Distributions to ShareholdersDividends and RepurchasesCHAPT.docx

Distributions to Shareholders:
Dividends and Repurchases
CHAPTER 14
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classroom use.
Topics in Chapter
Theories of investor preferences
Signaling effects
Residual model
Stock repurchases
Stock dividends and stock splits
Dividend reinvestment plans
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Free Cash Flow: Distributions to Shareholders
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What is “distribution policy”?
The distribution policy defines:
The level of cash distributions to shareholders
The form of the distribution (dividend vs. stock repurchase)
The stability of the distribution
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Distributions Patterns Over Time (1 of 2)
Percentage of cash distributions relative to net income:
Around 27% until the early 2000’s
Exceeded 90% since 2012
Net income is not cash flow!
Since 1998, repurchases have exceeded dividends. In 2017, the
average
Dividend yield = 1.84%
Repurchase yield = 2.28%
Total yield = 4.12%.
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Distributions Patterns Over Time (2 of 2)
Percentage of companies paying a dividend has changed over
time. The number of NYSE, AMEX, and NASDAQ firms paying
a dividend has changed:
66.5% in 1978
20.8% in 1999 (lots of IPOs that didn’t pay dividends)
46% in 2017

There are now fewer, but larger, publicly traded companies due
to.
Mergers
Acquisition by private equity funds of small start-up firms that
would have had an IPO.
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Dividend Yields and Payout Ratios for
Selected IndustriesIndustryDividend YieldPayout ratioElectric
Utilities3.0125.7Computer Hardware2.9073.5Oil & Gas
Refining and
Marketing2.7430.1Aluminium2.4923.6Banks2.4635.4Wireless
Telecommunications1.5738.3AERO/DEF1.2720.6Drug
Retailers1.1817.5Healthcare Facilities &
Services0.9325.3Restaurants & Bars0.9124.9
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Do investors prefer high or low payouts?
There are three dividend theories:
Dividends are irrelevant: Investors don’t care about payout.
Dividend preference, or bird-in-the-hand: Investors prefer a
high payout.
Tax effect: Investors prefer a low payout.

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Dividend Irrelevance Theory
Investors are indifferent between dividends and retention-
generated capital gains. If they want cash, they can sell stock.
If they don’t want cash, they can use dividends to buy stock.
Modigliani-Miller support irrelevance.
Implies payout policy has no effect on stock value or the
required return on stock.
Theory is based on unrealistic assumptions (no taxes or
brokerage costs).
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Dividend Preference (Bird-in-the-Hand) Theory
Investors might think dividends (i.e., the-bird-in-the-hand) are
less risky than potential future capital gains.
Also, high payouts help reduce agency costs by depriving
managers of cash to waste and causing managers to have more
scrutiny by going to the external capital markets more often.
Therefore, investors would value high payout firms more highly
and would require a lower return to induce them to buy its
stock.
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Tax Effect Theory
Low payouts mean higher capital gains. Capital gains taxes are
deferred until they are realized, so they are taxed at a lower
effective rate than dividends.
This could cause investors to require a higher pre-tax return to
induce them to buy a high payout stock, which would result in a
lower stock price.
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Empirical Tests: Dividends and Required Returns
Research shows that investors require higher pre-tax returns on
stock in high payout companies.
But taxes alone can’t explain the difference in required returns
between high-payout companies and low-payout companies.
These finding support the tax effect hypothesis, but are not
conclusive.
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Empirical Tests: International Evidence
on Taxes and Payouts
Different countries have different tax laws, with some countries
taxing dividends more heavily than capital gains.
This “dividend tax penalty” can be measured for different
countries.
Research shows that in countries with relatively low dividend
tax penalties:

More companies pay dividends
Dividend payments are larger
In countries with relatively high dividend tax penalties:
More companies repurchase stock
This evidence doesn’t directly support the tax effect hypothesis,
but it does show that taxes affect payout policies.
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Empirical Tests: Changes in Tax Codes
In 2005, Congress reduced the tax rate on dividends to be equal
to the tax rate on capital gains.
But law was temporary and was set to expire at end of 2010
In mid-December 2010, Congress extended the tax treatment
temporarily for two more years.
Set to expire at end of 2012.
January 2013, Congress enacted law to “permanently” tax
dividends and capital gains at 20% for high-income investors.*
Lots of uncertainty in late 2010 and 2012, making them
excellent periods to study dividend changes. See next slide for
more.
*This is the essence of the tax law, but the actual tax law is a
bit more complicated.
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Empirical Tests: Uncertainty about tax laws leads to changes in

dividends.
2010 and 2012: Fear of tax increases on dividends.
Comparing late 2010 and 2012 (great uncertainty) with late
2009 and 2011:
Additional special dividends of over $7 billion.
176 companies moved up payment dates from beginning of next
year to late in 2010 and 2012 before rates changed.
Over $12 billion in sooner-than-normal regular dividend
payments.
Companies with higher insider ownership were more likely to
pay special dividends or accelerate payment dates.
This evidence doesn’t directly support the tax effect hypothesis,
but it does show that taxes affect payout policies.
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Empirical Tests: Tax Effects versus Agency Costs
Some countries have legal system with poor investor protection.
Agency costs, such as perquisite consumption and wasteful
acquisitions, are harder for investors to to prevent.
Low dividend payouts make more cash available for these
activities.
Research shows that in countries with poor investor protection
(where agency costs are most severe), high payout companies
are valued more highly than low payout companies.
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Summary of Empirical Tests
Taxes certainly affect dividend policies chosen by companies.
Evidence that investors prefer to avoid taxation.
Some evidence that investors require higher pre-tax returns on
stocks with big dividend payouts.
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What’s the “clientele effect”?
Different groups of investors, or clienteles, prefer different
dividend policies.
Firm’s past dividend policy determines its current clientele of
investors.
Clientele effects impede changing dividend policy. Taxes &
brokerage costs hurt investors who have to switch companies
due to a change in payout policy.
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The Signaling Hypothesis
(also called the information content hypothesis)
Investors view dividend changes as signals of management’s
view of the future. Managers hate to cut dividends, so won’t
raise dividends unless they think raise is sustainable.
Therefore, a stock price increase at time of a dividend increase
could reflect higher expectations for future EPS, not a desire for
dividends.

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What’s the “residual distribution model”?
Find the reinvested earnings needed for the capital budget.
Pay out any leftover earnings (the residual) as either dividends
or stock repurchases.
This policy minimizes flotation and equity signaling costs,
hence minimizes the WACC.
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Using the Residual Model to Calculate Distributions Paid
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Application of the Residual Distribution Approach: Data for
IWT
Capital budget: $112.5 million.
Target capital structure: 20% debt, 80% equity. Want to
maintain.
Forecasted net income: $140 million.
Number of shares: 100 million.

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Application of the Residual Distribution ApproachNumber of
shares100100100Equity ratio (ws)80%80%80%Capital
budget$112.5 $112.5 $112.5 Net income$140.0 $90.0 $160.0
Req. equ.: (ws X Cap. Bgt.)$90.0 $90.0 $90.0 Dist. paid: (NI –
Req. equity)$50.0 $0.0 $70.0 Payout ratio
(Dividend/NI)35.7%0.0%43.8%Dividend per share$0.50 $0.00
$0.70
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Investment Opportunities and Residual Dividends
Fewer good investments would lead to smaller capital budget,
hence to a higher dividend payout.
More good investments would lead to a lower dividend payout.
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Advantages and Disadvantages of the
Residual Dividend Policy
Advantages: Minimizes new stock issues and
flotation costs.

