FIN 534 Week 8 Part 2: Capital Structure Decisions Slide 1 Introduction Welcome to Financial Management. In this lesson we will discuss capital structure decisions. Next slide Slide 2 Topics The following topics will be covered in this lesson: A preview of capital structure issues; Business risk and financial risk; Capital structure theory; Capital structure evidence and implications; Estimating the optimal capital structure; and Anatomy of recapitalization. Next slide Slide 3 A preview of capital structure issues Managers should make capital structure decisions to maximize the intrinsic value of the firm. The firm’s capital structure is its mixture of debt and equity. While the actual levels of debt and equity may vary over time, most firms try to maintain a financing mix that is close to its target capital structure. Recall, the value of the firm’s operations is the present value of its expected future cash flows, FCF, discounted at the firm’s weighted average cost of capital, WACC. Mathematically, the value of the firm’s operations is given by the following equation: V sub OP equals summation T equals one through infinity FCF sub T divided by the quantity one plus WACC raised to the tth power; Where WACC equals w sub D times the quantity one minus T times R sub D plus W sub S times R sub S; and WACC depends on the percentages of debt and common equity, W sub D and W sub S, the cost of debt, R sub D, the cost of equity, R sub S, and the corporate tax rate T. The only way any decision can change the firm’s value is by changing either FCF or its cost of capital. Debtholders’ claim on the firm’s cash flows rank ahead of the stockholders’ claim because they have a residual claim on the cash flows after debtholders’ are paid. The fixed claim of debtholders increases the cost of equity, R sub S, because their residual claim becomes riskier. Interest expense is tax deductible which reduces the firm’s taxable income and therefore its tax bill. The tax reduction reduces the after-tax cost of debt which results in more income available to debtholders and other investors. When the firm increases its debt level the probability of financial distress or bankruptcy increases. This results in an increased pretax cost of debt, R sub D, because debt-holders will require a higher interest rate. The net impact on the WACC is indeterminate because both R sub D and R sub S change because it is a weighted average of relatively low-cost debt and relatively high-cost equity. The risk of bankruptcy can reduce FCF and the value of the firm. When the risk of bankruptcy increases, customers may make purchases from another firm and hence sales decline which reduces net operating profit as well as FCF. Additionally any type of financial distress negatively impacts the productivity of managers and employees and reduces net operating profit after taxes, NOPAT, and FCF. Moreover the firm experiences a reduction in accounts payable and results in an ...

1. FIN 534 Week 8 Part 2: Capital Structure Decisions
Slide 1
Introduction
Welcome to Financial Management. In this lesson we will
discuss capital structure decisions.
Next slide
Slide 2
Topics
The following topics will be covered in this lesson:
A preview of capital structure issues;
Business risk and financial risk;
Capital structure theory;
Capital structure evidence and implications;
Estimating the optimal capital structure; and
Anatomy of recapitalization.
Next slide
Slide 3
A preview of capital structure issues
Managers should make capital structure decisions to maximize
the intrinsic value of the firm. The firm’s capital structure is its
mixture of debt and equity. While the actual levels of debt and
equity may vary over time, most firms try to maintain a
financing mix that is close to its target capital structure.
Recall, the value of the firm’s operations is the present value of
its expected future cash flows, FCF, discounted at the firm’s
weighted average cost of capital, WACC. Mathematically, the
value of the firm’s operations is given by the following
equation:
V sub OP equals summation T equals one through infinity FCF

2. sub T divided by the quantity one plus WACC raised to the tth
power;
Where WACC equals w sub D times the quantity one minus T
times R sub D plus W sub S times R sub S; and
WACC depends on the percentages of debt and common equity,
W sub D and W sub S, the cost of debt, R sub D, the cost of
equity, R sub S, and the corporate tax rate T. The only way any
decision can change the firm’s value is by changing either FCF
or its cost of capital. Debtholders’ claim on the firm’s cash
flows rank ahead of the stockholders’ claim because they have a
residual claim on the cash flows after debtholders’ are paid.
The fixed claim of debtholders increases the cost of equity, R
sub S, because their residual claim becomes riskier. Interest
expense is tax deductible which reduces the firm’s taxable
income and therefore its tax bill. The tax reduction reduces the
after-tax cost of debt which results in more income available to
debtholders and other investors.
When the firm increases its debt level the probability of
financial distress or bankruptcy increases. This results in an
increased pretax cost of debt, R sub D, because debt-holders
will require a higher interest rate. The net impact on the WACC
is indeterminate because both R sub D and R sub S change
because it is a weighted average of relatively low-cost debt and
relatively high-cost equity. The risk of bankruptcy can reduce
FCF and the value of the firm. When the risk of bankruptcy
increases, customers may make purchases from another firm and
hence sales decline which reduces net operating profit as well
as FCF. Additionally any type of financial distress negatively
impacts the productivity of managers and employees and
reduces net operating profit after taxes, NOPAT, and FCF.
Moreover the firm experiences a reduction in accounts payable
and results in an increase in net working capital which reduces
FCF. Higher debt levels may impact managers’ behavior in two
opposing ways.
First, in good times, managers may waste cash flow on
unnecessary expenditures. When faced with an increased threat

3. of bankruptcy, unnecessary expenditures are reduced and FCF
increases.
Second, managers may reject positive but risky net present
value, or NPV, projects which may negatively impact
stockholders.
Therefore, high debt levels can result in managers forgoing
positive NPV projects unless they’re very safe. This is referred
to as the underinvestment problem.
Next slide
Slide 4
Business risk and financial risk
Business risk and financial risk jointly determine the total risk
of the firm’s future return on equity. Business risk is the
uncertainty inherent in the firm’s future operating earnings
before interest and taxes. Business risk depends upon a number
of factors:
First variability and product demand;
Second, variability in sales prices and input costs;
Third, business risk is higher in firms that are slow to bring new
products to the market;
Fourth, the risk of currency fluctuations and political risk that
arise from international operations;
Last if the firm has a high percentage of fixed costs that do not
decrease when demand falls the firm has a high degree of
operating leverage and hence increased business risk.
Operating leverage is the extent to which fixed costs are part of
the firm’s operations. If the firm has a high degree of operating
leverage a relatively small change in sales results in a relatively
large change in earnings before interest and taxes, EBIT, net
operating profit after taxes, NOPAT, and the return on invested
capital, ROIC. The higher the firm’s fixed costs the higher the
firm’s operating leverage. Generally, higher fixed costs are
associated with capital intensive firms, firms that employ highly
skilled workers, and firms with high product development costs.
The firm’s breakeven point is given by the following:

