L5- Payout Policy and Capital Structure Flashcards
Characteristics of Payout Policy (I think)
–Dividend payments
–Stock repurchase plans
–Dividends have gradually been replaced as a means of payout by stock repurchase plans (starting around 1980)
–Proportion of dividend paying firms has declined, from about 64% in 1980 to 41% in 2005
Who decides on dividend payments, and what key date do they set?
the board of directors, who also set a
record date
What is the ex-dividend date, and why is it important?
the ex-dividend date occurs a few days before the record date. Investors who buy the stock before the ex-dividend date receive the dividend; those who buy on or after do not.
How does a stock’s price typically react on the ex-dividend date?
The stock price typically drops on the ex-dividend date to reflect the loss of dividend entitlement. The number of shares remains the same, but the price adjusts downward.
Why are managers reluctant to adopt dividend policies that may need to be reversed?
Managers see dividends as a “smooth” version of earnings, protecting the investors from fall in earning by holding back on
dividend payments when the earnings are high
How do managers use dividends to “smooth” earnings for investors?
Managers aim to keep dividends stable by holding back on payments during high earnings periods so they can continue payouts when earnings decline.
Which is more significant: dividend levels or dividend changes? Why?
Dividend changes are more significant. For example, an increase from $1 to $2 per share signals strong growth, whereas a constant $2 dividend may not be as impactful.
Who approves stock repurchase plans, and who decides the timing and form?
The board of directors approves the plan, but often management decides the timing and method of execution.
What are the three main ways to implement a stock repurchase plan?
–Open market operations
–Auction methods
–Negotiated trades
Are stock repurchase plans a direct substitute for dividend payments?
No, firms that pay dividends also participate in stock repurchases, meaning repurchases complement rather than replace dividends.
How do stock repurchases impact stock price and shares outstanding?
Stock repurchases reduce the number of shares in the market, helping the price per share remain stable.
Which is more volatile: dividend payments or stock repurchases?
Stock repurchases are more volatile than dividend payments, as companies adjust repurchases more flexibly based on market conditions.
What does an increase in dividend payments typically signal to investors?
An increase in dividend payments is interpreted as good news, suggesting confidence in future earnings.
How do investors view a reduction in dividend payments?
A reduction in dividends is seen as bad news, possibly indicating financial difficulties or lower expected earnings.
Do investors see stock repurchase plans as a long-term commitment?
No, investors do not view stock repurchase plans as a long-term commitment, unlike dividends
Why do stock prices respond positively to stock repurchase plans?
–Management believes the stock is undervalued.
–Returning cash to investors prevents management from misusing “free cash flow”
What does the Modigliani-Miller (MM) theory say about dividend policy?
MM-theory states that dividend policy does not affect shareholder wealth, as long as the firm’s investment policy remains fixed
Under MM-theory, how does a firm fund a new investment while maintaining dividends?
If a firm pays out dividends and still wants to invest, it must raise new funds, either through debt or equity issuance
In MM-theory, what happens if a firm funds an investment directly from cash instead of paying dividends?
If the firm uses cash for investment instead of dividends, shareholders receive value through future investment returns rather than immediate payouts.
REVISE BALANCE SHEET MM THEORY AND INVESTMENT
What key assumption does the Modigliani-Miller (MM) dividend irrelevance theory rely on?
MM-theory assumes no market frictions
What are market frictions
–Taxation
–Agency costs
–Signalling
What is Taxation in context of payout policy
If dividends are taxed more heavily than capital gains, investors may prefer firms to retain earnings or repurchase shares rather than pay dividends
What are agency costs in the context of payout policy?
dividend payments to the shareholders may undermine the debt holders’ claim on the firm’s assets
How does dividend signaling theory explain payout decisions?
Dividends can signal strong future prospects, as firms are unlikely to increase payouts unless they expect sustainable earnings.
What is the Discounted Dividend Model (DDM) formula for valuing a stock?
value per share formula
P0=D1/(r-g)….. g=growth, r= required return
REDO Discounted Dividend Model and MM-Irrelevance
What is capital structure?
refers to the mix of debt and equity on the liability side of the corporate balance sheet.