Disadvantages: Results in variable dividends, sends conflicting
signals, increases risk, and doesn’t appeal to any specific
clientele.
Conclusion: Consider residual policy when setting target
payout, but don’t follow it rigidly.
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The Procedures of a Dividend
Payment: An Example
November 21: Board declares a quarterly dividend of $0.50 per
share to holders of record as of December 15, payable on
January 5.November 21, 2019:Declaration dateDecember 17,
2019:Dividend goes with stock (owner on this day will get
dividend)December 18, 2019:Ex-dividend date (purchaser on or
after this date doesn't get dividend)December 19,
2019:December 20, 2019:Holder-of-record dateJanuary 10,
2020:Payment date
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Stock Repurchases
Repurchases: Buying own stock back from stockholders.
Reasons for repurchases:
As an alternative to distributing cash as dividends.
To dispose of one-time cash from an asset sale.
To make a large capital structure change.
To use when employees exercise stock options.

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The Procedures of a Repurchase
Firm announces intent to repurchase stock.
Three ways to purchase:
Have broker/trustee purchase on open market over period of
time.
Make a tender offer to shareholders.
Make a block (targeted) repurchase.
Firm doesn’t have to complete its announced intent to
repurchase.
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IWT Before a Distribution: Inputs (Millions)Value of
operations$1,937.50 Short-term investments$50.00 Debt$387.50
Number of shares 100.00
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Intrinsic Value Before Distribution Vop$1,937.50+ ST Inv.
50.00 VTotal$1,987.50− Debt 387.50S$1,600.00÷n 100.00
P$16.00

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Intrinsic Value After a $50 Million
Dividend DistributionBeforeAfter Dividend
Vop$1,937.50$1,937.50+ ST Inv. 50.00 0.00
VTotal$1,987.50$1,937.50− Debt 387.50
387.50S$1,600.00$1,550.00÷n 100.00 100.00
P$16.00$15.50DPS$0.50
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Drop in Price with Dividend Distribution
Note that stock price drops by dividend per share in model.
If it didn’t there would be arbitrage opportunity (assuming no
taxes).
In real world, stock price drops on average by about 90% of
dividend.
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A repurchase has no effect on stock price!
The announcement of an intended repurchase might send a
signal that affects stock price, and the previous events that led

to cash available for a distribution affect stock price, but the
actual repurchase has no impact on stock price because:
If investors thought that the repurchase would increase the stock
price, they would all purchase stock the day before, which
would drive up its price.
If investors thought that the repurchase would decrease the
stock price, they would all sell short the stock the day before,
which would drive down the stock price.
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Remaining Number of Shares After
Repurchase (1 of 2)
# shares repurchased = nPrior − nPost
# shares repurchased =CashRep/PPrior
nPrior − nPost = CashRep/PPrior
nPost = nPrior − (CashRep/PPrior)
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Remaining Number of Shares After
Repurchase (2 of 2)
nPost = nPrior − (CashRep/PPrior)
nPost = 100 − ($50/$16)
nPost = 100 − 3.125 = 96.875

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Intrinsic Value After a $50 Million RepurchaseBeforeAfter
Repurchase Vop$1,937.50$1,937.50+ ST Inv. 50.00
0.00 VTotal$1,987.50$1,937.50− Debt 387.50
387.50S$1,600.00$1,550.00÷n 100.00 96.875
P$16.00$16.00Shares rep.3.125
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Key Points
ST investments fall because they are used to repurchase stock.
Stock price is unchanged by actual repurchase.
Value of equity falls from $1,600 to $1,550 because firm no
longer owns the ST investments.
Wealth of shareholders remains at $1,600 because shareholders
now directly own the $50 that was previously held by firm in ST
investments.
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Repurchase vs. Dividends
Repurchase
Stock price doesn’t fall at time of repurchase
Number of shares falls
Dividend distribution

