Theory of the Optimal Capital Structure and Dividend Policy

Active Management vs. Passive Management

Task:

Theoretical and least practical of the chapters that I have asked you to read for the course. The prime focus of the chapter is consideration of a theory of a firm’s capital structure that is based on a number of assumptions not usually applicable in the real world, and can lead to conclusions that are counterintuitive. This material is assigned because it is a long standing component of corporate finance and not to know about it will put you at a disadvantage, especially if you are to move on to graduate study in finance. My cautionary note here is that this material is theoretical and will not usually be considerations for real world managers as they face decisions regarding capital items on their balance sheet.
The theory of the optimal capital structure involves considerations of what sorts and amounts of debt, equity and retained earnings will maximize the value of the firm.
Capital items are subject to active management because firms can sell one type of capital and use the proceeds to retire other kinds of capital which is called restructuring. Advantage: can change capital structure quickly. Disadvantage: flotation costs and possible call premiums on bonds.
Set against this is passive management. When the firm needs more capital, use one type of claim (debt or equity) to adjust the financing mix over time. Advantage: might be cheaper (less flotation and other costs). Disadvantage: takes a longer time
Which approach is better Depends on three factors: `1) How quickly the firm is growing, 2) How much flotation costs the firm faces under the active management approach and 3) How strongly and quickly the firm wishes to change capital structure. For businesses that plan to add significant assets in the near future, the passive approach might work best, but since it’s passive in nature we will in this chapter we focus on the active management approach
Slide 2
In finance we refer to the debt in a firm’s capital structure as leverage because debt magnifies potential returns to equity as well as the variability of returns
The basic tool for examining various variables’ effects on the firm’s choice of optimal capital structure is the Modigliani-Miller (M&M) theory, now some 50 years old.

The development of the M&M theorem starts with a “perfect world” which features 4 critical assumptions:  1) No taxes 2) No chance of bankruptcy 3) Perfectly efficient markets and 4) symmetric information sets for all participants, this means that everyone knows everything.
The reason cost of equity increases with increased D/E is to compensate stockholders for bearing more and more residual risk as the number of stockholders declines
Slide 3
The real value of the M&M theorem lies in examining what happens to the two propositions when we relax the unrealistic assumptions of no corporate taxes and then the possibility of bankruptcy. 
Let’s assume that corporations are taxed and that the debt is perpetual and tax-deductible.  This situation is often referred to as the “The More Debt, The Better” condition where value forever increases as the firm takes on more debt and WACC forever decreases
Making this new assumption dramatically altered the firm’s suggested capital structure strategy
In the “perfect world” capital structure didn’t matter
In the slightly more realistic world with corporate taxes, managers maximize firm value by taking on as much debt as possible
Also it is a feature of this new assumption doesn’t radically change the effect that an increase in leverage has on stockholders’ expected return or the volatility of the returns.
Clearly this cannot be a situation that would hold in the real world as bond holders would at some point stop lending to the firm out of fear of bankruptcy. As they now bear more risk they will demand more compensation.
Also there are other costs of Financial Distress. In addition to the direct costs of lawyers fees, consultants, and accountants, there are costs even if a firm gets close to bankruptcy (i.e. the firm is in financial distress)
Customers may be leery of buying from them (lack of post-sales support, warranties, etc.). Suppliers may be concerned about selling to the firm, and they may tighten their credit terms. Other firms will be reluctant to partner with the distressed firm, reducing the number of profitable opportunities and the firm’s best employees may leave. 

Modigliani-Miller Theory and the Perfect World

What do we see in the real world based on capital structure theory?
Firms facing high tax rates should make more use of debt
Firms with stable, predictable income streams will have a higher debt capacity than firms with volatile income streams
Slide 4
There are two basic strategies to distributing gains to stockholders. One is to pay dividends and the other is not to pay them in which case the gains go to growth in share prices. Investors receive benefits from both dividend payments and capital gains – share price growth.
Firms that pay out a relatively high percentage of current earnings will have fewer retained earnings and hence less capital to fund future growth in earnings and dividends
Conversely, if firms hold on to retained earnings they won’t have much left to pay current dividends
Firms should only retain earnings to the extent that they can invest those funds in projects that will earn a return at least as high as investors could earn elsewhere at similar risk.
Until recently, the capital gains tax rate was substantially lower than the tax rate on dividends, which were taxed as normal income. This inequality led some firms to pay out lower dividends/retain higher levels of earnings than they would have otherwise. In 2003, tax rates on capital gains and most dividends were lowered. Investors now find dividends are much more attractive than they have been in the past.
Some Investors favor dividends as a sort of Bird-in-the-Hand theory since dividends are less risky (and therefore more attractive to risk-averse investors) than potential future capital gains.
Some Investors Favor Capital Gains Even when tax rates on dividends and capital gains are the same, capital gains retain a potential tax advantage over dividends. When the firm pays dividends, all shareholders pay taxes on the dividends received. When the firm retains earnings and the firm grows, only shareholders who want the equivalent of a dividend and who sell their stock will incur taxes on their realized capital gains. The ability to “time” their taxes on capital gains is a potential advantage for some investors.
Some corporate concerns with actual dividend policy are:

The Information Effect: Investors hate dividend cuts, and managers hate to cut dividends. Managers will hesitate to increase dividends unless they believe the firm can safely maintain the new dividend over time. When a firm increases its dividend, analysts often interpret the increase as a positive signal about the firm’s future cash flows.
The Clientele Effect: Refers to the fact that investors do not have identical desires about the taxability and timing of firm payouts. Different groups of investors (clienteles) will be attracted to different firms based on their different payout policies. When firms change their dividend policies, investors who preferred the previous policy will sell their shares and reinvest in another firm with a more attractive policy
Corporate Control Issues: The clientele effect implies a passive role for shareholders. Firms with shareholders who have significant stakes in the firm may find that shareholders influence the dividend policy.
Most firms seem to pay relatively consistent dividends from one year to the next. Managers seem to prefer paying a steadily increasing dividend rather than one that fluctuates dramatically over time. Firm’s managers feel that their investor’s value stability in their personal dividend stream more than those investors resent the burden that such a strategy places on the firm’s cash flows.
Extraordinary Dividends: To minimize the burden of stable dividends, many firm divide dividends into two classes:
1.Ordinary dividends
2.Extraordinary dividends
Ordinary dividends are set fairly low and during periods when the firm needs to retain earnings for projects they simply forego the extraordinary dividend.