4. EBIT equals P times Q minus V times Q minus F equals zero;
Where EBIT is interest before interest and taxes, P times Q is
sales revenue, V times Q equals variable costs, and F equals
fixed costs. Solving for breakeven quantity yields the
following:
Q sub BE equals F divide by the quantity P minus V.
Financial risk is the additional business risk stockholders
assume because the firm decides to finance with debt.
Stockholders assume a certain amount of business risk which
results from uncertainty in EBIT, NOPAT, and ROIC. The use
of debt, or financial leverage, shifts business risk to the
common stockholders because debtholders are paid before
stockholders.
Next slide
Slide 5
Capital structure theory
Capital structures differ across industries and within industries.
To explain these differences several theories have been
developed. In 1958, Franco Modigliani and Merton Miller,
known as MM, develop the first model to explain the firm’s
capital structure. Based on some very restrictive assumptions,
MM proposed two hypothetical portfolios. One portfolio
consists of all the equity of the unlevered firm where the firm’s
value is denoted as V sub U or simply the value of the
unlevered firm. Under MM assumptions, the firm has no growth
and pays no taxes so it can pay out all of its EBIT in the form of
dividends. Hence the portfolios cash flow equals EBIT. The
second firm is the same as the first but it is partially financed
with debt. The second portfolio includes the entire levered
firm’s stock, S sub L and debt, D, so the total value of the
portfolio is denoted V sub L or simply the total value of the
levered firm.
Assuming the interest on debt is R sub D, the firm pays R sub D
times D amount in interest. Assuming no growth and no taxes,
the firm pays out EBIT minus R sub D times D in dividends.
The cash flow of each portfolio is EBIT. Using this information

5. MM concluded that since both portfolios have the same cash
flow they must have the same value.
Therefore, V sub L equals V sub U equals S sub L plus D.
Given their assumptions, MM concluded that the value of the
firm is independent of the firm’s capital structure. In 1963MM
modified their original model to include corporate taxation.
Since interest on debt is tax deductible but dividends paid to
stockholders are not, the differential tax treatment favors the
use of debt in the firm’s capital structure. The interest paid on
debt reduces the firm’s tax liability to the government and is
referred to as a tax shield. In this case MM concluded that the
value of the levered firm equals at the value of the unlevered
firm plus the present value of the tax shield.
Under their assumptions MM showed that the present value of
the tax shield equals the corporate tax rate, T, times the amount
of debt, D.
In1977, Merton Miller included personal taxes in the modified
model he developed with Modigliani where they included
corporate taxes. Miller argued that investors will accept a
relatively lower before-tax returns on stock relative to the
before tax return on bonds. Miller concluded that one, since
interest on debt is tax deductible debt financing is favored but
two, the more favorable tax treatment of the income from stock
decreases the required rate of return on stock and therefore
equity financing is favored. According to Miller the net impact
of corporate and personal taxes is given by the formula:
V sub L equals V sub U plus the quantity one minus the
quantity one minus T sub C times the quantity one minus T sub
S divided by the quantity one minus T sub D the entire quantity
multiplied by D, where T sub C is in corporate tax rate;
T sub S is the personal tax rate on income from stocks, and T
sub D is the tax rate on income from debt. Miller concluded
that in the presence of personal and corporate taxes parcel taxes
reduce but do not completely eliminate the advantage from debt
financing.
Another assumption made by MM is that there are no

6. bankruptcy costs. Realistically, firms in bankruptcy have high
legal and accounting costs and have difficulty retaining
customers, suppliers, and employees. Costs related to
bankruptcy have two components, first the probability of
financial distress and second, the costs that would be incurred if
financial distress occurs. The tradeoff theory says that the
value of the unlevered firm equals the value of the unlevered
firm plus the value of the tax shield and the expected costs
related to financial distress and any other side effects.
MM assumed that investors and managers have the same
information about the firm’s prospects. This is referred to as
symmetrical information. Usually managers have better
information than the investors and this is referred to as
asymmetrical information which impacts the firm’s optimal
capital structure. In good times firm should use more equity and
less debt than suggested by the trade-off theory so they can
maintain a reserve borrowing capacity. That way when a good
investment opportunity is presented, the firm can finance it with
debt. When the firm is faced with flotation costs asymmetric
information may cause the firm to raise capital according to a
pecking order. Specifically, the firm will first finance with
retained earnings and selling short term marketable securities,
then debt, and then preferred stock. The firm should issue
common stock only as a last resort.
If managers have too much of cash available to them it may
create an agency problem in that they may spend funds in a
wasteful manner. One way the firm can control this problem is
to increase the debt level. In doing this the firm can bond that
the cash flow. An example of bonding the cash flow is a
leveraged buyout in which the firm uses a high level of debt and
a small amount of cash to finance the purchase of the firm’s
shares and takes the firm private. Although bankruptcy and
financial distress are costly, if the firm has few profitable
investment opportunities a high debt level may increase the
value of the firm. If we assume that markets are efficient
security prices include all available information because shares

7. are fairly priced. The windows of opportunity theory says that
managers don’t believe this and instead believe that stock prices
and interest rates are either too high or too low when compared
to their fundamental values. This theory says that managers try
to time the market and issue equity when they think the stock
market is too high and debt when they think interest rates are
too low.
Next slide
Slide 6
Capital structure evidence and implications
Firms try to focus on the tax benefit of issuing debt while
avoiding the costs associated with financial distress and
sometimes allow debt ratios to deviate from the optimal target
ratios. While there is a great deal of evidence to support the
windows of opportunity theory, there is little evidence to
support a pecking order and the use of issuing securities as a
signal. Finally, firms with numerous growth opportunities or
problems with informational asymmetry usually maintain
reserve a reserve capacity.
Next slide
Slide 7
Estimating the optimal capital structure
When determining its optimal capital structure the firm follows
a set procedure.
First, estimate the interest rate it will pay.
Second, estimate the cost of equity.
Third, estimate the WACC.
Finally, estimate the value of the firm’s operations.
Its objective is to determine the level of debt financing that
maximizes the value of the firm’s operations. To estimate the
cost of debt investment bankers first analyze industry
conditions and prospects.
Next, they appraise the firm’s business risk based on historic
financial statements, current technology, and customer base.
The investment bankers also forecast financial statements using
different capital structures and analyze key ratios.

