401 Test 3 Flashcards
Distribution Policy
- level of cash distributions to shareholders
- form of distribution (dividend vs repurchase)
- stability of distribution
3 preference theories
Dividend irrelevance theory
- investors don’t care what form value comes from
- Modigliani-Miller
- assumptions: no taxes or brokerage costs
Dividend Preference Theory
- less risky
- reduce agency costs
Tax Effect Theory
- capital gains deferred until realized
- lower effective rate than dividends
Clientele effect
- different investors prefer different policies
- consistency is most important
Signaling hypothesis
- investors view dividend changes as signals for the future
- an increase in dividend leading to an increase in stock may reflect increased EPS rather than desire for dividends
- reduces asymmetric information
Residual Dividend Policy
Advantages: minimize new stock issues and flotation costs
Disadvantages: variable dividends, conflicting signals, increases risk, doesn’t appeal to specific clientele
Residual Priority
Capital Budget
Capital Structure
Dividend Policy
Compromise priorities
Capital budget
Dividend policy
Capital structure
Dividend payments
November 21: declaration date December 17: dividend goes with stock December 18: ex-dividend date December 20: holder-of-record date January 10: payment date
3 ways to repurchase
Broker purchase on open market
Tender offer to shareholders
Block (targeted) repurchase - greenmail
Repurchase vs. Dividends
Repurchase:
- stock price doesn’t fall
- number of shares falls
Dividend:
- stock price falls by amount of dividend
- number of shares doesn’t change
Repurchases
Advantages:
- stockholder can choose to sell or not
- avoid high dividend that cannot be maintained
- capital gains instead of higher-taxed dividend
- positive signal- stock is undervalued
Disadvantages:
- negative signal- poor investment opportunities
- IRS could impose penalties
Optimal Price Range
$20-$80
Leads to stock splits or stock dividends to lower price per share
Dividend reinvestment plan
Open market:
- trustee buys shares on open market
- brokerage costs reduced by volume purchases
- convenient
New stock plan:
- firm issues new stock to DRIP enrollees, keeps money and buys assets
- no fees charged, stock sold at discount
Business vs. financial risk
Business:
Uncertainty in future EBIT, NOPAT, ROIC
Depends on factors like competition and operating leverage
Financial:
Concentrated on common stockholders when financial leverage is used
Depends on amount of debt and preferred stock financing
Zero Taxes
Because FCF and values are equal, WACCs must be equal
-capital structure is irrelevant
Corporate taxes
- interest deducted, less taxes
- VL does not equal Vu
- greater the debt use, higher the value of the firm
- rSL increases with leverage at a slower rate when taxes are considered
APV model
Assumes rTS = rsU
Implications for managers
Take advantage of tax benefits by using debt
Avoid financial distress costs by maintaining excess borrowing capacity
With asymmetric info, avoid issuing equity
Consider impact of capital structure choices on lenders’ and ratings agencies’ attitudes
Operating leverage
The change in EBIT caused by change in quantity sold
Higher fixed costs, greater operating leverage
6 capital structure theories
M+M
-proposition 1: vl=vu
Pecking Order
-internal funds, debt, equity
Trade off
-at low leverage, tax benefits outweigh bankruptcy costs
-at high levels, bankruptcy costs outweigh tax benefits
Signaling
-sell stock for overvalued and bonds for undervalued
-financial slack
Agency
Over and underinvestment problems
Market timing
-issue equity when mkt is high, debt when it is low
