Capital

ost of C (Modigliani-)Miller* and Personal Taxes

Usually: Taxes on interest > Taxes on capital gains

d the Co

vs.
al Structture and

ƒ “Grossed-up” interest rates on debt

ƒ Advantage of debt is reduced

3) Capita

ƒ Equilibrium amount of aggregate debt determined

by relative corporate and personal tax rates

* Cp. Miller (1977).

333.313 PS Corporate Finance, WS 2009 52
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Cost of Capital for Projects
ƒ Adjustment for risk (How?)
d the Co

ƒ CAPM-determined cost of capital:

( )
al Structture and

E ⎣⎡ R% p ⎦⎤ = R f + β p ⋅ E ⎣⎡ R% m ⎦⎤ − R f

ƒ Effect of tax shield:

⎛ B ⎞
WACC = ρ ⋅ ⎜1 − τ c ⋅
B + S ⎟⎠
3) Capita

Source: CWS (2005), p. 579.

333.313 PS Corporate Finance, WS 2009 53

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Cost of Capital Given Risky Debt
The cost of capital given risky debt, without and
d the Co

with corporate taxes:

al Structture and
3) Capita

Source: CWS (2005)

(2005), p
p. 588
588.

333.313 PS Corporate Finance, WS 2009 54

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Implications of Financial Distress*
ƒ Direct and indirect implications
d the Co

– Increasing cost of capital

– Loss of customers, suppliers, and employees
al Structture and

– Legal and administrative costs

– Price risk in emergency liquidation of assets
ƒ Behavioural implications
– Incentive to take large
g risks
3) Capita

– Incentive toward underinvestment or “milking the

property”
– Cashing out
ƒ Free cash flow hypothesis
yp
* Cp. BD (2007), pp. 497-498; 503-505, RWJ (2002), pp. 425-430.
333.313 PS Corporate Finance, WS 2009 55
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C The Optimal Capital Structure…
Structure
…with risky debt, bankruptcy costs, and taxes.
d the Co
al Structture and
3) Capita

Source: RWJ (2002), p. 432

2.
333.313 PS Corporate Finance, WS 2009 56
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Treadeoff Theory
ƒ Tradeoff between positive (tax shield) and negative
d the Co

(costs of financial distress) effects of debt:

VL = VU + PV ⎡⎣Tax Shield ( B ) ⎤⎦ − PV ⎡⎣ Financial Distress Cost ( B ) ⎤⎦
al Structture and

ƒ Tax shield and cost of financial distress are non

non-
linear functions of debt:
Tax Shield ( B ) = max [ EBIT , kb ⋅ B ] ⋅τ c
3) Capita

Bankruptcy Cost ( B ) = PD ( B ) ⋅ LGD

333.313 PS Corporate Finance, WS 2009 57

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C The Pecking Order Theory
ƒ Use internal financing
d the Co

(No direct transaction cost)

ƒ Use debt (low

(low-risk)
risk) financing
al Structture and

(1-3% direct transaction cost*)

ƒ U equity
Use it (high-risk)
(high i k) financing
fi i g
(3.5-7% direct transaction cost*)
3) Capita

ƒ Issue when overvalued

ƒ Forego projects when undervalued?
* Cp. BD (2007), p. 533.
333.313 PS Corporate Finance, WS 2009 58
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Stakeholders‘ Claims as Options
Stakeholders
How can the positions of shareholders and
d the Co

bondholders be described with call options?

al Structture and

S
Shareholders
ƒ are long a call option
45°
3) Capita

Bondholders
ƒ own the firm 45°

ƒ are short a call option

p
333.313 PS Corporate Finance, WS 2009 59
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Stakeholders‘ Claims as Options
Stakeholders
How can the positions of shareholders and
d the Co

bondholders be described with put options?

al Structture and

Shareholders
S
ƒ own the firm
ƒ are short
h a risk-less
i kl bond
b d
ƒ are long a put option
45°
3) Capita

Bondholders
ƒ are long a risk-less
risk less bond
ƒ are short a put option
45°

333.313 PS Corporate Finance, WS 2009 60

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Stakeholders‘ Claims as Options
Stakeholders
Reconciliation of the options
p approach:
pp
d the Co
al Structture and

45°

+ ⇒
3) Capita

45°

45°

333.313 PS Corporate Finance, WS 2009 61

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Some Statements from BD (2007)
“When securities are fairly priced, the original shareholders
d the Co

of a firm capture the full benefit of the interest tax shield

from an increase in leverage”
al Structture and

BD (2007),
(2007) p. 469
469.

ƒ Leverage increases riskiness of equity

ƒ Risk is compensated by higher return to equity holders
3) Capita

ƒ Attention:
Ri
Risk
k also
l iincreases expected
t d costt off fi
financial
i l di
distress
t
(see next slide)

333.313 PS Corporate Finance, WS 2009 62

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 Capital
ost of C Some Statements from BD (2007)
“When securities are fairly priced, the original shareholders
d the Co

of a firm pay the present value of the costs associated with

bankruptcy and financial distress.”
al Structture and

BD (2007),
(2007) p. 500
500.