8. Finally, they incorporate current conditions in financial
markets. To estimate the cost of equity the firm must first
estimate the value of the unlevered beta, B sub U because the
stock’s beta is the measure of risk for well-diversified
investors. Moreover, beta increases with financial leverage
because an increase in the debt ratio is the risk assumed by the
stockholders.
Mathematically the impact of financial average on beta is given
by B equals B sub U times the quantity one plus the quantity
one minus T times the quantity W sub D divided by W sub S;
Where W sub D and W sub S are the percentages of debt and
equity. This format can be arranged to solve for B sub U and
the capital asset pricing model can be used to estimate R sub S
for various capital structures. Then, the firm’s WACC and the
value of the firm are determined and the capital structure that
maximizes the value of the firms selected.
Next slide
Slide 8
Anatomy of Recapitalization
When a firm recapitalizes it issues enough additional debt to
optimize its capital structure and uses the proceeds to
repurchase its stock. Before the firm issues additional debt it
analyzes the impact of the additional debt on the wealth of the
stockholders. If the firm practices value based management
sometimes small improvements in operations resulted in large
increases in value. However, very often it is difficult to
improve operations especially when the firm is in a competitive
industry and is well managed. While it’s easy for the firm to
change its capital structure doing this will add only a small
amount of value. A firm should deleverage if its debt level
ismore than optimal. With the debt level decreased the firm
issues new shares of stock and uses the proceeds to pay off the
debt.

9. Next slide
Slide 9
Check Your Understanding
Slide 10
Summary
We have now reached the end of this lesson. Let’s review what
we’ve covered.
First, we looked at a number of issues that impact the capital
structure decision by the firm. Factors like the risk of
bankruptcy risk, business risk, and financial risk affect the
firm’s WACC which affects the capital structure.
Next, we learned business risk and financial risk jointly
determine the total risk of the firm’s future return on equity.
Business risk is the uncertainty inherent in the firm’s future
operating earnings before interest and taxes.
Then, we studied MM’s theory that is based on some very
restrictive assumptions, but relaxed the assumption of no
corporate taxes. Miller extended the model to include personal
taxes and concluded that they do not completely eliminate the
advantage of debt financing.
Then, we looked at several other theories and how they impact
the firm’s capital structure. Empirically we found that there is a
great deal of evidence to support the windows of opportunity
theory, but little evidence to support a pecking order and the
use of issuing securities as a signal.
Next, we looked at the procedure the firm uses to determine its
optimal capital structure. When determining its optimal capital
structure the firm follows a set procedure.
First, estimate the interest rate it will pay.
Second, estimate the cost of equity.
Third, estimate the WACC.
And fourth, estimate the value of the firm’s operations.
Finally, we looked at what happens when the firm recapitalizes.
It issues enough additional debt to optimize its capital structure

10. and uses the proceeds to repurchase its stock.
This concludes this lesson.
FIN 534 Week 8 Part 1: Distribution to Shareholders: Dividends
and Repurchases
Slide 1
Introduction
Welcome to Financial Management. In this lesson we will
discuss distribution to shareholders: dividends and repurchases.
Next slide
Slide 2
Topics
The following topics will be covered in this lesson:
An overview of cash distributions;
Procedures for cash distributions;
Cash distributions and firm value;
Clientele effect;
Information content or signaling hypothesis;
Implications for dividend stability;
Setting the target distribution level: the residual distribution
model;
The residual distribution model in practice;
A tale of two cash distributions: dividends versus stock
repurchases;
The pros and cons of dividends and repurchases;
Other factors influencing distributions;

11. Summarizing the distribution policy decision;
Stock splits and stock dividends; and
Dividend reinvestment plans.
Next slide
Slide 3
An Overview of Cash Distributions
More often than not the firm’s cash comes from internally
generated free cash flow, FCF. Remember, FCF is that amount
of cash available for distribution to all investors and funds are
available after expenses, taxes, and required investments in
operating capital. The level of FCF is determined by the firm’s
investment opportunities and its operating plans. During a high
growth period, the firm’s FCF may be negative, but as growth
slows and assuming it is profitable the FCF will be positive.
When this happens there are five ways in which the firm can use
FCF:
Pay interest expense;
Pay down its principle on debt;
Pay dividends;
Repurchase stock; or
Buy non-operating assets.
Next slide
Slide 4
Procedures for Cash Distributions
Usually dividends are paid quarterly and are distributed in the
form of cash dividends or stock repurchases. When the firm
distributes cash to its stockholders it follows a certain
procedure. First, the declaration date is a date on which the firm
announces the amount of the dividend and the date on which the
dividend will be paid. The holder of record date is the date on
which the firm prepares the stockholder list.
The security industry has set up a convention under which the
right to the dividend remains with the stock until two business
days prior to the holder of record date. The date when the right