Stock price falls by amount of dividend at time of payment
Number of shares doesn’t change
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Repurchase vs. Dividends Over Time
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Advantages of Repurchases
Stockholders can choose to sell or not.
Helps avoid setting a high dividend that cannot be maintained.
Income received is capital gains rather than higher-taxed
dividends.
Stockholders may take as a positive signal--management thinks
stock is undervalued.
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Disadvantages of Repurchases
May be viewed as a negative signal (firm has poor investment
opportunities).
IRS could impose penalties if repurchases were primarily to

avoid taxes on dividends.
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Setting Dividend Policy
Forecast capital needs over a planning horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual model.
Generally, some dividend growth rate emerges. Maintain target
growth rate if possible, varying capital structure somewhat if
necessary.
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Stock Dividends vs. Stock
Splits (1 of 2)
Stock dividend: Firm issues new shares in lieu of paying a cash
dividend. If 10%, get 10 shares for each 100 shares owned.
Stock split: Firm increases the number of shares outstanding,
say 2:1. Sends shareholders more shares.
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Stock Dividends vs. Stock
Splits (2 of 2)
Both stock dividends and stock splits increase the number of
shares outstanding, so “the pie is divided into smaller pieces.”
Unless the stock dividend or split conveys information, or is
accompanied by another event like higher dividends, the stock
price falls so as to keep each investor’s wealth unchanged.
But splits/stock dividends may get us to an “optimal price
range.”
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When should a firm consider splitting its stock?
There’s a widespread belief that the optimal price range for
stocks is $20 to $80.
Stock splits can be used to keep the price in the optimal range.
Stock splits generally occur when management is confident, so
are interpreted as positive signals.
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What’s a “dividend reinvestment
plan (DRIP)”?
Shareholders can automatically reinvest their dividends in
shares of the company’s common stock. Get more stock than
cash.
There are two types of plans:
Open market

New stock
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Open Market Purchase Plan
Dollars to be reinvested are turned over to trustee, who buys
shares on the open market.
Brokerage costs are reduced by volume purchases.
Convenient, easy way to invest, thus useful for investors.
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New Stock Plan (1 of 2)
Firm issues new stock to DRIP enrollees, keeps money and uses
it to buy assets.
No fees are charged, plus sells stock at discount of 5% from
market price, which is about equal to flotation costs of
underwritten stock offering.
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New Stock Plan (2 of 2)
Optional investments sometimes possible, up to $150,000 or so.
Firms that need new equity capital use new stock plans.

Firms with no need for new equity capital use open market
purchase plans.
Most NYSE listed companies have a DRIP. Useful for
investors.
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Capital Structure Decisions
CHAPTER 15

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Topics in Chapter
Overview and preview of capital structure effects
Business versus financial risk
The impact of debt on returns
Capital structure theory, evidence, and implications for
managers
Example: Choosing the optimal structure
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Determinants of Intrinsic Value:
The Capital Structure Choice
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Basic Definitions
V = value of firm
FCF = free cash flow
WACC = weighted average cost of capital
rs and rd are costs of stock and debt
ws and wd are percentages of the firm that are financed with
stock and debt.

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How can capital structure affect value?
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A Preview of Capital Structure Effects
The impact of capital structure on value depends upon the effect
of debt on:
WACC
FCF
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The 2017 Tax Cuts and Jobs Act (TCJA)
Corporate tax rate:
TCJA rate is flat 21%.
Previous rate was graduated, with top rate of 35%.
Limits on interest expense deductions:
Interest/EBITDA < 30% for 2018-2021
Interest/EBIT < 30% for subsequent years
Excess carried forward indefinitely.

