Corporate Finance Flashcards
What Determines PVGO?
Formula for estimating TV and CFs with Terminal Growth Method
The price of a stock can be decomposed into two components
Assume that the firm follows a policy of reinvesting a fraction k of its yearly earnings in new projects. k is called…
the plowback ratio and (= reinvestment rate or retention rate) and 1 - k is the payout ratio
Equation sources and uses of funds
Dividend Policy - Stylized facts documented by Lintner (1956):
- Firms have long-run target dividend payout ratios
- Dividend policies are sticky. Cuts are extremely rare, and managers will only raise the dividend if long-run sustainable earnings have risen
- Managers focus more on dividend changes than on absolute levels
Does dividend policy matter? In theory?
Famous 1961 article by Miller and Modigliani (MM), showing that in a perfect capital market (no taxes, transactions costs, or inefficiencies), dividend policy is irrelevant.
Firm has 1,000 shares outstanding, and assets worth £ 12,000 so that the share price is £ 12 - if dividend of £ 1,000 is paid out, what are the new shares worth?
The above argument shows the fallacy of arguments often made in favor of dividend payments:
-) Dividend irrelevance is inconsistent with the stock price being the PV of future dividends.
-) The ‘bird-in-the-hand’ fallacy : since dividends are cash in hand, while capital gains are risky, increasing dividends should make the equity less risky, and hence more valuable.
- Paying a dividend of $1,000 entails a capital loss of $1,000 for certain. Thus, it trades a certain income (dividend) with a certain loss (capital loss), rather than trading something certain for something risky
- Both of these notions are fully consistent. Dividends are irrelevant because a higher dividend today requires you to sell more stock to finance the dividend. Therefore, future dividends are lower because they are shared among a greater number of shareholders. It is exactly because the stock price is the PV of all future dividends that makes dividends irrelevant - even though the immediate dividend rises, future dividends fall and these effects cancel out.
Dividends as Signals:
- A higher dividend may raise a firm’s value by signaling management’s favorable information about the firm’s future earnings
- Evidence supports this signaling hypothesis: Aharony and Swary (1980) found that dividend decreases (increases) are associated with the stock price falling 3.76% (rising 0.72%)
- More recently, Ham, Kaplan, and Leary (2020) found that dividend decreases (increases) are associated with the stock price falling 3.3% (rising 0.9%)
MM does not apply in the presence of market imperfections, which e.g. are:
- Issuance costs
- Taxes
- Agency costs
Pfizer’s stock price is expected to be $112.50 next year. It is paying no dividend, and its stock price is currently $100. The current tax rate on dividends is 50%, and that on capital gains is 20%. Suppose that Pfizer announces that it will pay a $10 dividend next year. What will happen to the stock price upon announcement?
- Step 1: Calculate the after-tax rate of return under the current no-dividend policy: Capital gain is $112.50 - $100 = $12.50 –> tax rate of 20%, the tax is $2.50. The after-tax income is $12.50 - $2.50 = $10 = 10%
- Step 2: Under the new policy, the after-tax rate of return must remain at 10%. Pfizer’s business and financial risk are unchanged by the dividend policy, so the rate of return must also be unchanged
- Step 3: Solve for the new stock price that gives an after-tax rate of return of 10%. New capital gains is $2.5, after tax $2.0; dividend $10 * 0.5 (tax rate); Total after-tax
income is given by Post-Tax Dividend + Post-Tax Capital Gain
= 10 (1 - 0.5) + (102.50 - P)(1 - 0.2) = 87 - 0.8P –> of
(87 - 0.8P) / P = 10% which yields P = $96.67
If taxes matter, then high-dividend stocks should offer higher pre-tax returns. What does research find?
Mixed/weak evidence
Dividend Policy - The Effect of Agency Costs
- Agency costs are the loss in frm value that results from managers having different interests from shareholders
- Dividends force the payout of excess cash, preventing managers from wasting it. This is particularly the case since dividends are sticky and hard to cut later without a strong negative market reaction
- If we agency costs matter, we would expect dividends to be higher if: (-) High agency costs, measured by a high number of shareholders (Shhr) and a low percentage of the firm held by insiders (Ins). (-) Low cash needs (since dividends are a use of cash), measured by a low growth rate in revenues (Grow) and low volatility (Beta).
Costs / benefits of dividends:
Modigliani and Miller’s (1958) Proposition I states that in a perfect capital market, a firm’s value…?
…is independent of capital structure
How Leverage A§ects Expected Returns - rE and rA
What are Miller and Modigliani’s (MM) two propositions?
WACC and rA are conceptually different, but in a perfect capital market…
…they are numerically the same. A company cannot reduce its WACC below the level that it would have if it were all Equity-financed: In a perfect capital market, WACC is always rA
Formula for asset beta
Where might violations of MMís propositions arise from?
- Taxes
- Bankruptcy costs
- Agency costs
- Asymmetric information
Value of the tax shield for a firm (APV)
The tax advantage of debt in the presence of both corporate and personal taxes becomes
WACC with Corporate and Personal Taxes
With taxes and bankruptcy costs, the WACC curve now becomes:
With taxes and bankruptcy cost, firm value consists of Vu + …
The joint effect of taxes, bankruptcy costs and agency costs leads to a trade-off theory of capital structure. The firm’s target debt-equity ratio depends on a trade-off between:
WACC curve with agency costs and bankruptcy costs
The APV of a project is…
We have calculated Cytec’s WACC at 16.0% - now unlever it to get to rA
The MM formula assumes that the project supports a permanent additional debt ∆D issued at rD - i.e., what is r* if you have found rA and assume fixed or amortized debt
We now relever Inditherm’s rA of 19.5% to take into account the 30% debt financing:
r* = rA(1 - tcL) = 0.195(1 - 0.34 * 0.3) = 17.5%
Key Takeaways: Interaction of Investment and Financing
Decisions
The baseline rule for choosing between alternative investments is simple: pick the one with the highest NPV. However, this does not apply when comparing investments with different lives. In this case we can use one of two equivalent criteria:
compute the equivalent annual cost: the cash flow C of an annuity having the same life and PV as the machine - for Machine B
If resource constraints, calculate Profitability Index:
Using the CAPM to Evaluate Risky Projects - Correct discount rate for a project and correct measure of project risk is its…
What Determines the Equity Beta? What is the formula for Equity Beta?
three forms of market efficiency:
