average D/E ratio of the industry to which the firm belongs.

Guidelines for Capital Structure Planning : 

Guidelines for Capital Structure Planning Avail of the tax advantage of debt Preserve flexibility Ensure that the total risk exposure is reasonable Examine the control implications of alternative financing plans Subordinate financial policy to corporate strategy Mitigate potential agency costs Resort to timing judiciously Finance proactively not reactively Know the norms of lenders & credit rating agencies Issue innovative securities Widen the range of financing sources Communicate intelligently with investors

Capital Structure Policies : 

Capital Structure Policies Five common policies: No debt should be used. Debt should be employed to a very limited extent. The debt-equity ratio should be maintained around 1:1. The debt-equity ratio should be kept within 2:1. Debt should be tapped to the extent available.

DIVIDEND POLICY & FIRM VALUE : 

DIVIDEND POLICY & FIRM VALUE Since the principal objective of corporate financial management is to maximize the market value of equity shares, the key question of interest is: What is the relationship between dividend policy & market price of equity shares? The key decisions revolving around dividends are: Long-term pay out ratio? How stable is it?

Models in which Investment & Dividend Decisions are related : 

Models in which Investment & Dividend Decisions are related 1. WALTER MODEL: P= D+(E-D)r/k k 2. GORDON MODEL: P0= E1 (1-b) k-br

Traditional Position : 

Traditional Position A traditional approach places more weight on dividends than retained earnings. Traditional position says that a generous policy enhances the share value. P= m [4D/3 + R/3] Where, P= market price per share D=dividend per share R=retained earnings per share m= a multiplier

Miller & Modigliani Position : 

Miller & Modigliani Position MM have argued that the value of a firm depends solely on its earning power & isn’t influenced by the manner in which earnings are split b/w dividends & retained earnings. EARNINGS DIVIDENDS CURRENT INCOME RETAINED EARNINGS CAPITAL APPRECIATION

MM assumptions : 

MM assumptions There is no tax advantage or disadvantage associated with dividends. Investment & dividend decisions are independent. Firms can issue without incurring any floatation or transaction costs.

Criticisms of MM Position : 

Criticisms of MM Position Critics agree that, under the assumptions made by MM, dividends are irrelevant. However they dispute the validity of ‘dividend irrelevance’ theorem by challenging the assumptions used by MM. CRITICISMS: Info about Prospects Uncertainty & Fluctuations Offering of additional equity at lower prices Issue costs Transaction costs Differential rates of taxes Rationing-limiting the amount Unwise investments

Rational expectations hypotheses : 

Rational expectations hypotheses In a world of rational expectations, unexpected announcements would transmit messages about changes in earning potential which were not incorporated in market price earlier. The reappraisal that occurs as a result of these signals leads to price movements which look like responses to the dividends themselves, though they are actually caused by an underlying revision of the estimate of earnings potential.

Radical Position : 

Radical Position Directly or indirectly dividends are generally taxed more heavily than capital gains. So, radicalists argue that firms should pay as little dividends as they can get away with so that investors earn more by way of capital gains & less by ways of dividends. Lower pay-out ratio improves the welfare of shareholders.

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