12. to the dividend leaves a stock is called the ex-dividend date.
The payment date is a date on which the dividend is paid to the
holders of record. A stock repurchase is one in which the firm
buys back some of its outstanding shares. When the firm
repurchases its stock it does so for one of three reasons.
First, the firm may issue more debt and use the proceeds to
repurchase the stock.
Second, it may sell shares to its employees in the form of stock
options.
Last, the firm may have excess cash.
Next slide
Slide 5
Cash Distributions and Firm Value
Does an optimal distribution policy that maximizes the firm’s
intrinsic value exist?
The answer is that it depends, in part on investors’ preferences
for dividend yield versus capital gains. The combination of
dividend yield and capital gains is determined by the target
distribution ratio which is the percentage of net income
distributed to shareholders and the target payout ratio which is
the percentage of net income paid as cash dividends. There are
three theories that address investor preferences for dividend
yield versus capital gains.
The dividend irrelevance theory was developed by Merton
Miller and Franco Modigliani, known as MM. Using a number
of simplifying assumptions they argued that the value of the
firm depends solely on the income produced by its assets and
not how its income is divided between dividends and retained
earnings. Therefore dividend policy is irrelevant and cannot
affect the stock’s value, risk, or the required rate of return on
equity, R sub S.
In contrast, Myron Gordon and John Lintner proposed that as
dividends increase a stock’s risk declines. Hence, a return in
the form of dividends is certain but a return in the form of
capital gains is risky. Therefore, investors prefer dividends and
are willing to accept a lower required rate of return on equity.

13. This theory is called the-bird-in-the-hand theory.
The tax effect theory says that capital gains are preferred to
dividends for two reasons.
First, because of the time value of money a dollar of taxes paid
in the future results in a lower effective cost than a dollar paid
today.
Second, no taxes are paid on capital gains if the stock is held
until the shareholder dies. While empirical evidence is mixed
with respect to whether the average investor prefers either
higher or lower dividend distribution levels there individual
investors who prefer different dividend payout policies.
Next slide
Slide 6
Clientele Effect
Different groups of investors, or clienteles, of stockholders
prefer different dividend payout policies. Stockholders in a low
or zero tax bracket such as retired individuals and pension
funds, usually prefer cash income and may want the firm to pay
out a high percentage of its earnings.
In contrast, stockholders in their peak earning years may prefer
reinvestment, since this group has less need for current income.
Therefore, investors who need income prefer to own shares in
high dividend payout firms and investors with no need for
current income preferred to own shares in low dividend paid
firms. Empirical evidence suggests there is a clientele effect.
MM and others claim that the existence of a clientele effect
does not imply that one dividend policy is better than another.
However no one has been able to prove that overall firms
disregard clientele effects.
Next slide
Slide 7
Information Content or Signaling Hypothesis
When MM developed their irrelevancy of dividends theory, they
assumed that everyone has the same information about the
firm’s future earnings and dividends. Realistically, this is not
always true. MM argued that since firms are reluctant to cut an

14. established dividend this implies that firms don’t increase
dividends unless they anticipate higher earnings in the future.
In this way MM argued that a higher than expected dividend
increase is a signal to investors that the firm’s management
forecasts good earnings.
On the other hand, a reduction in dividends or a smaller
increase than expected signals that future earnings are expected
to be poor. MM claimed that investors’ reactions to changes in
dividend policy do not necessarily show that investors prefer
dividends to retained earnings. Hence, any price change
following dividend actions indicates that there is important
information or signaling, contained in dividend announcements.
On balance there is some information content in dividend
announcements because stock prices tend to decrease when
dividends are cut and don’t always increase when dividends are
increased.
Next slide
Slide 8
Implications for Dividend Stability
With respect to stable versus volatile dividends the clientele
effect and information content in dividend announcements
suggest that maximizing the firm’s stock price requires the firm
to maintain a steady dividend policy. In the case where
stockholders need income they prefer a stable dividend to one
that is unstable. Additionally, if the firm changes its dividend
policy to increase funds available for investment this may send
the wrong signal to stockholders because stockholders may sell
their shares in which case the stock price decreases. Hence,
most companies follow a small but steady cash dividend along
with stock repurchases.
Next slide
Slide 9
Setting the Target Distribution Level: The Residual Distribution
Model
The residual distribution model says that the firm’s optimal
distribution ratio depends on the firm’s investment

15. opportunities, its target capital structure, and the availability
and cost of external funds. Additionally the firm considers the
investors preference for dividends versus capital gains. To
establish its target distribution ratio the firm follows a process.
First, the firm determines its optimal capital budget. Given the
optimal capital budget, it determines the amount of equity
needed to finance the budget.
Next, to the extent possible, the firm uses reinvested earnings to
satisfy its equity requirements.
Last, provided earnings are greater than that needed to support
its optimal capital budget, the firm pays dividends or
repurchases its stock.
In this way, distributions are paid out of leftover earnings. If
we assume the firm strictly follows the residual dividend policy
then distributions equal net income minus the quantity target
equity ratio times the total capital budget. But if the firm
strictly adheres to the residual distribution policy this results in
unstable distributions because investment opportunities and
earnings vary from year to year.
Next slide
Slide 10
The Residual Distribution Model in Practice
Since a strict adherence to the residual distribution model yields
volatile, unstable dividends the firm should use it to help set
their long-run target distribution ratio but should not use it to
distribute funds in any given year. Instead, the firm should
proceed as follows:
First project earnings at investments for about five years;
Use the forecasted information and the target capital structure
to determine the average residual model distributions and
dollars of dividends during the planning period;
Last, based on the average projected data set a target payout
ratio.
Some firms follow a low–regular-dividend–plus extras policy in
which they pay a low but regular dividend and supplement it
with an extra dividend when profits are high. This ensures that

16. the firm maintains a regular dividend and investors recognize
that the extra dividend may not be maintained in the future.
Next slide
Slide 11
A Tale of Two Cash Distributions: Dividends versus Stock
Repurchases
Regardless of whether the distribution is in the form of cash
dividends or stock repurchases the forecasted income statements
are the same and so are the liabilities on the forecasted balance
sheets. However when the distribution is in the form of
dividends the retained earnings account is reduced but when it
is in the form of a stock repurchase the treasury stock account
in the in the balance sheet is reduced. Let’s look at the impact
on the firm’s intrinsic value.
First the firm must determine its expected FCF and its expected
return on invested capital or ROIC, its growth in FCF and its
growth in sales.
Next the firm calculates its value of operations. Since the
distribution choice does not affect the projected FCF it doesn’t
matter whether the distribution is in the form of cash or stock
repurchase. If the firm distributes the dividend in the form of
cash the intrinsic value of equity and the intrinsic stock price
drop. In fact the stock price drops by the amount of the
dividend per share. If this didn’t happened there would be an
opportunity for arbitrage. Despite the drop in the stock price,
shareholder wealth remains the same because shareholders own
the stock plus the cash dividend.
However, the distribution is in the form of a stock repurchase
the intrinsic stock price doesn’t change but the number of
shares outstanding does. The number shares repurchased equals
n sub prior minus n sub post which equals cash sub rep divided
by P sub prior where n sub prior is the number of shares
outstanding prior to the repurchase, n sub post is the number
shares outstanding after the repurchase, cash sub rep is the
amount of cash and used to repurchase shares, and P sub prior is

