Financial Management
Dr. Andrea Rigamonti
andrea.rigamonti@econ.muni.cz
Lecture 8
Content:
• Capital structure in a perfect market
• Capital structure with corporate taxes
• Payout policy
• Adjusted stock returns
Capital structure in a perfect market
Capital structure: the relative proportions of outstanding
debt, equity, and other securities that a firm has.
Unlevered equity: equity in a firm with no debt.
Levered equity: equity in a firm with outstanding debt.
Modigliani and Miller argue that with perfect capital
markets, the total value of a firm should not depend on its
capital structure. The firm’s total cash flows still equal the
cash flows of the project, and therefore have the same
present value. While debt may be cheaper when considered
on its own, it raises the cost of capital for equity, so the
firm’s average cost of capital does not change.
Capital structure in a perfect market
Conditions to have perfect capital markets:
1. Investors and firms can trade the same set of securities
at competitive market prices equal to the present value
of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs
associated with security trading.
3. A firm’s financing decisions do not change the cash
flows generated by its investments, nor do they reveal
new information about them.
Capital structure in a perfect market
MM Proposition I: In a perfect capital market, the total
value of a firm’s securities is equal to the market value
of the total cash flows generated by its assets and is not
affected by its choice of capital structure.
The value of the levered firm 𝑉𝐿 (i.e., financed with both
equity and debt) is equal to the value of the unlevered
firm 𝑉𝑈 (i.e., financed only with equity):
𝑉𝐿 = 𝑉𝑈
Capital structure in a perfect market
MM Proposition II: The cost of capital of levered equity
increases with the firm’s market value debt-equity ratio:
𝑅 𝐸 = 𝑅 𝑈 +
𝐷
𝐸
𝑅 𝑈 − 𝑅 𝐷
where 𝐷 and 𝐸 are the market value of debt and equity
respectively, while 𝑅 𝐸, 𝑅 𝑈 and 𝑅 𝐷 are the returns of
levered equity, unlevered equity, and debt, respectively.
Even though debt is generally cheaper than equity,
increasing debt makes the latter more expensive. So, in
perfect capital markets, the relative proportion of debt
and equity does not impact the total cost of financing.
Capital structure in a perfect market
What about the effect of a capital increase on the existing
shareholders?
Raising additional equity capital by issuing additional shares
of already listed stocks is called seasoned equity offering,
or seasoned issue, or even simply capital increase.
Issuing new shares has a dilutive effect: the total amount of
shares on the market increases. Does this cause a drop in
the share price? NO
The increase in shares supply is offset by the increase in the
firm’s assets that result from the cash it receives from the
issuance.
Capital structure in a perfect market
While it has no direct impact on the price of the shares
owned by the existing shareholders, a capital increase can
reduce their voting power, as these shareholders now
hold a lower proportion of the total market capitalization.
There often are legal mechanism to prevent this. Most
notably, existing shareholders might have pre-emptive
rights, i.e., they have a right to buy additional shares
before they are offered to the general public.
This allows existing shareholders to keep (if they want)
their proportion of ownership of the company.
Capital structure with corporate taxes
The assumption of no taxes is obviously not realistic.
Therefore, we now consider the effect of corporate taxes.
The MM Proposition I with taxes becomes:
𝑉𝐿 = 𝑉𝑈 + 𝑇𝐷
where T is the tax rate.
As interest payments on debt are usually tax-deductible,
the value of the levered company is higher than the value
of the unlevered company.
Capital structure with corporate taxes
The MM Proposition II with taxes becomes:
𝑅 𝐸 = 𝑅 𝑈 +
𝐷
𝐸
𝑅 𝑈 − 𝑅 𝐷 (1 − 𝑇)
The cost of equity still rises as debt increases, but not as
fast as without taxes, because debt acts as a tax shield.
Therefore, ignoring the financial distress that excessive
debt can cause, more debt decreases the WACC, and
therefore it increases the firm value.
Capital structure with corporate taxes
Excessive debt can lead to bankruptcy. Therefore,
increasing debt cannot be done without limits.
In practice managers need to balance various factors to
achieve an optimal capital structure.
While in reality it is not completely true that capital
structure does not impact the value of a firm, the main
message of M-M however still largely holds: the most
important thing is not how the money is raised, but how
effectively it is invested.
Payout policy
Payout policy: the way a firm chooses between alternative
uses of free cash flow (i.e. flow available after the outflows
necessary to support operations and maintain capital assets).
On the declaration date, the board of directors authorizes a
divided of a certain amount, to be paid on the record date.
Only shareholders who purchase the stock at least three days
prior to the record date receive the dividend. The date two
business days prior to the record date is known as the exdividend
date; anyone who purchases the stock on or after
the ex-dividend date will not receive the dividend.
On the payable (or distribution) date the firm actually makes
the payment.
Payout policy
Special dividend: a non-recurring dividend, usually much
larger than a regular dividend.
Other types of payments the firm can do in special cases:
• Return of capital: investors get back a portion of their
investment that is not considered income or capital gain
• Liquidating dividend: paid during partial or full liquidation
Payout policy
Share repurchase (or buyback): the firm uses cash to buy
shares of its own outstanding stock. Can be done via:
• open market repurchase: the company buys back its shares
directly on the market. It is the most common method
• tender offer: the firm offers to buy back the shares at a
predetermined price over a short period of time
• Dutch auction: the firm offers different prices and investors
state how many shares they would sell at each price. The
company then buys at the lowest price that meets the
desired quantity
• targeted repurchase: through direct negotiation with a
major shareholder
Payout policy
In a perfect capital market (the setting of Modigliani-Miller):
• when a dividend is paid, the share price drops by the amount
of the dividend when the stock begins to trade ex-dividend.
• an open market share repurchase has no effect on the stock
price, and the stock price is the same as the cum-dividend
price if a dividend were paid instead (because the number of
outstanding shares decreases, and so the future per-share
dividends will be higher)
• investors are indifferent between the firm distributing funds
via dividends or share repurchases. By reinvesting dividends
or selling shares, they can replicate either payout method on
their own.
Payout policy
MM Dividend Irrelevance: in perfect capital markets,
holding fixed the investment policy of a firm, the firm’s
choice of dividend policy is irrelevant and does not affect
the initial share price.
In a realistic setting, however, managers need to
consider the fiscal effects of the dividend policy, as well
as the possible signalling effect of dividends.
Paying dividends might be perceived by investors as an
indicator of positive performance of the firm, which
would increase the value of the company.
Therefore, various aspects need to be balanced when
deciding the dividend policy.
Adjusted stock returns
Regardless of their possible impact on the value of the
firm, corporate actions like those following from the
payout policy can greatly impact the nominal share prices.
The two events that mostly affect the unadjusted share
prices are dividend payments and stock splits.
Adjusted stock returns
When dividends are paid, all else equal, the price of the
shares decreases by an amount equal to the dividend.
After a dividend payment, unadjusted returns register a
loss that is not real, as we are fully compensated for the
decrease in the price by receiving an equal amount of
wealth in form of dividend.
We adjust the return by summing to the share price the
dividend 𝐷𝑖𝑣 𝑡 paid at time 𝑡:
𝑅𝑡 =
𝑃𝑡 + 𝐷𝑖𝑣 𝑡 − 𝑃𝑡−1
𝑃𝑡−1
Adjusted stock returns
A stock split is a corporate action in which a company
increases the number of shares without changing its market
capitalization.
For example, a 2 for 1 split involves giving to every
shareholder 2 shares for each share owned before the split.
A reverse stock split is the opposite of a stock split, i.e., it
consists in reducing the number of shares with no change in
the market capitalization.
For example, a 1 for 2 split means that every shareholder
will end up with half the stocks owned before the split.
Adjusted stock returns
Splits can be accounted for by dividing the stock prices
before the split by the split ratio. So, for example:
• in the case of a 2 for 1 stock split, the split ratio is 2. The
prices up to the period before the one in which the split
happened must be divided by 2.
• In the case of a 1 for 2 reverse stock split, the split ratio
is ½. The prices up to the period before the one in
which the split happened must be divided by ½ (i.e.,
they must be multiplied by 2).
This avoids a fictitious -50% return in the former case, and
a fictitious +100% return in the latter.
Adjusted stock returns
The split ratio does not need to be an integer. A company
might perform a 1.5 for 1 split, for example.
Companies perform stock splits when the management
believes that the price of the shares is too high or too low.
If in an unadjusted series of prices both a dividend
payment and a stock split happen, the amount of the
dividend also has to be divided by the split ratio.
You must always use adjusted returns when working with
stock returns, otherwise large errors might happen.