What is the main focus of capital structure theory?
It examines the effects of a pure exchange of debt and equity on the total value of the firm
What are 3 Capital structure Theories
–Modigliani-Miller irrelevance theory (no frictions)
–Trade off theory
–Pecking order theory
REVISE MM IRRELEVANCE ON SLIDES
What does the Modigliani-Miller theorem say about capital structure and WACC?
–Capital structure is irrelevant, but this does not imply that the cost of debt and equity remain constant when leverage changes.
–The WACC (Weighted Average Cost of Capital) remains constant as leverage changes, but both debt and equity risks increase as leverage rises, which causes their respective costs to increase.
What is the formula for the Weighted Average Cost of Capital (WACC)?
r= [(D/V) * rD] + [(E/V) * rE]
V=D+E, rd=cost of debt, D=debt
What is the formula for beta (β) in the context of capital structure?
β= [(D/V) * βD] + [(E/V) * βE]
βD= beta of debt, D=debt, V=D+E
What is the leverage formula for cost of equity (r_E)?
rE= r + [D/E * (r - rD)]
r= cost of capital, rD= cost of debt, D=debt
What is the leverage formula for beta (β_E)?
βE= β +[D/E * (β - βD)]
β=beta, βD= beta of debt, D= debt
REVISE CHANGING LEVERAGE
What does the Trade-Off Theory of capital structure suggest?
The Trade-Off Theory suggests that a company balances the benefits of borrowing (like the debt tax shield) with the costs of borrowing (like the risk of financial distress and bankruptcy) to find an optimal level of debt.
What are the benefits of borrowing according to the Trade-Off Theory?
–Debt tax shield: Interest on debt is tax-deductible, reducing taxable income and providing value.
–Reduced agency costs: Borrowing can limit cash available to management, encouraging more disciplined decision-making.
What are the costs of borrowing according to the Trade-Off Theory?
–Financial distress send a bad signal to customers
–Financial distress makes dealings with suppliers harder
–Financial distress distracts management from focusing on medium to long term strategic planning, and therefore the firm can lose competitive advantage
REVISE
Linking Trade Off Theory with MM-Theory
What is the Pecking Order Theory?
Pecking Order Theory suggests that due to information asymmetry between management and outside investors, firms prefer to finance projects in a specific order. The hierarchy is:
–Retained earnings (free cash flow)
–Debt
–Equity (last resort when debt becomes too risky).
According to Pecking Order Theory, why is equity financing considered the last resort?
Equity financing is the last resort because it involves the highest adverse selection costs due to information asymmetry. When the firm issues equity, investors may suspect the firm is overvalued, leading to higher costs for the firm.
What is the role of information asymmetry in the Pecking Order Theory?
Information asymmetry refers to the fact that management knows more about the firm’s future prospects than outside investors. This creates adverse selection costs when seeking external funding. To minimize these costs, firms prefer to first use retained earnings, then debt, and only issue equity when necessary
What does Trade Off Theory predict about profitable firms and borrowing?
Trade Off Theory predicts that profitable firms (with greater need for tax deductions and lower probability of financial distress) should borrow more, as they benefit from the tax shield that debt provides.
What does Pecking Order Theory predict about profitable firms and borrowing?
Pecking Order Theory predicts that profitable firms (with greater access to free cash flow) should borrow less, as they can finance their investments using retained earnings rather than taking on debt.
What is the relationship between growth and borrowing according to Trade Off Theory?
According to Trade Off Theory, high-growth firms should borrow less because they face higher costs of financial distress and agency costs. The increased risk of financial distress reduces their ability to take on debt
What is the relationship between growth and borrowing according to Pecking Order Theory?
Pecking Order Theory predicts that high-growth firms should borrow more, as they have greater investment opportunities and a greater reliance on external capital, which often requires debt financing.
REVISE EMPIRICAL PREDICTIONS RUSHED FLASH CARDS