17. the intrinsic stock price prior to the repurchase. After the
repurchase the total value of shares outstanding declines but
total shareholder wealth does not because shareholders receive
cash in the repurchase.
Therefore, it doesn’t matter whether the firm pays dividends or
repurchases stock because the total market value of equity is the
same provided we ignore taxes and signals. When stock is
repurchased the stock price doesn’t change but the number of
shares outstanding is reduced. The share price of the firm that
repurchases stock increases faster than an identical firm that
pays a cash dividend but the total return to both firms’
shareholders is the same.
Next slide
Slide 12
The Pros and Cons of Dividends and Repurchases
The pros and cons of dividends and repurchases can be
summarized as follows:
Stock repurchases have an advantage over dividends because of
the deferred tax on capital gains;
Signaling effects require that the firm not have volatile dividend
payments;
Therefore the firm can set a low regular dividend and use
repurchases to distribute excess cash;
Last, repurchases are advantageous when the firm wants to
distribute cash from the sale of an asset or shift its capital
structure or when it wants to distribute shares in employee stock
option plan.
Next slide
Slide 13
Other Factors Influencing Distributions
Other factors that impact distributions fall into one of two
categories either constraints on dividend payments or the
availability of alternative sources of capital.
Constraints on dividend payments occur in the form of bond
indentures, preferred stock restrictions, impairment of capital
rule, the availability of cash, and the penalty tax on improperly

18. accumulated dividends.
The cost and availability of capital is another factor that affects
distributions and the availability of alternate sources of capital.
Examples of this influence or the cost of selling new stock, the
firm’s ability to substitute debt for equity and the desire on the
part of management to maintain control.
Next slide
Slide 14
Summarizing The Distribution Policy Decision
Firms make the distribution policy decision jointly with the
capital structure and capital budgeting decisions because of
asymmetric information. Asymmetric information theory
assumes that managers prefer to finance projects first with
retained earnings, second with debt and last with common stock
because they have better information than investors. Managers
are reluctant to issue new common stock. Issuing common
stock includes issuance costs and dilutes ownership and
investors view this as a negative signal. Changes in the firm’s
dividend policy provide signals about how managers feel about
the firm’s future prospects. A reduction in the firm’s dividends
has a negative effect on its stock price. Managers understand
this and set dividends low enough so there is little chance that
the dividend will be reduced in the future.
Next slide
Slide 15
Stock Splits and Stock Dividends
While there is no empirical evidence to support it, it is believed
there is an optimal price range for stocks where optimal means
that if the stock price is within this range, the firm’s value is
maximized. If the stock price trades at the maximum of the
range the firm may declare a stock split where current
stockholders are given either some number or fraction of shares
for each share owned. For example, a two for one stock split
results in doubling the number of shares outstanding, reducing
earnings and dividends by one-half and lowering the stock
price.

19. The firm may issue a reverse split in which each shareholder is
issued a smaller number of new shares in exchange for a
particular number of old shares. Usually the firm issues a
reverse a split if it wants to increase its stock price. A stock
dividend increases the number of shares outstanding and current
shareholders are issued additional stock on a proportional basis.
Like a stock split, the total number shares outstanding increases
and earnings, dividends, and the stock price decline.
What impact does a stock split or stock dividend have on stock
price? Empirical evidence suggests the following: after the firm
announces a stock split or stock dividend on average its stock
price increases; the price increase is most likely the result of
signaling; the firm’s stock price tends to increase after the
announcement of a stock split or stock dividend but in the next
few months if the firm does not announce an increase in
earnings and dividends, its stock price will most likely declined
to the earlier price; last since it is more expensive to trade
lower-priced stocks than higher-priced stocks, stock splits may
decrease the liquidity of the firm’s shares. This suggests that
stock splits and stock dividends may be harmful.
Next slide
Slide 16
Dividend Reinvestment Plans
Dividend reinvestment plans, or DRIPs, were issued during the
nineteen seventies by many large corporations in which
stockholders chose to automatically reinvested dividends in the
stock of the paying corporation. DRIPs take one of two forms
either plans that involves of all the outstanding or old stock or
plans that involve newly issued shares. In both plans the
stockholder must pay taxes on the amount of dividends. DRIPs
enable stockholders to purchase additional shares without
brokerage fees.
Next slide
Slide 17
Check Your Understanding

20. Slide 18
Summary
We have now reached the end of this lesson. Let’s review what
we’ve covered.
First, we learned that firm’s distributions to its shareholders can
be in the form of cash dividends, stock dividends, and stock
repurchases. If the firm pays a cash dividend it follows a set
procedure before the distribution.
Next, we discussed how when the firm’s distributions are in the
form of cash dividends or stock repurchases, the forecasted
income statements and the liabilities section of the forecasted
balance sheets is the same. However when the distribution is in
the form of dividends the retained earnings account is reduced
but when it is in the form of a stock repurchase the treasury
stock account in the in the balance sheet is reduced.
Then, we identified that there are three theories that address the
issue of an optimal dividend policy for the firm. The irrelevancy
of dividends theory says that the value of the firm depends only
on the income produced by the firm’s assets. The bird-in-the-
hand-theory says that dividends are preferred over capital gains
because the difference in risk. Last, the tax effect theory says
that capital gains are preferred to dividends.
Also, we learned that because of the clientele effect and
information content in dividend announcements it is
advantageous for the firm to maintain a steady dividend policy.
If an investor needs income they prefer a stable dividend to one
that is unstable. Additionally, a change in dividend policy may
send the wrong signal to stockholders.
Then, we discussed how reduction in dividends or a smaller
increase than expected signals that future earnings are expected
to be poor. Any price change following dividend actions
indicates that there is important information or signaling,
contained in dividend announcements.

