Today's Lecture

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Today's Lecture

• Finish Capital Budgeting for the Levered Firm
• Dividend Policy

TIP If you do not understand something, a
sk me!
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Club Singles

• Club Singles operates holiday resorts in the
  Carribean. The company is thinking of opening a
  resort in the Baja. Revenues are expected to be
  500,000/yr in perpetuity, with cost running at
  72 of revenues. The initial investment is
  475,000. The corporate tax rate is 34. By
  studying a similar investment made by Club Med,
  Club Singles has determined that the cost of
  capital for this project for an all equity firm
  is 20. Furthermore it can borrow at 10.
  Assuming that it has previously been determined
  that the optimal debt/equity ratio for firms in
  this industry is 33 (which implies a debt level
  of 126,229.50), should the project be taken on?

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All Equity

• To do this, lets first see what would happen if
  Club Singles was all equity financed

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Flow-to-Equity

• The way to think about this approach is to
  consider the decision from the perspective of a
  shareholder.
  
• A shareholder is only interested in the cashflows
  to him, that is,
  
• earnings after both interest and taxes
• the amount of the initial investment he has to
  finance

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Adjusted-Present-Value

• Think of this approach as the all equity value
  plus the additional advantages/disadvantages due
  to leverage, i.e., things like
  
• tax shield
• costs of financial distress

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Another Approach

• Discount the unlevered cashflows at a discount
  rate that adjusts for the tax shield.
  
• IF there was not tax shield then MM would imply
  that the correct rate to discount at is the WACC
  
• In this spirit we will call the discount rate
  that gives the correct answer in the presence of
  taxes the WACC

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What is this discount rate?

• Let x be the fudge factor

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What is this discount rate? (contd)
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Weighted-Average-Cost-of-Capital

• Think of this approach as the decision of all
  claim holders. That is, discount the unlevered
  cashflow at a rate that takes into account the
  benefits of the tax shield. This rate is

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To Avoid confusion

• This definition of the WACC is not the only one
  that one could think of. That is, a perhaps more
  logical definition of the WACC is the same one as
  before, simply the weighted average without the
  tax adjustment. This would be the correct rate
  if the CASHFLOWS were adjusted to incorporate the
  tax shield.
• Think about the WACC defined our way as the
  fudged discount rate to get the right answer if
  the unlevered cashflows are used. That is, this
  is rate when the discount rate, rather than the
  cashflow is adjusted for the tax shield.

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Which method is right?

• Theory
• Under the assumptions, all three methods are
  consistent and so will give the same answer!
  
• Practice
• Each method requires estimating different
  quantities. To the extent that these estimates
  are incorrect (and therefore inconsistent),
  different methods will give different values

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How do you choose between methods?

• Since the only difference between the methods are
  the estimates that are required, always pick the
  method for which you have the highest confidence
  in the estimates.
• All three methods require estimating a discount
  rate, but the adjustment for leverage requires
  knowing the
  
• Dept-to-value ratio for WACC and FTE
• level of debt for APV

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How do you choose between methods? (contd)

• If you have more confidence in your debt-to-value
  ratio, use WACC or FTE.
  
• If you have more confidence in your level of debt
  forecast, use APV.

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Real World

• Debt-to-equity ratios are more stable
• Why?
• There is an optimal debt-to-equity ratio, so the
  level of debt must change as the value of the
  firm changes
  
• Consequently, WACC is used most often
• One exception is an LBO.
• Why?
• Other situations that favor APV
• Government Subsidies
• Flotation Costs

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World-Wide Enterprises

• WWE is thinking of entering the widget business,
  where it plans to finance project with a
  debt-to-equity ratio of 33. American Widgets is
  40 debt and 60 equity. Its beta is 1.5 and
  borrows at 12. WWE, has a lower chance of
  bankruptcy, so its borrowing rate is 10.
  Corporate taxes are 40, the market risk premium
  is 8.5 and the riskless rate is 8. What is the
  discount rate WWE should use for its widget
  venture?

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Flotation Costs

• Lucky Enterprises is considering a 10 million
  project. Cashflows less expenses are expected to
  be 4,500,000/yr for 5 years. Taxes are 34. The
  cost of debt is 10. The cost of unlevered equity
  is 20.
• Should the project be taken on if the firm is all
  equity?
  
• Should the project be taken on if the firm
  borrows 7.5 million (fixed coupon, principal in
  5 yrs)?

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Another Application of APV --- subsidies

• What happens if the state lends Lucky 7.5
  million (fixed coupon, principal in 5 yrs) at a
  below market rate of 8?

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Dividends

• What is a dividend?
• How are they paid out?

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Dividend dates

• Declaration date
• Day the board of directors makes a decision to
  pay a dividend
  
• March 29, 1999
• Date of Record
• List of stockholders of record who will get a
  dividend
  
• Monday April 19, 1999

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Dividend dates (contd)

• Ex-dividend date
• 2 business days before date of record. All
  brokerage houses guarantee that if the stock is
  purchased before this date, the holder will get
  the dividend
• Thursday, April 15, 1999
• On April 15 the stock trades ex-dividend while on
  April 14 it trades cum-dividend.
  