Should cause firms to reduce debt.
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Business Risk: Uncertainty in EBIT,
NOPAT, and ROIC
Uncertainty about demand (unit sales).
Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage (DOL).
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What is operating leverage, and how does it
affect a firm’s business risk?
Operating leverage is the change in EBIT caused by a change in
quantity sold.
The higher the proportion of fixed costs relative to variable
costs, the greater the operating leverage.
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Higher operating leverage leads to more business risk: small

sales decline causes a larger EBIT decline.
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Operating Breakeven
Q is quantity sold, F is fixed cost, V is variable cost, TC is total
cost, and P is price per unit.
Operating breakeven = QBE
QBE = F / (P – V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
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Business Risk versus Financial Risk
Business risk:
Uncertainty in future EBIT, NOPAT, and ROIC.
Depends on business factors such as competition, operating
leverage, etc.
Financial risk:
Additional business risk concentrated on common stockholders
when financial leverage is used.
Depends on the amount of debt and preferred stock financing.

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Consider Two Hypothetical Firms Identical
Except for DebtFirm UFirm LCapital$20,000 $20,000
EBIT$2,400 $2,400 Tax Rate25%25%Equity$20,000 $16,000
Debt$0 $4,000 rd =8%
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Impact of Leverage on Income StatementsFirm UFirm
LEBIT$2,400 $2,400 Interest$0 $320 EBT$2,400 $2,080
Taxes$600 $520 NI$1,800 $1,560
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NOPAT, ROIC, and ROEFirm UFirm LEBIT =$2,400 $2,400
NOPAT = EBIT(1 − T) =$1,800 $1,800 Operating capital
=$20,000 $20,000 ROIC = NOPAT/Op. Cap. =9.0%9.0%Equity
=$20,000 $16,000 Net income =$1,800 $1,560 ROE = NI/Equity
=9.0%9.8%
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What does this example illustrate about the impact of financial
leverage?
ROIC wasn’t affected by financial leverage.
ROE went up, increasing the expected return to shareholders.
ROEL was greater than ROEU.
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Why did leverage increase ROE in this example?
More total dollars paid to L’s investors:
U: NI = $1,800.
L: NI + Int = $1,560 + $320 = $1,880.
Lower taxes paid by L:
U: $600
L: $520.
Less equity tied up in L:
U: $20,000
L: $16,000
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Impact of Leverage on Returns if
EBIT Falls to $1,600Firm UFirm LEBIT $1,600 $1,600 Interest
$0 $320 EBT $1,600 $1,280 Taxes (40%)$400
$320 NI $1,200 $960 ROIC6.0%6.0%ROE6.0%6.0%

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Impact of Leverage on Returns if
EBIT Falls to $1,200Firm UFirm LEBIT $1,200 $1,200 Interest
$0 $320 EBT $1,200 $880 Taxes (40%)$300
$220 NI $900 $660 ROIC4.5%4.5%ROE4.5%4.1%
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Leverage only adds value if ROIC is greater than the after-tax
cost of debt.EBITEBITEBIT$2,400 $1,600 $1,200
ROIC9.0%6.0%4.5%rd(1-T)6.0%6.0%6.0%ROE9.8%6.0%4.1%
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Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Windows of opportunity

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MM Theory: Zero TaxesFirm UFirm LEBIT
$3,000$3,000Interest 0 1,000NI
$3,000$2,000CF to shareholder$3,000$2,000CF to
debtholder 0$1,000Total CF$3,000$3,000
Notice that the total CF are identical for both firms.
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MM Results for Zero Taxes: VL = VU
MM assume: (1) no transactions costs; (2) no restrictions or
costs to short sales; and (3) individuals can borrow at the same
rate as corporations.
MM prove that if the total CF to investors of Firm U and Firm L
are equal, then arbitrage is possible unless the total values of
Firm U and Firm L are equal:
VL = VU.
Because FCF and values of firms L and U are equal, their
WACCs are equal.
Therefore, capital structure is irrelevant.
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MM Theory: Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces
taxes paid by levered firms.
Therefore, more CF goes to investors and less to taxes when
leverage is used.
In other words, the debt “shields” some of the firm’s CF from
taxes.
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MM Result for Corporate Taxes: VL = VU + TD
MM show that the total CF to Firm L’s investors is equal to the
total CF to Firm U’s investor plus additional amount due to
interest deductibility:
CFL = CFU + rdDT.
What is value of these cash flows?
Value of CFU = VU
MM show that the value of rdDT = TD
Therefore, VL = VU + TD.
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MM relationship between value and debt when corporate taxes
are considered.
Under MM with corporate taxes, the firm’s value increases
continuously as more and more debt is used.