21. Next, we discovered that regardless of whether the distribution
is in the form of cash dividends or stock repurchases the
forecasted income statements are the same and so are the
liabilities on the forecasted balance sheets.
Also, we identified four pros and cons of dividends and
repurchases.
Next, identified that other factors that impact distributions fall
into one of two categories either constraints on dividend
payments or the availability of alternative sources of capital.
Constraints on dividend payments occur in the form of bond
indentures, preferred stock restrictions, impairment of capital
rule, the availability of cash, and the penalty tax on improperly
accumulated dividends
We also learned that the firm makes the distribution policy
decision jointly with the capital structure and capital budgeting
decisions because of asymmetric information. Asymmetric
information theory assumes that managers prefer to finance
projects first with retained earnings, second with debt and last
with common stock because they have better information than
investors.
We learned about stock splits and stock dividends. A firm
declares a stock split if it wants to lower its share price. A stock
dividend increases the number of shares outstanding and current
shareholders are issued additional stock on a proportional basis.
Both stock splits and stock dividends may be harmful to the
firm.
Finally, we learned that DRIPs were issued during the nineteen
seventies by many large corporations in which stockholders
chose to automatically reinvested dividends in the stock of the
paying corporation. DRIPs enable stockholders to purchase
additional shares without brokerage fees.
This concludes this lesson.
FIN534 Week 8 Scenario Script: An Overview of cash

22. dividends; Procedures for Cash Dividends; and The pros and
cons of dividends and repurchases
Slide #
Scene/Interaction
Narration
Slide 1
Intro Scene
Slide 2
Scene 2
· Joe in front of TFC with Don
· End of scene
FIN534_8_2_Joe-1: Don, I am glad that I ran into you. I
have some great news. Late last night I met with the board of
directors and updated them on the expansion project. They
really liked all the details and analyses that have gone into this
project so far. However, two of the board members are
concerned about our emphasis on retaining as much cash as
possible.
FIN534_8_2_Joe-2: While our projections are showing that in
the first expansion year, our cash account will take a significant
hit, our fellow board members think that we should still
continue to reward our shareholders through dividends. I
explained to them that we are planning on a constant ten percent
growth rate. While they were pleased with that move, they still
want us to revisit our cash dividend distribution policy. They
also want us to look at a cash budget for TFC since building a
sustainable level of cash is one of our primary financial goals.
FIN534_8_2_Joe-3: So, please gather your team to work on
this next assignment. I believe that if we provide the
information that these board members want, then we will be on
our way to expanding out west.

23. Good luck!
FIN534_8_2_Don-1: Joe, we are again up to the challenge. I
am supposed to meet Linda and the Intern in the conference
room now, so I’ll fill them in on this assignment. You can
always count on us!
Slide 3
Scene 3
· Don in conference room with Linda
·
· Go to next slide
FIN534_8_3_Don-1: As you know things move fast around
here. I met with Joe a few minutes ago and he has another
assignment for us. The board of directors liked what we have
done so far but they want more information on our dividend
distribution policy and cash budget planning before they will
make a decision on the project.
FIN534_8_3_Linda-1: Don, we are right on it.
Up until now we have been focusing on how TFC will generate
cash flow. Now, we are going to look at ways we can use those
free cash flows.
FIN534_8_3_Linda-2: Our free cash flows can be thought of
as the amount of cash flow available to our investors after
payment of the required operating expenses and other corporate
actions.
FIN534_8_3_Linda-3: And in comparison with many
companies, our effective ways to use this free cash flow are
very similar. We use these cash flows to pay our interest
expenses, reduce the principal portion of our debts, pay
dividends, and purchase short term marketable securities.

24. Another choice would be to repurchase company stock, but we
have never done that.
FIN534_8_3_Linda-4: When we use free cash flows to pay
down debt, we always need to keep in mind our capital
structure. If we would pay down our debt entirely, then we
would not be able to take advantage of the interest expense
deduction.
FIN534_8_3_Linda-5: With purchasing marketable securities,
it is a nice risk reducing move on our part in case we need cash
immediately. But it still doesn’t feel like we are giving
something back to our shareholders. That comes from our
dividend policy. We have the option of issuing a stock dividend
or a cash dividend. At our company, we are about cash, so that
is the dividend we issue.
Let us review one of our most recent cash dividend
distributions.
Slide 4
Scene 4
· Dollar Sign
· Linda speaking
THE DATES TO SHOW ON THE TABLET.
FIN534_8_4_Linda-1: When we went public, we were not
declaring dividends. However, as we generated more free cash
flow, we started distributing a dividend as a type of reward for
our shareholders.
FIN534_8_4_Linda-2: Here are some specifics about our most

25. recent dividend. Typically companies pay dividends on a
quarterly basis, but here, as you know, we are anything but
normal. We pay dividends on an annual basis. Our most recent
dividend was ten dollars a share. But we are projecting that to
go up at a constant rate.
FIN534_8_4_Linda-3: Before actually paying a dividend we
had to set a few dates. Earlier this morning I sent you an email
that contained some helpful information on the different types
of dates. Turn on your tablet and follow along as I go over each
of the dates.
FIN534_8_4_Linda-4: Declaration Date – this is the date our
board of directors met to decide if TFC should pay a dividend
and how much. They also decide when the dividend payment
would be made to the shareholders and would be eligible to
receive it. This is also the date that TFC, for accounting
purposes, takes on the liability of paying the dividend. The
declaration date is also referred as the announcement date.
FIN534_8_4_Linda-5: Holder-of Record Date – This is the
determination date of who gets paid. If someone is a
shareholder on that date, they will receive the dividend. In
other words, this is the date when TFC needs to know the
rightful owner of a share of stock in regard to receiving a
dividend. Keep in mind that this may not be the actual owner of
a share of stock.
FIN534_8_4_Linda-6: Ex-dividend Date – This can be
considered the actual owner date of the stock. In other words if
a stock is traded on that date the new owner will receive the
dividend. If it is traded the next day, the previous owner will
receive the dividend. This Ex-dividend date is two business
days before the Holder of Record Date
FIN534_8_4_Linda-7: Payment Date – This is the date the