ƒ In financial distress,
distress shareholders are indifferent to costs
to bondholders
ƒ Bondholders anticipate financial distress costs
3) Capita

ƒ Present value of the costs is priced into cost of debt

ƒ Cost of debt reduces return to equity

333.313 PS Corporate Finance, WS 2009 63

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 e Finance, WS 2009 Homework for Chapter 4
ƒ BD Chapter 17

ƒ CWS Chapter 16
orporate

ƒ RWJ Chapter 18
PS Co

ƒ Q&A, Articles, etc.

ƒ Reader-Articles

333.313 PS Corporate Finance, WS 2009 64

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 e Finance, WS 2009
Karl-Franzens-University Graz
INSTITUTE OF BANKING AND FINANCE

Chapter 4
Payout Policy
orporate

ƒ Modigliani-Miller
Modigliani Miller and Homemade Dividends
PS Co

ƒ Share Repurchases
ƒ Real-World Factors
 4) Payout Policy Homemade Dividends: Example
Assumptions:
ƒ No taxes, no transaction costs, no information
asymmetry

Example:
ƒ COF Corp. (share price of € 21,50)
– Announces
A dividend
di id d off € 1,50/share
1 50/ h
ƒ John Checker (owns
( 40 shares of COF Corp.)
p)
– Wants dividend of (a) € 2,50/share or
((b)) € 0,50/share
, /
333.313 PS Corporate Finance, WS 2009 66
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Homemade Dividends: Example
Initial wealth:
€ 21.50 x 40 shares = € 860.00

Wealth after dividend payout:

Dividend of € 1.50
1 50
Proceeds from dividend € 1.50 x 40 shares = € 60.00
Value of stock holdings € 20
20.00
00 x 40 shares = € 800
800.00
00
Total € 860.00

333.313 PS Corporate Finance, WS 2009 67

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Homemade Dividends: Example
Desired dividend: € 2.50

Dividend of € 2.50 Homemade dividend

Proceeds from € 2.50 x 40 shares = € 1.50 x 40 shares =
dividend € 100.00 € 60.00
Proceeds from stock € 20.00 x 2 shares =
€ 0.00
sale € 40.00
Sum € 100.00 € 100.00
Value of stock € 19.00 x 40 shares = € 20.00 x 38 shares =
h ldi
holdings € 760
760.00
00 € 760
760.00
00
Total € 860.00 € 860.00

333.313 PS Corporate Finance, WS 2009 68

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Homemade Dividends: Example
Desired dividend: € 0.50

Dividend of € 0.50 Homemade dividend

Proceeds from € 0.50 x 40 shares = € 1.50 x 40 shares =
dividend € 20.00 € 60.00
Cost of stock € -20.00 x 2 shares =
€ 0.00
purchase € -40.00
Sum € 20.00 € 20.00
Value of stock € 21.00 x 40 shares = € 20.00 x 42 shares =
h ldi
holdings € 840
840.00
00 € 840
840.00
00
Total € 860.00 € 860.00

333.313 PS Corporate Finance, WS 2009 69

Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Implications of Homemade Dividends
ƒ Dividend policy is irrelevant under the
assumptions made

ƒ Investors will not pay more for high-dividend firms

ƒ Any iincome stream

A tr can be
b created
r t d using
i g
homemade dividends

ƒ Firms should never forego positive NPV-projects

ƒ Taxes and transaction costs can change

conclusions
333.313 PS Corporate Finance, WS 2009 70
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Share Repurchase: Example
Consider the following balance sheet:

Assets Liabilities
Cash € 500,000 Debt € 3,000,000
Other assets € 7,500,000 Equity € 5,000,000
Total € 8,000,000 Total € 8,000,000
Shares outstanding: 50,000
50 000
Price per share: € 5,000,000 / 50,000 = € 100.00

The company wants to distribute € 200,000 to

its shareholders.
shareholders
333.313 PS Corporate Finance, WS 2009 71
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Share Repurchase: Example
Balance sheet after € 4.00 dividend/share:

Assets Liabilities
Cash € 300,000 Debt € 3,000,000
Other assets € 7,500,000 Equity € 4,800,000
Total € 7,800,000 Total € 7,800,000
Shares outstanding: 50,000
50 000
Price per share: € 4,800,000 / 50,000 = € 96.00

Price per share plus dividend equals value before

distribution (€ 100.00).
333.313 PS Corporate Finance, WS 2009 72
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Share Repurchase: Example
Balance sheet after repurchase of 2,000 shares:

Assets Liabilities
Cash € 300,000 Debt € 3,000,000
Other assets € 7,500,000 Equity € 4,800,000
Total € 7,800,000 Total € 7,800,000
Shares outstanding: 48,000
48 000
Price per share: € 4,800,000 / 48,000 = € 100.00

Balance sheet is the same as after the dividend

payment
payment.
333.313 PS Corporate Finance, WS 2009 73
Stefan Palan, Institute of Banking & Finance © 2009 IBF
 4) Payout Policy Implications of Share Repurchases
ƒ Share repurchase is equivalent to dividend if
there are no taxes

ƒ Taxes and transaction costs can change

conclusions

ƒ Open-market repurchase or tender offer (possibly

“ rong” price)
“wrong”

333.313 PS Corporate Finance, WS 2009 74

Stefan Palan, Institute of Banking & Finance © 2009 IBF