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Impact of the TCJA on the MM Result:
VL = VU + TD
The TCJA cut the federal corporate tax rate to 21%, reducing
the combined federal-plus-state tax rate from about 40% to
about 25%.
This significantly reduces the tax shield of TD.
The slope of the graph on the previous slide is lower since the
TCJA took effect.
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Miller’s Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can
deduct interest expenses.
Personal taxes favor equity financing, since no gain is reported
until stock is sold, and long-term gains are taxed at a lower rate.
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Miller’s Model with Corporate and Personal Taxes

Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
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Tc = 25%, Td = 30%, and Ts = 12%.
Value rises with debt; each $1 increase in debt raises L’s value
by about $0.06.
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Conclusions with Personal Taxes
Use of debt financing remains advantageous, but benefits are
less than under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in equilibrium, the tax rates
of marginal investors would adjust until there was no advantage
to debt.
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Impact of the TCJA on the Miller
Model (1 of 2)
Cut the combined federal-plus-state Tc from about 40% to about
25%.
Did not significantly affect the personal tax rate on stocks, Ts.
The TCJA cut the top personal rate from 39.6% to 35%
(although the changes to the personal rates will revert back to
the pre-TCJA values after 2025). The result is relatively small
changes in Td.
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Impact of the TCJA on the Miller
Model (2 of 2)
The TCJA significantly reduced the numerator, (1 − Tc)
(1 − Ts), because Tc is much smaller now.
The TCJA made small changes to the denominator, (1 − Td).
The net effect is that the term in brackets is much
smaller now.
This means that debt adds much less value than before
the TCJA.
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Trade-off Theory

MM theory ignores bankruptcy (financial distress) costs, which
increase as more leverage is used.
At low leverage levels, tax benefits outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these costs and
benefits.
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Tax Shield vs. Cost of Financial Distress
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Impact of the TCJA on the Trade-off Theory
The slope of the tax shield line in the previous graph is less
steep due to the reduction in corporate taxes.
The TCJA did not affect financial distress costs.
The net affect is that the curved line for VL is much lower and
flatter now.
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Signaling Theory

MM assumed that investors and managers have the
same information.
But, managers often have better information.
Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as
a negative signal.
Implications for managers?
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Pecking Order Theory
Firms use internally generated funds first, because there are no
flotation costs or negative signals.
If more funds are needed, firms then issue debt because it has
lower flotation costs than equity and not negative signals.
If more funds are needed, firms then issue equity.
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Debt Financing and Agency Costs
(1 of 2)
One agency problem is that managers can use corporate funds
for non-value maximizing purposes.
The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers to avoid perks and non-value

adding acquisitions.
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Debt Financing and Agency Costs
(2 of 2)
A second agency problem is the potential for
“underinvestment”.
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have
positive NPVs.
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Investment Opportunity Set and Reserve Borrowing Capacity
Firms with many investment opportunities should maintain
reserve borrowing capacity, especially if
they have problems with asymmetric information
(which would cause equity issues to be costly).
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Market Timing Theory
Managers try to “time the market” when issuing securities.

They issue equity when the market is “high” and after big stock
price run ups.
They issue debt when the stock market is “low” and when
interest rates are “low.”
The issue short-term debt when the term structure is upward
sloping and long-term debt when it is relatively flat.
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Empirical Evidence (1 of 4)
Tax benefits are important
At optimal capital structure, $1 debt adds about $0.10 to $0.20
to value on average.
For average firm financed with 25% to 30% debt, this adds
about 3% to 6% to the total value.
Warning! These results were for periods before the TCJA and
may now overstate the benefits of debt.
Bankruptcies are costly– costs can be up to 10% to 20% of firm
value.
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Firms have targets, but don’t make quick corrections when stock
price changes cause their debt ratios to change.
Average speed of adjustment from current capital structure is
about 30% per year.
Speed is about 50% per year for firms with high cash flow.