26. dividend is actually paid. On this date, the shareholders of
record will be sent a check for the declared dividend. This is the
last date of all of the dates.
Slide 5
Scene 5 - CYU
· Set up click and drag here
TFC would like you to match up one of their next dividend
distribution with each term.
Declaration Date - Wednesday November 20, 2013
Holder-of-Record-Date - Thursday December 19, 2013
Ex-Dividend Date – Tuesday, December 17, 2013
Payment Date – Friday, January 10, 2014
(have the students match up the dates. If they get it wrong, you
can put in:
Declaration Date is when the dividend is decided;
Holder-of- Record Date – when a shareholder gets the dividend
Ex-Dividend Date – two business days before Holder-of-Record
Date
Payment Date – when the dividends are actually paid
·
Slide 6
Scene 6
· Linda speaking
· Reinvestment of Dividends
· Stock Dividends
FIN534_8_6_Linda-1: Great job. Our dividend policy is really
important to us as our shareholders have invested in us and we

27. want to reward them. Remember earlier when two of our board
of directors wanted us to revisit our cash dividend policy? They
know how much investor wealth means to us and making sure
we are rewarding our owners is important. I am really glad they
wanted us to look into this policy more.
FIN534_8_6_Linda-2: Another point about cash dividends is
reinvestment of them for more stock. While we haven’t
implemented it yet, we are considering a dividend reinvestment
plan or DRIP as they are known to our shareholders. What
happens here is instead of receiving a cash dividend, our
shareholders can opt to purchase more shares of stock. The
benefit of this is our shareholders will increase their stock
balance in TFC. Also, shares are typically purchased at a
discount. So it is a great offering for shareholders if they
choose. We are however still reviewing the corporate action
and may offer it in the future.
FIN534_8_6_Linda-3: Another option is to issue dividends in
the form of stock instead of cash. We have never done that and
would rather have our shareholders choose how they would like
to use their investment. However, it is a good way for
companies to give back to their shareholders.
Slide 7
Scene 7
· Don speaking
· Stock repurchase
FIN534_8_7_Don-1: Linda, great explanations. Also there is
the stock repurchase option that we utilize. There are many
reasons why we would repurchase shares in the secondary
market.
FIN534_8_7_Don-2: First, we may need to look at our capital
structure and offer more debt and less equity. We can do that
by issuing debt and using the proceeds to buy stock.

28. FIN534_8_7_Don-3: Another reason has to do with stock
options. If our employees decide to exercise them, we need to
make sure we have available shares. By repurchasing stock, we
can have a reserve for our employees when they exercise their
options.
FIN534_8_7_Don-4: And our last reason has to deal with cash.
If we have excess cash, we may repurchase shares. It really
depends on our cash situation.
FIN534_8_7_Don-5: To date, TFC has not repurchased shares.
It has been a corporate decision on our part, but it is something
we revisit periodically as we are always looking for ways to
increase shareholder wealth.
Slide 8
Scene 8
· Don in Conference Room
· Pros and Cons of Repurchasing stock
· Next slide
FIN534_8_8_Don-1: As I mentioned, we haven’t repurchased
any shares; however, we revisit this option for a number of
reasons.
FIN534_8_8_Don-2: Let’s look at some of the reasons we
always look into this option.
Some advantages of repurchasing stock are as follows:
FIN534_8_8_Don-3: First, from a psychological standpoint,
if we decide to repurchase stock, investors usually look at this
as a good sign since the stock price is undervalued. It is
believed that if TFC feels the stock is undervalued and can
purchase it at a discount. So, timing is important here and in
the public eye, investors would feel that the stock is an
attractive investment.

29. FIN534_8_8_Don-4: Second, shareholders can get cash for
shares. Typically shareholders will decide if they want to sell
their stock when a repurchase is planned. This is different from
a cash dividend where all shareholders need to receive the cash
dividend. So choice is mainly at the discretion of the
shareholder.
FIN534_8_8_Don-5: The third advantage is that it is pretty
much the norm that companies only raise dividends; whereas
reducing the cash dividend rate can be thought of as bad
company business. Also if there is an anticipated positive cash
flow that cannot be sustained, our company may decide that it is
best to repurchase stock instead of paying out a cash dividend.
FIN534_8_8_Don-6: Fourth is capital structure. If we decide
that our current capital structure of sixty percent equity and
forty percent debt needs to be changed then a repurchase can do
that. For example, when repurchasing stock TFC may decide to
borrow lots of money. This would modify the capital structure
as debt would increase.
FIN534_8_8_Don-7: Another advantage is that there are
stock options. While TFC has never offered stock options, if we
did we would need to have a supply of stock shares available to
employees. Repurchasing stock is a way to build up a reserve
for those options.
FIN534_8_8_Don-8: The last advantage is the cash dividend
component factor. If a total dividend amount is set without
regard to shares outstanding, and if shares are repurchased that
means there will be more to go around in the form of dividends
as there will be less stock outstanding.
Slide 9
Scene 9 –
· Linda in room

30. · Disadvantages of repurchasing shares
FIN534_8_9_Linda-1: Good points Don. But there are also
some disadvantages to repurchasing stock. Let’s look at a
few.......
FIN534_8_9_Linda-2:When looking at the price of a share of
stock, cash dividends are generally considered to be more
consistent than repurchasing shares. As we saw when we were
pricing a share of TFC stock, we use a growth factor that is
based on dividends growth, not repurchase of stock.
FIN534_8_9_Linda-3:Another disadvantage is awareness for the
selling shareholders. While it may sound like a good idea that a
shareholder wants to have more cash available, keep in mind
that if they don’t know all the planned activities for a company,
they may miss out on future stock price growth.
FIN534_8_9_Linda-4:And a big disadvantage involves the price
paid to repurchase stock. If a company pays more than what the
stock is worth, the remaining stockholders may see price
fluctuations. For example, if a company repurchases shares at a
price higher than what the market is asking, the stock will go
up, but after the repurchase is done, the stock price will correct
itself. So there is a chance the stock will be repurchased at an
inflated price only to see it drop, which may not be beneficial to
long term stockholders.
Slide 10
Scene 10
· Don
· Next screen
·
FIN534_8_10_Don-1: Linda you brought up some very good
points and it is why we as a company have stayed away from
repurchase actions. There are advantages to both.