• Date of Payment
• Day the dividend checks are mailed
• Friday, May 28

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What happens to the stock price on the above dates

• In perfect markets
• No change on all except the ex-dividend date
• What happens on the ex-dividend date
• why?
• What effects could change this?
• Taxes
• Agency
• Information

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An Example

• The Cash Cow Corporation has no growth
  opportunities but generates 10,000/yr in
  perpetuity. Currently this is all paid out as
  1 dividend on the 10,000 shares outstanding.
  One stockholder suggests that it would be value
  enhancing to pay extra dividends on each dividend
  date by selling an extra 1,000 shares each year
  and paying out the proceeds immediately as
  dividends. In a perfect market, if the risk less
  rate is 10, is he right?
  
  

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Irrelevance of Dividend Policy

• To first order (i.e., in the absence of taxes)
  dividend policy is irrelevant -- it cannot affect
  firm value.
  
• The reason is any investor can change dividend
  policy by either selling or buying more shares.
  
• Since dividend policy is a financial decision,
  this is really just and example of MM. Based on
  this point, when might dividend policy matter?

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Example

• The Nothing Corporation has no assets or growth
  opportunities. It nevertheless wants to pay a
  dividend. Thus it has decided to issue stock and
  pay out the proceeds as a dividend. Assuming a
  flat personal tax rate of 34, would anybody
  invest in this stock?

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Another Example

• Cash Out Corp. is about to pay a dividend of
  1/share. Its current stock price is 50. If
  the marginal investors highest marginal tax rate
  is 39, and capital gains are taxed at a flat
  28, what will the stock price drop be?

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Swedish Lottery Bonds

• Interest on these bonds are tax free. However,
  the capital gain/loss is taxed.
  
• So you can deduct the capital loss against income
  and take the interest payment tax free.
  
• How much should the price drop if the marginal
  tax on capital gains is 54?

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Empirical Results

• The great thing about Sweden if you are an
  empiricist (not so great if you live there) is
  that all income tax returns are public
  information.
• So you can actually test this. Here are the
  imputed and actual taxes over two regimes
  
• Actual 54 Imputed 53.7 (5)
• Actual 21 Imputed 22.3 (4.9)

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Dividend Policy with Taxes (in the US)

• Dividends are taxed at personal income.
• Since personal income is usually taxed at higher
  rate than capital gains, it is not optimal for a
  firm to issue dividends.
  
• i.e., rather than pay dividends firms should
  reinvest the money and let shareholders
  manufacture dividends by selling stock.

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Example

• The Lack of Imagination Company has assets of
  1000 in cash. It can either invest this money
  in a risk free and tax free (to the firm)
  perpetuity yielding 10 or pay it out as cash. If
  the company does this it will also reinvest all
  interest earned in the same perpetuity. Assume
  that stockholder have the same investment open to
  them and that the capital gains rate is 28 and
  the personal income tax rate is 34 Which
  dividend policy is preferred?

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Lack of Imagination
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How does dividend policy affect expected returns

• In a frictionless world, dividend policy is
  irrelevant so it cannot affect expected returns.
  
• In a world with taxes, investors will equate
  their after tax return.

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Example

• Consider two equally risky firms. Both are all
  equity, however one expects to pay a dividend
  next period while the other will not. Both firms
  sell for 100. Assume the capital gains tax is
  zero while the income tax rate is 30. The
  expected price of the no dividend firm is 130
  under the risk neutral probabilities. The
  expected dividend of the other firm is 30 under
  the risk neutral probabilities. What is the
  pretax return of both firms?

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Dividend Yields and Returns

• Controlling for risk, the dividend yield should
  be positively related to the firms expected
  return
  
• Mixed empirical results on testing this
• Why?

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Why then do most firms pay dividends?

• Lack of NPV projects
• Agency costs associated with large FCFs.
• Other gimmicks (like repurchasing shares) would
  be viewed by the IRS as a dividend.

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Lack of positive NPV projects

• What can a firm do with excess cash if it does
  not have positive NPV projects
  
• Invest in negative NPV projects
• Invest in zero NPV projects
• Financial assets

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No Creativity Corp

• No Creativity corp has 1Mil but no positive NPV
  projects to invest in. Should it invest in
  T-Bills or pay the extra cash out as a dividend?
  Assume the 1 year bill is yielding 5, the
  personal income and capital gains tax rate is
  39, while the corporate tax rate is 34.

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Investments in Financial Assets

• It might be optimal for the firm to invest for
  its equity holders, but this depends on the
  relative tax rates
  
• Quirk in the tax law
• 70 of corporate dividends in other firms are
  excluded from corporate taxes

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Agency Costs

• It is often stated in the popular press (and by
  some financial advisors) that a firm that pays
  dividends should command a premium
  
• MM shows that this cannot be true in a perfect
  market
  
• However, other factors might be influencing this.

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Free Cash Flows

• One can think of dividends as a way to signal to
  the market that the firm is not wasting money on
  negative NPV investments.

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Information in Dividend Changes

• If a firm pays a dividend, information is
  communicated on a dividend change that otherwise
  would not be communicated if there were no
  dividends
• In particular a lowering of the dividend could be
  construed as bad news.
  
• Thus by increasing the dividend the managers must
  be VERY optimistic because this sets a higher
  hurdle rate

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Stock Repurchases

• OK, all this is well and good, but if the capital
  gains tax is zero, the thing is the firm can get
  its cake and eat it by just doing a stock
  repurchase!
• So why do firms not do this?
• They do --- much larger percentage of cash
  distribution today
  
• Can be traced to an SEC decision in the early
  eighties.
  
• There is an upper limit on this

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Other reasons for repurchases

• Targeted Repurchases
• Repurchasing as an investment.

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What do Corporations seem to do?

• Target pay out ratio of earnings
• Smooth dividends

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