Speed is about 70% for firms with high cash flow that are above
target.
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Lost value from being above target is bigger than lost value
from being below target.
When above target, distress costs rise very rapidly.
Sometimes companies will deliberately increase debt to above
target to take advantage of unexpected investment opportunity.
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After big stock price run ups, debt ratio falls, but firms tend to
issue equity instead of debt.
Inconsistent with trade-off model.
Inconsistent with pecking order.
Consistent with windows of opportunity.
Many firms, especially those with growth options and
asymmetric information problems, tend to maintain excess
borrowing capacity.

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Implications for Managers (1 of 3)
Take advantage of tax benefits by issuing debt, especially if the
firm has:
High tax rate
Stable sales
Low operating leverage
classroom use.
Avoid financial distress costs by maintaining excess borrowing
capacity, especially if the firm has:
Volatile sales
High operating leverage
Many potential investment opportunities
Special purpose assets (instead of general purpose assets that
make good collateral)
classroom use.
If manager has asymmetric information regarding firm’s future
prospects, then avoid issuing equity if actual prospects are
better than the market perceives.
Always consider the impact of capital structure choices on
lenders’ and rating agencies’ attitudes

classroom use.
Choosing the Optimal Capital Structure: Example
b = 1.0; rRF = 6%; RPM = 6%.
Cost of equity using CAPM:
rs = rRF +b (RPM)= 6% + 1(6%) = 12%
Currently has no debt: wd = 0%.
WACC = rs = 12%.
Tax rate is T = 25%.
classroom use.
Current Value of Operations
Expected FCF = $90 million.
Firm expects zero growth: g = 0.
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$90(1+0)]/(0.12 − 0)
Vop = $750 million.
classroom use.
Other Data for Valuation Analysis
Company has no ST investments.

Company has no preferred stock.
10 million shares outstanding
classroom use.
Current Valuation Analysis Vop$750 + ST Inv. 0
VTotal$750 − Debt 0S$750 ÷ n 10 P$75.00
classroom use.
Investment bankers provided estimates of rd for different
capital
structures.wd0%20%30%40%50%rd0.0%8.0%8.5%10.0%12.0%
If company recapitalizes, it will use proceeds from debt
issuance to repurchase stock.
classroom use.
The Cost of Equity at Different Levels of Debt: Hamada’s
Formula
MM theory implies that beta changes with leverage.
bU is the beta of a firm when it has no debt (the unlevered beta)
b = bU [1 + (1 - T)(wd/ws)]

classroom use.
The Cost of Equity for wd = 20%
Use Hamada’s equation to find beta:
b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.25) (20% / 80%) ]
= 1.188
Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% + 1.188 (6%) = 13.13%
classroom use.
The WACC for wd = 20%
WACC = wd (1-T) rd + ws rs
WACC =
0.2 (1 – 0.25) (8%) + 0.8 (13.13%)
WACC = 11.7%
Repeat this for all capital structures under consideration.
classroom use.
Beta, rs, and
WACCwd0%20%30%40%50%rd0.0%8.0%8.5%10.0%12.0%ws1

00%80%70%60%50%b1.001.1881.321.501.75rs12.00%13.13%1
3.93%15.00%16.50%WACC12.00%11.70%11.66%12.00%12.75
%
The WACC is minimized for wd = 30%. This is the optimal
capital structure.
classroom use.
Corporate Value for wd = 20%
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$90(1+0)]/(0.117 − 0)
Vop = $769.23 million.
Debt = DNew = wd …

Distributions to ShareholdersDividends and RepurchasesCHAPT.docx

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