31. FIN534_8_10_Don-2: For example, if we wanted to change our
capital structure to fifty percent equity and fifty percent debt,
repurchasing stock may help us achieve that goal if we had to
acquire debt to pay for the repurchased shares. There is also a
tax benefit. Taxes have to be paid on cash dividends and
repurchasing stock. The difference is when they have to be
paid. In our case, dividends are paid annually so shareholders
have to report the dividend on their taxes.
FIN534_8_10_Don-3: Repurchases have to be reported as well
but only when sold. If a shareholder decides to have shares
repurchased after owning it for many years, the tax reporting
transaction occurs when sold. So the shareholder has been able
to defer paying taxes on any distribution if they don’t receive a
dividend.
FIN534_8_10_Don-4: So there are many pros and cons, but at
this time we at TFC have decided that it is best not to
repurchase shares. But we are considering a stock split.
FIN534_8_10_Linda-1: A stock split? This is news hot of the
press! Please tell us more
Slide 11
Scene 11
· Don – stock split
· Next Slide
FIN534_8_11_Don-1: We have seen tremendous growth here
and our stock price has benefited from it. But at this point we
think it may be too high.
FIN534_8_11_Don-2: Joe believes that when a price becomes
too high there are some investors who we cannot reach. And
you know how Joe wants to reach everyone that is working out
and investing in us. While reaching everyone is not possible,
making our stock attractive in price is. A stock split will enable

32. us to do that.
FIN534_8_11_Don-3: With a stock split, everything works out
the same mathematically. It is just how it is divided.
FIN534_8_11_Don-4: For example, if TFC’s stock price is
trading at two hundred dollars a share and a shareholder owns
one hundred shares, the shareholder’s value in TFC would be
twenty thousand dollars. If we declare a stock split of two for
one, what happens is the number of shares the stockholder owns
is now multiplied by two or two hundred shares and the share
price is divided by the same two for a per share price of one
hundred dollars.
FIN534_8_11_Don-5: The shareholder’s value is still the same,
but now the shareholder owns two hundred shares at a share
price of one hundred dollars a share. It is understood that with
this stock split we can now reach more shareholders because our
stock will be priced lower. And let’s not even mention the
possibility of stock growth should the shares go up. Also, there
is the optimal stock price level that we would want to reach. We
are still uncertain as to what that would be for TFC, but too
high of a price may push some investors away.
FIN534_8_11_Linda-1: Thanks Don. Do you think it is
something we will implement now?
FIN534_8_11_Don-6: With this expansion project going on,
we don’t know if the timing is right. But since we have you and
the intern doing several analyses, we would like you to do some
more research on the stock splits.
Slide 12
Scene 12
· CYU
· Stock splits – plug in answers as in 2 answers with the first
being new share price and second new shares owns

33. (share price, shares owned)
Linda and Don would like you to calculate the stock splits as
follows:
Please calculate the following stock splits for a shareholder
owning five hundred shares (500). Assuming TFC’s stock price
is $200.
1) 2 for 1 split – answer ($100 share price; 1000 shares owned
2) 3 for 1 split ($67 share price; 1,500 shares owned)
3) 4 for 1 split ($50 share price; 2,000 shares owned
4) 5 for 1 split ($40 share price; 2,500 shares owned)
Correct feedback. Great job! When stock splits occur the share
price will go down accordingly with the hope that additional
investors will now have the funds to acquire an interest in the
company.
Incorrect feedback. Nice try. New stock price is old stock price
divided by split while new shares owned is old shares owned
multiplied by the split.
Slide 13
Scene 13
· Linda talking about stock splits
·
FIN534_8_13_Linda-1: As you saw, the higher the stock split,
the higher the number of shares owned and the lower the price.
It is that inverse relationship, just like when we were pricing
bonds. It is very interesting to see how finance is all related.
FIN534_8_13_Linda-2: One thing I know for sure is we really
examined a lot with dividends at the request of our board

34. members. I am sure they will be pleased with our analysis.
FIN534_8_13_Linda-3: Before we end the day, let’s go to
Don’s office and review what we covered today.
Slide 14
Scene 14
· Don Summary slide
· Don’s office
· Next Slide
FIN534_8_14_Don-1: I just reviewed your findings and what
an excellent job on it. Joe is going to be pleased as will the
board members.
FIN534_8_14_Don-2: Let’s review what we covered today.
First we looked at our dividend policy and we learned that there
are many dates that go into setting dividends, which also
determines who is the rightfully owner of the dividends once
payment is made.
FIN534_8_14_Don-3: We also looked at offering stock
dividends instead of cash as a possible option to shareholders.
FIN534_8_14_Don-4: We then switched gears and looked at
TFC repurchasing shares back from stockholders. While it isn’t
something we are currently doing, we may revisit it in the
future thanks to your research on it.
FIN534_8_14_Don-5: Finally, we looked at stock splits as a
way of setting an appropriate share price for investors to
consider.
FIN534_8_14_Don-6: The analysis again was well done and it
will help answer a lot of questions that may arise by our board
of directors and any interested party.
FIN534_8_14_Don-7: But the dividend policy was only one part

35. of our assignment. They also want us to look at our cash
budget.
FIN534_8_14_Don-8: Before we move onto that area of our
assignment. Let’s get a workout in because as they say,
“working out pays huge dividends to your health!”
<everyone laughing>
Slide 15
Scene 15
· Closing slide
Closing slide